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FNMA > SEC Filings for FNMA > Form 10-K on 2-Apr-2013All Recent SEC Filings

Show all filings for FEDERAL NATIONAL MORTGAGE ASSOCIATION FANNIE MAE | Request a Trial to NEW EDGAR Online Pro

Form 10-K for FEDERAL NATIONAL MORTGAGE ASSOCIATION FANNIE MAE


2-Apr-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
You should read this MD&A in conjunction with our consolidated financial statements as of December 31, 2012 and related notes, and with "Business-Executive Summary."
This report contains forward-looking statements that are based upon management's current expectations and are subject to significant uncertainties and changes in circumstances. Please review "Business-Forward-Looking Statements" for more information on the forward-looking statements in this report and "Risk Factors" for a discussion of factors that could cause our actual results to differ, perhaps materially, from our forward-looking statements. Please also see "Glossary of Terms Used in This Report."
CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements in accordance with GAAP requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the consolidated financial statements. Understanding our accounting policies and the extent to which we use management judgment and estimates in applying these policies is integral to understanding our financial statements. We describe our most significant accounting policies in "Note 1, Summary of Significant Accounting Policies."
We evaluate our critical accounting estimates and judgments required by our policies on an ongoing basis and update them as necessary based on changing conditions. Management has discussed any significant changes in judgments and assumptions in applying our critical accounting policies with the Audit Committee of our Board of Directors. See "Risk Factors" for a discussion of the risk associated with the need for management to make judgments and estimates in applying our accounting policies and methods. We have identified four of our accounting policies as critical because they involve significant judgments and assumptions about highly complex and inherently uncertain matters, and the use of reasonably different estimates and assumptions could have a material impact on our reported results of operations or financial condition. These critical accounting policies and estimates are as follows:
Fair Value Measurement
Total Loss Reserves
Other-Than-Temporary Impairment of Investment Securities
Deferred Tax Assets Fair Value Measurement The use of fair value to measure our assets and liabilities is fundamental to our financial statements and our fair value measurement is a critical accounting estimate because we account for and record a portion of our assets and liabilities at fair value. In determining fair value, we use various valuation techniques. We describe the valuation techniques and inputs used to determine the fair value of our assets and liabilities and disclose their carrying value and fair value in "Note 17, Fair Value." The fair value accounting rules provide a three-level fair value hierarchy for classifying financial instruments. This hierarchy is based on whether the inputs to the valuation techniques used to measure fair value are observable or unobservable. Each asset or liability is assigned to a level based on the lowest level of any input that is significant to its fair value measurement. The three levels of the fair value hierarchy are described below:
Level 1: Quoted prices (unadjusted) in active markets for identical assets or liabilities.
Level 2: Observable market-based inputs, other than quoted prices in active markets for identical assets or liabilities. Level 3: Unobservable inputs.
The majority of the financial instruments that we report at fair value in our consolidated financial statements fall within the Level 2 category and are valued primarily utilizing inputs and assumptions that are observable in the marketplace, that can be derived from observable market data or that can be corroborated by recent trading activity of similar instruments with similar characteristics. For example, we generally request non-binding prices from at least three independent pricing services to estimate the fair value of our trading and available-for-sale securities at an individual security level. We use the average of these prices to determine the fair value.
In the absence of such information or if we are not able to corroborate these prices by other available, relevant market information, we estimate their fair values based on single source quotations from brokers or dealers or by using internal calculations or discounted cash flow techniques that incorporate inputs, such as prepayment rates, discount rates and


