e10vq
 



UNITED STATES

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
 
  For the Quarterly Period Ended June 30, 2003
  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
  20016
Washington, DC
  (Zip Code)
(Address of principal executive offices)
   

Registrant’s telephone number, including area code: (202) 752-7000

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.

x Yes                    o No

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

o Yes                    x No

As of the close of business on July 31, 2003, there were 973,819,180 shares of common stock outstanding.




 

CROSS-REFERENCE INDEX TO FORM 10-Q

             
Page

PART I
  FINANCIAL INFORMATION     1  
ITEM 1.
  FINANCIAL STATEMENTS     33  
    Independent Accountant’s Review Report     33  
    Statements of Income     34  
    Balance Sheets     35  
    Statements of Changes in Stockholders’ Equity     36  
    Statements of Cash Flows     37  
    Notes to Financial Statements     38  
ITEM 2.
  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS     1  
    Selected Financial Data     1  
    Results of Operations     3  
    Core Business Earnings and Business Segment Results     8  
    Off-Balance Sheet Arrangements     21  
    Critical Accounting Policies     22  
    Risk Management     23  
    Liquidity and Capital Resources     30  
    Pending Accounting Standards     32  
ITEM 3.
  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK     48  
ITEM 4.
  CONTROLS AND PROCEDURES     48  
PART II
  OTHER INFORMATION     49  
ITEM 1.
  LEGAL PROCEEDINGS     49  
ITEM 2.
  CHANGES IN SECURITIES AND USE OF PROCEEDS     49  
ITEM 3.
  DEFAULTS UPON SENIOR SECURITIES     50  
ITEM 4.
  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS     50  
ITEM 5.
  OTHER INFORMATION     51  
ITEM 6.
  EXHIBITS AND REPORTS ON FORM 8-K     51  
SIGNATURES     52  
CERTIFICATIONS     54  

The interim financial information provided in this report reflects all adjustments that, in the opinion of management, are necessary for a fair presentation of the results for such periods. Such adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q. The results of operations in our interim financial statements are not necessarily indicative of the results that may be expected for the full year. The interim financial information should be read in conjunction with Fannie Mae’s 2002 Annual Report on Form 10-K, filed with the Securities and Exchange Commission and available on our Web site at www.fanniemae.com/ir and the SEC’s Web site at www.sec.gov under “Federal National Mortgage Association” or CIK number 0000310522. We do not intend these internet addresses to be active links. Therefore, other than our 2002 Annual Report on Form 10-K, the information that appears on these Web sites is not incorporated into this Form 10-Q.


 

PART I—FINANCIAL INFORMATION

 
Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

SELECTED FINANCIAL DATA

The following selected financial data includes performance measures and ratios based on our reported results and core business earnings, a supplemental non-GAAP (generally accepted accounting principles) measure used by management in operating our business. Our core business earnings measures are not defined terms within GAAP and may not be comparable to similarly titled measures presented by other companies. See “Management’s Discussion and Analysis— Core Business Earnings and Business Segment Results” for a discussion of how we use core business earnings measures and why we believe they are helpful to investors. Our results for the three-month and six-month periods ended June 30, 2003 and 2002 are unaudited and, in the opinion of management, include all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation. We have reclassified certain prior period amounts to conform to our current year presentation. Results for the reported period are not necessarily indicative of the results that may be expected for the full year.

                                 
Three Months Ended Six Months Ended
June 30, June 30,


2003 2002 2003 2002




(Dollars and shares in millions,
except per share amounts)
Reported Earnings Data:
                               

                               
Net income
  $ 1,102     $ 1,464     $ 3,042     $ 2,672  
Preferred stock dividends
    (34 )     (24 )     (64 )     (57 )
     
     
     
     
 
Net income available to common stockholders
  $ 1,068     $ 1,440     $ 2,978     $ 2,615  
     
     
     
     
 
Basic earnings per common share
  $ 1.09     $ 1.45     $ 3.03     $ 2.63  
Diluted earnings per common share
    1.09       1.44       3.02       2.61  
Weighted-average diluted common shares outstanding
    982       1,000       987       1,001  
Cash dividends per common share
  $ .39     $ .33     $ .78     $ .66  
Net interest yield, taxable-equivalent basis
    1.63 %     1.33 %     1.61 %     1.32 %
Return on average assets
    .47       .70       .66       .64  
Average equity to average assets
    1.9       2.3       1.9       2.3  
Return on common equity
    31.3       33.9       43.1       32.2  
Ratio of earnings to combined fixed charges and preferred stock dividends(1)
    1.15:1       1.19:1       1.21:1       1.17:1  
Core Business Earnings Data:(2)
                               

                               
Core business earnings(3)
  $ 1,860     $ 1,573     $ 3,710     $ 3,091  
Core business earnings per diluted common share
    1.86       1.55       3.70       3.03  
Core taxable-equivalent revenues(4)
    3,980       2,971       7,583       5,811  
Net interest margin, taxable-equivalent basis(5)
    1.30 %     1.16 %     1.28 %     1.16 %
Core return on average assets(6)
    .80       .76       .80       .75  
Core return on average realized common equity(7)
    27.7       25.8       27.9       25.8  
                                   
June 30, December 31,
2003 2002


Balance Sheet Data:
                               

                               
Mortgage portfolio, net
  $ 820,276     $ 797,693                  
Liquid assets
    69,089       61,554                  
Total assets
    923,795       887,515                  
Borrowings:
                               
 
Due within one year
    422,274       382,412                  
 
Due after one year
    461,807       468,570                  
Total liabilities
    906,431       871,227                  
Preferred stock
    3,883       2,678                  
Stockholders’ equity
    17,364       16,288                  
Core capital(8)
    30,675       28,079                  
Total capital(9)
    31,469       28,871                  

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Three Months Ended Six Months Ended
June 30, June 30,


Other Performance Measures: 2003 2002 2003 2002





Average effective guaranty fee rate(10)
    .212 %     .183 %     .208 %     .184 %
Credit loss ratio(11)
    .005       .004       .004       .005  
Administrative expense ratio(12)
    .071       .073       .072       .073  
Efficiency ratio(13)
    8.9       10.1       9.2       10.2  
Mortgage purchases
  $ 127,960     $ 56,917     $ 259,965     $ 147,863  
MBS issues acquired by others(14)
    282,502       102,909       486,435       209,713  
Outstanding MBS(15)
    1,237,461       945,497       1,237,461       945,497  
Book of business(16)
    2,049,928       1,686,241       2,049,928       1,686,241  


  (1)  “Earnings” consists of (a) income before federal income taxes and (b) fixed charges. Fixed charges represent interest expense.
 
  (2)  See Management’s Discussion and Analysis of Financial Condition and Results of Operations— Core Business Earnings and Business Segment Results for additional discussion of our supplemental non-GAAP (generally accepted accounting principles) core business earnings measures and for a reconciliation to comparable GAAP measures.
 
  (3)  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 changes in the time value of 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, together with any acceleration of expense related to options extinguished prior to exercise.
 
  (4)  A non-GAAP measure that includes revenues net of operating losses primarily on low-income housing tax credit limited partnerships and purchased options premiums amortization expense, adjusted to include taxable-equivalent amounts of tax-exempt income using the applicable federal income tax rate of 35 percent.
 
  (5)  A non-GAAP measure calculated based on annualized core net interest income on a tax-equivalent basis divided by the weighted average net investment balance.
 
  (6)  A non-GAAP measure calculated based on core business earnings less preferred stock dividends divided by average assets.
 
  (7)  A non-GAAP measure calculated based on core business earnings less preferred stock dividends divided by average realized common stockholders’ equity (common stockholders’ equity excluding accumulated other comprehensive income).
 
  (8)  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.
 
  (9)  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 $13 million at June 30, 2003 and $19 million at December 31, 2002.

(10)  Calculated based on guaranty fee and related income from outstanding MBS.
 
(11)  Charge-offs, net of recoveries, and foreclosed property income as a percentage of average mortgage portfolio (on an amortized cost basis) and average outstanding MBS.
 
(12)  Administrative expenses as a percentage of average net mortgage portfolio and average outstanding MBS.
 
(13)  Administrative expenses as a percentage of core taxable-equivalent revenues.
 
(14)  Fannie Mae guaranteed MBS and other mortgage-related securities issued and purchased by investors other than Fannie Mae.
 
(15)  Includes MBS and other mortgage-related securities guaranteed by Fannie Mae and held by investors other than Fannie Mae.
 
(16)  Mortgage portfolio and outstanding MBS, based on unpaid principal balances.

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Fannie Mae is the nation’s largest source of funds for mortgage lenders and investors. Although we operate under a federal charter, we are a private, shareholder-owned company. Our 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 exclusively in the secondary mortgage market by purchasing mortgages and mortgage-related securities, including Fannie Mae mortgage-backed 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 market by guaranteeing mortgages and issuing and guaranteeing mortgage-related securities. We generate revenue from these activities through our two primary lines of business: Portfolio Investment Business and Credit Guaranty Business.

This report on Form 10-Q highlights significant factors influencing Fannie Mae’s results of operations and financial condition. Management’s Discussion and Analysis and other sections of our Form 10-Q contain forward-looking statements based on management’s estimates of trends and economic factors in the markets in which Fannie Mae is active as well as the company’s business plans. Such estimates and plans may change without notice and future results may vary from expected results if there are significant changes in economic, regulatory, or legislative conditions affecting Fannie Mae or its competitors. For a discussion of these factors, investors should review our Annual Report on Form 10-K for the year ended December 31, 2002. We undertake no duty to update these forward-looking statements.

RESULTS OF OPERATIONS

Overview

Our reported net income for the second quarter of 2003 totaled $1.102 billion, a decrease of 25 percent over our second quarter 2002 reported results of $1.464 billion. Diluted earnings per share (“diluted EPS”) decreased 24 percent to $1.09 from $1.44 in the second quarter of 2002. The decrease in second quarter 2003 reported net income and diluted EPS was driven by an increase in purchased options expense, which more than offset an increase in net interest income, guaranty fee income, and fee and other income. Our reported net income for the first half of 2003 totaled $3.042 billion, an increase of 14 percent over our first half 2002 reported results of $2.672 billion. Diluted EPS increased 16 percent to $3.02 from $2.61 in the first half of 2002. The increase in reported net income and diluted EPS for the first half of 2003 was driven by an increase in net interest income, guaranty fee income, and fee and other income, which more than offset an increase in purchased options expense. Our reported results are based on generally accepted accounting principles (“GAAP”), which include the effects of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities (“FAS 133”). FAS 133 generates significant volatility in our reported net income because it requires that we record in our income statement changes in the time value 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 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. Purchased options expense for the second quarter and first half of 2003 increased $1.385 billion and $1.222 billion, respectively, over the corresponding prior year periods.

Reported net interest income for the second quarter and first half of 2003 increased 38 percent in each period to $3.501 billion and $6.869 billion, respectively, while guaranty fee income increased 49 percent and 42 percent to $632 million and $1.179 billion, respectively. Increases in net interest income were driven primarily by growth in our reported net interest yield and our mortgage portfolio, while increases in guaranty fee income were driven primarily by growth in outstanding MBS balances and our effective guaranty fee rate. Our market— residential mortgage debt outstanding— remained strong, growing at an annualized rate of 11.5 percent during the first quarter of 2003 despite slow economic growth and high market volatility. Record amounts of refinancing volumes during the first half of 2003 led to strong growth in our MBS. Rapid refinancings also led to a rise in the effective guaranty fee rate as rapid prepayments caused deferred guaranty fee revenues to be recognized more quickly. Despite the strong market, our

3


 

mortgage portfolio grew slowly during the first half of 2003 due to continued demand for mortgages from banks and other financial institutions. However, this slow portfolio growth was offset by a further temporary increase in our net interest yield, which benefited from the steep yield curve and low short-term interest rates that persisted throughout the first half of the year.

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.”

Net Interest Income

Table 1 presents Fannie Mae’s net interest yield based on reported net interest income calculated on a taxable-equivalent basis. 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).

