UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-Q

 

 

Commission File No.: 0-50231

 

Federal National Mortgage Association

(Exact name of registrant as specified in its charter)

 

Fannie Mae

 

 

Registrant’s telephone number, including area code:

(202) 752-7000

 

 

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

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

As of June 30, 2008, there were 1,076,594,797 shares of common stock outstanding.

 

 

TABLE OF CONTENTS

 

 

MD&A TABLE REFERENCE

 

PART I—FINANCIAL INFORMATION

 

 

You should read this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) in conjunction with our unaudited condensed consolidated financial statements and related notes, and the more detailed information contained in our Annual Report on Form 10-K for the year ended December 31, 2007 (“2007 Form 10-K”). The results of operations presented in our interim financial statements and discussed in MD&A are not necessarily indicative of the results that may be expected for the full year. Please refer to “Glossary of Terms Used in This Report” in our 2007 Form 10-K for an explanation of key terms used throughout this discussion.

 

Fannie Mae is a government-sponsored enterprise (“GSE”), owned by private shareholders (NYSE: FNM) and chartered by Congress to support liquidity and stability in the secondary mortgage market. Our business includes three integrated business segments—Single-Family Credit Guaranty (“Single-Family”), Housing and Community Development (“HCD”), and Capital Markets—that work together to provide services, products and solutions to our lender customers and a broad range of housing partners. Together, our business segments contribute to our chartered mission objectives, helping to increase the total amount of funds available to finance housing in the United States and to make homeownership more available and affordable for low-, moderate- and middle-income Americans. We also work with our customers and partners to increase the availability and affordability of rental housing. Although we are a corporation chartered by the U.S. Congress, the U.S. government does not guarantee, directly or indirectly, our securities or other obligations. Our business is self-sustaining and funded exclusively with private capital.

 

Our Single-Family business works with our lender customers to securitize single-family mortgage loans into Fannie Mae mortgage-backed securities (“Fannie Mae MBS”) and to facilitate the purchase of single-family mortgage loans for our mortgage portfolio. Our HCD business works with our lender customers to securitize multifamily mortgage loans into Fannie Mae MBS and to facilitate the purchase of multifamily mortgage loans for our mortgage portfolio. Our HCD business also makes debt and equity investments to increase the supply of affordable housing. Our Capital Markets group manages our investment activity in mortgage loans, mortgage-related securities and other investments, our debt financing activity, and our liquidity and capital positions. We fund our investments primarily through proceeds from our issuance of debt securities in the domestic and international capital markets.

 

The selected financial data presented below is summarized from our condensed consolidated results of operations for the three and six months ended June 30, 2008 and 2007, as well as from selected condensed consolidated balance sheet data as of June 30, 2008 and December 31, 2007. This data should be read in conjunction with this MD&A, as well as with the unaudited condensed consolidated financial statements and related notes included in this report and with our audited consolidated financial statements and related notes included in our 2007 Form 10-K.

 

 

 

 

 

 

 

Note:

 

* Average balances for purposes of the ratio calculations are based on beginning and end of period balances.

 

Our “Executive Summary” presents a high-level overview of the most significant factors focused on by our management in currently evaluating our business and financial position and prospects.

 

Conditions in the Housing and Mortgage Markets

 

The housing and mortgage markets have experienced unprecedented challenges during 2008 and those challenges have driven our financial results. The housing market downturn that began in 2006 continued through 2007 and has further deteriorated in 2008. The market continues to experience declines in new and existing home sales, mortgage originations and home prices, as well as increases in inventories of unsold homes, mortgage delinquencies, defaults and foreclosures. Growth in U.S. residential mortgage debt outstanding slowed to an estimated annual rate of 2.9% based on the first three months of 2008, compared with an estimated annual rate of 8.0% based on the first three months of 2007. We estimate that home prices declined by 0.6% on a national basis during the second quarter of 2008, which translates to an 8% total national decline since the beginning of the downturn in the second quarter of 2006. We have seen more severe declines in certain states, such as California, Florida, Nevada and Arizona, which have experienced home price declines of 24% or more since their 2006 peaks. While we continue to expect home price declines in 2008 to be within our estimated 7% to 9% range, and peak-to-trough home price declines to be within our estimated 15% to 19% range, we see the trend moving toward the high end of those ranges, driven in particular by higher home price declines in certain regions.

 

Summary of Our Financial Results for the Second Quarter of 2008

 

The challenges experienced in the housing and mortgage markets during 2008 have impacted our financial results. For the second quarter of 2008, we recorded a net loss of $2.3 billion and a diluted loss per share of $2.54, compared with a net loss of $2.2 billion and a diluted loss per share of $2.57 for the first quarter of 2008. We recorded net income of $1.9 billion and diluted earnings per share of $1.86 for the second quarter of 2007. The $114 million increase in our net loss for the second quarter of 2008 compared with the first quarter of 2008 was driven principally by credit-related expenses. During the quarter, net deferred tax assets increased by $2.8 billion from $17.8 billion at March 31, 2008 to $20.6 billion at June 30, 2008, due primarily to the increase in our combined loan loss reserves. As we have continued to serve the market, we have seen growth in our book of business and market share since December 31, 2007. Our mortgage credit book of business increased to $3.0 trillion as of June 30, 2008, up from $2.9 trillion as of December 31, 2007. Our estimated market share of new single-family mortgage-related securities issuances remains high at approximately 45.4% for the second quarter of 2008, compared with an estimated 50.1% in the first quarter, and an estimated 27.9% for the second quarter of 2007.

 

We provide a more detailed discussion of key factors affecting changes in our results of operations and financial condition in “Consolidated Results of Operations,” “Business Segment Results,” “Consolidated Balance Sheet Analysis,” “Supplemental Non-GAAP Information—Fair Value Balance Sheets,” and “Risk Management—Credit Risk Management—Mortgage Credit Risk Management—Mortgage Credit Book of Business.”

