10-Q 1 w99629e10vq.htm FORM 10-Q FEDERAL NATIONAL MORTGAGE ASSOCIATION e10vq
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 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
  20016
Washington, DC
  (Zip Code)
(Address of principal executive offices)
   

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

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

x Yes                    o No

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

o Yes                    x No

As of the close of business on July 31, 2004, there were 967,903,726 shares of common stock outstanding.




CROSS-REFERENCE INDEX TO FORM 10-Q

               
Page

   FINANCIAL INFORMATION     1  
   FINANCIAL STATEMENTS     44  
     Report of Independent Registered Public Accounting Firm     44  
     Statements of Income     45  
     Balance Sheets     46  
     Statements of Changes in Stockholders’ Equity     47  
     Statements of Cash Flows     48  
     Notes to Financial Statements     49  
   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS     1  
     Selected Financial Data     1  
     Executive Summary     3  
       About Fannie Mae     3  
       Market Dynamics     3  
       Performance Overview     4  
       Regulatory Developments     5  
     Reported Results of Operations     6  
       Net Interest Income     6  
       Guaranty Fee Income     8  
       Fee and Other Income (Expense), Net     9  
       Credit-Related Expense     10  
       Administrative Expenses     10  
       Purchased Options Expense     11  
       Debt Extinguishments, Net     11  
       Income Taxes     11  
     Critical Accounting Policies and Estimates     12  
       Allowance for Loan Losses and Guaranty Liability for MBS     12  
       Deferred Price Adjustments     12  
       Other-Than-Temporary Impairment     13  
     Core Business Earnings and Business Segment Results     14  
       Core Business Earnings     14  
       Business Segment Results     20  
     Portfolio Investment Business Operations     21  
       Investments     21  
       Funding     25  
       Interest Rate Risk Management     35  
     Credit Guaranty Business Operations     36  
       Off-Balance Sheet Transactions     36  
       Credit Risk Management     37  
     Liquidity and Capital Resources     39  
       Liquidity     39  
       Capital Resources     40  
     Pending Accounting Pronouncements     43  
       SOP 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer     43  
   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK     61  
   CONTROLS AND PROCEDURES     61  
   OTHER INFORMATION     62  
   LEGAL PROCEEDINGS     62  
   CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES     63  
   DEFAULTS UPON SENIOR SECURITIES     64  
   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS     64  
   OTHER INFORMATION     65  
   EXHIBITS AND REPORTS ON FORM 8-K     65  
 SIGNATURES     67  
 INDEX TO EXHIBITS     68  
 Exhibit 10.1 -- Employment Agreement Franklin D. Raines
 Exhibit 10.2 -- Employment Agreement Daniel H. Mudd
 Exhibit 10.3 -- Employment Agreement J. Timothy Howard
 Exhibit 31.1 -- Rule 13a-14 Certification of CEO
 Exhibit 31.2 -- Rule 13a-14 Certification of CFO
 Exhibit 32.1 -- Sarbanes-Oxley Certification of CEO
 Exhibit 32.2 -- Sarbanes-Oxley Certification of CFO


Table of Contents

TABLE REFERENCE

                 
Table Description Page



      Selected Financial Data     1  
  1     Net Interest Yield     6  
  2     Rate/Volume Analysis of Reported Net Interest Income     8  
  3     Guaranty Fee Data     8  
  4     Reconciliation of Core Business Earnings to Reported Results     16  
  5     Core Taxable-Equivalent Revenues     17  
  6     Net Interest Margin     18  
  7     Rate/Volume Analysis of Core Net Interest Income     19  
  8     Mortgage Portfolio Activity     21  
  9     Mortgage Portfolio Composition     22  
  10     Credit Ratings of Private Label Mortgage-Related Securities Secured by Manufactured Housing Loans     23  
  11     Mortgage Commitments     24  
  12     Master Delivery and Optional Purchase Commitments     25  
  13     Nonmortgage Investments     25  
  14     Debt Activity     26  
  15     Activity and Maturity Data for Derivative Instruments     26  
  16     Effect of Derivatives on Outstanding Debt     27  
  17     Effective Variable-Rate and Fixed-Rate Debt     28  
  18     Maturities of Effective Long-Term Debt     28  
  19     Reconciliation of Debt Redemption Amount to Total Reported Debt     28  
  20     Credit Loss Exposure of Derivative Instruments     30  
  21     Notional and Fair Value of Derivatives by Hedge Designation     31  
  22     Other Risk Management Derivatives Activity     32  
  23     AOCI Activity Related to Derivatives Designated as Cash Flow Hedges     33  
  24     AOCI Amounts Reclassified to Earnings     34  
  25     Net Interest Income at Risk     35  
  26     Guaranteed MBS and Credit Enhancements     37  
  27     Composition of Mortgage Credit Book of Business     38  
  28     Mortgage Credit Performance     38  
  29     Conventional Single-Family Serious Delinquency Rates     39  
  30     Capital Requirements     41  
  31     Regulatory Stress Test Results     41  
  32     AOCI Components     42  

The interim financial information provided in this report reflects all adjustments that, in the opinion of management, are necessary for a fair presentation of the results for such periods. Such adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q. The results of operations in our interim financial statements are not necessarily indicative of the results that may be expected for the full year. The interim financial information should be read in conjunction with Fannie Mae’s 2003 Annual Report on Form 10-K, filed with the Securities and Exchange Commission (“SEC”) and available on our Web site at www.fanniemae.com/ir and the SEC’s Web site at www.sec.gov under “Federal National Mortgage Association” or CIK number 0000310522. We do not intend these internet addresses to be active links. Therefore, other than the portions of our 2003 Annual Report on Form 10-K explicitly stated to be incorporated herein, the information that appears on these Web sites is not incorporated into this Form 10-Q.

This report on Form 10-Q highlights significant factors influencing Fannie Mae’s results of operations and financial condition. Management’s Discussion and Analysis and other sections of our Form 10-Q contain forward-looking statements based on management’s estimates of trends and economic factors in the markets in which Fannie Mae is active as well as the company’s business plans. Such estimates and plans may change without notice and future results may vary from expected results if there are significant changes in economic, regulatory, or legislative conditions affecting Fannie Mae or its competitors. For a discussion of these factors, investors should review our Annual Report on Form 10-K for the year ended December 31, 2003. We undertake no duty to update these forward-looking statements.


Table of Contents

PART I—FINANCIAL INFORMATION

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

SELECTED FINANCIAL DATA

The following selected financial data includes performance measures and ratios based on our reported results and core business earnings, a supplemental non-GAAP (generally accepted accounting principles) measure used by management in operating our business. Our core business earnings measures are not defined terms within GAAP and may not be comparable to similarly titled measures presented by other companies. See “Management’s Discussion and Analysis (‘MD&A’)— Reported Results and Core Business Earnings” for a discussion of how we use core business earnings measures and why we believe they are helpful to investors. Our results for the three and six-month periods ended June 30, 2004 and 2003 are unaudited and, in the opinion of management, include all adjustments of a normal recurring nature necessary for a fair presentation. We have reclassified certain prior period amounts to conform to our current year presentation. Results for the reported period are not necessarily indicative of the results that may be expected for the full year.

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


2004 2003 2004 2003




(Dollars and shares in millions,
except per share amounts)
Reported Earnings Data:
                               
 
Net income
  $ 1,112     $ 1,102     $ 3,012     $ 3,042  
Preferred stock dividends and issuance costs on redemptions
    (40 )     (34 )     (84 )     (64 )
     
     
     
     
 
Net income available to common stockholders
  $ 1,072     $ 1,068     $ 2,928     $ 2,978  
     
     
     
     
 
Basic earnings per common share
  $ 1.11     $ 1.09     $ 3.02     $ 3.03  
Diluted earnings per common share
    1.10       1.09       3.01       3.02  
Weighted-average diluted common shares outstanding
    970       982       973       987  
Cash dividends per common share
  $ .52     $ .39     $ 1.04     $ .78  
Net interest yield, taxable-equivalent basis
    1.37 %     1.63 %     1.38 %     1.61 %
Return on average assets
    .43       .47       .59       .66  
Return on common equity
    21.2       31.3       30.6       43.1  
Average equity to average assets
    2.5       1.9       2.3       1.9  
Dividend payout ratio
    47.0       35.8       34.5       25.8  
Ratio of earnings to combined fixed charges and preferred stock dividends(1)
    1.14:1       1.15:1       1.21:1       1.21:1  
 
Core Business Earnings Data:(2)
                               
 
Core business earnings(3)
  $ 1,896     $ 1,860     $ 3,916     $ 3,710  
Core business earnings per diluted common share
    1.91       1.86       3.94       3.70  
Core taxable-equivalent revenues(4)
    3,259       3,980       6,786       7,583  
Net interest margin, taxable-equivalent basis(5)
    1.04 %     1.30 %     1.05 %     1.28 %
Core return on average assets(6)
    .75       .80       .77       .80  
Core return on average realized common equity(7)
    23.4       27.7       24.5       27.9  
                                   
June 30, December 31,
2004 2003


Balance Sheet Data:
                               
 
Mortgage portfolio, net
  $ 891,386     $ 901,802                  
Liquid assets(8)
    51,664       65,148                  
Total assets
    989,341       1,009,569                  
Borrowings:
                               
 
Due within one year
    424,372       483,193                  
 
Due after one year
    515,296       478,539                  
Total liabilities
    963,220       987,196                  
Preferred stock
    4,108       4,108                  
Stockholders’ equity
    26,121       22,373                  
Core capital(9)
    36,115       34,405                  
Total capital(10)
    36,862       35,182                  

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


Other Performance Measures: 2004 2003 2004 2003





Average effective guaranty fee rate(11)
    .194 %     .212 %     .207 %     .208 %
Credit loss ratio(12)
    .003       .005       .002       .004  
Administrative expense ratio(13)
    .069       .071       .069       .072  
Efficiency ratio(14)
    11.8       8.9       11.3       9.2  
Mortgage purchases(15)
  $ 91,299     $ 127,960     $ 132,303     $ 259,965  
MBS issues acquired by others(16)
    134,595       282,502       256,603       486,435  
Business volume(17)
    225,894       410,462       388,906       746,400  
                                 
June 30, December 31,
2004 2003


Gross mortgage portfolio(18)
  $ 891,210     $ 898,445                  
Outstanding MBS(19)
    1,360,045       1,300,166                  
Book of business(20)
    2,251,255       2,198,611                  


  (1)  For purposes of this ratio, “earnings” includes reported net income plus (a) provision for federal income taxes and (b) fixed charges. Fixed charges include interest expense. “Combined fixed charges and preferred stock dividends” include (a) fixed charges, (b) preferred stock dividends, and (c) issuance costs on redemptions of preferred stock.
 
  (2)  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations— Core Business Earnings and Business Segment Results” for additional discussion of our supplemental non-GAAP (generally accepted accounting principles) core business earnings measures and for a reconciliation to comparable GAAP measures.
 
  (3)  Core business earnings is a non-GAAP measure developed by management in conjunction with the adoption of FAS 133 to evaluate and assess the quality of Fannie Mae’s earnings from its principal business activities on a consistent basis. Core business earnings is presented on a net of tax basis and excludes changes in the time value of purchased options recorded under FAS 133 and includes purchased options premiums amortized over the original estimated life of the option and any acceleration of expense related to options extinguished prior to exercise.
 
  (4)  A non-GAAP measure that includes revenues net of operating losses, primarily on low-income housing tax credit limited partnerships, and purchased options premiums amortization expense, adjusted to include taxable-equivalent amounts of tax-exempt income using the applicable federal income tax rate of 35 percent.
 
  (5)  A non-GAAP measure calculated based on annualized core net interest income on a tax-equivalent basis divided by the weighted average net investment balance.
 
  (6)  A non-GAAP measure calculated based on annualized core business earnings less preferred stock dividends and issuance costs on redemptions divided by average assets.
 
  (7)  A non-GAAP measure calculated based on annualized core business earnings less preferred stock dividends and issuance costs on redemptions divided by average realized common stockholders’ equity (common stockholders’ equity excluding accumulated other comprehensive income).
 
  (8)  Liquid assets include (a) cash and cash equivalents less any pledged collateral, (b) nonmortgage investments, and (c) mortgage assets designated for securitization.
 
  (9)  Core capital represents a regulatory measure of capital that includes the sum of (a) the stated value of common stock, (b) the stated value of outstanding noncumulative perpetual preferred stock, (c) paid-in capital, and (d) retained earnings, less treasury stock.

(10)  Total capital represents a regulatory measure of capital. Total capital includes the sum of (a) core capital and (b) the total allowance for loan losses and guaranty liability for MBS, less (c) the specific loss allowance. Specific loss allowances totaled $10 million and $20 million at June 30, 2004 and December 31, 2003, respectively.
 
(11)  Annualized guaranty fee income as a percentage of average outstanding MBS.
 
(12)  Annualized charge-offs and foreclosed property expense (income), net of recoveries, as a percentage of average mortgage credit book of business.
 
(13)  Annualized administrative expenses as a percentage of average gross mortgage portfolio and average outstanding MBS.
 
(14)  Administrative expenses as a percentage of core taxable-equivalent revenues.
 
(15)  Unpaid principal balance of loans, MBS, and other mortgage-related securities purchased by Fannie Mae during the reporting period.
 
(16)  Unpaid principal balance of MBS issued and guaranteed by Fannie Mae and acquired by investors other than Fannie Mae during the reporting period.
 
(17)  Business volume for the period includes the sum of (a) mortgage purchases and (b) MBS issues acquired by others.
 
(18)  Unpaid principal balance of mortgages held in portfolio, excluding the effect of unrealized gains or losses on available-for-sale securities, unrealized losses on held-for-sale loans, deferred balances, and the allowance for loan losses.
 
(19)  Unpaid principal balance of MBS guaranteed by Fannie Mae and held by investors other than Fannie Mae.
 
(20)  Book of business includes the sum of (a) gross mortgage portfolio and (b) outstanding MBS.

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Reported Results and Core Business Earnings

Our reported results, which are based on GAAP, may fluctuate significantly from period to period because of the accounting for purchased options under Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities (“FAS 133”). FAS 133 requires that we record in earnings changes in the time value of purchased options that we use to manage interest rate risk; however, we do not record in earnings changes in the intrinsic value of some of those options or similar changes in the fair value of options in all of our callable debt or mortgage assets. We expect changes in the time value of purchased options to create temporary unrealized gains and losses that will often vary substantially from period to period with changes in interest rates, expected interest rate volatility, and derivatives activity.

Management also tracks and analyzes Fannie Mae’s financial results based on “core business earnings.” We developed core business earnings as a supplemental non-GAAP measure in conjunction with our January 1, 2001 adoption of FAS 133 to adjust for accounting differences between alternative transactions we use to hedge interest rate risk that produce similar economic results but require different accounting treatment under FAS 133. For example, our core business earnings measure allows management and investors to evaluate the quality of earnings from Fannie Mae’s principal business activities in a way that accounts for comparable hedging transactions in a similar manner. While the core business earnings measure is not a substitute for GAAP net income, we rely on core business earnings in operating our business because we believe core business earnings provides our management and investors with a better measure of our financial results and better reflects our risk management strategies than our GAAP net income. We provide additional information on our core business earnings results in “MD&A—Core Business Earnings and Business Segment Results.”

EXECUTIVE SUMMARY

About Fannie Mae

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

We generate revenues by investing in and managing one primary asset class— residential mortgage assets (in the form of mortgage loans and mortgage-related securities) through two complementary business lines: our Portfolio Investment business and our Credit Guaranty business.

Market Dynamics

In the second quarter of 2004, our market began to fully reflect the impact of a transition we had anticipated for some time— from an environment of extremely low interest rates and record mortgage refinance volume to one of higher rates with very low levels of refinance-driven volume. We expect this transition to reduce mortgage originations by as much as $1 trillion in 2004, from the unprecedented refinance-driven origination level of $3.7 trillion in 2003. We anticipate this year’s volume of mortgages for home purchases to slightly exceed last year’s record levels, helping to support still robust growth in total mortgage debt outstanding in a range of 9-10 percent for the full year.

The second quarter included a complete reversal of the decline in interest rates at the end of the first quarter of the year, reflecting the impact of actual and anticipated tightening actions by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The relative increases in short- and long-term interest rates led to a notable flattening of the yield curve. Interest rates on thirty-year fixed rate mortgages rose from an average of 5.52 percent at the end of March 2004 to 6.21 percent by the end of

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June. The changing interest rate environment had a pronounced effect on our competitive market— affecting mortgage product mix, competition for mortgage assets, and the level of issuances of mortgage-related securities by entities other than Fannie Mae, Freddie Mac, or Ginnie Mae (known as “private label securities”)— all of which have had a notable impact on our financial results.