4


 

Table 1: Net Interest Yield

                                     
Three Months Ended Six Months Ended
June 30, June 30,


2003 2002 2003 2002




(Dollars in millions)
Interest income:
                               
 
Mortgage portfolio
  $ 12,256     $ 12,326     $ 24,846     $ 24,497  
 
Nonmortgage investments and cash equivalents
    336       420       642       826  
     
     
     
     
 
 
Total interest income
    12,592       12,746       25,488       25,323  
     
     
     
     
 
Interest expense:(1)
                               
 
Short-term debt
    697       646       1,447       1,430  
 
Long-term debt
    8,394       9,568       17,172       18,930  
     
     
     
     
 
 
Total interest expense
    9,091       10,214       18,619       20,360  
     
     
     
     
 
Net interest income
    3,501       2,532       6,869       4,963  
 
Taxable-equivalent adjustment on tax-exempt investments (2)
    119       126       242       249  
     
     
     
     
 
Taxable-equivalent net interest income
  $ 3,620     $ 2,658     $ 7,111     $ 5,212  
     
     
     
     
 
Average balances:(3)
                               
Interest-earning assets:(4)
                               
 
Mortgage portfolio, net
  $ 808,215     $ 732,796     $ 806,510     $ 724,200  
 
Nonmortgage investments and cash equivalents
    81,966       69,187       74,550       67,176  
     
     
     
     
 
Total interest-earning assets
    890,181       801,983       881,060       791,376  
   
Interest-free funds(5)
    (32,431 )     (24,196 )     (30,432 )     (24,083 )
     
     
     
     
 
Total interest-earning assets funded by debt
    857,750       777,787       850,628       767,293  
     
     
     
     
 
Interest-bearing liabilities:(1)
                               
 
Short-term debt
    231,718       128,885       221,063       130,153  
 
Long-term debt
    626,032       648,902       629,565       637,140  
     
     
     
     
 
Total interest-bearing liabilities
  $ 857,750     $ 777,787     $ 850,628     $ 767,293  
     
     
     
     
 
Average interest rates:(2, 3)
                               
Interest-earning assets:
                               
 
Mortgage portfolio, net
    6.07 %     6.77 %     6.17 %     6.81 %
 
Nonmortgage investments and cash equivalents
    1.66       2.45       1.74       2.49  
     
     
     
     
 
 
Total interest-earning assets
    5.66       6.40       5.80       6.44  
   
Interest-free return(5)
    .21       .18       .18       .18  
     
     
     
     
 
Total interest-earning assets and interest-free return
    5.87       6.58       5.98       6.62  
     
     
     
     
 
Interest-bearing liabilities:(1)
                               
 
Short-term debt
    1.19       1.99       1.29       2.18  
 
Long-term debt
    5.36       5.90       5.46       5.94  
     
     
     
     
 
 
Total interest-bearing liabilities
    4.24       5.25       4.37       5.30  
     
     
     
     
 
Net interest yield
    1.63 %     1.33 %     1.61 %     1.32 %
     
     
     
     
 


(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. In the first quarter of 2003, we revised our method of classifying interest expense between short-term and long-term on certain derivative instruments. This reclassification does not affect Fannie Mae’s total interest expense. We reclassified $73 million and $31 million between short-term and long-term interest expense for the three months and six months ended June 30, 2002 to conform to our current year presentation.
 
(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 $5.9 billion and $4.5 billion for the three months ended June 30, 2003 and 2002, respectively, and $5.8 billion and $4.3 billion for the six months ended June 30, 2003 and 2002, respectively.
 
(5)  Interest-free funds represent the portion of our investment portfolio funded by equity and non-interest bearing liabilities.

Reported net interest income for the second quarter and first half of 2003 increased 38 percent in each period over the corresponding prior year periods to $3.501 billion and $6.869 billion, respectively, driven by an 11 percent increase in our average net investment balance for each period, and a 30 basis point and 29 basis point expansion in our reported net interest yield to 1.63 percent and 1.61 percent, respectively. Our average net investment balance (also referred to as total interest-earning assets) consists of our mortgage portfolio (net of unrealized gains and losses on available-for-sale securities and deferred balances) and nonmortgage investments. The upfront cost of purchased options is not included in our reported net interest income and net interest yield. However, the interest expense on callable debt is included in reported net interest income. Accordingly, our net interest yield benefited from increases in the amount of purchased options used as a substitute for callable debt.

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A rate/volume analysis of the changes in our reported net interest income between the second quarter and first half of 2003 and the second quarter and first half of 2002 is shown in Table 2.

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

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



(Dollars in millions)
Second Quarter 2003 vs. Second Quarter 2002
                           
Interest income:
                           
 
Mortgage portfolio
  $ (70 )   $ 1,205     $ (1,275 )    
 
Nonmortgage investments and cash equivalents
    (84 )     68       (152 )    
     
     
     
   
 
Total interest income
    (154 )     1,273       (1,427 )    
     
     
     
   
Interest expense:(2)
                           
 
Short-term debt
    51       378       (327 )    
 
Long-term debt
    (1,174 )     (328 )     (846 )    
     
     
     
   
 
Total interest expense
    (1,123 )     50       (1,173 )    
     
     
     
   
Change in net interest income
  $ 969     $ 1,223     $ (254 )    
     
     
     
   
Change in taxable-equivalent adjustment on tax-exempt investments(3)
    (7 )                    
     
                     
Change in taxable-equivalent net interest income
  $ 962                      
     
                     
First Six Months 2003 vs. First Six Months 2002
                           
Interest income:
                           
 
Mortgage portfolio
  $ 349     $ 2,645     $ (2,296 )    
 
Nonmortgage investments and cash equivalents
    (184 )     83       (267 )    
     
     
     
   
 
Total interest income
    165       2,728       (2,563 )    
     
     
     
   
Interest expense:(2)
                           
 
Short-term debt
    17       743       (726 )    
 
Long-term debt
    (1,758 )     (222 )     (1,536 )    
     
     
     
   
 
Total interest expense
    (1,741 )     521       (2,262 )    
     
     
     
   
Change in net interest income
  $ 1,906     $ 2,207     $ (301 )    
     
     
     
   
Change in taxable-equivalent adjustment on tax-exempt investments(3)
    (7 )                    
     
                     
Change in taxable-equivalent net interest income
  $ 1,899                      
     
                     


(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 grew 49 percent and 42 percent over the second quarter and first half of 2002 to $632 million and $1.179 billion, respectively. The increase in guaranty fee income in the second quarter of 2003 was driven by a 29 percent growth in average outstanding MBS and a 16 percent increase in the average effective guaranty fee rate on outstanding MBS. The increase in guaranty fee income in the first half of 2003 was driven by a 26 percent growth in average outstanding MBS and a 13 percent increase in the average effective guaranty fee rate on outstanding MBS. We use the term “MBS” (mortgage-backed securities) to refer to mortgage-related securities we issue or on which Fannie Mae guarantees timely payment of scheduled principal and interest.

Average outstanding MBS totaled $1.193 trillion and $1.135 trillion in the second quarter and first half of 2003, respectively, compared with $927 billion and $902 billion in the second quarter and first half of 2002. MBS issues acquired by other investors totaled $283 billion and $486 billion in the second quarter and first half of 2003, respectively, versus $103 billion and $210 billion in the second quarter and first half of 2002. MBS issuances expanded in response to increased demand from lenders and investors as the result of an increase in refinance activity driven by lower interest rates. The growth in the average effective guaranty fee rate between the second quarters and first six months of 2003 and 2002 was largely the result

6


 

of faster revenue recognition of deferred fees due to accelerated mortgage prepayments, together with somewhat higher fee rates on new business.

Fee and Other Income, Net

Fee and other income totaled $232 million and $345 million in the second quarter and first half of 2003, up from $42 million and $45 million of income in the second quarter and first half of 2002. During the first half of 2003, we experienced a significant increase in transaction, technology, and multifamily fees due to a surge in business volumes associated with a stronger refinancing market. Transaction, technology, and multifamily fees totaled $283 million and $524 million for the second quarter and first half of 2003, increases of $187 million and $341 million over the second quarter and first half of 2002.

We recorded $99 million and $32 million of gains from the sale of mortgage-related securities classified as available-for-sale during the three months ended June 30, 2003 and 2002. We recorded $110 million and $21 million of gains from the sale of mortgage-related securities classified as available-for-sale during the six months ended June 30, 2003 and 2002.

We recognized impairment totaling $102 million and $197 million in the second quarter and first half of 2003, respectively, due to other than temporary declines in the fair value of certain mortgage and nonmortgage securities or investments. These securities were downgraded during the year and their fair values were significantly lower than cost. It is uncertain whether we will receive all principal and interest due to us.

Credit-Related Expenses

Our overall credit performance remained relatively stable in the second quarter and first half of 2003 compared to the corresponding prior year periods. Credit-related expenses, which include provision for losses and foreclosed property income, declined slightly to $23 million and $43 million in the second quarter and first half of 2003, compared with $24 million and $46 million in the second quarter and first half of 2002. The decrease in credit-related expenses was driven by a decline in provision for losses, which more than offset a decline in foreclosed property income. Provision for losses decreased $7 million and $12 million from the second quarter and first half of 2002 to $26 million and $49 million, respectively. Foreclosed property income totaled $3 million and $6 million in the second quarter and first half of 2003, down from $9 million and $15 million in the second quarter and first half of 2002, primarily due to less income on foreclosed property dispositions.

Credit-related losses, which include charge-offs plus foreclosed property income, remained low in the first half of 2003 due to continued home price gains resulting from the strong housing market, the use of credit enhancements to manage our credit risk, and aggressive management of problem loans. Credit-related losses increased slightly to $23 million and $43 million in the second quarter and first half of 2003, from $17 million and $39 million in the second quarter and first half of 2002, primarily due to a decline in foreclosed property income.

Administrative Expenses

Administrative expenses totaled $354 million and $698 million in the second quarter and first half of 2003, increases of 18 percent over both the second quarter and first half of 2002. The above-average growth in administrative expenses was due primarily to costs incurred in reengineering Fannie Mae’s core technology infrastructure to enhance our ability to process and manage the risk on mortgage assets and the expensing of new stock-based compensation. On January 1, 2003, we adopted the expense recognition provisions of the fair value method of accounting for stock-based compensation under Financial Accounting Standard No. 123, Accounting for Stock-Based Compensation (“FAS 123”) and began expensing all new stock-based compensation.

We evaluate growth in administrative expenses based on growth in core taxable-equivalent revenues and our average book of business. Core taxable-equivalent revenues is a supplemental non-GAAP measure

7


 

discussed further in “MD&A— Core Business Earnings and Business Segment Results.” Despite the above-average growth in administrative expenses, our efficiency ratio— the ratio of administrative expenses to core taxable-equivalent revenues— improved to 8.9 percent and 9.2 percent in the second quarter and first half of 2003 from 10.1 percent and 10.2 percent in the second quarter and first half of 2002. The ratio of administrative expenses as a percentage of our average book of business improved to .071 percent and .072 percent in the second quarter and first half of 2003, compared with ..073 percent in both the second quarter and first half of 2002.

Purchased Options Expense

Purchased options expense totaled $1.883 billion and $2.508 billion in the second quarter and first half of 2003, respectively, up significantly from $498 million and $1.286 billion in the second quarter and first half of 2002. The mark-to-market of the time value of our purchased options will vary from period to period with changes in interest rates, expected interest rate volatility, and derivative activity.

Debt Extinguishments

We recognized $740 million and $1.132 billion in losses on debt extinguishments during the second quarter and first half of 2003, respectively, up from $225 million and $396 million in losses on debt extinguishments that we recognized during the second quarter and first half of 2002. These losses resulted from the call and repurchase of $73 billion and $121 billion of debt during the second quarter and first half of 2003, respectively, and the call and repurchase of $30 billion and $60 billion of debt during the second quarter and first half of 2002, respectively. The year-over-year increase in debt extinguishment activity was driven by attractive opportunities to repurchase relatively high-cost debt. We regularly call or repurchase debt as part of our interest rate risk management strategy.

Income Taxes

Our effective tax rate on reported net income in the second quarter and first half of 2003 was 19 percent and 24 percent based on a provision for federal income taxes of $263 million and $970 million, respectively. In comparison, our effective tax rate for the same prior year periods was 25 percent and 24 percent and our tax provision totaled $485 million and $848 million in the second quarter and first half of 2002. Because of the significant decrease in our pre-tax reported income for the second quarter of 2003, our tax-exempt income and the tax credits we receive on our tax-advantaged investments provided disproportionate tax benefit to our base of pre-tax reported income which reduced our effective tax rate. Our effective tax rate based on core business earnings, which is adjusted for the impact of FAS 133 on our purchased options, was 27 percent and 26 percent in the second quarter and first half of 2003, compared with 26 percent in the same prior year periods.

CORE BUSINESS EARNINGS AND BUSINESS SEGMENT RESULTS

Management relies primarily on core business earnings, a supplemental non-GAAP measure developed in conjunction with our 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 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 strategies. Core business earnings includes amortization of purchased option premiums on a straight-line basis over the original expected life of the options, together with any acceleration of expense related to any options extinguished prior to exercise or expiration. 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

8


 

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 treatment. The calculation of core capital and total capital includes retained earnings, which incorporates GAAP net income, not core business earnings. Our core capital and total capital levels are important determinants of the amount of capital available to shareholders for dividends and our dividend policies take into account these capital levels.

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 core 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

Core business earnings for the second quarter of 2003 grew 18 percent over the second quarter of 2002 to $1.860 billion. Core business earnings per diluted common share increased 20 percent to $1.86 from $1.55 in the second quarter of 2002 and increased 22 percent to $3.70 from $3.03 in the first half of 2002. Increases in our core business earnings and core business earnings per diluted common share were due primarily to strong growth in our core net interest income, guaranty fee income, and fee and other income. Highlights of our second quarter 2003 performance compared with second quarter 2002 include:

  •  34 percent increase in core taxable-equivalent revenues to $3.980 billion
 
  •  26 percent increase in core net interest income to $2.785 billion
 
  •  14 basis point increase in the net interest margin to 1.30 percent
 
  •  49 percent increase in guaranty fee income
 
  •  $190 million increase in fee and other income to $232 million
 
  •  Losses of $740 million from the call and repurchase of debt compared with $225 million
 
  •  29 percent annualized growth in our combined book of business (gross mortgage portfolio and outstanding MBS) during the second quarter of 2003, up from 14 percent annualized growth in the second quarter of 2002

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 3 shows our line of business and consolidated core business earnings results for the second quarter and first half of 2003 and 2002. The only difference between core business earnings and reported net income relates to the FAS 133 accounting treatment for purchased options, which affects our Portfolio Investment business. Core business earnings does not exclude any other accounting effects related to the application of FAS 133. The FAS 133 related reconciling items between our core business earnings and reported results have no effect on our Credit Guaranty business.