 

Market Events of July 2008

 

In mid-July, following the close of the second quarter, liquidity and trading levels in the capital markets became extremely volatile, and the functioning of the markets was disrupted. The market value of our common stock dropped rapidly, to its lowest level since October 1990, and we experienced reduced demand for our unsecured debt and MBS products. This market disruption caused a significant increase in our cost of funding and a substantial increase in mark-to-market losses on our trading securities arising from a significant widening of credit spreads. In addition, during July, credit performance continued to deteriorate, and we recorded charge-offs and foreclosed property expenses that were higher than we had experienced in any month during the second quarter and higher than we expected, driven by higher defaults and higher loan loss

severities in markets most affected by the steep home price declines. Greater credit losses in July not only reduce our July net income through our actual realized losses, but also affect us as we expect that we will need to make further increases to our combined loss reserves in the second half of 2008 to incorporate our experience in July.

 

Credit

 

As noted above, the housing and mortgage market downturn negatively impacted us in the second quarter. Our quarterly default rate increased from 12 basis points in the first quarter of 2008 to 14 basis points in the second quarter of 2008, with particular acceleration in defaults from states, such as California, Arizona, Nevada and Florida, and certain vintages (2006 and 2007) that carry a higher than average unpaid principal balance. Average initial charge-off severity has also increased, with our average initial charge-off severity rate increasing from 19% in the first quarter of 2008 to 23% in the second quarter of 2008. Increases in our default and initial charge-off severity rates are both driven primarily by losses on our Alt-A loans in markets most affected by the steep home price declines. The deterioration in the credit performance of our higher risk loans is especially pronounced in our Alt-A mortgage book, with particular pressure on loans with layered risk, such as loans with subordinate financing and interest-only payment terms. As of June 30, 2008, our Alt-A mortgage loans represented approximately 11% of our total single-family mortgage credit book of business, and accounted for 49% of our credit losses for the second quarter of 2008.

 

Because we use our most recent actual experience to make projections, we are incorporating the July events described above into our current forecasts. In light of our experience during the second quarter and our credit performance in July, we are increasing our forecast for our credit loss ratio (which excludes SOP 03-3 and HomeSaver Advance^tm fair value losses) to 23 to 26 basis points for 2008, as compared with our previous guidance of 13 to 17 basis points. We continue to anticipate that our credit loss ratio will increase further in 2009 compared with 2008. We also expect significant additions to our combined loss reserves through the remainder of 2008. Finally, while we expect that 2008 will be our peak year for credit-related expenses as we build our combined loss reserves in anticipation of charge-offs we expect to incur in 2009 and 2010, the total amount of credit-related expenses will be significant in 2009.

 

One significant offset to credit-related expenses is the revenue we earn. We have two main sources of revenue: the guaranty fee income we generate over time from our existing guaranty book of business and from new guaranty business, and the net interest income we earn on the assets we hold in our portfolio. We generated $7.7 billion of revenue in the first half of 2008 and expect to generate revenues in the second half of the year similar to those generated in the first half of the year.

 

In light of continued deterioration in credit performance, we have been, and are continuing, to take steps designed to mitigate our credit losses. During the second quarter, we took a variety of steps to address credit losses using a variety of tools.

 

 

 

In addition to these specific activities, we are continuing to develop strategies designed to mitigate the increase in our credit losses. We have formed a multi-disciplinary team in credit risk, operations and financial management devoted to supporting loss mitigation and foreclosure prevention and have significantly increased the level of internal management and staff resources engaged in that effort.

 

For a further description of our credit risk management, refer to “Consolidated Results of Operations—Credit-Related Expenses” and “Risk Management—Credit Risk Management—Mortgage Credit Risk Management.”

 

Capital

 

As noted above, the market conditions that we experienced during the second quarter were more negative than we anticipated, and that trend accelerated in July. Our core capital as of June 30, 2008 was $47.0 billion, $14.3 billion above our statutory minimum capital requirement and $9.4 billion above our regulator-directed 15% surplus requirement. We currently expect that we will remain above our regulatory capital requirement for the remainder of 2008. (Our “regulatory capital requirement” is equal to our statutory minimum capital requirement plus any additional surplus above that statutory minimum that we expect our regulator will require us to hold.) Due to the volatile market conditions, we now have less visibility into our capital position in 2009. We currently have internally prepared scenarios, derived from our own statistical models and management’s judgment, that indicate that we will remain above our regulatory capital requirement through 2009, and others that show that we may not. There are a variety of current uncertainties that make estimates for 2009 challenging, including:

 

For more information regarding risks to our business that may impact performance and capital levels, refer to “Part II—Item 1A—Risk Factors.”

 

Our capital position, and whether we are classified as “adequately capitalized” for regulatory purposes, also depends on the level of capital we are required to hold by our regulator. In May 2008, the Office of Federal Housing Enterprise Oversight (“OFHEO”) indicated its intention to reduce our capital surplus requirement by five percentage points to a 10% surplus requirement in September 2008, based upon our continued maintenance of excess capital well above OFHEO’s regulatory requirement and no material adverse change to our ongoing regulatory compliance. Under the recently enacted Federal Housing Finance Regulatory Reform Act of 2008 (the “Regulatory Reform Act”), our new regulator, the Federal Housing Finance Authority (“FHFA”), has new authority to increase our regulatory capital requirement pursuant to a formal rulemaking process and consultation with the Chairman of the Board of Governors of the Federal Reserve System, but we do not yet know what those capital levels will be. In addition, OFHEO has recently finalized rules modifying our regulatory risk-based capital stress test which will be applied beginning with the third quarter of 2008. The uncertainties that make 2009 estimates challenging also impact the calculation of this requirement, adding additional uncertainty to the regulatory requirements for capital. We are in ongoing dialogue with our regulator regarding our capital position. For more information regarding our regulatory capital requirements, including the newly finalized risk-based capital requirements, refer to “Liquidity and Capital Management—Capital Management—Regulatory Capital Requirements.”

