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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 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
Washington, DC
(Address of principal executive offices)
  20016
(Zip Code)

Registrant’s telephone number, including area code:

(202) 752-7000

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

None

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

Common Stock, without par value
(Title of class)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

x Yes                    o No

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

x Yes                    o No

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

o Yes                    x No

As of February 29, 2004, there were 973,632,716 shares of common stock outstanding. As of June 30, 2003 (the last business day of Registrant’s most recent second fiscal quarter), the aggregate market value of the common stock held by non-affiliates of the registrant was approximately $65,845 million. As of February 29, 2004, the aggregate market value of the common stock held by non-affiliates of the registrant was approximately $72,925 million.

DOCUMENTS INCORPORATED BY REFERENCE

1.  Portions of the registrant’s definitive proxy statement for its 2004 Annual Meeting of Shareholders (Part III)




 

TABLE OF CONTENTS

               
Page

 PART I     1  
   Business     1  
     Overview     1  
       Introduction     1  
       Definitions     1  
       Business Segments     2  
       Additional Information     2  
     The Residential Mortgage Market     3  
       Residential Mortgage Debt Outstanding     3  
       Our Role in the Secondary Mortgage Market     4  
     Fannie Mae Business Standards     4  
       Principal Balance Limits     4  
       Loan-to-Value Ratios     5  
       Underwriting Guidelines     5  
       The Mortgage Seller or Servicer     6  
     Mortgage Committing and Servicing Arrangements     6  
       Mortgage Commitments     6  
       Servicing Arrangements     6  
     Business Segments     7  
       Portfolio Investment Business     7  
       Credit Guaranty Business     10  
       Fee-Based Services     14  
     Housing Goals     14  
     Competition     15  
     Employees     17  
     Government Regulation and Charter Act     17  
       Charter Act     17  
       Regulatory Approval and Oversight     18  
       Capital Requirements     19  
       Dividend Restrictions     20  
   Properties     20  
   Legal Proceedings     21  
   Submission of Matters to a Vote of Security Holders     21  
 PART II     22  
   Market for Registrant’s Common Equity and Related Stockholder Matters     22  
   Selected Financial Data     24  
   Management’s Discussion and Analysis of Financial Condition and Results of Operations     26  
     Forward-Looking Information     26  
     Executive Summary     27  
       About Fannie Mae     27  
       Our Businesses     27  
       How We Manage Risk     28  
       Our Market     28  
       Our Competitive Dynamics     29  
       Our 2003 Financial Performance     30  
       Principal Challenges We Anticipate     30  
       Organization of MD&A     31  
     Reported Results of Operations     31  
       Overview     31  
       Net Interest Income     32  

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Page

       Guaranty Fee Income     35  
       Fee and Other Income, Net     35  
       Credit-Related Expenses     36  
       Administrative Expenses     37  
       Special Contribution     37  
       Purchased Options Expense     38  
       Debt Extinguishments, Net     38  
       Income Taxes     39  
       Cumulative Effect of Change in Accounting Principle     39  
     Critical Accounting Policies and Estimates     39  
       Allowance for Loan Losses and Guaranty Liability for MBS     40  
       Deferred Price Adjustments     42  
       Time Value of Purchased Options     44  
       Other-Than-Temporary Impairment     45  
     Core Business Earnings and Business Segment Results     46  
       Core Business Earnings     46  
       Core Taxable-Equivalent Revenues     52  
       Core Net Interest Income     52  
       Business Segment Results     54  
       Corporate Financial Disciplines     56  
     Portfolio Investment Business Operations     57  
       Investments     57  
       Funding     65  
       Interest Rate Risk Management     81  
     Credit Guaranty Business Operations     88  
       Off-Balance Sheet Transactions     88  
       Credit Risk Management     91  
     Operations Risk Management     111  
     Liquidity and Capital Resources     113  
       Liquidity     113  
       Capital Resources     115  
     Pending Accounting Pronouncements     119  
       FIN 46, Consolidation of Variable Interest Entities (“VIE”)     119  
       SOP 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer     120  
   Quantitative and Qualitative Disclosures About Market Risk     120  
   Financial Statements and Supplementary Data     121  
   Changes in and Disagreements With Accountants on Accounting and Financial Disclosure     175  
   Controls and Procedures     175  
 PART III     175  
   Directors and Executive Officers of the Registrant     175  
   Executive Compensation     179  
   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters     179  
   Certain Relationships and Related Transactions     179  
   Principal Accounting Fees and Services     179  
 PART IV     180  
   Exhibits, Financial Statement Schedules and Reports on Form 8-K     180  
 SIGNATURES     181  

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PART I

Item 1. Business

OVERVIEW

Introduction

At Fannie Mae (formally, the Federal National Mortgage Association), our purpose is to facilitate the flow of low-cost mortgage capital in order to increase the availability and affordability of homeownership for low-, moderate-, and middle-income Americans. We are an instrument of national housing policy, originally established in 1938 as a U.S. government entity, and we currently operate under a federal charter. Our primary regulator is the Office of Federal Housing Enterprise Oversight (“OFHEO”). However, we are a private, shareholder-owned company. We became a shareholder-owned company by legislation enacted in 1968, which we refer to as the “Charter Act” (the Federal National Mortgage Association Charter Act, 12 U.S.C. §1716 et seq.). Our common stock is traded primarily on the New York Stock Exchange under the symbol “FNM.” The U.S. government does not guarantee, directly or indirectly, Fannie Mae’s securities or other obligations.

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

Fannie Mae expands equal housing access and opportunity in America by helping our lender customers reach the nation’s underserved families and communities. In 1994, we launched our Trillion Dollar Commitment to provide $1 trillion in home financing for 10 million families traditionally underserved by mainstream mortgage finance. After achieving that goal ahead of plan, in 2000 Fannie Mae announced a new, redoubled affordable housing plan, our $2 trillion American Dream Commitment®, to serve 18 million underserved families by 2010. Having met that goal, Fannie Mae announced in January 2004 the next stage of the American Dream Commitment.

Working closely with our partners (including lenders, mortgage insurers, non-profit organizations, home builders, housing finance agencies, and other federal, state, and local government partners), Fannie Mae has set goals of expanding access to homeownership for millions of first-time home buyers and helping to raise the minority homeownership rate to 55 percent, by creating 6 million new homeowners, including 1.8 million new minority homeowners by 2014. Steps Fannie Mae has outlined to achieve these goals include applying technology to lower the costs of mortgage originations and expand access to mortgage credit; building stronger partnerships with those who serve as trusted advisors to first-time home buyers; adapting products and processes that build upon public sector assistance to potential home buyers; and working to transform manufactured housing lending.

Definitions

In this document, the terms “loans,” “mortgage loans” and “mortgages,” refer to both whole loans and loan participations secured by residential real estate or by manufactured housing units. Mortgage loans secured by four or fewer residential dwelling units are referred to as “single-family” mortgage loans and mortgage loans secured by more than four residential dwelling units are referred to as “multifamily” mortgage loans.

We use the term “mortgage-related securities” to refer generally to mortgage securities that represent beneficial interests in pools of mortgage loans or in other mortgage-related securities. These securities may be issued by Fannie Mae or by others.

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We use the term mortgage-backed securities (“MBS”) to refer only to those mortgage-related securities we issue and on which we guarantee the timely payment of principal and interest.

We use the term “outstanding MBS” to refer only to MBS held by investors other than Fannie Mae.

We use the term “mortgage assets” to refer to both mortgage loans and mortgage-related securities we hold in our portfolio.

Business Segments

We provide liquidity in the secondary mortgage market through our two primary business segments: the Portfolio Investment business and the Credit Guaranty business.

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

In the Credit Guaranty business, we receive fees for our guaranty of timely payment of principal and interest payments due to certificateholders on MBS. The guaranty fees we charge are based on the credit risk we assume, the costs of administering the MBS and market and competitive factors. We typically issue MBS by exchanging mortgage loans from a lender for MBS. The lender may then hold the MBS as an investment or sell the MBS in the market to replenish its funds for additional lending. This activity provides liquidity to the lender because MBS, which carry Fannie Mae’s guaranty, are more readily marketable than mortgage loans without this guaranty.

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

Additional Information

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

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

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THE RESIDENTIAL MORTGAGE MARKET

Residential Mortgage Debt Outstanding

The housing market in which we operate consists of the supply, or “stock,” of total outstanding residential mortgages. In its Flow of Funds Accounts, the Board of Governors of the Federal Reserve System estimates and publishes figures each quarter on the stock of residential mortgages. The total residential mortgage debt outstanding figures published by the Federal Reserve include loans secured by single-family properties and multifamily properties. As of December 31, 2003, the latest date for which information is available, the Federal Reserve’s estimate for total residential mortgage debt outstanding was $7.8 trillion. (See “Business— Fannie Mae Business Standards— Principal Balance Limits” for a discussion of the limits on mortgages we purchase.) The following table shows the Federal Reserve’s estimate for residential mortgage debt outstanding for the last 13 years.

(Mortgage Debt Bar Graph)

We expect growth in residential mortgage debt outstanding during the decade ending 2010 to be driven by the following factors:

  •  Household Formation. Household formation represents the number of new households that will need homes. Household formation is a principal driver of demand for homes. Growth in household formation is driven by growth in the population and “headship rates,” the rate at which the population forms into households.
 
  •  Homeownership Rates. Homeownership rates reflect the percentage of the population that owns a home. As reported by the Census Bureau, Department of Commerce, the national homeownership rate has grown approximately one-half a percent a year since 1990, rising from 64 percent in 1990 to 69 percent in 2003. The growth in homeownership rates was driven by increased affordability of homes, improved technology (e.g., automated underwriting), and low downpayment lending. We expect future growth in homeownership rates to be driven by economic growth, increases in minority homeownership rates, and demographic trends as baby-boomers continue to move into age groups that traditionally experience higher homeownership rates.
 
  •  Home Price Appreciation. Home price appreciation reflects the combined effect of two components: the underlying rate of inflation and the amount that home prices appreciate, net of inflation. Home price appreciation allows current homeowners to borrow against the additional equity in their homes and causes new homebuyers to borrow more to finance the purchase of a home. Home prices have typically appreciated faster than inflation. While inflation and home price appreciation were relatively low for most of the 1990s, home price appreciation returned to more historical levels in the latter part of the decade. Home price appreciation in the current decade will depend upon the demand and supply for housing. We expect the supply of housing to be somewhat constrained relative to demand due to limited availability of land and the increase of land use controls.

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  •  Debt-to-Value Ratios. The debt-to-value ratio represents the percentage of total housing value that is financed with mortgage debt. Over the past 50 years, homeowners have steadily increased the percentage of their home value that is financed with debt, from around 20 percent to 45 percent at the end of 2003. This increase reflects the rising prices of homes, the increased popularity of cash-out refinancing as a means to access home equity, availability of home equity lines of credit, and increased lower downpayment lending. Growth in the mortgage debt-to-value ratio over the coming decade will be driven by continued expansion of lower downpayment lending and increased use by homeowners of the equity, or value, in their homes for other purposes.

As of December 31, 2003, Fannie Mae held 11 percent of total residential mortgage debt outstanding in our mortgage portfolio, which includes mortgage-related securities. Outstanding MBS (held by investors other than Fannie Mae) represented an additional 17 percent of total residential mortgage debt outstanding.

Our Role in the Secondary Mortgage Market

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

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

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

We have a selling and servicing contract with over three thousand primary market lenders under which we may both purchase loans for our portfolio and issue MBS. Ten of those lender customers accounted for approximately 67 percent of the single-family mortgage loans that we purchased or exchanged for MBS in 2003. In addition, we purchase mortgage loans and mortgage-related securities from securities dealers, investors and other participants in the secondary market.

FANNIE MAE BUSINESS STANDARDS

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

Principal Balance Limits

Under the Charter Act, our purchase and guarantee of single-family “conventional” mortgage loans (loans not federally insured or guaranteed) are subject to certain maximum original principal balance limits, often referred to as the “conforming loan limit.” For 2003, the limit for a one-family residence was $322,700 (except for loans secured by properties in Alaska, Hawaii, Guam, and the Virgin Islands). Higher principal

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balance limits apply to loans secured by properties in those areas and to mortgage loans secured by two- to four-family residences. We can adjust the maximum principal balance limits applicable to conventional single-family mortgage loans annually based on the year-to-year change in the national average price of a one-family house as surveyed by the Federal Housing Finance Board each October. In November 2003, the limit for loans acquired in 2004, secured by a one-family residence (and not located Alaska, Hawaii, Guam, or the Virgin Islands), was increased to $333,700. There are no statutory limits on the maximum principal balance, or per-dwelling unit balance, for multifamily mortgage loans that we purchase. The Charter Act imposes no maximum principal balance limits for mortgage loans we purchase that are insured by the Federal Housing Administration (“FHA”) or guaranteed by the Department of Veterans Affairs (“VA”) or by the Rural Housing Service of the U.S. Department of Agriculture (“RHS”).

Loan-to-Value Ratios

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

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

Underwriting Guidelines

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

We generally rely on the selling lender’s representations and warranties that the mortgage loans we purchase or guarantee conform to our applicable guidelines. After purchase, we also perform quality control reviews of selected loans to monitor compliance with the guidelines. In the event that a lender is found to have breached its representations and/or warranties with respect to a loan’s compliance with the guidelines, we can require that the lender repurchase the loan or, in some cases, provide an indemnity agreement.

Over the last several years, we have enhanced Desktop Underwriter®, our automated underwriting system, to assist lenders in applying Fannie Mae underwriting standards for single-family loans. Desktop Underwriter is designed to help lenders process mortgage applications in a more efficient and accurate manner and to apply our underwriting criteria to all prospective borrowers consistently, objectively, and in a more customized manner.

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The Mortgage Seller or Servicer

Before we approve a lender or other customer to become a seller or servicer, we require that it meet certain standards, which include satisfying to us that the lender:

  •  has as one of its principal business purposes the origination, selling, and/or servicing of residential mortgages;
 
  •  has a proven ability to originate, sell, and/or service the type of mortgages for which our approval is being requested;
 
  •  employs a staff with adequate experience;
 
  •  is duly organized, validly existing, properly licensed (and in good standing), or otherwise authorized, to conduct its business in each of the jurisdictions in which it originates, sells, or services residential mortgages;
 
  •  meets our financial criteria and standards;
 
  •  has internal audit and management systems to evaluate and monitor the overall quality of its loan production and servicing activities; and
 
  •  is covered by a fidelity bond and errors and omissions insurance that meets our requirements.

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

MORTGAGE COMMITTING AND SERVICING ARRANGEMENTS

Mortgage Commitments

We enter into master agreements with lenders to facilitate ongoing transactions. Mortgage loans delivered to us for pooling into MBS generally require a master agreement, while mortgage loans purchased in cash transactions may or may not be under a master agreement, depending on whether the lender has negotiated any waivers of, or variances to, our standard guidelines. Pursuant to a master agreement, a lender agrees to deliver a specified volume of mortgage loans over a specified period of time, usually 12 months.

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

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

Servicing Arrangements

Mortgage loans held in our mortgage portfolio or that back our MBS must be serviced, in most cases, only by a Fannie Mae approved servicer. We typically do not service mortgage loans directly. However, we have ultimate responsibility for servicing the loans we purchase or guarantee under Fannie Mae’s mortgage selling and servicing contracts. Typically, lenders who sell single-family mortgage loans and conventional multifamily loans to Fannie Mae initially service the mortgage loans they sell to us. There is an active market in which

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lenders sell servicing rights and obligations to other servicers. Further, some lenders assign the servicing rights and obligations concurrently with sale of the loan to Fannie Mae. All servicing transfers, whenever they occur, require Fannie Mae approval. Finally, we may at times engage a servicing entity to service loans on our behalf due to termination of a servicer or for other reasons.

Mortgage servicers collect and remit principal and interest payments, administer escrow accounts (if required), evaluate transfers of ownership interests, respond to requests for partial releases of security, and handle proceeds from casualty and condemnation losses. For problem loans, servicing includes negotiating workouts, engaging in loss mitigation and, if necessary, inspecting and preserving properties and processing foreclosures and bankruptcies. In the case of multifamily loans, servicing also may include performing routine property inspections, evaluating the financial condition of owners, and administering various types of agreements (including agreements regarding replacement reserves, completion or repair, and operations and maintenance). We compensate servicers primarily by permitting them to retain a specified portion of each interest payment on a serviced mortgage loan, called a “servicing fee.” The weighted average servicing fee for conventional single-family loans owned or guaranteed by Fannie Mae in 2003 was .366 percent. We have the right to remove servicing responsibilities from any lender under criteria established in our contractual arrangements with servicers.

BUSINESS SEGMENTS

Portfolio Investment Business

Overview. Our Portfolio Investment business has two principal components: a mortgage portfolio and liquid investments. The mortgage portfolio includes mortgage loans, mortgage-related securities, and other investments purchased from lenders, securities dealers, investors, and other market participants. Liquid investments, which serve principally as a source of liquidity and an investment vehicle for our surplus capital, include cash and cash equivalents, nonmortgage investments, and loans held for securitization or sale. We primarily purchase readily marketable, high credit quality nonmortgage securities from securities dealers for our liquid investments. The securities have short-term maturities or can be sold as a source of funds to meet our cash flow needs. We fund the purchase of assets for our mortgage portfolio and liquid investments primarily by borrowing money in the domestic and international capital markets through the sale of debt securities and by entering into derivative contracts. We derive income from the difference, or “spread,” between the yield we earn on our portfolio investments and the interest we pay on our borrowings.

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

Morgage Portfolio Loan Purchase

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

Our mortgage portfolio is also exposed to the credit risk that borrowers may fail to repay mortgage loans held in our portfolio or backing mortgage-related securities held in our portfolio. Our Credit Guaranty business is responsible for managing mortgage credit risk on loans and mortgage-related securities (including MBS) held in our portfolio and outstanding MBS. For segment reporting purposes, we allocate a fee comparable to an MBS guaranty fee from the Portfolio Investment business to the Credit Guaranty business for management of the credit risk on the mortgage loans and mortgage-related securities (including MBS)

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held in the portfolio. Likewise, all mortgage-related credit expenses arising from mortgage loans and mortgage-related securities held in our portfolio are allocated to the Credit Guaranty business. This inter-segment allocation of a credit risk management fee and mortgage-related credit expenses has no impact on Fannie Mae’s reported net income.

Mortgage Portfolio

Assets Purchased. Fannie Mae purchases primarily conventional single-family fixed- or adjustable-rate, first lien mortgage loans, or mortgage-related securities backed by such loans. In addition, we purchase loans insured by the FHA, loans guaranteed by the VA or RHS, manufactured housing loans, multifamily mortgage loans, subordinate lien mortgage loans (e.g., loans secured by second liens) and other mortgage-related securities. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations— Portfolio Investment Business Operations— Investments— Mortgage Portfolio— Table 14” for information on the composition of our mortgage portfolio.

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

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

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

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

Sources of Investments. We purchase mortgage loans and mortgage-related securities from a variety of sources, including lenders, securities dealers, investors and other market participants. Mortgage loan purchases from lenders typically occur pursuant to standing arrangements to purchase ongoing loan volume or through negotiated transactions. Transactions with other investors typically occur through the mortgage capital markets (including the “TBA” market described below) or on a negotiated basis. We routinely enter into forward purchase commitments that allow us to lock in the future delivery of mortgage loans or mortgage-related securities for our mortgage portfolio at a fixed price or yield. The commitments generally are short-term in nature and end when the loans or securities are delivered to Fannie Mae or the commitment period expires. Our primary goal is to purchase mortgage loans and mortgage-related securities for our portfolio. Primarily in connection with our customer transactions and services activities (described

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immediately below), we may enter into forward commitments to purchase mortgage loans or mortgage-related securities that we decide not to retain in our portfolio. In these instances, we generally will enter into an offsetting sell commitment with an investor other than Fannie Mae or require the lender to deliver a sell commitment to Fannie Mae together with the loans to be pooled into mortgage-related securities.

Customer Transactions and Services. Our Portfolio Investment business provides services to our lender customers and their affiliates, which include: offering to purchase a wide variety of loan products, including non-standard products, which we either retain in our portfolio for investment or sell to other investors as a service to assist our customers in accessing the market; segregating customer portfolios to obtain optimal pricing for their mortgage loans (for example, segregating Community Reinvestment Act or “CRA” eligible loans which typically command a premium); providing funds at the loan delivery date for purchase of loans delivered for securitization; and assisting customers with the hedging of their mortgage business, including entering into options and forward contracts on mortgage-related securities. These activities provide a significant source of assets for our mortgage portfolio, help to create a broader market for our customers and enhance liquidity in the secondary mortgage market. We do not maintain a trading account or otherwise undertake speculative activities.

