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

 

Form 10-Q

 

 

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o   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):

 

 

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 March 31, 2009, there were 1,107,781,938 shares of common stock of the registrant outstanding.

 

 

TABLE OF CONTENTS

 

 

 

Housing and Economic Conditions

 

Mortgage and Housing Market and Economic Conditions

 

The U.S. residential mortgage market continued to experience significant deterioration in the first quarter of 2009, which adversely affected our financial condition and results.

 

Virtually all fundamental measures of the housing market’s health worsened in the first quarter of 2009 compared with the fourth quarter of 2008. The market experienced declines in new and existing home sales, housing starts and home prices, as well as increases in mortgage delinquencies.

 

The recession that began in December 2007 continued to deepen in the first quarter. The U.S. gross domestic product, or GDP, for the fourth quarter of 2008 was revised downward to (6.3)% on an annualized basis, and declined further, although at a slower pace, by (6.1)% in the first quarter of 2009. The U.S. has lost a net total of over 5.1 million jobs since the start of the recession, and in the first quarter of 2009, the total number of Americans receiving unemployment benefits increased to the highest levels on record dating back to 1967. The U.S. Bureau of Labor Statistics reported successive increases in the unemployment rate in each month of the first quarter, reaching 8.5% in March. Unemployment rates in Florida, California, Arizona and Nevada rose to 9.7%, 11.2%, 7.8% and 10.4%, respectively, in March 2009.

 

High levels of unemployment, coupled with severe declines in home equity and household wealth, have contributed to a continued increase in residential mortgage delinquencies.

 

The actual number of unsold homes in inventory has begun to decline in recent months, but the supply of homes as measured by the inventory/sales ratio remains high since the pace of sales has slowed in recent months in response to rising unemployment. Although affordability measures have risen dramatically since home prices peaked and subsequently began falling, the limited availability of credit for many potential homebuyers and low consumer confidence have dampened purchase activity even at the decreasing price levels. Surveys of bank loan officers by the Federal Reserve showed lenders were still tightening credit standards in the first quarter.

 

While first quarter housing market indicators were worse than the fourth quarter, there were some tentative signs of improvement. On a seasonally adjusted basis, single-family housing starts, new home sales, and existing home sales were all higher in March than in January, though down from February.

 

Long-term mortgage rates declined to near-record lows in March, resulting in a wave of mortgage refinancing that drove an increase in mortgage originations overall—from approximately $363 billion in the fourth quarter of 2008 to approximately $511 billion in the first quarter of 2009. Approximately 73% of first quarter 2009 mortgage originations were refinancings, compared with 63% in the first quarter of 2008.

 

Multifamily housing fundamentals are under increasing stress that reflects broader unfavorable economic conditions, including higher unemployment and severely restricted capital. These conditions are negatively affecting multifamily property level cash flows, vacancy rates and rent levels. Property values are declining due to both the downward pressure on cash flows and the higher premium required by investors.

 

As of December 31, 2008, the latest date for which information was available, the amount of U.S. residential mortgage debt outstanding was estimated by the Federal Reserve to be approximately $11.9 trillion, including $11.0 trillion of single-family mortgages. Total U.S. residential mortgage debt outstanding decreased by 0.3% in 2008, compared with an increase of 7.0% in 2007 and 10.9% in 2006. Our mortgage credit book of business, which includes mortgage assets we hold in our investment portfolio, our Fannie Mae MBS held by third parties and credit enhancements that we provide on mortgage assets, was $3.1 trillion as of December 31, 2008, or approximately 26% of total U.S. residential mortgage debt outstanding. See “Part I—Item 1A—Risk Factors” of our 2008 Form 10-K for a description of the risks associated with the housing market downturn and continued home price declines.

U.S. Government Actions to Stabilize the Markets and Support Economic Recovery

 

The U.S. government has taken a number of actions intended to strengthen market stability, improve the strength of financial institutions, enhance market liquidity, and provide support to homeowners, including the following actions, which were taken in 2009:

 

 

Our Business Objectives and Strategy

 

Our Board of Directors and management consult with FHFA, as our conservator, in establishing our strategic direction, and FHFA has approved our business objectives and strategy.

 

We face a variety of different, and potentially conflicting, objectives, including:

 

 

These objectives create conflicts in strategic and day-to-day decision-making that could lead to less than optimal outcomes for some or all of these objectives. For example, limiting the amount of funds Treasury must invest in us under the senior preferred stock purchase agreement in order to eliminate a net worth deficit could require us to constrain some of our business activities, including activities targeted at providing liquidity, stability and affordability to the mortgage market. Conversely, to the extent we expand our efforts to assist the mortgage market, our financial results are likely to suffer, at least in the short term, which will increase the amount of funds that Treasury is required to provide to us and further limit our ability to return to long-term profitability. We regularly consult with and receive direction from our conservator on how to balance our objectives.

Accordingly, we currently are primarily focusing on the first two objectives listed above:

 

 

We are concentrating our efforts on keeping people in their homes and preventing foreclosures. We also are continuing to be active in the secondary mortgage market through our guaranty business. The essence of this strategy is to support liquidity and affordability in the mortgage market, while creating and implementing successful foreclosure prevention approaches. Currently, one of the principal ways in which we are focusing on these objectives is through our participation in the government’s Making Home Affordable Program, which we describe in more detail below. Focusing on these objectives, rather than on returning to long-term profitability, is likely to contribute to further deterioration in both our results of operations and our net worth. Continuing deterioration in the housing and mortgage markets, along with the continuing deterioration in our guaranty book of business and the costs associated with the objectives on which we are focused, will increase the amount of funds that Treasury is required to provide to us. In turn, these factors put additional pressure on our ability to return to long-term profitability. If, however, the Making Home Affordable Program is successful in reducing foreclosures and keeping borrowers in their homes, it may benefit the overall housing market and help in reducing our long-term credit losses. We therefore consult regularly with our conservator on how to balance these two objectives against the competing objectives we face.

 

Summary of Our Financial Results for the First Quarter of 2009

 

Our financial results for the first quarter of 2009 were adversely affected by ongoing deterioration in the housing, mortgage, financial and credit markets.

 

We recorded a net loss of $23.2 billion and a diluted loss per share of $4.09 for the first quarter of 2009. In comparison, we recorded a net loss of $25.2 billion and a diluted loss per share of $4.47 for the fourth quarter of 2008, and a net loss of $2.2 billion and a diluted loss per share of $2.57 for the first quarter of 2008. Our results for the first quarter of 2009 were driven primarily by credit-related expenses of $20.9 billion, other-than-temporary impairment related to available-for-sale securities of $5.7 billion and fair value losses of $1.5 billion.

 

The $2.1 billion decrease in our net loss for the first quarter of 2009 from the fourth quarter of 2008 was driven principally by a $10.9 billion reduction in net fair value losses, which was partially offset by an $8.9 billion increase in credit-related expenses. The $21.0 billion increase in our net loss for the first quarter of 2009 compared to the loss we incurred in the first quarter of 2008 was driven principally by the significant increase in credit-related expenses.

 

Our credit-related expenses included a provision for credit losses of $20.3 billion, compared with a provision for credit losses of $11.0 billion in the fourth quarter of 2008. Our combined loss reserves, which reflect our best estimate of credit losses incurred in our guaranty book of business as of each balance sheet date, increased to $41.7 billion as of March 31, 2009, or 28.78% of our nonperforming loans, from $24.8 billion as of December 31, 2008, or 20.76% of our nonperforming loans. The substantial increase in our loss reserves primarily reflected further deterioration in the credit quality of both our single-family and multifamily guaranty book of business, evidenced by a significant increase in our nonperforming loans (loans for which we believe collectability of interest or principal is not reasonably assured) and seriously delinquent loans (single-family loans three months or more past due or in the foreclosure process or multifamily loans 60 days or more past due), as market conditions such as the severe economic downturn and rising unemployment continued to adversely affect the performance of our guaranty book of business. In addition, our average loss severities increased as a result of the continued decline in home prices during the first quarter of 2009. Because of the existing stress in the housing and credit markets, and the speed and extent to which these markets have deteriorated, our process for determining the adequacy of our loss reserves has become more complex and involves a greater degree of management judgment. The current state of the housing and mortgage markets is unprecedented in many respects, greatly reducing the usefulness of relying on our historical loan performance data in estimating our loss reserves. To address the limitations in these historical data, we made refinements to

our loss estimation process during the first quarter of 2009. We provide additional information on our loss reserves, including refinements we made to our loss reserve process in response to the rapidly changing and unprecedented conditions in the housing and mortgage markets, in “Critical Accounting Policies and Estimates—Allowance for Loan Losses and Reserve for Guaranty Losses” and in “Consolidated Results of Operations—Credit Related Expenses.”

 

The other-than-temporary impairment on available-for-sale securities of $5.7 billion that we recognized in the first quarter of 2009 related to additional impairment losses on some of our Alt-A and subprime private-label securities that we had previously impaired, as well as impairment losses on other Alt-A and subprime securities, attributable to a continued deterioration in the credit quality of the loans underlying these securities and further declines in the expected cash flows.