delinquency, default and cumulative loss expectations, that are implied by market prices for similar securities and collateral structure types. Because this valuation technique relies on significant unobservable inputs, the fair value estimation is classified as Level 3. The process for determining fair value using unobservable inputs 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. Fair Value Hierarchy-Level 3 Assets and Liabilities The assets and liabilities that we have classified as Level 3 consist primarily of financial instruments for which there is limited market activity and therefore little or no price transparency. As a result, the valuation techniques that we use to estimate the fair value of Level 3 instruments involve significant unobservable inputs, which generally are more subjective and involve a high degree of management judgment and assumptions. Our Level 3 assets and liabilities consist of certain mortgage-backed securities and residual interests, certain mortgage loans, acquired property, certain long-term debt arrangements and certain highly structured, complex derivative instruments. Table 8 displays a comparison of the amount of financial assets carried in our consolidated balance sheets at fair value on a recurring basis ("recurring assets") that were classified as Level 3 as of December 31, 2012 and 2011. The availability of observable market inputs to measure fair value varies based on changes in market conditions, such as liquidity. As a result, we expect the amount of financial instruments carried at fair value on a recurring basis and classified as Level 3 to vary each period.

Table 8: Level 3 Recurring Financial Assets at Fair Value
                                                                   As of December 31,
                                                                2012                2011
                                                                  (Dollars in millions)
Trading securities                                          $     2,286         $     4,238
Available-for-sale securities                                    25,034              29,492
Mortgage loans                                                    2,634               2,319
Other assets                                                        175                 238
Level 3 recurring assets                                    $    30,129         $    36,287
Total assets                                                $ 3,222,422         $ 3,211,484
Total recurring assets measured at fair value               $   116,261         $   156,552
Level 3 recurring assets as a percentage of total assets              1 %                 1 %
Level 3 recurring assets as a percentage of total
recurring assets measured
at fair value                                                        26 %                23 %
Total recurring assets measured at fair value as a
percentage of total assets                                            4 %                 5 %

Assets measured at fair value on a nonrecurring basis and classified as Level 3, which are not presented in the table above, primarily include mortgage loans and acquired property. The fair value of Level 3 nonrecurring assets totaled $29.5 billion as of December 31, 2012.
Financial liabilities measured at fair value on a recurring basis and classified as Level 3 consisted of long-term debt with a fair value of $1.5 billion as of December 31, 2012 and $1.2 billion as of December 31, 2011, and other liabilities with a fair value of $161 million as of December 31, 2012 and $173 million as of December 31, 2011.
Valuation Control Processes
We have control processes that are designed to ensure that our fair value measurements are appropriate and reliable, that they are based on observable inputs wherever possible and that our valuation approaches are consistently applied and the assumptions used are reasonable. Our control processes consist of a framework that provides for a segregation of duties and oversight of our fair value methodologies and valuations, as well as validation procedures. We provide a detailed discussion of our Valuation Control Processes in "Note 17, Fair Value."
Total Loss Reserves
Our total loss reserves consist of the following components:
Allowance for loan losses;


Allowance for accrued interest receivable;

Reserve for guaranty losses; and

Allowance for preforeclosure property tax and insurance receivable.

