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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2002

Commission File No.: 0-50231

Federal National Mortgage Association

(Exact name of registrant as specified in its charter)

Fannie Mae


Federally chartered corporation		52-0883107
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

3900 Wisconsin Avenue, NW Washington, DC (Address of principal executive offices)		20016 (Zip Code)

Registrant’s telephone number, including area code:

(202) 752-7000

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, without par value

(Title of class)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes o No þ

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes o No þ

As of the close of business on February 28, 2003, there were 986,925,508 shares of common stock outstanding. As of June 28, 2002 (the last business day of Registrant’s most recent second fiscal quarter), the aggregate market value of the common stock held by non-affiliates of the registrant was approximately $73,217 million. As of February 28, 2003, the aggregate market value of the common stock held by non-affiliates of the registrant was approximately $63,262 million.

DOCUMENTS INCORPORATED BY REFERENCE

Material contained in the registration statement of Fannie Mae on Form 10 filed with the Securities and Exchange Commission on March 31, 2003 is incorporated by reference in Part II, Item 5, and Part III of this Form 10-K.

TABLE OF CONTENTS


PART I
Item 1. Business
Overview
The Residential Mortgage Market
Fannie Mae Business Standards
Mortgage Committing and Servicing Arrangements
Business Segments
Housing Goals
Competition
Employees
Government Regulation and Charter Act
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Submission of Matters to a Vote of Security Holders
PART II
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters
Item 6. Selected Financial Data
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Information
ORGANIZATION OF INFORMATION
2002 OVERVIEW
ABOUT FANNIE MAE
RESULTS OF OPERATIONS
CORE BUSINESS EARNINGS AND BUSINESS SEGMENT RESULTS
OFF-BALANCE SHEET TRANSACTIONS
APPLICATION OF CRITICAL ACCOUNTING POLICIES
RISK MANAGEMENT
LIQUIDITY AND CAPITAL RESOURCES
PERFORMANCE OUTLOOK
NEW ACCOUNTING STANDARDS
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 8. Financial Statements and Supplementary Data
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
PART III
Item 10. Directors and Executive Officers of the Registrant
Section 16(a) Beneficial Ownership Reporting Compliance
Item 11. Executive Compensation
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13. Certain Relationships and Related Transactions
Item 14. Controls and Procedures
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K
SIGNATURES
CERTIFICATIONS
Ex-99.1 Certification by Chief Executive Officer
Ex-99.2 Certification by Chief Financial Officer

TABLE OF CONTENTS


		Page

PART I			1
Item 1.	Business		1
	Overview		1
	Introduction		1
	Business Segments		1
	Additional Information		2
	The Residential Mortgage Market		3
	Residential Mortgage Debt Outstanding		3
	Our Role in the Secondary Mortgage Market		4
	Fannie Mae Business Standards		4
	Principal Balance Limits		4
	Loan-to-Value Ratios		5
	Underwriting Guidelines		5
	The Mortgage Seller or Servicer		6
	Mortgage Committing and Servicing Arrangements		6
	Single-Family Mortgage Commitments		6
	Servicing Arrangements		6
	Business Segments		7
	Portfolio Investment Business		7
	Credit Guaranty Business		10
	Fee-Based Services		13
	Housing Goals		14
	Competition		14
	Employees		16
	Government Regulation and Charter Act		16
	Charter Act		16
	Regulatory Approval and Oversight		17
	Capital Requirements		18
	Dividend Restrictions		18
Item 2.	Properties		19
Item 3.	Legal Proceedings		19
Item 4.	Submission of Matters to a Vote of Security Holders		19
PART II			19
Item 5.	Market for Registrant’s Common Equity and Related Stockholder Matters		19
Item 6.	Selected Financial Data		20
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		22
	Forward-Looking Information		22
	Organization of Information		23
	2002 Overview		23
	About Fannie Mae		25
	Results of Operations		26
	Net Interest Income		27
	Guaranty Fee Income		29
	Fee and Other Income (Expense)		30
	Credit-Related Expenses		30
	Administrative Expenses		31
	Special Contribution		32
	Purchased Options Expense		32
	Debt Extinguishments		32


		Page

	Income Taxes		33
	Cumulative Effect of Change in Accounting Principle		33
	Core Business Earnings and Business Segment Results		33
	Core Business Earnings		33
	Taxable-Equivalent Revenues		37
	Core Net Interest Income		38
	Business Segment Results		40
	Off-Balance Sheet Transactions		53
	Guaranteed MBS and Other Mortgage-Related Securities		53
	Commitments		54
	Application of Critical Accounting Policies		55
	Allowance for Loan Losses and Guaranty Liability for MBS		55
	Deferred Price Adjustments		57
	Time Value of Purchased Options		59
	Risk Management		61
	Interest Rate Risk Management		61
	Credit Risk Management		75
	Operations Risk Management		94
	Liquidity and Capital Resources		96
	Liquidity		96
	Capital Resources		97
	Performance Outlook		100
	New Accounting Standards		100
	Accounting for Stock Compensation		100
	Guarantor’s Accounting and Disclosure Requirements for Guarantees		101
	Special Purpose Entities (“SPEs”)		101
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk		102
Item 8.	Financial Statements and Supplementary Data		103
Item 9.	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure		151
PART III			151
Item 10.	Directors and Executive Officers of the Registrant		151
	Section 16(a) Beneficial Ownership Reporting Compliance		151
Item 11.	Executive Compensation		151
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		151
Item 13.	Certain Relationships and Related Transactions		151
Item 14.	Controls and Procedures		151
PART IV			152
Item 15.	Exhibits, Financial Statement Schedules and Reports on Form 8-K		152
SIGNATURES			153
CERTIFICATIONS			155

PART I

Item 1. Business

Overview

Introduction

At Fannie Mae (formally, the Federal National Mortgage Association), our purpose is to facilitate the flow of low-cost mortgage capital in order to increase the availability and affordability of homeownership for low-, moderate-, and middle-income Americans. We operate under a federal charter and our primary regulator is the Office of Federal Housing Enterprise Oversight (“OFHEO”). However, we are a private, shareholder-owned company. The U.S. government does not guarantee, directly or indirectly, Fannie Mae’s debt securities or other obligations.

Fannie Mae is the nation’s largest source of funds for mortgage lenders and investors, providing resources for our customers to make additional mortgage loans or investments in mortgage-related securities. We provide liquidity to the mortgage market for the benefit of borrowers; however, we do not lend money directly to consumers. We operate exclusively in the secondary mortgage market by purchasing mortgages and mortgage-related securities, including Fannie Mae mortgage-related securities, from primary market institutions, such as commercial banks, savings and loan associations, mortgage companies, securities dealers and other investors. We provide additional liquidity in the secondary mortgage market by issuing and guaranteeing mortgage-related securities.

We also offer fee-based services to our customers that facilitate our purpose and mission. These services include issuing and administering a variety of mortgage-related securities, providing credit enhancements and offering technology products to aid in originating and underwriting mortgage loans.

Fannie Mae expands equal housing access and opportunity in America by helping our lender customers reach the nation’s underserved families and communities. In 1994, we launched our Trillion Dollar Commitment to provide $1 trillion in home financing for 10 million families traditionally underserved by mainstream mortgage finance. After achieving that goal ahead of plan, in 2000 Fannie Mae announced a new, redoubled affordable housing plan, our $2 trillion American Dream Commitment®, to serve 18 million underserved families by 2010.

Under the American Dream Commitment, Fannie Mae has pledged to promote mortgage consumer rights, including broader, more equal access to lowest-cost mortgage credit; fight mortgage discrimination and lead the housing market in serving minority families, including a pledge to provide $700 billion in financing for 4.6 million minority households; address the unique housing needs of women-headed households, young families, new immigrants, seniors, and urban and rural dwellers; strengthen inner-city communities and older suburban areas; provide new technologies to mortgage lenders and consumers in order to lower mortgage financing costs; and increase the supply of affordable rental housing.

Fannie Mae was established in 1938 as a United States government-owned entity to provide supplemental liquidity to the secondary market for residential mortgages and to promote access to mortgage credit throughout the nation. We became a stockholder-owned and privately-managed corporation by legislation enacted in 1968, which we refer to as the “Charter Act” (the Federal National Mortgage Association Charter Act, 12 U.S.C. §1716 et seq.). Our common stock is traded primarily on the New York Stock Exchange under the symbol “FNM.”

Business Segments

We provide liquidity in the secondary mortgage market through our two primary business segments: the portfolio investment business and the credit guaranty business.

In the portfolio investment business, we purchase loans and mortgage-related securities from mortgage lenders, which replenishes those lenders’ funds for making additional mortgage loans. We also purchase loans, mortgage-related securities and other investments from securities dealers, investors and other market

participants. In addition, our liquid investment portfolio invests in high quality, short-term, non-mortgage assets that can provide us with liquidity as the need arises. We acquire the funds to purchase these loans, mortgage-related securities and other investments from our equity capital and by selling debt securities to domestic and international capital markets investors. By doing so, we expand the total amount of funds available to finance housing in the United States. Income from our portfolio investment business comes primarily from the difference, or spread, between the yield on mortgage loans and other investments in our portfolio and our borrowing costs.

In the credit guaranty business, we receive fees for our guaranty of timely payment of scheduled principal and interest on mortgage-related securities guaranteed by Fannie Mae and held by investors other than Fannie Mae. For segment reporting purposes, we also allocate a fee comparable to an MBS guaranty fee from the portfolio investment business to the credit guaranty business for management of the credit risk on mortgage portfolio investments. The guaranty fees we charge are based on the credit risk we assume, the costs of administering the mortgage-related securities and market and competitive factors. In a typical mortgage-related securities transaction, a lender will deliver mortgage loans to us that it has originated or purchased. We place these loans in a trust and issue certificates evidencing beneficial interests in the trust, then deliver the certificates with our guaranty to the lender or its designee. The lender may then hold the mortgage-related securities as an investment or sell the securities in the market to replenish its funds for additional lending. This activity provides liquidity to the lender because mortgage-related securities, with Fannie Mae’s guaranty, are more readily marketable than mortgage loans without this guaranty.

We have described our business segments in more detail under “Business — Overview — Business Segments.”

Additional Information

In this document, we refer to both whole loans and participation interests in loans as “loans,” “mortgage loans” and “mortgages.” The term “mortgage” also is used to refer to the deed of trust or other security instrument securing a loan. The terms “loans” and “mortgage loans” may include loans secured by manufactured housing. Mortgage loans secured by four or fewer dwelling units are referred to as “single-family” mortgage loans and mortgage loans secured by more than four dwelling units are referred to as “multifamily” mortgage loans. We use the term “mortgage-related securities” generally to refer to mortgage pass-through trust certificates representing beneficial interests in pools of mortgage loans or other mortgage-related securities. The term “MBS” (mortgage-backed securities) specifically refers to mortgage-related securities we issue and on which we guarantee timely payment of scheduled principal and interest.

Debt, equity and mortgage-related securities we issue are exempt from registration under the Securities Act of 1933 and are “exempted securities” under the Securities Exchange Act of 1934. In July 2002, we announced a voluntary initiative to register our common stock, without par value, with the Securities and Exchange Commission under Section 12(g) of the Securities Exchange Act of 1934. The registration of our common stock became effective on March 31, 2003. Registration of our common stock does not impact the exempt status of debt, equity and mortgage-related securities we issue.

We file reports, proxy statements and other information with the Securities and Exchange Commission, beginning in 2003. You may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site (http://www.sec.gov) that contains reports, proxy statements, and other information that we file with the SEC. You may also inspect our SEC reports and other information at the New York Stock Exchange, Inc., 20 Broad Street, New York, NY 10005 or obtain them, free of charge, from our website at http://www.fanniemae.com. We are providing the addresses of the SEC’s and our Internet sites solely for the information of investors. We do not intend the Internet addresses to be active links.

The Residential Mortgage Market


	*Residential Mortgage Debt Outstanding*

The housing market in which we operate consists of the supply, or “stock,” of total outstanding residential mortgages. In its Flow of Funds Accounts, the Board of Governors of the Federal Reserve System estimates and publishes figures each quarter on the stock of residential mortgages. The total residential mortgage debt outstanding figures published by the Federal Reserve include loans secured by single-family properties and multifamily properties. As of December 31, 2002, the latest date for which information is available, the Federal Reserve’s estimate for total residential mortgage debt outstanding was $7 trillion. (See “Business — Fannie Mae Business Standards — Principal Balance Limits” for a discussion of the limits on mortgages we purchase.) The following table shows the Federal Reserve’s estimate for residential mortgage debt outstanding for the last 12 years.

LOGO

We expect growth in residential mortgage debt outstanding over the next ten years to be driven by the following factors:


	•	Household Formation. Household formation represents the number of new households that will need homes. Household formation is a principal driver of demand for homes. Growth in household formation is driven by growth in the population and “headship rates,” the rate at which the population forms into households.

	•	Homeownership Rates. Homeownership rates reflect the percentage of the population that owns a home. As reported by the Census Bureau, Department of Commerce, the national homeownership rate grew at approximately one-half a percent a year during the decade of the 1990s, rising from 64 percent to over 67 percent. The growth in homeownership rates was driven by increased affordability of homes, improved technology (e.g., automated underwriting), and low downpayment lending. We expect future growth in homeownership rates to be driven by economic growth, increases in minority homeownership rates, and demographic trends as baby-boomers move into age groups that traditionally experience higher homeownership rates. We anticipate that minority homeownership rates will benefit from a shortage in rental housing, the expansion of more flexible, low downpayment lending, and tax incentives.

	•	Home Price Appreciation. Home price appreciation reflects the combined effect of two components: the underlying rate of inflation and the amount that home prices appreciate net of inflation. Home price appreciation allows current homeowners to borrow against the additional equity in their homes and causes new homebuyers to borrow more to finance the purchase of a home. Home prices have typically appreciated faster than inflation. While inflation and home price appreciation over inflation were relatively low for most of the 1990s, home price appreciation over inflation returned to more historical levels in the latter part of the decade. Home price appreciation in the current decade will depend upon the demand and supply for housing. We expect the supply of housing to be somewhat constrained relative to demand due to limited availability of land and the increase of land use controls.


	•	Debt-to-Value Ratios. The debt-to-value ratio represents the percentage of total housing value that is financed with mortgage debt. Over the past 50 years, homeowners have steadily increased the percentage of their home value that is financed with debt, from around 20 percent to 44.4 percent at the end of 2002. This increase reflects the rising prices of homes, the increased popularity of cash-out refinancing as a means to tap equity wealth, availability of home equity lines of credit, and increased lower downpayment lending. Growth in the mortgage debt-to-value ratio over the coming decade will be driven by continued expansion of lower downpayment lending, and increased use by homeowners of the equity, or value, in their homes for other purposes.

As of December 31, 2002, Fannie Mae held 11 percent of total residential mortgage debt outstanding in our mortgage portfolio, which includes mortgage-related securities. MBS issued by Fannie Mae and held by investors other than Fannie Mae represented an additional 15 percent of total residential mortgage debt outstanding.


	*Our Role in the Secondary Mortgage Market*

Our lender customers are part of the primary mortgage market, where mortgages are originated and funds are loaned to borrowers. Primary market lenders include mortgage companies, savings and loan associations, commercial banks, credit unions, and state and local housing finance agencies.

Lenders sell mortgages into the “secondary market,” where mortgages are bought and sold by various investors. Secondary market investors include Fannie Mae, the Federal Home Loan Mortgage Corporation (“Freddie Mac”), the Federal Home Loan Banks, pension funds, insurance companies, securities dealers, and other financial institutions. Lenders may sell their mortgages into the secondary market in the form of whole loans or in the form of mortgage-related securities. For lenders that want to hold or sell mortgages in the form of mortgage-related securities, we may create those securities for them.

As the secondary market leader, Fannie Mae’s central role in providing a steady stream of mortgage funds to lenders across the country is supported by technologies that help us manage our risks and make the process of buying a home quicker, easier, and less expensive. We have developed an automated underwriting system for single-family mortgage loans that our lender customers are using nationwide, and allows consumers to obtain loan approval more quickly and consistently, and with lower closing costs than ever before.

We purchase mortgage loans for our portfolio and exchange mortgage-related securities for mortgage loans from over two thousand primary market lenders that have a selling and servicing contract with us. Five of those customers accounted for approximately 50 percent of the single-family mortgage loans that we purchased or guaranteed in 2002. Ten lender customers accounted for approximately 63 percent of the single-family mortgage loans that we purchased or guaranteed in 2002. In addition, we purchase mortgage loans and mortgage-related securities from securities dealers, investors and other participants in the secondary market.

Fannie Mae Business Standards

The mortgage loans we purchase or guarantee must meet standards required by the Charter Act, including maximum principal balance limits and credit enhancement requirements. The Charter Act also requires that, so far as practicable and in our judgment, the mortgage loans be of a quality, type, and class that meet, generally, the purchase standards imposed by private institutional mortgage investors. Consistent with those requirements, and with the purposes for which we were chartered, we establish additional eligibility criteria and policies for the mortgage loans we purchase or guaranty, and for the sellers and servicers of those mortgage loans. Servicers are the entities that collect loan payments and perform other administrative functions with respect to the mortgage loans we purchase or guarantee.


	*Principal Balance Limits*

Our purchase and guaranty of single-family “conventional” mortgage loans (loans not federally insured or guaranteed) are subject to certain maximum original principal balance limits, often referred to as the “conforming loan limit.” For 2002, the limit for a one-family residence was $300,700 (except for loans secured

by properties in Alaska, Hawaii, Guam, and the Virgin Islands). Higher principal balance limits apply to loans secured by properties in those areas or secured by two- to four-family residences. We can adjust the maximum principal balance limits applicable to conventional single-family mortgage loans annually based on the year-to-year change in the national average price of a one-family house as surveyed by the Federal Housing Finance Board each October. In November 2002, the limit for loans acquired in 2003, secured by a one-family residence, was increased to $322,700. There are no statutory limits on the maximum principal balance of multifamily mortgage loans that we purchase or guarantee. Mortgage loans insured by the Federal Housing Administration (“FHA”) are subject to separate statutory maximum amount limitations. There are no statutory limits on the principal balance of loans guaranteed by the Department of Veterans Affairs (“VA”) or by the Rural Housing Service (“RHS”).


	*Loan-to-Value Ratios*

The loan-to-value ratio requirements for loans we purchase or guaranty may vary depending upon a variety of factors such as the loan purpose, the number of dwelling units in the property securing the loan, the repayment terms, borrower credit history, and FHA or VA loan-to-value limits. Depending upon these factors, the loan-to-value ratio for loans we purchase or guarantee can be in excess of 100 percent.

The Charter Act requires credit enhancement on any conventional single-family mortgage loan that we purchase or guarantee if it has a loan-to-value ratio over 80 percent at the time of purchase or guaranty. Credit enhancement may take several forms, including insurance or a guaranty issued by a qualified insurer, repurchase arrangements with the seller of the mortgage loans, and seller-retained participation interests. We may require credit enhancement in excess of the minimum required to satisfy this provision of the Charter Act.


	*Underwriting Guidelines*

We have established underwriting guidelines for the purchase or guaranty of mortgage loans to effectively manage the risk of loss from borrower defaults. Lenders determine whether to make mortgage loans and frequently have several investors to whom they sell loans. When originating loans to be purchased or guaranteed by Fannie Mae, lenders look to our underwriting guidelines. We designed these guidelines to assess the creditworthiness of the borrower, as well as the value of the mortgaged property relative to the amount of the mortgage loan. At our discretion, we may grant waivers from these underwriting guidelines. We also review and change these guidelines from time to time. As part of our affordable housing initiatives, we continue to introduce new underwriting criteria in an attempt to make the mortgage finance system more accessible to minorities, low- and moderate-income families, underserved and rural residents, and people with special housing needs. In addition, we continue to look for more effective methods of assessing the creditworthiness of potential borrowers and property values.

We generally rely on lender representations and warranties that the mortgage loans we purchase or guaranty conform to our applicable guidelines. We also perform quality control reviews of selected loans to monitor compliance with the guidelines. In the event that a lender is found to have breached its representations with respect to a loan’s compliance with the guidelines, we can require that the lender repurchase the loan, indemnify us against any loss or, in some cases, share a greater percentage of any loss.

Over the last several years, we have enhanced Desktop Underwriter®, our automated underwriting system, to assist lenders in applying Fannie Mae underwriting standards for single-family loans. Desktop Underwriter is designed to help lenders process mortgage applications in a more efficient and accurate manner and to apply our underwriting criteria consistently, objectively, and in a more customized manner to all prospective borrowers. If Desktop Underwriter provides an “approve/ eligible” or “expanded approval/ eligible” recommendation to a lender regarding a loan application, we waive certain representations by the lender as long as the information that was submitted by the lender through Desktop Underwriter is accurate and the lender complies with other specified requirements.


	*The Mortgage Seller or Servicer*

Before we approve a lender or other customer to become a seller or servicer, we require that it meet certain standards which include demonstrating, to our satisfaction, that it:


	•	has a proven ability to originate or service the type of mortgages for which our approval is being requested;

	•	employs a staff with adequate experience;

	•	has as one of its principal business purposes the origination or servicing of residential mortgages;

	•	is properly licensed, or otherwise authorized, to originate, sell, or service residential mortgages in each of the jurisdictions in which it does business;

	•	meets financial criteria and standards;

	•	has quality control and management systems to evaluate and monitor the overall quality of its loan production and servicing activities; and

	•	is adequately covered by a fidelity bond and errors and omissions insurance.

We enter into a written mortgage selling and servicing contract with each approved customer. In this contract, the customer agrees to a number of obligations, including ongoing compliance with the foregoing provisions to our satisfaction.