9


 

Table 3: Reconciliation of Core Business Earnings to Reported Results

                                           
Three Months Ended June 30, 2003

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





(Dollars in millions)
Net interest income
  $ 3,280     $ 221     $ 3,501     $     $ 3,501  
Purchased options amortization expense
    (716 )           (716 )     716 (2)      
     
     
     
     
     
 
Core net interest income
    2,564       221       2,785       716       3,501  
Guaranty fee income (expense)
    (404 )     1,036       632             632  
Fee and other income, net
    231       1       232             232  
Credit-related expenses(1)
          (23 )     (23 )           (23 )
Administrative expenses
    (103 )     (251 )     (354 )           (354 )
Purchased options expense under FAS 133
                      (1,883 )(3)     (1,883 )
Debt extinguishments
    (740 )           (740 )           (740 )
     
     
     
     
     
 
Income before federal income taxes
    1,548       984       2,532       (1,167 )     1,365  
Provision for federal income taxes
    (454 )     (218 )     (672 )     409 (4)     (263 )
     
     
     
     
     
 
 
Net income
  $ 1,094     $ 766     $ 1,860     $ (758 )   $ 1,102  
     
     
     
     
     
 
                                           
Three Months Ended June 30, 2002

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





Net interest income
  $ 2,375     $ 157     $ 2,532     $     $ 2,532  
Purchased options amortization expense
    (330 )           (330 )     330 (2)      
     
     
     
     
     
 
Core net interest income
    2,045       157       2,202       330       2,532  
Guaranty fee income (expense)
    (336 )     759       423             423  
Fee and other income, net
    82       (40 )     42             42  
Credit-related expenses(1)
          (24 )     (24 )           (24 )
Administrative expenses
    (91 )     (210 )     (301 )           (301 )
Purchased options expense under FAS 133
                      (498 )(3)     (498 )
Debt extinguishments
    (225 )           (225 )           (225 )
     
     
     
     
     
 
Income before federal income taxes
    1,475       642       2,117       (168 )     1,949  
Provision for federal income taxes
    (430 )     (114 )     (544 )     59 (4)     (485 )
     
     
     
     
     
 
 
Net income
  $ 1,045     $ 528     $ 1,573     $ (109 )   $ 1,464  
     
     
     
     
     
 


(1)  Credit-related expenses include the income statement line items “Provision for losses” and “Foreclosed property income.”
 
(2)  Represents the straight-line amortization of purchased options expense that we allocate to interest expense over the original expected life of the options. We include this amount in core business earnings instead of recording changes in the time value of purchased options because this treatment is more consistent with the accounting for the embedded options in our callable debt and the vast majority of our mortgages.
 
(3)  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 do 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. In addition, the accounting for purchased options under FAS 133 is inconsistent with the accounting for embedded options in our callable debt and mortgages.
 
(4)  Represents the net federal income tax effect of core business earnings adjustments based on the applicable federal income tax rate of 35 percent.
                                           
Six Months Ended June 30, 2003

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





(Dollars in millions)
Net interest income
  $ 6,466     $ 403     $ 6,869     $     $ 6,869  
Purchased options amortization expense
    (1,481 )           (1,481 )     1,481 (2)      
     
     
     
     
     
 
Core net interest income
    4,985       403       5,388       1,481       6,869  
Guaranty fee income (expense)
    (807 )     1,986       1,179             1,179  
Fee and other income, net
    353       (8 )     345             345  
Credit-related expenses(1)
          (43 )     (43 )           (43 )
Administrative expenses
    (204 )     (494 )     (698 )           (698 )
Purchased options expense under FAS 133
                      (2,508 )(3)     (2,508 )
Debt extinguishments
    (1,132 )           (1,132 )           (1,132 )
     
     
     
     
     
 
Income before federal income taxes
    3,195       1,844       5,039       (1,027 )     4,012  
Provision for federal income taxes
    (938 )     (391 )     (1,329 )     359 (4)     (970 )
     
     
     
     
     
 
 
Net income
  $ 2,257     $ 1,453     $ 3,710     $ (668 )   $ 3,042  
     
     
     
     
     
 

10


 

                                           
Six Months Ended June 30, 2002

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





Net interest income
  $ 4,647     $ 316     $ 4,963     $     $ 4,963  
Purchased options amortization expense
    (641 )           (641 )     641 (2)      
     
     
     
     
     
 
Core net interest income
    4,006       316       4,322       641       4,963  
Guaranty fee income (expense)
    (654 )     1,485       831             831  
Fee and other income, net
    142       (97 )     45             45  
Credit-related expenses(1)
          (46 )     (46 )           (46 )
Administrative expenses
    (176 )     (415 )     (591 )           (591 )
Purchased options expense under FAS 133
                      (1,286 )(3)     (1,286 )
Debt extinguishments
    (396 )           (396 )           (396 )
     
     
     
     
     
 
Income before federal income taxes
    2,922       1,243       4,165       (645 )     3,520  
Provision for federal income taxes
    (858 )     (216 )     (1,074 )     226 (4)     (848 )
     
     
     
     
     
 
 
Net income
  $ 2,064     $ 1,027     $ 3,091     $ (419 )   $ 2,672  
     
     
     
     
     
 


(1)  Credit-related expenses include the income statement line items “Provision for losses” and “Foreclosed property income.”
 
(2)  Represents the straight-line amortization of purchased options expense that we allocate to interest expense over the original expected life of the options. We include this amount in core business earnings instead of recording changes in the time value of purchased options because this treatment is more consistent with the accounting for the embedded options in our callable debt and the vast majority of our mortgages.
 
(3)  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 do 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. In addition, the accounting for purchased options under FAS 133 is inconsistent with the accounting for embedded options in our callable debt and mortgages.
 
(4)  Represents the net federal income tax effect of core business earnings adjustments based on the applicable federal income tax rate of 35 percent.

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. For line of business reporting purposes, we allocate transaction fees that we earn for structuring and facilitating securities transactions primarily to our Portfolio Investment business. We allocate technology-related fees that we earn from providing Desktop Underwriter and other technology services to our customers and fees we earn for providing credit enhancement alternatives to our customers primarily to our Credit Guaranty business.

Core Taxable-Equivalent Revenues

Core taxable-equivalent revenues for the second quarter and first half of 2003 increased 34 percent and 30 percent over the second quarter and first half of 2002 to $3.980 billion and $7.583 billion, primarily due to strong growth in core net interest income, guaranty fee income, and fee and other income. Table 4 reconciles core taxable-equivalent revenues to taxable-equivalent revenues and provides a comparison between the second quarter and first half of 2003 and 2002.

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Table 4: Core Taxable-Equivalent Revenues

                                   
Three Months Six Months
Ended June 30, Ended June 30,


2003 2002 2003 2002




(Dollars in millions)
Net interest income
  $ 3,501     $ 2,532     $ 6,869     $ 4,963  
Guaranty fees
    632       423       1,179       831  
Fee and other income, net(1)
    232       42       345       45  
     
     
     
     
 
 
Total revenues
    4,365       2,997       8,393       5,839  
Taxable-equivalent adjustments:
                               
 
Investment tax credits(2)
    212       178       429       364  
 
Tax-exempt investments(3)
    119       126       242       249  
     
     
     
     
 
Taxable-equivalent revenues
    4,696       3,301       9,064       6,452  
Purchased options amortization expense(4)
    (716 )     (330 )     (1,481 )     (641 )
     
     
     
     
 
Core taxable-equivalent revenues
  $ 3,980     $ 2,971     $ 7,583     $ 5,811  
     
     
     
     
 


(1)  Includes net losses on certain tax-advantaged investments totaling $52 million and $75 million for the three months ended June 30, 2003 and 2002, respectively, and $124 million and $140 million for the six months ended June 30, 2003 and 2002, 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)  Represents 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.

Core Net Interest Income

Table 5 reconciles taxable-equivalent core net interest income to our reported net interest income and presents an analysis of our net interest margin. 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.

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Table 5: Net Interest Margin

                                     
Three Months Six Months Ended
Ended June 30, June 30,


2003 2002 2003 2002




(Dollars in millions)
Net interest income
  $ 3,501     $ 2,532     $ 6,869     $ 4,963  
 
Purchased options amortization expense(1)
    (716 )     (330 )     (1,481 )     (641 )
     
     
     
     
 
Core net interest income
    2,785       2,202       5,388       4,322  
 
Taxable-equivalent adjustment on tax-exempt investments (2)
    119       126       242       249  
     
     
     
     
 
Taxable-equivalent core net interest income
  $ 2,904     $ 2,328     $ 5,630     $ 4,571  
     
     
     
     
 
Average balances:(3)
                               
Interest-earning assets:(4)
                               
 
Mortgage portfolio, net
  $ 808,215     $ 732,796     $ 806,510     $ 724,200  
 
Nonmortgage investments and cash equivalents
    81,966       69,187       74,550       67,176  
     
     
     
     
 
Total interest-earning assets
    890,181       801,983       881,060       791,376  
 
Interest-free funds(5)
    (32,431 )     (24,196 )     (30,432 )     (24,083 )
     
     
     
     
 
Total interest-earning assets funded by debt
    857,750       777,787       850,628       767,293  
     
     
     
     
 
Interest-bearing liabilities:(6)
                               
 
Short-term debt
    231,718       128,885       221,063       130,153  
 
Long-term debt
    626,032       648,902       629,565       637,140  
     
     
     
     
 
Total interest-bearing liabilities
  $ 857,750     $ 777,787     $ 850,628     $ 767,293  
     
     
     
     
 
Average interest rates:(2, 3)
                               
Interest-earning assets:
                               
 
Mortgage portfolio, net
    6.07 %     6.77 %     6.17 %     6.81 %
 
Nonmortgage investments and cash equivalents
    1.66       2.45       1.74       2.49  
     
     
     
     
 
 
Total interest-earning assets
    5.66       6.40       5.80       6.44  
   
Interest-free return(5)
    .20       .18       .20       .19  
     
     
     
     
 
Total interest-earning assets and interest-free return
    5.86       6.58       6.00       6.63  
     
     
     
     
 
Interest-bearing liabilities:(6)
                               
 
Short-term debt
    1.43       2.21       1.54       2.39  
 
Long-term debt
    5.72       6.06       5.83       6.10  
     
     
     
     
 
 
Total interest-bearing liabilities
    4.56       5.42       4.72       5.47  
     
     
     
     
 
Net interest margin
    1.30 %     1.16 %     1.28 %     1.16 %
     
     
     
     
 


(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 $5.9 billion and $4.5 billion for the three months ended June 30, 2003 and 2002, respectively, and $5.8 billion and $4.3 billion for the six months ended June 30, 2003 and 2002, respectively.
 
(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.

Core net interest income for the second quarter and first half of 2003 increased $583 million and $1.066 billion, or 26 percent and 25 percent, over the second quarter and first half of 2002 to $2.785 billion and $5.388 billion. The increase was due primarily to 11 percent growth in our average net investment balance (total interest earning assets) in each period and a 14 basis point and 12 basis point increase in the net interest margin to 1.30 percent and 1.28 percent in the second quarter and first half of 2003, respectively. Table 6 shows changes in core net interest income between the second quarter and first half of 2003 and the second quarter and first half of 2002.

13


 

Table 6: Rate/Volume Analysis of Changes in Core Net Interest Income

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



(Dollars in millions)
Second Quarter 2003 vs. Second Quarter 2002
                       
Interest income:
                       
 
Mortgage portfolio
  $ (70 )   $ 1,205     $ (1,275 )
 
Nonmortgage investments and cash equivalents
    (84 )     68       (152 )
     
     
     
 
 
Total interest income
    (154 )     1,273       (1,427 )
     
     
     
 
Interest expense:(2)
                       
 
Short-term debt
    51       378       (327 )
 
Long-term debt
    (1,174 )     (328 )     (846 )
     
     
     
 
 
Total interest expense
    (1,123 )     50       (1,173 )
     
     
     
 
Change in net interest income
  $ 969     $ 1,223     $ (254 )
     
     
     
 
Change in purchased options amortization expense(3)
    (386 )                
     
                 
Change in core net interest income
  $ 583                  
Change in taxable-equivalent adjustment on tax-exempt investments(4)
    (7 )                
     
                 
Change in taxable-equivalent core net interest income
  $ 576                  
     
                 
 
First Six Months 2003 vs. First Six Months 2002
                       
Interest income:
                       
 
Mortgage portfolio
  $ 349     $ 2,645     $ (2,296 )
 
Nonmortgage investments and cash equivalents
    (184 )     83       (267 )
     
     
     
 
 
Total interest income
    165       2,728       (2,563 )
     
     
     
 
Interest expense:(2)
                       
 
Short-term debt
    17       743       (726 )
 
Long-term debt
    (1,758 )     (222 )     (1,536 )
     
     
     
 
 
Total interest expense
    (1,741 )     521       (2,262 )
     
     
     
 
Change in net interest income
  $ 1,906     $ 2,207     $ (301 )
     
     
     
 
Change in purchased options amortization expense(3)
    (840 )                
     
                 
Change in core net interest income
  $ 1,066                  
Change in taxable-equivalent adjustment on tax-exempt investments(4)
    (7 )                
     
                 
Change in taxable-equivalent core net interest income
  $ 1,059                  
     
                 


(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 we would have recorded under GAAP prior to adopting FAS 133.
 
