10-Q 1 w58421e10vq.htm 10-Q e10vq
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-Q
 
     
     
þ
  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
     
    For the quarterly period ended June 30, 2008
OR
     
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
     
    For the transition period from          to          
 
Commission File No.: 0-50231
 
Federal National Mortgage Association
(Exact name of registrant as specified in its charter)
 
Fannie Mae
 
     
Federally chartered corporation
(State or other jurisdiction of
incorporation or organization)
  52-0883107
(I.R.S. Employer
Identification No.)
     
3900 Wisconsin Avenue, NW
Washington, DC
(Address of principal executive offices)
  20016
(Zip Code)
 
Registrant’s telephone number, including area code:
(202) 752-7000
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
             
Large accelerated filer þ
  Accelerated filer o   Non-accelerated filer o
(Do not check if a smaller reporting company)
  Smaller reporting company o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ
 
As of June 30, 2008, there were 1,076,594,797 shares of common stock outstanding.
 


 

 
TABLE OF CONTENTS
 
                 
    1  
      Financial Statements     91  
      Condensed Consolidated Balance Sheets     91  
      Condensed Consolidated Statements of Operations     92  
      Condensed Consolidated Statements of Cash Flows     93  
      Condensed Consolidated Statements of Changes in Stockholders’ Equity     94  
        Note 1— Summary of Significant Accounting Policies     95  
        Note 2—  Consolidations     100  
        Note 3—  Mortgage Loans     100  
        Note 4—  Allowance for Loan Losses and Reserve for Guaranty Losses     103  
        Note 5—  Investments in Securities     105  
        Note 6—  Financial Guarantees     107  
        Note 7—  Acquired Property, Net     109  
        Note 8—  Short-term Borrowings and Long-term Debt     110  
        Note 9—  Derivative Instruments and Hedging Activities     111  
        Note 10— Income Taxes     113  
        Note 11— Earnings (Loss) Per Share     115  
        Note 12— Employee Retirement Benefits     116  
        Note 13— Segment Reporting     117  
        Note 14— Stockholders’ Equity     119  
        Note 15— Regulatory Capital Requirements     120  
        Note 16— Concentrations of Credit Risk     122  
        Note 17— Fair Value of Financial Instruments     124  
        Note 18— Commitments and Contingencies     135  
        Note 19— Subsequent Events     139  
      Management’s Discussion and Analysis of Financial Condition and Results of Operations     1  
      Introduction     1  
      Selected Financial Data     2  
      Executive Summary     5  
      Legislation Relating to Our Regulatory Framework     9  
      Critical Accounting Policies and Estimates     11  
      Consolidated Results of Operations     16  
      Business Segment Results     37  
      Consolidated Balance Sheet Analysis     41  
      Supplemental Non-GAAP Information—Fair Value Balance Sheets     58  
      Liquidity and Capital Management     63  
      Off-Balance Sheet Arrangements and Variable Interest Entities     69  
      Risk Management     71  
      Impact of Future Adoption of Accounting Pronouncements     88  
      Forward-Looking Statements     88  
      Quantitative and Qualitative Disclosures About Market Risk     140  
      Controls and Procedures     140  


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    140  
      Legal Proceedings     140  
      Risk Factors     142  
      Unregistered Sales of Equity Securities and Use of Proceeds     151  
      Defaults Upon Senior Securities     154  
      Submission of Matters to a Vote of Security Holders     154  
      Other Information     155  
      Exhibits     155  
      Signatures
      Index to Exhibits


ii


 

 
MD&A TABLE REFERENCE
 
             
Table
 
Description
  Page
 
  Selected Financial Data     2  
1
  Level 3 Recurring Assets at Fair Value     13  
2
  Summary of Condensed Consolidated Results of Operations     16  
3
  Analysis of Net Interest Income and Yield     17  
4
  Rate/Volume Analysis of Net Interest Income     19  
5
  Guaranty Fee Income and Average Effective Guaranty Fee Rate     21  
6
  Investment Gains (Losses), Net     23  
7
  Fair Value Gains (Losses), Net     24  
8
  Derivatives Fair Value Gains (Losses), Net     25  
9
  Credit-Related Expenses     28  
10
  Allowance for Loan Losses and Reserve for Guaranty Losses     28  
11
  Statistics on Seriously Delinquent Loans Purchased from MBS Trusts Subject to SOP 03-3     30  
12
  Activity of Seriously Delinquent Loans Purchased from MBS Trusts Subject to SOP 03-3     31  
13
  Re-performance Rates of Seriously Delinquent Single-Family Loans Purchased from MBS Trusts     31  
14
  Re-performance Rates of Seriously Delinquent Single-Family Loans Purchased from MBS Trusts and Modified     32  
15
  Required and Optional Purchases of Loans from MBS Trusts     33  
16
  Credit Loss Performance Metrics     34  
17
  Single-Family Credit Loss Sensitivity     36  
18
  Single-Family Business Results     38  
19
  HCD Business Results     39  
20
  Capital Markets Group Results     40  
21
  Mortgage Portfolio Activity     41  
22
  Mortgage Portfolio Composition     42  
23
  Trading and AFS Investment Securities     44  
24
  Investments in Private-Label Mortgage-Related Securities and Mortgage Revenue Bonds     45  
25
  Investments in Alt-A Private-Label Mortgage-Related Securities, Excluding Wraps     49  
26
  Investments in Subprime Private-Label Mortgage-Related Securities, Excluding Wraps     51  
27
  Alt-A and Subprime Private-Label Wraps     53  
28
  Debt Activity     55  
29
  Outstanding Debt     56  
30
  Changes in Risk Management Derivative Assets (Liabilities) at Fair Value, Net     57  
31
  Purchased Options Premiums     58  
32
  Supplemental Non-GAAP Consolidated Fair Value Balance Sheets     59  
33
  Non-GAAP Estimated Fair Value of Net Assets (Net of Tax Effect)     61  
34
  Selected Market Information     62  
35
  Fannie Mae Credit Ratings     67  
36
  Composition of Mortgage Credit Book of Business     71  
37
  Risk Characteristics of Conventional Single-Family Business Volume and Mortgage Credit Book of Business     73  


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Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
You should read this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) in conjunction with our unaudited condensed consolidated financial statements and related notes, and the more detailed information contained in our Annual Report on Form 10-K for the year ended December 31, 2007 (“2007 Form 10-K”). The results of operations presented in our interim financial statements and discussed in MD&A are not necessarily indicative of the results that may be expected for the full year. Please refer to “Glossary of Terms Used in This Report” in our 2007 Form 10-K for an explanation of key terms used throughout this discussion.
 
INTRODUCTION
 
Fannie Mae is a government-sponsored enterprise (“GSE”), owned by private shareholders (NYSE: FNM) and chartered by Congress to support liquidity and stability in the secondary mortgage market. Our business includes three integrated business segments—Single-Family Credit Guaranty (“Single-Family”), Housing and Community Development (“HCD”), and Capital Markets—that work together to provide services, products and solutions to our lender customers and a broad range of housing partners. Together, our business segments contribute to our chartered mission objectives, helping to increase the total amount of funds available to finance housing in the United States and to make homeownership more available and affordable for low-, moderate- and middle-income Americans. We also work with our customers and partners to increase the availability and affordability of rental housing. Although we are a corporation chartered by the U.S. Congress, the U.S. government does not guarantee, directly or indirectly, our securities or other obligations. Our business is self-sustaining and funded exclusively with private capital.
 
Our Single-Family business works with our lender customers to securitize single-family mortgage loans into Fannie Mae mortgage-backed securities (“Fannie Mae MBS”) and to facilitate the purchase of single-family mortgage loans for our mortgage portfolio. Our HCD business works with our lender customers to securitize multifamily mortgage loans into Fannie Mae MBS and to facilitate the purchase of multifamily mortgage loans for our mortgage portfolio. Our HCD business also makes debt and equity investments to increase the supply of affordable housing. Our Capital Markets group manages our investment activity in mortgage loans, mortgage-related securities and other investments, our debt financing activity, and our liquidity and capital positions. We fund our investments primarily through proceeds from our issuance of debt securities in the domestic and international capital markets.


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SELECTED FINANCIAL DATA
 
The selected financial data presented below is summarized from our condensed consolidated results of operations for the three and six months ended June 30, 2008 and 2007, as well as from selected condensed consolidated balance sheet data as of June 30, 2008 and December 31, 2007. This data should be read in conjunction with this MD&A, as well as with the unaudited condensed consolidated financial statements and related notes included in this report and with our audited consolidated financial statements and related notes included in our 2007 Form 10-K.
 
                                 
    For the
    For the
 
    Three Months Ended
    Six Months Ended
 
    June 30,     June 30,  
    2008     2007(1)     2008     2007(1)  
    (In millions, except per share amounts)  
 
Statement of operations data:
                               
Net interest income
  $ 2,057     $ 1,193     $ 3,747     $ 2,387  
Guaranty fee income
    1,608       1,120       3,360       2,218  
Losses on certain guaranty contracts
          (461 )           (744 )
Trust management income
    75       150       182       314  
Fair value gains (losses), net(2)
    517       1,424       (3,860 )     858  
Other income (expenses), net(3)
    (889 )     (3 )     (1,059 )     397  
Credit-related expenses(4)
    (5,349 )     (518 )     (8,592 )     (839 )
Net income (loss)
    (2,300 )     1,947       (4,486 )     2,908  
Preferred stock dividends and issuance costs at redemption
    (303 )     (118 )     (625 )     (253 )
Net income (loss) available to common stockholders
    (2,603 )     1,829       (5,111 )     2,655  
                                 
Per common share data:
                               
Earnings (loss) per share:
                               
Basic
  $ (2.54 )   $ 1.88     $ (5.11 )   $ 2.73  
Diluted
    (2.54 )     1.86       (5.11 )     2.72  
Weighted-average common shares outstanding:
                               
Basic
    1,025       973       1,000       973  
Diluted
    1,025       1,001       1,000       1,001  
Cash dividends declared per common share
  $ 0.35     $ 0.50     $ 0.70     $ 0.90  
                                 
New business acquisition data:
                               
Fannie Mae MBS issues acquired by third parties(5)
  $ 137,731     $ 134,440     $ 293,433     $ 259,642  
Mortgage portfolio purchases(6)
    61,347       48,676       97,670       84,833  
                                 
New business acquisitions
  $ 199,078     $ 183,116     $ 391,103     $ 344,475  
                                 
 


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    As of  
    June 30,
    December 31,
 
    2008     2007(1)  
    (Dollars in millions)  
 
Balance sheet data:
               
Investments in securities:
               
Trading
  $ 99,562     $ 63,956  
Available-for-sale
    245,226       293,557  
Mortgage loans:
               
Loans held for sale
    6,931       7,008  
Loans held for investment, net of allowance
    411,300       396,516  
Total assets
    885,918       879,389  
Short-term debt
    240,223       234,160  
Long-term debt
    559,279       562,139  
Total liabilities
    844,528       835,271  
Preferred stock
    21,725       16,913  
Total stockholders’ equity
    41,226       44,011  
                 
Regulatory capital data:
               
Core capital(7)
  $ 46,964     $ 45,373  
Total capital(8)
    55,568       48,658  
                 
Book of business data:
               
Mortgage portfolio(9)
  $ 754,116     $ 727,903  
Fannie Mae MBS held by third parties(10)
    2,252,282       2,118,909  
Other guarantees(11)
    31,812       41,588  
                 
Mortgage credit book of business
  $ 3,038,210     $ 2,888,400  
                 
Guaranty book of business(12)
  $ 2,898,207     $ 2,744,237  
                 
 
                                 
    For the
    For the
 
    Three Months Ended
    Six Months Ended
 
    June 30,     June 30,  
    2008     2007(1)     2008     2007(1)  
 
Ratios:
                               
Return on assets ratio(13)*
    (1.20 )%     0.86 %     (1.16 )%     0.62 %
Return on equity ratio(14)*
    (50.3 )     22.6       (43.9 )     16.6  
Equity to assets ratio(15)*
    4.6       4.8       4.8       4.8  
Dividend payout ratio(16)
    N/A       26.8       N/A       33.1  
Average effective guaranty fee rate (in basis points)(17)
    26.3 bp     21.5 bp     27.9 bp     21.6 bp
Credit loss ratio (in basis points)(18)
    17.5 bp     4.0 bp     15.1 bp     3.7 bp
 
 
  (1) Certain prior period amounts have been reclassified to conform to the current period presentation.
 
  (2) Consists of the following: (a) derivatives fair value gains (losses), net; (b) trading securities gains (losses), net; (c) hedged mortgage assets gains (losses), net; (d) debt foreign exchange gains (losses), net; and (e) debt fair value gains (losses), net.
 
  (3) Consists of the following: (a) investment gains (losses), net; (b) debt extinguishment gains (losses), net; (c) losses from partnership investments; and (d) fee and other income.
 
  (4) Consists of provision for credit losses and foreclosed property expense.
 
  (5) Unpaid principal balance of Fannie Mae MBS issued and guaranteed by us during the reporting period less: (a) securitizations of mortgage loans held in our portfolio during the reporting period and (b) Fannie Mae MBS purchased for our investment portfolio during the reporting period.

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  (6) Unpaid principal balance of mortgage loans and mortgage-related securities we purchased for our investment portfolio during the reporting period. Includes mortgage-related securities acquired through the extinguishment of debt and capitalized interest.
 
  (7) The sum of (a) the stated value of outstanding common stock (common stock less treasury stock); (b) the stated value of outstanding non-cumulative perpetual preferred stock; (c) paid-in capital; and (d) our retained earnings. Core capital excludes accumulated other comprehensive income (loss).
 
  (8) The sum of (a) core capital and (b) the total allowance for loan losses and reserve for guaranty losses, less (c) the specific loss allowance (that is, the allowance required on individually impaired loans).
 
  (9) Unpaid principal balance of mortgage loans and mortgage-related securities held in our portfolio.
 
(10) Unpaid principal balance of Fannie Mae MBS held by third-party investors. The principal balance of resecuritized Fannie Mae MBS is included only once in the reported amount.
 
(11) Includes single-family and multifamily credit enhancements that we have provided and that are not otherwise reflected in the table.
 
(12) Unpaid principal balance of: mortgage loans held in our mortgage portfolio; Fannie Mae MBS (whether held in our mortgage portfolio or held by third parties); and other credit enhancements that we provide on mortgage assets. Excludes non-Fannie Mae mortgage-related securities held in our investment portfolio for which we do not provide a guaranty. The principal balance of resecuritized Fannie Mae MBS is included only once in the reported amount.
 
(13) Annualized net income (loss) available to common stockholders divided by average total assets during the period.
 
(14) Annualized net income (loss) available to common stockholders divided by average outstanding common equity during the period.
 
(15) Average stockholders’ equity divided by average total assets during the period.
 
(16) Common dividends declared during the period divided by net income (loss) available to common stockholders for the period.
 
(17) Annualized guaranty fee income as a percentage of average outstanding Fannie Mae MBS and other guarantees during the period.
 
(18) Annualized (a) charge-offs, net of recoveries and (b) foreclosed property expense, as a percentage of the average guaranty book of business during the period. We exclude from our credit loss ratio any initial losses recorded on delinquent loans purchased from MBS trusts pursuant to Statement of Position No. 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (“SOP 03-3”), when the purchase price of seriously delinquent loans that we purchase from Fannie Mae MBS trusts exceeds the fair value of the loans at the time of purchase. Also excludes the difference between the unpaid principal balance of HomeSaver Advancetm loans at origination and the estimated fair value of these loans. Our credit loss ratio including the effect of these initial losses recorded pursuant to SOP 03-3 and related to HomeSaver Advance loans was 22.6 basis points and 4.7 basis points for the three months ended June 30, 2008 and 2007, respectively, and 21.7 basis points and 4.4 basis points for the six months ended June 30, 2008 and 2007, respectively. We previously calculated our credit loss ratio based on credit losses as a percentage of our mortgage credit book of business, which includes non-Fannie Mae mortgage-related securities held in our mortgage investment portfolio that we do not guarantee. Because losses related to non-Fannie Mae mortgage-related securities are not reflected in our credit losses, we revised the calculation of our credit loss ratio to reflect credit losses as a percentage of our guaranty book of business. Our credit loss ratio calculated based on our mortgage credit book of business would have been 16.7 basis points and 3.8 basis points for the three months ended June 30, 2008 and 2007, respectively, and 14.3 basis points and 3.5 basis points for the six months ended June 30, 2008 and 2007, respectively.
 
Note:
 
* Average balances for purposes of the ratio calculations are based on beginning and end of period balances.


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EXECUTIVE SUMMARY
 
Our “Executive Summary” presents a high-level overview of the most significant factors focused on by our management in currently evaluating our business and financial position and prospects.
 
Conditions in the Housing and Mortgage Markets
 
The housing and mortgage markets have experienced unprecedented challenges during 2008 and those challenges have driven our financial results. The housing market downturn that began in 2006 continued through 2007 and has further deteriorated in 2008. The market continues to experience declines in new and existing home sales, mortgage originations and home prices, as well as increases in inventories of unsold homes, mortgage delinquencies, defaults and foreclosures. Growth in U.S. residential mortgage debt outstanding slowed to an estimated annual rate of 2.9% based on the first three months of 2008, compared with an estimated annual rate of 8.0% based on the first three months of 2007. We estimate that home prices declined by 0.6% on a national basis during the second quarter of 2008, which translates to an 8% total national decline since the beginning of the downturn in the second quarter of 2006. We have seen more severe declines in certain states, such as California, Florida, Nevada and Arizona, which have experienced home price declines of 24% or more since their 2006 peaks. While we continue to expect home price declines in 2008 to be within our estimated 7% to 9% range, and peak-to-trough home price declines to be within our estimated 15% to 19% range, we see the trend moving toward the high end of those ranges, driven in particular by higher home price declines in certain regions.
 
Summary of Our Financial Results for the Second Quarter of 2008
 
The challenges experienced in the housing and mortgage markets during 2008 have impacted our financial results. For the second quarter of 2008, we recorded a net loss of $2.3 billion and a diluted loss per share of $2.54, compared with a net loss of $2.2 billion and a diluted loss per share of $2.57 for the first quarter of 2008. We recorded net income of $1.9 billion and diluted earnings per share of $1.86 for the second quarter of 2007. The $114 million increase in our net loss for the second quarter of 2008 compared with the first quarter of 2008 was driven principally by credit-related expenses. During the quarter, net deferred tax assets increased by $2.8 billion from $17.8 billion at March 31, 2008 to $20.6 billion at June 30, 2008, due primarily to the increase in our combined loan loss reserves. As we have continued to serve the market, we have seen growth in our book of business and market share since December 31, 2007. Our mortgage credit book of business increased to $3.0 trillion as of June 30, 2008, up from $2.9 trillion as of December 31, 2007. Our estimated market share of new single-family mortgage-related securities issuances remains high at approximately 45.4% for the second quarter of 2008, compared with an estimated 50.1% in the first quarter, and an estimated 27.9% for the second quarter of 2007.
 
We provide a more detailed discussion of key factors affecting changes in our results of operations and financial condition in “Consolidated Results of Operations,” “Business Segment Results,” “Consolidated Balance Sheet Analysis,” “Supplemental Non-GAAP Information—Fair Value Balance Sheets,” and “Risk Management—Credit Risk Management—Mortgage Credit Risk Management—Mortgage Credit Book of Business.”
 
Market Events of July 2008
 
In mid-July, following the close of the second quarter, liquidity and trading levels in the capital markets became extremely volatile, and the functioning of the markets was disrupted. The market value of our common stock dropped rapidly, to its lowest level since October 1990, and we experienced reduced demand for our unsecured debt and MBS products. This market disruption caused a significant increase in our cost of funding and a substantial increase in mark-to-market losses on our trading securities arising from a significant widening of credit spreads. In addition, during July, credit performance continued to deteriorate, and we recorded charge-offs and foreclosed property expenses that were higher than we had experienced in any month during the second quarter and higher than we expected, driven by higher defaults and higher loan loss


5


 

severities in markets most affected by the steep home price declines. Greater credit losses in July not only reduce our July net income through our actual realized losses, but also affect us as we expect that we will need to make further increases to our combined loss reserves in the second half of 2008 to incorporate our experience in July.
 