 

Our mortgage credit book of business remained relatively unchanged at $3.1 trillion as of March 31, 2009, roughly the same level as at December 31, 2008, as high levels of refinancing activity led to high volumes of acquisitions and liquidations. Our estimated market share of new single-family mortgage-related securities issuances was 44.2% for the first quarter of 2009, compared with 41.7% for the fourth quarter of 2008.

 

We provide more detailed discussions of key factors affecting changes in our results of operations and financial condition in “Consolidated Results of Operations,” “Business Segment Results,” “Consolidated Balance Sheet Analysis,” “Supplemental Non-GAAP Information—Fair Value Balance Sheets,” and “Risk Management—Credit Risk Management—Mortgage Credit Risk Management—Mortgage Credit Book of Business.”

 

Homeowner Assistance and Foreclosure Prevention Initiatives

 

On March 4, 2009, the Obama Administration announced the details of its Making Home Affordable Program. The program includes a Home Affordable Refinance Program, which provides for the refinance of mortgage loans owned or guaranteed by us or Freddie Mac, and the Home Affordable Modification Program, which provides for the modification of mortgage loans owned or guaranteed by us or Freddie Mac, as well as other mortgage loans. On April 28, 2009, the Obama Administration announced the Second Lien Program, which provides participating servicers with alternatives for addressing second-lien loans when the servicers are modifying the associated first-lien mortgage loan under the Home Affordable Modification Program.

 

On March 4, 2009, we announced our participation in the Home Affordable Refinance and Home Affordable Modification Programs and released guidelines for Fannie Mae sellers and servicers in offering these two programs for Fannie Mae borrowers. These two programs are designed to significantly expand the number of borrowers who can refinance or modify their mortgages to achieve a monthly payment that is more affordable now and into the future. We also are serving as program administrator under the Home Affordable Modification Program and the Second Lien Program for loans we do not own or guarantee.

 

Key aspects of the Making Home Affordable Program are as follows.

 

Home Affordable Refinance Program

 

The Home Affordable Refinance Program is targeted at borrowers who have demonstrated an acceptable payment history on their mortgage loans but have been unable to refinance due to a decline in home prices or the unavailability of mortgage insurance. Loans under this program are available only if the new mortgage loan either reduces the monthly principal and interest payment for the borrower or provides a more stable loan product (such as movement from an adjustable-rate mortgage to a fixed-rate mortgage loan). Other eligibility requirements that must be met under this program include the following.

 

 

 

 

We made the program available for newly refinanced mortgage loans delivered to us on or after April 1, 2009. The program replaced the streamlined refinance options we previously offered. If interest rates remain near record lows, we expect that the Home Affordable Refinance Program will bolster refinance volumes over time as major lenders adopt necessary system changes and consumer awareness continues to build.

 

Home Affordable Modification Program

 

The Home Affordable Modification Program is aimed at helping borrowers whose loan either is currently delinquent or is at imminent risk of default by modifying their mortgage loan to make their monthly payments more affordable. The program is designed to provide a uniform, consistent regime for servicers to use in modifying mortgage loans to prevent foreclosures, including loans owned or guaranteed by Fannie Mae and other qualifying mortgage loans. We expect borrowers at risk of foreclosure who are not eligible for a loan refinance under the Home Affordable Refinance Program to be evaluated for eligibility under the Home Affordable Modification Program before any other workout alternative is considered. Borrowers ineligible for the Home Affordable Modification Program may be considered under other workout alternatives we provide, such as HomeSaver Advance ^tm and our recently introduced HomeSaver Forbearance initiative. For modifications under the Home Affordable Modification Program of qualifying mortgage loans that are not owned or guaranteed by Fannie Mae, we serve as the program administrator for Treasury, as described further below.

 

The key elements of the Home Affordable Modification Program include the following.

 

 

 

 

 

 

 

 

 

The Home Affordable Modification Program expires on December 31, 2012.

 

Our Role as Program Administrator of the Home Affordable Modification Program and Second Lien Program

 

Treasury has engaged us to serve as program administrator for loans modified under the Home Affordable Modification Program that are not owned or guaranteed by us. In April 2009, we released guidance to servicers for adoption and implementation of the Home Affordable Modification Program for mortgage loans that are not owned or guaranteed by us or Freddie Mac. Freddie Mac maintains guidelines for modification under the program of loans it owns or guarantees. Freddie Mac bears the costs of loan modifications under the Home Affordable Modification Program for all loans owned or guaranteed by Freddie Mac, and Treasury bears the costs for loans other than Fannie Mae’s or Freddie Mac’s modified under the program. Treasury also generally will compensate investors (other than Fannie Mae or Freddie Mac) for 50% of the amount by which

a payment is reduced due to the modification, subject to certain limits, and will pay an up-front incentive fee of $1,500 to such investors if the borrower was current on the loan before the trial period and the borrower’s monthly mortgage payment was reduced by 6% or more.

 

Our principal activities as program administrator include the following:

 

 

Treasury also has engaged us to serve as program administrator of the Second Lien Program for loans that are not owned or guaranteed by us. Our principal activities as program administrator for the Second Lien Program are similar to those described above for the Home Affordable Modification Program.

 

Expected Impact of the Making Home Affordable Program

 

The actions we are taking and the initiatives we have introduced to assist homeowners and limit foreclosures, including those described above, are significantly different from our historical approach to delinquencies, defaults and problem loans. As a result, it will take time for us to assess and provide statistical information both on the relative success of these efforts and their effect on our results of operations and financial condition. Some of the initiatives we undertook prior to the Making Home Affordable Program have not achieved the results we expected. We will continue to work with our conservator as we move forward under the Making Home Affordable Program to help us best fulfill our objective of helping homeowners and the mortgage market. As we gain more experience under these programs, we may supplement them with other initiatives to help us assist more homeowners. We have included data relating to our borrower loss mitigation activities for the first quarter and prior periods in “Risk Management—Credit Risk Management—Mortgage Credit Risk Management.” Given the timing of implementation of the Making Home Affordable Program, these data do not include activities under the program.

 

The nature of the Making Home Affordable Program is unprecedented. As a result, it is difficult for us to predict the full extent of our activities under the program and how those will affect us, the response rates we will experience, or the costs that we will incur. We do expect modifications of loans to increase in 2009 as a result of the Home Affordable Modification Program, however, we cannot predict the degree of increase in part due to the complexity involved in the process from the time we identify a potential loan for modification to actually modifying the loan. The steps in the process, which are generally performed by servicers, include:

 

 

We are working with servicers to effectively implement the program and reach borrowers who are eligible for a modification under the program. However, the need to complete the steps detailed above, including having multiple servicer contacts with the borrower, creates significant uncertainty in our ability to estimate the number of modifications we will accomplish. It is also uncertain whether the borrower and servicer incentives under the Home Affordable Modification Program will provide sufficient motivation for modifications.

 

We expect modifications under the Home Affordable Modification Program of loans we own or guarantee in particular to adversely affect our financial results and condition for several reasons, including:

 

 

We also expect to incur additional operational expenses associated with the Making Home Affordable Program. Accordingly, the Making Home Affordable Program will likely have a material adverse effect on our business, results of operations and financial condition, including our net worth. If the program is successful in reducing foreclosures and keeping borrowers in their homes, however, it may benefit the overall housing market and help in reducing our long-term credit losses.

 

Providing Mortgage Market Liquidity and Other Market Support

 

Ongoing provision of liquidity to the mortgage markets.   During the first quarter of 2009, we purchased or guaranteed an estimated $175.4 billion in new business, measured by unpaid principal balance. These purchases and guarantees consisted primarily of single-family mortgage loans, providing financing for approximately 730,000 conventional single-family loans. Our purchase or guarantee of approximately $3.8 billion of new and existing multifamily loans during the first quarter of 2009 helped to finance approximately 87,000 multifamily units. The $175.4 billion in new business for the quarter consisted of $125.4 billion in Fannie Mae MBS that were acquired by third parties, and $50.0 billion in mortgage loans and mortgage-related securities we purchased for our mortgage investment portfolio. Our estimated market share of new single-family mortgage-related securities issuances was 44.2% for the first quarter of 2009, compared with 41.7% for the fourth quarter of 2008, making us the largest single provider of mortgage-related securities in the secondary market.

 

Suspension of foreclosures.   We maintained a suspension of foreclosures from November 26, 2008 through January 31, 2009, and from February 17, 2009 through March 6, 2009. We extended the suspension to allow us time to implement the Making Home Affordable Program.

 

Adoption of National Real Estate Owned Rental Policy.   In January 2009, we adopted our National Real Estate Owned Rental Policy, which is designed to allow qualified renters in Fannie Mae-owned foreclosed properties to stay in their homes. Under the policy, eligible renters are offered a new month-to-month lease with Fannie Mae or financial assistance for their transition to new housing should they choose to vacate the property.

 

Enhancing multifamily Fannie Mae MBS.   Our HCD business is proactively working with our DUS lenders and other parties to expand our Fannie Mae multifamily MBS product suite to increase third-party investor interest and provide liquidity and stability in the multifamily market. Third-party multifamily Fannie Mae MBS execution was 32% of total multifamily commitment volume during the first quarter of 2009, compared with 2% of total multifamily commitment volume during the first quarter of 2008.

