Fannie Mae 2011 Annual Report Download - page 359

FANNIE MAE
(In conservatorship)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
makers/dealers. The projected cash flows of the underlying swaps of these option-based derivatives are
discounted to present value using yield curves derived from observable interest rates and spreads. Exchange-
traded futures are valued using market quoted prices, resulting in Level 1 classification. Certain highly complex
structured derivatives use only a single external source of price information due to lack of transparency in the
market and may be modeled using observable interest rates and volatility levels as well as significant
assumptions, resulting in Level 3 classification. Mortgage commitment derivatives use observable market data,
quotes and actual transaction price 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 nonrecurring 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. This discount is based on market quotes from
dealers.
The fair value of the guaranty assets includes 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 reflects all guaranty arrangements, the carrying value
primarily reflects only those arrangements entered into subsequent to our adoption of the accounting guidance on
guarantor’s accounting and disclosure requirements for guarantees.
Debt—The majority of debt of Fannie Mae is recorded in our consolidated balance sheets at the principal amount
outstanding, net of cost basis adjustments. We elected the fair value option for certain structured debt
instruments, which are recorded in our consolidated balance sheets at fair value on a recurring basis.
We use third-party pricing services that reference observable market data such as interest rates and spreads to
measure the fair value of debt, and thus classify that debt as Level 2. When third-party pricing is not available,
we use a discounted cash flow approach based on a yield curve derived from market prices observed for Fannie
Mae Benchmark Notes and adjusted to reflect fair values at the offer side of the market.
For structured debt instruments that are not valued by third-party pricing services, cash flows are evaluated
taking into consideration any structured derivatives through which we have swapped out of the structured
features of the notes. The resulting cash flows are discounted to present value using a yield curve derived from
market prices observed for Fannie Mae Benchmark Notes and adjusted to reflect fair values at the offer side of
the market. Market swaption volatilities are also referenced for the valuation of callable structured debt
instruments. Given that the derivatives considered in the valuations of these structured debt instruments are
classified as Level 3, the valuations of the structured debt instruments result in a Level 3 classification.
F-120