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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 September 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 þ     No o
 
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.
 


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TABLE OF CONTENTS
 
             
    1  
  Financial Statements     64  
    Condensed Consolidated Balance Sheets     64  
    Condensed Consolidated Statements of Income     65  
    Condensed Consolidated Statements of Cash Flows     66  
    Condensed Consolidated Statements of Changes in Stockholders’ Equity     67  
    Notes to Condensed Consolidated Financial Statements     68  
      Note 1—Summary of Significant Accounting Policies     68  
      Note 2—Consolidations     71  
      Note 3—Mortgage Loans     72  
      Note 4—Allowance for Loan Losses and Reserve for Guaranty Losses     73  
      Note 5—Investments in Securities     74  
      Note 6—Financial Guaranties     75  
      Note 7—Acquired Property, Net     77  
      Note 8—Short-term Borrowings and Long-term Debt     77  
      Note 9—Derivative Instruments     78  
      Note 10—Income Taxes     79  
      Note 11—Earnings Per Share     81  
      Note 12—Employee Retirement Benefits     82  
      Note 13—Segment Reporting     83  
      Note 14—Preferred Stock     86  
      Note 15—Fair Value of Financial Instruments     86  
      Note 16—Commitments and Contingencies     90  
      Note 17—Subsequent Events     95  
  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     25  
    Consolidated Balance Sheet Analysis     29  
    Supplemental Non-GAAP Information—Fair Value Balance Sheets     35  
    Liquidity and Capital Management     41  
    Off-Balance Sheet Arrangements and Variable Interest Entities     46  
    Risk Management     47  
    Impact of Future Adoption of Accounting Pronouncements     62  
    Forward-Looking Statements     62  
  Quantitative and Qualitative Disclosures About Market Risk     96  
  Controls and Procedures     96  


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Part II—Other Information     102  
  Legal Proceedings     102  
  Risk Factors     104  
  Unregistered Sales of Equity Securities and Use of Proceeds     108  
  Defaults Upon Senior Securities     110  
  Submission of Matters to a Vote of Security Holders     110  
  Other Information     110  
  Exhibits     111  
    112  
    E-1  


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MD&A TABLE REFERENCE
 
                 
 
    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 Losses, Net     21  
 
7
    Administrative Expenses     23  
 
8
    Single-Family Business Results     25  
 
9
    HCD Business Results     27  
 
10
    Capital Markets Business Results     28  
 
11
    Mortgage Portfolio Composition     30  
 
12
    Mortgage Portfolio Activity     32  
 
13
    Outstanding Debt     34  
 
14
    Changes in Risk Management Derivative Assets (Liabilities) at Fair Value, Net     35  
 
15
    Non-GAAP Supplemental Consolidated Fair Value Balance Sheets     37  
 
16
    Non-GAAP Estimated Fair Value of Net Assets (Net of Tax Effect)     39  
 
17
    Selected Market Information     40  
 
18
    Debt Activity     41  
 
19
    Fannie Mae Debt Credit Ratings and Risk Ratings     42  
 
20
    Regulatory Capital Measures     44  
 
21
    On- and Off-Balance Sheet MBS and Other Guaranty Arrangements     47  
 
22
    Composition of Mortgage Credit Book of Business     48  
 
23
    Product Distribution of Conventional Single-Family Business Volume and Mortgage Credit Book of Business     50  
 
24
    Serious Delinquency Rates     53  
 
25
    Single-Family and Multifamily Foreclosed Properties     54  
 
26
    Credit Loss Performance     55  
 
27
    Single-Family Credit Loss Sensitivity     56  
 
28
    Activity and Maturity Data for Risk Management Derivatives     59  
 
29
    Interest Rate Sensitivity to Changes in Level and Slope of Yield Curve     61  
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1
 Exhibit 32.2


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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 third quarter of 2007 concurrently with the filing of our Quarterly Reports on Form 10-Q for the first and second quarters of 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.
 
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


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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 nine months ended September 30, 2007 and 2006, as well as from selected condensed consolidated balance sheet data as of September 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
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
    (Dollars and shares in millions, except per share amounts)  
 
Income Statement Data:
                               
Net interest income
  $ 1,058     $ 1,528     $ 3,445     $ 5,407  
Guaranty fee income(1)
    1,232       1,084       3,450       2,968  
Losses on certain guaranty contracts
    (294 )     (103 )     (1,038 )     (181 )
Derivatives fair value losses, net
    (2,244 )     (3,381 )     (891 )     (854 )
Other income (loss)(1)(2)
    242       659       449       (612 )
Credit-related expenses(3)
    (1,200 )     (197 )     (2,039 )     (457 )
Net income (loss)
    (1,399 )     (629 )     1,509       3,455  
Preferred stock dividends and issuance costs at redemption
    (119 )     (131 )     (372 )     (380 )
Net income (loss) available to common stockholders
    (1,518 )     (760 )     1,137       3,075  
                                 
Common Share Data:
                               
Earnings (loss) per share:
                               
Basic
  $ (1.56 )   $ (0.79 )   $ 1.17     $ 3.17  
Diluted
    (1.56 )     (0.79 )     1.17       3.16  
Weighted-average common shares outstanding:
                               
Basic
    974       972       973       971  
Diluted
    974       972       975       972  
Cash dividends declared per common share
  $ 0.50     $ 0.26     $ 1.40     $ 0.78  
                                 
New Business Acquisition Data:
                               
Fannie Mae MBS issues acquired by third parties(4)
  $ 148,320     $ 107,027     $ 407,962     $ 308,371  
Mortgage portfolio purchases(5)
    49,574       51,576       134,407       150,340  
                                 
New business acquisitions
  $ 197,894     $ 158,603     $ 542,369     $ 458,711  
                                 
 
                 
    As of  
    September 30,
    December 31,
 
    2007     2006  
    (Dollars in millions)  
 
Balance Sheet Data:
               
Investments in securities:
               
Trading
  $ 48,683     $ 11,514  
Available-for-sale
    315,012       378,598  
Mortgage loans:
               
Loans held for sale
    5,053       4,868  
Loans held for investment, net of allowance
    394,550       378,687  
Total assets
    839,783       843,936  
Short-term debt
    153,146       165,810  
Long-term debt
    608,619       601,236  
Total liabilities
    799,740       802,294  
Preferred stock
    9,008       9,108  
Total stockholders’ equity
    39,922       41,506  


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    As of  
    September 30,
    December 31,
 
    2007     2006  
    (Dollars in millions)  
 
Regulatory Capital Data:
               
Core capital(6)
  $ 41,713     $ 41,950  
Total capital(7)
    43,798       42,703  
                 