Liquid Investments

Our liquid investments serve principally as a source of liquidity and an investment vehicle for our surplus capital. If our access to the debt capital markets is ever impaired, we may utilize our liquid investments to generate cash to meet our liquidity needs. We may use funds received at maturity of our short-term investments or sell assets to generate those funds. We primarily invest in high-quality assets that have short-term maturities and/or are readily marketable. We also may purchase liquid investments secured by mortgage-related collateral from time to time (e.g., commercial paper secured in part by mortgage assets).

We have set a goal to maintain liquid assets equal to at least 5 percent of total on-balance sheet assets. Liquid assets include our liquid investments, net of any cash and cash equivalents pledged as collateral. Our ratio of liquid assets to total assets at December 31, 2003 and 2002 was 6.5 percent and 6.4 percent, respectively. Because our liquid assets are maintained for liquidity purposes and not principally as an investment business, the income generated from these investments is considerably lower than the income generated by mortgage portfolio investments. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations— Portfolio Investment Business Operations— Investments— Liquid Investments” for additional information on our liquid investments.

Credit Guaranty Business

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

Our Credit Guaranty business manages Fannie Mae’s mortgage credit risk through sound asset acquisition practices, use of credit enhancements, active management of the mortgage credit book of business, and aggressive problem loan management. We share mortgage credit risk with third parties as an integral part of our risk management strategy. In our credit enhancement arrangements, we bear institutional counterparty

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risk that the parties assuming credit enhancement obligations may be unable to meet their contractual obligations. Mortgage credit enhancements are primarily mortgage insurance, lender recourse, and other risk sharing contracts. We routinely monitor the risks associated with credit enhancement and other risk sharing arrangements. We have provided a detailed description of how we manage the mortgage-related credit risk associated with the Credit Guaranty business, as well as other types of credit risk, in “Management’s Discussion and Analysis of Financial Condition and Results of Operations— Credit Guaranty Business Operations— Credit Risk Management.”

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

(MBS Guaranty Process Diagram)

MBS. We typically create MBS in the following manner; First, a Fannie Mae seller transfers a pool or pools of mortgage loans to Fannie Mae. We set aside and place these mortgage loans in a trust that assumes the legal ownership of the mortgage loans. We serve as trustee of the trust. In exchange for the mortgage loans, we issue and deliver to the seller (or its designee) our MBS certificates that are backed by the pool(s) of mortgage loans and represent an equitable ownership interest in each of the mortgage loans in the trust. These MBS carry Fannie Mae’s corporate guaranty of timely payment of principal and interest. MBS monthly distributions are made from principal and interest payments from the underlying mortgage loans; however, a portion of the interest cashflow is used to pay the costs of servicing the mortgage loans and providing Fannie Mae’s corporate guaranty.

In some instances, a seller requests that we resecuritize their mortgage-related securities into a new MBS. In this case, the seller transfers the mortgage-related securities to Fannie Mae. We set aside and place these mortgage-related securities in a trust that assumes the legal ownership of the mortgage-related securities. We

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serve as trustee of the trust. In exchange for the mortgage-related securities, we issue and deliver to the seller (or its designee), our MBS certificates that are backed by the mortgage-related securities. These MBS carry Fannie Mae’s corporate guaranty of timely payment of principal and interest. MBS monthly distributions are made from principal and interest payments from the underlying mortgage-related securities, with a portion of the interest cashflow used to pay the costs of providing Fannie Mae’s corporate guaranty. However, where the mortgage-related securities are MBS (which are already guaranteed by Fannie Mae), there is a one-time transaction fee collected at the time of issuance of the new MBS but no additional guaranty fee.

A separate trust is created for each MBS. We are the trustee for each MBS trust and hold the underlying mortgage loans or mortgage-related securities separate and apart from our assets, for the benefit of the MBS certificateholders. The MBS, and the mortgage loans and mortgage-related securities backing MBS, are not assets of Fannie Mae, except when we acquire them for mortgage portfolio investment purposes.

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

Single-Class MBS. Single-class MBS are MBS that are typically created through single-lender transactions in which a lender delivers mortgage loans in exchange for MBS representing beneficial interests in those mortgage loans. Another form of single-class MBS, referred to as “Fannie Majors®,” allows one or more lenders to pool mortgage loans that are delivered to us and, in exchange, receive MBS representing each lender’s proportionate share of the larger pool.

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

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

The MBS TBA Market. Single-class MBS constituted approximately 81 percent of Fannie Mae’s total MBS issued and outstanding as of December 31, 2003. The vast majority of these MBS are sold by lenders into the “TBA” (“to be announced”) securities market. A TBA trade represents a forward contract for the purchase or sale of single-family mortgage-related securities to be delivered at a future agreed-upon date. The specific pool numbers that will be delivered to fulfill the forward contract are unknown at the time of the trade. Parties to a TBA trade agree upon the issuer, product type and amount of securities to be delivered (denoted by a pool prefix), and the interest rate, price and settlement date of the trade. The single-class MBS that ultimately will be delivered, and the loans backing that MBS, frequently have not been created or originated at the time of the TBA trade, even though a price for the securities is agreed to at that time. A TBA trade may be entered into as early as several months before actual settlement of that trade. TBA sales enable the originating lender to hedge its interest rate risk and efficiently “lock-in” interest rates for mortgage loan applicants throughout the loan origination process. A lender may satisfy its delivery requirement under a TBA trade by delivering any mortgage-related security meeting the agreed-upon terms.

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Resecuritized Single-Class MBS. We also create single-class MBS referred to as “Fannie Megas®” or “Megas.” Megas are pass-through certificates backed by multiple pools of single-class MBS with similar characteristics and/or other pooled Megas with similar characteristics. Megas are issued in transactions in which a lender or investment banker exchanges pooled single-class MBS and/or other pooled Megas for newly issued Mega certificates. We receive a transaction fee for each Mega issuance but no additional guaranty fee for the Mega. A guaranty fee is received, however, on each of the single-class MBS certificates that back a Mega (other than an underlying Mega), and the Mega certificateholders receive the benefits of that guaranty.

Multi-Class MBS. We also issue multi-class MBS, such as real estate mortgage investment conduits, commonly referred to as “REMICs,” certain grantor trust certificates, and stripped mortgage-backed certificates, commonly referred to as “SMBS.” REMICs are a vehicle by which an issuer can structure interest and principal payments on mortgage loans or mortgage-related securities (including MBS) into separately tradeable interests. By directing the cash flows from the underlying mortgage loans or mortgage-related securities, we can create a security having several classes, also called “tranches,” which, among other things, may have different coupon rates, average lives, repayment sensitivities and final maturities. SMBS operate in a manner similar to REMICs, though we typically use SMBS to create tranches that pay only principal or only interest.

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

If the multi-class MBS are backed by mortgage loans or mortgage-related securities we have not already guaranteed, we receive a monthly guaranty fee for our guaranty of payments on the multi-class MBS, and a transaction fee where they are backed by mortgage-related securities. If the multi-class MBS is backed by our MBS, we receive a one-time transaction fee. We do not receive an additional guaranty fee because we have already assumed the credit risk and receive a guaranty fee on the underlying MBS.

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

The aggregate amount of guaranty fees we receive in any financial statement period depends primarily upon the amount of MBS issued and outstanding during that financial statement period and on the applicable guaranty fee rates. The amount of MBS issued and outstanding is influenced by factors including the rates at which the underlying mortgage loans are repaid, the rate of defaults on loans or breaches of lender

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representations resulting in repurchases from the pool, and the rate at which we issue new MBS. In general, when prevailing interest rates decline below the interest rates on loans underlying MBS, both the rate of mortgage loan prepayments and the issuance of new MBS are likely to increase. Conversely, when interest rates rise above the interest rates on mortgage loans underlying our MBS, the rate of mortgage loan prepayments and new MBS issuance is likely to slow. The rate of principal prepayments also is influenced by a variety of economic, demographic, and other factors.

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

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

Fee-Based Services

We offer services to lenders and other customers in return for fees. These include transaction fees for issuing and administering REMICs, SMBS, Fannie Megas and certain grantor trust securities. In addition, we receive fee income through other activities, such as providing credit enhancements and other investment alternatives for customers.

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

HOUSING GOALS

The Federal Housing Enterprises Financial Safety and Soundness Act (the “1992 Act”) requires the Secretary of the U.S. Department of Housing and Urban Development (“HUD”) to establish goals for low- and moderate-income housing and underserved areas, and a special affordable housing goal for mortgages purchased or guaranteed by Fannie Mae. We are required to submit an annual report to the House Committee on Financial Services, the Senate Committee on Banking, Housing and Urban Affairs, and the Secretary of HUD regarding our performance in meeting the housing goals. By regulation, HUD has established the low- and moderate-income housing goal at 50 percent of the total number of dwelling units financed by eligible mortgage purchases annually, the underserved areas housing goal at 31 percent, and the special affordable housing goal, a more targeted measure, at 20 percent. “Eligible mortgage purchases” include MBS guarantees but exclude several activities, including the purchase or guaranty of non-conventional mortgages and mortgages on second homes, commitments to purchase or guarantee mortgages at a later date, and equity investments in low-income housing tax credits. For the year ended December 31, 2003,

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eligible mortgage purchases represented approximately 97 percent of our business volume. In addition, HUD has established Fannie Mae’s targeted multifamily subgoal at $2.85 billion.

Each of these goals applied annually during 2001 through 2003. HUD has informed Fannie Mae that the 2003 goals will remain in force during 2004, and that during the year HUD will issue new goals for 2005 and beyond. During 2001 through 2003, HUD provided incentive points for serving small multifamily and owner-occupied rental housing. These incentive points are no longer available in 2004, making the same goal levels more difficult to achieve. A unit may be counted in more than one category of goals. If HUD determines that Fannie Mae has failed to meet its housing goals and that achievement of the goals was feasible, taking into account market and economic conditions and Fannie Mae’s financial condition, Fannie Mae must submit a housing plan to HUD describing the actions it will take to meet the goal in the next calendar year. If HUD determines that Fannie Mae has failed to submit a housing plan or failed to make a good faith effort to comply with the plan, HUD may take certain administrative actions. The following table shows Fannie Mae’s housing goals and results for the past three years.

                                                 
2003 2002 2001



Housing Goals Goal(1) Result(2) Goal(1) Result(2) Goal(1) Result(2)







(Dollars in billions)
Low- and moderate-income housing
    50.0 %     51.8 %     50.0 %     51.8 %     50.0 %     51.6 %
Underserved areas
    31.0       32.0       31.0       32.8       31.0       32.5  
Special affordable housing
    20.0       20.9       20.0       21.4       20.0       21.6  
Multifamily minimum in special affordable housing
  $ 2.85     $ 11.62     $ 2.85     $ 7.22     $ 2.85     $ 7.40  


(1)  Goals are expressed as a percentage of the total number of dwelling units financed through eligible mortgage purchases during the period, except for the targeted multifamily goal.
 
(2)  Results reflect the impact of the provisions that reduce the penalty for missing data and the incentive points for small multifamily and owner-occupied rental housing.

In order to be able to meet these housing goals, the Charter Act permits Fannie Mae to undertake “activities . . . involving a reasonable economic return that may be less than the return earned on other activities.” Accordingly, we may agree to less favorable economic terms or offer other incentives to obtain business that contributes toward meeting our housing goals. Because the housing goals are generally expressed as a percentage of the total number of dwelling units financed during the period, meeting the goals can be more challenging during a time of high refinancing volume, such as 2003 when interest rates remained at historically low levels, because a large portion of the refinance business does not materially contribute to our housing goals. We were able to meet HUD’s goals during 2003, but in order to do so we entered into transactions that were meaningful to our own housing goals but had less favorable economic terms and provided other incentives. This practice is consistent with our Charter Act and may be necessary to meet our housing goals. These transactions in 2003 did not, in the aggregate, materially adversely affect our financial performance in 2003.

COMPETITION

In the case of single-family mortgage loans, Fannie Mae competes, within the limits prescribed by the Charter Act, for the purchase of mortgage loans for our own portfolio, for the guaranty of mortgage credit risk, and for the issuance in the secondary mortgage market of mortgage-related securities. For single-family products, we compete with Freddie Mac (another government-sponsored enterprise with a mission, authority, and regulatory oversight that are virtually identical to our own), commercial banks, savings and loan associations, savings banks, pension funds, insurance companies, securities dealers, and other financial entities that purchase single-family mortgage loans or mortgage-related securities for their own portfolio or pool single-family mortgage loans for sale to investors as mortgage loans or mortgage-related securities. We compete with the Federal Home Loan Banks, which also finance single-family mortgage loans through a variety of programs that were initiated in 1997. We compete with mortgage insurers, bond insurers, and other financial guarantors that provide mortgage credit guaranty services on loans and pools of loans.

Commercial banks and thrifts are the largest participants in the U.S. mortgage industry. Banks and thrifts originate mortgages (which we are not empowered to do under the Charter Act), have access to low cost,

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FDIC-insured deposits and can borrow advances from Federal Home Loan Banks. There has been significant consolidation among commercial banks and thrifts, increasing the size of individual organizations and resulting in concentration in the banking industry. This has created larger institutions with the scale necessary to permit them to securitize their own mortgages and manage large and complex portfolios. As institutions become larger, they have increasing bargaining power in their negotiations with Fannie Mae, and are able to offer us volume in return for lower guaranty fees and customization of services.

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

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

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

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

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

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

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EMPLOYEES

As of February 29, 2004, Fannie Mae employed approximately 5,055 permanent personnel.

GOVERNMENT REGULATION AND CHARTER ACT

Charter Act

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

Under the Charter Act, our purpose is:

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

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

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

Thirteen members of our eighteen-member Board of Directors are elected by the holders of our common stock. The President of the United States appoints the remaining five members. The appointed directors must include one person from the home building industry, one person from the mortgage lending industry, one person from the real estate industry, and one person from a consumer or community interest organization or who has demonstrated a career commitment to providing low-income housing. Any member of the Board of Directors that is appointed by the President of the United States may be removed by the President for good cause. All members of the Board of Directors are elected or appointed annually. Based on best practice standards established by the Board’s Nominating and Corporate Governance Committee, 14 of our 15 non-management directors are considered independent under New York Stock Exchange standards.

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

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

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

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

Regulatory Approval and Oversight

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

OFHEO, an independent office within HUD, is responsible for ensuring that we are adequately capitalized and operating safely in accordance with the 1992 Act. OFHEO conducts on-site examinations of Fannie Mae for purposes of ensuring our financial safety and soundness. We are required to submit annual and quarterly reports of our financial condition and operations to OFHEO. OFHEO is authorized to levy annual assessments on Fannie Mae and Freddie Mac, pursuant to annual Congressional appropriations, to cover OFHEO’s reasonable expenses. OFHEO’s formal enforcement powers include the power to impose temporary and final cease-and-desist orders and civil monetary penalties on us and on our directors and executive officers, provided certain conditions are met. OFHEO may use other informal supervisory tools of the type that are generally used by agencies with authority to regulate other financial institutions. In accordance with OFHEO regulation, Fannie Mae has elected to follow the applicable corporate governance practices and procedures of the Delaware General Corporation Law, as it may be amended from time to time.

In addition, on April 30, 2003, regulations promulgated by OFHEO went into effect, requiring Fannie Mae to file with the SEC all reports, proxy statements and forms relating to our common stock that are required to be filed under Sections 14(a) and (c) of the Exchange Act and the rules and regulations under those sections and requiring Fannie Mae’s directors and officers to file all reports and forms relating to our common stock that are required to be filed under Section 16 of the Exchange Act and the rules and regulations under that section.

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

Recent Legislative and Regulatory Developments

During 2003, several bills were introduced in Congress that propose to alter the regulatory regime under which Fannie Mae operates. These bills seek to transfer regulatory responsibility for overseeing Fannie Mae’s financial safety and soundness from OFHEO to a bureau under the U.S. Department of the Treasury. Some of the bills would also move various of the HUD’s regulatory authorities over Fannie Mae to a Treasury bureau. Several bills seek to provide additional or expanded powers to Fannie Mae’s regulators. Congress will continue to consider possible regulatory reform legislation in 2004. We cannot predict whether any legislation will be approved by Congress and signed into law by the President and, if so, the final form or effective date of the legislation.

In July 2003, the Director of OFHEO announced that OFHEO would undertake a special examination of the accounting policies, as well as internal controls, at Fannie Mae. The Director stated that OFHEO was undertaking the special examination as a prudential matter. In February 2004, OFHEO announced that it had selected an independent accounting firm to supplement its efforts. OFHEO also stated that it expects the examination of Fannie Mae to take up to a year. The special examination is ongoing, and we are fully cooperating with OFHEO during the process.

Capital Requirements

The 1992 Act established minimum capital, risk-based capital, and critical capital requirements for Fannie Mae. See also “Management’s Discussion and Analysis of Financial Condition and Results of Operations— Liquidity and Capital Resources— Capital Resources— Regulatory Environment.” OFHEO issued a final rule in 1996 that sets forth the minimum capital requirements for Fannie Mae and Freddie Mac, which are to be calculated, reported, and classified on a quarterly basis. We believe we were in compliance with the minimum capital rule as of December 31, 2003, and have been in compliance for every reporting period since the rule became effective. We expect OFHEO to confirm our December 31, 2003 minimum capital results when it reports our fourth quarter 2003 minimum and risk-based capital at the end of March 2004.

OFHEO issued regulations in September 2001, as subsequently amended, to establish a risk-based capital test to be used to determine the amount of total capital Fannie Mae must hold to meet the risk-based capital standard. Fannie Mae and Freddie Mac are required to hold enough capital to withstand a severe 10-year stress period, characterized by extreme interest-rate movements and credit losses occurring simultaneously, plus 30 percent of that amount for management and operations risk. The risk-based capital test evaluates combined interest-rate and credit stress for both rising and declining interest-rate scenarios. The more stringent of these two scenarios determines the required risk-based capital. The test assumes that (1) interest rates increase or decrease by up to 600 basis points over the first year, and remain constant at this new level for the remaining 9 years of the test; (2) severe credit conditions apply nationwide; and (3) we acquire no new business during this period except to meet outstanding mortgage commitments. The regulations specify that “benchmark loss experience” will be combined with other assumptions and applied each quarter to our book of business to establish expected credit losses based on the stress assumptions under the risk-based capital standard. The regulations also specify the housing price index that OFHEO will use in connection

19


 

with the standard and how the test will be used to determine Fannie Mae’s risk-based capital requirements. On December 31, 2003, OFHEO announced that Fannie Mae complied with the risk-based capital rule as of September 30, 2003. OFHEO has not announced the results for December 31, 2003. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations— Liquidity and Capital Resources— Capital Resources— Regulatory Environment.”

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

Dividend Restrictions

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

  •  Fannie Mae may not pay any dividend, without the approval of OFHEO, if the dividend payment would decrease our total capital below the risk-based capital level or our core capital below the minimum capital level.
 
  •  If we do not meet the risk-based capital standard but do meet the minimum capital standard, we may not make any dividend payment that would cause us to fail to meet the minimum capital standard.
 
  •  If we meet neither the risk-based capital standard nor the minimum capital standard but do meet the critical capital standard established under the 1992 Act, we may make a dividend payment only if we would not fail to meet the critical capital standard as a result of the payment and the Director of OFHEO approves the payment after finding that the payment satisfies certain statutory conditions.

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

Item 2. Properties

We own our principal office, which is located at 3900 Wisconsin Avenue, NW, Washington, DC, offices at 3939 Wisconsin Avenue, NW, and 4250 Connecticut Avenue, NW, in Washington, DC. We also own two facilities in Herndon, Virginia as well as a facility in Reston, Virginia. These owned facilities total approximately 1,200,000 square feet of space. In addition, we lease 375,000 square feet of office space at 4000 Wisconsin Avenue, NW, which is adjacent to Fannie Mae’s principal office. The present lease for 4000 Wisconsin Avenue expires in 2008, and we have options to extend the lease for up to 10 additional years, in 5-year increments. We also lease an additional 389,000 square feet of office space in four locations in Washington, D.C., suburban Virginia, and Maryland.

We maintain offices in leased premises in Pasadena, California; Atlanta, Georgia; Chicago, Illinois; Philadelphia, Pennsylvania; and Dallas, Texas. In addition, we have 55 “Fannie Mae Partnership Offices” in leased premises around the United States, which work with cities, rural areas, and underserved communities.

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Item 3. Legal Proceedings

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

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

Fannie Mae is the subject of a lawsuit filed on September 13, 2002, as a class action in the United States District Court for the District of Columbia seeking declaratory and injunctive relief, as well as statutory and punitive damages. The complaint identified as a class all minority borrowers who have been denied loans as a result of Fannie Mae’s automated underwriting systems (“AUS”). The lawsuit alleges that Fannie Mae’s AUS unlawfully fails to give adverse action notices to borrowers who are not approved for the loans for which they apply, and unlawfully discriminates against minorities.

