Fannie Mae 2006 Annual Report Download - page 72

using the retrospective effective interest method applying a constant effective yield assuming (i) a 100 basis
point increase in interest rates and (ii) a 50 basis point decrease in interest rates as of December 31, 2006 and
2005. We based our sensitivity analysis on these hypothetical interest rate changes because we believe they
reflect reasonably possible near-term outcomes as of December 31, 2006 and 2005.
Table 2: Amortization of Cost Basis Adjustments for Investments in Loans and Securities
2006 2005
For the Year Ended
December 31,
(Dollars in millions)
Unamortized cost basis adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (140) $ 344
Reported net interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,752 11,505
Decrease in net interest income from net amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (120) (97)
Percentage effect on net interest income of change in interest rates:
(1)
100 basis point increase . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.6% 1.6%
50 basis point decrease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3.1) (2.2)
(1)
Calculated based on an instantaneous change in interest rates.
As mortgage rates increase, expected prepayment rates generally decrease, which slows the amortization of
cost basis adjustments. Conversely, as mortgage rates decrease, expected prepayment rates generally increase,
which accelerates the amortization of cost basis adjustments.
Allowance for Loan Losses and Reserve for Guaranty Losses
The allowance for loan losses and the reserve for guaranty losses represent our estimate of probable credit
losses inherent in our portfolio of loans classified as held for investment in our mortgage portfolio, loans that
back mortgage-related securities we guarantee, and loans that we have guaranteed under long-term standby
commitments. We use the same methodology to determine our allowance for loan losses and our reserve for
guaranty losses as the relevant factors affecting credit risk are the same. We strive to mitigate our credit risk
by, among other things, working with lender servicers, monitoring loan-to-value ratios and requiring mortgage
insurance. See “Risk Management—Credit Risk Management” below for further discussion of how we manage
credit risk.
Estimating the allowance for loan losses and the reserve for guaranty losses is complex and requires judgment
by management about the effect of matters that are inherently uncertain. We employ a systematic methodology
to determine our best estimate of incurred credit losses. When appropriate, our methodology involves grouping
loans into pools or cohorts based on similar risk characteristics, including origination year, loan-to-value ratio,
loan product type and credit rating. We use internally developed models that consider relevant factors
historically affecting loan collectibility, such as default rates, severity of loss rates and adverse situations that
may have occurred affecting the borrowers’ ability to repay. Management also applies judgment in considering
factors that have occurred but are not yet reflected in the loss factors, such as the estimated value of the
underlying collateral, other recoveries and external and economic factors. The methodology and the amount of
our allowance for loan losses and reserve for guaranty losses are reviewed and approved on a quarterly basis
by our Allowance for Loan Losses Oversight Committee, which is a committee chaired by the Chief Risk
Officer or his designee and comprised of senior management from the Single-Family and HCD businesses, the
Chief Risk Office and the finance organization.
We adjust our estimate of the allowance for loan losses and reserve for guaranty losses based on period-to-
period fluctuations in the factors described above. Changes in assumptions used in estimating our allowance
for loan losses and reserve for guaranty losses could have a material effect on our net income.
Given that a minimal change in any factor listed above that is used for calculation purposes would have a
significant impact to the allowance and reserve liability and that these factors have significant
interdependencies, we do not believe a sensitivity analysis isolating one factor is meaningful. Therefore, the
following example loss event illustrates the impact to the allowance and reserve liability given changes to
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