These components can be further allocated into our single-family and multifamily loss reserves.
We maintain an allowance for loan losses and an allowance for accrued interest receivable for loans classified as held for investment, including both loans we hold in our portfolio and loans held in consolidated Fannie Mae MBS trusts. We maintain a reserve for guaranty losses for loans held in unconsolidated Fannie Mae MBS trusts we guarantee and loans we have guaranteed under long-term standby commitments and other credit enhancements we have provided. We also maintain an allowance for preforeclosure property tax and insurance receivable on delinquent loans that is included in "Other assets" in our consolidated balance sheets. These amounts, which we collectively refer to as our total loss reserves, represent probable losses incurred related to loans in our guaranty book of business, including concessions granted to borrowers upon modifications of their loans, as of the balance sheet date.
The allowance for loan losses, allowance for accrued interest receivable and allowance for preforeclosure property tax and insurance receivable are valuation allowances that reflect an estimate of incurred credit losses related to our recorded investment in loans held for investment. The reserve for guaranty losses is a liability account in our consolidated balance sheets that reflects an estimate of incurred credit losses related to our guaranty to each unconsolidated Fannie Mae MBS trust that we will supplement amounts received by the Fannie Mae MBS trust as required to permit timely payments of principal and interest on the related Fannie Mae MBS. As a result, the guaranty reserve considers not only the principal and interest due on the loan at the current balance sheet date, but also an estimate of any additional interest payments due to the trust from the current balance sheet date until the point of loan acquisition or foreclosure. Our loss reserves consist of a specific loss reserve for individually impaired loans and a collective loss reserve for all other loans.
We have an established process, using analytical tools, benchmarks and management judgment, to determine our loss reserves. Our process for determining our loss reserves is complex and involves significant management judgment. Although our loss reserve process benefits from extensive historical loan performance data, this process is subject to risks and uncertainties, including a reliance on historical loss information that may not be representative of current conditions. We continually monitor delinquency and default trends and make changes in our historically developed assumptions and estimates as necessary to better reflect present conditions, including current trends in borrower risk and/or general economic trends, changes in risk management practices, and changes in public policy and the regulatory environment. We also consider the recoveries that we expect to receive on mortgage insurance and other loan-specific credit enhancements entered into contemporaneously with and in contemplation of a guaranty or loan purchase transaction, as such recoveries reduce the severity of the loss associated with defaulted loans. Single-Family Loss Reserves
We establish a specific single-family loss reserve for individually impaired loans, which includes loans we restructure in TDRs, certain nonperforming loans in MBS trusts and acquired credit-impaired loans that have been further impaired subsequent to acquisition. The single-family loss reserve for individually impaired loans represents the majority of our single-family loss reserves due to the high volume of restructured loans. We typically measure impairment based on the difference between our recorded investment in the loan and the present value of the estimated cash flows we expect to receive, which we calculate using the effective interest rate of the original loan or the effective interest rate at acquisition for an acquired credit-impaired loan. However, when foreclosure is probable on an individually impaired loan, we measure impairment based on the difference between our recorded investment in the loan and the fair value of the underlying property, adjusted for the estimated discounted costs to sell the property and estimated insurance or other proceeds we expect to receive. We then allocate a portion of the reserve to interest accrued on the loans as of the balance sheet date.
We establish a collective single-family loss reserve for all other single-family loans in our single-family guaranty book of business using a model that estimates the probability of default of loans to derive an overall loss reserve estimate given multiple factors such as: origination year, mark-to-market LTV ratio, delinquency status and loan product type. We believe that the loss severity estimates we use in determining our loss reserves reflect current available information on actual events and conditions as of each balance sheet date, including current home prices. Our loss severity estimates do not incorporate assumptions about future changes in home prices. We do, however, use a look back period to develop our loss severity estimates for all loan categories. We then allocate a portion of the reserve to interest accrued on the loans as of the balance sheet date.
In the third quarter of 2012, we enhanced our collective single-family loss reserve model and our model that calculates loss reserves for individually impaired loans. The combined impact from these changes resulted in an approximately $3.5 billion


increase to our allowance for loan losses and provision for credit losses. The components of the enhancement to our loan loss models are as follows:
We enhanced our loan loss models for loans in our collective single-family loss reserve to reflect more recent experience of default expectations. The impact of this change had the most pronounced effect on loans with higher mark-to-market LTV ratios, where we have observed better than anticipated payment performance in recent periods. Historically, we had limited information on the performance of loans with higher mark-to-market LTV ratios. However, we have recently observed that loans with higher mark-to-market LTV ratios have performed better than the prior models estimated since the prior models had limited observations. As a result of incorporating these recent observations, our loss expectations have improved for these loans. The change resulted in an approximately $1.5 billion decrease to our allowance for loan losses and provision for credit losses.

We enhanced our single-family loan loss models for individually impaired loans based on current observable trends of payment behavior on our modified loans to reflect slower prepayment and default expectations for these loans, which significantly extended the expected average life of our modified loans. Since a loan modification changes the contractual terms of a loan such that a concession is granted to the borrower, an extension of the average life of a modified loan increases the charge we record related to the concession. Therefore, while our expectations of credit losses decreased due to better performance of our modified loans, this decrease was more than offset by an increase in the present value of the concession granted to the borrower by the modification. The change resulted in an approximately $5.0 billion increase to our allowance for loan losses and provision for credit losses.