Fannie Mae moved to dismiss the complaint in its entirety and the court granted that motion in part and denied it in part. The court held that Fannie Mae did not have a legal obligation to provide adverse action notices and the court declined the plaintiff’s motion to reconsider that decision or certify it for appeal. The court held that the plaintiff had met the minimal requirements for pleading the discrimination claim, but that plaintiff must demonstrate that she was qualified to obtain a loan. Fannie Mae anticipates that it will file dispositive motions on a variety of factual and legal grounds, as well as file briefs to defeat class certification.

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

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

None.

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PART II

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

Fannie Mae’s common stock is publicly traded on the New York, Pacific, and Chicago stock exchanges and is identified by the ticker symbol “FNM.” The transfer agent and registrar for the common stock is EquiServe Trust Company, N.A., P.O. Box 43069, Providence, Rhode Island 02940.

The following table shows, for the periods indicated, the high and low sales prices per share of Fannie Mae’s common stock on the New York Stock Exchange Composite Transactions as reported in the Bloomberg Financial Markets service and the dividends paid in each period.

Quarterly Common Stock Data

                                                 
2003 2002


Quarter High Low Dividend High Low Dividend







First
  $ 70.40     $ 58.40     $ .39     $ 83.75     $ 75.08     $ .33  
Second
    75.84       65.30       .39       84.10       72.00       .33  
Third
    72.07       60.11       .45       77.55       58.85       .33  
Fourth
    75.95       68.47       .45       72.12       61.45       .33  

The closing price of Fannie Mae’s common stock on March 1, 2004, as so reported, was $77.25.

At February 29, 2004, there were approximately 974 million shares of common stock outstanding. At December 31, 2003, there were approximately 25,000 stockholders of record and, based on the number of requests for proxies and quarterly reports, Fannie Mae estimates that there are approximately 385,000 additional stockholders who held shares through banks, brokers and nominees.

Fannie Mae’s payment of dividends is subject to certain statutory restrictions, including approval by the Director of the Office of Federal Housing Enterprise Oversight, of any dividend payment that would cause Fannie Mae’s capital to fall below specified capital levels. See the information under “Business— Government Regulation and Charter Act.” Fannie Mae has exceeded the applicable capital standards since the adoption of these restrictions in 1992 and, consequently, has been making dividend payments without the need for such approval. Payment of dividends on common stock is also subject to payment of dividends on preferred stock outstanding.

Sales of Unregistered Securities

The securities Fannie Mae issues are “exempted securities” under laws administered by the SEC to the same extent as securities that are obligations of, or guaranteed as to principal and interest by, the United States. Registration statements with respect to offerings of Fannie Mae securities are not filed with the SEC. However, we voluntarily filed a Form 10 on March 31, 2003 to register our common stock under the Securities Exchange Act of 1934. As a result of our voluntary registration, we are now required to file periodic reports with the SEC.

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Share Repurchases

The following table shows shares of Fannie Mae common stock we repurchased during 2003 under our publicly announced share repurchase program. We repurchased no shares outside of this program.

Issuer Purchases of Equity Securities

(Shares in millions)
                                   
Total Number of Maximum
Shares Purchased as Number of Shares
Total Number Average Part of Publicly that May Yet Be
of Shares Price Paid Announced Purchased Under
For the 2003 Month of: Purchased(1) per Share Program(2) the Program(3)





January 1-31
                      49.4  
February 1-28
    2.6     $ 63.33       2.6       47.5  
March 1-31
    6.0       61.72       6.0       41.6  
April 1-30
    1.4       68.70       1.4       40.4  
May 1-31
    1.7       72.10       1.7       39.1  
June 1-30
    2.3       68.33       2.3       36.9  
July 1-31
    2.6       66.26       2.6       34.4  
August 1-31
    2.9       62.83       2.9       31.6  
September 1-30
          62.55             31.7  
October 1-31
                      31.7  
November 1-30
    1.5       69.50       1.5       31.1  
December 1-31
    .3       69.75       .3       31.0  
     
     
     
     
 
 
Total
    21.3     $ 65.28       21.3       31.0  
     
     
     
     
 


(1)  All purchases were open market transactions completed in compliance with SEC Rule 10b-18.
 
(2)  On January 21, 2003, Fannie Mae publicly announced the approval by the Board of Directors of a share repurchase program under which up to 49.4 million shares (5 percent of common shares outstanding as of December 31, 2002) could be purchased by Fannie Mae (the “General Repurchase Authority”). At the same time, the Board approved the repurchase of additional shares to offset stock issued (or expected to be issued) under Fannie Mae’s employee benefit plans. This share repurchase program replaces the repurchase program in effect since 1996 and has no specified expiration date. Of the 21.3 million shares repurchased in 2003, 2.9 million shares were repurchased to offset stock issued under Fannie Mae’s employee benefit plans.
 
(3)  Reflects maximum number of shares that may yet be purchased under the General Repurchase Authority, but does not include additional shares that may be repurchased to offset stock issued (or expected to be issued) under Fannie Mae’s employee benefit plans. See “Notes to Financial Statements—Note 9, Stock-Based Compensation Plans,” for information about shares issued or to be issued, under Fannie Mae’s employee benefit plans. At December 31, 2003, a total of 42.8 million shares were available for grant pursuant to Fannie Mae’s employee benefit plans. At the Annual Meeting of Shareholders in May 2004, shareholders will be asked to vote on whether to increase the number of shares available for issuance under Fannie Mae’s Employee Stock Purchase Plan by 9 million shares.

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Item 6.  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 of Financial Condition and Results of Operation (‘MD&A’)— 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. We have reclassified certain prior period amounts to conform to our current year presentation. This financial information should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business,” and our financial statements and related notes, included elsewhere in this report.

                                         
Year Ended December 31,

Reported Earnings Data: 2003 2002 2001 2000 1999






(Dollars and shares in millions, except per share amounts)
 
Net income
  $ 7,905     $ 4,619     $ 5,894     $ 4,448     $ 3,912  
Preferred stock dividends and issuance costs on redemptions
    (150 )     (111 )     (146 )     (121 )     (78 )
     
     
     
     
     
 
Net income available to common stockholders
  $ 7,755     $ 4,508     $ 5,748     $ 4,327     $ 3,834  
     
     
     
     
     
 
Basic earnings per common share
  $ 7.93     $ 4.54     $ 5.75     $ 4.31     $ 3.75  
Diluted earnings per common share
    7.91       4.52       5.71       4.29       3.72  
Weighted-average diluted common shares outstanding
    981       997       1,006       1,009       1,031  
Cash dividends per common share
  $ 1.68     $ 1.32     $ 1.20     $ 1.12     $ 1.08  
Net interest yield, taxable-equivalent basis
    1.54 %     1.38 %     1.19 %     1.01 %     1.01 %
Return on average assets
    .82       .55       .78       .71       .73  
Return on common equity
    49.9       30.1       39.8       25.6       25.2  
Average equity to average assets
    2.0       2.1       2.3       3.1       3.1  
Dividend payout ratio
    21.2       29.1       20.9       26.0       28.8  
Ratio of earnings to combined fixed charges and preferred stock dividends and issuance costs on redemptions(1)
    1.27:1       1.15:1       1.18:1       1.16:1       1.17:1  
Core Business Earnings Data:(2)
                                       
Core business earnings(3)
  $ 7,306     $ 6,394     $ 5,367     $ 4,448     $ 3,912  
Core business earnings per diluted common share
    7.29       6.30       5.19       4.29       3.72  
Core taxable-equivalent revenues(4)
    14,794       11,896       10,187       7,825       6,975  
Net interest margin, taxable-equivalent basis(5)
    1.20 %     1.15 %     1.11 %     1.01 %     1.01 %
Core return on average assets(6)
    .76       .76       .71       .71       .73  
Core return on average realized common equity(7)
    26.0       26.0       25.4       25.2       25.0  
                                           
December 31,

Balance Sheet Data: 2003 2002 2001 2000 1999






Mortgage portfolio, net
  $ 901,795     $ 801,043     $ 706,755     $ 607,680     $ 523,046  
Liquid assets(8)
    65,155       56,941       74,178       55,069       41,703  
Total assets
    1,009,569       887,515       799,948       675,224       575,308  
Borrowings:
                                       
 
Due within one year
    483,193       382,412       343,492       280,322       226,582  
 
Due after one year
    478,539       468,570       419,975       362,360       321,037  
Total liabilities
    987,196       871,227       781,830       654,386       557,679  
Preferred stock
    4,108       2,678       2,303       2,278       1,300  
Stockholders’ equity
    22,373       16,288       18,118       20,838       17,629  
Core capital(9)
    34,405       28,079       25,182       20,827       17,876  
Total capital(10)
    35,182       28,871       25,976       21,634       18,677  

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Year Ended December 31,

Other Performance Measures: 2003 2002 2001 2000 1999






Average effective guaranty fee rate(11)
    .202 %     .191 %     .190 %     .195 %     .193 %
Credit loss ratio(12)
    .006       .005       .006       .007       .011  
Administrative expense ratio(13)
    .072       .072       .071       .072       .071  
Efficiency ratio(14)
    9.9       10.2       10.0       11.6       11.5  
Mortgage purchases(15)
  $ 572,852     $ 370,641     $ 270,584     $ 154,231     $ 195,210  
MBS issues acquired by others(16)
    850,204       478,260       344,739       105,407       174,850  
Business volume(17)
    1,423,056       848,901       615,323       259,638       370,060  
                                         
December 31,

2003 2002 2001 2000 1999





Gross mortgage portfolio(18)
  $ 898,438     $ 794,124       708,447       610,253       524,447  
Outstanding MBS(19)
    1,300,166       1,029,456       858,965       706,722       679,145  
Book of business(20)
    2,198,604       1,823,580       1,567,412       1,316,975       1,203,592  


(1)  “Earnings” consist of (a) income before federal income taxes and cumulative effect of change in accounting principle 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 over the original estimated life of the option and 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 and issuance costs on redemptions divided by average assets.
(7)  A non-GAAP measure calculated based on core business earnings less preferred stock dividends and issuance costs on redemptions divided by average realized common stockholders’ equity (common stockholders’ equity excluding accumulated other comprehensive income).
(8)  Liquid assets include (a) cash and cash equivalents less any pledged collateral, (b) nonmortgage investments, and (c) loans held for securitization or sale.
(9)  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.
(10)  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 $20 million, $19 million, $13 million, $2 million, and $3 million at December 31, 2003, 2002, 2001, 2000, and 1999.
(11)  Calculated based on guaranty fees and the amortization of deferred price adjustments related to average outstanding MBS.
(12)  Charge-offs and foreclosed property expense (income), net of recoveries, as a percentage of average mortgage credit book of business.
(13)  Administrative expenses as a percentage of average net mortgage portfolio and average outstanding MBS.
(14)  Administrative expenses as a percentage of core taxable-equivalent revenues.
(15)  Unpaid principal balance of loans, MBS, and other mortgage-related securities purchased by Fannie Mae during the reporting period.
(16)  Unpaid principal balance of MBS issued and guaranteed by Fannie Mae and acquired by investors other than Fannie Mae during the reporting period.
(17)  Includes mortgage purchases and MBS issues acquired by others.
(18)  Unpaid principal balance of mortgages held in portfolio, excluding the effect of unrealized gains or losses on available-for-sale securities, deferred balances and the allowance for loan losses.
(19)  Unpaid principal balance of MBS guaranteed by Fannie Mae and held by investors other than Fannie Mae.
(20)  Includes gross mortgage portfolio and outstanding MBS.

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

FORWARD-LOOKING INFORMATION

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

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

  •  significant changes in borrower preferences for fixed- or adjustable-rate mortgages, originator preferences for selling mortgages in the secondary market, investor preferences for our securities versus other investments, the availability of funding at attractive spreads in the financial markets (in particular from callable debt), and other factors affecting the overall mix of mortgage loans available for purchase, our funding opportunities, or our net interest margins;
 
  •  significant changes in housing price valuations, employment rates, or other factors affecting delinquency or foreclosure levels and credit losses;
 
  •  significant changes in our policies or strategies, such as our underwriting requirements or our interest rate risk management, credit loss mitigation, or investment strategies;
 
  •  regulatory or legislative changes affecting us, our competitors, or the markets in which we are active, including changes in tax law or capital requirements applicable to us or our activities, or loss of certain exemptions or the Treasury’s ability to purchase our obligations (see “Business— Government Regulation and Charter Act”);
 
  •  competitive developments in the markets for mortgage purchases and for the sale of mortgage-related and debt securities, or significant changes in the rate of growth in conforming residential mortgage debt;
 
  •  significant changes in the amount and rate of growth of our expenses, and the costs (and effects) of legal or administrative proceedings (see “Legal Proceedings”) or changes in accounting policies or practices;
 
  •  significant changes in general economic conditions or the monetary or fiscal policy of the United States;
 
  •  unanticipated, substantial changes in interest rates. It is possible that sudden, severe swings in interest rates could have at least a short-term significant effect on our results; and
 
  •  political events in the United States and internationally.

Any forward-looking statements in this document or that we may make from time to time are representative only as of the date they are made, and we undertake no obligation to update any forward-looking statement.

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EXECUTIVE SUMMARY

About Fannie Mae

Fannie Mae is the nation’s largest source of financing for home mortgages. We are a shareholder-owned corporation, chartered by the U.S. Congress to provide liquidity in the secondary mortgage market to increase the availability and affordability of homeownership for low-, moderate-, and middle-income Americans. Our charter limits our operations to activities related to housing, mortgages and related financial products. Our business activities are aligned with national policies that support the expansion of homeownership in America, and serve to increase the total amount of funds available to finance housing. Though chartered by Congress, our business is self-sustaining and funded exclusively with private capital. The U.S. government does not guarantee, directly or indirectly, Fannie Mae’s securities or other obligations.

Our Businesses

We compete in the secondary market for residential mortgage debt outstanding (“MDO”), and we invest in and manage one primary asset class— residential mortgage assets (in the form of mortgage loans and mortgage-related securities). Fannie Mae generates revenues primarily through two complementary business lines: our Portfolio Investment business and our Credit Guaranty business. We manage and evaluate the results of our business lines as though each were a stand-alone business, and accordingly, we allocate certain income and expenses to each line of business for purposes of business segment reporting.

The chart below is a simplified representation of our line of business revenue model.(1) In our Portfolio Investment business, we purchase mortgage loans, mortgage-related securities, and liquid investments for our portfolios and earn income primarily from the difference, or spread, between the yield on these assets and the cost of the debt, which is supplemented by our use of derivatives, and capital used to fund these assets (“net interest yield” on a GAAP basis and “net interest margin” on a non-GAAP or “core” basis). We fund the assets in our portfolio by issuing debt securities in the global capital markets and by entering into derivative contracts. In our Credit Guaranty business, primary mortgage lenders deliver pools of mortgages to us to package into Fannie Mae guaranteed mortgage-backed securities (“MBS”). We receive guaranty fees to compensate us for guaranteeing the timely payment of principal and interest on MBS, which are included in guaranty fee income if the MBS is held by other investors and in interest income if the MBS is held in our portfolio.

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(1)  This model does not reflect allocations made between our Portfolio Investment business and Credit Guaranty business for segment reporting purposes as described in “MD&A—Core Business Earnings and Business Segment Results.”
 
(2)  “Net interest margin” and “Core net interest income” are supplemental non-GAAP measures that we use to evaluate the performance of our Portfolio Investment business. See “MD&A— Core Business Earnings and Business Segment Results” for more information about these and other non-GAAP measures.

As illustrated in the diagram above, earnings growth from core net interest income depends principally on two factors: growth in the average balance of our mortgage investments and the interest margin we earn on those investments. Our objective is to maintain a disciplined approach to growing our portfolio, purchasing mortgages when the spread between our cost of funds and the yield on mortgage assets is attractive and

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when supply is available in the market. The pace of growth in our mortgage portfolio has largely tracked these factors, and we anticipate that this dynamic will continue.

Guaranty fee income growth depends upon the growth in average outstanding MBS and the guaranty fee rate we receive for our guaranty of timely payment of principal and interest on outstanding MBS (MBS held by investors other than Fannie Mae). Growth in outstanding MBS depends largely on the volume of mortgages made available for securitization and the perceived quality and value of our MBS in the secondary market. Growth in our average effective guaranty fee rate will depend upon our ability to further implement risk-based pricing fees on new business and the credit quality of the loans we securitize. In addition, changes in mortgage prepayment speeds will affect the pace of recognition of deferred fee price adjustments, which also impacts our average effective guaranty fee rate.

How We Manage Risk

Our ability to achieve desired returns and to meet the objectives of our housing mission depend to a significant degree on our success in applying professional expertise, sophisticated financial tools, and experience to manage the risks inherent in the assets we own or guarantee. During 2003, we undertook a comprehensive review and assessment of our corporate financial disciplines. In conjunction with this assessment, we adopted several internal financial discipline objectives to maintain or enhance Fannie Mae’s financial strength. We discuss these objectives further in Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”).

Because we guarantee the timely payment of principal and interest on the MBS we issue, we assume the risk that a homeowner will default on his or her mortgage obligation. To manage this risk, our Credit Guaranty business employs technology-driven underwriting tools, risk-sharing strategies, and active asset management strategies focused on anticipating and minimizing potential losses. For 2003, our total credit-related losses remained low, totaling only $123 million or .006 percent of our average mortgage credit book of business.

Our Portfolio Investment business manages the interest rate risk associated with the mortgage assets we own— the risk that changes in interest rates could impact cash flows on our mortgage assets and debt in a way that adversely affects our earnings or long-term value. To manage this risk, we seek to maintain a close match between the durations of the debt we issue and the mortgage assets we purchase. To help us achieve this objective, we issue debt securities, including securities callable at our option. We also use interest-rate derivatives— including interest rate swaps, swaptions and interest rate caps— to supplement our issuance of debt, increase our funding flexibility and limit our exposure to interest rate volatility. The principal interest rate risk measures used by management to evaluate our risk position are reported on a monthly basis. In 2003, a year defined by historic levels of interest rate volatility, we were able to maintain our risk measures at acceptable levels throughout the year and deliver record financial performance. A more detailed discussion of our interest rate risk management practices and results is included in “MD&A— Portfolio Investment Business Operations— Interest Rate Risk Management.”

In some cases, accounting results may not reflect the purpose or economic impact of a specific transaction or type of transaction in the same way that management views the purpose or impact. For example, we discuss the effect of our adoption of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities (“FAS 133”), on our reported net income and how we use core business earnings, a supplemental non-GAAP measure, to evaluate Fannie Mae’s results in “MD&A— Core Business Earnings and Business Segment Results.” We also provide a reconciliation of core business earnings to Fannie Mae’s reported net income. We devote much of our MD&A discussion to our management of interest rate and credit risk and our use of derivatives and off-balance sheet arrangements because we focus significant attention and resources on these areas. We believe that understanding our approach to managing these risks helps in understanding our financial strategy and results.

Our Market

Fannie Mae’s growth is tied principally to the growth of our underlying market— residential MDO. Residential MDO has grown every year since the Federal Reserve began tracking the measure in 1958, and

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has typically outpaced the growth of nominal GDP. In addition, our book of business, which includes our gross mortgage portfolio and outstanding MBS, has typically grown somewhat faster than MDO, and we expect this trend to continue.

For the current decade, our economic forecasts project that MDO will grow at an annualized rate of 8-10 percent. In the first three years of the current decade, MDO grew at an annualized rate of 11.7 percent, substantially outpacing our projection for average annual growth for the decade as a whole. This growth was largely attributable to a sustained period of low interest rates, which fueled record levels of refinancings, record home sales and strong home price appreciation. The period 2001-2003 comprised the first three consecutive years of double-digit growth in residential MDO since 1987-1989. Growth dynamics for this period are represented in the following table:

                                                     
2003 2002 2001



Amount Change Amount Change Amount Change






Housing Market:
                                               
 
Home sale units (in thousands)
    7,192       10 %     6,539       5 %     6,204       3 %
 
OFHEO House Price Index(1)
    8.0 %     3       7.7 %     2       7.5 %     (5 )
 
Single-family mortgage originations (in billions)
  $ 3,712       42     $ 2,614       29     $ 2,027       94  
   
Purchase share
    31.9 %     (17 )     38.5 %     (11 )     43.5 %     (45 )
   
Refinance share
    68.1       11       61.5       9       56.5       163  
 
Mortgage debt outstanding (in billions)
  $ 7,818       12     $ 6,951       12     $ 6,184       10  
Fannie Mae (in billions):
                                               
 
Business volume
  $ 1,423       68 %   $ 849       38 %   $ 615       137 %
 
Book of business
    2,199       21       1,824       16       1,567       19  


(1)  OFHEO’s House Price Index is a quarterly report issued by OFHEO that analyzes housing appreciation trends.

