10-K 1 w26699e10vk.htm FORM 10-K e10vk
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-K
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2004
 
Commission File No.: 0-50231
 
Federal National Mortgage Association
(Exact name of registrant as specified in its charter)
Fannie Mae
 
     
Federally chartered corporation
  52-0883107
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
     
3900 Wisconsin Avenue,
NW Washington, DC
(Address of principal executive offices)
  20016
(Zip Code)
 
Registrant’s telephone number, including area code:
(202) 752-7000
 
Securities registered pursuant to Section 12(b) of the Act:
None
 
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, without par value
(Title of class)
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.  Yes o     No þ
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes o     No þ
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ
 
The aggregate market value of the common stock held by non-affiliates of the registrant computed by reference to the price at which the common stock was last sold on June 30, 2006 (the last business day of the registrant’s most recently completed second fiscal quarter) was approximately $46,790 million.
 
As of October 31, 2006, there were 975,052,687 shares of common stock of the registrant outstanding.
 


Table of Contents

 
TABLE OF CONTENTS
 
                 
  1
  Business   1
    Explanatory Note about this Report   1
    Overview   1
    Financial Restatement, Regulatory Reviews and Other Significant Recent Events   1
    Residential Mortgage Market Overview   4
    Business Segments   6
    Competition   22
    Our Charter and Regulation of Our Activities   23
    Employees   32
    Where You Can Find Additional Information   32
    Forward-Looking Statements   33
    Glossary of Terms Used in this Report   35
  Risk Factors   39
  Unresolved Staff Comments   50
  Properties   50
  Legal Proceedings   50
    Restatement-Related Matters   51
    Restatement-Related Investigations by U.S. Attorney’s Office, OFHEO and the SEC   53
    Other Legal Proceedings   54
  Submission of Matters to a Vote of Security Holders   56
       
  57
  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities   57
  Selected Financial Data   62
  Management’s Discussion and Analysis of Financial Condition and Results of Operations   65
    Organization of MD&A   65
    Executive Summary   65
    Restatement   71
    Critical Accounting Policies and Estimates   95
    Consolidated Results of Operations   101
    Business Segment Results   119
    Supplemental Non-GAAP Information—Fair Value Balance Sheet   126
    Risk Management   132
    Liquidity and Capital Management   169
    Off-Balance Sheet Arrangements   184
    Impact of Future Adoption of Accounting Pronouncements   187
    2004 Quarterly Review   190
  Quantitative and Qualitative Disclosures About Market Risk   197
  Financial Statements and Supplementary Data   197
  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   197


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  Controls and Procedures   198
    Evaluation of Disclosure Controls and Procedures   198
    Management’s Report on Internal Control Over Financial Reporting   199
    Remediation Activities and Changes in Internal Control Over Financial Reporting   204
    Report of Independent Registered Public Accounting Firm   211
  Other Information   213
       
  213
  Directors and Executive Officers of the Registrant   213
  Executive Compensation   220
  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   233
  Certain Relationships and Related Transactions   237
  Principal Accounting Fees and Services   239
       
  241
  Exhibits, Financial Statement Schedules   241
  E-1


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MD&A TABLE REFERENCE
 
                 
Table
 
Description
  Page  
 
    Selected Financial Data     62  
1
  Cumulative Impact of Restatement     74  
2
  Balance Sheet Impact of Restatement as of December 31, 2003     87  
3
  Balance Sheet Impact of Restatement as of December 31, 2002     89  
4
  Balance Sheet Impact of Restatement as of December 31, 2001     90  
5
  Stockholders’ Equity Impact of Restatement as of December 31, 2001     91  
6
  Income Statement Impact of Restatement for the Year Ended December 31, 2003     92  
7
  Income Statement Impact of Restatement for the Year Ended December 31, 2002     93  
8
  Impact of Restatement on Statements of Cash Flows for the Years Ended December 31, 2003 and 2002     94  
9
  Regulatory Capital Impact of Restatement as of December 31, 2003 and 2002     95  
10
  Risk Management Derivative Fair Value Sensitivity Analysis     97  
11
  Amortization of Cost Basis Adjustments     98  
12
  Condensed Consolidated Results of Operations     101  
13
  Analysis of Net Interest Income and Yield     103  
14
  Rate/Volume Analysis of Net Interest Income     104  
15
  Analysis of Guaranty Fee Income and Average Effective Guaranty Fee Rate     106  
16
  Investment Losses, Net     107  
17
  Changes in Risk Management Derivative Assets (Liabilities) at Fair Value, Net     111  
18
  Derivatives Fair Value Gains (Losses), Net     113  
19
  Notional and Fair Value of Derivatives     114  
20
  Business Segment Results Summary     119  
21
  Mortgage Portfolio Activity     123  
22
  Mortgage Portfolio Composition     125  
23
  Amortized Cost, Maturity and Average Yield of Investments in Securities     126  
24
  Non-GAAP Supplemental Consolidated Fair Value Balance Sheets     128  
25
  Selected Market Information     130  
26
  Composition of Mortgage Credit Book of Business     136  
27
  Risk Characteristics of Conventional Single-Family Mortgage Credit Book     140  
28
  Risk Characteristics of Conventional Single-Family Mortgage Business Volumes     142  
29
  Statistics on Conventional Single-Family Problem Loan Workouts     148  
30
  Serious Delinquency Rates     150  
31
  Nonperforming Single-Family and Multifamily Loans     151  
32
  Single-Family and Multifamily Credit Loss Performance     151  
33
  Single-Family Credit Loss Sensitivity     152  
34
  Single-Family Foreclosed Property Activity     153  
35
  Allowance for Loan Losses and Reserve for Guaranty Losses     154  
36
  Credit Loss Exposure of Derivative Instruments     158  


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PART I
 
Item 1.   Business
 
EXPLANATORY NOTE ABOUT THIS REPORT
 
This annual report is our first periodic report covering periods after June 30, 2004. Because of the delay in our periodic reporting and the changes that have occurred in our business since our last periodic filing, where appropriate, the information contained in this report reflects current information about our business.
 
This report contains our consolidated financial statements and related notes for the year ended December 31, 2004, as well as a restatement of our previously issued consolidated financial statements and related notes for the years ended December 31, 2003 and 2002, and for the quarters ended June 30, 2004 and March 31, 2004. All restatement adjustments relating to periods prior to January 1, 2002 have been presented as adjustments to retained earnings as of December 31, 2001, which is available in “Item 6—Selected Financial Data.” In light of the substantial time, effort and expense incurred since December 2004 to complete the restatement of our consolidated financial statements for 2003 and 2002, we have determined that extensive additional efforts would be required to restate all 2001 and 2000 financial data. In particular, significant complexities of accounting standards, turnover of relevant personnel, and limitations of systems and data all limit our ability to reconstruct additional financial information for 2001 and 2000.
 
OVERVIEW
 
Fannie Mae’s activities enhance the liquidity and stability of the mortgage market. These activities include providing funds to mortgage lenders through our purchases of mortgage assets, and issuing and guaranteeing mortgage-related securities that facilitate the flow of additional funds into the mortgage market. We also make other investments that increase the supply of affordable rental housing. Our activities contribute to making housing in the United States more affordable and more available to low-, moderate- and middle-income Americans.
 
We are a government-sponsored enterprise (“GSE”) chartered by the U.S. Congress under the name “Federal National Mortgage Association” and are aligned with national policies to support expanded access to housing and increased opportunities for homeownership. We are subject to government oversight and regulation. Our regulators include the Office of Federal Housing Enterprise Oversight (“OFHEO”), the Department of Housing and Urban Development (“HUD”), the Securities and Exchange Commission (“SEC”) and the Department of the Treasury.
 
While we are a Congressionally-chartered enterprise, the U.S. government does not guarantee, directly or indirectly, our securities or other obligations. We are a stockholder-owned corporation, and our business is self-sustaining and funded exclusively with private capital. Our common stock is listed on the New York Stock Exchange and traded under the symbol “FNM.” Our debt securities are actively traded in the over-the-counter market.
 
FINANCIAL RESTATEMENT, REGULATORY REVIEWS AND OTHER SIGNIFICANT RECENT EVENTS
 
We have undertaken comprehensive reviews of our accounting policies and procedures, financial reporting, internal controls, corporate governance and the structure of our management team and Board of Directors. We commenced these reviews in 2004 following our Board of Directors’ receipt of an interim report from OFHEO on its findings in a special examination. Since then, we have made extensive organizational and operational changes, improved our internal controls, and been subject to additional reviews and investigations. The following are summary descriptions of these events.
 
OFHEO Special Examination and Interim Report.  In July 2003, OFHEO notified us that it intended to conduct a special examination of our accounting policies and internal controls, as well as other areas of inquiry. OFHEO began its special examination in November 2003 and delivered an interim report of its findings to our Board of Directors in September 2004. In this interim report, and as further outlined in its May 2006 final report described below, OFHEO identified areas within our accounting that it determined did not


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conform to U.S. generally accepted accounting principles (“GAAP”) and specified weaknesses in our internal controls, compensation practices and corporate governance. We entered into agreements with OFHEO in September 2004 and March 2005 in which we agreed to take specified actions with respect to our accounting practices, capital levels and activities, organization and staffing, corporate governance, internal controls, compensation practices and other matters. See also “OFHEO Final Report and Settlement” below.
 
Special Review Committee and Paul Weiss Investigation and Report.  After receiving OFHEO’s interim report in September 2004, our Board of Directors established a Special Review Committee of independent directors to review OFHEO’s findings and oversee an independent investigation of issues raised in the report. The Special Review Committee engaged former Senator Warren B. Rudman and the law firm of Paul, Weiss, Rifkind, Wharton & Garrison LLP (“Paul Weiss”) to conduct the investigation and to prepare a detailed report of its findings and conclusions. Paul Weiss obtained independent professional accounting assistance and, in February 2006, reported its findings that our accounting practices in many areas were not consistent with GAAP, and aspects of our accounting were designed to show stable earnings growth and achieve forecasted earnings. Paul Weiss also concluded that the accounting systems we previously utilized were inadequate.
 
SEC Review of Our Accounting Practices.  Following the receipt of OFHEO’s interim report, we requested that the SEC’s Office of the Chief Accountant review our accounting practices with respect to two areas identified in OFHEO’s interim findings – hedge accounting and the amortization of purchase premiums and discounts on securities and loans, as well as other deferred charges – to determine whether our practices complied with the applicable GAAP requirements. In December 2004, the SEC’s Office of the Chief Accountant advised us that, from 2001 to mid-2004, our accounting practices with respect to these two areas did not comply in material respects with GAAP requirements. Accordingly, the Office of the Chief Accountant advised us to (1) restate our financial statements filed with the SEC to eliminate the use of hedge accounting and (2) evaluate our accounting for the amortization of premiums and discounts, and restate our financial statements filed with the SEC if the amounts required for correction were material. The SEC’s Office of the Chief Accountant also advised us to reevaluate the GAAP and non-GAAP information that we previously provided to investors, particularly in view of the decision that hedge accounting was not appropriate.
 
Accounting-Related Changes and Financial Restatement.  After receiving OFHEO’s interim findings and the SEC’s determination, the Audit Committee of our Board of Directors concluded in December 2004 that our previously filed interim and audited consolidated financial statements should not be relied upon since they were prepared applying accounting practices that did not comply with GAAP and, consequently, we would restate our consolidated financial statements. As part of the restatement, we have undertaken a comprehensive review of, and made numerous corrections to, our accounting policies and procedures as well as the information systems used to produce our accounting records and financial reports. The consolidated financial statements for the years ended December 31, 2003 and 2002 included in this Annual Report on Form 10-K include restatement adjustments that we have categorized into the following seven areas: our accounting for debt and derivatives; our accounting for commitments; our accounting for investments in securities; our accounting for MBS trust consolidation and sale accounting; our accounting for financial guaranties and master servicing; our accounting for amortization of cost basis adjustments; and other adjustments.
 
The overall impact of our restatement was a total reduction in retained earnings of $6.3 billion through June 30, 2004. This amount includes:
 
  •  a $7.0 billion net decrease in earnings for periods prior to January 1, 2002 (as reflected in beginning retained earnings as of January 1, 2002);
 
  •  a $705 million net decrease in earnings for the year ended December 31, 2002;
 
  •  a $176 million net increase in earnings for the year ended December 31, 2003; and
 
  •  a $1.2 billion net increase in earnings for the six months ended June 30, 2004.
 
We previously estimated that errors in accounting for derivative instruments, including mortgage commitments, would result in a total of $10.8 billion in after-tax cumulative losses through December 31, 2004. In a subsequent 12b-25 filing in August 2006, we confirmed our estimate of after-tax cumulative losses on


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derivatives of $8.4 billion, but disclosed that our previous estimate of $2.4 billion in after-tax cumulative losses on mortgage commitments would be significantly less. We did not provide estimates of the effects on net income or retained earnings of any other accounting errors, nor did we provide any estimates of the effects of our restatement on total assets, total liabilities or stockholders’ equity. As reflected in the results we are reporting in this Annual Report on Form 10-K, our retained earnings as of December 31, 2004 includes after-tax cumulative losses on derivatives of $8.4 billion and after-tax cumulative net gains on derivative mortgage commitments of $535 million, net of related amortization, for a total after-tax cumulative impact as of December 31, 2004 of approximately $7.9 billion related to these two restatement items. For more information regarding the restatement, see “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”)—Restatement” and “Notes to Consolidated Financial Statements—Note 1, Restatement of Previously Issued Financial Statements.”
 
Changes to Management and Board of Directors.  Since the announcement of our decision to restate in December 2004, we have made extensive changes in our senior management team and our Board of Directors. In December 2004, Franklin D. Raines, who had served as Chairman of the Board and our Chief Executive Officer, left his position. Our Board of Directors appointed Daniel H. Mudd as our new Chief Executive Officer. In addition, we have replaced all of our senior financial and accounting officers who served during the period in which we issued the consolidated financial statements that have been restated, including our Chief Financial Officer and Controller, and we hired a new General Counsel, Chief Risk Officer, Chief Audit Executive and Chief Compliance Officer. Our Board of Directors also appointed Stephen B. Ashley as non-executive Chairman of the Board of Directors and has added six new directors to the Board since our receipt of OFHEO’s interim report in September 2004. In addition to these appointments and new additions to our Board of Directors and management team, we have reorganized our internal operations and made changes in the committee structure of our Board of Directors.
 
Replacement of Independent Auditors.  In December 2004, the Audit Committee of our Board of Directors dismissed KPMG LLP (“KPMG”) as our independent registered public accounting firm. KPMG had served as our independent auditor since 1969 and had audited the previously issued financial statements that we have restated. The Audit Committee engaged Deloitte & Touche LLP (“Deloitte & Touche”) to serve as our independent registered public accounting firm effective January 2005. The consolidated financial statements included in this Annual Report on Form 10-K have been audited by Deloitte & Touche.
 
Capital Restoration Plan and 30% Capital Surplus Requirement.  In December 2004, OFHEO determined that we were significantly undercapitalized as of September 30, 2004. We prepared a capital restoration plan to comply with OFHEO’s directive that we achieve a 30% surplus over our statutory minimum capital requirement by September 30, 2005. In accordance with our plan, we met this capital requirement principally by issuing $5.0 billion in non-cumulative preferred stock, significantly decreasing the size of our mortgage investment portfolio, accumulating retained earnings and reducing our quarterly common stock dividend from $0.52 per share to $0.26 per share. Pursuant to our May 2006 consent order with OFHEO (described below), this requirement to maintain a 30% capital surplus remains in effect and may be modified or terminated only at OFHEO’s discretion. For additional information on our capital requirements, see “Item 7—MD&A—Liquidity and Capital Management—Capital Management—Capital Adequacy Requirements.”
 
OFHEO Final Report and Settlement.  On May 23, 2006, OFHEO issued a final report on its special examination. OFHEO’s final report concluded that, during the period covered by the report (1998 to mid-2004), a large number of our accounting policies and practices did not comply with GAAP and we had serious problems in our internal controls, financial reporting and corporate governance. On May 23, 2006, we agreed to OFHEO’s issuance of a consent order that resolved open matters relating to their investigation of us. Under the consent order, we neither admitted nor denied any wrongdoing and agreed to make changes and take actions in specified areas, including our accounting practices, capital levels and activities, corporate governance, Board of Directors, internal controls, public disclosures, regulatory reporting, personnel and compensation practices. In addition, as part of this consent order and our settlement with the SEC discussed below, we have paid a $400 million civil penalty, with $50 million paid to the U.S. Treasury and $350 million paid to the SEC for distribution to stockholders pursuant to the Fair Funds for Investors provision of the Sarbanes-Oxley Act of 2002.


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Limitation on the Size of Our Mortgage Portfolio.  As part of OFHEO’s May 2006 consent order, we agreed not to increase the size of our net mortgage portfolio above the $727.75 billion amount of net mortgage assets held as of December 31, 2005, except in limited circumstances at OFHEO’s discretion. Our “net mortgage assets” refers to the unpaid principal balance of our mortgage assets, net of GAAP adjustments. The consent order permitted us to propose increases in the size of our mortgage portfolio in a business plan submitted to OFHEO by July 2006. We may also propose to OFHEO increases in the size of our portfolio to respond to disruptions in the mortgage markets. The business plan we submitted to OFHEO in July 2006 did not request an increase in the current limitation on the size of our mortgage portfolio during 2006. We anticipate submitting an updated business plan to OFHEO in early 2007 that may include a request for modest growth in our mortgage portfolio. Until the Director of OFHEO has determined that modification or expiration of the limitation is appropriate, we will remain subject to this limitation on portfolio growth.
 
SEC Investigation and Settlement.  The SEC initiated an investigation of our accounting practices and, in May 2006, without admitting or denying the SEC’s allegations, we consented to the entry of a final judgment which resolved all of the SEC’s claims against us in its civil proceeding. The judgment permanently restrains and enjoins us from future violations of specified provisions of the federal securities laws. In addition, as discussed under “OFHEO Final Report and Settlement” above, as part of our settlements with OFHEO and the SEC, we have paid a $400 million civil penalty, with $50 million paid to the U.S. Treasury and $350 million paid to the SEC for distribution to stockholders pursuant to the Fair Funds for Investors provision of the Sarbanes-Oxley Act of 2002.
 
Investigation by the U.S. Attorney’s Office.  In October 2004, the U.S. Attorney’s Office for the District of Columbia notified us that it was investigating our past accounting practices. In August 2006, the U.S. Attorney’s Office advised us that it had discontinued its investigation and would not be filing any charges against us.
 
Stockholder Lawsuits and Other Litigation.  A number of lawsuits related to our accounting practices prior to December 2004 are currently pending against us and certain of our current and former officers and directors. For more information on these lawsuits, see “Item 3—Legal Proceedings.”
 
Impairment Determination.  On December 6, 2006, the Audit Committee of our Board of Directors reviewed the conclusion of our Chief Financial Officer and our Controller that we are required under GAAP to take the impairment charges described in this Annual Report on Form 10-K for the periods presented in this report and, following discussion with our independent registered public accounting firm, the Audit Committee affirmed that material impairments have occurred. Additional information relating to the impairment charges, including the amounts of the impairment charges and our estimates of the amounts of the impairment charges that we expect to result in future cash expenditures, are discussed in “Item 7—MD&A—Restatement—Summary of Restatement Adjustments.”
 
RESIDENTIAL MORTGAGE MARKET OVERVIEW
 
Residential Mortgage Debt Outstanding
 
Our business operates within the U.S. residential mortgage market. Because we support activity in the U.S. residential mortgage market, we consider the amount of U.S. residential mortgage debt outstanding to be the best measure of the size of our overall market. As of June 30, 2006, the latest date for which information was available, the amount of U.S. residential mortgage debt outstanding was estimated by the Federal Reserve to be approximately $10.5 trillion. Our book of business, which includes mortgage assets we hold in our mortgage portfolio and our Fannie Mae mortgage-backed securities held by third parties, was $2.4 trillion as of June 30, 2006, or nearly 23% of total U.S. residential mortgage debt outstanding. “Fannie Mae mortgage-backed securities” or “Fannie Mae MBS” generally refers to those mortgage-related securities that we issue and with respect to which we guarantee to the related trusts that we will supplement mortgage loan collections as required to permit timely payment of principal and interest due on these Fannie Mae MBS. We also issue some forms of mortgage-related securities for which we do not provide this guaranty.
 
The mortgage market has experienced strong long-term growth. According to Federal Reserve estimates, total U.S. residential mortgage debt outstanding has increased each year from 1945 to 2005. Growth in U.S.


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residential mortgage debt outstanding averaged 10.6% per year over that period, which is faster than the 6.9% average growth in the U.S. economy over the same period, as measured by nominal gross domestic product. Growth in U.S. residential mortgage debt outstanding was particularly strong during 2001 through 2005. Total U.S. residential mortgage debt outstanding grew at an estimated annual rate of almost 13% in 2002 and 2003, approximately 15% in 2004 and approximately 14% in 2005.
 
Homeownership rates, home price appreciation and certain macroeconomic factors such as interest rates are large drivers of growth in U.S. residential mortgage debt outstanding. Growth in U.S. residential mortgage debt outstanding in recent years has been driven primarily by record home sales, strong home price appreciation and historically low interest rates. Also contributing to growth in U.S. residential mortgage debt outstanding in recent years was the increased use of mortgage debt financing by homeowners and demographic trends that contributed to increased household formation and higher homeownership rates. Growth in U.S. residential mortgage debt outstanding has moderated in 2006 in response to slower home price growth, a sharp drop-off in home sales and declining refinance activity. While total U.S. residential mortgage debt outstanding as of June 30, 2006 was 12.3% higher than year-ago levels, the annualized growth rate in the second quarter of 2006 slowed to 9.6%. We expect that growth in total U.S. residential mortgage debt outstanding will continue at a slower pace in 2007, as the housing market continues to cool and home price gains moderate further or possibly decline modestly. We believe that the continuation of positive demographic trends, such as stable household formation rates, will help mitigate this slowdown in the growth in residential mortgage debt outstanding, but these trends are unlikely to completely offset the slowdown in the short- to medium-term.
 
Over the past 30 years, home values (as measured by the OFHEO House Price Index) and income (as measured by per capita personal income) have both risen at around a 6% annualized rate. During 2001 through 2005, however, this comparability between home values and income eroded, with income growth averaging approximately 4.1% and home price appreciation averaging over 9%. Moreover, home price appreciation was especially rapid in 2004 and 2005, with rates of home price appreciation of approximately 11% in 2004 and 13% in 2005 on a national basis (with some regional variations). This period of extraordinary home price appreciation appears to be ending. According to the OFHEO House Price Index, home prices increased at a 3.45% annualized rate in the third quarter of 2006, which was the slowest pace of home price appreciation since 1998. We believe a modest decline in national home prices in 2007 is possible.
 
The amount of residential mortgage debt available for us to purchase or securitize and the mix of available loan products are affected by several factors, including the volume of single-family mortgages within the loan limits imposed under our charter, consumer preferences for different types of mortgages, and the purchase and securitization activity of other financial institutions. See “Item 1A—Risk Factors” for a description of the risks associated with the recent slowdown in home price appreciation, as well as competitive factors affecting our business.
 
Our Role in the Secondary Mortgage Market
 
The mortgage market comprises a major portion of the domestic capital markets and provides a vital source of financing for the large housing segment of the economy, as well as one of the most important means for Americans to achieve their homeownership objectives. The U.S. Congress chartered Fannie Mae and certain other GSEs to help ensure stability and liquidity within the secondary mortgage market. Our activities are especially valuable when economic or financial market conditions constrain the flow of funds for mortgage lending. In addition, we believe our activities and those of other GSEs help lower the costs of borrowing in the mortgage market, which makes housing more affordable and increases homeownership, especially for low- to moderate-income families. We believe our activities also increase the supply of affordable rental housing.
 
Our principal customers are lenders that operate within the primary mortgage market by originating mortgage loans for homebuyers and current homeowners refinancing their existing mortgage loans. Our customers include mortgage banking companies, savings and loan associations, savings banks, commercial banks, credit unions, community banks, and state and local housing finance agencies. Lenders originating mortgages in the primary market often sell them in the secondary mortgage market in the form of loans or in the form of mortgage-related securities.


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We operate in the secondary mortgage market where mortgages are bought and sold. We securitize mortgage loans originated by lenders in the primary market into Fannie Mae MBS, which can then be readily bought and sold in the secondary mortgage market. We also participate in the secondary mortgage market by purchasing mortgage loans (often referred to as “whole loans”) and mortgage-related securities, including Fannie Mae MBS, for our mortgage portfolio. By delivering loans to us in exchange for Fannie Mae MBS, lenders gain the advantage of holding a highly liquid instrument and the flexibility to determine under what conditions they will hold or sell the MBS. By selling loans to us, lenders replenish their funds and, consequently, are able to make additional loans. Pursuant to our charter, we do not lend money directly to consumers in the primary mortgage market.
 
BUSINESS SEGMENTS
 
We operate an integrated business that contributes to providing liquidity to the mortgage market and increasing the availability and affordability of housing in the United States. We are organized in three complementary business segments:
 
  •  Our Single-Family Credit Guaranty business (“Single-Family”) works with our lender customers to securitize single-family mortgage loans into Fannie Mae MBS and to facilitate the purchase of single-family mortgage loans for our mortgage portfolio. Our Single-Family business has responsibility for managing our credit risk exposure relating to the single-family Fannie Mae MBS held by third parties (such as lenders, depositories and global investors), as well as the single-family mortgage loans and single-family Fannie Mae MBS held in our mortgage portfolio. Our Single-Family business also has responsibility for pricing the credit risk of the single-family mortgage loans we purchase for our mortgage portfolio. Revenues in the segment are derived primarily from the guaranty fees the segment receives as compensation for assuming the credit risk on the mortgage loans underlying single-family Fannie Mae MBS and on the single-family mortgage loans held in our portfolio.
 
  •  Our Housing and Community Development business (“HCD”) helps to expand the supply of affordable and market-rate rental housing in the United States by working 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 helps to expand the supply of affordable housing by making investments in rental and for-sale housing projects, including investments in rental housing that qualify for federal low-income housing tax credits. Our HCD business has responsibility for managing our credit risk exposure relating to the multifamily Fannie Mae MBS held by third parties, as well as the multifamily mortgage loans and multifamily Fannie Mae MBS held in our mortgage portfolio. Revenues in the segment are derived from a variety of sources, including the guaranty fees the segment receives as compensation for assuming the credit risk on the mortgage loans underlying multifamily Fannie Mae MBS and on the multifamily mortgage loans held in our portfolio, transaction fees associated with the multifamily business and bond credit enhancement fees. In addition, HCD’s investments in housing projects eligible for the low-income housing tax credit and other investments generate both tax credits and net operating losses that reduce our federal income tax liability.
 
  •  Our Capital Markets group manages our investment activity in mortgage loans and mortgage-related securities, and has responsibility for managing our assets and liabilities and our liquidity and capital positions. Through the issuance of debt securities in the capital markets, our Capital Markets group attracts capital from investors globally to finance housing in the United States. In addition, our Capital Markets group increases the liquidity of the mortgage market by maintaining a constant, reliable presence as an active investor in mortgage assets. Our Capital Markets group has responsibility for managing our interest rate risk. Our Capital Markets group generates income primarily from the difference, or spread, between the yield on the mortgage assets we own and the cost of the debt we issue in the global capital markets to fund these assets.


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Although we operate our business through three separate business segments, there are important interrelationships among the functions of these three segments. For example:
 
  •  Mortgage Acquisition.  As noted above, our Single-Family and HCD business segments work with our lender customers to securitize mortgage loans into Fannie Mae MBS and to facilitate the purchase of mortgage loans for our mortgage portfolio. Accordingly, although the Single-Family and HCD businesses principally manage the relationships with our lender customers, our Capital Markets group works closely with Single-Family and HCD in making mortgage acquisition decisions. Our Capital Markets group works directly with our lender customers on structured Fannie Mae MBS transactions.
 
  •  Portfolio Credit Risk Management.  Our Single-Family and HCD business segments support our Capital Markets group by assuming and managing the credit risk of borrowers defaulting on payments of principal and interest on the mortgage loans held in our mortgage portfolio or underlying Fannie Mae MBS held in our mortgage portfolio. Our Single-Family business also prices the credit risk of the single-family mortgage loans purchased by our Capital Markets group for our mortgage portfolio.
 
  •  Securitization Activities.  All three of our business segments engage in securitization activities. Our Single-Family business issues our single-class, single-family Fannie Mae MBS. These securities are principally created through lender swap transactions and constitute the substantial majority of our Fannie Mae MBS issues. The Multifamily Group within our HCD business segment issues our single-class, multifamily Fannie Mae MBS that are principally created through lender swap transactions. Our Capital Markets group creates Fannie Mae MBS using mortgage loans that we hold in our mortgage portfolio and also issues structured Fannie Mae MBS.
 
  •  Liquidity Support.  The Capital Markets group supports the liquidity of single-family and multifamily Fannie Mae MBS by holding Fannie Mae MBS in our mortgage portfolio. This support of our Fannie Mae MBS helps to maintain the competitiveness of our Single-Family and HCD businesses, and increases the value of our Fannie Mae MBS.
 
  •  Mission Support.  All three of our business segments contribute to meeting the statutory housing goals established by HUD. We meet our housing goals both by purchasing mortgage loans for our mortgage portfolio and by securitizing mortgage loans into Fannie Mae MBS. Both our Single-Family and HCD businesses securitize mortgages that contribute to our housing goals. In addition, our Capital Markets group purchases mortgages for our mortgage portfolio that contribute to our housing goals.


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The table below displays the revenues, net income and total assets for each of our business segments for each of the three years in the period ended December 31, 2004. In our previously reported financial statements, we disclosed only two business segments, Portfolio Investment (which has since been renamed “Capital Markets”) and Credit Guaranty, because we aggregated the Single-Family Credit Guaranty and the HCD business segments into a single Credit Guaranty business segment. As described in “Notes to Consolidated Financial Statements—Note 15, Segment Reporting,” we determined that this previous presentation of our business segments did not comply with GAAP.
 
Business Segment Summary Financial Information
 
                         
    For the Year Ended December 31,  
    2004     2003     2002  
          (Restated)     (Restated)  
    (Dollars in millions)  
 
Revenue(1):
                       
Single-Family Credit Guaranty
  $ 5,153     $ 4,994     $ 3,957  
Housing and Community Development
    538       398       305  
Capital Markets
    46,135       47,293       49,267  
                         
Total
  $ 51,826     $ 52,685     $ 53,529  
                         
Net income:
                       
Single-Family Credit Guaranty
  $ 2,514     $ 2,481     $ 1,958  
Housing and Community Development
    337       286       184  
Capital Markets
    2,116       5,314       1,772  
                         
Total
  $ 4,967     $ 8,081     $ 3,914  
                         
 
                 
    As of December 31,  
    2004     2003  
          (Restated)  
 
Total assets:
               
Single-Family Credit Guaranty
  $ 11,543     $ 8,724  
Housing and Community Development
    10,166       7,853  
Capital Markets
    999,225       1,005,698  
                 
Total
  $ 1,020,934     $ 1,022,275  
                 
 
 
(1) Includes interest income, guaranty fee income, and fee and other income.
 
We use various management methodologies to allocate certain balance sheet and income statement line items to the responsible operating segment. For a description of our allocation methodologies, see “Notes to Consolidated Financial Statements—Note 15, Segment Reporting.” For further information on the results and assets of our business segments, see “Item 7—MD&A—Business Segment Results.”
 
Single-Family Credit Guaranty
 
Our Single-Family Credit Guaranty business works with our lender customers to securitize single-family mortgage loans into Fannie Mae MBS and to facilitate the purchase of single-family mortgage loans for our mortgage portfolio. Our Single-Family business manages our relationships with over 1,000 lenders from which we obtain mortgage loans. These lenders are part of the primary mortgage market, where mortgage loans are originated and funds are loaned to borrowers. Our lender customers include mortgage companies, savings and loan associations, savings banks, commercial banks, credit unions, and state and local housing finance agencies.
 
In our Single-Family business, mortgage lenders generally deliver mortgage loans to us in exchange for our Fannie Mae MBS. In a typical MBS transaction, we guaranty to each MBS trust that we will supplement mortgage loan collections as required to permit timely payment of principal and interest due on the related


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Fannie Mae MBS. In return, we receive a fee for providing that guaranty. Our guaranty supports the liquidity of Fannie Mae MBS and makes it easier for lenders to sell these securities. When lenders receive Fannie Mae MBS in exchange for mortgage loans, they may hold the Fannie Mae MBS for investment or sell the MBS in the secondary mortgage market. This option allows lenders to manage their assets so that they continue to have funds available to make new mortgage loans. In holding Fannie Mae MBS created from a pool of whole loans, a lender has securities that are generally more liquid than whole loans, which provides the lender with greater financial flexibility. The ability of lenders to sell Fannie Mae MBS quickly allows them to continue making mortgage loans even under economic and capital markets conditions that might otherwise constrain mortgage financing activities.
 
The following table provides a breakdown of our single-family mortgage credit book of business as of December 31, 2004. Our single-family mortgage credit book of business refers to the sum of the unpaid principal balance of: (1) the single-family mortgage loans we hold in our investment portfolio; (2) the Fannie Mae MBS and non-Fannie Mae mortgage-related securities backed by single-family mortgage loans we hold in our investment portfolio; (3) Fannie Mae MBS backed by single-family mortgage loans that are held by third parties; and (4) credit enhancements that we provide on single-family mortgage assets. Our Single-Family business manages the risk that borrowers will default in the payment of principal and interest due on the single-family mortgage loans held in our investment portfolio or underlying Fannie Mae MBS (whether held in our investment portfolio or held by third parties).
 
Single-Family Mortgage Credit Book of Business
 
                         
    As of December 31, 2004  
    Conventional(1)     Government(2)     Total  
    (Dollars in millions)  
 
Mortgage portfolio:(3)
                       
Mortgage loans(4)
  $ 345,575     $ 10,112     $ 355,687  
Fannie Mae MBS(4)
    341,768       1,239       343,007  
Agency mortgage-related securities(4)(5)
    37,422       4,273       41,695  
Mortgage revenue bonds
    6,344       4,951       11,295  
Other mortgage-related securities(6)
    108,082       669       108,751  
                         
Total mortgage portfolio
    839,191       21,244       860,435  
Fannie Mae MBS held by third parties(7)
    1,319,066       32,337       1,351,403  
                         
Book of business
    2,158,257       53,581       2,211,838  
Other(8)
    346             346  
                         
Total single-family mortgage credit book of business
  $ 2,158,603     $ 53,581     $ 2,212,184  
                         
 
 
(1) Refers to mortgage loans and mortgage-related securities that are not guaranteed or insured by the U.S. government or any of its agencies.
 
(2) Refers to mortgage loans and mortgage-related securities guaranteed or insured by the U.S. government or one of its agencies.
 
(3) Mortgage portfolio data is reported based on unpaid principal balance. Our Single-Family business manages the credit risk relating to the single-family mortgage loans and Fannie Mae MBS held in our portfolio that are backed by single-family mortgage loans. Our Capital Markets group manages the institutional counterparty credit risk relating to the agency mortgage-related securities, mortgage revenue bonds and other mortgage-related securities held in our portfolio.
 
(4) Mortgage loan data includes mortgage-related securities that were consolidated and reported in our consolidated balance sheet as loans.
 
(5) Includes mortgage-related securities issued by Freddie Mac and Ginnie Mae.
 
(6) Includes mortgage-related securities issued by entities other than Fannie Mae, Freddie Mac or Ginnie Mae.
 
(7) Includes Fannie Mae MBS held by third-party investors. The principal balance of resecuritized Fannie Mae MBS is included only once.
 
(8) Includes additional single-family credit enhancements that we provide not otherwise reflected in the table.


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To ensure that acceptable loans are received from lenders as well as to assist lenders in efficiently and accurately processing loans that they deliver to us, we have established guidelines for the types of loans and credit risks that we accept. These guidelines also ensure compliance with the types of loans that our charter authorizes us to purchase. For a description of our charter requirements, see “Our Charter and Regulation of Our Activities.” We have developed technology-based solutions that assist our lender customers in delivering loans to us efficiently and at lower costs. Our automated underwriting system for single-family mortgage loans, known as Desktop Underwriter®, assists lenders in applying our underwriting guidelines to the single-family loans they originate. Desktop Underwriter is designed to help lenders process mortgage applications in a more efficient and accurate manner and to apply our underwriting criteria to all prospective borrowers consistently and objectively. After assessing the creditworthiness of the borrowers and originating the loans, lenders deliver the whole loans to us and represent and warrant to us that the loans meet our guidelines and any agreed-upon variances from the guidelines.
 