(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

Fannie Mae’s Portfolio Investment business manages the interest rate risk of our mortgage portfolio and nonmortgage investments. Core business earnings generated by our Portfolio Investment business is primarily reflected in core net interest income. Second quarter and first half 2003 core business earnings for our Portfolio Investment business grew 5 percent and 9 percent over the corresponding periods in 2002 to $1.094 billion and $2.257 billion, respectively. This growth was driven primarily by strong growth in core net interest income in both periods, partially offset by a significant increase in losses from debt extinguishments.

The increase in core net interest income for our Portfolio Investment business was driven by an increase in our net interest margin, which averaged 130 basis points and 128 basis points in the second quarter and first half of 2003, respectively, compared with 116 basis points in both the second quarter and first half of 2002. These increases in our net interest margin were partially offset by slower growth in our mortgage portfolio, which declined at an annualized rate of 2 percent during the second quarter of 2003 and slowed

14


 

to an annualized growth rate of 6 percent during the first half of 2003. This relatively slow growth in the portfolio was driven by continued high levels of liquidations together with strong competition for mortgages from banks and other investors that periodically narrowed spreads between mortgage yields and our debt costs (mortgage-to-debt spreads) which produced less attractive purchase opportunities. In addition, during the second quarter of 2003 we took advantage of favorable pricing in the forward market and delayed settlement on many of our mortgage purchase commitments. As these commitments settle during the second half of the year, our portfolio growth should accelerate noticeably.

Our net interest margin for the second quarter and first half of 2003 benefited significantly from very low mortgage rates and high levels of anticipated refinancing. We had expected our net interest margin to begin to decline in early 2003 as interest rates leveled off or moved higher. However, interest rates dropped further in the first half of 2003, resulting in an increase in projected mortgage liquidations. As a result, we maintained an unusually high percentage of short-term financing at a lower cost for longer than we had anticipated, which reduced our interest expense and caused a further temporary increase in our net interest margin.

Losses from debt extinguishments increased by $515 million and $736 million during the second quarter and first half of 2003, respectively. These increases were driven by attractive opportunities to repurchase high-cost debt.

Mortgage Portfolio

Table 7 summarizes mortgage portfolio activity on a gross basis and average yields for the second quarter and first half of 2003 and 2002, and Table 8 shows the distribution of Fannie Mae’s mortgage portfolio by product type at June 30, 2003 and December 31, 2002.

15


 

Table 7: Mortgage Portfolio Activity(1)

                                                     
Purchases Sales Repayments(2)



Three Months Three Months Three Months
Ended June 30, Ended June 30, Ended June 30,



2003 2002 2003 2002 2003 2002






(Dollars in millions)
Single-family:
                                               
 
Government insured or guaranteed
  $ 1,493     $ 5,879     $     $ 67     $ 4,536     $ 2,708  
     
     
     
     
     
     
 
 
Conventional:
                                               
   
Long-term, fixed-rate
    102,204       35,712       5,116       3,562       102,860       34,621  
   
Intermediate-term, fixed-rate
    17,904       11,667       107             15,239       6,715  
   
Adjustable-rate
    3,896       1,928       202             2,817       2,030  
     
     
     
     
     
     
 
 
Total conventional single-family
    124,004       49,307       5,425       3,562       120,916       43,366  
     
     
     
     
     
     
 
 
Total single-family
    125,497       55,186       5,425       3,629       125,452       46,074  
Multifamily
    2,463       1,731                   494       401  
     
     
     
     
     
     
 
 
Total
  $ 127,960     $ 56,917     $ 5,425     $ 3,629     $ 125,946     $ 46,475  
     
     
     
     
     
     
 
Average net yield
    5.09 %     6.37 %                     6.45 %     6.89 %
Annualized repayments as a percentage of average mortgage portfolio
                                    61.8 %     25.2 %
                                                     
Purchases Sales Repayments(2)



Six Months Six Months Six Months
Ended June 30, Ended June 30, Ended June 30,



2003 2002 2003 2002 2003 2002






Single-family:
                                               
 
Government insured or guaranteed
  $ 2,421     $ 7,134     $ 58     $ 73     $ 8,818     $ 5,549  
     
     
     
     
     
     
 
 
Conventional:
                                               
   
Long-term, fixed-rate
    207,988       109,974       6,075       6,120       196,917       85,549  
   
Intermediate-term, fixed-rate
    37,474       23,535       307       74       19,540       11,019  
   
Adjustable-rate
    7,451       3,442       256       114       5,231       4,420  
     
     
     
     
     
     
 
 
Total conventional single-family
    252,913       136,951       6,638       6,308       221,688       100,988  
     
     
     
     
     
     
 
 
Total single-family
    255,334       144,085       6,696       6,381       230,506       106,537  
Multifamily
    4,631       3,778             379       1,048       910  
     
     
     
     
     
     
 
 
Total
  $ 259,965     $ 147,863     $ 6,696     $ 6,760     $ 231,554     $ 107,447  
     
     
     
     
     
     
 
Average net yield
    5.22 %     6.34 %                     6.52 %     6.96 %
Annualized repayments as a percentage of average mortgage portfolio
                                    57.1 %     29.4 %


(1)  Excludes premiums, discounts, and other deferred price adjustments.
 
(2)  Includes mortgage loan prepayments, scheduled amortization, and foreclosures.

16


 

Table 8: Mortgage Portfolio Composition(1)

                         
June 30, December 31,
2003 2002


(Dollars in millions)
Mortgages
               

               
Single-family:
               
 
Government insured or guaranteed
  $ 6,045     $ 5,458  
     
     
 
 
Conventional:
               
     
Long-term, fixed-rate
    110,488       103,220  
     
Intermediate-term, fixed-rate(2)
    67,946       54,503  
     
Adjustable-rate
    10,600       9,045  
     
     
 
       
Total conventional single-family
    189,034       166,768  
     
     
 
Total single-family
    195,079       172,226  
     
     
 
Multifamily:
               
 
Government insured or guaranteed
    1,212       1,353  
 
Conventional
    14,855       12,218  
     
     
 
Total multifamily
    16,067       13,571  
     
     
 
Total mortgages
  $ 211,146     $ 185,797  
     
     
 
Mortgage-related securities
               

               
Single-family:
               
 
Government insured or guaranteed
  $ 26,137     $ 33,293  
     
     
 
 
Conventional:
               
   
Long-term, fixed-rate
    506,704       510,435  
   
Intermediate-term, fixed-rate(2)
    43,284       39,409  
   
Adjustable-rate
    14,564       13,946  
     
     
 
     
Total conventional single-family
    564,552       563,790  
     
     
 
Total single-family
    590,689       597,083  
     
     
 
Multifamily:
               
 
Government insured or guaranteed
    8,012       7,370  
 
Conventional
    7,620       7,050  
     
     
 
Total multifamily
    15,632       14,420  
     
     
 
Total mortgage-related securities
  $ 606,321     $ 611,503  
     
     
 
Mortgage portfolio, net
               

               
Single-family:
               
 
Government insured or guaranteed
  $ 32,182     $ 38,751  
     
     
 
 
Conventional:
               
   
Long-term, fixed-rate
    617,192       613,655  
   
Intermediate-term, fixed-rate(2)
    111,230       93,912  
   
Adjustable-rate
    25,164       22,991  
     
     
 
     
Total conventional single-family
    753,586       730,558  
     
     
 
Total single-family
    785,768       769,309  
     
     
 
Multifamily:
               
 
Government insured or guaranteed
    9,224       8,723  
 
Conventional
    22,475       19,268  
     
     
 
Total multifamily
    31,699       27,991  
     
     
 
Total mortgage portfolio
    817,467       797,300  
 
Unamortized premium, discount, and deferred price adjustments, net(3)
    2,892       472  
 
Allowance for loan losses(4)
    (83 )     (79 )
     
     
 
Mortgage portfolio, net
  $ 820,276     $ 797,693  
     
     
 
Average net yield
    5.99 %     6.45 %


(1)  Data reflects 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 $1,587 million at June 30, 2003 and $135 million at December 31, 2002 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.”

Nonmortgage Investments

Nonmortgage investments consist of our Liquid Investment Portfolio (“LIP”) and other non-mortgage related investments. Nonmortgage investments increased 12 percent to $67 billion at June 30, 2003, from

17


 

$60 billion at December 31, 2002. We regularly review these investments for other than temporary declines in their fair value and record impairment where appropriate in fee and other income.

Table 9 shows the composition, weighted-average maturities, and credit ratings of our available-for-sale and held-to-maturity nonmortgage investments at June 30, 2003 and December 31, 2002.

Table 9: Nonmortgage Investments

Available-for-Sale

                                                     
June 30, 2003

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
  $ 27,533     $ 83     $ (40 )   $ 27,576       24.0       99.3  
 
Floating rate notes(1)
    12,649       17       (4 )     12,662       14.4       92.5  
 
Corporate bonds
    1,134       44             1,178       21.8       73.1  
 
Taxable auction notes
    784                   784       .5       100.0  
 
Auction rate preferred stock
    63       2             65       1.0        
 
Other
    50                   50       7.8       100.0  
     
     
     
     
     
     
 
   
Total
  $ 42,213     $ 146     $ (44 )   $ 42,315       20.6       96.4  
     
     
     
     
     
     
 
                                                     
December 31, 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  
 
Commercial paper
    100                   100       2.2       100.0  
 
Auction rate preferred stock
    112             (4 )     108       2.5       43.5  
 
Other
    400                   400       1.1       100.0  
     
     
     
     
     
     
 
   
Total
  $ 36,745     $ 150     $ (101 )   $ 36,794       22.0       93.5  
     
     
     
     
     
     
 


(1)  As of June 30, 2003 and December 31, 2002, 100 percent of floating rate notes repriced at intervals of 90 days or less.

18


 

Held-to-Maturity

                                                     
June 30, 2003

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
  $ 18,294     $     $     $ 18,294       .5       100.0  
 
Federal funds
    5,100                   5,100       .3       100.0  
 
Auction rate preferred stock
    774                   774       .8       100.0  
 
Other
    441                   441       7.3       100.0  
     
     
     
     
     
     
 
   
Total
  $ 24,609     $     $     $ 24,609       .6       100.0  
     
     
     
     
     
     
 
                                                     
December 31, 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  
 
Federal funds
    150                   150       1.9       100.0  
 
Auction rate preferred stock
    402                   402       1.0       100.0  
 
Eurodollar time deposits
    1,398                   1,398       .8       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  
     
     
     
     
     
     
 

Our nonmortgage investments combined with cash and cash equivalents represent our total liquid investments. Our liquid investments totaled $69 billion at June 30, 2003, compared with $62 billion at December 31, 2002.

Debt Securities

Total debt outstanding increased 4 percent to $884 billion at June 30, 2003 from $851 billion at December 31, 2002. Table 10 shows a comparison of debt issuances and repayments between the second quarter and first half of 2003 and the second quarter and first half of 2002.

Table 10: Debt Activity

                   
Three Months
Ended June 30,

2003 2002


(Dollars in millions)
Issued:
               
 
Amount
  $ 686,729     $ 389,024  
 
Average cost
    1.23 %     2.27 %
Redeemed:
               
 
Amount
  $ 679,863     $ 372,815  
 
Average cost
    1.78 %     2.31 %
                   
Six Months
Ended June 30,

2003 2002


Issued:
               
 
Amount
  $ 1,337,602     $ 912,889  
 
Average cost
    1.32 %     2.19 %
Redeemed:
               
 
Amount
  $ 1,308,238     $ 890,169  
 
Average cost
    1.75 %     2.28 %

We adjust the maturity and redemption value of our outstanding debt to show the effect of our use of derivatives to supplement our issuance of debt and to hedge against fluctuations in interest rates. Table 11 shows that we increased the relative amount of our effective short-term debt relative to effective long-term debt and lowered our effective debt costs at June 30, 2003 compared to December 31, 2002 due to the rise

19


 

in mortgage asset liquidations and the steep yield curve. Table 12 shows the maturity and cost of our effective long-term debt.

Table 11: Effective Short-Term and Long-Term Debt

                   
June 30, December 31,
2003 2002


(Dollars in millions)
Outstanding:
               
Short-term:(1)
               
 
Net amount
  $ 294,432     $ 192,702  
 
Cost
    1.28 %     1.52 %
 
Weighted-average maturity (in months)
    2       3  
 
Percent of total debt outstanding
    34 %     23 %
Long-term:(2)
               
 
Net amount
  $ 579,676     $ 651,827  
 
Cost
    5.57 %     5.48 %
 
Weighted-average maturity (in months)
    74       75  
 
Percent of total debt outstanding
    66 %     77 %
Total:
               
 
Net amount(3)
  $ 874,108     $ 844,529  
 
Cost
    4.13 %     4.81 %
 
Weighted-average maturity (in months)
    50       58  


(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 period end. Excludes the effect of amortization of premiums, discounts, issuance costs, and hedging results.

