Commission File No.: 0-50231

 

 

 

 

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 June 30, 2010, there were 1,117,616,288 shares of common stock of the registrant outstanding.

 

 

TABLE OF CONTENTS

 

 

 

 

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 of our objectives: supporting liquidity, stability and affordability in the mortgage market and minimizing our credit losses from delinquent loans. 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 future single-family credit losses, and our strategies and actions to reduce credit losses on our single-family loans. Please see “Business—Executive Summary—Our Business Objectives and Strategy” in our 2009 Form 10-K for more information on our business objectives, which have been approved by FHFA.

 

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”), Housing and Community Development (“HCD”) and Capital Markets. Our Single-Family and HCD 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 half of 2010, we purchased or guaranteed approximately $423 billion in loans, measured by unpaid principal balance, which includes approximately $170 billion in delinquent loans we purchased from our single-family MBS trusts. Our purchases and guarantees financed approximately 1,026,000 conventional single-family loans, excluding delinquent loans purchased from our MBS trusts, and approximately 115,000 multifamily units. From January 2009 through the first half of 2010, we purchased or guaranteed an estimated $1.2 trillion in loans, measured by unpaid principal balance, which includes approximately $205 billion in delinquent loans we purchased from our single-family MBS trusts, financing approximately 4,151,000 conventional single-family loans and approximately 487,000 multifamily units.

 

We remained the largest single issuer of mortgage-related securities in the secondary market during the second quarter of 2010, with an estimated market share of new single-family mortgage-related securities of 39.1%, compared with 40.7% in the first 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.

The Performance of Single-Family Loans Acquired Beginning in 2009 and Our Expectations Regarding Future Credit Losses

 

In this section we discuss our expectations regarding the performance 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 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 our loans, our future 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 assumptions about 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 as a result of home price changes, changes in interest rates, unemployment, government policy matters, 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. Changes in our underlying assumptions and actual outcomes, which could be affected by the economic environment, government policy, and many other factors, including those discussed in “Risk Factors” and elsewhere in this report, could result in actual results being materially different from our expectations and estimates.

 

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 years 1991 through 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 Conventional Single-Family Loans Acquired” and in “Table 37: Risk Characteristics of Conventional Single-Family 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 home prices were to decline significantly, these loans could become unprofitable. We believe that these loans would become unprofitable if home prices declined more than 20% from their June 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. 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 30% of our single-family guaranty book of business as of June 30, 2010, and we expect that these loans will generally remain in our guaranty book of business for a relatively extended period of time due to their historically low interest rates. The loans we acquired in the first half of 2010, like those we acquired in 2009, have a weighted average interest rate at origination of 4.9%. 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 45% as of June 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 was seriously delinquent (three or more months past due or in the foreclosure process) as of the end of the second quarter following the acquisition year. As Table 2 shows, the percentage of our 2009 acquisitions that was seriously delinquent as of the end of the second quarter following their acquisition year was more than eight 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 June 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 June 30, 2010 serious delinquency rate generally tracks the trend of the serious delinquency rate as of the end of the second 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, as well as by other higher-risk loan attributes such as low or no documentation and interest-only payment features. As a result of the sharp declines in home prices, 24% of the loans that we acquired from 2005 through 2008 had mark-to-market LTV ratios that were greater than 100% as of June 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. This 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 other loans. For example, we believe a strong predictor of loan 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 this type of loan. 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 half 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. If the volume of HARP loans continues at the current pace, the LTV ratios at origination for our 2010 acquisitions will be 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 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 those loans would be 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

 

Since the beginning of 2009, we have reserved for or realized approximately $100 billion of credit losses on single-family loans, almost all of which are attributable to single-family loans that 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 these losses. Our reserves for credit losses consist of our allowance for loan losses, our allowance for accrued interest receivable, our allowance for 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. We show how we calculate our realized credit losses in “Table 13: Credit Loss Performance Metrics.”

 

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 June 30, 2010. As our draws from Treasury for credit losses abate, we expect our draws instead to be driven increasingly by dividend payments. We believe that the losses we ultimately will realize on certain loans may be less than what we will have provided for in our reserves due to accounting requirements. If this occurs, we will adjust our reserves over time as losses are realized, including recapturing reserves.

