UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-Q

 

 

 

 

Commission File No.: 0-50231

 

 

Federal National Mortgage Association

(Exact name of registrant as specified in its charter)

 

 

Fannie Mae

 

 

 

 

Registrant’s telephone number, including area code:

(202) 752-7000

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

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 September 30, 2010, there were 1,119,413,062 shares of common stock of the registrant outstanding.

 

 

TABLE OF CONTENTS

 

 

MD&A TABLE REFERENCE

 

 

 

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

 

You should read this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) in conjunction with our unaudited condensed consolidated financial statements and related notes, and the more detailed information contained in our 2009 Form 10-K.

 

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

 

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

 

 

INTRODUCTION

 

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

 

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

 

Our Mission, Objectives and Strategy

 

Our public mission is to support liquidity and stability in the secondary mortgage market and increase the supply of affordable housing. We are concentrating our efforts on two objectives: supporting liquidity, stability and affordability in the mortgage market and minimizing our credit losses from delinquent loans. Please see “Business—Executive Summary—Our Business Objectives and Strategy” in our 2009 Form 10-K for more information on these and our other business objectives, which have been approved by FHFA. Below we discuss our contributions to the liquidity of the mortgage market, the performance of the single-family loans we have acquired since January 2009, our single-family credit losses, and our strategies and actions to reduce credit losses on our single-family loans.

 

Providing Mortgage Market Liquidity

 

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

 

During the first nine months of 2010, we purchased or guaranteed approximately $613 billion in loans, measured by unpaid principal balance, which includes approximately $195 billion in delinquent loans we purchased from our single-family MBS trusts. Our purchases and guarantees financed approximately 1,749,000 single-family conventional loans, excluding delinquent loans purchased from our MBS trusts, and approximately 199,000 units in multifamily properties.

 

We remained the largest single issuer of mortgage-related securities in the secondary market during the third quarter of 2010, with an estimated market share of new single-family mortgage-related securities of 44.5%, compared with 39.1% in the second quarter of 2010. If the Federal Housing Administration (“FHA”) continues to be the lower-cost option for some consumers, and in some cases the only option, for loans with higher loan-to-value (“LTV”) ratios, our market share could be adversely impacted if the market shifts away from refinance activity, which is likely to occur when interest rates rise. In the multifamily market, we remain a constant source of liquidity and have been successful with our goal of expanding our multifamily MBS business and broadening our multifamily investor base.

Our Expectations Regarding Profitability, the Single-Family Loans We Acquired Beginning in 2009, and Credit Losses

 

In this section we discuss our expectations regarding profitability, the performance and credit profile of the single-family loans we have purchased or guaranteed since the beginning of 2009, shortly after entering into conservatorship in late 2008, and our expected single-family credit losses. We refer to loans we have purchased or guaranteed as loans that we have “acquired.”

 

 

Factors that Could Cause Actual Results to be Materially Different from Our Estimates and Expectations

 

In this discussion, we present a number of estimates and expectations regarding the profitability of the loans we have acquired, our single-family credit losses, and our draws from and dividends to be paid to Treasury. These estimates and expectations are forward-looking statements based on our current assumptions regarding numerous factors, including future home prices and the future performance of our loans. Our future estimates of these amounts, as well as the actual amounts, may differ materially from our current estimates and expectations as a result of home price changes, changes in interest rates, unemployment, direct and indirect consequences resulting from failures by servicers to follow proper procedures in the administration of foreclosure cases, government policy, changes in generally accepted accounting principles (“GAAP”), credit availability, social behaviors, other macro-economic variables, the volume of loans we modify, the effectiveness of our loss mitigation strategies, management of our real estate owned (“REO”) inventory and pursuit of contractual remedies, changes in the fair value of our assets and liabilities, impairments of our assets, or many other factors, including those discussed in “Risk Factors,” “Forward-Looking Statements,” and elsewhere in this report and in “Risk Factors” and “Forward-Looking Statements” in our 2009 Form 10-K. For example, if the economy were to enter a deep recession during this time period, we would expect actual outcomes to differ substantially from our current expectations.

 

Expected Profitability of Our Single-Family Acquisitions

 

While it is too early to know how loans we have acquired since January 1, 2009 will ultimately perform, given their strong credit risk profile, low levels of payment delinquencies shortly after their acquisition, and low serious delinquency rate, we expect that, over their lifecycle, these loans will be profitable. Table 1 provides information about whether we expect loans we acquired in 1991 through September 30, 2010 to be profitable. The expectations reflected in Table 1 are based on the credit risk profile of the loans we have acquired, which we discuss in more detail in “Table 3: Credit Profile of Single-Family Conventional Loans Acquired” and in “Table 38: Risk Characteristics of Single-Family Conventional Business Volume and Guaranty Book of Business.” These expectations are also based on numerous other assumptions, including our expectations regarding home price declines set forth below in “Outlook.” As shown in Table 1, we expect loans we have acquired in 2009 and 2010 to be profitable. If future macroeconomic conditions turn out to be significantly more adverse than our expectations, these loans could become unprofitable. For example, we believe that these loans would become unprofitable if home prices declined more than 20% from their September 2010 levels over the next five years based on our home price index, which would be an approximately 34% decline from their peak in the third quarter of 2006.

 

 

As Table 1 shows, the key years in which we acquired loans that we expect will be unprofitable are 2005 through 2008, and the vast majority of our realized credit losses in 2009 and 2010 to date are attributable to these loans. Loans we acquired in 2004 were originated under more conservative acquisition policies than loans we acquired from 2005 through 2008; however, we expect them to perform close to break-even because those loans were made as home prices were rapidly increasing and therefore suffered from the subsequent decline in home prices.

 

Loans we have acquired since the beginning of 2009 comprised over 35% of our single-family guaranty book of business as of September 30, 2010. Our 2005 to 2008 acquisitions are becoming a smaller percentage of our guaranty book of business, having decreased from 63% of our guaranty book of business as of December 31, 2008 to 42% as of September 30, 2010.

 

Performance of Our Single-Family Acquisitions

 

In our experience, an early predictor of the ultimate performance of loans is the rate at which the loans become seriously delinquent within a short period of time after acquisition. Loans we acquired in 2009 have experienced historically low levels of delinquencies shortly after their acquisition. Table 2 shows, for loans we acquired in each year since 2001, the percentage that were seriously delinquent (three or more months past due or in the foreclosure process) as of the end of the third quarter following the acquisition year. As Table 2 shows, the percentage of our 2009 acquisitions that were seriously delinquent as of the end of the third quarter following their acquisition year was more than nine times lower than the average comparable serious delinquency rate for loans acquired in 2005 through 2008. Table 2 also shows serious delinquency rates for each year’s acquisitions as of September 30, 2010. Except for the most recent acquisition years, whose serious

delinquency rates are likely lower than they will be after the loans have aged, Table 2 shows that the September 30, 2010 serious delinquency rate generally tracks the trend of the serious delinquency rate as of the end of the third quarter following the year of acquisition. Below the table we provide information about the economic environment in which the loans were acquired, specifically home price appreciation and unemployment levels.