Mortgage Committing and Servicing Arrangements


	*Single-Family Mortgage Commitments*

We enter into master agreements with lenders to facilitate ongoing transactions. Mortgage loans delivered to us for pooling into MBS generally require a master agreement, while mortgage loans purchased in cash transactions may or may not be under a master agreement. Pursuant to a master agreement, a lender agrees to deliver a specified volume of mortgage loans over a specified period of time, usually 12 months.

The master agreement usually requires mandatory delivery by the lender of an agreed upon volume, but may also contain an amount that is optional for the lender to deliver after it has met the required mandatory delivery commitment. If a lender does not deliver the mandatory portion of the specified volume, we may assess a buyout fee based on the undelivered amount. The optional portion of the volume does not obligate the lender to sell loans to us.

Whether or not there is a master agreement, we purchase mortgage loans for our portfolio pursuant to “mandatory delivery commitments,” which can be for either standard or negotiated loan products. Under these commitments, lenders are obligated to sell to us the mortgage loans described in the commitment at an agreed-upon price and within an agreed-upon time period (generally from one to ninety days for fixed-rate mortgages and from one to sixty days for adjustable-rate mortgages). If a lender is unable to deliver some or all of the mortgage loans required under a mandatory delivery commitment during the term of the commitment, the lender may repurchase the remaining balance of the commitment for a “pair-off ” fee. We may assess the pair-off fee based on the amount of the commitment being paired off and the difference between the commitment price and the current price.


	*Servicing Arrangements*

Mortgage loans held in our mortgage portfolio or in a trust for holders of our MBS may be serviced only by an approved servicer. We do not service mortgage loans directly. Typically, lenders who sell single-family mortgage loans and conventional multifamily loans to Fannie Mae initially service the mortgage loans they sell to us. There is an active market in which lenders sell servicing rights to other servicers. In addition, we may at times engage a servicing entity to service loans on our behalf due to termination of a servicer or for other reasons.

Mortgage servicers collect and remit principal and interest payments, administer escrow accounts, evaluate transfers of ownership interests, respond to requests for partial releases of security, and handle proceeds from casualty and condemnation losses. For problem loans, servicing includes negotiating workouts and, if necessary, inspecting and preserving properties and processing foreclosures and bankruptcies. In the case of multifamily loans, servicing also may include performing routine property inspections, evaluating the financial condition of owners, and administering various types of agreements (including agreements regarding replacement reserves, completion or repair, and operations and maintenance). We compensate servicers primarily by permitting them to retain a specified portion of each interest payment on a serviced mortgage loan, called a “servicing fee.” The weighted average servicing fee for conventional single-family loans owned or guaranteed by Fannie Mae in 2002 was .389 percent. We have the right to remove servicing responsibilities from any lender under criteria established in our contractual arrangements with lenders.

Business Segments


	*Portfolio Investment Business*

Overview. Our portfolio investment business has two principal components: a mortgage portfolio and a liquid investment portfolio. The mortgage portfolio purchases mortgage loans, mortgage-related securities, and other investments from lenders, securities dealers, investors, and other market participants. The liquid investment portfolio primarily purchases readily marketable, high credit quality, non-mortgage securities from securities dealers. The securities have short term maturities or can be sold as a source of funds to meet our cash flow needs. We fund the purchase of assets for our mortgage and liquid investment portfolios primarily by borrowing money in the domestic and international capital markets through the sale of debt securities. We derive income from the difference, or “spread,” between the yield we earn on our portfolio investments and the interest we pay on our borrowings.

The following diagram illustrates the basic structure of how we purchase a loan and fund that mortgage portfolio investment.

Morgage Portfolio Loan Purchase

Most of the single-family mortgage loans in our mortgage portfolio or backing mortgage-related securities in our portfolio may be prepaid by the borrower at any time without penalty. We, therefore, bear the risk that if our mortgage assets are paid off as interest rates decline, or as a result of other factors, we may not be able to prepay the outstanding indebtedness used to finance those assets or to reinvest the prepayment proceeds at a rate at or above our borrowing costs. If interest rates rise, our debt costs could rise faster than the yield on our mortgage assets and thereby reduce our interest spread. In contrast, most multifamily loans contain a prepayment premium that compensates us for the loss of yield in the event of a prepayment, or provide some other mechanism to protect us from prepayment risk. We actively manage our mortgage portfolio to mitigate prepayment risks. Our approach to managing interest rate risk includes three central elements. First, we attempt to fund purchases of mortgage assets with liabilities that have similar cash flow patterns through time and in different interest rate environments. We use a combination of debt securities and interest rate derivatives to achieve the appropriate funding mix. Second, we regularly assess the mortgage portfolio’s exposure to changes in interest rates using a diverse set of analyses and measures. Third, we establish appropriate parameters for taking rebalancing actions that meet our objectives, and undertake rebalancing actions as necessary.

Our mortgage portfolio is also exposed to the credit risk that borrowers may fail to repay mortgage loans held in our portfolio or backing mortgage-related securities held in our portfolio. Our credit guaranty business is responsible for managing mortgage credit risk on loans and mortgage-related securities held in our portfolio and mortgage-related securities guaranteed by us that are held by other investors. Accordingly, for segment reporting purposes, we allocate a fee comparable to an MBS guaranty fee from the portfolio investment business to the credit guaranty business for management of the credit risk on the mortgage loans and mortgage-related securities held in the portfolio. Likewise, all mortgage-related credit expenses are allocated to the credit guaranty business. We establish a loss reserve for credit risk allocated to the credit guaranty

business. This intersegment allocation of a credit risk management fee and mortgage-related credit expenses has no impact on Fannie Mae’s reported net income.


	Mortgage Portfolio

Assets Purchased. Fannie Mae purchases primarily single-family, conventional, fixed- or adjustable-rate, first lien mortgage loans, or mortgage-related securities backed by such loans. In addition, we purchase loans insured by the FHA, loans guaranteed by the VA or RHS, manufactured housing loans, multifamily mortgage loans, subordinate mortgage loans (e.g., loans secured by second liens) and other mortgage-related securities. See “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Business Segment Results — Portfolio Investment Business — Mortgage Portfolio — Table 8” for information on the composition of our mortgage portfolio.

Maturities. Fannie Mae purchases conventional, single-family fixed-rate mortgages with original maturities of up to 30 years and conventional, single-family adjustable-rate mortgages (“ARMs”) with maturities of up to 40 years. Only a small portion of ARMs we purchase have maturities of more than 30 years. The multifamily mortgage loans we purchase generally are fixed-rate loans with maturities of up to 30 years.

Payment Structure; Balloon Payments. The majority of fixed-rate mortgage loans we purchase provide for equal or “level” monthly installments of principal and interest. Some of these loans have larger or “balloon” payments due 5, 7, or 10 years after origination, but with monthly payments based on longer (e.g., 30-year) amortization schedules. Most of the 7-year balloon single-family mortgage loans permit the borrower to refinance the balloon payment at maturity with a 23-year fixed-rate mortgage loan if certain requirements are satisfied. Many of the multifamily mortgage loans have balloon payments due 5, 7, 10, or 15 years after origination, but with payments based on 25- or 30-year amortization schedules.

Adjustable-Rate Mortgage Loans. The interest rates on ARMs are determined by formulas providing for automatic adjustment, up or down, at specified intervals in accordance with changes in specified indices. Fixed-period ARMs have an interest rate that is fixed for the first 2 to 10 years, and is adjusted at specified intervals after the initial period. The payments of interest, or principal and interest, on substantially all ARMs adjust (up or down) after the interest rate on the loan is adjusted because of changes in the applicable index. We currently purchase single-family ARMs only if the ARMs limit the amount the interest rate may change over the life of the loan. We purchase a small amount of ARMs that may permit negative amortization. We generally require that those loans be reamortized at least annually to limit the amount of negative amortization that may accrue.

We also purchase certain ARMs, called reverse mortgages, that provide for periodic installments of principal to be paid to the borrower. Over the life of these loans, interest and certain other fees accrue on the balance of the payments made to the borrower. Generally, the loan is due when the borrower no longer occupies the property. We currently purchase reverse mortgages only if the reverse mortgages are subject to a limit on the amount the interest rate may change over the life of the loan. Most of the reverse mortgages we purchase are guaranteed by the Federal government.


	Liquid Investment Portfolio

The liquid investment portfolio serves principally as a source of liquidity and an investment vehicle for our surplus capital. If our access to the debt capital markets is ever impeded, we first will utilize assets in our liquid investment portfolio to generate cash to meet our liquidity needs. We may use funds received at maturity of the short-term investments in the portfolio or sell assets from the portfolio to generate those funds. The liquid investment portfolio primarily invests in high quality securities that are readily marketable or have short-term maturities. The liquid investment portfolio does not invest in mortgage loans or mortgage-related securities.

We have set a goal to maintain liquid assets equal to at least 5 percent of total on balance-sheet assets. Our ratio of liquid assets to total assets at December 31, 2002 and 2001 was 6.9 percent and 9.5 percent,

respectively. Because our liquid assets are maintained for liquidity purposes and not principally as an investment business, the income generated from these investments is considerably lower than the income generated by mortgage portfolio investments. See “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Business Segment Results — Portfolio Investment Business — Nonmortgage Investments — Tables 11 and 12” for information on our liquid investment portfolio.


	*Credit Guaranty Business*

Overview. Our credit guaranty business has primary responsibility for managing our mortgage credit risk. Credit risk is the risk of nonpayment by borrowers and counterparties. The primary source of income for the credit guaranty business is fees we receive for our guaranty of the timely payment of scheduled principal and interest on MBS that are held by other investors, less the cost of providing this service. In addition, the portfolio investment business compensates the credit guaranty business, for segment reporting purposes, through a fee comparable to an MBS guaranty fee. Consequently, we generally allocate mortgage credit expenses, including credit losses, to the credit guaranty business for business segment reporting purposes. The credit guaranty business also provides investment capital to the portfolio investment business for which it is allocated income, and earns interest income on the temporary investment of principal and interest payments on mortgage loans underlying MBS prior to remittance to investors.

Our credit guaranty business manages Fannie Mae’s mortgage credit risk through sound asset acquisition practices, use of credit enhancements, active management of the credit book of business, and aggressive problem loan management. We share mortgage credit risk with third parties as an integral part of our risk management strategy. In our credit enhancement arrangements, we bear institutional counterparty risk that the parties assuming credit enhancement obligations may be unable to meet their contractual obligations. Mortgage credit enhancements are primarily mortgage insurance, lender recourse, and other risk sharing contracts. We routinely monitor the risks associated with credit enhancement and other risk sharing arrangements. We have provided a detailed description of how we manage the mortgage-related credit risk associated with the credit guaranty business, as well as other types of credit risk, in “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Risk Management — Credit Risk Management.”

The following diagram illustrates the basic structure of how we create a typical MBS in the case where a lender chooses to sell the MBS to a third party.

MBS Guaranty Process

MBS. We create both single-class and multi-class MBS. The MBS represent beneficial interests in pools of mortgage loans or in other mortgage-related securities. The MBS, and the mortgage loans and mortgage-related securities backing MBS, are not assets of Fannie Mae, except when we acquire them for mortgage portfolio investment purposes.

We create MBS backed by mortgage loans bearing interest at either fixed or adjustable rates, and secured by first or subordinate liens on either single-family or multifamily residential properties. Mortgage loans can be either conventional mortgage loans or government guaranteed or insured mortgage loans. Conventional single-family and multifamily loans are subject to the underwriting guidelines applicable to our loan purchases. The majority of our outstanding MBS represent beneficial interests in conventional fixed-rate first mortgage loans secured by single-family dwellings.

We are the trustee for each trust and hold the underlying mortgage loans or mortgage-related securities separate and apart from our assets, for the benefit of the certificateholders.

Single-Class MBS. Single-class MBS are MBS that are typically created through single-lender transactions in which a lender delivers mortgage loans in exchange for MBS representing beneficial interests in those mortgage loans and our guaranty. Another form of single-class MBS, referred to as “Fannie Majors®”, allows multiple lenders to pool mortgage loans that are delivered to us and, in exchange, receive MBS representing each lender’s proportionate share of the larger pool. We also create single-class MBS referred to as “Fannie Megas®” or “Megas.” Megas are pass-through certificates backed by pooled multiple single-class MBS with similar characteristics and/or other pooled Megas with similar characteristics. Megas are issued in transactions in which a lender or investment banker exchanges pooled single-class MBS and/or other pooled Megas for newly issued Mega certificates.

Principal and interest from the mortgage loans underlying the single-class MBS are passed through to the certificateholders less a fee for servicing the mortgage loans and a fee for our guaranty. We guarantee the timely payment of scheduled principal due on the underlying mortgage loans and interest at the MBS pass-through rate to the certificateholders, even if we have not received the payments on the underlying mortgage loans. In other words, through our guaranty to certificateholders, we assume the credit risk of borrower defaults on the underlying mortgage loans, as well as any risk arising from a default or bankruptcy of the seller and servicer of the loans.

We have a responsibility to certificateholders for the servicing of the mortgage loans underlying the MBS and certain other mortgage-related securities, although we do not directly service the mortgage loans. See “Item 1 — Business — Fannie Mae Business Standards — Servicing Arrangements.” We are also responsible for certain administrative functions, such as the collection and receipt of payments from the contract servicer, maintaining accounting records for each trust, and for the distribution of payments and reports due to certificateholders.

The MBS TBA Market. Single-class MBS outstanding constituted approximately 75 percent of Fannie Mae’s total MBS outstanding as of December 31, 2002. The vast majority of these MBS are sold by lenders into the “TBA” (“to be announced”) securities market. A TBA trade represents a contract for the purchase or sale of single-family mortgage-related securities to be delivered at a future agreed-upon date. The specific pool numbers that will be delivered to fulfill the trade obligation or terms of the contract are unknown at the time of the trade. Parties to a TBA trade agree upon the issuer and product type to be delivered (denoted by a pool prefix), the coupon or interest rate of the security to be delivered, the settlement date of the trade, the amount of securities to be delivered, and the price of those securities. The single-class MBS that ultimately will be delivered, and the loans backing that MBS, frequently have not been created or originated at the time of the TBA trade, even though a price for the securities is agreed to at that time. A TBA trade may be entered into as much as several months before actual settlement of that trade. TBA sales enable the originating lender to hedge its interest rate risk and “lock-in” interest rates for mortgage loan applicants throughout the loan origination process. A lender may satisfy its delivery requirement under a TBA trade by delivering any mortgage-related security meeting the agreed-upon terms.

Multi-Class MBS. We also create and guarantee multi-class MBS, such as real estate mortgage investment conduits, commonly referred to as “REMICs”, certain grantor trust certificates, and stripped mortgage-backed certificates, commonly referred to as “SMBS”. REMICs are a vehicle by which an issuer can restructure interest and principal payments on mortgage assets into separately tradeable interests. By redirecting the cash flows from the underlying mortgage assets, we can create a security having several classes, also called “tranches,” which, among other things, may have different coupon rates, average lives, repayment sensitivities and final maturities. SMBS operate in a manner similar to REMICs, though we typically use SMBS to create tranches that pay only principal or only interest. We generally receive one-time fees for swapping mortgage loans, MBS and other mortgage-related securities for our multi-class MBS. If the multi-class MBS are backed by whole loans or securities we have not already guaranteed, we may receive a guaranty fee in addition to a transaction fee. We otherwise receive no separate guaranty fees for these transactions because we have already assumed the credit risk on the underlying securities and receive guaranty fees for that assumption on the underlying securities.

Multi-class MBS provide a variety of cash flow options for investors. In multi-class MBS, each class is entitled to different cash flows. For example, these cash flows may consist of (1) principal only payments from the underlying mortgage loans, (2) interest only payments from the underlying mortgage loans, or (3) different percentages of principal and interest payments. In addition, the timing of payments may vary among the classes of REMIC certificates. For example, a REMIC class may receive payments for only a limited period during the life of the trust. Our multi-class MBS may be backed directly by mortgage loans or by other mortgage-related securities, including single-class MBS, REMIC certificates, grantor trust certificates, or mortgage-related securities of an issuer other than Fannie Mae. In general, our guaranty for multi-class mortgage-related securities covers timely payment of scheduled principal and interest due on these certificates and ultimate payment of principal by the date specified for each class of certificates. We have created a limited number of subordinated REMIC classes that are not guaranteed by Fannie Mae. Most Fannie Mae

multi-class mortgage-related securities are created in transactions in which an investment banker, or less frequently a lender or a mortgage banker, exchanges mortgage loans or mortgage-related securities, or a combination of both, for the newly-issued Fannie Mae multi-class MBS.

Guaranty Fees. We receive guaranty fees for our guaranty of timely payment of scheduled principal and interest on MBS. When we create an MBS, we establish a guaranty fee for the MBS, taking into consideration the credit risk associated with the loans backing the MBS. We either (1) determine a weighted average guaranty fee based on the characteristics of the loans in the trust and assign that fee to each loan in the trust or (2) assign each loan in the trust a guaranty fee based on its risk characteristics. In the latter instance, our weighted average guaranty fee for the MBS may increase or decrease over time depending upon prepayment activity. Guaranty fees generally are paid to us on a monthly basis from a portion of the interest payments received on the underlying mortgage loans, as long as the loans are in the MBS. Guaranty fees are typically calculated for MBS at the loan level as a percent of the unpaid principal balance remaining on a loan. The monthly guaranty fee may be adjusted up or down through a cash payment to or from the lender at the time the MBS is issued.

The aggregate amount of guaranty fees we receive in any financial statement period depends primarily upon the amount of Fannie Mae MBS outstanding during that financial statement period and on the applicable guaranty fee rates. The amount of MBS outstanding is influenced by factors including the rates at which the underlying mortgage loans are repaid, the rate of defaults on loans or breaches of lender representations resulting in repurchases from the pool, and the rate at which we issue new MBS and purchase or sell MBS in our mortgage portfolio business. In general, when prevailing interest rates decline below the interest rates on loans underlying outstanding MBS, both the rate of mortgage loan prepayments and the issuance of new MBS are likely to increase. Conversely, when interest rates rise above the interest rates on mortgage loans underlying our outstanding MBS, the rate of mortgage loan prepayments and new MBS issuance is likely to slow. The rate of principal prepayments also is influenced by a variety of economic, demographic, and other factors.

Delinquencies and REO. We manage loans in partnership with our servicers to minimize the frequency of foreclosure and the severity of loss in the event of foreclosure. When a loan is in default, generally the servicer takes appropriate loss mitigation steps or, if necessary, pursues foreclosure on behalf of Fannie Mae. If a mortgage is liquidated through foreclosure or deed in lieu of foreclosure we would acquire the underlying property (as real estate owned, or “REO”) and attempt to sell the REO. If the defaulted loan backs an MBS, we may repurchase the loan out of the MBS trust and pay the principal balance on the loan to the MBS certificateholders when the loan is delinquent by four or more consecutive monthly payments (or eight biweekly installments.) This is generally our current practice given the level of interest rates, because it is often less expensive for us to fund the purchase of the loan at our lower borrowing cost than to continue to pass through to the investor the coupon rate of the MBS. We have a policy to repurchase the loan if it is delinquent by twenty-four consecutive months or at the time of foreclosure, if it is still in the MBS trust at that time. As long as the loan or REO remains in the MBS trust, we continue to pay scheduled principal and interest to the certificateholders and defer payment of the remaining principal balance until the earlier of the repurchase of the loan from the MBS trust, the sale of the REO or the third year following foreclosure.

The level of delinquencies and number of REO are affected by economic conditions, loss mitigation efforts (which include contacting delinquent borrowers to offer a repayment plan, loan modification, preforeclosure sale, or other options), contractual provisions in credit enhancements, and a variety of other factors. We manage the risk of delinquencies and REO, including the risk on loans and mortgage-related securities held in our mortgage portfolio, as described in “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Risk Management — Credit Risk Management.”


	*Fee-Based Services*

We offer services to lenders and other customers in return for fees. These include transaction fees for issuing and administering REMICs, SMBS, Fannie Megas and certain grantor trust securities, and facilitating securities transactions.

We also receive fee income in return for providing technology-related services, such as Desktop Underwriter, Desktop Originator®, and other on-line services. These services provide lenders the ability to underwrite mortgage loans electronically, communicate with third-party originators, access our loan pricing schedules, and enter into sale commitments with us on a real-time basis.

We also facilitate securities transactions for customers. For this service, we may earn a spread on the purchase and sale of MBS and certain other mortgage-related securities, such as Ginnie Mae certificates, or may receive a fee from the customer. In addition, we receive fee income through other activities, such as providing credit enhancements and other investment alternatives for customers.

Housing Goals

The Federal Housing Enterprises Financial Safety and Soundness Act (the “1992 Act”) requires the Secretary of the U.S. Department of Housing and Urban Development (“HUD”) to establish a low-and moderate-income, an underserved areas, and a special affordable housing goal for loans purchased or guaranteed by Fannie Mae. We are required to submit an annual report to the House Committee on Financial Services, the Senate Committee on Banking, Housing and Urban Affairs, and the Secretary of HUD regarding our performance in meeting the housing goals. By regulation, HUD has established the low- and moderate-income housing goal at 50 percent of the total number of dwelling units financed by eligible mortgage purchases annually, the underserved areas housing goal at 31 percent, and the special affordable housing goal, a more targeted measure, at 20 percent. “Eligible mortgage purchases” include MBS guarantees but exclude several activities, including the purchase or guaranty of non-conventional mortgages and mortgages on second homes, commitments to purchase or guarantee mortgages at a later date, and equity investments in low-income housing tax credits. For the year ended December 31, 2002, “eligible mortgage purchases” represented approximately 97% of our business volume. In addition, HUD has established Fannie Mae’s targeted multifamily subgoal at $2.85 billion.