Guaranty Services
 
Our Single-Family business provides guaranty services by assuming the credit risk of the single-family mortgage loans underlying our guaranteed Fannie Mae MBS held by third parties. Our Single-Family business also assumes the credit risk of the single-family mortgage loans held in our investment portfolio, as well as the single-family mortgage loans underlying Fannie Mae MBS held in our portfolio.
 
Our most common type of guaranty transaction is referred to as a “lender swap transaction.” Lenders pool their loans and deliver them to us in exchange for Fannie Mae MBS backed by these loans. After receiving the loans in a lender swap transaction, we place them in a trust that is established for the sole purpose of holding the loans separate and apart from our assets. We serve as trustee for the trust. Upon creation of the trust, we deliver to the lender (or its designee) Fannie Mae MBS that are backed by the pool of mortgage loans in the trust and that represent a beneficial ownership interest in each of the loans. We guarantee to each MBS trust that we will supplement mortgage loan collections as required to permit timely payment of principal and interest due on the related Fannie Mae MBS. The mortgage servicers for the underlying mortgage loans collect the principal and interest payments from the borrowers. We permit them to retain a portion of the interest payment as compensation for servicing the mortgage loans before distributing the principal and remaining interest payments to us. We retain a portion of the interest payment as the fee for providing our guaranty, and then, on behalf of the trust, we make monthly distributions to the Fannie Mae MBS certificate holders from the principal and interest payments and other collections on the underlying mortgage loans.
 
The following diagram illustrates the basic process by which we create a typical Fannie Mae MBS in the case where a lender chooses to sell the Fannie Mae MBS to a third party investor.
 


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To better serve the needs of our lender customers as well as to respond to changing market conditions and investor preferences, we offer different types of Fannie Mae MBS backed by single-family loans, as described below:
 
  •  Single-Family Single-Class Fannie Mae MBS represent beneficial interests in single-family mortgage loans held in an MBS trust that were delivered to us typically by a single lender in exchange for the single-class Fannie Mae MBS. The certificate holders in a single-class Fannie Mae MBS issue receive principal and interest payments in proportion to their percentage ownership of the MBS issue.
 
  •  Fannie Majors® are a form of single-class Fannie Mae MBS in which generally two or more lenders deliver mortgage loans to us, and we then group all of the loans together in one MBS pool. In this case, the certificate holders receive beneficial interests in all of the loans in the pool and, as a result, may benefit from a diverse group of lenders contributing loans to the MBS rather than having an interest in loans obtained from only one lender, as well as increased liquidity from a larger-sized pool.
 
  •  Single-Family Whole Loan Multi-Class Fannie Mae MBS are multi-class Fannie Mae MBS that are formed from single-family whole loans. Our Single-Family business works with our Capital Markets group in structuring these single-family whole loan multi-class Fannie Mae MBS. Single-family whole loan multi-class Fannie Mae MBS divide the cash flows on the underlying loans and create several classes of securities, each of which represents a beneficial ownership interest in a separate portion of the cash flows.
 
Guaranty Fees
 
We enter into agreements with our lender customers that establish the guaranty fee arrangements for that customer’s Fannie Mae MBS transactions. Guaranty fees are generally paid to us on a monthly basis from a portion of the interest payments made on the underlying mortgage loans in the MBS trust.
 
The aggregate amount of single-family guaranty fees we receive in any period depends on the amount of Fannie Mae MBS outstanding during that period and the applicable guaranty fee rates. The amount of Fannie Mae MBS outstanding at any time is primarily determined by the rate at which we issue new Fannie Mae MBS and by the repayment rate for the loans underlying our outstanding Fannie Mae MBS. Less significant factors affecting the amount of Fannie Mae MBS outstanding are the rates of borrower defaults on the loans and the extent to which lenders repurchase loans from the pools because the loans do not conform to the representations made by the lenders.
 
Since we began issuing our Fannie Mae MBS nearly 25 years ago, the total amount of our outstanding single-family Fannie Mae MBS (which includes both Fannie Mae MBS held in our portfolio and Fannie Mae MBS held by third parties) has grown steadily. As of December 31, 2004 and 2005, total outstanding single-family Fannie Mae MBS was $1.8 trillion and $1.9 trillion, respectively. As of September 30, 2006, our total outstanding single-family Fannie Mae MBS was $2.0 trillion. Growth in our total outstanding Fannie Mae MBS has been supported by the value that lenders and other investors place on Fannie Mae MBS.
 
Our Customers
 
Our Single-Family business is primarily responsible for managing the relationships with our lender customers that supply mortgage loans both for securitization into Fannie Mae MBS and for purchase by our mortgage portfolio. During 2004, over 1,000 lenders delivered mortgage loans to us, either for purchase by our mortgage portfolio or for securitization into Fannie Mae MBS. We acquire a significant portion of our single-family mortgage loans from several large mortgage lenders. During 2004, our top five lender customers, in the aggregate, accounted for approximately 53% of our single-family business volumes (which refers to both single-family mortgage loans that we purchase for our mortgage portfolio as well as single-family mortgage loans that we securitize into Fannie Mae MBS). Our top customer, Countrywide Financial Corporation (through its subsidiaries), accounted for approximately 26% of our single-family business volumes in 2004. Due to consolidation within the mortgage industry, we, as well as our competitors, have been competing for business from a decreasing number of large mortgage lenders. See “Item 1A—Risk Factors” for a discussion of the risks to our business resulting from this customer concentration.


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TBA Market
 
The TBA, or “to be announced,” securities market is a forward, or delayed delivery, market for 30-year and 15-year fixed-rate single-family mortgage-related securities issued by us and other agency issuers. Most of our single-class single-family Fannie Mae MBS are sold by lenders in the TBA market. Lenders use the TBA market both to purchase and sell Fannie Mae MBS.
 
A TBA trade represents a forward contract for the purchase or sale of single-family mortgage-related securities to be delivered on a specified future date. In a typical TBA trade, the specific mortgage pools that will be delivered to fulfill the forward contract are unknown at the time of the trade. Parties to a TBA trade agree upon the issuer, coupon, price, product type, amount of securities and settlement date for delivery. Settlement for TBA trades is standardized to occur on one specific day each month. The mortgage-related securities that ultimately will be delivered, and the loans backing those mortgage-related securities, frequently have not been created or originated at the time of the TBA trade, even though a price for the securities is agreed to at that time. Some trades are stipulated trades, in which the buyer and seller agree on specific characteristics of the mortgage loans underlying the mortgage-related securities to be delivered (such as loan age, loan size or geographic area of the loan). Some other transactions are specified trades, in which the buyer and seller identify the actual mortgage pool to be traded (specifying the pool or CUSIP number). These specified trades typically involve existing, seasoned TBA-eligible securities issued in the market. TBA sales enable originating mortgage lenders to hedge their interest rate risk and efficiently lock in interest rates for mortgage loan applicants throughout the loan origination process. The TBA market lowers transaction costs, increases liquidity and facilitates efficient settlement of sales and purchases of mortgage-related securities.
 
Credit Risk Management
 
Our Single-Family business bears the credit risk of borrowers defaulting on their payments of principal and interest on the single-family mortgage loans that back our guaranteed Fannie Mae MBS, including Fannie Mae MBS held in our mortgage portfolio. In addition, Single-Family bears the credit risk associated with the single-family whole mortgage loans held in our mortgage portfolio. The Single-Family business receives a guaranty fee in return for bearing the credit risk on guaranteed single-family Fannie Mae MBS, including Fannie Mae MBS held in our mortgage portfolio. In return for bearing credit risk on the single-family whole mortgage loans held in our mortgage portfolio, Single-Family is allocated fees from the Capital Markets group comparable to the guaranty fees that Single-Family receives on guaranteed Fannie Mae MBS. As a result, in our segment reporting, the expenses of the Capital Markets group include the transfer cost of the guaranty fees and related fees allocated to Single-Family, and the revenues of Single-Family include the guaranty fees and related fees received from the Capital Markets group.
 
The credit risk associated with a single-family mortgage loan is largely determined by the creditworthiness of the borrower, the nature and terms of the loan, the type of property securing the loan, the ratio of the unpaid principal amount of the loan to the value of the property that serves as collateral for the loan (the “loan-to-value ratio” or “LTV ratio”) and general economic conditions, including employment levels and the rate of increases or decreases in home prices. We actively manage, on an aggregate basis, the extent and nature of the credit risk we bear, with the objective of ensuring that we are adequately compensated for the credit risk we take, consistent with our mission goals. For a description of our methods for managing mortgage credit risk and a description of the credit characteristics of our single-family mortgage credit book of business, refer to “Item 7—MD&A—Risk Management—Credit Risk Management.” Refer to “Item 1A—Risk Factors” for a description of the risks associated with our management of credit risk.
 
Our Single-Family business is also responsible for managing the credit risk to our business posed by defaults by most of our institutional counterparties, such as our mortgage insurance providers and mortgage servicers. See “Item 7—MD&A—Risk Management—Credit Risk Management” for a description of our methods for managing institutional counterparty credit risk and “Item 1A—Risk Factors” for a description of the risks associated with our management of credit risk.


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Housing and Community Development
 
Our Housing and Community Development business engages in a range of activities primarily related to increasing the supply of affordable rental and for-sale housing, as well as increasing liquidity in the debt and equity markets related to such housing. In 2005, approximately 88% of the multifamily mortgage loans we purchased or securitized contributed to the housing goals established by HUD. See “Our Charter and Regulation of Our Activities—Regulation and Oversight of Our Activities—HUD Regulation—Housing Goals” for a description of our housing goals.
 
Our HCD business also engages in other activities through our Community Investment and Community Lending Groups, including investing in affordable rental properties that qualify for federal low-income housing tax credits, making equity investments in other rental and for-sale housing, investing in acquisition, development and construction financing for single-family and multifamily housing developments, providing loans and credit support to public entities such as housing finance agencies and public housing authorities to support their affordable housing efforts, and working with not-for-profit entities and local banks to support community development projects in underserved areas.
 
Multifamily Group
 
HCD’s Multifamily Group securitizes multifamily mortgage loans into Fannie Mae MBS and facilitates the purchase of multifamily mortgage loans for our mortgage portfolio. The amount of multifamily mortgage loan volume that we purchase for our portfolio as compared to the amount that we securitize into Fannie Mae MBS fluctuates from period to period. In recent years, the percentage of our multifamily business that has consisted of purchases for our investment portfolio has increased relative to our securitization activities. Our multifamily mortgage loans relate to properties with five or more residential units. The properties may be apartment communities, cooperative properties or manufactured housing communities.
 
Most of the multifamily loans we purchase or securitize are made by lenders that participate in our Delegated Underwriting and Servicing, or DUStm, program. Under the DUS program, we delegate the underwriting of loans to qualified lenders. As long as the lender represents and warrants that eligible loans meet our underwriting guidelines, we will not require the lender to obtain loan-by-loan approval before acquisition by us. DUS lenders generally act as servicers on the loans they sell to us, and servicing transfers must be approved by us. We also work with DUS lenders to provide credit enhancement for taxable and tax-exempt bonds issued by entities such as housing finance authorities. DUS lenders generally share the credit risk of loans they sell to us by absorbing a portion of the loss incurred as a result of a loan default. DUS lenders receive a higher servicing fee to compensate them for this risk. We believe that the risk-sharing feature of the DUS program aligns our interests and the interests of the lenders in making a sound credit decision at the time the loan is originated by the lender and acquired by us, and in servicing the loan throughout its life.


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The following table provides a breakdown of our multifamily mortgage credit book of business as of December 31, 2004. Our multifamily mortgage credit book of business refers to the sum of the unpaid principal balance of: (1) the multifamily mortgage loans we hold in our investment portfolio; (2) the Fannie Mae MBS and non-Fannie Mae mortgage-related securities backed by multifamily mortgage loans we hold in our investment portfolio; (3) Fannie Mae MBS backed by multifamily mortgage loans that are held by third parties; and (4) credit enhancements that we provide on multifamily mortgage assets. Our HCD business manages the risk that borrowers will default in the payment of principal and interest due on the multifamily mortgage loans held in our investment portfolio or underlying Fannie Mae MBS (whether held in our investment portfolio or held by third parties).
 
Multifamily Mortgage Credit Book of Business
 
                         
    As of December 31, 2004  
    Conventional(1)     Government(2)     Total  
    (Dollars in millions)  
 
Mortgage portfolio:(3)
                       
Mortgage loans(4)
  $ 43,396     $ 1,074     $ 44,470  
Fannie Mae MBS(4)
    505       892       1,397  
Agency mortgage-related securities(4)(5)
          68       68  
Mortgage revenue bonds
    8,037       2,744       10,781  
Other mortgage-related securities(6)
    12       46       58  
                         
Total mortgage portfolio
    51,950       4,824       56,774  
Fannie Mae MBS held by third parties(7)
    54,639       2,005       56,644  
                         
Book of business
    106,589       6,829       113,418  
Other(8)
    14,111       368       14,479  
                         
Total multifamily mortgage credit book of business
  $ 120,700     $ 7,197     $ 127,897  
                         
 
 
(1) Refers to mortgage loans and mortgage-related securities that are not guaranteed or insured by the U.S. government or any of its agencies.
 
(2) Refers to mortgage loans and mortgage-related securities guaranteed or insured by the U.S. government or one of its agencies.
 
(3) Mortgage portfolio data is reported based on unpaid principal balance. Our HCD business manages the credit risk relating to the multifamily mortgage loans and Fannie Mae MBS held in our portfolio that are backed by multifamily mortgage loans. Our Capital Markets group manages the institutional counterparty credit risk relating to the agency mortgage-related securities, mortgage revenue bonds and other mortgage-related securities held in our portfolio.
 
(4) Mortgage loan data includes mortgage-related securities that were consolidated and reported in our consolidated balance sheet as loans.
 
(5) Includes mortgage-related securities issued by Freddie Mac and Ginnie Mae.
 
(6) Includes mortgage-related securities issued by entities other than Fannie Mae, Freddie Mac or Ginnie Mae.
 
(7) Includes Fannie Mae MBS held by investors other than Fannie Mae. The principal balance of resecuritized Fannie Mae MBS is included only once.
 
(8) Includes additional multifamily credit enhancements that we provide not otherwise reflected in the table.
 
Unlike single-family loans, most multifamily loans require that the borrower pay a prepayment premium if the loan is paid before the maturity date. Additionally, some multifamily loans are subject to lock-out periods during which the loan may not be prepaid. The prepayment premium can take a variety of forms, including yield maintenance, defeasance or declining percentage. These prepayment provisions may provide incremental levels of certainty and reinvestment cash flow protection to investors in multifamily loans and mortgage-related securities, and may reduce the likelihood that a borrower will prepay a loan during a period of declining interest rates.
 
Our Multifamily Group generally creates multifamily Fannie Mae MBS in the same manner as our Single-Family business creates single-family Fannie Mae MBS. Mortgage lenders deliver multifamily mortgage loans


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to us in exchange for our Fannie Mae MBS, which thereafter may be held by the lenders or sold in the capital markets. We guarantee to each MBS trust that we will supplement mortgage loan collections as required to permit timely payment of principal and interest due on the related multifamily Fannie Mae MBS. In return for our guaranty, we are paid a guaranty fee out of a portion of the interest on the loans underlying the multifamily Fannie Mae MBS. For a description of a typical lender swap transaction by which we create Fannie Mae MBS, see “Single-Family Credit Guaranty—Guaranty Services” above.
 
As with our Single-Family business, our Multifamily Group offers different types of Fannie Mae MBS as a service to our lenders and as a response to specific investor preferences. The most commonly issued multifamily Fannie Mae MBS are described below:
 
  •  Multifamily Single-Class Fannie Mae MBS represent beneficial interests in multifamily mortgage loans held in an MBS trust and that were delivered to us by a lender in exchange for the single-class Fannie Mae MBS. The certificate holders in a single-class Fannie Mae MBS issue receive principal and interest payments in proportion to their percentage ownership of the MBS issue.
 
  •  Discount Fannie Mae MBS are short-term securities that generally have maturities between three and nine months and are backed by one or more participation certificates representing interests in multifamily loans. Investors earn a return on their investment in these securities by purchasing them at a discount to their principal amounts and receiving the full principal amount when the securities reach maturity. Discount MBS have no prepayment risk since prepayments are not allowed prior to maturity.
 
  •  Multifamily Whole Loan Multi-Class Fannie Mae MBS are multi-class Fannie Mae MBS that are formed from multifamily whole loans, Federal Housing Administration (“FHA”) participation certificates and/or Government National Mortgage Association (“Ginnie Mae”) participation certificates. Our HCD business works with our Capital Markets group in structuring these multifamily whole loan multi-class Fannie Mae MBS. Multifamily whole loan multi-class Fannie Mae MBS divide the cash flows on the underlying loans or participation certificates and create several classes of securities, each of which represents a beneficial ownership interest in a separate portion of the cash flows.
 
The fee and guaranty arrangements between HCD and Capital Markets are similar to the arrangements between Single-Family and Capital Markets. Our HCD business bears the credit risk of borrowers defaulting on their payments of principal and interest on the multifamily mortgage loans that back our guaranteed Fannie Mae MBS, including Fannie Mae MBS held in our mortgage portfolio. In addition, HCD bears the credit risk associated with the multifamily whole mortgage loans held in our mortgage portfolio. The HCD business receives a guaranty fee in return for bearing the credit risk on guaranteed multifamily Fannie Mae MBS, including Fannie Mae MBS held in our mortgage portfolio. In return for bearing credit risk on the multifamily whole mortgage loans held in our mortgage portfolio, our HCD business is allocated fees from the Capital Markets group comparable to the guaranty fees that it receives on guaranteed Fannie Mae MBS. As a result, in our segment reporting, the expenses of the Capital Markets group include the transfer cost of the guaranty fees and related fees allocated to our HCD segment, and the revenues of the HCD segment include the guaranty fees and related fees received from the Capital Markets group.
 
HCD’s Multifamily Group manages credit risk in a manner similar to that of Single-Family by managing the quality of the mortgages we acquire for our portfolio or securitize into Fannie Mae MBS, diversifying our exposure to credit losses, continually assessing the level of credit risk that we bear, and actively managing problem loans and assets to mitigate credit losses. Additionally, multifamily loans sold to us are often subject to lender risk-sharing or other lender recourse arrangements. As of December 31, 2004, credit enhancements existed on approximately 95% of the multifamily mortgage loans that we owned or that backed our Fannie Mae MBS. As described above, in our DUS program, lenders typically bear a portion of the losses incurred on an individual DUS loan. From time to time, we acquire multifamily loans pursuant to transactions in which the lenders do not bear any risk on the loan and we therefore bear all of the risk. In such cases, we are compensated accordingly for bearing all of the credit risk on the loan. For a description of our management of multifamily credit risk, see “Item 7—MD&A—Risk Management—Credit Risk Management.” Refer to “Item 1A—Risk Factors” for a description of the risks associated with our management of credit risk.


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Community Investment Group
 
HCD’s Community Investment Group makes investments that increase the supply of affordable housing. Most of these investments are in rental housing that qualifies for federal low-income housing tax credits, and the remainder are in conventional rental and primarily entry-level, for-sale housing. These investments are consistent with our focus on serving communities in need and making affordable housing more available and easier to rent or own.
 
The Community Investment Group’s investments have been made predominantly in low-income housing tax credit (“LIHTC”) limited partnerships or limited liability companies (referred to collectively in this report as “LIHTC partnerships”) that directly or indirectly own an interest in rental housing that the partnerships or companies have developed or rehabilitated. By renting a specified portion of the housing units to qualified low-income tenants over a 15-year period, the partnerships become eligible for the federal low-income housing tax credit. The low-income housing tax credit was enacted as part of the Tax Reform Act of 1986 to encourage investment by private developers and investors in low-income rental housing. To qualify for this tax credit, among other requirements, the project owner must irrevocably elect that either (1) a minimum of 20% of the residential units will be rent-restricted and occupied by tenants whose income does not exceed 50% of the area median gross income, or (2) a minimum of 40% of the residential units will be rent-restricted and occupied by tenants whose income does not exceed 60% of the area median gross income. The LIHTC partnerships are generally organized by fund manager sponsors who seek out investments with third-party developers who in turn develop or rehabilitate the properties and subsequently manage them. We invest in these partnerships as a limited partner with the fund manager acting as the general partner.
 
In making investments in these LIHTC partnerships, our Community Investment Group identifies qualified sponsors and structures the terms of our investment. Our risk exposure is limited to the amount of our investment and the possible recapture of the tax benefits we have received from the partnership. To manage the risks associated with a partnership, we track compliance with the LIHTC requirements, as well as the property condition and financial performance of the underlying investment throughout the life of the investment. In addition, we evaluate the strength of the partnership’s sponsor through periodic financial and operating assessments. Furthermore, in some of our partnership investments, our exposure to loss is further mitigated by our having a guaranteed economic return from an investment grade counterparty.
 
As of December 31, 2004, we had a recorded investment in these LIHTC partnerships of $6.8 billion. We earn a return on our investments in LIHTC partnerships through reductions in our federal income tax liability as a result of the use of the tax credits for which the partnerships qualify, as well as the deductibility of the partnerships’ net operating losses. The tax benefits associated with these partnerships was the primary reason for our effective tax rate in 2004 being 17% versus the federal statutory rate of 35%.
 
In addition to its investments in LIHTC partnerships, HCD’s Community Investment Group provides equity investments for rental and for-sale housing. These investments are typically made through fund managers or directly with developers and operators that are well-recognized firms within the industry. Because we invest as a limited partner or as a non-managing member in a limited liability company, our exposure is generally limited to the amount of our investment. Most of our investments in for-sale housing involve the construction of entry-level homes that are generally eligible for conforming mortgages. As of December 31, 2004, we had a recorded investment in these equity investments of $1.3 billion.
 
Community Lending Group
 
HCD’s Community Lending Group supports the expansion of available housing by participating in specialized debt financing for a variety of customers and by acquiring mortgage loans. These activities include:
 
  •  helping to meet the financing needs of single-family and multifamily home builders by purchasing participation interests in acquisition, development and construction (“AD&C”) loans from lending institutions;
 
  •  acquiring small multifamily loans from a variety of lending institutions;


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  •  providing financing to designated communities to expand the affordable housing stock in those communities as part of their community development efforts; and
 
  •  providing financing for single-family and multifamily housing to housing finance agencies, public housing authorities and municipalities.
 
In August 2006, OFHEO advised us to suspend new AD&C business until we have finalized and implemented specified policies and procedures required to strengthen risk management practices related to this business. We expect to have finalized and substantially completed implementation of these policies and procedures by December 2006. We will not engage in new AD&C business until OFHEO determines the finalized policies and procedures are satisfactory.
 
Capital Markets
 
Our Capital Markets group manages our investment activity in mortgage loans, mortgage-related securities and other liquid investments. We purchase mortgage loans and mortgage-related securities from mortgage lenders, securities dealers, investors and other market participants. We also sell mortgage loans and mortgage-related securities.
 
We fund our investments primarily through the proceeds from our issuance of debt securities in the domestic and international capital markets. By using the proceeds of this debt funding to invest in mortgage loans and mortgage-related securities, we directly and indirectly increase the amount of funding available to mortgage lenders. By managing the structure of our debt obligations and through our use of derivatives, we strive to substantially limit adverse changes in the net fair value of our investment portfolio that result from interest rate changes.
 
Our Capital Markets group earns most of its income from the difference, or spread, between the interest we earn on our mortgage portfolio and the interest we pay on the debt we issue to fund this portfolio, which is referred to as our net interest yield. As described below, our Capital Markets group uses various debt and derivative instruments to help manage the interest rate risk inherent in our mortgage portfolio. Changes in the fair value of the derivative instruments we hold impact the net income reported by the Capital Markets group business segment. Our Capital Markets group also earns transaction fees for issuing structured Fannie Mae MBS, as described below under “Securitization Activities.”
 
Mortgage Investments
 
The amount of our net mortgage investments was $924.8 billion as of December 31, 2004 and $919.3 billion as of December 31, 2003. As described in “Item 7—MD&A—Business Segment Results—Capital Markets Group,” the amount of our mortgage investments has decreased since December 31, 2004. We estimate that the amount of our net mortgage investments was $720.3 billion as of September 30, 2006. As described above under “Financial Restatement, Regulatory Reviews and Other Significant Recent Events,” as part of our May 2006 consent order with OFHEO, we agreed not to increase the size of our net mortgage portfolio above $727.75 billion, except in limited circumstances at OFHEO’s discretion. We will be subject to this limitation on mortgage investment growth until the Director of OFHEO has determined that modification or expiration of the limitation is appropriate in light of specified factors such as resolution of accounting and internal control issues. For additional information on our capital requirements and regulations affecting the amount of our mortgage investments, see “Our Charter and Regulation of Our Activities” and “Item 7—MD&A—Liquidity and Capital Management—Capital Management.”
 
Our mortgage investments include both mortgage-related securities and mortgage loans. We purchase primarily conventional single-family fixed-rate or adjustable-rate, first lien mortgage loans, or mortgage-related securities backed by such loans. In addition, we purchase loans insured by the FHA, loans guaranteed by the Department of Veterans Affairs (“VA”) or by the Rural Housing Service of the Department of Agriculture (“RHS”), manufactured housing loans, multifamily mortgage loans, subordinate lien mortgage loans (e.g., loans secured by second liens) and other mortgage-related securities. Most of these loans are prepayable at the option of the borrower. Some of our investments in mortgage-related securities are effected in the TBA market, which is described above under “Single-Family Credit Guaranty—TBA Market.” Our investments in mortgage-related


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securities include structured mortgage-related securities such as real estate mortgage investment conduits (“REMICs”). The interest rates on the structured mortgage-related securities held in our portfolio may not be the same as the interest rates on the underlying loans. For example, we may hold a floating rate REMIC security with an interest rate that adjusts periodically based on changes in a specified market reference rate, such as the London Inter-Bank Offered Rate (“LIBOR”); however, the REMIC may be backed by fixed-rate mortgage loans. The REMIC securities we own primarily fall into two categories: agency REMICs, which are generally Fannie Mae-issued REMICs, and non-agency REMICs issued by private-label issuers. For information on the composition of our mortgage investment portfolio by product type, refer to Table 22 in “Item 7—MD&A—Business Segment Results—Capital Markets Group—Mortgage Investments.”
 
While our Single-Family and HCD businesses are responsible for managing the credit risk associated with our investments in mortgage loans and Fannie Mae MBS, our Capital Markets group is responsible for managing the credit risk of the non-Fannie Mae mortgage-related securities in our portfolio.
 
Investment Activities and Objectives
 
Our Capital Markets group seeks to maximize long-term total returns, subject to our risk constraints, while fulfilling our chartered liquidity function. We pursue these objectives by purchasing, selling and managing mortgage assets based on market dynamics and our assessment of the economic attractiveness of specific transactions at given points in time. This approach is an enhancement to our strategy prior to 2005, which focused primarily on buying mortgage assets when anticipated returns met or exceeded our hurdle rates and generally holding those assets to maturity. We now also consider asset sales in order to generate economic value when supply and demand dynamics in our market result in attractive pricing for certain assets in our portfolio.
 
The level of our purchases and sales of mortgage assets in any given period has been generally determined by the rates of return that we expect to be able to earn on the equity capital underlying our investments. When we expect to earn returns greater than our cost of equity capital, we generally will be an active purchaser of mortgage loans and mortgage-related securities. When few opportunities exist to earn returns above our cost of equity capital, we generally will be a less active purchaser, and may be a net seller, of mortgage loans and mortgage-related securities. This investment strategy is consistent with our chartered liquidity function, as the periods during which our purchase of mortgage assets is economically attractive to us generally have been periods in which market demand for mortgage assets is low.
 
The difference, or spread, between the yield on mortgage assets available for purchase or sale and our borrowing costs, after consideration of the net risks associated with the investment, is an important factor in determining whether we are a net buyer or seller of mortgage assets. When the spread between the yield on mortgage assets and our borrowing costs is wide, which is typically when demand for mortgage assets from other investors is low, we will look for opportunities to add liquidity to the market primarily by purchasing mortgage assets and issuing debt to investors to fund those purchases. When this spread is narrow, which is typically when market demand for mortgage assets is high, we will look for opportunities to meet demand by selling mortgage assets from our portfolio. Even in periods of high market demand for mortgage assets, however, we expect to be an active purchaser of less liquid forms of mortgage loans and mortgage-related securities. The amount of our purchases of these mortgage loans and mortgage-related securities may be less than the amortization, prepayments and sales of mortgage loans we hold and, as a result, our investment balances may decline during periods of high market demand.
 
We determine our total return by measuring the change in the fair value of our net assets attributable to common stockholders, as adjusted for our capital transactions, such as dividend payments and share issuances and repurchases. The fair value of our net assets will change from period to period as a result of changes in the mix of our assets and liabilities and changes in interest rates, expected volatility and other market factors. The fair value of our net assets is also subject to change due to inherent market fluctuations in the yields on our mortgage assets relative to the yields on our debt securities. The fair value of our guaranty assets and guaranty obligations will also fluctuate in the short term due to changes in interest rates. These fluctuations are likely to produce volatility in the fair value of our net assets in the short-term that may not be representative of our long-term performance.


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Customer Transactions and Services
 
Our Capital Markets group provides services to our lender customers and their affiliates, which include:
 
  •  offering to purchase a wide variety of mortgage assets, including non-standard mortgage loan products, which we either retain in our portfolio for investment or sell to other investors as a service to assist our customers in accessing the market;
 
  •  segregating customer portfolios to obtain optimal pricing for their mortgage loans (for example, segregating Community Reinvestment Act or “CRA” eligible loans, which typically command a premium);
 
  •  providing funds at the loan delivery date for purchase of loans delivered for securitization; and
 
  •  assisting customers with the hedging of their mortgage business, including entering into options and forward contracts on mortgage-related securities, which we offset in the capital markets.
 
These activities provide a significant source of assets for our mortgage portfolio, help to create a broader market for our customers and enhance liquidity in the secondary mortgage market. Although certain securities acquired in this activity are accounted for as “trading” securities, we contemporaneously enter into economically offsetting positions if we do not intend to retain the securities in our portfolio.
 
In connection with our customer transactions and services activities, we may enter into forward commitments to purchase mortgage loans or mortgage-related securities that we decide not to retain in our portfolio. In these instances, we generally will enter into an offsetting sell commitment with another investor or require the lender to deliver a sell commitment to us together with the loans to be pooled into mortgage-related securities.
 
Mortgage Innovation
 
Our Capital Markets group also aids our lender customers in their efforts to introduce new mortgage products into the marketplace. Lenders often face limited secondary market appetite for new or innovative mortgage products. Our Capital Markets group supports these lenders by purchasing new products for our investment portfolio before they develop full track records for credit performance and pricing. Among the innovations that our Capital Markets group has supported recently are 40-year mortgages, interest-only mortgages and reverse mortgages.
 
Housing Goals
 
Our Capital Markets group contributes to our regulatory housing goals by purchasing goals-qualifying mortgage loans and mortgage-related securities for our mortgage portfolio. In particular, our Capital Markets group is able to purchase highly-rated mortgage-related securities backed by mortgage loans that meet our regulatory housing goals requirements. Our Capital Markets group’s purchase of goals-qualifying mortgage loans is a critical factor in our ability to meet our housing goals.
 
Funding of Our Investments
 
Our Capital Markets group funds its investments primarily through the issuance of debt securities in the domestic and international capital markets. The objective of our debt financing activities is to manage our liquidity requirements while obtaining funds as efficiently as possible. We structure our financings not only to satisfy our funding and risk management requirements, but also to access the market in an orderly manner with debt securities designed to appeal to a wide range of investors. International investors, seeking many of the features offered in our debt programs for their U.S. dollar-denominated investments, have been a


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significant and growing source of funding in recent years. The most significant of the debt financing programs that we conduct are the following:
 
  •  Benchmark Securities®.  Through our Benchmark Securities program, we sell large, regularly scheduled issues of unsecured debt. Our Benchmark Securities issues tend to appeal to investors who value liquidity and price transparency. The Benchmark Securities program includes:
 
  •  Benchmark Bills have maturities of up to one year.  On a weekly basis, we auction three-month and six-month Benchmark Bills with a minimum issue size of $1.0 billion. On a monthly basis, we auction one-year Benchmark Bills with a minimum issue size of $1.0 billion.
 
  •  Benchmark Notes have maturities ranging between two and ten years. Each month, we typically sell one or more new, fixed-rate issues of Benchmark Notes through dealer syndicates. Each issue has a minimum size of $3.0 billion.
 
  •  Discount Notes.  We issue short-term debt securities called Discount Notes with maturities ranging from overnight to 360 days from the date of issuance. Investors purchase these notes at a discount to the principal amount and receive the principal amount when the notes mature.
 
  •  Medium-Term Notes.  We issue medium-term notes (“MTNs”) with a wide range of maturities, interest rates and call features. The specific terms of our MTN issuances are determined through individually-negotiated transactions with broker-dealers. Our MTNs are often callable prior to maturity. We issue both fixed-rate and floating-rate securities, as well as various types of structured notes that combine features of traditional debt with features of other capital market instruments.
 
  •  Subordinated Debt.  Pursuant to voluntary commitments that we made in October 2000, from time to time we have issued subordinated debt. The terms of our qualifying subordinated debt require us to defer interest payments on this debt in specified limited circumstances. The difference, or spread, between the trading prices of our subordinated debt and our senior debt serves as a market indicator to investors of the relative credit risk of our debt. A narrow spread between the trading prices of our subordinated debt and senior debt implies that the market perceives the credit risk of our debt to be relatively low. A wider spread between these prices implies that the market perceives our debt to have a higher relative credit risk. As of the date of this filing, we had $11.0 billion in qualifying subordinated debt outstanding. We have not issued any subordinated debt since 2003. During 2004, we suspended further issuances of subordinated debt and are not likely to resume issuances until we return to timely reporting of our financial results. Our October 2000 voluntary commitments relating to subordinated debt have been replaced by an agreement we entered into with OFHEO on September 1, 2005, pursuant to which we agreed to maintain a specified amount of qualifying subordinated debt. Although we have not issued subordinated debt since 2003, we are in compliance with our obligations relating to the maintenance of subordinated debt under our September 1, 2005 agreement with OFHEO. For more information on our subordinated debt, see “Item 7—MD&A—Liquidity and Capital Management—Capital Management—Capital Activity—Subordinated Debt.”
 
For more information regarding our approach to funding our investments and other activities, see “Item 7—MD&A—Liquidity and Capital Management—Liquidity—Debt Funding.”
 
While we are a corporation chartered by the U.S. Congress, we are solely responsible for our debt obligations, and neither the U.S. government nor any instrumentality of the U.S. government guarantees any of our debt. Our debt trades in the “agency sector” of the capital markets, along with the debt of other GSEs. Debt in the agency sector benefits from bank regulations that allow commercial banks to invest in our debt and other agency debt to a greater extent than other debt. These factors, along with the high credit rating of our senior unsecured debt securities and the manner in which we conduct our financing programs, contribute to the favorable trading characteristics of our debt. As a result, we generally are able to borrow at lower interest rates than other corporate debt issuers. For information on the credit ratings of our long-term and short-term senior unsecured debt, qualifying subordinated debt and preferred stock, refer to “Item 7—MD&A—Liquidity and Capital Management—Liquidity—Credit Ratings and Risk Ratings.”


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In order to support the liquidity and strength of our debt programs, we engage in periodic repurchases of our debt securities. During 2004, we repurchased $4.3 billion of our outstanding debt through market purchases. We also called $155.6 billion of our outstanding debt.
 
Securitization Activities
 
Our Capital Markets group engages in two principal types of securitization activities:
 
  •  creating and issuing Fannie Mae MBS from our mortgage portfolio assets, either for sale into the secondary market or to retain in our portfolio; and
 
  •  issuing structured Fannie Mae MBS for customers in exchange for a transaction fee.
 