 

 

 

Credit Profile of Our Single-Family Acquisitions

 

Single-family loans we purchased or guaranteed from 2005 through 2008 were acquired during a period when home prices were rising rapidly, peaked, and then started to decline sharply, and underwriting and eligibility standards were more relaxed than they are now. These loans were characterized, on average and as discussed below, by higher LTV ratios and lower FICO credit scores than loans we have acquired since January 1, 2009. In addition, many of these loans were Alt-A loans or had other higher-risk loan attributes such as interest-only payment features. As a result of the sharp declines in home prices, 25% of the loans that we acquired from 2005 through 2008 had mark-to-market LTV ratios that were greater than 100% as of September 30, 2010, which means the principal balance of the borrower’s primary mortgage exceeded the current market value of the borrower’s home. This percentage is higher when second lien loans secured by the same properties that secure our loans are considered. The sharp decline in home prices and the severe economic recession that began in December 2007 significantly and adversely impacted the performance of loans we acquired from 2005 through 2008. We are taking a number of actions to reduce our credit losses, and we describe these actions and our strategy below in “Our Strategies and Actions to Reduce Credit Losses on Loans in our Single-Family Guaranty Book of Business.”

 

In 2009, we began to see the effect of actions we took, beginning in 2008, to significantly tighten our underwriting and eligibility standards and change our pricing to promote and provide prudent sustainable homeownership options and stability in the housing market. As a result of these changes and other market conditions, we reduced our acquisitions of loans with higher-risk loan attributes. The loans we have purchased or guaranteed since January 1, 2009 have had a better credit risk profile overall than loans we acquired in 2005 through 2008, and their early performance has been strong. Our experience has been that loans with stronger credit risk profiles perform better than loans without stronger credit risk profiles. For example, one measure of a loan’s credit risk profile that we believe is a strong predictor of performance is LTV ratio, which indicates the amount of equity a borrower has in the underlying property. As Table 3 demonstrates, the loans we have acquired since January 1, 2009 have a strong credit risk profile, with lower original LTV ratios, higher FICO credit scores, and a product mix with a greater percentage of fully amortizing fixed-rate mortgage loans than loans we acquired from 2005 through 2008.

 

 

 

 

Improvements in the credit risk profile of our 2009 and 2010 acquisitions over prior years reflect changes that we made to our pricing and eligibility standards, as well as changes mortgage insurers made to their eligibility standards. In addition, FHA’s role as the lower-cost option for some consumers for loans with higher LTV ratios has also reduced our acquisitions of these types of loans. In October 2010, changes to FHA’s pricing structure became effective, which may reduce its cost advantage to some consumers. The credit risk profile of

our 2009 and 2010 acquisitions has been influenced further by a significant percentage of refinanced loans, which generally perform well as they demonstrate a borrower’s desire to maintain homeownership. In the first nine months of 2010 our acquisitions of refinanced loans included a significant number of loans under the Home Affordable Refinance Program (“HARP”), which involves refinancing existing, performing Fannie Mae loans with current LTV ratios between 80% and 125% and possibly lower FICO credit scores into loans that reduce the borrowers’ monthly payments or are otherwise more sustainable, such as fixed-rate loans. Due to the volume of HARP loans, the LTV ratios at origination for our 2010 acquisitions to date are higher than for our 2009 acquisitions. However, the overall credit profile of our 2010 acquisitions is expected to remain significantly stronger than the credit profile of our 2005 through 2008 acquisitions. Whether the loans we acquire in the future exhibit an overall credit profile similar to our acquisitions since January 1, 2009 will also depend on a number of factors, including our future eligibility standards and those of mortgage insurers, the percentage of loan originations representing refinancings, our future objectives, and market and competitive conditions.

 

The changes we made to our pricing and eligibility standards and underwriting beginning in 2008 were intended to more accurately reflect the risk in the housing market and to significantly reduce our acquisitions of loans with higher-risk attributes. These changes included the following:

 

 

If we had applied our current pricing and eligibility standards and underwriting to loans we acquired in 2005 through 2008, our losses on loans acquired in those years would have been lower, although we would still have experienced losses due to the rise and subsequent sharp decline in home prices and increased unemployment.

 

Expectations Regarding Credit Losses

 

The single-family credit losses we have realized from the beginning of 2009 through September 30, 2010, combined with the amounts we have reserved for single-family credit losses as of September 30, 2010, total approximately $110 billion. The vast majority of these losses are attributable to single-family loans we purchased or guaranteed from 2005 through 2008.

 

While loans we acquired in 2005 through 2008 will give rise to additional credit losses that we have not yet realized, we estimate that we have reserved for the substantial majority of the remaining losses. While we believe our results of operations have already reflected a substantial majority of the credit losses we have yet to realize on these loans, we expect that defaults on these loans and the resulting charge-offs will occur over a

period of years. In addition, we anticipate that it will take years to dispose of the REO we expect to acquire upon their default, given the large current and anticipated supply of single-family homes in the market.

 

We show how we calculate our realized credit losses in “Table 14: Credit Loss Performance Metrics.” Our reserves for credit losses consist of our allowance for loan losses, our allowance for accrued interest receivable, our allowance for preforeclosure property taxes and insurance receivables, our reserve for guaranty losses, and the portion of fair value losses on loans purchased out of MBS trusts reflected in our condensed consolidated balance sheets that we estimate represents accelerated credit losses we expect to realize.

 

As a result of the substantial reserving for and realizing of our credit losses to date, we have drawn a significant amount of funds from Treasury through September 30, 2010. As our draws from Treasury for credit losses abate, we expect our draws instead to be driven increasingly by dividend payments to Treasury.

 

Our Strategies and Actions to Reduce Credit Losses on Loans in our Single-Family Guaranty Book of Business

 

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

 

 

As “Table 4: Credit Statistics, Single-Family Guaranty Book of Business” illustrates, our single-family serious delinquency rate decreased to 4.56% as of September 30, 2010 from 4.99% as of June 30, 2010. This decrease is primarily the result of the approximately 218,000 workouts and foreclosed property acquisitions completed during the quarter and reflects our work with servicers to reduce delays in determining and executing the appropriate approach for a given loan. As of September 30, 2010, we experienced the first year-over-year decline in our serious delinquency rate since 2007. We expect serious delinquency rates may be affected in the future by home price changes, changes in other macroeconomic conditions, and the extent to which borrowers with modified loans again become delinquent in their payments.

 

Reducing Defaults.  We are working to reduce defaults through improved servicing, refinancing initiatives and solutions that help borrowers retain their homes, such as modifications. We refer to actions taken by our servicers with borrowers to resolve the problem of existing or potential delinquent loan payments as “workouts,” which include the home retention solutions and the foreclosure alternatives discussed below.

 

 

 

 

 

It is too early to determine the ultimate success of the loan modifications we completed during the third quarter of 2010. Of the loans we modified during 2009, approximately 53% were current or had paid off as of nine months following the loan modification date, compared with approximately 31% for loans we modified during 2008. Please see “Risk Management—Credit Risk Management—Single-Family Mortgage Credit Risk Management—Management of Problem Loans and Loan Workout Metrics” for a discussion of the significant uncertainty regarding the ultimate long-term success of our modification efforts.

 

During the third quarter of 2010, we introduced our Second Lien Modification Program, which is designed to work in tandem with HAMP by lowering payments on second lien mortgage loans for borrowers whose second lien mortgage loan is owned by us and whose first lien mortgage loan has been modified under HAMP, even where we do not own the first lien mortgage loan. This program will be implemented in the coming months.