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:

 

 

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 second quarter of 2010. Approximately 58% of loans we modified during 2009 were current or had paid off as of six months following the loan modification date, compared to approximately 37% of loans we modified during 2008. Please see “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.

 

As Table 4 illustrates, our single-family serious delinquency rate decreased during the second quarter of 2010, but remains high. This decrease in our serious delinquency rate is partly the result of the home retention workouts we completed during the quarter, as well as the foreclosure alternative workouts we discuss below.

 

During the second quarter, we announced enhancements to improve the effectiveness of our home retention solutions. These changes become effective in the coming months and include:

 

 

 

 

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 reduce the severity of our loss resulting from a borrower’s default while permitting the borrower to avoid going through a foreclosure. In the second quarter of 2010, we completed approximately 21,500 preforeclosure sales and deeds-in-lieu of foreclosures, compared with approximately 17,300 in the first quarter of 2010. 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 to remain high throughout 2010.

 

Managing Foreclosure Timelines Efficiently.   We are working to manage our foreclosure timelines efficiently to reduce our foreclosed property expenses. As of June 30, 2010, 38% of the loans in our conventional single-family guaranty book of business that were seriously delinquent were in the process of foreclosure.

 

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 second quarter of 2010, we acquired approximately 69,000 foreclosed single-family properties, up from approximately 62,000 during the first quarter of 2010, and we disposed of approximately 50,000 single-family properties. The carrying value of the single-family REO we held as of June 30, 2010 was $13.0 billion, and we expect our REO inventory to continue to increase significantly throughout 2010.

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 half of 2010, the number of repurchase and reimbursement requests remained high. During the second quarter of 2010, lenders repurchased approximately $1.5 billion in loans from us, measured by unpaid principal balance, pursuant to their contractual obligations. 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 $1.2 billion for the second quarter of 2010. Please see “Risk Management—Institutional Counterparty Credit Risk Management” for a discussion of our high balance of outstanding 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.

 

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 and obtaining recoveries. Minimizing delays prior to foreclosure and focusing on maximizing sales proceeds and recoveries from lenders and credit enhancers also accelerate our receipt of recoveries.

 

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 second quarter of 2010 and the $2.2 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 and second 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.

 

 

 

 

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.”

 

Impact on our Condensed Consolidated Financial Statements

 

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.”

 

Purchases from our Single-Family MBS Trusts

 

With our adoption of the new accounting standards, we no longer recognize the acquisition of a credit-impaired loan from the majority of our MBS trusts as a purchase with an associated fair value loss for the difference between the fair value of the acquired loan and its acquisition cost, as they are now consolidated and the loan is already reflected in our condensed consolidated balance sheets at the time of acquisition. Without these fair value losses, the cost of purchasing most delinquent loans from Fannie Mae MBS trusts and holding them in our portfolio is less than the cost of advancing delinquent payments to holders of the Fannie Mae MBS. As a result, in the first quarter of 2010 we began to significantly increase our purchases of delinquent loans from single-family MBS trusts to reduce our costs associated with these loans. Under our single-family MBS trust documents, we have the option to purchase from our MBS trusts loans that are delinquent as to four or more consecutive monthly payments. Through June 30, 2010, we had purchased the substantial majority of our delinquent loan population, which resulted in an increase in our Capital Market’s mortgage portfolio. We purchased approximately 858,000 delinquent loans with an unpaid principal balance of approximately $170 billion from single-family MBS trusts in the first half of 2010, including the purchase of approximately 570,000 delinquent loans with an unpaid principal balance of approximately $114 billion in the second quarter of 2010.

We expect to continue to purchase loans from our single-family MBS trusts as they become four or more consecutive monthly payments delinquent subject to market conditions, servicer capacity, and other constraints including the limit on the mortgage assets that we may own pursuant to the senior preferred stock purchase agreement. As of June 30, 2010, the total unpaid principal balance of all loans in single-family MBS trusts that were delinquent four or more months was approximately $9 billion. In July 2010, we purchased approximately 50,000 delinquent loans with an unpaid principal balance of approximately $9 billion from our MBS trusts.