Our Capital Markets group creates Fannie Mae MBS using mortgage loans and mortgage-related securities that we hold in our investment portfolio (referred to as “portfolio securitizations”). Our Capital Markets group may sell these Fannie Mae MBS into the secondary market or may retain the Fannie Mae MBS in our investment portfolio. The types of Fannie Mae MBS that our Capital Markets group creates through portfolio securitizations include the same types as those created by our Single-Family and HCD businesses, as described in “Single-Family Credit Guaranty—Guaranty Services” above. In addition, the Capital Markets group issues structured Fannie Mae MBS, which are described below. The structured Fannie Mae MBS are generally created through swap transactions, typically with our lender customers or securities dealer customers. In these transactions, the customer “swaps” a mortgage-related security they own for one of the types of structured Fannie Mae MBS described below. This process is referred to as “resecuritization.”
 
Our Capital Markets group earns transaction fees for issuing structured Fannie Mae MBS for third parties. The most common forms of such securities are the following:
 
  •  Fannie Megas®, which are resecuritized single-class Fannie Mae MBS that are created in transactions in which a lender or a securities dealer contributes two or more previously issued single-class Fannie Mae MBS or previously issued Megas, or a combination of Fannie Mae MBS and Megas, in return for a new issue of Mega certificates.
 
  •  Multi-class Fannie Mae MBS, including REMICs, which may separate the cash flows from underlying single-class and/or multi-class Fannie Mae MBS, other mortgage-related securities or whole mortgage loans into separately tradable classes of securities. By separating the cash flows, the resulting classes may consist of: (1) interest-only payments; (2) principal-only payments; (3) different portions of the principal and interest payments; or (4) combinations of each of these. Terms to maturity of some multi-class Fannie Mae MBS, particularly REMIC classes, may match or be shorter than the maturity of the underlying mortgage loans and/or mortgage-related securities. As a result, each of the classes in a multi-class Fannie Mae MBS may have a different coupon rate, average life, repayment sensitivity or final maturity. In some of our multi-class Fannie Mae MBS transactions, we may issue senior classes where we have guaranteed to the trust that we will supplement collections on the underlying mortgage assets as required to permit timely payment of principal and interest due on the related senior class. In these multi-class Fannie Mae MBS transactions, we also may issue one or more subordinated classes for which we do not provide a guaranty. Our Capital Markets group may work with our Single-Family or HCD businesses in structuring multi-class Fannie Mae MBS.
 
Interest Rate Risk Management
 
Our Capital Markets group is subject to the risks of changes in long-term earnings and net asset values that may occur due to changes in interest rates, interest rate volatility and other factors within the financial markets. These risks arise because the expected cash flows of our mortgage assets are not perfectly matched with the cash flows of our debt instruments.
 
Our principal source of interest rate risk arises from our investment in mortgage assets that give the borrower the option to prepay the mortgage at any time. For example, if interest rates decrease, borrowers are more likely to refinance their mortgages. Refinancings could result in prepaid loans being replaced with new investments in lower interest rate loans and, consequently, a decrease in future interest income earned on our


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mortgage assets. At the same time, we may not be able to redeem or repay a sufficient portion of our existing debt to lower our interest expense by the same amount, which may reduce our net interest yield.
 
We strive to maintain low exposure to the risks associated with changes in interest rates. To manage our exposure to interest rate risk, we engage in the following activities:
 
  •  Issuance of Callable and Non-Callable Debt.  We issue a broad range of both callable and non-callable debt securities to manage the duration and prepayment risk of expected cash flows of the mortgage assets we own.
 
  •  Use of Derivative Instruments.  While our debt is the primary means by which we manage our interest rate risk exposure, we supplement our issuance of debt with interest rate-related derivatives to further manage duration and prepayment risk. We use derivatives in combination with our issuance of debt to reduce the volatility of the estimated fair value of our mortgage investments. The benefits of derivatives include:
 
  —  the speed and efficiency with which we can alter our risk position; and
 
  —  the ability to modify some aspects of our expected cash flows in a specialized manner that might not be readily achievable with debt instruments.
 
The use of derivatives also involves costs to our business. Changes in the estimated fair value of these derivatives impact our net income. Accordingly, our net income will be reduced to the extent that we incur losses relating to our derivative instruments. In addition, our use of derivatives exposes us to credit risk relating to our derivative counterparties. We have derivative transaction policies and controls in place to minimize our derivative counterparty risk. See “Item 7—MD&A—Risk Management—Credit Risk Management—Institutional Counterparty Credit Risk Management—Derivatives Counterparties” for a description of our derivative counterparty risk and our policies and controls in place to minimize such risk. Refer to “Item 1A—Risk Factors” for a description of the risks associated with transactions with our derivatives counterparties.
 
  •  Continuous Monitoring of Our Risk Position.  We continuously monitor our risk position and actively rebalance our portfolio of interest-rate sensitive financial instruments to maintain a close match between the duration of our assets and liabilities. We use a wide range of risk measures and analytical tools to assess our exposure to the risks inherent in the asset and liability structure of our business and use these assessments in the day-to-day management of the mix of our assets and liabilities. If market conditions do not permit us to fund and manage our investments within our risk parameters, we will not be an active purchaser of mortgage assets.
 
For more information regarding our methods for managing interest rate risk and other market risks that impact our business, refer to “Item 7—MD&A—Risk Management—Interest Rate Risk Management and Other Market Risks.”
 
COMPETITION
 
Our competitors include the Federal Home Loan Mortgage Corporation, referred to as Freddie Mac, the Federal Home Loan Banks, financial institutions, securities dealers, insurance companies, pension funds and other investors. Our market share of loans purchased for our investment portfolio or securitized into Fannie Mae MBS is affected by the amount of residential mortgage loans offered for sale in the secondary market by loan originators and other market participants, and the amount purchased or securitized by our competitors. Our market share is also affected by the mix of available mortgage loan products and the credit risk and prices associated with those loans.
 
We are an active investor in mortgage-related assets and we compete with a broad range of investors for the purchase and sale of these assets. Our primary competitors for the purchase and sale of mortgage assets are participants in the secondary mortgage market that we believe also share our general investment objective of seeking to maximize the returns they receive through the purchase and sale of mortgage assets. In addition, in recent years, several large mortgage lenders have increased their retained holdings of the mortgage loans they


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originate. Competition for mortgage-related assets among investors in the secondary market was intense in 2004 and 2005. The spreads between the yield on our debt securities and expected yields on mortgage assets, after consideration of the net risks associated with the investments, were very narrow in 2004 and 2005, reflecting strong investor demand from banks, funds and other investors. This high demand for mortgage assets increased the price of mortgage assets relative to the credit risks associated with these assets.
 
We have been the largest agency issuer of mortgage-related securities in every year since 1990. Competition for the issuance of mortgage-related securities is intense and participants compete on the basis of the value of their products and services relative to the prices they charge. Value can be delivered through the liquidity and trading levels for an issuer’s securities, the range of products and services offered, and the reliability and consistency with which it conducts its business. In recent years, there has been a significant increase in the issuance of mortgage-related securities by non-agency issuers. Non-agency issuers, also referred to as private-label issuers, are those issuers of mortgage-related securities other than agency issuers Fannie Mae, Freddie Mac or Ginnie Mae. Private-label issuers have significantly increased their share of the mortgage-related securities market and accounted for more than half of new single-family mortgage-related securities issuances in 2005. As the market share for private-label securities has increased, our market share has decreased. During 2005, our estimated market share of new single-family mortgage-related securities issuance was 23.5%, compared to 29.2% in 2004 and 45.0% in 2003. For the third quarter of 2006, our estimated market share of new single-family mortgage-related securities issuance was 24.7%. Our estimates of market share are based on publicly available data and exclude previously securitized mortgages. We expect private-label issuers to continue to provide significant competition to our Single-Family business.
 
We also expect private-label issuers to provide increasingly significant competition to our HCD business. The commercial mortgage-backed securities (“CMBS”) issued by private-label issuers are typically backed not only by loans secured by multifamily residential property, but also by loans secured by a mix of retail, office, hotel and other commercial properties. We are restricted by our charter to issuing Fannie Mae MBS backed by residential loans, which often have lower yields than other types of commercial real estate loans. Private-label issuers include multifamily residential loans in pools backing CMBS because those properties, while generally generating lower cash flow than other types of commercial properties, generally have lower default rates, which improves the overall performance of CMBS pools. To obtain multifamily residential property loans for CMBS pools, private-label issuers are sometimes willing to purchase loans of a lesser credit quality than the loans we purchase and to price their purchases of these loans more aggressively than we typically price our purchases. Because we usually guarantee our Fannie Mae MBS, we generally maintain high credit standards to limit our exposure to defaults. Private-label issuers often structure their CMBS transactions so that certain classes of the securities issued in each transaction bear most of the default risk on the loans underlying the transaction. These securities are placed with investors that are prepared to assume that risk in exchange for higher yields. We are responding to this increased competition from private-label issuers of CMBS, in part, by investing in investment grade CMBS securities backed by multifamily loans.
 
OUR CHARTER AND REGULATION OF OUR ACTIVITIES
 
We are a stockholder-owned corporation organized and existing under the Federal National Mortgage Association Charter Act, which we refer to as the Charter Act or our charter. We were established in 1938 pursuant to the National Housing Act and originally operated as a U.S. government entity. Title III of the National Housing Act amended our charter in 1954, and we became a mixed-ownership corporation, with our preferred stock owned by the federal government and our common stock held by private investors. In 1968, our charter was further amended and our predecessor entity was divided into the present Fannie Mae and Ginnie Mae. Ginnie Mae remained a government entity, but all of the preferred stock of Fannie Mae that had been held by the U.S. government was retired, and Fannie Mae became privately owned.


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Charter Act
 
The Charter Act, as it was further amended from 1970 through 1998, sets forth the activities that we are permitted to conduct, authorizes us to issue debt and equity securities, and describes our general corporate powers. The Charter Act states that our purpose is to:
 
  •  provide stability in the secondary market for residential mortgages;
 
  •  respond appropriately to the private capital market;
 
  •  provide ongoing assistance to the secondary market for residential mortgages (including activities relating to mortgages on housing for low- and moderate-income families involving a reasonable economic return that may be less than the return earned on other activities) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing; and
 
  •  promote access to mortgage credit throughout the nation (including central cities, rural areas and underserved areas) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing.
 
In addition to our overall strategy being aligned with these purposes, all of our business activities must be permissible under the Charter Act. Our charter specifically authorizes us to “deal in” conventional mortgage loans and to “purchase,” “sell,” “service,” and “lend on the security of” these types of mortgages, subject to limitations on the maximum original principal balance for single-family loans and requirements for credit enhancement for some loans. Under our Charter Act authority, we can purchase mortgage loans secured by first or second liens, issue debt and issue mortgage-backed securities. In addition, we can guarantee mortgage-backed securities. We can also act as a depository, custodian or fiscal agent for our “own account or as fiduciary, and for the account of others.” Furthermore, the Charter Act expressly enables us to “lease, purchase, or acquire any property, real, personal, or mixed, or any interest therein, to hold, rent, maintain, modernize, renovate, improve, use, and operate such property, and to sell, for cash or credit, lease, or otherwise dispose of the same” as we may deem necessary or appropriate and also “to do all things as are necessary or incidental to the proper management of [our] affairs and the proper conduct of [our] business.”
 
Loan Standards
 
The single-family conventional mortgage loans we purchase or securitize must meet the following standards required by the Charter Act.
 
  •  Principal Balance Limitations.  Our charter permits us to purchase and securitize single-family conventional mortgage loans subject to maximum original principal balance limits. Conventional mortgage loans are loans that are not federally insured or guaranteed. The principal balance limits are often referred to as “conforming loan limits” and are established each year by OFHEO based on the national average price of a one-family residence. In 2004, 2005 and 2006, the conforming loan limit for a one-family residence generally was $333,700, $359,650 and $417,000, respectively. In November 2006, OFHEO announced that the conforming loan limit will remain at $417,000 for 2007. Higher original principal balance limits apply to mortgage loans secured by two- to four-family residences and also to loans in Alaska, Hawaii, Guam and the Virgin Islands. No statutory limits apply to the maximum original principal balance of multifamily mortgage loans (loans secured by properties that have five or more residential dwelling units) that we purchase or securitize. In addition, the Charter Act imposes no maximum original principal balance limits on loans we purchase or securitize that are insured by the FHA or guaranteed by the VA.
 
  •  Quality Standards.  The Charter Act requires that, so far as practicable and in our judgment, the mortgage loans we purchase or securitize must be of a quality, type and class that generally meet the purchase standards of private institutional mortgage investors. To comply with this requirement and for the efficient operation of our business, we have eligibility policies and make available guidelines for the mortgage loans we purchase or securitize as well as for the sellers and servicers of these loans.
 
  •  Loan-to-Value and Credit Enhancement Requirements.  The Charter Act requires credit enhancement on any conventional single-family mortgage loan that we purchase or securitize if it has a loan-to-value ratio


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  over 80% at the time of purchase or securitization. Credit enhancement may take the form of insurance or a guaranty issued by a qualified insurer, a repurchase arrangement with the seller of the loans or seller-retained loan participation interests. In addition, our policies and guidelines have loan-to-value ratio requirements that depend upon a variety of factors, such as the borrower credit history, the loan purpose, the repayment terms and the number of dwelling units in the property securing the loan. Depending on these factors and the amount and type of credit enhancement we obtain, our underwriting guidelines provide that the loan-to-value ratio for loans that we purchase or securitize can be up to 100% for conventional single-family loans; however, from time to time, we may make an exception to these guidelines and acquire loans with a loan-to-value ratio greater than 100%.
 
Other Charter Act Limitations and Requirements
 
In addition to specifying our purpose, authorizing our activities and establishing various limitations and requirements relating to the loans we purchase and securitize, the Charter Act has the following provisions related to issuances of our securities, exemptions for our securities from the registration requirements of the federal securities laws, the taxation of our income, the structure of our Board of Directors and other limitations and requirements.
 
  •  Issuances of Our Securities.  The Charter Act authorizes us, upon approval of the Secretary of the Treasury, to issue debt obligations and mortgage-related securities. At the discretion of the Secretary of the Treasury, the U.S. Department of the Treasury may purchase obligations of Fannie Mae up to a maximum of $2.25 billion outstanding at any one time. We have not used this facility since our transition from government ownership in 1968. Neither the United States nor any of its agencies guarantees our debt or is obligated to finance our operations or assist us in any other manner. On June 13, 2006, the U.S. Department of the Treasury announced that it would undertake a review of its process for approving our issuances of debt. We cannot predict whether the outcome of this review will materially impact our current business activities.
 
  •  Exemptions for Our Securities.  Securities we issue are “exempted securities” under laws administered by the SEC. As a result, registration statements with respect to offerings of our securities are not filed with the SEC. In March 2003, however, we voluntarily registered our common stock with the SEC pursuant to Section 12(g) of the Securities Exchange Act of 1934 (the “Exchange Act”). We are thereby required to file periodic and current reports with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K. Since undertaking to restate our 2002 and 2003 consolidated financial statements and improve our accounting practices and internal control over financial reporting, we have not been a timely filer of our periodic reports on Form 10-K or Form 10-Q. We are continuing to improve our accounting and internal control over financial reporting and are striving to become a timely filer as soon as practicable. We are also required to file proxy statements with the SEC. In addition, our directors and certain officers are required to file reports with the SEC relating to their ownership of Fannie Mae equity securities.
 
  •  Exemption from Certain Taxes and Qualifications.  Pursuant to the Charter Act, we are exempt from taxation by states, counties, municipalities or local taxing authorities, except for taxation by those authorities on our real property. We are not exempt from the payment of federal corporate income taxes. In addition, we may conduct our business without regard to any qualification or similar statute in any state of the United States, including the District of Columbia, the Commonwealth of Puerto Rico, and the territories and possessions of the United States. In accordance with OFHEO regulation, we have elected to follow the applicable corporate governance practices and procedures of the Delaware General Corporation Law, as it may be amended from time to time.
 
  •  Structure of Our Board of Directors.  The Charter Act provides that our Board of Directors will consist of 18 persons, five of whom are to be appointed by the President of the United States and the remainder of whom are to be elected annually by our stockholders at our annual meeting of stockholders. All members of our Board of Directors either are elected by our stockholders for one-year terms, or until their successors are elected and qualified, or are appointed by the President for one-year terms. The five appointed director positions have been vacant since May 2004. Of the remaining 13 director positions, one director has announced that he will be resigning at the end of 2006. Our Board has determined that


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  all but two of our current directors, one of whom is our Chief Executive Officer, are independent directors under New York Stock Exchange standards. Because we have not held an annual meeting of stockholders since 2004, some of our directors have currently served for longer than one-year terms.
 
  •  Other Limitations and Requirements.  Under the Charter Act, we may not originate mortgage loans or advance funds to a mortgage seller on an interim basis, using mortgage loans as collateral, pending the sale of the mortgages in the secondary market. In addition, we may only purchase or securitize mortgages originated in the United States, including the District of Columbia, the Commonwealth of Puerto Rico, and the territories and possessions of the United States.
 
Regulation and Oversight of Our Activities
 
As a federally chartered corporation, we are subject to Congressional legislation and oversight and are regulated by HUD and OFHEO. In addition, we are subject to regulation by the U.S. Department of the Treasury and by the SEC. The Government Accountability Office is authorized to audit our programs, activities, receipts, expenditures and financial transactions.
 
HUD Regulation
 
Program Approval
 
HUD has general regulatory authority to promulgate rules and regulations to carry out the purposes of the Charter Act, excluding authority over matters granted exclusively to OFHEO. We are required under the Charter Act to obtain approval of the Secretary of HUD for any new conventional mortgage program that is significantly different from those approved or engaged in prior to the 1992 amendment of the Charter Act through enactment of the Federal Housing Enterprises Financial Safety and Soundness Act (the “1992 Act”). The Secretary must approve any new program unless the Charter Act does not authorize it or the Secretary finds that it is not in the public interest.
 
On June 13, 2006, HUD announced that it would conduct a review of our investments and holdings, including certain equity and debt investments classified in our consolidated financial statements as “other assets/other liabilities,” to determine whether our investment activities are consistent with our charter authority. We are fully cooperating with this review, but cannot predict the outcome of this review or whether it may require us to modify our investment approach or restrict our current business activities.
 
Housing Goals
 
The Secretary of HUD establishes annual housing goals pursuant to the 1992 Act for housing (1) for low- and moderate-income families, (2) in HUD-defined underserved areas, including central cities and rural areas, and (3) for low-income families in low-income areas and for very low-income families, which is referred to as “special affordable housing.” Each of these three goals is set as a percentage of the total number of dwelling units financed by eligible mortgage loan purchases. A dwelling unit may be counted in more than one category of goals. Included in eligible mortgage loan purchases are loans underlying our Fannie Mae MBS issuances, second mortgage loans and refinanced mortgage loans. Several activities are excluded from eligible mortgage loan purchases, such as most purchases of non-conventional mortgage loans, equity investments (even if they facilitate low-income housing), mortgage loans secured by second homes and commitments to purchase or securitize mortgage loans at a later date. In addition to the three goals set as a percentage of dwelling units financed by eligible mortgage loan purchases, beginning in 2005, HUD also established three home purchase mortgage subgoals that measure our purchase or securitization of loans by the number of loans (not dwelling units) providing purchase money for owner-occupied single-family housing in metropolitan areas. We also have a subgoal for multifamily special affordable housing that is expressed as a dollar amount.
 
Each year, we are required to submit an annual report on our performance in meeting our housing goals. We deliver the report to the Secretary of HUD as well as to the House Committee on Financial Services and the Senate Committee on Banking, Housing and Urban Affairs. The following table shows each of the housing


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goals, which were constant during the 2002 through 2004 period, and our performance against those goals in each of the years in this period.
 
Housing Goals Performance: 2002-2004
 
                                 
    Goal(1)     Fannie Mae Actual Results(2)  
    (2002-2004)     2004     2003     2002  
 
Low- and moderate-income housing
    50.0 %     53.4 %     52.3 %     51.8 %
Underserved areas
    31.0       33.5       32.1       32.8  
Special affordable housing
    20.0       23.6       21.2       21.4  
Multifamily minimum in special affordable housing ($ in billions)
  $ 2.85     $ 7.32     $ 12.23     $ 7.57  
 
 
(1) Goals are expressed as a percentage of the total number of dwelling units financed by eligible mortgage loan purchases during the period, except for the multifamily subgoal.
 
(2) Actual results for 2004, 2003 and 2002 reflect the impact of provisions that allow us to estimate the affordability of units with missing income and rent data. Actual results for 2003 and 2002 reflect the impact of incentive points for small multifamily and owner-occupied rental housing, which were no longer available starting in 2004. The source of this data is HUD’s analysis of data we submitted to HUD. Some results differ from the results we reported in our Annual Housing Activities Reports for 2002, 2003 and 2004.
 
As shown by the table above, we were able to meet all of our housing goals in each of the years from 2002 through 2004.
 
On November 2, 2004, HUD published a final regulation amending its housing goals rule effective January 1, 2005. The regulation increased housing goal levels and also created the three new home purchase mortgage subgoals described above. The increased housing goal levels and new subgoal levels over the four-year period beginning January 1, 2005 are shown below.
 
New Housing Goals and Home Purchase Subgoals
 
                                 
    2005     2006     2007     2008  
 
Housing goals:
                               
Low- and moderate-income housing
    52.0 %     53.0 %     55.0 %     56.0 %
Underserved areas
    37.0       38.0       38.0       39.0  
Special affordable housing
    22.0       23.0       25.0       27.0  
Home purchase subgoals:
                               
Low- and moderate-income housing
    45.0 %     46.0 %     47.0 %     47.0 %
Underserved areas
    32.0       33.0       33.0       34.0  
Special affordable housing
    17.0       17.0       18.0       18.0  
Multifamily minimum in special affordable housing ($ in billions)
  $ 5.49     $ 5.49     $ 5.49     $ 5.49  


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The following table shows each of our housing goals and home purchase subgoals during 2005, and our performance against those goals and subgoals in 2005.
 
Housing Goals and Subgoals Performance: 2005
 
                 
    2005
        Fannie Mae Actual
    Goal(1)   Results(2)
 
Housing goals:
               
Low- and moderate-income housing
    52.0 %     55.1 %
Underserved areas
    37.0       41.4  
Special affordable housing
    22.0       26.3  
Home purchase subgoals:
               
Low- and moderate-income housing
    45.0 %     44.6 %
Underserved areas
    32.0       32.6  
Special affordable housing
    17.0       17.0  
Multifamily minimum in special affordable housing ($ in billions)
  $ 5.49     $ 10.39  
 
 
(1) The home purchase subgoals measure our performance by the number of loans (not dwelling units) providing purchase money for owner-occupied single-family housing in metropolitan areas.
 
(2) The source of this data is HUD’s analysis of data we submitted to HUD. Some results differ from the results reported in our Annual Housing Activities Report for 2005.
 
As shown in the table above, we met all of our three affordable housing goals: the low- and moderate-income housing goal, the underserved areas goal and the special affordable housing goal. We also met three of the four subgoals: the special affordable home purchase subgoal, the underserved areas home purchase subgoal, and the special affordable multifamily subgoal. We fell slightly short of the low- and moderate-income home purchase subgoal.
 
The affordable housing goals are subject to enforcement by the Secretary of HUD. HUD’s regulations allow HUD to require us to submit a housing plan if we fail to meet our housing goals and HUD determines that achievement was feasible, taking into account market and economic conditions and our financial condition. The housing plan must describe the actions we will take to meet the goals in the next calendar year. If HUD determines that we have failed to submit a housing plan or to make a good faith effort to comply with the plan, HUD has the right to take certain administrative actions. The potential penalties for failure to comply with HUD’s housing plan requirements are a cease-and-desist order and civil money penalties. Pursuant to the 1992 Act, the low- and moderate-income housing subgoal and the underserved areas subgoal are not enforceable by HUD. As noted above, we did not meet the low- and moderate-income home purchase subgoal in 2005. Because this subgoal is not enforceable, there is no penalty for failing to meet this subgoal.
 
These new housing goals and subgoals are designed to increase the amount of mortgage financing that we make available to target populations and geographic areas defined by the goals. We have made, and continue to make, significant adjustments to our mortgage loan sourcing and purchase strategies in an effort to meet these increased housing goals and the subgoals. These strategies include entering into some purchase and securitization transactions with lower expected economic returns than our typical transactions. We have also relaxed some of our underwriting criteria to obtain goals-qualifying mortgage loans and increased our investments in higher-risk mortgage loan products that are more likely to serve the borrowers targeted by HUD’s goals and subgoals, which could increase our credit losses. The Charter Act explicitly authorizes us to undertake “activities . . . involving a reasonable economic return that may be less than the return earned on other activities” in order to meet these goals.
 
We believe that we are making progress toward achieving our 2006 housing goals and subgoals. Meeting the higher subgoals for 2006 is challenging, however, as increased home prices and higher interest rates have reduced housing affordability. Since HUD set the home purchase subgoals in 2004, the affordable housing markets have experienced a dramatic change. Newly-released Home Mortgage Disclosure Act data show that the share of the primary mortgage market serving low- and moderate-income borrowers declined in 2005,


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reducing our ability to purchase and securitize mortgage loans that meet the HUD subgoals. The National Association of REALTORS® (“NAR”) housing affordability index has dropped from 130.7 in 2003 to 99.6 in July of 2006—the lowest level of affordability seen in the market since 1986. If our efforts to meet the new housing goals and subgoals prove to be insufficient, we may need to take additional steps that could increase our credit losses and reduce our profitability. See “Item 1A—Risk Factors” for more information on how changes we are making to our business strategies in order to meet HUD’s new housing goals and subgoals may reduce our profitability.
 
OFHEO Regulation
 
OFHEO is an independent office within HUD that is responsible for ensuring that we are adequately capitalized and operating safely in accordance with the 1992 Act. We are required to submit to OFHEO annual and quarterly reports on our financial condition and results of operations. OFHEO is authorized to levy annual assessments on Fannie Mae and Freddie Mac, to the extent authorized by Congress, to cover OFHEO’s reasonable expenses. OFHEO’s formal enforcement powers include the power to impose temporary and final cease-and-desist orders and civil monetary penalties on us and our directors and executive officers. OFHEO also may use other informal supervisory procedures of the type that are generally used by federal bank regulatory agencies.
 
OFHEO Special Examination
 
In 2003, OFHEO commenced a special examination of our accounting policies and practices, internal controls, financial reporting, corporate governance, and other matters. In its September 2004 interim report and May 2006 final report of the findings of its special examination, OFHEO concluded that, during the period covered by the reports (1998 to mid-2004), a large number of our accounting policies and practices did not comply with GAAP and we had serious problems in our internal controls, financial reporting and corporate governance. We entered into agreements with OFHEO in September 2004 and March 2005 pursuant to which we agreed to take specified corrective actions to address the concerns and issues that OFHEO raised in its examination.
 
On May 23, 2006, concurrently with OFHEO’s release of its final report, we agreed to OFHEO’s issuance of a consent order without admitting or denying any wrongdoing or any asserted or implied finding or other basis for the consent order. This consent order superseded and terminated both our September 2004 and March 2005 agreements with OFHEO, and resolved all matters addressed by OFHEO’s interim and final reports of its special examination. Under this consent order, we agreed to undertake specified remedial actions to address the recommendations contained in OFHEO’s May 2006 report, including actions relating to our corporate governance, Board of Directors, capital plans, internal controls, accounting practices, public disclosures, regulatory reporting, personnel and compensation practices. We also agreed not to increase our net mortgage assets above the amount shown in our minimum capital report to OFHEO for December 31, 2005 ($727.75 billion), except in limited circumstances at OFHEO’s discretion. Given our need to remediate our identified control deficiencies, the business plan we submitted to OFHEO in July 2006 did not request an increase in the current limitation on the size of our mortgage portfolio during 2006. We anticipate submitting an updated business plan to OFHEO in early 2007 that will take into account our remediation efforts completed at that time. The business plan may include a request for modest growth in our mortgage portfolio.
 
As part of this consent order and our settlement with the SEC discussed below, we agreed to pay a $400 million civil penalty, with $50 million payable to the U.S. Treasury and $350 million payable to the SEC for distribution to stockholders pursuant to the Fair Funds for Investors provision of the Sarbanes-Oxley Act of 2002. We have paid this civil penalty in full and it has been recorded as an expense in our 2004 consolidated financial statements.
 
Capital Requirements
 
As part of its responsibilities under the 1992 Act, OFHEO has regulatory authority as to the capital requirements established by the 1992 Act, issuing regulations on capital adequacy and enforcing capital standards. The 1992 Act capital requirements include minimum and critical capital requirements calculated as specified percentages of our assets and our off-balance sheet obligations, such as outstanding guaranties. In


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addition, the 1992 Act capital requirements include a risk-based capital requirement that is calculated as the amount of capital needed to withstand a severe ten-year stress period in which it is assumed that there would simultaneously be extreme movements in interest rates and severe credit losses. Moreover, to allow for management and operations risks, an additional 30% is added to the amount necessary to withstand the ten-year stress period. On a quarterly basis, we are required by regulation to report to OFHEO on the level of our capital and whether we are in compliance with the capital requirements established by OFHEO. We also provide monthly reports to OFHEO on the level of our capital and our compliance with the capital requirements.
 
Compliance with the capital requirements could limit our operations that require intensive use of capital and could restrict our ability to make payments on our qualifying subordinated debt or pay dividends on our preferred and common stock. If we fail to meet our capital requirements, OFHEO is permitted or required, depending on the requirement we fail to meet, to take remedial actions. Further, if we fail to meet our capital requirements, we are required to submit a capital restoration plan. We currently operate under a capital restoration plan, described below, that OFHEO approved in February 2005. In addition, if OFHEO determines that we are engaging in conduct not approved by OFHEO’s Director that could result in a rapid depletion of our core capital, or that the value of the property securing mortgage loans we hold or have securitized has decreased significantly, or if OFHEO does not approve the capital restoration plan or determines that we have failed to make reasonable efforts to comply with the plan, then OFHEO may take remedial measures as if we were not meeting the capital requirements that we otherwise meet.
 
The 1992 Act gives OFHEO the authority, after following prescribed procedures, to appoint a conservator. Under OFHEO’s regulations, appointment of a conservator is mandatory, with limited exceptions, if we are critically undercapitalized (that is, our core capital is less than our critical capital). Appointment of a conservator is discretionary under OFHEO’s rules if we are significantly undercapitalized (that is, our core capital is less than our required minimum capital), and alternative remedies are unavailable. The 1992 Act and OFHEO’s rules also specify other grounds for appointing a conservator.
 
In December 2004, OFHEO determined that we were significantly undercapitalized as of September 30, 2004. We prepared a capital restoration plan to comply with OFHEO’s directive that we achieve a 30% surplus over our statutory minimum capital requirement by September 30, 2005. Our plan was accepted by OFHEO in February 2005 and, in accordance with the plan, we increased our capital in 2005 by:
 
  •  generating capital through retained earnings;
 
  •  significantly reducing the size of our mortgage portfolio, which reduced our overall minimum capital requirements;
 
  •  issuing $5.0 billion in non-cumulative preferred stock in December 2004;
 
  •  reducing our quarterly common stock dividend from $0.52 per share to $0.26 per share; and
 
  •  canceling our plans to build major new corporate facilities in Southwest Washington, DC and undertaking other cost-cutting efforts.
 
OFHEO announced on November 1, 2005 that we had achieved a 30% surplus over our minimum capital requirement as of September 30, 2005. Under our May 2006 consent order with OFHEO, we agreed to continue to maintain a 30% capital surplus over our statutory minimum capital requirement until the Director of OFHEO, in his discretion, determines the requirement should be modified or allowed to expire, taking into account factors such as resolution of accounting and internal control issues. For additional information on our capital requirements, see “Item 7—MD&A—Liquidity and Capital Management—Capital Management—Capital Adequacy Requirements.”


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Dividend Restrictions
 
Our capital requirements under the Charter Act and as administered by OFHEO may restrict the ability of our Board of Directors to declare dividends, authorize repurchases of our preferred or common stock, or approve any other capital distributions in the following circumstances:
 
  •  if a capital distribution would decrease our total capital below the risk-based capital requirement or our core capital below the minimum capital requirement, we may not make the distribution;
 
  •  if we do not meet the risk-based capital requirement but do meet the minimum capital requirement, we may not make any capital distribution that would cause us to fail to meet the minimum capital requirement; and
 
  •  if we meet neither the risk-based capital requirement nor the minimum capital requirement, but do meet the critical capital requirement established under the 1992 Act, we may make a capital distribution only if, immediately after making the distribution, we would still meet the critical capital requirement and the Director of OFHEO approves the distribution after determining that specified statutory conditions are satisfied.
 
In addition, under our May 2006 consent order with OFHEO, we agreed to the following additional restrictions relating to our capital distributions:
 
  •  As long as the capital restoration plan is in effect, we must seek the approval of the Director of OFHEO before engaging in any transaction that could have the effect of reducing our capital surplus below an amount equal to 30% more than our statutory minimum capital requirement; and
 
  •  We must submit a written report to OFHEO detailing the rationale and process for any proposed capital distribution before making the distribution.
 
Refer to “Item 7—MD&A—Liquidity and Capital Management—Capital Management—Capital Adequacy Requirements” for a description of our statutory capital requirements and our core capital, total capital and other capital classification measures as of December 31, 2004, 2003 and 2002.
 
Recent Legislative Developments and Possible Changes in Our Regulations
 
The U.S. Congress is considering legislation that would change the regulatory framework under which we, Freddie Mac and the Federal Home Loan Banks operate. The Senate Committee on Banking, Housing and Urban Affairs and the U.S. House of Representatives each advanced GSE regulatory oversight legislation in 2005 during the first session of the 109th Congress. On October 26, 2005, the House of Representatives passed a bill and on July 28, 2005, the Senate Committee on Banking, Housing and Urban Affairs passed a bill, which has not yet been brought to the floor of the Senate for a vote. While the House and Senate bills differ in a number of respects, both bills would affect us and other GSEs by significantly altering the scope of:
 
  •  our authorized and permissible activities;
 
  •  the potential level of our required capital;
 
  •  the size and composition of our mortgage investment portfolio (a potential limitation in the House bill and a specific limitation in the Senate bill);
 
  •  the levels of affordable housing goals; and
 
  •  the process by which any new activities and programs would be approved and the extent of regulatory oversight.
 
In addition, the House bill would require Fannie Mae and Freddie Mac to contribute a portion of their profits to a fund to support affordable housing.
 
The specific provisions of legislation, if any, that may ultimately be passed by both the House and the Senate are uncertain. Also uncertain is the timing for enactment of such legislation. We support any legislation that


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will improve our effectiveness in increasing liquidity and lowering the cost of borrowing in the mortgage market and, as a result, expanding access to housing and increasing opportunities for homeownership.
 
As Fannie Mae has testified before Congress, we continue to support legislation:
 
  •  to create a single independent, well-funded regulator with oversight for safety and soundness and mission;
 
  •  to provide the regulator with strong bank-like regulatory powers over capital, activities, supervision and prompt corrective action;
 
  •  to provide the regulator with bank-like regulatory authority to reduce on-balance sheet activities, based on safety and soundness; and
 
  •  to provide a structure for housing goals that includes an affordable housing fund that strengthens our housing and liquidity mission.
 
It is possible, however, that the enactment of legislation could have a material adverse effect on our earnings and the prospects for our business. Refer to “Item 1A—Risk Factors” for a description of how these proposed changes in the regulation of our business could materially adversely affect our business and earnings.
 
EMPLOYEES
 
As of December 31, 2004, we employed approximately 5,400 personnel, including full-time and part-time employees, term employees and employees on leave. During 2005 and 2006, we increased the number of our employees, both as part of significantly improving our accounting practices, risk management, internal controls and corporate governance, and as appropriate to complete the restatement of our previously issued consolidated financial statements. As of October 31, 2006, we employed approximately 6,400 personnel, including full-time and part-time employees, term employees and employees on leave.
 
WHERE YOU CAN FIND ADDITIONAL INFORMATION
 
We file reports, proxy statements and other information with the SEC. Our Web site address is www.fanniemae.com, and we make available free of charge through our Web site our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all other SEC reports and amendments to those reports as soon as reasonably practicable after we electronically file the material with, or furnish it to, the SEC. Materials that we file with the SEC are also available from the SEC’s Web site, www.sec.gov. In addition, these materials may be inspected, without charge, and copies may be obtained at prescribed rates, at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. You may also request copies of any filing from us, at no cost, by telephone at (202) 752-7000 or by mail at 3900 Wisconsin Avenue, NW, Washington, DC 20016.
 