 

 

Pursuing Foreclosure Alternatives.  If we are unable to provide a viable home retention solution for a problem loan, we seek to offer foreclosure alternatives and complete them in a timely manner. These foreclosure alternatives are primarily preforeclosure sales, which are sometimes referred to as “short sales,” as well as deeds-in-lieu of foreclosure. These alternatives are intended to reduce the severity of our loss resulting from a borrower’s default while permitting the borrower to avoid going through a foreclosure. In the third quarter of 2010, we completed approximately 20,900 preforeclosure sales and deeds-in-lieu of foreclosures, compared with approximately 21,500 in the second quarter of 2010. The decrease was primarily due to weak market conditions affecting pre-foreclosure sales during the quarter. We have increasingly relied on foreclosure alternatives as a growing number of borrowers have faced longer-term economic hardships that cannot be solved through a home retention solution, and we expect the volume of our foreclosure alternatives through 2010 to remain higher than 2009 volumes.

 

Managing Timelines.  A key theme underlying our strategies for reducing our credit losses is minimizing delays. We believe that repayment plans, short-term forbearances and loan modifications can be most effective in preventing defaults when completed at an early stage of delinquency. Similarly, we believe that our foreclosure alternatives are more likely to be successful in reducing our loss severity if they are executed expeditiously. Accordingly, it is important to work with delinquent borrowers early in the delinquency to determine whether a home retention or foreclosure alternative will be viable and, where no alternative is viable, to reduce delays in proceeding to foreclosure. We are working to manage our foreclosure timelines more efficiently. As of September 30, 2010, 46% of the seriously delinquent loans in our single-family conventional guaranty book of business were in the process of foreclosure, compared with 38% as of June 30, 2010. During the third quarter of 2010, we announced adjustments to the time frames within which we expect foreclosures to be completed in four states. To hold servicers accountable for meeting their servicing obligations, we also reiterated at that time that we may exercise our right to assess fees on servicers to compensate us for delays. As we discuss below in “Servicer Foreclosure Process Deficiencies and Foreclosure Pause,” we cannot yet predict the extent to which the pause in foreclosures implemented by a number of our servicers in response to the discovery of deficiencies in their foreclosure processes will delay our foreclosures or increase our credit losses. In connection with the foreclosure pause, we recently reminded servicers again that we may exercise our right to assess fees on them to compensate us for damages resulting from their failure to take diligent action, consistent with applicable laws, in compliance with our servicing requirements. For additional discussion of the foreclosure pause and its potential consequences, please see “Risk Factors.”

 

Managing Our REO Inventory.  Since January 2009, we have strengthened our REO sales capabilities by significantly increasing the number of resources in this area, and we are working to manage our REO inventory to reduce costs and maximize sales proceeds. During the third quarter of 2010, we acquired approximately 85,000 foreclosed single-family properties, up from approximately 69,000 during the second quarter of 2010, and we disposed of approximately 48,000 single-family properties. The carrying value of the single-family REO we held as of September 30, 2010 was $16.4 billion, and we expect our REO inventory at the end of the year to remain higher than 2009 levels. Given the large number of seriously delinquent loans in our single-family guaranty book of business and the large current and anticipated supply of single-family homes in the market, we expect it will take a number of years before our REO inventory approaches pre-2008 levels.

 

Pursuing Contractual Remedies.  We conduct reviews of delinquent loans and, when we discover loans that do not meet our underwriting and eligibility requirements, we make demands for lenders to repurchase these loans or compensate us for losses sustained on the loans. We also make demands for lenders to repurchase or compensate us for loans for which the mortgage insurer rescinds coverage. In 2009 and during the first nine months of 2010, the number of repurchase and reimbursement requests remained high. During the third quarter of 2010, lenders repurchased from us or reimbursed us for losses on approximately $1.6 billion in

loans, measured by unpaid principal balance, pursuant to their contractual obligations. In addition, as of September 30, 2010, we had outstanding requests for lenders to repurchase from us or reimburse us for losses on $7.7 billion in loans, of which 36% had been outstanding for more than 120 days. We are also pursuing contractual remedies from providers of credit enhancement on our loans, including mortgage insurers. We received proceeds under our mortgage insurance policies for single-family loans of $1.6 billion for the third quarter of 2010. Please see “Risk Management—Credit Risk Management—Institutional Counterparty Credit Risk Management” for a discussion of our repurchase and reimbursement requests and outstanding receivables from mortgage insurers, as well as the risk that one or more of these counterparties fails to fulfill its obligations to us.

 

The actions we have taken to stabilize the housing market and minimize our credit losses have had and may continue to have, at least in the short term, a material adverse effect on our results of operations and financial condition, including our net worth. See “Consolidated Results of Operations—Financial Impact of the Making Home Affordable Program on Fannie Mae” for information on HAMP’s financial impact on us during the third quarter of 2010 and the $2.0 billion we incurred in loan impairments in connection with HAMP during the quarter. These actions have been undertaken with the goal of reducing our future credit losses below what they otherwise would have been. It is difficult to predict how effective these actions ultimately will be in reducing our credit losses and, in the future, it may be difficult to measure the impact our actions ultimately have on our credit losses.

 

Credit Performance

 

Table 4 presents information for the first three quarters of 2010 and for each quarter of 2009 about the credit performance of mortgage loans in our single-family guaranty book of business and our loan workouts. The workout information in Table 4 does not reflect repayment plans and forbearances that have been initiated but not completed, nor does it reflect trial modifications under HAMP that have not become permanent.

 

 

 

 

We provide additional information on our credit-related expenses in “Consolidated Results of Operations—Credit-Related Expenses” and on the credit performance of mortgage loans in our single-family book of business and our loan workouts in “Risk Management—Credit Risk Management—Single-Family Mortgage Credit Risk Management.”

 

Servicer Foreclosure Process Deficiencies and Foreclosure Pause

 

Recently, a number of our single-family mortgage servicers temporarily halted foreclosures in some or all states after discovering deficiencies in their processes relating to the execution of affidavits in connection with the foreclosure process. Deficiencies include improperly notarized affidavits and affidavits signed without appropriate knowledge and review of the documents. These foreclosure process deficiencies have generated significant public concern, are currently being investigated by various government agencies and by the attorneys general of all fifty states, and have resulted in courts in at least two states issuing rules applying to the foreclosure process that we anticipate will increase costs and may result in delays.

 

We have directed our servicers to review their policies and procedures relating to the execution of affidavits, verifications and other legal documents in connection with the foreclosure process. We are also addressing concerns that have been raised regarding the practices of some law firms that handle the foreclosure process for our mortgage servicers in Florida. In the case of one firm under investigation by the Florida attorney general’s office, we instructed the firm to stop processing foreclosures and other legal matters for our mortgage loans except as necessary to avoid prejudice to our legal interests, and have stopped servicers from referring new Fannie Mae matters to the firm. We are in the process of expanding the list of law firms that our servicers may use to process foreclosures in Florida.

 

The Acting Director of FHFA issued statements on October 1 and October 13, 2010 regarding servicers’ foreclosure processing issues. We are currently coordinating with FHFA regarding appropriate corrective actions consistent with the four-point policy framework issued by FHFA on October 13, 2010. Under this framework, servicers are required to (1) review their processes and verify that all documents are in compliance with legal requirements; (2) remediate problems identified through this review in an appropriate, timely and sustainable manner; (3) report suspected fraudulent activity; and (4) without delay, proceed to foreclose on mortgage loans that have no problems relating to process, on which the borrower has stopped payment, and for which foreclosure alternatives have been unsuccessful. During the first nine months of 2010, 80% of the single-family properties we acquired through foreclosures involved mortgages on which the borrowers had made three or fewer payments in the preceding 12 months.