 

In light of volatile market conditions, it is critical that we manage our capital levels to maintain a capital cushion well in excess of our regulatory capital requirement. To that end, we use strategies designed to preserve and protect our capital. In addition, we may, from time to time, raise capital opportunistically. Management continues to carefully monitor our capital and dividend positions and the trends impacting those positions and, if necessary, intends to take actions designed to help mitigate the impacts of a worsening environment on those positions. In this environment, conditions that negatively impact capital can develop rapidly and are based on a variety of factors. Therefore, we may need to take action quickly to respond.

 

We have already begun to take some of those actions. Today, the Board of Directors announced that the company is decreasing the dividend on our common stock to five cents per share. On August 4, 2008, we announced an increase in our guaranty fee pricing on new acquisitions commensurate with the risks in the current market. We are also prudently managing the size of our balance sheet. Finally, we are evaluating our costs and expenses and expect to reduce ongoing operating costs by 10% by year end 2009. Additional steps we could take include: reducing or eliminating our dividends; slowing growth; decreasing the size of the balance sheet; further raising guaranty fees; and raising additional capital (which could be dilutive). Some of these actions could have negative consequences, including decreased revenue due to growth limitations, or increased mark-to-market charges associated with the decreased liquidity for mortgage assets that could arise from a reduction in our market activity. If our capital fails to meet standards set by our regulator, our regulator could require us to enter into a capital restoration plan or take other actions. As discussed below, the U.S. Treasury is authorized to buy Fannie Mae’s debt, equity and other securities, subject to our agreement.

 

For more information regarding our capital management, including our recent capital raises, refer to “Liquidity and Capital Management—Capital Management—Capital Activity—Capital Management Actions.” For more information regarding our capital measures, refer to “Notes to the Condensed Consolidated Financial Statements—Note 15, Regulatory Capital Requirements.”

 

Legislative and Regulatory Actions

 

On July 30, 2008, President Bush signed into law the Housing and Economic Recovery Act of 2008 that included GSE regulatory reform legislation. The legislation, which is described in more detail in “Legislation Relating to Our Regulatory Framework,” establishes FHFA as our new safety, soundness and mission regulator, replacing OFHEO and the U.S. Department of Housing and Urban Development (“HUD”) for this purpose.

 

In general, the legislation strengthens the existing safety and soundness oversight of the GSEs, providing FHFA with safety and soundness authority that is comparable to and in some respects broader than that of the

federal bank regulatory agencies. For example, FHFA will have enhanced powers to raise capital levels above statutory minimum levels, to regulate the size and content of our portfolio, and to approve new mortgage products. The legislation also increases the financial and administrative cost of our affordable housing mission.

 

In addition, the legislation includes provisions that were initially proposed by Treasury Secretary Henry Paulson, Jr. on July 13, 2008. These provisions:

 

 

Both provisions lapse at the end of 2009.

 

For a further description of the new legislation, including a discussion of its potential impact on us, refer to “Legislation Relating To Our Regulatory Framework” and “Part II—Item 1A—Risk Factors.”

 

The Regulatory Reform Act was signed into law by President Bush on July 30, 2008, and became effective immediately. The legislation establishes FHFA as an independent agency with general supervisory and regulatory authority over Fannie Mae, Freddie Mac, and the 12 Federal Home Loan Banks. FHFA assumes the duties of our former regulators, OFHEO and HUD, with respect to safety, soundness and mission oversight of Fannie Mae and Freddie Mac. We expect that our new regulator will implement the various provisions of the legislation over the next several months, generally though rulemaking. In general, we remain subject to existing regulations, orders and determinations until new ones are issued or made. Refer to “Item 1. Business—Our Charter and Regulation of Our Activities” in our 2007 Form 10-K for a description of our regulation prior to enactment of this legislation.

 

Safety and Soundness Provisions

 

Capital.  The legislation provides significant new authority to FHFA with respect to our risk-based and minimum capital requirements. FHFA has broad authority to establish risk-based capital standards for us and Freddie Mac to ensure that we operate in a safe and sound manner and maintain sufficient capital and reserves. FHFA also has broad authority to increase the level of our required minimum capital and to establish capital or reserve requirements for specific products and activities, so as to ensure that we operate in a safe and sound manner.

 

Portfolio.  The legislation requires FHFA to establish standards governing our portfolio holdings, to ensure that they are backed by sufficient capital and consistent with our mission and safe and sound operations. The legislation further requires FHFA to monitor our portfolio and, in some circumstances, authorizes FHFA to require us to dispose of or acquire assets.

 

Prudential Standards.  The legislation requires FHFA to establish prudential management and operations standards, including standards for internal controls, risk management, and investments and acquisitions.

 

Prompt Corrective Action.  The legislation strengthens FHFA’s prompt corrective action authority, including its discretionary authority to change our capital classification under certain circumstances and to restrict our growth and activities if we are not adequately capitalized.

 

Conservatorship and Receivership.  The legislation provides FHFA new authority to place us into receivership, and enhanced authority to place us into conservatorship, based on certain specified grounds. Further, FHFA must place us into receivership if it determines that our debts have exceeded our assets for 60 days, or we have not been paying our debts as they become due for 60 days.

Enforcement Powers.  The legislation provides FHFA with enhanced enforcement powers, including greater cease-and-desist authority and increased civil monetary penalties, and new authority to suspend or remove directors and management.