In 2003, low interest rates throughout the year, including 45-year lows reached in mid-June, coupled with a housing market that remained resilient despite uncertainties regarding the pace of economic recovery, resulted in record mortgage originations. Residential MDO rose by approximately 12.5 percent in 2003 to a record $7.8 trillion, the fastest pace of growth in 16 years. For the remainder of the decade, we expect that growth in residential MDO will slow from the extraordinary pace of the past three years. We anticipate, however, that annualized growth for MDO during this period will average between 6.50 and 9.25 percent due to positive demographic and economic drivers such as population and immigration growth, increased homeownership rates among the minority population, and continued growth in home values.

Our Competitive Dynamics

Because Fannie Mae’s current share of interest rate risk is only about 11 percent of total residential MDO and our share of credit risk is only 27 percent of MDO, we believe that the market presents significant opportunities for continued growth in each of our primary businesses. However, to achieve our objective of strong and consistent growth over time, each of our businesses must effectively address the challenges of an extremely competitive business environment.

In our Portfolio Investment business, we compete with commercial banks, thrifts, other government sponsored enterprises, credit unions, finance companies and other investors for mortgage assets made available in the secondary market. Competition for mortgage assets has been particularly intense during the past three years, and our market share has remained virtually unchanged at approximately 11 percent. This is largely a result of our adherence to a disciplined approach to growing our mortgage portfolio.

In our Credit Guaranty business, our success compared with competitors in the market that securitize originated mortgages is determined largely by the liquidity and perceived value of the MBS we issue. During the past three years, our market share in the Credit Guaranty business has increased by approximately five percentage points.

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Our 2003 Financial Performance

Fannie Mae achieved record financial performance in 2003. Our Portfolio Investment business benefited greatly from the low interest rate environment and steep yield curve that existed during the first half of 2003, which kept our cost of funds low and, correspondingly, elevated our net interest margin to higher than anticipated levels. As a result, our net interest income and core net interest income reached record levels. This facilitated the repurchase of a greater amount of higher cost debt securities, which generated significant losses in 2003 but will contribute to lower funding costs in the future.

The Credit Guaranty business also benefited from the low interest rate environment in the first half of 2003, which contributed to record MBS issuance. The effective guaranty rate also rose due to an increase in risk-based pricing fees and faster recognition of deferred fees due to accelerated prepayments on MBS.

Our strong growth in GAAP net income in 2003, together with preferred stock issuances, allowed us to increase our core capital base by over $6 billion during the year and to return a record amount of capital to shareholders in the form of increased dividends and share repurchases. We raised our common stock dividend by 27 percent— from $1.32 in 2002 to $1.68 in 2003— and also repurchased over 21 million shares of common stock.

Principal Challenges We Anticipate

Portfolio Investment Business

Our portfolio growth of 13 percent in 2003 was slightly below our expectations. While low interest rates during the first half of the year spurred record mortgage originations, aggressive purchasing by banks and other investors resulted in relatively narrow mortgage to debt spreads and lower than expected sales into the secondary market. Consistent with our disciplined growth strategy, the Portfolio Investment business purchased mortgage investments when spreads exceeded our hurdle rates and when supply was available in the market. The level of growth in our mortgage portfolio in 2004 will likewise depend largely upon spread levels and availability of investments in the secondary market. It is extremely difficult to predict when the catalysts that have driven aggressive purchasing of mortgage assets by depository institutions will change to a degree sufficient to slow purchasing, or to drive net selling, of mortgage assets by depositories. However, we do anticipate that at some point during 2004, the variables that have resulted in a highly competitive market for mortgage assets will begin to follow historical, cyclical trends, which should result in a more favorable environment for growth in our mortgage portfolio.

Credit Guaranty Business

Our Credit Guaranty business in 2003 reported record guaranty fee income while maintaining all major measures of credit quality within historically low ranges. Delivering sustained above-market growth within a stringent risk framework will continue to be the primary challenge faced by our Credit Guaranty business. As our mortgage credit book of business becomes more seasoned, we anticipate an upward trend in serious delinquency rates and foreclosures, but we expect that any dollar increase in credit losses will be modest.

Legislative Proposals

During 2003, several bills were introduced in Congress that propose to alter the regulatory regime under which Fannie Mae operates. These bills seek to transfer regulatory responsibility for overseeing Fannie Mae’s safety and soundness from our current regulator Office of Federal Housing Enterprise Oversight (“OFHEO”) to a bureau within the U.S. Department of the Treasury or to a newly created independent entity. Some of the bills also would transfer various of HUD’s regulatory authorities over Fannie Mae to a Treasury bureau or other entity. Several bills seek to provide additional or expanded powers to the proposed new regulator, including the power to set capital levels that are now fixed by the 1992 Act. Congress will continue to consider possible regulatory reform in 2004. We support a strong, well-funded, independent regulator, but object to any changes to our regulatory structure that will inhibit the success of our statutory mission. We will continue to work with policymakers to reach a consensus that strengthens the safety and soundness

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oversight of Fannie Mae. However, we cannot predict whether any legislation will be approved by Congress and signed into law by the President and, if so, the final form or effective date of the legislation.

Organization of MD&A

We intend for our MD&A to provide information that will assist in better understanding our financial statements, the changes in certain key items in our financial statements from year to year, the primary factors driving those changes, any known trends or uncertainties that we are aware of that we believe may have a material effect on our future performance, as well as how certain accounting principles affect our financial statements. We provide additional information about our two lines of business to explain how these business segments and their results affect Fannie Mae’s financial condition and results of operations. This discussion should be read in conjunction with our financial statements as of December 31, 2003 and the notes accompanying those financial statements. Our MD&A is organized as follows:

  •  Reported Results of Operations
 
  •  Critical Accounting Policies and Estimates
 
  •  Core Business Earnings and Business Segment Results
 
  •  Portfolio Investment Business Operations
 
  •  Credit Guaranty Business Operations
 
  •  Operations Risk Management
 
  •  Liquidity and Capital Resources
 
  •  Pending Accounting Pronouncements

REPORTED RESULTS OF OPERATIONS

The following discussion is based on Fannie Mae’s reported GAAP results. We have reclassified certain amounts in our prior years’ reported results to conform to our current presentation.

Overview

The record housing year generated record volumes, business growth, and revenues for Fannie Mae in 2003. We reported a substantial increase in our reported net income in 2003, due to a combination of increased revenues and changes in the mark-to-market values of our option-based derivatives under FAS 133. Reported net income and diluted earnings per share (“EPS”) totaled $7.905 billion and $7.91, respectively, in 2003, compared with $4.619 billion and $4.52 in 2002, and $5.894 billion and $5.71 in 2001. Our reported results, which are based on GAAP, may fluctuate significantly from period to period because of the accounting for purchased options under FAS 133. FAS 133 requires that we record changes in the time value of purchased options that we use to manage interest rate risk in our income; however, we do not 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 the mark-to-market adjustment on purchased options to create temporary unrealized gains and losses that will often vary substantially from period to period with changes in interest rates, expected interest rate volatility, and derivative activity.

During 2003, we saw historic levels of interest rate volatility in the fixed income markets. The year was characterized by mortgage interest rates that fell sharply in the first half of the year, with rates generally higher in the second half of the year. Most long-term rates ended the year modestly higher than where they started in 2003, although mortgage rates were little changed from the end of 2002 to the end of 2003. Yields on 30-year fixed-rate mortgages dropped to about 5.20 percent in June, the lowest level in 45 years, before moving up briefly to 6.45 percent in September and then slipping again to end the year slightly below 6.00 percent. The generally higher interest rate environment at the end of the year and normal seasoning of our options resulted in our recording $2.168 billion of expense from changes in the time value of purchased

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options in 2003, a decline of $2.377 billion from the prior year. Purchased options expense for 2002 and 2001 totaled $4.545 billion and $37 million, respectively.

Excluding the effect of purchased options expense, we experienced strong growth in 2003 that was partially offset by a significant increase in losses on the extinguishment of debt as we took advantage of market opportunities to repurchase significant amounts of higher cost debt. Reported net interest income increased 28 percent in 2003 and 31 percent in 2002. Increases in net interest income were driven primarily by the combined growth in our reported net interest yield and expansion of our mortgage portfolio. Guaranty fee income was up 33 percent in 2003 and 23 percent in 2002, due primarily to growth in outstanding MBS and our average effective guaranty fee rate.

Our 2003 results also include an after-tax gain of $185 million related to the cumulative effect of adopting Financial Accounting Standard No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“FAS 149”). FAS 149 amends and clarifies certain aspects of FAS 133 and applies to mortgage loan purchase commitments entered into or modified after June 30, 2003, and purchase and sale commitments for when-issued mortgage securities outstanding as of June 30, 2003 and entered into after that date.

Management also tracks and analyzes Fannie Mae’s financial results based on “core business earnings.” We developed core business earnings as a supplemental non-GAAP measure 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. While the core business earnings measure 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 discuss our core business earnings results in “MD&A— Core Business Earnings and Business Segment Results.”

Net Interest Income

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

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

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Table 1:    Net Interest Yield

                             
2003 2002 2001



(Dollars in millions)
Interest income:
                       
 
Mortgage portfolio
  $ 49,754     $ 49,265     $ 46,478  
 
Liquid investments
    1,166       1,588       2,692  
     
     
     
 
 
Total interest income
    50,920       50,853       49,170  
     
     
     
 
Interest expense(1):
                       
 
Short-term debt
    2,820       2,732       5,737  
 
Long-term debt
    34,531       37,555       35,343  
     
     
     
 
 
Total interest expense
    37,351       40,287       41,080  
     
     
     
 
Net interest income
    13,569       10,566       8,090  
 
Taxable-equivalent adjustment on tax-exempt investments (2)
    479       502       470  
     
     
     
 
Taxable-equivalent net interest income
  $ 14,048     $ 11,068     $ 8,560  
     
     
     
 
Average balances(3):
                       
Interest-earning assets(4):
                       
 
Mortgage portfolio, net
  $ 839,172     $ 735,943     $ 658,195  
 
Liquid investments
    75,113       68,658       58,811  
     
     
     
 
Total interest-earning assets
    914,285       804,601       717,006  
   
Interest-free funds(5)
    (27,336 )     (23,992 )     (23,630 )
     
     
     
 
Total interest-earning assets funded by debt
  $ 886,949     $ 780,609     $ 693,376  
     
     
     
 
Interest-bearing liabilities(1):
                       
 
Short-term debt
  $ 240,628     $ 141,727     $ 137,078  
 
Long-term debt
    646,321       638,882       556,298  
     
     
     
 
Total interest-bearing liabilities
  $ 886,949     $ 780,609     $ 693,376  
     
     
     
 
Average interest rates(2,3):
                       
Interest-earning assets:
                       
 
Mortgage portfolio, net
    5.92 %     6.73 %     7.11 %
 
Liquid investments
    1.59       2.34       4.63  
     
     
     
 
Total interest-earning assets
    5.56       6.35       6.90  
   
Interest-free return(5)
    .19       .18       .21  
     
     
     
 
Total interest-earning assets and interest-free return
    5.75       6.53       7.11  
     
     
     
 
Interest-bearing liabilities(1):
                       
 
Short-term debt
    1.16       1.90       4.16  
 
Long-term debt
    5.34       5.88       6.35  
     
     
     
 
Total interest-bearing liabilities
    4.21       5.15       5.92  
     
     
     
 
Net interest yield
    1.54 %     1.38 %     1.19 %
     
     
     
 


(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 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 $246 million and $160 million between short-term and long-term interest expense in 2002 and 2001, respectively, 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 $6.0 billion in 2003, $4.6 billion in 2002, and $2.6 billion in 2001.
 
(5)  Interest-free funds represent the portion of our investment portfolio funded by equity and non-interest bearing liabilities.

Reported net interest income of $13.569 billion for 2003 was up 28 percent over 2002, driven by a 14 percent increase in our average net investment balance and a 16 basis point expansion in our reported net interest yield to 1.54 percent. 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 liquid investments, which include cash equivalents pledged as collateral. The increased

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amount of purchased options used as a substitute for callable debt had a positive effect on our net interest yield in 2003 because the cost of purchased options is not reflected in our net interest yield or reported net interest income. Reported net interest income for 2002 increased 31 percent over 2001, driven by a 12 percent increase in our average net investment balance and a 19 basis point expansion in our reported net interest yield to 1.38 percent. Our net interest yield continued to benefit and remained elevated during 2003 and 2002 because of the unusually steep yield curve, which afforded us the opportunity to significantly lower our debt costs by calling or retiring higher-cost debt and temporarily replacing it with shorter-term, lower-cost debt in anticipation of faster mortgage prepayments. The following table shows a rate/volume analysis of the changes in our reported net interest income during 2003 and 2002.

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

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



(Dollars in millions)
2003 vs. 2002
                       

                       
Interest income:
                       
 
Mortgage portfolio
  $ 489     $ 6,475     $ (5,986 )
 
Liquid investments
    (422 )     138       (560 )
     
     
     
 
 
Total interest income
    67       6,613       (6,546 )
     
     
     
 
Interest expense:(2)
                       
 
Short-term debt
    88       1,428       (1,340 )
 
Long-term debt
    (3,024 )     433       (3,457 )
     
     
     
 
 
Total interest expense
    (2,936 )     1,861       (4,797 )
     
     
     
 
Change in net interest income
  $ 3,003     $ 4,752     $ (1,749 )
     
     
     
 
Change in taxable-equivalent adjustment on tax-exempt investments(3)
    (23 )                
     
                 
Change in taxable-equivalent net interest income
  $ 2,980                  
     
                 
2002 vs. 2001
                       

                       
Interest income:
                       
 
Mortgage portfolio
  $ 2,787     $ 5,292     $ (2,505 )
 
Liquid investments
    (1,104 )     394       (1,498 )
     
     
     
 
 
Total interest income
    1,683       5,686       (4,003 )
     
     
     
 
Interest expense:(2)
                       
 
Short-term debt
    (3,005 )     188       (3,193 )
 
Long-term debt
    2,212       4,986       (2,774 )
     
     
     
 
 
Total interest expense
    (793 )     5,174       (5,967 )
     
     
     
 
Change in net interest income
  $ 2,476     $ 512     $ 1,964  
     
     
     
 
Change in taxable-equivalent adjustment on tax-exempt investments(3)
    32                  
     
                 
Change in taxable-equivalent net interest income
  $ 2,508                  
     
                 


(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 35 percent marginal tax rate.

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Guaranty Fee Income

Guaranty fee income reported in our total corporate results and our average guaranty fee rate primarily include guaranty fees we receive on outstanding MBS. We classify guaranty fees on MBS held in our portfolio as net interest income. The guaranty fee income allocated for line of business reporting purposes to the Credit Guaranty business on MBS held in our portfolio is eliminated by an equal and offsetting allocation of guaranty expense to the Portfolio Investment business.

Table 3 presents our guaranty fee income and average effective guaranty fee rate for the past three years.

Table 3:    Guaranty Fee Data

                                         
Year Ended December 31,

2003 % Change 2002 % Change 2001





(Dollars in millions)
Guaranty fee income
  $ 2,411       33 %   $ 1,816       23 %   $ 1,482  
Average balance of outstanding MBS(1)
    1,191,717       25       950,232       22       779,647  
Average effective guaranty fee rate (basis points)
    20.2       6       19.1       1       19.0  


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

The 33 percent increase in guaranty fee income in 2003 was driven by 25 percent growth in average outstanding MBS and a 6 percent increase in the average effective guaranty fee rate on outstanding MBS to 20.2 basis points. Guaranty fee income in 2002 was up 23 percent over 2001, primarily due to 22 percent growth in average outstanding MBS.

We expanded our issuances of MBS during 2003 and 2002 in response to increased volumes from lenders, fueled in part by the substantial level of refinance activity. MBS issues acquired by other investors rose 78 percent in 2003 to $850 billion and 39 percent in 2002 to $478 billion. Our market share also increased in 2003 due to our ability to meet record customer demands, coupled with uncertainty related to our major competitors and more favorable price spreads on Fannie Mae securities. The increase in our average effective guaranty fee rate during 2003 resulted primarily from accelerated recognition of deferred fee price adjustments due to faster prepayment speeds associated with the unprecedented level of refinancings, along with an increase in risk-based pricing fees on new business. As the rate of refinancings decrease, prepayment speeds and our recognition of deferred fee price adjustments will slow.

Over the past three years, our combined book of business has grown at an exceptional pace with outstanding MBS growing much faster than our portfolio, averaging 23 percent per year compared with about 14 percent per year for our portfolio. A key driver of this growth differential has been the increased demand among depository institutions for fixed-rate mortgages, partially stemming from the unusually steep yield curve. We anticipate that the unusually high demand for mortgages among depository institutions will begin to diminish during 2004. As this happens and mortgage originations slow from the record levels of the past 3 years, we anticipate growth in outstanding MBS to slow from the recent extraordinary levels.

Fee and Other Income, Net

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

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Fee and other income totaled $437 million in 2003, an increase of $205 million over 2002 driven largely by an increase in volume-related transaction and technology fees. The following table shows the components of fee and other income.

Table 4:    Fee and Other Income, Net

                                         
Year Ended December 31,

2003 % Change 2002 % Change 2001





(Dollars in millions)
 
Transaction fees
  $ 491       140 %   $ 205       60 %   $ 128  
Technology fees
    274       39       197       21       163  
Multifamily fees
    140       63       86       37       63  
Tax-advantaged investments
    (263 )     17       (225 )     1       (222 )
Credit enhancement expense
    (169 )     37       (123 )     173       (45 )
Other
    (36 )     (139 )     92       (44 )     64  
     
             
             
 
    $ 437       88 %   $ 232       54 %   $ 151  
     
             
             
 

We experienced a significant increase in transaction, technology, and multifamily fees in 2003 due to a surge in business volumes associated with the robust refinancing market. Transaction, technology, and multifamily fees almost doubled from the prior year to $905 million as our business volume, which includes portfolio purchases and MBS issues acquired by other investors, swelled to $1,423 billion from $849 billion in 2002. We expect markedly lower total business volumes in 2004, which is likely to result in a considerable reduction in transaction and technology fees.

We recognized other-than-temporary impairment totaling $308 million in 2003, compared with $110 million in 2002. The increase in impairment amounts recorded during 2003 was primarily related to securities or investments that were downgraded during the year and suffered significant declines in fair value, and for which we concluded that it was uncertain whether we would recover all principal and interest due to us.

Fee and other income totaled $232 million in 2002, up from $151 million of income in 2001. The $81 million increase was driven by a $111 million increase in transaction and technology fees resulting primarily from increased real estate mortgage investment conduit (“REMIC”) transaction volumes and a $69 million increase in net gains from the sale of investments. These increases were offset partially by a $78 million increase in credit enhancement expenses and a $61 million increase in impairment write-downs on a variety of investments. The increase in credit enhancement expenses was attributable to an increase in the volume of business covered by credit enhancements purchased directly by Fannie Mae, stemming from our expansion into new products and markets.

Credit-Related Expenses

Credit-related expenses include foreclosed property expenses (income) and the provision for losses.

Credit-related expenses increased $20 million in 2003 to $112 million, compared with $92 million in 2002 and $78 million in 2001. The increase in credit-related expenses was due primarily to increasing acquisitions of single-family foreclosed properties. Although foreclosed single-family property acquisitions increased in 2003 to 26,788, from 19,500 in 2002 and 14,486 in 2001, average severities on the sale of these properties have remained low by historical standards due to overall strong home prices and credit enhancement proceeds. Foreclosed property expense (income) was a net loss of $12 million in 2003, compared with a net gain of $36 million in 2002 and $16 million in 2001, as home price growth has moderated somewhat and gains on sales of properties have declined. We recorded a provision for losses of $100 million in 2003, compared with $128 million in 2002 and $94 million in 2001. This component of credit-related expenses has grown more slowly than foreclosed property acquisitions due largely to the receipt of proceeds from credit enhancements. Forgone interest on non-performing assets, which we report as a reduction to net interest income, totaled $177 million in 2003, $148 million in 2002, and $70 million in 2001.

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Credit-related losses, which include charge-offs plus foreclosed property expense (income), totaled $123 million in 2003, $87 million in 2002, and $81 million in 2001. Despite the increase in credit-related losses during 2003 and 2002, they have remained at historically low levels. The strong housing market combined with our aggressive management of problem loans and protection through credit enhancement have mitigated the impact of recent increases in foreclosure activity due to general economic weakness.