Table 12: Maturities of Effective Long-Term Debt

                                 
Assuming Callable Debt
Redeemed at Initial
Contractual Maturity Call Date


Amount Accounting Amount Accounting
Outstanding(1) Cost(2) Outstanding(1) Cost(2)




(Dollars in millions)
Currently callable
  $       %   $ 3,445       5.08 %
2003
    28,889       6.07       132,125       4.57  
2004
    89,444       4.99       195,942       5.24  
2005
    84,890       4.21       82,386       5.28  
2006
    78,622       4.24       70,922       5.27  
2007
    49,411       5.95       36,562       7.11  
2008 and later
    248,420       6.55       58,294       8.88  
     
     
     
     
 
    $ 579,676       5.57     $ 579,676       5.57  
     
     
     
     
 


(1)  Amount outstanding includes long-term debt, effective fixed-rate debt and notional amount of long-term interest rate swaps. Also includes debt linked to swaptions, which makes it effective callable debt. Excludes effective variable-rate debt.
 
(2)  Accounting cost represents the monthly equivalent yield that discounts the amount due at maturity to the net proceeds over the expected life of the debt. Includes the impact of debt swaps.

Seventy-five percent of our mortgage portfolio had option-embedded protection at June 30, 2003, the same level that we had at December 31, 2002, but still above the average range of the past three years. Effectively callable debt accounted for 78 percent of the $618 billion in option-embedded debt outstanding at June 30, 2003. In comparison, effectively callable debt accounted for 58 percent of the $601 billion in option-embedded debt outstanding at December 31, 2002. Table 13 presents option-embedded debt instruments as a percentage of our net mortgage portfolio at June 30, 2003 and 2002, and December 31, 2002.

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Table 13: Option-Embedded Debt Instruments

                         
Six Months
Ended
June 30,

December 31,
2003 2002 2002



(Dollars in millions)
Issued during period
  $ 213     $ 117     $ 384  
Outstanding
    618       430       601  
Percentage of net mortgage portfolio
    75 %     58 %     75 %

Credit Guaranty Business

Our Credit Guaranty business has primary responsibility for managing all of our mortgage credit risk. Core business earnings generated by our Credit Guaranty business are primarily reflected in guaranty fee income, administrative expenses, and net interest income. Second quarter and first half 2003 core business earnings for our Credit Guaranty business grew 45 percent and 41 percent over the corresponding periods in 2002 to $766 million and $1.453 billion, respectively. The increase in core business earnings for our Credit Guaranty business was driven primarily by a 36 percent and 34 percent increase in guaranty fee income. Guaranty fee income for our Credit Guaranty business increased largely due to 20 percent and 19 percent growth in our average book of business and a 2 basis point increase in the average fee rate for each period to 20.8 basis points and 20.5 basis points, respectively. The increase in the average fee rate was a result of higher fee rates on new business, together with the faster revenue recognition of deferred fees due to accelerated prepayments. 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 average effective guaranty fee rate, which excludes guaranty fees on Fannie Mae MBS held in our portfolio because these fees are reported as interest income.

OFF-BALANCE SHEET ARRANGEMENTS

We enter into off-balance sheet 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 may involve elements of credit and interest rate risk in excess of amounts recognized on Fannie Mae’s balance sheet. Table 14 shows our off-balance sheet arrangements at June 30, 2003 and December 31, 2002, which primarily include guaranteed MBS and other mortgage-related securities and commitments to purchase mortgage assets or issue and guarantee MBS.

Table 14: Off-Balance Sheet Arrangements

                   
June 30, December 31,
2003 2002


(Dollars in billions)
Contractual amounts:
               
 
Outstanding MBS(1)
  $ 1,237     $ 1,029  
 
Master commitments:
               
 
Mandatory
    60       41  
 
Optional
    10       6  
 
Portfolio purchase commitments:
               
 
Mandatory
    135       85  
 
Optional
    4       3  
 
Credit enhancements
    12       12  
Other investments
    3       3  


(1)  MBS held by investors other than Fannie Mae.

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Table 15 summarizes outstanding MBS and total MBS outstanding at June 30, 2003 and December 31, 2002. In addition, it presents total MBS issued plus MBS issues acquired by others, including REMICs, in the second quarter and first half of 2003 and 2002.

Table 15: Outstanding MBS(1)

                 
June 30, December 31,
2003 2002


(Dollars in millions)
Outstanding MBS held by other investors
  $ 1,237,461     $ 1,029,456  
Total MBS outstanding(2)
    1,749,896       1,538,287  
                 
Three Months Ended
June 30,

2003 2002


MBS issues acquired by others
  $ 282,502     $ 102,909  
Total MBS issued(3)
    352,985       132,042  
                 
Six Months Ended
June 30,

2003 2002


MBS issues acquired by others
  $ 486,435     $ 209,713  
Total MBS issued(4)
    645,558       305,958  


(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 $512 billion at June 30, 2003 and $509 billion at December 31, 2002 of MBS in Fannie Mae’s portfolio.
 
(3)  Total issued for the three months ended June 30, 2003 and 2002 includes $70 billion and $29 billion, respectively, of MBS purchased by Fannie Mae. Total issued for the three months ended June 30, 2003 and 2002 excludes $3 billion of MBS that we issued from loans in our portfolio.
 
(4)  Total issued for the six months ended June 30, 2003 and 2002 includes $159 billion and $96 billion, respectively, of MBS purchased by Fannie Mae. Total issued for the six months ended June 30, 2003 and 2002 excludes $9 billion and $5 billion, respectively, of MBS that we issued from loans in our portfolio.

REMIC issuances totaled $72 billion and $145 billion in the second quarter and first half of 2003, compared with $22 billion and $58 billion in the second quarter and first half of 2002. Lower interest rates continued to fuel MBS issuances, making more collateral available for REMICs. The REMIC market continued to be attractive to investors because of the effect of the steep yield curve. The outstanding balance of REMICs (including REMICs held in Fannie Mae’s portfolio) was $382 billion at June 30, 2003, compared with $347 billion at December 31, 2002.

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 believe the application of the following accounting policies involve the most critical or complex estimates and assumptions used in preparing Fannie Mae’s financial statements: 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. We discuss the assumptions involved in applying these policies in Fannie Mae’s 2002 Annual Report on Form 10-K under “Management’s Discussion and Analysis of Financial Condition and Results of Operation—Application of Critical Accounting Policies”

As of June 30, 2003, we have not made any significant changes to the estimates and assumptions used in applying our critical accounting policies from our audited financial statements except as follows. In conjunction with this ongoing assessment and continual updating of assumptions, management significantly changed the prepayment projections for mortgages and mortgage-related securities held in portfolio and

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guaranteed mortgage-related securities as a result of substantially lower interest rates. This resulted in an acceleration of the recognition of deferred price adjustments related to our guaranty business as discussed in the guaranty fee section. While we believe our estimates and assumptions are reasonable based on historical experience and other factors, actual results could differ from those estimates and these differences could be material to the financial statements.

RISK MANAGEMENT

Fannie Mae is exposed to several major areas of risk, including interest rate risk and credit risk, that are discussed in our Annual Report on Form 10-K for the year ended December 31, 2002 under “Management’s Discussion and Analysis of Financial Condition and Results of Operation—Risk Management.”

Corporate Financial Disciplines

We recently completed a comprehensive assessment of our corporate financial disciplines. We concluded that with our risk-based capital standard in place—and given the growing scale of our business and the potential for continued financial market volatility—it was prudent to review our financial disciplines, and to consider updating the business risk management strategies they govern. During our review we formalized the following internal financial discipline objectives.

•  To maintain a standalone “risk-to-the-government” credit rating from Standard and Poor’s of at least AA-, and to maintain a standalone “bank financial strength” credit rating from Moody’s of at least A-:

  Our senior debt securities carry AAA/Aaa ratings. We also are given “standalone” credit ratings by both Standard and Poor’s and Moody’s. These standalone ratings are important external indicators of Fannie Mae’s intrinsic financial strength.

•  To sufficiently capitalize and hedge our mortgage portfolio and credit guaranty business so that each is able to withstand internal and external “stress tests” set to at least a AA/Aa standard:

  The most common way that regulators, rating agencies and financial analysts judge the adequacy of a company’s capital and the quality of its risk management practices is by assessing how well that company would perform under conditions of extreme and prolonged economic and financial stress.
 
  Our regulator now uses a quarterly risk-based capital stress test to evaluate Fannie Mae’s capital adequacy, and it makes the results of these tests public. This risk-based capital test provides the company with a direct regulatory incentive to maintain a low risk profile. We traditionally have used stress tests internally as well.

•  To keep our mortgage prepayment and credit risks low enough that over time our core business earnings are less variable than the median of all AA/Aa and AAA/Aaa S&P 500 companies.

  We examined the net income pattern over the past ten years of all of the companies that were able to maintain ratings of AA-/Aa3 or higher during the entire period. From this review we determined that we should set as an objective to manage our interest rate and credit risks so that Fannie Mae’s long-term earnings variability remains below the median of all AA/Aa and AAA/Aaa companies. In conjunction with our stress test standards, we believe that meeting this income variability objective will allow us to maintain our standalone ratings with a comfortable margin of safety, and possibly to improve them.

Interest Rate Risk Management

Interest rate risk is the risk of loss to future earnings or long-term value that may result from changes in interest rates. We utilize a wide range of risk measures and analyses to manage the interest rate risk inherent in the mortgage portfolio, including ongoing business risk measures and run-off measures of the existing portfolio. We rely on net interest income at risk as our primary ongoing business measure of interest rate risk and the portfolio duration gap as our primary run-off measure of interest rate risk. We

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disclose our net interest income at risk and duration gap measures on a monthly basis. We believe these measures together provide a more informative profile of our overall interest rate risk position than either measure alone.

• Net Interest Income at Risk

Net interest income at risk measures the projected impact of changes in the level of interest rates and the shape of the yield curve on the mortgage portfolio’s expected or “base” core net interest income over the immediate future one- and four-year periods. Our net interest income at risk disclosure represents the extent to which our core net interest income over the next one-year and four-year periods is at risk due to a plus or minus 50 basis point parallel change in the current Fannie Mae yield curve and from a 25 basis point change in the slope of Fannie Mae’s yield curve. These changes in interest rates were selected as part of our six voluntary initiatives announced in 2000.

Table 16 compares our June 30, 2003 and December 31, 2002 net interest income at risk over a one-year and four-year period under each of the interest rate scenarios. A positive number indicates the percent by which projected adjusted net interest income could be reduced by the rate shock. These calculations reflect management’s assumptions of most likely market conditions. Actual portfolio core net interest income may differ from these calculations because of specific interest rate movements, changing business conditions, changing prepayments, and management actions.

Table 16: Net Interest Income at Risk

                                 
Assuming a 50 basis Assuming a 25 basis
point change in point change in slope
interest rates of the yield curve


One-year Four-year One-year Four-year




June 30, 2003
    2.1 %     6.6 %     3.9 %     5.9 %
December 31, 2002
    .6       1.6       4.7       6.6  

• Duration Gap

We apply the same interest rate process, prepayment models, and volatility assumptions used in our net interest income at risk measure to generate the portfolio duration gap. However, we do not incorporate projected future business activity or nonmortgage investments into our duration gap measure. The duration gap measures the difference between the estimated durations of portfolio assets and liabilities and summarizes the extent to which estimated cash flows for assets and liabilities are matched, on average, over time and across interest rate scenarios. A positive duration gap signals a greater exposure to rising interest rates because it indicates that the duration of our assets exceeds the duration of our liabilities. A negative duration gap signals a greater exposure to declining interest rates because the duration of our assets is less than the duration of our liabilities.

For March 2003, disclosed in April, we began reporting our duration gap as a weighted average for the month. Previously, we had reported the duration gap as of the last business day of each month. We believe that reporting a weighted average monthly duration gap provides a more representative measure of our portfolio’s risk position for the month and reduces the effect of any financial anomalies that may occur on the last day of the month. Fannie Mae’s duration gap for June 2003 calculated on a monthly average basis was minus 1 month. In comparison, the duration gap calculated at month end was minus 5 months at December 31, 2002.

We maintain to the extent possible a relatively close match between the durations of the assets and liabilities in our mortgage portfolio investment business, using a combination of option-based funding and

24


 

rebalancing actions to meet this objective. Prior to this year, Fannie Mae’s duration gap has been wider than plus or minus 6 months approximately one-third of the time. Going forward, our objective will be to maintain the portfolio’s duration gap within a range of plus-or-minus six months substantially all of the time. This narrower range for the portfolio duration gap should reduce potential core business earnings variability, but also could produce a somewhat lower net interest margin over the longer term.

Derivatives

Derivative instruments are important tools that we use to manage interest rate risk and supplement our issuance of debt in the capital markets. We are an end user of derivatives and do not take speculative positions with derivatives. We primarily use interest rate derivative instruments as a substitute for notes and bonds we issue in the debt markets. The ability to either issue debt securities or modify debt through the use of derivatives increases our funding flexibility and potentially reduces our overall funding costs. The funding flexibility provided by using derivatives also helps us to better match the cash flow variability inherent in mortgages. The types of derivatives we use— primarily interest-rate swaps, basis swaps, swaptions, and caps— are generally regarded in the marketplace as relatively straightforward interest rate derivatives.

Table 17 summarizes the notional balances and fair values of our derivatives by type at June 30, 2003 and December 31, 2002.