Multifamily Loss Reserves
We establish a collective multifamily loss reserve for all loans in our multifamily guaranty book of business that are not individually impaired using an internal model that applies loss factors to loans in similar risk categories. Our loss factors are developed based on our historical default and loss severity experience. Management may also apply judgment to adjust the loss factors derived from our models, taking into consideration model imprecision and specific, known events, such as current credit conditions, that may affect the credit quality of our multifamily loan portfolio but are not yet reflected in our model-generated loss factors. We then allocate a portion of the reserve to interest accrued on the loans as of the balance sheet date.
We establish a specific multifamily loss reserve for multifamily loans that we determine are individually impaired. We identify multifamily loans for evaluation for impairment through a credit risk assessment process. As part of this assessment process, we stratify multifamily loans into different internal risk categories based on the credit risk inherent in each individual loan and management judgment. We categorize loan credit risk, taking into consideration available operating statements and expected cash flows from the underlying property, the estimated value of the property, the historical loan payment experience and current relevant market conditions that may impact credit quality. If we conclude that a multifamily loan is impaired, we measure the impairment based on the difference between our recorded investment in the loan and the fair value of the underlying property less the estimated discounted costs to sell the property and any lender loss sharing or other proceeds we expect to receive. When a multifamily loan is deemed individually impaired because we have modified it, we measure the impairment based on the difference between our recorded investment in the loan and the present value of expected cash flows discounted at the loan's original interest rate unless foreclosure is probable, at which time we measure impairment the same way we measure it for other individually impaired multifamily loans. We generally obtain property appraisals from independent third-parties to determine the fair value of multifamily loans that we consider to be individually impaired. We also obtain property appraisals and broker price opinions when we foreclose on a multifamily property. We then allocate a portion of the reserve to interest accrued on the loans as of the balance sheet date.
Other-Than-Temporary Impairment of Investment Securities We evaluate available-for-sale securities in an unrealized loss position as of the end of each quarter for other-than-temporary impairment. We recognize other-than-temporary impairment in earnings if one of the following conditions exists: (1) our intent is to sell the security; (2) it is more likely than not that we will be required to sell the security before the impairment is recovered; or (3) we do not expect to recover our amortized cost basis. If, by contrast, we do not intend to sell the security and will not be required to sell prior to recovery of the amortized cost basis, we recognize only the credit component of other-than-temporary impairment in earnings. We record the noncredit component in other comprehensive income. The credit component is the difference between the security's amortized cost basis and the present value of its expected future cash flows, while the noncredit component is the remaining difference between the security's fair value and the present value of expected future cash flows. If, subsequent to recognizing other-than-temporary impairment, our estimates of future cash flows improve, we recognize the change in estimate prospectively over the remaining life of securities as a component of interest income.


Our evaluation requires significant management judgment and consideration of various factors to determine if we will receive the amortized cost basis of our investment securities. We evaluate a debt security for other-than-temporary impairment using an econometric model that estimates the present value of cash flows given multiple factors. These factors include: the severity and duration of the impairment; recent events specific to the issuer and/or industry to which the issuer belongs; the payment structure of the security; external credit ratings and the failure of the issuer to make scheduled interest or principal payments. We rely on expected future cash flow projections to determine if we will recover the amortized cost basis of our available-for-sale securities. In the second quarter of 2012, we updated our assumptions used to project cash flow estimates on our Alt-A and subprime private-label securities to incorporate recent observable market trends, which included extending the time it takes to liquidate loans underlying these securities and increasing severity rates for loans where the servicer stopped advancing payments. These updates resulted in lower net present value of cash flow projections on our Alt-A and subprime private-label securities and increased our other-than-temporary impairment expense by approximately $500 million.
We provide more detailed information on our accounting for other-than-temporary impairment in "Note 1, Summary of Significant Accounting Policies" and "Note 5, Investments in Securities." See "Risk Factors" for a discussion of the risks associated with possible future write-downs of our investment securities. Deferred Tax Assets
We recognize deferred tax assets and liabilities for future tax consequences arising from differences between the carrying amounts of existing assets and liabilities under GAAP and their respective tax bases, and for net operating loss carryforwards and tax credit carryforwards. We evaluate the recoverability of our deferred tax assets, weighing all positive and negative evidence, and are required to establish or maintain a valuation allowance for these assets if we determine that it is more likely than not that some or all of the deferred tax assets will not be realized. The weight given to the evidence is commensurate with the extent to which the evidence can be objectively verified. If negative evidence exists, positive evidence is necessary to support a conclusion that a valuation allowance is not needed.
Our framework for assessing the recoverability of deferred tax assets requires us to weigh all available evidence, including:
the sustainability of recent profitability required to realize the deferred tax assets;