Credit
 
As noted above, the housing and mortgage market downturn negatively impacted us in the second quarter. Our quarterly default rate increased from 12 basis points in the first quarter of 2008 to 14 basis points in the second quarter of 2008, with particular acceleration in defaults from states, such as California, Arizona, Nevada and Florida, and certain vintages (2006 and 2007) that carry a higher than average unpaid principal balance. Average initial charge-off severity has also increased, with our average initial charge-off severity rate increasing from 19% in the first quarter of 2008 to 23% in the second quarter of 2008. Increases in our default and initial charge-off severity rates are both driven primarily by losses on our Alt-A loans in markets most affected by the steep home price declines. The deterioration in the credit performance of our higher risk loans is especially pronounced in our Alt-A mortgage book, with particular pressure on loans with layered risk, such as loans with subordinate financing and interest-only payment terms. As of June 30, 2008, our Alt-A mortgage loans represented approximately 11% of our total single-family mortgage credit book of business, and accounted for 49% of our credit losses for the second quarter of 2008.
 
Because we use our most recent actual experience to make projections, we are incorporating the July events described above into our current forecasts. In light of our experience during the second quarter and our credit performance in July, we are increasing our forecast for our credit loss ratio (which excludes SOP 03-3 and HomeSaver Advancetm fair value losses) to 23 to 26 basis points for 2008, as compared with our previous guidance of 13 to 17 basis points. We continue to anticipate that our credit loss ratio will increase further in 2009 compared with 2008. We also expect significant additions to our combined loss reserves through the remainder of 2008. Finally, while we expect that 2008 will be our peak year for credit-related expenses as we build our combined loss reserves in anticipation of charge-offs we expect to incur in 2009 and 2010, the total amount of credit-related expenses will be significant in 2009.
 
One significant offset to credit-related expenses is the revenue we earn. We have two main sources of revenue: the guaranty fee income we generate over time from our existing guaranty book of business and from new guaranty business, and the net interest income we earn on the assets we hold in our portfolio. We generated $7.7 billion of revenue in the first half of 2008 and expect to generate revenues in the second half of the year similar to those generated in the first half of the year.
 
In light of continued deterioration in credit performance, we have been, and are continuing, to take steps designed to mitigate our credit losses. During the second quarter, we took a variety of steps to address credit losses using a variety of tools.
 
  •  Underwriting Changes.  We have continued to review and revise our underwriting standards through eligibility changes, including those implemented through our most recent release of DesktopUnderwriter®, which tightens existing standards. These revisions have resulted in a significant reduction in the volume of the types of loans that currently represent a majority of our credit losses. Effective January 1, 2009, we are discontinuing the purchase of newly originated lender-channel Alt-A loans. In addition, we will continue to review our underwriting standards and may in the future make additional changes as necessary to reflect future changes in the market.
 
  •  Workout Rates of Delinquent Loans.  We have increased our workout rate from approximately 50% of problem loans in 2007 to 56% in the first half of the year. We are targeting a workout ratio goal of 60% by the end of the year, reflecting a substantial expansion of our loss mitigation activities, personnel and initiatives.
 
  •  Review of Defaulted Loans.  We have increased efforts to pursue recoveries from lenders, focusing especially on our Alt-A book, by expanding loan reviews in cases where we incurred a loss or


6


 

  could incur a loss due to fraud or improper lending practices. We expect this effort is likely to increase our recoveries in 2008 and 2009.
 
  •  REO Inventory Management.  As our foreclosure rates have increased, our inventory of REO properties has increased. We are enhancing our REO inventory management capabilities by opening offices in the hardest hit regions, such as California and Florida, and increasing our local resources devoted to property management and sales efforts. We have expanded our network of firms to assist in property disposition to ensure we have adequate capacity to sell the additional properties we expect to acquire through foreclosure. Finally, we are evaluating various proposals we have received from third parties involving the sale of properties in bulk transactions.
 
In addition to these specific activities, we are continuing to develop strategies designed to mitigate the increase in our credit losses. We have formed a multi-disciplinary team in credit risk, operations and financial management devoted to supporting loss mitigation and foreclosure prevention and have significantly increased the level of internal management and staff resources engaged in that effort.
 
For a further description of our credit risk management, refer to “Consolidated Results of Operations—Credit-Related Expenses” and “Risk Management—Credit Risk Management—Mortgage Credit Risk Management.”
 
Capital
 
As noted above, the market conditions that we experienced during the second quarter were more negative than we anticipated, and that trend accelerated in July. Our core capital as of June 30, 2008 was $47.0 billion, $14.3 billion above our statutory minimum capital requirement and $9.4 billion above our regulator-directed 15% surplus requirement. We currently expect that we will remain above our regulatory capital requirement for the remainder of 2008. (Our “regulatory capital requirement” is equal to our statutory minimum capital requirement plus any additional surplus above that statutory minimum that we expect our regulator will require us to hold.) Due to the volatile market conditions, we now have less visibility into our capital position in 2009. We currently have internally prepared scenarios, derived from our own statistical models and management’s judgment, that indicate that we will remain above our regulatory capital requirement through 2009, and others that show that we may not. There are a variety of current uncertainties that make estimates for 2009 challenging, including:
 
  •  the credit performance of the loans in our mortgage credit book of business;
 
  •  the pace at which we realize credit losses;
 
  •  the impact of the recently passed housing legislation, and the timing of that impact;
 
  •  the amount and pace of home price declines;
 
  •  the impact of other factors, such as unemployment rates and energy prices, on overall economic conditions and borrower behavior;
 
  •  the amount of impairments we are required to take on our securities;
 
  •  the impact of credit spreads on mark-to-market values;
 
  •  changes in state laws and judicial actions with respect to foreclosure;
 
  •  the cost of our funding;
 
  •  the amount of mortgage insurance claims that are paid;
 
  •  the ability to recover our deferred tax asset;
 
  •  the amount of revenue we generate; and
 
  •  the inter-relationship among and between these factors in the current mortgage market.


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For more information regarding risks to our business that may impact performance and capital levels, refer to “Part II—Item 1A—Risk Factors.”
 
Our capital position, and whether we are classified as “adequately capitalized” for regulatory purposes, also depends on the level of capital we are required to hold by our regulator. In May 2008, the Office of Federal Housing Enterprise Oversight (“OFHEO”) indicated its intention to reduce our capital surplus requirement by five percentage points to a 10% surplus requirement in September 2008, based upon our continued maintenance of excess capital well above OFHEO’s regulatory requirement and no material adverse change to our ongoing regulatory compliance. Under the recently enacted Federal Housing Finance Regulatory Reform Act of 2008 (the “Regulatory Reform Act”), our new regulator, the Federal Housing Finance Authority (“FHFA”), has new authority to increase our regulatory capital requirement pursuant to a formal rulemaking process and consultation with the Chairman of the Board of Governors of the Federal Reserve System, but we do not yet know what those capital levels will be. In addition, OFHEO has recently finalized rules modifying our regulatory risk-based capital stress test which will be applied beginning with the third quarter of 2008. The uncertainties that make 2009 estimates challenging also impact the calculation of this requirement, adding additional uncertainty to the regulatory requirements for capital. We are in ongoing dialogue with our regulator regarding our capital position. For more information regarding our regulatory capital requirements, including the newly finalized risk-based capital requirements, refer to “Liquidity and Capital Management—Capital Management—Regulatory Capital Requirements.”
 
In light of volatile market conditions, it is critical that we manage our capital levels to maintain a capital cushion well in excess of our regulatory capital requirement. To that end, we use strategies designed to preserve and protect our capital. In addition, we may, from time to time, raise capital opportunistically. Management continues to carefully monitor our capital and dividend positions and the trends impacting those positions and, if necessary, intends to take actions designed to help mitigate the impacts of a worsening environment on those positions. In this environment, conditions that negatively impact capital can develop rapidly and are based on a variety of factors. Therefore, we may need to take action quickly to respond.
 
We have already begun to take some of those actions. Today, the Board of Directors announced that the company is decreasing the dividend on our common stock to five cents per share. On August 4, 2008, we announced an increase in our guaranty fee pricing on new acquisitions commensurate with the risks in the current market. We are also prudently managing the size of our balance sheet. Finally, we are evaluating our costs and expenses and expect to reduce ongoing operating costs by 10% by year end 2009. Additional steps we could take include: reducing or eliminating our dividends; slowing growth; decreasing the size of the balance sheet; further raising guaranty fees; and raising additional capital (which could be dilutive). Some of these actions could have negative consequences, including decreased revenue due to growth limitations, or increased mark-to-market charges associated with the decreased liquidity for mortgage assets that could arise from a reduction in our market activity. If our capital fails to meet standards set by our regulator, our regulator could require us to enter into a capital restoration plan or take other actions. As discussed below, the U.S. Treasury is authorized to buy Fannie Mae’s debt, equity and other securities, subject to our agreement.
 
For more information regarding our capital management, including our recent capital raises, refer to “Liquidity and Capital Management—Capital Management—Capital Activity—Capital Management Actions.” For more information regarding our capital measures, refer to “Notes to the Condensed Consolidated Financial Statements—Note 15, Regulatory Capital Requirements.”
 
Legislative and Regulatory Actions
 
On July 30, 2008, President Bush signed into law the Housing and Economic Recovery Act of 2008 that included GSE regulatory reform legislation. The legislation, which is described in more detail in “Legislation Relating to Our Regulatory Framework,” establishes FHFA as our new safety, soundness and mission regulator, replacing OFHEO and the U.S. Department of Housing and Urban Development (“HUD”) for this purpose.
 
In general, the legislation strengthens the existing safety and soundness oversight of the GSEs, providing FHFA with safety and soundness authority that is comparable to and in some respects broader than that of the


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federal bank regulatory agencies. For example, FHFA will have enhanced powers to raise capital levels above statutory minimum levels, to regulate the size and content of our portfolio, and to approve new mortgage products. The legislation also increases the financial and administrative cost of our affordable housing mission.
 
In addition, the legislation includes provisions that were initially proposed by Treasury Secretary Henry Paulson, Jr. on July 13, 2008. These provisions:
 
  •  Authorize U.S. Treasury to buy Fannie Mae’s debt, equity and other securities, subject to our agreement; and
 
  •  Give the Chairman of the Board of Governors of the Federal Reserve System a consultative role in our regulator’s process for setting capital requirements and other safety and soundness standards.
 
Both provisions lapse at the end of 2009.
 
For a further description of the new legislation, including a discussion of its potential impact on us, refer to “Legislation Relating To Our Regulatory Framework” and “Part II—Item 1A—Risk Factors.”
 
LEGISLATION RELATING TO OUR REGULATORY FRAMEWORK
 
The Regulatory Reform Act was signed into law by President Bush on July 30, 2008, and became effective immediately. The legislation establishes FHFA as an independent agency with general supervisory and regulatory authority over Fannie Mae, Freddie Mac, and the 12 Federal Home Loan Banks. FHFA assumes the duties of our former regulators, OFHEO and HUD, with respect to safety, soundness and mission oversight of Fannie Mae and Freddie Mac. We expect that our new regulator will implement the various provisions of the legislation over the next several months, generally though rulemaking. In general, we remain subject to existing regulations, orders and determinations until new ones are issued or made. Refer to “Item 1. Business—Our Charter and Regulation of Our Activities” in our 2007 Form 10-K for a description of our regulation prior to enactment of this legislation.
 
Safety and Soundness Provisions
 
Capital.  The legislation provides significant new authority to FHFA with respect to our risk-based and minimum capital requirements. FHFA has broad authority to establish risk-based capital standards for us and Freddie Mac to ensure that we operate in a safe and sound manner and maintain sufficient capital and reserves. FHFA also has broad authority to increase the level of our required minimum capital and to establish capital or reserve requirements for specific products and activities, so as to ensure that we operate in a safe and sound manner.
 
Portfolio.  The legislation requires FHFA to establish standards governing our portfolio holdings, to ensure that they are backed by sufficient capital and consistent with our mission and safe and sound operations. The legislation further requires FHFA to monitor our portfolio and, in some circumstances, authorizes FHFA to require us to dispose of or acquire assets.
 
Prudential Standards.  The legislation requires FHFA to establish prudential management and operations standards, including standards for internal controls, risk management, and investments and acquisitions.
 
Prompt Corrective Action.  The legislation strengthens FHFA’s prompt corrective action authority, including its discretionary authority to change our capital classification under certain circumstances and to restrict our growth and activities if we are not adequately capitalized.
 
Conservatorship and Receivership.  The legislation provides FHFA new authority to place us into receivership, and enhanced authority to place us into conservatorship, based on certain specified grounds. Further, FHFA must place us into receivership if it determines that our debts have exceeded our assets for 60 days, or we have not been paying our debts as they become due for 60 days.


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Enforcement Powers.  The legislation provides FHFA with enhanced enforcement powers, including greater cease-and-desist authority and increased civil monetary penalties, and new authority to suspend or remove directors and management.
 
Mission Provisions
 
Products and Activities.  The legislation requires us, with some exceptions, to obtain the approval of FHFA before we initially offer a product. The process for obtaining FHFA’s approval includes a 30-day public notice and comment period relating to the product. A product may be approved only if it is authorized by our charter, in the public interest, and consistent with the safety and soundness of the enterprise and the mortgage finance system. We must provide written notice to FHFA before commencing any new activity.
 
Affordable Housing Allocations.  The legislation requires us and Freddie Mac to make annual allocations to fund government affordable housing programs, based on the dollar amount of our total new business purchases, at the rate of 4.2 basis points per dollar. If this requirement had been in effect in 2007, our contribution for that year would have been approximately $300 million. For the first three years, a diminishing portion (100%, 50%, 25%) of our allocation will be used to pay for the Federal Housing Administration’s (“FHA”) HOPE for Homeowners Program. The legislation requires FHFA to temporarily suspend our allocation upon finding that it: is contributing or would contribute to our financial instability; is causing or would cause us to be classified as undercapitalized; or is preventing or would prevent us from successfully completing a capital restoration plan. FHFA must issue regulations prohibiting us from redirecting the cost of our allocations, through increased charges or fees, or decreased premiums, or in any other manner, to the originators of mortgages that we purchase or securitize.
 
Affordable Housing Goals and Duty to Serve.  The legislation restructures our affordable housing goals and creates a new duty for us and Freddie Mac to serve three underserved markets—manufactured housing, affordable housing preservation, and rural housing. With respect to these markets, we are required to “provide leadership to the market in developing loan products and flexible underwriting guidelines to facilitate a secondary market for mortgages for very low-, low-, and moderate-income families.” Both the restructured goals and the new duty to serve take effect in 2010. The legislation provides that the housing goals established by HUD for 2008 will remain in effect for 2009, except that by April 2009, FHFA must review the 2009 goals to determine their feasibility given the market conditions current at such time and, after seeking public comment for up to 30 days, FHFA may make appropriate adjustments to the 2009 goals consistent with such market conditions.
 
Temporary Provisions
 
Enhanced Authority of U.S. Treasury to Purchase GSE Securities.  The Secretary of the Treasury has long had authority to purchase up to $2.25 billion in our obligations. The legislation provides the Secretary of the Treasury with additional temporary authority to purchase our obligations and other securities on terms that the Secretary may determine, subject to our agreement. This expanded authority expires on December 31, 2009. To exercise this authority, the Secretary must determine that such a purchase is necessary to provide stability to the financial markets, prevent disruptions in the availability of mortgage finance, and protect taxpayers. In connection with exercising this authority, the Secretary must consider: the need for preferences or priorities regarding payments to the government; limits on maturity or disposition of obligations or securities to be purchased; the company’s plan for orderly resumption of private market funding or capital market access; the probability of our fulfilling the terms of the obligations or other securities, including repayment; the need to maintain our status as a private shareholder-owned company; and restrictions on the use of our resources, including limitations on the payment of dividends and executive compensation.
 
Consultation with the Federal Reserve.  Until December 31, 2009, our regulator must consult with the Chairman of the Board of Governors of the Federal Reserve on risks posed by the GSEs to the financial system before taking certain regulatory actions such as issuance of regulations regarding capital or portfolio, or appointment of a conservator or receiver.


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Other Provisions
 
Conforming Loan Limits.  The legislation permanently increases our conforming loan limit in high cost areas, to the lower of 115% of the median home price for comparable properties in the area, or 150% of the otherwise applicable loan limit (currently $625,500). This provision takes effect on January 1, 2009, upon expiration of the loan limit provisions contained in the Economic Stimulus Act of 2008.
 
SEC Registration.  The legislation provides that no class of equity securities of Fannie Mae or Freddie Mac shall be treated as exempted securities for purposes of section 12, 13, 14, or 16 of the Securities Exchange Act of 1934. (Fannie Mae voluntarily registered its common stock with the U.S. Securities and Exchange Commission (“SEC”) on March 31, 2003. We registered our preferred stock on July 29, 2008, in accordance with the legislation.)
 
Executive Compensation.  FHFA may at any time review the reasonableness of executive compensation, and may prohibit payment to the officer during such review. In addition, FHFA is authorized to prohibit or limit certain golden parachute and indemnification payments to directors, officers, and certain other parties. Until December 31, 2009, FHFA shall have the power to approve, disapprove or modify executive compensation.
 
Board of Directors.  The legislation eliminates the five presidential appointees from our board of directors, and provides that our board shall consist of 13 persons elected by the shareholders, or such other number as the Director of FHFA determines appropriate. The legislation leaves in place the requirement that our board shall at all times have as members at least one person from the homebuilding, mortgage lending, and real estate industries, and at least one person from an organization representing consumer or community interests or one person who has demonstrated a career commitment to the provision of housing for low-income households.
 
For a description of how this GSE regulatory reform legislation could materially adversely affect our business and earnings, see “Part II—Item 1A—Risk Factors” of this report.
 
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
 
The preparation of financial statements in accordance with generally accepted accounting principles (“GAAP”) requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the consolidated financial statements. Understanding our accounting policies and the extent to which we use management judgment and estimates in applying these policies is integral to understanding our financial statements. We have identified the following as our most critical accounting policies and estimates:
 
  •  Fair Value of Financial Instruments
 
  •  Other-than-temporary Impairment of Investment Securities
 
  •  Allowance for Loan Losses and Reserve for Guaranty Losses
 
  •  Deferred Tax Assets
 
We describe below significant changes in the judgments and assumptions we made during the first six months of 2008 in applying our critical accounting policies and estimates. Also see “Part II—Item 7—MD&A—Critical Accounting Policies and Estimates” of our 2007 Form 10-K for additional information about our critical accounting policies and estimates.
 
Fair Value of Financial Instruments
 
We adopted SFAS No. 157, Fair Value Measurements (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value and outlines a fair value hierarchy based on the inputs to valuation techniques used to measure fair value, effective January 1, 2008. SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (also referred to as an exit price). SFAS 157 categorizes fair value measurements into a three-level hierarchy based on the extent to which the measurement relies on observable


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market inputs in measuring fair value. Level 1, which is the highest priority in the fair value hierarchy, is based on unadjusted quoted prices in active markets for identical assets or liabilities. Level 2 is based on observable market-based inputs, other than quoted prices, in active markets for identical assets or liabilities. Level 3, which is the lowest priority in the fair value hierarchy, is based on unobservable inputs. Assets and liabilities are classified within this hierarchy in their entirety based on the lowest level of any input that is significant to the fair value measurement.
 
The use of fair value to measure our financial instruments is fundamental to our financial statements and is a critical accounting estimate because a substantial portion of our assets and liabilities are recorded at estimated fair value. The majority of our financial instruments carried at fair value fall within the level 2 category and are valued primarily utilizing inputs and assumptions that are observable in the marketplace, can be derived from observable market data or corroborated by observable levels at which transactions are executed in the marketplace. Because items classified as level 3 are generally based on unobservable inputs, the process to determine fair value is generally more subjective and involves a high degree of management judgment and assumptions. These assumptions may have a significant effect on our estimates of fair value, and the use of different assumptions as well as changes in market conditions could have a material effect on our results of operations or financial condition. We provide additional information regarding our level 3 assets below.
 