 

Summary of Our Financial Performance for the Second Quarter and First Half of 2010

 

Our financial results for the second quarter and first half 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 $1.2 billion for the second quarter of 2010, driven primarily by credit-related expenses of $4.9 billion, which were partially offset by net interest income of $4.2 billion. Our net loss for the second quarter 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 second quarter of 2010 was $3.1 billion and our diluted loss per share was $0.55. In comparison, we recognized a net loss of $11.5 billion, a net loss attributable to common stockholders of $13.1 billion and a diluted loss per share of $2.29 for the first quarter of 2010. We recognized a net loss of $14.8 billion, a net loss attributable to common stockholders of $15.2 billion and a diluted loss per share of $2.67 for the second quarter of 2009.

 

The $10.3 billion decrease in our net loss in the second quarter of 2010 compared with the first quarter of 2010 was primarily due to:

 

 

The $13.6 billion decrease in our net loss in the second quarter of 2010 compared with the second quarter of 2009 was primarily due to a $13.9 billion decrease in credit-related expenses, a $616 million decrease in net other-than-temporary impairments and a $545 million decrease in losses from partnership investments. These improvements in our financial results were offset in part by a $1.6 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 $4.9 billion for the second quarter of 2010 compared with $18.8 billion for the second quarter of 2009. The reduction in credit-related expenses was due largely to a decline in the rate of seriously delinquent single-family loans in the second quarter of 2010, due partly to the home retention and foreclosure alternative workouts that we have completed and a higher volume of foreclosures, as compared with an increase in the rate in the second quarter of 2009. In addition, although we acquired significantly more credit-impaired loans in the second quarter of 2010 as compared with the second quarter of 2009, fair value losses recognized on acquired credit-impaired loans were substantially lower due to our adoption of the new accounting standards. Effective January 1, 2010, only purchases of credit-deteriorated loans from unconsolidated MBS trusts or as a result of other credit guarantees result in the recognition of fair value losses upon acquisition. These decreases in our credit-related expenses for the second quarter of 2010 as compared with the second quarter of 2009 were partially offset by an out-of-period adjustment of $1.1 billion related to an additional provision for losses on preforeclosure property taxes and insurance receivables. See “Note 5—Allowance for Loan Losses and Reserve for Guaranty Losses.”

 

Year-to-Date Results

 

Net loss.   We recognized a net loss of $12.8 billion for the first half of 2010, driven primarily by credit-related expenses of $16.7 billion and fair value losses of $1.4 billion, which were offset in part by net interest income of $7.0 billion. Our net loss for the first half 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 half of 2010 was $16.2 billion and our diluted loss per share was $2.84. In comparison, we recognized a net loss of $38.0 billion, a net loss attributable to common stockholders of $38.4 billion and a diluted loss per share of $6.76 for the first half of 2009.

 

The $25.2 billion decrease in our net loss for the first half of 2010 compared with the first half of 2009 was due primarily to a $22.9 billion decrease in credit-related expenses and a $6.0 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 a result of this new standard, we only recognize the credit portion of an other-than-temporary impairment in our condensed consolidated statements of operations. These decreases were partially offset by lower guaranty fee income of $3.3 billion due to our adoption of the new accounting standards effective January 1, 2010.

 

Our credit-related expenses were $16.7 billion for the first half of 2010 compared with $39.7 billion for the first half of 2009. The reduction in credit-related expenses was due largely to a decrease in the rate of seriously delinquent single-family loans in the first half of 2010, due partly to the home retention and foreclosure alternative workouts that we have completed and a higher volume of foreclosures, as compared with an increase in the rate in the first half of 2009. In addition, although we acquired significantly more credit-impaired loans in the first half of 2010 as compared with the first half of 2009, fair value losses recognized on acquired credit-impaired loans were substantially lower due to our adoption of the new accounting standards.

 

Net Worth.   We had a net worth deficit of $1.4 billion as of June 30, 2010, compared with a net worth deficit of $8.4 billion as of March 31, 2010 and $15.3 billion as of December 31, 2009. Our net worth as of June 30, 2010 was negatively impacted by the recognition of our net loss of $1.2 billion and senior preferred stock dividends of $1.9 billion during the second quarter. These reductions in our net worth were offset by our receipt of $8.4 billion in funds from Treasury on June 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 $1.5 billion for the second 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 August 2010, the Acting Director of

FHFA submitted a request to Treasury on our behalf for $1.5 billion to eliminate our net worth deficit as of June 30, 2010. When Treasury provides the requested funds, the aggregate liquidation preference on the senior preferred stock will be $86.1 billion, which will require an annualized dividend of $8.6 billion. This amount exceeds our reported annual net income for each of the last eight fiscal years, in most cases by a significant margin.

