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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  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 March 31, 2010, there were 1,117,363,226 shares of common stock of the registrant outstanding.

 

 

TABLE OF CONTENTS

 

 

MD&A TABLE REFERENCE

 

 

 

We have been under conservatorship, with the Federal Housing Finance Agency (“FHFA”) acting as conservator, since September 6, 2008. As conservator, FHFA succeeded to all rights, titles, powers and privileges of the company, and of any shareholder, officer or director of the company with respect to the company and its assets. The conservator has since delegated specified authorities to our Board of Directors and has delegated to management the authority to conduct our day-to-day operations. Our directors do not have any duties to any person or entity except to the conservator and, accordingly, are not obligated to consider the interests of the company, the holders of our equity or debt securities or the holders of Fannie Mae MBS unless specifically directed to do so by the conservator. We describe the rights and powers of the conservator, key provisions of our agreements with the U.S. Department of the Treasury (“Treasury”), and their impact on shareholders in our Annual Report on Form 10-K for the year ended December 31, 2009 (“2009 Form 10-K”) in “Business—Conservatorship and Treasury Agreements.”

 

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 2009 Form 10-K.

 

This report contains forward-looking statements that are based upon management’s current expectations and are subject to significant uncertainties and changes in circumstances. Our actual results may differ materially from those reflected in these forward-looking statements due to a variety of factors including, but not limited to, those described in “Risk Factors” and elsewhere in this report and in “Risk Factors” in our 2009 Form 10-K. Please review “Forward-Looking Statements” for more information on the forward-looking statements in this report.

 

You can find a “Glossary of Terms Used in This Report” in the “MD&A” of our 2009 Form 10-K.

 

Fannie Mae is a government-sponsored enterprise that was chartered by Congress in 1938 to support liquidity, stability and affordability in the secondary mortgage market, where existing mortgage-related assets are purchased and sold. Our most significant activities include providing market liquidity by securitizing mortgage loans originated by lenders in the primary mortgage market into Fannie Mae mortgage-backed securities, which we refer to as Fannie Mae MBS, and purchasing mortgage loans and mortgage-related securities in the secondary market for our mortgage portfolio. We acquire funds to purchase mortgage-related assets for our mortgage portfolio by issuing a variety of debt securities in the domestic and international capital markets. We also make other investments that increase the supply of affordable housing. Our charter does not permit us to originate loans and lend money directly to consumers in the primary mortgage market.

 

Although we are a corporation chartered by the U.S. Congress, our conservator is a U.S. government agency, Treasury owns our senior preferred stock and a warrant to purchase 79.9% of our common stock, and Treasury has made a commitment under a senior preferred stock purchase agreement to provide us with funds under specified conditions to maintain a positive net worth, the U.S. government does not guarantee our securities or other obligations.

 

Our Mission, Objectives and Strategy

 

Our public mission is to support liquidity and stability in the secondary mortgage market and increase the supply of affordable housing. As we discuss below, we are concentrating our efforts on two of our objectives:

supporting liquidity, stability and affordability in the mortgage market and minimizing our credit losses from delinquent loans. Please see “Business—Executive Summary—Our Business Objectives and Strategy” in our 2009 Form 10-K for more information on our business objectives, which have been approved by FHFA.

 

Providing Mortgage Market Liquidity

 

We support liquidity and stability in the secondary mortgage market, serving as a stable source of funds for purchases of homes and multifamily housing and for refinancing existing mortgages. We provide this financing through the activities of our three complementary businesses: Single-Family Credit Guaranty, Housing and Community Development (“HCD”) and Capital Markets. Our Single-Family and HCD businesses work with our lender customers to purchase and securitize mortgage loans they deliver to us into Fannie Mae MBS. Our Capital Markets group manages our investment activity in mortgage-related assets, funding investments primarily through proceeds we receive from the issuance of debt securities in the domestic and international capital markets. The Capital Markets group is increasingly focused on making short-term use of our balance sheet rather than on long-term buy and hold strategies and, in this role, the group works with lender customers to provide funds to the mortgage market through short-term financing, investing and other activities. These include whole loan conduit activities, early funding activities, dollar roll transactions, and Real Estate Mortgage Investment Conduit (“REMIC”) and other structured securitization activities, which we describe in more detail in our 2009 Form 10-K in “Business Segments—Capital Markets Group.”

 

During the first quarter of 2010, we purchased or guaranteed an estimated $191.4 billion in loans, measured by unpaid principal balance, which includes approximately $40 billion in delinquent loans we purchased in March 2010 from our MBS trusts, as we discuss below. Our purchases and guarantees financed approximately 516,000 conventional single-family loans, excluding delinquent loans purchased from our MBS trusts, and approximately 61,000 multifamily units.

 

We remained the largest single issuer of mortgage-related securities in the secondary market during the first quarter of 2010, with an estimated market share of new single-family mortgage-related securities of 40.8%, compared with 38.9% in the fourth quarter of 2009. In the coming months, we expect our market share may be adversely impacted by a shift of the market away from refinance activity if interest rates are higher and the Federal Housing Administration (“FHA”) continues to be the lower-cost option, and in some cases the only option, for loans with higher loan-to-value (“LTV”) ratios. In the multifamily market, we remain a constant source of liquidity and have been successful with our goal of expanding our multifamily MBS business and broadening our multifamily investor base.

 

During 2008 and early 2009 we made changes in our pricing and eligibility standards that were intended to promote sustainable homeownership and stability in the housing market, and that have resulted in the loans we have acquired since their implementation having, on average, a strong risk profile. The single-family loans we purchased or guaranteed in the first quarter of 2010 had an average original LTV ratio of 69%, an average FICO credit score of 758, and a product mix with a significant percentage of fully amortizing fixed-rate mortgage loans. As with all our loans, we expect the ultimate performance of these loans will be affected by macroeconomic trends, including unemployment, the economy, and home prices. We expect that the loans we purchased or guaranteed in the first quarter of 2010 may have relatively slow prepayment speeds, and therefore remain in our book of business for an extended time, due to historically low interest rates during the first quarter of 2010, which resulted in our first quarter 2010 acquisitions having a weighted average interest rate of 4.9%. Whether our acquisitions for all of 2010 exhibit the same credit profile as our recent acquisitions will depend on many factors, including our future pricing and eligibility standards, our future objectives, mortgage insurers’ eligibility standards, our future volume of loans acquired under our Refi Plus^tm initiative, and future activity by our competitors, including FHA and Freddie Mac. Improvements in the credit profile of our acquisitions since January 1, 2009 reflect changes we made in our pricing and eligibility standards, as well as changes mortgage insurers made to their eligibility standards. In addition, FHA’s role as the lower-cost option, or in some cases the only option, for loans with higher LTV ratios further reduced our acquisition of these types of loans.

The credit profile of our first quarter 2010 acquisitions was further enhanced by a significant percentage of our acquisitions representing refinanced loans, which generally have a stronger credit profile because refinancing demonstrates the borrower’s ongoing commitment to make their mortgage payment and desire to maintain homeownership. Refinancings represented 78% of our first quarter 2010 acquisitions. While refinanced loans have historically tended to perform better than loans used for initial home purchase, Home Affordable Refinance Program (“HARP”) loans may not ultimately perform as strongly as traditional refinanced loans because these loans, which relate to non-delinquent Fannie Mae mortgages that were refinanced, may have original LTV ratios of up to 125% and lower FICO credit scores than traditional refinanced loans.