Fair Value Hierarchy—Level 3 Assets
 
Level 3 is primarily comprised of financial instruments whose fair value is estimated based on valuation methodologies utilizing significant inputs and assumptions that are generally less observable because of limited market activity or little or no price transparency. We typically classify financial instruments as level 3 if the valuation is based on inputs from a single source, such as a dealer quotation, where we are not able to corroborate the inputs and assumptions with other available, relevant market information. Our level 3 financial instruments include certain mortgage- and asset-backed securities and residual interests, certain performing residential mortgage loans, non-performing mortgage-related assets, our guaranty assets and buy-ups, our master servicing assets and certain highly structured, complex derivative instruments.
 
Some of our financial instruments, such as our trading and available-for-sale (“AFS”) securities and our derivatives, are measured at fair value on a recurring basis in periods subsequent to initial recognition. We measure some of our other financial instruments at fair value on a non-recurring basis in periods subsequent to initial recognition, such as held-for-sale mortgage loans. Table 1 presents, by balance sheet category, the amount of financial assets carried in our condensed consolidated balance sheets at fair value on a recurring basis and classified as level 3 as of June 30, 2008. We also identify the types of financial instruments within each asset category that are based on level 3 measurements and describe the valuation techniques used for determining the fair value of these financial instruments. The availability of observable market inputs to measure fair value varies based on changes in market conditions, such as liquidity. As a result, we expect the financial instruments carried at fair value on a recurring basis and classified as level 3 to vary each period.


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Table 1:  Level 3 Recurring Assets at Fair Value
 
             
    As of June 30, 2008
    Estimated
     
Balance Sheet Category
  Fair Value    
Description and Valuation Technique
(Dollars in millions)
 
Trading securities
  $ 14,325     Primarily consists of mortgage-related securities backed by Alt-A loans and subprime loans. We generally have estimated the fair value based on the use of average prices obtained from multiple pricing services. In the absence of such information or if we are not able to corroborate these prices by other available, relevant market information, we estimate the fair value based on broker or dealer quotations or using internal calculations that incorporate inputs that are implied by market prices for similar securities and structure types. These inputs may be adjusted for various factors, such as prepayment speeds and credit spreads.
AFS securities
    40,033     Primarily consists of mortgage-related securities backed by Alt-A loans and subprime loans and mortgage revenue bonds. The valuation techniques are the same as those noted above for trading securities.
Derivatives assets
    270     Primarily consists of a limited population of certain highly structured, complex interest rate risk management derivatives. Examples include certain swaps with embedded caps and floors that reference non-standard indexes. We determine the fair value of these derivative instruments using indicative market prices obtained from large, experienced dealers. Indicative market prices from a single source that cannot be corroborated are classified as level 3.
Guaranty assets and buy-ups
    1,947     Represents the present value of the estimated compensation we expect to receive for providing our guaranty related to portfolio securitization transactions. We generally estimate the fair value based on internal models that calculate the present value of expected cash flows. Key model inputs and assumptions include prepayment speeds, forward yield curves and discount rates that are commensurate with the level of estimated risk.
             
Level 3 recurring assets
  $ 56,575      
             
Total assets
  $ 885,918      
Total recurring assets measured at fair value
  $ 347,748      
Level 3 recurring assets as a percentage of total assets
    6 %    
Level 3 recurring assets as a percentage of total recurring assets measured at fair value
    16 %    
Total recurring assets measured at fair value as a percentage of total assets
    39 %    
 
Level 3 recurring assets totaled $56.6 billion, or 6% of our total assets, as of June 30, 2008, compared with 7% of our total assets as of March 31, 2008. The balance of level 3 recurring assets increased by $451 million and $15.3 billion for the second quarter and first six months of 2008, respectively. These level 3 balance increases were principally driven by an increase in the portion of mortgage assets for which there is a lack of market liquidity and limited availability of external pricing data, resulting in transfers of these assets from level 2 to level 3. These transfers reflect the ongoing effects of the significant disruption in the mortgage market and severe reduction in market liquidity for certain mortgage products, such as private-label mortgage-related securities backed by Alt-A loans or subprime loans. Because of the reduction in recently executed transactions and market price quotations for these instruments, the market inputs for these instruments are less observable.


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Financial assets measured at fair value on a non-recurring basis and classified as level 3, which are not presented in the table above, include held-for-sale (“HFS”) loans that are measured at lower of cost or market and that were written down to fair value as of the end of the period. The fair value of these loans totaled $812 million as of June 30, 2008. In addition, certain financial assets measured at cost that have been written down to fair value during the period due to impairment are classified as non-recurring. The fair value of these level 3 non-recurring financial assets, which primarily consisted of certain guaranty assets and acquired property, totaled $8.2 billion as of June 30, 2008. Financial liabilities measured at fair value on a recurring basis and classified as level 3 as of June 30, 2008 consisted of long-term debt with a fair value of $3.3 billion and derivatives liabilities with a fair value of $107 million. See “Notes to Condensed Consolidated Financial Statements—Note 17, Fair Value of Financial Instruments” for further information regarding SFAS 157, including the classification within the three-level hierarchy of all of our assets and liabilities carried in our condensed consolidated balance sheet at fair value as of June 30, 2008.
 
Fair Value Control Processes
 
We employ control processes to validate the fair value of our financial instruments. These control processes are designed to ensure that the values used for financial reporting are based on observable inputs wherever possible. If observable market-based inputs are not available, the control processes are designed to ensure that the valuation approach used is appropriate and consistently applied and that the assumptions are reasonable. Our control processes provide for segregation of duties and oversight of our fair value methodologies and valuations by our Valuation Oversight Committee. Valuations are performed by personnel independent of our business units. A price verification group reviews selected valuations and compares the valuations to alternative external market data (e.g., quoted market prices, broker or dealer quotations, pricing services, recent trading activity and comparative analyses to similar instruments) for reasonableness. The price verification group also performs independent reviews of the assumptions used in determining the fair value of products with material estimation risk for which observable market-based inputs do not exist. Valuation models are regularly reviewed and approved for use for specific products by the Chief Risk Office, which also is independent from our business units. Any changes to the valuation methodology or pricing are reviewed by the Valuation Oversight Committee to confirm the changes are appropriate.
 
We continue to refine our valuation methodologies as markets and products develop and the pricing for certain products becomes more or less transparent. While we believe our valuation methods are appropriate and consistent with those of other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a materially different estimate of fair value as of the reporting date.
 
Change in Measuring the Fair Value of Guaranty Obligations
 
Beginning January 1, 2008, as part of the implementation of SFAS 157, we changed our approach to measuring the fair value of our guaranty obligations. Specifically, we adopted a measurement approach that is based upon an estimate of the compensation that we would require to issue the same guaranty in a standalone arm’s-length transaction with an unrelated party. When we initially recognize a guaranty issued in a lender swap transaction after December 31, 2007, we measure the fair value of the guaranty obligation based on the fair value of the total compensation we receive, which primarily consists of the guaranty fee, credit enhancements, buy-downs, risk-based price adjustments and our right to receive interest income during the float period in excess of the amount required to compensate us for master servicing. Because the fair value of those guaranty obligations now equals the fair value of the total compensation we receive, we do not recognize losses or record deferred profit in our financial statements at inception of those guaranty contracts issued after December 31, 2007.
 
We also changed how we measure the fair value of our existing guaranty obligations, as disclosed in “Supplemental Non-GAAP Information—Fair Value Balance Sheets” and in “Notes to Condensed Consolidated Financial Statements,” to be consistent with our new approach for measuring guaranty obligations at initial recognition. The fair value of all guaranty obligations measured after their initial recognition represents our estimate of a hypothetical transaction price we would receive if we were to issue


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our guarantees to an unrelated party in a standalone arm’s-length transaction at the measurement date. To measure this fair value, we continue to use the models and inputs that we used prior to our adoption of SFAS 157 and calibrate those models to our current market pricing.
 
Prior to January 1, 2008, we measured the fair value of the guaranty obligations that we recorded when we issued Fannie Mae MBS based on market information obtained from spot transaction prices. In the absence of spot transaction data, which was the case for the substantial majority of our guarantees, we used internal models to estimate the fair value of our guaranty obligations. We reviewed the reasonableness of the results of our models by comparing those results with available market information. Key inputs and assumptions used in our models included the amount of compensation required to cover estimated default costs, including estimated unrecoverable principal and interest that we expected to incur over the life of the underlying mortgage loans backing our Fannie Mae MBS, estimated foreclosure-related costs, estimated administrative and other costs related to our guaranty, and an estimated market risk premium, or profit, that a market participant of similar credit standing would require to assume the obligation. If our modeled estimate of the fair value of the guaranty obligation was more or less than the fair value of the total compensation received, we recognized a loss or recorded deferred profit, respectively, at inception of the guaranty contract. See “Part II—Item 7—MD&A—Critical Accounting Policies and Estimates—Fair Value of Guaranty Assets and Guaranty Obligations—Effect on Losses on Certain Guaranty Contracts” of our 2007 Form 10-K for additional information.
 
The accounting for our guarantees in our condensed consolidated financial statements is unchanged with our adoption of SFAS 157. Accordingly, the guaranty obligation amounts recorded in our condensed consolidated balance sheets attributable to guarantees issued prior to January 1, 2008 will continue to be amortized in accordance with our established accounting policy. This change, however, affects how we determine the fair value of our existing guaranty obligations as of each balance sheet date. See “Supplemental Non-GAAP Information—Fair Value Balance Sheets” and “Notes to Condensed Consolidated Financial Statements” for additional information regarding the impact of this change.
 
Deferred Tax Assets
 
We recognize deferred tax assets and liabilities for the future tax consequences related to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and for tax credits. Our net deferred tax assets totaled $20.6 billion and $13.0 billion as of June 30, 2008 and December 31, 2007, respectively. We evaluate our deferred tax assets for recoverability based on available evidence, including assumptions about future profitability. We are required to establish a valuation allowance for deferred tax assets and record a charge to income if we determine, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. Such a charge likely would have a material adverse effect on our results of operations, financial condition and capital position. In evaluating the need for a valuation allowance, we estimate future taxable income based on management approved business plans and ongoing tax planning strategies. This process involves significant management judgment about assumptions that are subject to change from period to period based on changes in tax laws or variances between our future projected operating performance and our actual results. Accordingly, we have included the assessment of a deferred tax asset valuation allowance as a critical accounting policy.
 
We are in a cumulative book taxable loss position as of the three-year period ended June 30, 2008. The realization of our deferred tax assets is dependent upon the generation of sufficient future taxable income. For purposes of establishing a deferred tax valuation allowance, this cumulative book taxable loss position is considered significant, objective evidence that we may not be able to realize some portion of our deferred tax assets in the future. In assessing the nature of our cumulative book taxable loss position, we evaluated the factors contributing to these losses and analyzed whether these factors were temporary or indicative of a permanent decline in our earnings. We determined that our current cumulative book taxable loss position was caused primarily by an increase in our credit losses due to the current housing and credit market conditions. Prior to 2007, we had generated pre-tax book income for over 20 consecutive years. Based on our forecasts of future taxable income, which include assumptions about the depth and severity of home price depreciation and credit losses, we anticipate that it is more likely than not that our results of future operations will generate sufficient taxable income to allow us to realize our deferred tax assets. Therefore, we did not record a valuation allowance against our net deferred tax assets as of June 30, 2008 or December 31, 2007.


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Although current market conditions have created significant volatility in our pre-tax book income, our current forecasts of future taxable income reflect sufficient taxable income in future periods to realize our deferred tax assets based on the nature of our book-to-tax differences and the stability of our core business model. Included in our forecasts are credit assumptions regarding our estimate of future expected credit losses, which we believe is the most variable component of our current forecasts of future taxable income. If future events differ from our current forecasts, a valuation allowance may need to be established, which likely would have a material adverse effect on our results of operations, financial condition and capital position. We will continue to update our assumptions and forecasts of future taxable income and assess the need for a valuation allowance.
 
We provide additional detail on the components of our deferred tax assets and deferred tax liabilities as of December 31, 2007 in our 2007 Form 10-K in “Notes to Consolidated Financial Statements—Note 11, Income Taxes” and we provide information on the increase in our deferred tax assets since December 31, 2007 in “Notes to Condensed Consolidated Financial Statements—Note 10, Income Taxes” of this report.
 
CONSOLIDATED RESULTS OF OPERATIONS
 
The following discussion of our condensed consolidated results of operations is based on a comparison of our results between the three and six months ended June 30, 2008 and the three and six months ended June 30, 2007. Table 2 presents a summary of our unaudited condensed consolidated results of operations for each of these periods.
 
Table 2:  Summary of Condensed Consolidated Results of Operations
 
                                                                 
    For the
    For the
             
    Three Months Ended
    Six Months Ended
    Quarterly
    Year-to-Date
 
    June 30,     June 30,     Variance     Variance  
    2008     2007     2008     2007     $     %     $     %  
    (Dollars in millions, except per share amounts)  
 
Net interest income
  $ 2,057     $ 1,193     $ 3,747     $ 2,387     $ 864       72 %   $ 1,360       57 %
Guaranty fee income
    1,608       1,120       3,360       2,218       488       44       1,142       51  
Trust management income
    75       150       182       314       (75 )     (50 )     (132 )     (42 )
Fee and other income(1)
    225       257       452       534       (32 )     (12 )     (82 )     (15 )
                                                                 
Net revenues
    3,965       2,720       7,741       5,453       1,245       46       2,288       42  
Losses on certain guaranty contracts
          (461 )           (744 )     461       100       744       100  
Investment gains (losses), net(1)
    (883 )     (93 )     (994 )     202       (790 )     (849 )     (1,196 )     (592 )
Fair value gains (losses), net(1)
    517       1,424       (3,860 )     858       (907 )     (64 )     (4,718 )     (550 )
Losses from partnership investments
    (195 )     (215 )     (336 )     (380 )     20       9       44       12  
Administrative expenses
    (512 )     (660 )     (1,024 )     (1,358 )     148       22       334       25  
Credit-related expenses(2)
    (5,349 )     (518 )     (8,592 )     (839 )     (4,831 )     (933 )     (7,753 )     (924 )
Other non-interest expenses(1)(3)
    (286 )     (60 )     (791 )     (164 )     (226 )     (377 )     (627 )     (382 )
                                                                 
Income (loss) before federal income taxes and extraordinary losses
    (2,743 )     2,137       (7,856 )     3,028       (4,880 )     (228 )     (10,884 )     (359 )
Benefit (provision) for federal income taxes
    476       (187 )     3,404       (114 )     663       355       3,518       3,086  
Extraordinary losses, net of tax effect
    (33 )     (3 )     (34 )     (6 )     (30 )     (1,000 )     (28 )     (467 )
                                                                 
Net income (loss)
  $ (2,300 )   $ 1,947     $ (4,486 )   $ 2,908     $ (4,247 )     (218 )%   $ (7,394 )     (254 )%
                                                                 
Diluted earnings (loss) per common share
  $ (2.54 )   $ 1.86     $ (5.11 )   $ 2.72     $ (4.40 )     (237 )%   $ (7.83 )     (288 )%
                                                                 
 
 
(1) Certain prior period amounts have been reclassified to conform with the current period presentation in our condensed consolidated statements of operations.
 
(2) Consists of provision for credit losses and foreclosed property expense.
 
(3) Consists of debt extinguishment gains (losses), net, minority interest in earnings of consolidated subsidiaries and other expenses.


16


 

 
Our business generates revenues from four principal sources: net interest income, guaranty fee income, trust management income, and fee and other income. Other significant factors affecting our results of operations include: fair value gains and losses; the timing and size of investment gains and losses; credit-related expenses; losses from partnership investments; administrative expenses and our effective tax rate. We provide a comparative discussion of the effect of our principal revenue sources and other significant items on our condensed consolidated results of operations for the three and six months ended June 30, 2008 and 2007 below.
 
Net Interest Income
 
Table 3 presents an analysis of our net interest income and net interest yield for the three and six months ended June 30, 2008 and 2007.
 
Table 3:  Analysis of Net Interest Income and Yield
 
                                                 
    For the Three Months Ended June 30,  
    2008     2007  
          Interest
    Average
          Interest
    Average
 
    Average
    Income/
    Rates
    Average
    Income/
    Rates
 
    Balance(1)     Expense     Earned/Paid     Balance(1)     Expense     Earned/Paid  
    (Dollars in millions)  
 
Interest-earning assets:
                                               
Mortgage loans(2)
  $ 418,504     $ 5,769       5.51 %   $ 390,034     $ 5,625       5.77 %
Mortgage securities
    318,396       4,063       5.10       325,303       4,460       5.48  
Non-mortgage securities(3)
    57,504       400       2.75       68,515       928       5.36  
Federal funds sold and securities purchased under agreements to resell
    26,869       186       2.74       15,301       205       5.31  
Advances to lenders
    3,332       46       5.46       6,056       48       3.12  
                                                 
Total interest-earning assets
  $ 824,605     $ 10,464       5.07 %   $ 805,209     $ 11,266       5.59 %
                                                 
Interest-bearing liabilities:
                                               
Short-term debt
  $ 242,453     $ 1,685       2.75 %   $ 159,817     $ 2,193       5.43 %
Long-term debt
    550,940       6,720       4.88       611,777       7,879       5.15  
Federal funds purchased and securities sold under agreements to repurchase
    303       2       2.61       37       1       4.58  
                                                 
Total interest-bearing liabilities
  $ 793,696     $ 8,407       4.23 %   $ 771,631     $ 10,073       5.21 %
                                                 
Impact of net non-interest bearing funding
  $ 30,909               0.16 %   $ 33,578               0.22 %
                                                 
Net interest income/net interest yield(4)
          $ 2,057       1.00 %           $ 1,193       0.60 %
Taxable-equivalent adjustment on tax-exempt investments(5)
            82       0.04 %             90       0.04 %
                                                 
Taxable-equivalent net interest income/taxable-equivalent net interest yield(6)
          $ 2,139       1.04 %           $ 1,283       0.64 %
                                                 
 


17


 

                                                 
    For the Six Months Ended June 30,  
    2008     2007  
          Interest
    Average
          Interest
    Average
 
    Average
    Income/
    Rates
    Average
    Income/
    Rates
 
    Balance(1)     Expense     Earned/Paid     Balance(1)     Expense     Earned/Paid  
    (Dollars in millions)  
 
Interest-earning assets:
                                               
Mortgage loans(2)
  $ 414,163     $ 11,431       5.52 %   $ 388,095     $ 11,010       5.67 %
Mortgage securities
    317,107       8,207       5.18       328,288       9,027       5.50  
Non-mortgage securities(3)
    62,067       1,078       3.44       65,355       1,764       5.37  
Federal funds sold and securities purchased under agreements to resell
    31,551       579       3.63       14,484       387       5.31  
Advances to lenders
    3,780       111       5.81       5,159       84       3.24  
                                                 
Total interest-earning assets
  $ 828,668     $ 21,406       5.16 %   $ 801,381     $ 22,272       5.56 %
                                                 
Interest-bearing liabilities:
                                               
Short-term debt
  $ 249,949     $ 4,243       3.36 %   $ 161,022     $ 4,406       5.44 %
Long-term debt
    548,244       13,411       4.89       607,399       15,475       5.10  
Federal funds purchased and securities sold under agreements to repurchase
    371       5       2.67       123       4       5.22  
                                                 
Total interest-bearing liabilities
  $ 798,564     $ 17,659       4.41 %   $ 768,544     $ 19,885       5.17 %
                                                 
Impact of net non-interest bearing funding
  $ 30,104               0.16 %   $ 32,837               0.21 %
                                                 
Net interest income/net interest yield(4)
          $ 3,747       0.91 %           $ 2,387       0.60 %
Taxable-equivalent adjustment on tax-exempt investments(5)
            165       0.04 %             182       0.04 %
                                                 
Taxable-equivalent net interest income/taxable-equivalent net interest yield(6)
          $ 3,912       0.95 %           $ 2,569       0.64 %
                                                 
 
 
(1) For mortgage loans, average balances have been calculated based on the average of the amortized cost amounts at the beginning of the year and at the end of each month in the period. For all other categories, average balances have been calculated based on a daily average. The average balance for the three and six months ended June 30, 2008 for advances to lenders also has been calculated based on a daily average.
 
