Fannie Mae 2007 Annual Report Download - page 85

Net interest income of $6.8 billion for 2006 decreased by 41% from $11.5 billion in 2005, attributable to a
9% decrease in our average interest-earning assets and a 35% (46 basis points) decline in our net interest yield
to 0.85%. The decrease in our average interest-earning assets was due to a lower level of mortgage asset
purchases relative to the level of sales and liquidations during 2006. Sales, liquidations and reduced purchases
had the net effect of reducing our average interest-earning assets and resulted in a decrease of 1% in the
balance of our net mortgage portfolio to $726.1 billion as of December 31, 2006. Lower portfolio balances
have the effect of reducing the net interest income generated by our portfolio. We experienced compression in
our net interest margin as the cost of our debt increased due to the interest rate environment. As the Federal
Reserve raised the short-term Federal Funds target rate by 100 basis points to 5.25%, the highest level since
2001, the yield curve remained flat-to-inverted throughout 2006 and the cost of our short-term debt rose
significantly. The overall increase in the average cost of our debt of 91 basis points more than offset a 39 basis
point increase in the average yield on our interest-earning assets in 2006.
As discussed below in “Derivatives Fair Value Losses, Net,” we consider the net contractual interest accruals
on our interest rate swaps to be part of the cost of funding our mortgage investments. However, we reflect
these amounts in our consolidated statements of operations as a component of “Derivatives fair value losses,
net.” Although we experienced an increase in the average cost of our debt during 2007, we recorded net
contractual interest income on our interest rate swaps totaling $261 million. In comparison, we recorded net
contractual interest expense of $111 million and $1.3 billion for 2006 and 2005, respectively. The economic
effect of the interest accruals on our interest rate swaps, which is not reflected in the comparative net interest
yields presented above, resulted in a reduction in our funding costs of approximately 3 basis points for 2007
and an increase in our funding costs of approximately 2 basis points and 15 basis points for 2006 and 2005,
respectively.
Guaranty Fee Income
Guaranty fee income primarily consists of contractual guaranty fees related to Fannie Mae MBS held in our
portfolio and held by third-party investors, adjusted for the amortization of upfront fees and impairment of
guaranty assets, net of a proportionate reduction in the related guaranty obligation and deferred profit, and
impairment of buy-ups.
Guaranty fee income is primarily affected by the amount of outstanding Fannie Mae MBS and our other
guaranties and the compensation we receive for providing our guaranty on Fannie Mae MBS and for providing
other guaranties. The amount of compensation we receive and the form of payment varies depending on
factors such as the risk profile of the securitized loans, the level of credit risk we assume and the negotiated
payment arrangement with the lender. Our payment arrangements may be in the form of an upfront payment,
an ongoing payment stream from the cash flows of the MBS trusts, or a combination. We typically negotiate a
contractual guaranty fee with the lender and collect the fee on a monthly basis based on the contractual fee
rate multiplied by the unpaid principal balance of loans underlying a Fannie Mae MBS issuance. In lieu of
charging a higher contractual fee rate for loans with greater credit risk, we may require that the lender pay an
upfront fee to compensate us for assuming the additional credit risk. We refer to this payment as a risk-based
pricing adjustment. We also may adjust the monthly contractual guaranty fee rate so that the pass-through
coupon rates on Fannie Mae MBS are in more easily tradable increments of a whole or half percent by
making an upfront payment to the lender (“buy-up”) or receiving an upfront payment from the lender (“buy-
down”).
As we receive monthly contractual payments for our guaranty obligation, we recognize guaranty fee income.
We defer upfront risk-based pricing adjustments and buy-down payments that we receive from lenders and
recognize these amounts as a component of guaranty fee income over the expected life of the underlying
assets of the related MBS trusts. We record buy-up payments we make to lenders as an asset and reduce the
recorded asset as cash flows are received over the expected life of the underlying assets of the related MBS
trusts. We assess buy-ups for other-than-temporary impairment and include any impairment recognized as a
component of guaranty fee income. The extent to which we amortize deferred payments into income depends
on the rate of expected prepayments, which is affected by interest rates. In general, as interest rates decrease,
expected prepayment rates increase, resulting in accelerated accretion into income of deferred fee amounts,
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