Mortgage Credit Book of Business Data:
               
Mortgage portfolio(8)
  $ 728,578     $ 728,932  
Fannie Mae MBS held by third parties(9)
    2,003,382       1,777,550  
Other credit guaranties(10)
    35,508       19,747  
                 
Mortgage credit book of business
  $ 2,767,468     $ 2,526,229  
                 
 
                                 
    For the
  For the
    Three Months Ended
  Nine Months Ended
    September 30,   September 30,
    2007   2006   2007   2006
 
Ratios:
                               
Return on assets ratio(11)*
    (0.72 )%     (0.36 )%     0.18 %     0.49 %
Return on equity ratio(12)*
    (19.4 )     (9.8 )     4.8       13.1  
Equity to assets ratio(13)*
    4.7       4.7       4.8       4.8  
Dividend payout ratio(14)*
    N/A       N/A       120.4       24.7  
Average effective guaranty fee rate (in basis points)(15)*
    22.8 bp     22.5 bp     22.0 bp     20.9 bp
Credit loss ratio (in basis points)(16)*
    5.0 bp     2.3 bp     4.0 bp     1.8 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.
 
  (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 the period. Because we experienced a loss for the three months ended September 30, 2007 and 2006, earnings for each of those periods were insufficient to cover dividends declared during those periods.

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(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 nine months ended September 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.
 
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.


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  •  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.
 
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
 
We recorded a net loss and a diluted loss per share of $1.4 billion and $1.56, respectively, for the third quarter of 2007, compared with a net loss and a diluted loss per share of $629 million and $0.79, respectively, for the third quarter of 2006.
 
Net income for the first nine months of 2007 was $1.5 billion, a decrease of $1.9 billion, or 56%, from the first nine months of 2006. Diluted earnings per share decreased by 63% to $1.17 for the first nine months of 2007, from $3.16 for the first nine months of 2006.


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Refer to “Consolidated Results of Operations” below for a more detailed discussion of our financial results for the three and nine months ended September 30, 2007, compared with the three and nine months ended September 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. 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


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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 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


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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, and delinquent loans purchased from securitization trusts.
 
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.
 
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


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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.
 
Loans Purchased with Evidence of Credit Deterioration
 
For securitization trusts that include a Fannie Mae guaranty, we have the option to purchase loans from those trusts, at par plus accrued interest, after required payments have not been made in full for four consecutive months. Under long-term standby commitments, we also purchase loans from lenders when the loans subject to these commitments meet certain delinquency criteria. We record the acquisition of such defaulted loans at the lower of the loan’s acquisition price or its fair value.
 
During the period of reduced liquidity and market volatility that began in July 2007, we obtained indicative bids for delinquent loans from brokers. We used these bids to value delinquent loans that we purchased from trusts during the third quarter of 2007. The recent change in market conditions has had a significant impact on our estimate of the fair value of these delinquent loans. Given that the primary market for delinquent loans is currently illiquid, there is more limited price transparency. Therefore, the estimated fair value of defaulted loans is highly sensitive to changes in market conditions.


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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 third quarters of 2007 and 2006 and between the first nine 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
    Quarterly
    Year-to-Date
 
    Three Months Ended September 30,     Nine Months Ended September 30,     Variance     Variance  
    2007     2006     2007     2006     $     %     $     %  
    (Dollars in millions, except per share amounts)  
 
Net interest income
  $ 1,058     $ 1,528     $ 3,445     $ 5,407     $ (470 )     (31 )%   $ (1,962 )     (36 )%
Guaranty fee income(1)
    1,232       1,084       3,450       2,968       148       14       482       16  
Trust management income(2)
    146             460             146             460        
Fee and other income(1)
    76       234       546       567       (158 )     (68 )     (21 )     (4 )
                                                                 
Net revenues
    2,512       2,846       7,901       8,942       (334 )     (12 )     (1,041 )     (12 )
Losses on certain guaranty contracts
    (294 )     (103 )     (1,038 )     (181 )     (191 )     (185 )     (857 )     (473 )
Investment gains (losses), net
    136       550       (102 )     (758 )     (414 )     (75 )     656       87  
Derivatives fair value losses, net
    (2,244 )     (3,381 )     (891 )     (854 )     1,137       34       (37 )     (4 )
Losses from partnership investments
    (147 )     (197 )     (527 )     (579 )     50       25       52       9  
Administrative expenses
    (660 )     (761 )     (2,018 )     (2,249 )     101       13       231       10  
Credit-related expenses(3)
    (1,200 )     (197 )     (2,039 )     (457 )     (1,003 )     (509 )     (1,582 )     (346 )
Other non-interest expenses(4)
    (87 )     (29 )     (242 )     (40 )     (58 )     (200 )     (202 )     (505 )
                                                                 
Income (loss) before federal income taxes and extraordinary gains (losses)
    (1,984 )     (1,272 )     1,044       3,824       (712 )     (56 )     (2,780 )     (73 )
Benefit (provision) for federal income taxes
    582       639       468       (380 )     (57 )     (9 )     848       223  
Extraordinary gains (losses), net of tax effect
    3       4       (3 )     11       (1 )     (25 )     (14 )     (127 )
                                                                 
Net income (loss)
  $ (1,399 )   $ (629 )   $ 1,509     $ 3,455     $ (770 )     (122 )%   $ (1,946 )     (56 )%
                                                                 
Diluted earnings (loss) per common share
  $ (1.56 )   $ (0.79 )   $ 1.17     $ 3.16     $ (0.77 )     (97 )%   $ (1.99 )     (63 )%
                                                                 
 
 
(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 $148 million and approximately $447 million for the three and nine months ended September 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.
 
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


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condensed consolidated results of operations for the three and nine months ended September 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 nine months ended September 30, 2007 and 2006.
 
