Fannie Mae 2008 Annual Report Download - page 206

between the timing of receipt of cash flows related to our assets and the timing of payment of cash flows
related to our liabilities.
Duration is a measure of a financial instrument’s price sensitivity to changes in interest rates. Convexity is a
measure of the degree to which the duration of a bond changes as interest rates move. Changes in interest
rates, as well as other factors, influence mortgage prepayment rates and duration and also affect the value of
our mortgage assets. When interest rates decrease, prepayment rates on fixed-rate mortgages generally
accelerate because borrowers usually can pay off their existing mortgages and refinance at lower rates.
Accelerated prepayment rates have the effect of shortening the duration and average life of the fixed-rate
mortgage assets we hold in our portfolio. In a declining interest rate environment, existing mortgage assets
held in our portfolio tend to increase in value or price because these mortgages are likely to have higher
interest rates than new mortgages, which are being originated at the then-current lower interest rates.
Conversely, when interest rates increase, prepayment rates generally slow, which extends the duration and
average life of our mortgage assets and results in a decrease in value. Mortgage assets typically exhibit
negative convexity, which refers to the fact that the price or value of mortgages tends to fall steeply when
interest rates rise, but to increase more gradually when interest rates decline because borrowers have the
option to refinance and prepay their mortgages without penalty. Negative convexity also indicates that the
duration of our mortgage assets shortens as interest rates decline and lengthens as interest rates increase.
Interest Rate Risk Management Strategies
Our strategy for managing the interest rate risk of our net portfolio involves 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.
•Monitoring and Active Portfolio Rebalancing. We continually monitor our risk positions and actively
rebalance our portfolio of interest rate-sensitive financial instruments to maintain a close match between
the duration of our assets and liabilities.
Although the fair value of our guaranty assets and our guaranty obligations is highly sensitive to changes in
interest rates and the market’s perception of future credit performance, we do not actively manage the change
in the fair value of our guaranty business that is attributable to changes in interest rates. We do not believe
that periodic changes in fair value due to movements in interest rates are the best indication of the long-term
value of our guaranty business because these changes do not take into account future guaranty business
activity. To assess the value of our underlying guaranty business, we focus primarily on changes in the fair
value of our net guaranty assets resulting from business growth, changes in the credit quality of existing
guaranty arrangements and changes in anticipated future credit performance. Based on our historical experience,
we expect that the guaranty fee income generated from future business activity would largely replace any
guaranty fee income lost as a result of mortgage prepayments that result from changes in interest rates. We are
in the process of re-evaluating whether this expectation is appropriate given the current mortgage market
environment and the uncertainties related to recent government policy actions. See “Critical Accounting Policies
and Estimates—Fair Value of Financial Instruments” for information on how we determine the fair value of our
guaranty assets and guaranty obligations. Also see “Notes to Consolidated Financial Statements—Note 20, Fair
Value of Financial Instruments.”
Debt Instruments
Historically, the primary tool we have used to fund the purchase of mortgage assets and manage the interest
rate risk implicit in our mortgage assets is the variety of debt instruments we issue. The debt we issue is a mix
that typically consists of short- and long-term, non-callable debt and callable debt. The varied maturities and
flexibility of these debt combinations help us in reducing the mismatch of cash flows between assets and
liabilities in order to manage the duration risk associated with an investment in long-term fixed-rate assets.
Callable debt helps us manage the prepayment risk associated with fixed-rate mortgage assets because the
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