(2) Average balance amounts include nonaccrual loans with an average balance totaling $8.4 billion and $5.7 billion for the three months ended June 30, 2008 and 2007, respectively, and $8.3 billion and $5.9 billion for the six months ended June 30, 2008 and 2007, respectively. Interest income amounts include interest income related to SOP 03-3 loans returned to accrual status of $168 million and $115 million for the three months ended June 30, 2008 and 2007, respectively, and of $313 million and $219 million for the six months ended June 30, 2008 and 2007, respectively. Of these amounts recognized into interest income, $53 million and $15 million for the three months ended June 30, 2008 and 2007, respectively, and $88 million and $22 million for the six months ended June 30, 2008 and 2007, respectively, related to the accretion of the fair value loss recorded upon purchase of SOP 03-3 loans.
 
(3) Includes cash equivalents.
 
(4) Net interest yield computed by dividing annualized net interest income for the period by the average balance of total interest-earning assets during the period.
 
(5) Represents adjustment to permit comparison of yields on tax-exempt and taxable assets calculated using a 35% marginal tax rate for each of the periods presented.
 
(6) Taxable-equivalent net interest yield is computed by dividing annualized taxable-equivalent net interest income for the period by the average balance of total interest-earning assets during the period.

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Table 4 presents the total variance, or change, in our taxable-equivalent net interest income between the three and six months ended June 30, 2008 and 2007, and the extent to which that variance is attributable to (1) changes in the volume of our interest-earning assets and interest-bearing liabilities or (2) changes in the interest rates of these assets and liabilities.
 
Table 4:  Rate/Volume Analysis of Net Interest Income
 
                                                 
    For the Three Months
    For the Six Months
 
    Ended June 30,
    Ended June 30,
 
    2008 vs. 2007     2008 vs. 2007  
    Total
    Variance Due to:(1)     Total
    Variance Due to:(1)  
    Variance     Volume     Rate     Variance     Volume     Rate  
    (Dollars in millions)  
 
Interest income:
                                               
Mortgage loans(2)
  $ 144     $ 399     $ (255 )   $ 421     $ 725     $ (304 )
Mortgage securities
    (397 )     (93 )     (304 )     (820 )     (301 )     (519 )
Non-mortgage securities(3)
    (528 )     (131 )     (397 )     (686 )     (85 )     (601 )
Federal funds sold and securities purchased under agreements to resell
    (19 )     109       (128 )     192       343       (151 )
Advances to lenders
    (2 )     (28 )     26       27       (27 )     54  
                                                 
Total interest income
    (802 )     256       (1,058 )     (866 )     655       (1,521 )
                                                 
Interest expense:
                                               
Short-term debt
    (508 )     848       (1,356 )     (163 )     1,886       (2,049 )
Long-term debt
    (1,159 )     (756 )     (403 )     (2,064 )     (1,464 )     (600 )
Federal funds purchased and securities sold under agreements to repurchase
    1       1             1       4       (3 )
                                                 
Total interest expense
    (1,666 )     93       (1,759 )     (2,226 )     426       (2,652 )
                                                 
Net interest income
    864     $ 163     $ 701       1,360     $ 229     $ 1,131  
                                                 
Taxable-equivalent adjustment on tax-exempt investments(3)
    (8 )                     (17 )                
                                                 
Taxable-equivalent net interest income
  $ 856                     $ 1,343                  
                                                 
 
 
(1) Combined rate/volume variances are allocated to both rate and volume based on the relative size of each variance.
 
(2) Refer to footnote 2 in Table 3.
 
(3) Represents adjustment to permit comparison of yields on tax-exempt and taxable assets calculated using a 35% marginal tax rate for each of the periods presented.
 
Taxable-equivalent net interest income of $2.1 billion for the second quarter of 2008 increased by 67% from the second quarter of 2007, driven by a 63% (40 basis points) expansion of our taxable-equivalent net interest yield to 1.04% and a 2% increase in our average interest-earning assets. Taxable-equivalent net interest income of $3.9 billion for the first six months of 2008 increased by 52% from the first six months of 2007, driven by a 48% (31 basis points) expansion of our taxable-equivalent net interest yield to 0.95% and a 3% increase in our average interest-earning assets.
 
The increase in our taxable-equivalent net interest income and net interest yield for the second quarter and first six months of 2008 was mainly driven by the reduction in short-term borrowing rates, which reduced the average cost of our debt, and wider mortgage-to-debt spreads on acquisitions. Also contributing to the lower cost of funds was the redemption of step-rate debt securities, which provided an annualized benefit to our net interest yield of approximately 4 basis points and 11 basis points for the second quarter and first six months of 2008, respectively. Instead of having a fixed coupon for the life of the security, step-rate debt securities allow for the interest rate to increase at predetermined rates according to a specified schedule, resulting in increased interest payments. However, the interest expense on step-rate debt securities is recognized at a constant effective rate over the term of the security. Because we redeemed these securities prior to maturity, we reversed a portion of the interest expense that we had previously accrued.


19


 

The increase in our average interest-earning assets for the second quarter and first six months of 2008 was attributable to an increase in our portfolio purchases during the first six months of 2008, particularly in the second quarter of 2008, as mortgage-to-debt spreads reached historic highs. OFHEO’s reduction in our capital surplus requirement provided us with more flexibility to take advantage of opportunities to purchase mortgage assets at attractive prices and spreads.
 
Although we consider the periodic net contractual interest accruals on our interest rate swaps to be part of the cost of funding our mortgage investments, these amounts are not reflected in our taxable-equivalent net interest income and net interest yield. Instead, the net contractual interest accruals on our interest rate swaps are reflected in our condensed consolidated statements of operations as a component of “Fair value gains (losses), net.” As indicated in Table 8 below, we recorded net contractual interest expense on our interest rate swaps totaling $304 million and $330 million for the three and six months ended June 30, 2008, respectively, which had the economic effect of increasing our funding costs by approximately 15 basis points and 8 basis points for the three and six months ended June 30, 2008, respectively. We recorded net contractual interest income on our interest rate swaps of $64 million and $98 million for the three and six months ended June 30, 2007, respectively, which had the economic effect of reducing our funding costs by approximately 3 basis points for each period.
 
During July 2008, our cost of short-term funding as compared with the London Interbank Offered Rate (“LIBOR”) was less favorable than it was during the second quarter of 2008, which could result in a taxable equivalent net interest yield that is flat or lower for the remainder of 2008 depending on future market conditions. Our taxable-equivalent net interest yield may be offset, as it was during the second quarter of 2008, by accrual of higher payments on our net pay-fixed swap positions due to low short-term LIBOR rates.


20


 

Guaranty Fee Income
 
Table 5 shows the components of our guaranty fee income, our average effective guaranty fee rate, and Fannie Mae MBS activity for the three and six months ended June 30, 2008 and 2007.
 
Table 5:  Guaranty Fee Income and Average Effective Guaranty Fee Rate(1)
 
                                         
    For the Three Months Ended June 30,        
    2008     2007     Amount
 
    Amount     Rate(2)     Amount     Rate(2)     Variance  
    (Dollars in millions)  
 
Guaranty fee income/average effective guaranty fee rate, excluding certain fair value adjustments and buy-up impairment
  $ 1,458       23.8 bp   $ 1,104       21.2 bp     32 %
Net change in fair value of buy-ups and guaranty assets
    152       2.5       17       0.3       794  
Buy-up impairment
    (2 )           (1 )           100  
                                         
Guaranty fee income/average effective guaranty fee rate(3)
  $ 1,608       26.3 bp   $ 1,120       21.5 bp     44 %
                                         
Average outstanding Fannie Mae MBS and other guarantees(4)
  $ 2,442,886             $ 2,080,676               17 %
Fannie Mae MBS issues(5)
    177,763               149,879               19  
 
                                         
    For the Six Months Ended June 30,        
    2008     2007     Amount
 
    Amount     Rate(2)     Amount     Rate(2)     Variance  
    (Dollars in millions)  
 
Guaranty fee income/average effective guaranty fee rate, excluding certain fair value adjustments and buy-up impairment
  $ 3,177       26.4 bp   $ 2,204       21.5 bp     44 %
Net change in fair value of buy-ups and guaranty assets
    214       1.8       19       0.1       1,026  
Buy-up impairment
    (31 )     (0.3 )     (5 )           520  
                                         
Guaranty fee income/average effective guaranty fee rate(3)
  $ 3,360       27.9 bp   $ 2,218       21.6 bp     51 %
                                         
Average outstanding Fannie Mae MBS and other guarantees(4)
  $ 2,407,296             $ 2,050,797               17 %
Fannie Mae MBS issues(5)
    346,355               282,302               23  
 
 
(1) Guaranty fee income primarily consists of contractual guaranty fees related to Fannie Mae MBS held in our portfolio and held by third-party investors, adjusted for (1) the amortization of upfront fees and impairment of guaranty assets, net of a proportionate reduction in the related guaranty obligation and deferred profit, and (2) impairment of buy-ups. The average effective guaranty fee rate reflects our average contractual guaranty fee rate adjusted for the impact of amortization of deferred amounts and buy-up impairment. Losses recognized at inception on certain guaranty contracts for periods prior to January 1, 2008 are excluded from guaranty fee income and the average effective guaranty fee rate; however, as described in footnote 3 below, the accretion of these losses into income over time is included in our guaranty fee income and average effective guaranty fee rate.
 
(2) Presented in basis points and calculated based on annualized amounts of our guaranty fee income components divided by average outstanding Fannie Mae MBS and other guarantees for each respective period.
 
(3) Losses recognized at inception on certain guaranty contracts for periods prior to January 1, 2008, which are excluded from guaranty fee income, are recorded as a component of our guaranty obligation. We accrete a portion of our guaranty obligation, which includes these losses, into income each period in proportion to the reduction in the guaranty asset for payments received. This accretion increases our guaranty fee income and reduces the related guaranty obligation. Effective January 1, 2008, we no longer recognize losses at inception of our guaranty contracts due to a change in our method for measuring the fair value of our guaranty obligations. Although we will no longer recognize losses at inception of our guaranty contracts, we will continue to accrete previously recognized losses into our guaranty fee income over the remaining life of the mortgage loans underlying the Fannie Mae MBS.
 
(4) Other guarantees includes $31.8 billion and $41.6 billion as of June 30, 2008 and December 31, 2007, respectively, and $35.3 billion and $19.7 billion as of June 30, 2007 and December 31, 2006, respectively, related to long-term standby commitments we have issued and credit enhancements we have provided.
 
(5) Reflects unpaid principal balance of Fannie Mae MBS issued and guaranteed by us, including mortgage loans held in our portfolio that we securitized during the period and Fannie Mae MBS issued during the period that we acquired for our portfolio.


21


 

 
The 44% increase in guaranty fee income for the second quarter of 2008 over the second quarter of 2007 resulted from a 17% increase in average outstanding Fannie Mae MBS and other guarantees, and a 22% increase in the average effective guaranty fee rate to 26.3 basis points from 21.5 basis points. The 51% increase in guaranty fee income for the first six months of 2008 over the first six months of 2007 resulted from a 17% increase in average outstanding Fannie Mae MBS and other guarantees, and a 29% increase in the average effective guaranty fee rate to 27.9 basis points from 21.6 basis points.
 
The increase in average outstanding Fannie Mae MBS and other guarantees for the second quarter and first six months of 2008 reflected the significant growth in our market share of mortgage-related securities issuances, due in large part to the disruption in the credit and mortgage markets and dramatic shift in market dynamics, including a significant reduction in the issuances of private-label mortgage-related securities.
 
The increase in our average effective guaranty fee rate in the second quarter and first six months of 2008 was driven primarily by the accelerated recognition of deferred amounts into income as interest rates were lower in the second quarter and first six months of 2008, relative to the level of interest rates during the comparable prior year periods. Our guaranty fee income also includes accretion of deferred amounts on guaranty contracts where we recognized losses at the inception of the contract, which totaled an estimated $127 million and $424 million for the three and six months ended June 30, 2008, compared with $91 million and $183 million for the three and six months ended June 30, 2007. See “Part II—Item 7—MD&A—Critical Accounting Policies and Estimates” of our 2007 Form 10-K for additional information on our accounting for these losses and the impact on our financial statements.
 
The increase in our average effective guaranty fee rate was also affected by guaranty fee pricing changes that we believe enable us to more accurately price for the current risks in the housing market. These pricing changes include an adverse market delivery charge of 25 basis points for all loans delivered to us, which became effective March 1, 2008. The impact of our guaranty fee pricing changes was partially offset by a shift in the composition of our guaranty book of business to a greater proportion of higher-quality, lower risk and lower guaranty fee mortgages, as we reduced our acquisitions of higher risk, higher fee product categories, such as Alt-A loans. Our average charged guaranty fee on new single-family business was 28.0 basis points and 26.9 basis points for the second quarter and first six months of 2008, respectively, compared with 28.2 basis points and 27.1 basis points for the second quarter and first six months of 2007, respectively. The average charged guaranty fee on our new single-family business represents the average contractual fee rate for our single-family guaranty arrangements and the recognition of any upfront cash payments ratably over an estimated life of four years.
 
We expect the changes in our risk assessment and eligibility criteria to continue to enhance the risk profile of our new business. We also believe that our single-family guaranty book of business will continue to grow in 2008 and 2009 at a faster rate than the overall growth in U.S. single-family mortgage debt outstanding. We recently announced new pricing changes for loans delivered to us effective October 1, 2008. The new pricing changes increase our adverse market delivery charge to 50 basis points from 25 basis points and update our standard pricing adjustments for mortgage loans with certain risk characteristics. We believe that our guaranty fee income will grow in 2008 compared with 2007 due to an increase in our guaranty business volumes and prices in 2008 compared with 2007.
 
Trust Management Income
 
Trust management income decreased to $75 million and $182 million for the second quarter and first six months of 2008, respectively, from $150 million and $314 million for the second quarter and first six months of 2007, respectively. The decrease during each period was attributable to significantly lower short-term interest rates during the first six months of 2008 relative to the first six months of 2007, which reduced the amount of float income derived from the cash flows between the date of remittance of mortgage and other payments to us by servicers and the date of distribution of these payments to MBS certificateholders.


22


 

Fee and Other Income
 
Fee and other income decreased to $225 million and $452 million for the second quarter and first six months of 2008, respectively, from $257 million and $534 million for the second quarter and first six months of 2007, respectively. The decrease during each period was primarily attributable to lower multifamily fees due to a reduction in multifamily loan liquidations for the first six months of 2008.
 
Losses on Certain Guaranty Contracts
 
Effective January 1, 2008 with our adoption of SFAS 157, we no longer recognize losses or record deferred profit in our consolidated financial statements at inception of our guaranty contracts for MBS issued subsequent to December 31, 2007 because the estimated fair value of the guaranty obligation at inception now equals the estimated fair value of the total compensation received. For further discussion of this change, see “Critical Accounting Policies and Estimates—Fair Value of Financial Instruments—Change in Measuring the Fair Value of Guaranty Obligations” and “Notes to Condensed Consolidated Financial Statements—Note 1, Summary of Significant Accounting Policies.” We recorded losses on certain guaranty contracts totaling $461 million and $744 million for the three and six months ended June 30, 2007, respectively. These losses reflected the increase in the estimated market risk premium that a market participant would require to assume our guaranty obligations due to the decline in home prices and deterioration in credit conditions.
 
Investment Gains (Losses), Net
 
We summarize the components of investment gains (losses), net for the three and six months ended June 30, 2008 and 2007 below in Table 6 and discuss significant changes in these components between periods.
 
Table 6:  Investment Gains (Losses), Net
                                 
    For the
    For the
 
    Three Months Ended
    Six Months Ended
 
    June 30,     June 30,  
    2008     2007     2008     2007  
    (Dollars in millions)  
 
Other-than-temporary impairment on AFS securities(1)
  $ (507 )   $     $ (562 )   $ (3 )
Lower-of-cost-or-market adjustments on HFS loans
    (240 )     (115 )     (311 )     (118 )
Gains (losses) on Fannie Mae portfolio securitizations, net
    (67 )     (11 )     (25 )     38  
Gains (losses) on sale of AFS securities, net
    (20 )     55       13       326  
Other investment losses, net
    (49 )     (22 )     (109 )     (41 )
                                 
Investment gains (losses), net
  $ (883 )   $ (93 )   $ (994 )   $ 202  
                                 
 
 
(1) Excludes other-than-temporary impairment on guaranty assets and buy-ups as these amounts are recognized as a component of guaranty fee income. Refer to Table 5: Guaranty Fee Income and Average Effective Guaranty Fee Rate.
 
The increase in investment losses for the second quarter and first six months of 2008 over the second quarter and first six months of 2007 was primarily attributable to the following:
 
  •  A significant increase in other-than-temporary impairment on AFS securities, principally for Alt-A and subprime private-label securities, reflecting a reduction in expected cash flows due to higher expected defaults and loss severties on the underlying mortgages, which resulted in the recognition of other-than-temporary impairment on these securities totaling $492 million in the second quarter of 2008.
 
  •  An increase in losses resulting from lower-of-cost-or-market adjustments on HFS loans primarily, attributable to higher interest rates during the second quarter of 2008.
 
  •  A decrease in gains on the sale of AFS securities, net. The investment gains recorded during the first six months of 2007 were attributable to the recovery in value of securities we sold that we had previously written down due to other-than-temporary impairment.


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Fair Value Gains (Losses), Net
 
Beginning in mid-April 2008, we implemented fair value hedge accounting with respect to a portion of our derivatives to hedge, for accounting purposes, the interest rate risk related to some of our mortgage assets. Under fair value hedge accounting, we offset the fair value gains or losses on some of our derivative instruments against the corresponding fair value losses or gains attributable to changes in interest rates on the specific hedged mortgage assets. Although our implementation of hedge accounting does not affect our exposure to volatility in our financial results that is attributable to changes in spreads on the fair value of securities designated as trading, we believe this hedging strategy will reduce the level of volatility in our earnings, attributable to changes in interest rates, for our interest rate risk management derivatives. In addition, we generally expect that gains and losses on our trading securities, to the extent they are attributable to changes in interest rates, will offset a portion of the losses and gains on our derivatives because changes in the fair value of our trading securities typically move inversely to changes in the fair value of our derivatives. We also seek to eliminate our exposure to fluctuations in foreign exchange rates by entering into foreign currency swaps that effectively convert debt denominated in a foreign currency to debt denominated in U.S. dollars. The foreign currency exchange gains and losses on our foreign-denominated debt are offset in part by corresponding losses and gains on foreign currency swaps.
 
Table 7 summarizes the components of fair value gains (losses), net for the three and six months ended June 30, 2008 and 2007. Fair value gains and losses, net consists of (1) derivatives fair value gains and losses, including gains and losses on derivatives designated as accounting hedges; (2) trading securities gains and losses; (3) fair value adjustments to the carrying value of mortgage assets designated for hedge accounting that are attributable to changes in interest rates; (4) foreign exchange gains and losses on our foreign-denominated debt and (5) fair value gains and losses on certain debt securities carried at fair value. By presenting these items together in our condensed consolidated results of operations, we are able to show the net impact of mark-to-market adjustments that generally result in offsetting gains and losses attributable to changes in interest rates. We provide additional information below on the most significant components of the fair value gains (losses), net line item.
 
Table 7:  Fair Value Gains (Losses), Net
                                 
          For the
 
    For the
    Six Months
 
    Three Months Ended
    Ended
 
    June 30,     June 30,  
    2008     2007     2008     2007  
    (Dollars in millions)  
 
Derivatives fair value gains (losses), net
  $ 2,293     $ 1,916     $ (710 )   $ 1,353  
Trading securities losses, net
    (965 )     (501 )     (2,192 )     (440 )
Hedged mortgage assets losses, net(1)
    (803 )           (803 )      
                                 
Fair value gains (losses) on derivatives, trading securities and hedged mortgage assets, net
    525       1,415       (3,705 )     913  
Debt foreign exchange gains (losses), net
    (12 )     9       (169 )     (55 )
Debt fair value gains, net
    4             14        
                                 
Fair value gains (losses), net
  $ 517     $ 1,424     $ (3,860 )   $ 858  
                                 
 
 
(1) Represents adjustments to the carrying value of mortgage assets designated for hedge accounting that are attributable to changes in interest rates.
 
We recorded net fair value gains of $517 million for the second quarter of 2008, attributable to an increase in swap interest rates and a tightening of spreads. The increase in swap interest rates resulted in fair value gains on our derivatives and losses on our trading securities and hedged mortgage assets. The decrease in value of our trading securities from the increase in interest rates was partially offset by gains that resulted from the tightening of spreads during the quarter. The net fair value gains of $1.4 billion for the second quarter of 2007 were attributable to an increase in swap interest rates during the second quarter of 2007, which resulted in fair value gains on our derivatives.