Effective March 31, 2003, we voluntarily registered our common stock with the SEC under Section 12(g) of the Exchange Act. Our common stock, as well as the debt, preferred stock and mortgage-backed securities we issue, are exempt from registration under the Securities Act of 1933 and are “exempted” securities under the 1934 Act. The voluntary registration of our common stock does not affect the exempt status of the debt, equity and mortgage-backed securities that we issue.
 
With regard to OFHEO’s regulation of our activities, you may obtain materials from OFHEO’s Web site, www.ofheo.gov. These materials include the September 2004 interim report of OFHEO’s findings of its special examination and the May 2006 final report on its findings.
 
We are providing our Web site address and the Web site addresses of the SEC and OFHEO solely for your information. Information appearing on our Web site or on the SEC’s Web site or OFHEO’s Web site is not incorporated into this Annual Report on Form 10-K except as specifically stated in this Annual Report on Form 10-K.


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FORWARD-LOOKING STATEMENTS
 
This report contains forward-looking statements, which are statements about matters that are not historical or current facts. In addition, our senior management may from time to time make forward-looking statements orally to analysts, investors, the news media and others. Forward-looking statements often include words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “will,” “would,” “should,” “could,” “may,” or similar words. Among the forward-looking statements in this report are statements relating to:
 
  •  our intent to submit an updated business plan to OFHEO in early 2007 that may include a request for modest growth in our mortgage portfolio;
 
  •  our expectations regarding industry and economic trends, including our expectations that:
 
  •  growth in total U.S. residential mortgage debt outstanding will continue at a slower pace in 2007, as the housing market continues to cool and home price gains moderate further or decline modestly;
 
  •  the continuation of positive demographic trends, such as stable household formation rates, will help mitigate the slowdown in the growth in residential mortgage debt outstanding, but are unlikely to completely offset the slowdown in the short- to medium-term;
 
  •  there is a possibility of a modest decline in national home prices in 2007;
 
  •  our belief that demographic factors (such as stable household formation rates, a positive age structure of the population for homebuying and rising homeownership rates due to the high level of immigration over the past 25 years) that suggest a fundamentally strong mortgage market will support continued long-term demand for new capital to finance the substantial and sustained housing finance needs of American homebuyers;
 
  •  our credit losses will increase and serious delinquencies may trend upward, as a result of the sharp decline in the rate of home price appreciation during 2006 and the possibility of modest home price declines in 2007;
 
  •  our expectation that we will have finalized and substantially completed implementation of new policies and procedures to strengthen risk management practices relating to AD&C business by December 2006;
 
  •  our expectation that, when we expect to earn returns greater than our cost of equity capital, we generally will be an active purchaser of mortgage loans and mortgage-related securities, and that when few opportunities exist to earn returns above our cost of equity capital, we generally will be a less active purchaser, and may be a net seller, of mortgage loans and mortgage-related securities;
 
  •  our expectation that we will be an active purchaser of less liquid forms of mortgage loans and mortgage-related securities even in periods of high market demand for mortgage assets;
 
  •  our expectation that private-label issuers of mortgage-related securities will continue to provide significant competition for our Single-Family and HCD businesses;
 
  •  our belief that major elements of the restatement, including our comprehensive review of our accounting policies and practices, will contribute to a more expeditious completion of financial statements for the years ended December 31, 2005 and 2006;
 
  •  our belief that the estimated fair value of our derivatives may fluctuate substantially from period to period because of changes in interest rates, expected interest rate volatility and our derivative activity;
 
  •  our expectation that, based on the composition of our derivatives, we generally expect to report decreases in the aggregate fair value of our derivatives as interest rates decrease;
 
  •  our expectation that, as a result of the variety of ways in which we record financial instruments in our consolidated financial statements, our earnings will vary, perhaps substantially, from period to period and result in volatility in our stockholders’ equity and regulatory capital;


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  •  our expectation that we will experience high levels of period to period volatility in our financial results as part of our normal business activities, primarily due to changes in market conditions that result in periodic fluctuations in the estimated fair value of our derivatives;
 
  •  our expectation of a reduction in our net interest income and net interest yield in 2005 and 2006, due to the decrease in the volume of our interest-earning assets as well as in the spread between the average yield on these assets and our borrowing costs since year-end 2004;
 
  •  our expectation that unrealized gains and losses on trading securities will fluctuate each period with changes in volumes, interest rates and market prices;
 
  •  our expectation that tax credits and net operating losses resulting from our investments in LIHTC partnerships will grow in the future, which is likely to reduce our effective tax rate, and that it is more likely than not that the results of future operations will generate sufficient taxable income to realize the entire tax benefit;
 
  •  our belief that the guaranty fee income generated from future business activity will largely replace any guaranty fee income lost as a result of mortgage prepayments;
 
  •  our expectation that loans that permit a borrower to defer principal or interest payments, such as negative-amortizing and interest-only loans, will default more often than traditional mortgage loans;
 
  •  our belief that our short-term and long-term funding needs and uses of cash in 2007 will remain generally consistent with current needs and uses, and that our sources of liquidity will remain adequate to meet both our short-term and long-term funding needs in 2007;
 
  •  our expectation that, over the long term, our funding needs and sources of liquidity will remain relatively consistent with current needs and sources;
 
  •  our intent to consider an increase in our issuance of debt in future years, if we decide to increase our purchase of mortgage assets following the modification or expiration of the current limitation on the size of our mortgage portfolio;
 
  •  our expectation that the aggregate estimated fair value of our derivatives will decline and result in derivative losses if long-term interest rates decline;
 
  •  our expectation that the outcome of the current FASB assessment of what activities a QSPE may perform might affect the entities we consolidate in future periods;
 
  •  our estimate that we will complete testing of most of our newly implemented internal controls and remediate most of our remaining material weaknesses in connection with the filing of our Annual Report on Form 10-K for the year ended December 31, 2006, which we will not file on a timely basis;
 
  •  our expectation that the continued downturn in the manufactured housing sector will result in the recognition of additional impairment on our investments in manufactured housing securities;
 
  •  our expectation that there will not be any change in our ability to borrow funds through the issuance of debt securities in the capital markets in the foreseeable future;
 
  •  our expectation that our internal control environment will continue to be modified and enhanced in order to enable us to file periodic reports with the SEC on a current basis in the future;
 
  •  our intention to continue to make significant adjustments to our mortgage loan sourcing and purchase strategies in an effort to meet HUD’s increased housing goals and subgoals;
 
  •  our expectation that the Compensation Committee and the Board will review the performance shares program and determine the appropriate approach for settling our obligations with respect to the existing unpaid performance share cycles;
 
  •  our intent that, in the event that we were required to make payments under Fannie Mae MBS guaranties, we would pursue recovery of these payments by exercising our rights to the collateral backing the underlying loans or through available credit enhancements (which includes all recourse with third parties and mortgage insurance);


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  •  our expectation that we will experience periodic fluctuations in the estimated fair value of our net assets due to changes in market conditions, including changes in interest rates, changes in relative spreads between our mortgage assets and debt, and changes in implied volatility;
 
  •  our expectation that changes in implied volatility, mortgage OAS and debt OAS are the market conditions that will have the most significant impact on the fair value of our net assets;
 
  •  our expectation that, based on market conditions and the composition of our consolidated balance sheets in 2005 and 2006, we will not experience the same level of increase in the estimated fair value of our net assets in 2005 and 2006 that we experienced in 2004;
 
  •  our expectation that we will continue to incur significant administrative expenses in connection with complying with our remediation obligations, which will reduce our earnings for the years ended December 31, 2005 and 2006;
 
  •  our estimate that, for 2006, our restatement and related regulatory costs will total approximately $850 million and costs attributable to or associated with the preparation of our consolidated financial statements and periodic SEC financial reports for periods subsequent to 2004 will total over $200 million;
 
  •  our expectation that the costs associated with preparation of our post-2004 financial statements and periodic SEC reports will continue to have a substantial impact on administrative expenses until we are current in filing our periodic financial reports with the SEC;
 
  •  our belief that our administrative expenses for 2007 will be comparable to those for 2006;
 
  •  our expectation that the reduction in the size of our mortgage portfolio beginning in 2005 will contribute to significantly reduced net interest income for the years ended December 31, 2005 and 2006, compared to the years ended December 31, 2004 and 2003;
 
  •  our expectation that we will report significantly lower losses from our risk management derivatives in 2005 and 2006, relative to the losses reported in 2004;
 
  •  our belief that we will continue to work on improving our internal controls and procedures relating to the management of operational risk; and
 
  •  descriptions of assumptions underlying or relating to any of the foregoing.
 
Forward-looking statements reflect our management’s expectations or predictions of future conditions, events or results based on various assumptions and management’s estimates of trends and economic factors in the markets in which we are active, as well as our business plans. They are not guarantees of future performance. By their nature, forward-looking statements are subject to risks and uncertainties. Our actual results and financial condition may differ, possibly materially, from the anticipated results and financial condition indicated in these forward-looking statements. There are a number of factors that could cause actual conditions, events or results to differ materially from those described in the forward-looking statements contained in this report. A discussion of factors that could cause actual conditions, events or results to differ materially from those expressed in any forward-looking statements appears in “Item 1A—Risk Factors.”
 
Readers are cautioned not to place undue reliance on forward-looking statements in this report or that we make from time to time, and to consider carefully the factors discussed in “Item 1A—Risk Factors” in evaluating these forward-looking statements. These forward-looking statements are representative only as of the date they are made, and we undertake no obligation to update any forward-looking statement as a result of new information, future events or otherwise.
 
GLOSSARY OF TERMS USED IN THIS REPORT
 
Terms used in this report have the following meanings, unless the context indicates otherwise.
 
“Agency issuers” refers to the government-sponsored enterprises Fannie Mae and Freddie Mac, as well as Ginnie Mae.
 
“Alt-A mortgage” refers to a mortgage loan underwritten using more liberal standards such as higher loan-to-value ratios and less documentation of borrower income or assets.


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“ARM” or “adjustable-rate mortgage” refers to a mortgage loan with an interest rate that adjusts periodically over the life of the mortgage based on changes in a specified index.
 
“Book of business” refers to the sum of: (1) the unpaid principal balance of the mortgage loans and mortgage-related securities we hold in our mortgage portfolio and (2) the unpaid principal balance of Fannie Mae MBS held by third parties.
 
“Business volume” refers to both the unpaid principal balance of the mortgage loans and mortgage-related securities we purchase for our mortgage portfolio in a given period and the unpaid principal balance of the mortgage loans we securitize into Fannie Mae MBS that are acquired by third parties in such period.
 
“Charter Act” or “our charter” refers to the Federal National Mortgage Association Charter Act, 12 U.S.C. §1716 et seq.
 
“Conforming mortgage” refers to a conventional single-family mortgage loan with an original principal balance that is equal to or less than the applicable conforming loan limit, which is the applicable maximum original principal balance for a mortgage loan that we are permitted by our charter to purchase or securitize. The conforming loan limit is established each year by OFHEO based on the national average price of a one-family residence. The current conforming loan limit for a one-family residence in most geographic areas is $417,000.
 
“Conventional mortgage” refers to a mortgage loan that is not guaranteed or insured by the U.S. government or its agencies, such as the VA, FHA or RHS.
 
“Conventional single-family mortgage credit book of business” refers to the sum of the unpaid principal balance of: (1) the conventional single-family mortgage loans we hold in our investment portfolio; (2) the Fannie Mae MBS and non-Fannie Mae mortgage-related securities backed by conventional single-family mortgage loans we hold in our investment portfolio; (3) Fannie Mae MBS backed by conventional single-family mortgage loans that are held by third parties; and (4) credit enhancements that we provide on conventional single-family mortgage assets.
 
“Core capital” refers to a regulatory measure of our capital that represents the sum of the stated value of our outstanding common stock (common stock less treasury stock), the stated value of our outstanding non-cumulative perpetual preferred stock, our paid-in capital and our retained earnings, as determined in accordance with GAAP.
 
“Credit enhancement” refers to a method to reduce credit risk by requiring collateral, letters of credit, mortgage insurance, corporate guaranties, or other agreements to provide an entity with some assurance that it will be recompensed to some degree in the event of a financial loss.
 
“Critical capital requirement” refers to the amount of core capital below which we would be classified by OFHEO as critically undercapitalized and generally would be required to be placed in conservatorship. Our critical capital requirement is generally equal to the sum of: (1) 1.25% of on-balance sheet assets; (2) 0.25% of the unpaid principal balance of outstanding Fannie Mae MBS held by third parties; and (3) up to 0.25% of other off-balance sheet obligations.
 
“Delinquency” refers to an instance in which a principal or interest payment on a mortgage loan has not been made in full by the due date.
 
“Derivative” refers to a financial instrument that derives its value based on changes in an underlying, such as security or commodity prices, interest rates, currency rates or other financial indices. Examples of derivatives include futures, options and swaps.
 
“Duration” refers to the sensitivity of the value of a security to changes in interest rates. It can be calculated for non-callable securities as the weighted-average maturity of a security’s future cash flows, both principal and interest, where the present values of the cash flows serve as the weights.
 
“Fannie Mae mortgage-backed securities” or “Fannie Mae MBS” generally refer to those mortgage-related securities that we issue and with respect to which we guarantee to the related trusts that we will supplement mortgage loan collections as required to permit timely payment of principal and interest due on the related


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Fannie Mae MBS. We also issue some forms of mortgage-related securities for which we do not provide this guaranty. The term “Fannie Mae MBS” refers to all forms of mortgage-related securities that we issue, including single-class Fannie Mae MBS and multi-class Fannie Mae MBS.
 
“Fixed-rate mortgage” refers to a mortgage loan with an interest rate that does not change during the entire term of the loan.
 
“GAAP” refers to generally accepted accounting principles in the United States.
 
“GSEs” refers to government-sponsored enterprises such as Fannie Mae, Freddie Mac and the Federal Home Loan Banks.
 
“HUD” refers to the Department of Housing and Urban Development.
 
“Implied volatility” refers to the market’s expectation of potential changes in interest rates.
 
“Interest-only loan” refers to a mortgage loan that allows the borrower to pay only the monthly interest due, and none of the principal, for a fixed term. After the end of that term, typically five to ten years, the borrower can choose to refinance, pay the principal balance in a lump sum, or begin paying the monthly scheduled principal due on the loan, which results in a higher monthly payment at that time. Interest-only loans can be adjustable-rate or fixed-rate mortgage loans.
 
“Interest rate swap” refers to a transaction between two parties in which each agrees to exchange payments tied to different interest rates or indices for a specified period of time, generally based on a notional principal amount. An interest rate swap is a type of derivative.
 
“Intermediate-term mortgage” refers to a mortgage loan with a contractual maturity at the time of purchase equal to or less than 15 years.
 
“LIHTC partnerships” refer to low-income housing tax credit limited partnerships or limited liability companies. For a description of these partnerships, refer to “Business Segments—Housing and Community Development—Community Investment Group” above.
 
“Liquid assets” refers to our holdings of non-mortgage investments, cash and cash equivalents, and funding agreements with our lenders, including advances to lenders and repurchase agreements.
 
“Loans,” “mortgage loans” and “mortgages” refer to both whole loans and loan participations, secured by residential real estate, cooperative shares or by manufactured housing units.
 
“Loan-to-value ratio” or “LTV ratio” refers to the ratio, at any point in time, of the unpaid principal amount of a borrower’s mortgage loan to the value of the property that serves as collateral for the loan (expressed as a percentage).
 
“Minimum capital requirement” refers to the amount of core capital below which we would be classified by OFHEO as undercapitalized. Our minimum capital requirement is generally equal to the sum of: (1) 2.50% of on-balance sheet assets; (2) 0.45% of the unpaid principal balance of outstanding Fannie Mae MBS held by third parties; and (3) up to 0.45% of other off-balance sheet obligations.
 
“Mortgage assets,” when referring to our assets, refers to both mortgage loans and mortgage-related securities we hold in our portfolio.
 
“Mortgage credit book of business” refers to the sum of the unpaid principal balance of: (1) the mortgage loans we hold in our investment portfolio; (2) the Fannie Mae MBS and non-Fannie Mae mortgage-related securities we hold in our investment portfolio; (3) Fannie Mae MBS that are held by third parties; and (4) credit enhancements that we provide on mortgage assets.
 
“Mortgage-related securities” or “mortgage-backed securities” refer generally to securities that represent beneficial interests in pools of mortgage loans or other mortgage-related securities. These securities may be issued by Fannie Mae or by others.


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“Multifamily” mortgage loan refers to a mortgage loan secured by a property containing five or more residential dwelling units.
 
“Multifamily mortgage credit book of business” refers to the sum of the unpaid principal balance of: (1) the multifamily mortgage loans we hold in our investment portfolio; (2) the Fannie Mae MBS and non-Fannie Mae mortgage-related securities backed by multifamily mortgage loans we hold in our investment portfolio; (3) Fannie Mae MBS backed by multifamily mortgage loans that are held by third parties; and (4) credit enhancements that we provide on multifamily mortgage assets.
 
“Negative-amortizing loan” refers to a mortgage loan that allows the borrower to make monthly payments that are less than the interest actually accrued for the period. The unpaid interest is added to the principal balance of the loan, which increases the outstanding loan balance. Negative-amortizing loans are typically adjustable-rate mortgage loans.
 
“Notional principal amount” refers to the hypothetical dollar amount in an interest rate swap transaction on which exchanged payments are based. The notional principal amount in an interest rate swap transaction generally is not paid or received by either party to the transaction and is typically significantly greater than the potential market or credit loss that could result from such transaction.
 
“OFHEO” refers to the Office of Federal Housing Enterprise Oversight, our safety and soundness regulator.
 
“Option-adjusted spread” or “OAS” refers to the incremental expected return between a security, loan or derivative contract and a benchmark yield curve (typically, U.S. Treasury securities, LIBOR and swaps, or agency debt securities). The OAS provides explicit consideration of the variability in the security’s cash flows across multiple interest rate scenarios resulting from any options embedded in the security, such as prepayment options. For example, the OAS of a mortgage that can be prepaid by the homeowner is typically lower than a nominal yield spread to the same benchmark because the OAS reflects the exercise of the prepayment option by the homeowner, which lowers the expected return of the mortgage investor. In other words, OAS for mortgage loans is a risk-adjusted spread after consideration of the prepayment risk in mortgage loans. The market convention for mortgages is typically to quote their OAS to swaps. The OASs of our funding and hedging instruments are also frequently quoted to swaps. The OAS of our net assets is therefore the combination of these two spreads to swaps and is the option-adjusted spread between our assets and our funding and hedging instruments.
 
“Outstanding Fannie Mae MBS” refers to the total unpaid principal balance of Fannie Mae MBS that is held by third-party investors and held in our mortgage portfolio, without reflecting the impact of the consolidation of variable interest entities.
 
“Private-label issuers” or “non-agency issuers” refers to issuers of mortgage-related securities other than agency issuers Fannie Mae, Freddie Mac and Ginnie Mae.
 
“Private-label securities” or “non-agency securities” refers to mortgage-related securities issued by entities other than agency issuers Fannie Mae, Freddie Mac or Ginnie Mae.
 
“Qualifying subordinated debt” refers to our subordinated debt that contains an interest deferral feature that requires us to defer the payment of interest for up to five years if either: (1) our core capital is below 125% of our critical capital requirement; or (2) our core capital is below our minimum capital requirement and the U.S. Secretary of the Treasury, acting on our request, exercises his or her discretionary authority pursuant to Section 304(c) of the Charter Act to purchase our debt obligations.
 
“REO” refers to real-estate owned by Fannie Mae, generally because we have foreclosed on the property or obtained the property through a deed in lieu of foreclosure.
 
“Reverse mortgage” refers to a financial tool that provides seniors with funds from the equity in their homes. Generally, no borrower payments are made on a reverse mortgage until the borrower moves or the property is sold. The final repayment obligation is designed not to exceed the proceeds from the sale of the home.
 
“Risk-based capital requirement” refers to the amount of capital necessary to absorb losses throughout a hypothetical ten-year period marked by severely adverse circumstances. Refer to “Item 7—MD&A—Liquidity


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and Capital Management—Capital Management—Capital Adequacy Requirements—Statutory Risk-Based Capital Requirements” for a detailed definition of our statutory risk-based capital requirement.
 
“Secondary mortgage market” refers to the financial market in which residential mortgages and mortgage-related securities are bought and sold.
 
“Single-family” mortgage loan refers to a mortgage loan secured by a property containing four or fewer residential dwelling units.
 
“Single-family mortgage credit book of business” refers to the sum of the unpaid principal balance of: (1) the single-family mortgage loans we hold in our investment portfolio; (2) the Fannie Mae MBS and non-Fannie Mae mortgage-related securities backed by single-family mortgage loans we hold in our investment portfolio; (3) Fannie Mae MBS backed by single-family mortgage loans that are held by third parties; and (4) credit enhancements that we provide on single-family mortgage assets.
 
“Sub-prime mortgage” refers to a mortgage loan underwritten using lower credit standards than those used in the prime lending market.
 
“Swaptions” refers to options on interest rate swaps in the form of contracts granting an option to one party and creating a corresponding commitment from the counterparty to enter into specified interest rate swaps in the future. Swaptions are usually traded in the over-the-counter market and not through an exchange.
 
“Total capital” refers to a regulatory measure of our capital that represents the sum of core capital plus the total allowance for loan losses and reserve for guaranty losses in connection with Fannie Mae MBS, less the specific loss allowance (that is, the allowance required on individually-impaired loans).
 
“Yield curve” or “shape of the yield curve” refers to a graph showing the relationship between the yields on bonds of the same credit quality with different maturities. For example, a “normal” or positive sloping yield curve exists when long-term bonds have higher yields than short-term bonds. A “flat” yield curve exists when yields are relatively the same for short-term and long-term bonds. A “steep” yield curve exists when yields on long-term bonds are significantly higher than on short-term bonds. An “inverted” yield curve, which is rare, exists when yields on long-term bonds are lower than yields on short-term bonds.
 
Item 1A.   Risk Factors
 
This section identifies specific risks that should be considered carefully in evaluating our business. The risks described in “Company Risks” are specific to us and our business, while those described in “Risks Relating to Our Industry” relate to the industry in which we operate. Any of these risks could adversely affect our business, results of operations or financial condition. Although we believe that these risks represent the material risks relevant to us, our business and our industry, new material risks may emerge that we are currently unable to predict. As a result, this description of the risks that affect our business and our industry is not exhaustive. The risks discussed below could cause our actual results to differ materially from our historical results or the results contemplated by the forward-looking statements contained in this report.
 
COMPANY RISKS
 
Material weaknesses and other control deficiencies relating to our internal controls could result in errors in our reported results and could have a material adverse effect on our operations, investor confidence in our business and the trading prices of our securities.
 
Management’s assessment of our internal control over financial reporting as of December 31, 2004 identified numerous material weaknesses in our control environment, our application of GAAP, our financial reporting process, and our information technology applications and infrastructure as of December 31, 2004. Further, we identified additional material weaknesses in the independent model review process, treasury and trading operations, pricing and independent price verification processes, and wire transfer controls. In addition, following their separate investigations of our business and accounting practices, OFHEO and the law firm of Paul Weiss each issued reports identifying significant problems and deficiencies in our prior processes for corporate governance and internal controls. Until they are remediated, these material weaknesses and other


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control deficiencies could lead to errors in our reported financial results and could have a material adverse effect on our operations, investor confidence in our business and the trading prices of our securities.
 
As described in “Item 9A—Controls and Procedures—Remediation Activities and Changes in Internal Control Over Financial Reporting,” we are currently in the process of remediating our identified material weaknesses; however, management will not make a final determination that we have completed our remediation of these material weaknesses until we have completed testing of our newly implemented internal controls. In addition, we have not filed our Quarterly Reports on Form 10-Q for 2005 or 2006, or our Annual Report on Form 10-K for 2005, and we are not able at this time to file our periodic SEC reports on Form 10-Q and Form 10-K on a timely basis. We believe that we will not have remediated the material weakness relating to our disclosure controls and procedures until we are able to file required reports with the SEC and the New York Stock Exchange on a timely basis.
 
In the future, we may identify further material weaknesses or significant deficiencies in our internal control over financial reporting that we have not discovered to date. In addition, we cannot be certain that we will be able to maintain adequate controls over our financial processes and reporting in the future.
 
Competition in the mortgage and financial services industries, and the need to develop, enhance and implement strategies to adapt to changing trends in the mortgage industry and capital markets, may adversely affect our business and earnings.
 
Increasing Competition.  We compete to acquire mortgage loans for our mortgage portfolio or for securitization based on a number of factors, including our speed and reliability in closing transactions, our products and services, the liquidity of Fannie Mae MBS, our reputation and our pricing. We face increasing competition in the secondary mortgage market from other GSEs and from large commercial banks, savings and loan institutions, securities dealers, investment funds, insurance companies and other financial institutions. In addition, increasing consolidation within the financial services industry has created larger private financial institutions, which has increased pricing pressure. The recent decreased rate of growth in U.S. residential mortgage debt outstanding in 2006 also has increased competition in the secondary mortgage market by decreasing the number of new mortgage loans available for purchase. This increased competition may adversely affect our business and earnings.
 
Potential Decrease in Earnings Resulting from Changes in Industry Trends.  The manner in which we compete and the products for which we compete are affected by changing trends in our industry. If we do not effectively respond to these trends, or if our strategies to respond to these trends are not as successful as our prior business strategies, our business, earnings and total returns could be adversely affected. For example, in recent years, an increasing proportion of single-family mortgage loan originations has consisted of non-traditional mortgages such as interest-only mortgages, negative-amortizing mortgages and sub-prime mortgages, and demand for traditional 30-year fixed-rate mortgages has decreased. We did not participate in large amounts of these non-traditional mortgages in 2004 and 2005 because we determined that the pricing offered for these mortgages often was insufficient compensation for the additional credit risk associated with these mortgages. These trends and our decision not to participate in large amounts of these non-traditional mortgages contributed to a significant loss in our share of new single-family mortgage-related securities issuances to private-label issuers during this period, with our market share decreasing from 45.0% in 2003 to 29.2% in 2004 and 23.5% in 2005.
 
We have modified and enhanced a number of our strategies as part of our ongoing efforts to adapt to recent changes in the industry. For example, our Capital Markets group focused on buying and holding mortgage assets to maturity prior to 2005. Beginning in 2005, however, in response to both our capital plan requirements and market conditions at that time, our Capital Markets group engaged in more active management of our portfolio through both purchases and sales of mortgage assets, with the dual goals of supporting our chartered purpose of providing liquidity to the secondary mortgage market and maximizing total returns. In addition, we have been working with our lender customers to support a broad range of mortgage products, including sub-prime products, while closely monitoring credit risk and pricing dynamics across the full spectrum of mortgage product types. We may not be able to execute successfully any new or enhanced strategies that we adopt. In


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addition, these strategies may not increase our share of the secondary mortgage market, our revenues or our total returns.
 
The restatement of our consolidated financial statements and related events, including the lack of current financial and operating information about the company, have had, and likely will continue to have, a material adverse effect on our business and reputation.
 
We have become subject to several significant risks since our announcement in December 2004 that we would restate our previously filed consolidated financial statements. This Annual Report on Form 10-K, which contains information for the years ended December 31, 2004, 2003 and 2002, includes restated consolidated financial statements for the years ended December 31, 2003 and 2002, and is our first periodic report covering periods after June 30, 2004. Our need to restate our historical financial statements and the delay in producing both restated and more current consolidated financial statements has resulted in several risks to our business, as discussed in the following paragraphs.
 
Risks Relating to Lack of Current Information about our Business.  Material information about our current operating results and financial condition is unavailable because of the delay in filing our 2005 and 2006 annual and quarterly reports with the SEC. As a result, investors do not have access to full information about the current state of our business. When this information becomes available to investors, it may result in an adverse effect on the trading price of our common stock.
 
Risks Relating to Suspension and Delisting of Our Securities from the NYSE.  The delay in filing our Annual Report on Form 10-K for the year ended December 31, 2005 with the SEC could cause the New York Stock Exchange, or NYSE, to commence suspension and delisting proceedings of our common stock. In addition, we expect that we will not be able to file our Annual Report on Form 10-K for the year ended December 31, 2006 by its due date of March 1, 2007, which would be a separate violation of the NYSE’s listing rules. If the NYSE were to delist our common stock it could result in a significant decline in the trading price, trading volume and liquidity of our common stock and could have a similar effect on our preferred stock listed on the NYSE. We also expect that the suspension and delisting of our common stock could lead to decreases in analyst coverage and market-making activity relating to our common stock, as well as reduced information about trading prices and volume.
 
Risks Associated with Pending Civil Litigation.  We are subject to pending civil litigation that, if decided against us, could require us to pay substantial judgments or settlement amounts or provide for other relief, as discussed in “Item 3—Legal Proceedings.”
 
Reputational Risks and Other Risks Relating to Negative Publicity.  We have been subject to continuing negative publicity as a result of our accounting restatement and related problems, which we believe have contributed to significant declines in the price of our common stock. Continuing negative publicity could increase our cost of funds and adversely affect our customer relationships and the trading price of our stock. Negative publicity associated with our accounting restatement and related problems also has resulted in increased regulatory and legislative scrutiny of our business.
 
Decrease in Common Stock Dividends and Limitation on Our Ability to Increase Our Dividend Payments.  In January 2005, in an effort to accelerate our achievement of a 30% capital surplus over our minimum capital requirement as required by OFHEO, we reduced our previous quarterly common stock dividend rate by 50%, from $0.52 per share to $0.26 per share. Under our May 2006 consent order with OFHEO, we are required to continue to operate under the capital restoration plan approved by OFHEO in February 2005. Our consent order with OFHEO also requires us to provide OFHEO with prior notice of any planned dividend and a description of the rationale for its payment. In addition, our Board of Directors is not permitted to increase the dividend at any time if payment of the increased dividend would reduce our capital surplus to less than 30% above our minimum capital requirement. On December 6, 2006, the Board of Directors increased the quarterly common stock dividend to $0.40 per share.


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Changes in interest rates could materially impact our financial condition and our earnings.
 
We fund our operations primarily through the issuance of debt and invest our funds primarily in mortgage-related assets that permit the mortgage borrowers to prepay the mortgages at any time. These business activities expose us to market risk, which is the risk of loss from adverse changes in market conditions. Our most significant market risks are interest rate risk and option-adjusted spread risk. Interest rate risk is the risk of changes in our long-term earnings or in the value of our net assets due to changes in interest rates. Changes in interest rates affect both the value of our mortgage assets and prepayment rates on our mortgage loans. Changes in interest rates could have a material adverse impact on our business results and financial condition, particularly if actual conditions differ significantly from our expectations.
 
Our ability to manage interest rate risk depends on our ability to issue debt instruments with a range of maturities and other features at attractive rates and to engage in derivative transactions. We must exercise judgment in selecting the amount, type and mix of debt and derivative instruments that will most effectively manage our interest rate risk. The amount, type and mix of financial instruments we select may not offset possible future changes in the spread between our borrowing costs and the interest we earn on our mortgage assets. A discussion of how we manage interest rate risk is included in “Item 7—MD&A—Risk Management—Interest Rate Risk Management and Other Market Risks.”
 
Option-adjusted spread risk is the risk that the option-adjusted spreads on mortgage assets relative to those on our funding and hedging instruments (referred to as the OAS of our net assets) may increase or decrease. These increases or decreases may be a result of market supply and demand dynamics, including credit pricing basis risk between our assets and swaps and between swaps and our funding and hedging instruments. A widening of the OAS of our net assets typically causes a decline in the fair value of the company. A narrowing of the OAS of our net assets will reduce our opportunities to acquire mortgage assets and therefore could have a material adverse effect on our future earnings and financial condition. We do not attempt to actively manage or hedge the impact of changes in mortgage-to-debt OAS after we purchase mortgage assets, other than through asset monitoring and disposition.
 
We make significant use of business and financial models to manage risk, although we recognize that models are inherently imperfect predictors of actual results because they are based on assumptions about factors such as future loan demand, prepayment speeds and other factors that may overstate or understate future experience. Our business could be adversely affected if our models fail to produce reliable results.
 
We have several key lender customers and the loss of business volume from any one of these customers could adversely affect our business, market share and results of operations.
 
Our ability to generate revenue from the purchase and securitization of mortgage loans depends on our ability to acquire a steady flow of mortgage loans from the originators of those loans. We acquire a significant portion of our single-family mortgage loans from several large mortgage lenders. During 2004, our top five lender customers accounted for a total of approximately 53% of our single-family business volumes (which refers to both single-family mortgage loans that we purchase for our mortgage portfolio and single-family mortgage loans that we securitize into Fannie Mae MBS), with our top customer accounting for approximately 26% of that amount. Accordingly, maintaining our current business relationships and business volumes with our top lender customers is critical to our business. If any of our key lender customers significantly reduces the volume of mortgage loans that the lender delivers to us, we could lose significant business volume that we might be unable to replace. The loss of business from any one of our key lender customers could adversely affect our business, market share and results of operations. In addition, a significant reduction in the volume of mortgage loans that we securitize could reduce the liquidity of Fannie Mae MBS, which in turn could have an adverse effect on their market value.
 
We are subject to credit risk relating to the mortgage loans that we purchase or that back our Fannie Mae MBS, and any resulting delinquencies and credit losses could adversely affect our financial condition and results of operations.
 
Borrowers of mortgage loans that we purchase or that back our Fannie Mae MBS may fail to make the required payments of principal and interest on those loans, exposing us to the risk of credit losses. In addition,


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due to the current competitive dynamics of the mortgage market, we have recently increased our purchase and securitization of mortgage loans that pose a higher credit risk, such as negative-amortizing loans and interest-only loans. We also have increased the proportion of reduced documentation loans that we purchase or that back our Fannie Mae MBS.
 
For example, negative-amortizing adjustable-rate mortgages (“ARMs”) represented approximately 2% and 3%, respectively, of our conventional single-family business volumes (which refers to both conventional single-family mortgage loans we purchase for our mortgage portfolio and conventional single-family mortgage loans we securitize into Fannie Mae MBS) in 2004 and 2005, and approximately 4% for the first nine months of 2006. Interest-only mortgage loans represented approximately 5% and 10%, respectively, of our conventional single-family business volumes in 2004 and 2005, and approximately 15% for the first nine months of 2006. We estimate that negative-amortizing ARMs and interest-only loans represented approximately 2% and 6%, respectively, of our conventional single-family mortgage credit book of business as of September 30, 2006.
 
The increase in our exposure to credit risk resulting from the increase in these loans with higher credit risk may cause us to experience increased delinquencies and credit losses in the future, which could adversely affect our financial condition and results of operations. A discussion of how we manage mortgage credit risk and a description of the risk characteristics of our mortgage credit book of business is included in “Item 7—MD&A—Risk Management—Credit Risk Management—Mortgage Credit Risk Management.”
 
We depend on our institutional counterparties to provide services that are critical to our business, and our financial condition and results of operations may be adversely affected by defaults by our institutional counterparties.
 
We face the risk that our institutional counterparties may fail to fulfill their contractual obligations to us. Our primary exposure to institutional counterparties risk is with our mortgage insurers, mortgage servicers, lender customers, issuers of investments held in our liquid investment portfolio, dealers that commit to sell mortgage pools or loans to us, and derivatives counterparties. The products or services that these counterparties provide are critical to our business operations and a default by a counterparty with significant obligations to us could adversely affect our financial condition and results of operations. A discussion of how we manage institutional counterparty credit risk is included in “Item 7—MD&A—Risk Management—Credit Risk Management—Institutional Counterparty Credit Risk Management.”
 
Mortgage Insurers.  A mortgage insurer could fail to fulfill its obligation to reimburse us for claims under our mortgage insurance policies, which would require us to bear the full loss of the borrower default on the mortgage loans. As of December 31, 2004, we were the beneficiary of primary mortgage insurance coverage on $285.4 billion of single-family loans held in our portfolio or underlying Fannie Mae MBS, which represented approximately 13% of our single-family mortgage credit book of business.
 
Lender Risk-Sharing Agreements.  We enter into risk-sharing agreements with some of our lender customers that require them to reimburse us for losses under the loans that are the subject of those agreements. A lender’s default in its obligation to reimburse us could decrease our net income.
 