 

Reducing Credit Losses

 

Challenging housing market and economic conditions continue to expose Fannie Mae to significant risk of credit losses. As of March 31, 2010, the percentage of loans in our conventional single-family guaranty book of business that were seriously delinquent, which means the loans were three or more months past due or in the foreclosure process, was 5.47%, and our combined loss reserves, which reflect our estimate of the probable losses we have incurred in our guaranty book of business as of March 31, 2010, were $60.8 billion.

 

To reduce the credit losses we ultimately incur on our book of business, we are focusing our efforts on the following strategies:

 

 

Reducing Defaults.  We are working to reduce defaults through improving servicing, refinancing initiatives and solutions that help borrowers retain their homes, such as modifications.

 

 

 

It is too early to determine how successful the loan modifications we completed during the first quarter of 2010 will ultimately be. Approximately 47% of loans we modified during the first nine months of 2009 were current or had paid off as of six months following the loan modification date, compared to approximately 37% of loans we modified during the first nine months of 2008. Please see “Risk Management—Single-Family Mortgage Credit Risk Management—Management of Problem Loans and Loan Workout Metrics” for a discussion of the significant uncertainty regarding the ultimate long term success of our modification efforts.

 

As Table 1 demonstrates, although our single-family serious delinquency rate increased during the first quarter of 2010 and remains high, our single-family serious delinquency rate grew at a much slower rate during the first quarter of 2010 than during each quarter of 2009. This slowing in the rate of increase of our serious delinquency rate is partly the result of the home retention workouts we completed during the quarter, as well as the foreclosure alternative workouts we discuss below. We believe that growth in our serious delinquency rate during the first quarter was also slowed by improved employment trends in the economy.

 

Pursuing Foreclosure Alternatives.  If we are unable to provide a viable home retention solution for a problem loan, we seek to offer foreclosure alternatives, primarily preforeclosure sales and deeds-in-lieu of foreclosure. These alternatives reduce the severity of our loss resulting from a borrower’s default while permitting the borrower to avoid going through a foreclosure. In the first quarter of 2010, we completed approximately 17,300 preforeclosure sales and deeds-in-lieu of foreclosures, compared with approximately 13,500 in the fourth quarter of 2009. We have increasingly relied on foreclosure alternatives as a growing number of borrowers have faced longer-term economic hardships that cannot be solved through a home retention solution, and we expect the volume of our foreclosure alternatives to increase in 2010.

 

Managing Foreclosure Timelines Efficiently.  We are working to manage our foreclosure timelines efficiently to reduce our foreclosed property expenses. As of March 31, 2010, 29% of the loans in our conventional single-family guaranty book of business that were seriously delinquent were in the process of foreclosure.

 

Managing our REO Inventory.  Since January 2009, we have strengthened our REO sales capabilities by significantly increasing the number of resources in this area, and we are working to manage our REO inventory to reduce costs and maximize sales proceeds. During the first quarter of 2010, we acquired approximately 62,000 foreclosed single-family properties, up from approximately 47,000 during the fourth quarter of 2009, and we disposed of approximately 38,000 single-family properties. The carrying value of the single-family REO we held as of March 31, 2010 was $11.4 billion, and we expect our REO inventory to increase significantly throughout 2010.

Pursuing Contractual Remedies.  We conduct reviews of delinquent loans and, when we discover loans that do not meet our underwriting and eligibility requirements, we make demands for lenders to repurchase these loans or compensate us for losses sustained on the loans, as well as requests for repurchase or compensation for loans for which the mortgage insurer rescinds coverage. During the first quarter of 2010, lenders repurchased approximately $1.8 billion in loans from us, measured by unpaid principal balance, pursuant to their contractual obligations. We are also pursuing contractual remedies from providers of credit enhancement on our loans, including mortgage insurers. We received proceeds under our mortgage insurance policies for single-family loans of $1.5 billion for the three months ended March 31, 2010. Please see “Risk Management—Institutional Counterparty Credit Risk Management” for a discussion of our high balance of outstanding repurchase and reimbursement requests and outstanding receivables from mortgage insurers, as well as the risk that one or more of these counterparties fails to fulfill its obligations to us.

 

A key theme underlying our strategies for reducing our credit losses is reducing delays. We believe that repayment plans, short-term forbearances and loan modifications can be most effective in preventing defaults when completed at an early stage of delinquency. Similarly, we believe that our foreclosure alternatives are more likely to be successful in reducing our loss severity if they are executed expeditiously. Accordingly, it is important to work with delinquent borrowers early in the delinquency to determine whether a home retention or foreclosure alternative will be viable and, where none is, to reduce delays in proceeding to foreclosure and obtaining recoveries. Minimizing delays prior to foreclosure and focusing on maximizing sales proceeds and recoveries from lenders and credit enhancers also accelerate our receipt of recoveries.

 

The actions we have taken to stabilize the housing market and minimize our credit losses have had and may continue to have, at least in the short term, a material adverse effect on our results of operations and financial condition, including our net worth. See “Consolidated Results of Operations—Financial Impact of the Making Home Affordable Program on Fannie Mae” for information on HAMP’s financial impact on us during the first quarter of 2010 and the $7.6 billion we incurred in impairments in connection with HAMP during the quarter. These actions have been undertaken with the goal of reducing our future credit losses below what they otherwise would have been. It is difficult to predict how effective these actions ultimately will be in reducing our credit losses and, in the future, it may be difficult to measure the impact our actions ultimately have on our credit losses.

 

Credit Performance

 

Table 1 presents information for the first quarter of 2010 and for each quarter of 2009 about the credit performance of mortgage loans in our single-family guaranty book of business and our loan workouts. The workout information in Table 1 does not reflect repayment plans and forbearances that have been initiated but not completed, nor does it reflect trial modifications under HAMP that have not become permanent.

 

 

 

 

 

New Accounting Standards and Consolidation of a Substantial Majority of our MBS Trusts

 

Effective January 1, 2010, we prospectively adopted new accounting standards on the transfers of financial assets and the consolidation of variable interest entities. We refer to these accounting standards together as the “new accounting standards.” In this report, we also refer to January 1, 2010 as the “transition date.”

 

Impact on our Condensed Consolidated Financial Statements

 

Our adoption of the new accounting standards had a major impact on the presentation of our condensed consolidated financial statements. The new standards require that we consolidate the substantial majority of Fannie Mae MBS trusts we guarantee and recognize the underlying assets (typically mortgage loans) and debt (typically bonds issued by the trusts in the form of Fannie Mae MBS certificates) of these trusts as assets and liabilities in our condensed consolidated balance sheets.

 

Although the new accounting standards did not change the economic risk to our business, we recorded a decrease of $3.3 billion in our total deficit as of January 1, 2010 to reflect the cumulative effect of adopting these new standards. We provide a detailed discussion of the impact of the new accounting standards on our accounting and financial statements in “Note 2, Adoption of the New Accounting Standards on the Transfers of Financial Assets and Consolidation of Variable Interest Entities.” The table below sets forth the most significant changes to our condensed consolidated financial statements resulting from consolidation of these MBS trusts.