Rising mortgage rates and home price appreciation that remained generally strong resulted in a significant shift in the product mix of mortgage originations, with an increasing proportion of borrowers choosing alternative mortgage products, such as adjustable-rate mortgages (“ARMs”) and hybrid mortgages, to maintain affordability. Although we expect purchases of these products for our portfolio to provide economic profits over their lives similar to a fixed-rate mortgage, they typically have lower initial purchase spreads. In addition to the shift in product mix, competition for mortgage assets remained intense by historical standards, with depositories continuing to add to their mortgage holdings during the second quarter of 2004, although at a more moderate pace. Finally, since the beginning of 2004 the market share of private label mortgage-related securities has increased dramatically. This increase reflects modest contraction in the spreads between private label securities and Fannie Mae MBS in general, and considerable contraction of spreads on subordinated tranches of private label issuance representing higher credit risk product.

These factors directly affected growth in our mortgage portfolio and MBS during the second quarter of 2004. Despite the changed product mix and continued heightened competition for mortgage assets, our mortgage portfolio returned to positive growth in the second quarter of 2004 following two consecutive quarters of negative growth, reflecting modest improvements in mortgage-to-debt spreads and a substantial decline in mortgage liquidations in the latter part of the quarter. Our combined book of business, which includes our gross mortgage portfolio and outstanding MBS, grew 4 percent on an annualized basis during the second quarter of 2004. For the first six months of 2004, our combined book of business expanded at a 5 percent annualized rate, reflecting annualized growth of 9 percent in outstanding MBS that offset a 2 percent annualized decline in our mortgage portfolio.

The changing mix of mortgage assets made available in the secondary market and the sustained level of competition for mortgage assets affected earnings growth for both our Portfolio Investment and Credit Guaranty businesses, which we discuss in more detail in “MD&A—Core Business Earnings and Business Segment Results.”

Performance Overview

Despite significant challenges in our competitive environment, we delivered solid business results that reflected our continued focus on disciplined risk management. We reported net income and diluted earnings per common share (“EPS”) of $1.112 billion and $1.10, respectively, for the second quarter of 2004, substantially unchanged from the same period last year. Our results for the second quarter reflect the benefits from a $764 million reduction in losses on the call and repurchase of debt, guaranty fee income growth of $25 million or 4 percent, and lower than expected credit losses, which were offset by a $402 million decrease in fee and other income, a $388 million or 11 percent decline in reported net interest income, and a $97 million increase in expense related to the time value of our purchased options that was due primarily to fluctuations in interest rates and interest rate volatility. The decrease in fee and other income resulted largely from recognizing $278 million of other-than-temporary impairment expense in the second quarter of 2004. The substantial majority— $265 million— of this amount related to recognizing additional impairment on our investment in non-agency securities, including manufactured housing securities, which resulted from a change in our estimation process for identifying and recognizing when other-than-temporary impairment, as defined by our regulator, has occurred. Non-agency securities include any debt security issued by an entity other than the government-sponsored enterprises Fannie Mae, Freddie Mac, or Ginnie Mae. We provide additional detail on the change to our other-than-temporary impairment estimation process and its effect in “MD&A— Critical Accounting Policies and Estimates— Other-Than-Temporary Impairment.”

We reported net income of $3.012 billion and diluted EPS of $3.01 for the first six months of 2004, a decrease of less than 1 percent from the same period last year. A $1.129 billion reduction in losses on the

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call and repurchase of debt, growth in guaranty fee income of $215 million or 18 percent, and lower than expected credit losses had a favorable impact on our results. A $560 million or 8 percent decline in reported net interest income, a $513 million decrease in fee and other income that was due in part to the increase in other-than-temporary impairment expense during the second quarter of 2004, and a $431 million increase in purchased options expense reduced reported net income for the first six months of 2004.

Our core business earnings for the second quarter of 2004 increased 2 percent over the second quarter of 2003 to $1.896 billion, while core business diluted earnings per share increased 3 percent to $1.91. Growth in core business earnings was driven by the $764 million reduction in losses on the call and repurchase of debt and increase in guaranty fee income, which were partially offset by a $445 million or 16 percent decline in core net interest income resulting from the narrowing of our net interest margin and the decrease in fee and other income that was due in part to the increase in other-than-temporary impairment expense resulting from the change in our estimation process.

Core business earnings and core business diluted earnings per share for the first six months of 2004 increased 6 percent over the prior year period to $3.916 billion and $3.94, respectively, reflecting the benefit of reduced losses on the call and repurchase of debt and growth in guaranty fee income that were partially offset by a $627 million or 12 percent decline in core net interest income and decrease in fee and other income from the other-than-temporary impairment expense resulting from the revision to our estimation process.

Regulatory Developments

Our regulator, the Office of Federal Housing Enterprise Oversight (“OFHEO”), is conducting a special examination of the accounting policies and practices at Fannie Mae. The special examination is ongoing. We have provided OFHEO, at its request, a considerable amount of information and documentation and will continue to do so. We also are making available to OFHEO a number of our employees as part of the examination. We continue to meet with OFHEO staff frequently on a range of issues at their request.

OFHEO required us to change our estimation process for identifying and recognizing when other-than-temporary impairment has occurred on non-agency securities effective April 1, 2004. Consistent with OFHEO’s directive, we continue to account for these securities in accordance with the provisions of Financial Accounting Standard No. 115, Accounting for Certain Investments in Debt and Equity Securities (“FAS 115”). We provide additional detail on the change to our other-than-temporary impairment estimation process and its effect in “MD&A—Critical Accounting Policies and Estimates— Other-Than-Temporary Impairment.”

On April 12, 2004, OFHEO published a proposed regulation seeking to amend its corporate governance regulation that would change a number of the corporate governance standards applicable to Fannie Mae and Freddie Mac. Fannie Mae filed its comments on the proposal with OFHEO on June 11, 2004. The Nominating and Corporate Governance Committee of Fannie Mae’s Board of Directors filed separate comments on the proposal.

On May 3, 2004, the U.S. Department of Housing and Urban Development (“HUD”) published a proposal to amend its housing goals regulation. The regulation mandates goals for Fannie Mae’s and Freddie Mac’s overall mix of business— that is, the ratio of “goals business” to “non-goals business” that the companies must achieve each year. It imposes percent-of-business goals relating to the purchase or securitization of mortgages in three statutorily defined categories: loans to low- and moderate-income borrowers, loans to underserved areas, and special affordable housing. The proposed rule seeks to increase the housing goals in these three categories for Fannie Mae and Freddie Mac for calendar years 2005 through 2008; establish new subgoals for purchases of single-family, owner-occupied purchase money mortgages for the same period; and establish new data verification procedures, among other things. Fannie Mae filed comments on the proposal with HUD on July 16, 2004.

The proposed housing goals are designed to change the companies’ current mix of business. If the goals are adopted as proposed, and the mandated business mix goes beyond the mix of business available to us

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in the market, we may be forced to over-invest in market categories that are more likely to generate goals-qualifying mortgages or to reduce our investment in non goals-qualifying mortgages. We expect that HUD will issue a final regulation prior to the end of 2004, and possibly early enough so that the new requirements will be effective beginning in 2005. However, we cannot predict whether the final rule will be the same as or similar to the proposed rule. Accordingly, we are uncertain as to the effect the final regulation may have on our business.

REPORTED RESULTS OF OPERATIONS

Net Interest Income

Table 1 presents Fannie Mae’s net interest yield based on reported net interest income calculated on a taxable-equivalent basis. Our net interest yield calculation subsequent to the adoption of FAS 133 does not fully reflect the cost of our purchased options (see “MD&A—Core Business Earnings and Business Segment Results— Core Net Interest Income” for a discussion of our supplemental non-GAAP measures, core net interest income, and net interest margin).

Table 1: Net Interest Yield

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


2004 2003 2004 2003




(Dollars in millions)
Taxable-equivalent net interest income:
                               
Interest income:
                               
 
Mortgage portfolio
  $ 11,794     $ 12,256     $ 23,909     $ 24,846  
 
Liquid investments
    261       336       490       642  
     
     
     
     
 
 
Total interest income
    12,055       12,592       24,399       25,488  
     
     
     
     
 
Interest expense:(1)
                               
 
Short-term debt(2)
    750       697       1,463       1,447  
 
Long-term debt(3)
    8,192       8,394       16,627       17,172  
     
     
     
     
 
 
Total interest expense
    8,942       9,091       18,090       18,619  
     
     
     
     
 
Net interest income
    3,113       3,501       6,309       6,869  
Taxable-equivalent adjustment on tax-exempt investments (4)
    119       119       238       242  
     
     
     
     
 
Taxable-equivalent net interest income
  $ 3,232     $ 3,620     $ 6,547     $ 7,111  
     
     
     
     
 
Average balances:(5)
                               
Interest-earning assets:(6)
                               
 
Mortgage portfolio, net
  $ 870,229     $ 808,215     $ 876,615     $ 806,510  
 
Liquid investments
    76,732       81,966       71,629       74,550  
     
     
     
     
 
Total interest-earning assets
    946,961       890,181       948,244       881,060  
 
Interest-free funds(7)
    (20,407 )     (32,431 )     (21,242 )     (30,432 )
     
     
     
     
 
Total interest-earning assets funded by debt
  $ 926,554     $ 857,750     $ 927,002     $ 850,628  
     
     
     
     
 
Interest-bearing liabilities:(1)
                               
 
Short-term debt(2)
  $ 272,263     $ 231,718     $ 270,470     $ 221,063  
 
Long-term debt(3)
    654,291       626,032       656,532       629,565  
     
     
     
     
 
Total interest-bearing liabilities
  $ 926,554     $ 857,750     $ 927,002     $ 850,628  
     
     
     
     
 
Average interest rates:(4,5)
                               
Interest-earning assets:
                               
 
Mortgage portfolio, net
    5.43 %     6.07 %     5.47 %     6.17 %
 
Liquid investments
    1.39       1.66       1.40       1.74  
     
     
     
     
 
Total interest-earning assets
    5.10       5.66       5.16       5.80  
 
Interest-free return(7)
    .13       .21       .12       .18  
     
     
     
     
 
Total interest-earning assets and interest-free return
    5.23       5.87       5.28       5.98  
     
     
     
     
 
Interest-bearing liabilities:(1)
                               
 
Short-term debt(2)
    1.09       1.19       1.07       1.29  
 
Long-term debt(3)
    5.02       5.36       5.07       5.46  
     
     
     
     
 
Total interest-bearing liabilities
    3.86       4.24       3.90       4.37  
     
     
     
     
 
Net interest yield, taxable-equivalent basis
    1.37 %     1.63 %     1.38 %     1.61 %
     
     
     
     
 

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(1)  Classification of interest expense and interest-bearing liabilities as short-term or long-term is based on effective maturity or repricing date of outstanding debt, taking into consideration the effect of derivative financial instruments.
 
(2)  Short-term debt includes debt scheduled to reprice in one year or less, taking into consideration the effect of derivative instruments.
 
(3)  Long-term debt includes debt scheduled to reprice after one year, taking into consideration the effect of derivative instruments.
 
(4)  Reflects non-GAAP adjustments to permit comparison of yields on tax-exempt and taxable assets based on a 35 percent marginal tax rate.
 
(5)  Averages have been calculated on a monthly basis based on amortized cost.
 
(6)  Includes average balance of nonaccrual loans of $6.6 billion and $5.9 billion for the three months ended June 30, 2004 and 2003, respectively, and $6.6 billion and $5.8 billion for the six months ended June 30, 2004 and 2003, respectively.
 
(7)  Interest-free funds represent the portion of our investment portfolio funded by equity and non-interest bearing liabilities.

Reported net interest income for the second quarter of 2004 decreased 11 percent from the second quarter of 2003 to $3.113 billion, driven by a 16 percent (26 basis points) decline in our reported net interest yield to 1.37 percent that was partially offset by a 6 percent increase in our average net investment balance. Our average net investment balance (also referred to as total interest-earning assets) consists of our mortgage portfolio (net of unrealized gains and losses on available-for-sale securities and deferred balances) and liquid investments, excluding cash. Reported net interest income for the first six months of 2004 decreased 8 percent from the same prior year period to $6.309 billion, driven by a 14 percent (23 basis points) decline in our reported net interest yield to 1.38 percent that was partially offset by an 8 percent increase in our average net investment balance.

The decline in our net interest yield was primarily due to high levels of liquidations of higher yielding mortgages during the second half of 2003 and the purchase of lower yielding, current coupon mortgages. In addition, we extended the duration of our liabilities to offset the extended duration of our mortgage assets that resulted from the rise in interest rates.

Table 2 shows a rate/volume analysis of the changes in our reported net interest income between the three and six-month periods ended June 30, 2004 and 2003.

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

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



(Dollars in millions)
Second Quarter 2004 vs. Second Quarter 2003
                       
Interest income:
                       
 
Mortgage portfolio
  $ (462 )   $ 899     $ (1,361 )
 
Liquid investments
    (75 )     (21 )     (54 )
     
     
     
 
 
Total interest income
    (537 )     878       (1,415 )
     
     
     
 
Interest expense:(2)
                       
 
Short-term debt
    53       115       (62 )
 
Long-term debt
    (202 )     369       (571 )
     
     
     
 
 
Total interest expense
    (149 )     484       (633 )
     
     
     
 
Change in net interest income
  $ (388 )   $ 394     $ (782 )
     
     
     
 
Change in taxable-equivalent adjustment on tax-exempt investments(3)
                     
     
                 
Change in taxable-equivalent net interest income
  $ (388 )                
     
                 
First Six Months of 2004 vs. First Six Months of 2003
                       
Interest income:
                       
 
Mortgage portfolio
  $ (937 )   $ 2,053     $ (2,990 )
 
Liquid investments
    (152 )     (24 )     (128 )
     
     
     
 
 
Total interest income
    (1,089 )     2,029       (3,118 )
     
     
     
 
Interest expense:(2)
                       
 
Short-term debt
    16       292       (276 )
 
Long-term debt
    (545 )     717       (1,262 )
     
     
     
 
 
Total interest expense
    (529 )     1,009       (1,538 )
     
     
     
 
Change in net interest income
  $ (560 )   $ 1,020     $ (1,580 )
     
     
     
 
Change in taxable-equivalent adjustment on tax-exempt investments(3)
    (4 )                
     
                 
Change in taxable-equivalent net interest income
  $ (564 )                
     
                 


(1)  Combined rate/volume variances, a third element of the calculation, are allocated to the rate and volume variances based on their relative size.
(2)  Classification of interest expense and interest-bearing liabilities as short-term or long-term is based on effective maturity or repricing date, taking into consideration the effect of derivative financial instruments.
(3)  Reflects non-GAAP adjustments to permit comparison of yields on tax-exempt and taxable assets based on a 35 percent marginal tax rate.

Guaranty Fee Income

Table 3 compares guaranty fee income and our average effective guaranty fee rate for the three and six-month periods ended June 30, 2004 and 2003.

Table 3: Guaranty Fee Data

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


2004 2003 % Change 2004 2003 % Change






(Dollars in millions)
     
Guaranty fee income
  $ 657     $ 632       4 %   $ 1,394     $ 1,179       18 %
Average balance of outstanding MBS(1)
    1,355,868       1,193,264       14       1,344,654       1,134,797       18  
Average effective guaranty fee rate (basis points)
    19.4       21.2       (8 )     20.7       20.8        


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

Guaranty fee income for the second quarter of 2004 grew 4 percent over the second quarter of 2003 to $657 million, driven by 14 percent growth in average outstanding MBS that was partially offset by an

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8 percent decline in the average effective guaranty fee rate on outstanding MBS to 19.4 basis points. Guaranty fee income for the first six months of 2004 increased 18 percent to $1.394 billion, primarily due to 18 percent growth in average outstanding MBS combined with a slight decline in the average effective guaranty fee rate to 20.7 basis points.

Our issuance of single-family MBS was relatively low in the second quarter of 2004, resulting in an annualized growth in outstanding MBS of only 4 percent for the quarter and 9 percent for the first six months of 2004. MBS issues acquired by other investors fell by more than 50 percent to $135 billion in the second quarter of 2004, from $283 billion in the same prior year period. MBS issues acquired by other investors fell by 47 percent to $257 billion for the first six months of 2004, compared with $486 billion for the first six months of 2003.

The substantial decline in our MBS growth rate from the elevated levels of the past three years was due to a combination of factors, including the drop in mortgage origination volumes, the sustained high retention of mortgages by depository institutions supported by a continued rise in adjustable-rate mortgages, and a record level of issuances of private label securities backed largely by loans with higher credit risk. The decrease in our average effective guaranty fee rate reflects the effect of the rise in interest rates in the second quarter of 2004 and the resulting decrease in projected prepayments, which slowed our recognition of deferred fee income.

Fee and Other Income (Expense), Net

We recorded net expense of $170 million and $168 million in fee and other income for the second quarter and first six months of 2004, respectively, compared with income of $232 million and $345 million for the second quarter and first six months of 2003, respectively. Fee and other income includes transaction fees, technology fees, multifamily fees and other miscellaneous items and is net of credit enhancement expense and operating losses from tax-advantaged investments in affordable housing projects. We also include gains and losses on the sale of securities and any other-than-temporary impairment expense in fee and other income.