Although we expect the foreclosure pause will likely negatively affect our serious delinquency rates, credit-related expenses and foreclosure timelines, we cannot yet predict the extent of its impact. The foreclosure pause also could negatively affect housing market conditions and delay the recovery of the housing market. At this time, we cannot predict how long the pause on foreclosures will last, how many of our loans will be affected by it or its ultimate impact on our business or the housing market. See “Risk Factors” for further information about the potential impact of the servicer foreclosure process deficiencies and the foreclosure pause on our business, results of operations, financial condition and liquidity position.

 

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

 

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

 

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

 

Although the new accounting standards did not change the economic risk to our business, we recorded a decrease of $3.3 billion in our total deficit as of January 1, 2010 to reflect the cumulative effect of adopting these new standards. We provide a detailed discussion of the impact of the new accounting standards on our accounting and financial statements in “Note 2, Adoption of the New Accounting Standards on the Transfers of Financial Assets and Consolidation of Variable Interest Entities.” Upon adopting the new accounting standards, we changed the presentation of segment financial information that is currently evaluated by management, as we discuss in “Business Segment Results—Changes to Segment Reporting.”

 

Summary of Our Financial Performance for the Third Quarter and First Nine Months of 2010

 

Our financial results for the third quarter and the first nine months of 2010 reflect the continued weakness in the housing and mortgage markets, which remain under pressure from high levels of unemployment and underemployment.

 

Quarterly Results

 

Net loss.  We recognized a net loss of $1.3 billion for the third quarter of 2010, driven primarily by credit-related expenses of $5.6 billion, which were partially offset by net interest income of $4.8 billion. Including dividends on senior preferred stock, the net loss attributable to common stockholders we recognized for the third quarter of 2010 was $3.5 billion and our diluted loss per share was $0.61. In comparison, we recognized a net loss of $1.2 billion, a net loss attributable to common stockholders of $3.1 billion and a diluted loss per share of $0.55 for the second quarter of 2010. We recognized a net loss of $18.9 billion, a net loss attributable to common stockholders of $19.8 billion and a diluted loss per share of $3.47 for the third quarter of 2009.

 

The $121 million increase in our net loss in the third quarter of 2010 compared with the second quarter of 2010 was primarily due to a $710 million increase in credit-related expenses, driven in part by valuation adjustments that reduced the value of our REO inventory, and higher expenses due to increased acquisitions of foreclosed properties; and a $189 million increase in net other-than-temporary impairments, driven by a decline in forecasted home prices for certain geographic regions that resulted in a decrease in projected cash flows on subprime and Alt-A securities.

 

The increase in credit-related expenses and net other-than-temporary impairments from the second quarter of 2010 was partially offset by a $569 million increase in net interest income and a $222 million increase in net

fair value gains. Net interest income increased driven by lower debt funding costs and the purchase from MBS trusts of the substantial majority of the single-family loans that are four or more monthly payments delinquent, as the cost of purchasing these delinquent loans and holding them in our portfolio is less than the cost of advancing delinquent payments to security holders. The increase in net fair value gains was mainly driven by gains on our trading securities, as interest rates declined and credit spreads narrowed.

 

Our net loss decreased $17.5 billion in the third quarter of 2010 compared with the third quarter of 2009. The primary drivers of this decrease were a $16.4 billion decrease in credit-related expenses, due to the factors described below; $525 million in net fair value gains compared with $1.5 billion in net fair value losses in the prior period; a $946 million increase in net interest income; and a $613 million decrease in net other-than-temporary impairments. These reductions in losses were offset in part by a $1.9 billion decrease in guaranty fee income due to our adoption of the new accounting standards effective January 1, 2010. Upon adoption of these new accounting standards, we eliminated substantially all of our guaranty-related assets and liabilities in our condensed consolidated balance sheet, and therefore we no longer recognize income or loss for consolidated trusts from amortizing these assets and liabilities or from changes in their fair value.

 

Our credit-related expenses, which consist of the provision for loan losses and the provision for guaranty losses (collectively referred to as the “provision for credit losses”) plus foreclosed property expense, were $5.6 billion for the third quarter of 2010 compared with $22.0 billion for the third quarter of 2009. The reduction in credit-related expenses was due primarily to the moderate decline in our total loss reserves during the third quarter of 2010 compared with the substantial increase in our total loss reserves during the third quarter of 2009. The substantial increase in our total loss reserves during the third quarter of 2009 reflected the significant growth in the number of loans that were seriously delinquent during that period and higher losses on defaulted loans driven by the sharp decline in home prices, which were partly the result of the deterioration in economic conditions during 2009. In the third quarter of 2010, our provision for credit losses was substantially lower due to the lack of growth in the number of loans that were seriously delinquent and the absence of a significant decline in home prices, which resulted in a decrease of our reserves during the third quarter of 2010. Additionally, due to our adoption of the new accounting standards, during 2010 we recognized an insignificant amount of fair value losses on credit impaired loans. By contrast, in the third quarter of 2009, we recognized a significant amount of fair value losses on acquired credit-impaired loans.

 

Year-to-Date Results

 

Net loss.  We recognized a net loss of $14.1 billion for the first nine months of 2010, driven primarily by credit-related expenses of $22.3 billion, administrative expenses of $2.0 billion and net fair value losses of $877 million, which were offset in part by net interest income of $11.8 billion. Our net loss for the first nine months of 2010 included an out-of-period adjustment of $1.1 billion related to an additional provision for losses on preforeclosure property taxes and insurance receivables. Including dividends on senior preferred stock, the net loss attributable to common stockholders we recognized for the first nine months of 2010 was $19.6 billion and our diluted loss per share was $3.45. In comparison, we recognized a net loss of $56.8 billion, a net loss attributable to common stockholders of $58.1 billion and a diluted loss per share of $10.24 for the first nine months of 2009.

 

The $42.7 billion decrease in our net loss for the first nine months of 2010 compared with the first nine months of 2009 was due primarily to a $39.3 billion decrease in credit-related expenses due to the factors described below, a $6.6 billion decrease in net other-than-temporary impairments as a result of the adoption of a new other-than-temporary impairment accounting standard in the second quarter of 2009, as we only recognize the credit portion of an other-than-temporary impairment in our condensed consolidated statements of operations, a $1.4 billion decrease in losses from partnership investments, and a $1.3 billion decrease in net fair value losses driven by our risk management derivatives. These reductions in losses were partially offset by lower guaranty fee income of $5.2 billion resulting from our adoption of the new accounting standards effective January 1, 2010.

Our credit-related expenses were $22.3 billion for the first nine months of 2010 compared with $61.6 billion for the first nine months of 2009. The reduction in credit-related expenses was driven by the moderate increase in our total loss reserves during the first nine months of 2010, compared with the substantial increase in our total loss reserves during the first nine months of 2009. The substantial increase in our total loss reserves during the first nine months of 2009 reflected the significant growth in the number of loans that were seriously delinquent during that period, and higher losses on defaulted loans driven by the sharp decline in home prices, which were partly the result of the economic deterioration during 2009. Our provision for credit losses was substantially lower in the first nine months of 2010, because there has not been an increase in the number of seriously delinquent loans and the decline in home prices was not substantial, therefore we did not need to substantially increase our total loss reserves in the first nine months of 2010. Additionally, due to our adoption of the new accounting standards, during 2010 we recognized an insignificant amount of fair value losses on credit impaired loans. By contrast, in the first nine months of 2009, we recognized a significant amount of fair value losses on acquired credit-impaired loans.

