Fannie Mae 2008 Annual Report Download - page 89

provide an illustrative example of how to determine the fair value of a financial asset when the market for that
financial asset is not active. The SEC and FASB guidance did not have an impact on our application of
SFAS 157.
We generally consider a market to be inactive if the following conditions exist: (1) there are few transactions
for the financial instruments; (2) the prices in the market are not current; (3) the price quotes we receive vary
significantly either over time or among independent pricing services or dealers; and (4) there is a limited
availability of public market information.
SFAS 157 establishes a three-level fair value hierarchy for classifying financial instruments that is based on
whether the inputs to the valuation techniques used to measure fair value are observable or unobservable. The
three levels of the SFAS 157 fair value hierarchy are described below:
Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities.
Level 2: Observable market-based inputs, other than quoted prices in active markets for identical assets
or liabilities.
Level 3: Unobservable inputs.
Each asset or liability is assigned to a level based on the lowest level of any input that is significant to the fair
value measurement.
The majority of our financial instruments carried at fair value fall within the level 2 category and are valued
primarily utilizing inputs and assumptions that are observable in the marketplace, that can be derived from
observable market data or that can be corroborated by recent trading activity of similar instruments with
similar characteristics. For example, we generally request non-binding prices from at least four independent
pricing services to estimate the fair value of our trading and available-for-sale investment securities at an
individual security level. We use the average of these prices to determine the fair value. In the absence of such
information or if we are not able to corroborate these prices by other available, relevant market information,
we estimate their fair values based on single source quotations from brokers or dealers or by using internal
calculations or discounted cash flow techniques that incorporate inputs, such as prepayment rates, discount
rates and delinquency, default and cumulative loss expectations, that are implied by market prices for similar
securities and collateral structure types. Because items classified as level 3 are valued using significant
unobservable inputs, the process for determining the fair value of these items is generally more subjective and
involves a high degree of management judgment and assumptions. These assumptions may have a significant
effect on our estimates of fair value, and the use of different assumptions as well as changes in market
conditions could have a material effect on our results of operations or financial condition.
Fair Value Hierarchy—Level 3 Assets and Liabilities
Our level 3 assets and liabilities consist primarily of financial instruments for which the fair value is estimated
using valuation techniques that involve significant unobservable inputs because there is limited market activity
and therefore little or no price transparency. Our level 3 financial instruments include certain mortgage- and
asset-backed securities and residual interests, certain performing residential mortgage loans, nonperforming
mortgage-related assets, our guaranty assets and buy-ups, our master servicing assets and certain highly
structured, complex derivative instruments. As described in “Consolidated Results of Operations—Guaranty
Fee Income,” we use the term “buy-ups” to refer to upfront payments that we make to lenders to 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.
The following discussion identifies the types of financial assets we hold within each balance sheet category
that are based on level 3 inputs and the valuation techniques we use to determine their fair values, including
key inputs and assumptions.
•Trading and Available-for-Sale Investment Securities. Our financial instruments within these asset
categories that are classified as level 3 primarily consist of mortgage-related securities backed by Alt-A
loans, subprime loans and manufactured housing loans and mortgage revenue bonds. We have relied on
external pricing services to estimate the fair value of these securities and validated those results with our
internally-derived prices, which may incorporate spread, yield, or vintage and product matrices, and
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