Each of these goals applies annually during 2001 through 2003. If HUD does not establish different goals for 2004 and after, the goals will continue at the current levels. The goals also include certain provisions that reduce penalties for missing data and provide incentive points for serving small multifamily and owner-occupied rental housing. A loan may be counted in more than one category of goals. If HUD determines that Fannie Mae has failed to meet its housing goals and that achievement of the goals was feasible, taking into account market and economic conditions and Fannie Mae’s financial condition, Fannie Mae must submit a housing plan to HUD describing the actions it will take to meet the goal in the next calendar year. If HUD determines that Fannie Mae has failed to submit a housing plan or failed to make a good faith effort to comply with the plan, HUD may take certain administrative actions. The following table shows Fannie Mae’s housing goals and results for the past three years.



	2002						2001						2000

Housing Goals	Goal⁽¹⁾			Result			Goal⁽¹⁾			Result			Goal⁽¹⁾			Result


	(Dollars in billions)
Low- and moderate-income housing		50.0	%		51.8	%		50.0	%		51.6	%		42.0	%		49.5	%
Underserved areas		31.0			32.8			31.0			32.5			24.0			31.0
Special affordable housing		20.0			21.4			20.0			21.6			14.0			22.3
Multifamily minimum in special affordable housing	$	2.85		$	7.22		$	2.85		$	7.40		$	1.30		$	3.78


(1)	Goals are expressed as a percentage of the total number of dwelling units financed through eligible mortgage purchases during the period, except for the targeted multifamily goal.

Competition

In the case of single-family mortgage loans, Fannie Mae competes, within the limits prescribed by the Charter Act, for the purchase of mortgage loans for our own portfolio, for the guaranty of mortgage credit risk, and for the issuance in the secondary mortgage market of mortgage-related securities. For single-family products, we compete with Freddie Mac (another government-sponsored enterprise with a mission, authority, and regulatory oversight that are virtually identical to our own), commercial banks, savings and loan

associations, savings banks, pension funds, insurance companies, securities dealers, and other financial entities that purchase single-family mortgage loans or mortgage-related securities for their own portfolio or pool single-family mortgage loans for sale to investors as whole loans or mortgage-related securities. We compete with the Federal Home Loan Banks, which also finance single-family mortgage loans through a variety of programs that were initiated in 1997. We compete with mortgage insurers, bond insurers, and other financial guarantors that provide mortgage credit guaranty services on loans and pools of loans.

Commercial banks and thrifts are the largest participants in the U.S. mortgage industry. Banks and thrifts originate mortgages (which we are not empowered to do under the Charter Act), have access to low cost, FDIC-insured deposits and can borrow advances from Federal Home Loan Banks. There has been significant consolidation among commercial banks and thrifts, increasing the size of individual organizations and resulting in concentration in the banking industry. This has created larger institutions with the scale necessary to permit them to securitize their own mortgages and manage large and complex portfolios. As institutions become larger, they have increasing bargaining power in their negotiations with Fannie Mae, and are able to offer us volume in return for lower guaranty fees and customization of services.

We compete with the FHA insurance program, a program of HUD, for the business of guaranteeing the credit performance of mortgage loans and, because of the eligibility of such FHA-insured loans for securitization by the Government National Mortgage Association (“Ginnie Mae”), an entity within HUD, with Ginnie Mae as well. The base maximum principal balance for loans eligible for the FHA insurance program is 48 percent of our loan limit. The loan limit for FHA-insured loans in high-cost areas is as much as 87 percent of our limit. These higher FHA limits may result in increased competition for our credit guaranty business.

We compete primarily on the basis of price, products, structures, and services offered. Competition based on advances in technology-related and other fee-based services continues to increase, as do the types and nature of the products offered by us and other market participants. Our market share of loans purchased for cash or swapped for mortgage-related securities is affected by the volume of mortgage loans offered for sale in the secondary market by loan originators and other market participants and the amount purchased by our competitors.

In the case of multifamily mortgage loans, we generally compete with government housing programs, Freddie Mac, insurance companies, and the same kinds of entities we compete with in the single-family market. In addition, there is competition for multifamily mortgage loans from certain entities typically sponsored by investment banks and commercial banks that purchase such loans and pool them for sale to investors in the commercial mortgage-related securities market. Such entities are referred to as “conduits,” and their role in the multifamily mortgage market has increased significantly over the last five years. Conduits continue to be a strong source of competition.

Competition is particularly intense for multifamily mortgage loans eligible for government subsidies, which have low-income rent and occupancy restrictions. Commercial banks contemplating merger or expansion plans seek to fund such loans to secure favorable review under the Community Reinvestment Act and may either hold such loans as an investment or sell them to a secondary market investor. We compete for these investments in the secondary market to meet our housing goals.

Under the 1992 Act, the Secretary of HUD must approve any new Fannie Mae or Freddie Mac conventional mortgage program that is significantly different from those approved or engaged in prior to that Act’s enactment. Our ability to compete could be affected by this requirement. See “Government Regulation and Charter Act.”

Competition also is a consideration in connection with the issuance of Fannie Mae’s debt securities. We compete with Freddie Mac, the Federal Home Loan Bank system, and other government-sponsored entities for funds raised through the issuance of unsecured debt in the “agency” debt market. Increases in the issuance of unsecured debt by other government-sponsored entities generally, and in the issuance of callable debt in particular, may have an adverse effect on the issuance of our unsecured debt or result in the issuance of such debt at higher interest rates than would otherwise be the case. In addition, the availability and cost of funds

raised through the issuance of certain types of unsecured debt may be adversely affected by regulatory initiatives that may reduce investments by depository institutions in unsecured debt with greater than normal volatility or interest-rate sensitivity.

Employees

As of February 28, 2003, Fannie Mae employed approximately 4,800 permanent personnel.

Government Regulation and Charter Act

Charter Act

We were established in 1938 under Title III of the National Housing Act as a government owned entity. In 1954, under the Federal National Mortgage Association Charter Act, the entity became a mixed-ownership corporate instrumentality of the United States. Under the Housing and Urban Development Act of 1968, the entity was divided into two separate institutions, the present Fannie Mae and Ginnie Mae. Fannie Mae became an entirely stockholder-owned corporation, organized and existing under the Charter Act. The Charter Act provides that the corporation will continue until dissolved by an act of Congress. The Charter Act was further amended by the 1992 Act.

Under the Charter Act, our purpose is:

“to (1) provide stability in the secondary market for residential mortgages, (2) respond appropriately to the private capital market, (3) provide ongoing assistance to the secondary market for residential mortgages (including activities relating to mortgages on housing for low-and moderate-income families involving a reasonable economic return that may be less than the return earned on other activities) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing, [and] (4) promote access to mortgage credit throughout the nation (including central cities, rural areas and underserved areas) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing.”

The Charter Act authorizes us to “deal in” conventional mortgage loans, and “purchase,” “sell,” “service,” and “lend on the security of” such mortgages, subject to limitations on the quality of mortgages purchased and credit enhancement requirements. Fannie Mae can act as a depositary, custodian, or fiscal agent “for its own account or as fiduciary, and for the account of others.” The Charter Act expressly enables Fannie Mae “to lease, purchase, or acquire any property, real, personal, or mixed, or any interest therein, to hold, rent, maintain, modernize, renovate, improve, use, and operate such property, and to sell, for cash or credit, lease, or otherwise dispose of the same, at such time and in such manner as and to the extent that it may deem necessary or appropriate.” The Charter Act also permits Fannie Mae to “purchase,” “service,” “sell,” “lend on the security of” and otherwise deal in loans or advances of credit for the purchase and installation of home improvements (so long as the loans are secured by a lien against the property to be improved).

Under the Charter Act, we may not originate mortgage loans or advance funds on an interim basis pending the sale of a mortgage in the secondary market. We may not purchase loans in excess of the amount of the current loan limits. (See “Business—Fannie Mae Business Standards—Principal Balance Limits.”) We may conduct business only in the United States, its territories and possessions, the District of Columbia and the Commonwealth of Puerto Rico. Our activities must relate to housing, mortgages and related financial products.

Thirteen members of our eighteen-member Board of Directors are elected by the holders of our common stock. The President of the United States appoints the remaining five members. The appointed directors must include one person from the home building industry, one person from the mortgage lending industry, one person from the real estate industry, and one person from a consumer or community interest organization or who has demonstrated a career commitment to providing low-income housing. Any member of the Board of Directors that is appointed by the President of the United States may be removed by the President for good cause. All members of the Board of Directors are elected or appointed annually.

In general, HUD and OFHEO oversee the activities of Fannie Mae. HUD has “general regulatory power” over Fannie Mae. The 1992 Act established OFHEO to ensure that Fannie Mae is adequately capitalized and is operating safely.

The Secretary of the Treasury has the authority to approve Fannie Mae’s issuance of debt obligations and mortgage-related securities. At the discretion of the Secretary of the Treasury of the United States, the U.S. Treasury may purchase obligations of Fannie Mae up to a maximum of $2.25 billion outstanding at any one time. This facility has not been used since our transition from government ownership in 1968. Neither the United States nor any agency thereof is obligated to finance our operations or to assist us in any other manner. The Federal Reserve Banks are authorized to act as depositories, custodians, and fiscal agents for Fannie Mae, for the Bank’s own account, or as fiduciary.

Securities we issue are “exempt securities” under laws administered by the SEC to the same extent as securities that are obligations of, or guaranteed as to principal and interest by, the United States. Registration statements with respect to offerings of our securities are not filed with the SEC. In July 2002, we announced our voluntary initiative to register our common stock with the SEC under Section 12(g) of the Securities Exchange Act of 1934. The registration of our common stock became effective on March 31, 2003. As a result, we will file periodic reports with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, together with any required exhibits. These filings will be available on the SEC’s Electronic Data Gathering, Analysis, and Retrieval (“EDGAR”) system at www.sec.gov. Registration of our common stock with the SEC will not impact the status of our securities (including equity, debt and MBS) as exempt securities within the meaning of the laws administered by the SEC.

We are exempt from taxation by states, counties, municipalities, or local taxing authorities, except for taxation by those authorities on our real property. We are not exempt from payment of federal corporate income taxes. We also may conduct our business without regard to any qualification or similar statute in any state of the United States, including the District of Columbia, the Commonwealth of Puerto Rico, and the territories and possessions of the United States.

Regulatory Approval and Oversight

As a federally chartered corporation, Fannie Mae is subject to Congressional legislation and oversight and is regulated for various purposes by HUD, OFHEO and the U.S. Department of the Treasury, to the extent authorized by statute. In addition, the financial institutions with whom we do business are subject to extensive federal and state law and regulation. Changes to legislation, regulations or policy that impact us or our business partners could adversely or favorably affect the performance, development, or results of our business.

OFHEO, an independent office within HUD, is responsible for ensuring that we are adequately capitalized and operating safely in accordance with the 1992 Act. OFHEO conducts on-site examinations of Fannie Mae for purposes of ensuring our financial safety and soundness. We are required to submit annual and quarterly reports of our financial condition and operations to OFHEO. OFHEO is authorized to levy annual assessments on Fannie Mae and Freddie Mac, pursuant to annual Congressional appropriations, to cover OFHEO’s reasonable expenses. OFHEO’s formal enforcement powers include the power to impose temporary and final cease-and-desist orders and civil monetary penalties on us and on our directors and executive officers, provided certain conditions are met. OFHEO may use other informal supervisory tools of the type that are generally used by agencies with authority to regulate other financial institutions. In accordance with OFHEO regulation, Fannie Mae has elected to follow the applicable corporate governance practices and procedures of the Delaware General Corporation Law, as it may be amended from time to time. On January 21, 2003, OFHEO proposed regulations that would require Fannie Mae to file with the SEC all reports, statements and forms relating to our common stock that are required to be filed under Sections 14(a) and (c) of the Exchange Act and the rules and regulations under those sections and require Fannie Mae’s directors and officers to file all reports and forms relating to our common stock that are required to be filed under Section 16 of the Exchange Act and the rules and regulations under that section.

The Secretary of the Treasury has the authority to approve Fannie Mae’s issuance of debt obligations and mortgage-related securities. The General Accounting Office is authorized to audit the programs, activities,

receipts, expenditures, and financial transactions of Fannie Mae. The Secretary of HUD has general regulatory authority to promulgate rules and regulations to carry out the purposes of the Charter Act, excluding authority over matters granted exclusively to OFHEO. The Secretary of HUD has authority to approve any new conventional mortgage program that is significantly different from those approved or engaged in prior to the 1992 Act. The Secretary must approve any new program unless it is not authorized by the Charter Act or the Secretary finds that it is not in the public interest. The Secretary has adopted regulations related to the program approval requirement. We are also required to meet certain goals established by the Secretary of HUD to promote affordable housing and to serve the housing needs of those in underserved areas. See “Business — Housing Goals.”

Capital Requirements

The 1992 Act established minimum capital, risk-based capital, and critical capital requirements for Fannie Mae. See also “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Capital Resources — Regulatory Environment.” OFHEO issued a final rule in 1996 that sets forth the minimum capital requirements for Fannie Mae and Freddie Mac, which are to be calculated, reported, and classified on a quarterly basis. We were in compliance with the minimum capital rule as of December 31, 2002, and have been in compliance for every reporting period since the rule became effective. OFHEO issued regulations in September 2001, as subsequently amended, to establish a risk-based capital test to be used to determine the amount of total capital Fannie Mae must hold to meet the risk-based capital standard. Fannie Mae and Freddie Mac are required to hold enough capital to withstand a severe 10-year stress period, characterized by extreme interest-rate movements and credit losses occurring simultaneously, plus 30 percent of that amount for management and operations risk. The risk-based capital test evaluates combined interest-rate and credit stress for both rising and declining interest-rate scenarios. The more stringent of these two scenarios determines the required risk-based capital. The test assumes that (1) interest rates increase or decrease by up to 600 basis points over the first year, and remain constant at this new level for the remaining 9 years of the test; (2) severe credit conditions apply nationwide; and (3) we acquire no new business during this period except to meet outstanding mortgage commitments. The regulations specify that “benchmark loss experience” will be combined with other assumptions and applied each quarter to our book of business to establish expected credit losses based on the stress assumptions under the risk-based capital standard. The regulations also specify the housing price index that OFHEO will use in connection with the standard and how the test will be used to determine Fannie Mae’s risk-based capital requirements. On March 31, 2003, OFHEO announced that Fannie Mae complied with the risk-based capital rule as of December 31, 2002. See “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Capital Resources — Regulatory Environment.”

If we fail to meet the capital standards, OFHEO is permitted or required to take remedial measures, depending on the standards we fail to meet. Compliance with the capital standards could limit operations that require intensive use of capital and restrict our ability to repay debt or pay dividends on our common stock. We are required to submit a capital restoration plan if we fail to meet any of the capital standards. If OFHEO determines that we are engaging in conduct not approved by the Director that could result in a rapid depletion of core capital or that the value of the property subject to mortgages we hold or have securitized has decreased significantly, or if OFHEO does not approve the capital restoration plan or determines that we have failed to make reasonable efforts to comply with the plan, OFHEO may take remedial measures as if we were not meeting the capital standards we otherwise meet. The 1992 Act gives OFHEO authority, after following prescribed procedures, to appoint a conservator if we do not meet the critical capital level.

Dividend Restrictions

The Charter Act as amended by the 1992 Act restricts the ability of our Board of Directors to make capital distributions, including any dividends, in the following circumstances:


	•	Fannie Mae may not pay any dividend, without the approval of OFHEO, if the dividend payment would decrease our total capital below the risk-based capital level or our core capital below the minimum capital level.


	•	If we do not meet the risk-based capital standard but do meet the minimum capital standard, we may not make any dividend payment that would cause us to fail to meet the minimum capital standard.

	•	If we meet neither the risk-based capital standard nor the minimum capital standard but do meet the critical capital standard established under the 1992 Act, we may make a dividend payment only if we would not fail to meet the critical capital standard as a result of the payment and the Director of OFHEO approves the payment after finding that the payment satisfies certain statutory conditions.

The Director has the authority to require us to submit a report to the Director regarding any capital distribution we declare before we make the distribution.

Item 2. Properties

We own our principal office, which is located at 3900 Wisconsin Avenue, NW, Washington, DC, offices at 3939 Wisconsin Avenue, NW, and 4250 Connecticut Avenue, NW, in Washington, DC, and two facilities in Herndon, Virginia. These owned facilities total approximately 829,000 square feet of space. In addition, we lease 375,000 square feet of office space at 4000 Wisconsin Avenue, NW, which is adjacent to Fannie Mae’s principal office. The present lease for 4000 Wisconsin Avenue expires in 2008, and we have options to extend the lease for up to 10 additional years, in 5-year increments. We also lease an additional 377,000 square feet of office space in four locations in Washington, D.C. and suburban Virginia.

We maintain offices in leased premises in Pasadena, California; Atlanta, Georgia; Chicago, Illinois; Philadelphia, Pennsylvania; and Dallas, Texas. In addition, we have 54 “Fannie Mae Partnership Offices” in leased premises around the United States which work with cities, rural areas, and underserved communities.


Item 3.	*Legal Proceedings*

In the ordinary course of business, we are involved in legal proceedings that arise in connection with properties acquired either through foreclosure on properties securing delinquent mortgage loans we own or by receiving deeds to those properties in lieu of foreclosure. For example, claims related to possible tort liability arise from time to time, primarily in the case of single-family REO.

We are a party to legal proceedings from time to time arising from our relationships with our seller/ servicers. Disputes with lenders concerning their loan origination or servicing obligations to us, or disputes concerning termination by us (for any of a variety of reasons) of a lender’s authority to do business with us as a seller and/or servicer, can result in litigation. Also, loan servicing and financing issues have resulted from time to time in claims against us brought as putative class actions for borrowers. We also are a party to legal proceedings from time to time arising from other aspects of our business and administrative policies.

Claims and proceedings of all types are subject to many uncertain factors that generally cannot be predicted with assurance. However, in the case of the legal proceedings and claims that are currently pending against us, management believes that their outcome will not have a material adverse effect on our financial condition, results of operations or cashflows.


Item 4.	*Submission of Matters to a Vote of Security Holders*

None.

PART II


Item 5.	*Market for Registrant’s Common Equity and Related Stockholder Matters*

Information on the market for our common stock and related stockholder matters is set forth under Item 9 of the Form 10 we filed on March 31, 2003 (the “Form 10”) and incorporated by reference herein.


Item 6.	*Selected Financial Data*

The following selected financial data have been summarized or derived from our audited financial statements. This financial information should be read in conjunction with “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Item 1 — Business,” and our financial statements and related notes, included elsewhere in this report.