 

Net worth.  We had a net worth deficit of $2.4 billion as of September 30, 2010, compared with a net worth deficit of $1.4 billion as of June 30, 2010 and $15.3 billion as of December 31, 2009. Our net worth as of September 30, 2010 was negatively impacted by the recognition of our net loss of $1.3 billion and senior preferred stock dividends of $2.1 billion paid during the third quarter. These reductions in our net worth were offset by our receipt of $1.5 billion in funds from Treasury on September 30, 2010 under our senior preferred stock purchase agreement with Treasury as well as by a reduction in unrealized losses in our holdings of available-for-sale securities of $705 million for the third quarter. Our net worth, which is the basis for determining the amount that Treasury has committed to provide us under the senior preferred stock purchase agreement, equals the “Total deficit” reported in our condensed consolidated balance sheet. In November 2010, the Acting Director of FHFA submitted a request to Treasury on our behalf for $2.5 billion to eliminate our net worth deficit as of September 30, 2010. When Treasury provides the requested funds, the aggregate liquidation preference on the senior preferred stock will be $88.6 billion, which will require an annualized dividend payment of $8.9 billion. This amount exceeds our reported annual net income for each of the last eight fiscal years, in most cases by a significant margin. Through September 30, 2010, we have paid an aggregate of $8.1 billion to Treasury in dividends on the senior preferred stock.

 

Total loss reserves.  Our total loss reserves, which reflect our estimate of the probable losses we have incurred in our guaranty book of business, declined as of September 30, 2010 as compared with June 30, 2010. Our total loss reserves were $64.7 billion as of September 30, 2010 and $66.7 billion as of June 30, 2010, compared with $61.4 billion as of January 1, 2010 and $64.9 billion as of December 31, 2009. Our total loss reserve coverage to total nonperforming loans was 30.34% as of September 30, 2010, compared with 30.56% as of June 30, 2010 and 29.98% as of December 31, 2009.

 

Housing and Mortgage Market and Economic Conditions

 

During the third quarter of 2010, the United States economic recovery continued at a very slow pace. The U.S. gross domestic product, or GDP, rose by 2.0% on an annualized basis during the quarter, according to the Bureau of Economic Analysis advance estimate. Housing activity experienced a pullback after the expiration of the home buyer tax credit, with housing starts and home sales declining sharply in the third quarter. The overall economy lost jobs in the third quarter due to the layoff of census workers; however, the private sector continued its recent trend of moderate employment growth throughout the quarter. Unemployment was 9.6% in September 2010, compared with 9.5% in June 2010, based on data from the U.S. Bureau of Labor Statistics.

 

The Mortgage Bankers Association National Delinquency Survey reported that, as of June 30, 2010, the most recent date for which information is available, 9.11% of borrowers were seriously delinquent (90 days or more past due or in the foreclosure process), which we estimate represents nearly five million mortgages. In September, the supply of single-family homes as measured by the inventory/sales ratio remained above long-term average levels. Properties that are vacant and held off the market, combined with the portion of seriously

delinquent mortgages not currently listed for sale, represent a significant shadow inventory putting downward pressure on both home prices and rents.

 

We estimate that home prices on a national basis declined by 1.0% in the third quarter of 2010 and have declined by 18.1% from their peak in the third quarter of 2006. Our home price estimates are based on preliminary data and are subject to change as additional data become available. The decline in home prices has left many homeowners with “negative equity” in their mortgages, which means their principal mortgage balance exceeds the current market value of their home. This creates a risk that borrowers might walk away from their mortgage obligations and for the loans to become delinquent and proceed to foreclosure.

 

The multifamily sector improved during the third quarter of 2010 despite high unemployment. Multifamily fundamentals continued to strengthen, likely driven by slight increases in private sector payrolls and the uncertainty surrounding single-family housing prices. Many tenants appear to be staying in apartments rather than purchasing a home due to uncertainty surrounding home values. Preliminary third-party data suggests that the rate of apartment vacancies continued to fall for the third quarter in a row in the third quarter of 2010. Rents also appear to have risen in the third quarter of 2010, with overall rent growth up for the first nine months of 2010. As a result, rent concessions to secure tenancy fell again for the third quarter in a row.

 

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

 

Outlook

 

Overall Market Conditions.  We expect weakness in the housing and mortgage markets to continue throughout 2010 and into 2011. The high level of delinquent mortgage loans will result in the foreclosure of troubled loans, which is likely to add to the excess housing inventory. Home sales will likely be slow until the unemployment rate improves. In addition, the servicer foreclosure process deficiencies described above create uncertainty for potential home buyers. Foreclosed homes account for a substantial part of the existing home market. Thus, a widespread foreclosure pause could suppress home sales in the near term and interfere with the housing recovery.

 

We expect that default and severity rates and the level of foreclosures will remain high for the remainder of 2010. In addition, we expect that home prices in 2010 will decline slightly on a national basis, more so in some geographic areas than in others. Despite the initial signs of multifamily sector improvement, we expect multifamily charge-offs to remain at elevated levels throughout 2010 and 2011. All of these conditions, as well as the level of single-family delinquencies, may worsen if the unemployment rate increases on either a national or regional basis. We expect the decline in residential mortgage debt outstanding to continue through 2010, which would mark three consecutive annual declines. Approximately 73% of our single-family business in the third quarter of 2010 consisted of refinancings. We expect these trends, combined with an expected decline in total originations in 2010, will result in lower business volume in 2010 as compared with 2009.

 

Home Price Declines.  We expect that home prices on a national basis will decline slightly in 2010 and into 2011 before stabilizing, and that the peak-to-trough home price decline on a national basis will range between 19% and 25%. These estimates are based on our home price index, which is calculated differently from the S&P/Case-Shiller U.S. National Home Price Index and therefore results in different percentages for comparable declines. These estimates also contain significant inherent uncertainty in the current market environment regarding a variety of critical assumptions we make when formulating these estimates, including: the effect of actions the federal government has taken and may take with respect to the national economic recovery; the impact of the end of the Federal Reserve’s MBS purchase program; and the impact of those actions on home prices, unemployment and the general economic and interest rate environment. Because of these uncertainties, the actual home price decline we experience may differ significantly from these estimates. We also expect significant regional variation in home price declines and stabilization.

Our 19% to 25% peak-to-trough home price decline estimate corresponds to an approximate 32% to 40% peak-to-trough decline using the S&P/Case-Shiller index method. Our estimates differ from the S&P/Case-Shiller index in two principal ways: (1) our estimates weight expectations by number of properties, whereas the S&P/Case-Shiller index weights expectations based on property value, causing home price declines on higher priced homes to have a greater effect on the overall result; and (2) contrary to the S&P/Case-Shiller index, our estimates do not include known sales of foreclosed homes because we believe that differing maintenance practices and the forced nature of the sales make foreclosed home prices less representative of market values. The S&P/Case-Shiller comparison numbers are calculated using our models and assumptions, but modified to use these two factors (weighting of expectations based on property value and the inclusion of foreclosed property sales). In addition to these differences, our estimates are based on our own internally available data combined with publicly available data, and are therefore based on data collected nationwide, whereas the S&P/Case-Shiller index is based only on publicly available data, which may be limited in certain geographic areas of the country. Our comparative calculations to the S&P/Case-Shiller index provided above are not modified to account for this data pool difference.