Table 2:  Analysis of Net Interest Income and Yield
 
                                                 
    For the Three Months Ended September 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)
  $ 397,349     $ 5,572       5.61 %   $ 376,792     $ 5,209       5.53 %
Mortgage securities
    330,872       4,579       5.54       355,024       4,912       5.53  
Non-mortgage securities(3)
    72,075       999       5.43       59,464       812       5.34  
Federal funds sold and securities purchased under agreements to resell
    17,994       246       5.35       15,551       214       5.38  
Advances to lenders
    8,561       76       3.45       4,368       38       3.44  
                                                 
Total interest-earning assets
  $ 826,851     $ 11,472       5.54 %   $ 811,199     $ 11,185       5.50 %
                                                 
Interest-bearing liabilities:
                                               
Short-term debt
  $ 166,832     $ 2,400       5.63 %   $ 163,903     $ 2,121       5.07 %
Long-term debt
    613,801       8,013       5.22       613,374       7,533       4.91  
Federal funds purchased and securities sold under agreements to repurchase
    161       1       4.46       181       3       4.99  
                                                 
Total interest-bearing liabilities
  $ 780,794     $ 10,414       5.31 %   $ 777,458     $ 9,657       4.94 %
                                                 
Impact of net non-interest bearing funding
  $ 46,057               0.29 %   $ 33,741               0.21 %
                                                 
Net interest income/net interest yield(4)
          $ 1,058       0.52 %           $ 1,528       0.77 %
                                                 
 


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    For the Nine Months Ended September 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)
  $ 391,318     $ 16,582       5.65 %   $ 372,798     $ 15,495       5.54 %
Mortgage securities
    329,126       13,606       5.51       360,115       14,599       5.41  
Non-mortgage securities(3)
    67,595       2,763       5.39       52,531       1,983       4.98  
Federal funds sold and securities purchased under agreements to resell
    15,654       633       5.33       13,294       504       5.00  
Advances to lenders
    6,097       160       3.45       4,063       103       3.36  
                                                 
Total interest-earning assets
  $ 809,790     $ 33,744       5.55 %   $ 802,801     $ 32,684       5.42 %
                                                 
Interest-bearing liabilities:
                                               
Short-term debt
  $ 163,062     $ 6,806       5.50 %   $ 163,647     $ 5,671       4.57 %
Long-term debt
    609,018       23,488       5.14       607,106       21,596       4.74  
Federal funds purchased and securities sold under agreements to repurchase
    136       5       4.91       265       10       4.73  
                                                 
Total interest-bearing liabilities
  $ 772,216     $ 30,299       5.22 %   $ 771,018     $ 27,277       4.71 %
                                                 
Impact of net non-interest bearing funding
  $ 37,574               0.24 %   $ 31,783               0.19 %
                                                 
Net interest income/net interest yield(4)
          $ 3,445       0.57 %           $ 5,407       0.90 %
                                                 
 
 
(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 nine months ended September 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 $6.2 billion and $6.1 billion for the three months ended September 30, 2007 and 2006, respectively, and $6.0 billion and $7.0 billion for the nine months ended September 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.
 
Table 3 presents the total variance, or change, in our net interest income between the three months ended September 30, 2007 and 2006, and the nine months ended September 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.

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Table 3:  Rate/Volume Analysis of Net Interest Income
 
                                                 
    For the Three Months Ended September 30, 2007 vs. 2006     For the Nine Months Ended September 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
  $ 363     $ 288     $ 75     $ 1,087     $ 781     $ 306  
Mortgage securities
    (333 )     (334 )     1       (993 )     (1,277 )     284  
Non-mortgage securities(2)
    187       175       12       780       605       175  
Federal funds sold and securities purchased under agreements to resell
    32       33       (1 )     129       94       35  
Advances to lenders
    38       37       1       57       54       3  
                                                 
Total interest income
    287       199       88       1,060       257       803  
                                                 
Interest expense:
                                               
Short-term debt
    279       39       240       1,135       (20 )     1,155  
Long-term debt
    480       5       475       1,892       68       1,824  
Federal funds purchased and securities sold under agreements to repurchase
    (2 )     (1 )     (1 )     (5 )     (5 )      
                                                 
Total interest expense
    757       43       714       3,022       43       2,979  
                                                 
Net interest income
  $ (470 )   $ 156     $ (626 )   $ (1,962 )   $ 214     $ (2,176 )
                                                 
 
 
(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 $1.1 billion for the third quarter of 2007 decreased by 31% from the third quarter of 2006, driven by a 32% (25 basis points) decline in our net interest yield to 0.52%. The overall increase of 37 basis points in the average cost of our debt, to 5.31%, more than offset a 4 basis points increase in the average yield on our interest-earning assets, to 5.54%.
 
Net interest income of $3.4 billion for the first nine months of 2007 decreased by 36% from the first nine months of 2006, driven by a 37% (33 basis points) decline in our net interest yield to 0.57%. The overall increase of 51 basis points in the average cost of our debt, to 5.22%, more than offset a 13 basis points increase in the average yield on our interest-earning assets, to 5.55%.
 
We continued to experience compression in our net interest yield during the first nine 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 and 8 basis points for the three and nine months ended September 30, 2007, respectively.
 
As discussed below in “Derivatives Fair Value Losses, 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 losses, net.” Although we experienced an increase in the average cost of our debt for the three and nine months ended September 30, 2007, we recorded net contractual interest income on our interest rate swaps totaling $95 million and $193 million for the three and nine months ended September 30, 2007, respectively. In comparison, we recorded net contractual interest income of $82 million and net contractual interest expense of $157 million for the three and nine months ended September 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


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presented above, resulted in a reduction in our funding costs of approximately 5 and 3 basis points for the three and nine months ended September 30, 2007, respectively. The effect of interest accruals on our interest rate swaps also resulted in a reduction in our funding costs of approximately 4 basis points for the three months ended September 30, 2006 and an increase in our funding costs of approximately 2 basis points for the nine months ended September 30, 2006.
 
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 nine months ended September 30, 2007 and 2006.
 
Table 4:  Guaranty Fee Income and Average Effective Guaranty Fee Rate(1)
 
                                         
    For the Three Months Ended September 30,  
    2007     2006        
    Amount     Rate(2)     Amount     Rate(2)     Variance  
    (Dollars in millions)  
 
Guaranty fee income/average effective guaranty fee rate, excluding buy-up impairment
  $ 1,235       22.8 bp   $ 1,092       22.6 bp     13 %
Buy-up impairment
    (3 )           (8 )     (0.1 )     (63 )
                                         
Guaranty fee income/average effective guaranty fee rate(4)(5)
  $ 1,232       22.8 bp   $ 1,084       22.5 bp     14 %
                                         
Average outstanding Fannie Mae MBS and other guaranties(6)
  $ 2,163,173             $ 1,929,303               12 %
Fannie Mae MBS issues(7)
    171,204               124,019               38  
 
                                         
    For the Nine Months Ended September 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
  $ 3,439       21.9 bp   $ 2,978       21.0 bp     15 %
Net change in fair value of buy-ups and guaranty assets(3)
    19       0.1                    
Buy-up impairment
    (8 )           (10 )     (0.1 )     (20 )
                                         
Guaranty fee income/average effective guaranty fee rate(4)(5)
  $ 3,450       22.0 bp   $ 2,968       20.9 bp     16 %
                                         
Average outstanding Fannie Mae MBS and other guaranties(6)
  $ 2,090,322             $ 1,893,843               10 %
Fannie Mae MBS issues(7)
    453,506               357,480               27  
 
 
(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 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 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


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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 $144 million and $60 million for the three months ended September 30, 2007 and 2006, respectively, and $327 million and $157 million for the nine months ended September 30, 2007 and 2006, respectively.
 
