Fannie Mae 2006 Annual Report Download - page 93

foreign-denominated debt, we swap out of the foreign currency completely at the time of the debt issue in
order to minimize our exposure to currency risk. As a result, our foreign currency exchange losses are
primarily offset by gains in fair value of the related derivatives.
Investment losses decreased by $723 million or 48%, due to a decrease in the amount of impairments
recognized on AFS securities in 2006 as compared to 2005, combined with a decline in unrealized losses
recognized on our trading securities. We recognized other-than-temporary impairment of $853 million in 2006
as compared to $1.2 billion in 2005. The decrease in other-than-temporary impairment in 2006 was due to the
level of the change in interest rates in 2006 relative to 2005, coupled with impairment amounts recognized on
these securities in 2005. We recorded unrealized gains on trading securities of $8 million in 2006, compared
with unrealized losses of $415 million in 2005. The unrealized gain in 2006 reflects favorable changes in fair
value due to implied volatility, virtually offset by increasing interest rates during the year. In 2005, we
recorded an unrealized loss mainly due to fair value losses resulting from the increase in interest rates and the
widening of option adjusted spreads.
Derivatives fair value losses decreased 64% to $1.5 billion in 2006 primarily due to the overall rise in interest
rates in 2006 from 2005, which resulted in an increase in the fair value of our derivatives. In particular, 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.
Expenses increased 30% in 2006 from 2005 primarily due to an increase in the segment allocation of indirect
corporate expenses during the period, mostly driven by an increase in costs associated with our restatement
and related matters. The provision for income taxes decreased by $607 million as a result of lower segment
net income in 2006.
Net income for the Capital Markets group increased by $1.1 billion, or 50%, in 2005 from 2004. The reduction in
net interest income and an increase in investment losses were offset by lower derivatives fair value losses. Net
interest income decreased $6.9 billion, or 39%, in 2005 from 2004 largely due to a 10% decline in the average
mortgage portfolio balance resulting from a decrease in securities purchases and an increase in sales activity
throughout 2005. The majority of the portfolio sales and a large portion of portfolio liquidations were comprised of
fixed-rate Fannie Mae MBS, which caused the product mix of the portfolio to shift slightly as floating-rate
securities and adjustable-rate mortgage products increased as a percentage of our total mortgage portfolio. In
addition, significant increases in short-term interest rates had the effect of increasing the cost of our short-term
debt, which further reduced net interest income. The significant increase in fee and other income was primarily
attributable to foreign currency exchange gains on our foreign-denominated debt as the dollar strengthened against
the Japanese yen in 2005 as compared to 2004. Derivatives fair value losses dropped 66% to $4.2 billion in 2005,
reflecting a rise in interest rates that resulted in (i) the fair value of our interest rate derivatives to increase relative
to 2004 and (ii) the spread between our pay-fixed and receive-variable swap positions to narrow causing our
interest accruals on our interest rate swaps to decrease by $3.7 billion.
The Capital Markets group continues to seek ways to maximize long-term total returns while fulfilling our
chartered liquidity function. Our total return management involves acquiring mortgage assets that allow us to
achieve an acceptable spread over our cost of funding. In an effort to gain better returns, we have acquired
new products for which we have been attractively compensated for the risk assumed. We will continue to seek
out these beneficial opportunities in the future.
Changes to Business Segment Reporting in 2007
During 2007, we began to develop new metrics based on fair value changes, inclusive of fee income and costs
incurred, and may use these measures in the future as an indicator of segment profitability. Refer to “Glossary
of Terms Used in This Report” for additional information on option-adjusted spreads.
Additionally, we changed our methodology for the allocation of indirect administrative expenses, primarily our
corporate overhead functions, to better align these expenses to the segment these functions serve. As a result,
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