 

Credit-Related Expenses and Credit Losses.  We expect that our credit-related expenses will remain high for the remainder of 2010. However, we expect that, if current trends continue, our credit-related expenses will be lower in 2010 than in 2009. We describe our credit loss outlook above under “Our Expectations Regarding Profitability, the Single-Family Loans We Acquired Beginning in 2009, and Credit Losses.”

 

Uncertainty Regarding our Long-Term Financial Sustainability and Future Status.  There is significant uncertainty in the current market environment, and any changes in the trends in macroeconomic factors that we currently anticipate, such as home prices and unemployment, may cause our future credit-related expenses and credit losses to vary significantly from our current expectations. Although Treasury’s funds under the senior preferred stock purchase agreement permit us to remain solvent and avoid receivership, the resulting dividend payments are substantial. Given our expectations regarding future losses, which we describe above under “Our Expectations Regarding Profitability, the Single-Family Loans We Acquired Beginning in 2009, and Credit Losses,” we do not expect to earn profits in excess of our annual dividend obligation to Treasury for the indefinite future. As a result of these factors, there is significant uncertainty as to our long-term financial sustainability.

 

In addition, there is significant debate regarding the future of Fannie Mae and Freddie Mac, and proposals to reform them. We cannot predict the prospects for the enactment, timing or content of legislative proposals regarding longer-term reform of the GSEs. Please see “Legislation” for a discussion of recent legislative reform of the financial services industry, and proposals for GSE reform, that could affect our business.

 

Financial Regulatory Reform Legislation

 

On July 21, 2010, President Obama signed into law financial regulatory reform legislation known as the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The Dodd-Frank Act will significantly change the regulation of the financial services industry, including by its creation of new standards related to regulatory oversight of systemically important financial companies, derivatives transactions, asset-backed securitization, mortgage underwriting and consumer financial protection. The Dodd-Frank Act will directly affect our business since new and additional regulatory oversight and standards will apply to us. We may also be affected by provisions of the Dodd-Frank Act and implementing regulations that impact the activities of our customers and counterparties in the financial services industry. Extensive regulatory guidance is needed to implement and clarify many of the provisions of the Dodd-Frank Act and agencies have just begun to initiate the required administrative processes. It is therefore difficult to assess fully the impact of this legislation on our business and industry at this time. Refer to “Legislation—Financial Regulatory Reform Legislation” in our Second Quarter 2010 Form 10-Q for a further description of the Dodd-Frank Act and its potential impact on our business and industry. Also see “Risk Factors” for a discussion of the potential risks to our business resulting from the Dodd-Frank Act.

GSE Reform

 

The Dodd-Frank Act does not contain substantive GSE reform provisions, but does state that it is the sense of Congress that efforts to regulate the terms and practices related to residential mortgage credit would be incomplete without enactment of meaningful structural reforms of Fannie Mae and Freddie Mac. The Dodd-Frank Act also requires the Treasury Secretary to submit a report to Congress by January 31, 2011, with recommendations for ending the conservatorships of Fannie Mae and Freddie Mac. In August, September and October 2010, the Obama Administration hosted conferences on housing finance reform, at which proposals regarding the future of Fannie Mae and Freddie Mac were discussed. Since June 2009, Congressional committees and subcommittees have held hearings to discuss the present condition and future status of Fannie Mae and Freddie Mac. We expect hearings on GSE reform to continue and additional proposals to be discussed. We cannot predict the prospects for the enactment, timing or content of legislative proposals regarding the future status of the GSEs. See “Risk Factors” for a discussion of the risks to our business relating to the uncertain future of our company.

 

2010-2011 Housing Goals

 

On September 14, 2010, FHFA published a final rule establishing 2010 and 2011 housing goals for Fannie Mae. The final rule implements a new goal structure established by the Federal Housing Finance Regulatory Reform Act of 2008 (the “2008 Reform Act”) and sets new housing goals.

 

FHFA’s final rule and a subsequent notice received in October 2010 established the following single-family home purchase and refinance housing goal benchmarks for 2010 and 2011. A home purchase mortgage may be counted toward more than one home purchase benchmark.

 

 

If we do not meet these benchmarks, we may still meet our goals. The final rule specifies that our single-family housing goals performance will be measured against these benchmarks and against goals-qualifying originations in the primary mortgage market. We will be in compliance with the housing goals if we meet either the benchmarks or market share measures.

 

The final rule also established a new multifamily goal and subgoal. Our multifamily mortgage purchases must finance at least 177,750 units affordable to families with incomes no higher than 80% of area median income, of which at least 42,750 units must be affordable to families with incomes no higher than 50% of area median income. There is no market-based alternative measurement for the multifamily goals.

FHFA’s final rule made significant changes to prior housing goals regulations regarding the types of products that count towards the housing goals. Private-label mortgage-related securities, second liens and single-family government loans do not count towards the housing goals. In addition, only permanent modifications of mortgages under HAMP completed during the year will count towards the housing goals; trial modifications will not be counted. Moreover, these modifications will count only towards the single-family low-income families refinance goal, not any of the home purchase goals.

 

The final rule notes that “FHFA does not intend for [Fannie Mae] to undertake uneconomic or high-risk activities in support of the [housing] goals. However, the fact that [Fannie Mae is] in conservatorship should not be a justification for withdrawing support from these market segments.” If our efforts to meet our goals prove to be insufficient, FHFA will determine whether the goals were feasible. If FHFA finds that our goals were feasible, we may become subject to a housing plan that could require us to take additional steps that could have an adverse effect on our results of operations and financial condition. The housing plan must describe the actions we will take to meet the goal in the next calendar year and be approved by FHFA. The potential penalties for failure to comply with housing plan requirements include a cease-and-desist order and civil money penalties. See “Risk Factors” for a description of how we may be unable to meet our housing goals and how actions we may take to meet these goals and other regulatory requirements could adversely affect our business, results of operations and financial condition.

 

Delisting of our Common and Preferred Stock

 

We were directed by FHFA to delist our common stock and each listed series of our preferred stock from the New York Stock Exchange and the Chicago Stock Exchange. The last trading day for our listed securities on these exchanges was July 7, 2010, and since July 8, 2010, these securities have been quoted in the over-the-counter market. See “Risk Factors” for a description of the risks to our business relating to the delisting of our common and preferred stock.

 

For additional information on regulatory matters affecting us, refer to “Business—Our Charter and Regulation of Our Activities” in our 2009 Form 10-K and “MD&A—Regulatory Action” in our quarterly report on Form 10-Q for the quarter ended June 30, 2010 (“Second Quarter 2010 Form 10-Q”).

 

The preparation of financial statements in accordance with GAAP requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the condensed consolidated financial statements. Understanding our accounting policies and the extent to which we use management judgment and estimates in applying these policies is integral to understanding our financial statements. We describe our most significant accounting policies in “Note 1, Summary of Significant Accounting Policies” of this report and in our 2009 Form 10-K.