(6) Other guaranties includes $35.5 billion and $19.7 billion as of September 30, 2007 and December 31, 2006, respectively, and $21.7 billion and $19.2 billion as of September 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 14% increase in guaranty fee income for the third quarter of 2007 from the third quarter of 2006 resulted from a 12% increase in average outstanding Fannie Mae MBS and other guaranties, and a 1% increase in the average effective guaranty fee rate to 22.8 basis points from 22.5 basis points.
 
The 16% increase in guaranty fee income for the first nine months of 2007 from the first nine months of 2006 resulted from a 10% increase in average outstanding Fannie Mae MBS and other guaranties, and a 5% increase in the average effective guaranty fee rate to 22.0 basis points from 20.9 basis points.
 
Growth in average outstanding Fannie Mae MBS and other guaranties for the three and nine months ended September 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 nine 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.
 
Trust Management Income
 
Trust management income totaled $146 million and $460 million for the three and nine months ended September 30, 2007, respectively. Trust management income consists of the fees we earn as master servicer, issuer and trustee for Fannie Mae MBS. We derive these fees from the interest earned on cash flows between the date of remittance 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 $148 million and approximately $447 million for the three and nine months ended September 30, 2006, 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.


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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 decreased to $76 million for the third quarter of 2007, from $234 million for the third quarter of 2006. The $158 million decrease in fee and other income in the third quarter of 2007 resulted from changes in foreign currency exchange rates. We recorded a foreign currency exchange loss of $133 million on our foreign-denominated debt in the third quarter of 2007, due to the weakening of the U.S. dollar against the Japanese yen during the third quarter of 2007. In contrast, we recorded a foreign currency exchange gain of $37 million in the third quarter of 2006. 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 losses, 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 decreased to $546 million for the first nine months of 2007, from $567 million for the first nine months of 2006. The $21 million decrease in fee and other income for the first nine months of 2007 was due in part to the recognition of a foreign currency exchange loss of $188 million on our foreign-denominated debt for the first nine months of 2007, compared with a foreign currency exchange loss of $123 million for the first nine months of 2006. The increase in foreign currency exchange losses was due to the weakening of the U.S. dollar against the Japanese yen during the first nine months of 2007. The decrease in fee and other income was also due to a decrease in certain multifamily fees related to consolidated loans, partially offset by increased multifamily loan prepayment and yield maintenance fees.
 
Losses on Certain Guaranty Contracts
 
Losses on certain guaranty contracts increased by $191 million to $294 million for the third quarter of 2007, from $103 million for the third quarter of 2006. Losses on certain guaranty contracts increased by $857 million to $1.0 billion for the first nine months of 2007, from $181 million for the first nine 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-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.


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  •  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 nine 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 nine 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 nine 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 nine months of 2007, due to the higher credit 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


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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 nine months ended September 30, 2007 and 2006.
 
Table 5:  Investment Gains (Losses), Net
 
                                 
    For the
    For the
 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
    (Dollars in millions)  
 
Other-than-temporary impairment on investment securities(1)
  $ (81 )   $ (6 )   $ (84 )   $ (852 )
Lower-of-cost-or-market adjustments on held-for-sale loans
    3       47       (115 )     (45 )
Gains (losses) on Fannie Mae portfolio securitizations, net
    (65 )     45       (27 )     74  
Gains on sale of investment securities, net
    99       115       414       125  
Unrealized gains (losses) on trading securities, net
    249       364       (180 )     (25 )
Other investment losses, net
    (69 )     (15 )     (110 )     (35 )
                                 
Investment gains (losses), net
  $ 136     $ 550     $ (102 )   $ (758 )
                                 
 
 
(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 $414 million decrease in investment gains for the third quarter of 2007 from the third quarter of 2006 was primarily attributable to the combined effect of the following:
 
  •  A decrease of $115 million in unrealized gains on trading securities. We recorded $249 million in unrealized gains on trading securities during the third quarter of 2007, primarily due to a decline in interest rates during the quarter, which increased the fair value of our trading securities. This increase was partially offset by a decline in the fair value of private-label mortgage-related securities backed by subprime and Alt-A loans due to a widening of credit spreads on these securities during the quarter. In contrast, we recorded $364 million in unrealized gains on trading securities during the third quarter of 2006, due to a decline in interest rates during the quarter.
 
  •  A net loss of $65 million for the third quarter of 2007 on Fannie Mae portfolio securitizations, compared with a net gain of $45 million for the third quarter of 2006. We securitized some subprime mortgage assets that were in a loss position during the third quarter of 2007. Cash proceeds related to portfolio securitizations accounted for as sales totaled $9.2 billion and $5.7 billion for the third quarter of 2007 and 2006, respectively.
 
  •  An increase of $75 million in other-than-temporary impairment on investment securities. We recognized other-than-temporary impairment of $81 million for the third quarter of 2007, due to credit ratings downgrades and other credit-related events relating to certain non-mortgage investments that we had designated as available for sale, which caused the fair value of these securities to decline below their


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  carrying value, and a deterioration in the credit quality of some of our mortgage revenue bond investments. In contrast, we recognized other-than-temporary impairment of $6 million for the third quarter of 2006.
 
The $656 million decrease in investment losses for the first nine months of 2007 from the first nine months of 2006 was primarily attributable to the combined effect of the following:
 
  •  A decrease of $768 million in other-than-temporary impairment on investment securities. We recognized other-than-temporary impairment of $84 million for the first nine months of 2007, largely due to the impairments recorded during the third quarter of 2007. In contrast, we recognized other-than-temporary impairment of $852 million for the first nine 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. 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 $289 million in gains on sale of investment securities, net. We recorded net gains of $414 million and $125 million for the first nine months of 2007 and 2006, respectively, related to the sale of securities totaling $45.3 billion and $46.3 billion, respectively. The investment gains recorded during the first nine 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.
 
  •  An increase of $155 million in unrealized losses on trading securities. 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. We recorded unrealized losses of $180 million on our trading securities for the first nine months of 2007, reflecting 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 the significant widening of credit spreads during the period.
 