Mortgage Servicers.  One or more of our mortgage servicers could fail to fulfill its mortgage loan servicing obligations, which include collecting payments from borrowers under the mortgage loans that we own or that are part of the collateral pools supporting our Fannie Mae MBS, paying taxes and insurance on the properties secured by the mortgage loans, monitoring and reporting loan delinquencies, and repurchasing any loans that are subsequently found to have not met our underwriting criteria. In that event, we could incur credit losses associated with loan delinquencies or penalties for late payment of taxes and insurance on the properties that secure the mortgage loans serviced by that mortgage servicer. In addition, we likely would be forced to incur the costs necessary to replace the defaulting mortgage servicer. These events would result in a decrease in our net income. As of December 31, 2004, our ten largest single-family mortgage servicers serviced 71% of our single-family mortgage credit book of business, and the largest single-family mortgage servicer serviced 21% of the single-family mortgage credit book of business. Accordingly, the effect of a default by one of these servicers could result in a more significant decrease in our net income than if our loans were serviced by a more diverse group of servicers.


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Agreements with Dealers.  We enter into agreements with dealers under which they commit to deliver pools of mortgages to us at an agreed-upon date and price. We commit to sell Fannie Mae MBS based in part on these commitments. If a dealer defaults in its commitment obligation, it could cause us to default in our obligation to deliver the Fannie Mae MBS on our commitment date or may force us to replace the loans at a higher cost in order to meet our commitment.
 
Liquid Investment Portfolio Issuers.  The primary credit exposure associated with investments held in our liquid investment portfolio is that the issuers of these investments will not repay principal and interest in accordance with the contractual terms. The failure of these issuers to make these payments could have a material adverse effect on our business results.
 
Derivatives Counterparties.  If a derivatives counterparty defaults on payments due to us, we may need to enter into a replacement derivative contract with a different counterparty at a higher cost or we may be unable to obtain a replacement contract. As of December 31, 2004, we had 23 interest rate and foreign currency derivatives counterparties. Eight of these counterparties accounted for approximately 83% of the total outstanding notional amount of our derivatives contracts, and each of these eight counterparties accounted for between approximately 7% and 14% of the total outstanding notional amount. The insolvency of one of our largest derivatives counterparties combined with an adverse move in the market before we are able to transfer or replace the contracts could adversely affect our financial condition and results of operations. A discussion of how we manage the credit risk posed by our derivatives transactions and a detailed description of our derivatives credit exposure is contained in “Item 7—MD&A—Risk Management—Credit Risk Management—Institutional Counterparty Credit Risk Management—Derivatives Counterparties.”
 
Our ability to operate our business, meet our obligations and generate net interest income depends primarily on our ability to issue substantial amounts of debt frequently and at attractive rates.
 
The issuance of short-term and long-term debt securities in the domestic and international capital markets is our primary source of funding for purchasing assets for our mortgage portfolio and repaying or refinancing our existing debt. Moreover, our primary source of revenue is the net interest income we earn from the difference, or spread, between our borrowing costs and the return that we receive on our mortgage assets. Our ability to obtain funds through the issuance of debt, and the cost at which we are able to obtain these funds, depends on many factors, including:
 
  •  our corporate and regulatory structure, including our status as a GSE;
 
  •  legislative or regulatory actions relating to our business, including any actions that would affect our GSE status;
 
  •  rating agency actions relating to our credit ratings;
 
  •  our financial results and changes in our financial condition;
 
  •  significant events relating to our business or industry;
 
  •  the public’s perception of the risks to and financial prospects of our business or industry;
 
  •  the preferences of debt investors;
 
  •  the breadth of our investor base;
 
  •  prevailing conditions in the capital markets;
 
  •  interest rate fluctuations; and
 
  •  general economic conditions in the United States and abroad.
 
In addition, the other GSEs, such as Freddie Mac and the Federal Home Loan Banks, also issue significant amounts of AAA-rated agency debt to fund their operations, which may negatively impact the prices we are able to obtain for these securities.
 
Approximately 47% of the Benchmark Notes we have issued in 2006 were purchased by non-U.S. investors, including both private institutions and non-U.S. governments and government agencies. Accordingly, a significant reduction in the purchase of our debt securities by non-U.S. investors could have a material adverse effect on both the amount of debt securities we are able to issue and the price we are able to obtain for these securities. Many of the factors that affect the amount of our securities that foreign investors purchase, including economic


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downturns in the countries where these investors are located, currency exchange rates and changes in domestic or foreign fiscal or monetary policies, are outside our control.
 
If we are unable to issue debt securities at attractive rates in amounts sufficient to operate our business and meet our obligations, it would have a material adverse effect on our liquidity, financial condition and results of operations. A description of how we obtain funding for our business by issuing debt securities in the capital markets is contained in “Item 7—MD&A—Liquidity and Capital Management—Liquidity—Debt Funding.” For a description of how we manage liquidity risk, see ‘‘Item 7—MD&A—Liquidity and Capital Management—Liquidity—Liquidity Risk Management.”
 
On June 13, 2006, the U.S. Department of the Treasury announced that it would undertake a review of its process for approving our issuances of debt, which could adversely impact our flexibility in issuing debt securities in the future. We cannot predict whether the outcome of this review will materially impact our current business activities.
 
A decrease in our current credit ratings would have an adverse effect on our ability to issue debt on acceptable terms, which could adversely affect our liquidity and our results of operations.
 
Our borrowing costs and our broad access to the debt capital markets depends in large part on our high credit ratings. Our senior unsecured debt currently has the highest credit rating available from Moody’s Investors Service (“Moody’s”), Standard & Poor’s, a division of The McGraw-Hill Companies (“Standard & Poor’s”), and Fitch Ratings (“Fitch”). These ratings are subject to revision or withdrawal at any time by the rating agencies. Any reduction in our credit ratings could increase our borrowing costs, limit our access to the capital markets and trigger additional collateral requirements in derivative contracts and other borrowing arrangements. A substantial reduction in our credit ratings would reduce our earnings and materially adversely affect our liquidity, our ability to conduct our normal business operations and our competitive position. A description of our credit ratings and current ratings outlook is included in “Item 7—MD&A—Liquidity and Capital Management—Liquidity—Credit Ratings and Risk Ratings.”
 
Our business is subject to laws and regulations that may restrict our ability to compete optimally. In addition, legislation that would change the regulation of our business could, if enacted, reduce our competitiveness and adversely affect our results of operations and financial condition. The impact of existing regulation on our business is significant, and both existing and future regulation may adversely affect our business.
 
As a federally chartered corporation, we are subject to the limitations imposed by the Charter Act, extensive regulation, supervision and examination by OFHEO and HUD, and regulation by other federal agencies, such as the U.S. Department of the Treasury and the SEC. We are also subject to many laws and regulations that affect our business, including those regarding taxation and privacy. A description of the laws and regulations that affect our business is contained in “Item 1—Business—Our Charter and Regulation of Our Activities.”
 
Regulation by OFHEO.  OFHEO has broad authority to regulate our operations and management in order to ensure our financial safety and soundness. For example, in order to meet our capital plan requirements in 2005, we were required to make significant changes to our business in 2005, including reducing the size of our mortgage portfolio and reducing our quarterly common stock dividend by 50%. Pursuant to our May 2006 consent order with OFHEO, we may not increase our net mortgage portfolio assets above $727.75 billion, except in limited circumstances at OFHEO’s discretion. We expect that this reduction in the size of our mortgage portfolio beginning in 2005 will contribute to significantly reduced net interest income for the years ended December 31, 2005 and 2006, as compared to the years ended December 31, 2004 and 2003. In addition, we have incurred and expect to continue to incur significant administrative expenses in connection with complying with our remediation obligations, which will reduce our earnings for the years ended December 31, 2005 and 2006. If we fail to comply with any of our agreements with OFHEO or with any OFHEO regulation, we may incur penalties and could be subject to further restrictions on our activities and operations, or to investigation and enforcement actions by OFHEO.
 
Regulation by HUD and Charter Act Limitations.  HUD supervises our compliance with the Charter Act, which defines our permissible business activities. For example, our business is limited to the U.S. housing finance sector and we may not purchase loans in excess of our conforming loan limits, which are currently $417,000 for a one-family mortgage loan in most geographic regions and may be lower in future periods


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subsequent to 2007. As a result of these limitations on our ability to diversify our operations, our financial condition and earnings depend almost entirely on conditions in a single sector of the U.S. economy, specifically, the U.S. housing market. Our substantial reliance on conditions in the U.S. housing market may adversely affect the investment returns we are able to generate. In addition, the Secretary of HUD must approve any new Fannie Mae conventional mortgage program that is significantly different from those approved or engaged in prior to the enactment of the 1992 Act. As a result, we have only limited ability to respond quickly to changes in market conditions by offering new programs in response to these changes. These restrictions on our business operations may negatively affect our ability to compete successfully with other companies in the mortgage industry from time to time, which in turn may adversely affect our market share, our earnings and our financial condition. As described below under “To meet HUD’s new housing goals and subgoals, we enter into transactions that may reduce our profitability,” we are also subject to housing goals established by HUD, which require that a specified portion of our business relate to the purchase or securitization of mortgages for low- and moderate-income housing, underserved areas and special affordable housing. Meeting these goals may adversely affect our profitability.
 
Legislative Proposals.  Legislative proposals currently being considered by the U.S. Congress, if enacted into law, could materially restrict our operations and adversely affect our business and our earnings. During 2005, several bills were introduced in Congress that propose to change the regulatory framework under which we, Freddie Mac and the Federal Home Loan Banks operate. The Senate Committee on Banking, Housing and Urban Affairs and the U.S. House of Representatives each advanced GSE regulatory oversight legislation in 2005 during the first session of the 109th Congress. On October 26, 2005, the House of Representatives passed a bill and on July 28, 2005, the Senate Committee on Banking, Housing and Urban Affairs passed a bill, which has not yet been brought to the floor of the Senate for a vote. While the House and Senate bills differ in a number of respects, both bills would affect us and other GSEs by significantly altering the scope of:
 
  •  our authorized and permissible activities;
 
  •  the potential level of our required capital;
 
  •  the size and composition of our mortgage investment portfolio (a potential limitation in the House bill and a specific limitation in the Senate bill);
 
  •  the levels of affordable housing goals; and
 
  •  the process by which any new activities and programs would be approved and the extent of regulatory oversight.
 
In addition, the House bill would require Fannie Mae and Freddie Mac to contribute a portion of their profits to a fund to support affordable housing.
 
This legislation could materially adversely affect our business and earnings. We cannot predict the prospects for the enactment, timing or content of any legislation, the form any enacted legislation will take or its impact on our financial condition or results of operations.
 
Changes in Existing Regulations or Regulatory Practices.  Our business and earnings could also be materially affected by changes in the regulation of our business made by any one or more of our existing regulators. A regulator may change its current process for regulating our business, change its current interpretations of our regulatory requirements or exercise regulatory authority over our business beyond current practices, and any of these changes could have a material adverse effect on our business and earnings. For example, on June 13, 2006, HUD announced that it will conduct a review of specified investments and holdings to determine whether our investment activities are consistent with our charter authority. We cannot predict the outcome of this review or whether HUD will seek to restrict our current business activities as a result of this or other reviews.
 
To meet HUD’s new housing goals and subgoals, we enter into transactions that may reduce our profitability.
 
As part of our mission of increasing the availability and affordability of financing for residential mortgage loans in the United States, we must comply with the housing goals and subgoals established by HUD. HUD’s housing goals require that a specified portion of our business relate to the purchase or securitization of


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mortgage loans serving low- and moderate-income households, households in underserved areas and households qualifying under the definition of special affordable housing. HUD has increased our housing goals for 2005 through 2008, and has created new purchase money mortgage subgoals effective beginning in 2005 that also increase over the 2005 to 2008 period.
 
Meeting the increased housing goals and subgoals established by HUD for 2006 and future years may reduce our profitability and compete with our goal of maximizing total returns. In order to obtain business that contributes to our new housing goals and subgoals, we have made, and continue to make, significant adjustments to our mortgage loan sourcing and purchase strategies. These strategies include entering into some purchase and securitization transactions with lower expected economic returns than our typical transactions. We have also relaxed some of our underwriting criteria to obtain goals-qualifying mortgage loans and increased our investments in higher-risk mortgage loan products that are more likely to serve the borrowers targeted by HUD’s goals and subgoals, which could increase our credit losses.
 
The specific housing goals and subgoals levels for 2005 through 2008, as well as our performance against these goals in 2005, are described in “Item 1—Business—Our Charter and Regulation of Our Activities—Regulation and Oversight of Our Activities—HUD Regulation—Housing Goals.” We did not meet one of our 2005 subgoals, and it is possible that we may not meet one or more of our 2006 subgoals. Meeting the higher subgoals for 2006 is particularly challenging because increased home prices and higher interest rates have reduced housing affordability. Since HUD set the home purchase subgoals in 2004, the affordable housing markets have experienced a dramatic change. Newly-released Home Mortgage Disclosure Act data show that the share of the primary mortgage market serving low- and moderate-income borrowers declined in 2005, reducing our ability to purchase and securitize mortgage loans that meet the HUD subgoals. If our efforts to meet the new housing goals and subgoals in 2006 and future years prove to be insufficient, we may need to take additional steps that could increase our credit losses and reduce our profitability.
 
Our business faces significant operational risks and an operational failure could materially adversely affect our business.
 
Shortcomings or failures in our internal processes, people or systems could have a material adverse effect on our risk management, liquidity, financial condition and results of operations; disrupt our business; and result in legislative or regulatory intervention, damage to our reputation and liability to customers. For example, our business is dependent on our ability to manage and process, on a daily basis, a large number of transactions across numerous and diverse markets. These transactions are subject to various legal and regulatory standards. We rely on the ability of our employees and our internal financial, accounting, data processing and other operating systems, as well as technological systems operated by third parties, to process these transactions and to manage our business. As a result of events that are wholly or partially beyond our control, these employees or third parties could engage in improper or unauthorized actions, or these systems could fail to operate properly. In the event of a breakdown in the operation of our or a third party’s systems, or improper actions by employees or third parties, we could experience financial losses, business disruptions, legal and regulatory sanctions, and reputational damage.
 
Because we use a process of delegated underwriting for the single-family mortgage loans we purchase and securitize, we do not independently verify most borrower information that is provided to us. This exposes us to mortgage fraud risk, which is the risk that one or more parties involved in a transaction (the borrower, seller, broker, appraiser, title agent, lender or servicer) will misrepresent the facts about a mortgage loan. We may experience financial losses and reputational damage as a result of mortgage fraud.
 
In addition, our operations rely on the secure processing, storage and transmission of a large volume of private borrower information, such as names, residential addresses, social security numbers, credit rating data and other consumer financial information. Despite the protective measures we take to reduce the likelihood of information breaches, this information could be exposed in several ways, including through unauthorized access to our computer systems, computer viruses that attack our computer systems, software or networks, accidental delivery of information to an unauthorized party and loss of unencrypted media containing this information. Any of these events could result in significant financial losses, legal and regulatory sanctions, and reputational damage.


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The occurrence of a major natural or other disaster in the United States could increase our delinquency rates and credit losses or disrupt our business operations and lead to financial losses.
 
The occurrence of a major natural disaster, terrorist attack or health epidemic in the United States could increase our delinquency rates and credit losses in the affected region or regions, which could have a material adverse effect on our financial condition and results of operations. For example, we experienced an increase in our delinquency rates and credit losses as a result of Hurricanes Katrina and Rita. In addition, as of December 31, 2004, approximately 18% of the gross unpaid principal balance of the conventional single-family loans we held or securitized in Fannie Mae MBS and approximately 28% of the gross unpaid principal balance of the multifamily loans we held or securitized in Fannie Mae MBS were concentrated in California. Due to this geographic concentration in California, a major earthquake or other disaster in that state could lead to significant increases in delinquency rates and credit losses.
 
Despite the contingency plans and facilities that we have in place, our ability to conduct business also may be adversely affected by a disruption in the infrastructure that supports our business and the communities in which we are located. Potential disruptions may include those involving electrical, communications, transportation and other services we use or that are provided to us. Substantially all of our senior management and investment personnel work out of our offices in the Washington, DC metropolitan area. If a disruption occurs and our senior management or other employees are unable to occupy our offices, communicate with other personnel or travel to other locations, our ability to service and interact with each other and with our customers may suffer, and we may not be successful in implementing contingency plans that depend on communication or travel. A description of our disaster recovery plans and facilities in the event of a disruption of this type is included in “Item 7—MD&A—Risk Management—Operational Risk Management.”
 
In many cases, our accounting policies and methods, which are fundamental to how we report our financial condition and results of operations, require management to make estimates and rely on the use of models about matters that are inherently uncertain.
 
Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. Our management must exercise judgment in applying many of these accounting policies and methods so that these policies and methods comply with GAAP and reflect management’s judgment of the most appropriate manner to report our financial condition and results of operations. In some cases, management must select the appropriate accounting policy or method from two or more alternatives, any of which might be reasonable under the circumstances but might affect the amount of assets, liabilities, revenues and expenses that we report. See “Notes to Consolidated Financial Statements—Note 2, Summary of Significant Accounting Policies” for a description of our significant accounting policies.
 
We have identified the following four accounting policies as critical to the presentation of our financial condition and results of operations:
 
  •  estimating the fair value of financial instruments;
 
  •  amortizing cost basis adjustments on mortgage loans and mortgage-related securities held in our portfolio and underlying outstanding Fannie Mae MBS using the effective interest method;
 
  •  determining our allowance for loan losses and reserve for guaranty losses; and
 
  •  determining whether an entity in which we have an ownership interest is a variable interest entity and whether we are the primary beneficiary of that variable interest entity and therefore must consolidate the entity.
 
We believe these policies are critical because they require management to make particularly subjective or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. Due to the complexity of these critical accounting policies, our accounting methods relating to these policies involve substantial use of models. Models are inherently imperfect predictors of actual results because they are based on assumptions, including assumptions about future events, and actual results could differ significantly. More information about these policies is included in “Item 7—MD&A—Critical Accounting Policies and Estimates.”


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We are subject to pending civil litigation that, if decided against us, could require us to pay substantial judgments, settlements or other penalties.
 
A number of lawsuits have been filed against us and certain of our current and former officers and directors relating to our accounting restatement. These suits are currently pending in the U.S. District Court for the District of Columbia and fall within three primary categories: a consolidated shareholder class action lawsuit, a consolidated shareholder derivative lawsuit and a consolidated Employee Retirement Income Security Act of 1974 (“ERISA”)-based class action lawsuit. We may be required to pay substantial judgments, settlements or other penalties and incur significant expenses in connection with the consolidated shareholder class action and consolidated ERISA-based class action, which could have a material adverse effect on our business, results of operations and cash flows. In addition, our current and former directors, officers and employees may be entitled to reimbursement for the costs and expenses of these lawsuits pursuant to our indemnification obligations with those persons. We are also a party to several other lawsuits that, if decided against us, could require us to pay substantial judgments, settlements or other penalties. These include a proposed class action lawsuit alleging violations of federal and state antitrust laws and state consumer protection laws in connection with the setting of our guaranty fees and a proposed class action lawsuit alleging that we violated purported fiduciary duties with respect to certain escrow accounts for FHA-insured multifamily mortgage loans. We are unable at this time to estimate our potential liability in these matters. We expect all of these lawsuits to be time-consuming, and they may divert management’s attention and resources from our ordinary business operations. More information regarding these lawsuits is included in “Item 3—Legal Proceedings” and “Notes to Consolidated Financial Statements—Note 20, Commitments and Contingencies.”
 
RISKS RELATING TO OUR INDUSTRY
 
Changes in general market and economic conditions in the United States and abroad may adversely affect our financial condition and results of operations.
 
Our financial condition and results of operations may be adversely affected by changes in general market and economic conditions in the United States and abroad. These conditions include short-term and long-term interest rates, the value of the U.S. dollar as compared to foreign currencies, fluctuations in both the debt and equity capital markets, employment rates and the strength of the U.S. national economy and local economies. These conditions are beyond our control, and may change suddenly and dramatically.
 
Changes in market and economic conditions could adversely affect us in many ways, including the following:
 
  •  fluctuations in the global debt and equity capital markets, including sudden and unexpected changes in short-term or long-term interest rates, could decrease the fair value of our mortgage assets, derivatives positions and other investments, negatively affect our ability to issue debt at attractive rates, and reduce our net interest income; and
 
  •  an economic downturn or rising unemployment in the United States could decrease homeowner demand for mortgage loans and increase the number of homeowners who become delinquent or default on their mortgage loans. An increase in delinquencies or defaults would likely result in a higher level of credit losses, which would adversely affect our earnings. Also, decreased homeowner demand for mortgage loans could reduce our guaranty fee income, net interest income and the fair value of our mortgage assets. An economic downturn could also increase the risk that our counterparties will default on their obligations to us, increasing our liabilities and reducing our earnings.
 
A decline in U.S. housing prices or in activity in the U.S. housing market could negatively impact our earnings and financial condition.
 
U.S. housing prices have risen significantly in recent years. As described above, this period of extraordinary home price appreciation appears to be ending. The rate of home price appreciation has slowed and we believe there is a possibility of a modest decline in national home prices in 2007. Declines in housing prices could result in increased delinquencies or defaults on the mortgage loans we own or that back our guaranteed Fannie Mae MBS. An increase in delinquencies or defaults would likely result in a higher level of credit losses, which would adversely affect our earnings. In addition, housing price declines would reduce the fair value of our mortgage assets.


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Growth in the amount of U.S. residential mortgage debt outstanding has also been significant in recent years. Our business volume is affected by the rate of growth in total U.S. residential mortgage debt outstanding and the size of the U.S. residential mortgage market. If the rate of growth in total U.S. residential mortgage debt outstanding were to decline, the growth rate of mortgage loans available for us to purchase or securitize likely would slow, which could lead to a reduction in our net interest income and guaranty fee income.
 
Item 1B.   Unresolved Staff Comments
 
None.
 
Item 2.   Properties
 
We own our principal office, which is located at 3900 Wisconsin Avenue, NW, Washington, DC, as well as additional Washington, DC facilities at 3939 Wisconsin Avenue, NW and 4250 Connecticut Avenue, NW. We also own two office facilities in Herndon, Virginia, as well as two additional facilities located in Reston, Virginia, and Urbana, Maryland. These owned facilities contain a total of approximately 1,460,000 square feet of space. We lease the land underlying the 4250 Connecticut Avenue building pursuant to a lease that automatically renews on July 1, 2029 for an additional 49 years unless we elect to terminate the lease by providing notice to the landlord of our decision to terminate at least one year prior to the automatic renewal date. In addition, we lease approximately 375,000 square feet of office space at 4000 Wisconsin Avenue, NW, which is adjacent to our principal office. The present lease for 4000 Wisconsin Avenue expires in 2008, and we have the option to extend the lease for up to 10 additional years, in 5-year increments. We also lease an additional approximately 417,000 square feet of office space at five locations in Washington, DC, suburban Virginia and Maryland. We maintain approximately 426,000 square feet of office space in leased premises in Pasadena, California; Atlanta, Georgia; Chicago, Illinois; Philadelphia, Pennsylvania; and Dallas, Texas. In addition, we have 55 Fannie Mae Community Business Centers around the United States, which work with cities, rural areas and underserved communities.
 
Item 3.   Legal Proceedings
 
This item describes the material legal proceedings, examinations and other matters that: (1) were pending as of December 31, 2004; (2) were terminated during the period from the beginning of the third quarter of 2004 through the filing of this report; or (3) are pending as of the filing of this report. Thus, the description of a matter may include developments that occurred since December 31, 2004, as well as those that occurred during 2004. The matters include legal proceedings relating to the restatement of our consolidated financial statements, such as class action and individual securities lawsuits, shareholder derivative actions and governmental proceedings, and class action lawsuits alleging antitrust violations and abuse of escrow accounts.
 
As described below, a number of lawsuits have been filed against us and certain of our current and former officers and directors relating to the accounting matters discussed in our SEC filings and OFHEO’s interim and final reports, and in the report issued by the law firm of Paul Weiss on the results of its independent investigation. These lawsuits currently are pending in the U.S. District Court for the District of Columbia and fall within three primary categories: (1) a consolidated shareholder class action, (2) a consolidated shareholder derivative lawsuit, and (3) a consolidated ERISA-based class action lawsuit. In addition, the Department of Labor is conducting a review of our Employee Stock Ownership Plan (“ESOP”).
 
In 2003, OFHEO commenced its special examination of us. The SEC and the U.S. Attorney’s Office for the District of Columbia also commenced investigations against us relating to matters discussed in the OFHEO reports. On May 23, 2006, we reached a settlement with OFHEO and the SEC. In August 2006, we were advised by the U.S. Attorney’s Office for the District of Columbia that it was discontinuing its investigation of us and does not plan to file charges against us.
 
Presently, we are also a defendant in a proposed class action lawsuit alleging violations of federal and state antitrust laws and state consumer protection laws in connection with the setting of our guaranty fees. In addition, we are a defendant in a proposed class action lawsuit alleging that we violated purported fiduciary duties with respect to certain escrow accounts for FHA-insured multifamily mortgage loans.


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We are involved in a number of legal and regulatory proceedings that arise in the ordinary course of business. For example, we are involved in legal proceedings that arise in connection with properties acquired either through foreclosure on properties securing delinquent mortgage loans we own or through our receipt of deeds to those properties in lieu of foreclosure. Claims related to possible tort liability occur from time to time, primarily in the case of single-family real estate owned (“REO”) property.
 
From time to time, we are also a party to legal proceedings arising from our relationships with our sellers and servicers. Litigation can result from disputes with lenders concerning their loan origination or servicing obligations to us, or can result from disputes concerning termination by us (for a variety of reasons) of a lender’s authority to do business with us as a seller and/or servicer. In addition, loan servicing and financing issues sometimes result in claims, including potential class actions, brought against us by borrowers.
 
We also are a party to legal proceedings arising from time to time from the conduct of our business and administrative functions, including contractual disputes and employment-related claims.
 
Litigation claims and proceedings of all types are subject to many factors that generally cannot be predicted accurately. For additional information on these proceedings, see “Notes to Consolidated Financial Statements—Note 20, Commitments and Contingencies.”
 
RESTATEMENT-RELATED MATTERS
 
Securities Class Action Lawsuits
 
In Re Fannie Mae Securities Litigation
 
Beginning on September 23, 2004, 13 separate complaints were filed by holders of our securities against us, as well as certain of our former officers, in the U.S. District Court for the District of Columbia, the U.S. District Court for the Southern District of New York and other courts. The complaints in these lawsuits purport to have been made on behalf of a class of plaintiffs consisting of purchasers of Fannie Mae securities between April 17, 2001 and September 21, 2004. The complaints alleged that we and certain of our officers, including Franklin D. Raines, J. Timothy Howard and Leanne Spencer, made material misrepresentations and/or omissions of material facts in violation of the federal securities laws. Plaintiffs’ claims were based on findings contained in OFHEO’s September 2004 interim report regarding its findings to that date in its special examination of our accounting policies, practices and controls.
 
All of the cases were consolidated and/or transferred to the U.S. District Court for the District of Columbia. A consolidated complaint was filed on March 4, 2005 against us and former officers Franklin D. Raines, J. Timothy Howard and Leanne Spencer. The court entered an order naming the Ohio Public Employees Retirement System and State Teachers Retirement System of Ohio as lead plaintiffs. The consolidated complaint generally made the same allegations as the individually-filed complaints, which is that we and certain of our former officers made false and misleading statements in violation of the federal securities laws in connection with certain accounting policies and practices. More specifically, the consolidated complaint alleged that the defendants made materially false and misleading statements in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and SEC Rule 10b-5 promulgated thereunder, largely with respect to accounting statements that were inconsistent with the GAAP requirements relating to hedge accounting and the amortization of premiums and discounts. Plaintiffs contend that the alleged fraud resulted in artificially inflated prices for our common stock. Plaintiffs seek compensatory damages, attorneys’ fees, and other fees and costs. Discovery commenced in this action following the denial of the defendants’ motions to dismiss on February 10, 2006.
 
On April 17, 2006, the plaintiffs in the consolidated class action filed an amended consolidated complaint against us and former officers Franklin D. Raines, J. Timothy Howard and Leanne Spencer, that added purchasers of publicly traded call options and sellers of publicly traded put options to the putative class and sought to extend the end of the putative class period from September 21, 2004 to September 27, 2005. We and the individual defendants filed motions to dismiss addressing the extended class period and the deficiency of the additional accounting allegations. On August 14, 2006, while those motions were still pending, the plaintiffs filed a second amended complaint adding KPMG LLP and Goldman, Sachs & Co., Inc. as additional


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defendants and adding allegations based on the May 2006 report issued by OFHEO and the February 2006 report issued by Paul Weiss. Our answer to the second amended complaint is due to be filed on January 8, 2007. Plaintiffs filed a motion for class certification on May 17, 2006 that is still pending.
 
In addition, two individual securities cases have been filed by institutional investor shareholders in the U.S. District Court for the District of Columbia. The first case was filed on January 17, 2006 by Evergreen Equity Trust, Evergreen Select Equity Trust, Evergreen Variable Annuity Trust and Evergreen International Trust against us and the following current and former officers and directors: Franklin D. Raines, J. Timothy Howard, Leanne Spencer, Thomas P. Gerrity, Anne M. Mulcahy, Frederick V. Malek, Taylor Segue, III, William Harvey, Joe K. Pickett, Victor Ashe, Stephen B. Ashley, Molly Bordonaro, Kenneth M. Duberstein, Jamie Gorelick, Manuel Justiz, Ann McLaughlin Korologos, Donald B. Marron, Daniel H. Mudd, H. Patrick Swygert and Leslie Rahl.
 
The second individual securities case was filed on January 25, 2006 by 25 affiliates of Franklin Templeton Investments against us, KPMG LLP, and all of the following current and former officers and directors: Franklin D. Raines, J. Timothy Howard, Leanne Spencer, Thomas P. Gerrity, Anne M. Mulcahy, Frederick V. Malek, Taylor Segue, III, William Harvey, Joe K. Pickett, Victor Ashe, Stephen B. Ashley, Molly Bordonaro, Kenneth M. Duberstein, Jamie Gorelick, Manuel Justiz, Ann McLaughlin Korologos, Donald B. Marron, Daniel H. Mudd, H. Patrick Swygert and Leslie Rahl.
 
The two related individual securities actions assert various federal and state securities law and common law claims against us and certain of our current and former officers and directors based upon essentially the same alleged conduct as that at issue in the consolidated shareholder class action, and also assert insider trading claims against certain former officers. Both cases seek compensatory and punitive damages, attorneys’ fees, and other fees and costs. In addition, the Evergreen plaintiffs seek an award of treble damages under state law.
 
On June 29, 2006 and then again on August 14 and 15, 2006, the individual securities plaintiffs filed first amended complaints and then second amended complaints seeking to address certain of the arguments made by the defendants in their original motions to dismiss and adding additional allegations regarding improper accounting practices. On August 17, 2006, we filed motions to dismiss certain claims and allegations of the individual securities plaintiffs’ second amended complaints. The individual plaintiffs seek to proceed independently of the potential class of shareholders in the consolidated shareholder class action, but the court has consolidated these cases as part of the consolidated shareholder class action for pretrial purposes and possibly through final judgment.
 
We believe we have defenses to the claims in these lawsuits and intend to defend these lawsuits vigorously.
 
Shareholder Derivative Lawsuits
 
In Re Fannie Mae Shareholder Derivative Litigation
 
Beginning on September 28, 2004, ten plaintiffs filed twelve shareholder derivative actions (i.e., lawsuits filed by shareholder plaintiffs on our behalf) in three different federal district courts and the Superior Court of the District of Columbia on behalf of the company against certain of our current and former officers and directors and against us as a nominal defendant. Plaintiffs contend that the defendants purposefully misapplied GAAP, maintained poor internal controls, issued a false and misleading proxy statement, and falsified documents to cause our financial performance to appear smooth and stable, and that Fannie Mae was harmed as a result. The claims are for breaches of the duty of care, breach of fiduciary duty, waste, insider trading, fraud, gross mismanagement, violations of the Sarbanes-Oxley Act of 2002 and unjust enrichment. Plaintiffs seek compensatory damages, punitive damages, attorneys’ fees, and other fees and costs, as well as injunctive relief related to the adoption by us of certain proposed corporate governance policies and internal controls.
 
All of these individual actions have been consolidated into the U.S. District Court for the District of Columbia and the court entered an order naming Pirelli Armstrong Tire Corporation and Wayne County Employees’ Retirement System as co-lead plaintiffs. A consolidated complaint was filed on September 26, 2005. The consolidated complaint named the following current and former officers and directors as defendants: Franklin D. Raines, J. Timothy Howard, Thomas P. Gerrity, Frederick V. Malek, Joe K. Pickett, Anne M. Mulcahy,


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Daniel H. Mudd, Kenneth M. Duberstein, Stephen B. Ashley, Ann McLaughlin Korologos, Donald B. Marron, Leslie Rahl, H. Patrick Swygert and John K. Wulff.
 
When document production commenced in In re Fannie Mae Securities Litigation, we agreed to simultaneously provide our document production from that action to the plaintiffs in the shareholder derivative action.
 
All of the defendants filed motions to dismiss the action on December 14, 2005. These motions were fully briefed but not ruled upon. In the interim, the plaintiffs filed an amended complaint on September 1, 2006, thus mooting the previously filed motions to dismiss. Among other things, the amended complaint adds Goldman Sachs Group Inc., Goldman, Sachs & Co., Inc., Lehman Brothers Inc. and Radian Insurance Inc. as defendants, adds allegations concerning the nature of certain transactions between these entities and Fannie Mae, adds additional allegations from OFHEO’s May 2006 report on its special examination, the Paul Weiss report and other additional details. We filed motions to dismiss the first amended complaint on October 20, 2006.
 
ERISA Action
 
In re Fannie Mae ERISA Litigation (formerly David Gwyer v. Fannie Mae)
 
Three ERISA-based cases have been filed against us, our Board of Directors’ Compensation Committee, and against the following former and current officers and directors: Franklin D. Raines, J. Timothy Howard, Daniel H. Mudd, Vincent A. Mai, Stephen Friedman, Anne M. Mulcahy, Ann McLaughlin Korologos, Joe K. Pickett, Donald B. Marron, Kathy Gallo and Leanne Spencer.
 
On October 15, 2004, David Gwyer filed a class action complaint in the U.S. District Court for the District of Columbia. Two additional class action complaints were filed by other plaintiffs on May 6, 2005 and May 10, 2005. All of these cases were consolidated on May 24, 2005 in the U.S. District Court for the District of Columbia. A consolidated complaint was filed on June 15, 2005. The plaintiffs in the consolidated ERISA-based lawsuit purport to represent a class of participants in our ESOP between January 1, 2001 and the present. Their claims are based on alleged breaches of fiduciary duty relating to accounting matters discussed in our SEC filings and in OFHEO’s interim report. Plaintiffs seek unspecified damages, attorneys’ fees, and other fees and costs, and other injunctive and equitable relief. We filed a motion to dismiss the consolidated complaint on June 29, 2005. Our motion and all of the other defendants’ motions to dismiss were fully briefed and argued on January 13, 2006. As of the date of this filing, these motions are still pending.
 
We believe we have defenses to the claims in these lawsuits and intend to defend these lawsuits vigorously.
 
Department of Labor ESOP Investigation
 
In November 2003, the Department of Labor commenced a review of our ESOP and Retirement Savings Plan. The Department of Labor has concluded its investigation of our Retirement Savings Plan, but continues to review the ESOP. We continue to cooperate fully in this investigation.
 
RESTATEMENT-RELATED INVESTIGATIONS BY U.S. ATTORNEY’S OFFICE, OFHEO AND THE SEC
 
U.S. Attorney’s Office Investigation
 
In October 2004, we were told by the U.S. Attorney’s Office for the District of Columbia that it was conducting an investigation of our accounting policies and practices. In August 2006, we were advised by the U.S. Attorney’s Office for the District of Columbia that it was discontinuing its investigation of us and does not plan to file charges against us.
 
OFHEO and SEC Settlements
 
On May 23, 2006, we entered into comprehensive settlements with OFHEO and the SEC that resolved open matters related to their recent investigations of us.


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OFHEO Special Examination and Settlement
 
In July 2003, OFHEO notified us that it intended to conduct a special examination of our accounting policies and internal controls, as well as other areas of inquiry. OFHEO began its special examination in November 2003 and delivered an interim report of its findings in September 2004. On May 23, 2006, OFHEO released its final report on its special examination. OFHEO’s final report concluded that, during the period covered by the report (1998 to mid-2004), a large number of our accounting policies and practices did not comply with GAAP and we had serious problems in our internal controls, financial reporting and corporate governance. The final OFHEO report is available on our Web site (www.fanniemae.com) and on OFHEO’s Web site (www.ofheo.gov).
 