Increased flexibility to allow more loans to one borrower.   In February 2009, we modified our policies to allow investor and second home borrowers to own up to ten financed properties if they meet certain eligibility, underwriting and delivery requirements. We previously limited the number of properties to five.

 

HomeSaver Forbearance.   On March 4, 2009, we introduced HomeSaver Forbearance, which is a new loss mitigation option available for borrowers whose loan either is delinquent or is at imminent risk of default and who do not qualify for a modification under the Home Affordable Modification Program. We have directed servicers to offer forbearance if an eligible borrower has a willingness and ability to make reduced monthly payments of at least one-half of their contractual monthly payment amount. The forbearance period lasts for six months, during which time the servicer works with the borrower to identify a more permanent foreclosure prevention alternative. We have instructed servicers to identify such an alternative during the first three months of the forbearance period and implement the alternative by the end of the six-month period.

 

Increase in conforming loan limit for 2009.   In March 2009, we announced our requirements for the acquisition of high-balance mortgage loans during 2009 under temporary authority granted under the 2009 Stimulus Act. This authority set the conforming loan limit for a one-family residence in high cost areas at a maximum of $729,750 for 2009.

 

New multifamily trust documents.   In January 2009, we introduced new master trust agreements for multifamily Fannie Mae MBS. The new agreements, which include an amendment and restatement of a prior master trust agreement, are designed to increase flexibility in managing delinquent loans backing multifamily Fannie Mae MBS issued on or after February 1, 2009, without requiring a repurchase of the affected loans or a change to an investor’s cash flows.

 

Credit Overview

 

We continued to experience a deterioration in the credit performance of mortgage loans in our guaranty book of business during the first quarter of 2009, reflecting the ongoing impact of the adverse conditions in the housing market, as well as the deepening economic recession and rising unemployment. We expect these conditions to continue to adversely affect our credit results in 2009. Table 1 below presents information about the credit performance of mortgage loans in our single-family guaranty book of business for the year ended December 31, 2008 and for each subsequent quarter, illustrating the worsening trend in performance throughout 2008 and continuing in the first quarter of 2009.

 

 

 

Our entire guaranty book of business, including loans with lower risk characteristics, has begun to experience increases in delinquency and default rates as a result of the sharp rise in unemployment, the continued decline in home prices, the prolonged downturn in the economy, and the resulting increase in mark-to-market LTV ratios. In addition, certain loan types have continued to contribute disproportionately to the increases in serious delinquencies and credit losses we reported for the first quarter of 2009. These include loans on properties in California, Florida, Arizona and Nevada; loans originated in 2006 and 2007; and loans in higher-risk categories such as Alt-A loans and interest-only loans.

 

“Alt-A loans” generally refers to mortgage loans that can be underwritten with reduced or alternative documentation than that required for a full documentation mortgage loan but may also include other alternative product features. In reporting our credit exposure, we classify mortgage loans as Alt-A if the lenders that deliver the mortgage loans to us have classified the loans as Alt-A based on documentation or other product features. We have classified loans as nonperforming, and placed them on nonaccrual status, when we believe collectability of interest or principal on the loan is not reasonably assured.

Net Worth and Fair Value Deficit

 

Net Worth and Fair Value Deficit Amounts

 

Under the senior preferred stock purchase agreement that was entered into between us and Treasury in September 2008 and amended in May 2009, Treasury committed to provide us funds of up to $200 billion, on a quarterly basis, in the amount, if any, by which our total liabilities exceed our total assets at the end of the applicable fiscal quarter. This net worth deficit equals the total deficit that we report in our condensed consolidated balance sheets, and is calculated by subtracting our total liabilities from our total assets, each as shown on our condensed consolidated balance sheets prepared in accordance with generally accepted accounting principles (“GAAP”) for that fiscal quarter. We describe the amended terms of the agreement in more detail below in “Amendment to Senior Preferred Stock Purchase Agreement” and we describe the terms of the agreement prior to its May 2009 amendment, most of which continue to apply, in our 2008 Form 10-K in “Part I—Item 1—Business—Conservatorship, Treasury Agreements, Our Charter and Regulation of Our Activities—Treasury Agreements.”

 

Our net worth as of March 31, 2009 was negative and is presented in our condensed consolidated GAAP balance sheets as a total deficit of $18.9 billion as of March 31, 2009, which is an increase of $3.8 billion over our total deficit of $15.2 billion as of December 31, 2008. The increase in our net worth deficit was primarily attributable to the net loss we recorded during the first quarter of 2009, partially offset by the $15.2 billion we received from Treasury.

 

Our fair value deficit as of March 31, 2009, which is reflected in our supplemental non-GAAP fair value balance sheet, was $110.3 billion, an increase of $5.2 billion over our fair value deficit of $105.2 billion as of December 31, 2008. The amount that Treasury committed to provide us under the senior preferred stock purchase agreement is determined based on our GAAP balance sheet, not our non-GAAP fair value balance sheet. There are significant differences between our GAAP balance sheet and our non-GAAP fair value balance sheet, which we describe in greater detail in “Supplemental Non-GAAP Information—Fair Value Balance Sheets.”

 

Due to current trends in the housing and financial markets, we expect to have a net worth deficit in future periods, and therefore will be required to obtain additional funding from Treasury pursuant to the senior preferred stock purchase agreement.

 

Request for and Effect of Treasury Funding

 

Under the Federal Housing Finance Regulatory Reform Act (“Regulatory Reform Act”), FHFA must place us into receivership if the Director of FHFA makes a written determination that our assets are, and during the preceding 60 days have been, less than our obligations. FHFA has notified us that the measurement period for such a determination begins no earlier than the date of the SEC filing deadline for our quarterly and annual financial statements and continues for a period of 60 days after that date. FHFA also has advised us that, if we receive funds from Treasury during that 60-day period in order to eliminate our net worth deficit as of the prior period end in accordance with the senior preferred stock purchase agreement, the Director of FHFA will not make a mandatory receivership determination. On March 31, 2009, we received our first investment from Treasury under the senior preferred stock purchase agreement of $15.2 billion, which eliminated our net worth deficit as of December 31, 2008.

 

The Director of FHFA submitted a request to Treasury on May 6, 2009 for $19.0 billion on our behalf under the terms of the senior preferred stock purchase agreement to eliminate our net worth deficit as of March 31, 2009, and requested receipt of those funds on or prior to June 30, 2009.

 

When Treasury provides the additional funds that FHFA requested on our behalf, the aggregate liquidation preference of our senior preferred stock will total $35.2 billion and the annualized dividend on the senior preferred stock will be $3.5 billion, based on the 10% dividend rate. This dividend amount exceeds 50% of our reported annual net income in six of the past seven years, in most cases by a significant margin. If we do not make cash payments on time, the dividend rate increases to 12% annually, and the unpaid dividend is added to the liquidation preference, further increasing the amount of the annual dividends.

Significance of Net Worth Deficit, Fair Value Deficit and Combined Loss Reserves

 

Our net worth deficit, which equals our total deficit reported on our consolidated GAAP balance sheet, includes the combined loss reserves of $41.7 billion that we recorded in our consolidated balance sheet as of March 31, 2009. Our non-GAAP fair value balance sheet presents all of our assets and liabilities at estimated fair value as of the balance sheet date. “Fair value” represents the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, which is also referred to as the “exit price.” In determining fair value, we use a variety of valuation techniques and processes. In general, fair value incorporates the market’s current view of the future, and that view is reflected in the current price of the asset or liability. However, future market conditions may be different from what the market has currently estimated and priced into these fair value measures. We describe our use of assumptions and management judgment and our valuation techniques and processes for determining fair value in more detail in “Supplemental Non-GAAP information—Fair Value Balance Sheets,” “Critical Accounting Policies and Estimates—Fair Value of Financial Instruments” and “Notes to Condensed Consolidated Financial Statements—Note 18, Fair Value of Financial Instruments.”

 

Neither our GAAP combined loss reserves nor our estimate of the fair value of our guaranty obligations, which we disclose in our consolidated non-GAAP fair value balance sheet, reflects our estimate of the future credit losses inherent in our existing guaranty book of business. Rather, our combined loss reserves reflect only probable losses that we believe we have already incurred as of the balance sheet date, while the fair value of our guaranty obligation is based not only on future expected credit losses over the life of the loans underlying our guarantees as of March 31, 2009, but also on the estimated profit that a market participant would require to assume that guaranty obligation. Because of the severe deterioration in the mortgage and credit markets, there is significant uncertainty regarding the full extent of future credit losses in the mortgage industry as a whole, as well as to any participant in the industry. Therefore, we are not currently providing guidance or other estimates of the credit losses that we will experience in the future.

 

Amendment to Senior Preferred Stock Purchase Agreement

 

Treasury and FHFA, acting on our behalf in its capacity as our conservator, entered into an amendment to the senior preferred stock purchase agreement between us and Treasury on May 6, 2009. Unless the context indicates otherwise, references in this report to the senior preferred stock purchase agreement refer to the agreement as amended on May 6, 2009. The May 6, 2009 amendment revised the terms of the senior preferred stock purchase agreement in the following ways:

 

 

 

 

Liquidity

 

We fund our purchases of mortgage loans primarily from the proceeds from sales of our debt securities. In September 2008, Treasury made available to us two additional sources of funds: the Treasury credit facility and the senior preferred stock purchase agreement.

 

The dynamics of our funding program have improved significantly since late November 2008, including demand for our long-term and callable debt. As a result of our improved access to the long-term debt markets, we have decreased the portion of our total outstanding debt represented by short-term debt to 32% as of March 31, 2009 from 38% as of December 31, 2008, and the aggregate weighted-average maturity of our debt increased to 45 months as of March 31, 2009 from 42 months as of December 31, 2008.

 

We believe the improvement in our debt funding is due to actions taken by the federal government to support us and our debt securities, including the senior preferred stock purchase agreement entered into in September 2008, Treasury’s program announced in September 2008 to purchase MBS of the GSEs, the Treasury credit facility made available to us in September 2008 and the Federal Reserve’s program announced in November 2008 to purchase up to $100 billion in debt securities of Fannie Mae, Freddie Mac and the FHLBs and up to $500 billion in mortgage-backed securities of Fannie Mae, Freddie Mac and Ginnie Mae. On February 18, 2009, Treasury announced that it will continue to purchase Fannie Mae and Freddie Mac mortgage-backed securities to promote stability and liquidity in the marketplace. On March 18, 2009, the Federal Reserve announced that it intended to increase purchases of debt securities of Fannie Mae, Freddie Mac and the FHLBs and of Fannie Mae, Freddie Mac and Ginnie Mae mortgage-backed securities under its program to a total of up to $200 billion and $1.25 trillion, respectively.

 

There can be no assurance that the improvements in our access to the unsecured debt markets and in our ability to issue long-term and callable debt will continue. We believe the improvements stem from federal government support, such as the support described above, and, as a result, changes or perceived changes in the government’s support of us may have a material adverse affect on our ability to fund our operations. In particular, to the extent the market for our debt securities has improved due to the availability to us of the Treasury credit facility, we believe that the actual and perceived risk that we will be unable to refinance our debt as it becomes due is likely to increase substantially as we progress toward December 31, 2009, which is the date on which the Treasury credit facility terminates. Accordingly, we continue to have significant roll-over risk notwithstanding improved access to long-term funding, and this risk is likely to increase as we approach expiration of the Treasury credit facility. See “Liquidity and Capital Management—Liquidity

Management—Debt Funding” for more information on our debt funding activities and “Part II—Item 1A—Risk Factors” of this report and “Part I—Item 1A—Risk Factors” of our 2008 Form 10-K for a discussion of the risks to our business posed by our reliance on the issuance of debt to fund our operations.

 

Outlook

 

We anticipate that adverse market dynamics and certain of our activities undertaken to stabilize and support the housing and mortgage markets will negatively affect our financial condition and performance through the remainder of 2009.

 

Overall Market Conditions.   We expect the current financial market crisis to continue through 2009. We expect further home price declines and rising default and severity rates, all of which may worsen if unemployment rates continue to increase and if the U.S. continues to experience a broad-based recession. We continue to expect the level of foreclosures and single-family delinquency rates to increase further in 2009, as well as the level of multifamily defaults and loss severities. We expect growth in residential mortgage debt outstanding to be flat in 2009.

 

Home Price Declines:   Following a decline of approximately 10% in 2008, we expect that home prices will decline another 7% to 12% on a national basis in 2009. We also continue to expect that we will experience a peak-to-trough home price decline of 20% to 30%. These estimates are based on our home price index, which is calculated differently from the S&P/Case-Schiller index and therefore results in lower percentages for comparable declines. These estimates also contain significant inherent uncertainty in the current market environment, due to historically unprecedented levels of uncertainty 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 national economic recovery; the impact of those actions on home prices, unemployment and the general economic environment; and the rate of unemployment and/or wage decline. 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 decline percentages.

 

Our estimate of a 7% to 12% home price decline for 2009 compares with a home price decline of approximately 12% to 18% using the S&P/Case-Schiller index method, and our 20% to 30% peak-to- trough home price decline estimate compares with an approximately 33% to 46% peak-to-trough decline using the S&P/Case-Schiller index method. Our estimates differ from the S&P/Case-Schiller index in two principal ways: (1) our estimates weight expectations for each individual property by number of properties, whereas the S&P/Case-Schiller index weights expectations of home price declines based on property value, causing declines in home prices on higher priced homes to have a greater effect on the overall result; and (2) our estimates do not include 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, whereas the S&P/Case-Schiller index includes sales of foreclosed homes. The S&P/Case-Schiller comparison numbers shown above 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-Schiller 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-Schiller index provided above are not modified to account for this data pool difference.

 

Credit Losses and Credit-Related Expenses.   We continue to expect our credit losses and our credit loss ratio (each of which excludes fair value losses under SOP 03-3 and our HomeSaver Advance product) in 2009 will exceed our credit losses and our credit loss ratio in 2008. We also expect a significant increase in our SOP 03-3 fair value losses as we increase the number of loans we repurchase from MBS trusts in order to modify them. In addition, if our book of business continues to be adversely affected by market and economic conditions or other factors, we expect our credit-related expenses to be higher in 2009 than they were in 2008, although we believe that our credit-related expenses for the first quarter of 2009 are not necessarily indicative of the expenses we will incur in subsequent quarters during 2009. Because of the current state of the market

and a focus on keeping people in their homes and supporting liquidity and stability in the mortgage market, we are no longer providing guidance on expected changes in our combined loss reserves during 2009.

 

Expected Lack of Profitability for Foreseeable Future.   We expect to continue to have losses as our guaranty book of business continues to deteriorate and as we continue to incur ongoing costs in our efforts to keep people in homes and provide liquidity to the mortgage market. We expect that we will not operate profitably for the foreseeable future.

 

Uncertainty Regarding our Future Status and Long-Term Financial Sustainability:   We expect that we will experience adverse financial effects because of our strategy of concentrating our efforts on keeping people in their homes and preventing foreclosures, including our efforts under the Making Home Affordable Program, while remaining active in the secondary mortgage market. In addition, future activities that our regulators, other U.S. government agencies or Congress may request or require us to take to support the mortgage market and help borrowers may contribute to further deterioration in our results of operations and financial condition. Although Treasury’s additional funds under the senior preferred stock purchase agreement permit us to remain solvent and avoid receivership, the resulting dividend payments are substantial and will increase as we request additional funds from Treasury under the senior preferred stock purchase agreement. As a result of these factors, along with current and expected market and economic conditions and the deterioration in our single-family and multifamily books of business, there is significant uncertainty as to our long-term financial sustainability. We expect that for the foreseeable future the earnings of the company, if any, will not be sufficient to pay the dividends on the senior preferred stock. As a result, future dividend payments will be paid from equity drawn from the Treasury. Further, the conservatorship that we are under has no specified termination date, and the future structure of our business during and following termination of the conservatorship is uncertain.

 

Proposed 2009 Housing Goals

 

As described in our 2008 Form 10-K, the Regulatory Reform Act provides that the housing goals previously established by the Department of Housing and Urban Development for 2008 remain in effect for 2009; however, the Regulatory Reform Act also includes a requirement that the Director of FHFA review these goals to determine their feasibility for 2009 in light of current market conditions and, after seeking public comment, make appropriate adjustments to the goals consistent with these market conditions.

 

In April 2009, FHFA issued a proposed rule lowering our 2009 housing goals from the 2008 levels. FHFA determined that, in light of current market conditions, the previously established 2009 housing goals were not feasible unless adjusted. FHFA’s proposed adjustments would reduce our 2009 housing goals approximately to the levels that prevailed in 2004 through 2006. FHFA’s proposed rule would also permit loan modifications that we make in accordance with HASP to be treated as mortgage purchases and count towards the housing goals. In addition, the proposed rule would exclude from counting towards the 2009 housing goals any purchases of loans on one-to four-unit properties with a maximum original principal balance higher than the nationwide conforming loan limit (currently set at $417,000). The adverse market conditions that FHFA took into consideration in its determination that the existing 2009 goals were not feasible included tighter underwriting practices, the sharply increased standards of private mortgage insurers, the increased role of the FHA in the marketplace, the collapse of the private-label mortgage-related securities market, increasing unemployment, multifamily market volatility and the prospect of a refinancing surge in 2009. These conditions contribute to fewer goals-qualifying mortgages available for purchase by us. FHFA’s proposed rule notes that, even with these reductions, the proposed 2009 goals are generally at the upper end of FHFA’s market estimates for 2009.

The following table sets forth FHFA’s proposed 2009 housing goals and subgoals, and for comparative purposes our 2008 housing goals and subgoals, and our performance against those goals and subgoals. The 2008 performance results have not yet been validated by FHFA.

 

 

 

 

Determination by FHFA Regarding 2008 Housing Goals Compliance

 

As described above and in our 2008 Form 10-K, we believe that we did not meet our two income-based housing goals (the low- and moderate-income housing goal and the special affordable housing goal) or any of our three home purchase subgoals for 2008. In March 2009, FHFA notified us of its determination that achievement of these housing goals and subgoals was not feasible due to housing and economic conditions and our financial condition in 2008. As a result, we will not be required to submit a housing plan for failure to meet these goals and subgoals pursuant to the Federal Housing Enterprises Safety and Soundness Act of 1992.

 

For additional background information on our housing goals and subgoals, refer to “Part I—Item 1—Business—Conservatorship, Treasury Agreements, Our Charter and Regulation of Our Activities—Regulation and Oversight of Our Activities—Housing Goals and Subgoals” of our 2008 Form 10-K.

 

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 “Notes to Consolidated Financial Statements—Note 2, Summary of Significant Accounting Policies” of our 2008 Form 10-K and in “Notes to Condensed Consolidated Financial Statements—Note 2, Summary of Significant Accounting Policies” of this report.

 

We have identified four of our accounting policies as critical because they involve significant judgments and assumptions about highly complex and inherently uncertain matters and the use of reasonably different

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

 

 

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. We describe below significant changes in the judgments and assumptions we made during the first quarter of 2009 in applying our critical accounting policies and estimates. Management has discussed any changes in judgments and assumptions in applying our critical accounting policies with the Audit Committee of the Board of Directors. See “Part II—Item 7—MD&A—Critical Accounting Policies and Estimates” of our 2008 Form 10-K for additional information about our critical accounting policies and estimates.

 

Fair Value of Financial Instruments

 

The use of fair value to measure our financial instruments is fundamental to our financial statements and is a critical accounting estimate because we account for and record a substantial portion of our assets and liabilities at fair value. SFAS No. 157, Fair Value Measurements (“SFAS 157”), defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (also referred to as an exit price). SFAS 157 establishes a three-level fair value hierarchy for classifying financial instruments that is based on whether the inputs to the valuation techniques used to measure fair value are observable or unobservable. Each asset or liability is assigned to a level based on the lowest level of any input that is significant to the fair value measurement. The three levels of the SFAS 157 fair value hierarchy are described below:

 

Level 1:  Quoted prices (unadjusted) in active markets for identical assets or liabilities.

 

 

Level 3:  Unobservable inputs.

 

In determining fair value, we use various valuation techniques. We disclose the carrying value and fair value of our financial assets and liabilities and describe the specific valuation techniques used to determine the fair value of these financial instruments in “Notes to Condensed Consolidated Financial Statements—Note 18, Fair Value of Financial Instruments.” The majority of our financial instruments carried at fair value fall within the level 2 category and are valued primarily utilizing inputs and assumptions that are observable in the marketplace, that can be derived from observable market data or that can be corroborated by recent trading activity of similar instruments with similar characteristics. For example, we generally request non-binding prices from at least four independent pricing services to estimate the fair value of our trading and available-for-sale investment securities at an individual security level. We use the average of these prices to determine the fair value. In the absence of such information or if we are not able to corroborate these prices by other available, relevant market information, we estimate their fair values based on single source quotations from brokers or dealers or by using internal calculations or discounted cash flow techniques that incorporate inputs, such as prepayment rates, discount rates and delinquency, default and cumulative loss expectations, that are implied by market prices for similar securities and collateral structure types. Because items classified as level 3 are valued using significant unobservable inputs, the process for determining the fair value of these items is generally more subjective and involves a high degree of management judgment and assumptions. These assumptions may have a significant effect on our estimates of fair value, and the use of different assumptions as well as changes in market conditions could have a material effect on our results of operations or financial condition.

 

In April 2009, the Financial Accounting Standards Board (“FASB”) issued two FASB Staff Positions (“FSPs”) to clarify the guidance on fair value measurement and to amend the recognition, measurement and presentation requirements of other-than-temporary impairments for debt securities. These FSPs consist of:

(1) FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly and (2) FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments . These FSPs are effective for interim and annual periods ending after June 15, 2009 with early adoption permitted. See “Notes to Condensed Consolidated Financial Statements—Note 2, Summary of Significant Accounting Policies” for additional information, including the expected impact of these recently issued pronouncements on our condensed consolidated financial statements.

 

Fair Value Hierarchy—Level 3 Assets and Liabilities

 

Our level 3 assets and liabilities consist primarily of financial instruments for which the fair value is estimated using valuation techniques that involve significant unobservable inputs because there is limited market activity and therefore little or no price transparency. We generally consider a market to be inactive if the following conditions exist: (1) there are few transactions for the financial instruments; (2) the prices in the market are not current; (3) the price quotes we receive vary significantly either over time or among independent pricing services or dealers; and (4) there is a limited availability of public market information.

 

Our level 3 financial instruments include certain mortgage- and asset-backed securities and residual interests, certain performing residential mortgage loans, nonperforming mortgage-related assets, our guaranty assets and buy-ups, our master servicing assets and certain highly structured, complex derivative instruments. We use the term “buy-ups” to refer to upfront payments that we make to lenders to adjust the monthly contractual guaranty fee rate so that the pass-through coupon rates on Fannie Mae MBS are in more easily tradable increments of a whole or half percent.

 

The following discussion identifies the types of financial assets and liabilities within each balance sheet category that are based on level 3 inputs and the valuation techniques we use to determine their fair values, including key inputs and assumptions.

 

 

Fair value measurements related to financial instruments that are reported at fair value in our condensed consolidated financial statements each period, such as our trading and available-for-sale securities and derivatives, are referred to as recurring fair value measurements. Fair value measurements related to financial instruments that are not reported at fair value each period, such as held-for-sale mortgage loans, are referred to as non-recurring fair value measurements.

 

Table 3 presents a comparison, by balance sheet category, of the amount of financial assets carried in our consolidated balance sheets at fair value on a recurring basis and classified as level 3 as of March 31, 2009 and December 31, 2008. 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.

 

previous years. This decreased demand has reduced the value of these investments. We determine the fair value of our LIHTC investments using internal models that estimate the present value of the expected future tax benefits (tax credits and tax deductions for net operating losses) expected to be generated from the properties underlying these investments. Our estimates are based on assumptions that other market participants would use in valuing these investments. The key assumptions used in our models, which require significant management judgment, include discount rates and projections related to the amount and timing of tax benefits. We compare the model results to the limited number of observed market transactions and make adjustments to reflect differences between the risk profile of the observed market transactions and our LITHC investments.

 

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 $867 million and $2.9 billion as of March 31, 2009 and December 31, 2008, respectively, and derivatives liabilities with a fair value of $23 million and $52 million as of March 31, 2009 and December 31, 2008, respectively.

 

Fair Value Control Processes

 

We have control processes that are designed to ensure that our fair value measurements are appropriate and reliable, that they are based on observable inputs wherever possible and that our valuation approaches are consistently applied and the assumptions used are reasonable. Our control processes consist of a framework that provides for a segregation of duties and oversight of our fair value methodologies and valuations and validation procedures.

 

Our Valuation Oversight Committee, which includes senior representation from business areas, our Enterprise Risk Office and our Finance Division, is responsible for reviewing and approving the valuation methodologies and pricing models used in our fair value measurements and any significant valuation adjustments, judgments, controls and results. Actual valuations are performed by personnel independent of our business units. Our Price Verification Group, which is an independent control group separate from the group that is responsible for obtaining the prices, also is responsible for performing monthly independent price verification. The Price Verification Group also performs independent reviews of the assumptions used in determining the fair value of products we hold that have material estimation risk because observable market-based inputs do not exist.

 

Our validation procedures are intended to ensure that the individual prices we receive are consistent with our observations of the marketplace and prices that are provided to us by pricing services or other dealers. We verify selected prices using a variety of methods, including comparing the prices to secondary pricing services, corroborating the prices by reference to other independent market data, such as non-binding broker or dealer quotations, relevant benchmark indices, and prices of similar instruments, checking prices for reasonableness based on variations from prices provided in previous periods, comparing prices to internally calculated expected prices and conducting relative value comparisons based on specific characteristics of securities. In addition, we compare our derivatives valuations to counterparty valuations as part of the collateral exchange process. We have formal discussions with the pricing services as part of our due diligence process in order to maintain a current understanding of the models and related assumptions and inputs that these vendors use in developing prices. The prices provided to us by independent pricing services reflect the existence of credit enhancements, including monoline insurance coverage, and the current lack of liquidity in the marketplace. If we determine that a price provided to us is outside established parameters, we will further examine the price, including having follow-up discussions with the specific pricing service or dealer. If we conclude that a price is not valid, we will adjust the price for various factors, such as liquidity, bid-ask spreads and credit considerations. These adjustments are generally based on available market evidence. In the absence of such evidence, management’s best estimate is used. All of these processes are executed before we use the prices in the financial statement process.

 

We continually refine our valuation methodologies as markets and products develop and the pricing for certain products becomes more or less transparent. While we believe our valuation methods are appropriate and consistent with those of other market participants, using different methodologies or assumptions to determine fair value could result in a materially different estimate of the fair value of some of our financial instruments.

Allowance for Loan Losses and Reserve for Guaranty Losses

 

We maintain an allowance for loan losses for loans in our mortgage portfolio classified as held-for-investment. We maintain a reserve for guaranty losses for loans that back Fannie Mae MBS 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 the consolidated balance sheets. These amounts, which we collectively refer to as our combined loss reserves, represent our best estimate of credit losses incurred in our guaranty book of business as of the balance sheet date.

 

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. It is our practice to continually monitor delinquency and default trends and make changes in our historically developed assumptions and estimates as necessary to better reflect the impact of 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.

 

Because of the current stress in the housing and credit markets, and the speed and extent to which these markets have deteriorated, our process for determining our loss reserves has become more complex and involves a greater degree of management judgment. As a result of the continued decline in home prices, more limited opportunities for refinancing due to the tightening of the credit markets and the sharp rise in unemployment, mortgage delinquencies have reached record levels. Our historical loan performance data indicates a pattern of default rates and credit losses that typically occur over time, which are strongly dependent on the age of a mortgage loan. However, we have witnessed significant changes in traditional loan performance and delinquency patterns, including an increase in early-stage delinquencies for certain loan categories and faster transitions to later stage delinquencies. We believe that recently announced government policies and our initiatives under these policies have partly contributed to these newly observed delinquency patterns. For example, our level of foreclosures and associated charge-offs were lower in the first quarter of 2009 than they otherwise would have been due to foreclosure delays resulting from our foreclosure suspension, our requirement that loan modification options be pursued with the borrower before proceeding to a foreclosure sale, and state-driven changes in foreclosure rules to slow and extend the foreclosure process. As a result, we determined that it was necessary to refine our loss reserve estimation process to reflect these newly observed delinquency patterns, as we describe in more detail below.

 

We historically have relied on internally developed default loss curves derived from observed default trends in our single-family guaranty book of business to determine our single-family loss reserve. These loss curves are shaped by the normal pattern of defaults, based on the age of the book, and informed by historical default trends and the performance of the loans in our book to date. We develop the loss curves by aggregating homogeneous loans into pools based on common underlying risk characteristics, such as origination year and seasoning, original LTV ratio and loan product type, to derive an overall estimate. We use these loss curve models to estimate, based on current events and conditions, the number of loans that will default (“default rate”) and how much of a loan’s balance will be lost in the event of default (“loss severity”). For the majority of our loan risk categories, our default rate estimates have traditionally been based on loss curves developed from available historical loan performance data dating back to 1980. However, we have recently used a shorter, more near-term default loss curve based on a one quarter “look-back” period to generate estimated default rates for loans originated in 2006 and 2007 and for Alt-A loans originated in 2005. More recently, we also have relied on a one-quarter look back period to develop loss severity estimates for all of our loan categories.

 

We experienced a substantial reduction in foreclosures and charge-offs during the periods November 26, 2008 through January 31, 2008 and February 17, 2009 through March 6, 2009 when our foreclosure suspension was in effect and a surge in foreclosures during the two-week period of February 1, 2009 through February 16, 2009. Since February 16, 2009, we have continued to observe a reduced level of foreclosures as our servicers, in keeping with our guidelines, evaluate borrowers for newly introduced workout options before proceeding to a foreclosure. Because of the distortion in defaults caused by these temporary events, we adjusted our loss curves to incorporate default estimates derived from an assessment of our most recently observed loan

delinquencies and the related transition of loans through the various delinquency categories. We used this delinquency assessment and our most recent default information prior to the foreclosure suspension to estimate the number of defaults that we would have expected to occur during the first quarter of 2009 if the foreclosure moratorium had not been in effect. We then used these estimated defaults, rather than the actual number of defaults that occurred during the first quarter of 2009, to estimate our loss curves and derive the default rates used in determining our loss reserves. Consistent with our approach during the fourth quarter of 2008, we also made management adjustments to our model-generated results to capture incremental losses that may not be fully reflected in our models related to geographically concentrated areas that are experiencing severe stress as a result of significant home price declines and the sharp rise in unemployment rates.

 

We also made several enhancements to the models used in determining our multifamily loss reserves to reflect the impact of the deterioration in the credit performance of loans in our multifamily guaranty book of business resulting from current market conditions, including the severe economic downturn and lack of liquidity in the multifamily mortgage market. Our model enhancements involved weighting more heavily our recent loan performance experience to derive the key parameters used in calculating our expected default rates. We expect increased multifamily defaults and loss severities in 2009.

 

Our combined loss reserves increased by $17.0 billion during the first quarter of 2009 to $41.7 billion as of March 31, 2009, reflecting further deterioration in both our single-family and multifamily guaranty book of business, as evidenced by the significant increase in delinquent, seriously delinquent and nonperforming loans, as well as an increase in our average loss severities as a result of the continued decline in home prices during the first quarter of 2009. The incremental management adjustment to our loss reserves for geographic and unemployment stresses accounted for approximately $5.6 billion of our combined loss reserves of $41.7 billion as of March 31, 2009, compared with approximately $2.3 billion of our combined loss reserves of $24.8 billion as of December 31, 2008.

 

We provide additional information on our combined loss reserves and the impact of adjustments to our loss reserves on our condensed consolidated financial statements in “Consolidated Results of Operations—Credit-Related Expenses” and “Notes to Condensed Consolidated Financial Statements—Note 5, Allowance for Loan Losses and Reserve for Guaranty Losses.”

 

Our business generates revenues from three principal sources: net interest income; guaranty fee income; and fee and other income. Other significant factors affecting our results of operations include: fair value gains and losses; the timing and size of investment gains and losses; credit-related expenses; losses from partnership investments; administrative expenses and our effective tax rate. We expect high levels of period-to-period volatility in our results of operations and financial condition, principally due to changes in market conditions that result in periodic fluctuations in the estimated fair value of financial instruments that we mark-to-market through our earnings. These instruments include trading securities and derivatives. The estimated fair value of our trading securities and derivatives may fluctuate substantially from period to period because of changes in interest rates, credit spreads and expected interest rate volatility, as well as activity related to these financial instruments.

 

Table 4 presents a condensed summary of our consolidated results of operations for the three months ended March 31, 2009 and 2008 and selected performance metrics that we believe are useful in evaluating changes in our results between periods.

 

 

 

 

The section below provides a comparative discussion of our condensed consolidated results of operations for the three months ended March 31, 2009 and 2008. Following this section, we provide a discussion of our business segment results. You should read this section together with our “Executive Summary” where we discuss trends and other factors that we expect will affect our future results of operations.

 

Net Interest Income

 

Net interest income represents the difference between interest income and interest expense and is a primary source of our revenue. Our net interest yield represents the difference between the yield on our interest-earning assets and the cost of our debt. We supplement our issuance of debt with interest rate-related derivatives to manage the prepayment and duration risk inherent in our mortgage investments. The effect of these derivatives, in particular the periodic net interest expense accruals on interest rate swaps, is not reflected in net interest income. See “Fair Value Gains (Losses), Net” for additional information.

We expect net interest income and our net interest yield to fluctuate based on changes in interest rates and changes in the amount and composition of our interest-earning assets and interest-bearing liabilities. Table 5 presents an analysis of our net interest income and net interest yield for the first quarters of 2009 and 2008.

 

 

 

 

Net interest income of $3.2 billion for the first quarter of 2009 reflected an increase of 92% over net interest income of $1.7 billion for the first quarter of 2008, driven by a 77% (63 basis point) expansion of our net interest yield to 1.45% and a 7% increase in our average interest-earning assets.

 

Table 6 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.

 

 

 

 

The 63 basis point increase in our net interest yield during the first quarter of 2009 was attributable to a 134 basis point reduction in the average cost of our debt to 3.25%, which more than offset the 59 basis point decline in the average yield on our interest-earning assets to 4.66%. The reduction in our borrowing costs was attributable to a decline in short-term borrowing rates and a shift in our funding mix to more short-term debt because of the reduced demand for our longer-term and callable debt securities during the second half of 2008. In addition, our net interest yield for the first quarter of 2008 reflected a benefit from the redemption of step-rate debt securities, which reduced the average cost of our debt. Because we paid off these securities prior to maturity, we reversed a portion of the interest expense that we had previously accrued.

 

Although we consider the periodic net contractual interest accruals on our interest rate swaps to be part of the cost of funding our mortgage investments, these amounts are not reflected in our net interest income and net interest yield. Instead, these amounts are included in our derivatives gains (losses) and reflected in our consolidated statements of operations as a component of “Fair value losses, net.” As shown in Table 10 below, we recorded net contractual interest expense on our interest rate swaps totaling $940 million and $26 million for the first quarter of 2009 and 2008, respectively. The economic effect of the interest accruals on our interest rate swaps increased our funding costs by approximately 42 basis points for the first quarter of 2009 and approximately 1 basis point for the first quarter of 2008.

 

The 7% increase in our average interest-earning assets was attributable to an increase in portfolio purchases during the second half of 2008, as mortgage-to-debt spreads reached historic highs, and a reduction in liquidations due to the disruption in the housing and credit markets. In the first quarter of 2009, we significantly reduced our purchases of agency MBS, largely due to the significant narrowing of spreads on agency MBS during the quarter in response to the Federal Reserve’s agency MBS purchase program, which was announced in November 2008 and expanded in March 2009 to include the purchase of up to $1.25 trillion of agency MBS by the end of 2009. The Federal Reserve currently is the primary purchaser of agency MBS.

 

Under the senior preferred stock purchase agreement, we are prohibited from issuing debt in amount greater than 120% of the amount of mortgage assets we are allowed to own. Through December 30, 2010, our debt cap equals $1,080 billion. Beginning December 31, 2010, and on December 31 of each year thereafter, our debt cap that will apply through December 31 of the following year will equal 120% of the amount of mortgage assets we are allowed to own on December 31 of the immediately preceding calendar year. We are permitted to increase our mortgage portfolio up to $900 billion through December 31, 2009. Beginning in

2010, we are required to reduce our mortgage portfolio by 10% per year, until the amount of our mortgage assets reaches $250 billion. Although the debt and mortgage portfolio caps did not have a significant impact on our portfolio activities during the first quarter of 2009, these limits may have significant adverse impact on our future portfolio activities and net interest income. For additional information on our portfolio investment and funding activity, see “Consolidated Balance Sheet Analysis—Mortgage Investments” and “Liquidity and Capital Management—Liquidity Management—Debt Funding.” For a description of the amended terms of the senior preferred stock purchase agreement, see “Executive Summary—Amendment to Senior Preferred Stock Purchase Agreement” and see “Part I—Item 1—Business—Conservatorship, Treasury Agreements, Our Charter and Regulation of Our Activities—Treasury Agreements” of our 2008 Form 10-K for a description the terms of the agreement prior to its May 2009 amendment, most of which continue to apply.

 

Guaranty Fee Income

 

Guaranty fee income primarily consists of contractual guaranty fees related to both Fannie Mae MBS held in our portfolio and held by third-party investors, adjusted for the amortization of upfront fees over the estimated life of the loans underlying the MBS and impairment of guaranty assets, net of a proportionate reduction in the related guaranty obligation and deferred profit, and impairment of buy-ups. The average effective guaranty fee rate reflects our average contractual guaranty fee rate adjusted for the impact of amortization of upfront fees and buy-up impairment.

 

Table 7 shows the components of our guaranty fee income, our average effective guaranty fee rate and Fannie Mae MBS activity for the first quarters of 2009 and 2008.

 

 

 

 

Our guaranty fee income in the first quarter of 2009 was at the same level as the first quarter of 2008. We experienced an 8% increase in average outstanding Fannie Mae MBS and other guarantees, which was offset by a 7% decrease in the average effective guaranty fee rate to 27.4 basis points from 29.5 basis points for the first quarter of 2008. We experienced an increase in our average outstanding Fannie Mae MBS and other guarantees as our MBS issuances exceeded liquidations throughout 2008 and in early 2009. Our market share

of MBS issuances remained strong during 2008 and into 2009, reflecting the continuing shift in the composition of originations in the primary mortgage market to agency-conforming loans.

 

The decrease in our average effective guaranty fee rate for the first quarter of 2009 was attributable to the guaranty fee pricing changes we implemented during 2008 to address the current risks in the housing market. As result of these pricing changes, coupled with changes in our underwriting standards, we reduced or eliminated our acquisitions of higher risk, higher fee product categories, such as Alt-A, subprime, high LTV and low FICO score loans. As a result, we experienced a shift in the composition of our new business and overall guaranty book of business to a greater proportion of higher-quality, lower risk and lower guaranty fee mortgages. The average charged guaranty fee on our new single-family business for the first quarter of 2009 was 21.0 basis points, compared with 25.7 basis points for the first quarter of 2008. The average charged fee represents the average contractual fee rate for our single-family guaranty arrangements plus the recognition of any upfront cash payments ratably over an estimated average life. Beginning in 2009, we extended the estimated average life used in calculating the recognition of upfront cash payments for the purpose of determining our single-family new business average charged guaranty fee to reflect a longer expected duration because of the record low interest rate environment. This change did not have a material impact on the average charged guaranty fee on our new single-family business in the first quarter of 2009.

 

Our guaranty fee income includes an estimated $192 million and $297 million for the first quarter of 2009 and 2008, respectively, related to the accretion of deferred amounts on guaranty contracts where we recognized losses at the inception of the contract.

 

Trust Management Income

 

Trust management income consists of the fees we earn as master servicer, issuer and trustee for Fannie Mae MBS. We derive these fees from the interest earned on cash flows between the date of remittance of mortgage and other payments to us by servicers and the date of distribution of these payments to MBS certificateholders, which we refer to as float income. Trust management income decreased to $11 million for the first quarter of 2009, from $107 million for the first quarter of 2008. This decrease was attributable to the significant decline in short-term interest rates.

 

Fee and Other Income

 

Fee and other income consists of transaction fees, technology fees and multifamily fees. These fees are largely driven by our business volume. Fee and other income decreased to $181 million for the first quarter of 2009, from $227 million for the first quarter of 2008. The decrease was primarily attributable to lower multifamily fees due to slower multifamily loan prepayments during the first quarter of 2009 relative to the first quarter of 2008.

 

Investment Gains (Losses), Net

 

Investment gains and losses, net includes other-than-temporary impairment on available-for-sale securities; lower of cost or fair value adjustments on held-for-sale loans; gains and losses recognized on the securitization of loans or securities from our portfolio and from the sale of available-for-sale securities; and other investment losses. Investment gains and losses may fluctuate significantly from period to period depending upon our portfolio investment and securitization activities and changes in market and credit conditions that may result in other-than-temporary impairment. Table 8 details the components of investment gains and losses for the first quarters of 2009 and 2008.

 

 

 

 

The $5.3 billion increase in investment losses for the first quarter of 2009 over the first quarter of 2008 was primarily attributable to an increase in other-than-temporary impairment on available-for- sale securities. The other-than-temporary impairment of $5.7 billion that we recognized in the first quarter of 2009 included additional impairment losses on some of our Alt-A and subprime private-label 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. See “Consolidated Balance Sheet Analysis—Trading and Available-for-Sale Investment Securities— Investments in Private-Label Mortgage-Related Securities” for additional information on the other-than-temporary impairment recognized on our investments in Alt-A and subprime private-label mortgage-related securities. See “Part II—Item 1A—Risk Factors” for a discussion of the risks associated with possible future write-downs of our investment securities.

 

Fair Value Gains (Losses), Net

 

Fair value gains and losses, net consists of (1) derivatives fair value gains and losses; (2) trading securities gains and losses; (3) foreign exchange gains and losses on our foreign-denominated debt; and (4) fair value gains and losses on certain debt securities carried at fair value. By presenting these items together in our consolidated results of operations, we are able to show the net impact of mark-to-market adjustments that generally result in offsetting gains and losses attributable to changes in interest rates.

 

We generally have expected that gains and losses on our agency MBS and commercial mortgage-backed securities backed by multifamily mortgage loans (“CMBS”) classified as trading securities, to the extent they are attributable to changes in interest rates, would offset a portion of the losses and gains on our derivatives because changes in the fair value of our trading securities typically moved inversely to changes in the fair value of our derivatives.

 

We seek to eliminate our exposure to fluctuations in foreign exchange rates by entering into foreign currency swaps that effectively convert debt denominated in a foreign currency to debt denominated in U.S. dollars. The foreign currency exchange gains and losses on our foreign-denominated debt are offset in part by corresponding losses and gains on foreign currency swaps.

 

Table 9 summarizes the components of fair value gains (losses), net for the first quarter of 2009 and 2008. The decrease in fair value losses in the first quarter of 2009 from the first quarter of 2008 was largely due to a decline in losses on our derivatives and net gains on our trading securities.

 

 

Derivatives Fair Value Gains (Losses), Net

 

Derivative instruments are an integral part of our management of interest rate risk. We supplement our issuance of debt with derivative instruments to further reduce duration and prepayment risks. Table 10 presents, by type of derivative instrument, the fair value gains and losses on our derivatives for the first quarters of 2009 and 2008. Table 10 also includes an analysis of the components of derivatives fair value gains and losses attributable to net contractual interest accruals on our interest rate swaps, the net change in the fair value of terminated derivative contracts through the date of termination and the net change in the fair value of outstanding derivative contracts. The 5-year swap interest rate, which is shown below in Table 10, is a key reference interest rate that affects the fair value of our derivatives.

 

 

 

 

 

The derivatives fair value losses of $1.7 billion for the first quarter of 2009 were primarily attributable to fair value losses on our option-based derivatives due to the combined effect of a decrease in implied volatility and the time decay of these options.

 

The derivatives fair value losses of $3.0 billion for the first quarter of 2008 were driven by a decline in interest rates during the quarter. The 5-year swap interest rate fell by 88 basis points to 3.31% as of March 31, 2008, resulting in fair value losses on our pay-fixed swaps that exceeded the fair value gains on our receive-fixed swaps. We experienced partially offsetting fair value gains on our option-based derivatives due to an increase in implied volatility that more than offset the combined effect of the time decay of these options and the decrease in swap interest rates during the first quarter of 2008.

 

For additional information on our interest rate risk management strategy and our use of derivatives in managing our interest rate risk, see “Part II—Item 7—MD&A—Risk Management—Interest Rate Risk Management and Other Market Risks—Interest Rate Risk Management Strategies” of our 2008 Form 10-K. Also see “Consolidated Balance Sheet Analysis—Derivative Instruments” for a discussion of the effect of derivatives on our condensed consolidated balance sheets.

 

Trading Securities Gains (Losses), Net

 

We recorded net gains on trading securities of $167 million for the first quarter of 2009, compared with net losses of $1.2 billion for the first quarter of 2008. The gains on our trading securities during the first quarter of 2009 were attributable to the significant decline in mortgage interest rates and the narrowing of spreads on agency MBS during the quarter. These gains were partially offset by a continued decrease in the fair value of the private-label mortgage-related securities backed by Alt-A and subprime loans that we hold. The losses on our trading securities during the first quarter of 2008 were attributable to a significant widening of credit spreads during the quarter, particularly related to private-label mortgage-related securities backed by Alt-A and subprime loans and CMBS.

 

We provide additional information on our trading and available-for-sale securities in “Consolidated Balance Sheet Analysis—Trading and Available-for-Sale Investment Securities” and disclose the sensitivity of changes in the fair value of our trading securities to changes in interest rates in “Risk Management—Interest Rate Risk Management and Other Market Risks—Interest Rate Risk Metrics.”

 

Losses from Partnership Investments

 

Our partnership investments, which primarily include investments in LIHTC partnerships as well as investments in other affordable rental and for-sale housing partnerships, totaled approximately $8.9 billion as of March 31, 2009, compared with $9.3 billion as of December 31, 2008. Losses from partnership investments increased to $357 million for the first quarter of 2009, from $141 million for the first quarter of 2008. The increase in losses was largely due to the recognition of additional other-than-temporary impairment of $147 million in the first quarter of 2009 on a portion of our LIHTC and other affordable housing investments, reflecting the decline in value of these investments as result of the severe economic downturn. In addition, our

partnership losses for the first quarter of 2008 were partially reduced by a gain on the sale of some of our LIHTC investments. We did not have any sales of LIHTC investments during the first quarter of 2009.

 

Administrative Expenses

 

Administrative expenses include ongoing operating costs, such as salaries and employee benefits, professional services, occupancy costs and technology expenses. Administrative expenses increased to $523 million for the first quarter of 2009, from $512 million for the first quarter of 2008. We took steps in the fourth quarter of 2008 and the first quarter of 2009 to realign our organization, personnel and resources to focus on our most critical priorities, which include providing liquidity to the mortgage market and preventing foreclosures. As part of this realignment, we reduced staffing levels in some areas of the company during the first quarter of 2009. This reduction in staff, however, was partially offset by an increase in employee and contractor staffing levels in other areas, particularly those divisions of the company that focus on our foreclosure-prevention efforts.

 

Credit-Related Expenses

 

Credit-related expenses included in our consolidated statements of operations consist of the provision for credit losses and foreclosed property expense. We detail the components of our credit-related expenses below in Table 11. The substantial increase in our credit-related expenses in the first quarter of 2009 from the first quarter of 2008 was largely due to the significant increase in our provision for credit losses, reflecting the deteriorating credit performance of the loans in our guaranty book of business given the current economic environment, including continued weakness in the housing market and rising unemployment.

 

 

 

 

Provision for Credit Losses Attributable to Guaranty Book of Business

 

Our allowance for loan losses and reserve for guaranty losses, which we collectively refer to as our combined loss reserves, provide for probable credit losses inherent in our guaranty book of business as of each balance sheet date. We build our loss reserves through the provision for credit losses for losses that we believe have been incurred and will eventually be reflected over time in our charge-offs. When we determine that a loan is uncollectible, typically upon foreclosure, we record the charge-off against our loss reserves. We record recoveries of previously charged-off amounts as a credit to our loss reserves. Table 12, which summarizes changes in our loss reserves for the three months ended March 31, 2009 and 2008, details the provision for credit losses recognized in our condensed consolidated statements of operations each period and the charge-offs recorded against our combined loss reserves.

 

 

 

 

 

 

We have continued to build our combined loss reserves through provisions that have been well in excess of our charge-offs due to the general deterioration in the overall credit performance of loans in our guaranty book of business. This deterioration continues to be concentrated in certain states, certain higher risk loan categories and our 2006 and 2007 loan vintages. Our mortgage loans in the Midwest, which has experienced prolonged economic weakness, and California, Florida, Arizona and Nevada, which previously experienced rapid home price increases and continue to experience steep declines in home prices, have exhibited much higher delinquency rates and accounted for a disproportionate share of our foreclosures and charge-offs. Loans in our Alt-A book, particularly the 2006 and 2007 loan vintages, also have exhibited significantly higher delinquency rates and represented a disproportionate share of our foreclosures and charge-offs. We also are beginning to experience some deterioration in the credit performance of loans in our single-family guaranty book of business with lower risk characteristics, reflecting the adverse impact of the sharp rise in unemployment and the continued decline in home prices.

 

The provision for credit losses attributable to our guaranty book of business of $18.8 billion for the first quarter of 2009 exceeded net charge-offs of $1.9 billion and included an incremental build in our combined loss reserves of $16.9 billion for the quarter. In comparison, we recorded a provision for credit losses attributable to our guaranty book of business of $2.3 billion for the first quarter of 2008. Our increased provision levels were largely driven by a substantial increase in nonperforming single-family loans, higher delinquencies and an increase in the average loss severity, or initial charge-off per default. Our conventional single-family serious delinquency rate increased to 3.15% as of March 31, 2009, from 2.42% as of December 31, 2008 and 1.15% as of March 31, 2008. The average default rate and loss severity, excluding fair value losses related to SOP 03-3 and HomeSaver Advance loans, was 0.17% and 36%, respectively, for the first quarter of 2009, compared with 0.13% and 19%, respectively, for the first quarter of 2008.

 

As a result of our higher loss provisioning levels, we substantially increased our combined loss reserves in the first quarter of 2009, both in absolute terms and as a percentage of our total guaranty book of business, to $41.7 billion, or 1.38% of our total guaranty book of business, as of March 31, 2009, from $24.8 billion, or 0.83% of our total guaranty book of business, as of December 31, 2008. Our combined loss reserves as a percentage of our total nonperforming loans increased to 28.78% as of March 31, 2009, from 20.76% as of December 31, 2008.

 

We increased the portion of our combined loss reserves attributable to our multifamily guaranty book of business by $520 million during the first quarter of 2009, to $624 million, or 0.36% of our multifamily guaranty book of business, as of March 31, 2009, from $104 million, or 0.06% of our multifamily guaranty book of business, as of December 31, 2008. This increase reflects the stress on our multifamily guaranty book of business due to the severe economic downturn and lack of liquidity in the market, which has adversely affected multifamily property values, vacancy rates and rent levels, as well as the cash flows generated from these investments and refinancing options. These conditions have contributed to higher delinquency and default rates.

 

Provision for Credit Losses Attributable to SOP 03-3 and HomeSaver Advance Fair Value Losses

 

In our capacity as guarantor of our MBS trusts, we have the option under the trust agreements, to purchase specified mortgage loans from our MBS trusts. We generally are not permitted to complete a modification of a

loan while the loan is held in the MBS trust. As a result, we must exercise our option to purchase any delinquent loan that we intend to modify from an MBS trust prior to the time that the modification becomes effective. The proportion of delinquent loans purchased from MBS trusts for the purpose of modification varies from period to period, driven primarily by factors such as changes in our loss mitigation efforts, as well as changes in interest rates and other market factors. See “Part I—Item 1—Business—Business Segments—Single-Family Credit Guaranty Business—MBS Trusts” of our 2008 10-K for additional information on the provisions in our MBS trusts agreements that govern the purchase of loans from our MBS trusts and the factors that we consider in determining whether to purchase delinquent loans from our MBS trusts.

 

“SOP 03-3” refers to the accounting guidance issued by the American Institute of Certified Public Accountants Statement of Position No. 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer. This guidance is generally applicable to delinquent loans purchased from our MBS trusts and delinquent loans held in any MBS trust that we are required to consolidate, which we collectively refer to as “Acquired Loans from MBS Trusts Subject to SOP 03-3.” We record our net investment in these loans at the lower of the acquisition cost of the loan or the estimated fair value at the date of purchase or consolidation. To the extent the acquisition cost exceeds the estimated fair value, we record a SOP 03-3 fair value loss charge-off against the “Reserve for guaranty losses” at the time we acquire the loan.

 

We introduced HomeSaver Advance in the first quarter of 2008. HomeSaver Advance serves as a foreclosure prevention tool early in the delinquency cycle and does not conflict with our MBS trust requirements because it allows borrowers to cure their payment defaults without modifying their mortgage loan. HomeSaver Advance allows servicers to provide qualified borrowers with a 15-year unsecured personal loan in an amount equal to all past due payments relating to their mortgage loan, generally up to the lesser of $15,000 or 15% of the unpaid principal balance of the delinquent first lien loan. We record HomeSaver Advance loans at their estimated fair value at the date we purchase these loans from servicers, and, to the extent the acquisition cost exceeds the estimated fair value, we record a HomeSaver fair value loss charge-off against the “Reserve for guaranty losses” at the time we acquire the loan.

 

As indicated in Table 11 above, SOP 03-3 and HomeSaver Advance fair value losses increased to $1.5 billion in the first quarter of 2009, from $733 million in the first quarter of 2008, reflecting both an increase in the number of acquired delinquent loans and a decrease in the fair value of these loans.

 

Table 13 provides a quarterly comparison of the number of delinquent loans acquired from MBS trusts subject to SOP 03-3, the unpaid principal balance and accrued interest of these loans, and the average fair value based on indicative market prices. The decline in home prices and significant reduction in liquidity in the mortgage markets, along with the increase in mortgage credit risk, have resulted in continued downward pressure on the fair value of these loans.