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, due to the effect on our trading securities of the significant widening of credit spreads. 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 Losses, Net
 
Table 6 presents, by type of derivative instrument, the fair value gains and losses on our derivatives for the three and nine months ended September 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 Losses, Net
 
                                 
    For the
    For the
 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2007     2006     2007     2006  
    (Dollars in millions)  
 
Risk management derivatives:
                               
Swaps:
                               
Pay-fixed
  $ (7,500 )   $ (7,198 )   $ (1,780 )   $ 1,852  
Receive-fixed
    3,834       3,329       956       (11 )
Basis
    90       38       (35 )     25  
Foreign currency(1)
    140       (65 )     97       32  
Swaptions:
                               
Pay-fixed
    (237 )     (822 )     32       (925 )
Receive-fixed
    1,460       1,405       (199 )     (1,951 )
Interest rate caps
    (3 )     (33 )     5       92  
Other(2)
    3       2       4       4  
                                 
Risk management derivatives fair value losses, net
    (2,213 )     (3,344 )     (920 )     (882 )
Mortgage commitment derivatives fair value gains (losses), net
    (31 )     (37 )     29       28  
                                 
Total derivatives fair value losses, net
  $ (2,244 )   $ (3,381 )   $ (891 )   $ (854 )
                                 
Risk management derivatives fair value gains (losses) attributable to:
                               
Net contractual interest income (expense) on interest rate swaps
  $ 95     $ 82     $ 193     $ (157 )
Net change in fair value of terminated derivative contracts from end of prior period to date of termination
    (50 )     (110 )     (187 )     (154 )
Net change in fair value of outstanding derivative contracts, including derivative contracts entered into during the period
    (2,258 )     (3,316 )     (926 )     (571 )
                                 
Risk management derivatives fair value losses, net(3)
  $ (2,213 )   $ (3,344 )   $ (920 )   $ (882 )
                                 
 
                 
    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  
As of September 30
    4.87       5.08  
 
 
(1) Includes the effect of net contractual interest expense of approximately $16 million and $20 million for the three months ended September 30, 2007 and 2006, respectively, and $50 million and $55 million for the nine months ended September 30, 2007 and 2006, respectively. The change in fair value of foreign currency swaps excluding this item resulted in a net gain of $156 million and a net loss of $45 million for the three months ended September 30, 2007 and 2006, respectively, and net gains of $147 million and $87 million for the nine months ended September 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 nine months ended September 30, 2007. In comparison, we recorded net contractual interest income for the three months ended September 30, 2006 and net contractual interest expense for the nine months ended September 30, 2006. Although these amounts are included in the net derivatives fair value losses 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.
 
We recorded derivatives fair value losses totaling $2.2 billion and $3.4 billion for the third quarter of 2007 and 2006, respectively, due to fair value losses on our interest rate swaps that were partially offset by fair value gains on our option-based derivatives. The fair value losses on our interest rate swaps were attributable to a decrease in swap rates during each period, which resulted in fair value losses on our pay-fixed swaps that exceeded the fair value gains on our receive-fixed swaps. We experienced fair value gains on our option-based derivatives in each period due to an increase in fair value resulting from an increase in implied volatility that more than offset a decrease in fair value resulting from the combined effect of the decrease in swap rates and the time decay of these options. Time decay refers to the diminishing value of an option over time as less time remains to exercise the option. The less time left on an option, the greater the effects of time decay.
 
We recorded derivatives fair value losses totaling $891 million and $854 million for the first nine months of 2007 and 2006, respectively. The derivatives fair value losses recorded in the third quarter of 2007 and 2006 more than offset the cumulative derivatives fair value gains recorded for the first six months of each year.
 
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 decreased to $147 million for the third quarter of 2007, from $197 million for the third quarter of 2006. The decrease in losses for the third quarter of 2007 was attributable to the recognition of a gain on the sale of investments in federal low-income housing tax credit (“LIHTC”) partnerships in July 2007, as well as a lower LIHTC portfolio balance compared to the third quarter of 2006, which resulted in fewer net operating losses. LIHTC partnerships generate tax credits and incur operational losses for which we obtain tax benefits through tax deductions. See “Benefit (Provision) for Federal Income Taxes” for further discussion of LIHTC tax benefits.
 
Losses from partnership investments decreased to $527 million for the first nine months of 2007, from $579 million for the first nine months of 2006. The decrease in losses for the first nine months of 2007 was due to the recognition of gains on sales of investments in LIHTC partnerships in March 2007 and July 2007, which was partially offset by an increase in 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.


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Table 7:  Administrative Expenses
 
                                                 
    For the
          For the
       
    Three Months Ended
          Nine Months Ended
       
    September 30,           September 30,        
    2007     2006     Variance     2007     2006     Variance  
    (Dollars in millions)  
 
Ongoing operating costs(1)
  $ 528     $ 509       4 %   $ 1,563     $ 1,424       10 %
Restatement and related regulatory expenses(2)
    132       252       (48 )     455       825       (45 )
                                                 
Total administrative expenses
  $ 660     $ 761       (13 )%   $ 2,018     $ 2,249       (10 )%
                                                 
 
 
(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.
 
The decreases in administrative expenses for the third quarter of 2007 from the third quarter of 2006, and for the first nine months of 2007 from the first nine 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 costs associated with an early retirement program and various involuntary severance initiatives implemented in 2007, as well as costs associated with 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 to these costs, 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 $1.2 billion for the third quarter of 2007, from $197 million for the third quarter of 2006. Credit-related expenses increased to $2.0 billion for the first nine months of 2007, from $457 million for the first nine 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 $942 million, or 650%, to $1.1 billion for the third quarter of 2007, from $145 million for the third quarter of 2006. The provision for credit losses increased by $1.4 billion, or 381%, to $1.8 billion for the first nine months of 2007, from $368 million for the first nine months of 2006.
 
Approximately $670 million and $805 million of the provision for credit losses for the three and nine months ended September 30, 2007, respectively, relates to charge-offs recorded when we purchase delinquent loans from MBS trusts and the purchase price, which is equal to the par amount, exceeds the fair value at the purchase date. These charges totaled $37 million and $153 million for the three and nine months ended September 30, 2006, respectively. Accordingly, $633 million and $652 million of the increase in the provision for credit losses for the three and nine months ended September 30, 2007, respectively, was attributable primarily to a substantial decrease in the market value of delinquent loans we purchased from MBS trusts. The decrease began in July 2007 as housing and credit market conditions deteriorated, causing increased credit spread requirements and decreased liquidity for this type of asset.
 