Credit losses as a percentage of our average mortgage credit book of business have remained relatively steady at .6 basis points in 2003, .5 basis points in 2002, and .6 basis points in 2001, despite the weak economic environment. Our mortgage credit book of business includes mortgages, MBS and mortgage-related securities in our mortgage portfolio, outstanding MBS held by other investors, and other contractual arrangements or guarantees. The strong growth in our mortgage credit book of business over the past two years is likely to result in a modest increase in our credit losses during 2004; however, we do not anticipate a significant increase in credit losses as a percentage of our average mortgage credit book of business.

Administrative Expenses

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

Administrative expenses totaled $1.463 billion in 2003, up 20 percent from 2002. The above-average rate of spending was primarily related to costs incurred in reengineering Fannie Mae’s core technology infrastructure to enhance our ability to process and manage the risk on mortgage assets, the expensing of all new stock-based compensation beginning in 2003 in conjunction with our adoption of the fair value recognition provisions of Financial Accounting Standard No. 123, Accounting for Stock-Based Compensation (“FAS 123”), and higher levels of charitable contributions including a $50 million contribution to the Fannie Mae Foundation. Compensation expense rose 23 percent to $837 million, due in part to the increase in stock-based compensation expense recognized under FAS 123 combined with a 7 percent increase in the number of employees and annual salary increases.

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

We evaluate growth in administrative expenses in relation to growth in core taxable-equivalent revenues and our average book of business. Core taxable-equivalent revenues is a supplemental non-GAAP measure discussed further in “MD&A—Core Business Earnings and Business Segment Results.” Despite the growth in administrative expenses over the past two years, our efficiency ratio— the ratio of administrative expenses to core taxable-equivalent revenues— improved to 9.9 percent in 2003, from 10.2 percent in 2002, and 10.0 percent in 2001 because of the significant growth in revenues generated by the expansion of our book of business. The ratio of administrative expenses as a percentage of our average book of business was .072 percent in 2003, unchanged from 2002 and slightly above the ..071 percent ratio in 2001. As we near completion of our multi-year core infrastructure project, we expect the growth rate in administrative expenses to slow significantly in 2004.

Special Contribution

Special contribution expense reflects a contribution we made to the Fannie Mae Foundation in the form of common stock.

We made a special commitment in 2001 to contribute $300 million of our common stock to the Fannie Mae Foundation. We acquired the shares through open market purchases and contributed them to the Foundation in 2002. The Fannie Mae Foundation creates affordable homeownership and housing opportunities through innovative partnerships and initiatives that build healthy, vibrant communities across the United States. It is a separate, private, nonprofit organization that we do not consolidate, but is supported solely by Fannie Mae.

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We may also periodically make smaller, discretionary cash contributions to the Fannie Mae Foundation that are included in “Administrative expenses.”

Purchased Options Expense

Purchased options expense includes the change in the fair value of the time value of purchased options in accordance with FAS 133. Intrinsic value and time value are the two primary components of an option’s price. The intrinsic value is the amount that can be immediately realized by exercising the option—the amount by which the strike price of the option is in-the-money. The intrinsic value of an option is not affected by the passage of time. Time value is the amount by which the price of an option exceeds its intrinsic value, and it is directly related to how much time an option has until expiration. As the remaining life of an option shortens, the time value declines and becomes less sensitive to changes in interest rate volatility. We include only the intrinsic value of options in our assessment of hedge effectiveness under FAS 133. We exclude the time value from our assessment of hedge effectiveness and mark-to-market changes in the time value through earnings. The change in the fair value of the time value of purchased options will vary from period to period with changes in interest rates, expected interest rate volatility, and our derivative activity.

We recorded purchased options expense of $2.168 billion in 2003, which was related primarily to the normal seasoning of our options. Purchased options expense totaled $4.545 billion in 2002 and $37 million in 2001. The significant increase in purchased options expense in 2002 was due primarily to a sharp decline in interest rates at the end of 2002 that resulted in a decrease in time value, coupled with an increase in the average notional balance of caps and swaptions, two types of purchased options we commonly use to manage interest rate risk. Under FAS 133, we do not recognize in earnings changes in the intrinsic value of some of these options, which, in combination with the fair value of options in our mortgage assets and callable debt, would have more than offset the decrease in time value of our options during 2002. Prior to the adoption of FAS 133, we amortized premiums on purchased options into interest expense over the expected life of the option.

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

Debt Extinguishments, Net

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

We recognized a pre-tax loss of $2.261 billion in 2003 from the call of $246 billion and repurchase of $20 billion of debt in 2003. In comparison, we recognized a pre-tax loss of $710 million in 2002 from the call of $174 billion and repurchase of $8 billion of debt in 2002. The weighted-average cost of redeemed debt and interest rate swaps in 2003 and 2002 was 3.39 percent and 5.36 percent, respectively. During 2001, we repurchased or called $183 billion in debt securities and notional principal of interest rate swaps carrying a weighted-average cost of 6.23 percent and recognized a pre-tax loss of $524 million. The substantial increase in debt extinguishment activity during 2003 was driven by several factors. The historically low interest rate environment that persisted through the first half of 2003 made it economical for us to call or redeem high cost debt. In anticipation of increasing liquidations in our mortgage portfolio as a result of heavy refinancing activity, we replaced the higher cost debt with shorter-term, lower-cost debt. This dynamic resulted in a

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temporarily elevated spread between the yield on our mortgage assets and our funding cost. We chose to reinvest a portion of the income generated from these temporary circumstances in debt repurchases to reduce our future debt costs. A loss realized on a debt repurchase in the current year results in correspondingly lower debt costs in the future. The debt cost savings will be realized over the period remaining until the scheduled maturity of the debt repurchased. We select individual securities to repurchase based on which securities we believe are trading at attractive prices in the market as well as asset/liability risk management purposes. We expect a significant reduction in the level of debt repurchases in 2004.

Income Taxes

Our effective tax rate on reported income was 26 percent in 2003 based on a tax provision of $2.793 billion, 24 percent in 2002 based on a tax provision of $1.429 billion, and 27 percent in 2001 based on a tax provision of $2.131 billion. The increase in the effective tax rate on reported income in 2003 is primarily due to the significant increase in our reported income, which diminishes the relative tax benefit we receive from tax-exempt income and tax credits. In 2002, our pre-tax income was significantly reduced by the $4.545 billion we recorded in purchased options expense. As a result, we received a greater relative benefit from our low-income housing tax credits that contributed to a reduction in our effective tax rate on reported income. Our effective tax rate based on our core business earnings, a non-GAAP measure that adjusts for the effect of FAS 133 on our purchased options, was 25 percent in 2003, 27 percent in 2002, and 26 percent in 2001. The decrease in the effective tax rate on core business earnings in 2003 was primarily due to the increased benefit from tax credits. See “MD&A—Core Business Earnings and Business Segment Results.”

Cumulative Effect of Change in Accounting Principle

Effective July 1, 2003, we adopted FAS 149, which amends and clarifies certain aspects of FAS 133, including the accounting for commitments to purchase loans and commitments to purchase and sell when-issued securities. FAS 149 applies to Fannie Mae’s mortgage loan purchase commitments entered into or modified after June 30, 2003, and purchase and sale commitments for when-issued mortgage securities entered into after and outstanding at June 30, 2003. As a result of the adoption of FAS 149, we are required to account for the majority of our commitments to purchase mortgage loans and to purchase or sell mortgage-related securities as derivatives and record these commitments on our balance sheet at fair value. We recorded a cumulative after-tax transition gain of $185 million ($285 million pre-tax) from the adoption of FAS 149. The transition gain primarily relates to recording the fair value of open portfolio purchase commitments for when-issued securities totaling $113 billion at June 30, 2003. The offset to the transition gain related to these commitments resulted in recording a fair value purchase price adjustment on our balance sheet that will amortize into future earnings as a reduction of interest income over the estimated life of the underlying mortgage securities retained in our portfolio.

Our adoption of FAS 133 on January 1, 2001, resulted in a cumulative after-tax increase to income of $168 million ($258 million pre-tax) in 2001. The cumulative effect on earnings from the change in accounting principle was primarily attributable to recording the fair value of the time value of purchased options, which are used as a substitute for callable debt securities.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Fannie Mae’s reported results and financial statements are based on GAAP, which requires us in some cases to make estimates and assumptions that affect our reported results and disclosures. We describe our most significant accounting policies in the Notes to Financial Statements under Note 1, “Summary of Significant Accounting Policies.” Several of our accounting policies involve the use of accounting estimates we consider to be critical because: (1) they are likely to change from period to period because they require significant management judgment and assumptions about highly complex and uncertain matters; and (2) the use of a

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different estimate or a change in estimate could have a material effect on our reported results of operations or financial condition. Our critical accounting estimates include:

  •  determining the adequacy of the allowance for loan losses and guaranty liability for MBS;
 
  •  projecting mortgage prepayments to calculate the amortization of the deferred price components of mortgages and mortgage-related securities held in portfolio and outstanding MBS;
 
  •  estimating the time value of our purchased options; and
 
  •  assessing other-than-temporary impairment.

We evaluate our critical accounting estimates and judgments on an on-going basis and update them as necessary based on changing conditions. Management has specifically discussed the development and selection of each critical accounting estimate with the Audit Committee of Fannie Mae’s Board of Directors. Our Audit Committee has also reviewed our disclosures in this MD&A regarding Fannie Mae’s critical accounting estimates.

Allowance for Loan Losses and Guaranty Liability for MBS

We establish an allowance for loan losses on single-family and multifamily loans in our mortgage portfolio. We maintain a guaranty liability for loan losses associated with the loans that back our MBS. The guaranty liability covers our guaranty of both MBS held by us in our portfolio and outstanding MBS. However, we use the same methodology to determine the amounts for our allowance and guaranty liability for MBS because the underlying credit risks are the same. Our allowance for loan losses and guaranty liability for MBS consist of the following key elements:

  •  Single-family: We evaluate various risk characteristics such as product type, original loan-to-value ratio, and loan age to determine the allowance for loan losses on single-family mortgage loans and the guaranty liability for MBS backed by single-family mortgage loans. We estimate defaults for each risk characteristic based on historical experience and apply a historical severity to each risk category in accordance with Financial Accounting Standard No. 5, Accounting for Contingencies (“FAS 5”). Severity refers to the amount of loss suffered on a default relative to the unpaid principal balance of the loan. We charge-off single-family loans when we foreclose on the loans.
 
  •  Multifamily: We determine the allowance for loan losses on multifamily mortgage loans and guaranty liability for MBS backed by multifamily mortgage loans by separately evaluating loans that are impaired and all other loans. Impaired loans consist of loans that are not performing according to their original contractual terms. For loans that we consider impaired, we apply Financial Accounting Standard No. 114, Accounting by Creditors for Impairment of a Loan (“FAS 114”) to estimate the amount of impairment. For all other loans, we apply FAS 5 to establish an allowance for loan losses and guaranty liability by rating each loan not individually evaluated for impairment and segmenting the loan into one of the main risk categories we use to monitor the multifamily portfolio. We then apply historical default rates and a corresponding severity to the loans in each segment to estimate the probable loss amount at each balance sheet date.

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

We include the allowance for loan losses in the balance sheet under “Mortgage portfolio, net.” We include the guaranty liability for estimated losses on MBS held by us or other investors as a liability under “Guaranty liability for MBS.” Table 5 shows the amounts of these components and summarizes the changes for the years 1999 to 2003.

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Table 5:    Allowance for Loan Losses and Guaranty Liability for MBS

                                           
2003 2002 2001 2000 1999





(Dollars in millions)
Allowance for loan losses:
                                       
 
Beginning balance
  $ 79     $ 48     $ 51     $ 56     $ 79  
 
Provision
    17       44       7       9       (5 )
 
Charge-offs(1)
    (11 )     (13 )     (10 )     (14 )     (18 )
     
     
     
     
     
 
 
Ending balance
  $ 85     $ 79     $ 48     $ 51     $ 56  
     
     
     
     
     
 
Guaranty liability for MBS:
                                       
 
Beginning balance
  $ 729     $ 755     $ 755     $ 745     $ 720  
 
Provision
    83       84       87       113       156  
 
Charge-offs
    (100 )     (110 )     (87 )     (103 )     (131 )
     
     
     
     
     
 
 
Ending balance
  $ 712     $ 729     $ 755     $ 755     $ 745  
     
     
     
     
     
 
Combined allowance for loan losses and guaranty liability for MBS:
                                       
 
Beginning balance
  $ 808     $ 803     $ 806     $ 801     $ 799  
 
Provision
    100       128       94       122       151  
 
Charge-offs(1)
    (111 )     (123 )     (97 )     (117 )     (149 )
     
     
     
     
     
 
 
Ending balance
  $ 797     $ 808     $ 803     $ 806     $ 801  
     
     
     
     
     
 
Balance at end of each period attributable to:
                                       
 
Single-family
  $ 638     $ 641     $ 636     $ 639     $ 634  
 
Multifamily
    159       167       167       167       167  
     
     
     
     
     
 
    $ 797     $ 808     $ 803     $ 806     $ 801  
     
     
     
     
     
 
Percent of allowance in each category to related mortgage credit book of business:(2)
                                       
 
Single-family loans
    .030 %     .037 %     .042 %     .051 %     .055 %
 
Multifamily loans
    .135       .184       .201       .254       .313  
     
     
     
     
     
 
      .036 %     .044 %     .051 %     .061 %     .066 %
     
     
     
     
     
 
Charge-offs:(1)
                                       
 
Single-family loans
  $ 100     $ 104     $ 96     $ 114     $ 145  
 
Multifamily loans
    11       19       1       3       4  
     
     
     
     
     
 
    $ 111     $ 123     $ 97     $ 117     $ 149  
     
     
     
     
     
 
Charge-offs as a percentage of average mortgage credit book of business
    .005 %     .007 %     .007 %     .009 %     .013 %
Credit losses as a percentage of average mortgage credit book of business
    .006       .005       .006       .007       .011  


(1)  Charge-offs exclude $1 million in 2002 related to foreclosed Federal Housing Administration loans that are reported in the balance sheet under “Acquired property and foreclosure claims, net.”
 
(2)  Represents ratio of allowance balance by loan type to mortgage credit book of business by loan type.

Over the past five years, our combined allowance for loan losses and guaranty liability for MBS as a percentage of the mortgage credit book of business has steadily declined to ..036 percent in 2003, from .044 percent in 2002, and ..051 percent in 2001 although our mortgage credit book of business has expanded. This trend reflects our historically low level of severities on foreclosed properties and credit losses. Over the last three years, our credit loss ratio has remained relatively stable— .6 basis points in 2003, .5 basis points in 2002, and .6 basis points in 2001. We recorded a provision for losses of $100 million, $128 million, and $94 million, respectively, in 2003, 2002, and 2001. Our provision represented between 1 and 2 percent of our pre-tax reported income and core business earnings in each of the past three years. Management believes the combined balance of our allowance for loan losses and guaranty liability for MBS are adequate to absorb losses inherent in Fannie Mae’s mortgage credit book of business.

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Deferred Price Adjustments

When Fannie Mae buys MBS, loans, or mortgage-related securities, we may not pay the seller the exact amount of the unpaid principal balance (“UPB”). If we pay more than the UPB and purchase the mortgage assets at a premium, the premium reduces the yield we recognize on the assets below the coupon amount. If we pay less than the UPB and purchase the mortgage assets at a discount, the discount increases the yield above the coupon amount. In addition, we may charge an upfront payment in lieu of a higher guaranty fee for certain loan types that have higher credit risk. To facilitate the pooling of mortgages into a Fannie Mae MBS, we also may adjust the monthly MBS guaranty fee rate that we receive by either negotiating an upfront cash disbursement to the lender (a “buy-up”) or an upfront cash receipt from the lender (a “buy-down”) when the MBS is formed. We refer to the upfront payments or receipts as “deferred guaranty fee price adjustments.” These amounts adjust our monthly guaranty fee so that the coupons on MBS are generally in increments of whole or half point interest rates, which tend to be more easily traded.

We recognize premiums, discounts, and other deferred purchase and guaranty fee price adjustments over the estimated life of purchased or guaranteed assets as an adjustment to income in accordance with Financial Accounting Standard No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (“FAS 91”). Concurrent with our adoption of Financial Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (“FIN 45”), we now account for buy-ups related to guarantees issued on or after January 1, 2003 as available-for-sale securities. Accordingly, we record buy-ups paid on or after January 1, 2003 at fair value on our balance sheet with changes in fair value recorded in AOCI. We assess buy-ups for other-than-temporary impairment in a manner similar to our assessment of impairment on other available-for-sale securities. Our change in accounting for buy-ups does not change our FAS 91 income recognition model for the underlying asset, and it did not have a material effect on our financial statements for the year ended December 31, 2003. We amortize deferred premiums and discounts into interest income, which affects the results of our Portfolio Investment business. The amortization of deferred guaranty fee price adjustments is included in guaranty fee income, which affects the results of our Credit Guaranty business.

We amortize premiums, discounts, and other deferred purchase price and guaranty fee price adjustments into income using the effective yield method, adjusted for prepayment activity. We believe the accounting estimates related to deferred premium/discount and deferred guaranty fee price adjustments are “critical accounting estimates” because they require us to make significant judgments and assumptions about borrower prepayment patterns in various interest rate environments that involve a significant degree of uncertainty. We regularly evaluate whether it is necessary to change the estimated prepayment rates used in our amortization calculation based on changes in interest rates and expected mortgage prepayments. We reassess our estimate of the sensitivity of prepayments to changes in interest rates and compare actual prepayments versus anticipated prepayments. If changes are necessary, we recalculate the constant effective yield and adjust net interest income or guaranty fee income for the amount of premiums, discounts, and other deferred purchase price and guaranty fee price adjustments that would have been recorded if we had applied the new effective yield since acquisition of the mortgage assets or inception of a guaranty. In general, decreases in mortgage interest rates tend to increase prepayment rates, which accelerates the amortization of deferred price adjustments.

Table 6 shows the estimated effect on our reported net interest income and guaranty fee income of changes in the amortization of our deferred price adjustments based on 100 and 50 basis point instantaneous changes in interest rates at December 31 beyond the levels assumed in our base prepayment rate models.

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Table 6:    Deferred Price Adjustments

                                                   
Premium/Discount Deferred Guaranty Fees


2003 2002 2001 2003 2002 2001






(Dollars in millions)
Unamortized premium (discount) and deferred price adjustments, net
  $ 3,716 (1 )   $ 472 (1)   $ (2,104 ) (1)   $ (3,382 )   $ (1,454 )   $ (382 )
     
     
     
     
     
     
 
Reported net interest income/guaranty fee income
  $ 13,569     $ 10,566     $ 8,090     $ 2,411     $ 1,816     $ 1,482  
     
     
     
     
     
     
 
Increase (decrease) in net interest income/guaranty fee income from net amortization(2)
  $ (336 )   $ 71     $ 358     $ 508     $ 104     $ (87 )
Percentage effect of increase (decrease) on reported net income(3)
    (3 )%     1 %     4 %     4 %     1 %     (1 )%
Percentage effect on net interest income/guaranty fee income of change in interest rates:(4)
                                               
 
100 basis point increase
    .6       (.3 )           (3.3 )           .1  
 
100 basis point decrease
          2.4       2.2       9.5       3.1       (2.7 )
 
 50 basis point increase
    .3                   (1.2 )            
 
 50 basis point decrease
          1.0       .3       3.4       .8       (.3 )


(1)  Includes unamortized premium (discount) and deferred price adjustments for available-for-sale and held-to-maturity mortgage-related securities and loans held for investment. Excludes fair value purchase price adjustments related to mortgage purchase commitments accounted for as derivatives under FAS 149.
 
(2)  Amortization of premium/discount amounts is recorded in net interest income, while amortization of deferred price adjustments related to guaranty fees is recorded in guaranty fee income.
 
(3)  Reflects after-tax effect on reported net income from net amortization amounts based on the applicable federal income tax rate of 35 percent.
 
(4)  Calculated based on an instantaneous change in interest rates.

Premium/ Discount

As shown in Table 6, our mortgage portfolio had a net premium position of $3.716 billion at December 31, 2003, compared with a net premium position of $472 million at the end of 2002 and a net discount position of $2.104 billion at year-end 2001. We shifted to a net premium position from a net discount position at the end of 2001. As interest rates fell during 2003 and 2002, the fair value of mortgages we purchased with higher weighted-average coupons increased. As a result, we paid premiums on a higher proportion of our mortgage purchases. The $3.716 billion net premium amount at December 31, 2003 excludes fair value purchase price adjustments related to mortgage commitments accounted for as derivatives under FAS 149. Except for the $285 million pre-tax transition gain recorded from our July 1, 2003 adoption of FAS 149, the amortization of our fair value purchase price adjustments is offset by an equal amount of amortization from accumulated other comprehensive income (“AOCI”) and thus has no effect on our net income (see “MD&A—Portfolio Investment Business Operations—Investments—Mortgage Commitments”). Amortization of deferred price adjustments related to our mortgage portfolio reduced reported net income by 3 percent in 2003 and increased reported net income by 1 percent in 2002 and 4 percent in 2001.