the cumulative net losses in our consolidated statements of operations in recent years;

unsettled circumstances that, if unfavorably resolved, would adversely affect future operations and profit levels on a continuing basis in future years; and

the carryforward periods for net operating losses and tax credits.

As of December 31, 2012, we have concluded that it is more likely than not that our deferred tax asset will not be realized in its entirety and that therefore we should retain the valuation allowance against our net deferred tax assets. The valuation allowance as of December 31, 2012 was $58.9 billion. Giving more weight to evidence that could be objectively verified than to evidence that could not be objectively verified, we determined that the factors in favor of releasing the allowance were outweighed by the evidence against releasing the valuation allowance. The factors that weighed against releasing the allowance as of December 31, 2012 and ultimately outweighed the factors in favor of releasing the reserve discussed below were the following:
on a cumulative basis, we reported losses in our consolidated statements of operations for the three years ended December 31, 2012;

the impact of a reduction in funds available to us under the senior preferred stock purchase agreement that would have resulted from releasing the valuation allowance in the fourth quarter of 2012, which we discuss below;

stability in the housing market is relatively recent and home prices, while improving, are still well below their peak, which results in uncertainty regarding our projections of future credit losses;

the uncertainty surrounding the future of our company given we are in conservatorship; and

we have a limited recent history of profitability and a large number of delinquent loans in our book of business.

Under the terms of the senior preferred stock purchase agreement, the amount of funding available to us after December 31, 2012 is adjusted based on our positive net worth as of December 31, 2012 and is not affected by any positive net worth we may have on future dates. Accordingly, the amount of funding available under the senior preferred stock purchase agreement will be reduced only to the extent that we draw funds from Treasury under the agreement in the future. A decision to release the valuation allowance in 2013 will not reduce the funding available to us under the senior preferred stock purchase agreement.


Releasing the valuation allowance in the fourth quarter of 2012 would have decreased our available funding under the senior preferred stock purchase agreement to approximately $84 billion, compared to approximately $118 billion of available funding that resulted from not releasing the valuation allowance in the fourth quarter.
There was significant uncertainty regarding the effects that an approximately $34 billion reduction in the funds available to us under the senior preferred stock purchase agreement would have had on our business and financial results, including regulatory actions that would limit our business operations to ensure safety and soundness of the company, particularly in view of the fact that stability in the housing market and improvements in our financial results are relatively recent. This uncertainty was a significant consideration in our determination not to release the valuation allowance as of December 31, 2012. In addition, it is difficult to conclude a valuation allowance is not required when there is significant objective and verifiable negative evidence, such as cumulative losses in recent years. We utilize a rolling three years of pre-tax income or loss as the primary measure of cumulative losses in recent years. Over the three years ended December 31, 2012, we remain in a cumulative loss position. However, we expect that as of the end of the first quarter 2013, we will report income for the fifth consecutive quarter and we will show cumulative profits for the past twelve quarters.
The following factors weighed in favor of releasing the allowance as of December 31, 2012:
our 2012 profitability and our expectations regarding the sustainability of profits;

the strong credit profile of the loans we have acquired since 2009;

the significant size of our guaranty book of business and our contractual rights for future revenue from this book of business;

our taxable income for 2012 and our expectations regarding the likelihood of future taxable income; and

. . .

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