 

Loss Reserves.   Our combined loss reserves, which reflect our estimate of the probable losses we have incurred in our guaranty book of business, remained at the same level as of June 30, 2010 as compared with March 31, 2010. Our combined loss reserves were $60.8 billion as of June 30, 2010 and March 31, 2010, compared with $53.8 billion as of January 1, 2010 and $64.4 billion as of December 31, 2009. Our combined loss reserves decreased as of January 1, 2010 compared with December 31, 2009 as a result of our adoption of the new accounting standards. Our loss reserve coverage to total nonperforming loans was 27.87% as of June 30, 2010 compared with 27.15% as of March 31, 2010 and 29.73% as of December 31, 2009.

 

Housing and Mortgage Market and Economic Conditions

 

During the second quarter of 2010, concern grew that the European crisis and concern over sovereign debt could slow the economic recovery in the United States. The pace of economic recovery in the U.S. slowed, with the U.S. gross domestic product, or GDP, rising by 2.4% on an annualized basis during the quarter, according to the Bureau of Economic Analysis advance estimate.

 

The housing market remains under pressure due in part to the weak labor market. The slowdown in job growth in the latter part of the second quarter, after solid increases in March and April, occurred across industries. Unemployment was 9.5% in June 2010, a decrease from 9.7% in March 2010, based on data from the U.S. Bureau of Labor Statistics. This decrease however, resulted from individuals leaving the labor force (and therefore no longer counted as “unemployed”) in numbers substantially greater than the decrease in household employment.

 

The Mortgage Bankers Association National Delinquency Survey reported that, as of March 31, 2010, the most recent date for which information is available, 9.54% of borrowers were seriously delinquent (90 days or more past due or in the foreclosure process), which we estimate represents approximately five million mortgages. In June, 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 the estimated five million seriously delinquent mortgages not currently listed for sale, represent a shadow inventory putting downward pressure on both home prices and rents.

 

We estimate that home prices on a national basis improved by 2.2% in the second quarter of 2010 and have declined by 16.9% 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. As we have previously disclosed, 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.

 

Unemployment, the slow economic recovery, and below average household formations continue to impact the multifamily sector, with apartment property sales, occupancy levels, and asking rents remaining at depressed levels. However, the preliminary data for the second quarter of 2010 indicate that multifamily housing fundamentals continue to show signs of improvement, which is evidenced by a decrease in the national vacancy rate. In addition, national asking rents appear to have held steady, based on preliminary third-party data, and apartment property sales increased slightly during the quarter. The anticipated volume of new multifamily loans remains uncertain. Although the number of distressed multifamily properties remains elevated, properties are not showing up on the sales market as lenders and servicers appear to be entering into workouts and extensions, instead of pursuing foreclosures. This could result in fewer multifamily properties

being offered for sale or refinanced and may constrain the amount of new multifamily loan origination volume in 2010.

 

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. Home sales increased during the second quarter of 2010, but we expect the pace to slow substantially in the third quarter, and be basically flat for all of 2010. In addition, the continued deterioration in the performance of outstanding mortgages will result in the foreclosure of troubled loans, which is likely to add to the excess housing inventory.

 

We expect that during 2010: (1) default and severity rates will remain high, (2) home prices will decline slightly on a national basis, more so in some geographic areas than in others, and (3) the level of foreclosures will increase. We also expect the level of multifamily defaults and serious delinquencies to increase further during 2010. All of these conditions, including 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 69% of our single-family business in the second quarter of 2010 consisted of refinancings. We expect these trends, combined with an expected decline in total originations in 2010, will have an adverse impact on our business volumes during the remainder of 2010.

 

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 18% 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 18% 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.   As described above, we expect our financial results will continue to be negatively affected by losses primarily on a subset of loans we acquired between 2005 through

2008. We expect that our credit-related expenses will remain high in 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 “The performance of single-family loans acquired beginning in 2009 and our expectation regarding future credit losses.”

