Fannie Mae 2009 Annual Report Download - page 377

absence of observable or corroborated market data, we use internally developed estimates, incorporating
market-based assumptions wherever such information is available. The fair values are estimated by using
pricing models, quoted prices of securities with similar characteristics, or discounted cash flows. Such
instruments may generally be classified within Level 2 of the valuation hierarchy. Where there is limited
activity or less transparency around inputs to the valuation, securities are classified as Level 3.
Derivatives Assets and Liabilities (collectively “derivatives”)—Derivatives are recorded in our consolidated
balance sheets at fair value on a recurring basis. The valuation of risk management derivatives uses observable
market data provided by third-party sources where available, resulting in Level 2 classification. Certain highly
complex derivatives use only a single source of price information due to lack of transparency in the market
and may be modeled using significant assumptions, resulting in Level 3 classification. Mortgage commitment
derivatives use observable market data, quotes and actual transaction levels adjusted for market movement, and
are typically classified as Level 2. Adjustments for market movement based on internal model results that
cannot be corroborated by observable market data are classified as Level 3.
Guaranty Assets and Buy-ups—Guaranty assets related to our portfolio securitizations are recorded in our
consolidated balance sheets at fair value on a recurring basis and are classified within Level 3 of the valuation
hierarchy. Guaranty assets in lender swap transactions are recorded in our consolidated balance sheets at the
lower of cost or fair value. These assets, which are measured at fair value on a non-recurring basis are
classified within Level 3 of the fair value hierarchy.
We estimate the fair value of guaranty assets based on the present value of expected future cash flows of the
underlying mortgage assets using management’s best estimate of certain key assumptions, which include
prepayment speeds, forward yield curves, and discount rates commensurate with the risks involved. These cash
flows are projected using proprietary prepayment, interest rate and credit risk models. Because guaranty assets
are like an interest-only income stream, the projected cash flows from our guaranty assets are discounted using
one month LIBOR plus the option-adjusted spread (“OAS”) for interest-only trust securities. The interest-only
OAS is calibrated using prices of a representative sample of interest-only trust securities. We believe the
remitted fee income is less liquid than interest-only trust securities and more like an excess servicing strip. We
take a further haircut of the present value for liquidity considerations. The haircut is based on market quotes
from dealers.
The fair value of the guaranty assets include the fair value of any associated buy-ups, which is estimated in
the same manner as guaranty assets but is recorded separately as a component of “Other assets” in our
consolidated balance sheets. While the fair value of the guaranty assets reflect all guaranty arrangements, the
carrying value primarily reflects only those arrangements entered into subsequent to our adoption of the
current FASB guidance on guarantor’s accounting and disclosure requirements for guarantees.
Short-Term Debt and Long-Term Debt (collectively “debt”)—The majority of our debt is recorded in our
consolidated balance sheets at the principal amount outstanding, net of cost basis adjustments. We elected the
fair value option for all structured debt instruments which are recorded in our consolidated balance sheets at
fair value on a recurring basis. We use pricing services to measure the fair value of our debt instruments.
When third-party pricing is not available on non-callable debt, we use a discounted cash flow approach based
on the Fannie Mae yield curve with an adjustment to reflect fair values at the offer side of the market. When
third-party pricing is not available for callable bonds, we use internally-developed models calibrated to market
to price these bonds. To estimate the fair value of structured notes, cash flows are evaluated taking into
consideration any derivatives through which we have swapped out of the structured features of the notes.
Where the inputs into the valuation are primarily based upon observable market data, our debt is classified
within Level 2 of the valuation hierarchy. Where significant inputs are unobservable or valued with a quote
from a single source, our debt is classified within Level 3 of the valuation hierarchy.
F-119
FANNIE MAE
(In conservatorship)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)