 

 

Upon adopting the new accounting standards, we changed the presentation of segment financial information that is currently evaluated by management, as we discuss in “Business Segment Results—Changes to Segment Reporting.”

 

Purchases from our Single-Family MBS Trusts

 

With our adoption of the new accounting standards, we no longer recognize the acquisition of a credit-impaired loan from the majority of our MBS trusts as a purchase with an associated fair value loss for the difference between the fair value of the acquired loan and its acquisition cost, as they are now consolidated

and the loan is already reflected in our condensed consolidated balance sheets at the time of acquisition. Without these fair value losses, the cost of purchasing most delinquent loans from Fannie Mae MBS trusts and holding them in our portfolio is less than the cost of advancing delinquent payments to holders of the Fannie Mae MBS. As a result, we have begun to significantly increase our purchases of delinquent loans from single-family MBS trusts to reduce our costs associated with these loans. Under our single-family MBS trust documents, we have the option to purchase from our MBS trusts loans that are delinquent as to four or more consecutive monthly payments. In March 2010, we purchased approximately 216,000 delinquent loans with an unpaid principal balance of approximately $40 billion from MBS trusts, which increased our Capital Markets’ mortgage portfolio balance. As of March 31, 2010, the total unpaid principal balance of all loans in single-family MBS trusts that were delinquent four or more months was approximately $94 billion. In April 2010, we purchased approximately 229,000 delinquent loans with an unpaid principal balance of approximately $46 billion from our MBS trusts. We expect to continue to purchase a significant portion of the remaining delinquent population within a few months subject to market conditions, servicer capacity, and other constraints including the limit on the mortgage assets that we may own pursuant to our senior preferred stock purchase agreement with Treasury.

 

Summary of our Financial Performance for the First Quarter of 2010

 

Our financial results for the first quarter of 2010 reflect the continued weakness in the housing and mortgage markets, which showed some signs of stabilization in the first quarter of 2010 but which remain under pressure due to high levels of unemployment and underemployment.

 

Net loss.  We recorded a net loss of $11.5 billion for the first quarter of 2010, primarily driven by credit-related expenses of $11.9 billion and fair value losses of $1.7 billion, which were partially offset by net interest income of $2.8 billion. Including dividends on senior preferred stock, the net loss attributable to common stockholders we recorded for the first quarter of 2010 was $13.1 billion and our diluted loss per share was $2.29. In comparison, we recorded a net loss of $15.2 billion, a net loss attributable to common stockholders of $16.3 billion and a diluted loss per share of $2.87 for the fourth quarter of 2009. We recorded a net loss and a net loss attributable to common stockholders of $23.2 billion and a diluted loss per share of $4.09 for the first quarter of 2009.

 

The $3.6 billion decrease in our net loss in the first quarter of 2010 compared with the fourth quarter of 2009 was primarily due to:

 

 

The decrease in losses was partially offset by an increase in fair value losses, net of $1.1 billion and a $2.7 billion decrease in revenue primarily due to our adoption of the new accounting standards, which resulted in the following impacts:

 

 

The $11.7 billion decrease in our net loss in the first quarter of 2010 compared with the first quarter of 2009 was primarily due to:

 

 

The decrease in losses compared with the first quarter of 2009 was partially offset by a $2.2 billion decrease in net revenue that was primarily due to the adoption of the new accounting standards.

 

Net Worth.  We had a net worth deficit of $8.4 billion as of March 31, 2010, compared with a net worth deficit of $15.3 billion as of December 31, 2009. Our net worth as of March 31, 2010 was negatively impacted by the recognition of our net loss of $11.5 billion and senior preferred stock dividends of $1.5 billion. These reductions in our net worth were offset by our receipt of $15.3 billion in funds from Treasury on March 31, 2010 under our senior preferred stock purchase agreement with Treasury, as well as from a $3.3 billion benefit due to the cumulative effect of our adoption of the new accounting standards. Our net worth, which is the basis for determining the amount that Treasury has committed to provide us under the senior preferred stock purchase agreement, equals the “Total deficit” reported in our condensed consolidated balance sheet. In May 2010, the Acting Director of FHFA submitted a request to Treasury on our behalf for $8.4 billion to eliminate our net worth deficit as of March 31, 2010. When Treasury provides the requested funds, the aggregate liquidation preference on the senior preferred stock will be $84.6 billion, which will require an annualized dividend of approximately $8.5 billion. This amount exceeds our reported annual net income for each of the last eight fiscal years, in most cases by a significant margin.

 

Credit-Related Expenses and Credit Losses.  Our credit-related expenses, which consist of the provision for loan losses and the provision for guaranty losses (collectively referred to as the “provision for credit losses”) plus foreclosed property expense, were $11.9 billion for the first quarter of 2010. Due to our adoption of the new accounting standards, effective January 1, 2010, we no longer recognize fair value losses on credit-impaired loans newly acquired from MBS trusts that we consolidated, which affects our provision for credit losses. During the first quarter of 2010 we recognized a higher level of impairments as compared with the fourth quarter of 2009 because loan modifications, which result in the loans being treated as individually impaired, increased substantially. In aggregate, the increase in individual impairment, as well as the high level of nonperforming loans, delinquencies, and defaults due to the general deterioration in our guaranty book of business, resulted in our provision for credit losses for the first quarter of 2010 of $11.9 billion decreasing only slightly from our $12.2 billion provision for credit losses in the fourth quarter of 2009, despite the reduction in fair-value losses on credit-impaired loans acquired from MBS trusts.

 

Credit-related expenses are included in our condensed consolidated statements of operations. Our credit losses, by contrast, are not defined within generally accepted accounting principles, or GAAP, and may not be calculated in the same manner as similarly titled measures reported by other companies. We measure our credit losses as our charge-offs, net of recoveries, plus our foreclosed property expense, adjusted to eliminate the impact associated with our HomeSaver Advance loans (unsecured personal loans used to bring mortgage loans current) and our acquisition of credit-impaired loans from MBS trusts. Our credit losses increased to $5.1 billion in the first quarter of 2010 from $4.1 billion in the fourth quarter of 2009 and $2.5 billion in the first quarter of 2009. The increase in our credit losses from the fourth quarter of 2009 primarily reflects the

increase in the number of defaults, which was partially offset by a slight reduction in loss severity. While the level of our credit losses increased, it remained substantially lower than our credit-related expenses during the first quarter of 2010, due partly to our home retention and foreclosure alternative efforts, and partly to changes in the foreclosure process in a number of states and foreclosure processing backlogs in some jurisdictions. During the first quarter of 2010, our loss severity and average initial charge-off per default declined slightly but remained high. Please see “Consolidated Results of Operations—Credit-Related Expenses—Credit Loss Performance Metrics” in our 2009 Form 10-K for more detail on how we measure our credit losses.

 

Loss Reserves.  Our combined loss reserves, which reflect our estimate of the probable losses we have incurred in our guaranty book of business, decreased as of January 1, 2010 compared to December 31, 2009 as a result of our adoption of the new accounting standards. Our combined loss reserves were $60.8 billion as of March 31, 2010, compared to $53.8 billion as of January 1, 2010 and $64.4 billion as of December 31, 2009. Our loss reserve coverage to total nonperforming loans decreased to 27.15% as of March 31, 2010 from 29.73% as of December 31, 2009.