Concurrently with OFHEO’s release of its final report, we entered into comprehensive settlements that resolved open matters with OFHEO, as well as with the SEC (described below). As part of the OFHEO settlement, we agreed to OFHEO’s issuance of a consent order. In entering into this settlement, we neither admitted nor denied any wrongdoing or any asserted or implied finding or other basis for the consent order. Under this consent order, in addition to the civil penalty described below, we agreed to undertake specified remedial actions to address the recommendations contained in OFHEO’s final report, including actions relating to our corporate governance, Board of Directors, capital plans, internal controls, accounting practices, public disclosures, regulatory reporting, personnel and compensation practices. We also agreed not to increase our net mortgage assets above the amount shown in our minimum capital report to OFHEO for December 31, 2005 ($727.75 billion), except in limited circumstances at OFHEO’s discretion. The consent order superseded and terminated both our September 27, 2004 agreement with OFHEO and the March 7, 2005 supplement to that agreement, and resolved all matters addressed by OFHEO’s interim and final reports of its special examination. As part of the OFHEO settlement, we also agreed to pay a $400 million civil penalty, with $50 million payable to the U.S. Treasury and $350 million payable to the SEC for distribution to stockholders pursuant to the Fair Funds for Investors provision of the Sarbanes-Oxley Act of 2002. We have paid this civil penalty in full. This $400 million civil penalty, which has been recorded as an expense in our 2004 consolidated financial statements, is not deductible for tax purposes.
 
SEC Investigation and Settlement
 
Following the issuance of the September 2004 interim OFHEO report, the SEC informed us that it was investigating our accounting practices.
 
Concurrently, at our request, the SEC reviewed our accounting practices with respect to hedge accounting and the amortization of premiums and discounts, which OFHEO’s interim report had concluded did not comply with GAAP. On December 15, 2004, the SEC’s Office of the Chief Accountant announced that it had advised us to (1) restate our financial statements filed with the SEC to eliminate the use of hedge accounting, and (2) evaluate our accounting for the amortization of premiums and discounts, and restate our financial statements filed with the SEC if the amounts required for correction were material. The SEC’s Office of the Chief Accountant also advised us to reevaluate the GAAP and non-GAAP information that we previously provided to investors.
 
On May 23, 2006, without admitting or denying the SEC’s allegations, we consented to the entry of a final judgment requiring us to pay the civil penalty described above and permanently restraining and enjoining us from future violations of the anti-fraud, books and records, internal controls and reporting provisions of the federal securities laws. The settlement, which included the $400 million civil penalty described above, resolved all claims asserted against us in the SEC’s civil proceeding. Our consent to the final judgment was filed as an exhibit to the Form 8-K that we filed with the SEC on May 30, 2006. The final judgment was entered by the U.S. District Court of the District of Columbia on August 9, 2006.
 
OTHER LEGAL PROCEEDINGS
 
Former CEO Arbitration
 
On September 19, 2005, Franklin D. Raines, our former Chairman and Chief Executive Officer, initiated arbitration proceedings against Fannie Mae before the American Arbitration Association. On April 10, 2006,


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the parties convened an evidentiary hearing before the arbitrator. The principal issue before the arbitrator was whether we were permitted to waive a requirement contained in Mr. Raines’ employment agreement that he provide six months notice prior to retiring. On April 24, 2006, the arbitrator issued a decision finding that we could not unilaterally waive the notice period, and that the effective date of Mr. Raines’ retirement was June 22, 2005, rather than December 21, 2004 (his final day of active employment). Under the arbitrator’s decision, Mr. Raines’ election to receive an accelerated, lump-sum payment of a portion of his deferred compensation must now be honored. Moreover, we must pay Mr. Raines any salary and other compensation to which he would have been entitled had he remained employed through June 22, 2005, less any pension benefits that Mr. Raines received during that period. On November 7, 2006, the parties entered into a consent award, which partially resolved the issue of amounts due Mr. Raines. In accordance with the consent award, we paid Mr. Raines $2.6 million on November 17, 2006. By agreement, final resolution of the unresolved issues was deferred until after our accounting restatement results are announced. Each party has the right, within sixty days of the announcement of our accounting restatement results, to notify the arbitrator whether it believes that further proceedings are necessary.
 
Antitrust Lawsuits
 
In Re G-Fees Antitrust Litigation
 
Since January 18, 2005, we have been served with 11 proposed class action complaints filed by single-family borrowers that allege that we and Freddie Mac violated the Clayton and Sherman Acts and state antitrust and consumer protection statutes by agreeing to artificially fix, raise, maintain or stabilize the price of our and Freddie Mac’s guaranty fees. Two of these cases were filed in state courts. The remaining cases were filed in federal court. The two state court actions were voluntarily dismissed. The federal court actions were consolidated in the U.S. District Court for the District of Columbia. Plaintiffs filed a consolidated amended complaint on August 5, 2005. Plaintiffs in the consolidated action seek to represent a class of consumers whose loans allegedly “contain a guarantee fee set by” us or Freddie Mac between January 1, 2001 and the present. The consolidated amended complaint alleges violations of federal and state antitrust laws and state consumer protection and other laws. Plaintiffs seek unspecified damages, treble damages, punitive damages, and declaratory and injunctive relief, as well as attorneys’ fees and costs.
 
We and Freddie Mac filed a motion to dismiss on October 11, 2005. The motion to dismiss has been fully briefed and remains pending.
 
We believe we have defenses to the claims in these lawsuits and intend to defend these lawsuits vigorously.
 
Escrow Litigation
 
Casa Orlando Apartments, Ltd., et al. v. Federal National Mortgage Association (formerly known as Medlock Southwest Management Corp., et al. v. Federal National Mortgage Association)
 
We are the subject of a lawsuit in which plaintiffs purport to represent a class of multifamily borrowers whose mortgages are insured under Sections 221(d)(3), 236 and other sections of the National Housing Act and are held or serviced by us. The complaint identified as a class low- and moderate-income apartment building developers who maintained uninvested escrow accounts with us or our servicer. Plaintiffs Casa Orlando Apartments, Ltd., Jasper Housing Development Company and the Porkolab Family Trust No. 1 allege that we violated fiduciary obligations that they contend we owe to borrowers with respect to certain escrow accounts and that we were unjustly enriched. In particular, plaintiffs contend that, starting in 1969, we misused these escrow funds and are therefore liable for any economic benefit we received from the use of these funds. Plaintiffs seek a return of any profits, with accrued interest, earned by us related to the escrow accounts at issue, as well as attorneys’ fees and costs.
 
The complaint was filed in the U.S. District Court for the Eastern District of Texas (Texarkana Division) on June 2, 2004 and served on us on June 16, 2004. Our motion to dismiss and motion for summary judgment were denied on March 10, 2005. We filed a partial motion for reconsideration of our motion for summary judgment, which was denied on February 24, 2006.


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Plaintiffs have filed an amended complaint and a motion for class certification. A hearing on plaintiffs’ motion for class certification was held on July 19, 2006, and the motion remains pending.
 
We believe we have defenses to the claims in this lawsuit and intend to defend this lawsuit vigorously.
 
Item 4.   Submission of Matters to a Vote of Security Holders
 
None.


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PART II
 
Item 5.   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
Our common stock is publicly traded on the New York, Pacific and Chicago stock exchanges and is identified by the ticker symbol “FNM.” The transfer agent and registrar for our common stock is Computershare, P.O. Box 43081, Providence, Rhode Island 02940.
 
Quarterly Common Stock Data
 
The following table shows, for the periods indicated, the high and low sales prices per share of our common stock in the consolidated transaction reporting system as reported in the Bloomberg Financial Markets service, as well as the dividends per share paid in each period.
 
Quarterly Common Stock Data
 
                         
Quarter
  High     Low     Dividend  
 
2003
                       
First Quarter
  $ 70.40     $ 58.40     $ 0.39  
Second Quarter
    75.84       65.30       0.39  
Third Quarter
    72.07       60.11       0.45  
Fourth Quarter
    75.95       68.47       0.45  
2004
                       
First Quarter
  $ 80.82     $ 70.75     $ 0.52  
Second Quarter
    75.47       65.89       0.52  
Third Quarter
    77.80       63.05       0.52  
Fourth Quarter
    73.81       62.95       0.52  
2005
                       
First Quarter
  $ 71.70     $ 53.72     $ 0.26  
Second Quarter
    61.66       49.75       0.26  
Third Quarter
    60.21       41.34       0.26  
Fourth Quarter
    50.80       41.41       0.26  
2006
                       
First Quarter
  $ 58.60     $ 48.41     $ 0.26  
Second Quarter
    54.53       46.17       0.26  
Third Quarter
    56.31       46.30       0.26  
 
Holders
 
As of October 31, 2006, we had approximately 20,000 registered holders of record of our common stock.
 
Dividends
 
The table set forth under “Quarterly Common Stock Data” above sets forth the quarterly dividends we have paid on our common stock from the first quarter of 2003 through and including the third quarter of 2006.
 
In January 2005, our Board of Directors reduced our quarterly common stock dividend rate by 50%, from $0.52 per share to $0.26 per share. We reduced our common stock dividend rate in order to increase our capital surplus, which was a component of our capital restoration plan. See “Item 7—MD&A—Liquidity and Capital Management—Capital Management—Capital Adequacy Requirements—Capital Restoration Plan and OFHEO-Directed Minimum Capital Requirement” for a description of our capital restoration plan. On December 6, 2006, the Board of Directors increased the quarterly common stock dividend to $0.40 per share. The Board determined that the increased dividend would be effective beginning in the fourth quarter of 2006, and therefore declared a special common stock dividend of $0.14 per share, payable on December 29, 2006, to stockholders of record on December 15, 2006. This special dividend of $0.14, combined with our previously declared dividend of $0.26 paid on November 27, 2006, will result in a total common stock


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dividend of $0.40 per share for the fourth quarter of 2006. Our Board of Directors will continue to assess dividend payments for each quarter based upon the facts and conditions existing at the time.
 
Our payment of dividends is subject to certain restrictions, including the submission of prior notification to OFHEO detailing the rationale and process for the proposed dividend and prior approval by the Director of OFHEO of any dividend payment that would cause our capital to fall below specified capital levels. See “Item 7—MD&A— Liquidity and Capital Management—Capital Management—Capital Activity—OFHEO Oversight of Our Capital Activity” for a description of these restrictions. Payment of dividends on our common stock is also subject to the prior payment of dividends on our 13 series of preferred stock, representing an aggregate of 132,175,000 shares outstanding. Quarterly dividends on the shares of our preferred stock outstanding totaled $130.7 million for the quarter ended September 30, 2006. See “Notes to Consolidated Financial Statements—Note 17, Preferred Stock” for detailed information on our preferred stock dividends.
 
Securities Authorized for Issuance under Equity Compensation Plans
 
The information required by Item 201(d) of Regulation S-K is provided under “Item 12—Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters,” which is incorporated herein by reference.
 
Recent Sales of Unregistered Securities
 
Under the Stock Compensation Plan of 1993 and the Stock Compensation Plan of 2003 (the “Plans”), we regularly provide stock compensation to our employees and members of our Board of Directors to attract, motivate and retain these individuals and promote an identity of interests with our stockholders. During the year ended December 31, 2004, we issued 3,262,894 shares of common stock upon the exercise of stock options for an aggregate exercise price of approximately $129 million, almost all of which was paid in cash and the remainder of which was paid by the delivery of 8,936 shares of common stock. Additionally, in consideration of services rendered or to be rendered, we issued 2,594,769 options to purchase common stock at a weighted average exercise price of $78.04 per share, 998,425 shares of restricted stock and 38,134 restricted stock units. Options granted under the Plans typically vest 25% per year beginning on the first anniversary of the date of grant and expire ten years after the grant. Shares of restricted stock and restricted stock units granted under the Plans typically vest in equal annual installments over three or four years beginning on the first anniversary of the date of grant. Each restricted stock unit represents the right to receive a share of common stock at the time of vesting. As a result, the economic consequences of restricted stock units are generally similar to restricted stock, except that restricted stock units do not confer voting rights on their holders.
 
All options and shares of restricted stock and restricted stock units were granted to persons who were employees or members of the Board of Directors. During the year ended December 31, 2004, 236,521 restricted stock awards vested, as a result of which 155,679 shares of common stock were issued and 80,842 shares of common stock that otherwise would have been issued were withheld in lieu of requiring the recipients to pay the withholding taxes due upon vesting to us. Additionally, during the year ended December 31, 2004, 8,014 restricted stock units vested, as a result of which 5,252 shares of common stock were issued and 2,762 shares of common stock that otherwise would have been issued were withheld in lieu of requiring the recipients to pay the withholding taxes due upon vesting to us.
 
In January 2004, we contributed an aggregate of 104,886 shares to the Employee Stock Ownership Plan (“ESOP”). Benefits for employees vest under the ESOP based on age or years of service. Eligible employees become 100% vested in their ESOP accounts upon the earlier of age 65 or completion of five years of service.
 
During the year ended December 31, 2004, we also issued 2,568 shares under our Employee Stock Purchase Plan for an aggregate exercise price of approximately $190,000 to former employees or the estates of former employees.
 
We have a Performance Share Program that compensates senior management for meeting financial and non-financial objectives over a three-year period. Objectives are set at the beginning of the three-year period and


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the Compensation Committee of the Board of Directors determines achievement against the goals at the end of such period, setting the amount of the award at that time. The performance shares are generally paid out over a two- or three-year period. In January 2004, we paid out 87,329 and 224,926 shares of common stock to senior management under our Performance Share Program for the three-year performance share cycles that ended in 2001 and 2002, respectively. Additionally, we determined that senior management was entitled to receive 662,780 shares of common stock under our Performance Share Program for the three-year performance share cycle that ended in 2003, of which 366,428 shares were paid out in 2004, and the balance of which was scheduled to be paid out in January 2005. Of the 678,683 aggregate shares of common stock that were paid out in 2004 under our Performance Share Program, 444,281 shares of common stock were issued and 234,402 shares of common stock that otherwise would have been issued were withheld in lieu of requiring the recipients to pay the withholding taxes due to us at the time of issuance. As previously announced, and in connection with the restatement of our consolidated financial statements, because we did not have reliable financial data for years within the award cycles, the Compensation Committee and the Board decided to postpone the determination of the amount of the awards under the Performance Share Program for the three-year performance share cycles that ended in 2004 and 2005, and to postpone payment of the second installment of shares for the three-year performance share cycle that ended in 2003 (the first installment of which was paid in January 2004). In the future, the Compensation Committee and the Board will review the Performance Share Program and determine the appropriate approach for settling its obligations with respect to the existing unpaid performance share cycles.
 
The securities we issue are “exempted securities” under the Securities Act and the Exchange Act to the same extent as obligations of, or guaranteed as to principal and interest by, the United States. As a result, we do not file registration statements with the SEC with respect to offerings of our securities.


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Purchases of Equity Securities by the Issuer
 
The following table shows shares of our common stock we repurchased during 2004, 2005 and the first three quarters of 2006.
 
                                 
                      Maximum Number
 
                Total Number of
    of Shares that
 
    Total Number
    Average
    Shares Purchased
    May Yet be
 
    of Shares
    Price Paid
    as Part of Publicly
    Purchased Under
 
    Purchased(1)     per Share     Announced Program(2)     the Program(3)  
    (Shares in thousands)  
 
2004
                               
January
    51     $ 74.49             70,433  
February
    843       77.56       840       69,798  
March
    3,273       75.52       3,270       67,246  
April
    1,486       72.78       1,485       67,072  
May
    976       68.48       970       66,969  
June
    353       67.43       350       66,725  
July
    185       70.33       185       66,572  
August
    1       71.49             66,390  
September
    1       75.33             65,540  
October
    0       68.74             65,025  
November
    35       69.62             64,890  
December
    1       70.48             64,434  
                                 
Total
    7,205     $ 73.67       7,100       64,434  
                                 
2005
                               
January
    107     $ 65.60             63,503  
February
    21       57.86             63,234  
March
    3       57.17             63,957  
April
    3       55.02             63,723  
May
    11       57.24             63,510  
June
    9       58.79             63,359  
July
    5       58.86             63,070  
August
    4       52.44             62,951  
September
    15       46.70             62,755  
October
    37       45.42             62,525  
November
    259       47.35             62,123  
December
    18       47.67             61,364  
                                 
Total
    492     $ 52.29             61,364  
                                 
2006
                               
January
    196     $ 53.23             60,596  
February
    58       58.10             60,112  
March
    61       54.04             60,269  
April
    10       52.60             61,267  
May
    13       50.38       4       61,160  
June
    13       48.11       4       61,046  
July
    11       48.55             60,983  
August
    52       49.29       23       60,900  
September
    19       53.91       7       60,669  
                                 
Total
    433     $ 53.20       38       60,669  
                                 


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(1) In addition to shares repurchased as part of the publicly announced programs described in footnote 2 below, these shares consist of: (a) 563,229 shares of common stock reacquired from employees to pay an aggregate of approximately $33.1 million in withholding taxes due upon the vesting of restricted stock; (b) 92,590 shares of common stock reacquired from employees to pay an aggregate of approximately $4.8 million in withholding taxes due upon the exercise of stock options; (c) 321,405 shares of common stock repurchased from employees and members of our Board of Directors to pay an aggregate exercise price of approximately $15.8 million for stock options; and (d) 14,430 shares of common stock repurchased from employees in a limited number of instances relating to employees’ financial hardship.
 
(2) Consists of (a) 7,100,200 shares of common stock purchased pursuant to our publicly announced share repurchase program in open market transactions effected in compliance with SEC Rule 10b-18, and (b) 38,217 shares of common stock repurchased from employees pursuant to our publicly announced employee stock repurchase program. On January 21, 2003, we publicly announced that the Board of Directors had approved a share repurchase program (the “General Repurchase Authority”) under which we could purchase in open market transactions the sum of (a) up to 5% of the shares of common stock outstanding as of December 31, 2002 (49.4 million shares) and (b) additional shares to offset stock issued or expected to be issued under our employee benefit plans. On May 9, 2006, we announced that the Board of Directors had authorized a stock repurchase program (the “Employee Stock Repurchase Program”) under which we may repurchase up to $100 million of Fannie Mae shares from non-officer employees. Neither the General Repurchase Authority nor the Employee Stock Repurchase Program has a specified expiration date.
 
(3) Consists of the total number of shares that may yet be purchased under the General Repurchase Authority as of the end of the month, including the number of shares that may be repurchased to offset stock that may be issued pursuant to the Stock Compensation Plan of 1993 and the Stock Compensation Plan of 2003. Repurchased shares are first offset against any issuances of stock under our employee benefit plans. To the extent that we repurchase more shares than have been issued under our plans in a given month, the excess number of shares is deducted from the 49.4 million shares approved for repurchase under the General Repurchase Authority. Because of new stock issuances and expected issuances pursuant to new grants under our employee benefit plans, the number of shares that may be purchased under the General Repurchase Authority fluctuates from month to month. No shares were repurchased from August 2004 through September 30, 2006 in the open market pursuant to the General Repurchase Authority. See “Notes to Consolidated Financial Statements—Note 13, Stock-Based Compensation Plans,” for information about shares issued, shares expected to be issued, and shares remaining available for grant under our employee benefit plans. Excludes the remaining number of shares authorized to be repurchased under the Employee Stock Repurchase Program. Assuming a price per share of $55.93, the average of the high and low stock prices of Fannie Mae common stock on September 30, 2006, approximately 1.8 million shares may yet be purchased under the Employee Stock Repurchase Program.


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Item 6.   Selected Financial Data
 
The selected consolidated financial data presented below is summarized from our results of operations for the three-year period ended December 31, 2004 (restated for 2003 and 2002), as well as selected consolidated balance sheet data as of December 31, 2004, 2003, 2002 and 2001. All restatement adjustments relating to periods prior to January 1, 2002 have been presented as adjustments to retained earnings as of December 31, 2001. In light of the substantial time, effort and expense incurred since December 2004 to complete the restatement of our consolidated financial statements for 2003 and 2002, we have determined that extensive additional efforts would be required to restate all 2001 and 2000 financial data. In particular, significant complexities of accounting standards, turnover of relevant personnel, and limitations of systems and data all limit our ability to reconstruct additional financial information for 2001 and 2000. Previously published information for 2001 and 2000 should not be relied upon.
 
                         
    For the Year Ended December 31,  
    2004     2003     2002  
          (Restated)     (Restated)  
    (Dollars in millions, except
 
    per share amounts)  
 
Income Statement Data:
                       
Net interest income
  $ 18,081     $ 19,477     $ 18,426  
Guaranty fee income
    3,604       3,281       2,516  
Derivative fair value losses, net
    (12,256 )     (6,289 )     (12,919 )
Other income (loss)(1)
    (812 )     (4,220 )     (1,735 )
                         
Income before extraordinary gains (losses) and cumulative effect of change in accounting principle
    4,975       7,852       3,914  
Extraordinary gains (losses), net of tax effect
    (8 )     195        
Cumulative effect of change in accounting principle, net of tax effect
          34        
                         
Net income
    4,967       8,081       3,914  
Preferred stock dividends and issuance costs at redemption
    (165 )     (150 )     (111 )
                         
Net income available to common stockholders
  $ 4,802     $ 7,931     $ 3,803  
                         
Per Common Share Data:
                       
Earnings per share before extraordinary gains (losses) and cumulative effect of change in accounting principle
                       
Basic
  $ 4.96     $ 7.88     $ 3.83  
Diluted
    4.94       7.85       3.81  
Earnings per share after extraordinary gains (losses) and cumulative effect of change in accounting principle
                       
Basic
  $ 4.95     $ 8.12     $ 3.83  
Diluted
    4.94       8.08       3.81  
Weighted-average common shares outstanding:
                       
Basic
    970       977       992  
Diluted
    973       981       998  
Cash dividends declared per share
  $ 2.08     $ 1.68     $ 1.32  
             
Business Activity Data:
                       
Fannie Mae MBS issues(2)
  $ 552,482     $ 1,220,066     $ 743,630  
Mortgage portfolio purchases(3)
    258,478       525,759       353,193  
                         
Business volume
  $ 810,960     $ 1,745,825     $ 1,096,823  
                         
 


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    As of December 31,  
    2004     2003     2002     2001  
          (Restated)     (Restated)     (Restated)  
    (Dollars in millions)  
 
Balance Sheet Data:
                               
Investments in securities:
                               
Trading(4)
  $ 35,287     $ 43,798     $ 14,909     $ (45 )
Available-for-sale
    532,095       523,272       520,176       503,381  
Mortgage loans:
                               
Loans held for sale
    11,721       13,596       20,192       11,327  
Loans held for investment, net of allowance
    389,651       385,465       304,178       267,510  
Total assets
    1,020,934       1,022,275       904,739       814,561  
Short-term debt
    320,280       343,662       293,538       280,848  
Long-term debt
    632,831       617,618       547,755       484,182  
Total liabilities
    981,956       990,002       872,840       791,305  
Preferred stock
    9,108       4,108       2,678       2,303  
Total stockholders’ equity
    38,902       32,268       31,899       23,256  
                 
Regulatory Capital Data:
                               
Core capital(5)
  $ 34,514     $ 26,953     $ 20,431     $ 18,234  
Total capital(6)
    35,196       27,487       20,831       18,500  
                 
Book of Business Data:
                               
Mortgage portfolio(7)
  $ 917,209     $ 908,868     $ 799,779     $ 715,953  
Fannie Mae MBS held by third parties(8)
    1,408,047       1,300,520       1,040,439       878,039  
                                 
Book of business
  $ 2,325,256     $ 2,209,388     $ 1,840,218     $ 1,593,992  
                                 
 
                         
    2004     2003     2002  
          (Restated)     (Restated)  
 
Ratios:
                       
Return on assets ratio(9)*
    0.47 %     0.82 %     0.44 %
Return on equity ratio(10)*
    16.6       27.6       15.2  
Equity to assets ratio(11)*
    3.5       3.3       3.2  
Dividend payout ratio(12)*
    42.1       20.8       34.5  
Average effective guaranty fee rate (in basis points)(13)*
    20.8  bp     21.0  bp     19.3  bp
Credit loss ratio (in basis points)(14)*
    1.0  bp     0.9  bp     0.8  bp
Earnings to combined fixed charges and preferred stock dividends and issuance costs at redemption ratio(15)
    1.22:1       1.36:1       1.16:1  
 
 
(1) Includes investment losses, net; debt extinguishment losses, net; loss from partnership investments; and fee and other income.
 
(2) Unpaid principal balance of Fannie Mae MBS acquired by third-party investors during the reporting period.
 
(3) Unpaid principal balance of mortgage loans and mortgage-related securities we purchased for our portfolio during the reporting period.
 
(4) Balance as of December 31, 2001 primarily represents the fair value of forward purchases of TBA mortgage securities that were in a loss position.
 
(5) The sum of (a) the stated value of outstanding common stock (common stock less treasury stock); (b) the stated value of outstanding non-cumulative perpetual preferred stock; (c) paid-in-capital; and (d) retained earnings. Core capital excludes accumulated other comprehensive income.
 
(6) The sum of (a) core capital and (b) the total allowance for loan losses and reserve for guaranty losses, less (c) the specific loss allowance (that is, the allowance required on individually-impaired loans).
 
(7) Unpaid principal balance of mortgage loans and mortgage-related securities held in our portfolio.

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(8) Unpaid principal balance of Fannie Mae MBS held by third-party investors. The principal balance of resecuritized Fannie Mae MBS is included only once.
 
(9) Net income available to common stockholders divided by average total assets.
 
(10) Net income available to common stockholders divided by average outstanding common equity.
 
(11) Average stockholders’ equity divided by average total assets.
 
(12) Common dividend payments divided by net income available to common stockholders.
 
(13) Guaranty fee income as a percentage of average outstanding Fannie Mae MBS and other guaranties.
 
(14) Charge-offs, net of recoveries and foreclosed property expense (income), as a percentage of the average mortgage credit book of business.
 
(15) “Earnings” includes reported income before extraordinary gains (losses), net of tax effect and cumulative effect of change in accounting principle, net of tax effect plus (a) provision for federal income taxes, minority interest in earnings of consolidated subsidiaries, loss from partnership investments, capitalized interest and total interest expense. “Combined fixed charges and preferred stock dividends and issuance costs at redemption” includes (a) fixed charges (b) preferred stock dividends and issuance costs on redemptions of preferred stock, defined as pretax earnings required to pay dividends on outstanding preferred stock using our effective income tax rate for the relevant periods. Fixed charges represent total interest expense and capitalized interest.
 
Notes
 
Average balances for purposes of the ratio calculations are based on beginning and end of year balances.


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Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
ORGANIZATION OF MD&A
 
We intend for our MD&A to provide information that will assist in better understanding our consolidated financial statements. This section explains the changes in certain key items in our consolidated financial statements from year to year, the primary factors driving those changes, our risk management processes and results, any known trends or uncertainties of which we are aware that we believe may have a material effect on our future performance, as well as how certain accounting principles affect our consolidated financial statements. Our MD&A also provides information about our three complementary business segments in order to explain how the activities of each segment impact our results of operations and financial condition. This discussion also addresses the accounting errors that resulted in the restatement of our consolidated financial statements for the years ended December 31, 2003 and 2002, and the six months ended June 30, 2004, and the impact of the restatement on our previously reported financial results.
 
Our MD&A is organized as follows:
 
  •  Executive Summary
 
  •  Restatement
 
  •  Critical Accounting Policies and Estimates
 
  •  Consolidated Results of Operations
 
  •  Business Segment Results
 
  •  Supplemental Non-GAAP Information—Fair Value Balance Sheet
 
  •  Risk Management
 
  •  Liquidity and Capital Management
 
  •  Off-Balance Sheet Arrangements
 
  •  Impact of Future Adoption of Accounting Pronouncements
 
  •  2004 Quarterly Review
 
This discussion should be read in conjunction with our consolidated financial statements as of December 31, 2004 and the notes accompanying those consolidated financial statements. Readers should also review carefully “Item 1—Business—Forward-Looking Statements” and “Item 1A—Risk Factors” for a description of the forward-looking statements in this report and a discussion of the factors that might cause our actual results to differ, perhaps materially, from these forward-looking statements. Readers may refer to “Item 1—Business—Glossary of Terms Used in this Report” for an explanation of key terms used throughout this discussion. Unless otherwise noted, all financial information provided in this report gives effect to our restatement as described in “Restatement.”
 
EXECUTIVE SUMMARY
 
Our Mission and Business
 
We are a stockholder-owned corporation (NYSE: FNM) chartered by the U.S. Congress to support liquidity and stability in the secondary mortgage market. Our business includes three integrated business segments—Single-Family Credit Guaranty, Housing and Community Development 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.


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In our Single-Family and HCD business segments, we securitize mortgage loans delivered to us by mortgage lenders and then return Fannie Mae MBS to the lenders. We generally guarantee to the MBS trust that we will supplement mortgage loan collections as required to permit timely payment of principal and interest due on the related Fannie Mae MBS. Our Fannie Mae MBS are generally highly liquid, enabling mortgage lenders to raise capital to fund additional mortgage loans by selling the Fannie Mae MBS in the secondary mortgage market. We generate revenues in our Single-Family business segment primarily from the guaranty fees the segment receives as compensation for assuming the credit risk on the mortgage loans underlying single-family Fannie Mae MBS and on the single-family mortgage loans held in our portfolio.
 
Our HCD business also engages in a number of additional activities designed to expand the supply of affordable housing in America. These activities, which are described in detail in “Item 1—Business Segments—Housing and Community Development,” include investing in affordable rental properties that qualify for low-income housing tax credits; making equity investments in affordable for-sale and rental housing; and providing loans and credit support to housing finance agencies and other public entities to support their affordable housing efforts. Revenues in the segment are derived from a variety of sources, including the guaranty fees the segment receives as compensation for assuming the credit risk on the mortgage loans underlying multifamily Fannie Mae MBS and on the multifamily mortgage loans held in our portfolio, transaction fees associated with the multifamily business and bond credit enhancement fees. In addition, HCD’s investments in housing projects eligible for the low-income housing tax credit and other investments generate both tax credits and net operating losses that reduce our federal income tax liability.
 
In our Capital Markets group, our principal business is the purchase and sale of mortgage loans and mortgage-related assets through a full range of economic and competitive cycles. By maintaining a constant, reliable presence as an active investor in mortgage assets, we support liquidity and increase the stability of the pricing of mortgage loans in the secondary mortgage market. To fund our investment activities, our Capital Markets group issues Fannie Mae debt securities that attract capital from investors globally to support housing in the United States. Our Capital Markets group generates income primarily from the difference, or spread, between the yield on the mortgage assets we own and the cost of the debt we issue to fund these assets. Through our investment activities, we seek to maximize total returns, subject to our risk constraints, while fulfilling our chartered liquidity function.
 
Our businesses are self-sustaining and funded exclusively with private capital. The U.S. government does not guarantee, directly or indirectly, our securities or other obligations.
 
We operate our three business segments with oversight by our Board of Directors. Relevant committees of the Board (Audit Committee, Risk Policy and Capital Committee, Nominating and Corporate Governance Committee, Compensation Committee, Technology and Operations Committee, Compliance Committee, Housing and Community Finance Committee and Executive Committee) engage on matters within their respective charters. We encourage management and employees to have frequent and open dialogue with the Board.
 
Our non-executive Chairman of the Board is an important link between the Board and the company, and our CEO sits on the Board to ensure translation of Board policies into business activities. Within the company, the CEO works with the Management Executive Committee, comprised primarily of officers directly reporting to him, to develop, implement and execute the company’s plans and strategy. Our strategy is managed as a set of initiatives, which are typically assigned to individual executives within each business. The Management Executive Committee tracks these initiatives throughout the year and regularly reviews progress with management and the Board. We have established cross-functional management committees to ensure appropriate focus and effective decision-making in critical areas such as risk management, operations, compliance and disclosure.
 
Managing Our Risk
 
Our business activities expose us to four primary risks: credit risk, market risk (including interest rate risk), operational risk and liquidity risk. Effectively managing these risks is a principal focus of our organization, a key determinant of our success in achieving our mission and business objectives, and is critical to our safety


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and soundness. A detailed discussion of our risk management strategies, processes and measures is included in “Risk Management” below.
 
We devoted significant resources in 2005 and 2006 to addressing weaknesses identified in our risk governance structure and to ensuring that we have the personnel, processes and controls in place to allow us to achieve our risk management objectives. In 2005, we adopted an enhanced corporate risk governance framework, including the creation of a corporate risk oversight function led by a Chief Risk Officer who reports directly to our Chief Executive Officer and independently to the Risk Policy and Capital Committee of the Board of Directors.
 
Our businesses have responsibility for managing the day-to-day risks inherent in our business activities. Risk management at the business level is conducted in accordance with enterprise-wide corporate risk policies approved by our Board of Directors.
 
Our Single-Family and HCD businesses have responsibility for managing the credit risk inherent in the mortgage loans and Fannie Mae MBS that we either hold in our portfolio or guarantee. We take a disciplined approach in managing credit risk. We believe our mortgage credit book of business has strong credit characteristics, as measured by loan-to-value ratios, credit scores and other loan characteristics that reflect the effectiveness of our credit risk management strategy. Our credit losses for the period 2002 to 2004 have remained at what we consider to be low levels, averaging approximately 0.01% of our mortgage credit book of business. A detailed discussion of our credit risk management strategies and results can be found in “Risk Management—Credit Risk Management.”
 
Our Capital Markets group is responsible for managing the interest rate risk inherent in the mortgage loans and mortgage-related securities that we purchase and the debt we issue. The objective of our interest rate risk management strategy is to maintain a conservative, disciplined approach to managing interest rate risk. A detailed discussion of our interest rate risk management strategy and results can be found in “Risk Management—Interest Rate Risk Management and Other Market Risks” below. Our Capital Markets group is also responsible for managing the credit risk of the non-Fannie Mae mortgage-related securities in our portfolio.
 
Our Restatement
 
In December 2004, we announced that we would restate our previously filed consolidated financial statements because those financial statements were prepared applying accounting practices that did not comply with GAAP. Since the time of our announcement, we have devoted substantial resources towards the completion of our restatement. We have worked closely with and benefited from the guidance of OFHEO, our safety and soundness regulator, throughout this process. We have also obtained assistance from a variety of resources, including PricewaterhouseCoopers LLP, technology consulting firms and outside counsel.
 
The restatement process included a comprehensive review of our accounting policies and practices, implementing revised accounting policies, obtaining and/or validating market values for various financial instruments at multiple points in time, and enhancing or developing new systems to track, value and account for our transactions. The restatement was a complex undertaking that required the dedicated efforts of thousands of financial and accounting professionals, including external consultants. As described below under “Consolidated Results of Operations—Other Non-interest Expense—Administrative Expenses,” our administrative expenses in 2005 and 2006 were substantially affected by costs associated with our restatement and related matters, which we estimate totaled $1.3 billion. We anticipate that the costs associated with preparation of our post-2004 financial statements and periodic SEC reports will continue to have a substantial impact on administrative expenses until we are current in filing our periodic financial reports with the SEC. As part of our settlements with OFHEO and the SEC, we paid a $400 million civil penalty, which has been recorded as an expense in our 2004 consolidated financial statements.
 
In this Annual Report on Form 10-K, we have restated our previously filed audited consolidated financial statements for the years ended December 31, 2003 and 2002, and our unaudited consolidated financial statements for the quarters ended March 31, 2004 and June 30, 2004. The restatement adjustments resulted in a cumulative net decrease in retained earnings of $6.3 billion as of June 30, 2004 and a cumulative net


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increase in stockholders’ equity of $4.1 billion as of June 30, 2004. The restatement adjustments also resulted in an increase in previously reported net income attributable to common stockholders of $176 million for the year ended December 31, 2003 and a reduction in previously reported net income attributable to common stockholders of $705 million for the year ended December 31, 2002. For more information on the background, details and results of our restatement efforts, please see “Restatement” below.
 
The filing of this Annual Report on Form 10-K for the year ended December 31, 2004 represents a significant achievement in our efforts to return to timely financial reporting. We believe that major elements of the restatement, including our comprehensive review of our accounting policies and practices, will contribute to a more expeditious completion of financial statements for the years ended December 31, 2005 and 2006.
 