24


 

We recorded net fair value losses of $3.9 billion for the first six months of 2008. The net losses for the first six months reflected the impact of the decrease in swap interest rates during the first quarter of 2008, which resulted in net fair value losses on our derivatives that more than offset net fair value gains on our derivatives during the second quarter of 2008 that resulted from the increase in swap interest rates. We also experienced fair value losses on our trading securities that were attributable to the significant widening of spreads during the first quarter of 2008 and the increase in interest rates during the second quarter of 2008. In addition, we recorded losses on hedged mortgage assets during the second quarter of 2008 in connection with our implementation of fair value hedge accounting. In contrast, we recorded fair value gains of $858 million for the first six months of 2007, due to an increase in swap interest rates during the period, which resulted in net fair value gains on our derivatives. We did not apply hedge accounting during this period.
 
The fair value of our trading securities may not always move inversely to changes in the fair value of our derivatives because the fair values of these financial instruments are affected not only by interest rates, but also by other factors such as spreads and changes in implied volatility. Consequently, the gains and losses on our trading securities may not result in partially offsetting losses and gains on our derivatives.
 
Derivatives Fair Value Gains (Losses), Net
 
Table 8 presents, by type of derivative instrument, the fair value gains and losses on our derivatives for the three and six months ended June 30, 2008 and 2007. Table 8 also includes an analysis of the components of derivatives fair value gains and losses attributable to net contractual interest accruals on our interest rate swaps, the net change in the fair value of terminated derivative contracts through the date of termination and the net change in the fair value of outstanding derivative contracts.
 
Table 8:  Derivatives Fair Value Gains (Losses), Net
                                 
    For the
    For the
 
    Three Months
    Six Months
 
    Ended
    Ended
 
    June 30,     June 30,  
    2008     2007     2008     2007  
          (Dollars in millions)        
 
Risk management derivatives:
                               
Swaps:
                               
Pay-fixed
  $ 15,782     $ 6,206     $ (113 )   $ 5,720  
Receive-fixed
    (11,092 )     (3,241 )     1,700       (2,878 )
Basis
    (73 )     (111 )     (68 )     (125 )
Foreign currency(1)
    (20 )     (63 )     126       (43 )
Swaptions:
                               
Pay-fixed
    270       392       81       269  
Receive-fixed
    (2,499 )     (1,356 )     (2,226 )     (1,659 )
Interest rate caps
    4       7       3       8  
Other(2)
    (13 )     2       51       1  
                                 
Total risk management derivatives fair value gains (losses), net
    2,359       1,836       (446 )     1,293  
Mortgage commitment derivatives fair value gains (losses), net
    (66 )     80       (264 )     60  
                                 
Total derivatives fair value gains (losses), net
  $ 2,293     $ 1,916     $ (710 )   $ 1,353  
                                 
Risk management derivatives fair value gains (losses) attributable to:
                               
Net contractual interest income (expense) on interest rate swaps
  $ (304 )   $ 64     $ (330 )   $ 98  
Net change in fair value of terminated derivative contracts from end of prior period to date of termination
    (108 )     (29 )     174       (93 )
Net change in fair value of outstanding derivative contracts, including derivative contracts entered into during the period
    2,771       1,801       (290 )     1,288  
                                 
Risk management derivatives fair value gains, net(3)
  $ 2,359     $ 1,836     $ (446 )   $ 1,293  
                                 
 


25


 

                 
    2008     2007  
 
5-year swap rate:
               
As of January 1
    4.19 %     5.10 %
As of March 31
    3.31       4.99  
As of June 30
    4.26       5.50  
 
 
(1) Includes the effect of net contractual interest income of approximately $6 million and interest expense of $16 million for the three months ended June 30, 2008 and 2007, respectively, and interest income of $3 million and interest expense of $34 million for the six months ended June 30, 2008 and 2007, respectively. The change in fair value of foreign currency swaps excluding this item resulted in a net loss of $26 million and a net loss of $47 million for the three months ended June 30, 2008 and 2007, respectively, and a net gain of $123 million and a net loss of $9 million for the six months ended June 30, 2008 and 2007, respectively.
 
(2) Includes MBS options, swap credit enhancements and mortgage insurance contracts.
 
(3) Reflects net derivatives fair value losses, excluding mortgage commitments, recognized in the condensed consolidated statements of operations.
 
The derivatives fair value gains of $2.3 billion for the second quarter of 2008, which includes $754 million of gains on pay-fixed swaps designated as fair value hedges, reflected the impact of an increase in swap interest rates during the quarter. The 5-year swap interest rate, which is presented in Table 8, rose by 95 basis points to 4.26% as of June 30, 2008 from 3.31% as of March 31, 2008. This increase in swap interest rates resulted in fair value gains on our pay-fixed swaps that exceeded the fair value losses on our receive-fixed swaps. The derivatives fair value gains of $1.9 billion for the second quarter of 2007 also was attributable to an increase in swap interest rates during the quarter, which resulted in fair value gains on our pay-fixed swaps.
 
The derivatives fair value losses of $710 million for the first six months of 2008 was largely attributable to losses resulting from a combination of the time decay of our purchased options and rebalancing activities. These losses were partially offset by net fair value gains on our swaps. The derivatives fair value gains of $1.4 billion for the first six months of 2007 was attributable to an increase in swap interest rates during the period, which resulted in fair value gains on our pay-fixed swaps.
 
For additional discussion of the effect of our derivatives on our consolidated financial statements, see “Consolidated Balance Sheet Analysis—Derivative Instruments.” For information on changes in our derivatives activity and the outstanding notional amounts of our derivatives, see “Risk Management—Interest Rate Risk Management and Other Market Risks—Derivatives Activity.”
 
Trading Securities Gains (Losses), Net
 
Our portfolio of trading securities increased to $99.6 billion as of June 30, 2008, from $64.0 billion as of December 31, 2007. We recorded net losses on trading securities of $965 million and $2.2 billion for the second quarter and first six months of 2008, respectively. The losses for the second quarter of 2008 were primarily due to an increase in long-term interest rates during the quarter, partially offset by gains resulting from the tightening of spreads during the quarter relative to the first quarter of 2008. The losses for the first six months of 2008 were attributable to the significant widening of spreads during the first quarter of 2008, particularly related to private-label mortgage-related securities backed by Alt-A and subprime loans and commercial mortgage-backed securities (“CMBS”) backed by multifamily mortgage loans, and the increase in interest rates during the second quarter of 2008. In comparison, we recorded losses of $501 million and $440 million for the second quarter and first six months of 2007, respectively, which were attributable to the combined effect of an increase in long-term interest rates and widening of spreads during the second quarter of 2007.
 
We provide additional information on our trading and AFS securities in “Consolidated Balance Sheet Analysis—Trading and Available-for-Sale Investment Securities” and disclose the sensitivity of changes in the fair value of our trading securities to changes in interest rates in “Risk Management—Interest Rate Risk Management and Other Market Risks—Measuring Interest Rate Risk.”

26


 

Hedged Mortgage Assets Losses, Net
 
Our hedge accounting relationships during the second quarter of 2008 consisted of pay-fixed interest rate swaps designated as fair value hedges of changes in the fair value, attributable to changes in the LIBOR benchmark interest rate, of specified mortgage assets. As of June 30, 2008, we had a notional amount of $68.6 billion of pay-fixed swaps designated as fair value hedges of specified mortgage assets. We include changes in fair value of hedged mortgage assets attributable to changes in the benchmark interest rate in our assessment of hedge effectiveness. These fair value accounting hedges resulted in losses on the hedged mortgage assets for the three and six months ended June 30, 2008 of $803 million, which were partially offset by gains of $789 million on the pay-fixed swaps designated as hedging instruments. The gains on these pay-fixed swaps are included as a component of derivatives fair value gains (losses), net. We also record as a component of derivatives fair value gains (losses), net the ineffectiveness, or the portion of the change in the fair value of our derivatives that was not effective in offsetting the change in the fair value of the designated hedged mortgage assets. Included in our derivatives fair value gains (losses), net was a loss of $14 million for the second quarter and first six months of 2008 representing the ineffectiveness of our fair value hedges. We provide additional information on our application of hedge accounting in “Notes to Condensed Consolidated Financial Statements, Note 1—Summary of Significant Accounting Policies” and “Note 9—Derivative Instruments and Hedging Activities.”
 
Losses from Partnership Investments
 
Losses from partnership investments decreased to $195 million and $336 million for the second quarter and first six months of 2008, respectively, from $215 million and $380 million for the second quarter and first six months of 2007. The decrease in losses during each period was due to a reduction in net operating losses attributable to a decrease in our tax-advantaged partnership investments and gains from the sale of some of our low income housing tax credit (“LIHTC”) investments, which was partially offset by increases in losses from our non-tax-advantaged investments.
 
Administrative Expenses
 
Administrative expenses decreased to $512 million and $1.0 billion for the second quarter and first six months of 2008, respectively, from $660 million and $1.4 billion for the second quarter and first six months of 2007, respectively, reflecting significant reductions in restatement and related regulatory expenses and a reduction in our ongoing operating costs due to efforts we undertook in 2007 to increase productivity and lower our administrative costs. We are actively managing our administrative expenses with the intent to maintain our ongoing operating costs for 2008, which exclude costs associated with our restatement, such as regulatory examinations and litigation related to the restatement, near the $2.0 billion level that we achieved in 2007.
 
Credit-Related Expenses
 
Credit-related expenses included in our condensed consolidated statements of operations consist of the provision for credit losses and foreclosed property expense. We detail the components of our credit-related expenses in Table 9. The significant increase in credit-related expenses for the second quarter and first six months of 2008 compared with the second quarter and first six months of 2007 was driven by a substantial increase in our provision for credit losses due to higher charge-offs and to build our loss reserves and an increase in foreclosed property expense.


27


 

 
Table 9:  Credit-Related Expenses
                                 
    For the
    For the
 
    Three Months Ended
    Six Months Ended
 
    June 30,     June 30,  
    2008     2007     2008     2007  
    (Dollars in millions)  
 
Provision attributable to guaranty book of business
  $ 4,591     $ 368     $ 6,927     $ 548  
Provision attributable to SOP 03-3 and HomeSaver Advance fair value losses
    494       66       1,231       135  
                                 
Total provision for credit losses(1)
    5,085       434       8,158       683  
Foreclosed property expense
    264       84       434       156  
                                 
Credit-related expenses
  $ 5,349     $ 518     $ 8,592     $ 839  
                                 
 
 
(1) Reflects total provision for credit losses reported in Table 10 below under “Combined loss reserves.”
 
Provision Attributable to Guaranty Book of Business
 
Our allowance for loan losses and reserve for guaranty losses, which we collectively refer to as our combined loss reserves, provide for probable credit losses inherent in our guaranty book of business as of each balance sheet date. The change in our combined loss reserves each period is driven by the provision for credit losses recognized in our condensed consolidated statements of operations and the net charge-offs recorded against our loss reserves. Table 10 below summarizes changes in our combined loss reserves for the three and six months ended June 30, 2008 and 2007.
 
Table 10:  Allowance for Loan Losses and Reserve for Guaranty Losses
 
                                 
          For the
 
    For the
    Six Months
 
    Three Months Ended
    Ended
 
    June 30,     June 30,  
    2008     2007     2008     2007  
    (Dollars in millions)  
 
Changes in loss reserves:
                               
Allowance for loan losses:
                               
Beginning balance
  $ 993     $ 312     $ 698     $ 340  
Provision
    880       73       1,424       90  
Charge-offs(1)
    (495 )     (64 )     (774 )     (126 )
Recoveries
    98       16       128       33  
                                 
Ending balance(2)
  $ 1,476     $ 337     $ 1,476     $ 337  
                                 
Reserve for guaranty losses:
                               
Beginning balance
  $ 4,202     $ 618     $ 2,693     $ 519  
Provision
    4,205       361       6,734       593  
Charge-offs(3)
    (989 )     (168 )     (2,026 )     (321 )
Recoveries
    32       10       49       30  
                                 
Ending balance
  $ 7,450     $ 821     $ 7,450     $ 821  
                                 
Combined loss reserves:
                               
Beginning balance
  $ 5,195     $ 930     $ 3,391     $ 859  
Provision
    5,085       434       8,158       683  
Charge-offs(1)(3)
    (1,484 )     (232 )     (2,800 )     (447 )
Recoveries
    130       26       177       63  
                                 
Ending balance(2)
  $ 8,926     $ 1,158     $ 8,926     $ 1,158  
                                 
 


28


 

                 
    As of  
    June 30,
    December 31,
 
    2008     2007  
 
Allocation of combined loss reserves:
               
Balance at end of each period attributable to:
               
Single-family
  $ 8,866     $ 3,318  
Multifamily
    60       73  
                 
Total
  $ 8,926     $ 3,391  
                 
Single-family and multifamily loss reserve ratios:(4)
               
Single-family loss reserves as % of single-family guaranty book of business
    0.32 %     0.13 %
Multifamily loss reserves as % of multifamily guaranty book of business
    0.04       0.05  
Combined loss reserves as a percentage of:
               
Total guaranty book of business
    0.31       0.12  
Total nonperforming loans(5)
    19.4       9.5  
 
 
(1) Includes accrued interest of $161 million and $27 million for the three months ended June 30, 2008 and 2007, respectively, and $239 million and $52 million for the six months ended June 30, 2008 and 2007, respectively.
 
(2) Includes $114 million and $28 million as of June 30, 2008 and 2007, respectively, for acquired loans subject to the application of SOP 03-3.
 
(3) Includes charges recorded at the date of acquisition of $380 million and $66 million for the three months ended June 30, 2008 and 2007, respectively, and $1.1 billion and $135 million for the six months ended June 30, 2008 and 2007, respectively, for acquired loans subject to the application of SOP 03-3 where the acquisition cost exceeded the fair value of the acquired loan. Also includes charges recorded for our HomeSaver Advance initiative of $114 million and $123 million for the three and six months ended June 30, 2008, respectively.
 
(4) Represents loss reserves amount attributable to each loan type as a percentage of the guaranty book of business for each loan type.
 
(5) Loans are classified as nonperforming at the earlier of when payment of principal and interest is three months or more past due according to the loan’s contractual terms (unless we have recourse against the seller of the loan in the event of default) or when, in our opinion, collectability of interest or principal on the loan is not reasonably assured. See Table 39: Nonperforming Single-Family and Multifamily Loans for detail on nonperforming loans as of June 30, 2008 and December 31, 2007.
 
We have continued to build our combined loss reserves through provisions that have been well in excess of our charge-offs. The provision for credit losses attributable to our guaranty book of business totaled $4.6 billion and $6.9 billion for the second quarter and first six months of 2008, respectively. These amounts consisted of charge-offs, net of recoveries, totaling $860 million and $1.4 billion for the second quarter and first six months of 2008, respectively, and an incremental provision of $3.7 billion and $5.5 billion, respectively, to build our combined loss reserves. In comparison, we recorded a provision for credit losses attributable to our guaranty book of business of $368 million and $548 million for the second quarter and first six months of 2007. As a result of our higher loss provisioning levels, we have substantially increased our combined loss reserves both in absolute terms and as a percentage of our guaranty book of business, to $8.9 billion, or 0.31% of our guaranty book of business, as of June 30, 2008, from $3.4 billion, or 0.12% of our guaranty book of business, as of December 31, 2007.
 
The increase in our loss provisioning levels and combined loss reserves reflects our current estimate of inherent losses in our guaranty book of business as of June 30, 2008. The increased estimate of inherent losses is due to the continued decline in home prices, which worsened during the second quarter of 2008 and resulted in higher delinquencies and defaults and an increase in the average loan loss severity or charge-off per default. Our conventional single-family serious delinquency rate has doubled over the past year, increasing to 1.36% as of June 30, 2008, from 0.98% as of December 31, 2007 and 0.64% as of June 30, 2007. The average default rate and loan loss charge-off severity, excluding fair value losses related to SOP 03-3 loans, was 0.13% and 23%, respectively, for the second quarter of 2008, compared with 0.07% and 9% for the second quarter of 2007. These worsening credit performance trends have been most notable in certain states, certain higher risk loan categories and our 2006 and 2007 loan vintages. The Midwest, which has experienced prolonged

29


 

economic weakness, and California, Florida, Arizona and Nevada, which previously experienced rapid home price increases and are now experiencing steep home price declines, have accounted for a disproportionately large share of our seriously delinquent loans and charge-offs. Our Alt-A book, particularly the 2006 and 2007 loan vintages, has exhibited early stage payment defaults and represented a disproportionate share of our seriously delinquent loans and charge-offs for the first six months of 2008.
 
We expect our credit-related expenses to peak during 2008. In addition, we expect that the majority of the credit-related expenses that we will realize from our 2006 and 2007 vintages will be recognized by the end of 2008 through a combination of charge-offs, foreclosed property expense and increases to our combined loss reserves, although we expect that the total amount of our credit-related expenses will be significant in 2009. We also expect that a significant portion of the anticipated charge-offs from the 2006 and 2007 vintages will be provided for in our combined loss reserves by the end of 2008.
 
Provision Attributable to SOP 03-3 and HomeSaver Advance Fair Value Losses
 
We experienced a substantial increase in the SOP 03-3 fair value losses recorded upon the purchase of seriously delinquent loans from MBS trusts for the second quarter and first six months of 2008 relative to the second quarter and the first six months of 2007, due to the significant disruption in the mortgage market and severe reduction in market liquidity for certain mortgage products, such as delinquent loans, that has persisted since July 2007. As indicated in Table 9 above, SOP 03-3 and HomeSaver Advance fair value losses increased to $494 million and $1.2 billion for the second quarter and first six months of 2008, respectively, from $66 million and $135 million for the second quarter and first six months of 2007, respectively. We describe how we account for SOP 03-3 fair value losses and the process we use to value loans subject to SOP 03-3 in “Part II—Item 7—MD&A—Critical Accounting Policies and Estimates—Fair Value of Financial Instruments—Fair Value of Loans Purchased with Evidence of Credit Deterioration—Effect on Credit-Related Expenses” of our 2007 Form 10-K.
 
Seriously Delinquent Loans Purchased from MBS Trusts
 
Table 11 provides a quarterly comparison of the average market price, as a percentage of the unpaid principal balance and accrued interest, of seriously delinquent loans subject to SOP 03-3 purchased from MBS trusts and additional information related to these loans. Beginning in November 2007, we decreased the number of optional delinquent loan purchases from our single-family MBS trusts in order to preserve capital in compliance with our regulatory capital requirements. HomeSaver Advance, which is a loss mitigation tool discussed below that we implemented in the first quarter of 2008, has affected our optional delinquent loan purchases. The significant reduction in liquidity in the mortgage markets, along with the increase in mortgage credit risk, that was observed in the second half of 2007 has persisted and continued to exert downward pressure on the valuations of these loans.
 
Table 11:  Statistics on Seriously Delinquent Loans Purchased from MBS Trusts Subject to SOP 03-3
 
                                                 
    2008     2007  
    Q2     Q1     Q4     Q3     Q2     Q1  
 
Average market price(1)
    53 %     60 %     70 %     72 %     93 %     94 %
Unpaid principal balance and accrued interest of loans purchased (dollars in millions)
  $ 807     $ 1,704     $ 1,832     $ 2,349     $ 881     $ 1,057  
Number of seriously delinquent loans purchased
    4,618       10,586       11,997       15,924       6,396       8,009  
 
 
(1) The value of primary mortgage insurance is included as a component of the average market price.
 
Table 12 presents activity related to seriously delinquent loans subject to SOP 03-3 purchased from MBS trusts under our guaranty arrangements for the three months ended March 31, 2008 and June 30, 2008.