 

Mission Provisions

 

Products and Activities.  The legislation requires us, with some exceptions, to obtain the approval of FHFA before we initially offer a product. The process for obtaining FHFA’s approval includes a 30-day public notice and comment period relating to the product. A product may be approved only if it is authorized by our charter, in the public interest, and consistent with the safety and soundness of the enterprise and the mortgage finance system. We must provide written notice to FHFA before commencing any new activity.

 

Affordable Housing Allocations.  The legislation requires us and Freddie Mac to make annual allocations to fund government affordable housing programs, based on the dollar amount of our total new business purchases, at the rate of 4.2 basis points per dollar. If this requirement had been in effect in 2007, our contribution for that year would have been approximately $300 million. For the first three years, a diminishing portion (100%, 50%, 25%) of our allocation will be used to pay for the Federal Housing Administration’s (“FHA”) HOPE for Homeowners Program. The legislation requires FHFA to temporarily suspend our allocation upon finding that it: is contributing or would contribute to our financial instability; is causing or would cause us to be classified as undercapitalized; or is preventing or would prevent us from successfully completing a capital restoration plan. FHFA must issue regulations prohibiting us from redirecting the cost of our allocations, through increased charges or fees, or decreased premiums, or in any other manner, to the originators of mortgages that we purchase or securitize.

 

Affordable Housing Goals and Duty to Serve.  The legislation restructures our affordable housing goals and creates a new duty for us and Freddie Mac to serve three underserved markets—manufactured housing, affordable housing preservation, and rural housing. With respect to these markets, we are required to “provide leadership to the market in developing loan products and flexible underwriting guidelines to facilitate a secondary market for mortgages for very low-, low-, and moderate-income families.” Both the restructured goals and the new duty to serve take effect in 2010. The legislation provides that the housing goals established by HUD for 2008 will remain in effect for 2009, except that by April 2009, FHFA must review the 2009 goals to determine their feasibility given the market conditions current at such time and, after seeking public comment for up to 30 days, FHFA may make appropriate adjustments to the 2009 goals consistent with such market conditions.

 

Temporary Provisions

 

Enhanced Authority of U.S. Treasury to Purchase GSE Securities.  The Secretary of the Treasury has long had authority to purchase up to $2.25 billion in our obligations. The legislation provides the Secretary of the Treasury with additional temporary authority to purchase our obligations and other securities on terms that the Secretary may determine, subject to our agreement. This expanded authority expires on December 31, 2009. To exercise this authority, the Secretary must determine that such a purchase is necessary to provide stability to the financial markets, prevent disruptions in the availability of mortgage finance, and protect taxpayers. In connection with exercising this authority, the Secretary must consider: the need for preferences or priorities regarding payments to the government; limits on maturity or disposition of obligations or securities to be purchased; the company’s plan for orderly resumption of private market funding or capital market access; the probability of our fulfilling the terms of the obligations or other securities, including repayment; the need to maintain our status as a private shareholder-owned company; and restrictions on the use of our resources, including limitations on the payment of dividends and executive compensation.

 

Consultation with the Federal Reserve.  Until December 31, 2009, our regulator must consult with the Chairman of the Board of Governors of the Federal Reserve on risks posed by the GSEs to the financial system before taking certain regulatory actions such as issuance of regulations regarding capital or portfolio, or appointment of a conservator or receiver.

Other Provisions

 

Conforming Loan Limits.  The legislation permanently increases our conforming loan limit in high cost areas, to the lower of 115% of the median home price for comparable properties in the area, or 150% of the otherwise applicable loan limit (currently $625,500). This provision takes effect on January 1, 2009, upon expiration of the loan limit provisions contained in the Economic Stimulus Act of 2008.

 

SEC Registration.  The legislation provides that no class of equity securities of Fannie Mae or Freddie Mac shall be treated as exempted securities for purposes of section 12, 13, 14, or 16 of the Securities Exchange Act of 1934. (Fannie Mae voluntarily registered its common stock with the U.S. Securities and Exchange Commission (“SEC”) on March 31, 2003. We registered our preferred stock on July 29, 2008, in accordance with the legislation.)

 

Executive Compensation.  FHFA may at any time review the reasonableness of executive compensation, and may prohibit payment to the officer during such review. In addition, FHFA is authorized to prohibit or limit certain golden parachute and indemnification payments to directors, officers, and certain other parties. Until December 31, 2009, FHFA shall have the power to approve, disapprove or modify executive compensation.

 

Board of Directors.  The legislation eliminates the five presidential appointees from our board of directors, and provides that our board shall consist of 13 persons elected by the shareholders, or such other number as the Director of FHFA determines appropriate. The legislation leaves in place the requirement that our board shall at all times have as members at least one person from the homebuilding, mortgage lending, and real estate industries, and at least one person from an organization representing consumer or community interests or one person who has demonstrated a career commitment to the provision of housing for low-income households.

 

For a description of how this GSE regulatory reform legislation could materially adversely affect our business and earnings, see “Part II—Item 1A—Risk Factors” of this report.

 

The preparation of financial statements in accordance with generally accepted accounting principles (“GAAP”) requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the consolidated financial statements. Understanding our accounting policies and the extent to which we use management judgment and estimates in applying these policies is integral to understanding our financial statements. We have identified the following as our most critical accounting policies and estimates:

 

 

We describe below significant changes in the judgments and assumptions we made during the first six months of 2008 in applying our critical accounting policies and estimates. Also see “Part II—Item 7—MD&A—Critical Accounting Policies and Estimates” of our 2007 Form 10-K for additional information about our critical accounting policies and estimates.