Our Organizational Changes and Remediation Progress
 
Using the findings of the OFHEO special examination, the Paul Weiss review and our own internal reviews of our business and the practices of other financial services companies as a guide, we have taken a number of steps to address specific identified weaknesses and to build a foundation for what we believe will be a fundamentally stronger and sounder company.
 
We believe the items highlighted below, in addition to specific remediation actions related to our accounting policies and practices, reflect significant remediation progress.
 
  •  We have made significant changes to our Board of Directors, including the appointment of a non-executive Chairman of the Board, the creation of a Risk Policy and Capital Committee of the Board, the creation of a Technology and Operations Committee of the Board, and the re-designation of a new Compliance Committee of the Board composed entirely of independent directors. We have also added six new Board members with substantial experience and knowledge related to business operations, accounting and finance since our receipt of OFHEO’s interim report in September 2004, including a new Chairman of the Audit Committee and three other new members of the Audit Committee.
 
  •  We have made significant changes to our executive management team, including the appointment of a new Chief Executive Officer and a new Chief Financial Officer. Over 35% of our senior officers, including our Chief Financial Officer, Controller, Chief Audit Executive, Chief Risk Officer, General Counsel and all senior officers in our Controller’s and Accounting Policy functions, joined the company after December 2004.
 
  •  We have initiated a comprehensive plan to transform our corporate culture into one focused on service, open and honest engagement, accountability and effective management practices.
 
  •  We have modified our compensation practices to include non-financial metrics relating to our controls, culture and mission goals.
 
  •  We have established an enterprise-wide risk oversight organization to oversee the management of credit risk, market risk and operational risk. We hired a new Chief Risk Officer to lead the build-out and responsibilities of this organization. In addition, we have implemented a new organizational risk structure that includes risk management personnel within each business unit.
 
  •  We appointed a new Chief Audit Executive from outside the company, reporting directly to the Audit Committee of the Board of Directors. We have completed a comprehensive review of Internal Audit’s organizational design and audit processes. We have filled the key management positions of Internal Audit with highly credentialed and experienced audit professionals, and we continue to enhance staffing in this area.
 
  •  We have appointed a new Chief Compliance Officer and substantially enhanced the staffing and scope of our compliance function.
 
Our efforts to change the culture of our company, to implement effective controls and governance processes, to fully staff certain areas of our operations and to build out our infrastructure are ongoing. As noted in “Item 1A—Risk Factors,” we are still in the process of remediating the material weaknesses we had identified in our internal control over financial reporting as of December 31, 2004. Accordingly, we still have significant


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remediation work remaining before we will be able to file periodic financial reports with the SEC and the NYSE on a timely basis. However, we believe the actions described above are representative of our commitment to making fundamental, lasting changes that will strengthen the governance, controls, operational discipline and culture of our organization.
 
Summary of Our Financial Results
 
The financial performance discussed in this Annual Report on Form 10-K is based on our consolidated financial results for the year ended December 31, 2004 and our restated consolidated financial results for the years ended December 31, 2003 and 2002. Net income and diluted earnings per share totaled $5.0 billion and $4.94, respectively, in 2004, compared with $8.1 billion and $8.08 in 2003, and $3.9 billion and $3.81 in 2002. Below are highlights of our performance.
 
2004 versus 2003
 
  •  Business volume down 54% from record level of $1.7 trillion in 2003  
  •  5% growth in our book of business  
  •  7% decrease in net interest income to $18.1 billion  
  •  25 basis point decrease in net interest yield to 1.87%  
  •  10% increase in guaranty fee income to $3.6 billion  
  •  Derivative fair value losses of $12.3 billion, compared with derivative fair value losses of $6.3 billion in 2003  
  •  Losses of $152 million on debt extinguishments, compared with losses of $2.7 billion in 2003
 
2003 versus 2002
 
  •  Business volume up 59% to record level of $1.7 trillion  
  •  20% growth in our book of business  
  •  6% increase in net interest income to $19.5 billion  
  •  12 basis point decrease in net interest yield to 2.12%  
  •  30% increase in guaranty fee income to $3.3 billion  
  •  Derivative fair value losses of $6.3 billion, compared with derivative fair value losses of $12.9 billion in 2002  
  •  Losses of $2.7 billion on debt extinguishments, compared with losses of $814 million in 2002
 


 
 
Our assets and liabilities consist predominately of financial instruments. We expect significant volatility from period to period in our financial results, due in part to the various manners in which we account for our financial instruments under GAAP. We routinely use fair value measures to make investment decisions and to measure, monitor and manage our risk. As described more fully in “Critical Accounting Policies and Estimates—Fair Value of Financial Instruments,” we use various methodologies to estimate fair value depending on the nature of the instrument and availability of observable market information. However, under GAAP we are required to measure and record some financial instruments at fair value, while other financial instruments are recorded at historical cost. In addition, as summarized below, changes in the carrying values of financial instruments that we report at fair value in our consolidated balance sheets under GAAP are recognized in our results of operations in a variety of ways depending on the nature of the asset or liability.
 
  •  We record derivatives, mortgage commitments and trading securities at fair value in our consolidated balance sheets and recognize changes in the fair value of those financial instruments in our net income.
 
  •  We record available-for-sale securities, retained interests and guaranty fee buy-ups at fair value in our consolidated balance sheets and recognize changes in the fair value of those financial instruments in accumulated other comprehensive income (“AOCI”), a component of stockholders’ equity.
 
  •  We record held for sale mortgage loans at the lower of cost or market (“LOCOM”) in our consolidated balance sheets and recognize changes in the fair value (not to exceed the cost basis of these loans) in our net income.
 
  •  At the inception of a guaranty contract, we estimate the fair value of the guaranty asset and guaranty obligation and record each of those amounts in our consolidated balance sheet. In each subsequent period, we reduce the guaranty asset for guaranty fees received and any impairment. We amortize the guaranty


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  obligation in proportion to the reduction of the guaranty asset and recognize the amortization as guaranty fee income in our net income. We do not record subsequent changes in the fair value of the guaranty asset or guaranty obligation in our consolidated financial statements. The guaranty assets are, however, reviewed for impairment.
 
  •  We record debt instruments at amortized cost and recognize interest expense in our net interest income.
 
As a result of the variety of ways in which we record financial instruments in our consolidated financial statements, we expect our earnings to vary, perhaps substantially, from period to period and result in volatility in our stockholders’ equity and regulatory capital. For example, we purchase mortgage assets and use a combination of debt and derivatives to fund those assets and manage the interest rate risk inherent in our mortgage investments. Our net income reflects changes in the fair value of the derivatives we use to manage interest rate risk; however, it does not reflect offsetting changes in the fair value of the majority of our mortgage investments and none of our debt obligations.
 
We do not evaluate or manage changes in the fair value of our various financial instruments on a stand-alone basis. Rather, we manage the interest rate exposure on our net assets, which includes all of our assets and liabilities, on an aggregate basis regardless of the manner in which changes in the fair value of different types of financial instruments are recorded in our consolidated financial statements. In “Supplemental Non-GAAP Information—Fair Value Balance Sheet,” we provide a fair value balance sheet that presents all of our assets and liabilities on a comparable basis. Management uses the fair value balance sheet, in conjunction with other risk management measures, to assess our risk profile, evaluate the effectiveness of our risk management strategies and adjust our risk management decisions as necessary. Because the fair value of our net assets reflects the full impact of management’s actions as well as current market conditions, management uses this information to assess performance and gauge how much management is adding to the long-term value of the company as well as to understand how the overall value of the company is changing. Our consolidated GAAP balance sheet as of December 31, 2004 reflects an increase in the reported value of our net assets of $6.6 billion from the prior year, while our consolidated fair value balance sheet as of December 31, 2004 reflects an increase in the fair value of our net assets of $11.7 billion.
 
Our Market
 
Our business operates within the U.S. residential mortgage market, which represents a major portion of the domestic capital markets. As of June 30, 2006, the latest date for which data was available, the Federal Reserve estimated that total U.S. residential mortgage debt outstanding was approximately $10.5 trillion. This compares with total U.S. residential mortgage debt outstanding of $6.9 trillion, $7.7 trillion, $8.9 trillion and $10.1 trillion for the years 2002, 2003, 2004 and 2005, respectively. U.S. residential mortgage debt outstanding has increased each year from 1945 to 2005, at an average annualized rate of approximately 10.6%. For the years 2002 through 2005, growth in U.S. residential mortgage debt outstanding was particularly strong, growing at an estimated annual rate of nearly 13% in 2002 and 2003, approximately 15% in 2004 and approximately 14% in 2005. Our book of business, which includes both mortgage assets we hold in our mortgage portfolio and our Fannie Mae MBS held by third parties, was $2.4 trillion as of June 30, 2006, representing nearly 23% of total U.S. residential mortgage debt outstanding.
 
In 2006, growth in U.S. residential mortgage debt outstanding and home price appreciation has slowed from recent high levels. The annualized growth rate for U.S. residential mortgage debt outstanding slowed to 9.6% in the second quarter of 2006. According to the OFHEO House Price Index, home prices increased at a 3.45% annualized rate in the third quarter of 2006, which represents a substantial decline in home price appreciation from the double-digit growth recorded for each of the prior two years. We expect that growth in U.S. residential mortgage debt outstanding will continue at a slower pace in 2007, as the housing market continues to cool and home price gains moderate further or possibly decline modestly. However, due to the cumulative appreciation in home prices during the past several years, affordability continues to pose a challenge for many potential homebuyers. The volume of non-traditional mortgage products, including interest-only and negative-amortizing mortgage loans, remains high as consumers continue to struggle with affordability issues. Additionally, the sub-prime and Alt-A mortgage originations that account for a large portion of the growth in market share of


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private-label issuers of mortgage-related securities in recent years continue to represent an elevated level of originations by historical standards.
 
Over the next decade, we expect demographic demand (primarily from stable household formation rates, a positive age structure of the population for homebuying and rising homeownership rates due to the high level of immigration over the past 25 years) that suggests a fundamentally strong mortgage market. We believe that these and other underlying demographic factors will support continued long-term demand for new capital to finance the substantial and sustained housing finance needs of American homebuyers.
 
RESTATEMENT
 
Overview
 
Background.  In September 2004, OFHEO delivered to our Board of Directors an interim report of its findings, through that date, of its special examination of our accounting policies and internal controls. OFHEO’s interim report concluded that we misapplied GAAP in specified areas, including hedge accounting and the amortization of purchase premiums and discounts on securities and loans and on other deferred charges. The interim report also identified numerous control weaknesses relating to, among other matters, our processes for estimating amortization and developing and implementing accounting policies. The control weaknesses identified by the interim report included inadequate segregation of duties, key person dependencies, and a lack of written procedures and supporting documentation.
 
Following the receipt of OFHEO’s interim report, we requested that the SEC’s Office of the Chief Accountant review our accounting practices relating to hedge accounting and to our amortization of purchase premiums and discounts on securities and loans and on other deferred charges. On December 15, 2004, the SEC’s Office of the Chief Accountant announced that it had advised us to (1) restate our financial statements filed with the SEC to eliminate the use of hedge accounting, and (2) evaluate our accounting for the amortization of premiums and discounts, and restate our financial statements filed with the SEC if the amounts required for correction were material. The SEC’s Office of the Chief Accountant also advised us to reevaluate the GAAP and non-GAAP information that we previously provided to investors, particularly in view of the decision that hedge accounting was not appropriate.
 
Announcement of Restatement and Non-reliance on Previous Financial Statements.  On December 16, 2004, we announced that we would comply fully with the determination of the SEC’s Office of the Chief Accountant. On December 17, 2004, the Audit Committee of our Board of Directors concluded that our previously filed interim and audited consolidated financial statements for the periods from January 2001 through the second quarter of 2004 should no longer be relied upon because these financial statements were prepared applying accounting practices that did not comply with GAAP.
 
Replacement of Independent Registered Public Accounting Firm.  On December 21, 2004, the Audit Committee of the Board of Directors dismissed the firm of KPMG LLP as our independent registered public accounting firm and, effective January 28, 2005, engaged Deloitte & Touche LLP as our independent registered public accounting firm.
 
Changes to Senior Management.  On December 21, 2004, our Board of Directors appointed Stephen B. Ashley to serve as non-executive Chairman of the Board, and appointed Daniel H. Mudd as interim Chief Executive Officer and Robert J. Levin as interim Chief Financial Officer to replace Franklin D. Raines as Chairman of the Board of Directors and Chief Executive Officer, and Timothy Howard as Chief Financial Officer. In addition to our Chief Financial Officer, all of our other senior financial officers, including the previous Controller and previous Chief Audit Executive, were replaced following the discovery and announcement of the accounting errors discussed above. The Board of Directors subsequently appointed Daniel H. Mudd as Chief Executive Officer and Robert T. Blakely as Chief Financial Officer. The Board appointed Daniel H. Mudd as CEO following the completion of an executive search effort overseen by a subcommittee of the Board comprised of independent Board members and utilizing the services of an executive search firm.


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Restatement of Prior Consolidated Financial Statements.  Our restatement process began in December 2004. Due to the significant complexities associated with our restatement and the lack of effective internal control over financial reporting, the restatement process has required an extensive effort by thousands of financial and accounting professionals, including both employees and external consultants. The restatement process has included thoroughly and comprehensively reviewing our accounting policies and practices to ensure compliance with GAAP; implementing revised accounting policies; obtaining and/or validating market values for our various financial instruments at multiple points in time over the restatement period; and enhancing or developing new systems to track, value and account for our transactions. Beyond the initial errors identified by our regulators, we also identified additional errors in our accounting and a substantial number of material weaknesses in our internal control over financial reporting, including a material weakness relating to our application of GAAP. See “Item 9A—Controls and Procedures” for a description of these material weaknesses, as well as our remediation activities relating to these material weaknesses.
 
We have restated our previously reported audited consolidated financial statements for the years ended December 31, 2003 and 2002, as well as our unaudited consolidated financial statements for the quarters ended March 31, 2004 and June 30, 2004. We have also restated our previously reported December 31, 2001 balance sheet to reflect corrected items that relate to prior periods. As described in more detail below, the cumulative impact of the restatement adjustments resulted in:
 
  •  a net decrease in retained earnings of $6.3 billion as of June 30, 2004;
 
  •  a net increase in stockholders’ equity of $4.1 billion as of June 30, 2004; and
 
  •  a net decrease in regulatory core capital of $7.5 billion as of December 31, 2003.
 
Stockholders’ equity increased despite a decrease in retained earnings. This was because AOCI restatement adjustments were significantly higher than retained earnings restatement adjustments. Our restatement adjustments resulted in an increase in AOCI of $10.4 billion, a decrease in retained earnings of $6.3 billion and an increase of $91 million in other equity changes as of June 30, 2004. The most significant causes of the $10.4 billion AOCI adjustments were the reversal of previously recorded derivative cash flow hedge adjustments and the recognition of fair value adjustments on available-for-sale securities that were previously classified as held-to-maturity securities and recorded at amortized cost. The most significant cause of the $6.3 billion retained earnings adjustments was the recognition in income of fair value adjustments associated with derivatives due to the loss of hedge accounting.
 
Overall Impact
 
The overall impact of our restatement was a total reduction in retained earnings of $6.3 billion through June 30, 2004. This amount includes:
 
  •  a $7.0 billion net decrease in earnings for periods prior to January 1, 2002 (as reflected in beginning retained earnings as of January 1, 2002);
 
  •  a $705 million net decrease in earnings for the year ended December 31, 2002;
 
  •  a $176 million net increase in earnings for the year ended December 31, 2003; and
 
  •  a $1.2 billion net increase in earnings for the six months ended June 30, 2004.
 
We previously estimated that errors in accounting for derivative instruments, including mortgage commitments, would result in a total of $10.8 billion in after-tax cumulative losses through December 31, 2004. In a subsequent 12b-25 filing in August 2006, we confirmed our estimate of after-tax cumulative losses on derivatives of $8.4 billion, but disclosed that our previous estimate of $2.4 billion in after-tax cumulative losses on mortgage commitments would be significantly less. We did not provide estimates of the effects on net income or retained earnings of any other accounting errors, nor did we provide any estimates of the effects of our restatement on total assets, total liabilities or stockholders’ equity. As reflected in the results we are reporting in this Annual Report on Form 10-K, our retained earnings as of December 31, 2004 includes after-tax cumulative losses on derivatives of $8.4 billion and after-tax cumulative net gains on derivative mortgage commitments of $535 million, net of related amortization, for a total after-tax cumulative impact as of


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December 31, 2004 of approximately $7.9 billion related to these two restatement items. As a result of the restatement and our recognition of the $8.4 billion in the periods the losses were incurred, we will not amortize the $8.4 billion through earnings in future periods. Under our prior accounting, we would have amortized through earnings amounts related to closed derivatives positions while open derivatives positions would continue to have changes in fair value deferred and recognized in AOCI according to the hedge accounting guidelines. Of the $8.4 billion recognized from restating our derivatives accounting, $8.0 billion of closed derivatives positions would have amortized through earnings, with approximately $3.6 billion of that amount amortizing during the period from 2005 through 2009, and the remaining $4.4 billion amortizing from 2010 through 2038. With respect to commitments, the after-tax cumulative net gains on derivative mortgage commitments of $535 million, net of related amortization, will be recognized in future periods as a reduction to our earnings.
 
Except to the extent otherwise specified, all information presented in the consolidated financial statements includes all such restatements and adjustments.
 
Summary of Restatement Adjustments
 
The cumulative restatement period extended through June 30, 2004, which is the last period for which we filed a periodic report with the SEC. We have classified our restatement adjustments into the seven primary categories as set forth in the table below. These categories involve subjective judgments by management regarding classification of amounts and particular accounting errors that may fall within more than one category. While such classifications are not required under GAAP, management believes these classifications may assist investors in understanding the nature and impact of the corrections made in completing the restatement.


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Table 1:  Cumulative Impact of Restatement
 
                                                 
    Restatement Adjustments for:  
                      Cumulative
             
    Periods
                Adjustments
    Six Months
    Cumulative
 
    Prior to
    Year Ended
    Year Ended
    as of
    Ended
    Adjustments as
 
    January 1,
    December 31,
    December 31,
    December 31,
    June 30,
    of June 30,
 
    2002     2002     2003     2003     2004     2004  
    (Dollars in millions)  
 
Retained earnings, as previously reported
  $ 26,175     $ 29,385     $ 35,496                     $ 37,414  
Restatement adjustments for:
                                               
Debt and derivatives
    (10,622 )     (5,877 )     4,356     $ (12,143 )   $ 3,036       (9,107 )
Commitments
    413       5,387       (1,826 )     3,974       (546 )     3,428  
Investments in securities
    (660 )     (715 )     (332 )     (1,707 )     (142 )     (1,849 )
MBS trust consolidation and sale accounting
    119       (59 )     (226 )     (166 )     (185 )     (351 )
Financial guaranties and master servicing
    (206 )     178       175       147       (143 )     4  
Amortization of cost basis adjustments
    154       135       (1,348 )     (1,059 )     (70 )     (1,129 )
Other adjustments
    296       (343 )     (926 )     (973 )     (320 )     (1,293 )
                                                 
Total impact of restatement adjustments before federal income taxes, extraordinary gains (losses) and cumulative effect of change in accounting principle
    (10,506 )     (1,294 )     (127 )     (11,927 )     1,630       (10,297 )
(Benefit) provision for federal income taxes
    (3,465 )     (589 )     (259 )     (4,313 )     397       (3,916 )
Extraordinary gains (losses), net of tax effect
                195       195       7       202  
Cumulative effect of a change in accounting principle, net of tax effect
                (151 )     (151 )           (151 )
                                                 
Impact of current period restatement adjustments, except where cumulative
    (7,041 )     (705 )     176     $ (7,570 )   $ 1,240       (6,330 )
                                                 
Impact of prior period restatement and other stockholders’ equity adjustments(1)
            (7,042 )     (7,749 )                     (5 )
                                                 
Retained earnings, as restated
  $ 19,134     $ 21,638     $ 27,923                     $ 31,079  
                                                 
 
 
(1) Includes the impact of stock-based compensation dividend adjustments.
 
See the “Financial Statement Impact” section below for further details on the impact of the restatement adjustments in the consolidated financial statements for the restatement periods.
 
Debt and Derivatives
 
We identified five errors associated with our debt and derivatives. The most significant error was that we incorrectly designated derivatives as cash flow or fair value hedges for accounting and reporting purposes. For derivatives designated as cash flow hedges, this error resulted in the recognition of changes in the fair value of these derivatives in AOCI in the consolidated balance sheets instead of in the consolidated statements of income. For derivatives designated as fair value hedges, this error resulted in the recognition of changes in the fair value of the hedged items as fair value adjustments in the consolidated balance sheets and as gain or loss in the consolidated statements of income. In conjunction with the review of these transactions, we identified the following additional errors associated with our debt and derivatives: we incorrectly excluded foreign exchange derivatives from netting adjustments for transactions executed with the same counterparty; we did


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not record a small number of financial instruments as derivatives; we incorrectly valued certain option-based and foreign exchange derivatives; and we incorrectly calculated interest expense by using inappropriate estimates in our amortization of debt cost basis adjustments.
 
The restatement adjustments associated with these errors resulted in a cumulative pre-tax reduction in retained earnings of $12.1 billion as of December 31, 2003. This pre-tax loss, in combination with an incremental loss reflected in the 2004 consolidated financial statements of $729 million, resulted in a cumulative reduction in pre-tax net income of $12.9 billion, or $8.4 billion after tax, as of December 31, 2004. These restatement adjustments also resulted in a reduction in total assets of $5.0 billion as of December 31, 2003, primarily from a reduction in “Deferred tax assets” as a result of no longer applying hedge accounting and deferring losses. Additionally, we decreased total liabilities by $9.1 billion as of December 31, 2003, primarily from no longer recording debt at fair value due to the loss of hedge accounting as well as correcting the amortization of debt cost basis adjustments. The effect from the change in debt cost basis adjustments, in turn, had the effect of increasing the amount of “Debt extinguishment losses, net” recognized in the consolidated statements of income. Each of the errors that resulted in these adjustments is described below.
 
We incorrectly classified derivatives as cash flow or fair value hedges for accounting and reporting purposes, even though they did not qualify for hedge accounting treatment pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”). The primary reasons for the loss of hedge accounting treatment were the improper use of the “shortcut” method as defined by SFAS 133 and inadequate assessments of hedge effectiveness and ineffectiveness measurement, both at hedge inception and at each reporting period thereafter. In other instances, hedging relationships were not properly documented at the inception of the hedge. Under cash flow hedge accounting, we initially recorded unrealized gains or losses on derivatives in AOCI in the consolidated balance sheets to be recognized into income in subsequent periods. Under fair value hedge accounting, we recorded unrealized gains or losses on derivatives in the consolidated statements of income offset by unrealized gains or losses on the asset or liability being hedged. The impact of correcting errors on derivatives that were previously classified as cash flow hedges resulted in the reversal of all previously recorded fair value adjustments in AOCI and the recognition of these fair value adjustments in “Derivatives fair value losses, net” in the consolidated statements of income. The impact of correcting errors on derivatives that were previously classified as fair value hedges resulted in the reversal of previously recorded fair value adjustments recorded on the hedged items. As the majority of these derivatives were designated as hedges against debt, the reversal of fair value adjustments resulted in a reduction of “Short-term debt” and “Long-term debt” in the consolidated balance sheets and changes in “Interest expense” in the consolidated statements of income. This error impacted all previously reported results and varied substantially from period to period based on the portfolio size and prevailing interest rates.
 
We incorrectly excluded foreign exchange derivatives from netting adjustments for transactions executed with the same counterparty where we had the legal right and intent to offset pursuant to Financial Accounting Standards Board (“FASB”) Interpretation (“FIN”) No. 39, Offsetting of Amounts Related to Certain Contracts (an interpretation of APB Opinion No. 10 and FASB Statement No. 105). As a result, the amounts of derivative assets and liabilities in the consolidated balance sheets were misstated. The impact of correcting this error changed the reported amount of derivative assets and liabilities in the consolidated balance sheets.
 
We did not record a small number of financial instruments that met the definition of a derivative pursuant to SFAS 133, which resulted in a misstatement of derivative assets and liabilities at fair value in the consolidated balance sheets. The correction of this error resulted in the recognition of derivative assets and liabilities at fair value with subsequent changes in the fair value of these derivatives recognized in the consolidated statements of income.
 
We incorrectly valued certain option-based and foreign exchange derivatives. We incorrectly valued certain option-based derivatives by using inaccurate volatility measures, which resulted in incorrect fair value adjustments to the previously reported consolidated financial statements. To correct this error, we revalued option-based derivatives with new volatility measures supported by market analysis and revalued foreign exchange derivatives. We also incorrectly recorded fair value adjustments on foreign exchange derivatives


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previously accounted for as fair value hedges. We recorded adjustments on these derivatives equal to foreign currency translation adjustments of our foreign denominated debt. These foreign exchange derivatives should have been independently recorded at fair value. The impact of correcting this error resulted in changes in the fair value gain or loss associated with these derivatives, which was recognized in the consolidated statements of income.
 
We incorrectly calculated interest expense by using inappropriate estimates in our amortization of debt cost basis adjustments. We amortized discounts, premiums and other deferred price adjustments by amortizing these amounts through the expected call date of the borrowings as opposed to amortizing these amounts through the contractual maturity date of the borrowings. Additionally, we utilized a convention in the calculation that was based on the average number of days of interest in a month regardless of the days contractually agreed upon. We corrected these errors by recalculating amortization of these costs through the contractual maturity date of the respective borrowings and using the contractual number of days in the month. The correction of these errors resulted in changes in the recognition of “Interest expense” and “Debt extinguishment losses, net” in the consolidated statements of income.
 
For the six-month period ended June 30, 2004, we recorded a pre-tax increase in net income of $3.0 billion related to the accounting errors described above. In combination with the effect of these errors through December 31, 2003 discussed above, the cumulative impact of the restatement of these errors on our consolidated financial statements was to decrease retained earnings by $9.1 billion as of June 30, 2004. The increase in net income in the six-month period ended June 30, 2004 was primarily the result of the loss of hedge accounting, as the remaining errors described above had minimal impact on restated results for the six-month period.
 
Commitments
 
We identified five errors associated with mortgage loan and security commitments. The most significant errors were that we did not record certain mortgage loan and security commitments as derivatives under SFAS 133 and we incorrectly classified mortgage loan and security commitments as cash flow hedges, which resulted in changes in fair value not being reflected in earnings. We also incorrectly interpreted SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“SFAS 149”), and therefore we incorrectly recorded a transition adjustment in 2003. In conjunction with the review of these transactions, we identified the following additional errors associated with mortgage loan and security commitments: we did not record certain security commitments as securities and we incorrectly valued mortgage loan and security commitments.
 
The restatement adjustments associated with these errors resulted in a cumulative pre-tax increase in retained earnings of $4.0 billion as of December 31, 2003. This pre-tax increase, combined with a commitments-related gain of $135 million reflected in the 2004 consolidated financial statements, resulted in a cumulative pre-tax increase in retained earnings of $4.1 billion as of December 31, 2004. The net impact on retained earnings, including tax effects and the $185 million after-tax charge to “Cumulative effect of change in accounting principle” as described below, was $2.5 billion as of December 31, 2004. After considering the increased amortization recognized in restatement attributable to the commitments adjustment, the total net impact of these commitment adjustments was an increase in retained earnings of $535 million, net of tax, as of December 31, 2004. Each of the errors that resulted in these adjustments is described below.
 
Prior to July 1, 2003, we did not record as derivatives mortgage loan and security commitments that were derivatives pursuant to SFAS 133, which resulted in a misstatement of our derivative assets and liabilities in the consolidated balance sheets. The impact of correcting this error resulted in the recognition of these commitments as derivatives at fair value in the consolidated balance sheets, with changes in the fair value of these commitments recorded in the consolidated statements of income. This error impacted previously reported results and varied substantially from period to period based on volume, prevailing interest rates and the market price of the underlying collateral. The correction of this error also resulted in recording cost basis adjustments to the acquired assets for the value of these derivatives as of their settlement date. These cost basis adjustments are amortized into interest income over the life of the acquired assets. The impact of this amortization is reflected in the “Amortization of Cost Basis Adjustments” section below.


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We incorrectly classified mortgage loan and security commitments as cash flow hedges. The primary reasons we did not qualify for hedge accounting treatment were the lack of assessment of the effectiveness of the hedging relationship and the failure to adequately identify and document the forecasted transactions. As discussed above, under cash flow hedge accounting, we deferred unrealized gains or losses on derivatives in AOCI in the consolidated balance sheets. The impact of correcting this error resulted in the recognition of derivatives at fair value in the consolidated balance sheets, with changes in the fair value of these derivatives recognized in the consolidated statements of income. This error impacted previously reported results and varied substantially from period to period based on volume, prevailing interest rates and the market price of the underlying collateral.
 
As part of the adoption of SFAS 149 in 2003, we incorrectly recorded a SFAS 149 transition adjustment that was not required because the commitments for which the transition adjustment was recorded should previously have been accounted for as derivatives under SFAS 133 or as securities under Emerging Issues Task Force (“EITF”) Issue No. 96-11, Accounting for Forward Contracts and Purchased Options to Acquire Securities Covered by FASB Statement No. 115 (“EITF 96-11”). We also incorrectly recorded as derivatives certain multifamily mortgage loan commitments that did not qualify as derivatives. The transition adjustment originally recorded was an after-tax charge of $185 million in the consolidated statement of income for the year ended December 31, 2003 as a “Cumulative effect of change in accounting principle.” The impact of correcting these errors resulted in the removal of the fair value adjustments related to multifamily loan commitments and the reversal of the entire transition adjustment in the consolidated statement of income for the year ended December 31, 2003.
 
Prior to July 1, 2003, the effective date of SFAS 149, we did not account for certain qualifying security purchase commitments in the consolidated balance sheets pursuant to EITF 96-11, which resulted in a misstatement of “Investments in securities” and AOCI in the consolidated balance sheets and related “Investment losses, net” in the consolidated statements of income associated with these commitments. The impact of correcting this error resulted in the recognition of these commitments as either “trading” or “available-for-sale” (“AFS”) securities, and the recognition of changes in the fair value of the securities in “Investment losses, net” in the consolidated statements of income for trading securities or in AOCI in the consolidated balance sheets for AFS securities.
 
We incorrectly valued mortgage loan and security commitments that we recorded as derivatives by utilizing inconsistent or inaccurate pricing. We corrected this error by revaluing mortgage loan and security commitment derivatives. The impact of correcting this error resulted in changes in unrealized gains or losses associated with these commitments in the consolidated statements of income and corresponding changes in derivatives at fair value in the consolidated balance sheets.
 
For the six-month period ended June 30, 2004, we recorded a pre-tax decrease in net income of $546 million related to the accounting errors described above. In combination with the effect of these errors through December 31, 2003 discussed above, the cumulative impact of the restatement of these errors on our consolidated financial statements was to increase retained earnings by $3.4 billion as of June 30, 2004. The decrease in net income in the six-month period ended June 30, 2004 was primarily the result of the loss of hedge accounting, as the remaining errors described above had minimal impact on restated results for the six-month period.
 
Investments in Securities
 
We identified the accounting errors described below related to our investments in securities that resulted in a cumulative pre-tax reduction in retained earnings of $1.7 billion as of December 31, 2003.
 
Classification and Valuation of Securities
 
We identified three errors associated with the classification and valuation of securities. The most significant error was that we incorrectly classified securities at acquisition as “held-to-maturity” (“HTM”) that we did not intend to hold to maturity, which resulted in not recognizing changes in the fair value of these securities in AOCI or earnings. As a result of our review of acquired securities, we derecognized all previously recorded HTM securities recorded at amortized cost and recognized at fair value $419.5 billion and $69.5 billion of


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AFS and trading securities, respectively, in 2003. Our holding of investments in trading securities is a significant change from our previously reported consolidated financial statements, as the majority of our investments in securities were historically classified as HTM. As a part of our review of these transactions, we identified the following additional errors: we incorrectly valued securities and we incorrectly classified certain dollar roll repurchase transactions as short-term borrowings instead of purchases and sales of securities.
 
The restatement adjustments associated with these errors resulted in a cumulative pre-tax decrease in retained earnings of $186 million as of December 31, 2003. These restatement adjustments also resulted in an increase of $2.4 billion in total assets and $37 million in total liabilities as of December 31, 2003. Each of the errors that resulted in these adjustments is described below.
 
We incorrectly classified securities as HTM pursuant to SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS 115”). SFAS 115 requires that securities be classified based on management’s investment intent on the date of acquisition and that securities originally designated as HTM can only be reclassified if specified criteria are met. Previously, we selected HTM as a default designation on the date we acquired the security. Subsequently, we would select classification as either HTM or AFS at the end of the month in which the security was acquired. The effect of this error was that securities were incorrectly reclassified from HTM to AFS and the reclassification did not meet the criteria of SFAS 115 for such reclassification. The impact of correcting this error resulted in the classification of all securities previously classified as HTM securities as either AFS or trading securities, with changes in the fair value of securities classified as AFS recorded in AOCI and changes in the fair value of securities classified as trading recognized in “Investment losses, net” in the consolidated statements of income. We discontinued the use of the HTM designation during the restatement period. In our restatement process, we corrected this error using information contained within the historical trade system to determine the original investment intent for each security and the appropriate classification. Fair value adjustments related to “Investments in securities” resulted in an increase in AOCI of $2.3 billion for AFS securities as of December 31, 2003 in the consolidated balance sheet and a decrease of $100 million for trading securities for the year ended December 31, 2003 in “Investment losses, net” in the consolidated statement of income.
 
We had valuation errors associated with securities. We incorrectly recorded the cost basis for certain securities in connection with implementing a new settlement system in 2002. We also incorrectly accounted for certain securities on a settlement date basis rather than a trade date basis pursuant to Statement of Position (“SOP”) No. 01-6, Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others. In addition, we incorrectly valued our previously reported AFS securities. To correct these errors, we revalued securities and corrected the cost basis of the impacted securities. The impact of correcting these errors resulted in a change in the realized and unrealized gains or losses associated with these securities as well as amortization of the cost basis adjustments in “Interest income” in the consolidated statements of income. The impact of the amortization of the revised cost basis adjustments is reflected in the “Amortization of Cost Basis Adjustments” section below.
 
We enter into agreements referred to as “dollar roll repurchase transactions,” where we transfer MBS in exchange for funds and agree to repurchase substantially the same securities at a future date. We incorrectly classified some dollar roll repurchase transactions as secured borrowings as these repurchase transactions did not qualify for secured borrowing treatment under SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (“SFAS 125”) and SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (a replacement of FASB Statement No. 125) (“SFAS 140”). For transactions that did not qualify for secured borrowing treatment, the impact of correcting the errors resulted in the reversal of “Short-term debt” in the consolidated balance sheets and the recognition of a sale or purchase of a security for each transaction, resulting in the recognition of gains and losses in “Investment losses, net” in the consolidated statements of income.
 
Impairment of Securities
 
We identified the following errors associated with the impairment of securities: we did not assess certain types of securities for impairment and we did not assess interest-only securities and lower credit quality investments for impairment.


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The restatement adjustments associated with these errors resulted in a cumulative pre-tax decrease in retained earnings of $1.5 billion and a decrease in total assets of $1.2 billion as of December 31, 2003. Additionally, for the six-month period ended June 30, 2004, we recorded a pre-tax increase in net income of $233 million, resulting from the reversal of historical impairment charges that were recorded in 2003 in the restated financial statements. Each of the errors that resulted in these adjustments is described below.
 
We did not appropriately assess certain securities for impairment due to deteriorated credit quality of the securities’ underlying collateral and, in some cases, deteriorated credit quality of the securities’ issuer during the restatement period. Included in this population of securities were investments in manufactured housing bonds. Additionally, when we recorded impairment, in certain circumstances we did not use contemporaneous market prices where available. To correct these errors, we remeasured securities and assessed them for credit-related impairments. The impact of correcting these errors resulted in a change in the carrying amount of these securities in the consolidated balance sheets and a reduction in net income recorded in “Investment losses, net” in the consolidated statements of income.
 