Pursuant to our MBS trust agreement, we have the option to purchase loans from the MBS trust, at par plus accrued interest, after required payments have not been made in full for four consecutive months. We record


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these loans at their estimated fair value at the date of purchase from the trust and recognize the difference between the amount paid and the fair value as a component of charge-offs. Based on our past experience, the majority of the loans we purchase from MBS trusts cure or pay off; however, our cure rate has declined in recent periods and may decline further. If a loan pays off in full, we recover the loss previously recognized as a component of net interest income. If a loan cures, meaning that the borrower is no longer past due, we recover the loss previously recorded as a component of net interest income over the contractual life of the loan. If we foreclose upon a mortgage loan purchased from an MBS trust, the charge-off recognized at the date of foreclosure and the foreclosed property expense would be reduced because of the loss we previously recorded when we purchased the loan from the MBS trust. In some cases, losses that we record when we purchase loans from MBS trusts may result in our recording gains when we dispose of the foreclosed properties.
 
We are required by our MBS trust agreement to purchase loans from an MBS trust when specified predetermined triggers are met. Accordingly, we would expect to continue to incur these charges as part of our provision for credit losses in our consolidated financial statements. We do not expect the market prices for these delinquent loans to improve in the reasonably foreseeable future.
 
The remaining increase in our provision for credit losses of $309 million and $750 million for the three and nine months ended September 30, 2007, respectively, is attributable to an increase in net charge-offs and incremental additions to the allowance for loan losses and reserve for guaranty losses 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 nine months of 2007. The higher default rates are, in part, due to earlier than anticipated defaults on loans originated in 2006 and 2007. 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 loans going to foreclosure.
 
Foreclosed property expense increased by $61 million, or 117%, to $113 million for the third quarter of 2007, from $52 million for the third quarter of 2006. Foreclosed property expense increased by $180 million, or 202%, to $269 million for the first nine months of 2007, from $89 million for the first nine 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 declined in the first nine months 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.”
 
Other Non-Interest Expenses
 
We recorded other non-interest expenses of $87 million for the third quarter of 2007, compared with $29 million for the third quarter of 2006. We recorded other non-interest expenses of $242 million and $40 million for the first nine 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.


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Federal Income Taxes
 
We recorded net tax benefit amounts for the third quarter of 2007 and 2006, which produced an effective tax rate of 29% and 50%, respectively. We recorded a net tax benefit for the first nine months of 2007 that produced an effective tax rate of (45)%, compared with a net tax provision and an effective tax rate of 10% for the first nine months of 2006. 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 nine months ended September 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 13, Segment Reporting.”
 
Single-Family Business
 
Our Single-Family business recorded a net loss of $186 million for the third quarter of 2007, compared with net income of $529 million for the third quarter of 2006. Our Single-Family business recorded net income of $305 million for the first nine months of 2007, a decrease of $1.3 billion, or 81%, from net income of $1.6 billion for the first nine 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
    Nine Months Ended
    Quarterly
    Year-to-Date
 
    September 30,     September 30,     Variance     Variance  
    2007     2006     2007     2006     $     %     $     %  
    (Dollars in millions)  
 
Income Statement Data:
                                                               
Guaranty fee income
  $ 1,424     $ 1,242     $ 4,015     $ 3,406     $ 182       15 %   $ 609       18 %
Trust management income(1)
    138             433             138             433        
Other income(2)
    125       345       476       1,030       (220 )     (64 )     (554 )     (54 )
Losses on certain guaranty contracts
    (292 )     (101 )     (1,023 )     (175 )     (191 )     (189 )     (848 )     (485 )
Credit-related expenses(3)
    (1,195 )     (192 )     (2,040 )     (450 )     (1,003 )     (522 )     (1,590 )     (353 )
Other expenses(4)
    (484 )     (482 )     (1,397 )     (1,304 )     (2 )           (93 )     (7 )
                                                                 
Income (loss) before federal income taxes
    (284 )     812       464       2,507       (1,096 )     (135 )     (2,043 )     (81 )
Benefit (provision) for federal income taxes
    98       (283 )     (159 )     (871 )     381       135       712       82  
                                                                 
Net income (loss)
  $ (186 )   $ 529     $ 305     $ 1,636     $ (715 )     (135 )%   $ (1,331 )     (81 )%
                                                                 


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    For the
    For the
             
    Three Months Ended
    Nine Months Ended
    Quarterly
    Year-to-Date
 
    September 30,     September 30,     Variance     Variance  
    2007     2006     2007     2006     $     %     $     %  
    (Dollars in millions)  
 
Other Key Performance Data:
                                                       
Average single-family guaranty book of business(5)
  $ 2,432,904     $ 2,198,281     $ 2,359,126     $ 2,158,428     $ 234,623       11 %   $ 200,698       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 nine months ended September 30, 2007, compared with the three and nine months ended September 30, 2006 included the following.
 
  •  Increased guaranty fee income for both the three and nine months ended September 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 $2.1 trillion as of September 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 41.2% for the third quarter of 2007, from approximately 24.3% for the third quarter of 2006. Our market share has increased in the first nine months of 2007, due to the shift in the product mix of mortgage originations to more traditional conforming fixed-rate loans and reduced competition 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 nine months of 2007 as compared with the same period in 2006.
 
  •  Significantly higher losses on certain guaranty contracts for both the three and nine months ended September 30, 2007, due to the deterioration in home prices and overall housing market conditions during the first nine months of 2007, which led to an increase in mortgage 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 third quarter and first nine months of 2007.
 
  •  A substantial increase in credit-related expenses for both the three and nine months ended September 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 net tax benefit for the third quarter of 2007, which produced an effective tax rate of 35%, and a net tax provision and an effective tax rate of 34% for the nine months ended September 30, 2007. In comparison,

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  we recorded a net tax provision for the three and nine months ended September 30, 2006 and an effective tax rate of 35% for each period.
 