 

Fair Value of Financial Instruments

 

We adopted SFAS No. 157, Fair Value Measurements (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value and outlines a fair value hierarchy based on the inputs to valuation techniques used to measure fair value, effective January 1, 2008. SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (also referred to as an exit price). SFAS 157 categorizes fair value measurements into a three-level hierarchy based on the extent to which the measurement relies on observable

market inputs in measuring fair value. Level 1, which is the highest priority in the fair value hierarchy, is based on unadjusted quoted prices in active markets for identical assets or liabilities. Level 2 is based on observable market-based inputs, other than quoted prices, in active markets for identical assets or liabilities. Level 3, which is the lowest priority in the fair value hierarchy, is based on unobservable inputs. Assets and liabilities are classified within this hierarchy in their entirety based on the lowest level of any input that is significant to the fair value measurement.

 

The use of fair value to measure our financial instruments is fundamental to our financial statements and is a critical accounting estimate because a substantial portion of our assets and liabilities are recorded at estimated fair value. The majority of our financial instruments carried at fair value fall within the level 2 category and are valued primarily utilizing inputs and assumptions that are observable in the marketplace, can be derived from observable market data or corroborated by observable levels at which transactions are executed in the marketplace. Because items classified as level 3 are generally based on unobservable inputs, the process to determine fair value is generally more subjective and involves a high degree of management judgment and assumptions. These assumptions may have a significant effect on our estimates of fair value, and the use of different assumptions as well as changes in market conditions could have a material effect on our results of operations or financial condition. We provide additional information regarding our level 3 assets below.

 

Fair Value Hierarchy—Level 3 Assets

 

Level 3 is primarily comprised of financial instruments whose fair value is estimated based on valuation methodologies utilizing significant inputs and assumptions that are generally less observable because of limited market activity or little or no price transparency. We typically classify financial instruments as level 3 if the valuation is based on inputs from a single source, such as a dealer quotation, where we are not able to corroborate the inputs and assumptions with other available, relevant market information. Our level 3 financial instruments include certain mortgage- and asset-backed securities and residual interests, certain performing residential mortgage loans, non-performing mortgage-related assets, our guaranty assets and buy-ups, our master servicing assets and certain highly structured, complex derivative instruments.

 

Some of our financial instruments, such as our trading and available-for-sale (“AFS”) securities and our derivatives, are measured at fair value on a recurring basis in periods subsequent to initial recognition. We measure some of our other financial instruments at fair value on a non-recurring basis in periods subsequent to initial recognition, such as held-for-sale mortgage loans. Table 1 presents, by balance sheet category, the amount of financial assets carried in our condensed consolidated balance sheets at fair value on a recurring basis and classified as level 3 as of June 30, 2008. We also identify the types of financial instruments within each asset category that are based on level 3 measurements and describe the valuation techniques used for determining the fair value of these financial instruments. The availability of observable market inputs to measure fair value varies based on changes in market conditions, such as liquidity. As a result, we expect the financial instruments carried at fair value on a recurring basis and classified as level 3 to vary each period.

 

 

Level 3 recurring assets totaled $56.6 billion, or 6% of our total assets, as of June 30, 2008, compared with 7% of our total assets as of March 31, 2008. The balance of level 3 recurring assets increased by $451 million and $15.3 billion for the second quarter and first six months of 2008, respectively. These level 3 balance increases were principally driven by an increase in the portion of mortgage assets for which there is a lack of market liquidity and limited availability of external pricing data, resulting in transfers of these assets from level 2 to level 3. These transfers reflect the ongoing effects of the significant disruption in the mortgage market and severe reduction in market liquidity for certain mortgage products, such as private-label mortgage-related securities backed by Alt-A loans or subprime loans. Because of the reduction in recently executed transactions and market price quotations for these instruments, the market inputs for these instruments are less observable.

Financial assets measured at fair value on a non-recurring basis and classified as level 3, which are not presented in the table above, include held-for-sale (“HFS”) loans that are measured at lower of cost or market and that were written down to fair value as of the end of the period. The fair value of these loans totaled $812 million as of June 30, 2008. In addition, certain financial assets measured at cost that have been written down to fair value during the period due to impairment are classified as non-recurring. The fair value of these level 3 non-recurring financial assets, which primarily consisted of certain guaranty assets and acquired property, totaled $8.2 billion as of June 30, 2008. Financial liabilities measured at fair value on a recurring basis and classified as level 3 as of June 30, 2008 consisted of long-term debt with a fair value of $3.3 billion and derivatives liabilities with a fair value of $107 million. See “Notes to Condensed Consolidated Financial Statements—Note 17, Fair Value of Financial Instruments” for further information regarding SFAS 157, including the classification within the three-level hierarchy of all of our assets and liabilities carried in our condensed consolidated balance sheet at fair value as of June 30, 2008.

 

Fair Value Control Processes

 

We employ control processes to validate the fair value of our financial instruments. These control processes are designed to ensure that the values used for financial reporting are based on observable inputs wherever possible. If observable market-based inputs are not available, the control processes are designed to ensure that the valuation approach used is appropriate and consistently applied and that the assumptions are reasonable. Our control processes provide for segregation of duties and oversight of our fair value methodologies and valuations by our Valuation Oversight Committee. Valuations are performed by personnel independent of our business units. A price verification group reviews selected valuations and compares the valuations to alternative external market data (e.g., quoted market prices, broker or dealer quotations, pricing services, recent trading activity and comparative analyses to similar instruments) for reasonableness. The price verification group also performs independent reviews of the assumptions used in determining the fair value of products with material estimation risk for which observable market-based inputs do not exist. Valuation models are regularly reviewed and approved for use for specific products by the Chief Risk Office, which also is independent from our business units. Any changes to the valuation methodology or pricing are reviewed by the Valuation Oversight Committee to confirm the changes are appropriate.

 

We continue to refine our valuation methodologies as markets and products develop and the pricing for certain products becomes more or less transparent. While we believe our valuation methods are appropriate and consistent with those of other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a materially different estimate of fair value as of the reporting date.