We did not assess interest-only securities and lower credit quality investments for impairment pursuant to EITF Issue No. 99-20, Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets (“EITF 99-20”). In certain instances, we incorrectly combined interest-only and principal-only certificates issued from securitization trusts for impairment evaluation purposes even though the interest-only certificates could not be, or had not been, legally combined into a single security. To correct this error, we assessed these securities separately for impairment. The impact of correcting this error resulted in a decrease in the carrying amount of these securities in the consolidated balance sheets and a reduction in net income recorded in “Investment losses, net” in the consolidated statements of income.
 
For the six-month period ended June 30, 2004, we recorded a pre-tax decrease in net income of $142 million related to the accounting errors described above. In combination with the effect of these errors through December 31, 2003 discussed above, the cumulative impact of the restatement of these errors on our consolidated financial statements was to decrease retained earnings by $1.8 billion as of June 30, 2004. The decrease in net income in the six-month period ended June 30, 2004 was primarily the result of reversal of the held-to-maturity classification, as the remaining errors described above had minimal impact on restated results for the six-month period.
 
MBS Trust Consolidation and Sale Accounting
 
We identified three errors associated with MBS trust consolidation and sale accounting: we incorrectly recorded asset sales that did not meet sale accounting criteria; we did not consolidate certain MBS trusts that were not considered qualifying special purpose entities (“QSPE”) and for which we were deemed to be the primary beneficiary or sponsor of the trust; and we did not consolidate certain MBS trusts in which we owned 100% of the securities issued by the trust and had the ability to unilaterally cause the trust to liquidate.
 
The restatement adjustments associated with these errors resulted in a cumulative pre-tax decrease in retained earnings of $166 million as of December 31, 2003. This was the result of the net change in the value of the assets and liabilities that were recognized and derecognized in conjunction with consolidation or sale activity. These restatement adjustments also resulted in an increase of $8.9 billion in total assets and an increase of $8.6 billion in total liabilities as of December 31, 2003. Each of the errors that resulted in these adjustments is described below.
 
We incorrectly recorded asset sales that did not meet the sale accounting criteria set forth in SFAS 125 and SFAS 140, primarily because the assets were transferred to an MBS trust that did not meet the QSPE criteria. To correct this error, we reviewed our MBS trusts and accounted for the transfers of assets that did not meet the sale accounting criteria as secured borrowings. The impact of correcting this error resulted in the derecognition of retained interest and recourse obligations recorded upon transfer of the assets, the re-recognition of the transferred assets and the recognition of “Short-term debt” or “Long-term debt” in the consolidated balance sheets to the extent of any proceeds received in connection with the transfer of assets.


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Correcting this error also resulted in the reversal of any gains or losses related to these failed asset sales recorded in “Investment losses, net” in the consolidated statements of income.
 
We failed to consolidate MBS trusts that were not considered QSPEs and for which we were deemed to be the primary beneficiary or sponsor of the trust. These entities included those to which we transferred assets in a transaction that initially qualified as a sale and for QSPE status, but where the trust subsequently failed to meet the criteria to be a QSPE, primarily because our ownership interests in the trust exceeded the threshold permitted for a QSPE. Additionally, these entities included those where we were not the transferor of assets to the trust, but where the trust is not considered a QSPE and our investments or guaranty contracts provide us with the majority of the expected losses or residual returns, as defined by FIN No. 46 (revised December 2003), Consolidation of Variable Interest Entities (an interpretation of ARB No. 51) (“FIN 46R”). To correct this error, we consolidated these trusts, then deconsolidated trusts when they no longer required consolidation.
 
We incorrectly did not consolidate MBS trusts in which we owned or acquired over time 100% of the related securities issued by the trust and had the ability to unilaterally liquidate the trust. To correct this error, we consolidated those MBS trusts in which we had the unilateral ability to liquidate and deconsolidated these trusts when we no longer had the unilateral ability to liquidate.
 
Correcting these errors related to MBS trust consolidation and sale accounting resulted in a decrease in “Investments in securities” of $154.0 billion, an increase in “Mortgage loans” of $162.8 billion and an increase in debt of $9.9 billion as of December 31, 2003.
 
In situations where we were required to consolidate an MBS trust, we derecognized the MBS recorded in the consolidated balance sheets as “Investments in securities” and recognized the underlying assets held by the trust, either as mortgage loans or mortgage-related securities. Loans that were consolidated from trusts in which we were the transferor have been classified as held for sale (“HFS”) and are recorded at the lower of cost or market, whereas loans that were consolidated from trusts in which we were not the transferor have been classified as held for investment (“HFI”) and recorded at amortized cost. Mortgage-related securities that were consolidated from trusts have been classified as AFS securities. We also derecognized assets and liabilities associated with our guaranty and master servicing arrangements associated with the consolidated MBS trusts and recognized these amounts as cost basis adjustments to “Mortgage loans” in the consolidated balance sheets, where applicable. The impact of the amortization of this cost basis adjustment is reflected in the “Amortization of Cost Basis Adjustments” section below. For consolidated MBS trusts in which we owned less than 100% of the related securities, we recorded short-term or long-term debt in the consolidated balance sheets for the portion of the security position due to third parties.
 
Correcting these errors related to MBS trust consolidation and sale accounting also impacted the consolidated statements of income. We recorded an additional loss of $230 million and $26 million in “Investments losses, net” in the consolidated statements of income for the years ended December 31, 2003 and 2002, respectively, primarily due to reversing previously recorded asset sales. As a result of adopting FIN 46R, we consolidated certain MBS trusts created prior to February 1, 2003 and recorded a $34 million gain in “Cumulative effect of change in accounting principle, net of tax effect” in the consolidated statement of income for the year ended December 31, 2003. For MBS trusts created after January 31, 2003 and that were consolidated due to the application of FIN 46R, we recorded a $195 million gain in “Extraordinary gains (losses), net of tax effect” in the consolidated statement of income for the year ended December 31, 2003, reflecting the difference between the fair value of the consolidated assets and liabilities and the carrying amount of our interest in the MBS trust. In addition, we recorded a decrease in “Guaranty fee income” of $247 million and $198 million and an increase in “Interest income” of $594 million and $710 million for the years ended December 31, 2003 and 2002, respectively, as a result of derecognizing our guaranty assets and obligations and recognizing cost basis adjustments to the consolidated mortgage loans and mortgage-related securities.
 
For the six-month period ended June 30, 2004, we recorded a pre-tax decrease in net income of $185 million related to the accounting errors described above. In combination with the effect of these errors through December 31, 2003 discussed above, the cumulative impact of the restatement of these errors on our consolidated financial statements was to decrease retained earnings by $351 million as of June 30, 2004.


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Additionally, two REMIC transactions were specifically identified and questioned by OFHEO regarding our intent for entering into the transactions and the timing of income recognition. Our review concluded that the historical treatment of accounting for these transfers was appropriate and consistently applied.
 
Financial Guaranties and Master Servicing
 
We identified the accounting errors described below related to our financial guaranties and master servicing that resulted in a cumulative pre-tax increase in retained earnings of $147 million as of December 31, 2003.
 
Recognition, Valuation and Amortization of Guaranties and Master Servicing
 
We identified seven errors associated with the recognition, valuation and amortization of our guaranty and master servicing contracts. The most significant errors were that we incorrectly amortized guaranty fee buy-downs and risk-based pricing adjustments; we incorrectly valued our guaranty assets and guaranty obligations; we incorrectly accounted for buy-ups; we did not record credit enhancements associated with our guaranties as separate assets; and we incorrectly recorded adjustments to guaranty assets and guaranty obligations based on the amount of Fannie Mae MBS held in the consolidated balance sheets. In conjunction with the review of these issues, we identified the following additional errors: we did not record guaranty assets and guaranty obligations associated with our guaranties to MBS trusts in which we were the transferor of the trust’s underlying loans and we did not recognize master servicing assets and related deferred profit, where applicable.
 
The restatement adjustments associated with these errors resulted in a cumulative pre-tax increase in retained earnings of $2.4 billion as of December 31, 2003. These restatement adjustments also resulted in an increase of $144 million in total assets and a decrease in total liabilities of $1.6 billion as of December 31, 2003. Each of the errors that resulted in these adjustments is described below.
 
For guaranties entered into before January 1, 2003, the effective date of FIN No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No.  34) (“FIN 45”), we made errors in applying amortization to up-front cash receipts associated with our guaranties, known as buy-downs and risk-based pricing adjustments, pursuant to SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (an amendment of FASB Statements No. 13, 60, and 65 and rescission of FASB Statement No. 17) (“SFAS 91”). The errors in amortization of these items are described in the “Amortization of Cost Basis Adjustments” section below. The impact of correcting these errors resulted in changes in the periodic recognition of “Guaranty fee income” in the consolidated statements of income. For guaranties entered into or modified after the adoption of FIN 45, buy-downs and risk-based pricing adjustments should have been recorded as an additional component of “Guaranty obligations” and amortized in proportion to the reduction to “Guaranty assets.” The impact of correcting this error resulted in changes in the carrying amount of “Other liabilities” and “Guaranty obligations” in the consolidated balance sheets and changes in the periodic recognition of “Guaranty fee income” in the consolidated statements of income.
 
We had valuation errors associated with our guaranty assets and guaranty obligations. We incorrectly included up-front cash payments associated with our guaranties, known as buy-ups, in the basis of our guaranty assets while also recording these buy-ups as a separate asset included in “Other assets” in the consolidated balance sheets. We recorded guaranty obligations equal to the recorded guaranty assets, including any buy-ups, when we should have independently measured guaranty obligations at fair value based on estimates of expected credit losses and recorded deferred profit associated with these arrangements. The impact of correcting these errors resulted in decreases in “Other assets” and “Guaranty obligations” in the consolidated balance sheets.
 
We did not correctly account for buy-ups. Historically, we accounted for buy-ups at amortized cost under the retrospective effective interest method pursuant to SFAS 91. However, since the recognition of income on a buy-up is subject to the risk that we may not substantially recover our investment due to prepayments, we should have subsequently measured the fair value of the buy-ups as if they were debt securities pursuant to SFAS 140 and recorded imputed interest as a component of “Guaranty fee income” in the consolidated statements of income under the prospective interest method pursuant to EITF 99-20. The impact of correcting


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this error resulted in recording buy-ups at fair value as a component of “Other assets” in the consolidated balance sheets with changes in the fair value recorded in AOCI in the consolidated balance sheets.
 
In some transactions, we receive the benefit of lender-provided credit enhancements, such as lender recourse, in lieu of receiving a higher guaranty fee. Previously, we did not record these credit enhancements as assets in the consolidated balance sheets. The impact of correcting this error resulted in the recognition of credit enhancements as a component of “Other assets,” an offsetting increase to “Guaranty obligations” and subsequent amortization of the credit enhancement as a component of “Other expenses” in the consolidated statements of income.
 
Historically, when we acquired a Fannie Mae MBS, we reduced the recorded guaranty asset and guaranty obligation by an amount equal to the pro rata portion of Fannie Mae MBS held in the consolidated balance sheets relative to the total amount of gross outstanding Fannie Mae MBS. In addition, we reclassified a pro rata portion of recorded guaranty fee income to interest income in an amount equal to the ratio of the Fannie Mae MBS held in the consolidated balance sheets relative to the total amount of gross outstanding Fannie Mae MBS. Because each Fannie Mae MBS trust to which we have a guaranty obligation, and from which we have the right to receive guaranty fees, is separate from us, we should not have reduced the recorded guaranty asset and guaranty obligation or reclassified guaranty fee income with respect to Fannie Mae MBS held in the consolidated balance sheets unless we had consolidated the related MBS trust. Correcting this error increased “Guaranty assets” and “Guaranty obligations” in the consolidated balance sheets, and resulted in a decrease in “Net interest income” of $948 million and a corresponding increase in “Guaranty fee income” in the consolidated statements of income for the year ended December 31, 2003.
 
We did not record certain retained interests as guaranty assets and certain recourse obligations as guaranty obligations in connection with the transfer of loans to MBS trusts for which we were the transferor pursuant to SFAS 125 and SFAS 140. To correct this error, we examined all of our guaranty arrangements in these transactions and recorded guaranty assets and guaranty obligations as applicable. The impact of correcting this error resulted in an increase in “Guaranty assets” and “Guaranty obligations” in the consolidated balance sheets with any remaining difference being recorded as a component of “Investment losses, net” in the consolidated statements of income.
 
We assume an obligation to perform certain limited master servicing activities in connection with securitizations and are compensated for assuming this obligation. We did not previously recognize master servicing assets and related deferred profit associated with our role as master servicer pursuant to SFAS 125 and SFAS 140. To correct this error, we reviewed our trust agreements to determine when we had master servicing responsibilities. The impact of correcting this error generally resulted in the recognition of master servicing assets as a component of “Other assets” and the recognition of a corresponding amount of deferred profit as a component of “Other liabilities,” with subsequent amortization and impairment recorded to “Fee and other income” in the consolidated statements of income.
 
Impairment of Guaranty Assets and Buy-ups
 
We identified the following errors associated with the impairment of guaranties: we did not assess guaranty assets or buy-ups for impairment in accordance with EITF 99-20 and SFAS 115, as appropriate.
 
The restatement adjustments related to impairments resulted in a cumulative pre-tax decrease in retained earnings of $2.3 billion and a decrease of $1.8 billion in total assets as of December 31, 2003. Each of the errors that resulted in these adjustments is described below.
 
We did not assess guaranty assets for impairment. As a result, guaranty assets were overstated in previously issued financial statements. The impact of correcting this error resulted in a reduction to “Guaranty assets” with a proportional reduction to “Guaranty obligations” in the consolidated balance sheets. The impairment of the guaranty asset was fully offset by amortization of the guaranty obligation. While the impairment of the guaranty asset is categorized in this section, the proportionate reduction of the guaranty obligation is categorized in the “Recognition, Valuation and Amortization of Guaranties and Master Servicing” section above.


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We did not assess buy-ups for impairment. As a result, “Other assets” and “Guaranty fee income” were overstated in previously issued financial statements. The impact of correcting this error resulted in a decrease in “Other assets” in the consolidated balance sheets and a decrease in “Guaranty fee income” in the consolidated statements of income.
 
For the six-month period ended June 30, 2004, we recorded a pre-tax decrease in net income of $143 million related to the accounting errors described above. In combination with the effect of these errors through December 31, 2003 discussed above, the cumulative impact of the restatement of these errors on our consolidated financial statements was to increase retained earnings by $4 million as of June 30, 2004. The decrease in net income in the six-month period ended June 30, 2004 was primarily the result of the amortization of “Guaranty obligations.”
 
Amortization of Cost Basis Adjustments
 
We identified multiple errors in amortization of mortgage loan and securities premiums, discounts and other cost basis adjustments. The most significant errors were that we applied incorrect prepayment speeds to cost basis adjustments; we aggregated dissimilar assets in computing amortization; and we incorrectly recorded cumulative amortization adjustments. Additionally, the correction of cost basis adjustments in other error categories, primarily settled mortgage loan and security commitments, resulted in the recognition of additional amortization. The errors that led to these corrected cost basis adjustments are described in the “Commitments,” “Investments in Securities” and “MBS Trust Consolidation and Sale Accounting” sections above.
 
The restatement adjustments relating to these amortization errors resulted in a cumulative pre-tax decrease in retained earnings of $1.1 billion as of December 31, 2003. Each of the errors that resulted in these adjustments is described below.
 
SFAS 91 requires the recognition of cost basis adjustments as an adjustment to interest income over the life of a loan or security by using the interest method and applying a constant effective yield (“level yield”). In calculating a level yield, we calculate amortization factors, based on prepayment and interest rate assumptions. Our method for estimating prepayment rates applied incorrect assumptions to certain assets.
 
In addition, we incorrectly aggregated dissimilar assets in computing amortization. Our amortization calculation aggregated loans with a wide range of coupon rates, which in some cases led to amortization results that did not produce an appropriate level yield over the life of the loans. To correct this error, we recalculated amortization of loans and securities factoring in prepayment and interest rate assumptions that were applied to the appropriate asset types. The impact of correcting these errors resulted in changes in the periodic recognition of interest income in the consolidated statements of income.
 
The manner in which we calculated and recorded the cumulative “catch-up” adjustment was inconsistent with the provisions of SFAS 91. The impact of correcting this error resulted in changes in the periodic recognition of interest income in the consolidated statements of income.
 
For the six-month period ended June 30, 2004, we recorded a pre-tax decrease in net income of $70 million related to the accounting errors described above. In combination with the effect of these errors through December 31, 2003 discussed above, the cumulative impact of the restatement of these errors on our consolidated financial statements was to decrease retained earnings by $1.1 billion as of June 30, 2004.
 
Other Adjustments
 
In addition to the previously noted errors, we identified and recorded other restatement adjustments related to accounting, presentation, classification and other errors that did not fall within the six categories described above.
 
The accumulation of the other restatement adjustments listed below resulted in a cumulative pre-tax decrease in retained earnings of $973 million as of December 31, 2003. The other restatement adjustments resulted in an increase of $5.0 billion in total assets and an increase of $5.2 billion in total liabilities as of December 31, 2003.


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The following categories summarize the most significant other adjustments recorded as part of the restatement:
 
  •  Accounting for partnership investments.  We incorrectly accounted for a portion of our LIHTC and other partnership investments using the effective yield method instead of using the equity method of accounting. The correction of this error resulted in changes in the carrying amount of these investments in the consolidated balance sheets, the recognition of our obligations to fund the partnerships, and changes in the income recognition on these investments in the consolidated statements of income. Additionally, we failed to consolidate a portion of the LIHTC and other partnership investments in which we were deemed to be the primary beneficiary pursuant to FIN 46R, which resulted in the reversal of any previously recorded investment and recognition of the underlying assets and liabilities of the entity in the consolidated balance sheets and, at the same time, we incorrectly consolidated some partnership investments which had the reverse effect. We also made errors in the capitalization of interest expense, measurement of impairment and the recognition of our obligations to fund our partnership investments. The correction of these errors resulted in changes in the amount of interest expense and impairment recognized in the consolidated statements of income. Lastly, we made errors in the computation of net operating losses and tax credits allocated to us from these partnerships. The correction of these errors resulted in changes in “Deferred tax assets” in the consolidated balance sheets and changes in the “Provision for federal income taxes” in the consolidated statements of income. These restatement adjustments resulted in a cumulative pre-tax decrease in retained earnings of $603 million, an increase of $791 million in total assets and an increase of $878 million in total liabilities as of December 31, 2003. In addition to the tax provision recorded for the partnership investments restatement adjustments, we also recorded a decrease in federal income tax expense of $138 million for the year ended December 31, 2003 due to changes in the recognition and classification of related tax credits and net operating losses.
 
  •  Classification of loans held for sale.  We incorrectly classified loans held for securitization at a future date as HFI loans rather than HFS loans pursuant to SFAS No. 65, Accounting for Certain Mortgage Banking Activities. Accordingly, we did not record LOCOM adjustments on these loans. To correct this error, we recorded an adjustment to reclassify such loans from HFI to HFS and recorded an associated LOCOM adjustment. These restatement adjustments resulted in a cumulative pre-tax decrease in retained earnings of $386 million as of December 31, 2003.
 
  •  Provision for credit losses.  We incorrectly recorded the “Provision for credit losses” due to errors associated with the “Allowance for loan losses,” “Reserve for guaranty losses,” as well as REO and troubled debt restructurings (“TDRs”’).
 
  —  We made errors in developing our estimates of the “Allowance for loan losses” and the “Reserve for guaranty losses,” which resulted in an understatement of the provision for credit losses. These errors were primarily related to the use of inappropriate data in the calculation of the allowance and reserve, such as incorrect loan populations, inaccurate default statistics and inaccurate loss severity in the event that loans default. We also made judgmental adjustments to the calculated allowance without adequate support and incorrectly included an estimate of credit enhancement collections in the estimate of the “Allowance for loan losses.” Estimates of recoveries from credit enhancements that were not entered into contemporaneously or in contemplation of a guaranty or loan purchase should not have been included in the overall estimate of the allowance or the reserve. As a result of misclassifying certain loans as HFI, we incorrectly recorded an “Allowance for loan losses” on these loans. Finally, we did not properly allocate the reserve between the “Allowance for loan losses” and the “Reserve for guaranty losses.” To correct these errors, we recalculated the allowance and reserve with updated information and supportable data, reviewed and documented any judgmental adjustments and appropriately applied estimates of recoveries from credit enhancements to the loan population.
 
  —  We made errors in calculating loan charge-off amounts. These errors were related to REO and foreclosed property expense, including making inappropriate determinations of the initial cost basis of REO assets at foreclosure, as well as not expensing costs related to foreclosure activities in the proper periods. To correct these errors, we reviewed REO and foreclosed property expense to determine and record the appropriate cost basis and timing of charge-offs and expense recognition. We also


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  incorrectly recognized insurance proceeds in excess of estimated charge-off at foreclosure and fair value gains above the recorded investment of REO properties as recoveries to the allowance and the reserve. To correct this error, we recalculated the allowance and reserve.
 
  —  We historically did not recognize modifications that granted concessions to borrowers as TDRs pursuant to SFAS No. 114, Accounting by Creditors for Impairment of a Loan (an amendment of FASB Statement No. 5 and 15) (“SFAS 114”). To correct this error, we recognized these modifications as TDRs and recorded an adjustment to the “Allowance for loan losses” and the “Provision for credit losses” in the consolidated balance sheets and consolidated statements of income, respectively.
 
The restatement adjustments associated with these errors resulted in a pre-tax increase in the provision for credit losses of $273 million for the year ended December 31, 2003; however, the cumulative impact on retained earnings was a decrease of $87 million as of December 31, 2003.
 
  •  Early funding.  We offer early funding options to lenders that allow them to receive cash payments for mortgage loans that will be securitized into Fannie Mae MBS at a future date. A corresponding forward commitment to sell the security that will be backed by the mortgage loans is required to be delivered with the mortgage loans and is executed on the settlement date of the commitment. We incorrectly recorded these transactions as HFS loans prior to the actual creation of the Fannie Mae MBS when we were the intended purchaser of the MBS. The impact of correcting this error was to remove any previous HFS loans from these transactions and record the transactions as “Advances to lenders,” carried at amortized cost, in the consolidated balance sheets, resulting in a decrease of $4.7 billion in “Mortgage loans” with a corresponding increase in “Advances to lenders” as of December 31, 2003.
 
  •  Collateral associated with derivatives contracts.  We did not record cash collateral we received associated with some derivatives contracts. The impact of correcting this error was to record additional “Cash and cash equivalents” of $2.3 billion and “Restricted cash” of $1.1 billion, and a corresponding liability to our derivative counterparties in “Other liabilities” of $3.4 billion, as of December 31, 2003.
 
The following items, while restatement errors, were not individually significant to the consolidated financial statements for the restatement period:
 
  •  Accounting for reverse mortgages.  We made errors in accounting for reverse mortgages. When computing interest income on reverse mortgages we did not use the expected life of the borrower and house price expectations in the interest income calculations and did not apply the retrospective level yield method. To correct this error, we recalculated interest income for these mortgages and recorded the change in “Interest income” in the consolidated statements of income. We also incorrectly recorded loan loss reserves on these mortgages. To correct this error, we adjusted the “Allowance for loan losses” and the “Provision for credit losses” in the consolidated balance sheets and consolidated statements of income, respectively.
 
  •  Accrued interest on delinquent loans.  We incorrectly included a recovery rate, which was based on historic trends of loans that subsequently changed to current payment status, in calculating accrued interest on delinquent loans. The effect of this error was to record interest income on loans that should have been on nonaccrual status. The correction of this error resulted in the reversal of interest income recorded in the periods when loans should have been on nonaccrual status.
 
  •  Amortization of prepaid mortgage insurance.  We amortized prepaid mortgage insurance over a period that is not representative of the period in which we received the benefits of the mortgage insurance. To correct this error, we recalculated amortization of this mortgage insurance and recorded the difference in “Other expenses” in the consolidated statements of income.
 
  •  Computation of interest income.  We incorrectly calculated interest income on certain investments. The calculations utilized a convention that was based on the average number of days of interest in a month regardless of the actual number of days in the month. We corrected the calculation of interest using the actual number of days in the month and adjusted the timing of interest income recognition.


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  •  Mortgage insurance contract.  We entered into a mortgage insurance contract that did not transfer sufficient underlying risk of economic loss to the insurer and therefore did not qualify as mortgage insurance for accounting purposes. We incorrectly amortized the premiums paid as an expense. To correct this error, we recorded premiums paid on the policy as a deposit, reducing such deposit as recoveries from the policy were received.
 
  •  Stock-based compensation.  We made errors in the computation and classification of stock-based compensation, including the misclassification of some awards as non-compensatory when they were compensatory. The impact of correcting these errors resulted in the recognition of additional “Salaries and employee benefits expense” in the consolidated statements of income, a decrease in “Other liabilities” and an increase in “Additional paid-in capital” in the consolidated balance sheets. None of these errors related to awards that were not properly authorized and priced.
 
In addition to the specified errors listed and described above, we recognized other restatement adjustments related to our revised accounting policies and practices. These adjustments, both individually and in the aggregate, did not have a significant impact on the consolidated financial statements.
 
As a result of our restatement adjustments, our effective tax rate decreased from the previously reported 26% to 24% for the year ended December 31, 2003 and from the previously reported 24% to 18% for the year ended December 31, 2002. These decreases resulted from errors in our tax provision primarily relating to the recognition of higher levels of tax credits from our investment in affordable housing projects and changes to deferred tax balances. As a result, the change in the provision for federal taxes as a percentage of the change in pre-tax income was higher than the statutory federal rate or our effective tax rate. See “Notes to Consolidated Financial Statements—Note 11, Income Taxes” for our restated tax rate reconciliation. In addition, the tax effects were applied to each of the categories identified above to display each error category net of tax and with the earnings per share impact.
 
For the six-month period ended June 30, 2004, we recorded a pre-tax decrease in net income of $320 million related to the accounting errors described above. In combination with the effect of these errors through December 31, 2003 discussed above, the cumulative impact of the restatement of these errors on our consolidated financial statements was to decrease retained earnings by $1.3 billion as of June 30, 2004. The decrease in net income in the six-month period ended June 30, 2004 was primarily the result of accounting for partnership investments, classification of loans held for sale and the provision for credit losses.
 
In addition to the consolidated financial statement errors discussed above, we incorrectly applied the treasury stock method in computing the weighted average shares pursuant to SFAS No. 128, Earnings per Share. This resulted in a different number of weighted average dilutive shares outstanding being utilized in the earnings per share calculation. While common stock outstanding has not been restated, diluted EPS has been recalculated using the revised weighted average diluted shares.
 
We also identified errors in the presentation of business segments that were not in conformity with the requirements of SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. For further information on this error, see “Notes to Consolidated Financial Statements—Note 15, Segment Reporting.”
 
We made errors in the fair value disclosure of financial instruments pursuant to SFAS No. 107, Disclosures about Fair Value of Financial Instruments (“SFAS 107”), by incorrectly calculating the fair value of our derivatives, commitments and AFS securities, as described above. In addition, we incorrectly calculated the fair value of our guaranty assets and guaranty obligations, which affected the fair value of our whole loans. We also incorrectly calculated the fair value of our HTM securities and debt. For our guaranty obligations, we did not appropriately consider an estimate of the return on capital required by a third party to assume our liability. Correcting this error resulted in an increase in our guaranty obligations of approximately $1.2 billion (net of tax) and a decrease in the fair value of our whole loans of approximately $200 million (net of tax). This increase in the fair value of our guaranty obligations, coupled with other fair value changes made in re-estimating the guaranty components, resulted in a decrease in the fair value of our net guaranty assets of approximately $1.7 billion (net of tax) as of December 31, 2003. For our HTM securities, we did not


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appropriately consider security characteristics and aggregation in developing our estimate of fair value. Correcting these errors resulted in a reduction in the fair value of these assets of approximately $800 million (net of tax) as of December 31, 2003, which was primarily due to changes in the estimated fair values of mortgage revenue bonds and REMICs. For our debt, we did not appropriately exclude certain commission costs associated with the issuance of new debt securities in creating the yield curve we used for estimating fair value. Correcting this error resulted in an increase in the estimated fair value of our debt of approximately $300 million (net of tax) as of December 31, 2003. For our out-of-the-money derivative options, we did not fully incorporate available market information that differentiates at-the-money volatilities from out-of-the-money volatilities in estimating fair value. Correcting the error resulted in a decrease in the estimated fair value of our derivatives of approximately $200 million (net of tax) as of December 31, 2003. To correct these errors, we recalculated the fair value of these items using new assumptions, observable data and appropriate levels of specificity. The impact of recalculating the estimated fair value of these items is reflected in “Notes to Consolidated Financial Statements — Note 19, Fair Value of Financial Instruments.”
 
Financial Statement Impact
 
The following tables display the net impact of restatement adjustments in the previously issued consolidated balance sheets, consolidated statements of income, consolidated statements of cash flows and regulatory capital for 2003 and 2002. In addition, we have included tables displaying the net impact of restatement adjustments on stockholders’ equity and in the consolidated balance sheet as of December 31, 2001. The following consolidated financial statements are presented in a condensed format.
 
Balance Sheet Impact
 
The following table displays the cumulative impact of the restatement on the condensed consolidated balance sheet through and as of December 31, 2003.
 
Table 2:  Balance Sheet Impact of Restatement as of December 31, 2003
 
                                                                                 
    Restatement Adjustments for:  
                            MBS Trust
    Financial
    Amortization
                   
    As
                      Consolidation
    Guaranties
    of Cost
          Total
       
    Previously
    Debt and
          Investments
    and Sale
    and Master
    Basis
    Other
    Restatement
    As
 
    Reported(a)     Derivatives     Commitments     in Securities     Accounting     Servicing     Adjustments     Adjustments     Adjustments     Restated  
    (Dollars in millions)  
 
Assets:
                                                                               
Investments in securities
  $ 712,763     $     $ 3,479     $ 5,458     $ (153,971 )   $     $ (401 )   $ (258 )   $ (145,693 )(b)   $ 567,070  
Mortgage loans
    240,844             874       115       162,780             (519 )     (5,033 )     158,217 (c)     399,061  
Derivative assets at fair value
    8,191       (1,014 )     8                               33       (973 )(d)     7,218  
Guaranty assets
    5,666                         (200 )     (1,184 )                 (1,384 )(e)     4,282  
Deferred tax assets
    9,142       (2,221 )     (2,613 )     (646 )     (175 )     (106 )     332       369       (5,060 )(f)     4,082  
Other assets
    32,963       (1,760 )     3,097       (3,685 )     487       (411 )     10       9,861       7,599 (g)     40,562  
                                                                                 
Total assets
  $ 1,009,569     $ (4,995 )   $ 4,845     $ 1,242     $ 8,921     $ (1,701 )   $ (578 )   $ 4,972     $ 12,706     $ 1,022,275  
                                                                                 
Liabilities and Stockholders’ Equity
                                                                               
Liabilities:
                                                                               
Debt
  $ 958,064     $ (6,748 )   $     $     $ 9,906     $     $     $ 58     $ 3,216 (h)   $ 961,280  
Derivative liabilities at fair value
    1,600       1,632       (7 )                                   1,625 (d)     3,225  
Guaranty obligations
    5,666                         (796 )     1,531                   735 (i)     6,401  
Other liabilities
    21,815       (4,002 )     (1 )     37       (507 )     (3,442 )     39       5,157       (2,719 )(j)     19,096  
                                                                                 
Total liabilities
    987,145       (9,118 )     (8 )     37       8,603       (1,911 )     39       5,215       2,857       990,002  
                                                                                 
Minority interests in consolidated subsidiaries
    51                                           (46 )     (46 )     5  
Stockholders’ Equity:
                                                                               
Retained earnings
    35,496       (8,079 )     2,399       (1,106 )     118       101       (688 )     (318 )     (7,573 )(k)     27,923  
Accumulated other comprehensive income (loss)
    (12,032 )     12,202       2,454       2,311       200       109       71             17,347 (l)     5,315  
Other stockholders’ equity
    (1,091 )                                         121       121       (970 )
                                                                                 
Total stockholders’ equity
    22,373       4,123       4,853       1,205       318       210       (617 )     (197 )     9,895       32,268  
                                                                                 
Total liabilities and stockholders’ equity
  $ 1,009,569     $ (4,995 )   $ 4,845     $ 1,242     $ 8,921     $ (1,701 )   $ (578 )   $ 4,972     $ 12,706     $ 1,022,275  
                                                                                 


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(a) Certain previously reported balances have been reclassified to conform to the current condensed consolidated balance sheet presentation, as described in “Notes to Consolidated Financial Statements—Note 2, Summary of Significant Accounting Policies.”
 
(b) Reflects the impact of MBS trust consolidation and sale accounting; the derecognition of HTM securities at amortized cost and recognition of AFS and trading securities at fair value; the reversal of the SFAS 149 transition adjustment and recognition of revised securities commitment basis adjustments; the recognition of revised amortization on securities cost basis adjustments; and the derecognition of securities related to failed dollar roll repurchase transactions that did not meet the criteria for secured borrowing accounting.
 
(c) Reflects the impact of MBS trust consolidation and sale accounting; the reclassification of “Mortgage loans” to “Advances to lenders;” the recognition of revised mortgage loan commitment basis adjustments; the recognition of the LOCOM adjustment for loans classified as HFS; and the recognition of revised amortization on mortgage loan cost basis adjustments.
 
(d) Reflects the reclassification of interest rate swap accruals from accrued interest and recognition of derivative fair value adjustments.
 
(e) Reflects the impairment of guaranty assets; the reversal of buy-up amounts included in the basis of the guaranty assets; and the derecognition of guaranty arrangements upon consolidation.
 
(f) Reflects the impact of restatement adjustments on deferred taxes and the correction of tax credit-related errors associated with partnership investments.
 
(g) Reflects the reclassification of interest rate swap accruals to “Derivative assets at fair value;” the reclassification of “Advances to lenders” from “Mortgage loans;” the impairment of buy-ups; the recognition of “Restricted cash” and “Cash and cash equivalents” related to collateral received from derivatives counterparties; and the impact of cost basis transfers between error categories.
 
(h) Reflects the reversal of previously recorded unrealized gains and losses on the hedged items associated with fair value hedges; the recognition of revised amortization of debt basis adjustments; and the recognition of short-term and long-term debt upon consolidation of MBS trusts in which we own less than 100% of the related securities.
 
(i) Reflects the valuation adjustment related to the guaranty obligations; the reclassification of buy-downs and risk-based pricing adjustments from “Other liabilities;” and the derecognition of guaranty arrangements upon consolidation.
 
(j) Reflects the reclassification of interest rate swap accruals to “Derivative liabilities at fair value;” the reversal of short-term debt associated with failed dollar roll repurchase transactions; the reclassification of buy-downs and risk-based pricing adjustments to “Guaranty obligations;” and the recognition of liabilities to derivative counterparties associated with restricted cash.
 
(k) Reflects the recognition of derivative fair value adjustments to the consolidated statements of income and other income or expense related adjustments.
 
(l) Reflects the reversal of previously recorded derivatives fair value adjustments and the recognition of unrealized gains (losses) on AFS securities and buy-ups.


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The following table displays the cumulative impact of the restatement on the condensed consolidated balance sheet through and as of December 31, 2002.
 
Table 3:  Balance Sheet Impact of Restatement as of December 31, 2002
 
                                                                                 
    Restatement Adjustments for:  
                            MBS Trust
    Financial
    Amortization
                   
    As
                      Consolidation
    Guaranties
    of Cost
          Total
       
    Previously
    Debt and
          Investments
    and Sale
    and Master
    Basis
    Other
    Restatement
    As
 
    Reported(a)     Derivatives     Commitments     in Securities     Accounting     Servicing     Adjustments     Adjustments     Adjustments     Restated  
    (Dollars in millions)  
 
Assets:
                                                                               
Investments in securities
  $ 650,616     $     $ 230     $ 33,278     $ (128,809 )   $     $ 558     $ (20,788 )   $ (115,531 )(b)   $ 535,085  
Mortgage loans
    206,905             683       (20,576 )     136,097             (291 )     1,552       117,465 (c)     324,370  
Derivative assets at fair value
    3,666       (297 )     1,554                                     1,257 (d)     4,923  
Deferred tax assets
    8,053       (2,885 )     (2,035 )     (2,969 )     (309 )     (23 )     (111 )     279       (8,053 )(e)      
Other assets
    18,275       (501 )     3,737       (4,539 )     674       (864 )     108       23,471       22,086 (f)     40,361  
                                                                                 
Total assets
  $ 887,515     $ (3,683 )   $ 4,169     $ 5,194     $ 7,653     $ (887 )   <