The decreases in fee and other income in the second quarter and first six months of 2004 were primarily due to the change in our process for estimating when other-than-temporary impairment has occurred and a reduction in transaction and technology fees. In the second quarter of 2004, we changed our estimation process for identifying and recognizing other-than-temporary impairment on our investment in non-agency securities that resulted in a $265 million pre-tax increase in other-than-temporary impairment expense and an $.18 per share decrease in diluted EPS for the three and six-month periods ended June 30, 2004. We provide additional detail on our revised estimation process in “MD&A—Critical Accounting Policies and Estimates— Other-Than-Temporary Impairment.” Other-than-temporary impairment expense, including the amount attributable to our revised estimation process, totaled $278 million for the second quarter of 2004 and $341 million for the first six months of 2004 and related primarily to the change in the process we now use to estimate when other-than-temporary impairment has occurred. Other-than-temporary impairment expense totaled $102 million and $197 million for the second quarter and first six months of 2003, primarily attributable to our investments in certain nonmortgage investments and manufactured housing securities.

Transaction and technology fees are largely driven by business volumes, which have fallen significantly in 2004, in part due to the decline in mortgage originations. Market-related transaction and technology fees for the second quarter and first six months of 2004 were substantially reduced relative to the same prior year periods. Transaction and technology fees in the second quarter and first six months of 2004 totaled $110 million and $218 million, respectively, down by more than 50 percent from the same prior year periods. Our business volume, which includes portfolio purchases and MBS issues acquired by other investors, fell to $226 billion and $389 billion in the second quarter and first six months of 2004, respectively, from $410 billion and $746 billion in the second quarter and first six months of 2003. We expect markedly lower total business volumes for full year 2004, which is likely to result in a considerable reduction in transaction and technology fees from the prior year.

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Credit-Related Expense

Credit-related expense, which includes foreclosed property expense (income) and the provision for losses, totaled $21 million of income in the second quarter of 2004, compared with $23 million of expense in the second quarter of 2003. Credit-related expense for the first six months of 2004 totaled $13 million of income, compared with $43 million of expense for the first six months of 2003.

The decrease in credit-related expense was due primarily to incorporating the continued lower-than-projected level of credit losses into the assessment of our allowance for loan losses and guaranty liability for MBS. Based on recent credit performance, we reduced the allowance for loan losses and guaranty liability for MBS to $757 million at June 30, 2004, from $795 million at March 31, 2004 and $797 million at December 31, 2003, and recorded a negative loss provision of $12 million for the second quarter of 2004 and an expense of $20 million for the first six months of 2004. In comparison, we recorded a provision for losses of $26 million and $49 million for the second quarter and first six months of 2003, respectively. We provide additional detail on the update to the assumptions used in estimating our allowance for loan losses and guaranty liability for MBS in “MD&A—Critical Accounting Policies and Estimates— Allowance for Loan Losses and Guaranty Liability for MBS.”

We recorded foreclosed property income of $9 million in the second quarter of 2004, up from $3 million of income in the second quarter of 2003. Foreclosed property income increased to $33 million for the first six months of 2004 from $6 million for the first six months of 2003. At the same time, acquisitions of single-family foreclosed properties increased to 8,146 and 16,259 for the second quarter and first six months of 2004, respectively, from 6,569 and 12,487 for the second quarter and first six months of 2003. The strong housing market, combined with our management of problem loans and protection through credit enhancements and other risk sharing agreements, has mitigated the impact of recent increases in foreclosure activity.

Credit-related losses, which include charge-offs plus foreclosed property expense (income), were significantly lower than expected during the second quarter of 2004, driven by the continuation of a very low average loss per case on foreclosed properties. Average severities on the sale of foreclosed properties have remained low by historical standards due to overall strong home prices and greater benefits from our credit loss sharing strategies than we had anticipated. Credit-related losses totaled $16 million in the second quarter of 2004, down from $23 million in the second quarter of 2003. Credit-related losses for the first six months of 2004 decreased $17 million from the same prior year period to $26 million. As our mortgage credit book of business becomes more seasoned, we continue to expect an upward trend in serious delinquency rates and foreclosures. As a result, we anticipate a moderate upward trend in credit losses during the remainder of the year. However, because of the extremely low levels of losses in the first six months of 2004, we believe that total losses for the year—on a larger mortgage credit book of business— may be no higher than losses recorded in 2003.

Administrative Expenses

Administrative expenses totaled $384 million and $767 million in the second quarter and first six months of 2004, respectively, up 8 percent and 10 percent over the second quarter and first six months of 2003, primarily due to the combined effect of annual salary increases, a 5 percent increase in the number of employees, and a higher level of stock compensation expense recognized under the fair value recognition provisions of Financial Accounting Standard No. 123, Accounting for Stock-Based Compensation (“FAS 123”), which we adopted on January 1, 2003.

We evaluate growth in administrative expenses in relation to growth in core taxable-equivalent revenues and our average book of business. Core taxable-equivalent revenues is a supplemental non-GAAP measure discussed further in “MD&A—Core Business Earnings and Business Segment Results.” The increase in administrative expenses and decrease in core taxable-equivalent revenues during the second quarter and first six months of 2004 resulted in a higher efficiency ratio— the ratio of administrative expenses to core taxable-equivalent revenues— for each period. Our efficiency ratio increased to 11.8 percent for the second quarter of 2004 from 8.9 percent for the same prior year period, and 11.3 percent for the first six months

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of 2004 from 9.2 percent for the same prior year period. The ratio of administrative expenses as a percentage of our average book of business improved to .069 percent for both the second quarter and first six months of 2004, compared with .071 percent for the second quarter of 2003 and .072 percent for the first six months of 2003. We continue to expect the growth rate in administrative expenses to slow to single-digits in 2004 from double-digit growth in 2003, primarily due to reduced costs related to the multi-year project initiated in 2001 to re-engineer our core infrastructure systems.

Purchased Options Expense

We recorded purchased options expense of $1.980 billion in the second quarter of 2004, up from expense of $1.883 billion in the second quarter of 2003. Purchased options expense for the first six months of 2004 and 2003 totaled $2.939 billion and $2.508 billion, respectively. The expense recorded during each period was due primarily to changes in the time value of purchased options that resulted from fluctuations in interest rates, volatility, and the notional amount of options held during each quarter. The estimated fair value of the time value portion of our outstanding purchased options, which is included on our balance sheet under “Derivatives in gain positions,” decreased to $6.287 billion at June 30, 2004 from $8.139 billion at December 31, 2003. The fair value changes in the time value of our purchased options will vary from period to period with changes in interest rates, expected interest rate volatility, and derivative activity.

Debt Extinguishments, Net

We recognized gains of $24 million in the second quarter of 2004 on the call of $75 billion and repurchase of $2 billion of debt and losses of $3 million during the first six months of 2004 on the call of $189 billion and repurchase of $2 billion of debt. In comparison, we recognized losses of $740 million in the second quarter of 2003 on the call of $66 billion and repurchase of $7 billion of debt and losses of $1.132 billion during the first six months of 2003 on the call of $110 billion and repurchase of $11 billion of debt. The significant decrease in losses resulted from the reduced level of debt repurchases in 2004, combined with opportunities to repurchase debt at a discount during the second quarter of 2004. The level of debt repurchases typically has a greater impact on gains and losses recognized on debt extinguishments than the level of debt calls. We repurchase or call debt securities and related interest rate swaps on a regular basis as part of our interest rate risk management efforts and to reduce future debt costs. Because debt repurchases, unlike debt calls, may require the payment of a premium and therefore result in higher extinguishment costs, we generally repurchase high interest rate debt at times (and in amounts) when we believe Fannie Mae has sufficient income available to absorb or offset those higher costs.

We called or repurchased a significant amount of debt during 2003 as a result of the historically low interest rate environment, steep yield curve, and debt spreads relative to the swap market which created opportunities to replace longer-term, higher-cost debt with shorter-term, lower-cost debt. This environment also contributed to a temporary elevation of our net interest margin and provided Fannie Mae with substantial income that we chose to reinvest in the repurchase of above-market debt to reduce our future debt costs. We began to curb our debt repurchase activity in 2004 as interest rates rose and our net interest margin began to narrow, which reduced the level of earnings available to invest in significant debt repurchases.

Income Taxes

We recorded a provision for federal income taxes of $169 million based on our reported results in the second quarter of 2004 that resulted in an effective tax rate of 13 percent, compared with a provision of $263 million and effective tax rate of 19 percent in the same prior year quarter. We recorded a provision for federal income taxes of $827 million and effective tax rate of 22 percent for the first six months of 2004, compared with a provision of $970 million and effective tax rate of 24 percent for the first six months of 2003. The decrease in the effective tax rate in 2004 was primarily due to the combined effect of a decline in our reported income, which produces a higher relative tax benefit for tax-exempt income and tax credits, and an increase in the actual dollar amount of tax credits. Investment tax credits increased by

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$66 million during the second quarter of 2004 over the prior year quarter, most of which resulted from our affordable housing investments.

Our effective tax rate calculated based on our core business earnings results, which is a non-GAAP measure that adjusts for the effect of FAS 133 on our purchased options, was 24 percent and 25 percent for the second quarter and first six months of 2004, respectively, compared with 27 percent and 26 percent for the same prior year periods. The decrease in our core business earnings effective tax rate during 2004 was primarily due to the increase in tax credits on affordable housing investments.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Fannie Mae’s reported results and financial statements are based on GAAP, which in some cases requires us to make estimates and assumptions that affect our reported results and disclosures. For a complete discussion of Fannie Mae’s significant accounting policies, see “Notes to the Financial Statements— Note 1, Summary of Significant Accounting Policies” in our 2003 Annual Report on Form 10-K. We have identified four accounting policies that we believe are critical in the preparation and understanding of our financial statements because they are highly dependent upon subjective or complex judgments, assumptions, and estimates. These policies relate to the following:

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

We detail the assumptions and judgment involved in applying these policies in Fannie Mae’s 2003 Annual Report on Form 10-K under “Management’s Discussion and Analysis of Financial Condition and Results of Operation— Critical Accounting Policies and Estimates.” Following is an update of significant changes in the estimation process or assumptions used in applying our critical accounting policies since the end of 2003.

Allowance for Loan Losses and Guaranty Liability for MBS

Based on recent credit performance trends, the benefits we have received from credit enhancements and risk sharing arrangements have exceeded our expectations and reduced our average loss severity below historical levels. Accordingly, during the second quarter of 2004 we adjusted our allowance methodology for loan losses and guaranty liability for MBS to incorporate the lower than expected loss severity that we have continued to experience in accordance with the applicable accounting guidance provided in Financial Accounting Standard No. 5, Accounting for Contingencies (“FAS 5”) and SEC Staff Accounting Bulletin No. 102, Selected Loan Loss Allowance Methodology and Documentation Issues (“SAB No. 102”). As a result of incorporating this trend into the risk factors we assess in estimating the allowance and guaranty liability, we reduced the allowance for loan losses and guaranty liability for MBS to $757 million at June 30, 2004, from $795 million at March 31, 2004 and $797 million at December 31, 2003, and recorded a negative loss provision of $12 million for the second quarter of 2004 and a positive provision for losses of $20 million for the first six months of 2004. In comparison, we recorded a positive provision for losses of $26 million and $49 million for the second quarter and first six months of 2003, respectively.

Deferred Price Adjustments

We continually update projected mortgage prepayment speeds in response to changes in interest rates and the effect on expected prepayments. In general, as interest rates decline expected prepayment speeds increase, which accelerates the amortization of deferred price adjustments. As mortgage interest rates rose during the second quarter of 2004 after falling sharply at the end of the first quarter, expected prepayment rates decreased. Accordingly, we slowed the amortization of deferred price adjustments in the second

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quarter of 2004, after accelerating amortization in the first quarter of 2004 in response to the sharp decline in interest rates and related increase in expected prepayments at the end of that quarter. The effect in the second quarter of 2004 was to reduce the amortization of deferred net premium expense related to our mortgage portfolio, which increased net interest income, and to reduce the accretion of deferred net discount income related to guaranty fee price adjustments, which reduced guaranty fee income.

Other-Than-Temporary Impairment

In the second quarter of 2004, OFHEO directed Fannie Mae to incorporate additional criteria into our process for estimating when other-than-temporary impairment has occurred on non-agency securities. After meeting with OFHEO staff to discuss the implementation of its directive and to refine the prescribed estimation process, we modified our process for identifying and recognizing other-than-temporary impairment on all of Fannie Mae’s non-agency securities, including manufactured housing and certain asset-backed securities, effective April 1, 2004. In accordance with the provisions of Accounting Principles Board Opinion No. 20, Accounting Changes (“APB 20”), we accounted for this change prospectively as a change in accounting estimate, which resulted in the additional recognition of pre-tax other-than-temporary impairment expense of $265 million on certain manufactured housing and asset-backed securities in the second quarter of 2004 and reduced diluted EPS by $.18 per share for the three and six-month periods ended June 30, 2004.

We estimate other-than-temporary impairment in accordance with the guidance provided in FAS 115, SEC Staff Accounting Bulletin No. 59, Noncurrent Marketable Equity Securities (“SAB 59”) and EITF 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“EITF 03-1”). Prior to the April 1, 2004 modification of our estimation process, we generally recognized other-than-temporary impairment on our investments in debt securities when we determined that it was probable that we would be unable to collect all of the contractual principal and interest cash flows based on ongoing monitoring of our securities, extensive analysis, and consideration of the facts and circumstances related to each specific security, such as our ability and intent to hold the security to recover its value and the probability, extent, and timing of a valuation recovery.

In addition to the estimation process described above, we now apply a series of objective tests to recognize other-than-temporary impairment that include the current credit ratings of the security and the extent to which the fair value is below our current book value. We will continue to rigorously monitor all of our securities for potential other-than-temporary impairment. As we have previously done, at the end of each quarter we will perform a detailed analysis of both held-to-maturity and available-for-sale non-agency securities in our mortgage and nonmortgage investment portfolios that have unrealized losses to assess whether the losses are other than temporary. We will rely primarily on quoted market prices to estimate the fair value of our securities and determine the amount of unrealized losses.

When a held-to-maturity or available-for-sale security has an unrealized loss that is deemed to be other than temporary, we reduce the book value of the security to its current market value and recognize the decline as other-than-temporary impairment expense and include in our income statement as a component of fee and other income. Any unrealized gains or losses on available-for-sale securities are reflected in stockholders’ equity as a component of accumulated other comprehensive income.

Other-than-temporary impairment expense on non-agency investment securities totaled $265 million and $297 million in the second quarter and first six months of 2004, respectively, which were primarily related to investments in manufactured housing securities included in our mortgage portfolio. We recorded other-than-temporary impairment expense on non-agency investment securities of $89 million and $165 million in the second quarter and first six months of 2003, primarily related to investments in nonmortgage securities. These other-than-temporary impairment expense amounts impact the results of our Portfolio Investment business.

Subsequent to our initial recognition of other-than-temporary impairment, we will periodically reassess the cash flows expected to be collected on each security. Estimated cash flows expected to be collected in excess of the fair value of the security on the date of our initial recognition of other-than-temporary

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impairment expense will be accreted into interest income over the remaining life of the security in accordance with the requirements of EITF 03-1 and Statement of Position 03-3, Accounting for Certain Loans and Debt Securities Acquired in a Transfer (“SOP 03-3”). Based on our estimate of cash flows expected to be collected at June 30, 2004, we accreted $11 million of previously recognized other-than-temporary impairment expense into interest income during the second quarter of 2004.

We provide additional information on our investments in manufactured housing securities, which account for a substantial portion of the other-than-temporary impairment expense that we have recognized, in “MD&A—Portfolio Investment Business Operations— Mortgage Portfolio.”

CORE BUSINESS EARNINGS AND BUSINESS SEGMENT RESULTS

Management relies primarily on core business earnings and related supplemental non-GAAP measures developed in conjunction with our adoption of FAS 133 to evaluate Fannie Mae’s financial performance and measure the results of our lines of business.