 

Housing and Mortgage Market and Economic Conditions

 

The housing sector, while still fragile, continued to show some signs of stabilization and improvement in the first quarter of 2010. During the first quarter of 2010, the U.S. economy continued to emerge from the severe economic recession that started in December 2007, with the U.S. gross domestic product, or GDP, rising by 3.2% on an annualized basis during the quarter, according to the Bureau of Economic Analysis advance estimate.

 

However, the housing market remains under pressure due to high levels of unemployment and underemployment. Unemployment was 9.7% in March 2010, a decrease from 10.0% in December 2009, based on data from the U.S. Bureau of Labor Statistics. The Mortgage Bankers Association National Delinquency Survey reported that, as of December 31, 2009, the most recent date for which information is available, 9.67% of borrowers were seriously delinquent (90 days or more past due or in the foreclosure process), which we estimate represents approximately five million mortgages.

 

The supply of single-family homes as measured by the inventory/sales ratio remains above long-term average levels, with significant regional variation. Some regions, such as Florida, are struggling with large inventory overhang while others, such as California, are experiencing nearly depleted inventories in lower priced homes. Properties that are vacant and held off the market, combined with the portion of the estimated five million seriously delinquent mortgages not currently listed for sale, represent a shadow inventory putting downward pressure on both home prices and rents.

 

We estimate that, although home prices have improved in some geographic regions, home prices on a national basis declined by 1.5% in the first quarter of 2010 and have declined by 18.4% from their peak in the third quarter of 2006. Our home price estimates are based on preliminary data and are subject to change as additional data become available. As we have previously disclosed, the decline in home prices has left many homeowners with “negative equity” in their mortgages, which means their principal balance exceeds the current market value of their home. This provides an incentive for borrowers to walk away from their mortgage obligations and for the loans to become delinquent and proceed to foreclosure.

 

Preliminary data for the first quarter of 2010 indicate that multifamily housing fundamentals are showing the first signs of improvement. Unemployment, the slow economic recovery, and below-average household formations continue to depress the multifamily sector, with apartment property sales, occupancy levels, and asking rents remaining at depressed levels. However, the estimated national vacancy rate appears to have decreased in the first quarter of 2010. In addition, asking rents appear to have held steady and perhaps increased slightly, according to preliminary third-party data, and apartment property sales increased slightly during the quarter. The anticipated volume of new multifamily loans remains uncertain. Although the number of distressed multifamily properties remains elevated, properties are not showing up on the sales market as

lenders and servicers appear to be entering into workouts and extensions, instead of pursuing foreclosures. This could result in fewer multifamily properties being offered for sale or refinanced and may constrain the amount of new multifamily loan origination volume in 2010.

 

See “Risk Factors” in our 2009 Form 10-K for a description of risks to our business associated with the weak economy and housing market.

 

Outlook

 

Overall Market Conditions.  We expect weakness in the housing and mortgage markets to continue throughout 2010. Home sales fell during the first quarter of 2010. However, we expect the temporary tax credit combined with a seasonal increase in home sales in the second quarter and historically low mortgage rates to support increased sales in the second quarter of 2010 before the pace slows again in the third quarter. We also expect home sales to start a longer term growth path by the end of 2010, if the labor market shows improvement. The continued deterioration in the performance of outstanding mortgages, however, will result in the foreclosure of troubled loans, which is likely to add to the excess housing inventory. If, as we expect, interest rates rise modestly, the pace at which the excess inventory is absorbed will decline.

 

We expect that during 2010: (1) default and severity rates will remain heightened, (2) home prices will decline slightly further on a national basis, more in some geographic areas than in others, and (3) the level of foreclosures will increase. We also expect the level of multifamily defaults and serious delinquencies to increase further during 2010. All of these conditions, including the level of single-family delinquencies, may worsen if the unemployment rate increases on either a national or regional basis. We expect the decline in residential mortgage debt outstanding to continue through 2010, which would mark three consecutive annual declines. Approximately 78% of our single-family business in the first quarter of 2010 consisted of refinancings. In the coming months, we expect a shift of the market away from refinance activity if interest rates increase, which will be somewhat offset by a seasonal increase in home sales. We expect these trends, combined with an expected decline in total originations in 2010, will have an adverse impact on our business volumes during the remainder of 2010.

 

Home Price Declines:  Following a decline of approximately 2.9% in 2009, we expect that home prices on a national basis will decline slightly in 2010 before stabilizing, and that the peak-to-trough home price decline on a national basis will range between 18% and 23%. These estimates are based on our home price index, which is calculated differently from the S&P/Case-Shiller U.S. National Home Price Index and therefore results in different percentages for comparable declines. These estimates also contain significant inherent uncertainty in the current market environment regarding a variety of critical assumptions we make when formulating these estimates, including: the effect of actions the federal government has taken and may take with respect to the national economic recovery; the impact of the end of the Federal Reserve’s MBS purchase program; and the impact of those actions on home prices, unemployment and the general economic and interest rate environment. Because of these uncertainties, the actual home price decline we experience may differ significantly from these estimates. We also expect significant regional variation in home price declines and stabilization.

 

Our 18% to 23% peak-to-trough home price decline estimate compares with an approximately 32% to 40% peak-to-trough decline using the S&P/Case-Shiller index method. Our estimates differ from the S&P/Case-Shiller index in two principal ways: (1) our estimates weight expectations by number of properties, whereas the S&P/Case-Shiller index weights expectations based on property value, causing home price declines on higher priced homes to have a greater effect on the overall result; and (2) contrary to the S&P/Case-Shiller index, our estimates do not include known sales of foreclosed homes because we believe that differing maintenance practices and the forced nature of the sales make foreclosed home prices less representative of market values. The S&P/Case-Shiller comparison numbers are calculated using our models and assumptions, but modified to use these two factors (weighting of expectations based on property value and the inclusion of foreclosed property sales). In addition to these differences, our estimates are based on our own internally

available data combined with publicly available data, and are therefore based on data collected nationwide, whereas the S&P/Case-Shiller index is based only on publicly available data, which may be limited in certain geographic areas of the country. Our comparative calculations to the S&P/Case-Shiller index provided above are not modified to account for this data pool difference.

 

Credit-Related Expenses.  We expect that our credit-related expenses will remain high in 2010, as we believe that the level of our nonperforming loans will remain elevated for a period of time. We expect that, if current trends continue, our credit-related expenses could be lower in 2010 than in 2009. Our expectations for single-family credit-related expenses are based on several factors, including: (1) the decrease in average loss severities compared to 2009 as home price declines have begun to moderate and prices have stabilized in some regions; (2) our current expectation that, as 2010 progresses, the pace at which loans become delinquent will moderate which, coupled with an increase in the pace of foreclosures and problem loan workouts, will result in a slower rate of increase in, and possibly a leveling of, delinquencies; and (3) that, as a result of our adoption of the new accounting standards, we no longer recognize the acquisition of a credit-impaired loan from the majority of our MBS trusts as a purchase with an associated fair value loss for the difference between the fair value of the acquired loan and its acquisition cost, as they are now consolidated and the loan is already reflected in our condensed consolidated balance sheets at the time of acquisition.