 

Change in Measuring the Fair Value of Guaranty Obligations

 

Beginning January 1, 2008, as part of the implementation of SFAS 157, we changed our approach to measuring the fair value of our guaranty obligations. Specifically, we adopted a measurement approach that is based upon an estimate of the compensation that we would require to issue the same guaranty in a standalone arm’s-length transaction with an unrelated party. When we initially recognize a guaranty issued in a lender swap transaction after December 31, 2007, we measure the fair value of the guaranty obligation based on the fair value of the total compensation we receive, which primarily consists of the guaranty fee, credit enhancements, buy-downs, risk-based price adjustments and our right to receive interest income during the float period in excess of the amount required to compensate us for master servicing. Because the fair value of those guaranty obligations now equals the fair value of the total compensation we receive, we do not recognize losses or record deferred profit in our financial statements at inception of those guaranty contracts issued after December 31, 2007.

 

We also changed how we measure the fair value of our existing guaranty obligations, as disclosed in “Supplemental Non-GAAP Information—Fair Value Balance Sheets” and in “Notes to Condensed Consolidated Financial Statements,” to be consistent with our new approach for measuring guaranty obligations at initial recognition. The fair value of all guaranty obligations measured after their initial recognition represents our estimate of a hypothetical transaction price we would receive if we were to issue

our guarantees to an unrelated party in a standalone arm’s-length transaction at the measurement date. To measure this fair value, we continue to use the models and inputs that we used prior to our adoption of SFAS 157 and calibrate those models to our current market pricing.

 

Prior to January 1, 2008, we measured the fair value of the guaranty obligations that we recorded when we issued Fannie Mae MBS based on market information obtained from spot transaction prices. In the absence of spot transaction data, which was the case for the substantial majority of our guarantees, we used internal models to estimate the fair value of our guaranty obligations. We reviewed the reasonableness of the results of our models by comparing those results with available market information. Key inputs and assumptions used in our models included the amount of compensation required to cover estimated default costs, including estimated unrecoverable principal and interest that we expected to incur over the life of the underlying mortgage loans backing our Fannie Mae MBS, estimated foreclosure-related costs, estimated administrative and other costs related to our guaranty, and an estimated market risk premium, or profit, that a market participant of similar credit standing would require to assume the obligation. If our modeled estimate of the fair value of the guaranty obligation was more or less than the fair value of the total compensation received, we recognized a loss or recorded deferred profit, respectively, at inception of the guaranty contract. See “Part II—Item 7—MD&A—Critical Accounting Policies and Estimates—Fair Value of Guaranty Assets and Guaranty Obligations—Effect on Losses on Certain Guaranty Contracts” of our 2007 Form 10-K for additional information.

 

The accounting for our guarantees in our condensed consolidated financial statements is unchanged with our adoption of SFAS 157. Accordingly, the guaranty obligation amounts recorded in our condensed consolidated balance sheets attributable to guarantees issued prior to January 1, 2008 will continue to be amortized in accordance with our established accounting policy. This change, however, affects how we determine the fair value of our existing guaranty obligations as of each balance sheet date. See “Supplemental Non-GAAP Information—Fair Value Balance Sheets” and “Notes to Condensed Consolidated Financial Statements” for additional information regarding the impact of this change.

 

Deferred Tax Assets

 

We recognize deferred tax assets and liabilities for the future tax consequences related to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and for tax credits. Our net deferred tax assets totaled $20.6 billion and $13.0 billion as of June 30, 2008 and December 31, 2007, respectively. We evaluate our deferred tax assets for recoverability based on available evidence, including assumptions about future profitability. We are required to establish a valuation allowance for deferred tax assets and record a charge to income if we determine, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. Such a charge likely would have a material adverse effect on our results of operations, financial condition and capital position. In evaluating the need for a valuation allowance, we estimate future taxable income based on management approved business plans and ongoing tax planning strategies. This process involves significant management judgment about assumptions that are subject to change from period to period based on changes in tax laws or variances between our future projected operating performance and our actual results. Accordingly, we have included the assessment of a deferred tax asset valuation allowance as a critical accounting policy.

 

We are in a cumulative book taxable loss position as of the three-year period ended June 30, 2008. The realization of our deferred tax assets is dependent upon the generation of sufficient future taxable income. For purposes of establishing a deferred tax valuation allowance, this cumulative book taxable loss position is considered significant, objective evidence that we may not be able to realize some portion of our deferred tax assets in the future. In assessing the nature of our cumulative book taxable loss position, we evaluated the factors contributing to these losses and analyzed whether these factors were temporary or indicative of a permanent decline in our earnings. We determined that our current cumulative book taxable loss position was caused primarily by an increase in our credit losses due to the current housing and credit market conditions. Prior to 2007, we had generated pre-tax book income for over 20 consecutive years. Based on our forecasts of future taxable income, which include assumptions about the depth and severity of home price depreciation and credit losses, we anticipate that it is more likely than not that our results of future operations will generate sufficient taxable income to allow us to realize our deferred tax assets. Therefore, we did not record a valuation allowance against our net deferred tax assets as of June 30, 2008 or December 31, 2007.

Although current market conditions have created significant volatility in our pre-tax book income, our current forecasts of future taxable income reflect sufficient taxable income in future periods to realize our deferred tax assets based on the nature of our book-to-tax differences and the stability of our core business model. Included in our forecasts are credit assumptions regarding our estimate of future expected credit losses, which we believe is the most variable component of our current forecasts of future taxable income. If future events differ from our current forecasts, a valuation allowance may need to be established, which likely would have a material adverse effect on our results of operations, financial condition and capital position. We will continue to update our assumptions and forecasts of future taxable income and assess the need for a valuation allowance.

 

We provide additional detail on the components of our deferred tax assets and deferred tax liabilities as of December 31, 2007 in our 2007 Form 10-K in “Notes to Consolidated Financial Statements—Note 11, Income Taxes” and we provide information on the increase in our deferred tax assets since December 31, 2007 in “Notes to Condensed Consolidated Financial Statements—Note 10, Income Taxes” of this report.

