Fannie Mae 2006 Annual Report Download - page 84

(3)
The subsequent recognition in our consolidated statements of income associated with cost basis adjustments that we
record upon the settlement of mortgage commitments accounted for as derivatives resulted in income of approximately
$14 million in 2006 and expense of $870 million and $541 million in 2005 and 2004, respectively. These amounts are
reflected in our consolidated statements of income as a component of either “Net interest income” or “Investment
losses, net.”
(4)
Reflects net derivatives fair value losses recognized in the consolidated statements of income, excluding mortgage
commitments.
Because a significant portion of our derivatives consists of pay-fixed swaps, we expect the aggregate estimated
fair value of our derivatives to decline and result in derivatives losses when interest rates decline because we
are paying a higher fixed rate of interest relative to the current interest rate environment. Conversely, we
expect the aggregate fair value to increase when interest rates rise. In addition, even when there is no change
in interest rates or implied volatility, we generally would expect to record aggregate net fair value losses on
our derivatives because we have a significant amount of purchased options where the time value of the upfront
premium we pay for these options decreases due to the passage of time relative to the expiration date of these
options.
As shown in Table 9 above, we recorded net contractual interest expense accruals on interest rate swaps
totaling $111 million, $1.3 billion and $5.0 billion in 2006, 2005 and 2004, respectively. These amounts,
which we consider to be part of the cost of funding our mortgage investments, are included in the derivatives
fair value losses recognized in the consolidated statements of income. If we had elected to fund our mortgage
investments with long-term fixed-rate debt instead of a combination of short-term variable-rate debt and
interest rate swaps, the expense related to our interest rate swap accruals would have been reflected as interest
expense, resulting in a reduction in our net interest income and net interest yield, instead of as a component of
our derivatives fair value losses.
Interest rates have generally trended up since the end of 2004 and remained at overall higher levels through
July 2007. The $2.7 billion and $8.1 billion decrease in derivative losses in 2006 and 2005, respectively, was
largely attributable to the upward trend in interest rates. As a result, the aggregate fair value of our interest
rate swaps increased and we experienced a significant reduction in the net contractual interest expense
recognized on our interest rate swaps. This increase in fair value was partially offset by decreases in the fair
value of our option-based derivatives during each year due to the combined effect of time decay of these
options and decreases in implied volatility in each of these years. While we recorded fair value gains on our
derivatives for the first six months of 2007, the financial markets have exhibited extraordinary volatility since
mid-July 2007. In light of the market conditions as of the date of this filing and uncertainty about how long
the markets will remain volatile, we may experience an increased level of volatility in the fair value of our
derivatives for the remainder of 2007. Because the fair value of our derivatives is affected by market
fluctuations that cannot be predicted, we cannot estimate the impact of changes in the fair value of our
derivatives for the full year.
While changes in the estimated fair value of our derivatives resulted in net expense in each reported period,
we incurred this expense as part of our overall interest rate risk management strategy to economically hedge
the prepayment and duration risk of our mortgage investments. The derivatives fair value gains and losses
recognized in our consolidated statements of income should be examined in the context of our overall interest
rate risk management objectives and strategy, including the economic objective of our use of various types of
derivative instruments, the factors that drive changes in the fair value of our derivatives, how these factors
affect changes in the fair value of other assets and liabilities, and the differences in accounting for our
derivatives and other financial instruments. We provide additional information on our use of derivatives to
manage interest rate risk and the effect on our consolidated financial statements in “MD&A—Consolidated
Balance Sheet Analysis—Derivative Instruments” and “MD&A—Risk Management—Interest Rate Risk
Management and Other Market Risks.”
Debt Extinguishment Gains (Losses), Net
We call debt securities in order to reduce future debt costs as a part of our integrated interest rate risk
management strategy. We also repurchase debt in order to enhance the liquidity of our debt. Debt
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