 

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

estimates and assumptions could have a material impact on our reported results and operations or financial condition. These critical accounting policies and estimates are as follows:

 

 

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

 

We provide below information about our Level 3 assets and liabilities as of September 30, 2010 compared to December 31, 2009 and describe any significant changes in the judgments and assumptions we made during the first nine months of 2010 in applying our critical accounting policies and significant changes to critical estimates as well as the impact of the new accounting standards on our allowance for loan losses and reserve for guaranty losses.

 

Fair Value Measurement

 

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

 

Fair Value Hierarchy—Level 3 Assets and Liabilities

 

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

 

Table 5 presents a comparison, by balance sheet category, of the amount of financial assets carried in our condensed consolidated balance sheets at fair value on a recurring basis and classified as Level 3 as of September 30, 2010 and December 31, 2009. The availability of observable market inputs to measure fair value varies based on changes in market conditions, such as liquidity. As a result, we expect the amount of financial instruments carried at fair value on a recurring basis and classified as Level 3 to vary each period.

 

 

The decrease in assets classified as Level 3 during the first nine months of 2010 includes a $2.6 billion decrease due to derecognition of guaranty assets and buy-ups at the transition date as well as net transfers of approximately $3.9 billion in assets to Level 2 from Level 3. The assets transferred from Level 3 consist primarily of Fannie Mae guaranteed mortgage-related securities and private-label mortgage-related securities.

 

Assets measured at fair value on a nonrecurring basis and classified as Level 3, which are not presented in the table above, primarily include held-for-sale loans, held-for-investment loans, acquired property and partnership investments. The fair value of Level 3 nonrecurring assets totaled $46.0 billion during the first nine months of 2010, and $21.2 billion during the year ended December 31, 2009.

 

Financial liabilities measured at fair value on a recurring basis and classified as Level 3 consisted of long-term debt with a fair value of $536 million as of September 30, 2010 and $601 million as of December 31, 2009, and derivatives liabilities with a fair value of $159 million as of September 30, 2010 and $27 million as of December 31, 2009.

 

Allowance for Loan Losses and Reserve for Guaranty Losses

 

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

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

 

Single-Family Loss Reserves

 

We establish a specific single-family loss reserve for individually impaired loans, which includes loans we restructure in troubled debt restructurings, certain nonperforming loans in MBS trusts and acquired credit-impaired loans that have been further impaired subsequent to acquisition. The single-family loss reserve for individually impaired loans has grown as a proportion of the total single-family reserve in recent periods due to increases in the population 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 a 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 establish a collective single-family loss reserve for all other single-family loans in our single-family guaranty book of business using an econometric model that estimates the probability of default of loans to derive an overall loss reserve estimate given multiple factors such as: origination year, mark-to-market LTV ratio, delinquency status and loan product type. We believe that the loss severity estimates 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 one-quarter look back period to develop our loss severity estimates for all loan categories.

 

In the second quarter of 2010, we updated our allowance for loan loss model to reflect a change in our cohort structure for our severity calculations to use mark-to-market LTV ratios rather than LTV ratios at origination, which we believe better reflects the current values of the loans. This model change resulted in a change in estimate and a decrease to our allowance for loan losses of approximately $1.6 billion.

 

Combined Loss Reserves

 

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

consider only our net recorded investment in the loan at the balance sheet date, which includes only interest income accrued while the loan was on accrual status.

 

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

 

In addition to recognizing mortgage loans held by newly consolidated trusts at the transition date, we also recognized the associated accrued interest receivable from the mortgage loans held by the newly consolidated trusts. The accrued interest included delinquent interest on such loans which was previously considered in estimating our “Reserve for guaranty losses.” As a result, at transition, we reclassified $7.0 billion from our “Reserve for guaranty losses” to “Allowance for accrued interest receivable” in our condensed consolidated balance sheet. We collectively refer to our combined loss reserves, “Allowance for accrued interest receivable” and “Allowance for preforeclosure property tax and insurance” as our total loss reserves. For further information on our total loss reserves, see “Consolidated Results of Operations—Credit-Related Expenses—Provision for Credit Losses.”

 

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

 

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

 

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

Table 6 summarizes our condensed consolidated results of operations for the periods indicated.

 

 

 

 

Net Interest Income

 

Table 7 presents an analysis of our net interest income, average balances, and related yields earned on assets and incurred on liabilities for the periods indicated. For most components of the average balances, we used a daily weighted average of amortized cost. When daily average balance information was not available, such as for mortgage loans, we used monthly averages. Table 8 presents the change in our net interest income between periods and the extent to which that variance is attributable to: (1) changes in the volume of our interest-earning assets and interest-bearing liabilities; or (2) changes in the interest rates of these assets and liabilities.

 

 

 

 

 

 

 

 

Net interest income increased in the third quarter and first nine months of 2010 compared with the third quarter and first nine months of 2009 primarily as a result of an increase in interest income due to the recognition of contractual guaranty fees in interest income upon adoption of the new accounting standards and a reduction in the interest expense on debt that we have issued as lower borrowing rates allowed us to replace higher-cost debt with lower-cost debt. Partially offsetting these positive effects, for the first nine months of 2010, was lower interest income from the interest earning assets that we own due to lower yields on our mortgage and non-mortgage assets. In addition, for the third quarter and first nine months of 2010, there was a reduction in interest income due to a significant increase in the number of nonperforming loans in our condensed consolidated balance sheets, since we do not recognize interest income on nonperforming loans that have been placed on nonaccrual status.

 

For the third quarter of 2010, interest income that we did not recognize for nonaccrual mortgage loans, net of recoveries, was $1.8 billion, which reduced our net interest yield by 23 basis points, compared with $335 million for the third quarter of 2009, which reduced our net interest yield by 15 basis points. Of the $1.8 billion of interest income that we did not recognize for nonaccrual mortgage loans in the third quarter of 2010, $1.5 billion was related to the unsecuritized mortgage loans that we own. For the first nine months of 2010, the interest income that we did not recognize for nonaccrual mortgage loans, net of recoveries, was $6.7 billion, with a 28 basis point reduction in net interest yield, compared with $804 million for the first nine months of 2009, with a 12 basis point reduction in net interest yield. Of the $6.7 billion of interest income that we did not recognize for nonaccrual mortgage loans in the first nine months of 2010, $3.3 billion was related to the unsecuritized mortgage loans that we own.

 

Net interest yield significantly decreased in the third quarter and first nine months of 2010 compared with the third quarter and first nine months of 2009. We recognize the contractual guaranty fee and the amortization of deferred cash fees received after December 31, 2009 on the underlying mortgage loans of consolidated trusts as interest income, which represents the spread between the net interest yield on the underlying mortgage assets and the rate on the debt of the consolidated trusts. Upon adoption of the new accounting standards, our

interest-earning assets and interest-bearing liabilities both increased by approximately $2.4 trillion. The lower spread on these interest-earning assets and liabilities had the impact of reducing our net interest yield for the third quarter and first nine months of 2010 as compared with the third quarter and first nine months of 2009.

 

Net interest income in the second and third quarters of 2010, compared with the first quarter of 2010, benefited from the purchase from single-family MBS trusts of the substantial majority of the loans that are four or more consecutive monthly payments delinquent as the cost of purchasing these delinquent loans and holding them in our portfolio is less than the cost of advancing delinquent payments to security holders.