		Year Ended December 31,

Income Statement Data:		2002			2001			2000			1999			1998


		(Dollars and shares in millions, except per common share amounts)
Interest income		$	50,853		$	49,170		$	42,781		$	35,495		$	29,995
Interest expense			(40,287	)		(41,080	)		(37,107	)		(30,601	)		(25,885	)

Net interest income			10,566			8,090			5,674			4,894			4,110
Guaranty fee income			1,816			1,482			1,351			1,282			1,229
Fee and other income (expense), net			232			151			(44	)		191			275
Provision for losses			(128	)		(94	)		(122	)		(151	)		(245	)
Foreclosed property income (expense)			36			16			28			24			(16	)
Administrative expense			(1,219	)		(1,017	)		(905	)		(800	)		(708	)
Special contribution			—			(300	)		—			—			—
Purchased options expense⁽¹⁾			(4,545	)		(37	)		—			—			—
Debt extinguishments, net			(710	)		(524	)		49			(14	)		(40	)

Income before federal income taxes and cumulative effect of change in accounting principle			6,048			7,767			6,031			5,426			4,605
Provision for federal income taxes			(1,429	)		(2,041	)		(1,583	)		(1,514	)		(1,187	)

Income before cumulative effect of change in accounting principle			4,619			5,726			4,448			3,912			3,418
Cumulative effect of change in accounting principle, net of tax effect⁽²⁾			—			168			—			—			—

Net income		$	4,619		$	5,894		$	4,448		$	3,912		$	3,418

Preferred stock dividends			(99	)		(138	)		(121	)		(78	)		(66	)

Net income available to common stockholders		$	4,520		$	5,756		$	4,327		$	3,834		$	3,352

Basic earnings per common share:
	Earnings before cumulative effect of change in accounting principle	$	4.56		$	5.58		$	4.31		$	3.75		$	3.26
	Cumulative effect of change in accounting principle		—			.17			—			—			—

	Net earnings	$	4.56		$	5.75		$	4.31		$	3.75		$	3.26

Diluted earnings per common share:
	Earnings before cumulative effect of change in accounting principle	$	4.53		$	5.55		$	4.29		$	3.72		$	3.23
	Cumulative effect of change in accounting principle		—			.17			—			—			—

	Net earnings	$	4.53		$	5.72		$	4.29		$	3.72		$	3.23

Cash dividends per common share		$	1.32		$	1.20		$	1.12		$	1.08		$	.96



		December 31,

Balance Sheet Data:		2002		2001		2000		1999		1998

Mortgage portfolio, net		$	797,693	$	705,324	$	607,551	$	522,921	$	415,355
Liquid assets			61,554		76,072		55,585		41,850		59,258
Total assets			887,515		799,948		675,224		575,308		485,146
Borrowings:
	Due within one year		382,412		343,492		280,322		226,582		205,413
	Due after one year		468,570		419,975		362,360		321,037		254,878
Total liabilities			871,227		781,830		654,386		557,679		469,693
Preferred stock			2,678		2,303		2,278		1,300		1,150
Stockholders’ equity			16,288		18,118		20,838		17,629		15,453



	Year ended December 31,

Core Business Earnings Data⁽³⁾:	2002			2001			2000			1999			1998


	(Dollars and Shares in millions, except per common share amounts)
Core business earnings⁽⁴⁾	$	6,394		$	5,367		$	4,448		$	3,912		$	3,418
Total taxable-equivalent revenues⁽⁵⁾		11,896			10,187			7,825			6,975			6,272
Net interest margin		1.15	%		1.11	%		1.01	%		1.01	%		1.03	%
Return on average assets⁽⁶⁾		.76			.71			.71			.73			.78
Return on average realized common equity⁽⁷⁾		26.1			25.4			25.2			25.0			25.2



	December 31,

Other Data:	2002			2001			2000			1999			1998

Average effective guaranty fee rate		.191	%		.190	%		.195	%		.193	%		.202	%
Credit loss ratio⁽⁸⁾		.005			.006			.007			.011			.027
Administrative expense ratio⁽⁹⁾		.072			.071			.072			.071			.074
Efficiency ratio⁽¹⁰⁾		10.2			10.0			11.6			11.5			11.3
Dividend payout ratio		29.0			20.9			26.0			28.8			29.5
Ratio of earnings to combined fixed charges and preferred stock dividends⁽¹¹⁾		1.15:1			1.19:1			1.16:1			1.17:1			1.17:1
Mortgage purchases	$	370,641		$	270,584		$	154,231		$	195,210		$	188,448
MBS issues acquired by others⁽¹²⁾		478,260			344,739			105,407			174,850			220,723
Outstanding MBS⁽¹³⁾		1,029,456			858,867			706,684			679,169			637,143
Weighted-average diluted common shares outstanding		997			1,006			1,009			1,031			1,037
Return on average assets		.55	%		.78	%		.71	%		.73	%		.78	%
Average equity to average assets		2.1			2.3			3.1			3.1			3.3
Return on common equity		30.2			39.8			25.6			25.2			25.2
Core capital⁽¹⁴⁾	$	28,079		$	25,182		$	20,827		$	17,876		$	15,465
Total capital⁽¹⁵⁾		28,871			25,976			21,634			18,677			16,257


(1)		Represents the change in the fair value of the time value of purchased options under FAS 133, “Accounting for Derivative Instruments and Hedging Activities” (FAS 133).
(2)		Represents the after-tax effect on income of the adoption of FAS 133 on January 1, 2001.
(3)		Core business earnings data are non-GAAP (generally accepted accounting principles) measures management uses to track and analyze our financial performance. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations— Core Business Earnings and Business Segment Results” for additional discussion of these measures.
(4)		Core business earnings is a non-GAAP measure developed by management, in conjunction with the adoption of FAS 133, to evaluate and assess the quality of Fannie Mae’s earnings from its principal business activities on a consistent basis. Core business earnings is presented on a net of tax basis and excludes the transition adjustment from the adoption of FAS 133 and unrealized gains and losses on purchased options recorded under FAS 133, and includes purchased options premiums amortized on a straight-line basis over the original estimated life of the option.
(5)		Includes revenues net of operating losses on low-income housing tax credit limited partnerships (accounted for using the equity method of accounting) and amortization expense of purchased options premiums, plus taxable-equivalent adjustments for tax-exempt income and investment tax credits using the applicable federal income tax rate. This is a non-GAAP measure.
(6)		Core business earnings less preferred stock dividends divided by average assets. This is a non-GAAP measure.
(7)		Core business earnings less preferred stock dividends divided by average realized common stockholders’ equity (common stockholders’ equity excluding accumulated other comprehensive income). This is a non-GAAP measure.


(8)	Charge-offs, net of recoveries, and foreclosed property income (expense) as a percentage of average mortgage portfolio (on an amortized cost basis) and average outstanding MBS.
(9)	Administrative expenses as a percentage of average net mortgage portfolio and average outstanding MBS.


(10)	Administrative expenses as a percentage of taxable-equivalent revenues.
(11)	“Earnings” consists of (a) income before federal income taxes and cumulative effect of accounting changes and (b) fixed charges. Fixed charges represent interest expense.
(12)	Includes MBS and other mortgage-related securities guaranteed by Fannie Mae.
(13)	Includes MBS and other mortgage-related securities guaranteed by Fannie Mae and held by investors other than Fannie Mae.
(14)	The sum of (a) the stated value of common stock, (b) the stated value of outstanding noncumulative perpetual preferred stock, (c) paid-in capital, and (d) retained earnings, less treasury stock. Core capital represents a regulatory measure of capital. Refer to Note 11 of the financial statements, “Dividend Restrictions and Regulatory Capital Ratios,” for a discussion of core capital.
(15)	The sum of (a) core capital and (b) the total allowance for loan losses and guaranty liability for MBS, less (c) the specific loss allowance. Total capital represents a regulatory measure of capital. Specific loss allowances totaled $19 million, $13 million, $2 million, $3 million, and $10 million for the years ended December 31, 2002, 2001, 2000, 1999, and 1998, respectively. Refer to Note 11 of the financial statements, “Dividend Restrictions and Regulatory Capital Ratios,” for a discussion of total capital.


Item 7.	*Management’s Discussion and Analysis of Financial Condition and Results of Operations*

Forward-Looking Information

From time to time, we make forward-looking statements relating to matters such as our anticipated financial performance, business prospects, future business plans, financial condition, or other matters. This report includes forward-looking statements that are not historical facts or explanations of historical data. The words “believes,” “anticipates,” “expects,” “should” and similar expressions generally identify forward-looking statements.

Forward-looking statements reflect our management’s expectations based on various assumptions and management’s estimates of trends and economic factors in the markets in which we are active, as well as our business plans. As such, forward-looking statements are subject to risks and uncertainties, and our actual results may differ (possibly significantly) from those indicated in such statements. Among the factors that may affect the performance, development, or results of our business, and thereby cause actual results to differ from management’s expressed expectations, are the following:


	•	significant changes in borrower preferences for fixed- or adjustable-rate mortgages, originator preferences for selling mortgages in the secondary market, investor preferences for our securities versus other investments, the availability of funding at attractive spreads in the financial markets (in particular from callable debt), and other factors affecting the overall mix of mortgage loans available for purchase, our funding opportunities, or our net interest margins;

	•	significant changes in housing price valuations, employment rates, or other factors affecting delinquency or foreclosure levels and credit losses;

	•	significant changes in our policies or strategies, such as our underwriting requirements or our interest rate risk management, credit loss mitigation, or investment strategies;

	•	regulatory or legislative changes affecting us, our competitors, or the markets in which we are active, including changes in tax law or capital requirements applicable to us or our activities, or loss of certain exemptions or the Treasury’s ability to purchase our obligations (see “Item 1 — Business — Government Regulation and Charter Act”);

	•	competitive developments in the markets for mortgage purchases and for the sale of mortgage-related and debt securities, or significant changes in the rate of growth in conforming residential mortgage debt;

	•	significant changes in the amount and rate of growth of our expenses, and the costs (and effects) of legal or administrative proceedings (see “Item 3 — Legal Proceedings”) or changes in accounting policies or practices;

	•	significant changes in general economic conditions or the monetary or fiscal policy of the United States;

	•	unanticipated, substantial changes in interest rates. It is possible that sudden, severe swings in interest rates could have at least a short-term significant effect on our results; and

	•	political events in the United States and internationally.

We do not undertake to update any forward-looking statement in this document or that we may make from time to time.

ORGANIZATION OF INFORMATION

Management’s Discussion and Analysis (“MD&A”) provides a narrative on Fannie Mae’s financial performance and condition that should be read in conjunction with the accompanying financial statements. It includes the following sections:


	•	2002 Overview

	•	About Fannie Mae

	•	Results of Operations

	•	Core Business Earnings and Business Segment Results

	•	Off-Balance Sheet Transactions

	•	Application of Critical Accounting Policies

	•	Risk Management

	•	Liquidity and Capital Resources

	•	Performance Outlook

	•	New Accounting Standards

2002 OVERVIEW

2002 was a year of notable achievements for Fannie Mae. We produced strong financial results and made continued progress on our key strategic initiatives in an uncertain economic environment marked by significant interest rate volatility and more intense competition for mortgages in the secondary market. We reported net income of $4.619 billion and diluted earnings per share (“diluted EPS”) of $4.53 in 2002, compared with $5.894 billion and $5.72 in 2001, and $4.448 billion and $4.29 in 2000. Our reported results are based on generally accepted accounting principles (“GAAP”), which include the effects of our January 1, 2001 adoption of Financial Accounting Standard No. 133 (“FAS 133”), Accounting for Derivative Instruments and Hedging Activities. FAS 133 generates significant volatility in our reported net income because it requires that we record in our income changes in the time value portion of purchased options that we use to manage interest rate risk, but it does not allow us to record in earnings changes in the intrinsic value portion of some of those options or similar changes in the fair value of options in all of our callable debt or mortgage assets. We expect purchased options expense to vary, often substantially, from period to period with changes in interest rates, expected interest rate volatility, and derivative activity.

The 22 percent decrease in our 2002 net income resulted primarily from a $4.508 billion increase in purchased options expense, which occurred due to an increase in the notional amount of purchased options outstanding and the declining interest rate environment. We recorded $4.545 billion in purchased options expense in 2002, compared with $37 million in 2001. Excluding the impact of purchased options expense, we experienced solid growth in our business operations. Taxable-equivalent net interest income increased 29 percent over 2001 because of strong growth in our average net mortgage portfolio and actions taken during 2002 and 2001 to lower our debt costs. Guaranty fee income increased 23 percent, primarily due to an increase in the volume of outstanding MBS. These increases were partially offset by a modest rise in credit-related expenses and higher administrative expenses and losses on debt extinguishments.

Management also tracks and analyzes Fannie Mae’s financial results based on a supplemental non-GAAP measure called “core business earnings” (previously referred to by us as “operating net income”). While core business earnings is not a substitute for GAAP net income, we rely on core business earnings in operating our business because we believe core business earnings provides our management and investors with a better measure of our financial results and better reflects our risk management strategies than our GAAP net income. We developed core business earnings in conjunction with our January 1, 2001 adoption of FAS 133 to adjust for accounting differences between alternative transactions we use to hedge interest rate risk that produce similar economic results but require different accounting treatment under FAS 133. For example, our

core business earnings measure allows management and investors to evaluate the quality of earnings from Fannie Mae’s principal business activities in a way that accounts for comparable hedging transactions in a similar manner. We discuss our core business earnings results in “MD&A—Core Business Earnings and Business Segment Results.”

While the overall U.S. economy was weak during 2002, the U.S. housing market remained strong, with both home sales and mortgage originations reaching record levels. The decline in mortgage interest rates during the third quarter of 2002 to the lowest levels since the 1960s sparked a refinance boom and fueled record refinance as well as purchase originations. Single-family mortgage originations in 2002 totaled $2.6 trillion, surpassing 2001’s record of $2.0 trillion by 29 percent. Our market—residential mortgage debt outstanding—increased 12 percent in 2002 to $7.0 trillion as the demand for housing continued to grow, marking the first two consecutive years of double-digit residential mortgage debt outstanding (“MDO”) growth since 1988-1989.

During 2002, we made progress on several key strategic initiatives to support our mission of increasing homeownership and affordable rental housing for all Americans. We align our strategies with and measure our performance against six long-term corporate goals.


1.	Acknowledged Leadership in Increasing Access to Affordable Housing: One of our most significant initiatives to increase homeownership rates and serve 18 million targeted American families is our ten-year, $2 trillion American Dream Commitment. In 2002, we provided $670 billion for 5.5 million targeted families to own or rent a home, bringing us almost two-thirds of the way toward achieving this ten-year goal in three years.

2.	Leading Presence in the Secondary Market and Partner of Choice: Our goal is to be the secondary market partner of choice for mortgage lenders. We now have alliance agreements with 17 of the 30 largest lenders, and our business with smaller lenders has grown by over 150 percent during the past year. We achieved a net gain in major partnership accounts during 2002. We have provided increased liquidity to mortgage markets by owning approximately 11 percent of mortgage debt outstanding and guaranteeing 15 percent owned by other investors.

3.	Optimal Risk Management: Our financial success depends on the ability of our two core lines of business to effectively manage interest rate risk and credit risk on home mortgages. By taking an active, highly disciplined approach in managing these risks, we have honed our risk management tools over the years to reduce our risk exposure, expand our service to American homebuyers, and deliver double-digit core business earnings growth for the last 16 years through all kinds of economic scenarios.

4.	Record Financial Performance: One of our key financial performance goals, announced in 1999, is a five-year goal to double Fannie Mae’s core business diluted earnings per share to $6.46 by the end of 2003. With an increase in core business earnings of nearly 90 percent over the last 4 years, we are on track to achieve this five-year goal.

5.	Corporate Culture to Enhance Strategy Execution: Developing a corporate culture that ensures a diverse and fully engaged workforce is critical in executing our key strategic initiatives and fulfilling Fannie Mae’s mission to help more families achieve the American Dream of homeownership. In 2002, Fannie Mae received several awards in recognition of our commitment to being a world-class, diverse organization.

6.	E-Commerce Company Infrastructure to Increase Capabilities and Lower Costs: Our e-commerce strategy is intended to help us grow our business, while lowering the cost of mortgages and reducing our underwriting risk. For example, by expanding utilization of Desktop Underwriter® (“DU”), our automated underwriting system, we can help lenders streamline their processes and enhance further our credit risk management effectiveness. Today, approximately 60 percent of our total single-family business is processed through DU. In addition, we committed significant resources in 2002 to upgrading our core technology infrastructure to enhance the acquisition of mortgages through multiple channels, facilitate new products, and generate cost reductions for our customers.

Because of Fannie Mae’s critical role in the housing finance system, one of our core commitments is to maintain the highest standard of transparency in our financial disclosures. In our on-going efforts to enhance Fannie Mae’s transparency, we announced in 2002 our voluntary initiative to register Fannie Mae’s common stock with the Securities and Exchange Commission under Section 12(g) of the Securities Exchange Act of 1934. This report is our first periodic report filed pursuant to our voluntary initiative.

ABOUT FANNIE MAE

Fannie Mae’s purpose is to facilitate the flow of low-cost mortgage capital to increase the availability and affordability of homeownership for low-, moderate-, and middle-income Americans. We operate under a federal charter, and our primary regulator is the Office of Federal Housing Enterprise Oversight (“OFHEO”). However, we are a private, shareholder-owned company. The U.S. government does not guarantee, directly or indirectly, Fannie Mae’s debt securities or other obligations.

As the nation’s largest source of funds for mortgage lenders and investors, Fannie Mae provides resources for our customers to make additional mortgage loans or investments in mortgage-related securities. We provide liquidity to the mortgage market for the benefit of borrowers; however, we do not lend money directly to consumers. We operate exclusively in the secondary mortgage market by purchasing mortgages and mortgage-related securities, including Fannie Mae MBS, from primary market institutions, such as commercial banks, savings and loan associations, mortgage companies, securities dealers, and other investors. We provide additional liquidity in the secondary market by issuing and guaranteeing mortgage-related securities.

We have two lines of business that generate revenue. These business lines also focus on managing our key business risks. We measure the results of our lines of business based on core business earnings. We evaluate the results of our business lines as though each were a stand-alone business. Hence, we allocate certain income and expenses to each line of business for purposes of business segment reporting. We eliminate certain inter-segment allocations in our consolidated core business earnings results (see “MD&A—Core Business Earnings and Business Segment Results”).

Portfolio Investment Business: The Portfolio Investment business has two principal components: a mortgage portfolio and a liquid investment portfolio (“LIP”). The mortgage portfolio purchases mortgage loans, mortgage-related securities, and other investments from lenders, securities dealers, investors, and other market participants. The LIP serves as an alternative source of funds to meet our cash flow needs by investing in high quality, short-term investments that provide an ongoing supply of funds. We can use these funds as necessary for liquidity purposes or to reinvest in readily marketable, high credit quality securities that can be sold to raise cash. We fund the purchase of the assets in our Portfolio Investment business from our equity capital and by issuing debt in the global capital markets. The Portfolio Investment business generates profits by ensuring that the interest income from the mortgages, MBS, mortgage-related securities, and liquid investments we purchase is greater than our borrowing costs. A primary measure of profitability for the Portfolio Investment business is our “net interest margin”. Our net interest margin reflects the difference between taxable-equivalent income on our mortgage assets and non-mortgage investments and our borrowing expense divided by average interest earning assets.

Our Portfolio Investment business focuses on managing Fannie Mae’s interest rate risk. Interest rate risk is the risk that changes in interest rates could change cash flows on our mortgage assets and debt in a way that adversely affects Fannie Mae’s earnings or long-term value.

Credit Guaranty Business: Our Credit Guaranty business has primary responsibility for managing all of our mortgage credit risk. Credit risk is the risk of loss to future earnings and future cash flows that may result from the failure of a borrower or counterparty to fulfill its contractual obligation to Fannie Mae. The Credit Guaranty business primarily generates income from guaranty fees for guaranteeing the timely payment of scheduled principal and interest on mortgage-related securities we guarantee that are not owned by the Portfolio Investment business. The primary source of income for the Credit Guaranty business is the

difference between the guaranty fees earned and the costs of providing this service. Income is also allocated to the Credit Guaranty business for the following activities:


	•	Managing the credit risk on mortgage-related assets held by the Portfolio Investment business. The Portfolio Investment business compensates the Credit Guaranty business through a guaranty fee comparable to an MBS guaranty fee. These fees are recognized as guaranty fee income by the Credit Guaranty business. Similarly, all credit expenses, including credit losses on loans and on MBS and other mortgage-related securities held in Fannie Mae’s mortgage portfolio, are allocated to the Credit Guaranty business for business segment reporting purposes. Net interest income for the Credit Guaranty business is net of charges paid to the Portfolio Investment business for forgone interest on delinquent loans.

	•	Providing capital to the Portfolio Investment business. The Portfolio Investment business also compensates the Credit Guaranty business for the temporary use of capital generated by the Credit Guaranty business, which the Portfolio Investment business uses to fund investments. This compensation is classified as net interest income.

	•	Temporarily investing principal and interest payments on loans underlying MBS and other mortgage-related securities prior to remittance to investors. Interest income on the temporary investment of these funds is allocated to the Credit Guaranty business.

Our Credit Guaranty business manages Fannie Mae’s mortgage credit risk by managing the profile and quality of mortgages in the mortgage credit book of business, using credit enhancements to reduce our losses, assessing the sensitivity of credit losses to changes in economic conditions, and aggressively managing problem assets to mitigate losses.

Revenue growth in our business lines is driven fundamentally by growth in residential mortgage debt outstanding. This market has usually been one of the strongest growth markets in the U.S. economy, typically growing faster than the gross domestic product (“GDP”). During the 1990s, mortgage debt outstanding grew 7 percent annually. Since 2000, MDO has grown at an average annual rate of 11.3 percent. Our economic projections indicate an average annual growth rate of 8 to 10 percent during the current decade due to four fundamental demographic and economic drivers: (1) projected growth in immigration, population, and household formation; (2) increased rates of homeownership particularly by minorities, whose homeownership rates lag the average by 20 percentage points; (3) continued growth in property values as the average home grows larger, demand remains strong, and supply remains constrained because of land shortages and growth restrictions; and (4) projected growth in debt-to-value ratios as consumers increasingly use the equity in their homes as a financial investment option. In addition, our business has typically grown faster than our market because of our efficiency, innovation, and low costs, which have helped make Fannie Mae a preferred source of liquidity for fixed-rate mortgages.

The expenses related to our lines of business stem largely from costs incurred to manage our two primary business risks—interest rate risk and credit risk. We have highly skilled teams of experienced risk management professionals who take an active, highly disciplined approach in managing these risks to meet our objective of delivering consistent earnings growth and target returns on capital in a wide range of economic environments. They have been successful in dispersing Fannie Mae’s risk and loss exposure over the years within the global financial system by developing various mortgage risk management tools that increase our level of expertise and efficiency in managing mortgage prepayment and credit risk.

RESULTS OF OPERATIONS

The following discussion of our results of operations is based on Fannie Mae’s reported results. We have reclassified certain amounts in our prior years’ reported results to conform to our current presentation. We provide a separate discussion of our core business earnings and business segment results in “MD&A—Core Business Earnings and Business Segment Results.”

Net Interest Income

Reported net interest income is the difference between interest income and interest expense. Net interest income represents a principal source of earnings for Fannie Mae and is affected by net volume, asset yield, and the cost of debt and certain derivatives. Reported net interest income subsequent to our adoption of FAS 133 only includes a portion of the cost associated with using purchased options to hedge the borrowers’ prepayment option in mortgages. Prior to the adoption of FAS 133, we amortized purchased options premiums on a straight-line basis and reflected the cost in our net interest income as a component of our interest expense. With the adoption of FAS 133, we now report the change in the fair value of the time value of purchased options in a separate income statement category “purchased options expense.” We also present net interest income and the related net interest yield on a taxable-equivalent basis to consistently reflect income from taxable and tax-exempt investments based on a 35 percent marginal tax rate.

Table 1 presents Fannie Mae’s net interest yield based on our reported net interest income adjusted for tax-exempt investments and average balances of mortgage assets, nonmortgage investments, and debt. The net interest yield calculation subsequent to our adoption of FAS 133 does not fully reflect the cost of our purchased options (see “MD&A—Core Business Earnings and Business Segment Results—Core Net Interest Income” for a discussion of our supplemental non-GAAP measures, core net interest income and net interest margin).