 

Credit Losses.  We expect that our single-family and multifamily credit losses will continue to increase during 2010 as a result of anticipated continued high unemployment and overall economic weakness, which will contribute to an expected increase in our charge-offs as we pursue foreclosure alternatives and foreclosures on seriously delinquent loans for which we are not able to provide a sustainable home retention workout solution.

 

Uncertainty Regarding our Long-Term Financial Sustainability and Future Status.  We expect that the actions we take to stabilize the housing market and minimize our credit losses will continue to have, in the short term at least, a material adverse effect on our results of operations and financial condition, including our net worth. There is significant uncertainty in the current market environment, and any changes in the trends in macroeconomic factors that we currently anticipate, such as home prices and unemployment, may cause our future credit-related expenses and credit losses to vary significantly from our current expectations. Although Treasury’s funds under the senior preferred stock purchase agreement permit us to remain solvent and avoid receivership, the resulting dividend payments are substantial. Given our expectations regarding future losses and draws from Treasury, we do not expect to earn profits in excess of our annual dividend obligation to Treasury for the indefinite future. As a result of these factors, there is significant uncertainty as to our long-term financial sustainability.

 

In addition, there is uncertainty regarding the future of our business after the conservatorship is terminated, including whether we will continue in our current form, and we expect this uncertainty to continue. On April 14, 2010, the Obama Administration released seven broad questions for public comment on the future of the housing finance system, including Fannie Mae and Freddie Mac, and announced that it would hold a series of public forums across the country on housing finance reform. Treasury Secretary Geithner testified in March 2010 that the administration expects to present its proposals for reform to Congress “next year.” We cannot predict the prospects for the enactment, timing or content of legislative proposals regarding longer-term reform of Fannie Mae, Freddie Mac and the Federal Home Loan Banks (the “GSEs”). Please see “GSE Reform and Pending Legislation” in our 2009 Form 10-K for a discussion of legislation being considered that could affect our business, including a list of possible reform options for the GSEs.

 

The preparation of financial statements in accordance with 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 condensed 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 describe our most significant accounting policies in “Note 1, Summary of Significant Accounting Policies” of this report and in our 2009 Form 10-K.

 

We evaluate our critical accounting estimates and judgments required by our policies on an ongoing basis and update them as necessary based on changing conditions. Management has discussed any significant changes in judgments and assumptions in applying our critical accounting policies with the Audit Committee of our Board of Directors. See “Risk Factors” and “Risk Management—Model Risk Management” for a discussion of the risk associated with the use of models as well as “MD&A—Critical Accounting Policies and Estimates” in our 2009 Form 10-K for additional information about our accounting policies we have identified as critical because they involve significant judgments and assumptions about highly complex and inherently uncertain matters, and the use of reasonably different estimates and assumptions could have a material impact on our reported results of operations or financial condition. These critical accounting policies and estimates are as follows:

 

 

Effective January 1, 2010, we adopted the new accounting standards on the transfers of financial assets and the consolidation of variable interest entities. Refer to “Note 1, Summary of Significant Accounting Policies” and “Note 2, Adoption of the New Accounting Standards on the Transfers of Financial Assets and Consolidation of Variable Interest Entities” for additional information.

 

We provide below information about our Level 3 assets and liabilities as of March 31, 2010 compared to December 31, 2009 and describe any significant changes in the judgments and assumptions we made during the first quarter of 2010 in applying our critical accounting policies and significant changes to critical estimates as well as the impact of the new accounting standards on our allowance for loan losses and reserve for guaranty losses.

 

Fair Value Measurement

 

The use of fair value to measure our assets and liabilities is fundamental to our financial statements and is a critical accounting estimate because we account for and record a portion of our assets and liabilities at fair value. In determining fair value, we use various valuation techniques. We describe the valuation measurement techniques and inputs used to determine the fair value of our assets and liabilities and disclose their carrying value and fair value in “Note 16, Fair Value.”

 

Fair Value Hierarchy—Level 3 Assets and Liabilities

 

The assets and liabilities that we have classified as Level 3 in the fair value hierarchy consist primarily of financial instruments for which there is limited market activity and therefore little or no price transparency. As a result, the valuation techniques that we use to estimate the fair value of Level 3 instruments involve significant unobservable inputs, which generally are more subjective and involve a high degree of management judgment and assumptions. Our Level 3 financial instruments consist of certain mortgage- and asset-backed securities and residual interests, certain mortgage loans, acquired property, partnership investments, our guaranty assets and buy-ups, our master servicing assets and certain highly structured, complex derivative instruments.

 

Table 2 presents a comparison, by balance sheet category, of 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

March 31, 2010 and December 31, 2009. 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 amount of financial instruments carried at fair value on a recurring basis and classified as Level 3 to vary each period.

 

 

The decrease in assets classified as Level 3 during the first quarter of 2010 includes a $2.6 billion decrease due to derecognition of guaranty assets and buy-ups at the transition date as well as net transfers of approximately $2.5 billion in assets to Level 2 from Level 3. The assets transferred from Level 3 consist primarily of Fannie Mae guaranteed mortgage-related securities and private-label mortgage-related securities.

 

Assets measured at fair value on a nonrecurring basis and classified as Level 3, which are not presented in the table above, primarily include held-for-sale loans, held-for-investment loans, acquired property and partnership investments. The fair value of these Level 3 nonrecurring financial assets totaled $11.2 billion during the first quarter of 2010, and $21.2 billion during the year ended December 31, 2009.

 

Financial liabilities measured at fair value on a recurring basis and classified as Level 3 consisted of long-term debt with a fair value of $653 million as of March 31, 2010 and $601 million as of December 31, 2009, and derivatives liabilities with a fair value of $6 million as of March 31, 2010 and $27 million as of December 31, 2009.

 

Allowance for Loan Losses and Reserve for Guaranty Losses

 

We maintain an allowance for loan losses for loans classified as held for investment, including both loans held by us and by consolidated Fannie Mae MBS trusts. We maintain a reserve for guaranty losses for loans held in unconsolidated Fannie Mae MBS trusts we guarantee and loans that we have guaranteed under long-term standby commitments. We report the allowance for loan losses and reserve for guaranty losses as separate line items in our condensed consolidated balance sheets. These amounts, which we collectively refer to as our combined loss reserves, represent probable losses incurred in our guaranty book of business as of the balance sheet date. The allowance for loan losses is a valuation allowance that reflects an estimate of incurred credit losses related to our recorded investment in loans held for investment. The reserve for guaranty losses is a liability account in our condensed consolidated balance sheets that reflects an estimate of incurred credit losses related to our guaranty to each unconsolidated Fannie Mae MBS trust that we will supplement amounts received by the Fannie Mae MBS trust as required to permit timely payments of principal and interest on the related Fannie Mae MBS. As a result, the guaranty reserve considers not only the principal and interest due on the loan at the current balance sheet date, but also an estimate of any additional interest payments due to the trust from the current balance sheet date until the point of loan acquisition or foreclosure. We maintain separate loss reserves for single-family and multifamily loans. Our single-family and multifamily loss reserves consist of a specific loss reserve for individually impaired loans and a collective loss reserve for all other loans.