 

The following discussion of our condensed consolidated results of operations is based on a comparison of our results between the three and six months ended June 30, 2008 and the three and six months ended June 30, 2007. Table 2 presents a summary of our unaudited condensed consolidated results of operations for each of these periods.

 

 

 

 

 

Our business generates revenues from four principal sources: net interest income, guaranty fee income, trust management income, and fee and other income. Other significant factors affecting our results of operations include: fair value gains and losses; the timing and size of investment gains and losses; credit-related expenses; losses from partnership investments; administrative expenses and our effective tax rate. We provide a comparative discussion of the effect of our principal revenue sources and other significant items on our condensed consolidated results of operations for the three and six months ended June 30, 2008 and 2007 below.

 

Net Interest Income

 

Table 3 presents an analysis of our net interest income and net interest yield for the three and six months ended June 30, 2008 and 2007.

 

 

 

 

Table 4 presents the total variance, or change, in our taxable-equivalent net interest income between the three and six months ended June 30, 2008 and 2007, and the extent to which that variance is attributable to (1) changes in the volume of our interest-earning assets and interest-bearing liabilities or (2) changes in the interest rates of these assets and liabilities.

 

 

 

 

Taxable-equivalent net interest income of $2.1 billion for the second quarter of 2008 increased by 67% from the second quarter of 2007, driven by a 63% (40 basis points) expansion of our taxable-equivalent net interest yield to 1.04% and a 2% increase in our average interest-earning assets. Taxable-equivalent net interest income of $3.9 billion for the first six months of 2008 increased by 52% from the first six months of 2007, driven by a 48% (31 basis points) expansion of our taxable-equivalent net interest yield to 0.95% and a 3% increase in our average interest-earning assets.

 

The increase in our taxable-equivalent net interest income and net interest yield for the second quarter and first six months of 2008 was mainly driven by the reduction in short-term borrowing rates, which reduced the average cost of our debt, and wider mortgage-to-debt spreads on acquisitions. Also contributing to the lower cost of funds was the redemption of step-rate debt securities, which provided an annualized benefit to our net interest yield of approximately 4 basis points and 11 basis points for the second quarter and first six months of 2008, respectively. Instead of having a fixed coupon for the life of the security, step-rate debt securities allow for the interest rate to increase at predetermined rates according to a specified schedule, resulting in increased interest payments. However, the interest expense on step-rate debt securities is recognized at a constant effective rate over the term of the security. Because we redeemed these securities prior to maturity, we reversed a portion of the interest expense that we had previously accrued.

The increase in our average interest-earning assets for the second quarter and first six months of 2008 was attributable to an increase in our portfolio purchases during the first six months of 2008, particularly in the second quarter of 2008, as mortgage-to-debt spreads reached historic highs. OFHEO’s reduction in our capital surplus requirement provided us with more flexibility to take advantage of opportunities to purchase mortgage assets at attractive prices and spreads.

 

Although we consider the periodic net contractual interest accruals on our interest rate swaps to be part of the cost of funding our mortgage investments, these amounts are not reflected in our taxable-equivalent net interest income and net interest yield. Instead, the net contractual interest accruals on our interest rate swaps are reflected in our condensed consolidated statements of operations as a component of “Fair value gains (losses), net.” As indicated in Table 8 below, we recorded net contractual interest expense on our interest rate swaps totaling $304 million and $330 million for the three and six months ended June 30, 2008, respectively, which had the economic effect of increasing our funding costs by approximately 15 basis points and 8 basis points for the three and six months ended June 30, 2008, respectively. We recorded net contractual interest income on our interest rate swaps of $64 million and $98 million for the three and six months ended June 30, 2007, respectively, which had the economic effect of reducing our funding costs by approximately 3 basis points for each period.

 

During July 2008, our cost of short-term funding as compared with the London Interbank Offered Rate (“LIBOR”) was less favorable than it was during the second quarter of 2008, which could result in a taxable equivalent net interest yield that is flat or lower for the remainder of 2008 depending on future market conditions. Our taxable-equivalent net interest yield may be offset, as it was during the second quarter of 2008, by accrual of higher payments on our net pay-fixed swap positions due to low short-term LIBOR rates.

Guaranty Fee Income

 

Table 5 shows the components of our guaranty fee income, our average effective guaranty fee rate, and Fannie Mae MBS activity for the three and six months ended June 30, 2008 and 2007.

 

 

 

 

 

The 44% increase in guaranty fee income for the second quarter of 2008 over the second quarter of 2007 resulted from a 17% increase in average outstanding Fannie Mae MBS and other guarantees, and a 22% increase in the average effective guaranty fee rate to 26.3 basis points from 21.5 basis points. The 51% increase in guaranty fee income for the first six months of 2008 over the first six months of 2007 resulted from a 17% increase in average outstanding Fannie Mae MBS and other guarantees, and a 29% increase in the average effective guaranty fee rate to 27.9 basis points from 21.6 basis points.

 

The increase in average outstanding Fannie Mae MBS and other guarantees for the second quarter and first six months of 2008 reflected the significant growth in our market share of mortgage-related securities issuances, due in large part to the disruption in the credit and mortgage markets and dramatic shift in market dynamics, including a significant reduction in the issuances of private-label mortgage-related securities.

 

The increase in our average effective guaranty fee rate in the second quarter and first six months of 2008 was driven primarily by the accelerated recognition of deferred amounts into income as interest rates were lower in the second quarter and first six months of 2008, relative to the level of interest rates during the comparable prior year periods. Our guaranty fee income also includes accretion of deferred amounts on guaranty contracts where we recognized losses at the inception of the contract, which totaled an estimated $127 million and $424 million for the three and six months ended June 30, 2008, compared with $91 million and $183 million for the three and six months ended June 30, 2007. See “Part II—Item 7—MD&A—Critical Accounting Policies and Estimates” of our 2007 Form 10-K for additional information on our accounting for these losses and the impact on our financial statements.