Table 1: Taxable-Equivalent Net Interest Income and Average Balances


			2002			2001			2000


			(Dollars in millions)
Interest income:
	Mortgage portfolio		$	49,265		$	46,478		$	39,403
	Nonmortgage investments and cash equivalents			1,588			2,692			3,378

	Total interest income			50,853			49,170			42,781

Interest expense⁽¹⁾:
	Short-term debt			2,978			5,897			4,204
	Long-term debt			37,309			35,183			32,903

	Total interest expense			40,287			41,080			37,107

Net interest income				10,566			8,090			5,674
	Taxable-equivalent adjustment on tax-exempt investments ⁽²⁾			502			470			414

Taxable-equivalent net interest income			$	11,068		$	8,560		$	6,088

Average balances⁽³⁾:
Interest-earning assets⁽⁴⁾:
	Mortgage portfolio, net		$	735,943		$	658,195		$	553,531
	Nonmortgage investments and cash equivalents			68,658			58,811			51,490

Total interest-earning assets				804,601			717,006			605,021
		Interest-free funds⁽⁵⁾		(23,992	)		(23,630	)		(20,595	)

Total interest-earning assets funded by debt			$	780,609		$	693,376		$	584,426

Interest-bearing liabilities⁽¹⁾:
	Short-term debt		$	141,727		$	137,078		$	73,351
	Long-term debt			638,882			556,298			511,075

Total interest-bearing liabilities			$	780,609		$	693,376		$	584,426

Average interest rates^{(2, 3)}:
Interest-earning assets:
	Mortgage portfolio, net			6.73	%		7.11	%		7.16	%
	Nonmortgage investments and cash equivalents			2.34			4.63			6.60

	Total interest-earning assets			6.35			6.90			7.11
	Interest-free return⁽⁵⁾			.18			.21			.25

Total interest-earning assets funded by debt				6.53			7.11			7.36

Interest-bearing liabilities⁽¹⁾:
	Short-term debt			1.90			4.16			5.70
	Long-term debt			5.88			6.35			6.44

	Total interest-bearing liabilities			5.15			5.92			6.35

Net interest yield				1.38	%		1.19	%		1.01	%


(1)	Classification of interest expense and interest-bearing liabilities as short-term or long-term is based on effective maturity or repricing date, taking into consideration the effect of derivative financial instruments.
(2)	Reflects non-GAAP adjustments to permit comparison of yields on tax-exempt and taxable assets based on 35 percent marginal tax rate.
(3)	Averages have been calculated on a monthly basis based on amortized cost.
(4)	Includes average balance of nonaccrual loans of $4.6 billion in 2002, $2.6 billion in 2001, and $2.1 billion in 2000.
(5)	Interest-free funds represent the portion of our investment portfolio funded by equity and non-interest bearing liabilities.

Taxable-equivalent net interest income totaled $11.068 billion in 2002, compared with $8.560 billion in 2001 and $6.088 billion in 2000. The increase of $2.508 billion, or 29 percent, in taxable-equivalent net interest income was due primarily to 12 percent growth in our average net mortgage portfolio and a higher net interest yield, which was favorably affected by the low interest rate environment and unusually steep yield curve. As mortgage interest rates fell to the lowest level in 40 years and fixed-rate mortgage originations reached record levels, we took advantage of opportunities to grow our mortgage portfolio at attractive spreads relative to our debt costs. Our net interest yield continued to benefit and remained elevated during 2002 because of actions we took during 2002 and 2001 to lower our debt costs by calling or retiring higher-cost debt and temporarily replacing it with shorter-term, lower-cost debt.

During 2001, taxable-equivalent net interest income increased $2.472 billion or 41 percent over 2000, partially due to the effect of the change in accounting for our purchased options under FAS 133. Our taxable-equivalent net interest income in 2001 does not include all of the cost of purchased options. However, our taxable-equivalent net interest income in 2000 includes $231 million of expense related to the amortization of purchased options premiums on a straight-line basis. Prior to the adoption of FAS 133, we recorded purchased options premiums as interest expense in our reported net interest income. FAS 133 changed our accounting for purchased options, requiring that we report changes in the fair value of the time value of purchased options instead of expensing purchased options premiums on a straight-line basis. We report changes in the fair value of the time value of our purchased options in a separate income statement category “purchased options expense.” Our taxable-equivalent net interest income in 2001 also benefited from 19 percent growth in our average net mortgage portfolio and a significant decrease in our debt costs that elevated our net interest yield. A reduction in intermediate-term rates during 2001 boosted mortgage refinancings and originations, fueling an increase in the supply of mortgage assets in the secondary market and attractive mortgage-to-debt spreads.

Table 2 shows the changes in our reported and taxable-equivalent net interest income between 2002 and 2001 and 2001 and 2000 attributable to changes in rates and volume on our mortgage assets, nonmortgage investments, and debt.

Table 2: Rate/ Volume Analysis of Reported Net Interest Income



					Attributable to
					Changes in⁽¹⁾
		Increase
		(Decrease)			Volume		Rate


		(Dollars in millions)
2002 vs. 2001

Interest income:
	Mortgage portfolio	$	2,787		$	5,292	$	(2,505	)
	Nonmortgage investments and cash equivalents		(1,104	)		394		(1,498	)

	Total interest income		1,683			5,686		(4,003	)

Interest expense:⁽²⁾
	Short-term debt		(2,919	)		194		(3,113	)
	Long-term debt		2,126			4,959		(2,833	)

	Total interest expense		(793	)		5,153		(5,946	)

Change in net interest income		$	2,476		$	533	$	1,943

Change in taxable-equivalent adjustment on tax-exempt investments⁽³⁾			32

Change in taxable-equivalent net interest income		$	2,508



					Attributable to
					Changes in⁽¹⁾
		Increase
		(Decrease)			Volume		Rate


		(Dollars in millions)
2001 vs. 2000

Interest income:
	Mortgage portfolio	$	7,075		$	7,393	$	(318	)
	Nonmortgage investments and cash equivalents		(686	)		434		(1,120	)

	Total interest income		6,389			7,827		(1,438	)

Interest expense:⁽²⁾
	Short-term debt		1,693			2,945		(1,252	)
	Long-term debt		2,280			2,868		(588	)

	Total interest expense		3,973			5,813		(1,840	)

Change in net interest income		$	2,416		$	2,014	$	402

Change in taxable-equivalent adjustment on tax-exempt investments⁽³⁾			56

Change in taxable-equivalent net interest income		$	2,472


(1)	Combined rate/volume variances, a third element of the calculation, are allocated to the rate and volume variances based on their relative size.
(2)	Classification of interest expense and interest-bearing liabilities as short-term or long-term is based on effective maturity or repricing date, taking into consideration the effect of derivative financial instruments.
(3)	Reflects non-GAAP adjustments to permit comparison of yields on tax-exempt and taxable assets based on a 35 percent marginal tax rate.

Guaranty Fee Income

Guaranty fee income reported in our total corporate results and our average guaranty fee rate primarily include guaranty fees we receive on mortgage-related securities we issue that are held by other investors. We classify guaranty fees on Fannie Mae mortgage-related securities held in our portfolio as net interest income. The guaranty fee income allocated for line of business reporting purposes to the Credit Guaranty business on mortgage-related securities held in our portfolio is eliminated by an equal and offsetting allocation of guaranty expense to the Portfolio Investment business. We exclude the administrative costs of managing outstanding MBS and other mortgage-related securities from guaranty fee income.

Guaranty fee income increased 23 percent or $334 million in 2002 to $1.816 billion and 10 percent in 2001 to $1.482 billion. The increases were driven primarily by a 22 percent increase in average outstanding MBS (MBS and other mortgage-related securities guaranteed by Fannie Mae and held by investors other than Fannie Mae) during 2002 and a 12 percent increase during 2001.

Our average guaranty fee rate on outstanding MBS during 2002 increased slightly to 19.1 basis points from 19.0 basis points in 2001. During the last half of 2002, our average effective guaranty fee rate rose as a result of higher fee rates on new business and the faster amortization of deferred fees as we adjusted our prepayment amortization rates to reflect the acceleration of mortgage prepayments in the heavy refinance environment. Our average effective guaranty fee rate declined by ..5 basis points between 2000 and 2001, primarily due to increased competition and general market conditions. Recently, rates on new credit guaranty products have been higher because of our efforts to better align our pricing with the relative underlying risks of loans we guarantee and expansion into market segments that demand higher guaranty fees. As a result of these trends, we anticipate a modest increase in our average effective guaranty fee rates in the future. Table 3 presents our average effective guaranty fee rate for the past three years.

Table 3: Guaranty Fee Data



	Year Ended December 31,

	2002		2001		2000


	(Dollars in millions)
Guaranty fee income	$	1,816	$	1,482	$	1,351
Average balance of outstanding MBS⁽¹⁾		950,232		779,647		694,165
Average effective guaranty fee rate (basis points)		19.1		19.0		19.5


(1)	“Outstanding MBS” refers to MBS and other mortgage-related securities guaranteed by Fannie Mae and held by investors other than Fannie Mae. If an MBS has been resecuritized into another MBS, we only include the principal amount once in the outstanding balance.

Fee and Other Income (Expense), Net

Fee and other income (expense) consists of transaction fees, technology fees, multifamily fees, and other miscellaneous items and is net of costs associated with the purchase of additional mortgage insurance to protect against credit losses (“credit enhancement expense”) and operating losses from certain tax-advantaged investments in affordable housing projects. These tax-advantaged investments represent equity interests in limited partnerships that own rental housing and generate tax credits, which reduce Fannie Mae’s effective federal income tax rate. We account for the majority of these investments using the equity method. We do not guarantee any obligations of these partnerships, and our exposure is limited to the amount of our investments. We record the tax benefit related to these investments as a reduction in the provision for federal income taxes and as an increase in taxable-equivalent revenues.

We recorded $232 million of fee and other income in 2002, up from $151 million of income in 2001. The $81 million increase in fee and other income was driven by a $114 million increase in transaction and technology fees resulting primarily from increased REMIC transaction volumes and a $69 million increase in net gains from the sale of securities. These increases were offset partially by a $78 million increase in credit enhancement expenses and a $61 million increase in impairment write-downs on a variety of investments. The increase in credit enhancement expenses was attributable to an increase in the volume of business covered by credit enhancements purchased directly by Fannie Mae, stemming from our expansion into new products and markets.

Fee and other income totaled $151 million for 2001, up $195 million over expense of $44 million recorded in 2000 primarily because of a $146 million increase in technology and transaction fees. The increase in technology and transaction fees resulted largely from greater use of Fannie Mae’s Desktop Underwriter and Desktop Originator systems and higher structured transaction fees, such as REMIC fees, attributable to record mortgage business volumes. A hedging loss on an anticipated Benchmark Notes® issuance that occurred in April 2000 also contributed to the year-over-year increase in fee and other income in 2001.

Credit-Related Expenses

Credit-related expenses include foreclosed property expenses (income) and the provision for losses. In 2002, we reclassified recoveries in excess of charged-off amounts on foreclosed properties from “charge-off recoveries” to “foreclosed property expense (income).” In addition, with the rescission of the American Institute of Certified Public Accountants (“AICPA”) Statement of Position 92-3, “Accounting for Foreclosed Assets” (“SOP 92-3”) in the fourth quarter of 2002, we now include estimated selling costs in the determination of our initial charge-off when we foreclose on a loan. We adjusted our provision for losses to reflect a charge equal to the net change in charge-offs. We have also retroactively reclassified any excess recoveries in previous periods for comparability purposes.

Credit-related expenses increased $14 million over 2001 to $92 million, primarily due to an increase in multifamily credit-related losses stemming from two properties. We recorded a provision for losses of $128 million in 2002, an increase of $34 million over 2001. The increase in our provision was partially offset by $20 million in additional foreclosed property income primarily due to gains on foreclosed property dispositions. Foreclosed property income totaled $36 million in 2002, compared with $16 million in 2001. The 2002

increase in credit-related expenses follows a $16 million decline in 2001 that was largely due to a reduction in our provision for losses. Our provision for losses decreased $28 million in 2001 to $94 million. We also had forgone interest on non-performing assets that reduced our net interest income by $148 million in 2002, $70 million in 2001, and $43 million in 2000. Although foreclosed single-family property acquisitions increased in 2002 to 19,500 from 14,486 in 2001 and 14,351 in 2000, average severities declined due to strong home prices and credit enhancement proceeds.

We previously recorded gains from the sale of foreclosed properties and related mortgage insurance claims against our allowance for losses as a recovery of charge-offs. During 2002, we reclassified these gains to foreclosed property expense (income). Additionally, the AICPA rescinded SOP 92-3 during the fourth quarter of 2002. Under SOP 92-3, we recorded selling costs related to the disposition of foreclosed properties in our income statement under foreclosed property expense (income). We now include selling costs in our initial charge-off estimate. All prior periods have been reclassified to conform to the current year presentation. The reclassified amounts result in equal and offsetting changes to our provision for losses and foreclosed property expense (income) line items within our previously reported income statements. These reclassifications have no impact on previously reported net income, total credit-related expenses, total credit-related losses, or the combined balance of the allowance for loan losses and guaranty liability.

Despite significant growth in our book of business and overall weaker economic conditions during 2002 and 2001, credit losses as a percentage of Fannie Mae’s average book of business have steadily declined to .5 basis points in 2002, from .6 basis points in 2001, and .7 basis points in 2000. Our book of business includes mortgages and MBS in our mortgage portfolio and outstanding MBS held by other investors. Credit losses include charge-offs (net of recoveries) and foreclosed property income. The strong appreciation in home prices during 2002 and 2001 helped in strengthening the credit risk profile of our book of business. In addition, we have been able to effectively manage credit risk by using credit enhancements to minimize our credit losses during the economic slowdown, monitoring and assessing the sensitivity of our credit risk to changes in the economic environment, and taking an aggressive approach to problem asset management.

Administrative Expenses

Administrative expenses include those costs incurred to run our daily operations, such as personnel costs and technology expenses.

Administrative expenses increased 20 percent to $1.219 billion in 2002. The above average growth in administrative expenses was due primarily to costs incurred on a multi-year project initiated in 2001 to re-engineer our core infrastructure systems and expenses associated with relocating our primary data center. In addition, compensation expense increased 13 percent to $683 million in 2002, resulting primarily from a 5 percent increase in the number of employees and annual salary increases.

Administrative expenses grew 12 percent to $1.017 billion in 2001 from $905 million in 2000, primarily due to increased compensation expense related to 8 percent growth in the number of employees and annual salary increases, increased costs related to the multi-year core infrastructure project, and a contribution of $10 million in 2001 to support victims and families of victims affected by the September 11 tragedy.

We evaluate growth in administrative expenses based on growth in taxable-equivalent revenues and our average book of business. Taxable-equivalent revenues is a supplemental non-GAAP measure discussed further in “MD&A — Core Business Earnings and Business Segment Results.” While administrative expenses have grown in the past two years, the ratio of administrative expenses to taxable-equivalent revenues, which we refer to as our efficiency ratio, has increased only modestly to 10.2 percent from 10.0 percent in 2001. Our efficiency ratio for 2002 and 2001 remained fairly steady and improved over the 11.6 percent level of 2000 primarily due to strong growth in net interest income during both years. The ratio of administrative expenses to our average book of business has also remained relatively stable at ..072 percent in 2002, compared with .071 percent in 2001, and .072 percent in 2000.

Special Contribution

Special contribution expense reflects a contribution we made to the Fannie Mae Foundation.

We committed during the fourth quarter of 2001 to contribute $300 million of our common stock to the Fannie Mae Foundation. The Fannie Mae Foundation creates affordable homeownership and housing opportunities through innovative partnerships and initiatives that build healthy, vibrant communities across the United States. It is a separate, private, nonprofit organization that we do not consolidate, but is supported solely by Fannie Mae. We expect the 2001 contribution to the Fannie Mae Foundation to reduce the Foundation’s need for contributions over the next several years. We acquired the shares through open market purchases and contributed them to the Foundation in the first quarter of 2002.

Purchased Options Expense

Purchased options expense includes the change in the fair value of the time value of purchased options in accordance with FAS 133. The change in the fair value of the time value of purchased options will vary from period to period with changes in interest rates, market pricing of options, and our derivative activity.

Our reported income results for 2002 were unfavorably affected by $4.545 billion in purchased options expense related to changes in the time value of purchased options, significantly more than the $37 million expense recorded in 2001. The substantial increase in expense during 2002 was caused by an increase in the average notional balance of caps and swaptions, two types of purchased options we commonly use to manage interest rate risk, to $287 billion in 2002 from $154 billion in 2001, coupled with a sharp decline in interest rates that resulted in a decrease in time value. Under FAS 133, we are not allowed to recognize in earnings changes in the intrinsic value of some of these options, which, in combination with the fair value of options in our mortgage assets and callable debt, would have more than offset the decrease in the time value of these options during 2002. Prior to the adoption of FAS 133 on January 1, 2001, we amortized premiums on purchased options into interest expense on a straight-line basis. In 2000, we recorded $231 million in purchased options amortization expense that is included as a component of net interest income.

During the fourth quarter of 2002, we refined our methodology for estimating the initial time value of interest rate caps at the date of purchase and prospectively adopted a preferred method that resulted in a $282 million pre-tax reduction in purchased options expense and increased our diluted EPS for 2002 by $.18. Under our previous valuation method, we treated the entire premium paid on purchased “at-the-money” caps as time value with no allocation to intrinsic value. Our new methodology allocates the initial purchase price to reflect the value of individual caplets, some of which are above the strike rate of the cap, which results in a higher intrinsic value and corresponding lower time value at the date of purchase. This approach is more consistent with our estimation of time value subsequent to the initial purchase date. This change does not affect the total expense that will be recorded in our income statement over the life of our caps and has no effect on our non-GAAP core business earnings measure.

Debt Extinguishments

Fannie Mae strategically repurchases or calls debt securities and related interest rate swaps on a regular basis as part of our interest rate risk management efforts and to reduce future debt costs. We record gains and losses on debt extinguishments in this category.

We recognized a pre-tax loss of $710 million in 2002 from the call and repurchase of debt, compared with a pre-tax loss of $524 million in 2001. Market conditions during 2002 and 2001 made it advantageous for us to repurchase $8 billion and $9 billion, respectively, of debt securities that were trading at historically wide spreads to other fixed-income securities. We also called over $174 billion of high-coupon debt securities and notional principal of interest rate swaps in 2002 and $173 billion in 2001. The weighted-average cost of redeemed debt and interest rate swaps in 2002 and 2001 was 5.36 percent and 6.23 percent, respectively. During 2000, we repurchased or called $18 billion in debt securities and notional principal of interest rate swaps carrying a weighted-average cost of 7.10 percent and recognized a gain of $49 million.

During the second quarter of 2002, we adopted Financial Accounting Standard No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections (“FAS 145”). This standard eliminates the extraordinary treatment of the gains and losses on our debt

repurchases because debt extinguishment is a normal and recurring component of our interest rate risk management strategy. For comparative purposes, we have reclassified all prior periods to conform to the current presentation.

Income Taxes

The provision for federal income taxes, including tax related to the cumulative effect of change in accounting principle, decreased to $1.429 billion in 2002 from $2.131 billion in 2001. The 2002 decrease in tax expense was primarily related to the tax benefit recorded on the increased purchased options expense. Our tax provision totaled $1.583 billion in 2000. The combined effect of our low income housing tax credits and the reduction in our 2002 pre-tax income from purchased options expense caused our effective tax rate on reported net income to decline to 24 percent from 27 percent in 2001 and 26 percent in 2000. Our effective tax rate based on our core business earnings, which is adjusted for the impact of FAS 133 on our purchased options, was 27 percent in 2002 and 26 percent in 2001 and 2000. See “MD&A—Core Business Earnings and Business Segment Results.”

Cumulative Effect of Change in Accounting Principle

Effective January 1, 2001, we adopted FAS 133, as amended by Financial Accounting Standard No. 138, Accounting for Derivative Instruments and Certain Hedging Activities— an amendment of FASB Statement No. 133. Our adoption of FAS 133 on January 1, 2001, resulted in a cumulative after-tax increase to income of $168 million ($258 million pre-tax) in 2001. The cumulative effect on earnings from the change in accounting principle was primarily attributable to recording the fair value of the time value of purchased options, which are used as a substitute for callable debt securities.

CORE BUSINESS EARNINGS AND BUSINESS SEGMENT RESULTS

Management relies primarily on core business earnings, a supplemental non-GAAP measure developed in conjunction with our January 1, 2001 adoption of FAS 133, to evaluate Fannie Mae’s financial performance. While core business earnings is not a substitute for GAAP net income, we rely on core business earnings in operating our business because we believe core business earnings provides our management and investors with a better measure of our financial results and better reflects our risk management strategies than our GAAP net income. Core business earnings excludes the unpredictable volatility in the time value of purchased options because we generally intend to hold these options to maturity, and we do not believe the period-to-period variability in our reported net income from changes in the time value of our purchased options accurately reflects the underlying risks or economics of our hedging strategy. Core business earnings includes amortization of purchased options premiums on a straight-line basis over the original expected life of the options. The net amount of purchased options amortization expense recorded under our core business earnings measure will equal the net amount of purchased options expense ultimately recorded under FAS 133 in our reported net income over the life of our options. However, our amortization treatment is more consistent with the accounting for embedded options in our callable debt and more accurately reflects the underlying economics of our use of purchased options as a substitute for issuing callable debt— two alternate hedging strategies that are economically very similar but require different accounting under FAS 133.

Management also relies on several other non-GAAP performance measures related to core business earnings to evaluate Fannie Mae’s performance. These key performance measures include taxable-equivalent revenues, core net interest income, and net interest margin. We discuss these measures further in this section and provide a discussion of our business segments, which we also evaluate based on core business earnings. Our core business earnings measures are not defined terms within GAAP and may not be comparable to similarly titled measures reported by other companies.

Core Business Earnings

We delivered record core business earnings in 2002 for the 16th consecutive year. Core business earnings increased 19 percent over 2001 to $6.394 billion due primarily to strong mortgage portfolio and net interest

margin growth. Our core business earnings in 2001 grew 21 percent over 2000 to $5.367 billion, also due to strong portfolio and net interest margin growth.