Table 17: Derivative Notional Amounts and Net Fair Values

                                   
June 30, 2003 December 31, 2002


Notional Net Fair Notional Net Fair
Amounts Values(1) Amounts Values(1)




(Dollars in millions)
Pay-fixed swaps
  $ 219,307     $ (20,433 )   $ 168,512     $ (17,892 )
Receive-fixed swaps
    142,938       6,676       52,370       4,010  
Basis swaps
    24,250       1       25,525       4  
Caps and swaptions
    410,733       15,265       397,868       12,834  
Other
    14,165       (1,007 )     12,320       (987 )
     
     
     
     
 
 
Total
  $ 811,393     $ 502     $ 656,595     $ (2,031 )
     
     
     
     
 


(1)  Based on end of period fair values, estimated by calculating the cost, on a net present value basis, to settle at current market rates all outstanding derivative contracts.

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Table 18 shows the additions and maturities of derivatives by type during the first and second quarters of 2003, along with the expected maturities of derivatives outstanding at June 30, 2003.

Table 18: Derivative Activity and Maturity Data

                                                                     
Pay-Fixed/ Receive-Variable
Swaps(2)

Receive-Fixed/
Pay Receive Pay-Variable Basis Caps and
Amount Rate(3) Rate(3) Swaps Swaps Swaptions Other(4) Total








(Dollars in millions)
Notional Amounts:(1)
                                                               
Notional balance at December 31, 2002
  $ 168,512       6.07 %     1.67 %   $ 52,370     $ 25,525     $ 397,868     $ 12,320     $ 656,595  
 
Additions
    32,515       3.12       1.36       29,409       5,975       18,350       5,138       91,387  
 
Maturities(5)
    4,700       5.50       1.69       11,438       9,785       41,000       3,701       70,624  
     
     
     
     
     
     
     
     
 
Notional balance at March 31, 2003
  $ 196,327       5.59 %     1.39 %   $ 70,341     $ 21,715     $ 375,218     $ 13,757     $ 677,358  
 
Additions
    34,125       2.83       1.18       87,186       10,280       100,285       5,745       237,621  
 
Maturities(5)
    11,145       5.08       1.34       14,589       7,745       64,770       5,337       103,586  
     
     
     
     
     
     
     
     
 
Notional balance at June 30, 2003
  $ 219,307       5.32 %     1.28 %   $ 142,938     $ 24,250     $ 410,733     $ 14,165     $ 811,393  
     
     
     
     
     
     
     
     
 
 
Future Maturities of Notional Amounts:(6)
                                                               
 
2003
  $ 14,085       4.90 %     1.26 %   $ 3,365     $ 5,050     $ 49,228     $ 4,908     $ 76,636  
 
2004
    15,550       5.54       1.27       11,420       18,125       66,850       1,200       113,145  
 
2005
    25,160       3.92       1.28       12,125       175       68,500       1,409       107,369  
 
2006
    21,265       4.58       1.26       12,690       430       15,650       300       50,335  
 
2007
    16,000       5.26       1.27       27,585             14,000       3,346       60,931  
 
Thereafter
    127,247       5.73       1.28       75,753       470       196,505       3,002       402,977  
     
     
     
     
     
     
     
     
 
   
Total
  $ 219,307       5.32 %     1.28 %   $ 142,938     $ 24,250     $ 410,733     $ 14,165     $ 811,393  
     
     
     
     
     
     
     
     
 


(1)  Dollars represent notional amounts that indicate only the amount on which payments are being calculated and do not represent the amount at risk of loss.
 
(2)  Notional amounts include callable swaps of $36 billion, $35 billion, and $35 billion with weighted-average pay rates of 6.73 percent, 6.74 percent, and 6.75 percent and weighted-average receive rates of 1.29 percent, 1.40 percent and 1.68 percent at June 30, 2003, March 31, 2003, and December 31, 2002, respectively.
 
(3)  The weighted-average interest rate payable and receivable is as of the date indicated. The interest rates of the swaps may be variable rate, so these rates may change as prevailing interest rates change.
 
(4)  Includes foreign currency swaps, futures contracts, and derivative instruments that provide a hedge against interest rate fluctuations. Derivatives that served as economic hedges but did not meet the criteria for hedge accounting under FAS 133 totaled $444 million at June 30, 2003.
 
(5)  Includes matured, called, exercised, and terminated amounts.
 
(6)  Based on stated maturities. Assumes that variable interest rates remain constant at June 30, 2003 levels.

At June 30, 2003, 100 percent of the $811 billion notional amount of our outstanding derivative transactions were with counterparties rated A or better both by Standard & Poor’s (“S&P”) and Moody’s Investors Service (“Moody’s”). Our derivative instruments were diversified to reduce our credit risk concentrations among 22 counterparties at June 30, 2003, compared with 21 counterparties at December 31, 2002. At June 30, 2003, six counterparties with credit ratings of A or better represented approximately 69 percent of the total notional amount of outstanding derivatives transactions. The outstanding notional amount for each of these six counterparties ranged between 7 percent and 14 percent of our total outstanding notional amount at June 30, 2003. Each of the remaining counterparties accounted for less than five percent of the total outstanding notional amount at June 30, 2003. In comparison, eight counterparties with credit ratings of A or better represented approximately 76 percent of the total notional amount of outstanding derivatives transactions at December 31, 2002.

Our primary credit exposure on a derivative transaction is that a counterparty might default on payments due, which could result in Fannie Mae having to replace the derivative with a different counterparty at a higher cost. Although notional principal is a commonly used measure of volume in the derivatives market,

26


 

it is not a meaningful measure of market or credit risk since the notional amount does not change hands other than in the case of foreign currency swaps. Counterparties use the notional amounts of derivative instruments to calculate contractual cash flows to be exchanged. However, the notional amount is significantly greater than the potential market or credit loss that could result from such transactions. The replacement cost, after consideration of offsetting arrangements such as master netting agreements and collateral held, to settle at current market prices all outstanding derivatives in a gain position is a more meaningful measure of our credit market exposure on derivatives. Table 19 shows our exposure on derivatives at June 30, 2003 and December 31, 2002 by maturity and counterparty credit ratings based on these maturities.

Table 19: Derivative Credit Loss Exposure(1)

                                                                                   
June 30, 2003 December 31, 2002


Credit Rating Credit Rating


AAA AA A BBB Total AAA AA A BBB Total










(Dollars in millions)
Less than 1 year
  $     $ 28     $ 16     $     $ 44     $     $ 69     $ 6     $     $ 75  
1 to 5 years
    1       843       388             1,232             486       116             602  
Over 5 years
    28       2,086       3,080             5,194       21       1,334       2,328             3,683  
     
     
     
     
     
     
     
     
     
     
 
 
Subtotal
    29       2,957       3,484             6,470       21       1,889       2,450             4,360  
 
Maturity Distribution Netting(2)
    (29 )     (485 )     (572 )           (1,086 )     (21 )     (368 )     (670 )           (1,059 )
     
     
     
     
     
     
     
     
     
     
 
Exposure
          2,472       2,912             5,384             1,521       1,780             3,301  
Collateral Held
          2,223       2,864             5,087             1,382       1,722             3,104  
     
     
     
     
     
     
     
     
     
     
 
Exposure Net of Collateral (3)
  $     $ 249     $ 48     $     $ 297     $     $ 139     $ 58     $     $ 197  
     
     
     
     
     
     
     
     
     
     
 
Notional Amount(4)
  $ 19,120     $ 397,526     $ 394,380     $ 0     $ 811,026     $ 21,045     $ 316,813     $ 318,487     $ 250     $ 656,595  
 
Number of Counterparties
    3       11       8       0       22       2       11       7       1       21  


(1)  Represents the exposure to credit loss on derivative instruments, which is estimated by calculating the cost, on a present value basis, to replace all outstanding derivative contracts in a gain position. Reported on a net-by-counterparty basis where a legal right of offset exists under an enforceable master settlement agreement. Derivative gains and losses with the same counterparty in the same maturity category are presented net within the maturity category.
 
(2)  Represents impact of netting of derivatives in a gain position and derivatives in a loss position for the same counterparty across maturity categories.
 
(3)  “Exposure Net of Collateral” may not be exactly equal to “Exposure” minus “Collateral Held” due to rounding.
 
(4)  Total at June 30, 2003 excludes $367 million notional amount of unrated, mortgage-related derivatives with a fair value of less than $1 million.

Our derivative credit loss exposure, net of collateral held, was $297 million at June 30, 2003, compared with $197 million at December 31, 2002. We expect the credit exposure on derivative contracts to fluctuate as interest rates change. Our derivative credit loss exposure, net of collateral held, at June 30, 2003 represented approximately 2 weeks of annualized pre-tax core business earnings.

At June 30, 2003 and December 31, 2002, 100 percent of our exposure on derivatives, before consideration of collateral held, was with counterparties rated A or better by S&P and Moody’s. Five counterparties with credit ratings of A or better accounted for approximately 88 percent and 92 percent, respectively, of our exposure on derivatives before consideration of collateral held at June 30, 2003 and December 31, 2002. Seventy-four percent of our net exposure of $297 million at June 30, 2003 was with five counterparties rated AA or better by S&P and Aa or better by Moody’s. The percentage of our exposure with each of these five counterparties ranged from 12 to 17 percent. In comparison, six counterparties rated AA or better by S&P and Aa or better by Moody’s accounted for 71 percent of our net exposure of $197 million at December 31, 2002.

Fannie Mae has never experienced a loss on a derivative transaction due to credit default by a counterparty. The credit risk on our derivative transactions is low because our counterparties are of very high credit quality. Our counterparties consist of large banks, broker-dealers, and other financial institutions that have a significant presence in the derivatives market, most of whom are based in the United States. We manage derivative counterparty credit risk by contracting only with experienced counterparties that have high credit ratings. We initiate derivative contracts only with counterparties rated

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A or better. As an additional precaution, we have a conservative collateral management policy with provisions for requiring collateral on our derivative contracts in gain positions. Additional information on derivative instruments is presented in the Notes to Financial Statements.

Credit Risk Management

Credit risk is the risk of loss to future earnings or future cash flows that may result from the failure of a borrower or institution to fulfill its contractual obligation to make payments to Fannie Mae or an institution’s failure to perform a service for us.

Mortgage Credit Risk

As shown in Table 20, our overall credit performance remained relatively stable in the second quarter and first half of 2003 compared to the second quarter and first half of 2002 despite an increase in the number of properties acquired through foreclosure. The serious delinquency rate information in Table 20 is based on conventional loans in our single-family mortgage credit book for which we have access to loan level data and our total multifamily mortgage credit book of business.

Table 20: Mortgage Credit Performance

                                                   
Number of
Credit-Related Properties Serious
Losses(1) Acquired Delinquency Rate(2)



Three Months Three Months
Ended June 30, Ended June 30,


June 30, December 31,
2003 2002 2003 2002 2003 2002






(Dollars in millions)
Single-family
  $ 19     $ 16       6,569       4,688       .56 %     .57 %
Multifamily
    4       1       2             .13       .05  
     
     
                                 
 
Total
  $ 23     $ 17                                  
     
     
                                 
Credit loss ratio(3)
    .005 %     .004 %                                
Charge-off ratio(4)
    .005 %     .006 %                                
                                                   
Number of
Credit-Related Properties Serious
Losses(1) Acquired Delinquency Rate(2)



Six Months Six Months
Ended June 30, Ended June 30,


June 30, December 31,
2003 2002 2003 2002 2003 2002






(Dollars in millions)
Single-family
  $ 38     $ 37       12,487       9,025       .56 %     .57 %
Multifamily
    5       2       3             .13       .05  
     
     
                                 
 
Total
  $ 43     $ 39                                  
     
     
                                 
Credit loss ratio(3)
    .004%       .005 %                                
Charge-off ratio(4)
    .005%       .007 %                                


(1)  Includes charge-offs and foreclosed property income.
 
(2)  Serious delinquency rate for conventional single-family includes loans 90 days or more past due and loans in the process of foreclosure and is calculated based on number of loans. Serious delinquency rate for multifamily includes loans 60 days or more past due and is calculated based on unpaid principal balance (“UPB”).
 
(3)  Represents annualized credit losses divided by average book of business.
 
(4)  Represents annualized charge-offs divided by average book of business.

Our credit loss ratio— annualized credit losses as a percentage of Fannie Mae’s average book of business— was .5 basis points in the second quarter of 2003 and .4 basis points in the first half of 2003, compared with .4 basis points in the second quarter of 2002 and .5 basis points in the first half of 2002. Our book of business includes mortgages and MBS in our mortgage portfolio and outstanding MBS held by other investors. Our lower credit loss ratio in the first half of 2003 reflects some economic strengthening since the recessionary lows of 2001 and 2002 combined with continued strong housing markets, the efficacy of our loss mitigation strategies, and the targeting of our credit enhancements. While the number of single-family properties acquired rose by 1,881 to 6,569 properties as of June 30, 2003, our single-family credit-

28


 

related losses, which include charge-offs plus foreclosed property income, only increased $3 million and $1 million in the second quarter and first half of 2003 from the prior year periods.

Table 21 compares the serious delinquency rates for conventional single-family loans with credit enhancements and without credit enhancements at June 30, 2003 and December 31, 2002. The information in Table 21 is based on conventional loans in our single-family mortgage credit book for which we have access to loan level data.

Table 21: Conventional Single-Family Serious Delinquency Rates

                                   
June 30, 2003 December 31, 2002


Serious Serious
Book Delinquency Book Delinquency
Outstanding(1) Rate(2) Outstanding(1) Rate(2)




Credit enhanced
    23 %     1.42 %     27 %     1.29 %
Non-credit enhanced
    77       .29       73       .31  
     
             
         
 
Total conventional loans
    100 %     .56 %     100 %     .57 %
     
             
         


(1)  Reported based on unpaid principal balance.
 