We have an established process, using analytical tools, benchmarks and management judgment, to determine our loss reserves. Although our loss reserve process benefits from extensive historical loan performance data, this process is subject to risks and uncertainties, including a reliance on historical loss information that may not be representative of current conditions. We continually monitor delinquency and default trends and make changes in our historically developed assumptions and estimates as necessary to better reflect present conditions, including current trends in borrower risk and/or general economic trends, changes in risk management practices, and changes in public policy and the regulatory environment. We also consider the recoveries that we will receive on mortgage insurance and other credit enhancements entered into contemporaneously with and in contemplation of a guaranty or loan purchase transaction, as such recoveries reduce the severity of the loss associated with defaulted loans. Due to the stress in the housing and credit markets, and the speed and extent of deterioration in these markets, our process for determining our loss reserves has become significantly more complex and involves a greater degree of management judgment than prior to this period of economic stress.

 

Single-Family Loss Reserves

 

We establish a specific single-family loss reserve for individually impaired loans, which includes loans we restructure in troubled debt restructurings, certain nonperforming loans in MBS trusts and acquired credit-impaired loans that have been further impaired subsequent to acquisition. The single-family loss reserve for individually impaired loans is a growing portion of the total single-family reserve and will continue to grow in conjunction with our modification efforts. We typically measure impairment based on the difference between our recorded investment in the loan and the present value of the estimated cash flows we expect to receive, which we calculate using the effective interest rate of the original loan or the effective interest rate at acquisition for a credit-impaired loan. However, when foreclosure is probable, we measure impairment based on the difference between our recorded investment in the loan and the fair value of the underlying property, adjusted for the estimated discounted costs to sell the property and estimated insurance or other proceeds we expect to receive.

 

We establish a collective single-family loss reserve for all other single-family loans in our single-family guaranty book of business using an econometric model that estimates the probability of default of loans to derive an overall loss reserve estimate given multiple factors such as: origination year, mark-to-market LTV ratio, delinquency status and loan product type. We believe that the loss severity estimates used in determining our loss reserves reflect current available information on actual events and conditions as of each balance sheet date, including current home prices. Our loss severity estimates do not incorporate assumptions about future changes in home prices. We do, however, use a one-quarter look back period to develop our loss severity estimates for all loan categories.

 

Combined Loss Reserves

 

Upon recognition of the mortgage loans held by newly consolidated trusts at the transition date of our adoption of the new accounting standards, we increased our “Allowance for loan losses” by $43.6 billion and decreased our “Reserve for guaranty losses” by $54.1 billion. The decrease in our combined loss reserves of $10.5 billion reflects the difference in the methodology used to estimate incurred losses under our allowance for loan losses versus our reserve for guaranty losses and recording the portion of the reserve related to accrued interest to “Allowance for accrued interest receivable” in our condensed consolidated balance sheets. Our guaranty reserve considers not only the principal and interest due on a loan at the current balance sheet date, but also any interest payments expected to be missed from the balance sheet date until the point of loan acquisition or foreclosure. However, our loan loss allowance is an asset valuation allowance, and thus we consider only our net recorded investment in the loan at the balance sheet date, which includes only interest income accrued while the loan was on accrual status.

 

Upon adoption of the new accounting standards, we derecognized the substantial majority of the “Reserve for guaranty losses” relating to loans in previously unconsolidated trusts that were consolidated in our condensed consolidated balance sheet. We continue to record a reserve for guaranty losses related to loans in unconsolidated trusts and to loans that we have guaranteed under long-term standby commitments.

In addition to recognizing mortgage loans held by newly consolidated trusts at the transition date, we also recognized the associated accrued interest receivable from the mortgage loans held by the newly consolidated trusts. The accrued interest included delinquent interest on such loans which was previously considered in estimating our “Reserve for guaranty losses.” As a result, at transition, we reclassified $7.0 billion from our “Reserve for guaranty losses” to a valuation allowance within “Accrued interest receivable, net” in our condensed consolidated balance sheet.

 

The section below provides a discussion of our condensed consolidated results of operations for the periods indicated. You should read this section together with our condensed consolidated financial statements including the accompanying notes.

 

As discussed in “Executive Summary,” prospectively adopting the new accounting standards had a significant impact on the presentation and comparability of our condensed consolidated financial statements due to the consolidation of the substantial majority of our single-class securitization trusts and the elimination of previously recorded deferred revenue from our guaranty arrangements. While some line items in our condensed consolidated statements of operations were not impacted, others were impacted materially, which reduces the comparability of our results for the first quarter of 2010 with results of prior periods. The

following table describes the impact to our first quarter 2010 results for those line items that were impacted significantly as a result of our adoption of the new accounting standards.

 

 

See “Note 2, Adoption of the New Accounting Standards on the Transfers of Financial Assets and Consolidation of Variable Interest Entities” for a further discussion of the impacts of the new accounting standards on our condensed consolidated financial statements.

 

Table 3 summarizes our condensed consolidated results of operations for the periods indicated.

 

 

 

 

Net Interest Income

 

Table 4 presents an analysis of our net interest income, average balances, and related yields earned on assets and incurred on liabilities for the periods indicated. For most components of the average balances, we used a daily weighted average of amortized cost. When daily average balance information was not available, such as for mortgage loans, we used monthly averages. Table 5 presents the change in our net interest income between periods 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.

 

 

 

 

 

 

 

Net interest income decreased in the first quarter of 2010 as compared with the first quarter of 2009 primarily as a result of the interest expense recognized on long-term debt of the consolidated MBS trusts being greater than the interest income recognized on the underlying mortgage loans of the consolidated trusts. While we do not recognize interest income on the mortgage loans of the consolidated trusts that have been placed on nonaccrual status, we continue to recognize interest expense for the amounts owed to MBS certificateholders, which has decreased our net interest income. Prior to the adoption of the new accounting standards, interest income and expense on MBS trusts not owned by Fannie Mae were not recorded as components of net interest income but were considered in determining our provision for credit losses. For the first quarter of 2010, interest income that we did not recognize for nonaccrual mortgage loans was $2.7 billion, which reduced our net interest yield by 33 basis points, compared with $223 million for the first quarter of 2009, which reduced our net interest yield by 10 basis points.

 

We recognize the contractual guaranty fee and the amortization of deferred cash fees received after December 31, 2009 on the underlying mortgage loans of consolidated trusts as interest income, which represents the spread between the yield on the underlying mortgage assets and the rate on the debt of the consolidated trusts. Upon adoption of the new accounting standards, our interest-earning assets and interest-bearing liabilities both increased by approximately $2.4 trillion. The lower spread on these interest-earning assets and liabilities had the impact of reducing our net interest yield for the first quarter of 2010 as compared to the first quarter of 2009.

 

We report net interest income for our Capital Markets group in “Business Segment Results.” The net interest income for our Capital Markets group reflects interest income from the assets that we have purchased and the interest expense from the debt we have issued. See “Business Segment Results” for a detailed discussion of our Capital Markets group’s net interest income.