As mortgage rates rise, expected prepayment rates generally decrease, which slows the amortization of deferred price adjustments. Based on our prepayment sensitivity analysis, a 100 basis point instantaneous increase in interest rates beyond the levels assumed in our base prepayment rate models would have slowed our amortization of net premium/discount amounts, which would have increased reported net interest income by less than 1 percent in 2003 and had virtually no impact on 2002 and 2001 reported net interest income. In contrast, a decrease in mortgage rates tends to accelerate prepayments and our recognition of deferred price adjustments. A 100 basis point decrease in interest rates at December 31, 2003 would have had virtually no impact on the net premium expense recognized in 2003 or reported net interest income. During 2002 and 2001, amortization of deferred price adjustments related to our mortgage portfolio resulted in the recognition of net discount amounts, which increased reported net interest income. The acceleration of amortization of net discount amounts during 2002 and 2001 from a 100 basis point decrease in interest rates would have increased our reported net interest income in each year by approximately 2 percent.

This sensitivity analysis is only one component of Fannie Mae’s overall net interest income at risk assessment. It does not include the effect of new business or the impact of changes in interest rates on our debt costs or net cash flows related to our derivatives contracts. A comprehensive analysis of the impact of interest rate

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changes on projected net interest income is presented in “MD&A—Portfolio Investment Business Operations—Interest Rate Risk Management.”

Deferred Guaranty Fees

Our net discount position on deferred guaranty fee price adjustments increased to $3.382 billion at December 31, 2003, from a net discount position of $1.454 billion and $382 million at December 31, 2002 and 2001, respectively. A net discount position reflects that the combined up-front payments we collect in lieu of higher guaranty fees on more risky loans and the up-front payments we receive from lenders in exchange for a lower guaranty fee rate over time exceed the up-front payments we make to lenders in exchange for a higher guaranty fee rate over time. A net premium position would indicate that our upfront payments to lenders exceed the upfront fees collected from lenders. The significant increase in our net discount position on deferred guaranty fees in 2003 and 2002 was largely attributable to an increase in up-front payments collected on loans with higher credit risk.

Amortization of deferred guaranty fee price adjustments increased guaranty fee income by $508 million in 2003 (4 percent of reported net income) and $104 million in 2002 (1 percent of reported net income) and reduced guaranty fee income by $87 million in 2001 (1 percent of reported net income). We accelerated our amortization of deferred guaranty fee price adjustments in 2003 in response to the dramatic increase in mortgage prepayments resulting from the record level of refinancings. Similarly, the upward adjustment to guaranty fee income in 2002 versus 2001 was primarily related to a faster pace of recognition of deferred discount amounts due to lower mortgage rates and accelerated prepayments. We also made enhancements to our amortization model in 2002 to better reflect the impact of interest rates on prepayment behavior that accelerated the recognition of net discount amounts and increased our guaranty income.

Based on our prepayment sensitivity analysis for deferred guaranty fee price adjustments, a 100 basis point instantaneous increase in interest rates at the end of each year beyond the levels assumed in our base prepayment rate models would have reduced guaranty fee income by approximately 3 percent in 2003 and increased guaranty fee income by less than 1 percent in 2001. A 100 basis point instantaneous decrease in interest rates at the end of each year would have increased our guaranty fee income by approximately 10 percent in 2003 and 3 percent in 2002 and reduced our guaranty fee income by approximately 3 percent in 2001. A 100 basis point instantaneous decrease in interest rates would have a more significant impact on the amortization of our deferred guaranty fee price adjustments because mortgage prepayments generally tend to be more sensitive to declines in interest rates than increases.

Time Value of Purchased Options

Fannie Mae issues various types of debt to finance the acquisition of mortgages. We typically use derivative instruments to supplement our issuance of debt in the capital markets and hedge against the effect of fluctuations in interest rates on our debt costs to preserve our net interest margin. With the adoption of FAS 133, we began recording all derivatives on our balance sheet at estimated fair value. We record changes in the fair value of derivatives designated as cash flow hedges in AOCI. We recognize in our reported earnings changes in the fair value of the time value associated with purchased options and changes in the fair value of derivatives designated as fair value hedges.

Fannie Mae’s purchased options portfolio currently includes swaptions and caps, which are discussed in more detail under “MD&A—Portfolio Investment Business Operations—Funding—Derivative Instruments.” The total fair value for purchased options consists of the time value plus the intrinsic value. Under FAS 133, the mark-to-market on the time value component of our purchased options flows through our reported earnings. The time value of purchased options will vary from period to period with changes in interest rates, expected interest rate volatility, and derivative activity. However, the total expense included in earnings over the original expected life of an option will generally equal the initial option premium paid. Since adopting FAS 133, we have reported significant fluctuations in our reported net income because of unrealized fluctuations in the estimated time value of purchased options. Purchased options expense totaled $2.168 billion in 2003, $4.545 billion in 2002, and $37 million in 2001.

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Our methodology for valuing purchased options is based on commonly used market conventions and assumptions. We obtain quoted mid-market prices for a benchmark set of interest rate options, which include caps and swaptions. Based on these quoted market prices, we apply our valuation model, which effectively utilizes these prices to estimate the fair value of our purchased options. We then allocate the fair value of our purchased options into the time value and intrinsic value components. Because the benchmark securities are only a subset of the purchased options that we hold, the estimation of time value is not exact and can vary depending on the market source and methodology used. This variation could have a material effect on our reported net income. Hence, we believe our estimate of the time value component of purchased options is a “critical accounting estimate.”

To gauge the potential sensitivity of changes in the estimated time value of our purchased options, we recalculated our estimates based on plus and minus changes of 5 percent and 10 percent in the time value portion of our outstanding purchased options at December 31, 2003, 2002 and 2001. These changes are generally greater than changes we have observed historically in our valuation process. Table 7 shows the potential effect on our reported results from these changes in time value. An increase in the estimated fair value of the time value portion of our purchased options would reduce purchased options expense and increase our reported net income and stockholders’ equity, while a decrease in the estimated time value would increase purchased options expense and reduce our reported net income and stockholders’ equity.

Table 7:    Impact of Changes in the Time Value of Purchased Options

                                                                           
Percentage Effect of Change in Time Value On

Time Value of Purchased Options Reported Net Income(1) Total Stockholders’ Equity(1)



2003 2002 2001 2003 2002 2001 2003 2002 2001









(Dollars in millions)
Time value of purchased options (2)
  $ 8,139     $ 5,425     $ 4,927                                                  
     
     
     
                                                 
Purchased options expense(3)
  $ 2,168     $ 4,545     $ 37                                                  
     
     
     
                                                 
Effect of:
                                                                       
 
10% change in time value
  $ 814     $ 543     $ 493       7 %     8 %     5 %     2 %     2 %     2 %
 
 5% change in time value
    407       271       246       3       4       3       1       1       1  


(1)  Reflects after-tax effect of time value adjustment based on applicable federal income tax rate of 35 percent.
 
(2)  Represents reported fair value of the time value of purchased options outstanding at December 31, 2003, 2002, and 2001. Amount included on our balance sheet in “Derivatives in gain positions.”
 
(3)  GAAP purchased options expense reported in our income statement.

The estimated fair value of the time value portion of our outstanding purchased options, which is included on our balance sheet under “Derivatives in gain positions,” totaled $8.139 billion, $5.425 billion, and $4.927 billion at December 31, 2003, 2002, and 2001, respectively. Table 7 shows that a plus or minus change of 10 percent at the end of each year in the reported time value portion of our purchased options would have changed our reported purchased options expense by $814 million in 2003, $543 million in 2002, and $493 million in 2001, which would have changed our reported net income by 7 percent in 2003, 8 percent in 2002, and 5 percent in 2001. The effect on stockholders’ equity of a 10 percent change in the time value portion of our purchased options would be approximately 2 percent at December 31, 2003, 2002, and 2001. Our core business earnings results would not be affected by these estimates because we amortize purchased options premiums over the original expected life of the option in measuring core business earnings and do not include mark-to-market changes in the fair value of purchased options.

Other-Than-Temporary Impairment

We regularly monitor all of Fannie Mae’s investments for changes in fair value and record impairment when we judge a decline in fair value to be other-than-temporary. An investment is considered impaired if the estimated fair value is less than the carrying value. When an investment appears to be impaired, we evaluate whether the impairment is other-than-temporary. An other-than-temporary decline in fair value is generally

45


 

considered to have occurred if it is probable that an investor will be unable to collect all amounts due according to the contractual terms of the investment security.

Estimating the fair value of our investments is a critical part of our impairment evaluation process. The estimated fair value of our mortgage-related and nonmortgage securities, which represent the majority of Fannie Mae’s investments, is based on quoted market prices for specific securities where available or quoted prices for similar securities. The fair value of our mortgage-related and nonmortgage securities will change from period-to-period with changes in interest rates and changes in credit performance. We show gross unrealized gains and losses on our mortgage-related and nonmortgage investment securities at December 31, 2003, 2002, and 2001 in the Portfolio Investment Business Operations section of MD&A.

When market quotations are not readily available because of the nature of the security or illiquid market conditions— as occurred during the downturn in the manufactured housing sector— we estimate the fair value based primarily on the present value of future cash flows, adjusted for the quality of the rating of the securities, prepayment assumptions, and other factors, such as credit enhancements Fannie Mae has to offset potential losses. Determining the fair value where there is little or no market liquidity is a subjective process involving significant management judgment because of inherent uncertainties related to the actual future performance of assets underlying our securities. Changes in various assumptions used in our cash flow analyses can result in significant changes in valuation. We update our assumptions on an ongoing basis based on changes in market conditions and actual performance of the assets underlying the securities.

Determining whether a decline in fair value is other-than-temporary often involves estimating the outcome of future events and accordingly requires significant management judgment. We consider various factors, both subjective and objective, in determining whether we should recognize an other-than-temporary impairment charge. As a primary indicator of other-than-temporary impairment, we consider the duration and extent to which the fair value is less than our book value coupled with our intent and ability to hold the investment for a period of time sufficient to allow us to recover our contractual principal and interest. Our assessment of other-than-temporary impairment focuses primarily on issuer or collateral specific factors, such as operational and financing cash flows, rating agency actions, and business and financial outlook. We incorporate the impact of any credit enhancements in our assessment. We also evaluate broader industry and sector performance indicators. We determine other-than-temporary impairment based on information available as of each balance sheet date. New information or economic developments in the future could lead to additional impairment.

We monitor our investments within capital risk limits approved by management and the Board. We actively perform market research, monitor market conditions, and segment our investments by credit risk to minimize any impairment risk. If we believe that the impairment of a security or other investment is other-than-temporary, we recognize the amount as a realized loss in “Fee and other income, net” and write down the carrying value of the investment to fair value. Once we have recognized an other-than-temporary impairment, we do not adjust the carrying value of the investment for any subsequent increases in fair value. We recognized other-than-temporary impairment totaling $308 million in 2003, $110 million in 2002, and $50 million in 2001.

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 and measure the results of our lines of business. We discuss these measures further in this section, provide information on our business segments, and explain our results and risk management in terms of the underlying businesses.

Core Business Earnings

We delivered double-digit growth in core business earnings for the 17th consecutive year in 2003. Core business earnings increased 14 percent over 2002 to $7.306 billion due primarily to exceptional growth in our book of business and net interest margin. Our core business earnings in 2002 grew 19 percent over 2001 to $6.394 billion, also due to strong growth in our book of business and net interest margin growth.

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The extreme financial market volatility during 2003 resulted in significant variability in the growth of our business throughout the year and caused the growth rates of our two books of business to diverge substantially. While low interest rates during the first half of the year spurred record mortgage originations, aggressive purchasing of mortgages by banks and other investors resulted in relatively narrow mortgage-to-debt spreads and lower than expected sales in the secondary market. Our Portfolio Investment business grew our mortgage portfolio by 13 percent by maintaining disciplined portfolio growth throughout the year, purchasing mortgage assets when spreads exceeded our hurdle rates and when supply was available in the market. Our opportunistic and disciplined purchasing approach resulted in a sporadic pattern of portfolio growth during the year, including two quarters of declines that were more than offset by annualized growth of over 60 percent in the third quarter. While we curbed our purchases at certain points during the year in response to narrow mortgage-to-debt spreads, outstanding MBS for our Credit Guaranty business grew 26 percent during 2003. Our Credit Guaranty business received a substantial benefit due to the record amount of refinancing during the year, which fueled our MBS issuance.

2003 financial highlights include:

  •  Record business volume of $1,423 billion, up 68 percent over 2002
 
  •  21 percent growth in our combined book of business (gross mortgage portfolio and outstanding MBS), compared with 16 percent growth in 2002
 
  •  Core taxable-equivalent revenues of $14.794 billion, up 24 percent over 2002
 
  •  Record core net interest income of $10.479 billion, a 20 percent increase
 
  •  5 basis point increase in the net interest margin to 1.20 percent
 
  •  Record guaranty fee income of $2.411 billion, up 33 percent
 
  •  Record fee and other income of $437 million, an 88 percent increase
 
  •  Credit-related expenses of $112 million, compared with $92 million in 2002
 
  •  Losses of $2.261 billion from the call and repurchase of $266 billion of outstanding debt, compared with losses related to similar activities of $710 million in 2002

Core business earnings differs from reported net income by using a different method of recognizing the period cost of purchased options. Our core business earnings measure excludes the unpredictable volatility in the time value of purchased options that is included in our reported net income because we generally intend to hold these options to maturity, and we do not believe the period-to-period variability in our reported net income from changes in the time value of our purchased options accurately reflects the underlying risks or economics of our hedging strategy. Core business earnings includes amortization of purchased options premiums over the original expected life of the options and any accelerated expense resulting from 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 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. 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.

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. Our core business earnings measures are not

47


 

defined terms within GAAP and may not be comparable to similarly titled measures reported by other companies. Although we rely on core business earnings to measure and evaluate Fannie Mae’s period-to-period results of operations, we do not use core business earnings in calculating our regulatory core capital and total capital measures. We calculate these measures based on stockholders’ equity reported in our financial statements, which includes retained earnings based on our reported GAAP net income. We consider our core capital and total capital levels in establishing our dividend policies because they are critical in determining the amount of capital available for distribution to shareholders.

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 8 shows our line of business and consolidated core business earnings results for 2003, 2002, and 2001. We evaluate the results of our business lines as though each were a stand-alone business. Hence, we allocate certain income and expenses to each line of business for purposes of business segment reporting. Income is also allocated from the Portfolio Investment business to the Credit Guaranty business for the following activities:

  •  Managing the credit risk on mortgage-related assets held by the Portfolio Investment business. The Portfolio Investment business compensates the Credit Guaranty business through a fee comparable to an MBS guaranty fee. These fees are recognized as guaranty fee income by the Credit Guaranty business. Similarly, all credit expenses related to credit losses on loans and on MBS and other mortgage-related securities held in Fannie Mae’s mortgage portfolio are allocated to the Credit Guaranty business for business segment reporting purposes. Net interest income for the Credit Guaranty business is net of charges paid to the Portfolio Investment business for forgone interest on delinquent loans.
 
  •  Providing capital to the Portfolio Investment business. The Portfolio Investment business also compensates the Credit Guaranty business for the temporary use of capital generated by the Credit Guaranty business, which the Portfolio Investment business uses to fund investments. This compensation is classified as net interest income.
 
  •  Temporarily investing principal and interest payments on loans underlying MBS and other mortgage-related securities prior to remittance to investors. Interest income on the temporary investment of these funds is allocated to the Credit Guaranty business.

We eliminate certain inter-segment allocations in our consolidated core business earnings results (see “MD&A—Core Business Earnings and Business Segment Results”). We have reclassified certain amounts in our prior years’ results to conform to our current presentation.

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Table 8:    Reconciliation of Core Business Earnings to Reported Results

                                           
2003

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





(Dollars in millions)
 
Net interest income
  $ 12,766     $ 803     $ 13,569     $     $ 13,569  
Purchased options amortization expense
    (3,090 )           (3,090 )     3,090  (2)      
     
     
     
     
     
 
Core net interest income
    9,676       803       10,479       3,090       13,569  
Guaranty fee income (expense)
    (1,667 )     4,078       2,411             2,411  
Fee and other income (expense), net
    495       (58 )     437             437  
Credit-related expenses(1)
          (112 )     (112 )           (112 )
Administrative expenses
    (429 )     (1,034 )     (1,463 )           (1,463 )
Purchased options expense under FAS 133
                      (2,168 )(3)     (2,168 )
Debt extinguishments
    (2,261 )           (2,261 )           (2,261 )
     
     
     
     
     
 
Income before federal income taxes and cumulative effect of change in accounting principle
    5,814       3,677       9,491       922       10,413  
Provision for federal income taxes
    (1,641 )     (729 )     (2,370 )     (323 )(4)     (2,693 )
     
     
     
     
     
 
Income before cumulative effect of change in accounting principle
    4,173       2,948       7,121       599       7,720  
Cumulative effect of change in accounting principle, net of tax effect
    185   (5)           185             185  
     
     
     
     
     
 
 
Net income
  $ 4,358     $ 2,948     $ 7,306     $ 599     $ 7,905  
     
     
     
     
     
 
                                           
2002

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





Net interest income
  $ 9,869     $ 697     $ 10,566     $     $ 10,566  
Purchased options amortization expense
    (1,814 )           (1,814 )     1,814  (2)      
     
     
     
     
     
 
Core net interest income
    8,055       697       8,752       1,814       10,566  
Guaranty fee income (expense)
    (1,374 )     3,190       1,816             1,816  
Fee and other income (expense), net
    348       (116 )     232             232  
Credit-related expenses(1)
          (92 )     (92 )           (92 )
Administrative expenses
    (357 )     (862 )     (1,219 )           (1,219 )
Purchased options expense under FAS 133
                      (4,545 )(3)     (4,545 )
Debt extinguishments
    (710 )           (710 )           (710 )
     
     
     
     
     
 
Income before federal income taxes
    5,962       2,817       8,779       (2,731 )     6,048  
Provision for federal income taxes
    (1,747 )     (638 )     (2,385 )     956  (4)     (1,429 )
     
     
     
     
     
 
 
Net income
  $ 4,215     $ 2,179     $ 6,394     $ (1,775 )   $ 4,619  
     
     
     
     
     
 

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2001

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





Net interest income
  $ 7,369     $ 721     $ 8,090     $     $ 8,090  
Purchased options amortization expense
    (590 )           (590 )     590  (2)      
     
     
     
     
     
 
Core net interest income
    6,779       721       7,500       590       8,090  
Guaranty fee income (expense)
    (1,109 )     2,591       1,482             1,482  
Fee and other income (expense), net
    211       (60 )     151             151  
Credit-related expenses(1)
          (78 )     (78 )           (78 )
Administrative expenses
    (302 )     (715 )     (1,017 )           (1,017 )
Special contribution
    (192 )     (108 )     (300 )           (300 )
Purchased options expense under FAS 133
                      (37 )(3)     (37 )
Debt extinguishments
    (524 )           (524 )           (524 )
     
     
     
     
     
 
Income before federal income taxes and cumulative effect of change in accounting principle
    4,863       2,351       7,214       553       7,767  
Provision for federal income taxes
    (1,374 )     (473 )     (1,847 )     (194 )(4)     (2,041 )
     
     
     
     
     
 
Income before cumulative effect of change
    3,489       1,878       5,367       359       5,726  
 
in accounting principle
                                       
Cumulative effect of change in accounting principle, net of tax effect
                      168  (6)     168  
     
     
     
     
     
 
   
Net income
  $ 3,489     $ 1,878     $ 5,367     $ 527     $ 5,894  
     
     
     
     
     
 


(1)  Credit-related expenses include the income statement line items “Provision for losses” and “Foreclosed property expense (income).”
 
(2)  Represents the amortization of purchased options premiums 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.
 
(4)  Represents the net federal income tax effect of core business earnings adjustments based on the applicable federal income tax rate of 35 percent.
 
(5)  This non-recurring amount represents the one-time transition gain recorded upon the adoption of FAS 149 on July 1, 2003.
 
(6)  This non-recurring amount represents the one-time transition gain recorded upon the adoption of FAS 133 on January 1, 2001. We exclude the transition gain from core business earnings because it relates to unrealized gains on purchased options that were recorded when we adopted FAS 133.