HCD Business
 
Net income for our HCD business increased by $8 million, or 9%, to $97 million for the third quarter of 2007, from $89 million for the third quarter of 2006. Net income for our HCD business increased by $46 million, or 14%, to $370 million for the first nine months of 2007, from $324 million for the first nine 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
    Nine Months Ended
    Quarterly
    Year-to-Date
 
    September 30,     September 30,     Variance     Variance  
    2007     2006     2007     2006     $     %     $     %  
    (Dollars in millions)  
 
Income Statement Data:
                                                               
Guaranty fee income(1)
  $ 115     $ 120     $ 326     $ 381     $ (5 )     (4 )%   $ (55 )     (14 )%
Other income(1)(2)
    78       50       278       156       28       56       122       78  
Losses on partnership investments
    (147 )     (197 )     (527 )     (579 )     50       25       52       9  
Credit-related expenses(3)
    (5 )     (5 )     1       (7 )                 8       114  
Other expenses(4)
    (245 )     (239 )     (755 )     (672 )     (6 )     (3 )     (83 )     (12 )
                                                                 
Loss before federal income taxes
    (204 )     (271 )     (677 )     (721 )     67       25       44       6  
Benefit for federal income taxes
    301       360       1,047       1,045       (59 )     (16 )     2        
                                                                 
Net income
  $ 97     $ 89     $ 370     $ 324     $ 8       9 %   $ 46       14 %
                                                                 
Other Key Performance Data:
                                                               
Average multifamily guaranty book of business(5)
  $ 131,643     $ 117,629     $ 127,061     $ 117,845     $ 14,014       12 %   $ 9,216       8 %
 
 
(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 (provision) 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 nine months ended September 30, 2007, compared with the three and nine months ended September 30, 2006 included the following.
 
  •  Decreased guaranty fee income for both the three and nine months ended September 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 nine months ended September 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. In the third quarter of 2007, this trend began to reverse as a result of the growing need for credit and liquidity in the multifamily mortgage market. These market factors


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  contributed to a higher fee rate on new multifamily business and to faster growth in our multifamily guaranty book of business during the third quarter of 2007.
 
  •  A decrease in losses on partnership investments for the third quarter of 2007, due to the recognition of a gain on the sale of investments in LIHTC partnerships in July 2007, as well as a lower LIHTC portfolio balance compared to the third quarter of 2006, which resulted in fewer net operating losses. Losses on partnership investments declined slightly for the first nine months of 2007 as a result of the recognition of gains on sales of investments in LIHTC partnerships in March 2007 and July 2007, which was partially offset by increased operating losses on retained LIHTC partnerships.
 
  •  An increase in other income for the first nine months of 2007, due to an increase in loan prepayment and yield maintenance fees resulting from higher liquidations in the first nine months of 2007 relative to the first nine months of 2006.
 
  •  An increase in other expenses for the first nine months of 2007, primarily resulting from higher net interest expense associated with an increase in segment assets.
 
Capital Markets Group
 
Our Capital Markets group recorded a net loss of $1.3 billion for the third quarter of 2007, compared with a net loss of $1.2 billion for the third quarter of 2006. Our Capital Markets group recorded net income of $834 million for the first nine months of 2007, a decrease of $661 million, or 44%, from net income of $1.5 billion for the first nine 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
    Nine Months Ended
    Quarterly
    Year-to-Date
 
    September 30,     September 30,     Variance     Variance  
    2007     2006     2007     2006     $     %     $     %  
    (Dollars in millions)  
 
Net interest income
  $ 1,064     $ 1,352     $ 3,455     $ 4,879     $ (288 )     (21 )%   $ (1,424 )     (29 )%
Investment gains (losses), net
    183       529       (56 )     (831 )     (346 )     (65 )     775       93  
Derivatives fair value losses, net
    (2,244 )     (3,381 )     (891 )     (854 )     1,137       34       (37 )     (4 )
Fee and other income (expense)
    (66 )     117       66       219       (183 )     (156 )     (153 )     (70 )
Other expenses(1)
    (433 )     (430 )     (1,317 )     (1,375 )     (3 )     (1 )     58       4  
                                                                 
Income (loss) before federal income taxes and extraordinary gains (losses), net of tax effect
    (1,496 )     (1,813 )     1,257       2,038       317       17       (781 )     (38 )
Benefit (provision) for federal income taxes
    183       562       (420 )     (554 )     (379 )     (67 )     134       24  
Extraordinary gains (losses), net of tax effect
    3       4       (3 )     11       (1 )     (25 )     (14 )     (127 )
                                                                 
Net income (loss)
  $ (1,310 )   $ (1,247 )   $ 834     $ 1,495     $ (63 )     (5 )%   $ (661 )     (44 )%
                                                                 
 
 
(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 nine months ended September 30, 2007, compared with the three and nine months ended September 30, 2006 included the following.
 
  •  A significant reduction in net interest income for both the three and nine months ended September 30, 2007 due to continued compression in our net interest yield, largely attributable to the increase in our


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  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 investment gains for the three months ended September 30, 2007, due to a decrease in unrealized gains on trading securities, a net loss on Fannie Mae portfolio securitizations and an increase in other-than-temporary impairment on investment securities. In addition, a reduction in investment losses for the nine months ended September 30, 2007, 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 recognized $81 million and $84 million in other-than-temporary impairment on investment securities for the three and nine months ended September 30, 2007. The impairment recognized in the third quarter of 2007 was the result of credit ratings downgrades and other credit-related events relating to certain non-mortgage investments that we had designated as available for sale, which caused the fair value of these securities to decline below their carrying value, and a deterioration in the credit quality of some of our mortgage revenue bond investments. In contrast, we recognized other-than-temporary impairment on investment securities totaling $6 million and $852 million for the three and nine months ended September 30, 2006, due to a decline in fair value below carrying value of certain securities that we designated for sale.
 
  —  We experienced a decrease in gains on the sale of investment securities for the three months ended September 30, 2007. We experienced an increase in gains on the sale of investment securities for the nine months ended September 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 a decreased level of unrealized gains on trading securities for the three months ended September 30, 2007, and an increased level of unrealized losses on trading securities for the nine months ended September 30, 2007, reflecting the decrease in the fair value of these securities due to wider mortgage-to-debt spreads.
 
  •  Derivatives fair value losses of $2.2 billion and $3.4 billion for the third quarter of 2007 and 2006, respectively, which were largely attributable to fair value losses on our interest rate swaps due to a decline in interest rates during each period. The derivatives fair value losses recorded in the third quarter of 2007 and 2006 more than offset the cumulative derivatives fair value gains for the first six months of each year.
 
  •  A shift to fee and other expense for the three months ended September 30, 2007, compared with fee and other income for the three months ended September 30, 2006. We experienced a decrease in fee and other income for the nine months ended September 30, 2007, as compared with the nine months ended September 30, 2006. The variance between each period was attributable to an increase in foreign currency exchange losses on our foreign-denominated debt and a decrease in the recognition of certain multifamily fees.
 
  •  A net tax benefit for the third quarter of 2007, which produced an effective tax rate of 12%, and a net tax provision and effective tax rate of 33% for the nine months ended September 30, 2007. In comparison, we recorded a net tax benefit for the third quarter of 2006, which produced an effective tax rate of 31%, and a net tax provision and effective tax rate of 27% for the nine months ended September 30, 2006. The variance in the effective tax rate and statutory rate was primarily due to fluctuations in our pre-tax income and the relative benefit of tax-exempt income generated from our investments in mortgage revenue bonds.
 
