Fannie Mae 2008 Annual Report Download - page 205

We monitor current market conditions, including the interest rate environment, to assess the impact of these
conditions on individual positions and our overall interest rate risk profile. In addition to qualitative factors,
we use various quantitative risk metrics in determining the appropriate composition of our consolidated
balance sheet and relative mix of debt and derivatives positions in order to remain within pre-defined risk
tolerance levels that we consider acceptable. We regularly disclose two interest rate risk metrics that estimate
our overall interest rate exposure: (i) fair value sensitivity to changes in interest rate levels and the slope of the
yield curve and (ii) duration gap. The metrics used to measure our interest rate exposure are generated using
internal models that require numerous assumptions, the reliability of which depends on the availability and
quality of historical performance data.
There are inherent limitations in any methodology used to estimate the exposure to changes in market interest
rates. The capital and credit markets experienced significant volatility and disruption during 2008, which
reached unprecedented levels during the second half of the year. This market turmoil and tightening of credit
have led to an increased level of concern about the stability of the financial markets generally. When market
conditions change rapidly and dramatically, as they did during 2008, the assumptions that we use in our
models to measure our interest rate exposure may not keep pace with changing conditions. For example, the
existing prepayment models used to generate our interest rate risk disclosures for December 2008 reflected a
higher level of responsiveness to changes in mortgage rates for our Alt-A and subprime private-label
mortgage-related securities than we believe is reasonable given current market conditions. As a result, we
began supplementing our existing interest rate risk metrics with risk metrics adjusted to exclude the sensitivity
associated with our Alt-A and subprime private-label mortgage-related securities.
Our overall interest rate exposure, as reflected in the fair value sensitivity to changes in interest rate levels and
the slope of the yield curve and duration gap, was within acceptable, pre-defined corporate limits as of
December 31, 2008. The volatility and disruption in the credit markets, however, have created a number of
challenges for us in managing our market-related risks. The extreme levels of market volatility have resulted
in a higher level of volatility in the interest rate risk profile of our net portfolio and led us to take more
frequent rebalancing actions. In addition, our ability to issue callable debt or long-term debt was severely
limited during the second half of 2008. As a result, we relied increasingly on a combination of short-term
debt, interest rate swaps and swaptions to fund mortgage purchases and to manage our interest rate risk. Our
access to the debt markets has recently improved, allowing us to issue callable and longer-term debt in early
2009; however, there can be no assurance that this recent improvement will continue. There also have been
significant changes in the spreads between our mortgage assets and the instruments we use to manage the
interest rate risk associated with those assets, including longer-term debt and swap-based interest-rate
derivatives throughout 2008, and particularly since August 2008. Because of the large dislocation in historical
pricing relationships between various financial instruments, we cannot be certain that some of the hedging
instruments that we historically have used in managing our interest rate risk will perform in the same manner
as the past and be as effective in the future. Accordingly, there is an increased risk that our debt and derivative
instruments will be less effective in reducing our overall interest rate risk.
We provide additional detail on our interest rate risk and our strategies for managing this risk in this section,
including: (1) the primary sources of our interest rate risk; (2) our current interest rate risk management
strategies; and (3) our interest rate risk metrics.
Sources of Interest Rate Risk
The primary source of our interest rate risk is our net portfolio. 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, and any
fixed-price asset, liability or derivative commitments. It also includes our LIHTC partnership investment assets
and preferred stock, but excludes our existing guaranty business.
Our mortgage assets consist mainly of single-family fixed-rate mortgage loans that give borrowers the option
to prepay at any time before the scheduled maturity date or continue paying until the stated maturity. Given
this prepayment option held by the borrower, we are exposed to uncertainty as to when or at what rate
prepayments will occur, which affects the length of time our mortgage assets will remain outstanding and the
timing of the cash flows related to these assets. This prepayment uncertainty results in a potential mismatch
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