Core Business Earnings

Core business earnings for the second quarter of 2004 grew 2 percent over the prior year period to $1.896 billion, and core business earnings per diluted common share increased 3 percent to $1.91 driven by reduced losses from the call and repurchase of debt and growth in guaranty fee income that was partially offset by a decline in core net interest income and the recognition of additional other-than-temporary impairment expense during the quarter. Core business earnings for the first six months of 2004 increased 6 percent over the same prior year period to $3.916 billion, and core business earnings per diluted common share increased 6 percent to $3.94 primarily due to reduced losses from the call and repurchase of debt and growth in guaranty fee income that more than offset a decline in core net interest income and fee and other income. Highlights of our performance for the second quarter and first six months of 2004 compared with the same prior year periods include:

 
Second Quarter 2004 versus Second Quarter 2003:

  •  26 basis point decline in the net interest margin to 1.04 percent
 
  •  4 percent increase in guaranty fee income to $657 million
 
  •  $402 million decrease in fee and other income, due in part to other-than-temporary impairment expense
 
  •  Credit-related income of $21 million, versus expense of $23 million in the second quarter of 2003
 
  •  $764 million reduction in losses from the call and repurchase of debt

First Six Months of 2004 versus First Six Months of 2003:

  •  23 basis point decline in the net interest margin to 1.05 percent
 
  •  18 percent increase in guaranty fee income to $1.394 billion
 
  •  $513 million decrease in fee and other income, due in part to other-than-temporary impairment expense
 
  •  Credit-related income of $13 million, versus expense of $43 million for the first six months of 2003
 
  •  $1.129 billion reduction in losses from the call and repurchase of debt

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Core business earnings differs from reported net income by using a different method of recognizing the period cost of purchased options. Our core business earnings measure excludes the unpredictable volatility in the time value of purchased options that is included in our reported net income because we generally intend to hold these options to maturity, and we do not believe the period-to-period variability in our reported net income from changes in the time value of our purchased options accurately reflects the underlying risks or economics of our hedging strategy. Core business earnings includes amortization of purchased options premiums over the original expected life of the options and any accelerated expense resulting from options extinguished prior to exercise or expiration. The net amount of purchased options amortization expense recorded under our core business earnings measure will equal the net amount of purchased options expense ultimately recorded under FAS 133 in our reported net income over the life of our options. However, our amortization treatment is more consistent with the accounting for embedded options in our callable debt and more accurately reflects the underlying economics of our use of purchased options as a substitute for issuing callable debt—two alternate hedging strategies that are economically very similar but require different accounting treatment. While core business earnings is not a substitute for GAAP net income, we rely on core business earnings in operating our business because we believe it provides our management and investors with a better measure of our financial results and better reflects our risk management strategies than our GAAP net income.

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

Table 4 shows our line of business and consolidated core business earnings results for the three and six-month periods ended June 30, 2004 and 2003. The only difference in core business earnings and reported net income relates to the FAS 133 accounting treatment for purchased options, which affects our Portfolio Investment business. Core business earnings does not adjust for any other accounting effects related to the application of FAS 133 or other accounting standards under GAAP. The FAS 133 related reconciling items between our core business earnings and reported results have no effect on our Credit Guaranty business. The specific FAS 133 related adjustments affecting our Portfolio Investment business are identified and explained in Table 4.

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Table 4: Reconciliation of Core Business Earnings to Reported Results

                                           
Three Months Ended June 30, 2004

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





(Dollars in millions)
 
Net interest income
  $ 2,944     $ 169     $ 3,113     $     $ 3,113  
Purchased options amortization expense
    (773 )           (773 )     773 (2)      
     
     
     
     
     
 
Core net interest income
    2,171       169       2,340       773       3,113  
Guaranty fee income (expense)
    (421 )     1,078       657             657  
Fee and other income (expense), net
    (144 )     (26 )     (170 )           (170 )
Credit-related income (expense)(1)
          21       21             21  
Administrative expenses
    (119 )     (265 )     (384 )           (384 )
Purchased options expense under FAS 133.
                      (1,980 )(3)     (1,980 )
Debt extinguishments gain (loss), net
    24             24             24  
     
     
     
     
     
 
Income before federal income taxes
    1,511       977       2,488       (1,207 )     1,281  
Provision for federal income taxes
    (430 )     (162 )     (592 )     423 (4)     (169 )
     
     
     
     
     
 
 
Net income
  $ 1,081     $ 815     $ 1,896     $ (784 )   $ 1,112  
     
     
     
     
     
 
                                           
Three Months Ended June 30, 2003

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





Net interest income
  $ 3,280     $ 221     $ 3,501     $     $ 3,501  
Purchased options amortization expense
    (716 )           (716 )     716 (2)      
     
     
     
     
     
 
Core net interest income
    2,564       221       2,785       716       3,501  
Guaranty fee income (expense)
    (404 )     1,036       632             632  
Fee and other income (expense), net
    231       1       232             232  
Credit-related income (expense)(1)
          (23 )     (23 )           (23 )
Administrative expenses
    (103 )     (251 )     (354 )           (354 )
Purchased options expense under FAS 133.
                      (1,883 )(3)     (1,883 )
Debt extinguishments gain (loss), net
    (740 )           (740 )           (740 )
     
     
     
     
     
 
Income before federal income taxes
    1,548       984       2,532       (1,167 )     1,365  
Provision for federal income taxes
    (454 )     (218 )     (672 )     409 (4)     (263 )
     
     
     
     
     
 
 
Net income
  $ 1,094     $ 766     $ 1,860     $ (758 )   $ 1,102  
     
     
     
     
     
 
                                           
Six Months Ended June 30, 2004

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





Net interest income
  $ 5,989     $ 320     $ 6,309     $     $ 6,309  
Purchased options amortization expense
    (1,548 )           (1,548 )     1,548 (2)      
     
     
     
     
     
 
Core net interest income
    4,441       320       4,761       1,548       6,309  
Guaranty fee income (expense)
    (884 )     2,278       1,394             1,394  
Fee and other income (expense), net
    (102 )     (66 )     (168 )           (168 )
Credit-related income (expense)(1)
          13       13             13  
Administrative expenses
    (232 )     (535 )     (767 )           (767 )
Purchased options expense under FAS 133.
                      (2,939 )(3)     (2,939 )
Debt extinguishments gain (loss), net
    (3 )           (3 )           (3 )
     
     
     
     
     
 
Income before federal income taxes
    3,220       2,010       5,230       (1,391 )     3,839  
Provision for federal income taxes
    (937 )     (377 )     (1,314 )     487 (4)     (827 )
     
     
     
     
     
 
 
Net income
  $ 2,283     $ 1,633     $ 3,916     $ (904 )   $ 3,012  
     
     
     
     
     
 

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Six Months Ended June 30, 2003

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





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


(1)  Credit-related income (expense) includes the income statement line items “Provision for losses” and “Foreclosed property income.”
 
(2)  Represents the amortization of purchased options premiums that we allocate to interest expense over the original expected life of the options. We include this amount in core business earnings instead of recording changes in the time value of purchased options because this treatment is more consistent with the accounting for the embedded options in our callable debt and the vast majority of our mortgages.
 
(3)  Represents changes in the fair value of the time value of purchased options recorded in accordance with FAS 133. We exclude this amount from our core business earnings measure because the period-to-period fluctuations in the time value portion of our options do not reflect the economics of our current risk management strategy, which generally is to hold our purchased options to maturity or exercise date. Consequently, we do not expect to realize the period-to-period fluctuations in time value.
 
(4)  Represents the net federal income tax effect of core business earnings adjustments based on the applicable federal income tax rate of 35 percent.

Core Taxable-Equivalent Revenues

Core taxable-equivalent revenues for the second quarter and first six months of 2004 decreased by 18 percent and 11 percent, respectively, from the same prior year periods, primarily due to a reduction in core net interest income that resulted from the compression of our net interest margin and a decline in fee and other income, which were partially offset by growth in guaranty fee income and an increase in tax credits from affordable housing investments. Table 5 shows the components of core taxable-equivalent revenues and provides a comparison between the three and six-month periods ended June 30, 2004 and 2003.

Table 5: Core Taxable-Equivalent Revenues

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


2004 2003 % Change 2004 2003 % Change






(Dollars in millions)
 
Net interest income
  $ 3,113     $ 3,501        (11 )%   $ 6,309     $ 6,869         (8 )%
Guaranty fee income
    657       632          4       1,394       1,179         18  
Fee and other income (expense), net(1)
    (170 )     232       (173 )     (168 )     345       (149 )
     
     
             
     
         
 
Total revenues
    3,600       4,365        (18 )     7,535       8,393        (10 )
Taxable-equivalent adjustments:
                                               
 
Investment tax credits(2)
    313       212         48       561       429         31  
 
Tax-exempt investments(3)
    119       119                238       242         (2 )
     
     
             
     
         
Taxable-equivalent revenues
    4,032       4,696        (14 )     8,334       9,064         (8 )
Purchased options amortization expense(4)
    (773 )     (716 )        8       (1,548 )     (1,481 )        5  
     
     
             
     
         
Core taxable-equivalent revenues
  $ 3,259     $ 3,980        (18 )   $ 6,786     $ 7,583        (11 )
     
     
             
     
         


(1)  Includes net losses on certain tax-advantaged investments totaling $76 million and $52 million for the three months ended June 30, 2004 and 2003, respectively, and $156 million and $124 million for the six months ended June 30, 2004 and 2003, respectively.
 
(2)  Represents non-GAAP taxable-equivalent adjustments for tax credits related to losses on certain affordable housing tax-advantaged equity investments and other investment tax credits using the applicable federal income tax rate of 35 percent.
 
(3)  Represents non-GAAP adjustments to permit comparisons of yields on tax-exempt and taxable assets based on a 35 percent marginal tax rate.
 
(4)  Represents non-GAAP adjustment for amortization of purchased options premiums that would have been recorded prior to the adoption of FAS 133 in 2001.

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Core Net Interest Income

Table 6 reconciles our non-GAAP taxable-equivalent core net interest income to reported net interest income and presents an analysis of our net interest margin. Our taxable-equivalent core net interest income and net interest margin are significantly different than our taxable-equivalent net interest income and net interest yield, which are based on our reported results, because our core measures include the amortization of our purchased options premiums over the original estimated life of the option.

Table 6: Net Interest Margin

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


2004 2003 2004 2003




(Dollars in millions)
 
Net interest income
  $ 3,113     $ 3,501     $ 6,309     $ 6,869  
 
Purchased options amortization expense(1)
    (773 )     (716 )     (1,548 )     (1,481 )
     
     
     
     
 
Core net interest income
    2,340       2,785       4,761       5,388  
 
Taxable-equivalent adjustment on tax-exempt investments (2)
    119       119       238       242  
     
     
     
     
 
Taxable-equivalent core net interest income
  $ 2,459     $ 2,904     $ 4,999     $ 5,630  
     
     
     
     
 
 
Average balances:(3)
                               
Interest-earning assets:(4)
                               
 
Mortgage portfolio, net
  $ 870,229     $ 808,215     $ 876,615     $ 806,510  
 
Liquid investments
    76,732       81,966       71,629       74,550  
     
     
     
     
 
Total interest-earning assets
    946,961       890,181       948,244       881,060  
 
Interest-free funds(5)
    (20,407 )     (32,431 )     (21,242 )     (30,432 )
     
     
     
     
 
 
Total interest-earning assets funded by debt
  $ 926,554     $ 857,750     $ 927,002     $ 850,628  
     
     
     
     
 
 
Interest-bearing liabilities:(6)
                               
 
Short-term debt(7)
  $ 272,263     $ 231,718     $ 270,470     $ 221,063  
 
Long-term debt(8)
    654,291       626,032       656,532       629,565  
     
     
     
     
 
Total interest-bearing liabilities
  $ 926,554     $ 857,750     $ 927,002     $ 850,628  
     
     
     
     
 
 
Average interest rates:(2,3)
                               
Interest-earning assets:
                               
 
Mortgage portfolio, net
    5.43 %     6.07 %     5.47 %     6.17 %
 
Liquid investments
    1.39       1.66       1.40       1.74  
     
     
     
     
 
Total interest-earning assets
    5.10       5.66       5.16       5.80  
   
Interest-free funds(5)
    .14       .20       .13       .20  
     
     
     
     
 
Total interest-earning assets and interest-free return
    5.24       5.86       5.29       6.00  
     
     
     
     
 
 
Interest-bearing liabilities:(6)
                               
 
Short-term debt(7)
    1.27       1.43       1.27       1.54  
 
Long-term debt(8)
    5.41       5.72       5.46       5.83  
     
     
     
     
 
Total interest-bearing liabilities
    4.20       4.56       4.24       4.72  
     
     
     
     
 
Net interest margin, taxable-equivalent basis
    1.04 %     1.30 %     1.05 %     1.28 %
     
     
     
     
 


(1)  Reflects non-GAAP adjustment for amortization of purchased options premiums.
 
(2)  Reflects non-GAAP adjustments to permit comparison of yields on tax-exempt and taxable assets based on 35 percent marginal tax rate.
 
(3)  Averages have been calculated on a monthly basis based on amortized cost.
 
(4)  Includes average balance of nonaccrual loans of $6.6 billion and $5.9 billion for the three months ended June 30, 2004 and 2003, respectively, and $6.6 billion and $5.8 billion for the six months ended June 30, 2004 and 2003, respectively.
 
(5)  Interest-free funds represent the portion of our investment portfolio funded by equity and non-interest bearing liabilities.
 
(6)  Classification of interest expense and interest-bearing liabilities as short-term or long-term is based on effective maturity or repricing date, taking into consideration the effect of derivative financial instruments. The cost of debt includes expense for the amortization of purchased options.
 
(7)  Short-term debt includes debt scheduled to reprice in one year or less, taking into consideration the effect of derivative instruments.
 
(8)  Long-term debt includes debt scheduled to reprice after one year, taking into consideration the effect of derivative instruments.

Core net interest income for the second quarter of 2004 fell by 16 percent from the second quarter of 2003 to $2.340 billion, driven by a 20 percent (26 basis points) decline in our net interest margin to 1.04 percent that was partially offset by a 6 percent increase in our average net investment balance. Core net interest income for the first six months of 2004 declined by 12 percent over the same year-ago period to $4.761 billion, driven by an 18 percent (23 basis points) decline in our net interest margin to 1.05 percent that was partially offset by an 8 percent increase in our average net investment balance.

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Table 7 shows a rate/volume analysis of the changes in our core net interest income between the three and six-month periods ended June 30, 2004 and 2003.

Table 7: Rate/ Volume Analysis of Core Net Interest Income

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



(Dollars in millions)
Second Quarter 2004 vs. Second Quarter 2003
                       
Interest income:
                       
 
Mortgage portfolio
  $ (462 )   $ 899     $ (1,361 )
 
Liquid investments
    (75 )     (21 )     (54 )
     
     
     
 
 
Total interest income
    (537 )     878       (1,415 )
     
     
     
 
Interest expense:(2)                        
 
Short-term debt
    53       115       (62 )
 
Long-term debt
    (202 )     369       (571 )
     
     
     
 
 
Total interest expense
    (149 )     484       (633 )
     
     
     
 
Change in net interest income
  $ (388 )   $ 394     $ (782 )
     
     
     
 
Change in purchased options amortization expense(3)
    (57 )                
     
                 
Change in core net interest income
    (445 )                
Change in taxable-equivalent adjustment on tax-exempt investments(4)
                     
     
                 
Change in taxable-equivalent core net interest income
  $ (445 )                
     
                 
First Six Months of 2004 vs. First Six Months of 2003
                       
Interest income:
                       
 
Mortgage portfolio
  $ (937 )   $ 2,053     $ (2,990 )
 
Liquid investments
    (152 )     (24 )     (128 )
     
     
     
 
 
Total interest income
    (1,089 )     2,029       (3,118 )
     
     
     
 
Interest expense:(2)
                       
 
Short-term debt
    16       292       (276 )
 
Long-term debt
    (545 )     717       (1,262 )
     
     
     
 
 
Total interest expense
    (529 )     1,009       (1,538 )
     
     
     
 
Change in net interest income
  $ (560 )   $ 1,020     $ (1,580 )
     
     
     
 
Change in purchased options amortization expense(3)
    (67 )                
     
                 
Change in core net interest income
    (627 )                
Change in taxable-equivalent adjustment on tax-exempt investments(4)
    (4 )                
     
                 
Change in taxable-equivalent core net interest income
  $ (631 )                
     
                 


(1)  Combined rate/volume variances, a third element of the calculation, are allocated to the rate and volume variances based on their relative size.
 
(2)  Classification of interest expense and interest-bearing liabilities as short-term or long-term is based on effective maturity or repricing date, taking into consideration the effect of derivative financial instruments.
 
(3)  Reflects non-GAAP adjustment for amortization of purchased options premiums that would have been recorded under GAAP prior to our adoption of FAS 133.
 
(4)  Reflects non-GAAP adjustments to permit comparison of yields on tax-exempt and taxable assets based on a 35 percent marginal tax rate.

The compression of our net interest margin in 2004 primarily reflects the decline in yield on our mortgage assets as higher coupon mortgages liquidated during the refinancing wave of 2003 and we purchased current coupon mortgages at lower yields. In addition, as the duration of our mortgage assets lengthened as a result of the rising interest rate environment, we extended the duration of our liabilities to offset the extended duration of our assets.

Based on recent trends in the market, including the continued spirited competition for mortgage assets and a shift by consumers to adjustable-rate mortgages that provide lower initial yields, we expect our net interest margin to compress further during the second half of 2004, and to move lower than we anticipated earlier in the year.

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Business Segment Results

Portfolio Investment Business

Our Portfolio Investment business generated core business earnings of $1.081 billion in the second quarter of 2004, a decrease of 1 percent from the second quarter of 2003, and $2.283 billion for the first six months of 2003, an increase of 1 percent over the same prior year period. The $265 million of other-than-temporary impairment expense that we recorded during the second quarter of 2004 as a result of the change in our estimation process for identifying and recognizing other-than-temporary impairment affected the results of our Portfolio Investment business. Excluding the effect of this change in estimate, core business earnings for our Portfolio Investment business grew 15 percent for the second quarter and 9 percent for the first six months of 2004. The key factors that generally affect earnings growth for our Portfolio Investment business are growth in the average balance of our mortgage investments and the interest spread or margin that we earn on those investments. Our objective is to maintain a disciplined approach to growing our portfolio, purchasing mortgages when the spread between our cost of funds and the yield on mortgage assets is attractive and when supply is available in the market.