(2)  Reported based on number of loans.

The serious delinquency rate for conventional loans in our single-family mortgage credit book at June 30, 2003 decreased to .56 percent from the December 31, 2002 rate of .57 percent. The serious delinquency rate for conventional loans in our single-family mortgage credit book without credit enhancement improved to .29 percent at June 30, 2003, compared with .31 percent at December 31, 2002. The serious delinquency rate for conventional loans in our single-family mortgage credit book with credit enhancement increased to 1.42 percent from 1.29 percent at the end of 2002. These loans have a higher risk profile and tend to be more sensitive to changes in the economy than loans without credit enhancement.

Institutional Counterparty Credit Risk

Non-derivative institutional counterparty risk primarily includes exposure created through the potential nonperformance of our counterparties on mortgage insurance policies, other credit enhancement arrangements with lenders and others, mortgage servicing contracts with lenders, and liquidity investments in corporate obligations or nonmortgage asset-backed securities.

Mortgage Servicers

We have purchased mortgage-related securities secured by manufacturing housing loans that were issued by entities other than Fannie Mae both for our portfolio and, to a limited extent, for securitization into REMIC securities we have issued and guaranteed. At July 31, 2003, we owned or guaranteed approximately $9.1 billion of these securities, approximately 70 percent of which are serviced by Green Tree Investments Holding LLC, successor as servicer of the securities to Conseco Finance Corp. On March 14, 2003, the U.S. Bankruptcy Court for the Northern District of Illinois issued a final order approving the servicing arrangements for the securities then serviced by Conseco Finance. The order, based upon an agreement reached between Conseco Finance, Green Tree (under its former name, CFN Investment Holdings), Fannie Mae and other certificate holders, provided for revised servicing fees and an enhanced servicing protocol. Green Tree completed the acquisition in June 2003.

Table 22 presents the credit ratings of the securities (or for insured securities, the credit rating of the financial institution providing credit enhancement) purchased or guaranteed by Fannie Mae as of July 31, 2003. As of July 31, 2003, a majority of our securities were rated AA- or better by the major rating agencies or were insured by counterparties rated AA- or better. We have reviewed these securities for other than temporary declines in their fair value and recorded impairment where appropriate in fee and other income. Future ratings will be influenced by the performance of the underlying manufactured housing loan collateral. Additional downgrades may occur in the future, but management believes that any potential additional impairment that might be recorded will not be material to Fannie Mae’s operating results.

29


 

 
  Table 22: Credit Ratings of Mortgage-Related Securities Secured by Manufactured Housing Loans
                   
Credit rating as of July 31, 2003: UPB % of Total UPB



(Dollars in millions)
Investment Grade:
               
AAA/Aaa
  $ 3,316       36.27 %
AA+/Aa1 to AA-/Aa3
    2,723       29.79  
A+/A1 to A-/A3
    775       8.47  
BBB+/Baa1 to BBB-/Baa3
    2,253       24.64  
     
     
 
 
Total UPB of Investment Grade Securities
    9,067       99.17  
Non-Investment Grade:
               
BB+/Ba1 to BB-/Ba3
    18       .20  
B+/B1 to B-/B3
    58       .63  
     
     
 
 
Total UPB of Non-Investment Grade Securities
    76       .83  
     
     
 
 
Total UPB of Securities
  $ 9,143       100.00 %
     
     
 

LIQUIDITY AND CAPITAL RESOURCES

Liquidity

Our primary sources of liquidity include proceeds from the issuance of debt, principal and interest received on our mortgage portfolio, guaranty fees earned on our MBS, and principal and interest received on our liquid investment portfolio. Primary uses of liquidity include the purchase of mortgage assets, repayment of debt, interest payments, administrative expenses, taxes, and fulfillment of Fannie Mae’s MBS guaranty obligations. Our mortgage asset purchases based on unpaid principal balance totaled $260 billion in the first half of 2003. We issued $1.338 trillion in debt to fund those purchases and to replace maturing, called or repurchased debt. Our debt securities, and the interest payable thereon, are not guaranteed by the United States and do not constitute a debt or obligation of the United States or any agency or instrumentality thereof other than Fannie Mae.

As part of our voluntary commitments, we have publicly pledged to maintain a portfolio of high-quality, liquid, nonmortgage-related securities equal to at least 5 percent of total on-balance-sheet assets. Our liquid assets totaled $69 billion at June 30, 2003, compared with $62 billion at December 31, 2002. The ratio of our liquid assets to total assets was 7.5 percent at June 30, 2003 and 6.9 percent at December 31, 2002.

Capital Resources

Fannie Mae is subject to capital adequacy standards established by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (“1992 Act”) and continuous examination by the Office of Federal Housing Enterprise Oversight (“OFHEO”), which was established by the 1992 Act. The capital adequacy standards require that our core capital (defined by OFHEO as the stated value of outstanding common stock, the stated value of outstanding noncumulative perpetual preferred stock, paid-in capital, and retained earnings, less treasury stock) equal or exceed a minimum capital standard and a critical capital standard. Core capital excludes accumulated other comprehensive income/loss (“AOCI”) because AOCI incorporates gains (losses) on derivatives and certain securities, but not the gains (losses) on the remaining mortgages and securities or liabilities used to fund the purchase of these items. Table 23 compares Fannie Mae’s core capital and total capital at June 30, 2003 and December 31, 2002 to our capital requirements. Total capital is defined by OFHEO as core capital plus the general allowance for losses. Core capital grew to $30.7 billion at June 30, 2003 from $28.1 billion at December 31, 2002, while total capital increased by $2.6 billion to $31.5 billion at June 30, 2003.

30


 

Table 23: Capital Requirements(1)

                         
June 30, March 31, December 31,
2003 2003 2002



(Dollars in millions)
Core capital(2)
  $ 30,675     $ 29,517     $ 28,079  
Required minimum capital(3)(4)
    29,147       28,226       27,203  
     
     
     
 
Excess of core capital over minimum capital
  $  1,527     $ 1,291     $ 877  
     
     
     
 
Total capital(5)
  $ 31,469     $ 30,309     $ 28,871  
Required risk-based capital(6)
    Not available       16,555       17,434  
             
     
 
Excess of total capital over required risk-based capital (6)
    Not available     $ 13,753     $ 11,437  
             
     
 
Required critical capital(7)
  $ 14,912     $ 14,414     $ 13,880  
Excess of core capital over required critical capital
    15,762       15,103       14,199  


(1)  Amounts at June 30, 2003 represent estimates, pending OFHEO’s certification, which is generally provided no later than 3 months following the end of each quarter.
 
(2)  The sum of (a) the stated value of outstanding 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 excludes accumulated other comprehensive income (AOCI).
 
(3)  The sum of (a) 2.50 percent of on-balance sheet assets; (b) .45 percent of outstanding MBS; and (c) .45 percent of other off-balance sheet obligations, which may be adjusted by the Director of OFHEO under certain circumstances (See 12 CFR 1750.4 for existing adjustments made by the Director of OFHEO).
 
(4)  These amounts do not reflect the effect of the December 31, 2002 balance sheet reclassification of amounts associated with the guaranty obligation for MBS that we own from our “Allowance for loan losses” to a “Guaranty liability for MBS.”
 
(5)  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. Specific loss allowances totaled $13 million and $19 million at June 30, 2003 and December 31, 2002, respectively.
 
(6)  Amounts at June 30, 2003 will not be available until the end of September 2003. OFHEO reports on Fannie Mae’s risk-based capital at the end of each quarter on a lagged quarterly basis.
 
(7)  The sum of (a) 1.25 percent of on-balance sheet assets; (b) .25 percent of outstanding MBS; and (c) .25 percent of other off-balance sheet obligations, which may be adjusted by the Director of OFHEO under certain circumstances.

Common shares outstanding, net of shares held in treasury, totaled approximately 976 million and 989 million at June 30, 2003 and December 31, 2002, respectively. During the first half of 2003, Fannie Mae issued approximately 1.4 million common shares from treasury for employee and other stock compensation plans. We repurchased 13.9 million common shares during the first half of 2003 at a weighted average cost of $65.04 per share.

We raised additional equity from the issuance of 8 million shares or $400 million of variable rate Non-Cumulative Preferred Stock, Series K on March 18, 2003, from the issuance of 6.9 million shares or $345 million of fixed rate Non-Cumulative Preferred Stock, Series L on April 29, 2003, and from the issuance of 9.2 million shares or $460 million of fixed rate Non-Cumulative Preferred Stock, Series M on June 10, 2003. Preferred stock accounted for 12.7 percent of our core capital at June 30, 2003, versus 9.5 percent at December 31, 2002.

Subordinated debt totaled $11.5 billion at June 30, 2003, or 1.2 percent of on-balance sheet assets. Total capital and outstanding subordinated debt represented 3.9 percent of on-balance sheet assets at June 30, 2003 and 3.7 percent of on-balance sheet assets at December 31, 2002. Subordinated debt serves as a supplement to our equity capital, although it is not a component of core capital. By the end of 2003, we intend to issue sufficient subordinated debt to bring the sum of total capital and outstanding subordinated debt to at least 4 percent of on-balance sheet assets, after providing adequate capital to support off-balance sheet MBS.

Our credit quality is continuously monitored by rating agencies. At the end of June 2003 and year-end 2002, our senior unsecured debt had a rating of AAA by S&P, Aaa by Moody’s, and AAA by Fitch, Inc, unchanged from the ratings at December 31, 2002. Our short-term debt was rated A-1+, Prime-1 or P-1, and F1+ by S&P, Moody’s, and Fitch, respectively, at June 30, 2003, also unchanged from the ratings at December 31, 2002.

31


 

PENDING ACCOUNTING STANDARDS

Commitments to Purchase or Sell Mortgages and Mortgage-Related Securities

In April 2003, the FASB issued FASB Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“FAS 149”). FAS 149 requires Fannie Mae to account for many commitments to purchase or sell mortgage-related securities existing or entered into after June 30, 2003 and mortgages entered into after June 30, 2003 as derivatives, which will increase our notional balance of derivatives outstanding. Under FAS 149, some of these derivatives will qualify as cash flow hedges of forecasted mortgage purchases or sales. Therefore, we will record changes in the fair values of these derivatives as assets or liabilities with a corresponding increase or decrease in AOCI in the future. Some of these derivatives will not qualify for hedge accounting, particularly those where we have a matched purchase and sale commitment. We will mark those commitments to market through earnings and their values should offset to a significant extent. We expect to record a cumulative after-tax transition gain as a result of the adoption of FAS 149 on July 1, 2003.

Consolidation of Variable Interest Entities

FASB Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”), was issued in January 2003. FIN 46 provides guidance on when a company should include the assets, liabilities, and activities of a variable interest entity (“VIE”) in its financial statements and when it should disclose information about its relationship with a VIE. A VIE is a legal structure used to conduct activities or hold assets, which must be consolidated by a company if it is the primary beneficiary because it absorbs the majority of the entity’s expected losses, the majority of the expected returns, or both. Qualified special purpose entities (“QSPEs”), which we use to issue MBS, are exempt from FIN 46 unless a company has the unilateral ability to liquidate or change the QSPE. The provisions of FIN 46 were effective February 1, 2003 for all arrangements entered into after January 31, 2003. FIN 46 is effective in the third quarter of 2003 for those arrangements entered into prior to January 31, 2003.

We are currently reviewing whether we have relationships with VIEs and, if so, whether we should consolidate them and disclose information about them as the primary beneficiary or disclose information about them as an interest holder. We may have to consolidate some of our equity investments in partnerships based on recent interpretations from accounting professionals. We currently record the amount of our investment in these partnerships as an asset on our balance sheet, recognize our share of partnership income or losses in our income statement, and disclose how we account for material types of these investments in our 2002 financial statements. However, we do not yet know the extent of the impact of consolidating the assets and liabilities of these partnerships on our balance sheet because of the complexities of applying FIN 46, the evolving interpretations from accounting professionals, and the nuances of each individual partnership.

Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock

In July 2003, the SEC issued a clarification of Emerging Issues Task Force Topic D-42, “The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock (Topic D-42).” The SEC stated that the carrying amount of preferred stock should be reduced by the related issuance costs, regardless of where in the stockholders’ equity section those costs were initially classified at the time of issuance. As a result, the excess of the fair value of the consideration transferred to preferred stockholders over the carrying amount of the preferred stock must be subtracted from net earnings to determine net earnings available to common stockholders in the calculation of earnings per share. The clarification of Topic D-42 will be effective for us beginning with the third quarter of 2003, and we will restate the financial statements for the corresponding prior periods because we have not previously considered issuance costs in determining the carrying amount of the preferred stock we redeemed in 2003 and 2002. Our reported basic and diluted earnings per share for the three and six months ended June 30, 2003, and the three months ended June 30, 2002, will not change. Our reported basic and diluted earnings per share for the six months ended June 30, 2002 will be reduced by $.01 per share.

32


 

Item 1. Financial Statements

Independent Accountant’s Review Report

To the Board of Directors and Stockholders of Fannie Mae:

We have reviewed the accompanying balance sheet of Fannie Mae as of June 30, 2003 and related statements of income, changes in stockholders’ equity, and cash flows for the three-month and six-month periods ended June 30, 2003 and 2002. These condensed financial statements are the responsibility of Fannie Mae’s management.