 

The increase in our average effective guaranty fee rate was also affected by guaranty fee pricing changes that we believe enable us to more accurately price for the current risks in the housing market. These pricing changes include an adverse market delivery charge of 25 basis points for all loans delivered to us, which became effective March 1, 2008. The impact of our guaranty fee pricing changes was partially offset by a shift in the composition of our guaranty book of business to a greater proportion of higher-quality, lower risk and lower guaranty fee mortgages, as we reduced our acquisitions of higher risk, higher fee product categories, such as Alt-A loans. Our average charged guaranty fee on new single-family business was 28.0 basis points and 26.9 basis points for the second quarter and first six months of 2008, respectively, compared with 28.2 basis points and 27.1 basis points for the second quarter and first six months of 2007, respectively. The average charged guaranty fee on our new single-family business represents the average contractual fee rate for our single-family guaranty arrangements and the recognition of any upfront cash payments ratably over an estimated life of four years.

 

We expect the changes in our risk assessment and eligibility criteria to continue to enhance the risk profile of our new business. We also believe that our single-family guaranty book of business will continue to grow in 2008 and 2009 at a faster rate than the overall growth in U.S. single-family mortgage debt outstanding. We recently announced new pricing changes for loans delivered to us effective October 1, 2008. The new pricing changes increase our adverse market delivery charge to 50 basis points from 25 basis points and update our standard pricing adjustments for mortgage loans with certain risk characteristics. We believe that our guaranty fee income will grow in 2008 compared with 2007 due to an increase in our guaranty business volumes and prices in 2008 compared with 2007.

 

Trust Management Income

 

Trust management income decreased to $75 million and $182 million for the second quarter and first six months of 2008, respectively, from $150 million and $314 million for the second quarter and first six months of 2007, respectively. The decrease during each period was attributable to significantly lower short-term interest rates during the first six months of 2008 relative to the first six months of 2007, which reduced the amount of float income derived from the cash flows between the date of remittance of mortgage and other payments to us by servicers and the date of distribution of these payments to MBS certificateholders.

Fee and Other Income

 

Fee and other income decreased to $225 million and $452 million for the second quarter and first six months of 2008, respectively, from $257 million and $534 million for the second quarter and first six months of 2007, respectively. The decrease during each period was primarily attributable to lower multifamily fees due to a reduction in multifamily loan liquidations for the first six months of 2008.

 

Losses on Certain Guaranty Contracts

 

Effective January 1, 2008 with our adoption of SFAS 157, we no longer recognize losses or record deferred profit in our consolidated financial statements at inception of our guaranty contracts for MBS issued subsequent to December 31, 2007 because the estimated fair value of the guaranty obligation at inception now equals the estimated fair value of the total compensation received. For further discussion of this change, see “Critical Accounting Policies and Estimates—Fair Value of Financial Instruments—Change in Measuring the Fair Value of Guaranty Obligations” and “Notes to Condensed Consolidated Financial Statements—Note 1, Summary of Significant Accounting Policies.” We recorded losses on certain guaranty contracts totaling $461 million and $744 million for the three and six months ended June 30, 2007, respectively. These losses reflected the increase in the estimated market risk premium that a market participant would require to assume our guaranty obligations due to the decline in home prices and deterioration in credit conditions.

 

Investment Gains (Losses), Net

 

We summarize the components of investment gains (losses), net for the three and six months ended June 30, 2008 and 2007 below in Table 6 and discuss significant changes in these components between periods.

 

 

 

The increase in investment losses for the second quarter and first six months of 2008 over the second quarter and first six months of 2007 was primarily attributable to the following:

 

 

Fair Value Gains (Losses), Net

 

Beginning in mid-April 2008, we implemented fair value hedge accounting with respect to a portion of our derivatives to hedge, for accounting purposes, the interest rate risk related to some of our mortgage assets. Under fair value hedge accounting, we offset the fair value gains or losses on some of our derivative instruments against the corresponding fair value losses or gains attributable to changes in interest rates on the specific hedged mortgage assets. Although our implementation of hedge accounting does not affect our exposure to volatility in our financial results that is attributable to changes in spreads on the fair value of securities designated as trading, we believe this hedging strategy will reduce the level of volatility in our earnings, attributable to changes in interest rates, for our interest rate risk management derivatives. In addition, we generally expect that gains and losses on our trading securities, to the extent they are attributable to changes in interest rates, will offset a portion of the losses and gains on our derivatives because changes in the fair value of our trading securities typically move inversely to changes in the fair value of our derivatives. We also seek to eliminate our exposure to fluctuations in foreign exchange rates by entering into foreign currency swaps that effectively convert debt denominated in a foreign currency to debt denominated in U.S. dollars. The foreign currency exchange gains and losses on our foreign-denominated debt are offset in part by corresponding losses and gains on foreign currency swaps.

 

Table 7 summarizes the components of fair value gains (losses), net for the three and six months ended June 30, 2008 and 2007. Fair value gains and losses, net consists of (1) derivatives fair value gains and losses, including gains and losses on derivatives designated as accounting hedges; (2) trading securities gains and losses; (3) fair value adjustments to the carrying value of mortgage assets designated for hedge accounting that are attributable to changes in interest rates; (4) foreign exchange gains and losses on our foreign-denominated debt and (5) fair value gains and losses on certain debt securities carried at fair value. By presenting these items together in our condensed consolidated results of operations, we are able to show the net impact of mark-to-market adjustments that generally result in offsetting gains and losses attributable to changes in interest rates. We provide additional information below on the most significant components of the fair value gains (losses), net line item.