Fannie Mae 2007 Annual Report Download - page 165

Debt Security and Mortgage Dealers
The credit risk associated with dealers that commit to place our debt securities is that they will fail to honor
their contracts to take delivery of the debt, which could result in delayed issuance of the debt through another
dealer. The primary credit risk associated with dealers who make forward commitments to deliver mortgage
pools to us is that they may fail to deliver the agreed-upon loans to us at the agreed-upon date, which could
result in our having to replace the mortgage pools at higher cost to meet a forward commitment to sell the
MBS. We manage these risks by establishing approval standards and limits on exposure and monitoring both
our exposure positions and changes in the credit quality of dealers.
Interest Rate Risk Management and Other Market Risks
Our most significant market risks are interest rate risk and spread risk, which primarily arise from the
prepayment uncertainty associated with investing in mortgage-related assets with prepayment options and from
the changing supply and demand for mortgage assets. The majority of our mortgage investments are
intermediate-term or long-term fixed-rate loans that borrowers have the option to pay at any time before the
scheduled maturity date or continue paying until the stated maturity. An inverse relationship exists between
changes in interest rates and the value of fixed-rate investments, including mortgages. As interest rates decline,
the value or price of fixed-rate mortgages held in our portfolio will generally increase because mortgage assets
originated at the prevailing interest rates are likely to have lower yields and prices than the assets we currently
hold in our portfolio. Conversely, an increase in interest rates tends to result in a reduction in the value of our
assets. As interest rates decline prepayment rates tend to increase because more favorable financing is
available to the borrower, which shortens the duration of our mortgage assets. The opposite effect occurs as
interest rates increase.
One way of reducing the interest rate risk associated with investing in long-term, fixed-rate mortgages is to
fund these investments with long-term debt with similar offsetting characteristics. This strategy is complicated
by the fact that most borrowers have the option of prepaying their mortgages at any time, a factor that is
beyond our control and driven to a large extent by changes in interest rates. In addition, funding mortgage
investments with debt results in mortgage-to-debt OAS risk, or basis risk, which is the risk that interest rates
in different market sectors will not move in the same direction or amount at the same time. As discussed in
“Supplemental Non-GAAP Information—Fair Value Balance Sheets,” we do not attempt to actively manage or
hedge the impact of changes in mortgage-to-debt OAS after we purchase mortgage assets, other than through
asset monitoring and disposition. We accept period-to-period volatility in our financial performance due to
mortgage-to-debt OAS consistent with our corporate risk principles. The following discussion explains our
interest rate risk management process, including the actions we take to manage interest rate risk and the
measures we use to monitor interest rate risk.
Interest Rate Risk Management Strategies
Our net portfolio consists of our existing investments in mortgage assets, investments in non-mortgage
securities, our outstanding debt used to fund those assets, and the derivatives used to supplement our debt
instruments and manage interest rate risk. It also includes any priced asset, debt and derivatives commitments,
but excludes our existing guaranty business. These assets and liabilities have a variety of risk profiles and
sensitivities. Our Capital Markets group is responsible for managing the interest rate risk of our net portfolio
subject to our strategic objectives and corporate risk policies and limits.
We employ an integrated interest rate risk management strategy that includes asset selection and structuring of
our liabilities to match and offset the interest rate characteristics of our balance sheet assets and liabilities as
much as possible. Our strategy consists of the following principal elements:
•Debt Instruments. We issue a broad range of both callable and non-callable debt instruments to manage
the duration and prepayment risk of expected cash flows of the mortgage assets we own.
•Derivative Instruments. We supplement our issuance of debt with derivative instruments to further
reduce duration and prepayment risks.
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