 

Guaranty Fee Income

 

Guaranty fee income decreased in the first quarter of 2010 compared with the first quarter of 2009 because we consolidated the substantial majority of our MBS trusts and we recognize interest income and expense, instead

of guaranty fee income, from consolidated trusts. At adoption of the new accounting standards, our guaranty-related assets and liabilities pertaining to previously unconsolidated trusts were eliminated; therefore, we no longer recognize amortization of previously recorded deferred cash and non-cash fees or fair value adjustments related to our guaranty to these trusts. Guaranty fee income for the first quarter of 2010 reflects guaranty fees earned from unconsolidated trusts and other credit enhancements arrangements, such as our long-term standby commitments.

 

We continue to report guaranty fee income for our Single-Family business and our HCD business as a separate line item in “Business Segment Results.”

 

Investment Gains, Net

 

Investment gains recognized in the first quarter of 2010 were primarily the result of realized gains on sales of available-for-sale securities as spread tightening on agency MBS and a decline in mortgage rates led to higher sales prices. The decrease in investment gains in the first quarter of 2010 compared with the first quarter of 2009 was due to a decrease in securitization gains as a large majority of our portfolio securitization transactions no longer qualify for sale treatment under the new accounting standards. The decrease in investment gains was partially offset by a decrease in lower of cost or fair value adjustments on held-for-sale loans due to the reclassification of most of our held-for-sale loans to held for investment upon adoption of the new accounting standards.

 

Net Other-Than-Temporary Impairment

 

Net other-than-temporary impairment for the first quarter of 2010 significantly decreased compared with the first quarter of 2009, driven primarily by the adoption of a new accounting standard effective April 1, 2009. As a result of this accounting standard, beginning with the second quarter of 2009, we recognize only the credit portion of other-than-temporary impairment in our condensed consolidated statements of operations. The net other-than-temporary impairment charge recorded in the first quarter of 2010 was driven by a decrease in the present value of our cash flow projections on Alt-A and subprime securities. The net other-than-temporary impairment charge recorded in the first quarter of 2009 before our adoption of this accounting standard included both the credit and non-credit components of the loss in fair value and was driven primarily by additional impairment losses on some of our Alt-A and subprime private-label securities that we had previously impaired, as well as impairment losses on other Alt-A and subprime securities, due to continued deterioration in the credit quality of the loans underlying these securities and further declines in the expected cash flows.

 

Fair Value Losses, Net

 

Table 6 presents the components of fair value gains and losses.

 

 

 

Risk Management Derivatives Fair Value Losses, Net

 

We supplement our issuance of debt securities with derivative instruments to further reduce duration and prepayment risks. We generally are the purchaser of risk management derivatives. In cases where options obtained through callable debt issuance are not needed for risk management purposes, we may engage in sales of options in the over-the-counter derivatives market in order to offset the options obtained in the callable debt. During the first quarter of 2010, there were a small number of transactions of this type.

 

We recorded derivative losses in the first quarter of 2010 as a result of: (1) a decrease in implied interest rate volatility, which reduced the fair value of our purchased options; (2) a decrease in swap rates, which reduced the fair value of our pay-fixed derivatives; and (3) time decay on our purchased options.

 

Our derivative losses in the first quarter of 2009 were primarily driven by fair value losses on our option-based derivatives due to the combined effect of a decrease in implied volatility and the time decay of these options.

 

For additional information on our risk management derivatives, refer to “Note 10, Derivative Instruments.”

 

Mortgage Commitment Derivatives Fair Value Losses, Net

 

Commitments to purchase or sell some mortgage-related securities and to purchase single-family mortgage loans generally are derivatives and changes in their fair value are recognized in our condensed consolidated statements of operations. We recognized higher losses on our mortgage securities commitments in the first quarter of 2010 compared with the first quarter of 2009, driven primarily by increased losses on commitments to sell as a result of an increase in mortgage-related securities prices during the commitment period.

 

Trading Securities Gains, Net

 

Gains on trading securities in the first quarter of 2010 were primarily driven by the narrowing of spreads on commercial mortgage-backed securities (“CMBS”) as well as by a decrease in interest rates.

The gains on our trading securities during the first quarter of 2009 were attributable to the significant decline in mortgage interest rates and the narrowing of spreads on agency MBS during the quarter. These gains were partially offset by a decrease in the fair value of our private-label mortgage-related securities backed by Alt-A and subprime loans that we hold.

 

Losses from Partnership Investments

 

Losses from partnership investments decreased in the first quarter of 2010 compared with the first quarter of 2009 as we did not recognize net operating losses or other-than-temporary impairment on our LIHTC investments in the first quarter of 2010. In the fourth quarter of 2009, we reduced the carrying value of our LIHTC investments to zero. As a result, we no longer recognize net operating losses or other-than-temporary impairment on our LIHTC investments. Losses from partnership investments recognized in the first quarter of 2010 were due to other-than-temporary impairment on our other affordable housing investments.

 

Administrative Expenses

 

Administrative expenses increased in the first quarter of 2010 compared with the first quarter of 2009 due to an increase in employees and third-party services primarily related to our foreclosure prevention and credit loss mitigation efforts.

 

Credit-Related Expenses

 

Credit-related expenses consist of the provision for loan losses, provision for guaranty losses (collectively referred to as “provision for credit losses”) and foreclosed property expense. We detail the components of our credit-related expenses in Table 7.

 

 

 

 

Provision for Credit Losses

 

We summarize the changes in our combined loss reserves in Table 8. Upon recognition of the mortgage loans held by newly consolidated trusts on January 1, 2010, we increased our “Allowance for loan losses” and decreased our “Reserve for guaranty losses.” The impact at transition is reported as “Adoption of new accounting standards” in the table. The decrease in the combined loss reserves from transition represents a difference in the methodology used to estimate incurred losses for our allowance for loan losses as compared with our reserve for guaranty losses and our separate presentation of the portion of the allowance related to accrued interest as our “Allowance for accrued interest receivable.” These changes are discussed in “Note 2, Adoption of the New Accounting Standards on the Transfers of Financial Assets and Consolidation of Variable Interest Entities.”

 

 

 

 

Our provision for credit losses decreased in the first quarter of 2010 compared with the first quarter of 2009 primarily due to a slowing in the growth, relative to the first half of 2009, of loans that are seriously delinquent, which is partly the result of the home retention and the foreclosure alternative workouts that we completed during the quarter. While we have purchased significantly more delinquent loans from MBS trusts in the first quarter of 2010 compared to the first quarter of 2009, we experienced a significant decline in fair value losses on acquired credit-impaired loans because of our adoption of the new accounting standards. Only purchases of credit-deteriorated loans from unconsolidated MBS trusts or as a result of other credit guarantees generate fair value losses upon acquisition. However, our provision for credit losses, although lower through the first quarter of 2010, remained high and our combined loss reserves remained high due to:

 

 

 

 

While loans in certain states, certain higher risk categories and our 2006 and 2007 vintages continue to contribute disproportionately to our credit losses, the portion of our combined loss reserves attributable to these loan categories has declined slightly or remained flat as of March 31, 2010 compared with December 31, 2009. The Midwest accounted for approximately 13% of our combined single-family loss reserves as of March 31, 2010 and December 31, 2009. Our mortgage loans in California, Florida, Arizona and Nevada together accounted for approximately 51% of our combined single-family loss reserves as of March 31, 2010, compared with approximately 53% as of December 31, 2009. Our Alt-A loans represented approximately 34% of our combined single-family loss reserves as of March 31, 2010, compared with approximately 35% as of December 31, 2009, and our 2006 and 2007 loan vintages together accounted for approximately 67% of our combined single-family loss reserves as of March 31, 2010, compared with approximately 69% as of December 31, 2009.