The only difference in core business earnings and reported net income relates to the FAS 133 accounting treatment for purchased options, which affects our Portfolio Investment business. The FAS 133 related reconciling items between our core business earnings and reported results have no effect on our Credit Guaranty business. While the reconciling items to derive our core business earnings are significant components in understanding and assessing our reported results and financial performance, investors may not be able to directly discern the underlying economic impact of our interest rate risk management strategies without our core business results. We believe our core business earnings measures help to improve transparency and enhance investors’ understanding of our operations, as well as facilitate trend analysis. The specific FAS 133 related adjustments affecting our Portfolio Investment business are identified and explained in Table 8.

Core business earnings does not adjust for any other accounting effects related to the application of FAS 133 or other accounting standards under U.S. GAAP. The guaranty fee income that we allocate to the Credit

50


 

Guaranty business for managing most of the credit risk on mortgage assets held by the Portfolio Investment business is offset by a corresponding guaranty fee expense allocation to the Portfolio Investment business in our line of business results. Thus, there is no inter-segment elimination adjustment between our total line of business guaranty fee income and our reported guaranty fee income. We allocate transaction fees received for structuring and facilitating securities transactions for our customers primarily to our Portfolio Investment business. We allocate technology-related fees received for providing Desktop Underwriter and other on-line services and fees received for providing credit enhancement alternatives to our customers primarily to our Credit Guaranty business.

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

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

If we issue noncallable debt and purchased options to fund the purchase of mortgages and protect against the prepayment option in mortgages, we are required under FAS 133 to record the unrealized period-to-period fluctuations in the changes in time value of the purchased options in earnings. If instead, we issue callable debt to fund the purchase of the same mortgages, the expense related to the option in our callable debt would be recognized ratably over the option period as part of interest expense. Although the two transactions produce similar economic results, GAAP requires different accounting treatment. Under our core business earnings measure, the accounting treatment for purchased options is consistent and also comparable to the accounting treatment applied to these items in periods prior to the adoption of FAS 133. The table below compares our core business earnings to our reported net income for 2003, 2002, and 2001 and shows the significant variability in our reported net income, which is due primarily to the GAAP accounting for the time value of purchased options.

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Table 9: Comparison of Reported Net Income and Core Business Earnings
                                                 
Year Ended December 31,

2003 % Change 2002 % Change 2001 % Change






(Dollars in millions)
Reported net income
  $ 7,905       71 %   $ 4,619       (22 )%   $ 5,894       33 %
Core business earnings
    7,306       14       6,394       19       5,367       21  

Core Taxable-Equivalent Revenues

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

Table 10 compares core taxable-equivalent revenues and the components for 2003, 2002, and 2001.

 
Table 10: Core Taxable-Equivalent Revenues
                           
Year Ended December 31,

2003 2002 2001



(Dollars in millions)
Net interest income
  $ 13,569     $ 10,566     $ 8,090  
Guaranty fee income
    2,411       1,816       1,482  
Fee and other income, net
    437       232       151  
     
     
     
 
 
Total revenues
    16,417       12,614       9,723  
Taxable-equivalent adjustments:
                       
 
Investment tax credits(1)
    988       594       584  
 
Tax-exempt investments(2)
    479       502       470  
     
     
     
 
Taxable-equivalent revenues
    17,884       13,710       10,777  
Purchased options amortization expense(3)
    (3,090 )     (1,814 )     (590 )
     
     
     
 
Core taxable-equivalent revenues
  $ 14,794     $ 11,896     $ 10,187  
     
     
     
 


(1)  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.
(2)  Represents non-GAAP adjustments to permit comparisons of yields on tax-exempt and taxable assets based on a 35 percent marginal tax rate.
(3)  Represents non-GAAP adjustment for amortization of purchased options premiums that would have been recorded prior to the adoption of FAS 133 in 2001.

Core taxable-equivalent revenues increased 24 percent in 2003 and 17 percent in 2002, primarily due to strong growth in core net interest income, guaranty fee income, and fee and other income.

Core Net Interest Income

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

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Table 11 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 over the original estimated life of the option, which is not in accordance with GAAP.

 
Table 11: Net Interest Margin
                             
2003 2002 2001



(Dollars in millions)
Net interest income
  $ 13,569     $ 10,566     $ 8,090  
 
Purchased options amortization expense(1)
    (3,090 )     (1,814 )     (590 )
     
     
     
 
Core net interest income
    10,479       8,752       7,500  
 
Taxable-equivalent adjustment on tax-exempt investments (2)
    479       502       470  
     
     
     
 
Taxable-equivalent core net interest income
  $ 10,958     $ 9,254     $ 7,970  
     
     
     
 
Average balances(3):
                       
Interest-earning assets(4):
                       
 
Mortgage portfolio, net
  $ 839,172     $ 735,943     $ 658,195  
 
Liquid investments
    75,113       68,658       58,811  
     
     
     
 
Total interest-earning assets
    914,285       804,601       717,006  
 
Interest-free funds(5)
    (27,336 )     (23,992 )     (23,630 )
     
     
     
 
Total interest-earning assets funded by debt
  $ 886,949     $ 780,609     $ 693,376  
     
     
     
 
Interest-bearing liabilities(6):
                       
 
Short-term debt
  $ 240,628     $ 141,727     $ 137,078  
 
Long-term debt
    646,321       638,882       556,298  
     
     
     
 
Total interest-bearing liabilities
  $ 886,949     $ 780,609     $ 693,376  
     
     
     
 
Average interest rates (2, 3):
                       
Interest-earning assets:
                       
 
Mortgage portfolio, net
    5.92 %     6.73 %     7.11 %
 
Liquid investments
    1.59       2.34       4.63  
     
     
     
 
Total interest-earning assets
    5.56       6.35       6.90  
   
Interest-free return(5)
    .19       .18       .21  
     
     
     
 
Total interest-earning assets and interest-free return
    5.75       6.53       7.11  
     
     
     
 
Interest-bearing liabilities(6):
                       
 
Short-term debt
    1.40       2.15       4.28  
 
Long-term debt
    5.73       6.10       6.43  
     
     
     
 
Total interest-bearing liabilities
    4.55       5.38       6.00  
     
     
     
 
Net interest margin
    1.20 %     1.15 %     1.11 %
     
     
     
 


(1)  Reflects non-GAAP adjustment for amortization of purchased options premiums.
(2)  Reflects non-GAAP adjustments to permit comparison of yields on tax-exempt and taxable assets based on 35 percent marginal tax rate.
(3)  Averages have been calculated on a monthly basis based on amortized cost.
(4)  Includes average balance of nonaccrual loans of $6.0 billion in 2003, $4.6 billion in 2002, and $2.6 billion in 2001.
(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 grew 20 percent in 2003 to a record $10.479 billion, driven by 14 percent growth in our average net investment balance and a 5 basis point increase in our net interest margin to 1.20 percent. Core net interest income increased 17 percent in 2002 to $8.752 billion, primarily due to 12 percent growth in our average net investment balance and a 4 basis point increase in the net interest margin to 1.15 percent. Table 12 shows changes in core net interest income for 2003 and 2002.

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Table 12: Rate/ Volume Analysis of Core Net Interest Income
                           
Attributable to
Changes in(1)
Increase
(Decrease) Volume Rate



(Dollars in millions)
2003 vs. 2002
                       
Interest income:
                       
 
Mortgage portfolio
  $ 489     $ 6,475     $ (5,986 )
 
Liquid investments
    (422 )     138       (560 )
     
     
     
 
 
Total interest income
    67       6,613       (6,546 )
     
     
     
 
Interest expense:(2)
                       
 
Short-term debt
    88       1,428       (1,340 )
 
Long-term debt
    (3,024 )     433       (3,457 )
     
     
     
 
 
Total interest expense
    (2,936 )     1,861       (4,797 )
     
     
     
 
Change in net interest income
  $ 3,003     $ 4,752     $ (1,749 )
     
     
     
 
 
Change in purchased options amortization expense(3)
    (1,276 )                
     
                 
Change in core net interest income
    1,727                  
 
Change in taxable-equivalent adjustment on tax-exempt investments(4)
    (23 )                
     
                 
Change in taxable-equivalent core net interest income
  $ 1,704                  
     
                 
2002 vs. 2001
                       
Interest income:
                       
 
Mortgage portfolio
  $ 2,787     $ 5,292     $ (2,505 )
 
Liquid investments
    (1,104 )     394       (1,498 )
     
     
     
 
 
Total interest income
    1,683       5,686       (4,003 )
     
     
     
 
Interest expense:(2)
                       
 
Short-term debt
    (3,005 )     188       (3,193 )
 
Long-term debt
    2,212       4,986       (2,774 )
     
     
     
 
 
Total interest expense
    (793 )     5,174       (5,967 )
     
     
     
 
Change in net interest income
  $ 2,476     $ 512     $ 1,964  
     
     
     
 
 
Change in purchased options amortization expense(3)
    (1,224 )                
     
                 
Change in core net interest income
    1,252                  
 
Change in taxable-equivalent adjustment on tax-exempt investments(4)
    32                  
     
                 
Change in taxable-equivalent core net interest income
  $ 1,284                  
     
                 


(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 amortization of purchased options premiums that would have been recorded under GAAP prior to our adoption of 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 Earnings

Our Portfolio Investment business generated core business earnings of $4.358 billion in 2003, compared with $4.215 billion in 2002, and $3.489 billion in 2001. Core business earnings for the Portfolio Investment business grew 3 percent in 2003, compared with 21 percent in 2002. This growth was driven primarily by strong growth in core net interest income, partially offset by a significant increase in losses from debt extinguishments used to manage interest rate risk and lower debt costs in the future. Core net interest income rose from growth in our average investment balance and net interest margin. Although liquidations

54


 

reached a record high during 2003, we were able to grow our mortgage portfolio because of record portfolio purchases of $573 billion during the year as we took advantage of opportunities provided by attractive mortgage-to-debt spreads at different points during the year. However, the slowdown in refinance activity and increased demand for mortgage investments in the second half of 2003 resulted in tighter mortgage-to-debt spreads and sporadic portfolio growth during 2003— 12 percent growth during the first quarter of 2003, a contraction of 1 percent during the second quarter, an increase of 60 percent during the third quarter, followed by a decline of 8 percent in the fourth quarter. As a result of our disciplined growth approach, we ended 2003 with a marked decline in retained commitments, which is likely to result in negative portfolio growth during the first quarter of 2004. We expect that mortgage spreads will move back to more normal levels as the year progresses, which, combined with our expectations of a continued strong purchase market, should result in our being able to achieve double-digit portfolio growth during 2004.

The Portfolio Investment business was able to increase our net margin to an above-trend level by capitalizing on opportunities presented by the decline in interest rates that began in 2001 to temporarily reduce our debt costs relative to yields on assets. The Portfolio Investment business has replaced significant amounts of called or maturing debt over the past three years— particularly during 2003— with lower cost, shorter-term debt more quickly than our mortgage assets matured or prepaid. These actions temporarily reduced our debt cost relative to asset yield and elevated our net interest margin beginning in 2001. Our net interest margin remained elevated during 2003, averaging 1.20 percent, due to the continued benefits of historically low interest rates, the steep yield curve, 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 during the second quarter 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. During the second half of 2003, our net interest margin began to decline as expected as the record low mortgage interest rates during the earlier part of the year drove heavy liquidations of older, higher coupon mortgages, which have been replaced with new mortgages at lower coupon rates.

Credit Guaranty Business Earnings

Core business earnings for our Credit Guaranty business grew 35 percent in 2003 to $2.948 billion and 16 percent in 2002 to $2.179 billion. The increases in 2003 and 2002 in core business earnings for the Credit Guaranty business were driven primarily by a 28 percent and 23 percent increase, respectively, in guaranty fee income. Guaranty fee income increased in 2003 largely due to 20 percent growth in our average mortgage credit book of business and a 1.3 basis point increase in the average fee rate to 20.0 basis points. The increase in the average fee rate was a result of faster revenue recognition of deferred price components due to accelerated prepayments from the unprecedented level of refinancings together with increased risk-based pricing fees. Guaranty fee income increased in 2002 primarily due to 17 percent growth in our average mortgage credit book of business and a 1 basis point increase in the average fee rate to 18.7 basis points. The average fee rate for our Credit Guaranty business includes the effect of guaranty fee income allocated to the Credit Guaranty business for managing the credit risk on most of the mortgage assets held by the Portfolio Investment business. It therefore differs from our consolidated average effective guaranty fee rate, which excludes guaranty fees on MBS held in our portfolio because these fees are reported as interest income.

Record expansion of residential mortgage debt outstanding during 2003 and 2002, combined with our ability to offer reliable, low-cost mortgage funds, fueled growth in our mortgage credit book of business. The demand for housing was strong throughout 2003 and 2002, and borrowers also took advantage of the low interest rate environment to refinance their mortgages and extract equity from the appreciation in their homes. Residential mortgage debt outstanding increased 12.5 percent in 2003 to $7.8 trillion, 12.4 percent in 2002 to $7.0 trillion, and 10.3 percent in 2001 to $6.2 trillion. Refinancings represented 68 percent of total market originations in 2003, 62 percent in 2002, and 57 percent in 2001. Growth in Fannie Mae’s mortgage credit book of business outpaced growth in residential mortgage debt outstanding during 2003, 2002, and 2001.

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In 2002, we announced increases in the upfront-price adjustment Fannie Mae charges on cash-out refinance mortgages with loan-to-value (“LTV”) ratios between 70.01 and 85 percent that were implemented during 2003. As a result of these increases, which better compensate us for the higher risk on these loans, the upfront-price adjustments on cash-out refinance mortgages we purchase or guarantee with LTV ratios greater than 70 percent ranges from 50 to 75 basis points. The increased price adjustments, which are allocated to our Credit Guaranty business, have resulted in a modest increase in our guaranty fees.

Corporate Financial Disciplines

We completed a comprehensive review and assessment of our corporate financial disciplines during 2003. In conjunction with this assessment, we announced the following internal financial discipline objectives, which identify more explicitly what our overall risk discipline is designed to accomplish.

  •  To maintain a standalone “risk-to-the-government” credit rating from Standard and Poor’s (“S&P”) of at least AA-, and to maintain a standalone “bank financial strength” credit rating from Moody’s Investors Service (“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 Portfolio Investment and Credit Guaranty businesses 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 uses a quarterly risk-based capital stress test to evaluate our capital adequacy, and it makes the results of these tests public. This risk-based capital test provides Fannie Mae with a direct regulatory incentive to maintain a low risk profile. We traditionally have used stress tests internally as well.

  •  To keep our mortgage interest rate 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:

  Following a review of the net income pattern over the past ten years of all S&P 500 companies that were able to maintain ratings of AA-/ Aa3 or higher during the entire period, we 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 stability objective will allow us to maintain our standalone ratings with a comfortable margin of safety, and possibly to improve them.
 
  These financial disciplines led us to adopt an internal objective for our Portfolio Investment business to maintain the mortgage portfolio’s duration gap within a range of plus-or-minus six months substantially all of the time (see “MD&A— Portfolio Investment Business Operations— Interest Rate Risk Management” for further discussion). For our Credit Guaranty business, these objectives imply continued use of the risk-mitigation activities designed to help Fannie Mae achieve stable earnings growth and a competitive return on equity over time (see “MD&A— Credit Guaranty Business Operations— Credit Risk Management” for further discussion).

The financial disciplines act as supplemental governors of management discretion in a portion of our businesses within the constraints imposed by our capital and safety and soundness regulations. We are continuing to work toward implementing and maintaining these recently announced financial disciplines. Meeting all of these objectives is a major corporate initiative for 2004. We will continue to monitor rigorously our capital position relative to the risks we take in our businesses and adjust the hedges in those businesses to ensure that the capital we hold relative to the risks we take is consistent with achieving these objectives.

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PORTFOLIO INVESTMENT BUSINESS OPERATIONS

Our Portfolio Investment business has primary responsibility for Fannie Mae’s investing and funding activities and managing our interest rate risk. These activities are discussed further in this section.

Investments

Mortgage Portfolio

Despite a record level of liquidations during 2003 and aggressive purchasing of mortgages by banks and other investors, we grew our net mortgage portfolio by 13 percent to $902 billion at December 31, 2003 by purchasing mortgage assets when spreads exceeded our hurdle rates and supply was available in the market. Table 13 summarizes mortgage portfolio activity on a gross basis and average yields from 2001 through 2003.

 
Table 13: Mortgage Portfolio Activity(1)
                                                                               
Purchases Sales Repayments(2)



2003 2002 2001 2003 2002 2001 2003 2002 2001









(Dollars in millions)
Single-family:
                                                                       
 
Government insured or guaranteed
  $ 6,439     $ 9,493     $ 6,001     $ 59     $ 139     $     $ 17,015     $ 13,057     $ 8,125  
     
     
     
     
     
     
     
     
     
 
 
Conventional:
                                                                       
   
Long-term, fixed-rate
    433,059       280,815       226,516       11,198       8,253       7,621       368,813       216,218       120,787  
   
Intermediate-term, fixed-rate
    87,432       62,102       26,146       1,621       464       442       50,561       37,544       23,391  
   
Adjustable-rate
    32,740       10,739       3,777       849       347       228       12,048       8,806       9,937  
     
     
     
     
     
     
     
     
     
 
     
Total conventional single-family
    553,231       353,656       256,439       13,668       9,064       8,291       431,422       262,568       154,115  
     
     
     
     
     
     
     
     
     
 
Total single-family
    559,670       363,149       262,440       13,727       9,203       8,291       448,437       275,625       162,240  
Multifamily
    13,182       7,492       8,144             379       690       3,050       1,794       2,172  
     
     
     
     
     
     
     
     
     
 
Total
  $ 572,852     $ 370,641     $ 270,584     $ 13,727     $ 9,582     $ 8,981     $ 451,487     $ 277,419     $ 164,412  
     
     
     
     
     
     
     
     
     
 
Average net yield
    5.00 %     5.92 %     6.56 %                             6.36 %     6.83 %     7.23 %
Annualized repayments as a percentage of average gross mortgage portfolio
                                                    53.3 %     37.4 %     24.7 %


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

The liquidation rate on mortgages in portfolio (excluding sales) increased to 53 percent in 2003 from 37 percent in 2002, and 25 percent in 2001. Mortgage liquidations in 2003, 2002, and 2001 totaled $451 billion, $277 billion, and $164 billion, respectively. Liquidations increased significantly during this three-year period largely because of extensive refinancing in response to the prolonged low mortgage interest rate environment. Table 14 shows the distribution of Fannie Mae’s mortgage portfolio by product type. As reflected in Table 14, the net yield on our mortgage portfolio, net decreased to 5.54 percent at December 31, 2003, from 6.45 percent and 6.95 percent at the end of 2002 and 2001, respectively. The decrease in the net yield during 2003 and 2002 resulted largely from the general decline in mortgage rates on loans originated in the primary market and sold into the secondary market plus an increase in the level of liquidations of older, higher-rate loans.