 

Uncertainty Regarding our Long-Term Financial Sustainability and Future Status.   We expect that the actions we take to stabilize the housing market and minimize our credit losses will continue to have, in the short term at least, a material adverse effect on our results of operations and financial condition, including our net worth. 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 “The performance of single-family loans acquired beginning in 2009 and our expectation regarding future 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, Freddie Mac and the Federal Home Loan Banks (the “GSEs”), 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.

 

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 on the over-the-counter market.

 

Determination by FHFA Regarding 2009 Housing Goals Compliance

 

The Federal Housing Finance Regulatory Reform Act of 2008 (“2008 Reform Act”) provided that the housing goals established for 2008 would remain in effect for 2009, except that FHFA was required to review the 2009 goals to determine their feasibility given market conditions and, after seeking public comment, to make appropriate adjustments to the 2009 goals. The final 2009 housing goals FHFA adopted in August 2009 lowered our 2009 base goals and home purchase subgoals from 2008 levels, and increased our multifamily special affordable housing subgoal. Our 2009 housing goals were at approximately the levels that existed in 2004 through 2006.

 

In December 2009, FHFA notified us that we were likely to fail to meet the underserved areas goal. At that time, FHFA made no determination as to the underserved areas subgoal or the multifamily special affordable housing subgoal. We requested that FHFA determine, based on economic and market conditions and our financial condition, that the underserved areas goal and the increased multifamily special affordable housing subgoal were not feasible for 2009. In June 2010, FHFA notified us of its determination that achievement of this goal and subgoal was not feasible, primarily due to housing market and economic conditions in 2009. In July 2010, FHFA notified us that we had met all of the goals and subgoals except for the underserved areas goal and the multifamily special affordable housing subgoal. Because FHFA found these goals to be infeasible, we will not be required to submit a housing plan for failure to meet this goal and subgoal pursuant to the Federal Housing Enterprises Safety and Soundness Act of 1992.

For additional background information on our housing goals and subgoals, refer to “Business—Our Charter and Regulation of Our Activities—Housing Goals and Subgoals and Duty to Serve Underserved Markets” of our 2009 Form 10-K.

 

Proposed Rule Regarding Duty to Serve Underserved Markets

 

The 2008 Reform Act created the duty to serve underserved markets in order for us and Freddie Mac to “provide leadership to the market in developing loan products and flexible underwriting guidelines to facilitate a secondary market for very low-, low-, and moderate-income families” with respect to three underserved markets: manufactured housing, affordable housing preservation, and rural areas.

 

The duty to serve is a new oversight responsibility for FHFA beginning in 2010. The Director of FHFA is required to establish by regulation a method for evaluating and rating the performance by us and Freddie Mac of the duty to serve underserved markets. On June 7, 2010, FHFA published its proposed rule to implement this new duty.

 

The 2008 Reform Act requires FHFA to separately evaluate the following four assessment factors:

 

 

Under the proposed rule, FHFA would give the loan purchase and outreach assessment factors significant weight, while the investment and grants assessment factor would receive little or no weight. In addition, FHFA would consider the loan product assessment factor, even though we are not required to, and in fact are prohibited from, entering into new lines of business and developing new products. The proposed rule states that purchases and activities pursuant to the duty to serve should be profitable, even if less profitable than other activities.

 

Under the proposed rule, we would be required to submit an underserved markets plan at least 90 days before the plan’s effective date of January 1st of a particular year establishing benchmarks and objectives against which FHFA would evaluate and rate our performance. The plan term is two years. For the 2010 year, we must submit a plan as soon as practicable after the publication of the final rule, with the earliest feasible effective date.

 

FHFA would evaluate our performance on each assessment factor annually, and assign a rating of “satisfactory” or “unsatisfactory” to each factor and in each underserved market. Each factor would be evaluated and weighted based on the needs of the particular underserved market, overall market conditions and our financial condition. Based on the assessment factor findings, FHFA would assign a rating of “in compliance” or “noncompliance” with the duty to serve each underserved market.