 

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

 

Guaranty Fee Income

 

Guaranty fee income decreased in the third quarter and first nine months of 2010 compared with the third quarter and first nine months of 2009 because we consolidated the substantial majority of our MBS trusts and we recognize interest income and expense, instead of guaranty fee income, from consolidated trusts. At adoption of the new accounting standards, our guaranty-related assets and liabilities pertaining to previously unconsolidated trusts were eliminated; therefore, we no longer recognize amortization of previously recorded deferred cash and non-cash fees or fair value adjustments related to our guaranty to these trusts. Guaranty fee income for the third quarter and first nine months of 2010 reflects guaranty fees earned from unconsolidated trusts and other credit enhancement arrangements, such as our long-term standby commitments.

 

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

 

Investment Gains, Net

 

Investment gains declined in the third quarter and first nine months of 2010 compared with the third quarter and first nine months of 2009 due to a decline in gains from securitizations and gains from sales of available-for-sale securities as a result of adopting the new accounting standards. Under these standards, our portfolio securitization transactions that reflect transfers of assets to consolidated trusts no longer qualify for sale treatment, which reduced our portfolio securitization gains and losses; and we no longer record gains and losses on the sale from our portfolio of the substantial majority of available-for-sale Fannie Mae MBS because these securities were eliminated in consolidation. In the third quarter and first nine months of 2009, we recognized securitization gains due to MBS issuances and sales related to whole loan conduit activity and recognized gains on available-for-sale securities due to tightening of investment spreads on agency MBS, which led to higher sale prices. The decline in investment gains for the third quarter and first nine months of 2010 was partially offset by a decrease in lower of cost or fair value adjustments on held-for-sale loans due to the reclassification of most of our held-for-sale loans to held for investment upon adoption of the new accounting standards. In the third quarter and first nine months of 2009, we recorded lower of cost or fair value adjustments on loans primarily driven by a decline in the credit quality of these loans.

 

Net Other-Than-Temporary Impairment

 

For the third quarter of 2010, net other-than-temporary impairment decreased compared with the third quarter of 2009, primarily as a result of lower impairment on Alt-A and subprime securities. The net other-than-temporary impairment charge recorded in the third quarter of 2010 was primarily driven by a net decline in forecasted home prices for certain geographic regions which resulted in a decrease in the present value of our cash flow projections on Alt-A and subprime securities. See “Note 6, Investments in Securities” for additional information regarding the net other-than-temporary impairment recognized in the third quarter of 2010.

Net other-than-temporary impairment for the first nine months of 2010 significantly decreased compared with the first nine months of 2009, driven primarily by the adoption of a new accounting standard effective April 1, 2009. As a result of this accounting standard, beginning with the second quarter of 2009, we recognize only the credit portion of other-than-temporary impairment in our condensed consolidated statements of operations. Approximately 77% of the impairment recorded in the first nine months of 2009 was recorded in the first quarter of 2009 prior to the change in accounting standards. The net other-than-temporary impairment charge recorded in the first nine months of 2010 was primarily driven by a net decline in forecasted home prices for certain geographic regions which resulted in a decrease in the present value of our cash flow projections on Alt-A and subprime securities. The net other-than-temporary impairment charge recorded in the first nine months of 2009 before our adoption of this accounting standard included both the credit and non-credit components of the loss in fair value and was driven primarily by additional impairment losses on some of our Alt-A and subprime securities that we had previously impaired, as well as impairment losses on other Alt-A and subprime securities, due to continued deterioration in the credit quality of the loans underlying these securities and further declines in the expected cash flows.

 

Fair Value Gains (Losses), Net

 

Table 9 presents the components of fair value gains and losses.

 

 

 

Risk Management Derivatives Fair Value Gains (Losses), Net

 

We supplement our issuance of debt securities with derivative instruments to further reduce duration and prepayment risks. We recorded derivative gains in the third quarter of 2010 primarily due to gains on our foreign currency swaps. We use foreign currency swaps to manage the foreign exchange impact of foreign currency denominated debt issuances. The gains recognized on our foreign currency swaps mostly offset the

fair value losses on our foreign currency denominated debt. Derivative gains for the third quarter of 2010 were partially offset by time decay on our purchased options.

 

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

 

The derivative losses for the third quarter of 2009 were driven by a decrease in swap rates, which resulted in net losses on our net pay-fixed swap position, and by time decay associated with our purchased options.

 

For the first nine months of 2009, increases in swap rates resulted in gains on our net pay-fixed swap position; however, these gains were more than offset by losses on our option-based derivatives, as swap rate increases drove losses on our receive-fixed swaptions, and by time decay associated with our purchased options.

 

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

 

Mortgage Commitment Derivatives Fair Value Losses, Net

 

Commitments to purchase or sell some mortgage-related securities and to purchase single-family mortgage loans generally are derivatives, and changes in their fair value are recognized in our condensed consolidated statements of operations. We recognized losses on our mortgage securities commitments in the third quarter and first nine months of 2010 primarily due to losses on our commitments to sell because mortgage-related securities prices increased during the commitment period.

 

We recognized losses on our mortgage securities commitments in the third quarter and first nine months of 2009 primarily due to a large volume of commitments to sell, which were mainly associated with dollar roll transactions, and an increase in mortgage-related securities prices during the commitment period.

 

Trading Securities Gains, Net

 

Gains on trading securities in the third quarter and first nine months of 2010 were primarily driven by a decrease in interest rates and narrowing of credit spreads, primarily on commercial mortgage backed securities (“CMBS”).

 

The gains on our trading securities during the third quarter of 2009 were primarily attributable to the narrowing of credit spreads on CMBS, as well as to a decline in interest rates. The gains on our trading securities during the first nine months of 2009 were primarily attributable to the narrowing of credit spreads on CMBS, asset-backed securities, corporate debt securities and agency MBS, partially offset by an increase in interest rates in the first nine months of 2009.

 

Income (Losses) from Partnership Investments

 

In the fourth quarter of 2009, we reduced the carrying value of our low-income housing tax credit (“LIHTC”) investments to zero. As a result, we no longer recognize net operating losses or other-than-temporary impairment on our LIHTC investments, which resulted in a shift to income from partnership investments in the third quarter of 2010 from losses on these investments in the third quarter of 2009 and a decrease in losses from partnership investments in the first nine months of 2010 compared with the first nine months of 2009.

Administrative Expenses

 

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

 

Credit-Related Expenses

 

Credit-related expenses consist of the provision for loan losses, provision for guaranty losses and foreclosed property expense. We detail the components of our credit-related expenses in Table 10.

 

 

 

 

Provision for Credit Losses

 

Table 11 displays the components of our total loss reserves and our total fair value losses previously recognized on loans purchased out of MBS trusts reflected in our condensed consolidated balance sheets. We consider these fair value losses previously recognized as an “effective reserve” for credit losses because the mortgage loan balances were reduced by these fair value losses at acquisition. We exclude these fair value losses from our credit loss calculation as described in “Consolidated Results of Operations—Credit-Related Expenses—Credit Loss Performance Metrics.” We estimate that approximately half of this amount represents credit losses we expect to realize in the future and approximately half will eventually be recovered through our condensed consolidated statements of operations, primarily as net interest income if the loan cures or foreclosed property income if the sale of the collateral exceeds the recorded investment of the credit-impaired loan. See “MD&A—Critical Accounting Policies and Estimates—Fair Value of Loans Purchased with Evidence of Credit Deterioration” in our 2009 Form 10-K for additional information on how acquired credit-impaired loan fair value losses, credit-related expenses and credit losses related to loans underlying our guaranty contracts are recorded in our consolidated financial statements.