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Table 12:  Activity of Seriously Delinquent Loans Purchased from MBS Trusts Subject to SOP 03-3
 
                                         
                Allowance
             
    Contractual
    Market
    for Loan
    Net
       
    Amount(1)     Discount     Losses     Investment        
    (Dollars in millions)  
 
Balance as of December 31, 2007
  $ 8,096     $ (991 )   $ (39 )   $ 7,066          
Purchases of delinquent loans
    1,704       (728 )           976          
Provision for credit losses
                (35 )     (35 )        
Principal repayments
    (180 )     46       1       (133 )        
Modifications and troubled debt restructurings
    (915 )     331       5       (579 )        
Foreclosures, transferred to REO
    (619 )     169       18       (432 )        
                                         
Balance as of March 31, 2008
  $ 8,086     $ (1,173 )   $ (50 )   $ 6,863          
Purchases of delinquent loans
    807       (380 )           427          
Provision for credit losses
                (86 )     (86 )        
Principal repayments
    (192 )     28       2       (162 )        
Modifications and troubled debt restructurings
    (582 )     240       5       (337 )        
Foreclosures, transferred to REO
    (471 )     129       15       (327 )        
                                         
Balance as of June 30, 2008
  $ 7,648     $ (1,156 )   $ (114 )   $ 6,378          
                                         
 
 
(1) Reflects contractually required principal and accrued interest payments that we believe are probable of collection.
 
Tables 13 and 14 provide information about the re-performance, or cure rates, of seriously delinquent single-family loans we purchased from MBS trusts during the first and second quarters of 2008, each of the quarters for 2007 and each of the years 2004 to 2007, as of both (1) June 30, 2008 and (2) the end of each respective period in which the loans were purchased. Table 13 includes all seriously delinquent loans we purchased from our MBS trusts, while Table 14 includes only those seriously delinquent loans that we purchased from our MBS trusts because we intended to modify the loan.
 
We believe there are inherent limitations in the re-performance statistics presented in Tables 13 and 14, both because of the significant lag between the time a loan is purchased from an MBS trust and the conclusion of the delinquent loan resolution process and because, in our experience, it generally takes at least 18 to 24 months to assess the ultimate re-performance of a delinquent loan. Accordingly, these re-performance statistics, particularly those for more recent loan purchases, are likely to change, perhaps materially. As a result, we believe the re-performance rates as of June 30, 2008 for delinquent loans purchased from MBS trusts during 2008 and 2007, and, to a lesser extent, the latter half of 2006, may not be indicative of the ultimate long-term performance of these loans. In addition, our cure rates may be affected by changes in our loss mitigation efforts and delinquent loan purchase practices.
 
Table 13:  Re-performance Rates of Seriously Delinquent Single-Family Loans Purchased from MBS Trusts(1)
 
                                                                                 
    Status as of June 30, 2008  
    2008     2007                          
    Q2     Q1     Q4     Q3     Q2     Q1     2007     2006     2005     2004  
 
Cured without modification(2)
    10 %     15 %     16 %     19 %     18 %     25 %     20 %     37 %     45 %     43 %
Cured with modification(3)
    35       45       32       18       34       29       26       29       16       15  
                                                                                 
Total cured
    45       60       48       37       52       54       46       66       61       58  
Defaults(4)
    2       5       16       31       21       26       24       23       32       37  
90 days or more delinquent
    53       35       36       32       27       20       30       11       7       5  
                                                                                 
Total
    100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %
                                                                                 
 


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    Status as of the End of Each Respective Period  
    2008     2007                          
    Q2     Q1     Q4     Q3     Q2     Q1     2007     2006     2005     2004  
 
Cured without modification(2)
    10 %     7 %     11 %     10 %     11 %     17 %     16 %     32 %     31 %     33 %
Cured with modification(3)
    35       37       26       12       31       26       26       29       12       12  
                                                                                 
Total cured
    45       44       37       22       42       43       42       61       43       45  
Defaults(4)
    2       2       4       6       3       3       13       9       12       14  
90 days or more delinquent
    53       54       59       72       55       54       45       30       45       41  
                                                                                 
Total
    100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %
                                                                                 
 
 
(1) Re-performance rates calculated based on number of loans.
 
(2) Loans classified as cured without modification consist of the following: (1) loans that are brought current without modification; (2) loans that are paid in full; (3) loans that are repurchased by lenders; (4) loans that have not been modified but are returned to accrual status because they are less than 90 days delinquent; (5) loans for which the default is resolved through long-term forbearance; and (6) loans for which the default is resolved through a repayment plan. We do not extend the maturity date, change the interest rate or otherwise modify the principal amount of any loan that we resolve through long-term forbearance or a repayment plan unless we first purchase the loan from the MBS trust.
 
(3) Loans classified as cured with modification consist of loans that are brought current or are less than 90 days delinquent as a result of resolution of the default under the loan through the following: (1) a modification that does not result in a concession to the borrower; or (2) a modification that results in a concession to a borrower, which is referred to as a troubled debt restructuring. Concessions may include an extension of the time to repay the loan beyond its original maturity date or a temporary or permanent reduction in the loan’s interest rate.
 
(4) Consists of foreclosures, preforeclosure sales, sales to third parties and deeds in lieu of foreclosure.
 
Table 14 below presents cure rates only for seriously delinquent single-family loans that have been modified after their purchase from MBS trusts. The cure rates for these modified seriously delinquent loans differ substantially from those shown in Table 13, which presents the information for all seriously delinquent loans purchased from our MBS trusts. Loans that have not been modified tend to start with a lower cure rate than those of modified loans, and the cure rate tends to rise over time as loss mitigation strategies for those loans are developed and then implemented. In contrast, modified loans tend to start with a high cure rate, and the cure rate tends to decline over time. For example, as shown below in Table 14, the initial cure rate for modified loans as of the end of 2007 was 85%, compared with 72% as of June 30, 2008.
 
Table 14:   Re-performance Rates of Seriously Delinquent Single-Family Loans Purchased from MBS Trusts and Modified(1)
 
                                                                                 
    Status as of June 30, 2008  
    2008     2007                          
    Q2     Q1     Q4     Q3     Q2     Q1     2007     2006     2005     2004  
 
Cured
    99 %     90 %     77 %     70 %     68 %     70 %     72 %     79 %     76 %     73 %
Defaults(2)
                1       3       5       6       3       8       12       17  
90 days or more delinquent
    1       10       22       27       27       24       25       13       12       10  
                                                                                 
Total
    100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %
                                                                                 
 
                                                                                 
    Status as of the End of Each Respective Period  
    2008     2007                          
    Q2     Q1     Q4     Q3     Q2     Q1     2007     2006     2005     2004  
 
Cured
    99 %     99 %     100 %     100 %     99 %     99 %     85 %     91 %     87 %     88 %
Defaults(2)
                                        1       1       1       1  
90 days or more delinquent
    1       1                   1       1       14       8       12       11  
                                                                                 
Total
    100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %     100 %
                                                                                 

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(1) Re-performance rates calculated based on number of loans.
 
(2) Consists of foreclosures, preforeclosure sales, sales to third parties and deeds in lieu of foreclosure.
 
The substantial majority of the loans reported as cured in Tables 13 and 14 above represent loans for which we believe it is probable that we will collect all of the original contractual principal and interest payments because one or more of the following has occurred: (1) the borrower has brought the loan current without servicer intervention; (2) the loan has paid off; (3) the lender has repurchased the loan; or (4) we have resolved the loan through modification, long-term forbearances or repayment plans. The variance in the cumulative cure rates as of June 30, 2008, compared with the cure rates as of the end of each period in which the loans were purchased from the MBS trust, as displayed in Tables 13 and 14, is primarily due to the amount of time that has elapsed since the loan was purchased to allow for the implementation of a workout solution if necessary.
 
A troubled debt restructuring is the only form of modification in which we do not expect to collect the full original contractual principal and interest amount due under the loan, although other resolutions and modifications may result in our receiving the full amount due, or certain installments due, under the loan over a period of time that is longer than the period of time originally provided for under the loan. Of the percentage of loans reported as cured as of June 30, 2008 for the second and first quarters of 2008 and for the years 2007, 2006, 2005 and 2004, approximately 74%, 67%, 39%, 15%, 4% and 2%, respectively, represented troubled debt restructurings where we have provided a concession to the borrower.
 
Required and Optional Purchases of Single Family Loans from MBS Trusts
 
Table 15 presents information on our required and optional purchases of single-family loans from MBS trusts.
 
Table 15:  Required and Optional Purchases of Single-Family Loans from MBS Trusts
 
                                         
          Approximate
    Aggregate
             
    Serious
    Number of
    Unpaid
             
    Delinquency
    Loans
    Principal
    Required
    Optional
 
    Rate(1)     Purchased     Balance(2)     Purchases(3)     Purchases(4)  
    (Dollars in billions)  
 
For the quarter ended:
                                       
December 31, 2007
    0.67 %     13,200     $ 2.0       74 %     26 %
March 31, 2008
    0.85       11,400       1.8       97       3  
June 30, 2008
    1.10       5,000       0.9       91       9  
 
 
(1) Represents serious delinquency rates for conventional single-family loans in Fannie Mae MBS trusts.
 
(2) Represents unpaid principal balance and accrued interest for single-family loans purchased from MBS trusts during the quarter.
 
(3) Calculated based on the number of loans purchased that we were required to purchase, including purchases of loans we plan to modify, divided by the total number of loans we purchased from MBS trusts during the quarter.
 
(4) Calculated based on the number of loans purchased on an optional basis divided by the total number of loans we purchased from MBS trusts during the quarter.
 
The proportion of delinquent loans purchased from MBS trusts for the purpose of modification varies from period to period, driven primarily by factors such as changes in our loss mitigation efforts, as well as changes in interest rates and other market factors. HomeSaver Advance, which serves as a loss mitigation tool earlier in the delinquency cycle than a modification can be offered due to our MBS trust constraints, allows borrowers to cure their payment defaults without requiring modification of their mortgage loans. HomeSaver Advance allows servicers to provide qualified borrowers with a 15-year unsecured personal loan in an amount equal to all past due payments relating to their mortgage loan, up to the lesser of $15,000 or 15% of the unpaid principal balance of the delinquent first lien loan. Because HomeSaver Advance does not require modification of the first lien loan, we are not required to purchase the delinquent loans from the MBS trusts. We purchased 17,901 unsecured, outstanding HomeSaver Advances with an unpaid principal balance of $127 million as of June 30, 2008. The average advance made was approximately $7,100. We record these loans, which we report in our condensed consolidated balance sheets as a component of “Other assets,” at their estimated fair value at the date of purchase and assess for impairment subsequent to the date of purchase. The


33


 

carrying value of our HomeSaver Advances was $4 million as of June 30, 2008. The fair value of these loans is less than the outstanding unpaid principal balance for several reasons, including the lack of underlying collateral to secure the loans, the large discount that market participants have placed on mortgage-related financial assets, and the uncertainty about how these loans will perform given the current housing market and insufficient amount of time to adequately assess their performance. Although several months of payment history is generally required to fully assess loan performance, approximately 59% of the first lien mortgage loans associated with the HomeSaver Advances made through the end of May 2008 were current as of June 30, 2008.
 
We expect HomeSaver Advance to continue to reduce the number of delinquent loans that we otherwise would have purchased from our MBS trusts for the remainder of 2008. Although our optional loan purchases have decreased since the end of 2007, we expect that our SOP 03-3 fair value losses for 2008 will be higher than the losses recorded for 2007, based on the number of required and optional loans we purchased from MBS trusts during the first six months of 2008 and the continued weakness in the housing market, which has reduced the price of these loans.
 
Credit Loss Performance Metrics
 
Management views our credit loss performance metrics, which include our historical credit losses and our credit loss ratio, as significant indicators of the effectiveness of our credit risk management strategies. Management uses these metrics together with other credit risk measures to assess the credit quality of our existing guaranty book of business, make determinations about our loss mitigation strategies, evaluate our historical credit loss performance and determine the level of our loss reserves. These metrics, however, are not defined terms within GAAP and may not be calculated in the same manner as similarly titled measures reported by other companies. Because management does not view changes in the fair value of our mortgage loans as credit losses, we exclude SOP 03-3 and HomeSaver Advance fair value losses that have not yet produced an economic loss from our credit loss performance metrics. However, we include in our credit loss performance metrics the impact of any credit losses we experience on loans subject to SOP 03-3 or first lien loans associated with HomeSaver Advance loans that result in foreclosure.
 
We believe that our credit loss performance metrics are useful to investors because they reflect how management evaluates our credit performance and the effectiveness of our credit risk management strategies and loss mitigation efforts. They also provide a consistent treatment of credit losses for on- and off-balance sheet loans. Moreover, by presenting credit losses with and without the effect of SOP 03-3 and HomeSaver Advance fair value losses, investors are able to evaluate our credit performance on a more consistent basis among periods.
 
Table 16 below details the components of our credit loss performance metrics, which exclude the effect of SOP 03-3 and HomeSaver Advance fair value losses, for the three and six months ended June 30, 2008 and 2007.
 
Table 16:  Credit Loss Performance Metrics
 
                                                                 
    For the Three Months Ended June 30,     For the Six Months Ended June 30,  
    2008     2007     2008     2007  
    Amount     Ratio(1)     Amount     Ratio(1)     Amount     Ratio(1)     Amount     Ratio(1)  
    (Dollars in millions)  
 
Charge-offs, net of recoveries
  $ 1,354       18.9 bp   $ 206       3.3 bp   $ 2,623       18.6 bp   $ 384       3.1 bp
Foreclosed property expense
    264       3.7       84       1.4       434       3.1       156       1.3  
Less: SOP 03-3 and HomeSaver Advance fair value losses(2)
    (494 )     (6.9 )     (66 )     (1.1 )     (1,231 )     (8.7 )     (135 )     (1.1 )
Plus: Impact of SOP 03-3 on charge-offs and foreclosed property expense(3)
    129       1.8       26       0.4       298       2.1       51       0.4  
                                                                 
Credit losses(4)
  $ 1,253       17.5 bp   $ 250       4.0 bp   $ 2,124       15.1 bp   $ 456       3.7 bp
                                                                 


34


 

 
(1) Based on the annualized amount for each line item presented divided by the average guaranty book of business during the period. We previously calculated our credit loss ratio based on annualized credit losses as a percentage of our mortgage credit book of business, which includes non-Fannie Mae mortgage-related securities held in our mortgage investment portfolio that we do not guarantee. Because losses related to non-Fannie Mae mortgage-related securities are not reflected in our credit losses, we revised the calculation of our credit loss ratio to reflect credit losses as a percentage of our guaranty book of business. Our credit loss ratio calculated based on our mortgage credit book of business would have been 16.7 basis points and 3.8 basis points for the three months ended June 30, 2008 and 2007, respectively. Our charge-off ratio calculated based on our mortgage credit book of business would have been 18.0 basis points and 3.1 basis points for the three months ended June 30, 2008 and 2007, respectively. Our credit loss ratio calculated based on our mortgage credit book of business would have been 14.3 basis points and 3.5 basis points for the six months ended June 30, 2008 and 2007, respectively. Our charge-off ratio calculated based on our mortgage credit book of business would have been 17.7 basis points and 3.0 basis points for the six months ended June 30, 2008 and 2007, respectively.
 
(2) Represents the amount recorded as a loss when the acquisition cost of a seriously delinquent loan purchased from an MBS trust exceeds the fair value of the loan at acquisition. Also includes the difference between the unpaid principal balance of HomeSaver Advance loans at origination and the estimated fair value of these loans that we record in our condensed consolidated balance sheets.
 
(3) For seriously delinquent loans purchased from MBS trusts that are recorded at a fair value amount at acquisition that is lower than the acquisition cost, any loss recorded at foreclosure would be less than it would have been if we had recorded the loan at its acquisition cost instead of at fair value. Accordingly, we have added back to our credit losses the amount of charge-offs and foreclosed property expense that we would have recorded if we had calculated these amounts based on the purchase price.
 
(4) Interest forgone on nonperforming loans in our mortgage portfolio, which is presented in Table 39, reduces our net interest income but is not reflected in our credit losses total. In addition, other-than-temporary impairment losses resulting from deterioration in the credit quality of our mortgage-related securities and accretion of interest income on loans subject to SOP 03-3 are excluded from credit losses.
 
Our credit loss ratio increased to 17.5 basis points and 15.1 basis points for the second quarter and first six months of 2008, respectively, from 4.0 basis points and 3.7 basis points for the second quarter and first six months of 2007, respectively. The substantial increase in our credit losses reflected the impact of a further deterioration of conditions in the housing and credit markets. The decline in national home prices and the economic weakness in the Midwest have continued to contribute to higher default rates and loan loss severities, particularly for certain higher risk loan categories, loan vintages and loans within certain states that have had the greatest home price depreciation from their recent peaks. Our credit loss ratio including the effect of SOP 03-3 and HomeSaver Advance fair value losses was 22.6 basis points and 21.7 basis points for the second quarter and first six months of 2008, respectively, and 4.7 basis points and 4.4 basis points for the second quarter and first six months of 2007, respectively.
 
Certain higher risk loan types, such as Alt-A loans, interest-only loans, loans to borrowers with low credit scores and loans with high loan-to-value (“LTV”) ratios, many of which were originated in 2006 and 2007, represented approximately 29% of our single-family conventional mortgage credit book of business as of June 30, 2008, but accounted for approximately 72% and 70% of our credit losses for the second quarter and first six months of 2008, respectively, compared with 52% and 51% for the second quarter and first six months of 2007, respectively.
 
The states of California, Florida, Arizona and Nevada, which represented approximately 27% of our single-family conventional mortgage credit book of business as of June 30, 2008, accounted for 48% and 42% of our credit losses for the second quarter and first six months of 2008, respectively, compared with 8% and 5% for the second quarter and first six months of 2007, respectively. Michigan and Ohio, two key states driving credit losses in the Midwest, represented approximately 6% of our single-family conventional mortgage credit book of business as of June 30, 2008, but accounted for 18% and 23% of our credit losses for the second quarter and first six months of 2008, respectively, compared with 46% and 44% for the second quarter and first six months of 2007, respectively.
 
In light of our experience during the second quarter and our credit performance in July, we are increasing our forecast for our credit loss ratio (which excludes SOP 03-3 and HomeSaver Advance fair value losses) of 23 to 26 basis points for 2008, as compared with our previous guidance of 13 to 17 basis points. We continue to anticipate that our credit loss ratio will increase further in 2009 compared with 2008.


35


 

We provide more detailed credit performance information, including serious delinquency rates by geographic region, statistics on nonperforming loans and foreclosed property activity, in “Risk Management—Credit Risk Management—Mortgage Credit Risk Management—Mortgage Credit Book of Business.”
 
Credit Loss Sensitivity
 
Pursuant to our September 2005 agreement with OFHEO, we disclose on a quarterly basis the present value of the change in future expected credit losses from our existing single-family guaranty book of business from an immediate 5% decline in single-family home prices for the entire United States. Table 17 shows the credit loss sensitivity before and after consideration of projected credit risk sharing proceeds, such as private mortgage insurance claims and other credit enhancement, as of June 30, 2008 and December 31, 2007 for first lien single-family whole loans we own or that back Fannie Mae MBS. The sensitivity results represent the difference between our base case scenario of the present value of expected credit losses and credit risk sharing proceeds, derived from our internal home price path forecast, and a scenario that assumes an instantaneous nationwide 5% decline in home prices. The increase in the credit loss sensitivities since December 31, 2007 reflects the decline in home prices during the first half of 2008 and the current negative near-term outlook for the housing and credit markets. These higher sensitivities also reflect the impact of updates to our underlying credit loss estimation models to capture the credit risk associated with the rapidly changing and worsening of conditions in the housing market. An environment of continuing lower home prices affects the frequency and timing of defaults and increases the level of credit losses, resulting in greater loss sensitivities. Although the anticipated credit risk sharing proceeds have increased as home prices have declined, the expected amount of proceeds resulting from a 5% home price shock are lower. As home prices decline, the number of loans without mortgage insurance that are projected to default increases and the losses on loans with mortgage insurance that default are more likely to increase to a level that exceeds the level of mortgage insurance.
 
Table 17:  Single-Family Credit Loss Sensitivity(1)
 
                 
    As of  
    June 30,
    December 31,
 
    2008     2007  
    (Dollars in millions)  
 
Gross single-family credit loss sensitivity(2)
  $ 11,300     $ 9,644  
Less: Projected credit risk sharing proceeds
    (3,933 )     (5,102 )
                 
Net single-family credit loss sensitivity(2)
  $ 7,367     $ 4,542  
                 
Outstanding single-family whole loans and Fannie Mae MBS
  $ 2,660,098     $ 2,523,440  
Single-family net credit loss sensitivity as a percentage of outstanding single-family whole loans and Fannie Mae MBS
    0.28 %     0.18 %
 
 
(1) For purposes of this calculation, we assume that, after the initial 5% shock, home price growth rates return to the average of the possible growth rate paths used in our internal credit pricing models. The present value change reflects the increase in future expected credit losses under this shock scenario.
 