With some exceptions, the counting rules and other requirements would be similar to those established for the housing goals. For the loan purchase assessment factor, FHFA proposes to measure performance in terms of units rather than mortgages or unpaid principal balance. All single-family loans we purchase must meet the standards in the Interagency Statement on Subprime Mortgage Lending and the Interagency Guidance on Nontraditional Mortgage Product Risks. We are expected to review the operations of loan sellers to ensure compliance with these standards.

 

If we fail to comply with, or there is a substantial probability that we will not comply with, our duty to serve a particular underserved market in a given year, FHFA would determine whether the benchmarks and objectives in our underserved markets plan are or were feasible. If we fail to meet our duty to serve, and FHFA determines that the benchmarks and objectives in our underserved markets plan are or were feasible, then, in the Director’s discretion, we may be required to submit a housing plan. Under the proposed rule, the housing plan must describe the activities that we will take to comply with the duty to serve a particular underserved market for the next calendar year, or improvements and changes in operations that we will make during the remainder of the current year.

 

Under the proposed rule, we would be required to provide quarterly and annual reports on our performance and progress towards meeting our duty to serve.

 

See “Risk Factors” for a description of how changes we may make in our business strategies in order to meet our duty to serve requirement may increase our credit losses and adversely affect our results of operations.

 

Proposed Rule Regarding Conservatorship/Receivership Operations

 

On July 9, 2010, FHFA published a proposed rule to establish a framework for conservatorship and receivership operations for the GSEs, as contemplated by the 2008 Reform Act. The proposed rule clarifies (i) that all claims arising from an equity interest in a regulated entity in receivership would be given the same treatment as the interests of shareholders; (ii) that claims by shareholders would receive the lowest priority in a receivership, behind administrative expenses of the receiver, general liabilities of the regulated entity and liabilities subordinated to those of general creditors; (iii) that the ability of a regulated entity to make capital distributions during a conservatorship would be restricted; (iv) that the powers of the conservator or receiver include continuing the missions of a regulated entity and ensuring that the operations of the regulated entity foster liquid, efficient, competitive and resilient national housing finance markets; and (v) the status of claims against the conservator or receiver for breach of contract. The proposed rule would also provide that payment of certain securities litigation claims would be held in abeyance during conservatorship, except as otherwise ordered by FHFA.

 

The proposed rule is part of FHFA’s implementation of the powers provided by the 2008 Reform Act, and does not seek to anticipate or predict future conservatorships or receiverships. In announcing the publication of this proposed rule for comment, the Acting Director of FHFA said it had “no impact” on current conservatorship operations.

 

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 “Wall Street Reform Act”). Some key provisions of the legislation, include: (i) more stringent regulation of financial institutions deemed systemically important, and an orderly liquidation mechanism for these institutions; (ii) creation of a bureau of consumer financial protection with broad rulemaking and enforcement authority; (iii) greater oversight of derivatives; (iv) mortgage underwriting standards and liability for failure to meet them; (v) credit risk retention

requirements for certain asset-backed securities, including certain mortgage-backed securities; and (vi) independent appraisal standards for residential properties securing loans.

 

The Wall Street Reform Act establishes an interagency council chaired by the Secretary of the Treasury to identify systemically important institutions. These institutions will be subject to stricter prudential standards to be established by the Federal Reserve, including standards related to risk-based capital, leverage limits, liquidity, credit concentrations, resolution plans, reporting credit exposures, and other risk management measures. Institutions will also be subject to stress tests on a regular basis. The Federal Reserve may impose other standards related to contingent capital, enhanced public disclosure, short term debt limits and other requirements as appropriate.

 

The Wall Street Reform Act creates a resolution regime for the orderly dissolution of financial companies whose failure may jeopardize U.S. financial stability. Fannie Mae is expressly exempted from this resolution regime.

 

The Wall Street Reform Act establishes the independent Bureau of Consumer Financial Protection as a part of the Federal Reserve System, with responsibility for enforcing most existing federal financial consumer protection laws and authority to adopt new regulations.

 

The Wall Street Reform Act requires that most swap transactions be submitted for clearing with a clearing organization, with some exceptions (for example, if one of the parties is a commercial end user). It also requires certain institutions meeting the definition of a “major swap participant” to register with the Commodity Futures Trading Commission (the “CFTC”). The Wall Street Reform Act defines “major swap participant” broadly enough to include Fannie Mae.

