Fannie Mae 2007 Annual Report Download - page 75

between certain financial instruments. These conditions, which triggered greater market volatility, wider credit
spreads and a lack of price transparency, have had widespread implications on how companies measure the
fair value of certain financial instruments and a direct impact on the significant market-based valuation
adjustments recorded in our earnings that are identified in “Executive Summary—Impact of Market Conditions
on Our Business” and include: (1) Derivatives fair value losses, net; (2) Losses on certain guaranty contracts;
and (3) SOP 03-3 fair value losses. We provide additional information below on our accounting for these
items and discuss the effect of these market conditions on the valuation process, including the judgments and
uncertainties surrounding our estimates, the extent to which we have adjusted our assumptions used to derive
these estimates and the basis for these adjustments, and the impact that reasonably likely changes in either
market conditions or our estimates and assumptions may have on our results.
Fair Value of Derivatives—Effect on Derivatives Fair Value Gains (Losses)
Changes in the fair value of our derivatives, which we recognize in our consolidated statements of operations
in “Derivatives fair value gains (losses), net,” generally have produced the most significant volatility in our
earnings. Table 2 summarizes the estimated fair value of derivative assets and liabilities recorded in our
consolidated balance sheets as of December 31, 2007 and 2006. We present additional detail on the estimated
fair value and the related outstanding notional amount of our derivatives by derivative instrument type in
“Consolidated Balance Sheet Analysis—Derivative Instruments.”
Table 2: Derivative Assets and Liabilities at Estimated Fair Value
2007 2006
As of December 31,
(Dollars in millions)
Derivative assets at fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,797 $ 4,931
Derivative liabilities at fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,417) (1,184)
Net derivative asset (liability) at fair value. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (620) $ 3,747
Our derivatives consist primarily of over-the-counter (“OTC”) contracts and commitments to purchase and sell
mortgage assets. While exchange-traded derivatives can generally be valued using observable market prices or
market parameters, OTC derivatives are generally valued using industry-standard models or model-based
interpolations that utilize market inputs obtained from widely accepted third-party sources. The valuation
models that we use to derive the fair value of our OTC derivatives require inputs such as the contractual
terms, market prices, yield curves, and measures of implied volatility. A substantial majority of our OTC
derivatives trade in liquid markets, such as interest rate swaps and swaptions; in those cases, model selection
and inputs generally do not involve significant judgments.
When internal pricing models are used to determine fair value, we use recently executed comparable
transactions and other observable market data to validate the results of the model. Consistent with market
practice, we have individually negotiated agreements with certain counterparties to exchange collateral based
on the level of fair values of the derivative contracts they have executed. Through our derivatives collateral
exchange process, one party or both parties to a derivative contract provides the other party with information
about the fair value of the derivative contract to calculate the amount of collateral required. This sharing of
fair value information provides additional support of the recorded fair value for relevant OTC derivative
instruments. For more information regarding our derivative counterparty risk management practices, see “Risk
Management—Credit Risk Management—Institutional Counterparty Credit Risk Management—Derivatives
Counterparties.” In circumstances where we cannot verify the model with market transactions, it is possible
that a different valuation model could produce a materially different estimate of fair value. As markets and
products develop and the pricing for certain derivative products becomes more transparent, we continue to
refine our valuation methodologies. We did not make any material changes to the quantitative models used to
value our derivatives instruments for the years ended December 31, 2007, 2006 or 2005.
53