We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our review. We are not aware of any material modifications that should be made to the condensed financial statements referred to above for them to be in conformity with accounting principles generally accepted in the United States of America.

We have previously audited, in accordance with auditing standards generally accepted in the United States of America, the balance sheet of Fannie Mae as of December 31, 2002 (presented herein) and the related statements of income, changes in stockholders’ equity, and cash flows for the year then ended (not presented herein). In our report dated January 14, 2003, we expressed an unqualified opinion on those financial statements.

  /s/ KPMG LLP
 
  KPMG LLP

Washington, D.C.

July 10, 2003

33


 

FANNIE MAE

Statements of Income
(Dollars and shares in millions, except per share amounts)
                                     
Three Months Six Months
Ended June 30, Ended June 30,


2003 2002 2003 2002




(Unaudited)
Interest income:
                               
 
Mortgage portfolio
  $ 12,256     $ 12,326     $ 24,846     $ 24,497  
 
Nonmortgage investments and cash equivalents
    336       420       642       826  
     
     
     
     
 
   
Total interest income
    12,592       12,746       25,488       25,323  
     
     
     
     
 
Interest expense:
                               
 
Short-term debt
    697       646       1,447       1,430  
 
Long-term debt
    8,394       9,568       17,172       18,930  
     
     
     
     
 
   
Total interest expense
    9,091       10,214       18,619       20,360  
     
     
     
     
 
   
Net interest income
    3,501       2,532       6,869       4,963  
     
     
     
     
 
Other income:
                               
 
Guaranty fee income (includes imputed interest of $18 million and $21 million for the three and six months ended June 30, 2003— see Note 2)
    632       423       1,179       831  
 
Fee and other income, net
    232       42       345       45  
     
     
     
     
 
   
Total other income
    864       465       1,524       876  
     
     
     
     
 
Other expenses (income):
                               
 
Provision for losses
    26       33       49       61  
 
Foreclosed property income
    (3 )     (9 )     (6 )     (15 )
 
Administrative expenses
    354       301       698       591  
 
Purchased options expense
    1,883       498       2,508       1,286  
 
Debt extinguishments, net
    740       225       1,132       396  
     
     
     
     
 
   
Total other expenses (income)
    3,000       1,048       4,381       2,319  
     
     
     
     
 
Income before federal income taxes
    1,365       1,949       4,012       3,520  
Provision for federal income taxes
    (263 )     (485 )     (970 )     (848 )
     
     
     
     
 
Net income
  $ 1,102     $ 1,464     $ 3,042     $ 2,672  
     
     
     
     
 
Preferred stock dividends
    (34 )     (24 )     (64 )     (57 )
     
     
     
     
 
Net income available to common stockholders
  $ 1,068     $ 1,440     $ 2,978     $ 2,615  
     
     
     
     
 
 
Basic earnings per common share
  $ 1.09     $ 1.45     $ 3.03     $ 2.63  
 
Diluted earnings per common share
  $ 1.09     $ 1.44     $ 3.02     $ 2.61  
 
Cash dividends per common share
  $ .39     $ .33     $ .78     $ .66  
 
Weighted-average common shares outstanding:
                               
 
Basic
    979       995       983       996  
 
Diluted
    982       1,000       987       1,001  

See Notes to Financial Statements.

34


 

FANNIE MAE

Balance Sheets
(Dollars in millions, except per share amounts)
                         
June 30, December 31,
2003 2002


(Unaudited)
Assets
               
 
Mortgage portfolio:
               
   
Mortgage-related securities:
               
     
Held-to-maturity
  $ 458,333     $ 437,932  
     
Available-for-sale
    149,575       173,706  
     
     
 
       
Total
    607,908       611,638  
   
Loans held-for-investment
    211,136       185,652  
       
Allowance for loan losses
    (83 )     (79 )
       
Unamortized premiums, discounts, and deferred price adjustments, net
    1,305       337  
   
Loans held-for-sale
    10       145  
     
     
 
 
Mortgage portfolio, net
    820,276       797,693  
 
Nonmortgage investments:
               
     
Held-to-maturity
    24,609       23,050  
     
Available-for-sale
    42,315       36,794  
 
Cash and cash equivalents
    2,165       1,710  
 
Accrued interest receivable
    5,424       4,915  
 
Acquired property and foreclosure claims, net
    1,242       1,033  
 
Derivatives in gain positions
    5,934       3,666  
 
Other
    21,830       18,654  
     
     
 
Total assets
  $ 923,795     $ 887,515  
     
     
 
 
Liabilities and Stockholders’ Equity
               
Liabilities:
               
 
Debentures, notes and bonds, net:
               
   
Senior debt:
               
     
Due within one year
  $ 422,274     $ 382,412  
     
Due after one year
    450,288       458,600  
   
Subordinated debt:
               
     
Due after one year
    11,519       9,970  
     
     
 
       
Total
    884,081       850,982  
 
Accrued interest payable
    8,620       8,379  
 
Derivatives in loss positions
    5,432       5,697  
 
Guaranty liability for MBS
    725       729  
 
Other
    7,573       5,440  
     
     
 
   
Total liabilities
    906,431       871,227  
     
     
 
 
Stockholders’ Equity:
               
 
Preferred stock, $50 stated value, 100 million shares authorized— 77.7 million shares issued and outstanding at June 30, 2003 and 53.6 million shares issued and outstanding at December 31, 2002
    3,883       2,678  
 
Common stock, $.525 stated value, $.78 of dividends per share paid in the first half of 2003 and $1.32 of dividends per share paid in 2002; no maximum authorization— 1,129 million shares issued
    593       593  
 
Additional paid-in capital
    1,842       1,839  
 
Retained earnings
    31,595       29,385  
 
Accumulated other comprehensive loss
    (13,311 )     (11,792 )
     
     
 
      24,602       22,703  
 
 
Less: Treasury stock, at cost, 153 million shares at June 30, 2003 and 140 million shares at December 31, 2002
    7,238       6,415  
     
     
 
 
Total stockholders’ equity
    17,364       16,288  
     
     
 
Total liabilities and stockholders’ equity
  $ 923,795     $ 887,515  
     
     
 

See Notes to Financial Statements.

35


 

FANNIE MAE

Statements of Changes in Stockholders’ Equity
(Dollars and shares in millions)
                                                                           
Accumulated
Other
Net Additional Comprehensive Total
Common Shares Preferred Common Paid-In Retained Income Treasury Stockholders’
Outstanding Stock Stock Capital Earnings (Loss) Stock Equity








(Unaudited)
Balance, December 31, 2002
    989     $ 2,678     $ 593     $ 1,839     $ 29,385     $ (11,792 )   $ (6,415 )   $ 16,288      
 
Comprehensive income:
                                                                   
   
Net income
                            3,042                   3,042      
   
Other comprehensive income, net of tax effect:
                                                                   
     
Net cash flow hedging losses
                                  (702 )           (702 )    
     
Unrealized losses on available-for-sale securities
                                  (817 )           (817 )    
                                                             
     
   
Total comprehensive income
                                                            1,523      
 
Dividends
                            (832 )                 (832 )    
 
Shares repurchased
    (14 )                                   (906 )     (906 )    
 
Preferred stock issued
          1,205             (11 )                       1,194      
 
Treasury stock issued for stock options and benefit plans
    1                   14                   83       97      
     
     
     
     
     
     
     
     
   
Balance, June 30, 2003
    976     $ 3,883     $ 593     $ 1,842     $ 31,595     $ (13,311 )   $ (7,238 )   $ 17,364      
     
     
     
     
     
     
     
     
   
 
Balance, December 31, 2001
    997     $ 2,303     $ 593     $ 1,651     $ 26,175     $ (7,065 )   $ (5,539 )   $ 18,118      
 
Comprehensive income:
                                                                   
   
Net income
                              2,672                   2,672      
   
Other comprehensive income, net of tax effect:
                                                                   
     
Net cash flow hedging losses
                                  (2,154 )           (2,154 )    
     
Unrealized gains on available-for-sale securities
                                  567             567      
                                                             
     
   
Total comprehensive income
                                                            1,085      
 
Dividends
                            (714 )                 (714 )    
 
Shares repurchased
    (11 )                                   (841 )     (841 )    
 
Preferred stock redeemed
          (375 )                                   (375 )    
 
Treasury stock issued for stock options and benefit plans
    3                   58                   99       157      
 
Treasury stock issued for special contribution
    4                   136                   164       300      
     
     
     
     
     
     
     
     
   
Balance, June 30, 2002
    993     $ 1,928     $ 593     $ 1,845     $ 28,133     $ (8,652 )   $ (6,117 )   $ 17,730      
     
     
     
     
     
     
     
     
   

See Notes to Financial Statements.

36


 

FANNIE MAE

Statements of Cash Flows
(Dollars in millions)
                   
Six Months Ended
June 30,

2003 2002


(Unaudited)
Cash flows from operating activities:
               
Net income
  $ 3,042     $ 2,672  
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
               
 
Amortization of discount/ premium and deferred price adjustments
    2,495       3,161  
 
Provision for losses
    49       61  
 
Loss on debt extinguishments
    1,132       396  
 
Purchased options expense
    2,508       1,286  
 
Deferred income taxes
    (1,041 )     (557 )
 
Other increases, net
    512       90  
     
     
 
Net cash provided by operating activities
    8,697       7,109  
     
     
 
 
Cash flows from (used in) investing activities:
               
 
Mortgage portfolio purchases
    (262,667 )     (148,999 )
 
Proceeds from sales from mortgage portfolio
    6,923       6,783  
 
Mortgage portfolio principal repayments
    229,852       106,342  
 
Net proceeds from disposition of foreclosed properties
    1,474       1,061  
 
Purchases of held-to-maturity nonmortgage investments
    (1,470,026 )     (656,678 )
 
Maturities of held-to-maturity nonmortgage investments
    1,468,471       668,900  
 
Purchases of available-for-sale nonmortgage investments
    (41,343 )     (36,876 )
 
Maturities of available-for-sale nonmortgage investments
    34,437       33,555  
 
Proceeds from sales of available-for-sale nonmortgage investments
    1,425       1,707  
     
     
 
Net cash used in investing activities
    (31,454 )     (24,205 )
     
     
 
 
Cash flows from (used in) financing activities:
               
 
Proceeds from issuance of long-term debt
    154,759       111,909  
 
Payments to redeem long-term debt
    (162,303 )     (76,197 )
 
Proceeds from issuance of short-term debt
    1,180,619       798,359  
 
Payments to redeem short-term debt
    (1,145,879 )     (813,972 )
 
Net payments to purchase or settle hedge instruments
    (3,470 )     (1,829 )
 
Net payments from stock activities
    (514 )     (1,819 )
     
     
 
Net cash provided by financing activities
    23,212       16,451  
     
     
 
Net increase (decrease) in cash and cash equivalents
    455       (645 )
Cash and cash equivalents at beginning of period
    1,710       1,518  
     
     
 
Cash and cash equivalents at end of period
  $ 2,165     $ 873  
     
     
 
 
Supplemental disclosures of cash flow information:
               
Cash paid during the period for:
               
 
Interest
  $ 18,386     $ 20,174  
 
Income taxes
    2,015       1,542  

See Notes to Financial Statements.

37


 

FANNIE MAE

Notes to Financial Statements
(Unaudited)

1.     Basis of Presentation

The accompanying unaudited condensed financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”) for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation have been included. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Results for the three-month and six-month periods ended June 30, 2003 may not necessarily be indicative of the results for the year ending December 31, 2003. The unaudited financial statements should be read in conjunction with Fannie Mae’s audited financial statements and related notes included in the Annual Report on Form 10-K filed with the Securities Exchange Commission on March 31, 2003. We have reclassified certain amounts in 2002 to conform to the current presentation.

2.     New Accounting Standards

Stock-Based Compensation

Effective January 1, 2003, Fannie Mae adopted the expense recognition provisions of the fair value method of accounting for employee stock compensation pursuant to Financial Accounting Standard No. 123, Accounting for Stock-Based Compensation (“FAS 123”). Prior to this date, we used the intrinsic value method under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”) and disclosed the pro forma effect of the fair value method. Under the fair value expense recognition provisions of FAS 123, compensation expense is recognized over the vesting period based on the fair value of stock based compensation as of the date of grant. We elected to apply the prospective method of adoption described in the transition provisions of Financial Accounting Standard No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure (“FAS 148”). In accordance with these provisions, we will determine the fair value of all new stock-based compensation awarded on January 1, 2003 and thereafter at the grant date and recognize this amount as expense over the vesting period. We will continue to account for stock-based compensation awarded prior to January 1, 2003 under APB No. 25. The effect on net income and diluted earnings per share in the second quarter and first half of 2003 from the prospective adoption of the fair value method was not material to our financial results. Had compensation cost for all options granted been determined based on the fair value at grant

38


 

date consistent with the FAS 123 fair value method, our net income and earnings per share would have been as follows for the second quarter and first half of 2003 and 2002.
                                   
Three Months Six Months
Ended June 30, Ended June 30,


2003 2002 2003 2002




(Dollars in millions,
except per share amounts)
Net income available to common stockholders, as reported
  $ 1,068     $ 1,440     $ 2,978     $ 2,615  
Plus: Stock-based employee compensation expense included in reported net income, net of related tax effects