2002 financial highlights include:


	•	17 percent increase in total taxable-equivalent revenues

	•	12 percent growth in the average net mortgage portfolio

	•	16 percent increase in the total book of business

	•	4 basis point increase in the net interest margin

	•	Decline in our credit loss ratio to .5 basis points from .6 basis points in 2001

While our core business earnings measures should not be construed by investors as an alternative to net income and other measures determined in accordance with GAAP, they are critical performance indicators for Fannie Mae’s management. Core business earnings is the primary financial performance measure used by Fannie Mae’s management not only in developing the financial plans of our lines of business and tracking results, but also in establishing corporate performance targets and determining incentive compensation. In addition, the investment analyst community has traditionally relied on our core business earnings measures to evaluate Fannie Mae’s earnings performance and to issue earnings guidance. We believe these measures also can serve as valuable assessment tools for investors to judge the quality of our earnings because they provide more consistent accounting and reporting for economically similar interest rate risk hedging transactions, which allows investors to more readily identify sustainable trends and gauge potential future earnings trends.

Table 4 shows our line of business and consolidated core business earnings results for 2002, 2001, and 2000. We have reclassified certain amounts in our prior years’ results to conform to our current presentation. The only difference in core business earnings and reported net income relates to the FAS 133 accounting treatment for purchased options, which affects our Portfolio Investment business. The FAS 133 related reconciling items between our core business earnings and reported results have no effect on our Credit Guaranty business.

Table 4: Reconciliation of Core Business Earnings to Reported Results



		2002⁽¹⁾

											Reconciling
								Total Core			Items Related
		Portfolio			Credit			Business			to Purchased			Reported
		Investment			Guaranty			Earnings			Options			Results


		(Dollars in millions)
Net interest income		$	9,869		$	697		$	10,566		$	—		$	10,566
Purchased options amortization expense			(1,814	)		—			(1,814	)		1,814	^(a)		—

Core net interest income			8,055			697			8,752			1,814			10,566
Guaranty fee income (expense)			(1,374	)		3,190			1,816			—			1,816
Fee and other income (expense), net			348			(116	)		232			—			232
Credit-related expenses⁽²⁾			—			(92	)		(92	)		—			(92	)
Administrative expenses			(357	)		(862	)		(1,219	)		—			(1,219	)
Purchased options expense under FAS 133			—			—			—			(4,545	)^(b)		(4,545	)
Debt extinguishments, net			(710	)		—			(710	)		—			(710	)

Income before federal income taxes			5,962			2,817			8,779			(2,731	)		6,048
Provision for federal income taxes			(1,747	)		(638	)		(2,385	)		956	^(d)		(1,429	)

	Net income	$	4,215		$	2,179		$	6,394		$	(1,775	)	$	4,619



		2001⁽¹⁾

											Reconciling
								Total Core			Items Related
		Portfolio			Credit			Business			to Purchased			Reported
		Investment			Guaranty			Earnings			Options			Results

Net interest income		$	7,369		$	721		$	8,090		$	—		$	8,090
Purchased options amortization expense			(590	)		—			(590	)		590	^(a)		—

Core net interest income			6,779			721			7,500			590			8,090
Guaranty fee income (expense)			(1,109	)		2,591			1,482			—			1,482
Fee and other income (expense), net			211			(60	)		151			—			151
Credit-related expenses⁽²⁾			—			(78	)		(78	)		—			(78	)
Administrative expenses			(302	)		(715	)		(1,017	)		—			(1,017	)
Special contribution			(192	)		(108	)		(300	)		—			(300	)
Purchased options expense under FAS 133			—			—			—			(37	)^(b)		(37	)
Debt extinguishments, net			(524	)		—			(524	)		—			(524	)

Income before federal income taxes and effect of accounting change			4,863			2,351			7,214			553			7,767
Cumulative effect of accounting change, net of tax effect			—			—			—			168	^(c)		168
Provision for federal income taxes			(1,374	)		(473	)		(1,847	)		(194	)^(d)		(2,041	)

	Net income	$	3,489		$	1,878		$	5,367		$	527		$	5,894



		2000

											Reconciling
								Total Core			Items Related
		Portfolio			Credit			Business			to Purchased		Reported
		Investment			Guaranty			Earnings			Options		Results

Net interest income		$	5,055		$	619		$	5,674		$	—	$	5,674
Purchased options amortization expense			—			—			—			—		—
Core net interest income			5,055			619			5,674			—		5,674

Guaranty fee income (expense)			(1,079	)		2,430			1,351			—		1,351
Fee and other income (expense), net			27			(71	)		(44	)		—		(44	)
Credit-related expenses⁽²⁾			—			(94	)		(94	)		—		(94	)
Administrative expenses			(254	)		(651	)		(905	)		—		(905	)
Debt extinguishments, net			49			—			49			—		49

Income before federal income taxes			3,798			2,233			6,031			—		6,031
Provision for federal income taxes			(1,053	)		(530	)		(1,583	)		—		(1,583	)

	Net income	$	2,745		$	1,703		$	4,448		$	—	$	4,448


(1)	Reported net income for 2002 and 2001 includes the effect of FAS 133, which was adopted on January 1, 2001.
(2)	Credit-related expenses include the income statement line items “Provision for losses” and “Foreclosed property expense (income).”

While the reconciling items to derive our core business earnings are significant components in understanding and assessing our reported results and financial performance, investors may not be able to directly discern the underlying economic impact of our interest rate risk management strategies without our core business results. We believe our core business earnings measures help to improve transparency and enhance investors’ understanding of our operations, as well as facilitate trend analysis. The specific FAS 133 related adjustments affecting our Portfolio Investment business that we identify in Table 4 include:


(a)	Purchased options amortization expense: This amount represents the straight-line amortization of purchased options premiums over the original expected life of the options that we include in our core net interest income. We include this amount in core business earnings instead of recording changes in the time value of purchased options because it is more consistent with the accounting for the embedded options in our callable debt and the vast majority of our mortgages.

(b)	Purchased options expense: This amount, which is recorded in our income statement under purchased options expense, represents changes in the fair value of the time value of purchased options recorded in accordance with FAS 133. We exclude this amount from our core business earnings measure because the period-to-period fluctuations in the time value portion of our options does not reflect the economics of our current risk management strategy, which generally is to hold our purchased options to maturity or exercise date. Consequently, we do not expect to realize the period-to-period fluctuations in time value.

(c)	Cumulative after-tax gain upon adoption of FAS 133: This non-recurring amount represents the one-time transition recorded upon the adoption of FAS 133 on January 1, 2001. We exclude the transition gain from core business earnings because it relates to unrealized gains on purchased options that were recorded when we adopted FAS 133.

(d)	Provision for federal income taxes adjustment: Represents the net federal income tax effect of core business earnings adjustments based on the applicable federal income tax rate of 35 percent.

Core business earnings does not exclude any other accounting effects related to the application of FAS 133 or any other non-FAS 133 related adjustments. The guaranty fee income that we allocate to the Credit Guaranty business for managing the credit risk on mortgage-related assets held by the Portfolio Investment business is offset by a corresponding guaranty fee expense allocation to the Portfolio Investment business in our line of business results. Thus, there is no inter-segment elimination adjustment between our total line of business guaranty fee income and our reported guaranty fee income. We allocate transaction fees received for structuring and facilitating securities transactions for our customers primarily to our Portfolio Investment business. We allocate technology-related fees received for providing Desktop Underwriter and other on-line services and fees received for providing credit enhancement alternatives to our customers primarily to our Credit Guaranty business.

As discussed in “MD&A—Risk Management— Interest Rate Risk— Derivative Instruments,” we use various funding alternatives, including option-based derivative instruments, that produce similar economic results to manage interest rate risk and protect against the prepayment option in mortgages. The adjustments made to our Portfolio Investment business to derive core business earnings provide consistent accounting treatment for purchased options and the embedded option in callable debt securities— economically equivalent funding transactions— by allocating the cost of purchased options on a straight-line basis over the original expected life of the option in a manner similar to our accounting for options in callable debt. We calculate the original expected life of “European” options based on the exercise date. We calculate the original expected life of “American” options based on the expected life at the time the option is purchased. There is a difference in the original expected lives of European and American options because European options are exercisable only on one specific date in the future, while American options are exercisable any time after a specific future date. The actual life of an American option may differ from our original expected life because of movements in interest rates subsequent to the exercise date that may affect the value and benefit of exercising the option at a given time.

We can protect our net interest margin against changes in interest rates by either issuing callable debt to fund the purchase of mortgages or using a combination of callable debt, purchased options, and noncallable

debt. We generally use the method that helps us achieve our desired funding flexibility and lowest cost. If interest rates fall and our mortgages prepay, we have the option of retiring callable debt and issuing debt at a lower rate to preserve our interest spread on new mortgage purchases. If interest rates fall and we have instead used a combination of noncallable debt and purchased options— such as a swaption that would allow us to enter into a pay-variable interest rate swap— we can exercise our option to allow us to pay a variable or lower interest rate and receive a fixed rate of interest. The fixed rate of interest that we receive would offset the cost of our noncallable, fixed-rate debt. This hedging strategy would lower our funding costs and preserve our net interest margin as interest rates fall in a manner very similar to retiring callable debt and issuing new, lower cost debt. However, because the accounting for this hedging strategy is different under FAS 133, the cost of the purchased option would not be reflected in our reported net interest yield. We would be required to record the change in the fair value of the time value of the purchased option as a separate amount in our income statement. On the other hand, if interest rates increase, we would not exercise the option to call debt since the cost of issuing new debt would be higher. Similarly, we would not exercise the option provided by a purchased swaption to enter a pay-variable swap because under a higher interest rate environment, we could enter into a similar transaction with more favorable terms. See “MD&A— Risk Management— Interest Rate Risk Management— Derivative Instruments” for further discussion on how we use purchased options to simulate callable debt.

If we issue noncallable debt and purchased options to fund the purchase of mortgages and protect against the prepayment option in mortgages, we are required under FAS 133 to record the unrealized period-to-period fluctuations in the changes in time value of the purchased options in earnings. If instead, we issue callable debt to fund the purchase of the same mortgages, the expense related to the option in our callable debt would be recognized ratably over the option period as part of interest expense. Although the two transactions produce similar economic results, GAAP requires different accounting treatment. Under our core business earnings measure, the accounting treatment for purchased options is consistent and also comparable to the accounting treatment applied to these items in periods prior to the adoption of FAS 133.

Taxable-Equivalent Revenues

Taxable-equivalent revenues represent total revenues adjusted to reflect the benefits of investment tax credits and tax-exempt income based on applicable federal income tax rates and is net of the straight-line amortization of purchased options expense that would have been recorded prior to the adoption of FAS 133. For analytical purposes, we calculate revenues on a taxable-equivalent basis to measure income from lower yielding investments that are tax-exempt or generate tax credits on a basis comparable to higher yielding taxable investments.

Table 5 compares taxable-equivalent revenues and the components for 2002, 2001, and 2000.

Table 5: Taxable-Equivalent Revenues



		Year Ended December 31,

		2002			2001			2000


		(Dollars in millions)
Net interest income		$	10,566		$	8,090		$	5,674
Guaranty fee income			1,816			1,482			1,351
Fee and other income (expense), net⁽¹⁾			232			151			(44	)

	Total revenues		12,614			9,723			6,981
Taxable-equivalent adjustments:
	Investment tax credits⁽²⁾		594			584			430
	Tax-exempt investments⁽³⁾		502			470			414
Purchased options amortization expense⁽⁴⁾			(1,814	)		(590	)		—

Taxable-equivalent revenues		$	11,896		$	10,187		$	7,825


(1)	Includes net losses on certain tax-advantaged investments totaling $225 million, $222 million, and $188 million in 2002, 2001, and 2000, respectively.
(2)	Represents non-GAAP taxable-equivalent adjustments for tax credits related to losses on certain affordable housing tax- advantaged equity investments and other investment tax credits using the applicable federal income tax rate of 35 percent.
(3)	Reflects non-GAAP adjustments to permit comparisons of yields on tax-exempt and taxable assets based on a 35 percent marginal tax rate.
(4)	Represents non-GAAP adjustment for straight-line amortization of purchased options premiums that would have been recorded prior to the adoption of FAS 133 in 2001. This expense is included in net interest income in 2000.

Taxable-equivalent revenues increased 17 percent to $11.896 billion in 2002, compared with a 30 percent increase in 2001 to $10.187 billion. The increase in both years was primarily attributable to growth in net interest income resulting from the low rate environment that contributed to strong mortgage portfolio growth and a reduction in our average cost of debt relative to our mortgage asset yields. Tighter mortgage-to-debt spreads reduced mortgage portfolio growth during the first half of 2002 and slowed the increase in taxable-equivalent revenues to levels more in line with our expectations. Our 2001 growth rate was higher than expected because of the increased supply of mortgages in the secondary market and attractive mortgage-to-debt spreads.

Core Net Interest Income

Core net interest income and our related net interest margin are supplemental non-GAAP measures that management uses to evaluate Fannie Mae’s performance. Core net interest income includes our reported net interest income adjusted for the non-GAAP amortization of purchased options premiums on a straight-line basis over the original expected life of the options to reflect the cost associated with using purchased options to hedge the borrowers’ prepayment option in mortgages. We also calculate core net interest income on a taxable-equivalent basis to determine our net interest margin. We believe these measures are beneficial in understanding and analyzing Fannie Mae’s performance because they reflect consistent accounting for purchased options and callable debt, two of the principal instruments we use interchangeably to hedge the prepayment option in our mortgage investments. These measures also consistently reflect income from taxable and tax-exempt investments.

Table 6 reconciles taxable-equivalent core net interest income to our reported net interest income and presents an analysis of our net interest margin based on the average balances and yields of mortgage assets, nonmortgage investments, and debt. Our taxable-equivalent core net interest income and net interest margin are significantly different than our reported taxable-equivalent net interest income and net interest yield because our core measures include the amortization of our purchased options premiums on a straight-line basis over the life of the option, which is not in accordance with GAAP.


Table 6:	Taxable-Equivalent Core Net Interest Income and Average Balances


		2002			2001			2000


		(Dollars in millions)

Net interest income		$	10,566		$	8,090		$	5,674
	Purchased options amortization expense⁽¹⁾		(1,814	)		(590	)		—

Core net interest income			8,752			7,500			5,674
	Taxable-equivalent adjustment on tax-exempt investments ⁽²⁾		502			470			414

Taxable-equivalent core net interest income		$	9,254		$	7,970		$	6,088

Average balances:⁽³⁾
Interest-earning assets:⁽⁴⁾
	Mortgage portfolio, net	$	735,943		$	658,195		$	553,531
	Nonmortgage investments and cash equivalents		68,658			58,811			51,490

Total interest-earning assets			804,601			717,006			605,021
	Interest-free funds⁽⁵⁾		(23,992	)		(23,630	)		(20,595	)

Total interest-earning assets funded by debt		$	780,609		$	693,376		$	584,426

Interest-bearing liabilities:⁽⁶⁾
	Short-term debt	$	141,727		$	137,078		$	73,351
	Long-term debt		638,882			556,298			511,075

Total interest-bearing liabilities		$	780,609		$	693,376		$	584,426

Average interest rates:^{(2, 3)}
Interest-earning assets:
	Mortgage portfolio, net		6.73	%		7.11	%		7.16	%
	Nonmortgage investments and cash equivalents		2.34			4.63			6.60

	Total interest-earning assets		6.35			6.90			7.11
	Interest-free return⁽⁵⁾		.18			.21			.25

Total interest-earning assets funded by debt			6.53			7.11			7.36

Interest-bearing liabilities:⁽⁶⁾
	Short-term debt		2.15			4.28			5.70
	Long-term debt		6.10			6.43			6.44

	Total interest-bearing liabilities		5.38			6.00			6.35

Net interest margin			1.15	%		1.11	%		1.01	%


(1)	Reflects non-GAAP adjustment for straight-line amortization of purchased options premiums that would have been recorded prior to the adoption of FAS 133 in 2001.


(2)	Reflects non-GAAP adjustments to permit comparison of yields on tax-exempt and taxable assets based on a 35 percent marginal tax rate.


(3)	Averages have been calculated on a monthly basis based on amortized cost.


(4)	Includes average balance of nonaccrual loans of $4.6 billion in 2002, $2.6 billion in 2001, and $2.1 billion in 2000.


(5)	Interest-free funds represent the portion of our investment portfolio funded by equity and non-interest bearing liabilities.


(6)	Classification of interest expense and interest-bearing liabilities as short-term or long-term is based on effective maturity or repricing date, taking into consideration the effect of derivative financial instruments. The cost of debt includes expense for the amortization of purchased options.

Taxable-equivalent core net interest income totaled $9.254 billion in 2002, compared with $7.970 billion in 2001 and $6.088 billion in 2000. The $1.284 billion or 16 percent increase in taxable-equivalent core net interest income during 2002 was due primarily to a 12 percent increase in our average net mortgage portfolio and a 4 basis point increase in the net interest margin to 1.15 percent. During 2001, taxable-equivalent core net interest income increased $1.882 billion or 31 percent as the average net mortgage portfolio grew by 19 percent, and the net interest margin expanded by 10 basis points to 1.11 percent. Table 7 shows the changes in taxable-equivalent core net interest income for 2002 and 2001 attributable to changes in rates and the

volume of our mortgage assets, nonmortgage investments, and debt and changes in purchased options amortization expense and taxable-equivalent adjustments.

Table 7: Rate/ Volume Analysis of Core Net Interest Income



					Attributable to
					Changes in⁽¹⁾
		Increase
		(Decrease)			Volume		Rate


		(Dollars in millions)
2002 vs. 2001
Interest income:
	Mortgage portfolio	$	2,787		$	5,292	$	(2,505	)
	Nonmortgage investments and cash equivalents		(1,104	)		394		(1,498	)

	Total interest income		1,683			5,686		(4,003	)

Interest expense⁽²⁾:
	Short-term debt		(2,919	)		194		(3,113	)
	Long-term debt		2,126			4,959		(2,833	)

	Total interest expense		(793	)		5,153		(5,946	)

Change in net interest income		$	2,476		$	533	$	1,943

	Change in purchased options amortization expense⁽³⁾		(1,224	)

Change in core net interest income			1,252
	Change in taxable-equivalent adjustment on tax-exempt investments⁽⁴⁾		32

Change in taxable-equivalent core net interest income		$	1,284

2001 vs. 2000
Interest income:
	Mortgage portfolio	$	7,075		$	7,393	$	(318	)
	Nonmortgage investments and cash equivalents		(686	)		434		(1,120	)

	Total interest income		6,389			7,827		(1,438	)

Interest expense⁽²⁾:
	Short-term debt		1,693			2,945		(1,252	)
	Long-term debt		2,280			2,868		(588	)

	Total interest expense		3,973			5,813		(1,840	)

Change in net interest income		$	2,416		$	2,014	$	402

	Change in purchased options amortization expense⁽³⁾		(590	)

Change in core net interest income			1,826
	Change in taxable-equivalent adjustment on tax-exempt investments⁽⁴⁾		56

Change in taxable-equivalent core net interest income		$	1,882


(1)	Combined rate/volume variances, a third element of the calculation, are allocated to the rate and volume variances based on their relative size.

(2)	Classification of interest expense and interest-bearing liabilities as short-term or long-term is based on effective maturity or repricing date, taking into consideration the effect of derivative financial instruments.

(3)	Reflects non-GAAP adjustment for straight-line amortization of purchased options premiums that would have been recorded prior to the adoption of FAS 133 in 2001.

(4)	Reflects non-GAAP adjustments to permit comparison of yields on tax-exempt and taxable assets based on a 35 percent marginal tax rate.

Business Segment Results

Portfolio Investment Business

Core business earnings for our Portfolio Investment business totaled $4.215 billion in 2002, compared with $3.489 billion in 2001, and $2.745 billion in 2000. Core business earnings grew 21 percent in 2002, down from 27 percent growth in 2001. Growth in mortgage debt outstanding, combined with our ability to offer reliable, low-cost mortgage funds, helped us grow our average net mortgage portfolio by 12 percent in 2002

despite a record level of liquidations. The Portfolio Investment business also capitalized on opportunities presented by the decline in interest rates that began in 2001 to reduce our debt costs and increase the net interest margin 4 basis points to 115 basis points. In 2001, the average net mortgage portfolio grew 19 percent and the net interest margin increased 10 basis points to 111 basis points.

Low mortgage rates boosted originations of fixed-rate mortgages in the primary market to record levels in 2002. However, during the first half of 2002, primary market lenders retained a higher than traditional level of mortgage loans in their own portfolios. The demand for mortgage investments also increased among other secondary market participants. We believe this occurrence was in response to equity market volatility and the perceived safety of mortgage-related investments in a period of significant uncertainty about the impact of the economy on corporate creditworthiness. In addition, the steep yield curve lowered borrowing costs for banks and other primary market participants, which made it more attractive to hold mortgage investments. The increased competition for mortgages in the first half of 2002 resulted in tighter spreads between mortgage yields and our debt costs (mortgage-to-debt spreads), which slowed our overall portfolio growth. Our portfolio growth accelerated in the second half of the year as a sharp drop in mortgage rates sparked a refinancing wave that increased the supply of mortgages in the secondary market and generated wider mortgage-to-debt spreads. We substantially increased our mortgage commitments in response to these more attractive spreads. We also experienced higher portfolio growth in 2001 because of attractive mortgage-to-debt spreads stemming from an increased supply of mortgage assets in the secondary market because of a reduction in intermediate-term rates that boosted mortgage refinancings and originations.