 

If Fannie Mae is determined to be a major swap participant, minimum capital and margin requirements would apply to our swap transactions, including transactions that are not subject to clearing. Under the Wall Street Reform Act, FHFA, in consultation with the CFTC and SEC, would establish those requirements. Registrants with the CFTC are also subject to the CFTC’s reporting, record keeping, daily trading and business conduct regulations for swaps transactions.

 

The Wall Street Reform Act requires creditors to determine that borrowers have a “reasonable ability to repay” mortgage loans prior to making such loans. If a creditor fails to comply, borrowers can offset amounts they owe as part of a foreclosure or recoup monetary damages. The Wall Street Reform Act provides a presumption of compliance for mortgage loans that meet certain terms and characteristics; however, the presumption is rebuttable by a borrower bringing a claim.

 

The Wall Street Reform Act requires financial regulators to jointly prescribe regulations requiring securitizers and/or originators to maintain a portion of the credit risk in assets transferred, sold or conveyed through the issuance of asset-backed securities, with certain exceptions. This risk retention requirement would not appear to apply to Fannie Mae and, in any event, Fannie Mae already retains the credit risk on mortgages it owns or guarantees. How this requirement will affect our customers and counterparties on loans sold to and guaranteed by Fannie Mae will depend on how the regulations are implemented.

 

Within 90 days of enactment of the Wall Street Reform Act, the Federal Reserve must issue interim final regulations governing appraisal independence in the provision of mortgage lending and brokerage services. Upon issuance of the regulations, Fannie Mae’s Home Valuation Code of Conduct will expire.

 

Because extensive regulatory guidance is needed to clarify and implement many of the provisions of this legislation, we cannot predict its potential impact on our company or our industry.

GSE Reform

 

The Wall Street Reform Act contains two provisions related to secondary mortgage market reforms. The first 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. The second is a “sense” or opinion of Congress that efforts to regulate the terms and practices related to residential mortgage credit are incomplete without enactment of meaningful structural reforms of Fannie Mae and Freddie Mac. This nonbinding “sense” of the Congress has no legal effect.

 

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.

 

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” for a discussion of the risk associated with the use of models 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 the use of reasonably different estimates and assumptions could have a material impact on our reported results of operations or financial condition. These critical accounting policies and estimates are as follows:

 

 

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 June 30, 2010 compared to December 31, 2009 and describe any significant changes in the judgments and assumptions we made during the first half 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 June 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.

 

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 $690 million as of June 30, 2010 and $601 million as of December 31, 2009, and derivatives liabilities with a fair value of $111 million as of June 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 is a growing portion of the total single-family reserve and will continue to grow in conjunction with our modification efforts. 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, 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 used 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 a valuation allowance within “Accrued interest receivable, net” in our condensed consolidated balance sheet.

 

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 second quarter and first half of 2010 with the results of these

periods in prior years. The following table describes the impact to our second quarter and first half 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 second quarter of 2010 compared with the second quarter of 2009 primarily as a result of the recognition of contractual guaranty fees in interest income upon adoption of the new accounting standards and a reduction in interest expense related to debt that we have issued as lower borrowing rates allowed us to replace higher-cost debt with lower-cost debt. The increase in net interest income was partially offset by a reduction in interest income due to a significant increase of non-performing loans in our condensed consolidated balance sheets. While we do not recognize interest income on the mortgage loans of the consolidated trusts that have been placed on nonaccrual status, we continue to recognize interest expense for the amounts owed to MBS certificateholders, which has decreased our net interest income. Prior to the adoption of the new accounting standards, interest income and expense on MBS trusts not owned by Fannie Mae were not recorded as components of net interest income but were considered in determining our provision for credit losses. For the second quarter of 2010, interest income that we did not recognize for nonaccrual mortgage loans, net of recoveries, was $2.2 billion, which reduced our net interest yield by 27 basis points, compared with $245 million for the second quarter of 2009, which reduced our net interest yield by 11 basis points. Of the $2.2 billion of interest income that we did not recognize for nonaccrual mortgage loans in the second quarter of 2010, $1.2 billion was related to the unsecuritized mortgage loans that we own.

 

Net interest income in the second quarter of 2010 also benefited from the recent purchase of the substantial majority of the loans that are four or more consecutive monthly payments delinquent from single-family MBS trusts 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.