 

We acquired significantly more credit-impaired loans from MBS trusts in the first quarter of 2010 compared with the first quarter of 2009. However, with the adoption of the new accounting standards, only purchases of credit-deteriorated loans from unconsolidated MBS trusts or as a result of other credit guarantees generate fair value losses upon acquisition and accordingly our fair value losses on acquired credit-impaired loans significantly decreased. During the first quarter of 2010, we acquired approximately 289,000 loans of which approximately 700 credit-impaired loans were acquired from unconsolidated MBS trusts or as a result of other credit guarantees and for which we recorded fair value losses of $58 million upon acquisition. During the first quarter of 2009, we acquired approximately 12,200 loans from MBS trusts and recorded fair value losses of $1.5 billion upon acquisition.

 

For additional discussions on delinquent loans and concentrations, see “Risk Management—Mortgage Credit Risk Management—Single-Family Mortgage Credit Risk Management—Problem Loan Management and Foreclosure Prevention.” For discussions on our charge-offs, see “Consolidated Results of Operations—Credit-Related Expenses—Credit Loss Performance Metrics.”

 

Our balance of nonperforming single-family loans remained high as of March 31, 2010 due to both high levels of delinquencies and an increase in TDRs. The composition of our nonperforming loans is shown in Table 9. For information on the impact of TDRs and other individually impaired loans on our allowance for loan losses, see “Note 4, Mortgage Loans.”

 

 

 

 

 

Foreclosed Property Expense (Income)

 

The shift from foreclosed property expense in the first quarter of 2009 to foreclosed property income in the first quarter of 2010 was primarily driven by $562 million of fees recognized from the cancellation and restructuring of some of our mortgage insurance coverage. These fees represented an acceleration of, and discount on, claims to be paid pursuant to the coverage in order to reduce our future exposure to our mortgage insurers. In addition, we had lower valuation adjustments on our REO inventory in the first quarter of 2010, reflecting the stabilization of home prices in some geographic regions. This improvement was offset by an increase in REO holding costs due to the continued rise in foreclosure activity which resulted in higher REO inventory in the first quarter of 2010 compared with the first quarter of 2009.

Credit Loss Performance Metrics

 

Our credit-related expenses should be considered in conjunction with our credit loss performance. As our credit losses are now at such high levels, management has shifted focus away from the credit loss ratio to measure performance and has focused more on our loss mitigation strategies and reducing our credit losses on an absolute basis. Historically, management viewed our credit loss performance metrics, which include our historical credit losses and our credit loss ratio, as indicators of the effectiveness of our credit risk management strategies.

 

These metrics, however, are not defined terms within GAAP and may not be calculated in the same manner as similarly titled measures reported by other companies. Because management does not view changes in the fair value of our mortgage loans as credit losses, we adjust our credit loss performance metrics for the impact associated with HomeSaver Advance loans and the acquisition of credit-impaired loans. We also exclude interest forgone on nonperforming loans in our mortgage portfolio, other-than-temporary impairment losses resulting from deterioration in the credit quality of our mortgage-related securities and accretion of interest income on acquired credit-impaired loans from credit losses.

 

We believe that credit loss performance metrics may be useful to investors because they are metrics widely used by analysts, investors and other companies within the financial services industry. They also provide a consistent treatment of credit losses for on- and off-balance sheet loans. Moreover, by presenting credit losses with and without the effect of fair value losses associated with the acquisition of credit-impaired loans and HomeSaver Advance loans, investors are able to evaluate our credit performance on a more consistent basis among periods. Table 10 details the components of our credit loss performance metrics as well as our average default rate and loss severity.

 

 

 

 

The increase in our credit losses reflects the increase in the number of defaults, particularly due to the prolonged period of high unemployment, decline in home prices and our prior acquisition of loans with higher risk attributes. However, defaults in the first quarter of 2009 were lower than they could have been due to the foreclosure moratoria during the end of 2008 and first quarter of 2009. The increase in defaults was partially offset by a slight reduction in average loss severity as home prices have improved in some geographic regions.

 

Table 11 provides an analysis of our credit losses in certain higher risk loan categories, loan vintages and loans within certain states that continue to account for a disproportionate share of our credit losses as compared with our other loans.

 

 

 

 

Our 2009 and 2010 vintages accounted for less than 1% of our single-family credit losses. Typically, credit losses on mortgage loans do not peak until the third through fifth years following origination. We provide more detailed credit performance information, including serious delinquency rates by geographic region, statistics on nonperforming loans and foreclosure activity in “Risk Management—Credit Risk Management—Mortgage Credit Risk Management.”

 

Regulatory Hypothetical Stress Test Scenario

 

Under a September 2005 agreement with OFHEO, we are required to disclose on a quarterly basis the present value of the change in future expected credit losses from our existing single-family guaranty book of business from an immediate 5% decline in single-family home prices for the entire United States. Although other provisions of the September 2005 agreement were suspended in March 2009 by FHFA until further notice, the disclosure requirement was not suspended. For purposes of this calculation, we assume that, after the initial 5% shock, home price growth rates return to the average of the possible growth rate paths used in our internal credit pricing models. The sensitivity results represent the difference between future expected credit losses under our base case scenario, which is derived from our internal home price path forecast, and a scenario that assumes an instantaneous nationwide 5% decline in home prices.

Table 12 compares the credit loss sensitivities for the periods indicated for first lien single-family whole loans we own or that back Fannie Mae MBS, before and after consideration of projected credit risk sharing proceeds, such as private mortgage insurance claims and other credit enhancement.

 

 

 

 

Because these sensitivities represent hypothetical scenarios, they should be used with caution. Our regulatory stress test scenario is limited in that it assumes an instantaneous uniform 5% nationwide decline in home prices, which is not representative of the historical pattern of changes in home prices. Changes in home prices generally vary on a regional, as well as a local, basis. In addition, these stress test scenarios are calculated independently without considering changes in other interrelated assumptions, such as unemployment rates or other economic factors, which are likely to have a significant impact on our future expected credit losses.

 

Federal Income Taxes

 

We did not recognize an income tax benefit for our current period pre-tax loss as it is more likely than not that we will not generate sufficient taxable income in the foreseeable future to realize our net deferred tax assets. We recognized an income tax benefit in the first quarter of 2010 primarily due to the reversal of a portion of the valuation allowance for deferred tax assets resulting primarily from a settlement agreement reached with the IRS in the first quarter of 2010 for our unrecognized tax benefits for the tax years 1999 through 2004. The tax benefit recognized for the first quarter of 2009 was primarily due to the benefit of carrying back to prior years a portion of our 2009 tax loss, net of the reversal of the use of certain tax credits.

 

Financial Impact of the Making Home Affordable Program on Fannie Mae

 

Home Affordable Refinance Program

 

Because we already own or guarantee the mortgage loans that we refinance under HARP, our expenses under that program consist mostly of limited administrative costs.

Home Affordable Modification Program

 

We discuss below how modifying loans under HAMP that we own or guarantee directly affects our financial results.

 

Impairments and Fair Value Losses on Loans Under HAMP