We experienced positive annualized mortgage portfolio growth for both the month of June 2004 and the second quarter of 2004, following two consecutive quarters and eight consecutive months of portfolio contraction. Our mortgage portfolio grew 5 percent on an annualized basis in the second quarter, reflecting modestly more attractive opportunities for mortgage investment throughout the quarter and a substantial decline in liquidations in June. For the first six months of 2004, our mortgage portfolio contracted by 2 percent on an annualized basis. In comparison, our mortgage portfolio contracted by 1 percent and grew by 5 percent on an annualized basis in the second quarter and first six months of 2003, respectively.

The substantial reduction in our net interest margin from the second quarter and first six months of 2003 was primarily attributable to the liquidation of higher coupon mortgages during the refinancing wave in the second half of 2003 and the purchase of current coupon mortgages at lower yields. The changing product mix of originations in our underlying market— to more hybrid ARMs and floating-rate securities— resulted in a change in the mix of business for our mortgage portfolio and also had an effect on our net interest margin. Hybrid ARMs and floating-rate securities have lower initial purchase spreads relative to 30-year fixed-rate products because of their reduced optionality. The purchase of these products, combined with the effects of a flatter yield curve, lowered our initial mortgage purchase spreads during the second quarter of 2004 and further reduced our net interest margin. Finally, rising interest rates during the second quarter of 2004 extended the duration of mortgage assets. Accordingly, we lengthened the duration of our liabilities.

Credit Guaranty Business

Our Credit Guaranty business generated core business earnings of $815 million in the second quarter of 2004, an increase of 6 percent over the second quarter of 2003, and $1.633 billion for the first six months of 2004, an increase of 12 percent over the same prior year period. Earnings growth in our Credit Guaranty business is driven largely by growth in guaranty fee income and management of credit-related losses. Guaranty fee income growth is affected by growth in average outstanding MBS (MBS held by investors other than Fannie Mae) and the guaranty fee rate we receive for guaranteeing the timely payment of principal and interest on outstanding MBS. Growth in outstanding MBS depends largely on the volume of mortgages made available for securitization and the perceived quality and value of our MBS in the secondary market.

Annualized growth in outstanding MBS slowed to 4 percent for the second quarter of 2004, reflecting lower refinance-driven volume, a substantial increase in the origination of higher-risk forms of hybrid ARMs, and heightened competition from private label issuers. Market share gains by private label issuers have been driven by an increased proportion of sub-prime and Alt-A securitized mortgages, including interest-only hybrid ARMs. The decline in our market share in the second quarter reflects our belief that current market pricing of some of these products does not adequately compensate for credit risk. Despite the slowdown in MBS growth during the second quarter, outstanding MBS expanded by 9 percent on an

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annualized basis for the first six months of 2004. In comparison, outstanding MBS grew by 56 percent and 44 percent on an annualized basis in the second quarter and first six months of 2003, respectively. Our effective guaranty fee rate declined during the second quarter of 2004 relative to the second quarter of 2003 as rising interest rates slowed the recognition of deferred fee income.

The effectiveness of the credit enhancement and risk sharing techniques employed by our Credit Guaranty business has been clearly evident in our credit-related performance during 2004, with credit-related losses continuing to be exceptionally low compared with historical experience. Because of the extremely low levels of losses in the first six months of 2004, we believe that total losses for the year— on a larger mortgage credit book of business— may be no higher than losses recorded in 2003.

PORTFOLIO INVESTMENT BUSINESS OPERATIONS

Our Portfolio Investment business has primary responsibility for Fannie Mae’s investing and funding activities and managing our interest rate risk.

Investments

Mortgage Portfolio

Table 8 summarizes mortgage portfolio activity on a gross basis and compares the average yields for the three and six-month periods ended June 30, 2004 and 2003 of mortgage purchases and liquidations. Our net interest yield and margin have contracted in 2004, partly due to the purchase of lower coupon mortgages and the liquidation of higher coupon mortgages as reflected in Table 8. Table 9 shows the distribution of Fannie Mae’s mortgage portfolio by product type at June 30, 2004 and December 31, 2003.

Table 8: Mortgage Portfolio Activity(1)

                                                   
Purchases Sales Repayments(2)



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



2004 2003 2004 2003 2004 2003






(Dollars in millions)
 
Single-family
  $ 86,234     $ 125,497     $ 4,148     $ 5,425     $ 75,277     $ 125,452  
Multifamily
    5,065       2,463       15             1,509       494  
     
     
     
     
     
     
 
 
Total
  $ 91,299     $ 127,960     $ 4,163     $ 5,425     $ 76,786     $ 125,946  
     
     
     
     
     
     
 
Average net yield
    4.45 %     5.09 %                     5.73 %     6.45 %
Annualized repayments as a percentage of average gross mortgage portfolio
                                    34.8 %     61.8 %
                                                   
Purchases Sales Repayments(2)



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



2004 2003 2004 2003 2004 2003






Single-family
  $ 125,470     $ 255,334     $ 8,522     $ 6,696     $ 128,362     $ 230,506  
Multifamily
    6,833       4,631       15             2,560       1,048  
     
     
     
     
     
     
 
 
Total
  $ 132,303     $ 259,965     $ 8,537     $ 6,696     $ 130,922     $ 231,554  
     
     
     
     
     
     
 
Average net yield
    4.41 %     5.22 %                     5.81 %     6.52 %
Annualized repayments as a percentage of average gross mortgage portfolio
                                    29.6 %     57.1 %


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

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Table 9: Mortgage Portfolio Composition(1)

                         
June 30, December 31,
2004 2003


(Dollars in millions)
Mortgages
               
 
Single-family:
               
 
Government insured or guaranteed
  $ 8,328     $ 7,063  
     
     
 
 
Conventional:
               
     
Long-term, fixed-rate
    120,047       119,877  
     
Intermediate-term, fixed-rate(2)
    72,661       75,015  
     
Adjustable-rate
    15,172       13,185  
     
     
 
       
Total conventional single-family
    207,880       208,077  
     
     
 
Total single-family
    216,208       215,140  
     
     
 
Multifamily:
               
 
Government insured or guaranteed
    986       1,091  
 
Conventional
    21,679       18,475  
     
     
 
Total multifamily
    22,665       19,566  
     
     
 
Total mortgages
  $ 238,873     $ 234,706  
     
     
 
Mortgage-related securities
               
 
Single-family:
               
 
Government insured or guaranteed
  $ 18,502     $ 21,267  
     
     
 
 
Conventional:
               
   
Long-term, fixed-rate
    473,318       507,661  
   
Intermediate-term, fixed-rate(2)
    74,526       83,366  
   
Adjustable-rate
    66,561       35,564  
     
     
 
     
Total conventional single-family
    614,405       626,591  
     
     
 
Total single-family
    632,907       647,858  
     
     
 
Multifamily:
               
 
Government insured or guaranteed
    11,017       10,150  
 
Conventional
    9,506       9,231  
     
     
 
Total multifamily
    20,523       19,381  
     
     
 
Total mortgage-related securities
  $ 653,430     $ 667,239  
     
     
 
Mortgage portfolio, net
               
 
Single-family:
               
 
Government insured or guaranteed
  $ 26,830     $ 28,330  
     
     
 
 
Conventional:
               
   
Long-term, fixed-rate
    593,365       627,538  
   
Intermediate-term, fixed-rate(2)
    147,187       158,381  
   
Adjustable-rate
    81,733       48,749  
     
     
 
     
Total conventional single-family
    822,285       834,668  
     
     
 
Total single-family
    849,115       862,998  
     
     
 
Multifamily:
               
 
Government insured or guaranteed
    12,003       11,241  
 
Conventional
    31,185       27,706  
     
     
 
Total multifamily
    43,188       38,947  
     
     
 
Total mortgage portfolio
    892,303       901,945  
 
Unamortized premium, (discount), and deferred price adjustments,
net(3)
    (837 )     (58 )
 
Allowance for loan losses(4)
    (80 )     (85 )
     
     
 
Mortgage portfolio, net
  $ 891,386     $ 901,802  
     
     
 
Average net yield on mortgage portfolio, net
    5.38 %     5.54 %


(1)  Data reflects unpaid principal balance adjusted to include mark-to-market gains and losses on available-for-sale securities and any other-than-temporary impairment.
 
(2)  Intermediate-term, fixed-rate consists of portfolio loans with contractual maturities at purchase equal to or less than 20 years and MBS and other mortgage-related securities held in portfolio with maturities of 15 years or less at issue date.
 
(3)  Includes net unamortized discounts of $1,717 million at June 30, 2004 and $1,292 million at December 31, 2003 related to available- for-sale and held-to-maturity mortgage-related securities.
 
(4)  Guaranty liability for probable losses on loans underlying Fannie Mae guaranteed MBS is included on our balance sheet in “Guaranty liability for MBS.”

Our mortgage portfolio includes mortgage-related securities backed by manufactured housing loans that were issued by entities other than Fannie Mae. In addition, to a limited extent, we acquired mortgage-related securities that were backed by manufactured housing loans and issued by entities other than Fannie

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Mae for securitization into REMIC securities issued and guaranteed by Fannie Mae. When we began investing in and guaranteeing manufactured housing securities, we did so with significant credit enhancements on these investments, including bond insurance and subordination. Table 10 presents the book values or notional balances of these securities at June 30, 2004 and December 31, 2003 and compares the credit ratings of the underlying securities (or for insured securities, the credit rating of the financial institution providing credit enhancement) at each date. Where ratings differ among the major rating agencies, we have used the lowest rating.

Table 10: Credit Ratings of Private Label Mortgage-Related Securities Secured by Manufactured Housing Loans

                                                                     
June 30, 2004 December 31, 2003


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


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









(Dollars in millions)
Investment grade:
                                                               
 
AAA/ Aaa
  $ 1,646     $ 77     $ 1,723       24.41 %   $ 2,058     $ 90     $ 2,148       26.85 %
 
AA+/ Aa1 to AA-/ Aa3
    980       102       1,082       15.33       1,259       195       1,454       18.18  
 
A+/ A1 to A-/ A3
    584       137       721       10.22       593       112       705       8.81  
 
BBB+/ Baa1 to BBB-/ Baa3
    1,723       59       1,782       25.25       2,506       15       2,521       31.51  
     
     
     
     
     
     
     
     
 
   
Total investment grade securities
    4,933       375       5,308       75.21       6,416       412       6,828       85.35  
     
     
     
     
     
     
     
     
 
Non-investment grade:
                                                               
 
BB+/ Ba1 to BB-/ Ba3
    257             257       3.64       474             474       5.93  
 
B+/ B1 to B-/ B3
    1,389       33       1,422       20.15       633       52       685       8.56  
 
CCC+/ Caa1 to CCC-/ Caa3
    35       33       68       .96             13       13       .16  
 
CC/ Ca
    3             3       .04                          
     
     
     
     
     
     
     
     
 
   
Total non-investment grade securities
    1,684       66       1,750       24.79       1,107       65       1,172       14.65  
     
     
     
     
     
     
     
     
 
   
Total securities
  $ 6,617     $ 441     $ 7,058       100.00 %   $ 7,523     $ 477     $ 8,000       100.00 %
     
     
     
     
     
     
     
     
 


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

We owned or guaranteed manufactured housing securities with a book value (for securities held in our portfolio) or notional amount (for REMIC securities we have guaranteed) totaling $7.1 billion at June 30, 2004, compared with $8.0 billion at December 31, 2003. The decrease in the balance from the end of 2003 resulted from $597 million of principal payments and amortization of deferred price adjustments, $91 million in sales, and $261 million of other-than-temporary impairment, which was partially offset by the accretion of $7 million into interest income related to securities for which other-than-temporary impairment was recognized.

At June 30, 2004 and December 31, 2003, approximately 70 percent of these securities were serviced by Green Tree Investment Holdings LLC (during 2003, Green Tree Investment Holdings LLC succeeded Conseco Finance Corp. as servicer). At the end of 2002, substantially all of these securities had investment grade ratings. Due to weakness in the manufactured housing sector and financial difficulties experienced by certain manufactured housing loan servicers, the major ratings agencies have downgraded many of these securities since 2002. As a result of credit downgrades during the first six months of 2004, the percentage of securities rated investment grade or better was 75 percent and 74 percent as of June 30, 2004 and March 31, 2004, respectively, down from 85 percent as of December 31, 2003. Subsequent to June 30, 2004, additional credit downgrades reduced the percentage of securities we own or guarantee rated investment grade or better to 72 percent as of July 20, 2004, which may result in the recognition of additional other-than-temporary impairment expense based on our revised estimation process.

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In response to the rating downgrades over the last two years and general condition of the manufactured housing sector, we have regularly assessed the recoverability of scheduled principal and interest amounts on certain of these securities to determine if any were other-than-temporarily impaired. We recorded, as a component of fee and other income, other-than-temporary impairment expense on certain of these securities included in our portfolio of $250 million and $261 million in the second quarter and first six months of 2004, respectively, primarily due to the change in our other-than-temporary impairment estimation process in the second quarter of 2004. We recognized no other-than-temporary impairment on manufactured housing securities during the second quarter of 2003 and $67 million for the first six months of 2003. Since the downgrades of these securities began in 2002, we have recognized other-than-temporary impairment of $466 million on our investments in manufactured housing securities, of which $133 million relates to bonds that were subsequently sold at a net gain of $9 million because of the subsequent recovery of a portion of previously recognized other-than-temporary impairment expense.

We continue to rigorously monitor these securities and assess appropriate risk factors to determine the need to record any additional impairment. Despite recent downgrades, the market liquidity and price performance of the manufactured housing bond sector has shown signs of improvements since the end of 2003. However, changes in events or circumstances, such as the performance of the underlying manufactured housing loan collateral and the financial strength of servicers, will influence future credit ratings and may affect market prices or our projected cash flow analyses. See “MD&A—Critical Accounting Policies and Estimates— Other-Than-Temporary Impairment” for a discussion of our revised process for estimating other-than-temporary impairment that we adopted in the second quarter of 2004.

Mortgage Commitments

As a result of our July 1, 2003 adoption of Financial Accounting Standard No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“FAS 149”), we are required to account for the majority of our commitments to purchase mortgage loans and to purchase or sell mortgage-related securities, which we enter into in the normal course of business, as derivatives. Table 11 shows the fair value, outstanding notional amount, and average remaining contractual maturity of outstanding mortgage commitments at June 30, 2004 and December 31, 2003 that are accounted for as derivatives and recorded on our balance sheet.

Table 11: Mortgage Commitments

                                                 
June 30, 2004 December 31, 2003


Average Average
Change in Remaining Change in Remaining
Fair Notional Contractual Fair Notional Contractual
Value(1) Amount Maturity Value(1) Amount Maturity






(Dollars in millions)
Forward mortgage loan and mortgage-related security purchase commitments
  $ 137     $ 27,755 (2)     26 days     $ 103     $ 18,372 (2)     24 days  
Forward mortgage-related security sell commitments
    (121 )     15,147 (3)     31       (145 )     20,120 (3)     28  


(1)  Represents change in fair value of the commitment since contractual date of the commitment. Included in our balance sheet under either “Derivatives in gain positions” or “Derivatives in loss positions.”
 
(2)  Includes $10,796 million and $13,389 million at June 30, 2004 and December 31, 2003, respectively, of purchase commitments not designated for our mortgage portfolio.
 
(3)  Includes $13,359 million and $18,070 million at June 30, 2004 and December 31, 2003, respectively, of sell commitments related to mortgage assets designated for securitization.

We also enter mortgage commitments that are not accounted for as derivatives under FAS 149, primarily master delivery commitments and optional portfolio purchase commitments. Under master delivery commitment agreements, lenders are required to either deliver loans to Fannie Mae for securitization or to enter into mandatory commitments to sell loans or mortgage-related securities to Fannie Mae. Once a lender elects under a master delivery commitment to enter into a mandatory commitment to sell loans or mortgage securities to Fannie Mae, we account for our purchase obligation under the mandatory

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commitment as a derivative pursuant to FAS 149. Table 12 shows the outstanding balance of these commitments at June 30, 2004 and December 31, 2003.

Table 12: Master Delivery and Optional Purchase Commitments

                   
June 30, December 31,
2004 2003


(Dollars in billions)
Master delivery commitments:(1)
               
 
Mandatory
  $ 48     $ 60  
 
Optional
    15       19  
Optional portfolio purchase commitments
    7       5  


(1)  Master delivery commitments either require or permit lenders to either deliver loans to us for securitization or enter into a mandatory commitment to deliver loans or mortgage-related securities to us for purchase. These arrangements are off-balance sheet and not accounted for as derivatives unless we enter into a mandatory purchase commitment.

Liquid Investments

Our liquid investments include cash and cash equivalents, nonmortgage investments, and mortgage assets designated for securitization. Our liquid investments totaled $52 billion at June 30, 2004, compared with $66 billion at December 31, 2003. Nonmortgage investments, which account for the majority of our liquid investments, totaled $49 billion at June 30, 2004 and $59 billion at December 31, 2003. We met our voluntary commitment to maintain more than 5 percent of on-balance sheet assets in high-quality, liquid assets with a ratio of liquid assets to total assets of 5.2 percent at June 30, 2004 compared with 6.5 percent at December 31, 2003.

Table 13 shows the composition, weighted-average maturities, and credit ratings of our held-to-maturity and available-for-sale nonmortgage investments at June 30, 2004 and December 31, 2003.

Table 13: Nonmortgage Investments

                                                   
June 30, 2004

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






(Dollars in millions)
 
Held-to-maturity
  $ 5,516     $     $     $ 5,516       .7       100.0 %
Available-for-sale
    43,376       47       (66 )     43,357       20.6       98.4  
     
     
     
     
     
     
 
 
Total
  $ 48,892     $ 47     $ (66 )   $ 48,873       18.3       98.6 %
     
     
     
     
     
     
 
                                                   
December 31, 2003

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






Held-to-maturity
  $ 6,822     $     $     $ 6,822       .4       100.0 %
Available-for-sale
    52,605       89       (23 )     52,671       15.2       97.7  
     
     
     
     
     
     
 
 
Total
  $ 59,427     $ 89     $ (23 )   $ 59,493       13.5       98.0 %
     
     
     
     
     
     
 

Funding

As part of our interest rate risk management strategy, our Portfolio Investment business issues a variety of noncallable and callable debt securities in the global capital markets in a wide range of maturities to meet our large and consistent funding needs. We use derivative instruments to supplement our issuance of debt in the capital markets and manage interest rate risk.

Debt Securities

Total debt outstanding decreased $22 billion to $940 billion at June 30, 2004 from $962 billion at December 31, 2003. We rely on the issuance of debt securities to fund the purchase of mortgage assets. Generally as growth in our mortgage portfolio slows as in the first six months of 2004 we reduce the level

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of debt issued. Table 14 compares debt issuances and repayments between the three and six-month periods ended June 30, 2004 and 2003.

Table 14: Debt Activity

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


2004 2003 2004 2003




(Dollars in millions)
Issued:
                               
 
Amount
  $ 453,298     $ 686,729     $ 983,617     $ 1,337,602  
 
Average cost
    1.84 %     1.23 %     1.36 %     1.32 %
Redeemed:
                               
 
Amount
  $ 453,473     $ 679,863     $ 1,002,826     $ 1,308,238  
 
Average cost
    1.56 %     1.78 %     1.63 %     1.75 %

Derivative Instruments

Derivatives are important in helping us to manage interest rate risk, supplement our issuance of debt in the global capital markets, add risk management features not obtainable in the debt market, and efficiently rebalance our portfolio. We use only the most straightforward types of derivatives. The principal derivatives we use are priced in deep and liquid markets and are therefore relatively easy to value and evaluate. We do not take speculative positions with derivatives or any other financial instrument. We have derivative transaction policies and controls to minimize our derivative counterparty risk.

Summary of 2004 Derivative Activity

Table 15 shows the additions and maturities of derivatives by type during the first six months of 2004, along with the stated maturities of derivatives outstanding at June 30, 2004.

Table 15: Activity and Maturity Data for Derivative Instruments(1)

                                                                             
Pay-Fixed/
Receive-Variable Swaps(2)

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









(Dollars in millions)
Notional balance at January 1, 2004
  $ 335,102       4.73 %     1.17 %   $ 202,479     $ 32,260     $ 435,525     $ 30,475     $ 4,755     $ 1,040,596  
 
Additions
    79,747       4.20       1.28       121,693       26,200       45,075       57,956       4,066       334,737  
 
Maturities(5)
    (114,235 )     4.71       1.15       (137,112 )     (12,510 )     (49,800 )     (57,125 )     (2,974 )     (373,756 )
     
     
     
     
     
     
     
     
     
 
Notional balance at June 30, 2004
  $ 300,614       4.63 %     1.23 %   $ 187,060     $ 45,950     $ 430,800     $ 31,306     $ 5,847     $ 1,001,577  
     
     
     
     
     
     
     
     
     
 
Future maturities of notional amounts:(6)
                                                                       
 
2004
  $ 5,765       5.90 %     1.18 %   $ 21,298     $ 15,375     $ 50,895     $ 11,756     $ 1,445     $ 106,534  
 
2005
    23,695       3.46       1.20       45,063       28,750       94,850       12,200       223       204,781  
 
2006
    22,845       3.87       1.20       18,925       200       41,625       4,550       100       88,245  
 
2007
    18,970       4.14       1.22       26,110       200       19,200       1,400       2,034       67,914  
 
2008
    48,550       3.47       1.24       15,885             22,550             903       87,888  
 
Thereafter
    180,789       5.21       1.24       59,779       1,425       201,680       1,400       1,142       446,215  
     
     
     
     
     
     
     
     
     
 
   
Total
  $ 300,614       4.63 %     1.23 %   $ 187,060     $ 45,950     $ 430,800     $ 31,306     $ 5,847     $ 1,001,577  
     
     
     
     
     
     
     
     
     
 


(1)  Excludes mortgage commitments accounted for as derivatives under FAS 149. Dollars represent notional amounts that indicate only the amount on which payments are being calculated and do not represent the amount at risk of loss.
 
(2)  Notional amounts include callable swaps of $19 billion with weighted-average pay rates of 7.00 percent and weighted-average receive rates of 1.22 percent at June 30, 2004. This amount may include other risk management derivatives.
 
(3)  The weighted-average interest rate payable and receivable is as of the date indicated. The interest rates of the swaps may be variable rates, so these rates may change as prevailing interest rates change.
 
(4)  Includes foreign currency swaps and other derivative instruments that provide an economic hedge against interest rate fluctuations.
 
(5)  Includes matured, called, exercised, and terminated amounts.
 
(6)  Based on stated maturities. Assumes that variable interest rates remain constant at June 30, 2004 levels.

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We decreased the outstanding notional balance of derivatives by $39 billion to $1,002 billion at June 30, 2004 from $1,041 billion at December 31, 2003. The decline in outstanding derivatives resulted primarily from normal portfolio rebalancing activities and the termination of pay-fixed and receive-fixed swap positions with matching durations.

Effect of Derivatives on Our Debt Securities

We use derivatives to change the term, cost, or optionality of our debt. Table 16 reconciles the redemption amounts of variable and fixed-rate debt before and after the use of derivatives at June 30, 2004 and shows how each derivative instrument transforms the characteristics of our debt from one category to another.

Table 16: Effect of Derivatives on Outstanding Debt

                                                                                     
Effect of Derivatives on Outstanding Debt(2)

Outstanding Pay-Fixed/ Pay-Fixed/ Receive-
Debt(1) Receive Receive-Fixed/ Receive Fixed/ Total Effective
June 30, Variable Pay Variable Basis Variable Pay Variable Derivative Debt June
2004 Swaps Swaps Swaps Caps Swaptions Swaptions Other(5) Effect 30, 2004










(Dollars in millions)
Variable-rate debt:(3)
                                                                               
 
With options
  $ 9,469     $     $ (100 )   $ (2,720 )   $ 129,950     $ 156,855     $     $     $ 283,985     $ 293,454  
 
Without options
    385,293       (294,914 )     152,323       2,720       (129,950 )     (156,855 )                 (426,676 )     (41,383 )
     
     
     
     
     
     
     
     
     
     
 
   
Total variable rate
    394,762       (294,914 )     152,223                                     (142,691 )     252,071  
     
     
     
     
     
     
     
     
     
     
 
Fixed-rate debt:(4)
                                                                               
 
With options
    211,012       18,385       (19,105 )                       143,995             143,275       354,287  
 
Without options
    331,404       276,529       (133,118 )                       (143,995 )           (584 )     330,820  
     
     
     
     
     
     
     
     
     
     
 
   
Total fixed rate
    542,416       294,914       (152,223 )                                   142,691       685,107  
     
     
     
     
     
     
     
     
     
     
 
   
Total debt
  $ 937,178     $     $     $     $     $     $     $     $     $ 937,178  
     
     
     
     
     
     
     
     
     
     
 
Total debt:
                                                                               
 
With options
  $ 220,481     $ 18,385     $ (19,205 )   $ (2,720 )   $ 129,950     $ 156,855     $ 143,995     $     $ 427,260     $ 647,741  
 
Without options
    716,697       (18,385 )     19,205       2,720       (129,950 )     (156,855 )     (143,995 )           (427,260 )     289,437  
     
     
     
     
     
     
     
     
     
     
 
   
Total debt
  $ 937,178     $     $     $     $     $     $     $     $     $ 937,178  
     
     
     
     
     
     
     
     
     
     
 
Option-based debt as percentage of net mortgage portfolio
    25%                                                                       73%  
 
Outstanding derivatives:
                                                                               
 
That affect debt classification
          $ 294,914     $ 152,223     $ 2,720     $ 129,950     $ 156,855     $ 143,995     $     $ 880,657          
 
That do not affect debt classification
                  28,800       40,849                         37,120       106,769          
 
Other risk management derivatives
            5,700       6,037       2,381                         33       14,151          
             
     
     
     
     
     
     
     
         
   
Total outstanding derivatives
          $ 300,614     $ 187,060     $ 45,950     $ 129,950     $ 156,855     $ 143,995     $ 37,153     $ 1,001,577          
             
     
     
     
     
     
     
     
         


(1)  Outstanding debt amount represents the redemption value, which excludes the effects of currency adjustments, FAS 133 debt basis adjustments, and unamortized premiums, discounts, issuance costs, and hedging results.
 
(2)  Derivative amounts reflect the notional balance on which underlying interest payments are calculated and do not represent our risk of loss.
 
(3)  Variable-rate debt reflects the amount of debt scheduled to reprice or mature in one year or less.
 
(4)  Fixed-rate debt reflects the amount of debt scheduled to reprice or mature after one year.
 
(5)  Includes forward starting swaps, foreign currency swaps, and other derivative instruments that provide a hedge against interest rate fluctuations.

Table 17 categorizes our outstanding debt between variable rate and fixed rate and compares the outstanding redemption amount, effective term to repricing, and cost of our variable-rate and fixed-rate debt after considering the effect of derivatives at June 30, 2004 and December 31, 2003. Table 18 shows the maturities and cost of our effective long-term debt. The redemption amount of our debt presented in Tables 16, 17, and 18 differs from the debt amounts reported on our balance sheet because it excludes the effects of currency adjustments, FAS 133 debt basis adjustments, and unamortized premiums, discounts, issuance costs, and hedging results.

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Table 17: Effective Variable-Rate and Fixed-Rate Debt

                   
June 30, December 31,
2004 2003


(Dollars in millions)
Outstanding:
               
Variable-rate debt:(1)
               
 
Redemption amount(3)
  $ 252,071     $ 258,145  
 
Effective cost at month end
    1.33 %     1.25 %
 
Effective term to repricing (in months)
    2       3  
 
Percent of total debt outstanding
    27 %     27 %
Fixed-rate debt:(2)
               
 
Redemption amount(3)
  $ 685,107     $ 698,012  
 
Effective cost at month end
    4.92 %     5.26 %
 
Effective term to repricing (in months)
    76       78  
 
Percent of total debt outstanding
    73 %     73 %
Total:
               
 
Redemption amount(3)
  $ 937,178     $ 956,157  
 
Effective cost at month end
    3.95 %     4.18 %
 
Effective term to repricing (in months)
    56       58  


(1)  Variable-rate debt reflects the amount of debt scheduled to reprice in one year or less, taking into consideration the effect of derivative instruments.
 
(2)  Fixed-rate debt reflects the amount of debt scheduled to reprice after one year, taking into consideration the effect of derivative instruments.
 
(3)  Outstanding debt amount represents the redemption value, which excludes the effects of currency adjustments, FAS 133 debt basis adjustments, and unamortized premiums, discounts, issuance costs, and hedging results.

Table 18: Maturities of Effective Long-Term Debt

                                   
Assuming Callable Debt
Contractual Maturity Redeemed at Initial Call Date


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




(Dollars in millions)
Currently Callable
  $       %   $ 56,104       4.13 %
2004
    27,434       5.87       121,352       4.62  
2005
    75,354       3.83       149,505       4.61  
2006
    98,066       3.42       110,550       4.59  
2007
    70,511       4.36       65,788       5.53  
2008 and later
    413,742       5.18       181,808       4.84  
     
     
     
     
 
Effective long-term debt before pay-fixed swaption effect
    685,107       4.72       685,107       4.72  
Pay-fixed swaption effect
          .20             .20  
     
     
     
     
 
 
Total effective long-term debt
  $ 685,107       4.92 %   $ 685,107       4.92 %
     
     
     
     
 


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

Table 19 reconciles the redemption amount of our debt to the total debt reported on our balance sheet.

Table 19: Reconciliation of Debt Redemption Amount to Total Reported Debt

                   
June 30, December 31,
2004 2003


(Dollars in millions)
 
Debt redemption amount
  $ 937,178     $ 956,157  
 
FAS 133 and other basis adjustments(1)
    4,464       7,584  
 
Other debt adjustments(2)
    (1,974 )     (2,009 )
     
     
 
Total reported debt(3)
  $ 939,668     $ 961,732  
     
     
 


(1)  FAS 133 and other basis adjustments include changes in market value of fair value hedges of our debt and adjustment for foreign currency translation.
 
(2)  Other debt adjustments include unamortized premiums, discounts, issuance costs, and hedging results.
 
(3)  Represents total debt reported on Fannie Mae’s balance sheet. Amount is based on unamortized book value, which includes the effect of currency adjustments, FAS 133 debt basis adjustments, and unamortized premiums, discounts, issuance costs, and hedging results.

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Our use of derivatives had the following impact on Fannie Mae’s debt portfolio:

  •  Interest rate swaps lengthened the weighted-average final maturity of our outstanding debt by 22 months at June 30, 2004 and December 31, 2003. The weighted-average final maturity of our outstanding debt including the effect of derivatives was 56 months at June 30, 2004 and 58 months at December 31, 2003.
 
  •  Variable-rate debt totaled $395 billion at June 30, 2004 based on the redemption amount. Pay-fixed interest rate swaps helped in reducing our variable-rate debt by 36 percent to $252 billion at June 30, 2004. Most of our variable-rate debt has options associated with it to protect us against increases in interest rates.
 
  •  Without the use of derivatives, the percent of option-based debt financing our net mortgage portfolio would have been only 25 percent at June 30, 2004 and 27 percent at December 31, 2003. With derivatives, we increased the percentage of option-based debt financing our net mortgage portfolio to 73 percent at June 30, 2004 and 72 percent at the end of 2003. The percentages of option-based debt funding our net mortgage portfolio at June 30, 2004 and the end of 2003 are consistent with our general target of maintaining a ratio of optionality in our effective debt to the optionality on new mortgage portfolio business in a range of 50 to 60 percent. The value of an option-based instrument with the same notional or face amount, which is the basis for calculating the percent of option-based debt financing our mortgage portfolio, will differ based on the characteristics of the options. Because the characteristics of our debt options will vary based on our risk management needs, the percentage of the option-based debt financing our mortgage portfolio will change over time.

Credit Exposure from Derivatives

The primary credit exposure that we have on a derivative transaction is that a counterparty might default on payments due, which could result in our having to acquire a replacement derivative from a different counterparty at a higher cost. Notional amount is a commonly used measure of volume in the derivatives market. It generally represents the amount on which interest is calculated, but does not represent the amounts due to or from a counterparty. Therefore, the notional amount is significantly greater than the potential market or credit loss that could result from such transactions. The replacement cost to settle at current market prices all outstanding derivative contracts in a gain position, after consideration of offsetting agreements such as master netting agreements and collateral held, is a more meaningful measure of our credit exposure on derivatives. Table 20 shows the credit exposure on our outstanding derivatives at June 30, 2004 and December 31, 2003, by maturity and counterparty credit ratings on this basis.

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Table 20: Credit Loss Exposure of Derivative Instruments(1)

                                                                   
June 30, 2004 December 31, 2003


Credit Rating Credit Rating


AAA AA A Total AAA AA A Total








(Dollars in millions)
Credit loss exposure:(2)
                                                               
Less than 1 year
  $     $ 121     $ 190     $ 311     $     $ 91     $ 64     $ 155  
1 to 5 years
          1,669       1,767       3,436             1,261       290       1,551  
Over 5 years
    32       3,588       3,213       6,833       37       2,586       3,335       5,958  
     
     
     
     
     
     
     
     
 
 
Subtotal
    32       5,378       5,170       10,580       37       3,938       3,689       7,664  
 
Maturity distribution netting(3)
    (10 )     (43 )     (778 )     (831 )     (20 )     (369 )     (146 )     (535 )
     
     
     
     
     
     
     
     
 
Exposure
    22       5,335       4,392       9,749       17       3,569       3,543       7,129  
Collateral held(4)
          4,950       4,265       9,215             3,184       3,431       6,615  
     
     
     
     
     
     
     
     
 
Exposure net of collateral
  $ 22     $ 385     $ 127     $ 534     $ 17     $ 385     $ 112     $ 514  
     
     
     
     
     
     
     
     
 
Additional information:
                                                               
Notional amount(5)
  $ 1,557     $ 457,563     $ 542,457     $ 1,001,577     $ 1,807     $ 491,386     $ 547,403     $ 1,040,596  
Number of counterparties
    3       12       8       23       3       12       8       23  


(1)  Excludes mortgage commitments accounted for as derivatives under FAS 149.
 
(2)  Represents the exposure to credit loss on derivative instruments, which is estimated by calculating the cost, on a present value basis, to replace all outstanding contracts in a gain position. Derivative gains and losses with the same counterparty in the same maturity category are presented net within the maturity category where a legal right of offset exists under an enforceable master settlement agreement.
 
(3)  Represents impact of netting of derivatives in a gain position and derivatives in a loss position for the same counterparty across maturity categories.
 
(4)  We held collateral of $9.215 billion and $6.615 billion on our derivative contracts at June 30, 2004 and December 31, 2003, respectively. Based on our counterparties’ credit exposure to Fannie Mae at June 30, 2004, we did not post any collateral. We posted collateral of $151 million related to our counterparties’ credit exposure to Fannie Mae at December 31, 2003.
 
(5)  Reflects notional amounts, which only indicates the amount on which payments are being calculated and does not represent the amount at risk of loss.

Our derivative credit exposure, after consideration of the value of collateral held, was $534 million at June 30, 2004 compared with $514 million at December 31, 2003. We expect the credit exposure on derivative contracts to fluctuate with changes in interest rates, implied volatility, and the collateral thresholds of the counterparties. Assuming the highly unlikely event that all of the derivative counterparties to which Fannie Mae was exposed at June 30, 2004 were to default simultaneously, it would have cost an estimated $534 million to replace the economic value of those contracts. This replacement cost represents approximately 7 percent of our annualized pre-tax reported income for the first six months of 2004.

At June 30, 2004, 61 percent of our net exposure of $534 million after consideration of collateral held was with six counterparties rated AA or better by S&P and Aa or better by Moody’s. The percentage of our net exposure with each of these six counterparties ranged from 7 to 15 percent, or $37 million to $81 million. At December 31, 2003, 71 percent of our net exposure after consideration of collateral held of $514 million was with six counterparties rated AA or better by S&P and Aa or better by Moody’s.

Fannie Mae has never experienced a loss on a derivative transaction due to credit default by a counterparty. The credit risk on our derivative transactions is low because we have stringent counterparty eligibility requirements, a conservative collateral policy, and an intensive credit exposure monitoring and management process. Our counterparties are of very high credit quality, consisting of large banks, broker-dealers, and other financial institutions that have a significant presence in the derivatives market, most of which are based in the United States. We initiate derivative contracts only with experienced counterparties that have credit ratings of A or better. As an additional precaution, our collateral management policy has provisions for requiring collateral on certain derivative contracts in gain positions.

Accounting for Derivatives

Table 21 shows the notional amounts and fair values of our derivatives by type as of June 30, 2004 and December 31, 2003, based on the hedge classification. This table does not include mortgage commitments that are accounted for as derivatives.

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Table 21: Notional and Fair Value of Derivatives by Hedge Designation(1)

                                   
June 30, 2004 December 31, 2003


Notional Net Notional Net
Amounts Values(2) Amounts Values(2)




(Dollars in millions)
Cash flow hedges:
                               
 
Pay-fixed swaps
  $ 261,036     $ (2,389 )   $ 300,536     $ (11,400 )
 
Receive-fixed swaps
    82,355       642       148,923       1,510  
 
Basis swaps
    43,569       5       32,260       (2 )
 
Caps and swaptions(3)
    368,076       2,720       358,551       2,361  
 
Forward starting swaps
    30,710       (37 )     30,475       (193 )
 
Other(4)
    921       9       854       12  
     
     
     
     
 
      786,667       950       871,599       (7,712 )
     
     
     
     
 
Fair value hedges:
                               
 
Pay-fixed swaps
    33,878       37       34,566       (529 )
 
Receive-fixed swaps
    98,668       1,618       53,556       1,894  
 
Receive-fixed swaptions(3)
    62,724       2,168       76,974       4,429  
 
Forward starting swaps
    596                    
 
Other(4)
    4,893       301       3,858       412  
     
     
     
     
 
      200,759       4,124       168,954       6,206  
     
     
     
     
 
Other risk management derivatives:
                               
 
Pay-fixed swaps
    5,700       (187 )            
 
Receive-fixed swaps
    6,037       (206 )            
 
Basis swaps
    2,381       (3 )            
 
Other(4)
    33             43        
     
     
     
     
 
      14,151       (396 )     43        
     
     
     
     
 
Purchased options time value(3)
          6,287             8,139  
     
     
     
     
 
Total
  $ 1,001,577     $ 10,965     $ 1,040,596     $ 6,633  
     
     
     
     
 


(1)  Excludes mortgage commitments accounted for as derivatives under FAS 149.
 
(2)  Based on end of period values, estimated by calculating the cost, on a net present value basis, to settle at current market rates all outstanding derivative contracts.
 
(3)  The net value reflected for caps and swaptions reflects only the intrinsic value. The time value is presented separately because we exclude the time value of purchased options from our assessment of hedge effectiveness under FAS 133 and record changes in the time value of purchased options in earnings.
 
(4)  Includes foreign currency swaps and other derivative instruments that provide a hedge against interest rate fluctuations.

Under FAS 133, we recognize all derivatives as either assets or liabilities on the balance sheet at their fair value. FAS 133 requires that all derivatives be marked to market through earnings unless the derivative is designated and qualifies for hedge accounting. Subject to certain qualifying conditions, we may designate a derivative as either a hedge of the cash flows of a variable-rate instrument or anticipated transaction (cash flow hedge) or a hedge of the fair value of a fixed-rate instrument (fair value hedge). For a derivative designated as a cash flow hedge, we report fair value gains or losses in a separate component of accumulated other comprehensive income (“AOCI”), net of deferred taxes, in stockholders’ equity to the extent the hedge is effective. We recognize these fair value gains or losses in earnings during the period(s) in which the hedged cash flow affects earnings. For a derivative designated as a fair value hedge, we report fair value gains or losses on the derivative in earnings along with fair value gains or losses on the hedged item attributable to the risk being hedged. For a derivative not designated as a hedge, not qualifying as a hedge, or components of a derivative that are excluded from any hedge effectiveness assessment, we report fair value gains and losses through earnings.

We traditionally have designated and accounted for substantially all of our derivatives as cash flow or fair value hedges. However, we may from time to time terminate, discontinue, or change the designation of the hedging relationship for certain derivative instruments for interest rate risk management purposes. Our interest rate risk management actions are driven by the economics of the transaction and the market environment that exists at that time and generally not by the hedge accounting designations. Regardless of the FAS 133 hedge designation, virtually all of Fannie Mae’s derivatives serve as economic hedges because they reduce our interest rate risk by helping us maintain a relative balance between the cash flows of our mortgage assets and the liabilities used to fund those assets through time and across various interest rate scenarios. We do not take speculative positions with derivatives.

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FAS 133 imposes hedge effectiveness, documentation, and testing criteria that must be met to qualify for hedge accounting. Beginning January 2004, as part of our routine and ongoing assessment of Fannie Mae’s accounting and business practices, we expanded our classification of derivatives not designated for hedge accounting under FAS 133. Even though these derivatives are not designated for hedge accounting, they are subject to Fannie Mae’s risk management controls that govern their use, purpose, credit exposure and financial reporting. As shown in Table 21, we refer to this category of derivatives as “other risk management derivatives.” This additional classification provides our Portfolio Investment business with increased flexibility and operational efficiency in executing risk management actions. The accounting effect is that we are required under FAS 133 to report changes in the fair value of our other risk management derivatives in earnings. However, because these transactions are economically matched, we anticipate that the gains and losses will largely offset and not have a material impact on our reported net income or core business earnings. Table 22 shows activity related to our other risk management derivatives during the first six months of 2004.

Table 22: Other Risk Management Derivatives Activity(1)

                                                           
Pay-Fixed/ Receive-Fixed/ Forward
Receive Variable Pay Variable Basis Starting
Swaps Swaps Swaps Swaptions Swaps Other(2) Total







(Dollars in millions)
Notional balance at December 31, 2003
  $     $     $     $     $     $ 43     $ 43  
 
Additions
          1,100                   5,350             6,450  
 
Transfers(3)
    55,152       52,010       2,951       500                   110,613  
 
Maturities(4)
    (31,718 )     (34,325 )                       (5 )     (66,048 )
     
     
     
     
     
     
     
 
Notional balance at March 31, 2004
    23,434       18,785       2,951       500       5,350       38       51,058  
 
Additions
    250       5,365                   2,075             7,690  
 
Transfers(3)
    11,200       7,807       7       125                   19,139  
 
Maturities(4)
    (29,184 )     (25,920 )     (577 )     (625 )     (7,425 )     (5 )     (63,736 )
     
     
     
     
     
     
     
 
Notional balance at June 30, 2004
  $ 5,700     $ 6,037     $ 2,381     $     $     $ 33     $ 14,151  
     
     
     
     
     
     
     
 


(1)  Excludes mortgage commitments accounted for as derivatives under FAS 149. Dollars represent notional amounts that indicate only the amount on which payments are being calculated and do not represent the amount at risk of loss.
 
(2)  Includes foreign currency swaps and other derivative instruments that provide a hedge against interest rate fluctuations.
 
(3)  Includes derivatives previously designated for hedge accounting under FAS 133 for which the hedge accounting relationship was terminated. These derivatives continue to serve as economic hedges.
 
(4)  Includes matured, called, exercised, and terminated amounts.

We had $14 billion in outstanding notional amount of derivatives not designated for hedge accounting under FAS 133 at June 30, 2004, compared with $51 billion at March 31, 2004 and $43 million at December 31, 2003. Our other risk management derivatives primarily consist of receive-fixed swaps that are economically matched to pay-fixed swaps. The decrease in the balance from the end of the first quarter to the end of the second quarter resulted primarily from opportunities in the market to terminate certain offsetting positions.

With this expanded category of derivatives, we can more efficiently implement strategies to rebalance our portfolio when interest rates change. For example, when interest rates decline and the duration of our mortgage assets shorten, we can enter into a receive-fixed interest rate swap to shorten the duration of our liabilities. The receive-fixed interest rate swap has the effect of offsetting the economics of an existing pay-fixed swap. We then discontinue the designation of the existing pay-fixed swap as a cash flow hedge of discount notes, classify both swaps as other risk management derivatives, and mark both swaps to market through earnings. The future gains and losses on the matched swaps largely offset. In addition, at the time we discontinue the hedge designation of the pay-fixed swap, we classify the existing fair value in AOCI as a closed hedge and amortize the existing fair value over the life of the originally hedged item. We expect the volume of matched pay-fixed and receive-fixed swaps to fluctuate from period to period based on changes in our overall portfolio characteristics. However, our goal is to terminate these offsetting derivative positions as market conditions permit. We recognized as a component of fee and other income a pre-tax net gain of $21 million and $8 million in the second quarter and first six months of 2004, respectively, related to changes in the fair value of our other risk management derivatives.

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The fair value of our derivatives increased to $11.0 billion at June 30, 2004 from $6.6 billion at December 31, 2003, as indicated in Table 21. The fair value of our derivatives is affected by changes in the level of interest rates and implied market volatility, together with activity in the derivatives book, which includes additions of new derivative contracts and the maturity or termination of existing contracts. The increase in fair value was primarily related to derivatives designated as cash flow hedges, whose value shifted to a net gain of $1.0 billion at June 30, 2004 from a net loss of $7.7 billion at the end of 2003. Cash flow hedges consist primarily of pay-fixed swaps, caps, and swaptions that are used to create effective fixed-rate debt. These derivatives generally show market value losses when interest rates fall and increases when interest rates rise. Fair value hedges consist largely of receive-fixed swaps and swaptions that typically increase in value as interest rates fall. Under FAS 133 we are required to record the fair value gains and losses on derivatives designated as cash flow hedges in the AOCI component of stockholders’ equity. Gains and losses on derivatives designated as fair value hedges and other risk management derivatives are included in current earnings rather than AOCI.

There typically has been a direct correlation between movements in interest rates and the value of our derivatives instruments (as reported in the fair value of derivatives instruments and the FAS 133 component of AOCI). Increases in rates generally have had a positive effect on the fair value of derivatives and, accordingly, the FAS 133 component of AOCI and stockholders’ equity; decreases in rates have had the opposite effect.

Between the end of 2003 and the end of the first quarter of 2004, 5-year interest rate swap rates— a key measure affecting the value of our cash flow hedges— fell by 46 basis points to 3.17 percent, contributing to a $3.2 billion decline in the fair value of our derivatives. In the second quarter of 2004, the 5-year swap rate increased 113 basis points to 4.30 percent at the end of June 2004. This increase in rates resulted in an increase in the value of our pay-fixed swaps, which was partially offset by a decline in value of our receive-fixed swaps. As a result, the fair value of our derivatives increased by $7.6 billion during the second quarter of 2004, more than offsetting the first quarter decrease of $3.2 billion. When interest rates rise or fall, AOCI reflects the net gains or losses, respectively, on pay-fixed interest rate swaps, but not the offsetting gains or losses that typically exist on assets funded by those derivatives or the debt that is hedged.

Changes in the FAS 133 component of AOCI and in stockholders’ equity reflect only a partial mark to market of some of the instruments we employ to manage interest rate risk. Therefore, we do not believe that short-term fluctuations in the value of these measures represent a meaningful or comprehensive view of our operating results, financial condition, or risk management strategies and actions. Table 23 shows AOCI activity attributable to unrealized (or open) and realized (or closed) cash flow hedges for the six months ended June 30, 2004.

Table 23: AOCI Activity Related to Derivatives Designated as Cash Flow Hedges(1)

                           
AOCI Balance Related to
Cash Flow Hedges

Open Closed(2) Total



(Dollars in millions)
 
Balance (net of taxes) at December 31, 2003
  $ (5,334 )   $ (6,858 )   $ (12,192 )
 
Losses on cash flow hedges related to derivatives, net
    (4,080 )     (1,518 )(3)     (5,598 )
 
Reclassifications of net losses to earnings, net(4)
    1,157       435       1,592  
     
     
     
 
Balance (net of taxes) at March 31, 2004
  $ (8,257 )   $ (7,941 )   $ (16,198 )
 
Gains (losses) on cash flow hedges related to derivatives, net
    7,372       (1,067 )(3)     6,305  
 
Reclassifications of net losses to earnings, net(4)
    1,147       480       1,627  
     
     
     
 
Balance (net of taxes) at June 30, 2004
  $ 262     $ (8,528 )   $ (8,266 )
     
     
     
 


(1)  Excludes mortgage commitments accounted for as derivatives under FAS 149.
 
(2)  Includes gains and losses on derivatives that have been terminated and derivatives that remain open but for which the cash flow hedge relationship has been terminated.
 
(3)  Includes fair value of cash flow hedges on date derivative is terminated and settled in cash or the existing derivative is no longer in a cash flow hedge relationship.
 
(4)  Amounts are reclassified into earnings as a component of interest expense.

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The balance in AOCI related to closed hedges includes gains and losses on derivatives in a cash flow hedge relationship that have been terminated and settled in cash and gains and losses on derivatives that remain open but the existing derivative is no longer in a cash flow hedge relationship. Regardless of whether the derivative is terminated and settled in cash with the derivative counterparty or remains open but is no longer designated as a cash flow hedge, the gain or loss on the derivative on the date the cash hedge relationship is discontinued will be reported in AOCI as a closed hedge amount. Fluctuations in interest rates and market volatility therefore have no impact on the amounts recorded in AOCI related to closed hedges. Gains and losses in AOCI on open hedges, however, can fluctuate significantly from period to period due to changes in interest rates and market volatility. The increase in AOCI losses attributable to closed hedges during the first six months of 2004 was driven by discontinuing cash flow hedge designations for certain offsetting derivative positions that we reclassified to other risk management derivatives and by mortgage portfolio rebalancing activities that included terminating pay-fixed swaps to reduce the portfolio’s interest rate risk exposure.

Many derivative transactions can have similar economics but different accounting effects on open and closed AOCI hedge amounts. For example, entering into a new receive-fixed swap is economically equivalent to terminating a pay-fixed swap, but the accounting on these transactions can be quite different. A receive-fixed swap recorded as a fair value hedge of fixed-rate debt has no effect on AOCI. On the other hand, a receive-fixed swap in combination with an existing longer-term, pay-fixed swap designated as a cash flow hedge of future interest payments is recorded in AOCI as an open hedge. When we terminate or close a cash flow hedge and discontinue hedge accounting prospectively, we transfer the corresponding market value of the derivative into the closed hedge category of AOCI.

Both realized and unrealized AOCI are amortized into net interest income over the same period in which the related hedged item affects earnings. In the case of a cash flow hedge, the original hedged item is generally the repricing of variable-rate debt in the future. The deferred gains and losses on the hedging derivative instrument therefore are recognized in net interest income together with the hedged variable-rate debt expense. We amortize the hedge results from both open and closed hedges out of AOCI and into earnings as a component of interest expense. Table 24 compares the amounts attributable to open and closed cash flow hedges that were amortized from AOCI to earnings as a component of interest expense during the three and six-month periods ended June 30, 2004 and 2003.

Table 24: AOCI Amounts Reclassified to Earnings(1)

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


2004 2003 2004 2003




After-tax Pre-tax After-tax Pre-tax After-tax Pre-tax After-tax Pre-tax








(Dollars in millions)
Amortization of AOCI amounts to earnings related to:(2)                                                                
 
Open cash flow hedges
  $ 1,147     $ 1,764     $ 980     $ 1,508     $ 2,304     $ 3,545     $ 2,012     $ 3,096  
 
Closed cash flow hedges(3)
    480       737       217       334       915       1,406       427       657  
     
     
     
     
     
     
     
     
 
    $ 1,627     $ 2,501     $ 1,197     $ 1,842     $ 3,219     $ 4,951     $ 2,439     $ 3,753  
     
     
     
     
     
     
     
     
 


(1)  Excludes mortgage commitments accounted for as derivatives under FAS 149.
 
(2)  Amounts are amortized into earnings as a component of reported pre-tax interest expense.
 
(3)  Amounts relate to cash flow hedges that have been closed or terminated.

The expense related to open cash flow hedges in combination with the expense from the associated variable-rate debt equals the cost of our effective fixed-rate debt. Over time, all of our closed hedge

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results, and open hedge results not otherwise extinguished by changes in interest rates, will be reflected in earnings through interest expense.

For additional detail on our accounting for derivatives, see our 2003 Annual Report on Form 10-K, “Notes to Financial Statements— Note 14, Derivative Instruments and Hedging Activities.

Interest Rate Risk Management

Interest rate risk is the risk of loss to future earnings or long-term value that may result from changes in interest rates. We utilize a wide range of risk measures and analyses to manage the interest rate risk inherent in the mortgage portfolio, including ongoing business risk measures and run-off measures of the existing portfolio. We rely on net interest income at risk as our primary ongoing business measure of interest rate risk and the portfolio duration gap as our primary run-off measure of interest rate risk. Management develops rebalancing actions based on a number of factors that include the relative standing of both net interest income at risk and duration gap, as well as analyses based on additional risk measures and current market conditions.

In 2003 we updated our corporate financial disciplines and adjusted the risk tolerances of our mortgage portfolio. As a result, we committed to managing the portfolio’s duration gap within a target range of plus or minus 6 months substantially all of the time, compared to our historical performance of remaining within the target range about two-thirds of the time. We disclose our net interest income at risk and duration gap measures on a monthly basis. We believe these measures together provide a more informative profile of our overall interest rate risk position than either measure alone.

•  Net Interest Income at Risk

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

Table 25 compares net interest income at risk over a one-year and four-year period under each of the interest rate scenarios at June 30, 2004 and December 31, 2003. A positive number indicates the percent by which projected core net interest income could be reduced by the rate shock. These calculations reflect management’s assumptions of most likely market conditions. Actual changes in portfolio core net interest income may differ from these estimates because of specific interest rate movements, changing business conditions, changing prepayments, and management actions.

Table 25: Net Interest Income at Risk

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


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




June 30, 2004
    1.6 %     3.5 %     2.3 %     4.1 %
December 31, 2003
    2.6       2.1       3.6       6.1  

We consider our net interest income at risk at June 30, 2004 to be low as our exposure to a 50 basis point instantaneous change in the level of interest rates was estimated not to exceed 1.6 percent and 3.5 percent over a 1-year and 4-year horizon, respectively. Our exposure to a 25 basis point instantaneous change in the slope of the yield curve was estimated not to exceed 2.3 percent and 4.1 percent over a 1-year and 4-year horizon, respectively. The net interest income at risk for a 50 basis point change in the level of interest rates at June 30, 2004 was slightly lower for the one-year horizon and slightly higher for the 4-year horizon as compared to December 31, 2003 while the amount of risk associated with a change in the slope of the yield curve was lower over both horizons. The change in the risk profile during the period was

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largely driven by the increase in the level of interest rates, the change in the shape of the yield curve, and asset-liability management actions.

•  Duration Gap

The duration gap measures the difference between the estimated durations of portfolio assets and liabilities and summarizes the extent to which estimated cash flows for assets and liabilities are matched, on average, over time and across interest rate scenarios. A positive duration gap signals a greater exposure to rising interest rates because it indicates that the duration of our assets exceeds the duration of our liabilities. A negative duration gap signals a greater exposure to declining interest rates because the duration of our assets is less than the duration of our liabilities. The duration gap provides a relatively concise and simple measure of the interest rate risk inherent in the existing mortgage portfolio, but it is not directly linked to expected future earnings performance. Our duration gap reflects the current mortgage portfolio, including priced asset and debt commitments. We apply the same interest rate process, prepayment models, and volatility assumptions used in our net interest income at risk measure to generate the portfolio duration gap. However, we do not incorporate nonmortgage investments or projected future business activity, which can have a significant effect even over a very short horizon, into our duration gap measure.

Fannie Mae’s effective duration gap calculated on a weighted average monthly basis shifted to plus 2 months at June 30, 2004 from minus one month at December 31, 2003. Despite continued levels of relatively high volatility in the fixed income markets during second quarter and first half of 2004, we were able to maintain our duration gap within our tighter risk tolerances throughout the period. Our duration gap averaged plus 2 months in June, plus 3 months in May and plus 3 months in April. We accomplished this financial discipline objective by maintaining high levels of optionality in our liability structure and through strategic rebalancing actions that included a reduction in the percentage of our effective short-term debt and extending the duration of our liabilities to offset the extended duration of our mortgage assets. Fannie Mae’s duration gap has remained within our target range of plus or minus six months since October 2002.

CREDIT GUARANTY BUSINESS OPERATIONS

Our Credit Guaranty business has primary responsibility for managing Fannie Mae’s credit risk on our mortgage credit book of business, which includes both on-balance sheet and off-balance sheet mortgage assets.

Off-Balance Sheet Transactions

In the ordinary course of business, we enter into arrangements to facilitate our statutory purpose of providing mortgage funds to the secondary market and reduce Fannie Mae’s exposure to interest rate fluctuations. We structure transactions to meet the financial needs of customers, manage Fannie Mae’s credit, market or liquidity risks, diversify funding sources, or optimize our capital. Under GAAP, some of these arrangements are not recorded on Fannie Mae’s balance sheet or may be recorded in amounts different than the full contract or notional amount of the transaction. Our primary off-balance sheet arrangements result from mortgage loan securitizations in which Fannie Mae issues MBS and guarantees the timely payment of principal and interest on the MBS to investors in exchange for a guaranty fee. We may also assist state and local governmental entities in issuing taxable and tax-exempt housing bonds to obtain funding for low- and moderate-income multifamily housing by providing credit enhancements and liquidity support for the bonds. Under these agreements, we provide contractual assurance of payment of the bonds, which improves the bond ratings and thereby results in lower-cost financing for multifamily housing.

Outstanding MBS and credit enhancement arrangements totaled $1,374 billion and $1,314 billion at June 30, 2004 and December 31, 2003, respectively. We recorded as part of our combined allowance for loan losses and guaranty liability for MBS a guaranty liability of $677 million and $712 million at June 30, 2004 and December 31, 2003, respectively, based on the probable losses inherent in the mortgages underlying outstanding MBS as well as MBS included in our mortgage portfolio. We also recorded a

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guaranty fee obligation related to these arrangements of $5.810 billion and $4.391 billion at June 30, 2004 and December 31, 2003, respectively, under FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (“FIN 45”).

Table 26 provides information related to Fannie Mae MBS and credit enhancements.

Table 26: Guaranteed MBS(1) and Credit Enhancements

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


2004 2003 2004 2003




(Dollars in millions)
MBS issuance activity:
                               
 
Acquired by others
  $ 134,595     $ 282,502     $ 256,603     $ 486,435  
 
Total issued(2)
    168,793       352,985       297,757       645,558  
                                   
June 30, December
2004 31, 2003


Outstanding balance:
                               
 
MBS held by other investors
  $ 1,360,045     $ 1,300,166                  
 
Total MBS(3)
    1,879,009       1,857,045                  
 
Credit enhancements
    13,915       13,915                  


(1)  MBS may be resecuritized to back Fannie Megas, SMBS, or REMICs. With respect to those MBS, the amounts shown only include the principal amount of the MBS once. Amounts also include REMICs created from whole loans not owned or guaranteed by Fannie Mae.
 
(2)  Total issued includes MBS purchased by Fannie Mae totaling $34 billion and $70 billion for the three months ended June 30, 2004 and 2003, respectively, and $41 billion and $159 billion for the six months ended June 30, 2004 and 2003, respectively. Total issued excludes amounts issued from loans in our portfolio totaling $4 billion and $3 billion for the three months ended June 30, 2004 and 2003, respectively, and $9 billion for each of the six-month periods ended June 30, 2004 and 2003.
 
(3)  Includes $519 billion at June 30, 2004 and $557 billion at December 31, 2003, of MBS in Fannie Mae’s mortgage portfolio.

MBS held by investors other than Fannie Mae, which we refer to as outstanding MBS, grew 5 percent to $1.360 trillion at June 30, 2004, from $1.300 trillion at December 31, 2003. MBS issuances acquired by investors other than Fannie Mae totaled $135 billion in the second quarter of 2004, a decrease of over 50 percent from the same prior year quarter, and $257 billion for the first six months of 2004, a decrease of 47 percent from the same prior year period. The decrease in the volume of MBS issuances reflects the market reduction in mortgage originations from the record level of refinancings that occurred in 2003, the sustained high retention of mortgages by depository institutions, and a record level of issuances of private label securities backed largely by loans with higher credit risk.

REMIC issuances totaled $35 billion and $55 billion in the second quarter and first six months of 2004, compared with $72 billion and $145 billion in the second quarter and first six months of 2003. REMIC issuances were down from 2003 levels due in part to the increase in mortgage interest rates that has resulted in a sharp decline in mortgage origination volumes.

Credit Risk Management

Credit risk is the risk of loss to future earnings or future cash flows that may result from the failure of a borrower or institution to fulfill its contractual obligation to make payments to Fannie Mae or an institution’s failure to perform a service for us. We assume and manage mortgage credit risk and institutional credit risk that arise through a variety of transactions. We actively manage credit risk to maintain credit losses within levels that generate attractive profitability and returns on capital and meet our expectations for consistent financial performance.

Our mortgage credit risk stems from our mortgage credit book of business, where we bear the risk that borrowers fail to make payments required on their mortgages. Our mortgage credit book of business consists of mortgages, MBS and mortgage-related securities in our mortgage portfolio, outstanding MBS held by other investors, and other contractual arrangements or guarantees. Table 27 presents the composition of our mortgage credit book of business at June 30, 2004 and December 31, 2003.

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Table 27: Composition of Mortgage Credit Book of Business

                           
June 30, 2004

Single-family Multifamily Total



(Dollars in millions)
Mortgage portfolio(1)
  $ 848,030     $ 43,180     $ 891,210  
Outstanding MBS(2)
    1,294,645       65,400       1,360,045  
Credit enhancements
    168       13,747       13,915  
     
     
     
 
 
Mortgage credit book of business
  $ 2,142,843     $ 122,327     $ 2,265,170  
     
     
     
 
                           
December 31, 2003

Single-family Multifamily Total



Mortgage portfolio(1)
  $ 859,524     $ 38,921     $ 898,445  
Outstanding MBS(2)
    1,233,863       66,303       1,300,166  
Credit enhancements
    1,020       12,895       13,915  
     
     
     
 
 
Mortgage credit book of business
  $ 2,094,407     $ 118,119     $ 2,212,526  
     
     
     
 


(1)  Excludes mark-to-market gains of $1.093 billion at June 30, 2004 and $3.500 billion at December 31, 2003.
 
(2)  MBS held by investors other than Fannie Mae. The principal balance on resecuritized MBS is included only once.

Table 28 shows statistics related to our mortgage credit performance. A certain level of credit losses is an inherent consequence of engaging in the Credit Guaranty business. Our risk management focus is on controlling the level and volatility of credit losses that result from changes in economic conditions.

Table 28: Mortgage Credit Performance

                                                   
Credit-Related Losses(1)

Three Months Six Months
Ended Ended Serious Delinquency Rate(2)
June 30, June 30,


June 30, December 31,
2004 2003 2004 2003 2004 2003






(Dollars in millions)
 
Single-family
  $ 8     $ 19     $ 11     $ 38       .57 %     .60 %
Multifamily
    8       4       15       5       .14       .27  
     
     
     
     
                 
 
Total
  $ 16     $ 23     $ 26     $ 43                  
     
     
     
     
                 
Credit loss ratio(3)
    .003 %     .005 %     .002 %     .004 %                
Charge-off ratio(4)
    .005       .005       .005       .005                  
                                                 
Number of Properties Acquired

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


2004 2003 2004 2003




Single-family
    8,146       6,569       16,259       12,487                  
Multifamily
    4       2       14       3                  


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

Our credit loss ratio— annualized credit-related losses as a percentage of Fannie Mae’s average mortgage credit book of business— fell to .3 basis points for the second quarter of 2004 and .2 basis points in the first six months of 2004, from .5 basis points in the second quarter of 2003 and .4 basis points in the first six months of 2003. Despite an increase in the number of properties acquired through foreclosure and the expansion in our mortgage credit book of business over the past few years, our credit-related losses for 2004 have been exceptionally low by historical standards. We had previously anticipated a modest upward

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trend in credit losses during 2004. However, based on the actual level of credit losses during the first half of 2004, it is possible that our credit losses in 2004 will be no higher than in 2003.

Our conventional single-family serious delinquency rate, an indicator of potential future loss activity, was .57 percent at June 30, 2004, compared with .60 percent at December 31, 2003. Table 29 compares the serious delinquency rates for conventional single-family loans with credit enhancements and without credit enhancements at June 30, 2004 and December 31, 2003.

Table 29: Conventional Single-Family Serious Delinquency Rates

                                   
June 30, 2004 December 31, 2003


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




Credit enhanced
    20 %     1.62 %     21 %     1.65 %
Non-credit enhanced
    80       .29       79       .30  
     
     
     
     
 
 
Total conventional loans
    100 %     .57 %     100 %     .60 %
     
     
     
     
 


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

As part of our voluntary safety and soundness initiatives, we disclose on a quarterly lagged basis the lifetime credit loss sensitivity of the present value of expected future credit losses to an immediate 5 percent decline in home values. We base our lifetime credit loss sensitivity on all single-family mortgages held in Fannie Mae’s portfolio and underlying guaranteed MBS and calculate and report the amount before and after the expected receipt of private mortgage insurance claims and any other credit enhancements. The lifetime credit loss sensitivity before and after credit enhancements increased to $3.231 billion and $1.453 billion, respectively, at March 31, 2004, from $2.402 billion and $1.113 billion at December 31, 2003, reflecting the increase in our combined book of business, somewhat slower projected home price appreciation, and greater dispersion between regions within the U.S. in average home price appreciation.

LIQUIDITY AND CAPITAL RESOURCES

Our ability to continually raise low-cost capital is critical to fulfilling our housing mission of providing liquidity to the secondary mortgage market and promoting homeownership to low- and moderate-income families. We primarily rely on debt to purchase mortgage assets and to supply liquidity to the secondary market. Fannie Mae’s liquidity and capital position are actively managed to preserve stable, reliable, and cost-effective sources of cash to meet all current and future normal operating financial commitments, meet our regulatory capital requirements, and handle any unforeseen liquidity crisis.

Liquidity

Fannie Mae’s primary sources of liquidity include proceeds from the issuance of debt, principal and interest received on our mortgage portfolio, guaranty fees earned on our MBS, and principal and interest received on our liquid investments. Primary uses of liquidity include the purchase of mortgage assets, repayment of debt, interest payments, administrative expenses, taxes, and fulfillment of Fannie Mae’s MBS guaranty obligations. Mortgage asset purchases based on unpaid principal balance totaled $91 billion and $132 billion for the second quarter and first six months of 2004, respectively. We issued $453 billion and $984 billion of debt in the second quarter and first six months of 2004, respectively, to fund those purchases and to replace maturing, called or repurchased debt totaling $453 billion and $1,003 billion in each respective period.

Our debt securities, and the interest payable thereon, are not guaranteed by the United States and do not constitute a debt or obligation of the United States or any agency or instrumentality thereof other than Fannie Mae. Our credit quality is continuously monitored by rating agencies. At June 30, 2004, our senior

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