CONSOLIDATED BALANCE SHEET ANALYSIS
 
Our total assets of $839.8 billion as of September 30, 2007 decreased by $4.2 billion, or less than 1%, from December 31, 2006. Our total liabilities of $799.7 billion as of September 30, 2007 decreased by $2.6 billion, or less than 1%, from December 31, 2006. Stockholders’ equity of $39.9 billion as of September 30, 2007 reflected a decrease of $1.6 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.


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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 September 30, 2007 and December 31, 2006.
 
Table 11:  Mortgage Portfolio Composition(1)
 
                 
    As of  
    September 30,
    December 31,
 
    2007     2006  
    (Dollars in millions)  
 
Mortgage loans:(2)
               
Single-family:
               
Government insured or guaranteed
  $ 23,101     $ 20,106  
Conventional:
               
Long-term, fixed-rate
    199,200       202,339  
Intermediate-term, fixed-rate(3)
    48,358       53,438  
Adjustable-rate
    51,296       46,820  
                 
Total conventional single-family
    298,854       302,597  
                 
Total single-family
    321,955       322,703  
                 
Multifamily:
               
Government insured or guaranteed
    859       968  
Conventional:
               
Long-term, fixed-rate
    5,272       5,098  
Intermediate-term, fixed-rate(3)
    64,144       50,847  
Adjustable-rate
    7,190       3,429  
                 
Total conventional multifamily
    76,606       59,374  
                 
Total multifamily
    77,465       60,342  
                 
Total mortgage loans
    399,420       383,045  
                 
Unamortized premiums and other cost basis adjustments, net
    679       943  
Lower of cost or market adjustments on loans held for sale
    (101 )     (93 )
Allowance for loan losses for loans held for investment
    (395 )     (340 )
                 
Total mortgage loans, net
    399,603       383,555  
                 
Mortgage-related securities:
               
Fannie Mae single-class MBS
    102,506       124,383  
Non-Fannie Mae single-class mortgage securities
    28,015       27,980  
Fannie Mae structured MBS
    72,784       75,261  
Non-Fannie Mae structured mortgage securities(4)
    106,217       97,399  
Mortgage revenue bonds
    16,156       16,924  
Other mortgage-related securities
    3,480       3,940  
                 
Total mortgage-related securities
    329,158       345,887  
                 
Market value adjustments(5)
    (3,385 )     (1,261 )
Other-than-temporary impairments
    (619 )     (1,004 )
Unamortized premiums (discounts) and other cost basis adjustments, net(6)
    (990 )     (1,083 )
                 
Total mortgage-related securities, net
    324,164       342,539  
                 
Mortgage portfolio, net(7)
  $ 723,767     $ 726,094  
                 
 
 
(1) Mortgage loans and mortgage-related securities are reported at unpaid principal balance.


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(2) Mortgage loans include unpaid principal balance totaling $100.0 billion and $105.5 billion as of September 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 September 30, 2007, $76.2 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 $2.3 billion and $448 million as of September 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 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.


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Table 12 compares our mortgage portfolio activity for the three and nine months ended September 30, 2007 and 2006.
 
Table 12:  Mortgage Portfolio Activity(1)
 
                                                                 
    For the
          For the
       
    Three Months Ended
          Nine Months Ended
       
    September 30,     Variance     September 30,     Variance  
    2007     2006     $     %     2007     2006     $     %  
    (Dollars in millions)  
 
Purchases
  $ 49,574     $ 51,576     $ (2,002 )     (4 )%   $ 134,407     $ 150,340     $ (15,933 )     (11 )%
Sales
    20,222       21,415       (1,193 )     (6 )     45,301       46,251       (950 )     (2 )
Liquidations
    28,013       35,528       (7,515 )     (21 )     90,007       106,110       (16,103 )     (15 )
 
 
(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 nine months ended September 30, 2007 as compared with the same period 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 for most of the period. Our level of portfolio purchases for the third quarter of 2007 was comparable with that of the third quarter of 2006. Beginning in the third quarter of 2007, there was a significant widening of mortgage-to-debt spreads due to the reduction in liquidity and market estimates of slower prepayments. These market conditions presented more opportunities for us to purchase mortgage assets at attractive prices and spreads during the quarter. However, our ability to capitalize on these opportunities was limited by the OFHEO-directed minimum capital requirement and portfolio cap imposed by our May 2006 consent order with OFHEO.
 
While our levels of portfolio sales for the first nine months of 2007 were comparable to the first nine months of 2006, we experienced a decrease in sales activity during the third quarter of 2007 due to the widening of mortgage-to-debt spreads. The decrease in mortgage liquidations for the three and nine months ended September 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.
 
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.
 
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 $62.6 billion and $69.4 billion as of September 30, 2007 and December 31, 2006, respectively. Our non-mortgage investments, which are carried at fair value in our condensed consolidated balance sheets, totaled $39.5 billion and $47.6 billion as of September 30, 2007 and December 31, 2006, respectively. We provide additional detail on our non-mortgage investments in “Notes to Condensed Consolidated Financial Statements—Note 5, Investments in Securities.”


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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 $315.0 billion and $318.2 billion, respectively, as of September 30, 2007, and gross unrealized gains and gross unrealized losses recorded in AOCI related to these securities totaled $1.8 billion and $5.0 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. While we experienced a significant decrease in the fair value of our AFS securities at the end of the third quarter of 2007, we believe that substantially all of the decline in fair value 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.
 
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 September 30, 2007 and December 31, 2006.


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Table 13:  Outstanding Debt(1)
 
                                 
    As of
    As of
 
    September 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
  $ 1,645       5.60 %   $ 700       5.36 %
                                 
Short-term debt:
                               
Fixed-rate
    152,469       5.06       164,686       5.16  
From consolidations
    677       5.35       1,124       5.32  
                                 
Total short-term debt
  $ 153,146       5.06 %   $ 165,810       5.16 %
                                 
Long-term debt:
                               
Senior fixed-rate
  $ 575,346       5.20 %   $ 576,099       4.98 %
Senior floating-rate
    15,651       5.87       5,522       5.06  
Subordinated fixed-rate
    10,980       6.13       12,852       5.91  
From consolidations
    6,642       5.84       6,763       5.98  
                                 
Total long-term debt(2)
  $ 608,619       5.25 %   $ 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 $770.2 billion as of September 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 September 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 18 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 September 30, 2007 and December 31, 2006 in “Notes to Condensed Consolidated Financial Statements—Note 9, