e10vq
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-Q
 
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended June 30, 2007
 
OR
 
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from           to          
 
Commission File No.: 0-50231
 
Federal National Mortgage Association
(Exact name of registrant as specified in its charter)
Fannie Mae
 
     
Federally chartered corporation   52-0883107
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
     
3900 Wisconsin Avenue, NW
Washington, DC
(Address of principal executive offices)
  20016
(Zip Code)
     
 
Registrant’s telephone number, including area code:
(202) 752-7000
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes o     No þ
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one ):
Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ
 
APPLICABLE ONLY TO CORPORATE ISSUERS:
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
 
As of October 22, 2007, there were 978,167,971 shares of common stock outstanding.
 


Table of Contents

 
TABLE OF CONTENTS
 
             
    1  
  Financial Statements     57  
    Condensed Consolidated Balance Sheets     57  
    Condensed Consolidated Statements of Income     58  
    Condensed Consolidated Statements of Cash Flows     59  
    Condensed Consolidated Statements of Changes in Stockholders’ Equity     60  
    Notes to Condensed Consolidated Financial Statements     61  
      Note 1—Summary of Significant Accounting Policies     61  
      Note 2—Consolidations     64  
      Note 3—Mortgage Loans     65  
      Note 4—Allowance for Loan Losses and Reserve for Guaranty Losses     66  
      Note 5—Investments in Securities     67  
      Note 6—Financial Guaranties     68  
      Note 7—Short-term Borrowings and Long-term Debt     70  
      Note 8—Derivative Instruments     71  
      Note 9—Income Taxes     72  
      Note 10—Earnings Per Share     74  
      Note 11—Employee Retirement Benefits     75  
      Note 12—Segment Reporting     76  
      Note 13—Preferred Stock     79  
      Note 14—Commitments and Contingencies     79  
      Note 15—Subsequent Events     85  
  Management’s Discussion and Analysis of Financial Condition and Results of Operations     1  
    Explanatory Note About This Report     1  
    Introduction     1  
    Selected Financial Data     3  
    Executive Summary     5  
    Critical Accounting Policies     8  
    Consolidated Results of Operations     11  
    Business Segment Results     24  
    Consolidated Balance Sheet Analysis     29  
    Liquidity and Capital Management     35  
    Off-Balance Sheet Arrangements and Variable Interest Entities     40  
    Risk Management     41  
    Impact of Future Adoption of Accounting Pronouncements     55  
    Forward-Looking Statements     55  
  Quantitative and Qualitative Disclosures About Market Risk     86  
  Controls and Procedures     86  
       
Part II—Other Information     92  
  Legal Proceedings     92  


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  Risk Factors     94  
  Unregistered Sales of Equity Securities and Use of Proceeds     99  
  Defaults Upon Senior Securities     100  
  Submission of Matters to a Vote of Security Holders     100  
  Other Information     100  
  Exhibits     101  
    102  
    E-1  
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1
 Exhibit 32.2


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MD&A TABLE REFERENCE
 
                 
Table
 
Description
  Page
 
 
    Selected Financial Data     3  
 
1
    Summary of Condensed Consolidated Results of Operations     11  
 
2
    Analysis of Net Interest Income and Yield     12  
 
3
    Rate/Volume Analysis of Net Interest Income     14  
 
4
    Guaranty Fee Income and Average Effective Guaranty Fee Rate     15  
 
5
    Investment Gains (Losses), Net     19  
 
6
    Derivatives Fair Value Gains, Net     21  
 
7
    Administrative Expenses     22  
 
8
    Single-Family Business Results     25  
 
9
    HCD Business Results     26  
 
10
    Capital Markets Business Results     28  
 
11
    Mortgage Portfolio Composition     29  
 
12
    Mortgage Portfolio Activity     31  
 
13
    Outstanding Debt     33  
 
14
    Changes in Risk Management Derivative Assets (Liabilities) at Fair Value, Net     34  
 
15
    Debt Activity     35  
 
16
    Fannie Mae Debt Credit Ratings and Risk Ratings     36  
 
17
    Regulatory Capital Measures     37  
 
18
    On- and Off-Balance Sheet MBS and Other Guaranty Arrangements     40  
 
19
    Composition of Mortgage Credit Book of Business     41  
 
20
    Product Distribution of Conventional Single-Family Business Volume and Mortgage Credit Book of Business     43  
 
21
    Serious Delinquency Rates     46  
 
22
    Single-Family and Multifamily Foreclosed Properties     47  
 
23
    Credit Loss Performance     48  
 
24
    Single-Family Credit Loss Sensitivity     49  
 
25
    Activity and Maturity Data for Risk Management Derivatives     52  
 
26
    Interest Rate Sensitivity to Changes in Level and Slope of Yield Curve     54  


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PART I—FINANCIAL INFORMATION
 
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
You should read this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) in conjunction with our unaudited condensed consolidated financial statements and related notes, and the more detailed information contained in our Annual Report on Form 10-K for the year ended December 31, 2006 (“2006 Form 10-K”). The results of operations presented in our interim financial statements and discussed in MD&A are not necessarily indicative of the results that may be expected for the full year. Please refer to “Glossary of Terms Used in This Report” in our 2006 Form 10-K for an explanation of key terms used throughout this discussion.
 
EXPLANATORY NOTE ABOUT THIS REPORT
 
We are filing this Quarterly Report on Form 10-Q for the second quarter of 2007 concurrently with the filing of our Quarterly Reports on Form 10-Q for the first and third quarters of 2007. Where appropriate, the information contained in these Forms 10-Q reflects information about our business through September 30, 2007.
 
We filed our 2006 Form 10-K on August 16, 2007, after filing our Annual Report on Form 10-K for the year ended December 31, 2005 (“2005 Form 10-K”) on May 2, 2007 and our Annual Report on Form 10-K for the year ended December 31, 2004 (“2004 Form 10-K”) on December 6, 2006. Our 2004 Form 10-K contained our consolidated financial statements and related notes for the year ended December 31, 2004, as well as a restatement of our previously issued consolidated financial statements and related notes for the years ended December 31, 2003 and 2002, and for the quarters ended June 30, 2004 and March 31, 2004. The filing of the 2004 Form 10-K, the 2005 Form 10-K and the 2006 Form 10-K were delayed significantly as a result of the substantial time and effort devoted to ongoing controls remediation, and systems reengineering and development in order to complete the restatement of our financial results for 2003 and 2002, as presented in our 2004 Form 10-K. We have made significant progress in our efforts to remediate material weaknesses that have prevented us from reporting our financial results on a timely basis.
 
With the filing of our Quarterly Report on Form 10-Q for the third quarter of 2007 on a timely basis, we have accomplished our goal of returning to current filing status. On June 8, 2007, we announced that we plan to file our Annual Report on Form 10-K for the year ended December 31, 2007 (“2007 Form 10-K”) with the U.S. Securities and Exchange Commission (“SEC”) on a timely basis. At this time, we are confirming our expectation that we will file our 2007 Form 10-K on a timely basis.
 
INTRODUCTION
 
Fannie Mae is a mission-driven company, owned by private shareholders (NYSE: FNM) and chartered by Congress to support liquidity and stability in the secondary mortgage market. Our business includes three integrated business segments—Single-Family Credit Guaranty, Housing and Community Development, and Capital Markets—that work together to provide services, products and solutions to our lender customers and a broad range of housing partners. Together, our business segments contribute to our chartered mission objectives, helping to increase the total amount of funds available to finance housing in the United States and to make homeownership more available and affordable for low-, moderate- and middle-income Americans. We also work with our customers and partners to increase the availability and affordability of rental housing.
 
Our Single-Family Credit Guaranty (“Single-Family”) business works with our lender customers to securitize single-family mortgage loans into Fannie Mae mortgage-backed securities (“Fannie Mae MBS”) and to facilitate the purchase of single-family mortgage loans for our mortgage portfolio. Revenues in the segment are derived primarily from the guaranty fees the segment receives as compensation for assuming the credit risk on the mortgage loans underlying single-family Fannie Mae MBS and on the single-family mortgage loans held in our portfolio.


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Our Housing and Community Development (“HCD”) business works with our lender customers to securitize multifamily mortgage loans into Fannie Mae MBS and to facilitate the purchase of multifamily mortgage loans for our mortgage portfolio. Our HCD business also helps to expand the supply of affordable housing by investing in rental and for-sale housing projects, including rental housing that is eligible for federal low-income housing tax credits. Revenues in the segment are derived from a variety of sources, including the guaranty fees the segment receives as compensation for assuming the credit risk on the mortgage loans underlying multifamily Fannie Mae MBS and on the multifamily mortgage loans held in our portfolio, transaction fees associated with the multifamily business and bond credit enhancement fees. In addition, HCD’s investments in rental housing projects eligible for the federal low-income housing tax credit generate both tax credits and net operating losses that reduce our federal income tax liability. Other investments in rental and for-sale housing generate revenue from operations and the eventual sale of the assets.
 
Our Capital Markets group manages our investment activity in mortgage loans and mortgage-related securities, and has responsibility for managing our assets and liabilities and our liquidity and capital positions. Through the issuance of debt securities in the capital markets, our Capital Markets group attracts capital from investors globally that the company uses to finance housing in the United States. Our Capital Markets group generates income primarily from the difference, or spread, between the yield on the mortgage assets we own and the cost of the debt we issue in the global capital markets to fund these assets.
 
Although we are a corporation chartered by the U.S. Congress, the U.S. government does not guarantee, directly or indirectly, our securities or other obligations. Our business is self-sustaining and funded exclusively with private capital.


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SELECTED FINANCIAL DATA
 
The selected consolidated financial data presented below is summarized from our condensed results of operations for the three and six months ended June 30, 2007 and 2006, as well as from selected condensed consolidated balance sheet data as of June 30, 2007 and December 31, 2006. This data should be read in conjunction with this Management’s Discussion and Analysis of Financial Condition and Results of Operations, as well as with the unaudited condensed consolidated financial statements and related notes included in this report and with our audited consolidated financial statements and related notes included in our 2006 Form 10-K.
 
                                 
    For the
    For the
 
    Three Months Ended
    Six Months Ended
 
    June 30,     June 30,  
    2007     2006     2007     2006  
    (Dollars and shares in millions, except
 
    per share amounts)  
 
Income Statement Data:
                               
Net interest income
  $ 1,193     $ 1,867     $ 2,387     $ 3,879  
Guaranty fee income(1)
    1,120       937       2,218       1,884  
Losses on certain guaranty contracts
    (461 )     (51 )     (744 )     (78 )
Derivatives fair value gains, net
    1,916       1,621       1,353       2,527  
Other income (loss)(1)(2)
    (349 )     (710 )     207       (1,271 )
Credit-related expenses(3)
    (518 )     (158 )     (839 )     (260 )
Net income
    1,947       2,058       2,908       4,084  
Preferred stock dividends and issuance costs at redemption
    (118 )     (127 )     (253 )     (249 )
Net income available to common stockholders
    1,829       1,931       2,655       3,835  
                                 
Common Share Data:
                               
Earnings per share:
                               
Basic
  $ 1.88     $ 1.99     $ 2.73     $ 3.95  
Diluted
    1.86       1.97       2.72       3.91  
Weighted-average common shares outstanding:
                               
Basic
    973       971       973       971  
Diluted
    1,001       999       1,001       999  
Cash dividends declared per common share
  $ 0.50     $ 0.26     $ 0.90     $ 0.52  
                                 
New Business Acquisition Data:
                               
Fannie Mae MBS issues acquired by third parties(4)
  $ 134,440     $ 95,668     $ 259,642     $ 201,344  
Mortgage portfolio purchases(5)
    48,676       60,780       84,833       98,764  
                                 
New business acquisitions
  $ 183,116     $ 156,448     $ 344,475     $ 300,108  
                                 
 


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    As of  
    June 30,
    December 31,
 
    2007     2006  
    (Dollars in millions)  
 
Balance Sheet Data:
               
Investments in securities:
               
Trading
  $ 39,171     $ 11,514  
Available-for-sale
    341,073       378,598  
Mortgage loans:
               
Loans held for sale
    6,066       4,868  
Loans held for investment, net of allowance
    386,985       378,687  
Total assets
    857,802       843,936  
Short-term debt
    163,865       165,810  
Long-term debt
    616,814       601,236  
Total liabilities
    818,005       802,294  
Preferred stock
    8,008       9,108  
Total stockholders’ equity
    39,670       41,506  
                 
Regulatory Capital Data:
               
Core capital(6)
  $ 42,690     $ 41,950  
Total capital(7)
    43,798       42,703  
                 
Mortgage Credit Book of Business Data:
               
Mortgage portfolio(8)
  $ 726,649     $ 728,932  
Fannie Mae MBS held by third parties(9)
    1,907,658       1,777,550  
Other credit guaranties(10)
    35,285       19,747  
                 
Mortgage credit book of business
  $ 2,669,592     $ 2,526,229  
                 
 
                                 
    For the
    For the
 
    Three Months Ended
    Six Months Ended
 
    June 30,     June 30,  
    2007     2006     2007     2006  
 
Ratios:
                               
Return on assets ratio(11)*
    0.86 %     0.91 %     0.62 %     0.90 %
Return on equity ratio(12)*
    22.6       26.1       16.6       25.7  
Equity to assets ratio(13)*
    4.8       4.6       4.8       4.6  
Dividend payout ratio(14)*
    26.8       13.5       33.1       13.2  
Average effective guaranty fee rate (in basis points)(15)*
    21.5 bp     19.8 bp     21.6 bp     20.1 bp
Credit loss ratio (in basis points)(16)*
    3.8 bp     1.7 bp     3.5 bp     1.5 bp
 
 
  (1) Certain prior period amounts that previously were included as a component of “Fee and other income” have been reclassified to “Guaranty fee income” to conform to the current period presentation.
 
  (2) Consists of trust management income; investment gains (losses), net; debt extinguishment gains, net; losses from partnership investments; and fee and other income.
 
  (3) Consists of provision for credit losses and foreclosed property expense.
 
  (4) Unpaid principal balance of Fannie Mae MBS issued and guaranteed by us and acquired by third-party investors during the reporting period. Excludes securitizations of mortgage loans held in our portfolio.
 
  (5) Unpaid principal balance of mortgage loans and mortgage-related securities we purchased for our investment portfolio during the reporting period. Includes advances to lenders and mortgage-related securities acquired through the extinguishment of debt.

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  (6) The sum of (a) the stated value of outstanding common stock (common stock less treasury stock); (b) the stated value of outstanding non-cumulative perpetual preferred stock; (c) paid-in-capital; and (d) our retained earnings. Core capital excludes accumulated other comprehensive loss.
 
  (7) The sum of (a) core capital and (b) the total allowance for loan losses and reserve for guaranty losses, less (c) the specific loss allowance (that is, the allowance required on individually impaired loans).
 
  (8) Unpaid principal balance of mortgage loans and mortgage-related securities held in our portfolio.
 
  (9) Unpaid principal balance of Fannie Mae MBS held by third-party investors. The principal balance of resecuritized Fannie Mae MBS is included only once in the reported amount.
 
(10) Includes single-family and multifamily credit enhancements that we have provided and that are not otherwise reflected in the table.
 
(11) Annualized net income available to common stockholders divided by average total assets during the period.
 
(12) Annualized net income available to common stockholders divided by average outstanding common equity during the period.
 
(13) Average stockholders’ equity divided by average total assets during the period.
 
(14) Common dividends declared during the period divided by net income available to common stockholders for this period.
 
(15) Annualized guaranty fee income as a percentage of average outstanding Fannie Mae MBS and other guaranties during the period.
 
(16) Annualized charge-offs, net of recoveries and annualized foreclosed property expense, as a percentage of the average total mortgage credit book of business during the period. Effective January 1, 2007, we have excluded any initial losses recorded pursuant to Statement of Position No. 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer, on loans purchased from trusts from our credit losses when the purchase price of delinquent loans that we purchase from Fannie Mae MBS trusts exceeds the fair value of the loans at the time of purchase. We have revised our presentation of credit losses for the three and six months ended June 30, 2006 to conform to the current period presentation. Refer to “Risk Management—Credit Risk Management—Mortgage Credit Risk Management—Credit Losses” for more information regarding this change in presentation.
 
Note:
 
* Average balances for purposes of the ratio calculations are based on beginning and end of period balances.
 
EXECUTIVE SUMMARY
 
Overview
 
We are in the midst of a significant correction in the housing and mortgage markets. The market downturn that began in 2006 has continued through the first three quarters of 2007, with substantial declines in new and existing home sales, housing starts, mortgage originations, and home prices, as well as significant increases in inventories of unsold homes, mortgage delinquencies, and foreclosures. In recent months, the capital markets also have been characterized by high levels of volatility, reduced levels of liquidity in the mortgage and corporate credit markets, significantly wider credit spreads, and rating agency downgrades on a growing number of mortgage-related securities. Beginning with the third quarter of 2007, these factors have had a significant effect on our business. We expect these factors will continue to affect our financial condition and results of operations through the end of 2007 and into 2008.
 
Management believes that some factors in this correction may benefit our business in the short or long term, and that other factors in the correction may have a material adverse effect on our business. In particular, the reduced liquidity accompanying this correction has affected observable market pricing data, causing disruptions of historical pricing relationships and pricing gaps. This has had a negative impact on our estimates of the fair value of our assets and obligations. Given this pricing disruption and the complexity of our accounting policies and estimates, the amounts that we actually realize could vary significantly from our fair value estimates.


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Like other participants in the U.S. residential mortgage market, we have experienced and expect to continue to experience adverse effects from this market correction, which are reflected in our financial results. These include:
 
  •  Our credit losses and credit-related expenses have increased significantly due to national home price declines and economic weakness in some regional markets.
 
  •  Our “Losses on certain guaranty contracts” have increased significantly. As conditions in the housing market have deteriorated and market liquidity has declined, our estimates of the compensation required by market participants to assume our guaranty obligations, which is the basis we are required to use to estimate these losses, have increased significantly. Because of the manner in which we account for these contracts, we recognize an immediate loss in earnings at the time we issue MBS if our guaranty obligation exceeds the fair value of our guaranty asset. We expect to recover that loss over time as the associated MBS liquidates, while our credit losses over time will reflect our actual loss experience on these transactions.
 
  •  Because of the significant disruption in the housing and mortgage markets during the third quarter of 2007, the indicative market prices we obtained from third parties in connection with our purchases of delinquent loans from our MBS trusts have decreased significantly. This has caused us to reduce our estimates of the fair value of these loans, resulting in a significant increase in our initial recorded losses from these purchases.
 
  •  Increasing credit spreads and estimates of declines in future home prices have resulted in declines in the fair value of our net assets.
 
These challenging market conditions have had a negative impact on our earnings, which has reduced the amount of capital we hold to satisfy our regulatory capital requirements. We continue to maintain a strong capital position, and our access to sources of liquidity has been adequate to meet our funding needs. If these market and economic conditions continue, we may take actions to ensure that we meet our regulatory capital requirements, including forgoing some business opportunities, selling assets or issuing additional preferred equity securities.
 
We believe that some benefits from the market correction may enhance our strategic position in our market. These include:
 
  •  The market for Alt-A, subprime and other nontraditional mortgages has declined significantly. As that market has declined, the demand for more traditional mortgage products, such as 30-year fixed-rate conforming loans, has increased significantly. These products represent our core business and have historically accounted for the majority of our new business volume and profitability. Due to the higher mix of mortgage-related securities backed by more traditional products and reduced competition from private-label issuers of mortgage-related securities, our estimated market share of new single-family mortgage-related securities issuances increased to approximately 41.2% for the third quarter of 2007, from approximately 24.3% for the third quarter of 2006.
 
  •  We also have increased the guaranty fees we charge on new business. This increased pricing compensates us for the added risk that we assume as a result of current market conditions.
 
  •  As a result of the growing need for credit and liquidity in the multifamily market beginning in the third quarter of 2007, our HCD business produced higher guaranty fee rates on new multifamily business and faster growth in our multifamily guaranty book of business.
 
  •  Our total mortgage credit book of business has increased by 10% during the first nine months of 2007, from $2.5 trillion outstanding at December 31, 2006 to $2.8 trillion outstanding at September 30, 2007.
 
In addition, following a thorough review of our costs, we implemented a broad reengineering initiative that we expect will reduce our total administrative expenses by more than $200 million in 2007 as compared with 2006. With the filing of our Forms 10-Q today, we have become current in our SEC periodic financial reporting.


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Our business is also significantly affected by general conditions in the financial markets. During the first nine months of 2007, conditions in the financial markets contributed to the following financial results, compared with the first nine months of 2006:
 
  •  A decrease in our net interest income and net interest yield due to the higher cost of debt.
 
  •  An increase in losses on trading securities and unrealized losses on available-for-sale securities.
 
  •  An increased level of period-to-period volatility in the fair value of our derivatives and securities.
 
During the first nine months of 2007, our ability to issue debt and equity at rates we consider attractive has not been impaired. In addition, we have experienced a lower level of impairments on investment securities during the first nine months of 2007 than we experienced during the same period in 2006.
 
Summary of Our Financial Results
 
Net income for the second quarter of 2007 was $1.9 billion, a decrease of $111 million, or 5%, from the second quarter of 2006. Diluted earnings per share decreased by 6% to $1.86 for the second quarter of 2007, from $1.97 for the second quarter of 2006.
 
Net income for the first six months of 2007 was $2.9 billion, a decrease of $1.2 billion, or 29%, from the first six months of 2006. Diluted earnings per share decreased by 30% to $2.72 for the first six months of 2007, from $3.91 for the first six months of 2006.
 
Refer to “Consolidated Results of Operations” below for a more detailed discussion of our financial results for the three and six months ended June 30, 2007, compared with the three and six months ended June 30, 2006.
 
Market and Economic Factors Affecting Our Business
 
Mortgage and housing market conditions, which significantly affect our business and our financial performance, have worsened since the end of 2006. The housing market downturn that began in the second half of 2006 continued through the first three quarters of 2007 and into the fourth quarter of 2007. The most recent available data for the quarter ended September 30, 2007 show substantial declines in new and existing home sales, housing starts and mortgage originations compared with prior year levels. Moreover, home prices declined on a national basis during the first three quarters of 2007. Additionally, overall housing demand decreased over the past year because of a slowdown in the overall economy, affordability constraints, and declines in demand for investor properties and second homes, which had been a key driver of overall housing activity. Housing market conditions have deteriorated significantly in some Midwestern states, particularly in Michigan, Ohio and Indiana, which have experienced weak economic conditions and job losses. Additionally, in recent quarters, housing market weakness has expanded to other states, including Arizona, California, Florida and Nevada, where home prices had risen most dramatically and investor demand had been the highest in recent years. Inventories of unsold homes have risen dramatically over the past year, putting additional downward pressure on home prices.
 
These challenging market and economic conditions caused a material increase in mortgage delinquencies and foreclosures during 2007. The resetting of a substantial number of adjustable-rate mortgages (“ARMs”) to higher interest rates has also contributed to the increase in mortgage delinquencies and foreclosures. A mortgage loan foreclosure may occur when the borrower on an ARM is unable to make the higher payments required after an interest-rate adjustment, and is unable to either refinance the loan or sell the home for an amount sufficient to pay off the mortgage. Based on data provided by LoanPerformance, an independent provider of mortgage market data, as of the end of 2006, we estimate that there were approximately $150 billion in ARMs backing private-label subprime mortgage-related securities that were scheduled to reset for the first time at some point during 2007, subjecting those borrowers to significant payment shock. In addition, as of the end of July 2007, we estimate that there were approximately $185 billion in ARMs backing private-label subprime mortgage-related securities with payments that were scheduled to reset initially sometime in 2008. These resets could result in a further sharp increase in delinquency and foreclosure rates.


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The rising number of mortgage defaults and foreclosures, combined with declining home prices on a national basis and weak economic conditions in some regions, has resulted in significant increases in credit losses.
 
The credit performance of subprime and Alt-A loans, as well as other higher risk loans, has deteriorated sharply during the past year, and even the prime conventional portion of the mortgage market has seen signs of credit distress. Concerns about the potential for even higher delinquency rates and more severe credit losses have resulted in increases in mortgage rates in the non-conforming and subprime portions of the market. Many lenders have tightened lending standards or elected to stop originating subprime and other higher risk loans completely, which has adversely affected many borrowers seeking alternative financing to refinance out of ARMs resetting to higher rates.
 
The reduction in liquidity and funding sources in the mortgage credit market has led to a substantial shift in mortgage originations. The share of traditional fixed-rate conforming mortgages has increased substantially, while the share of Alt-A and subprime mortgages has dropped significantly. Moreover, credit concerns and the resulting liquidity issues have affected the general financial markets. In recent months, the financial markets have been characterized by high levels of volatility, reduced levels of liquidity in the mortgage and corporate credit markets, significantly wider credit spreads and rating agency downgrades on a growing number of mortgage-related securities. In response to concerns over liquidity in the financial markets, the Federal Reserve reduced its discount rate in August, September and October 2007 by a total of 125 basis points to 5.00% and lowered the federal funds rate in September and October 2007 by a total of 75 basis points to 4.50%. After rising in the first half of the year, long-term bond yields declined during the third quarter of 2007. As short-term interest rates decreased in the third quarter of 2007, the spread between long- and short-term interest rates widened, resulting in a steepening of the yield curve.
 
Outlook
 
We expect housing market weakness to continue in 2007 and 2008. We believe the continued downturn in housing will lead to further declines in mortgage originations in 2007 and 2008, and contribute to slower growth in U.S. residential mortgage debt outstanding (“MDO”) in 2007 and 2008. Based on our current market outlook, we expect:
 
  •  A relatively stable net interest yield for the remainder of 2007.
 
  •  Growth in our single-family guaranty book of business at a faster rate than the rate of overall MDO growth.
 
  •  A continued increase in our guaranty fee income for 2007.
 
  •  A significant increase in losses on certain guaranty contracts for 2007 as compared with 2006, due to the continued weakening in the housing and mortgage market.
 
  •  A significant increase in credit-related expenses and credit losses for both 2007 and 2008 as compared with the previous years, due to continued home price declines.
 
  •  Continued volatility in our net income, stockholders’ equity and regulatory capital due to market conditions and the effects of the manner in which we account for changes in the fair value of our derivatives and trading securities.
 
We provide additional detail on trends that may affect our result of operations, financial condition and regulatory capital position in future periods in “Consolidated Results of Operations” below.
 
CRITICAL ACCOUNTING POLICIES
 
The preparation of financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”) requires management to make a number of judgments, estimates and assumptions that affect the reported amount of assets, liabilities, income and expenses in the consolidated financial statements. Understanding our accounting policies and the extent to which we use management judgment and estimates in


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applying these policies is integral to understanding our financial statements. In our 2006 Form 10-K, we identified the following as our critical accounting polices:
 
  •  Fair Value of Financial Instruments
 
  •  Amortization of Cost Basis Adjustments on Mortgage Loans and Mortgage-Related Securities
 
  •  Allowance for Loan Losses and Reserve for Guaranty Losses
 
  •  Assessment of Variable Interest Entities
 
Our 2006 Form 10-K contains a discussion of the judgments and assumptions made in applying these policies and how changes in assumptions may impact our consolidated financial statements. Refer to “Notes to Condensed Consolidated Financial Statements—Note 1, Summary of Significant Accounting Policies” for updated information regarding our significant accounting policies, including the expected impact on our consolidated financial statements of recently issued accounting pronouncements.
 
As noted in our 2006 Form 10-K, we evaluate our critical accounting estimates and judgments required by our policies on an ongoing basis and update them as necessary based on changing conditions. We consider the estimation of fair value of our financial instruments to be our most critical accounting estimate because a substantial portion of our assets and liabilities are recorded at estimated fair value, and, in certain circumstances, our valuation techniques involve a high degree of management judgment. The downturn in the housing market and reduced liquidity in the credit markets, along with the uncertainty in the financial markets arising from these conditions, resulted in significant market volatility and a disruption of historical pricing relationships between certain financial instruments during the third quarter of 2007. This significant change in market conditions has had widespread implications on how companies measure the fair value of certain financial instruments. Accordingly, we have provided an update to our critical accounting policy on fair value to discuss how these recent market conditions have affected the determination of fair value for some of our financial instruments, most notably our guaranty assets and guaranty obligations.
 
Fair Value of Financial Instruments
 
Fair value is defined as the amount at which a financial instrument could be exchanged in a current transaction between willing, unrelated parties, other than in a forced or liquidation sale. We use one of the following three practices for estimating fair value, the selection of which is based on the availability and reliability of relevant market data: (1) actual, observable market prices or market prices obtained from multiple third parties when available; (2) market data and model-based interpolations using standard models widely accepted within the industry if market prices are not available; or (3) internally developed models that employ techniques such as a discounted cash flow approach and that include market-based assumptions, such as prepayment speeds and default and severity rates derived from internally developed models. Price transparency tends to be limited in less liquid markets where quoted market prices or observable market data may not be available. We regularly refine and enhance our valuation methodologies to correlate more closely to observable market data. When observable market prices or data are not readily available or do not exist, the estimation of fair value may require significant management judgment and assumptions. See “Part II—Item 1A—Risk Factors” for a discussion of the risks and uncertainties related to our use of valuation models.
 
Guaranty Assets and Guaranty Obligations
 
The recent changes in market conditions have had a significant impact on the estimation of the net fair value of our guaranty assets and guaranty obligations. As guarantor of our Fannie Mae MBS issuances, at inception we recognize a non-contingent liability for the fair value of our obligation to stand ready to perform over the term of the guaranty as a component of “Guaranty obligations” in our consolidated balance sheets. The fair value of this obligation represents management’s estimate of the amount that we would expect to pay a third party of similar credit standing to assume our obligation.


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Our guaranty business volume is generated through either our flow or bulk transaction channels. The contract terms and level of pricing flexibility for loans guaranteed through these channels differ and may adversely impact the estimated fair value of our guaranty obligations and losses on certain guaranty contracts. In our flow business, we enter into agreements that generally set base guaranty fee pricing for a lender’s future delivery of individual loans to us over a specified time period. Because we have established the base guaranty fee pricing for a specified time period, we may be limited in our ability to renegotiate the pricing on our flow transactions with individual lenders to reflect changes in market conditions and the credit risk of mortgage loans that meet our eligibility standards. As a result, the estimated amount that we would be required to pay a third party of similar credit standing to assume our obligation may be higher than our contractual price. Our bulk business consists of transactions in which a defined set of loans are to be delivered to us in bulk, and we have the opportunity to review the loans for eligibility and pricing prior to delivery in accordance with the terms of the specific contract for such transactions. We generally have greater ability to select risks in the bulk transaction channel and to adjust our pricing more rapidly to reflect changes in market conditions and the credit risk of the specific transactions.
 
Our guaranty obligations consist of future expected credit losses, including any unrecoverable principal and interest over the expected life of the underlying mortgages of our Fannie Mae MBS and foreclosure costs, estimated administrative and other costs related to our guaranty, and any deferred profit amounts. We base the fair value of the guaranty obligations that we record when we issue Fannie Mae MBS on market information obtained from spot transaction prices, when available. In the absence of spot transaction data, which is the case for the substantial majority of our Fannie Mae MBS issuances, we estimate the fair value using simulation models that estimate our potential future credit losses and calculate the present value of the expected cash flows associated with our guaranty obligations under various economic scenarios. The key inputs and assumptions for our models include default and severity rates. We also incorporate a market rate of return that we derive from observable market data. The objective of our valuation models is to estimate the amount that we would expect to pay a third party of similar credit standing to assume our guaranty obligation under current market conditions. Because of the recent significant reduction in liquidity in the mortgage and credit markets and increased volatility, estimating the fair value of our guaranty obligations has become more difficult in some cases and the degree of management judgment involved has increased. Although we review the reasonableness of the results of our simulation models by comparing those results with available market information, it is possible that different assumptions and inputs could produce a materially different estimate of the fair value of our guaranty obligations, particularly in the current market environment.
 
The fair value of our guaranty obligations is highly sensitive to changes in the market’s expectation for future levels of home price appreciation. When there is a market expectation of a decline in home prices, the level of credit risk for a mortgage loan tends to increase because the market anticipates a likelihood of higher credit losses. Incorporating this expectation of higher credit losses into our simulation models results in a significant increase in the estimated fair value of our guaranty obligations and increases the losses recognized at inception on certain guaranty contracts. Based on our experience, however, we expect our actual future credit losses to be significantly less than the estimated increase in the fair value of our guaranty obligations, as the fair value of our guaranty obligations includes not only future expected credit losses but also the economic return that we believe a third party would require to assume that credit risk. Our combined allowance for loan losses and reserve for guaranty losses reflects our estimate of the probable credit losses inherent in our mortgage credit book of business. We disclose on a quarterly basis the estimated impact on our expected credit losses from an immediate 5% decline in single-family home prices for the entire United States. See “Risk Management—Credit Risk Management—Mortgage Credit Risk Management” for our credit loss sensitivity disclosures.


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CONSOLIDATED RESULTS OF OPERATIONS
 
The following discussion of our consolidated results of operations is based on a comparison of our results between the second quarters of 2007 and 2006 and between the first six months of 2007 and 2006. Table 1 presents a summary of our unaudited condensed consolidated results of operations for these periods.
 
Table 1:  Summary of Condensed Consolidated Results of Operations
 
                                                                 
    For the
    For the
             
    Three Months Ended
    Six Months Ended
    Quarterly
    Year-to-Date
 
    June 30,     June 30,     Variance     Variance  
    2007     2006     2007     2006     $     %     $     %  
    (Dollars in millions, except per share amounts)  
 
Net interest income
  $ 1,193     $ 1,867     $ 2,387     $ 3,879     $ (674 )     (36 )%   $ (1,492 )     (38 )%
Guaranty fee income(1)
    1,120       937       2,218       1,884       183       20       334       18  
Trust management income(2)
    150             314             150             314        
Fee and other income(1)
    262       42       470       333       220       524       137       41  
                                                                 
Net revenues
    2,725       2,846       5,389       6,096       (121 )     (4 )     (707 )     (12 )
Losses on certain guaranty contracts
    (461 )     (51 )     (744 )     (78 )     (410 )     (804 )     (666 )     (854 )
Investment losses, net
    (594 )     (633 )     (238 )     (1,308 )     39       6       1,070       82  
Derivatives fair value gains, net
    1,916       1,621       1,353       2,527       295       18       (1,174 )     (46 )
Losses from partnership investments
    (215 )     (188 )     (380 )     (382 )     (27 )     (14 )     2       1  
Administrative expenses
    (660 )     (780 )     (1,358 )     (1,488 )     120       15       130       9  
Credit-related expenses(3)
    (518 )     (158 )     (839 )     (260 )     (360 )     (228 )     (579 )     (223 )
Other non-interest income (expense)(4)
    (56 )     5       (155 )     (11 )     (61 )     (1,220 )     (144 )     (1,309 )
                                                                 
Income before federal income taxes and extraordinary gains (losses)
    2,137       2,662       3,028       5,096       (525 )     (20 )     (2,068 )     (41 )
Provision for federal income taxes
    (187 )     (610 )     (114 )     (1,019 )     423       69       905       89  
Extraordinary gains (losses), net of tax effect
    (3 )     6       (6 )     7       (9 )     (150 )     (13 )     (186 )
                                                                 
Net income
  $ 1,947     $ 2,058     $ 2,908     $ 4,084     $ (111 )     (5 )%   $ (1,176 )     (29 )%
                                                                 
Diluted earnings per common share
  $ 1.86     $ 1.97     $ 2.72     $ 3.91     $ (0.11 )     (6 )%   $ (1.19 )     (30 )%
                                                                 
 
 
(1) Certain prior period amounts that previously were included as a component of “Fee and other income” have been reclassified to “Guaranty fee income” to conform to the current period presentation.
 
(2) We began separately reporting the revenues from trust management fees in our condensed consolidated statements of income effective January 1, 2007. We previously included these revenues, which totaled approximately $156 million and $299 million for the three and six months ended June 30, 2006, respectively, as a component of interest income.
 
(3) Consists of provision for credit losses and foreclosed property expense.
 
(4) Consists of debt extinguishment gains (losses), net, minority interest in earnings of consolidated subsidiaries and other expenses.


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Our business generates revenues from four principal sources: net interest income, guaranty fee income, trust management income, and fee and other income. Other significant factors affecting our net income include changes in the fair value of our derivatives, the timing and size of investment gains and losses, equity investments, losses on certain guaranty contracts, credit-related expenses and administrative expenses. We provide a comparative discussion of the effect of our principal revenue sources and other listed items on our condensed consolidated results of operations for the three and six months ended June 30, 2007 and 2006 below. We also discuss other significant items presented in our unaudited condensed consolidated statements of income.
 
Net Interest Income
 
Table 2 presents analyses of our net interest income and net interest yield for the three and six months ended June 30, 2007 and 2006.
 
Table 2:  Analysis of Net Interest Income and Yield
 
                                                 
    For the Three Months Ended June 30,  
    2007     2006  
          Interest
    Average
          Interest
    Average
 
    Average
    Income/
    Rates
    Average
    Income/
    Rates
 
    Balance(1)     Expense     Earned/Paid     Balance(1)     Expense     Earned/Paid  
    (Dollars in millions)  
 
Interest-earning assets:
                                               
Mortgage loans(2)
  $ 390,034     $ 5,625       5.77 %   $ 373,418     $ 5,204       5.57 %
Mortgage securities
    325,303       4,460       5.48       361,567       4,896       5.42  
Non-mortgage securities(3)
    68,515       928       5.36       54,697       685       4.95  
Federal funds sold and securities purchased under agreements to resell
    15,301       205       5.31       13,978       173       4.92  
Advances to lenders
    6,056       48       3.12       4,543       37       3.20  
                                                 
Total interest-earning assets
  $ 805,209     $ 11,266       5.59 %   $ 808,203     $ 10,995       5.44 %
                                                 
Interest-bearing liabilities:
                                               
Short-term debt
  $ 159,817     $ 2,193       5.43 %   $ 166,984     $ 1,904       4.51 %
Long-term debt
    611,777       7,879       5.15       612,008       7,221       4.72  
Federal funds purchased and securities sold under agreements to repurchase
    37       1       4.58       284       3       4.94  
                                                 
Total interest-bearing liabilities
  $ 771,631     $ 10,073       5.21 %   $ 779,276     $ 9,128       4.67 %
                                                 
Impact of net non-interest bearing funding
  $ 33,578               0.22 %   $ 28,927               0.16 %
                                                 
Net interest income/net interest yield(4)
          $ 1,193       0.60 %           $ 1,867       0.93 %
                                                 
 


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    For the Six Months Ended June 30,  
    2007     2006  
          Interest
    Average
          Interest
    Average
 
    Average
    Income/
    Rates
    Average
    Income/
    Rates
 
    Balance(1)     Expense     Earned/Paid     Balance(1)     Expense     Earned/Paid  
    (Dollars in millions)  
 
Interest-earning assets:
                                               
Mortgage loans(2)
  $ 388,095     $ 11,010       5.67 %   $ 370,924     $ 10,286       5.55 %
Mortgage securities
    328,288       9,027       5.50       364,232       9,687       5.32  
Non-mortgage securities(3)
    65,355       1,764       5.37       49,064       1,171       4.75  
Federal funds sold and securities purchased under agreements to resell
    14,484       387       5.31       12,166       290       4.75  
Advances to lenders
    5,159       84       3.24       4,093       65       3.16  
                                                 
Total interest-earning assets
  $ 801,381     $ 22,272       5.56 %   $ 800,479     $ 21,499       5.37 %
                                                 
Interest-bearing liabilities:
                                               
Short-term debt
  $ 161,022     $ 4,406       5.44 %   $ 165,245     $ 3,550       4.27 %
Long-term debt
    607,399       15,475       5.10       604,287       14,063       4.65  
Federal funds purchased and securities sold under agreements to repurchase
    123       4       5.22       308       7       4.66  
                                                 
Total interest-bearing liabilities
  $ 768,544     $ 19,885       5.17 %   $ 769,840     $ 17,620       4.57 %
                                                 
Impact of net non-interest bearing funding
  $ 32,837               0.21 %   $ 30,639               0.17 %
                                                 
Net interest income/net interest yield(4)
          $ 2,387       0.60 %           $ 3,879       0.97 %
                                                 
 
 
(1) The average balances for mortgage loans, advances to lenders and short- and long-term debt have been calculated based on the average of the amortized cost amount as of the beginning of each period and the amortized cost amount as of the end of each month within the respective period. This method was also used to calculate the average balance for mortgage securities for the three and six months ended June 30, 2006. The average balances for all other categories and periods have been calculated based on a daily average.
 
(2) Includes nonaccrual loans with an average balance totaling $5.7 billion and $6.8 billion for the three months ended June 30, 2007 and 2006, respectively, and $5.9 billion and $7.3 billion for the six months ended June 30, 2007 and 2006, respectively.
 
(3) Includes cash equivalents.
 
(4) We calculate our net interest yield by dividing our annualized net interest income for the period by the average balance of our total interest-earning assets during the period.

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Table 3 presents the total variance, or change, in our net interest income between the three months ended June 30, 2007 and 2006, and the six months ended June 30, 2007 and 2006, and the extent to which that variance is attributable to (1) changes in the volume of our interest-earning assets and interest-bearing liabilities or (2) changes in the interest rates of these assets and liabilities.
 
Table 3:  Rate/Volume Analysis of Net Interest Income
 
                                                 
                      For the Six Months Ended
 
    For the Three Months Ended June 30, 2007 vs. 2006     June 30, 2007 vs. 2006  
    Total
    Variance Due to:(1)     Total
    Variance Due to:(1)  
    Variance     Volume     Rate     Variance     Volume     Rate  
    (Dollars in millions)  
 
Interest income:
                                               
Mortgage loans
  $ 421     $ 236     $ 185     $ 724     $ 484     $ 240  
Mortgage securities
    (436 )     (496 )     60       (660 )     (980 )     320  
Non-mortgage securities(2)
    243       183       60       593       425       168  
Federal funds sold and securities purchased under agreements to resell
    32       17       15       97       60       37  
Advances to lenders
    11       12       (1 )     19       17       2  
                                                 
Total interest income
    271       (48 )     319       773       6       767  
                                                 
Interest expense:
                                               
Short-term debt
    289       (85 )     374       856       (93 )     949  
Long-term debt
    658       (3 )     661       1,412       73       1,339  
Federal funds purchased and securities sold under agreements to repurchase
    (2 )     (2 )           (3 )     (4 )     1  
                                                 
Total interest expense
    945       (90 )     1,035       2,265       (24 )     2,289  
                                                 
Net interest income
  $ (674 )   $ 42     $ (716 )   $ (1,492 )   $ 30     $ (1,522 )
                                                 
 
 
(1) Combined rate/volume variances are allocated to both rate and volume based on the relative size of each variance.
 
(2) Includes cash equivalents.
 
Net interest income of $1.2 billion for the second quarter of 2007 decreased by 36% from the second quarter of 2006, driven by a 35% (33 basis points) decline in our net interest yield to 0.60%. The overall increase of 54 basis points in the average cost of our debt, to 5.21%, more than offset a 15 basis points increase in the average yield on our interest-earning assets, to 5.59%.
 
Net interest income of $2.4 billion for the first six months of 2007 decreased by 38% from the first six months of 2006, driven by a 38% (37 basis points) decline in our net interest yield to 0.60%. The overall increase of 60 basis points in the average cost of our debt, to 5.17%, more than offset a 19 basis points increase in the average yield on our interest-earning assets, to 5.56%.
 
We continued to experience compression in our net interest yield during the first six months of 2007, largely attributable to the increase in our short-term and long-term debt costs as we continued to replace, at higher interest rates, maturing debt that we had issued at lower interest rates during the past few years. In addition, as discussed below, effective January 1, 2007, we reclassified the fees we receive from the interest earned on cash flows between the date of remittance by servicers and the date of distribution to MBS certificateholders, which we refer to as float income, from “Interest income” to “Trust management income.” The reclassification of these fees contributed to the decrease in our net interest yield, resulting in a reduction of approximately 7 basis points for the three months ended June 30, 2007 and 8 basis points for the six months ended June 30, 2007.
 
As discussed below in “Derivatives Fair Value Gains, Net,” we consider the net contractual interest accruals on our interest rate swaps to be part of the cost of funding our mortgage investments. These amounts, however, are reflected in our condensed consolidated statements of income as a component of “Derivatives fair value gains,


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net.” Although we experienced an increase in the average cost of our debt for the three and six months ended June 30, 2007, we recorded net contractual interest income on our interest rate swaps totaling $64 million and $98 million for the three and six months ended June 30, 2007, respectively. In comparison, we recorded net contractual interest expense of $68 million and $239 million for the three and six months ended June 30, 2006, respectively. The economic effect of the interest accruals on our interest rate swaps, which is not reflected in the comparative net interest yields presented above, resulted in a reduction in our funding costs of approximately 3 basis points for both the three and six months ended June 30, 2007. The effect of interest accruals on our interest rate swaps also resulted in an increase in our funding costs of approximately 4 basis points and approximately 6 basis points for the three and six months ended June 30, 2006.
 
Our net interest yield was 0.52% and 0.57% for the three and nine months ended September 30, 2007. Based on the current composition of our portfolio, our expected investment activity for the remainder of the year and the current interest rate environment, we expect our net interest yield to remain relatively stable for the remainder of 2007.
 
Guaranty Fee Income
 
Table 4 shows the components of our guaranty fee income, our average effective guaranty fee rate, and Fannie Mae MBS activity for the three and six months ended June 30, 2007 and 2006.
 
Table 4:  Guaranty Fee Income and Average Effective Guaranty Fee Rate(1)
 
                                         
    For the Three Months Ended June 30,  
    2007     2006        
    Amount     Rate(2)     Amount     Rate(2)     Variance  
    (Dollars in millions)  
 
Guaranty fee income/average effective guaranty fee rate, excluding certain fair value adjustments and buy-up impairment
  $ 1,104       21.2 bp   $ 937       19.8 bp     18 %
Net change in fair value of buy-ups and guaranty assets(3)
    17       0.3                    
Buy-up impairment
    (1 )                        
                                         
Guaranty fee income/average effective guaranty fee rate(4)(5)
  $ 1,120       21.5 bp   $ 937       19.8 bp     20 %
                                         
Average outstanding Fannie Mae MBS and other guaranties(6)
  $ 2,080,676             $ 1,892,208               10 %
Fannie Mae MBS issues(7)
    149,879               118,902               26  
 
                                         
    For the Six Months Ended June 30,  
    2007     2006        
    Amount     Rate(2)     Amount     Rate(2)     Variance  
    (Dollars in millions)  
 
Guaranty fee income/average effective guaranty fee rate, excluding certain fair value adjustments and buy-up impairment
  $ 2,204       21.5 bp   $ 1,886       20.1 bp     17 %
Net change in fair value of buy-ups and guaranty assets(3)
    19       0.1                    
Buy-up impairment
    (5 )           (2 )           150  
                                         
Guaranty fee income/average effective guaranty fee rate(4)(5)
  $ 2,218       21.6 bp   $ 1,884       20.1 bp     18 %
                                         
Average outstanding Fannie Mae MBS and other guaranties(6)
  $ 2,050,797             $ 1,874,764               9 %
Fannie Mae MBS issues(7)
    282,302               233,461               21  
 
 
(1) Guaranty fee income consists of contractual guaranty fees related to Fannie Mae MBS held in our portfolio and held by third-party investors, adjusted for (1) the amortization of upfront fees and impairment of guaranty assets, net of a proportionate reduction in the related guaranty obligation and deferred profit, and (2) impairment of buy-ups. The average effective guaranty fee rate reflects our average contractual guaranty fee rate adjusted for the impact of


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amortization of deferred amounts and buy-up impairment. Losses recognized at inception on certain guaranty contracts are excluded from guaranty fee income and the average effective guaranty fee rate, but as described in footnote 5 below the subsequent recovery of these losses over the life of the loans underlying the MBS issuances is reflected in our guaranty fee income and the average effective guaranty fee rate.
 
(2) Presented in annualized basis points and calculated based on guaranty fee income components divided by average outstanding Fannie Mae MBS and other guaranties for each respective period.
 
(3) Consists of the effect of the net change in fair value of buy-ups and guaranty assets from portfolio securitization transactions subsequent to January 1, 2007. We include the net change in fair value of buy-ups and guaranty assets from portfolio securitization transactions in guaranty fee income in our condensed consolidated statements of income pursuant to our adoption of Statement of Financial Accounting Standards (“SFAS”) No. 155, Accounting for Certain Hybrid Financial Instruments, an amendment of SFAS 133 and SFAS 140 (“SFAS 155”). We prospectively adopted SFAS 155 effective January 1, 2007. Accordingly, we did not record a fair value adjustment in earnings during 2006.
 
(4) Certain prior period amounts that previously were included as a component of “Fee and other income” have been reclassified to “Guaranty fee income” to conform to the current period presentation.
 
(5) Losses recognized at inception on certain guaranty contracts are recorded as a component of our guaranty obligation. We amortize a portion of our guaranty obligation, which includes these losses, into income each period in proportion to the reduction in the guaranty asset for payments received. This amortization increases our guaranty fee income and reduces the related guaranty obligation. The amortization of the guaranty obligation associated with losses recognized at inception on certain guaranty contracts totaled $91 million and $42 million for the three months ended June 30, 2007 and 2006, respectively, and $183 million and $97 million for the six months ended June 30, 2007 and 2006, respectively.
 
(6) Other guaranties includes $35.3 billion and $19.7 billion as of June 30, 2007 and December 31, 2006, respectively, and $22.0 billion and $19.2 billion as of June 30, 2006 and December 31, 2005, respectively, related to long-term standby commitments we have issued and credit enhancements we have provided.
 
(7) Reflects unpaid principal balance of Fannie Mae MBS issued and guaranteed by us, including mortgage loans held in our portfolio that we securitized during the period and Fannie Mae MBS issued during the period that we acquired for our portfolio.
 
The 20% increase in guaranty fee income for the second quarter of 2007 from the second quarter of 2006 resulted from a 10% increase in average outstanding Fannie Mae MBS and other guaranties, and a 9% increase in the average effective guaranty fee rate to 21.5 basis points from 19.8 basis points.
 
The 18% increase in guaranty fee income for the first six months of 2007 from the first six months of 2006 resulted from a 9% increase in average outstanding Fannie Mae MBS and other guaranties, and a 7% increase in the average effective guaranty fee rate to 21.6 basis points from 20.1 basis points.
 
Growth in average outstanding Fannie Mae MBS and other guaranties for the three and six months ended June 30, 2007 was attributable to an increase in Fannie Mae MBS issuances and a slower liquidation rate on our mortgage credit book of business. Although mortgage origination volumes fell during the first six months of 2007, our market share of MBS issuances increased due to the shift in the product mix of mortgage originations back to more traditional conforming products, such as 30-year fixed-rate loans, which represent our core product and historically have accounted for the majority of our new business volume, and reduced competition from private-label issuers of mortgage-related securities.
 
The increase in our average effective guaranty fee rate, which excludes the effect of losses recorded at inception on certain guaranty contracts, was attributable to targeted pricing increases on new business to reflect the higher risk premium resulting from the overall market increase in mortgage credit risk pricing, an increase in our acquisition of Alt-A mortgage loans, which generally have higher guaranty fee rates, and an increase in the accretion of our guaranty obligation and deferred profit into income.
 
Because of our increased market share, we expect our single-family guaranty book of business to grow at a faster rate than the rate of overall MDO growth in 2007, and our guaranty fee income to continue to increase for the remainder of 2007.


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Trust Management Income
 
Trust management income totaled $150 million and $314 million for the three and six months ended June 30, 2007, respectively. Trust management income consists of the fees that 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 by servicers and the date of distribution to MBS certificateholders, which we refer to as float income. Prior to November 2006, funds received from servicers were commingled with our corporate assets. Because our compensation for these roles could not be segregated, we included these amounts, which totaled approximately $156 million and approximately $299 million for the three and six months ended June 30, 2006, respectively, as a component of “Interest income” in our condensed consolidated statements of income. In November 2006, we made operational changes to segregate these funds from our corporate assets. Accordingly, we began separately reporting this compensation as “Trust management income” in our condensed consolidated statements of income effective January 1, 2007.
 
Fee and Other Income
 
Fee and other income increased to $262 million in the second quarter of 2007, from $42 million in the second quarter of 2006. The $220 million increase in fee and other income in the second quarter of 2007 resulted from changes in foreign currency exchange rates and an increase in multifamily fees. We recorded a foreign currency exchange gain of $9 million on our foreign-denominated debt in the second quarter of 2007, compared with a foreign currency exchange loss of $161 million in the second quarter of 2006, due to the strengthening of the U.S. dollar against the Japanese yen during the second quarter of 2007. Our foreign currency exchange gains (losses) are offset in part by corresponding net losses (gains) on foreign currency swaps, which are recognized in our condensed consolidated statements of income as a component of “Derivatives fair value gains, net.” 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.
 
Fee and other income increased to $470 million for the first six months of 2007, from $333 million for the first six months of 2006. The $137 million increase in fee and other income for the first six months of 2007 was due in part to the recognition of a foreign currency exchange loss of $55 million on our foreign-denominated debt for the first six months of 2007, compared with a foreign currency exchange loss of $160 million for the first six months of 2006. The reduction in foreign currency exchange losses was due to the strengthening of the U.S. dollar against the Japanese yen during the first six months of 2007. In addition, multifamily transaction fees increased by $70 million to $169 million for the first six months of 2007 due to an increase in multifamily loan prepayment and yield maintenance fees resulting from higher liquidations in the first six months of 2007 relative to the first six months of 2006. These increases in fee and other income were partially offset by a decrease in certain multifamily fees related to consolidated loans.
 
Losses on Certain Guaranty Contracts
 
Losses on certain guaranty contracts increased by $410 million to $461 million for the second quarter of 2007, from $51 million for the second quarter of 2006. Losses on certain guaranty contracts increased by $666 million to $744 million for the first six months of 2007, from $78 million for the first six months of 2006.
 
We recognize an immediate loss in earnings on new guaranteed Fannie Mae MBS issuances when our expectation of returns is below what we believe a market participant would require for that credit risk inclusive of a reasonable profit margin. We expect, however, to recover the losses that we recognize at inception on certain guaranty contracts in our consolidated income statements over time in proportion to our receipt of contractual guaranty fees on those guaranties and the decline in the unpaid principal balance on the mortgage loans underlying the MBS.
 
Following is an example to illustrate how losses recorded at inception on certain guaranty contracts affect our earnings over time. Assume that within one of our guaranty contracts, we have an individual Fannie Mae MBS issuance for which the present value of the guaranty fees we expect to receive over time based on both a five-


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year contractual and expected life of the fixed-rate loans underlying the MBS totals $100. Based on market expectations, we estimate that a market participant would require $120 to assume the risk associated with our guaranty of the principal and interest due to investors in the MBS trust. To simplify the accounting in our example, we assume that the expected life of the underlying loans remains the same over the five-year contractual period and the annual scheduled principal and interest loan payments are equal over the five-year period.
 
Accounting Upon Initial Issuance of MBS:
 
  •  We record a guaranty asset of $100, which represents the present value of the guaranty fees we expect to receive over time.
 
  •  We record a guaranty obligation of $120, which represents the estimated amount that a market participant would require to assume this obligation.
 
  •  We record the difference of $20, or the amount by which the guaranty obligation exceeds the guaranty asset, in our income statement as losses on certain guaranty contracts.
 
Accounting in Each of Years 1 to 5:
 
  •  We collect $20 in guaranty fees per year, which represents one-fifth of the outstanding receivable amount, and record this amount as a reduction in the guaranty asset.
 
  •  We reduce the guaranty obligation by a proportionate amount, or one-fifth, and record this amount, which totals $24, in our income statement as guaranty fee income.
 
                                                         
    For the Years Ended     Cumulative
 
    0     1     2     3     4     5     Effect  
 
Losses on certain guaranty contracts
  $ (20 )   $     $     $     $     $     $ (20 )
Guaranty fee income
          24       24       24       24       24       120  
                                                         
Pre-tax income
  $ (20 )   $ 24     $ 24     $ 24     $ 24     $ 24     $ 100  
                                                         
 
As illustrated in the example, the $20 loss recognized at inception of the guaranty contract will be accreted into earnings over time as a component of guaranty fee income. For additional information on our accounting for guaranty transactions, which is more complex than the example presented, refer to our 2006 Form 10-K in “Notes to Consolidated Financial Statements—Note 1, Summary of Significant Accounting Policies.”
 
As credit conditions deteriorated during the first six months of 2007, the market’s expectation of future credit risk increased. This change in market conditions increased the estimated risk premium or compensation that a market participant would require to assume our guaranty obligations. As a result, the estimated fair value of our guaranty obligations related to MBS issuances increased, contributing to a higher level of losses at inception on certain of our MBS issuances. Our losses on certain guaranty contracts also were affected by the following during the first six months of 2007:
 
  •  Lender Flow Transaction Contracts:  We enter into flow transaction contracts that establish our base guaranty fee pricing with a lender for a specified period of time. Because pricing is fixed for a period of time, these contracts may limit our ability to immediately adjust our base guaranty fee pricing to reflect changes in market conditions. As the market risk premium increased during the first six months of 2007, we experienced an increase in the losses related to some of these contracts because we had established our base guaranty fee pricing for a specified time period and could not increase our prices to reflect the increased market risk. To address this in part, we have expanded our use of standard risk-based price adjustments that apply to all deliveries of loans with certain risk characteristics.
 
  •  Affordability Mission—Housing Goals:  Our efforts to increase the amount of mortgage financing that we make available to target populations and geographic areas to support our housing goals contributed to an increase in losses on certain guaranty contracts for the first six months of 2007, due to the higher credit


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risk premium associated with these MBS issuances. In addition, certain contracts that support our affordability mission are priced at a discounted rate.
 
  •  Contract-Level Pricing:  We negotiate guaranty contracts with our customers based upon the overall economics of the transaction; however, the accounting for our guaranty-related assets and liabilities is not determined at the contract level for the substantial majority of our guaranty transactions. Instead, it is determined separately for each individual MBS issuance within a contract. Although we determine losses at an individual MBS issuance level, we largely price our guaranty business on an overall contract basis and establish a single price for all loans included in the contract. Accordingly, a single guaranty transaction may result in some loan pools for which we recognize a loss immediately in earnings and other loan pools for which we record deferred profits that are recognized as a component of guaranty fee income over the life of the loans underlying the MBS issuance.
 
We expect that the vast majority of our MBS guaranty transactions will generate positive economic returns over the lives of the related MBS because we expect our guaranty fees to exceed our incurred credit losses based on our experience. Losses on certain guaranty contracts do not reflect our estimate of incurred credit losses in our mortgage credit book of business. Instead, these losses are recognized as charges against our allowance for loan losses or reserve for guaranty losses, and are reflected in our credit losses. Our combined allowance for loan losses and reserve for guaranty losses reflects our estimate of the probable credit losses inherent in our mortgage credit book of business. See “Credit-Related Expenses” for a discussion of our current year provision for credit losses.
 
We have increased guaranty pricing for some of our loan products during 2007. Additionally, we have made targeted eligibility changes during 2007 to enhance the risk profile characteristics of mortgage loans that we guarantee. We previously disclosed that we expected losses on certain guaranty contracts to more than double in 2007 from the $439 million recorded in 2006. Based on the losses reported for the first nine months of 2007, we expect our losses on certain guaranty contracts for the full year 2007 to be significantly higher than previously estimated.
 
Investment Gains (Losses), Net
 
Table 5 summarizes the components of investment gains (losses), net, for the three and six months ended June 30, 2007 and 2006.
 
Table 5:  Investment Gains (Losses), Net
 
                                 
    For the
    For the
 
    Three Months Ended
    Six Months Ended
 
    June 30,     June 30,  
    2007     2006     2007     2006  
    (Dollars in millions)  
 
Other-than-temporary impairment on investment securities(1)
  $     $ (414 )   $ (3 )   $ (846 )
Lower-of-cost-or-market adjustments on held-for-sale loans
    (115 )     (50 )     (118 )     (92 )
Gains (losses) on Fannie Mae portfolio securitizations, net
    (11 )     12       38       29  
Gains on sale of investment securities, net
    28       4       315       10  
Unrealized losses on trading securities, net
    (474 )     (173 )     (429 )     (389 )
Other investment losses, net
    (22 )     (12 )     (41 )     (20 )
                                 
Investment losses, net
  $ (594 )   $ (633 )   $ (238 )   $ (1,308 )
                                 
 
 
(1) Excludes other-than-temporary impairment on guaranty assets and buy-ups as these amounts are recognized as a component of guaranty fee income.
 
The $39 million decrease in investment losses for the second quarter of 2007 from the second quarter of 2006 was primarily attributable to the following:
 
  •  A decrease of $414 million in other-than-temporary impairment on investment securities. We recognized $414 million in other-than-temporary impairment during the second quarter of 2006 due to a general


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  increase in interest rates during the quarter, which caused the fair value of certain securities that we designated for sale to decline below the carrying value of those securities. In contrast, we did not experience any other-than-temporary impairment during the second quarter of 2007.
 
  •  An increase of $301 million in unrealized losses on trading securities. The increase in unrealized losses reflects the combined effect of an increase in our portfolio of mortgage-related securities classified as trading and a decrease in the fair value of these securities due to an increase in long-term interest rates during the quarter and a widening of credit spreads.
 
  •  An increase of $65 million in lower-of-cost-or-market (“LOCOM”) adjustments on held-for-sale (“HFS”) loans. The increase in LOCOM adjustments was due to the combined effect of an increase in our portfolio of HFS loans and a significant increase in the sale of securities.
 
The $1.1 billion decrease in investment losses for the first six months of 2007 from the first six months 2006 was primarily attributable to the following:
 
  •  A decrease of $843 million in other-than-temporary impairment on investment securities. We recognized $846 million in other-than-temporary impairment for the first six months of 2006 due to a general increase in interest rates during the period, which caused the fair value of certain securities that we designated for sale to decline below the carrying value of those securities. In contrast, we recognized only $3 million in other-than-temporary impairment for the first six months of 2007. We expect other-than-temporary impairment on investment securities for the full year 2007 to be significantly lower than the amount recorded in 2006.
 
  •  An increase of $305 million in gains on sale of investment securities, net. We recorded net gains of $315 million and $10 million for the first six months of 2007 and 2006, respectively, related to the sale of securities totaling $25.1 billion and $24.8 billion, respectively. The investment gains recorded during the first six months of 2007 were attributable to the recovery in value of securities we sold that we had previously written down due to other-than-temporary impairment.
 
As described in “Consolidated Balance Sheet Analysis—Trading Securities,” we increased our portfolio of trading securities during the first nine months of 2007 to approximately $48.7 billion as of September 30, 2007, from $11.5 billion as of December 31, 2006. While changes in the fair value of our trading securities generally move inversely to changes in the fair value of our derivatives, we recorded losses on both our trading securities and derivatives for the first nine months of the year. We recorded unrealized losses of $180 million on our trading securities for the first nine months of 2007, reflecting the combined effect of the increase in our portfolio of mortgage-related securities classified as trading and a decrease in the fair value of these securities due to the significant widening of credit spreads during the period.
 
Because the fair value of our trading securities is affected by market fluctuations that cannot be predicted, we cannot estimate the impact of changes in the fair value of our trading securities for the full year. We provide information on the sensitivity of changes in the fair value of trading securities to changes in interest rates in “Risk Management—Interest Rate Risk Management and Other Market Risks—Measuring Interest Rate Risk.”


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Derivatives Fair Value Gains, Net
 
Table 6 presents, by type of derivative instrument, the fair value gains and losses on our derivatives for the three and six months ended June 30, 2007 and 2006. Table 6 also includes an analysis of the components of derivatives fair value gains and losses attributable to net contractual interest income (expense) 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 five-year interest rate swap rate, which is shown below in Table 6, is a key reference interest rate affecting the estimated fair value of our derivatives.
 
Table 6:  Derivatives Fair Value Gains, Net
 
                                 
    For the
    For the
 
    Three Months Ended
    Six Months Ended
 
    June 30,     June 30,  
    2007     2006     2007     2006  
    (Dollars in millions)  
 
Risk management derivatives:
                               
Swaps:
                               
Pay-fixed
  $ 6,206     $ 4,264     $ 5,720     $ 9,050  
Receive-fixed
    (3,241 )     (1,535 )     (2,878 )     (3,340 )
Basis
    (111 )     (13 )     (125 )     (13 )
Foreign currency(1)
    (63 )     126       (43 )     97  
Swaptions:
                               
Pay-fixed
    392       (100 )     269       (103 )
Receive-fixed
    (1,356 )     (1,203 )     (1,659 )     (3,356 )
Interest rate caps
    7       53       8       125  
Other(2)
  $ 2     $ (3 )   $ 1     $ 2  
                                 
Risk management derivatives fair value gains, net
    1,836       1,589       1,293       2,462  
Mortgage commitment derivatives fair value gains, net
    80       32       60       65  
                                 
Total derivatives fair value gains, net
  $ 1,916     $ 1,621     $ 1,353     $ 2,527  
                                 
Risk management derivatives fair value gains (losses) attributable to:
                               
Net contractual interest income (expense) on interest rate swaps
  $ 64     $ (68 )   $ 98     $ (239 )
Net change in fair value of terminated derivative contracts from end of prior period to date of termination
    (29 )     8       (93 )     (91 )
Net change in fair value of outstanding derivative contracts, including derivative contracts entered into during the period
    1,801       1,649       1,288       2,792  
                                 
Risk management derivatives fair value gains, net(3)
  $ 1,836     $ 1,589     $ 1,293     $ 2,462  
                                 
 
                 
    2007     2006  
 
5-year swap rate:
               
As of January 1
    5.10 %     4.88 %
As of March 31
    4.99       5.31  
As of June 30
    5.50       5.65  
 
 
(1) Includes the effect of net contractual interest expense of approximately $16 million and $17 million for the three months ended June 30, 2007 and 2006, respectively, and $34 million and $35 million for the six months ended June 30, 2007 and 2006, respectively. The change in fair value of foreign currency swaps excluding this item resulted in a net loss of $47 million and a net gain of $143 million for the three months ended June 30, 2007 and 2006, respectively, and a net loss of $9 million and net gain of $132 million for the six months ended June 30, 2007 and 2006, respectively.
 
(2) Includes MBS options, forward starting debt, swap credit enhancements and mortgage insurance contracts.
 
(3) Reflects net derivatives fair value gains (losses) recognized in the condensed consolidated statements of income, excluding mortgage commitments.


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As shown in Table 6 above, we recorded net contractual interest income on interest rate swaps for the three and six months ended June 30, 2007, compared with net contractual interest expense for the three and six months ended June 30, 2006. Although these amounts are included in the net derivatives fair value gains recognized in our condensed consolidated statements of income, we consider the interest accruals on our interest rate swaps to be part of the cost of funding our mortgage investments.
 
As a result of the increase in swap rates during the second quarter and first six months of both 2007 and 2006, we recorded derivatives fair value gains during each period. These gains were largely attributable to fair value gains on our pay-fixed swaps, which were partially offset by fair value losses on our receive-fixed swaps. The derivatives fair value gains of $1.4 billion recorded for the first six months of 2007 were significantly lower than the gains of $2.5 billion recorded for the first six months of 2006 because of the magnitude of interest rate movements during each period. For example, while the 5-year swap rate, one of our key reference rates, increased during each period, the increase was 40 basis points for the first six months of 2007, compared with an increase of 77 basis points for the first six months of 2006.
 
We recorded derivatives fair value losses of $2.2 billion for the third quarter of 2007 due to a decrease in swap rates during the quarter and derivatives fair value losses of $891 million for the first nine months of 2007. Because the fair value of our derivatives is affected by market fluctuations that cannot be predicted, we cannot estimate the impact of changes in the fair value of our derivatives for the remainder of 2007. We provide information on the sensitivity of changes in the fair value of our derivatives to changes in interest rates in “Risk Management—Interest Rate Risk Management and Other Market Risks—Measuring Interest Rate Risk.”
 
Losses from Partnership Investments
 
Losses from partnership investments increased to $215 million for the second quarter of 2007, from $188 million for the second quarter of 2006. The increase in losses for the second quarter of 2007 was attributable to continuing increases in the amount we invest in federal low-income housing tax credit (“LIHTC”) partnerships. LIHTC partnerships generate tax credits and incur operational losses for which we obtain tax benefits through tax deductions. See “Provision for Federal Income Taxes” for a discussion of LIHTC tax benefits.
 
Losses from partnership investments decreased to $380 million for the first six months of 2007, from $382 million for the first six months of 2006. The decrease in losses for the first six months of 2007 was due to the recognition of a gain on the sale of investments in LIHTC partnerships in March 2007, which was offset by an increase in net operating losses from our continuing investments in LIHTC partnerships.
 
Administrative Expenses
 
Table 7 details the components of our administrative expenses, which include ongoing operating costs, as well as costs associated with our efforts to return to timely financial reporting.
 
Table 7:  Administrative Expenses
 
                                                 
    For the
                   
    Three Months Ended
          For the
       
    June 30,           Six Months Ended June 30,        
    2007     2006     Variance     2007     2006     Variance  
    (Dollars in millions)  
 
Ongoing operating costs(1)
  $ 508     $ 494       3 %   $ 1,035     $ 915       13 %
Restatement and related regulatory expenses(2)
    152       286       (47 )     323       573       (44 )
                                                 
Total administrative expenses
  $ 660     $ 780       (15 )%   $ 1,358     $ 1,488       (9 )%
                                                 
 
 
(1) Excludes costs associated with our efforts to return to timely financial reporting and also excludes various costs that we do not expect to incur on a regular basis.
 
(2) Includes costs of restatement and related regulatory examinations, investigations and litigation, and costs associated with our efforts to return to timely financial reporting.


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The decreases in administrative expenses for the second quarter of 2007 from the second quarter of 2006, and for the first six months of 2007 from the first six months of 2006, were due to a significant reduction in restatement and related regulatory expenses. This reduction was partially offset by an increase in our ongoing operating costs, resulting from the significant investment we have made to remediate material weaknesses in our internal control over financial reporting by enhancing our organizational structure and systems. Due in part to this investment, we expect our ongoing operating costs for 2007 to exceed those for 2006.
 
As we have previously disclosed, we undertook a thorough review of our costs beginning in January 2007 as part of a broad reengineering initiative to increase productivity and lower administrative costs. As a result of this effort, we expect to reduce our total administrative expenses by more than $200 million in 2007 as compared with 2006, primarily through a reduction in employee and contract resources. We estimate that our 2007 productivity and cost reduction reengineering initiative will reduce our ongoing operating costs to approximately $2 billion in 2008.
 
Credit-Related Expenses
 
Our credit-related expenses consist of our provision for credit losses and our foreclosed property expense. Our credit-related expenses increased to $518 million for the second quarter of 2007, from $158 million for the second quarter of 2006. Credit-related expenses increased to $839 million for the first six months of 2007, from $260 million for the first six months of 2006. Following is a discussion of changes in the components of our credit-related expenses for each comparable period.
 
The provision for credit losses increased by $290 million, or 201%, to $434 million for the second quarter of 2007, from $144 million for the second quarter of 2006. The provision for credit losses increased by $460 million, or 206%, to $683 million for the first six months of 2007, from $223 million for the first six months of 2006. The increase in each period is attributable to an increase in net charge-offs during each period. The increase in net charge-offs in each period reflects higher default rates and an increase in the average amount of loss per loan, or charge-off severity, resulting from continued economic weakness in the Midwest region and the national decline in home prices during the first six months of 2007. The higher default rates are, in part, due to earlier than anticipated defaults on loans originated in 2006. The increase in charge-off severity is attributable to the combined effect of the national decline in home prices and the higher unpaid principal balances of these loans going to foreclosure.
 
Foreclosed property expense increased by $70 million, or 500%, to $84 million for the second quarter of 2007, from $14 million for the second quarter of 2006. Foreclosed property expense increased by $119 million, or 322%, to $156 million for the first six months of 2007, from $37 million for the first six months of 2006. These increases were driven by an increase in the inventory of foreclosed properties and rapidly declining sales prices on foreclosed properties, particularly in the Midwest, which accounted for the majority of the increase in our foreclosed property expense in each period. The national decline in home prices has contributed to further increases in foreclosure activity.
 
Any amounts due from mortgage insurance companies on primary mortgage insurance in excess of the amount of a loan charge-off and all pool mortgage insurance are recognized as a reduction to our credit losses when such amounts are collected from insurance companies. As such, a significant amount of our current year credit losses will result in a reduction in our credit losses in subsequent periods as cash collections are received from mortgage insurance companies, either as a recovery to our allowance for loan losses or reserve for guaranty losses or as a reduction of foreclosed property expense.
 
Home prices have continued to decline since the end of the second quarter of 2007, and we expect they will continue to decline for the remainder of 2007 and in 2008. As a result, we expect significant increases in our serious delinquency rates, foreclosure activity, credit losses and credit-related expenses for 2007 compared with 2006, and for 2008 compared with 2007. We provide additional detail on our credit losses and factors affecting our allowance for loan losses and reserve for guaranty losses in “Risk Management—Credit Risk Management—Mortgage Credit Risk Management.”


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Other Non-Interest Income (Expense)
 
We recorded other non-interest expenses of $56 million for the second quarter of 2007, compared with other non-interest income of $5 million for the second quarter of 2006. We recorded other non-interest expenses of $155 million and $11 million for the first six months of 2007 and 2006, respectively. The increase in expenses for each period was predominately due to higher credit enhancement expenses and a reduction in the amount of net gains recognized on the extinguishment of debt.
 
Federal Income Taxes
 
Our effective federal income tax rate, excluding the provision for taxes related to extraordinary amounts, was 9% and 23% for the second quarter of 2007 and 2006, respectively, and 4% and 20% for the first six months of 2007 and 2006, respectively. The difference between our federal statutory rate of 35% and our effective tax rate is primarily due to the tax benefits we receive from our investments in LIHTC partnerships and other equity investments that help to support our affordable housing mission. In calculating our interim provision for income taxes, we use an estimate of our annual effective tax rate, which we update each quarter based on actual historical information and forward-looking estimates. The estimated annual effective tax rate may fluctuate each period based upon changes in facts and circumstances, if any, as compared to those forecasted at the beginning of the year and each interim period thereafter. The variance in our effective tax rate between periods is primarily due to the combined effect of fluctuations in our actual pre-tax income and our estimated annual taxable income, which affects the relative tax benefit we expect to receive from tax-exempt income and tax credits, and changes in the actual dollar amount of these tax benefits.
 
BUSINESS SEGMENT RESULTS
 
Results of our three business segments are intended to reflect each segment as if it were a stand-alone business. We describe the management reporting and allocation process used to generate our segment results in our 2006 Form 10-K in “Notes to Consolidated Financial Statements—Note 15, Segment Reporting.” We summarize our segment results for the three and six months ended June 30, 2007 and 2006 in the tables below and provide a discussion of these results. We include more detail on our segment results in “Notes to Condensed Consolidated Financial Statements—Note 12, Segment Reporting.”


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Single-Family Business
 
Net income for our Single-Family business decreased by $396 million, or 74%, to $136 million for the second quarter of 2007, from $532 million for the second quarter of 2006. Net income for our Single-Family business decreased by $616 million, or 56%, to $491 million for the first six months of 2007, from $1.1 billion for the first six months of 2006. Table 8 summarizes the financial results for our Single-Family business for the periods indicated. The primary source of revenue for our Single-Family business is guaranty fee income. Other sources of revenue include trust management income and technology and other fees. Expenses primarily include credit-related expenses, losses on certain guaranty contracts and administrative expenses.
 
Table 8:  Single-Family Business Results
 
                                                                 
    For the
    For the
             
    Three Months Ended
    Six Months Ended
    Quarterly
    Year-to-Date
 
    June 30,     June 30,     Variance     Variance  
    2007     2006     2007     2006     $     %     $     %  
    (Dollars in millions)  
 
Income Statement Data:
                                                               
Guaranty fee income
  $ 1,304     $ 1,085     $ 2,591     $ 2,164     $ 219       20 %   $ 427       20 %
Trust management income(1)
    141             295             141             295        
Other income(2)
    180       355       351       685       (175 )     (49 )     (334 )     (49 )
Losses on certain guaranty contracts
    (451 )     (48 )     (731 )     (74 )     (403 )     (840 )     (657 )     (888 )
Credit-related expenses(3)
    (519 )     (146 )     (845 )     (258 )     (373 )     (255 )     (587 )     (228 )
Other expenses(4)
    (450 )     (433 )     (913 )     (822 )     (17 )     (4 )     (91 )     (11 )
                                                                 
Income before federal income taxes
    205       813       748       1,695       (608 )     (75 )     (947 )     (56 )
Provision for federal income taxes
    (69 )     (281 )     (257 )     (588 )     212       75       331       56  
                                                                 
Net income
  $ 136     $ 532     $ 491     $ 1,107     $ (396 )     (74 )%   $ (616 )     (56 )%
                                                                 
Other Key Performance Data:
                                                               
Average single-family guaranty book of business(5)
  $ 2,349,006     $ 2,156,059     $ 2,318,897     $ 2,136,854     $ 192,947       9 %   $ 182,043       9 %
 
 
(1) Effective January 1, 2007, we began separately reporting our float income as “Trust management income.” Float income for 2006 is included in “Other income.”
 
(2) Consists of net interest income, investment gains and losses, and fee and other income.
 
(3) Consists of the provision for credit losses and foreclosed property expense.
 
(4) Consists of administrative expenses and other expenses.
 
(5) The single-family guaranty book of business consists of single-family mortgage loans held in our portfolio, single-family Fannie Mae MBS held in our portfolio, single-family Fannie Mae MBS held by third parties and other single-family credit enhancements that we provide.
 
Key factors affecting the results of our Single-Family business for the three and six months ended June 30, 2007, compared with the three and six months ended June 30, 2006 included the following.
 
  •  Increased guaranty fee income for both the three and six months ended June 30, 2007, attributable to an increase in the average single-family guaranty book of business, coupled with an increase in the average effective single-family guaranty fee rate.
 
  —  The growth in our average single-family guaranty book of business was due to strong growth in single-family Fannie Mae MBS issuances and a decrease in the liquidation rate of the single-family guaranty book of business. Total single-family Fannie Mae MBS outstanding increased to $2.0 trillion as of June 30, 2007, from $1.9 trillion as of December 31, 2006. Our estimated overall market share of new single-family mortgage-related securities issuances increased to approximately 27.9% for the second quarter of 2007, from approximately 22.8% for the second quarter of 2006. Our market share has continued to increase since the end of the second quarter of 2007, due to the shift in the product mix of mortgage originations to more traditional conforming fixed-rate loans and reduced competition


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  from private-label issuers of mortgage-related securities. These market share estimates are based on publicly available data and exclude previously securitized mortgages.
 
  —  The growth in our average effective single-family guaranty fee rate resulted from targeted pricing increases on new business due to the increase in the market pricing of mortgage credit risk, an increase in our acquisition of Alt-A mortgage loans, which generally have higher guaranty fee rates, and an increase in the accretion of our guaranty obligation and deferred profit into income in the first six months of 2007 as compared with the same period in 2006.
 
  •  Significantly higher losses on certain guaranty contracts for both the three and six months ended June 30, 2007, due to the deterioration in home prices and overall housing market conditions during the first six months of 2007, which led to an increase in mortgage and credit risk pricing that resulted in an increase in the estimated fair value of our guaranty obligations. As a result, we recorded increased losses on certain guaranty contracts, in conjunction with our MBS issuances during the second quarter and first six months of 2007.
 
  •  A substantial increase in credit-related expenses for both the three and six months ended June 30, 2007, reflecting an increase in both the provision for credit losses and foreclosed property expense due to the continued impact of weak economic conditions in the Midwest and the effect of the national decline in home prices.
 
  •  A relatively stable effective income tax rate of 34% for the three and six months ended June 30, 2007, compared with 35% for the three and six months ended June 30, 2006.
 
HCD Business
 
Net income for our HCD business increased by $21 million, or 24%, to $110 million for the second quarter of 2007, from $89 million for the second quarter of 2006. Net income for our HCD business increased by $38 million, or 16%, to $273 million for the first six months of 2007, from $235 million for the first six months of 2006. Table 9 summarizes the financial results for our HCD business for the periods indicated. The primary sources of revenue for our HCD business are guaranty fee income and other income. Expenses primarily include administrative expenses, credit-related expenses and net operating losses associated with LIHTC investments. The losses on our LIHTC investments are offset by the tax benefits generated from these investments.
 
Table 9:  HCD Business Results
 
                                                                 
    For the
    For the
             
    Three Months Ended
    Six Months Ended
    Quarterly
    Year-to-Date
 
    June 30,     June 30,     Variance     Variance  
    2007     2006     2007     2006     $     %     $     %  
    (Dollars in millions)  
 
Income Statement Data:
                                                               
Guaranty fee income(1)
  $ 110     $ 125     $ 211     $ 261     $ (15 )     (12 )%   $ (50 )     (19 )%
Other income(1)(2)
    106       53       200       106       53       100       94       89  
Losses on partnership investments
    (215 )     (188 )     (380 )     (382 )     (27 )     (14 )     2       1  
Credit-related expenses(3)
    1       (12 )     6       (2 )     13       108       8       400  
Other expenses(4)
    (263 )     (246 )     (510 )     (433 )     (17 )     (7 )     (77 )     (18 )
                                                                 
Loss before federal income taxes
    (261 )     (268 )     (473 )     (450 )     7       3       (23 )     (5 )
Benefit for federal income taxes
    371       357       746       685       14       4       61       9  
                                                                 
Net income
  $ 110     $ 89     $ 273     $ 235     $ 21       24 %   $ 38       16 %
                                                                 
Other Key Performance Data:
                                                               
Average multifamily guaranty book of business(5)
  $ 126,575     $ 116,427     $ 124,818     $ 117,870     $ 10,148       9 %   $ 6,948       6 %


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(1) Certain prior period amounts that previously were included as a component of “Fee and other income” have been reclassified to “Guaranty fee income” to conform to the current period presentation.
 
(2) Consists of trust management income and fee and other income.
 
(3) Consists of the benefit for credit losses and foreclosed property income.
 
(4) Consists of net interest expense, losses on certain guaranty contracts, administrative expenses, minority interest in earnings of consolidated subsidiaries and other expenses.
 
(5) The multifamily guaranty book of business consists of multifamily mortgage loans held in our portfolio, multifamily Fannie Mae MBS held in our portfolio, multifamily Fannie Mae MBS held by third parties and other multifamily credit enhancements that we provide.
 
Key factors affecting the results of our HCD business for the three and six months ended June 30, 2007, compared with the three and six months ended June 30, 2006 included the following.
 
  •  Decreased guaranty fee income for both the three and six months ended June 30, 2007, resulting from a decline in the average effective multifamily guaranty fee rate, which was partially offset by an increase in the average multifamily guaranty book of business. The decline in our average effective multifamily guaranty fee rate for both the three and six months ended June 30, 2007 was due in part to the amortization and recognition of deferred profits in 2006 related to a large multifamily transaction that was terminated in December 2006. In addition, our HCD business continued to experience competitive fee pressure from private-label issuers of commercial mortgage-backed securities during the first six months of 2007.
 
  •  An increase in losses on partnership investments for the second quarter of 2007, due to the continuing increases in the amount we invest in LIHTC partnerships. Losses on partnership investments declined slightly for the first six months of 2007 as a result of the recognition of a gain on the sale of investments in LIHTC partnerships in March 2007, which was offset by an increase in net operating losses from our continuing investments in LIHTC partnerships.
 
  •  An increase in other income for the first six months of 2007, due to an increase in multifamily loan prepayment and yield maintenance fees resulting from higher liquidations in the first six months of 2007 relative to the first six months of 2006.
 
  •  An increase in other expenses for the first six months of 2007, resulting from higher net interest expense associated with an increase in segment assets and higher credit enhancement expenses.
 
  •  An increase in the relative tax benefit generated by our LIHTC investments due to the overall reduction in our consolidated pre-tax income and increase in the proportion of our pre-tax income offset by these tax benefits.


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Capital Markets Group
 
Net income for our Capital Markets group increased by $264 million, or 18%, to $1.7 billion for the second quarter of 2007, from $1.4 billion for the second quarter of 2006. Net income for our Capital Markets group decreased by $598 million, or 22%, to $2.1 billion for the first six months of 2007, from $2.7 billion for the first six months of 2006. Table 10 summarizes the financial results for our Capital Markets group for the periods indicated. The primary sources of revenue for our Capital Markets group are net interest income and fee and other income. Expenses primarily consist of administrative expenses. Derivatives fair value gains and losses, investment gains and losses, and debt extinguishment gains and losses also have a significant impact on the financial performance of our Capital Markets group.
 
Table 10:  Capital Markets Business Results
 
                                                                 
    For the
    For the
                         
    Three Months Ended
    Six Months Ended
    Quarterly
    Year-to-Date
 
    June 30,     June 30,     Variance     Variance  
    2007     2006     2007     2006     $     %     $     %  
    (Dollars in millions)  
 
Net interest income
  $ 1,182     $ 1,685     $ 2,391     $ 3,527     $ (503 )     (30 )%   $ (1,136 )     (32 )%
Investment losses, net
    (587 )     (663 )     (239 )     (1,360 )     76       11       1,121       82  
Derivatives fair value gains, net
    1,916       1,621       1,353       2,527       295       18       (1,174 )     (46 )
Fee and other income
    92       (73 )     132       102       165       226       30       29  
Other expenses(1)
    (410 )     (453 )     (884 )     (945 )     43       9       61       6  
                                                                 
Income before federal income taxes and extraordinary gains (losses), net of tax effect
    2,193       2,117       2,753       3,851       76       4       (1,098 )     (29 )
Provision for federal income taxes
    (489 )     (686 )     (603 )     (1,116 )     197       29       513       46  
Extraordinary (losses) gains, net of tax effect
    (3 )     6       (6 )     7       (9 )     (150 )     (13 )     (186 )
                                                                 
Net income
  $ 1,701     $ 1,437     $ 2,144     $ 2,742     $ 264       18 %   $ (598 )     (22 )%
                                                                 
 
 
(1) Includes debt extinguishment gains (losses), guaranty fee expense, administrative expenses and other expenses.
 
Key factors affecting the results of our Capital Markets group for the three and six months ended June 30, 2007, compared with the three and six months ended June 30, 2006 included the following.
 
  •  A significant reduction in net interest income for both the three and six months ended June 30, 2007 due to continued compression in our net interest yield, largely attributable to the increase in our short-term and long-term debt costs as we continued to replace, at higher interest rates, maturing debt that we had issued at lower interest rates during the past few years.
 
  •  A reduction in net investment losses, due to a lower level of other-than-temporary impairment on investment securities and an increase in gains on the sale of investment securities, which were partially offset by an increase in unrealized losses on trading securities.
 
  —  We did not experience any significant other-than-temporary impairment for the three and six months ended June 30, 2007. In contrast, we recognized other-than-temporary impairment on investment securities totaling $414 million and $846 million for the three and six months ended June 30, 2006, due to the general increase in interest rates during each period, which caused the fair value of certain securities that we designated for sale to decline below the carrying value of those securities.
 
  —  We experienced an increase in gains on the sale of investment securities for the three and six months ended June 30, 2007, due to the recovery in value of securities we sold that we had previously written down due to other-than-temporary impairment.
 
  —  We recorded an increased level of unrealized losses on trading securities for the three and six months ended June 30, 2007, reflecting the combined effect of an increase in our portfolio of mortgage-


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related securities classified as trading and a decrease in the fair value of these securities due to wider credit spreads.
 
  •  Derivatives fair value gains of $1.9 billion and $1.6 billion for the second quarter of 2007 and the second quarter of 2006, respectively, which were largely attributable to an increase in swap rates in each period that resulted in fair value gains on our pay-fixed swaps, which were partially offset by fair value losses on our receive-fixed swaps. We also recorded derivatives fair value gains for the first six months of 2007 and 2006 because of an increase in swap rates during each period. However, the net gains of $1.4 billion recorded for the first six months of 2007 were significantly lower than the net gains of $2.5 billion recorded for the first six months of 2006 because the movement in swap rates in 2007 was not as large.
 
  •  An increase in fee and other income attributable to a reduction in foreign currency exchange losses on our foreign-denominated debt.
 
  •  An effective income tax rate of 22% and 22% for the three and six months ended June 30, 2007, respectively, compared with 32% and 29% for the three and six months ended June 30, 2006. The reduction in the effective tax rate below the statutory rate was primarily due to tax-exempt income generated from our investments in mortgage revenue bonds.
 
CONSOLIDATED BALANCE SHEET ANALYSIS
 
Our total assets of $857.8 billion as of June 30, 2007 increased by $13.9 billion, or 2%, from December 31, 2006. Our total liabilities of $818.0 billion as of June 30, 2007 increased by $15.7 billion, or 2%, from December 31, 2006. Stockholders’ equity of $39.7 billion as of June 30, 2007 reflected a decrease of $1.8 billion, or 4%, from December 31, 2006. Following is a discussion of material changes since December 31, 2006 in the major components of our assets and liabilities.
 
Mortgage Investments
 
Table 11 shows the composition of our mortgage portfolio by product type and the carrying value, which reflects the net impact of our purchases, sales and liquidations, of these products as of June 30, 2007 and December 31, 2006.
 
Table 11:  Mortgage Portfolio Composition(1)
 
                 
    As of  
    June 30,
    December 31,
 
    2007     2006  
    (Dollars in millions)  
 
Mortgage loans:(2)
               
Single-family:
               
Government insured or guaranteed
  $ 21,970     $ 20,106  
Conventional:
               
Long-term, fixed-rate
    199,835       202,339  
Intermediate-term, fixed-rate(3)
    49,755       53,438  
Adjustable-rate
    48,903       46,820  
                 
Total conventional single-family
    298,493       302,597  
                 
Total single-family
    320,463       322,703  
                 


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    As of  
    June 30,
    December 31,
 
    2007     2006  
    (Dollars in millions)  
 
Multifamily:
               
Government insured or guaranteed
    895       968  
Conventional:
               
Long-term, fixed-rate
    5,085       5,098  
Intermediate-term, fixed-rate(3)
    60,714       50,847  
Adjustable-rate
    5,533       3,429  
                 
Total conventional multifamily
    71,332       59,374  
                 
Total multifamily
    72,227       60,342  
                 
Total mortgage loans
    392,690       383,045  
                 
Unamortized premiums and other cost basis adjustments, net
    833       943  
Lower of cost or market adjustments on loans held for sale
    (135 )     (93 )
Allowance for loan losses for loans held for investment
    (337 )     (340 )
                 
Total mortgage loans, net
    393,051       383,555  
                 
Mortgage-related securities:
               
Fannie Mae single-class MBS
    108,367       124,383  
Non-Fannie Mae single-class mortgage securities
    28,514       27,980  
Fannie Mae structured MBS
    71,493       75,261  
Non-Fannie Mae structured mortgage securities(4)
    105,593       97,399  
Mortgage revenue bonds
    16,359       16,924  
Other mortgage-related securities
    3,633       3,940  
                 
Total mortgage-related securities
    333,959       345,887  
                 
Market value adjustments(5)
    (5,687 )     (1,261 )
Other-than-temporary impairments
    (610 )     (1,004 )
Unamortized premiums (discounts) and other cost basis adjustments, net(6)
    (1,039 )     (1,083 )
                 
Total mortgage-related securities, net
    326,623       342,539  
                 
Mortgage portfolio, net(7)
  $ 719,674     $ 726,094  
                 
 
 
(1) Mortgage loans and mortgage-related securities are reported at unpaid principal balance.
 
(2) Mortgage loans include unpaid principal balance totaling $101.6 billion and $105.5 billion as of June 30, 2007 and December 31, 2006, respectively, related to mortgage-related securities that were consolidated under Financial Accounting Standards Board Interpretation (“FIN”) No. 46R (revised December 2003), Consolidation of Variable Interest Entities (an interpretation of ARB No. 51) (“FIN 46R”), and mortgage-related securities created from securitization transactions that did not meet the sales criteria under SFAS No. 140, Accounting for Transfer and Servicing of Financial Assets and Extinguishments of Liabilities (a replacement of FASB Statement No. 125) (“SFAS 140”), which effectively resulted in mortgage-related securities being accounted for as loans.
 
(3) Intermediate-term, fixed-rate consists of mortgage loans with contractual maturities at purchase equal to or less than 15 years.
 
(4) As of June 30, 2007, $76.5 billion of this amount consists of private-label mortgage-related securities backed by subprime or Alt-A mortgage loans. Refer to “Risk Management—Credit Risk Management—Mortgage Credit Risk Management—Mortgage Credit Book of Business” for a description of our investments in subprime and Alt-A securities.
 
(5) Includes unrealized gains and losses on mortgage-related securities and securities commitments classified as trading and available-for-sale.
 
(6) Includes the impact of other-than-temporary impairments of cost basis adjustments.
 
(7) Includes consolidated mortgage-related assets acquired through the assumption of debt. Also includes $802 million and $448 million as of June 30, 2007 and December 31, 2006, respectively, of mortgage loans and mortgage-related securities that we have pledged as collateral and for which counterparties have the right to sell or repledge.
 
Pursuant to a May 2006 consent order with the Office of Federal Housing Enterprise Oversight (“OFHEO”), we are currently subject to a limit on the size of our mortgage portfolio. For the first two quarters of 2007, we were restricted from increasing our net mortgage portfolio assets above $727.75 billion. On September 19, 2007, OFHEO issued an interpretation of the consent order revising the existing portfolio cap. The mortgage

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portfolio cap is no longer based on the amount of our “net mortgage portfolio assets,” which reflects GAAP adjustments, but is now based on our “average monthly mortgage portfolio balance.” Our average monthly mortgage portfolio balance is based on the unpaid principal balance of our mortgage portfolio as defined and reported in our Monthly Summary, which is a statistical measure rather than an amount computed in accordance with GAAP, and excludes both consolidated mortgage-related assets acquired through the assumption of debt and the impact on the unpaid principal balances recorded on our purchases of delinquent loans from MBS trusts pursuant to Statement of Position No. 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (“SOP 03-3”). The mortgage portfolio cap was set at $735 billion for the third quarter of 2007. For the fourth quarter of 2007, the portfolio cap increased by 1% to $742.35 billion. For each subsequent quarter, the portfolio cap increases by 0.5%, not to exceed 2% per year. Except as described below, compliance with the portfolio cap will be determined by comparing the applicable portfolio cap to the cumulative average month-end portfolio balances, measured by unpaid principal balance, since July 2007 (until the cumulative average becomes and remains a 12-month moving average). For purposes of this calculation, OFHEO’s interpretation sets the July 2007 month-end balance at $725 billion. In addition, any net increase in delinquent loan balances in our portfolio after September 30, 2007 will be excluded from the month-end portfolio balance. Our average monthly mortgage portfolio balance was $725.9 billion as of September 30, 2007, which was $9.1 billion below our applicable portfolio limit of $735 billion. We will be subject to the OFHEO-directed minimum capital requirement and portfolio cap until the Director of OFHEO determines that these requirements should be modified or allowed to expire, taking into account certain specified factors.
 
We continue to manage the size of our mortgage portfolio to meet the OFHEO-directed portfolio cap. In addition to the portfolio cap, our investment activities may be constrained by our regulatory capital requirements, certain operational limitations, tax classifications and our intent to hold certain temporarily impaired securities until recovery, as well as risk parameters applied to the mortgage portfolio.
 
Table 12 compares our mortgage portfolio activity for the three and six months ended June 30, 2007 and 2006.
 
Table 12:  Mortgage Portfolio Activity(1)
 
                                                                 
    For the
          For the
       
    Three Months Ended
          Six Months Ended
       
    June 30,     Variance     June 30,     Variance  
    2007     2006     $     %     2007     2006     $     %  
    (Dollars in millions)  
 
Purchases
  $ 48,676     $ 60,780     $ (12,104 )     (20 )%   $ 84,833     $ 98,764     $ (13,931 )     (14 )%
Sales
    8,092       15,380       (7,288 )     (47 )     25,079       24,836       243       1  
Liquidations
    30,917       36,049       (5,132 )     (14 )     61,994       70,582       (8,588 )     (12 )
 
 
(1) The amounts provided represent the unpaid principal balances. These unpaid principal balance amounts, which represent statistical measures of business activity, do not reflect certain GAAP adjustments, including market valuation adjustments, allowance for loan losses, impairments, unamortized premiums and discounts, and the impact of consolidation of variable interest entities.
 
We selectively identify and purchase mortgage assets that meet our targeted risk-adjusted return thresholds. We typically are a more active purchaser when mortgage-to-debt spreads are wider and the prices of mortgage assets are lower. We generally reduce our purchases when mortgage-to-debt spreads are narrower and prices are higher. Our level of portfolio purchases decreased during the three and six months ended June 30, 2007 as compared with the same periods in 2006, due to lower market volumes resulting from the reduction in mortgage origination activity and a more limited availability of mortgage assets that met our risk-adjusted return thresholds. While our levels of portfolio sales for the first six months of 2007 were comparable to the first six months of 2006, we experienced a decrease in sales activity during the second quarter of 2007. The decrease in mortgage liquidations for the three and six months ended June 30, 2007 was largely attributable to the decline in home prices, which reduced the level of refinancing activity relative to the same periods in the prior year.


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Liquid Investments
 
Our liquid assets consist of non-mortgage investments, cash and cash equivalents, and funding agreements with our lenders, including advances to lenders and repurchase agreements. Our non-mortgage investments, which account for the majority of our liquid assets, primarily consist of high-quality securities that are readily marketable or have short-term maturities, such as commercial paper. Our liquid assets, net of cash equivalents pledged as collateral, totaled approximately $82.9 billion and $69.4 billion as of June 30, 2007 and December 31, 2006, respectively. Our non-mortgage investments, which are carried at fair value in our condensed consolidated balance sheets, totaled $53.6 billion and $47.6 billion as of June 30, 2007 and December 31, 2006, respectively. We reduced the level of our liquid assets to $62.6 billion as of September 30, 2007. We provide additional detail on our non-mortgage investments in “Notes to Condensed Consolidated Financial Statements—Note 5, Investments in Securities.”
 
Trading Securities
 
During 2007, we began designating an increasingly large portion of the securities we purchase as trading securities. This change in practice was principally driven by our adoption of Statement of Financial Accounting Standards (“SFAS”) No. 155, Accounting for Certain Hybrid Financial Instruments, an amendment of SFAS 133 and SFAS 140 (“SFAS 155”), which requires us to evaluate securities for embedded derivatives unless they are designated as trading securities. We increased our portfolio of trading securities during the first nine months of 2007 to approximately $48.7 billion as of September 30, 2007, from $11.5 billion as of December 31, 2006.
 
Available-for-Sale Securities
 
Although we report both our trading and available-for-sale (“AFS”) securities at fair value in our condensed consolidated balance sheets, changes in the fair value of our trading securities are reported in our earnings while changes in the fair value of our AFS securities are reported as a separate component of stockholders’ equity in accumulated other comprehensive income (“AOCI”). The estimated fair value and amortized cost of our AFS securities totaled $341.1 billion and $346.0 billion, respectively, as of June 30, 2007, and gross unrealized gains and gross unrealized losses recorded in AOCI related to these securities totaled $1.4 billion and $6.3 billion, respectively. In comparison, the estimated fair value and amortized cost of our AFS securities totaled $378.6 billion and $379.5 billion, respectively, as of December 31, 2006, and gross unrealized gains and gross unrealized losses recorded in AOCI totaled $2.8 billion and $3.7 billion, respectively.
 
The fair value of our investment securities, which are primarily mortgage-backed securities, are affected by changes in interest rates, credit spreads and other market factors. We generally view changes in the fair value of our investment securities caused by movements in interest rates to be temporary, which is consistent with our experience. We experienced a significant decrease in the fair value of our AFS securities at the end of the third quarter of 2007. The estimated fair value and amortized cost of our AFS securities totaled $315.0 billion and $318.2 billion, respectively, as of September 30, 2007, and gross unrealized gains and gross unrealized losses recorded in AOCI totaled $1.8 billion and $5.0 billion, respectively. We believe that substantially all of the decline in fair value of our AFS securities as of September 30, 2007 was due to the significant widening of credit spreads during the first nine months of 2007. We have the intent and ability to hold these securities until the earlier of recovery of the unrealized loss amounts or maturity. Accordingly, we believe that it is probable that we will collect the full principal and interest due in accordance with the contractual terms of the securities, although we may experience future declines in value as a result of movements in interest rates.


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Debt Instruments
 
We issue debt instruments as the primary means to fund our mortgage investments and manage our interest rate risk exposure. Table 13 shows the amount of our outstanding short-term borrowings and long-term debt as of June 30, 2007 and December 31, 2006.
 
Table 13:  Outstanding Debt(1)
 
                                 
    As of
    As of
 
    June 30, 2007     December 31, 2006  
          Weighted
          Weighted
 
          Average
          Average
 
          Interest
          Interest
 
    Outstanding     Rate     Outstanding     Rate  
    (Dollars in millions)  
 
Federal funds purchased and securities sold under agreements to repurchase
  $ 912       4.72 %   $ 700       5.36 %
                                 
Short-term debt:
                               
Fixed-rate
    162,885       5.13       164,686       5.16  
From consolidations
    980       5.35       1,124       5.32  
                                 
Total short-term debt
  $ 163,865       5.13 %   $ 165,810       5.16 %
                                 
Long-term debt:
                               
Senior fixed-rate
  $ 586,965       5.15 %   $ 576,099       4.98 %
Senior floating-rate
    12,201       5.96       5,522       5.06  
Subordinated fixed-rate
    10,936       6.11       12,852       5.91  
From consolidations
    6,712       5.84       6,763       5.98  
                                 
Total long-term debt(2)
  $ 616,814       5.19 %   $ 601,236       5.01 %
                                 
 
 
(1) Outstanding debt amounts and weighted average interest rate reported in this table include the effect of unamortized discounts, premiums and other cost basis adjustments. The unpaid principal balance of outstanding debt, which excludes unamortized discounts, premiums and other cost basis adjustments, totaled $789.4 billion as of June 30, 2007, compared with $773.4 billion as of December 31, 2006.
 
(2) Reported amounts include a net premium and cost basis adjustments of $12.4 billion and $11.9 billion as of June 30, 2007 and December 31, 2006, respectively.
 
Despite our portfolio limit, we have been an active issuer of both short- and long-term debt for refunding and rebalancing purposes. We present our debt activity in Table 15 in “Liquidity and Capital Management—Liquidity—Debt Funding.”
 
Derivative Instruments
 
We supplement our issuance of debt with interest rate-related derivatives to manage the prepayment and duration risk inherent in our mortgage investments. We present, by derivative instrument type, the estimated fair value of derivatives recorded in our condensed consolidated balance sheets and the related outstanding notional amount as of June 30, 2007 and December 31, 2006 in “Notes to Condensed Consolidated Financial Statements—Note 8, Derivative Instruments.”


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Table 14 provides an analysis of the change in the estimated fair value of the net derivative asset (liability) amounts, excluding mortgage commitments, recorded in our condensed consolidated balance sheets between December 31, 2006 and June 30, 2007. As indicated in Table 14, we recorded a net derivative asset of $5.3 billion as of June 30, 2007 related to our risk management derivatives, compared with a net derivative asset of $3.7 billion as of December 31, 2006. The related outstanding notional amounts totaled $786.0 billion and $745.4 billion as of June 30, 2007 and December 31, 2006, respectively.
 
Table 14:   Changes in Risk Management Derivative Assets (Liabilities) at Fair Value, Net(1)
 
         
    (Dollars in millions)  
 
Net derivative asset as of December 31, 2006(2)
  $ 3,725  
Effect of cash payments:
       
Fair value at inception of contracts entered into during the period(3)
    161  
Fair value at date of termination of contracts settled during the period(4)
    82  
Periodic net cash contractual interest receipts
    (8 )
         
Total cash payments, net
    235  
         
Income statement impact of recognized amounts:
       
Periodic net contractual interest income on interest rate swaps
    98  
Net change in fair value during the period
    1,195  
         
Derivatives fair value gains, net(5)
    1,293  
         
Net derivative asset as of June 30, 2007(2)
  $ 5,253  
         
 
 
(1) Excludes mortgage commitments.
 
(2) Represents the net of “Derivative assets at fair value” and “Derivative liabilities at fair value” recorded in our condensed consolidated balance sheets, excluding mortgage commitments.
 
(3) Primarily includes upfront premiums paid on option contracts.
 
(4) Primarily represents cash paid upon termination of derivative contracts.
 
(5) Reflects net derivatives fair value gains recognized in our condensed consolidated statements of income, excluding mortgage commitments.
 
The $1.5 billion increase in the fair value of the net derivative asset was largely attributable to the increase in the aggregate net fair value of our interest rate swaps due to the increase in swap rates between December 31, 2006 and June 30, 2007. We present, by derivative instrument type, our risk management derivative activity for the six months ended June 30, 2007, along with the stated maturities of our derivatives outstanding as of June 30, 2007, in Table 25 in “Risk Management—Interest Rate Risk Management and Other Market Risks.”


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LIQUIDITY AND CAPITAL MANAGEMENT
 
Liquidity
 
Debt Funding
 
Our primary source of cash is proceeds from the issuance of our debt securities. As a result, we are dependent on our continuing ability to issue debt securities in the capital markets to meet our cash requirements. Table 15 summarizes our debt activity for the three and six months ended June 30, 2007 and 2006.
 
Table 15:  Debt Activity
 
                                 
    For the
    For the
 
    Three Months Ended
    Six Months Ended
 
    June 30,     June 30,  
    2007     2006     2007     2006  
    (Dollars in millions)  
 
Issued during the period:(1)
                               
Short-term:(2)
                               
Amount(3)
  $ 346,473     $ 693,463     $ 783,167     $ 1,282,519  
Weighted average interest rate
    5.11 %     4.86 %     5.13 %     4.66 %
Long-term:
                               
Amount(3)
  $ 54,160     $ 52,927     $ 113,291     $ 99,213  
Weighted average interest rate
    5.58 %     5.66 %     5.57 %     5.44 %
Total issued:
                               
Amount(3)
  $ 400,633     $ 746,390     $ 896,458     $ 1,381,732  
Weighted average interest rate
    5.17 %     4.92 %     5.19 %     4.71 %
Redeemed during the period:(1)(4)
                               
Short-term:(2)
                               
Amount(3)
  $ 340,874     $ 674,725     $ 784,222     $ 1,280,040  
Weighted average interest rate
    5.12 %     4.75 %     5.12 %     4.54 %
Long-term:
                               
Amount(3)
  $ 43,576     $ 48,282     $ 97,248     $ 76,560  
Weighted average interest rate
    4.75 %     3.30 %     4.54 %     3.49 %
Total redeemed:
                               
Amount(3)
  $ 384,450     $ 723,007     $ 881,470     $ 1,356,600  
Weighted average interest rate
    5.08 %     4.66 %     5.06 %     4.48 %
 
 
(1) Excludes debt activity resulting from consolidations and intraday loans.
 
(2) Includes Federal funds purchased and securities sold under agreements to repurchase.
 
(3) Represents the face amount at issuance or redemption.
 
(4) Represents all payments on debt, including regularly scheduled principal payments, payments at maturity, payments as the result of a call and payments for any other repurchases.
 
The amount of our total outstanding debt remained relatively consistent between December 31, 2006 and June 30, 2007, as we managed the size of our mortgage portfolio to meet the OFHEO-directed portfolio cap. In addition, the mix between our outstanding short-term and long-term debt remained relatively consistent. Despite a lack of portfolio growth for the first six months of 2007, we remained an active participant in the international capital markets to meet our consistent need for funding and rebalancing our portfolio. Changes in the amount of our debt issuances and redemptions between periods are influenced by investor demand for our debt, changes in interest rates, and the maturity of existing debt. For information on our outstanding short-term and long-term debt as of June 30, 2007, refer to “Consolidated Balance Sheet Analysis—Debt Instruments.”
 
Our sources of liquidity remained adequate to meet both our short-term and long-term funding needs during the first nine months of 2007, and we anticipate that they will remain adequate. Despite the overall reduction in liquidity and funding sources in the mortgage credit market in recent months, our ability to issue debt at


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rates we consider attractive has not been impaired. In addition, we issued $1.375 billion in preferred stock in September and October 2007.
 
Liquidity Contingency Plan
 
We maintain a liquidity contingency plan in the event that factors, whether internal or external to our business, temporarily compromise our ability to access capital through normal channels. Our contingency plan provides for alternative sources of liquidity that would allow us to meet all of our cash obligations for 90 days without relying upon the issuance of unsecured debt. In the event of a liquidity crisis in which our access to the unsecured debt funding market becomes impaired, our primary source of liquidity is the sale or pledge of mortgage assets in our unencumbered mortgage portfolio. Another source of liquidity in the event of a liquidity crisis is the sale of assets in our liquid investment portfolio.
 
Pursuant to our September 1, 2005 agreement with OFHEO, we periodically test our liquidity contingency plan. We believe we were in compliance with our agreement with OFHEO to maintain and test our liquidity contingency plan as of March 31, 2007, June 30, 2007 and September 30, 2007.
 
Credit Ratings and Risk Ratings
 
Our ability to borrow at attractive rates is highly dependent upon our credit ratings. Our senior unsecured debt (both long-term and short-term), benchmark subordinated debt and preferred stock are rated and continuously monitored by Standard & Poor’s, a division of The McGraw Hill Companies (“Standard & Poor’s”), Moody’s Investors Service (“Moody’s”), and Fitch Ratings (“Fitch”), each of which is a nationally recognized statistical rating organization. Table 16 below sets forth the credit ratings issued by each of these rating agencies of our long-term and short-term senior unsecured debt, qualifying benchmark subordinated debt and preferred stock as of November 8, 2007. To date, we have not experienced any limitations in our ability to access the capital markets due to a credit ratings downgrade. Table 16 also sets forth our “risk to the government” rating and our “Bank Financial Strength Rating” as of November 8, 2007.
 
Table 16:  Fannie Mae Debt Credit Ratings and Risk Ratings
 
                                                 
    Senior
    Senior
    Qualifying
                Bank
 
    Long-Term
    Short-Term
    Benchmark
    Preferred
    Risk to the
    Financial
 
    Unsecured Debt     Unsecured Debt     Subordinated Debt     Stock     Government(1)     Strength(1)  
 
Standard & Poor’s
    AAA       A-1+       AA- (2)     AA- (2)     AA- (2)      
Moody’s
    Aaa       P-1       Aa2       Aa3             B+  
Fitch
    AAA       F1+       AA-       AA-              
 
 
(1) Pursuant to our September 1, 2005 agreement with OFHEO, we agreed to seek to obtain a rating, which will be continuously monitored by at least one nationally recognized statistical rating organization, that assesses, among other things, the independent financial strength or “risk to the government” of Fannie Mae operating under its authorizing legislation but without assuming a cash infusion or extraordinary support of the government in the event of a financial crisis.
 
(2) Negative outlook.
 
Cash Flows
 
Our primary sources of funding include proceeds from our issuance of our debt securities, principal and interest payments on mortgage assets, and guaranty fees. Our primary uses of funds include the purchase of mortgage assets, repayment of debt and interest payments, payment of dividends, administrative expenses and taxes.
 
Six Months Ended June 30, 2007.  Cash and cash equivalents of $5.8 billion as of June 30, 2007 increased by $2.6 billion from December 31, 2006. We generated cash flows from financing activities of $4.2 billion, as proceeds from the issuance of debt exceeded amounts paid to extinguish debt. We also generated cash flows from investing activities of $1.5 billion, attributable to a reduction in mortgage asset purchases relative to the level of liquidations. These cash flows were partially offset by net cash used in operating activities of $3.1 billion, largely attributable to an increase in the purchase of HFS mortgage loans.


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Six Months Ended June 30, 2006.  Cash and cash equivalents of $18.9 billion as of June 30, 2006 increased by $16.1 billion from December 31, 2005. We generated cash flows from operating activities of $22.1 billion, largely attributable to a net decrease in trading securities. We also generated cash flows from financing activities of $11.1 billion, as proceeds from the issuance of debt exceeded amounts paid to extinguish debt. These cash flows were partially offset by net cash used in investing activities of $17.2 billion, attributable to a higher level of mortgage asset purchases relative to liquidations.
 
Because our cash flows are complex and interrelated and bear little relationship to our net earnings and net assets, we do not rely on this traditional cash flow analysis to evaluate our liquidity position. Instead, we rely on our liquidity contingency plan described above to ensure that we preserve stable, reliable and cost effective sources of cash to meet all obligations from normal operations and maintain sufficient excess liquidity to withstand both a severe and moderate liquidity stress environment.
 
Capital Management
 
Regulatory Capital
 
Table 17 displays our regulatory capital classification measures as of June 30, 2007 and December 31, 2006.
 
Table 17:  Regulatory Capital Measures
 
                 
    As of  
    June 30,
    December 31,
 
    2007(1)     2006  
    (Dollars in millions)  
 
Core capital(2)
  $ 42,690     $ 41,950  
Statutory minimum capital(3)
    30,328       29,359  
                 
Surplus of core capital over required minimum capital
  $ 12,363     $ 12,591  
                 
Surplus of core capital percentage over required minimum capital(4)
    40.8 %     42.9 %
                 
Core capital(2)
  $ 42,690     $ 41,950  
OFHEO-directed minimum capital(5)
    39,426       38,166  
                 
Surplus of core capital over OFHEO-directed minimum capital
  $ 3,265     $ 3,784  
                 
Surplus of core capital percentage over OFHEO-directed minimum capital(6)
    8.3 %     9.9 %
                 
Total capital(7)
  $ 43,798     $ 42,703  
Statutory risk-based capital(8)
    10,225       26,870  
                 
Surplus of total capital over required risk-based capital
  $ 33,573     $ 15,833  
                 
Surplus of total capital percentage over required risk-based capital(9)
    328.3 %     58.9 %
                 
Core capital(2)
  $ 42,690     $ 41,950  
Statutory critical capital(10)
    15,669       15,149  
                 
Surplus of core capital over required critical capital
  $ 27,021     $ 26,801  
                 
Surplus of core capital percentage over required critical capital(11)
    172.4 %     176.9 %
 
 
  (1) Except for statutory risk-based capital amounts, all amounts represent estimates that will be resubmitted to OFHEO for its certification. Statutory risk-based capital amounts represent previously announced results by OFHEO. OFHEO may determine that results require restatement in the future based upon analysis provided by us.
 
  (2) The sum of (a) the stated value of our outstanding common stock (common stock less treasury stock); (b) the stated value of our outstanding non-cumulative perpetual preferred stock; (c) our paid-in capital; and (d) our retained earnings. Core capital excludes accumulated other comprehensive income (loss).
 
  (3) Generally, the sum of (a) 2.50% of on-balance sheet assets; (b) 0.45% of the unpaid principal balance of outstanding Fannie Mae MBS held by third parties; and (c) up to 0.45% of other off-balance sheet obligations, which may be


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adjusted by the Director of OFHEO under certain circumstances (See 12 CFR 1750.4 for existing adjustments made by the Director of OFHEO).
 
  (4) Defined as the surplus of core capital over statutory minimum capital expressed as a percentage of statutory minimum capital.
 
  (5) Defined as a 30% surplus over the statutory minimum capital requirement. We are currently required to maintain this surplus under the OFHEO consent order until such time as the Director of OFHEO determines that the requirement should be modified or allowed to expire, taking into account certain specified factors.
 
  (6) Defined as the surplus of core capital over OFHEO-directed minimum capital expressed as a percentage of OFHEO-directed minimum capital.
 
  (7) The sum of (a) core capital and (b) the total allowance for loan losses and reserve for guaranty losses, less (c) the specific loss allowance (that is, the allowance required on individually-impaired loans). The specific loss allowance totaled $51 million as of June 30, 2007 and $106 million as of December 31, 2006.
 
  (8) Defined as the amount of total capital required to be held to absorb projected losses flowing from future adverse interest rate and credit risk conditions specified by statute (see 12 CFR 1750.13 for conditions), plus 30% mandated by statute to cover management and operations risk.
 
  (9) Defined as the surplus of total capital over statutory risk-based capital expressed as a percentage of statutory risk-based capital.
 
(10) Generally, the sum of (a) 1.25% of on-balance sheet assets; (b) 0.25% of the unpaid principal balance of outstanding Fannie Mae MBS held by third parties and (c) up to 0.25% of other off-balance sheet obligations, which may be adjusted by the Director of OFHEO under certain circumstances.
 
(11) Defined as the surplus of core capital over statutory critical capital expressed as a percentage of statutory critical capital.
 
Based on financial estimates that we provided to OFHEO, on September 27, 2007, OFHEO announced that we were classified as adequately capitalized as of June 30, 2007 (the most recent date for which results have been published by OFHEO). As of September 30, 2007, our core capital of $41.7 billion exceeded our statutory minimum capital requirement by $11.4 billion, or 37.7%, and our OFHEO-directed minimum capital requirement by $2.3 billion, or 5.9%.
 
In September 2007 we issued $1.0 billion in preferred stock, which was intended to partially replace the $1.1 billion in preferred stock we redeemed in February and April 2007. We issued an additional $375 million in preferred stock in October 2007. Our core capital and our capital surplus have decreased since September 30, 2007, due to market trends that have adversely affected our earnings. If these market trends continue to negatively affect our net income, they will continue to cause a reduction in our retained earnings and, as a result, in the amount of our core capital. We may be required to take actions, or refrain from taking actions, in order to maintain or increase our statutory and OFHEO-directed minimum capital surplus. Like the portfolio cap, our need to maintain capital at specific levels limits our ability to increase our portfolio investments. In order to maintain our regulatory capital at required levels, we may forgo purchase opportunities or sell assets. We also may issue additional preferred securities. Refer to “Item 1A—Risk Factors” for a more detailed discussion of how continued declines in our earnings could negatively impact our regulatory capital position.
 
The significant reduction in our statutory risk-based capital requirement from December 31, 2006 to June 30, 2007 resulted from risk management actions that served to lower our investment portfolio’s exposure to extreme interest rate movements. On October 11, 2007, OFHEO announced a proposed rule that would change the mortgage loan loss severity formulas used in the regulatory risk-based capital stress test. If adopted, the proposed changes would increase our risk-based capital requirement. Using data from the third and fourth quarters of 2006, OFHEO’s recalculation of the risk-based capital requirement for those periods using the proposed formulas showed that our total capital base would continue to exceed all risk-based capital requirements.
 
Capital Activity
 
Common Stock
 
Shares of common stock outstanding, net of shares held in treasury, totaled approximately 974 million, 973 million, 973 million and 972 million as of September 30, 2007, June 30, 2007, March 31, 2007 and


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December 31, 2006, respectively. We issued 0.3 million, 0.3 million and 1.0 million shares of common stock from treasury for our employee benefit plans during the quarters ended September 30, 2007, June 30, 2007 and March 31, 2007, respectively. We did not issue any common stock during the first three quarters of 2007 other than in accordance with these plans.
 
From April 2005 to November 2007, we prohibited all of our employees from engaging in purchases or sales of our securities except in limited circumstances relating to financial hardship. In May 2006, we implemented a stock repurchase program that authorized the repurchase of up to $100 million of our shares from our non-officer employees, who are employees below the level of vice president. From May 31, 2006 to September 30, 2007, we purchased an aggregate of approximately 122,000 shares of common stock from our employees under the program. In November 2007, the prohibition on employee sales and purchases of our securities was lifted and the employee stock repurchase program was terminated.
 
Non-Cumulative Preferred Stock
 
On February 28, 2007, we redeemed all of the shares of our Variable Rate Non-Cumulative Preferred Stock, Series J, with an aggregate stated value of $700 million.
 
On April 2, 2007, we redeemed all of the shares of our Variable Rate Non-Cumulative Preferred Stock, Series K, with an aggregate stated value of $400 million.
 
On September 28, 2007, we issued 40 million shares of Variable Rate Non-Cumulative Preferred Stock, Series P, with an aggregate stated value of $1.0 billion. The Series P Preferred Stock has a variable dividend rate that will reset quarterly on each March 31, June 30, September 30 and December 31, beginning December 31, 2007, at a per annum rate equal to the greater of (i) 3-Month LIBOR plus 0.75% and (ii) 4.50%. The Series P Preferred Stock may be redeemed, at our option, on or after September 30, 2012. The net proceeds from the issuance of Series P Preferred Stock were added to our working capital and will be used for general corporate purposes.
 
On October 4, 2007, we issued 15 million shares of 6.75% Non-Cumulative Preferred Stock, Series Q, with an aggregate stated value of $375 million. The Series Q Preferred Stock has a dividend rate of 6.75% per annum. The Series Q Preferred Stock may be redeemed, at our option, on or after September 30, 2010. The net proceeds from the issuance of Series Q Preferred Stock were added to our working capital and will be used for general corporate purposes.
 
Subordinated Debt
 
Pursuant to our September 1, 2005 agreement with OFHEO, we agreed to issue qualifying subordinated debt, rated by at least two nationally recognized statistical rating organizations, in a quantity such that the sum of our total capital plus the outstanding balance of our qualifying subordinated debt equals or exceeds the sum of (1) outstanding Fannie Mae MBS held by third parties times 0.45% and (2) total on-balance sheet assets times 4%, which we refer to as our “subordinated debt requirement.”
 
As of March 31, 2007, June 30, 2007 and September 30, 2007, we were in compliance with our subordinated debt requirement. As of March 31, 2007, our total capital plus the outstanding balance of our qualifying subordinated debt was approximately $49.8 billion and exceeded our subordinated debt requirement by $7.9 billion. As of June 30, 2007, our total capital plus the outstanding balance of our qualifying subordinated debt was approximately $51.0 billion and exceeded our subordinated debt requirement by $8.1 billion. Our total capital plus the outstanding balance of our qualifying subordinated debt was approximately $49.5 billion and exceeded our subordinated debt requirement by $6.9 billion as of September 30, 2007.
 
We have not issued any subordinated debt securities since 2003. We had qualifying subordinated debt totaling $2.0 billion, based on redemption value, that matured in January 2007. As of the date of this filing, we have $9.0 billion in outstanding qualifying subordinated debt.


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Dividends
 
We paid common stock dividends of $0.40 per share for the first quarter of 2007 and $0.50 per share for the second and third quarters of 2007. On October 16, 2007, our Board of Directors declared common stock dividends of $0.50 per share for the fourth quarter of 2007, payable on November 26, 2007.
 
We paid preferred stock dividends of $138 million, $121 million and $115 million in the first, second and third quarter of 2007, respectively. On October 16, 2007, our Board of Directors declared total preferred stock dividends of $137 million for the fourth quarter of 2007, payable on December 31, 2007.
 
OFF-BALANCE SHEET ARRANGEMENTS AND VARIABLE INTEREST ENTITIES
 
We enter into certain business arrangements that are not recorded in our condensed consolidated balance sheets or may be recorded in amounts that are different from the full contract or notional amount of the transaction. These arrangements are commonly referred to as “off-balance sheet arrangements,” and expose us to potential losses in excess of the amounts recorded in the condensed consolidated balance sheets. The most significant off-balance sheet arrangements that we engage in result from the mortgage loan securitization and resecuritization transactions that we routinely enter into as part of the normal course of our business operations. We also hold limited partnership interests in LIHTC partnerships that are established to finance the construction or development of low-income affordable multifamily housing and other limited partnerships. LIHTC and other limited partnerships may involve off-balance sheet entities, some of which are consolidated on our balance sheets and some of which are accounted for under the equity method.
 
Fannie Mae MBS Transactions and Other Financial Guaranties
 
Table 18 presents a summary of our on- and off-balance sheet Fannie Mae MBS and other guaranties as of June 30, 2007 and December 31, 2006.
 
Table 18:  On- and Off-Balance Sheet MBS and Other Guaranty Arrangements
 
                 
    As of  
    June 30,
    December 31,
 
    2007     2006  
    (Dollars in millions)  
 
Fannie Mae MBS and other guaranties outstanding(1)
  $ 2,122,803     $ 1,996,941  
Less: Fannie Mae MBS held in portfolio(2)
    179,860       199,644  
                 
Fannie Mae MBS held by third parties and other guaranties
  $ 1,942,943     $ 1,797,297  
                 
 
 
(1) Includes $35.3 billion and $19.7 billion in unpaid principal balance of other guaranties as of June 30, 2007 and December 31, 2006, respectively. Excludes $100.6 billion and $105.6 billion in unpaid principal balance of consolidated Fannie Mae MBS as of June 30, 2007 and December 31, 2006, respectively.
 
(2) Amounts represent unpaid principal balance and are recorded in “Investments in securities” in our condensed consolidated balance sheets.
 
LIHTC Partnership Interests
 
As of June 30, 2007, we had a recorded investment in LIHTC partnerships of $8.3 billion, compared with $8.8 billion as of December 31, 2006. In March 2007, we sold a portfolio of investments in LIHTC partnerships reflecting approximately $676 million in future LIHTC tax credits and the release of future capital obligations relating to the investments. In July 2007, we sold a portfolio of investments in LIHTC partnerships reflecting approximately $254 million in future LIHTC tax credits and the release of future capital obligations relating to the investments. For additional information regarding our holdings in off-balance sheet limited partnerships, refer to “Notes to Condensed Consolidated Financial Statements—Note 2, Consolidations.”


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RISK MANAGEMENT
 
Credit Risk Management
 
Mortgage Credit Risk Management
 
Mortgage credit risk is the risk that a borrower will fail to make required mortgage payments. We are exposed to credit risk on our mortgage credit book of business because we either hold the mortgage assets or have issued a guaranty in connection with the creation of Fannie Mae MBS backed by mortgage assets.
 
Mortgage Credit Book of Business
 
Table 19 displays the composition of our entire mortgage credit book of business, which consists of both on- and off-balance sheet arrangements, as of June 30, 2007 and December 31, 2006. Our single-family mortgage credit book of business accounted for approximately 94% of our entire mortgage credit book of business as of both June 30, 2007 and December 31, 2006.
 
Table 19:  Composition of Mortgage Credit Book of Business
 
                                                 
    As of June 30, 2007  
    Single-Family(1)     Multifamily(2)     Total  
    Conventional(3)     Government(4)     Conventional(3)     Government(4)     Conventional(3)     Government(4)  
    (Dollars in millions)  
 
Mortgage portfolio:(5)
                                               
Mortgage loans(6)
  $ 298,493     $ 21,970     $ 71,332     $ 895     $ 369,825     $ 22,865  
Fannie Mae MBS
    176,945       2,349       322       244       177,267       2,593  
Agency mortgage-related securities(7)
    30,783       1,811             56       30,783       1,867  
Mortgage revenue bonds
    3,292       3,015       7,730       2,322       11,022       5,337  
Other mortgage-related securities(8)
    85,381       1,185       18,490       34       103,871       1,219  
                                                 
Total mortgage portfolio
    594,894       30,330       97,874       3,551       692,768       33,881  
Fannie Mae MBS held by third parties(9)
    1,851,843       15,929       38,648       1,238       1,890,491       17,167  
Other credit guaranties(10)
    18,469             16,752       64       35,221       64  
                                                 
Mortgage credit book of business
  $ 2,465,206     $ 46,259     $ 153,274     $ 4,853     $ 2,618,480     $ 51,112  
                                                 
Guaranty book of business(11)
  $ 2,345,750     $ 40,248     $ 127,054     $ 2,441     $ 2,472,804     $ 42,689  
                                                 
 


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    As of December 31, 2006        
    Single-Family(1)     Multifamily(2)     Total        
    Conventional(3)     Government(4)     Conventional(3)     Government(4)     Conventional(3)     Government(4)        
    (Dollars in millions)        
 
Mortgage portfolio:(5)
                                                       
Mortgage loans(6)
  $ 302,597     $ 20,106     $ 59,374     $ 968     $ 361,971     $ 21,074          
Fannie Mae MBS
    198,335       709       277       323       198,612       1,032          
Agency mortgage-related securities(7)
    29,987       1,995             56       29,987       2,051          
Mortgage revenue bonds
    3,394       3,284       7,897       2,349       11,291       5,633          
Other mortgage-related securities(8)
    85,339       2,084       9,681       177       95,020       2,261          
                                                         
Total mortgage portfolio
    619,652       28,178       77,229       3,873       696,881       32,051          
Fannie Mae MBS held by third parties(9)
    1,714,815       19,069       42,184       1,482       1,756,999       20,551          
Other credit guaranties(10)
    3,049             16,602       96       19,651       96          
                                                         
Mortgage credit book of business
  $ 2,337,516     $ 47,247     $ 136,015     $ 5,451     $ 2,473,531     $ 52,698          
                                                         
Guaranty book of business(11)
  $ 2,218,796     $ 39,884     $ 118,437     $ 2,869     $ 2,337,233     $ 42,753          
                                                         
 
 
  (1) The amounts reported reflect our total single-family mortgage credit book of business. Of these amounts, the portion of our conventional single-family mortgage credit book of business for which we have access to detailed loan-level information represented approximately 95% of our total conventional single-family mortgage credit book of business as of both June 30, 2007 and December 31, 2006. Unless otherwise noted, the credit statistics we provide in the “Mortgage Credit Risk Management” discussion that follows relate only to this specific portion of our conventional single-family mortgage credit book of business. The remaining portion of our single-family mortgage credit book of business consists of non-Fannie Mae mortgage-related securities backed by single-family mortgage loans, credit enhancements that we provide on single-family mortgage assets and all other single-family government related loans and securities. Non-Fannie Mae mortgage-related securities held in our portfolio include Freddie Mac securities, Ginnie Mae securities, private-label mortgage-related securities, Fannie Mae MBS backed by private-label mortgage-related securities, and housing-related municipal revenue bonds. Our Capital Markets group prices and manages credit risk related to this specific portion of our single-family mortgage credit book of business. We may not have access to detailed loan-level data on these particular mortgage-related assets and therefore may not manage the credit performance of individual loans. However, a substantial majority of these securities benefit from significant forms of credit enhancement, including guaranties from Ginnie Mae or Freddie Mac, insurance policies, structured subordination and similar sources of credit protection. All non-Fannie Mae agency securities held in our portfolio as of June 30, 2007 and December 31, 2006 were rated AAA/Aaa by Standard & Poor’s and Moody’s. Over 90% of non-agency mortgage-related securities held in our portfolio as of both June 30, 2007 and December 31, 2006 were rated AAA/Aaa by Standard & Poor’s and Moody’s.
 
  (2) The amounts reported reflect our total multifamily mortgage credit book of business. Of these amounts, the portion of our multifamily mortgage credit book of business for which we have access to detailed loan-level information represented approximately 80% and 84% of our total multifamily mortgage credit book as of June 30, 2007 and December 31, 2006, respectively. Unless otherwise noted, the credit statistics we provide in the “Mortgage Credit Risk Management” discussion that follows relate only to this specific portion of our multifamily mortgage credit book of business.
 
  (3) Refers to mortgage loans and mortgage-related securities that are not guaranteed or insured by the U.S. government or any of its agencies.
 
  (4) Refers to mortgage loans and mortgage-related securities guaranteed or insured by the U.S. government or one of its agencies.
 
  (5) Mortgage portfolio data is reported based on unpaid principal balance.
 
  (6) Includes unpaid principal totaling $101.6 billion and $105.5 billion as of June 30, 2007 and December 31, 2006, respectively, related to mortgage-related securities that were consolidated under FIN 46R and mortgage-related securities created from securitization transactions that did not meet the sales criteria under SFAS 140, which effectively resulted in mortgage-related securities being accounted for as loans.
 
  (7) Consists of mortgage-related securities issued by Freddie Mac and Ginnie Mae.

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  (8) Consists of mortgage-related securities issued by entities other than Fannie Mae, Freddie Mac or Ginnie Mae.
 
  (9) Consists of Fannie Mae MBS held by third-party investors. The principal balance of resecuritized Fannie Mae MBS is included only once in the reported amount.
 
(10) Includes single-family and multifamily credit enhancements that we have provided and that are not otherwise reflected in the table.
 
(11) Consists of mortgage loans held in our portfolio, Fannie Mae MBS held in our portfolio, Fannie Mae MBS held by third parties and other credit guaranties. Excludes agency mortgage-related securities, mortgage revenue bonds and other mortgage-related securities held in our portfolio for which we do not provide a guaranty.
 
Single-Family
 
Table 20 provides information on the product distribution of our conventional single-family business volumes for the three months ended June 30, 2007 and 2006, and our conventional single-family mortgage credit book of business as of June 30, 2007 and December 31, 2006.
 
Table 20:   Product Distribution of Conventional Single-Family Business Volume and Mortgage Credit Book of Business(1)
 
                                 
    Percent of
    Percent of
 
    Business Volume(2)     Book of Business(3)  
    For the
       
    Three Months
       
    Ended
       
    June 30,     As of  
                June 30,
    December 31,
 
    2007     2006     2007     2006  
 
Fixed-rate:
                               
Long-term
    76 %     73 %     69 %     68 %
Intermediate-term
    6       7       16       18  
Interest-only
    10       5       3       1  
                                 
Total fixed-rate
    92       85       88       87  
Adjustable-rate:
                               
Interest-only
    6       9       5       4  
Negative-amortizing
          1       1       2  
Other ARMs
    2       5       6       7  
                                 
Total adjustable-rate
    8       15       12       13  
                                 
Total
    100 %     100 %     100 %     100 %
                                 
 
 
(1) As noted in Table 19 above, we generally have access to detailed loan-level statistics only on conventional single-family mortgage loans held in our portfolio and backing Fannie Mae MBS (whether held in our portfolio or held by third parties).
 
(2) Percentages calculated based on unpaid principal balance of loans at time of acquisition. Single-family business volume refers to both single-family mortgage loans we purchase for our mortgage portfolio and single-family mortgage loans we securitize into Fannie Mae MBS.
 
(3) Percentages calculated based on unpaid principal balance of loans as of the end of each period.
 
Fixed-Rate and ARM Loans:  As presented in Table 20 above, our conventional single-family mortgage credit book of business continues to consist mostly of long-term fixed-rate mortgage loans. In addition, a greater proportion of our conventional single-family business volumes consisted of fixed-rate loans for the second quarter of 2007, as compared with the second quarter of 2006. We did not acquire any negative-amortizing ARMs during the second quarter of 2007.
 
Alt-A Loans:  An Alt-A mortgage loan generally refers to a loan that can be underwritten with lower or alternative documentation than a full documentation mortgage loan but that may also include other alternative product features. Alt-A mortgage loans generally have a higher risk of default than non-Alt-A mortgage loans. In reporting our Alt-A exposure, we have classified mortgage loans as Alt-A if the lenders that deliver the


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mortgage loans to us have classified the loans as Alt-A based on documentation or other product features. As of June 30, 2007, we estimate that approximately 12% of our total single-family mortgage credit book of business consisted of Alt-A mortgage loans or Fannie Mae MBS backed by Alt-A mortgage loans. This percentage remained at approximately 12% as of September 30, 2007. During 2007, we restricted our eligibility standards for Alt-A mortgage loans eligible for delivery to us. Our acquisitions of Alt-A mortgage loans have a combination of credit enhancement and pricing that we believe adequately reflects the higher credit risk posed by these mortgages. We will determine the timing and level of our acquisition of Alt-A mortgage loans in the future based on our assessment of the availability and cost of credit enhancement with adequate levels of pricing to compensate for the risks.
 
Subprime Loans:  A subprime mortgage loan generally refers to a mortgage loan made to a borrower with a weaker credit profile than that of a prime borrower. As a result of the weaker credit profile, subprime borrowers have a higher likelihood of default than prime borrowers. Subprime mortgage loans are typically originated by lenders specializing in this type of business or by subprime divisions of large lenders, using processes unique to subprime loans. In reporting our subprime exposure, we have classified mortgage loans as subprime if the mortgage loans are originated by one of these specialty lenders or a subprime division of a large lender. Approximately 0.2% of our total single-family mortgage credit book of business as of June 30, 2007 consisted of subprime mortgage loans or Fannie Mae MBS backed by subprime mortgage loans. This percentage increased to approximately 0.3% as of September 30, 2007. Less than 1% of our single-family business volume for the nine months ended September 30, 2007 consisted of subprime mortgage loans or Fannie Mae MBS backed by subprime mortgage loans. Our acquisitions of subprime mortgage loans have a combination of credit enhancement and pricing that we believe adequately reflects the higher credit risk posed by these mortgages. In order to respond to the current subprime mortgage crisis and provide liquidity to the market, we intend to increase our purchase of subprime mortgages. We will determine the timing and level of our acquisition of subprime mortgage loans in the future based on our assessment of the availability and cost of credit enhancement with adequate levels of pricing to compensate for the risks.
 
Alt-A and Subprime Securities:  We held approximately $105.6 billion in non-Fannie Mae structured mortgage-related securities in our investment portfolio as of June 30, 2007. Of this amount, $76.5 billion consisted of private-label mortgage-related securities backed by subprime or Alt-A mortgage loans. As of June 30, 2007, we held in our investment portfolio approximately $33.8 billion in private-label mortgage-related securities backed by Alt-A mortgage loans and approximately $42.7 billion in private-label mortgage-related securities backed by subprime mortgage loans. We also guaranteed approximately $2.9 billion in resecuritized subprime mortgage-related securities as of June 30, 2007. Approximately $14.4 billion of these Alt-A- and subprime-backed private-label mortgage-related securities were classified as trading securities in our condensed consolidated balance sheets as of June 30, 2007. In reporting our Alt-A and subprime exposure, we have classified private-label mortgage-related securities as Alt-A or subprime if the securities were labeled as such when issued.
 
To date, we generally have focused our purchases of private-label mortgage-related securities backed by subprime or Alt-A loans on the highest-rated tranches of these securities available at the time of acquisition. In 2007, we began to acquire a limited amount of subprime-backed private-label mortgage-related securities of investment grades below AAA. As of September 30, 2007, approximately $441 million in unpaid principal balance, or 1%, of the subprime-backed private-label mortgage-related securities in our portfolio had a credit rating of less than AAA. All of these subprime-backed mortgage-related securities with a credit rating of less than AAA were classified as trading securities in our condensed consolidated balance sheets as of September 30, 2007.
 
In October 2007, the credit ratings of nine subprime private-label mortgage-related securities held in our portfolio, with an aggregate unpaid principal balance of $263 million as of September 30, 2007, were downgraded by Standard & Poor’s. One of these downgraded securities, with an unpaid principal balance of $178 million as of September 30, 2007, classified as available-for-sale, was downgraded from AAA to AA. The other eight downgraded securities, with an aggregate unpaid principal balance of $85 million as of September 30, 2007, are classified as trading. Prior to these downgrades, these eight securities had credit ratings that were less than AAA. During October 2007 and through November 8, 2007, seven of our AAA-


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rated subprime private-label mortgage-related securities, with an aggregate unpaid principal balance of approximately $1.3 billion, have been put under review for possible credit rating downgrade or on negative watch. As of November 8, 2007, all of these securities continue to be rated AAA. Of these securities, one security with an unpaid principal balance of $255 million is classified as trading, while the remaining six securities, with an aggregate unpaid principal balance of $1.0 billion, are classified as available-for-sale.
 
We have not recorded any impairment of the securities classified as available-for-sale, as they continue to be rated investment grade and we have the intent and ability to hold these securities until the earlier of recovery of the unrealized loss amounts or maturity. As of November 8, 2007, all of our private-label mortgage-related securities backed by Alt-A mortgage loans were rated AAA and none had been downgraded or placed under review for possible downgrade.
 
For the nine months ended September 30, 2007, we estimate that the fair value of the subprime private-label mortgage-related securities held in our portfolio decreased by $896 million. Of this decrease, $285 million related to securities classified as trading and is therefore reflected in our earnings as losses on trading securities, which are recorded as a component of “Investment gains (losses), net,” for the nine months ended September 30, 2007. The remaining $611 million of this decrease related to securities classified as available-for-sale and is therefore reflected after-tax in AOCI. In addition, we estimate that the fair value of the Alt-A private-label mortgage-related securities held in our portfolio decreased by $344 million for the nine months ended September 30, 2007. Of this decrease, $91 million was reflected in our earnings as losses on trading securities.
 
Credit Characteristics:  The weighted average credit score, the weighted average original loan-to-value ratio and the weighted average estimated mark-to-market loan-to-value ratio for our conventional single-family mortgage credit book of business were 722, 71% and 57%, respectively, as of June 30, 2007, as compared with 721, 70% and 55%, respectively, as of December 31, 2006. Approximately 13% of our conventional single-family mortgage credit book of business had an estimated mark-to-market loan-to-value ratio greater than 80% as of June 30, 2007, up from 10% as of December 31, 2006. As of September 30, 2007, the weighted average credit score, the weighted average original loan-to-value ratio and the weighted average estimated mark-to-market loan-to-value ratio for our conventional single-family mortgage credit book of business were 721, 71% and 59%, respectively. Approximately 16% of our conventional single-family mortgage credit book of business had an estimated mark-to-market loan-to-value ratio greater than 80% as of September 30, 2007.


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Multifamily
 
As of June 30, 2007, the weighted average original loan-to-value ratio for our multifamily mortgage credit book of business remained at 68%, and the percentage of our multifamily mortgage credit book of business with an original loan-to-value ratio greater than 80% remained at 6%.
 
Serious Delinquency
 
The serious delinquency rate is an indicator of potential future foreclosures, although most loans that become seriously delinquent do not result in foreclosure. Table 21 below compares the serious delinquency rates for all conventional single-family loans and multifamily loans with credit enhancements and without credit enhancements.
 
Table 21:  Serious Delinquency Rates
 
                                                 
    June 30, 2007     December 31, 2006     June 30, 2006  
          Serious
          Serious
          Serious
 
    Book
    Delinquency
    Book
    Delinquency
    Book
    Delinquency
 
    Outstanding(1)     Rate(2)     Outstanding(1)     Rate(2)     Outstanding(1)     Rate(2)  
 
Conventional single-family delinquency rates by geographic region:(3)
                                               
Midwest
    17 %     0.98 %     17 %     1.01 %     17 %     0.89 %
Northeast
    19       0.68       19       0.67       19       0.57  
Southeast
    24       0.68       24       0.68       24       0.64  
Southwest
    16       0.60       16       0.69       16       0.76  
West
    24       0.23       24       0.20       24       0.16  
                                                 
Total conventional single-family loans
    100 %     0.64 %     100 %     0.65 %     100 %     0.60 %
                                                 
Conventional single-family loans:
                                               
Credit enhanced
    20 %     1.81 %     19 %     1.81 %     18 %     1.70 %
Non-credit enhanced
    80       0.35       81       0.37       82       0.35  
                                                 
Total conventional single-family loans
    100 %     0.64 %     100 %     0.65 %     100 %     0.60 %
                                                 
Multifamily loans:
                                               
Credit enhanced
    90 %     0.09 %     96 %     0.07 %     96 %     0.18 %
Non-credit enhanced
    10       0.04       4       0.35       4       0.49  
                                                 
Total multifamily loans
    100 %     0.09 %     100 %     0.08 %     100 %     0.19 %
                                                 
 
 
(1) Reported based on unpaid principal balance of loans, where we have detailed loan-level information.
 
(2) Calculated based on number of loans for single-family and unpaid principal balance for multifamily. We include all of the conventional single-family loans that we own and that back Fannie Mae MBS in the calculation of the single-family delinquency rate. We include the unpaid principal balance of all multifamily loans that we own or that back Fannie Mae MBS and any housing bonds for which we provide credit enhancement in the calculation of the multifamily serious delinquency rate.
 
(3) Midwest consists of IL, IN, IA, MI, MN, NE, ND, OH, SD and WI. Northeast includes CT, DE, ME, MA, NH, NJ, NY, PA, PR, RI, VT and VI. Southeast consists of AL, DC, FL, GA, KY, MD, MS, NC, SC, TN, VA and WV. Southwest consists of AZ, AR, CO, KS, LA, MO, NM, OK, TX and UT. West consists of AK, CA, GU, HI, ID, MT, NV, OR, WA and WY.
 
The increase in our single-family serious delinquency rate as of June 30, 2007 from our rate as of June 30, 2006 was due to continued economic weakness in the Midwest, particularly in Ohio, Michigan and Indiana, and to the continued housing market downturn and decline in home prices throughout much of the country.
 
Our single-family serious delinquency rate has significantly increased since the second quarter, to 0.78% as of September 30, 2007, due to the continued decline in home prices on a national basis and the continued impact


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of weak economic conditions in the Midwest. We have experienced increases in serious delinquency rates across our conventional single-family mortgage credit book, including in higher risk loan categories, such as subprime loans, Alt-A loans, adjustable-rate loans, interest-only loans, loans made for the purchase of investment properties, negative-amortizing loans, loans to borrowers with lower credit scores and loans with high loan-to-value ratios. We have seen particularly rapid increases in serious delinquency rates in some higher risk loan categories, such as Alt-A loans, interest-only loans, loans with subordinate financing and loans made for the purchase of condominiums. Many of these higher risk loans were originated in 2006 and the first half of 2007. We have also experienced a significant increase in delinquency rates in loans originated in California, Florida, Nevada and Arizona. These states had previously experienced very rapid home price appreciation and are now experiencing home price declines. The conventional single-family serious delinquency rates for California and Florida, which represent the two largest states in our single-family mortgage credit book of business in terms of unpaid principal balance, climbed to 0.30% and 0.99%, respectively, as of September 30, 2007, from 0.11% and 0.37%, respectively, as of September 30, 2006. We expect the housing market to continue to deteriorate and home prices to continue to decline in these states and on a national basis. Accordingly, we expect our single-family serious delinquency rate to continue to increase for the remainder of 2007 and in 2008.
 
The significant decline in our multifamily serious delinquency rate as of June 30, 2007 from our rate as of June 30, 2006 was due primarily to payoffs and the resolution of problems associated with loans secured by properties affected by Hurricane Katrina. Our multifamily serious delinquency rate has remained relatively unchanged at 0.08% as of September 30, 2007.
 
Foreclosure and REO Activity
 
Foreclosure and real estate owned (“REO”) activity affect the level of our credit losses. Table 22 below provides information, by region, on our foreclosure activity for the first six months of 2007 and 2006. Regional REO acquisition and charge-off trends generally follow a pattern that is similar to, but lags, that of regional delinquency trends.
 
Table 22:  Single-Family and Multifamily Foreclosed Properties
 
                 
    For the
 
    Six Months Ended
 
    June 30,  
    2007     2006  
 
Single-family foreclosed properties (number of properties):
               
Beginning of year inventory of single-family foreclosed properties (REO)(1)
    25,125       20,943  
Acquisitions by geographic area:(2)
               
Midwest
    9,532       7,642  
Northeast
    1,798       1,309  
Southeast
    5,436       4,705  
Southwest
    4,675       3,810  
West
    804       264  
                 
Total properties acquired through foreclosure
    22,245       17,730  
Dispositions of REO
    (20,226 )     (15,744 )
                 
End of period inventory of single-family foreclosed properties (REO)(1)
    27,144       22,929  
                 
Carrying value of single-family foreclosed properties (dollars in millions)(3)
  $ 2,484     $ 1,837  
                 
Single-family foreclosure rate(4)
    0.1 %     0.1 %
                 
Multifamily foreclosed properties (number of properties):
               
Ending inventory of multifamily foreclosed properties (REO)
    13       4  
Carrying value of multifamily foreclosed properties (dollars in millions)(3)
  $ 78     $ 21  
 
 
(1) Includes deeds in lieu of foreclosure.


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(2) See footnote 3 to Table 21 for states included in each geographic region.
 
(3) Excludes foreclosed property claims receivables, which are reported in our condensed consolidated balance sheets as a component of “Acquired property, net.”
 
(4) Estimated based on the total number of properties acquired through foreclosure as a percentage of the total number of loans in our conventional single-family mortgage credit book as of the end of each respective period.
 
The increase in foreclosures during the first six months of 2007 was driven by the housing market downturn and the continued impact of weak economic conditions in the Midwest, particularly Ohio, Indiana and Michigan. The Midwest accounted for approximately 20% of the loans in our conventional single-family mortgage credit book of business as of December 31, 2006; however, this region accounted for approximately 43% of the single-family properties we acquired through foreclosure during the first six months of 2007.
 
Foreclosure and REO incidence and credit losses have increased since the second quarter of 2007 for our single-family book of business. The number of single-family properties acquired through foreclosure increased to 34,955 for the nine months ended September 30, 2007. The continued weakness in regional economic conditions in the Midwest and the continued housing market downturn and decline in home prices on a national basis has resulted in a higher percentage of our mortgage loans that transition from delinquent to foreclosure status, as well as a faster transition from delinquent to foreclosure status, particularly for loans originated in 2006 and 2007. In addition, the combined effect of the disruption in the subprime market, the overall erosion of property values and near record levels of unsold properties have slowed the sale of, and reduced the sales prices of, our foreclosed single-family properties. As a result, we expect an increase in our overall level of foreclosures and credit losses for 2007 as compared with 2006. We believe that our level of foreclosures and credit losses is likely to continue to increase in 2008.
 
Credit Losses
 
Credit losses consist of (1) charge-offs, excluding losses on delinquent loans we purchase from our MBS trusts, net of recoveries, plus (2) foreclosed property expense. Table 23 below presents credit losses for the three and six months ended June 30, 2007 and 2006.
 
Table 23:  Credit Loss Performance
 
                                                                                 
    For the
  For the
    Three Months Ended
  Six Months Ended
    June 30,   June 30,
    2007     Rate(1)   2006     Rate(1)   2007     Rate(1)   2006     Rate(1)
    (Dollars in millions)                      
 
Charge-offs, net of recoveries
  $ 206       3.1     bp   $ 107       1.8     bp   $ 384       3.0     bp   $ 226       1.9     bp
Foreclosed property expense
    84       1.3           14       0.2           156       1.2           37       0.3      
Less excess of purchase price over fair value of delinquent loans purchased from trusts(2)
    (66 )     (1.0)           (39 )     (0.6)           (135 )     (1.1)           (116 )     (1.0)      
Impact of SOP 03-3 on charge-offs and foreclosed property expense(3)
    26       0.4           18       0.3           51       0.4           36       0.3      
                                                                                 
Credit losses(4)(5)
  $ 250       3.8     bp   $ 100       1.7     bp   $ 456       3.5     bp   $ 183       1.5     bp
                                                                                 
 
(1) Based on annualized amount for line item presented divided by the average total mortgage credit book of business during the period.
 
(2) Represents the amount we record as a loss when the purchase price we pay to purchase delinquent loans from Fannie Mae MBS trusts exceeds the fair value of the loan at the time of purchase. Under our MBS trust agreements, we have the option to purchase loans from the MBS trust, at par plus accrued interest, if four or more consecutive monthly payments have not been made. When we purchase a delinquent loan from one of our MBS trusts, we record the delinquent loan at the lower of the loan’s acquisition price or its fair value in accordance with SOP 03-3. To the extent that the purchase price of the loan exceeds the fair value of the loan, we recognize a loss at the time we acquire the loan.
 
(3) Represents the impact of previously recorded SOP 03-3 reductions to the amount of charge-offs and foreclosed property expense for delinquent loans purchased from MBS trusts that go to foreclosure. Because the carrying value of these loans has been reduced below the purchase price, any charge-off and foreclosed property expense amounts that


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we record if we foreclose on the mortgage also are reduced. In order to reflect in our credit losses the total loss associated with SOP 03-3 loans that we subsequently determine are uncollectible, we have added back to our credit losses the loss we record at the date of purchase when the fair value is below the purchase price.
 
(4) Excludes impact of excess of purchase price over fair value of delinquent loans purchased from trusts.
 
(5) Interest forgone on nonperforming loans in our mortgage portfolio reduces our net interest income but is not reflected in our credit losses total. In addition, other-than-temporary impairment resulting from deterioration in credit quality of our mortgage-related securities is not included in our credit losses total.
 
The decline in home prices on a national basis during the first six months of 2007 contributed to higher default rates and loss severities, causing an increase in charge-offs and foreclosed property expense for the first six months of 2007.
 
We experienced a substantial increase in losses recorded on delinquent loans we purchased from our MBS trusts during the third quarter of 2007, as the disruption in the mortgage credit market and the continued decline in home prices substantially reduced the fair value of the delinquent loans we purchased from our MBS trusts.
 
We have revised our presentation of credit losses to reflect only our realized credit losses. Accordingly, we have excluded from our credit losses, and from our credit loss ratio, any initial losses that we are required to record pursuant to SOP 03-3 when the purchase price of delinquent loans that we purchase from Fannie Mae MBS trusts exceeds the fair value of the loans at the time of purchase. These initial losses affect our provision for credit losses and are reported as a component of our charge-offs, net of recoveries in our condensed consolidated financial statements.
 
In our 2006 Form 10-K, we provided an estimate that our credit loss ratio for 2007 would be within a range of 4 to 6 basis points. As of the date of this filing, we believe our credit loss ratio for 2007, based on our credit losses as reported in Table 23, will remain within our normal historical average range of 4 to 6 basis points. In certain periods, we expect our credit loss ratio is likely to move outside of this historical average range, primarily due to market conditions and the risk profile of our mortgage credit book of business. We expect that, in 2008, our credit loss ratio will increase above our normal historical average range of 4 to 6 basis points.
 
Pursuant to our September 1, 2005 agreement with OFHEO, we agreed to disclose on a quarterly basis the estimated impact on our expected credit losses from an immediate 5% decline in single-family home prices for the entire United States, which we believe is a stressful scenario based on housing data from OFHEO. Table 24 shows our single-family credit loss sensitivity, before and after consideration of the effect of projected credit risk sharing proceeds, such as private mortgage insurance claims and other credit enhancement, as of September 30, 2007, June 30, 2007, March 31, 2007 and December 31, 2006. The significant increase in the net credit loss sensitivity that occurred during the first nine months of 2007 from the end of 2006 was primarily attributable to the decline in home prices during the first nine months of 2007.
 
Table 24:  Single-Family Credit Loss Sensitivity(1)
 
                                 
    As of  
    September 30,
    June 30,
    March 31,
    December 31,
 
    2007     2007     2007     2006  
    (Dollars in millions)  
 
Gross credit loss sensitivity(2)
  $ 5,808     $ 5,185     $ 4,258     $ 3,887  
Less: Projected credit risk sharing proceeds
    (2,969 )     (2,577 )     (2,069 )     (1,926 )
                                 
Net credit loss sensitivity
  $ 2,839     $ 2,608     $ 2,189     $ 1,961  
                                 
Single-family whole loans and Fannie Mae MBS
  $ 2,421,550     $ 2,333,256     $ 2,260,575     $ 2,203,246  
Single-family net credit loss sensitivity as a percentage of single-family whole loans and Fannie Mae MBS
    0.12 %     0.11 %     0.10 %     0.09 %
 
 
(1) Represents total economic credit losses, which include net charge-offs/recoveries, foreclosed property expenses, forgone interest and the cost of carrying foreclosed properties. Excludes amounts recorded as losses in accordance with SOP 03-3 when the purchase price we pay to purchase delinquent loans from Fannie Mae MBS trusts exceeds the fair


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value of the loan at the time of purchase. Calculations based on approximately 93% of our total single-family mortgage credit book of business as of September 30, 2007, June 30, 2007, March 31, 2007 and 92% as of December 31, 2006. The mortgage loans and mortgage-related securities that are included in these estimates consist of: (i) single-family Fannie Mae MBS (whether held in our portfolio or held by third parties), excluding certain whole loan REMICs and private-label wraps; (ii) single-family mortgage loans, excluding mortgages secured only by second liens, subprime mortgages, manufactured housing chattel loans and reverse mortgages; and (iii) long-term standby commitments. We expect the inclusion in our estimates of the excluded products may impact the estimated sensitivities set forth in the preceding paragraphs.
 
(2) Reflects the gross sensitivity of our expected future credit losses to an immediate 5% decline in home values for first lien single-family whole loans we own or that back Fannie Mae MBS. After the initial shock, we estimate home price growth rates return to the rate projected by our credit pricing models.
 
Allowance for Loan Losses and Reserve for Guaranty Losses
 
The combined allowance for loan losses and reserve for guaranty losses increased to $1.2 billion as of June 30, 2007, from $859 million as of December 31, 2006. This increase reflects the increase in our provision for credit losses, which resulted from higher charge-offs attributable to the increase in loan loss severities and default rates due to the national decline in home prices and the impact of continued economic weakness in the Midwest. Our combined allowance for loan losses and reserve for guaranty losses continued to increase in the third quarter of 2007.
 
OFHEO Direction on Interagency Guidance on Nontraditional Mortgages and Subprime Lending
 
In September 2006, five federal financial regulatory agencies jointly issued “Interagency Guidance on Nontraditional Mortgage Product Risks” to address risks posed by mortgage products that allow borrowers to defer repayment of principal or interest, and the layering of risks that results from combining these product types with other features that may compound risk. In June 2007, the same financial regulatory agencies issued the “Statement on Subprime Mortgage Lending,” which addresses risks relating to certain subprime mortgages. The September 2006 and June 2007 interagency guidance directed regulated financial institutions that originate nontraditional and subprime mortgage loans to follow prudent lending practices, including safe and sound underwriting practices and providing borrowers with clear and balanced information about the relative benefits and risks of these products sufficiently early in the process to enable them to make informed decisions.
 
OFHEO directed us to apply the risk management, underwriting and consumer protection principles of both the September 2006 and June 2007 interagency guidance to the mortgage loans and mortgage-related securities that we acquire for our portfolio and for securitization into Fannie Mae MBS. Accordingly, we have made changes to our underwriting standards implementing the interagency guidance. In addition to the changes made to implement the interagency guidance, we have tightened loan eligibility in most high risk loan categories. We are actively managing our single-family eligibility standards and pricing to account for rapidly changing market conditions.
 
Institutional Counterparty Credit Risk Management
 
Institutional counterparty risk is the risk that institutional counterparties may be unable to fulfill their contractual obligations to us. Our primary exposure to institutional counterparty risk exists with our lending partners and servicers, mortgage insurers, dealers who distribute our debt securities or who commit to sell mortgage pools or loans, issuers of investments included in our liquid investment portfolio, and derivatives counterparties. Refer to “Part I—Item 1A—Risk Factors” of our 2006 Form 10-K, filed with the SEC on August 16, 2007, as updated by “Part II—Item 1A—Risk Factors” of this report for a description of the risks associated with our institutional counterparties.
 
Mortgage Insurers
 
As of September 30, 2007, we were the beneficiary of primary mortgage insurance coverage on $329.0 billion of single-family loans in our portfolio or underlying Fannie Mae MBS, which represented approximately 14% of our single-family mortgage credit book of business, compared with $272.1 billion, or approximately 12%, of our single-family mortgage credit book of business as of December 31, 2006. In addition, as of


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September 30, 2007, we were the beneficiary of pool mortgage insurance coverage on $128.3 billion of single-family loans, including conventional and government loans, in our portfolio or underlying Fannie Mae MBS, compared with $106.6 billion as of December 31, 2006.
 
Two of our seven primary mortgage insurers have recently had their external ratings for claims paying ability or insurer financial strength downgraded by Fitch from AA to AA-. Both have maintained their Standard & Poor’s and Moody’s ratings of AA and Aa3, respectively. As of September 30, 2007, these two mortgage insurers provided primary and pool mortgage insurance coverage on $59.1 billion and $27.8 billion, respectively, of the single-family loans in our portfolio or underlying Fannie Mae MBS, which represented approximately 2% and 1%, respectively, of our single-family mortgage credit book of business. Ratings downgrades imply an increased risk that these mortgage insurers will fail to fulfill their obligations to reimburse us for claims under insurance policies. We continue to closely monitor our exposure to our mortgage insurer counterparties.
 
Before we consider an insurer to be a qualified mortgage insurer, we generally require that an insurer obtain and maintain external ratings of claims paying ability of at least Aa3 from Moody’s and AA- from Standard & Poor’s and Fitch. If a mortgage insurer were downgraded below AA-/Aa3 by any of the three national rating agencies, we would evaluate the insurer, the current market environment and our alternative sources of credit enhancement. Based on the outcome of our evaluation, we could restrict that insurer from conducting certain types of business with us and we may take actions that may include not purchasing loans insured by that mortgage insurer. Restricting our business activity with one or more of the seven primary mortgage insurers would increase our concentration risk with the remaining insurers in the industry.
 
Recent Events Relating to Lender Customers and Mortgage Servicers
 
Mortgage and credit market conditions deteriorated rapidly in the third quarter of 2007. Factors negatively affecting the mortgage and credit markets in recent months include significant volatility, lower levels of liquidity, wider credit spreads, rating agency downgrades and significantly higher levels of mortgage foreclosures and delinquencies, particularly with respect to subprime mortgage loans. These challenging market conditions have adversely affected, and are expected to continue to adversely affect, the liquidity and financial condition of a number of our lender customers and mortgage servicers. Several of our lender customers and servicers have experienced ratings downgrades and liquidity constraints, including Countrywide Financial Corporation and its affiliates, our largest lender customer and servicer. The weakened financial condition and liquidity position of some of our lender customers and mortgage servicers may negatively affect their ability to perform their obligations to us and the quality of the services that they provide to us. In addition, our arrangements with our lender customers and mortgage servicers could result in significant exposure to us if any one of our significant lender customers were to default or experience a serious liquidity event. The failure of any of our primary lender customers or mortgage servicers to meet their obligations to us could have a material adverse effect on our results of operations and financial condition.
 
In response to these market conditions, we have increased the frequency and depth of our counterparty monitoring, including targeting higher risk counterparties for additional financial and on-site reviews. We have also changed the assumptions of our stress analyses to reflect deteriorating market conditions and are implementing measures to reduce our potential loss exposure to some of our higher risk counterparties.
 
Interest Rate Risk Management and Other Market Risks
 
Market risk represents the exposure to potential changes in the fair value of our net assets from changes in prevailing market conditions. A significant market risk we face and actively manage for our net portfolio is interest rate risk—the risk of changes in our long-term earnings or in the value of our net assets due to changes in interest rates. Our net portfolio consists of our existing investments in mortgage assets, investments in non-mortgage securities, our outstanding debt used to fund those assets, and the derivatives used to supplement our debt instruments and manage interest rate risk. It also includes any priced asset, debt and derivatives commitments, but excludes our existing guaranty business. Our Capital Markets group, which has primary responsibility for managing the interest rate risk of our net portfolio, employs an integrated interest


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rate risk management strategy that includes asset selection and structuring of our liabilities, including debt and derivatives, to match and offset the interest rate characteristics of our balance sheet assets and liabilities as much as possible.
 
Derivatives Activity
 
The primary tool we use to manage the interest rate risk implicit in our mortgage assets is the variety of debt instruments we issue. We supplement our issuance of debt with derivative instruments, which are an integral part of our strategy in managing interest rate risk. Table 25 presents, by derivative instrument type, our risk management derivative activity for the six months ended June 30, 2007, along with the stated maturities of derivatives outstanding as of June 30, 2007.
 
Table 25:  Activity and Maturity Data for Risk Management Derivatives(1)
 
                                                                         
    Interest Rate Swaps     Interest Rate Swaptions                    
    Pay-
    Receive-
          Foreign
    Pay-
    Receive-
    Interest
             
    Fixed(2)     Fixed(3)     Basis(4)     Currency     Fixed     Fixed     Rate Caps     Other(5)     Total  
    (Dollars in millions)  
 
Notional balance as of
December 31, 2006
  $ 268,068     $ 247,084     $ 950     $ 4,551     $ 95,350     $ 114,921     $ 14,000     $ 469     $ 745,393  
Additions
    108,728       85,479       7,151       708       2,260       21,548       100       165       226,139  
Terminations(6)
    (73,553 )     (83,647 )     (500 )     (790 )     (9,333 )     (9,671 )     (7,850 )     (160 )     (185,504 )
                                                                         
Notional balance as of
June 30, 2007
  $ 303,243     $ 248,916     $ 7,601     $ 4,469     $ 88,277     $ 126,798     $ 6,250     $ 474     $ 786,028  
                                                                         
Future maturities of notional amounts:(7)
                                                                       
Less than 1 year
  $ 15,905     $ 43,455     $     $ 3,128     $ 6,865     $ 10,215     $ 5,500     $ 20     $ 85,088  
1 year to 5 years
    138,683       154,184       25       487       42,812       36,588       750       194       373,723  
5 years to 10 years
    118,232       42,312       7,050             34,100       68,645             260       270,599  
Over 10 years
    30,423       8,965       526       854       4,500       11,350                   56,618  
                                                                         
Total
  $ 303,243     $ 248,916     $ 7,601     $ 4,469     $ 88,277     $ 126,798     $ 6,250     $ 474     $ 786,028  
                                                                         
Weighted-average interest rate as of June 30, 2007:
                                                                       
Pay rate
    5.16 %     5.34 %     5.13 %           6.24 %                          
Receive rate
    5.35 %     5.15 %     6.60 %                 4.86 %                    
Other
                                        3.71 %              
Weighted-average interest rate as of December 31, 2006:
                                                                       
Pay rate
    5.10 %     5.35 %     5.29 %           6.18 %                          
Receive rate
    5.36 %     5.01 %     6.58 %                 4.92 %                    
Other
                                        3.55 %              
 
 
(1) Excludes mortgage commitments accounted for as derivatives. Dollars represent notional amounts, which indicate only the amount on which payments are being calculated and do not represent the amount at risk of loss.
 
(2) Notional amounts include swaps callable by Fannie Mae of $8.2 billion and $10.8 billion as of June 30, 2007 and December 31, 2006, respectively.
 
(3) Notional amounts include swaps callable by derivatives counterparties of $19.8 billion and $6.7 billion as of June 30, 2007 and December 31, 2006, respectively.
 
(4) Notional amounts include swaps callable by derivatives counterparties of $7.2 billion and $600 million as of June 30, 2007 and December 31, 2006, respectively.
 
(5) Includes MBS options, forward starting debt and swap credit enhancements.
 
(6) Includes matured, called, exercised, assigned and terminated amounts. Also includes changes due to foreign exchange rate movements.
 
(7) Based on contractual maturities.


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The outst