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Table 14:    Mortgage Portfolio Composition(1)

                                               
2003 2002 2001 2000 1999





(Dollars in millions)
Mortgages
                                       

                                       
Single-family:
                                       
 
Government insured or guaranteed
  $ 7,063     $ 5,458     $ 5,070     $ 4,762     $ 4,472  
     
     
     
     
     
 
 
Conventional:
                                       
   
Long-term, fixed-rate
    119,870       106,570       97,848       87,134       86,912  
   
Intermediate-term, fixed-rate(2)
    75,015       54,503       43,522       39,134       43,878  
   
Adjustable-rate
    13,185       9,045       10,410       13,243       6,058  
     
     
     
     
     
 
 
Total conventional single-family
    208,070       170,118       151,780       139,511       136,848  
     
     
     
     
     
 
Total single-family
    215,133       175,576       156,850       144,273       141,320  
     
     
     
     
     
 
Multifamily:
                                       
 
Government insured or guaranteed
    1,091       1,353       1,551       1,814       2,347  
 
Conventional
    18,475       12,218       8,987       6,547       5,564  
     
     
     
     
     
 
Total multifamily
    19,566       13,571       10,538       8,361       7,911  
     
     
     
     
     
 
Total mortgages
  $ 234,699     $ 189,147     $ 167,388     $ 152,634     $ 149,231  
     
     
     
     
     
 
Mortgage-related securities
                                       

                                       
Single-family:
                                       
 
Government insured or guaranteed
  $ 21,267     $ 33,293     $ 37,111     $ 39,404     $ 36,557  
     
     
     
     
     
 
 
Conventional:
                                       
   
Long-term, fixed-rate
    507,661       510,435       456,046       367,344       298,534  
   
Intermediate-term, fixed-rate(2)
    83,366       39,409       25,890       27,965       25,317  
   
Adjustable-rate
    35,564       13,946       10,355       13,892       8,049  
     
     
     
     
     
 
 
Total conventional single-family
    626,591       563,790       492,291       409,201       331,900  
     
     
     
     
     
 
Total single-family
    647,858       597,083       529,402       448,605       368,457  
     
     
     
     
     
 
Multifamily:
                                       
 
Government insured or guaranteed
    10,150       7,370       6,481       5,370       4,392  
 
Conventional
    9,231       7,050       5,636       3,642       1,986  
     
     
     
     
     
 
Total multifamily
    19,381       14,420       12,117       9,012       6,378  
     
     
     
     
     
 
Total mortgage-related securities
  $ 667,239     $ 611,503     $ 541,519     $ 457,617     $ 374,835  
     
     
     
     
     
 
Mortgage portfolio, net
                                       

                                       
Single-family:
                                       
 
Government insured or guaranteed
  $ 28,330     $ 38,751     $ 42,181     $ 44,166     $ 41,029  
     
     
     
     
     
 
 
Conventional:
                                       
   
Long-term, fixed-rate
    627,531       617,005       553,894       454,478       385,446  
   
Intermediate-term, fixed-rate(2)
    158,381       93,912       69,412       67,099       69,195  
   
Adjustable-rate
    48,749       22,991       20,765       27,135       14,107  
     
     
     
     
     
 
     
Total conventional single-family
    834,661       733,908       644,071       548,712       468,748  
     
     
     
     
     
 
Total single-family
    862,991       772,659       686,252       592,878       509,777  
     
     
     
     
     
 
Multifamily:
                                       
 
Government insured or guaranteed
    11,241       8,723       8,032       7,184       6,739  
 
Conventional
    27,706       19,268       14,623       10,189       7,550  
     
     
     
     
     
 
Total multifamily
    38,947       27,991       22,655       17,373       14,289  
     
     
     
     
     
 
Total mortgage portfolio
    901,938       800,650       708,907       610,251       524,066  
 
Unamortized premium, (discount), and deferred price adjustments, net(3)
    (58 )     472       (2,104 )     (2,520 )     (964 )
 
Allowance for loan losses(4)
    (85 )     (79 )     (48 )     (51 )     (56 )
     
     
     
     
     
 
Mortgage portfolio, net
  $ 901,795     $ 801,043     $ 706,755     $ 607,680     $ 523,046  
     
     
     
     
     
 
Net yield on mortgage portfolio, net
    5.54 %     6.45 %     6.95 %     7.24 %     7.08 %


(1)  Data reflects unpaid principal balance adjusted to include mark-to-market gains and losses on available-for-sale securities and any impairment. The balance of mortgages at December 31, 2002, 2001, 2000, and 1999 includes certain loans held- for-investment that were previously classified as nonmortgage investments.
 
(2)  Intermediate-term, fixed-rate consists of portfolio loans with contractual maturities at purchase equal to or less than 20 years and MBS and other mortgage-related securities held in portfolio with maturities of 15 years or less at issue date.
 
(3)  Includes net unamortized premiums of $135 million and $536 million at December 31, 2002, and 2001, respectively, and net unamortized discounts of $1,292 million, $2,311 million, and $586 million at December 31, 2003, 2000 and

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1999, respectively, related to available-for-sale and held-to-maturity mortgage-related securities. Balance at December 31, 2003 includes fair value purchase price adjustments related to the settlement of mortgage and mortgage-related security purchase commitments accounted for as derivatives under FAS 149.
 
(4)  Guaranty liability for probable losses on loans underlying Fannie Mae guaranteed MBS is included on our balance sheet in “Guaranty liability for MBS.”

We classify mortgage loans on our balance sheet as either held-for-investment or held-for-sale. Our mortgage portfolio also includes MBS and other mortgage-related securities that we classify as either held-to-maturity or available-for-sale. On September 13, 2002, concurrent with the implementation of a new risk-based capital rule issued by OFHEO, we reclassified $124 billion of securities in our mortgage portfolio (including all of our private label securities) from held-to-maturity to available-for-sale in accordance with Financial Accounting Standard No. 115, Accounting for Certain Investments in Debt and Equity Securities (“FAS 115”). At the time of this noncash transfer, these mortgage-related securities had gross unrealized gains of $5.364 billion and unrealized losses of $53 million. Table 15 shows gross unrealized gains and losses on our MBS and mortgage-related securities at the end of 2003, 2002, and 2001.

Table 15:    Mortgage-Related Securities in Mortgage Portfolio

                                     
2003

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




(Dollars in millions)
Held-to-maturity:
                               
 
Fannie Mae MBS(2)
  $ 353,416     $ 7,876     $ (725 )   $ 360,567  
 
REMICs and Stripped MBS
    77,818       2,329       (559 )     79,588  
 
Other mortgage-related securities(3)
    43,918       2,198       (177 )     45,939  
     
     
     
     
 
   
Total
  $ 475,152     $ 12,403     $ (1,461 )   $ 486,094  
     
     
     
     
 
Available-for-sale:
                               
 
Fannie Mae MBS(2)
  $ 125,580     $ 3,396     $ (91 )   $ 128,885  
 
REMICs and Stripped MBS
    52,209       415       (567 )     52,057  
 
Other mortgage-related securities(3)
    9,506       392       (45 )     9,853  
     
     
     
     
 
   
Total
  $ 187,295     $ 4,203     $ (703 )   $ 190,795  
     
     
     
     
 
                                     
2002

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




Held-to-maturity:
                               
 
Fannie Mae MBS(2)
  $ 286,422     $ 11,173     $ (1 )   $ 297,594  
 
REMICs and Stripped MBS
    110,423       4,339       (87 )     114,675  
 
Other mortgage-related securities(3)
    41,087       2,813       (45 )     43,855  
     
     
     
     
 
   
Total
  $ 437,932     $ 18,325     $ (133 )   $ 456,124  
     
     
     
     
 
Available-for-sale:
                               
 
Fannie Mae MBS(2)
  $ 116,081     $ 5,425     $ (1 )   $ 121,505  
 
REMICs and Stripped MBS
    33,763       678       (369 )     34,072  
 
Other mortgage-related securities(3)
    17,358       782       (11 )     18,129  
     
     
     
     
 
   
Total
  $ 167,202     $ 6,885     $ (381 )   $ 173,706  
     
     
     
     
 

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2001

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




Held-to-maturity:
                               
 
Fannie Mae MBS(2)
  $ 333,896     $ 3,536     $ (54 )   $ 337,378  
 
REMICs and Stripped MBS
    127,675       2,432       (579 )     129,528  
 
Other mortgage-related securities(3)
    47,584       1,411       (87 )     48,908  
     
     
     
     
 
   
Total
  $ 509,155     $ 7,379     $ (720 )   $ 515,814  
     
     
     
     
 
Available-for-sale:
                               
 
Fannie Mae MBS(2)
  $ 9,119     $ 105     $ (27 )   $ 9,197  
 
REMICs and Stripped MBS
    1,083       211       (240 )     1,054  
 
Other mortgage-related securities(3)
    22,236       425       (12 )     22,649  
     
     
     
     
 
   
Total
  $ 32,438     $ 741     $ (279 )   $ 32,900  
     
     
     
     
 


(1)  Amortized cost includes unamortized premiums, discounts, and other deferred price adjustments.
(2)  Excludes Fannie Mae guaranteed REMICs and Stripped MBS.
(3)  Excludes Fannie Mae guaranteed securities.

Our mortgage portfolio includes mortgage-related securities backed by manufactured housing loans that were issued by entities other than Fannie Mae. In addition, to a limited extent, we acquired mortgage-related securities that were backed by manufactured housing loans and issued by entities other than Fannie Mae for securitization into REMIC securities issued and guaranteed by Fannie Mae. When we began investing in and guaranteeing manufactured housing securities, we did so with significant credit enhancements on these investments, including bond insurance and subordination. Table 16 presents the book values or notional balances of these securities at December 31, 2003 and December 31, 2002 and compares the credit ratings of the underlying securities (or for insured securities, the credit rating of the financial institution providing credit enhancement) at each date. Where ratings differ among the major rating agencies, we have used the lowest rating.

 
Table 16: Credit Ratings of Private Label Mortgage-Related Securities Secured by Manufactured Housing Loans
                                                                     
December 31, 2003 December 31, 2002


Book Value or Notional Balance(1) Book Value or Notional Balance(1)


Portfolio Guaranteed % of Portfolio Guaranteed % of
Credit ratings Securities(2) Securities(3) Total Total Securities(2) Securities(3) Total Total









(Dollars in millions)
Investment grade:
                                                               
 
AAA/Aaa
  $ 2,058     $ 90     $ 2,148       26.85 %   $ 5,938     $ 386     $ 6,324       63.01 %
 
AA+/Aa1 to AA-/Aa3
    1,259       195       1,454       18.18       2,072       98       2,170       21.62  
 
A+/A1 to A-/A3
    593       112       705       8.81       1,372       46       1,418       14.13  
 
BBB+/Baa1 to BBB-/Baa3
    2,506       15       2,521       31.51       91       33       124       1.23  
     
     
     
     
     
     
     
     
 
   
Total investment grade securities
    6,416       412       6,828       85.35       9,473       563       10,036       99.99  
Non-Investment grade:
                                                               
 
BB+/Ba1 to BB-/Ba3
    474             474       5.93                          
 
B+/B1 to B-/B3
    633       52       685       8.56       1             1       .01  
 
CCC+/Caa1 to CCC-/Caa3
          13       13       .16                          
     
     
     
     
     
     
     
     
 
   
Total non-investment grade securities
    1,107       65       1,172       14.65       1             1       .01  
     
     
     
     
     
     
     
     
 
   
Total securities
  $ 7,523     $ 477     $ 8,000       100.00 %   $ 9,474     $ 563     $ 10,037       100.00 %
     
     
     
     
     
     
     
     
 


(1)  Book value represents unpaid principal balance adjusted for unamortized premium/discounts and other-than-temporary impairment.
(2)  Amount reflects book value. These securities are included on balance sheet in Fannie Mae’s mortgage portfolio.
(3)  Amount reflects notional balance. These securities are included in outstanding MBS held by other investors. We maintain a guaranty liability for estimated losses on Fannie Mae guaranteed securities.

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We owned or guaranteed manufactured housing securities with a book value (for securities held in our portfolio) or notional amount (for REMIC securities we have guaranteed) totaling $8.0 billion at December 31, 2003, compared with $10.0 billion at December 31, 2002. The decrease in the balance from the end of 2002 resulted from $1.4 billion of principal payments and amortization of deferred price adjustments, $455 million of sales, and $155 million of other-than-temporary impairment. At December 31, 2003, approximately 70 percent of these securities were serviced by Green Tree Investment Holdings LLC (during 2003, Green Tree Investment Holdings LLC succeeded Conseco Finance, Corp. as servicer). Due to weakness in the manufactured housing sector and financial difficulties experienced by certain manufactured housing loan servicers, the major ratings agencies downgraded several of these securities in 2003 and 2002. On December 29, 2003, Moody’s Investor Service downgraded 215 classes of manufactured housing securities serviced by Green Tree Investment Holdings, reflecting their views on deteriorating collateral performance. As of December 31, 2003, $1.172 billion of non-investment grade securities held or guaranteed by Fannie Mae were affected by the December 29, 2003 downgrade action by Moody’s. The percentage of securities rated investment grade or better fell to 85 percent at December 31, 2003 as a result of credit downgrades during 2003. As a result of additional credit downgrades during the first quarter of 2004, the percentage of securities rated investment grade or better fell to 76 percent as of March 9, 2004. At the end of 2002, substantially all of these securities had investment grade ratings.

In response to the rating downgrades over the past year and general condition of the manufactured housing sector, we have regularly assessed the recoverability of scheduled principal and interest amounts on certain of these securities to determine if any were other-than-temporarily impaired. Our assessment is based on either market prices or, if the securities are illiquid, internal cash flow analyses. We model the projected cash flows of securities that have suffered a significant decline in fair value by calculating the potential underlying cash flows of the securities, incorporating issuer and pool specific loan performance data as well as information on the manufactured housing sector in general. Based on our analyses, we have recorded other-than-temporary impairment on certain securities included in our portfolio of $155 million in 2003, which is included in fee and other income. To date, we have recognized other-than-temporary impairment of $206 million on our investments in manufactured housing securities.

We continue to rigorously monitor these securities and assess appropriate risk factors to determine the need to record any additional impairment. Despite recent downgrades, the market liquidity and price performance of the manufactured housing bond sector showed signs of improvements during the last quarter of 2003. However, changes in events or circumstances, such as the performance of the underlying manufactured housing loan collateral and the financial strength of servicers, will influence future credit ratings and may affect market prices or our projected cash flow analyses. While it may be necessary to record additional other-than-temporary impairment on these securities in the future, management believes that any potential future impairment related to these securities will not have a material adverse effect on Fannie Mae’s operating results.

Mortgage Commitments

As an integral part of our Portfolio Investment business, we routinely enter into forward purchase commitments that allow us to lock in the future delivery of mortgage loans or mortgage-related securities for our mortgage portfolio at a fixed price or yield. Our purchase commitments are generally short-term in nature with a fixed expiration date. The commitment ends when the loans or securities are delivered to Fannie Mae or the commitment period expires. Retained commitments are a leading indicator of future acquisition volume and a key driver of earnings growth for our Portfolio Investment business. Although our primary goal is to purchase mortgage loans or mortgage-related securities for Fannie Mae’s portfolio, we may enter into forward commitments to purchase mortgage loans or mortgage-related securities that we decide not to retain in our portfolio. In these instances, the forward purchase commitment generally has an offsetting sell commitment with an investor other than Fannie Mae.

As a result of our July 1, 2003 adoption of FAS 149, we are required to account for the majority of our commitments to purchase mortgage loans and to purchase or sell mortgage-related securities, which we enter into in the normal course of business, as derivatives. During the commitment period, we now record

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commitments to purchase or sell mortgage loans or mortgage-related securities on our balance sheet at fair value and record changes in the fair value either in AOCI or earnings, depending on whether we apply hedge accounting, the hedge designation if we elect hedge accounting, and the applicable accounting treatment under FAS 133. When the commitment ultimately settles, we record purchased loans and securities on our balance sheet at fair value. FAS 149 applies prospectively to whole loan mortgage purchase commitments entered into or modified after June 30, 2003 and purchase and sale commitments for when-issued mortgage securities entered into after or outstanding at June 30, 2003.

We recorded an after-tax transition gain of $185 million as a result of the July 1, 2003 adoption of FAS 149. The transition gain primarily relates to recording the fair value of open portfolio purchase commitments for when-issued securities totaling $113 billion at June 30, 2003. The offset to the transition gain results in recording a fair value purchase price adjustment on our balance sheet that will amortize into future earnings as a reduction of interest income over the estimated life of the underlying mortgage securities retained in our portfolio. Subsequent to June 30, 2003, we designated and accounted for these commitments as cash flow hedges of forecasted transactions. Prior to the adoption of FAS 149, we accounted for the majority of our mortgage-related commitments as off-balance sheet arrangements and recorded purchased loans and securities on our balance sheet at settlement based on the purchase price. We disclosed the outstanding notional amount of purchase commitments retained in our portfolio. Consequently, our previous disclosure of off-balance sheet commitments does not include commitments not retained in Fannie Mae’s portfolio.

Following is a more detailed discussion of our mortgage commitment activities and the related accounting under FAS 149.

Retained Commitments

Fannie Mae typically enters into forward commitments to purchase mortgage loans or mortgage-related securities for our mortgage portfolio at a fixed price. Purchase commitments typically require mandatory delivery and are subject to the payment of pair-off fees for non-delivery. We also may sell MBS from our portfolio in various financial transactions, including forward trades. We now account for all mandatory forward purchase and sale commitments as derivatives. Forward purchase and sale commitments protect us from changes in interest rates between the time the commitment is entered into and the transaction occurs by allowing us to lock in the purchase or sale price of forecasted transactions.

Commencing July 1, 2003, we have designated these commitments as cash flow hedges to hedge the variability due to changes in interest rates of cash flows related to our forecasted mortgage portfolio transactions. Accordingly, changes in the fair value of the commitment are recorded in AOCI, to the extent effective. When we settle a purchase commitment, we record the purchase at fair value. The difference between the purchase price and fair value (“fair value purchase price adjustment”) is expected to equal the amount recorded in AOCI at settlement. We amortize the amount recorded in AOCI and the offsetting fair value purchase price adjustment into earnings as a component of interest income over the estimated life of the loans or securities. Because the amortization amounts are equal and offsetting, we do not expect any effect on our income statement. When we settle a sale commitment, we recognize the deferred AOCI amount into income as a component of the gain or loss on sale.

The notional balance of outstanding retained commitments, which are net of portfolio sell commitments, was $3 billion at December 31, 2003.

Non-Retained Commitments

Fannie Mae also buys loans or securities that we do not retain in our portfolio. The interest rate risk associated with non-retained purchase commitments is economically hedged with offsetting sale commitments. We currently do not intend to apply hedge accounting when we expect these offsetting transactions to settle at the same time. Consequently, the mark to market gains and losses on these commitments are recorded in earnings during the commitment period. Because the settlement dates, underlying securities, and amounts are offsetting, we expect the gains and losses to substantially offset and have a minimal impact on Fannie Mae’s earnings.

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In some cases, a counterparty may fulfill an MBS purchase commitment by delivering mortgage loans to us prior to the securitization. We may use the MBS created from the securitization of these loans to fulfill a forward commitment to sell MBS to a third party. We include these loans on our balance sheet under “Loans held for securitization or sale.” When this occurs, we intend to designate the forward sale commitment as a fair value hedge of the corresponding loans held for securitization and sale. Accordingly, we will record changes in the fair value of the forward sale commitment in earnings to offset changes in the fair value of the related loans. We also expect these gains and losses to largely offset with a minimal effect on our earnings.

Table 17 shows the fair value, outstanding notional amount, and average remaining contractual maturity of our outstanding mortgage commitments at December 31, 2003.

Table 17:    Mortgage Commitments

                         
December 31, 2003

Average
Remaining
Fair Notional Contractual
Value Amount Maturity



(Dollars in millions)
Forward mortgage loan and mortgage-related security purchase commitments
  $ 103     $ 18,372       24 days  
Forward mortgage-related security sell commitments
    (145 )     20,120       28  

We discuss the derivative instruments we use to manage interest rate risk and supplement our issuance of debt in “MD&A— Portfolio Investment Business Operations— Funding— Derivative Instruments” and provide additional information on all transactions accounted for as derivatives in the Notes to Financial Statements.

The primary credit risk associated with our mortgage commitment transactions is that counterparties either will not sell or purchase loans or securities to fulfill their forward commitments. We believe the credit risk related to outstanding mortgage commitments is much less than for outstanding loans or securities because commitment transactions are very short term in nature. Our lender customers account for the majority of Fannie Mae’s credit risk on commitment transactions. We control Fannie Mae’s risk of loss by subjecting our lender customers to credit reviews and assigning counterparty credit limits based on our risk assessment where appropriate. We monitor our commitment counterparties by performing quarterly credit reviews and updating trading limits based on these reviews.

Liquid Investments

Our liquid investments include cash and cash equivalents, nonmortgage investments, and loans held for securitization or sale. Liquid investments serve as Fannie Mae’s primary source of liquidity and an investment vehicle for our surplus capital. We obtain liquidity as necessary from our liquid investments through maturity of short-term investments or the sale of assets. We can use these funds as necessary for liquidity purposes or to reinvest in readily marketable, high credit quality securities that can be sold to raise cash. Our liquid investments totaled $66 billion at December 31, 2003, compared with $58 billion and $75 billion at December 31, 2002 and 2001, respectively. At the end of 2001, our liquid investments were at the highest level of the past three years because of delayed settlement of 2001 portfolio purchase commitments, which resulted in additional temporary capital for short-term investment. The average yield on liquid investments was 1.59 percent, 2.34 percent, and 4.63 percent during 2003, 2002, and 2001, respectively. The average yield decreased during 2003 and 2002 because of the sharp drop in short-term interest rates.

Nonmortgage investments, which account for the majority of our liquid investments, totaled $59 billion at December 31, 2003, $39 billion at December 31, 2002, and $66 billion at December 31, 2001. Our nonmortgage investments consist primarily of high-quality securities that are short-term or readily marketable, such as commercial paper, asset-backed securities, and corporate floating-rate notes, as well as federal funds and time deposits.

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We classify and account for our nonmortgage investments as either held-to-maturity or available-for-sale in accordance with FAS 115. Table 18 shows the composition, weighted-average maturities, and credit ratings of our held-to-maturity and available-for-sale nonmortgage investments at December 31, 2003, 2002, and 2001.

Table 18:    Nonmortgage Investments

<
                                                     
December 31, 2003

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