The sharp decline in short-term interest rates relative to long-term interest rates during 2001 resulted in a steeper yield curve that persisted throughout 2002. Our net interest margin in 2002 continued to benefit from actions taken during 2001 in response to opportunities presented by the unusually steep yield curve and low short-term interest rates. The Portfolio Investment business was able to replace significant amounts of called or maturing debt in 2001 with lower cost, shorter-term debt more quickly than our mortgage assets matured or prepaid. These actions temporarily reduced our debt cost relative to asset yield and elevated our net interest margin in 2001. Our net interest margin remained elevated in 2002 as the unusually steep yield curve and low interest rate environment persisted, and we called or otherwise retired additional high-cost debt.

Primary investing activities for the Portfolio Investment business include purchasing mortgage loans, mortgage-related securities, and other investments from lenders, securities dealers, investors, and other market participants. The Portfolio Investment business also issues real estate mortgage investment conduits (“REMICs”), Megas, and SMBS as a source of fee income. The Portfolio Investment business maintains the LIP, which consists of nonmortgage investments and serves as an alternative source of liquidity and an investment vehicle for our surplus capital. Our primary financing activities involve issuing various debt securities to fund our mortgage purchases and other business activities.

Mortgage Portfolio

Our mortgage portfolio includes whole loan mortgages, mortgage-related securities, and other mortgage investments, including other agency securities purchased from lenders, securities dealers, investors, and other market participants. We grew our net mortgage portfolio by 13 percent to $798 billion at December 31, 2002. In comparison, we expanded our net mortgage portfolio by 16 percent in 2001. We grew our portfolio more selectively and at a slower pace in 2002 in accordance with our disciplined approach to growth because of tighter mortgage-to-debt spreads during the first half of 2002. Table 8 shows the distribution of Fannie Mae’s mortgage portfolio by product type.

Table 8: Mortgage Portfolio Composition⁽¹⁾


				2002			2001			2000			1999			1998


				(Dollars in millions)
Mortgages
Single-family:
	Government insured or guaranteed			$	5,458		$	5,070		$	4,762		$	4,472		$	4,404

	Conventional:
		Long-term, fixed-rate			103,220			96,417			87,005			86,787			87,739
		Intermediate-term, fixed-rate⁽²⁾			54,503			43,522			39,134			43,878			47,818
		Adjustable-rate			9,045			10,410			13,243			6,058			7,632

			Total conventional single-family		166,768			150,349			139,382			136,723			143,189

Total single-family					172,226			155,419			144,144			141,195			147,593

Multifamily:
	Government insured or guaranteed				1,353			1,551			1,814			2,347			2,594
	Conventional				12,218			8,987			6,547			5,564			5,591

Total multifamily					13,571			10,538			8,361			7,911			8,185

Total mortgages				$	185,797		$	165,957		$	152,505		$	149,106		$	155,778

Mortgage-related securities
Single-family:
	Government insured or guaranteed			$	33,293		$	37,111		$	39,404		$	36,557		$	17,401

	Conventional:
		Long-term, fixed-rate			510,435			456,046			367,344			298,534			209,367
		Intermediate-term, fixed-rate⁽²⁾			39,409			25,890			27,965			25,317			23,948
		Adjustable-rate			13,946			10,355			13,892			8,049			4,241

			Total conventional single-family		563,790			492,291			409,201			331,900			237,556

Total single-family					597,083			529,402			448,605			368,457			254,957

Multifamily:
	Government insured or guaranteed				7,370			6,481			5,370			4,392			2,765
	Conventional				7,050			5,636			3,642			1,986			1,015

Total multifamily					14,420			12,117			9,012			6,378			3,780

Total mortgage-related securities				$	611,503		$	541,519		$	457,617		$	374,835		$	258,737

Mortgage portfolio, net
Single-family:
	Government insured or guaranteed			$	38,751		$	42,181		$	44,166		$	41,029		$	21,805

	Conventional:
		Long-term, fixed-rate			613,655			552,463			454,349			385,321			297,106
		Intermediate-term, fixed-rate⁽²⁾			93,912			69,412			67,099			69,195			71,766
		Adjustable-rate			22,991			20,765			27,135			14,107			11,873

			Total conventional single-family		730,558			642,640			548,583			468,623			380,745

Total single-family					769,309			684,821			592,749			509,652			402,550

Multifamily:
	Government insured or guaranteed				8,723			8,032			7,184			6,739			5,359
	Conventional				19,268			14,623			10,189			7,550			6,606

Total multifamily					27,991			22,655			17,373			14,289			11,965

Total mortgage portfolio					797,300			707,476			610,122			523,941			414,515
	Unamortized premium (discount) and deferred price adjustments, net⁽³⁾				472			(2,104	)		(2,520	)		(964	)		919
	Allowance for loan losses⁽⁴⁾				(79	)		(48	)		(51	)		(56	)		(79	)

Mortgage portfolio, net				$	797,693		$	705,324		$	607,551		$	522,921		$	415,355


(1)	Amounts presented have been restated to conform to the current year presentation. Data represents unpaid principal balance adjusted to include mark-to-market gains and losses on available-for-sale securities.

(2)	Intermediate-term, fixed-rate consists of portfolio loans with contractual maturities at purchase equal to or less than 20 years and MBS and other mortgage-related securities held in portfolio with maturities of 15 years or less at issue date.

(3)	Includes net unamortized premiums of $135 million, $536 million, and $559 million at December 31, 2002, 2001, and 1998, respectively, and net unamortized discounts of $2,311 million and $586 million at December 31, 2000 and 1999, respectively, related to available-for-sale and held-to-maturity mortgage-related securities.

(4)	Guaranty liability for probable losses on loans underlying Fannie Mae guaranteed MBS is included in “Guaranty liability for MBS.”

The average yield on our net mortgage portfolio decreased to 6.73 percent in 2002, from 7.11 percent in 2001, and 7.16 percent in 2000. The decrease in yield during 2002 and 2001 resulted largely from the general decline in mortgage rates on loans originated in the primary market and sold into the secondary market plus an increase in the level of liquidations of older, higher-rate loans. The liquidation rate on mortgages in portfolio (excluding sales) increased to 37 percent in 2002 from 25 percent in 2001— more than triple the 2000 liquidation rate of 10 percent. Mortgage liquidations in 2002, 2001, and 2000 totaled $277 billion, $164 billion, and $57 billion, respectively. Liquidations increased significantly in 2002 and 2001 largely because of extensive refinancing in response to falling mortgage interest rates.

Table 9 summarizes mortgage portfolio activity on a gross basis and average yields from 2000 through 2002.


Table 9:	Mortgage Portfolio Activity⁽¹⁾



			Purchases									Sales						Repayments⁽²⁾

			2002			2001			2000			2002		2001		2000		2002			2001			2000


			(Dollars in millions)
Single-family:
	Government insured or guaranteed		$	9,493		$	6,001		$	6,940		$	139	$	—	$	521	$	13,057		$	8,125		$	3,423

	Conventional:
		Long-term, fixed-rate		280,815			226,516			113,444			8,253		7,621		9,219		216,218			120,787			35,208
		Intermediate-term, fixed-rate		62,102			26,146			11,607			464		442		599		37,544			23,391			13,105
		Adjustable-rate		10,739			3,777			17,683			347		228		374		8,806			9,937			4,293

	Total conventional single-family			353,656			256,439			142,734			9,064		8,291		10,192		262,568			154,115			52,606

	Total single-family			363,149			262,440			149,674			9,203		8,291		10,713		275,625			162,240			56,029
Multifamily				7,492			8,144			4,557			379		690		269		1,794			2,172			1,204

	Total		$	370,641		$	270,584		$	154,231		$	9,582	$	8,981	$	10,982	$	277,419		$	164,412		$	57,233

Average net yield				5.92	%		6.56	%		7.62	%								6.83	%		7.23	%		7.18	%
Repayments as a percentage of average mortgage portfolio																			37.4	%		24.7	%		10.3	%


(1)	Excludes premiums, discounts, and other deferred price adjustments.

(2)	Includes mortgage loan prepayments, scheduled amortization, and foreclosures.

We classify mortgage loans on our balance sheet as either held-for-investment or held-for-sale. Our mortgage portfolio also includes MBS and other mortgage-related securities that we classify as either held-to-maturity or available-for-sale. On September 13, 2002, concurrent with the implementation of a new risk-based capital rule issued by OFHEO, we reclassified $124 billion of securities in our mortgage portfolio from held-to-maturity to available-for-sale in accordance with Financial Accounting Standard No. 115, Accounting for Certain Investments in Debt and Equity Securities (“FAS 115”). At the time of this noncash transfer, these mortgage-related securities had gross unrealized gains of $5.364 billion and unrealized losses of $53 million. Table 10 shows gross unrealized gains and losses on our MBS and mortgage-related securities at the end of 2002, 2001, and 2000.

Table 10: Mortgage-Related Securities in Mortgage Portfolio



			2002

					Gross		Gross
			Amortized		Unrealized		Unrealized			Fair
			Cost⁽¹⁾		Gains		Losses			Value


			(Dollars in millions)
Held-to-maturity:
	MBS⁽²⁾		$	286,422	$	11,173	$	(1	)	$	297,594
	REMICs and Stripped MBS			110,423		4,339		(87	)		114,675
	Other mortgage-related securities			41,087		2,813		(45	)		43,855

		Total	$	437,932	$	18,325	$	(133	)	$	456,124

Available-for-sale:
	MBS⁽²⁾		$	116,081	$	5,425	$	(1	)	$	121,505
	REMICs and Stripped MBS			33,763		678		(369	)		34,072
	Other mortgage-related securities			17,358		782		(11	)		18,129

		Total	$	167,202	$	6,885	$	(381	)	$	173,706



			2001

					Gross		Gross
			Amortized		Unrealized		Unrealized			Fair
			Cost⁽¹⁾		Gains		Losses			Value

Held-to-maturity:
	MBS⁽²⁾		$	333,896	$	3,536	$	(54	)	$	337,378
	REMICs and Stripped MBS			127,675		2,432		(579	)		129,528
	Other mortgage-related securities			47,584		1,411		(87	)		48,908

		Total	$	509,155	$	7,379	$	(720	)	$	515,814

Available-for-sale:
	MBS⁽²⁾		$	9,119	$	105	$	(27	)	$	9,197
	REMICs and Stripped MBS			1,083		211		(240	)		1,054
	Other mortgage-related securities			22,236		425		(12	)		22,649

		Total	$	32,438	$	741	$	(279	)	$	32,900



			2000

					Gross		Gross
			Amortized		Unrealized		Unrealized			Fair
			Cost⁽¹⁾		Gains		Losses			Value

Held-to-maturity:
	MBS⁽²⁾		$	272,829	$	3,414	$	(1,414	)	$	274,829
	REMICs and Stripped MBS			114,022		1,736		(652	)		115,106
	Other mortgage-related securities			57,021		760		(178	)		57,603

		Total	$	443,872	$	5,910	$	(2,244	)	$	447,538

Available-for-sale:
	MBS⁽²⁾		$	2,814	$	18	$	(7	)	$	2,825
	REMICs and Stripped MBS			220		57		(64	)		213
	Other mortgage-related securities			8,403		33		(40	)		8,396

		Total	$	11,437	$	108	$	(111	)	$	11,434


(1)	Amortized cost includes unamortized premiums, discounts, and other deferred price adjustments.

(2)	Excludes REMICs and Stripped MBS.

Nonmortgage Investments

Nonmortgage investments consist of the LIP and other investments. We classify and account for these investments as either held-to-maturity or available-for-sale according to FAS 115. Concurrent with the September 13, 2002 implementation of our new risk-based capital rule, we reclassified securities in our nonmortgage investment portfolio that had an amortized cost of $11 billion from held-to-maturity to available-for-sale in accordance with FAS 115. These nonmortgage securities had gross unrealized gains of $139 million and unrealized losses of $6 million at the time of this noncash transfer. Nonmortgage investments decreased 20 percent to $60 billion at December 31, 2002, from $75 billion at December 31, 2001. Our nonmortgage investments totaled $55 billion at December 31, 2000. Tables 11 and 12 show the composition, weighted-average maturities, and credit ratings of our held-to-maturity and available-for-sale nonmortgage investments.


Table 11:	Nonmortgage Investments Classified as Held-to-Maturity



			2002

											Weighted-
					Gross		Gross				Average
			Amortized		Unrealized		Unrealized		Fair		Maturity		% Rated A
			Cost		Gains		Losses		Value		in Months		or Better


			(Dollars in millions)
Held-to-maturity:
	Repurchase agreements		$	20,732	$	—	$	—	$	20,732		.5		100.0
	Eurodollar time deposits			1,398		—		—		1,398		.8		100.0
	Auction rate preferred stock			402		—		—		402		1.0		100.0
	Federal funds			150		—		—		150		1.9		100.0
	Commercial paper			100		—		—		100		.7		100.0
	Other			268		1		—		269		4.9		100.0

		Total	$	23,050	$	1	$	—	$	23,051		.6		100.0



			2001

												Weighted-
					Gross		Gross					Average
			Amortized		Unrealized		Unrealized			Fair		Maturity		% Rated A
			Cost		Gains		Losses			Value		in Months		or Better

Held-to-maturity:
	Repurchase agreements		$	9,380	$	—	$	—		$	9,380		.5		100.0
	Eurodollar time deposits			11,185		—		—			11,185		.3		100.0
	Auction rate preferred stock			2,127		—		—			2,127		1.7		100.0
	Federal funds			4,904		—		—			4,904		.4		100.0
	Commercial paper			2,844		1		—			2,845		.6		100.0
	Asset-backed securities			6,065		89		(1	)		6,153		10.6		100.0
	Other			2,166		73		—			2,239		16.7		56.4

		Total	$	38,671	$	163	$	(1	)	$	38,833		3.0		97.5



			2000

												Weighted-
					Gross		Gross					Average
			Amortized		Unrealized		Unrealized			Fair		Maturity		% Rated A
			Cost		Gains		Losses			Value		in Months		or Better

Held-to-maturity:
	Repurchase agreements		$	2,722	$	—	$	—		$	2,722		.5		100.0
	Eurodollar time deposits			4,046		—		—			4,046		1.2		100.0
	Auction rate preferred stock			1,812		—		—			1,812		1.9		98.6
	Federal funds			3,493		—		—			3,493		2.1		100.0
	Commercial paper			8,893		2		—			8,895		.7		90.1
	Asset-backed securities			9,043		30		(7	)		9,066		22.6		100.0
	Other			3,823		40		(11	)		3,852		17.6		100.0

		Total	$	33,832	$	72	$	(18	)	$	33,886		8.7		97.3

Table 12: Nonmortgage Investments Classified as Available-for-Sale



			2002

												Weighted-
					Gross		Gross					Average
			Amortized		Unrealized		Unrealized			Fair		Maturity		% Rated A
			Cost		Gains		Losses			Value		in Months		or Better


			(Dollars in millions)
Available-for-sale:
	Asset-backed securities		$	22,281	$	98	$	(68	)	$	22,311		30.0		100.0
	Floating-rate notes⁽¹⁾			11,754		10		(29	)		11,735		10.6		87.6
	Corporate bonds			1,149		42		—			1,191		12.8		25.2
	Taxable auction notes			949		—		—			949		.2		100.0
	Auction rate preferred stock			112		—		(4	)		108		2.5		43.5
	Commercial paper			100		—		—			100		2.2		100.0
	Other			400		—		—			400		1.1		100.0

		Total	$	36,745	$	150	$	(101	)	$	36,794		22.0		93.5



			2001

												Weighted-
					Gross		Gross					Average
			Amortized		Unrealized		Unrealized			Fair		Maturity		% Rated A
			Cost		Gains		Losses			Value		in Months		or Better

Available-for-sale:
	Asset-backed securities		$	14,876	$	21	$	(25	)	$	14,872		26.2		99.9
	Floating-rate notes⁽¹⁾			12,114		12		(45	)		12,081		18.2		84.3
	Commercial paper			8,879		1		—			8,880		.9		100.0
	Other			50		—		—			50		9.5		100.0

		Total	$	35,919	$	34	$	(70	)	$	35,883		17.2		94.7



			2000

												Weighted-
					Gross		Gross					Average
			Amortized		Unrealized		Unrealized			Fair		Maturity		% Rated A
			Cost		Gains		Losses			Value		in Months		or Better

Available-for-sale:
	Asset-backed securities		$	8,469	$	—	$	—		$	8,469		49.6		100.0
	Floating-rate notes⁽¹⁾			12,237		4		(17	)		12,224		18.5		99.7
	Commercial paper			443		—		—			443		.6		100.0
	Other			—		—		—			—		—		—

		Total	$	21,149	$	4	$	(17	)	$	21,136		30.6		99.8


(1)	As of December 31, 2002, 2001, and 2000, 100 percent of floating-rate notes repriced at intervals of 90 days or less.

Nonmortgage investments rated below single A totaled $2.4 billion and equaled 8.5 percent of our core capital at December 31, 2002, $2.9 billion and 11.4 percent of core capital at December 31, 2001, and $1 billion and 4.6 percent of core capital at December 31, 2000.

Our nonmortgage investments serve as Fannie Mae’s primary source of liquidity and an investment vehicle for our surplus capital. Nonmortgage investments include our early funding portfolio, which consists primarily of repurchase agreements, and our LIP. Our LIP consists primarily of high-quality securities that are short-term or readily marketable and includes investments in nonmortgage assets, such as federal funds and time deposits, commercial paper, asset-backed securities, and corporate floating-rate notes. The majority of LIP investments classified as held-to-maturity consist of federal funds and time deposits and auction rate preferred stock with maturities of three months or less. We obtain liquidity from our LIP through maturity of short-term investments or the sale of assets. Investments in our LIP totaled $39 billion at December 31, 2002, compared with $65 billion at year-end 2001 and $52 billion at year-end 2000. At the end of 2001, our LIP balance was at the highest level of the past three years because of delayed settlement of 2001 portfolio purchase commitments, which resulted in additional temporary capital for short-term investment in the LIP.

The LIP combined with our early funding portfolio and cash and cash equivalents represent our total liquid investments. The average yield on liquid investments during 2002, 2001, and 2000 was 2.34 percent, 4.63 percent, and 6.60 percent, respectively. The average yield decreased during 2002 and 2001 because of the sharp drop in short-term interest rates.


	Debt Securities

As part of our disciplined interest rate risk management strategy, we issue a variety of noncallable and callable debt securities in the domestic and global capital markets in a wide range of maturities to meet our large and consistent funding needs. We strive to structure debt products that match the needs of our portfolio with the interests of debt investors. A description of our principal debt securities follows.


	•	Benchmark Securities® Program


	Our Benchmark Securities program encompasses large, regularly scheduled issues of noncallable and callable debt securities designed to provide enhanced liquidity to investors while reducing the relative cost of debt. By issuing Benchmark Securities, we have consolidated much of our debt issuances from a large number of smaller, unscheduled issues to a smaller number of larger, more liquid scheduled issues.

	During 2002, we issued noncallable and callable Benchmark Securities in every month. Benchmark Bills® served as our weekly source for three-month and six-month discount debt issuances during the year. We issued one-year Benchmark Bills on a biweekly schedule during 2002 and 2001. Our issuances of Benchmark Bills totaled $420 billion, $437 billion, and $334 billion in 2002, 2001, and 2000, respectively. Issuances of Benchmark Bonds® and Benchmark Notes totaled $89 billion, $100 billion, and $77 billion, respectively, during the same period. Benchmark Notes have maturities of one to ten years, and Benchmark Bonds have maturities of more than ten years. We reintroduced Fannie Mae’s Callable Benchmark Notes in June 2001 and issued $22 billion and $10 billion of these securities during 2002 and 2001, respectively.


	•	Discount Notes and Other Debt Securities

We also issue other debt securities outside Fannie Mae’s Benchmark Securities program. These debt securities have various maturities, interest rates, and call provisions. We issue short-term debt securities called “Discount Notes” outside of our Benchmark Bills program. We sell discount notes at a market discount from the principal amount payable at maturity. They have maturities ranging from overnight to 360 days from the date of issuance and are available in minimum amounts of $1,000. We issued $1.107 trillion and $1.216 trillion of Discount Notes during 2002 and 2001, respectively. Outstanding discount notes increased to $134 billion at year-end 2002 from $93 billion at year-end 2001.


	•	Subordinated Debt

As part of our voluntary safety and soundness initiatives announced in October 2000, we began issuing Subordinated Benchmark Notes in the first quarter of 2001 on a periodic basis, which created a new class of fixed-income investments for investors under the Benchmark Securities program. We issued subordinated debt securities totaling $3.5 billion and $5.0 billion during 2002 and 2001, respectively. Outstanding Subordinated Benchmark Notes totaled $8.5 billion at December 31, 2002, versus $5.0 billion at the end of 2001.

Total debt outstanding increased 11 percent to $851 billion at December 31, 2002, from $763 billion at December 31, 2001. Table 13 summarizes our outstanding debt due within one year at the end of 2002, 2001, and 2000. Table 14 shows a comparison of our debt issuances and repayments for 2002, 2001, and 2000, the total outstanding at the end of each year, and the average cost.