 

Net interest income slightly increased in the first half of 2010 compared with the first half of 2009 primarily due to the recognition of contractual guaranty fees in interest income upon adoption of the new accounting standards and a reduction in interest expense related to debt that we have issued as we replaced higher-cost debt with lower-cost debt. The increase was partially offset by a reduction in net interest income due to the increase of non-performing loans on our condensed consolidated balance sheets and by lower interest income from the interest-earning assets that we own due to lower yields on our mortgage and non-mortgage assets. For the first half of 2010, the interest income that we did not recognize for nonaccrual mortgage loans, net of

recoveries, was $4.9 billion, with a 30 basis point reduction in net interest yield, compared with $468 million for the first half of 2009, with an 11 basis point reduction in net interest yield. Of the $4.9 billion of interest income that we did not recognize for nonaccrual mortgage loans in the first half of 2010, $1.8 billion was related to the unsecuritized mortgage loans that we own.

 

Net interest yield significantly decreased in the second quarter and first half of 2010 compared with the second quarter and first half 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 second quarter and first half of 2010 as compared to the second quarter and first half of 2009.

 

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 second quarter and first half of 2010 compared with the second quarter and first half 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 second quarter and first half of 2010 reflects guaranty fees earned from unconsolidated trusts and other credit enhancements arrangements, such as our long-term standby commitments.

 

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

 

Net Other-Than-Temporary Impairment

 

For the second quarter of 2010, net other-than-temporary impairment decreased compared with the second quarter of 2009, primarily as a result of lower impairment 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 second quarter of 2010.

 

Net other-than-temporary impairment for the first half of 2010 significantly decreased compared with the first half 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 88% of the impairment recorded in the first half 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 half of 2010 was driven by 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 half 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.

 

 

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 second quarter of 2010 primarily as a result of changes in implied interest rate volatility, partially offset by time decay on our purchased options.

 

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

 

During the second quarter and first half of 2009, increases in swap rates resulted in gains on our net pay-fixed swap position. These gains were more than offset by losses on our option-based derivatives as swap rate increases drove losses on our receive-fixed swaptions.

 

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

 

Mortgage Commitment Derivatives Fair Value Gains (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 higher losses on our mortgage securities commitments in the second quarter and first half of 2010 compared to gains in the second quarter of 2009 and losses in the first half of 2009, due primarily to losses on commitments to sell as a result of increased mortgage-related securities prices during the commitment period.

Trading Securities Gains, Net

 

Gains on trading securities in the second quarter and first half of 2010 were primarily driven by a decrease in interest rates and narrowing of credit spreads.

 

The gains on our trading securities during the second quarter and first half of 2009 were attributable to the narrowing of spreads on Commercial Mortgage-Backed Securities (“CMBS”), asset-backed securities, and corporate debt securities. Narrowing of spreads on agency MBS also contributed to the gains in the first half of 2009.

 

Losses from Partnership Investments

 

Losses from partnership investments decreased in the second quarter and first half of 2010 compared with the second quarter and first half of 2009 as we have not recognized net operating losses or other-than-temporary impairment on our LIHTC investments in 2010. In the fourth quarter of 2009, we reduced the carrying value of our LIHTC investments to zero. As a result, we no longer recognize net operating losses or other-than-temporary impairment on our LIHTC investments. Losses from partnership investments recognized in the second quarter and first half of 2010 were due to other-than-temporary impairment on our other affordable housing investments.

 

Administrative Expenses

 

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

 

 

 

 

Provision for Credit Losses

 

We summarize the changes in our combined loss reserves in Table 11. Upon recognition of the mortgage loans held by newly consolidated trusts on January 1, 2010, we increased our “Allowance for loan losses” and decreased our “Reserve for guaranty losses.” The impact at transition is reported as “Adoption of new accounting standards” in the table. The decrease in the combined loss reserves from transition represents a difference in the methodology used to estimate incurred losses for our allowance for loan losses as compared

with our reserve for guaranty losses and our separate presentation of the portion of the allowance related to accrued interest as our “Allowance for accrued interest receivable.” These changes are discussed in “Note 2, Adoption of the New Accounting Standards on the Transfers of Financial Assets and Consolidation of Variable Interest Entities.”