(2) Represents total economic credit losses, which consists of credit losses and forgone interest. Calculations are based on approximately 97% of our total single-family guaranty book of business as of both June 30, 2008 and December 31, 2007. The mortgage loans and mortgage-related securities that are included in these estimates consist of: (i) single-family Fannie Mae MBS (whether held in our mortgage portfolio or held by third parties), excluding certain whole loan real estate mortgage investment conduits (“REMICs”) and private-label wraps; (ii) single-family mortgage loans, excluding mortgages secured only by second liens, subprime mortgages, manufactured housing chattel loans and reverse mortgages; and (iii) long-term standby commitments. We expect the inclusion in our estimates of the excluded products may impact the estimated sensitivities set forth in this table.
 
We generated these sensitivities using the same models that we use to estimate fair value. Because these sensitivities represent hypothetical scenarios, they should be used with caution. They are limited in that they assume an instantaneous uniform nationwide decline in home prices, which is not representative of the historical pattern of changes in home prices. Changes in home prices generally vary on a regional basis. In addition, these sensitivities are calculated independently without considering changes in other interrelated


36


 

assumptions, such as unemployment rates or other economic factors, which would likely have a significant impact on our credit losses.
 
Other Non-Interest Expenses
 
Other non-interest expenses increased to $286 million and $791 million for the second quarter and first six months of 2008, respectively, from $60 million and $164 million for the second quarter and first six months of 2007, respectively. The increase in expenses for each period was predominately due to a reduction in the amount of net gains recognized on the extinguishment of debt and interest expense related to an increase in our unrecognized tax benefit.
 
Federal Income Taxes
 
We recorded a tax benefit of $476 million and $3.4 billion for the second quarter and first six months of 2008, respectively, which resulted in an effective tax rate, excluding the provision or benefit related to extraordinary amounts of 17% and 43%, respectively. The tax benefit for each period was due in part to the pre-tax loss for the period as well as the tax credits generated from our LIHTC partnership investments. The reduction of our tax benefit as a percentage of pre-tax loss in the three months ended June 30, 2008 as compared with the three months ended March 31, 2008, was due in part to an increase in our projected credit losses for 2008 which is used in computing our annual effective tax rate. In comparison, we recorded a tax provision of $187 million and $114 million for the second quarter and first six months of 2007, respectively, and our effective tax rate was 9% and 4%, respectively.
 
In calculating our interim provision for income taxes, we use an estimate of our annual effective tax rate, which we update each quarter based on actual historical information and forward-looking estimates. The estimated annual effective tax rate may fluctuate each period based upon changes in facts and circumstances, if any, as compared with those forecasted at the beginning of the year and each interim period thereafter.
 
BUSINESS SEGMENT RESULTS
 
The presentation of the results of each of our three business segments is intended to reflect each segment as if it were a stand-alone business. We describe the management reporting and allocation process that we use to generate our segment results in our 2007 Form 10-K in “Notes to Consolidated Financial Statements—Note 15, Segment Reporting.” We summarize our segment results for the three and six months ended June 30, 2008 and 2007 in the tables below and provide a discussion of these results. We include more detail on our segment results in “Notes to Condensed Consolidated Financial Statements—Note 13, Segment Reporting.”
 
Single-Family Business
 
Our Single-Family business recorded a net loss of $2.4 billion and $3.4 billion for the second quarter and first six months of 2008, respectively, compared with net income of $136 million and $491 million for the second quarter and first six months of 2007, respectively. Table 18 summarizes the financial results for our Single-Family business for the periods indicated.


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Table 18:  Single-Family Business Results
 
                                                                 
    For the
    For the
             
    Three Months Ended
    Six Months Ended
    Quarterly
    Year-to-Date
 
    June 30,     June 30,     Variance     Variance  
    2008     2007     2008     2007     $     %     $     %  
    (Dollars in millions)  
 
Statement of operations data:
                                                               
Guaranty fee income
  $ 1,819     $ 1,304     $ 3,761     $ 2,591     $ 515       39 %   $ 1,170       45 %
Trust management income
    74       141       179       295       (67 )     (48 )     (116 )     (39 )
Other income(1)(2)
    197       184       385       360       13       7       25       7  
Losses on certain guaranty contracts
          (451 )           (731 )     451       100       731       100  
Credit-related expenses(3)
    (5,339 )     (519 )     (8,593 )     (845 )     (4,820 )     (929 )     (7,748 )     (917 )
Other expenses(1)(4)
    (461 )     (454 )     (994 )     (922 )     (7 )     (2 )     (72 )     (8 )
                                                                 
Income (loss) before federal income taxes
    (3,710 )     205       (5,262 )     748       (3,915 )     (1,910 )     (6,010 )     (803 )
Benefit (provision) for federal income taxes
    1,304       (69 )     1,848       (257 )     1,373       1,990       2,105       819  
                                                                 
Net income (loss)
  $ (2,406 )   $ 136     $ (3,414 )   $ 491     $ (2,542 )     (1,869 )%   $ (3,905 )     (795 )%
                                                                 
Other key performance data:
                                                               
Average single-family guaranty book of business(5)
  $ 2,704,345     $ 2,349,006     $ 2,668,099     $ 2,318,897     $ 355,339       15 %   $ 349,202       15 %
 
 
(1) Certain prior period amounts have been reclassified to conform with the current period presentation in our condensed consolidated statements of operations.
 
(2) Consists of net interest income, investment gains and losses, and fee and other income.
 
(3) Consists of the provision for credit losses and foreclosed property expense.
 
(4) Consists of administrative expenses and other expenses.
 
(5) The single-family guaranty book of business consists of single-family mortgage loans held in our mortgage portfolio, single-family Fannie Mae MBS held in our mortgage portfolio, single-family Fannie Mae MBS held by third parties, and other credit enhancements that we provide on single-family mortgage assets. Excludes non-Fannie Mae mortgage-related securities held in our investment portfolio for which we do not provide a guaranty.
 
Key factors affecting the results of our Single-Family business for the second quarter and first six months of 2008 compared with the second quarter and first six months of 2007 included the following.
 
  •  Increased guaranty fee income, attributable to growth in the average single-family guaranty book of business, coupled with an increase in the average effective single-family guaranty fee rate.
 
  —  We experienced an increase of 15% in our average single-family guaranty book of business for the second quarter and first six months of 2008 over the second quarter and first six months of 2007, reflecting the significant increase in our market share since the end of the second quarter of 2007. Our single-family guaranty book of business increased to $2.7 trillion as of June 30, 2008, from $2.4 trillion as of June 30, 2007. Our estimated market share of new single-family mortgage-related securities issuances, which is based on publicly available data and excludes previously securitized mortgages, increased to approximately 45.4% and 47.6% for the second quarter and first six months of 2008, respectively, from 27.9% and 26.5% for the second quarter and first six months of 2007, respectively.
 
  —  Our average effective single-family guaranty fee rate increased to 26.9 basis points and 28.2 basis points for the second quarter and first six months of 2008, respectively, from 22.2 basis points and 22.3 basis points for the second quarter and first six months of 2007, respectively. The growth in our average effective single-family guaranty fee rate for the second quarter and first six months of 2008 over the comparable periods in 2007 reflects the accelerated recognition of deferred amounts into income as interest rates were lower in the second quarter and first six months of 2008, relative to the


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  level of interest rates during the comparable prior year periods. Our average effective single-family guaranty fee rate for the second quarter and first six months of 2008 also reflects the impact of guaranty fee pricing changes and a shift in the composition of our guaranty book of business to a greater proportion of higher-quality, lower risk and lower guaranty fee mortgages, as we reduced our acquisitions of higher risk, higher fee product categories, such as Alt-A loans.
 
  •  The elimination of losses on certain guaranty contracts due to the change in measuring the fair value of our guaranty obligation upon adoption of SFAS 157 on January 1, 2008.
 
  •  A substantial increase in credit-related expenses, primarily due to an increase in the provision for credit losses due to higher charge-offs, as well as a higher incremental provision to build our loss reserves, reflecting worsening credit performance trends, including significant increases in delinquencies, default rates and average loan loss severities, particularly in certain states and higher risk loan categories. We also experienced an increase in SOP 03-3 fair value losses, which are recorded as a component of our provision for credit losses.
 
  •  A relatively stable effective income tax rate of approximately 35%, which represents our statutory tax rate.
 
HCD Business
 
Our HCD business recorded net income of $72 million and $222 million for the second quarter and first six months of 2008, respectively, compared with net income of $110 million and $273 million for the second quarter and first six months of 2007, respectively. Table 19 summarizes the financial results for our HCD business for the periods indicated.
 
Table 19:  HCD Business Results
 
                                                                 
    For the
    For the
             
    Three Months Ended
    Six Months Ended
    Quarterly
    Year-to-Date
 
    June 30,     June 30,     Variance     Variance  
    2008     2007     2008     2007     $     %     $     %  
    (Dollars in millions)  
 
Statement of operations data:
                                                               
Guaranty fee income
  $ 134     $ 110     $ 282     $ 211     $ 24       22 %   $ 71       34 %
Other income(1)
    52       106       116       200       (54 )     (51 )     (84 )     (42 )
Losses on partnership investments
    (195 )     (215 )     (336 )     (380 )     20       9       44       12  
Credit-related income (expenses)(2)
    (10 )     1       1       6       (11 )     (1,100 )     (5 )     (83 )
Other expenses(3)
    (225 )     (263 )     (479 )     (510 )     38       14       31       6  
                                                                 
Loss before federal income taxes
    (244 )     (261 )     (416 )     (473 )     17       7       57       12  
Benefit for federal income taxes
    316       371       638       746       (55 )     (15 )     (108 )     (14 )
                                                                 
Net income
  $ 72     $ 110     $ 222     $ 273     $ (38 )     (35 )%   $ (51 )     (19 )%
                                                                 
Other key performance data:
                                                               
Average multifamily guaranty book of business(4)
  $ 158,444     $ 126,575     $ 155,173     $ 124,818     $ 31,869       25 %   $ 30,355       24 %
 
 
(1) Consists of trust management income and fee and other income (expense).
 
(2) Consists of provision for credit losses and foreclosed property income (expense).
 
(3) Consists of net interest expense, losses on certain guaranty contracts, administrative expenses, minority interest in earnings of consolidated subsidiaries and other expenses.
 
(4) The multifamily guaranty book of business consists of multifamily mortgage loans held in our mortgage portfolio, multifamily Fannie Mae MBS held in our mortgage portfolio, multifamily Fannie Mae MBS held by third parties and other credit enhancements that we provide on multifamily mortgage assets. Excludes non-Fannie Mae mortgage-related securities held in our investment portfolio for which we do not provide a guaranty.


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Key factors affecting the results of our HCD business for the second quarter and first six months of 2008 compared with the second quarter and first six months of 2007 included the following.
 
  •  Increased guaranty fee income, attributable to growth in the average multifamily guaranty book of business and an increase in the average effective multifamily guaranty fee rate. These increases reflect the increased investment and liquidity that we are providing to the multifamily mortgage market.
 
  •  A decrease in other income, attributable to lower multifamily fees due to a reduction in multifamily loan liquidations for the first six months of 2008.
 
  •  A decrease in losses on partnership investments, primarily due to a decline in tax-advantaged investments and gains on the sales of some of our LIHTC investments, partially offset by increases in our non-tax advantaged investments.
 
  •  A tax benefit of $316 million and $638 million for the second quarter and first six months of 2008, respectively, driven primarily by tax credits of $229 million and $490 million, respectively. In comparison, we recorded a tax benefit of $371 million and $746 million for the second quarter and first six months of 2007, respectively, driven by tax credits of $277 million and $577 million, respectively.
 
Capital Markets Group
 
Our Capital Markets group recorded net income of $34 million and a net loss of $1.3 billion for the second quarter and first six months of 2008, respectively, compared with net income of $1.7 billion and $2.1 billion for the second quarter and first six months of 2007, respectively. Table 20 summarizes the financial results for our Capital Markets group for the periods indicated.
 
Table 20:  Capital Markets Group Results
 
                                                                 
    For the
    For the
             
    Three Months Ended
    Six Months Ended
    Quarterly
    Year-to-Date
 
    June 30,     June 30,     Variance     Variance  
    2008     2007     2008     2007     $     %     $     %  
    (Dollars in millions)  
 
Statement of operations data:
                                                               
Net interest income
  $ 2,003     $ 1,182     $ 3,662     $ 2,391     $ 821       69 %   $ 1,271       53 %
Investment losses, net(1)
    (846 )     (86 )     (909 )     201       (760 )     (884 )     (1,110 )     (552 )
Fair value gains (losses), net(1)
    517       1,424       (3,860 )     858       (907 )     (64 )     (4,718 )     (550 )
Fee and other income(1)
    82       83       145       187       (1 )     (1 )     (42 )     (22 )
Other expenses(2)
    (545 )     (410 )     (1,216 )     (884 )     (135 )     (33 )     (332 )     (38 )
                                                                 
Income (loss) before federal income taxes and extraordinary losses, net of tax effect
    1,211       2,193       (2,178 )     2,753       (982 )     (45 )     (4,931 )     (179 )
Benefit (provision) for federal income taxes
    (1,144 )     (489 )     918       (603 )     (655 )     (134 )     1,521       252  
Extraordinary losses, net of tax effect
    (33 )     (3 )     (34 )     (6 )     (30 )     (1,000 )     (28 )     (467 )
                                                                 
Net income (loss)
  $ 34     $ 1,701     $ (1,294 )   $ 2,144     $ (1,667 )     (98 )%   $ (3,438 )     (160 )%
                                                                 
 
 
(1) Certain prior period amounts have been reclassified to conform with the current period presentation in our condensed consolidated statements of operations.
 
(2) Includes debt extinguishment losses, allocated guaranty fee expense, administrative expenses and other expenses.
 
Key factors affecting the results of our Capital Markets group for the second quarter and first six months of 2008 compared with the second quarter and first six months of 2007 included the following.
 
  •  An increase in net interest income, primarily attributable to an expansion of our taxable-equivalent net interest yield driven by the reduction in short-term interest rates, which reduced the average cost of our debt, and wider mortgage-to-debt spreads on acquisitions. The reversal of accrued interest expense on step-rate debt that we redeemed during the first quarter of 2008 also reduced the average cost of our debt.


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  •  A decrease in fair value gains for the second quarter of 2008 compared with the second quarter of 2007, largely due to adjustments on hedged mortgage assets attributable to the increase in interest rates during the quarter. The fair value losses recorded for the first six months of 2008 were primarily attributable to losses on our trading securities resulting from the significant widening of spreads during the first quarter of 2008 and the decrease in interest rates during the first quarter of 2008.
 
  •  A significant increase in investment losses due to other-than-temporary impairment on AFS securities, principally for Alt-A and subprime private-label securities, reflecting a reduction in expected cash flows due to higher expected defaults and loss severities on the underlying mortgages.
 
  •  An effective tax rate of 94% and 42% for the second quarter and first six months of 2008, respectively, compared with an effective tax rate of 22% for both the second quarter and first six months of 2007. Fluctuations in our effective tax rate and variances between the effective tax rate and statutory rate reflect fluctuations in our pre-tax earnings and the relative benefit of tax-exempt income generated from our investments in mortgage revenue bonds. In addition, the effective tax rate for the second quarter of 2008 reflected an adjustment during the quarter to our estimated annual 2008 corporate effective tax rate, which was due in part to the increase in our projected credit losses for 2008.
 
CONSOLIDATED BALANCE SHEET ANALYSIS
 
Total assets of $885.9 billion as of June 30, 2008 increased by $6.5 billion, or 1%, from December 31, 2007. Total liabilities of $844.5 billion increased by $9.3 billion, or 1%, from December 31, 2007. Stockholders’ equity of $41.2 billion reflected a decrease of $2.8 billion, or 6%, from December 31, 2007. Following is a discussion of material changes in the major components of our assets and liabilities since December 31, 2007.
 
Mortgage Investments
 
Table 21 summarizes our mortgage portfolio activity for the three and six months ended June 30, 2008 and 2007.
 
Table 21:  Mortgage Portfolio Activity(1)
 
                                                                 
    For the
          For the
       
    Three Months Ended
          Six Months Ended
       
    June 30,     Variance     June 30,     Variance  
    2008     2007     $     %     2008     2007     $     %  
    (Dollars in millions)  
 
Purchases(2)
  $ 60,315     $ 48,287     $ 12,028       25 %   $ 95,815     $ 84,004     $ 11,811       14 %
Sales
    9,051       8,048       1,003       12       22,580       25,039       (2,459 )     (10 )
Liquidations(3)
    25,020       32,671       (7,651 )     (23 )     48,591       64,908       (16,317 )     (25 )
 
 
(1) Excludes unamortized premiums, discounts and other cost basis adjustments.
 
(2) Excludes advances to lenders and mortgage-related securities acquired through the extinguishment of debt.
 
(3) Includes scheduled repayments, prepayments and foreclosures.
 
For the first two months of 2008, we were subject to an OFHEO-directed limitation on the size of our mortgage portfolio. OFHEO’s mortgage portfolio cap requirement, which is described in our 2007 Form 10-K, was eliminated by OFHEO effective March 1, 2008. OFHEO’s reduction in our capital surplus requirement provided us with more flexibility to take advantage of purchase opportunities. As a result, we were able to increase our portfolio purchases during the first six months of 2008, particularly in the second quarter of 2008, as mortgage-to-debt spreads reached historic highs, which presented more opportunities for us to purchase mortgage assets at attractive prices and spreads. We experienced a decrease in mortgage liquidations during the second quarter and first six months of 2008 relative to the second quarter and first six months of 2007, reflecting a decline in refinancing activity due to the continuing deterioration in the housing market and tightening of credit standards in the primary mortgage market, as well as higher mortgage interest rates.


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Table 22 shows the composition of our net mortgage portfolio by product type and the carrying value as of June 30, 2008 and December 31, 2007. Our net mortgage portfolio totaled $737.5 billion as of June 30, 2008, reflecting an increase of 2% from December 31, 2007.
 
Table 22:  Mortgage Portfolio Composition(1)
 
                 
    As of  
    June 30,
    December 31,
 
    2008     2007  
    (Dollars in millions)  
 
Mortgage loans:(2)
               
Single-family:
               
Government insured or guaranteed
  $ 36,009     $ 28,202  
Conventional:
               
Long-term, fixed-rate
    191,351       193,607  
Intermediate-term, fixed-rate(3)
    44,124       46,744  
Adjustable-rate
    43,758       43,278  
                 
Total conventional single-family
    279,233       283,629  
                 
Total single-family
    315,242       311,831  
                 
Multifamily:
               
Government insured or guaranteed
    753       815  
Conventional:
               
Long-term, fixed-rate
    5,537       5,615  
Intermediate-term, fixed-rate(3)
    83,296       73,609  
Adjustable-rate
    16,164       11,707  
                 
Total conventional multifamily
    104,997       90,931  
                 
Total multifamily
    105,750       91,746  
                 
Total mortgage loans
    420,992       403,577  
                 
Unamortized premiums (discounts) and other cost basis adjustments, net
    (1,050 )     726  
Lower of cost or market adjustments on loans held for sale
    (235 )     (81 )
Allowance for loan losses for loans held for investment
    (1,476 )     (698 )
                 
Total mortgage loans, net
    418,231       403,524  
                 
Mortgage-related securities:
               
Fannie Mae single-class MBS
    118,069       102,258  
Fannie Mae structured MBS
    75,052       77,905  
Non-Fannie Mae single-class mortgage securities
    28,599       28,129  
Non-Fannie Mae structured mortgage securities(4)
    92,524       96,373  
Mortgage revenue bonds
    15,788       16,315  
Other mortgage-related securities
    3,092       3,346  
                 
Total mortgage-related securities
    333,124       324,326  
                 
Market value adjustments(5)
    (11,531 )     (3,249 )
Other-than-temporary impairments
    (1,189 )     (603 )
Unamortized discounts and other cost basis adjustments, net(6)
    (1,147 )     (1,076 )
                 
Total mortgage-related securities, net
    319,257       319,398  
                 
Mortgage portfolio, net(7)
  $ 737,488     $ 722,922  
                 
 
 
(1) Mortgage loans and mortgage-related securities are reported at unpaid principal balance.
 