Table 13:	Outstanding Debt Due Within One Year



		2002


		Outstanding at					Average Outstanding					Maximum
		December 31,					During Year					Outstanding
												at Any
		Amount		Cost⁽¹⁾			Amount		Cost⁽¹⁾			Month-end


		(Dollars in millions)
Short-term notes		$	290,091		1.55	%	$	252,857		1.98	%	$	290,091
Other short-term debt			12,522		1.33			18,512		1.70			28,126
Current portion of borrowings due after one year ⁽²⁾:
	Universal Standard Debt		41,681		2.25
	Universal Benchmark Debt		37,376		4.89
	Universal Retail Debt		73		9.52
	Other		669		3.24

Total due within one year		$	382,412		1.95	%



		2001


		Outstanding at					Average Outstanding					Maximum
		December 31,					During Year					Outstanding
												at Any
		Amount		Cost⁽¹⁾			Amount		Cost⁽¹⁾			Month-end

Short-term notes		$	256,905		2.58	%	$	247,060		4.31	%	$	265,953
Other short-term debt			29,891		1.96			31,479		4.40			43,811
Current portion of borrowings due after one year ⁽²⁾:
	Universal Standard Debt		34,413		3.67
	Universal Benchmark Debt		21,987		5.31
	Universal Retail Debt		—		—
	Other		296		4.96

Total due within one year		$	343,492		2.81	%



		2000


		Outstanding at					Average Outstanding					Maximum
		December 31,					During Year					Outstanding
												at Any
		Amount		Cost⁽¹⁾			Amount		Cost⁽¹⁾			Month-end

Short-term notes		$	178,292		6.50	%	$	150,242		6.33	%	$	178,292
Other short-term debt			42,157		6.58			37,880		6.36			42,157
Current portion of borrowings due after one year ⁽²⁾:
	Universal Standard Debt		51,185		6.02
	Universal Benchmark Debt		6,984		5.71
	Universal Retail Debt		785		6.62
	Other		919		6.57

Total due within one year		$	280,322		6.38	%


(1)	Represents weighted-average cost, which includes the amortization of discounts, premiums, issuance costs, hedging results, and the effects of currency and debt swaps. Averages have been calculated on a monthly average basis.

(2)	Information on average amount and cost of debt outstanding during the year and maximum amount outstanding at any month-end is not meaningful. See “Table 14—Short-Term and Long-Term Debt Activity” for additional information.


Table 14:	Short-Term and Long-Term Debt Activity


		2002			2001			2000


		(Dollars in millions)
Issued during the year:
Short-term⁽¹⁾:
	Amount	$	1,635,919		$	1,756,691		$	1,143,131
	Average cost		1.67	%		3.69	%		6.27	%
Long-term⁽¹⁾:
	Amount	$	238,467		$	249,352		$	110,215
	Average cost		3.78	%		4.83	%		6.92	%
Total issued:
	Amount	$	1,874,386		$	2,006,043		$	1,253,346
	Average cost		2.21	%		3.97	%		6.34	%
Repaid during the year:
Short-term⁽¹⁾:
	Amount	$	1,620,644		$	1,691,240		$	1,106,956
	Average cost		1.84	%		4.22	%		6.15	%
Long-term⁽¹⁾:
	Amount	$	175,809		$	196,610		$	50,335
	Average cost		4.85	%		6.03	%		6.33	%
Total repaid:
	Amount	$	1,796,453		$	1,887,850		$	1,157,291
	Average cost		2.34	%		4.47	%		6.14	%
Outstanding at year-end:
Due within one year:
	Net amount	$	382,412		$	343,492		$	280,322
	Cost⁽²⁾		1.95	%		2.81	%		6.40	%
	Average term in months⁽⁴⁾		5			4			5
Due after one year:
	Net amount	$	468,570		$	419,975		$	362,360
	Cost⁽²⁾		5.14	%		5.52	%		6.46	%
	Average term in months⁽⁴⁾		67			70			76
Total debt:
	Net amount	$	850,982		$	763,467		$	642,682
	Cost⁽³⁾		4.81	%		5.49	%		6.47	%
	Average term in months⁽⁴⁾		58			66			69


(1)	“Short-term” refers to the face amount of debt issued with an original term of one year or less. “Long-term” refers to the face amount of debt issued with an original term greater than one year.

(2)	Cost includes the effects of currency, debt, and amortization of premiums, discounts, issuance costs, and hedging results.

(3)	Cost includes the effects of currency, debt, and interest rate swaps and amortization of premiums, discounts, issuance costs, and hedging results.

(4)	Average term includes the effects of interest rate swaps.

We took advantage of opportunities to repurchase $8 billion of debt in 2002 and $9 billion of debt in 2001 that was trading at historically wide spreads to other fixed-income securities. In addition, we continued to call significant levels of debt in 2002 as a result of the sharp decline in interest rates that began in 2001. We called $174 billion in debt and interest rate swaps in 2002 and $173 billion in 2001. We reissued much of this debt with short-term maturities in anticipation of the expected increase in mortgage liquidations. Interest rate swaps lengthened the weighted-average final maturity of our outstanding debt by 20 months at December 31, 2002, down from 26 months at December 31, 2001. Table 15 shows our adjusted effective short- and long-term debt at the end of 2002, 2001, and 2000.

Table 15: Effective Short-Term and Long-Term Debt


		2002			2001			2000


		(Dollars in millions)
Outstanding at year-end:
Short-term⁽¹⁾:
	Net amount	$	192,702		$	138,986		$	103,852
	Cost		1.52	%		2.75	%		6.13	%
	Weighted-average maturity (in months)		3			5			5
	Percent of total debt outstanding		23	%		18	%		16	%
Long-term⁽²⁾:
	Net amount	$	651,827		$	627,196		$	543,964
	Cost		5.48	%		5.96	%		6.48	%
	Weighted-average maturity (in months)		75			78			79
	Percent of total debt outstanding		77	%		82	%		84	%
Total:
	Net amount⁽³⁾	$	844,529		$	766,182		$	647,816
	Cost		4.81	%		5.49	%		6.47	%
	Weighted-average maturity (in months)		58			66			69


(1)	Represents the redemption value of short-term debt adjusted to include the effect of derivative instruments that replicate short-term, variable-rate debt securities and exclude short-term debt securities that have been economically converted into long-term debt funding through interest rate swaps.

(2)	Represents the redemption value of long-term debt adjusted to include the effect of short-to-long interest rate swaps that economically convert short-term debt securities into long-term debt securities and exclude long-term debt securities that have been economically converted into short-term funding through interest rate swaps.

(3)	Represents the redemption value of outstanding debt at year-end. Excludes the effect of amortization of premiums, discounts, issuance costs, and hedging results.

Our asset-liability management strategies, combined with favorable market conditions for borrowing, had the following effect on the debt portfolio:


	•	The average cost of outstanding debt during 2002 decreased to 5.38 percent from 6.00 percent in 2001. At December 31, 2002 and 2001, the cost of debt outstanding was 4.81 percent and 5.49 percent, respectively.

	•	Effective long-term debt, which takes into consideration the effect of derivative instruments on the maturity of long- and short-term debt, decreased to 77 percent of total debt outstanding at December 31, 2002 from 82 percent at year-end 2001.

	•	The weighted-average maturity of effective long-term, fixed-rate debt outstanding decreased to 75 months at year-end 2002 from 78 months at year-end 2001.

	•	Effective long-term debt as a percentage of the net mortgage portfolio decreased to 82 percent at the end of 2002 from 89 percent at the end of 2001.

	•	Option-embedded debt outstanding as a percentage of the net mortgage portfolio temporarily increased above historic levels to 75 percent at year-end 2002 versus 54 percent at the end of 2001. Table 16 presents option-embedded debt instruments as a percentage of our net mortgage portfolio for the past three years. Option-based derivative instruments represented 42 percent and callable debt accounted for 58 percent of the $601 billion in option-embedded debt outstanding at December 31, 2002. In comparison, option-based derivative instruments and callable debt represented 38 percent and 62 percent, respectively of the $378 billion in option-embedded debt outstanding at December 31, 2001.


Table 16:	Option-Embedded Debt Instruments


	2002			2001			2000


	(Dollars in billions)
Issued during the year	$	384		$	286		$	65
Outstanding at year-end		601			378			280
Percentage of total net mortgage portfolio		75	%		54	%		46	%


	*Credit Guaranty Business*

Core business earnings for our Credit Guaranty business grew 16 percent in 2002 to $2.179 billion and 10 percent in 2001 to $1.878 billion. The increase in 2002 core business earnings was driven primarily by a 23 percent increase in guaranty fee income. Guaranty fee income for our Credit Guaranty business increased largely due to 17 percent growth in our average book of business and a .9 basis point increase in the average fee rate to 18.9 basis points. The average fee rate for our Credit Guaranty business includes the effect of guaranty fee income allocated to the Credit Guaranty business for managing the credit risk on mortgage-related assets held by the Portfolio Investment business. It therefore differs from our consolidated effective average guaranty fee rate, which excludes guaranty fees on Fannie Mae MBS held in our portfolio because these fees are reported as interest income. Growth in earnings for the Credit Guaranty business lagged growth in guaranty fee income primarily due to increases in credit enhancement expenses, higher administrative expenses, and an increase in the effective tax rate. Administrative expenses increased primarily due to higher compensation costs and expenses related to re-engineering our core infrastructure systems and relocating our primary data center.

Record expansion of residential mortgage debt outstanding during 2002 and 2001, combined with our ability to offer reliable, low-cost mortgage funds, fueled growth in our book of business. The demand for housing was strong throughout 2002 and 2001, and borrowers also took advantage of the low interest rate environment to refinance their mortgages and extract equity from the appreciation in their homes. Residential mortgage debt outstanding increased 12.4 percent in 2002 to $7.0 trillion, 10.3 percent in 2001 to $6.2 trillion, and 8.9 percent in 2000 to $5.6 trillion. Refinancings represented 62 percent of total market originations in 2002 and 57 percent in 2001, compared with 19 percent in 2000. Growth in Fannie Mae’s mortgage credit book of business outpaced growth in residential mortgage debt outstanding during 2002, 2001, and 2000.

Earnings growth in 2001 for the Credit Guaranty business was also driven by an increase in guaranty fees. Guaranty fees rose 7 percent, stemming from 15 percent growth in the average book of business that more than offset a 1.4 basis point drop in the average fee rate to 18.0 basis points. Despite significant growth in our mortgage credit book of business and a softer economy, the Credit Guaranty business was successful in reducing credit losses as a percentage of Fannie Mae’s average book of business to .5 basis points in 2002, from .6 basis points in 2001 and .7 basis points in 2000.

In the third quarter of 2002, we announced increases in the upfront-price adjustment Fannie Mae charges on cash-out refinance mortgages with loan-to-value (“LTV”) ratios between 70.01 and 85 percent that we plan to implement during 2003. As a result of these increases, which will better compensate us for the higher risk on these loans, the upfront-price adjustments on cash-out refinance mortgages we purchase or guarantee with LTV ratios greater than 70 percent will range from 50 to 75 basis points.

In conjunction with these increases and to better align our underwriting, pricing policy, and relative risk profile of refinance transactions, we modified our loan purpose definitions on refinance transactions. We now define cash-out refinance transactions as a refinance transaction in which the funds are used for purposes other than to pay off an existing first mortgage lien, to pay off any permissible subordinate mortgage liens, and to provide limited unrestricted cash proceeds to the borrower. We expect the increased price adjustments, which will be allocated to our Credit Guaranty business, to modestly increase our future guaranty fees.

OFF-BALANCE SHEET TRANSACTIONS

We enter into certain off-balance sheet financial arrangements to facilitate our statutory purpose of providing mortgage funds to the secondary market and reduce Fannie Mae’s exposure to interest rate fluctuations. These arrangements, which may involve elements of credit and interest rate risk in excess of amounts recognized on Fannie Mae’s balance sheet, primarily include guaranteed MBS and other mortgage-related securities and commitments to purchase mortgage assets or issue and guarantee MBS. Following is an overview of our off-balance sheet exposure related to these transactions, including a description of how our MBS are created and our role in the process.

Guaranteed MBS and Other Mortgage-Related Securities

We issue MBS that are backed by mortgage loans from a single lender or from multiple lenders, or that are transferred from our held-for-sale mortgage portfolio. Single-lender MBS are typically issued through lender swap transactions whereby a lender exchanges pools of mortgages for MBS. Multiple-lender MBS allow several lenders to pool mortgages and receive, in return, MBS (referred to as “Fannie Majors”) representing a proportionate share of a larger pool. Lenders may retain the MBS or sell them to other investors. When we issue MBS, we assume trustee responsibilities. The loans underlying MBS are not our assets. Therefore, we do not record them on our balance sheet except when acquired and held in our mortgage portfolio for investment purposes, nor do we record them as liabilities. In some instances we buy mortgage loans or mortgage-related securities and concurrently enter into a forward sale commitment. We designate these loans as held-for-sale when acquired, and we sell them from the mortgage portfolio as MBS.

The Credit Guaranty business receives a guaranty fee for assuming the credit risk and guaranteeing timely payment of scheduled principal and interest to MBS investors and investors in other mortgage-related securities. The guaranty fee varies, depending on factors such as the risk profile of the loans securitized as well as the level of credit risk we assume. We are ultimately responsible for guaranteeing timely payment of scheduled principal and interest to investors whether or not we share primary default risk on loans underlying outstanding MBS. We accrue a liability on our balance sheet for our guaranty obligation based on the probability that mortgages underlying the $1.029 trillion of outstanding MBS will not perform according to contractual terms. At December 31, 2002, we have accrued a liability of $471 million for estimated losses on our guaranty of outstanding MBS, compared with $598 million at December 31, 2001. These amounts are a component of the “Guaranty liability for MBS” line on our balance sheet.

We issue REMICs backed by single-class MBS, Stripped MBS (“SMBS”), Government National Mortgage Association (“Ginnie Mae”) mortgage-related securities, other REMIC securities, or whole loans that are not owned or guaranteed by Fannie Mae. The Portfolio Investment business receives transaction fees for structuring REMICs backed by MBS, SMBS, Ginnie Mae securities, or existing Fannie Mae REMIC classes. When we issue REMICs, we assume trustee responsibilities. REMICs backed by guaranteed MBS do not subject us to any additional mortgage credit risk. We are only subject to additional credit risk if Fannie Mae guarantees REMICs backed by whole loans owned by other entities or private label securities. REMICs are not our assets except when acquired and held in our mortgage portfolio for investment purposes, nor do we record them as liabilities.

Table 17 summarizes issued and outstanding amounts for guaranteed MBS and other mortgage-related securities, including REMICs, for the years ended December 31, 2002, 2001, and 2000.


Table 17:	Guaranteed MBS and Other Mortgage-Related Securities⁽¹⁾



	Outstanding				Issues

	Held by				Acquired		Total
	Other Investors		Total⁽²⁾		by Others		Issued⁽³⁾


	(Dollars in millions)
2002	$	1,029,456	$	1,538,287	$	478,260	$	723,299
2001		858,867		1,290,351		344,739		525,321
2000		706,684		1,057,750		105,407		210,311


(1)	MBS may be resecuritized to back Fannie Megas, SMBS, or REMICs. With respect to those MBS, the amounts shown only include the principal amount of the MBS once. Amounts also include REMICs created from whole loans not owned or guaranteed by Fannie Mae.

(2)	Includes $509 billion, $431 billion, and $351 billion at December 31, 2002, 2001, and 2000, respectively, of MBS and other mortgage-related securities in Fannie Mae’s portfolio.

(3)	Total issued includes $245 billion, $181 billion, and $105 billion of MBS purchased by Fannie Mae in 2002, 2001, and 2000, respectively. Total issued excludes $16 billion, $3 billion, and $2 billion of MBS in 2002, 2001, and 2000, respectively, that Fannie Mae issued from loans in our portfolio.

Guaranteed MBS and other mortgage-related securities held by investors other than Fannie Mae, which we refer to as outstanding MBS, grew 20 percent to $1.029 trillion at December 31, 2002, from $859 billion at December 31, 2001. REMICs that could subject Fannie Mae to additional credit exposure totaled $35 billion at December 31, 2002 or 3 percent of outstanding MBS held by investors other than Fannie Mae. Total MBS, which includes guaranteed MBS and other mortgage-related securities held in our mortgage portfolio, grew 19 percent to $1.538 trillion at year-end 2002 from $1.290 trillion at year-end 2001.

MBS issues acquired by investors other than Fannie Mae increased $134 billion to $478 billion in 2002, while liquidations of outstanding MBS increased $124 billion to $324 billion. The increase in MBS issuances and liquidations in 2002 was attributable to the decline in mortgage interest rates during the year resulting in higher levels of mortgage originations, including refinancings. Total MBS issues, excluding MBS issued from Fannie Mae’s portfolio, increased 38 percent to $723 billion in 2002 from $525 billion in 2001, while total MBS liquidations grew 69 percent to $499 billion from $296 billion in 2001.

REMIC issuances totaled $144 billion in 2002, compared with $124 billion in 2001. Our REMIC issuances rebounded in 2001 with the rest of the REMIC market and steadily increased in 2002. The steeper yield curve made the REMIC market more attractive, resulting in an increased demand for REMICs. In addition, lower interest rates contributed to higher MBS issuances and increased collateral available for REMICs. The outstanding balance of REMICs (including REMICs held in Fannie Mae’s portfolio) was $347 billion at December 31, 2002, compared with $346 billion at December 31, 2001.

Commitments

Fannie Mae enters into master delivery commitments on either a mandatory or an optional basis. Under a mandatory master commitment, a lender must either deliver loans under an MBS contract at a specified guaranty fee rate or enter into a mandatory portfolio commitment with the yield established upon executing the portfolio commitment. We also accept mandatory or lender-option delivery commitments not issued pursuant to a master commitment. These commitments may be for our portfolio or for issuances of Fannie Mae MBS. The guaranty fee rate on MBS lender-option commitments is specified in the contract, while the yield for portfolio lender-optional commitments is set at the date of conversion to a mandatory commitment. We generally hedge the cost of funding future portfolio purchases upon issuance of, or conversion to, a mandatory commitment. Therefore, we largely mitigate the interest rate risk relating to loans purchased pursuant to those commitments. Our outstanding mandatory portfolio commitments, excluding commitments under master agreements, totaled $85 billion and $55 billion at December 31, 2002 and 2001, respectively.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

Fannie Mae’s financial statements and reported results are based on GAAP, which requires us in some cases to use estimates and assumptions that may affect our reported results and disclosures. We describe our significant accounting policies in the Notes to Financial Statements under Note 1, “Summary of Significant Accounting Policies.” Several of our accounting policies involve the use of accounting estimates we consider to be critical because: (1) they are likely to change from period to period because they require significant management judgment and assumptions about highly complex and uncertain matters; and (2) the use of a different estimate or a change in estimate could have a material impact on our reported results of operations or financial condition. Our critical accounting estimates include determining the adequacy of the allowance for loan losses and guaranty liability for MBS; projecting mortgage prepayments to calculate the amortization of deferred price adjustments on mortgages and mortgage-related securities held in portfolio and guaranteed mortgage-related securities; and estimating the time value of our purchased options. Management has specifically discussed the development and selection of each critical accounting estimate with the Audit Committee of Fannie Mae’s Board of Directors. Our Audit Committee has also reviewed our disclosures in this MD&A regarding Fannie Mae’s critical accounting estimates.

Allowance for Loan Losses and Guaranty Liability for MBS

We establish an allowance for loan losses and guaranty liability for MBS on single-family and multifamily loans in our book of business. We maintain a separate allowance for loan losses and guaranty liability for MBS. However, we use the same methodology to determine the amounts of each because the risks are the same. The allowance for loan losses is held against loans in our mortgage portfolio. We also have a guaranty liability for our guaranty of MBS held by us or by other investors. Our allowance and guaranty liability for MBS consist of the following key elements:


	•	Single-family: We evaluate various risk characteristics such as product type, original loan-to-value ratio, and loan age to determine the allowance and guaranty liability for single-family assets. We estimate defaults for each risk characteristic based on historical experience and apply a historical severity to each risk category in accordance with Financial Accounting Standard No. 5, Accounting for Contingencies (“FAS 5”). Severity refers to the amount of loss suffered on a default relative to the unpaid principal balance of the loan. In addition, we apply Financial Accounting Standard No. 114, Accounting by Creditors for Impairment of a Loan (“FAS 114”), to determine the amount of impairment on specific loans that have been restructured. We charge-off single-family loans when we foreclose on the loans.

	•	Multifamily: We determine the multifamily allowance and guaranty liability by separately evaluating loans that are impaired and all other loans. Impaired loans consist of loans that are not performing according to their original contractual terms. For loans that we consider impaired, we apply FAS 114 to estimate the amount of impairment. For all other loans, we apply FAS 5 to establish an allowance and guaranty liability by rating each loan not individually evaluated for impairment and segmenting the loan into one of the main risk categories we use to monitor the multifamily portfolio. We then apply historical default rates, adjusted for current conditions, and a corresponding severity to the loans in each segment to estimate the probable loss amount at each balance sheet date.

We believe the accounting estimate related to our allowance for loan losses and guaranty liability for MBS is a “critical accounting estimate” because it requires us to make significant judgments about probable future losses in our book of business as of the balance sheet date based on assumptions that are uncertain. We may have to increase or decrease the size of our overall allowance for loan losses and guaranty liability based on changes in delinquency levels, loss experience, economic conditions in areas of geographic concentration, and profile of mortgage characteristics. Different assumptions about default rates, severity, counterparty risk, and other factors that we could use in estimating our allowance for loan losses and guaranty liability could have a material effect on our results of operations.

We include the allowance for loan losses in the balance sheet under “Mortgage portfolio, net.” We include the guaranty liability for estimated losses on MBS held by us or other investors as a liability under

“Guaranty liability for MBS.” Table 18 shows the amounts of these components and summarizes the changes for the years 1998 to 2002.

Table 18: Allowance for Loan Losses and Guaranty Liability for MBS


		2002			2001			2000			1999			1998


		(Dollars in millions)
Allowance for loan losses⁽¹⁾:
	Beginning balance	$	48		$	51		$	56		$	79		$	131
	Provision		44			7			9			(5	)		(16	)
	Charge-offs⁽²⁾		(13	)		(10	)		(14	)		(18	)		(36	)

	Ending balance	$	79		$	48		$	51		$	56		$	79

Guaranty liability for MBS⁽¹⁾: