Fannie Mae 2009 Annual Report Download - page 182

The metrics used to measure our interest rate exposure are generated using internal models. Our internal
models, consistent with standard practice for models used in our industry, require numerous assumptions.
There are inherent limitations in any methodology used to estimate the exposure to changes in market interest
rates. The reliability of our prepayment estimates and interest rate risk metrics depends on the availability and
quality of historical data for each of the types of securities in our net portfolio. When market conditions
change rapidly and dramatically, as they did during the financial market crisis of late 2008, the assumptions of
our models may no longer accurately capture or reflect the changing conditions. On a continuous basis,
management makes judgments about the appropriateness of the risk assessments indicated by the models.
Sources of Interest Rate Risk Exposure
The primary source of our interest rate risk is the composition of 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.
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
between the timing of receipt of cash flows related to our assets and the timing of payment of cash flows
related to our liabilities.
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.
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.
Interest Rate Risk Management Strategy
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.
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