(2) Mortgage loans include unpaid principal balance totaling $82.4 billion and $81.8 billion as of June 30, 2008 and December 31, 2007, respectively, related to mortgage-related securities that were consolidated under Financial Accounting Standards Board Interpretation (“FIN”) No. 46R (revised December 2003), Consolidation of Variable Interest Entities (an interpretation of ARB No. 51) (“FIN 46R”), and mortgage-related securities created from


42


 

securitization transactions that did not meet the sales criteria under SFAS No. 140, Accounting for Transfer and Servicing of Financial Assets and Extinguishments of Liabilities (a replacement of FASB Statement No. 125) (“SFAS 140”), which effectively resulted in mortgage-related securities being accounted for as loans.
 
(3) Intermediate-term, fixed-rate consists of mortgage loans with contractual maturities at purchase equal to or less than 15 years.
 
(4) Includes private-label mortgage-related securities backed by Alt-A or subprime mortgage loans totaling $57.8 billion and $64.5 billion as of June 30, 2008 and December 31, 2007, respectively. Refer to “Trading and Available-for-Sale Investment Securities—Investments in Private-Label Mortgage-Related Securities” for a description of our investments in Alt-A and subprime securities.
 
(5) Includes unrealized gains and losses on mortgage-related securities and securities commitments classified as trading and available-for-sale.
 
(6) Includes the impact of other-than-temporary impairments of cost basis adjustments.
 
(7) Includes consolidated mortgage-related assets acquired through the assumption of debt. Also includes $736 million and $538 million as of June 30, 2008 and December 31, 2007, respectively, of mortgage loans and mortgage-related securities that we have pledged as collateral and which counterparties have the right to sell or repledge.
 
Liquid Investments
 
Our liquid assets consist of cash and cash equivalents, funding agreements with our lenders, including advances to lenders and repurchase agreements, and non-mortgage investment securities. Our liquid assets, net of cash equivalents pledged as collateral, decreased to $82.7 billion as of June 30, 2008 from $102.0 billion as of December 31, 2007, as we used funds to redeem a significant amount of higher cost long-term debt.
 
Trading and Available-for-Sale Investment Securities
 
Our mortgage investment securities are classified in our condensed consolidated balance sheets as either trading or AFS and reported at fair value. In conjunction with our January 1, 2008 adoption of SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”), we elected to reclassify all of our non-mortgage investment securities from AFS to trading. Table 23 shows the composition of our trading and AFS securities at amortized cost and fair value as of June 30, 2008, which totaled $356.7 billion and $344.8 billion, respectively. We also disclose the gross unrealized gains and gross unrealized losses related to our AFS securities as of June 30, 2008, and a stratification of these losses based on securities that have been in a continuous unrealized loss position for less than 12 months and for 12 months or longer.


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Table 23:  Trading and AFS Investment Securities
 
                                                                 
    As of June 30, 2008  
                            Less Than 12
    12 Consecutive
 
                            Consecutive Months     Months or Longer  
          Gross
    Gross
    Total
    Gross
    Total
    Gross
    Total
 
    Amortized
    Unrealized
    Unrealized
    Fair
    Unrealized
    Fair
    Unrealized
    Fair
 
    Cost(1)     Gains     Losses     Value     Losses     Value     Losses     Value  
    (Dollars in millions)  
 
Trading:
                                                               
Fannie Mae single-class MBS
  $ 42,604     $     $     $ 42,908     $     $     $     $  
Fannie Mae structured MBS
    10,992                   10,945                          
Non-Fannie Mae single-class
mortgage-related securities
    1,122                   1,123                          
Non-Fannie Mae structured
mortgage-related securities
    20,772                   18,338                          
Mortgage revenue bonds
    799                   717                          
Asset-backed securities
    13,077                   12,843                          
Corporate debt securities
    10,193                   10,049                          
Other non-mortgage-related securities
    2,638                   2,639                          
                                                                 
Total trading
  $ 102,197     $     $     $ 99,562     $     $     $     $  
                                                                 
Available for sale:
                                                               
Fannie Mae single-class MBS
  $ 74,659     $ 572     $ (1,100 )   $ 74,131     $ (795 )   $ 42,373     $ (305 )   $ 7,143  
Fannie Mae structured MBS
    63,828       670       (700 )     63,798       (397 )     26,331       (303 )     7,568  
Non-Fannie Mae single-class
mortgage-related securities
    27,267       371       (153 )     27,485       (126 )     7,806       (27 )     1,172  
Non-Fannie Mae structured
mortgage-related securities
    71,045       102       (8,380 )     62,767       (2,359 )     24,757       (6,021 )     32,812  
Mortgage revenue bonds
    14,989       64       (736 )     14,317       (258 )     6,237       (478 )     3,900  
Other mortgage-related securities
    2,711       110       (93 )     2,728       (78 )     1,025       (15 )     93  
                                                                 
Total available for sale
  $ 254,499     $ 1,889     $ (11,162 )   $ 245,226     $ (4,013 )   $ 108,529     $ (7,149 )   $ 52,688  
                                                                 
Total investments in securities
  $ 356,696     $ 1,889     $ (11,162 )   $ 344,788     $ (4,013 )   $ 108,529     $ (7,149 )   $ 52,688  
                                                                 
 
 
(1) Amortized cost includes unamortized premiums, discounts and other cost basis adjustments, as well as other-than-temporary impairment write downs.
 
The estimated fair value of our AFS securities decreased to $245.2 billion as of June 30, 2008 from $293.6 billion as of December 31, 2007. Gross unrealized losses related to these securities totaled $11.2 billion as of June 30, 2008, compared with $4.8 billion as of December 31, 2007. The increase in gross unrealized losses during the first six months of 2008 was primarily due to significantly wider spreads during the period, which reduced the fair value of substantially all of our mortgage-related securities, particularly our private-label mortgage-related securities backed by Alt-A, subprime, and commercial multifamily loans. We discuss our process for assessing our AFS investment securities for other-than-temporary impairment below.
 
Investments in Private-Label Mortgage-Related Securities
 
The non-Fannie Mae mortgage-related security categories presented in Table 23 above include agency mortgage-related securities issued or guaranteed by Freddie Mac or Ginnie Mae and private-label mortgage-related securities backed by Alt-A, subprime, multifamily, manufactured housing or other mortgage loans. We do not have any exposure to collateralized debt obligations, or CDOs. We classify private-label securities as Alt-A, subprime, multifamily or manufactured housing if the securities were labeled as such when issued. We also have invested in private-label Alt-A and subprime mortgage-related securities that we have resecuritized to include our guaranty (“wraps”), which we report in Table 23 above as a component of Fannie Mae structured MBS. We generally have focused our purchases of these securities on the highest-rated tranches available at the time of acquisition. Higher-rated tranches typically are supported by credit enhancements to reduce the exposure to losses. The credit enhancements on our private-label security investments generally are in the form of initial subordination provided by lower level tranches of these securities, prepayment proceeds within the trust and secondary guarantees from monoline financial guarantors based on specific performance


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triggers. The characteristics of the subprime securities that we hold are different than the securities underlying the ABX indices. For example, the pass-through securities in our portfolio reflect the entirety of the underlying AAA cash flows, while only a portion of the underlying AAA cash flows backs the securities in the ABX indices.
 
We owned $104.9 billion of private-label mortgage-related securities backed by Alt-A, subprime, multifamily, manufactured housing and other mortgage loans and mortgage revenue bonds as of June 30, 2008, down from $111.1 billion as of December 31, 2007, reflecting a reduction of $6.2 billion due to principal payments. Table 24 summarizes, by loan type, the composition of our investments in private-label securities and mortgage revenue bonds as of June 30, 2008 and the average credit enhancement. The average credit enhancement generally reflects the level of cumulative losses that must be incurred before we experience a loss of principal on the tranche of securities that we own. Table 24 also provides information on the credit ratings of our private-label securities as of July 31, 2008. The credit rating reflects the lowest rating as reported by Standard & Poor’s (“Standard & Poor’s”), Moody’s Investors Service (“Moody’s”), Fitch Ratings (“Fitch”) or Dominion Bond Rating Service Limited (“DBRS, Limited”), each of which is a nationally recognized statistical rating organization.
 
Table 24:  Investments in Private-Label Mortgage-Related Securities and Mortgage Revenue Bonds
 
                                                 
    As of June 30, 2008     As of July 31, 2008  
    Unpaid
    Average
                % Below
       
    Principal
    Credit
          % AA
    Investment
    Current %
 
    Balance     Enhancement(1)     % AAA(2)     to BBB-(2)     Grade(2)     Watchlist(3)  
    (Dollars in millions)  
 
Private-label mortgage-related securities backed by:
                                               
Alt-A mortgage loans
  $ 29,507       24 %     96 %     4 %     %     14 %
Subprime mortgage loans
    28,276       37       42       48       10       22  
Multifamily mortgage loans
    25,880       30       100                    
Manufactured housing mortgage loans
    3,065       37       6       39       55       1  
Other mortgage loans
    2,411       6       96       1       3        
                                                 
Total private-label mortgage-related securities
    89,139                                          
Mortgage revenue bonds(4)
    15,788       35       48       50       2       27  
                                                 
Total
  $ 104,927                                          
                                                 
 
 
(1) Average credit enhancement percentage reflects both subordination and financial guarantees. Reflects the ratio of the current amount of the securities that will incur losses in a securitization structure before any losses are allocated to securities that we own. Percentage calculated based on the quotient of the total unpaid principal balance of all credit enhancement in the form of subordination or financial guarantee of the security divided by the total unpaid principal balance of all of the tranches of collateral pools from which credit support is drawn for the security that we own.
 
(2) Reflects credit ratings as of July 31, 2008, calculated based on unpaid principal balance as of June 30, 2008. Investment securities that have a credit rating below BBB- or its equivalent or that have not been rated are classified as below investment grade.
 
(3) Reflects percentage of investment securities, calculated based on unpaid principal balance as of June 30, 2008, that have been placed under review by either Standard & Poor’s, Moody’s, Fitch or DBRS, Limited.
 
(4) Reflects that 35% of the outstanding unpaid principal balance of our mortgage revenue bonds are guaranteed by third parties.


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Investments in Alt-A and Subprime Private-Label Mortgage-Related Securities
 
As indicated in Table 24, the unpaid principal balance of our investments in private-label mortgage-related securities backed by Alt-A and subprime loans totaled $57.8 billion as of June 30, 2008. For our investments in Alt-A and subprime private-label securities, including wraps, classified as trading, we recognized fair value gains of $316 million for the second quarter of 2008 and fair value losses of $763 million for the first six months of 2008. These amounts are included in our condensed consolidated results of operations as a component of “Fair value gains (losses), net.” The gross unrealized losses on our Alt-A and subprime securities, including wraps, classified as AFS were $7.6 billion as of June 30, 2008, compared with $3.3 billion as of December 31, 2007.
 
The substantial majority of our Alt-A private-label mortgage securities, or 96%, continued to be rated AAA as of July 31, 2008, and the remaining 4% were rated AA to BBB- as of July 31, 2008. Approximately $4.1 billion, or 14%, of our Alt-A private-label mortgage-related securities had been placed under review for possible credit downgrade or on negative watch as of July 31, 2008.
 
The percentages of our subprime private-label mortgage-related securities rated AAA and rated AA to BBB- were 42% and 48%, respectively, as of July 31, 2008, compared with 97% and 3%, respectively, as of December 31, 2007. The percentage of our subprime private-label mortgage-related securities rated below investment grade was 10% as of July 31, 2008. None of these securities were rated below investment grade as of December 31, 2007. Approximately $6.2 billion, or 22%, of our subprime private-label mortgage-related securities had been placed under review for possible credit downgrade or on negative watch as of July 31, 2008.
 
Other-than-temporary Impairment Assessment
 
Our policy for determining whether an impairment is other-than-temporary is based on an analysis of our AFS securities in an unrealized loss position as of the end of each quarter. As discussed in our 2007 Form 10-K in “Item 7—MD&A—Critical Accounting Policies and Estimates—Other-than-temporary Impairment of Investment Securities,” the determination that a security has suffered an other-than-temporary decline in value requires management judgment and consideration of various factors, including, but not limited to, the severity and duration of the impairment, recent events specific to the issuer and/or the industry to which the issuer belongs, and external credit ratings, as well as the probability that we will not collect all of the contractual amounts due and our ability and intent to hold the security until recovery. Although external rating agency actions or changes in a security’s external credit rating is one criterion in our assessment of other-than-temporary impairment, a rating action alone is not necessarily indicative of other-than-temporary impairment.
 
We employ models to assess the expected performance of our Alt-A and subprime private-label securities under hypothetical scenarios. These models incorporate particular attributes of the loans underlying our securities and assumptions about changes in the economic environment, such as home prices and interest rates, to predict borrower behavior and the impact on default frequency, loss severity and remaining credit enhancement. We use these models to estimate the expected cash flows (“recoverable amount”) from our securities as part of our process in assessing whether it is probable that we will not collect all of the contractual amounts due. If the recoverable amount is less than the contractual principal and interest due, we may determine, based on this factor in combination with our assessment of other relevant factors, that the security is other-than-temporarily impaired. If we make that determination, the amount of other-than-temporary impairment is determined by reference to the security’s current fair value, rather than the expected cash flows of the security. We write down any other-than-temporarily impaired AFS security to its current fair value, record the difference between the cost basis and the fair value as an other-than-temporary loss in our consolidated statements of operations and establish a new cost basis for the security based on the current fair value. The fair value measurement we use to determine the amount of other- than-temporary impairment to record may be less than the actual amount we expect to realize by holding the security to maturity.
 
The performance of the loans underlying our Alt-A and subprime private-label securities has been adversely impacted by the significant deterioration of conditions in the mortgage and credit markets during the second quarter of 2008, including the rapid acceleration and deepening of home price declines. These conditions have


46


 

contributed to a sharp rise in expected defaults and loss severities and slower voluntary prepayment rates, particularly for the 2006 and 2007 loan vintages. Following is a comparison, based on data provided by Intex, where available, of the 60-plus days or more delinquency rates as of June 30, 2008 for Alt-A and subprime loans backing securities owned or guaranteed by Fannie Mae.
 
         
   
60+ Day Delinquencies(1)
 
Loan Categories
 
As of June 30, 2008
 
 
Option ARM Alt-A loans:
       
2004 and prior
    15.95 %
2005
    17.35  
2006
    21.44  
2007
    10.79  
Other Alt-A loans:
       
2004 and prior
    3.36  
2005
    8.78  
2006
    15.40  
2007
    17.55  
Subprime loans:
       
2004 and prior
    21.51  
2005
    36.51  
2006
    36.13  
2007
    23.87  
 
 
(1) For purposes of consistency, where appropriate, we have adjusted the delinquency data obtained from Intex to include in the delinquency rates all bankruptcies, foreclosures and real estate owned.
 
Our other-than-temporary impairment assessment as of the end of the second quarter of 2008, including an evaluation of the individual performance of the securities and the potential for continued adverse developments, indicated an increased level of uncertainty as to whether we would collect all principal and interest amounts due in accordance with the contractual terms. As a result, we determined that we did not have sufficient persuasive evidence to conclude that the impairment of certain AFS securities was temporary. For these securities, we recognized other-than-temporary impairment totaling $492 million in the second quarter of 2008, of which $116 million related to Alt-A securities with an unpaid principal balance of $449 million as of June 30, 2008, and $376 million related to subprime securities with an unpaid principal balance of $2.4 billion as of June 30, 2008. As of June 30, 2008, we had recognized cumulative other-than-temporary impairment totaling $714 million on our investments in Alt-A and subprime securities classified as AFS, including the $492 million that was recognized in the second quarter of 2008.
 
The current market pricing of Alt-A and subprime securities, which reflects a significant discount to cost, has been adversely affected by a significant reduction in the liquidity of these securities and market perceptions that defaults on the mortgages underlying these securities will increase significantly. As a result, the current fair value of some of these is substantially less than what we believe is indicated by the performance of the collateral underlying the securities and our calculation of the expected cash flows of the securities. Accordingly, although we have recognized other-than-temporary impairment equal to the difference between the cost basis and the fair value of the security, we anticipate at this time, based on the expected cash flows of the securities, that we will recover some of these impairment amounts. For the AFS Alt-A securities for which we recognized other-than-temporary impairment during the second quarter of 2008, the average credit enhancement was approximately 16% and the expected average collateral loss was approximately 17%, resulting in projected expected credit losses of $51 million. For the AFS subprime securities for which we recognized other-than-temporary impairment during the second quarter of 2008, the average credit enhancement was approximately 24% and the expected average collateral loss was approximately 37%, resulting in projected expected credit losses of $172 million. However, the other-than-temporary impairment we recorded on our Alt-A and subprime securities totaled $116 million and $376 million, respectively. We will accrete into interest income the portion of the amounts we expect to recover that exceeds the cost basis of these securities over the remaining life of the securities. The amount accreted into earnings on our Alt-A and subprime securities for which we have recognized other-than-temporary impairment totaled $26 million and $48 million for the three and six months ended June 30, 2008, respectively.


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We will continue to monitor and analyze the performance of these securities to assess the collectability of principal and interest as of each balance sheet date. If there is further deterioration in the housing and mortgage markets and the decline in home prices exceeds our current expectations, we may recognize significant other-than-temporary impairment amounts in the future. See “Part II—Item 1A—Risk Factors” of this report for a discussion of the risks related to potential future write-downs of our investment securities.
 
Hypothetical Performance Scenarios
 
Tables 25, 26 and 27 present additional information as of June 30, 2008 for our investments in Alt-A and subprime private-label mortgage-related securities, stratified by year of issuance (vintage) and by credit enhancement quartile for securities issued in 2005, 2006 and 2007. The 2006 and 2007 vintages of loans underlying these securities have experienced significantly higher delinquency rates than other vintages. Accordingly, the year of issuance or origination of the collateral underlying these securities is a significant factor in projecting expected cash flow performance and evaluating the ongoing credit performance. The credit enhancement quartiles presented range from the lowest level of credit enhancement to the highest. A higher level of credit enhancement generally reduces the exposure to loss.
 
We have disclosed for information purposes the net present value of projected losses (“NPV”) of our securities under four hypothetical scenarios, which assume specific cumulative constant default and loss severity rates against the loans underlying our Alt-A and subprime private-label securities. The projected loss results under these scenarios, which are considered stressful based on historical mortgage loan performance, are calculated based on the projected cash flows from each security and include the following additional key assumptions: (i) discount rate, (ii) expected constant prepayment rates (“CPR”) and (iii) average life of the securities. These scenarios assume a discount rate based on LIBOR and constant default and loss severity rates experienced over a six-year period. We assume CPRs of 15% for our Alt-A securities and 10% to 15% for our subprime securities, which vary in each scenario based on the loan age. We experienced a decrease in the NPV loss amounts as of June 30, 2008 from the NPV loss amounts previously disclosed as of March 31, 2008, which was attributable to the reduction in the outstanding principal balance of our securities from principal payments and better than expected performance of the loans underlying the securities.


48


 

 
Table 25:  Investments in Alt-A Private-Label Mortgage-Related Securities, Excluding Wraps*
 
                                                                                                 
    As of June 30, 2008  
    Unpaid Principal
                         
    Balance                 Credit Enhancement Statistics     Hypothetical Scenarios(6)  
                                              Monoline
                         
                                              Financial
                         
Vintage and
  Trading
    AFS
    Average
    Fair
    Average
          Minimum
    Guaranteed
    20d/40s
    20d/50s
    30d/40s
    50d/50s
 
CE Quartile(1)
  Securities(2)     Securities(3)     Price     Value     Current(4)     Original(4)     Current(4)     Amount(5)     NPV     NPV     NPV     NPV  
    (Dollars in millions)  
 
Investments in Alt-A securities:(7)
                                                                                               
Option ARM Alt-A securities:
                                                                                               
2004 and prior
  $     $ 704     $ 82.09     $ 578       22 %     9 %     16 %   $     $     $     $     $ 31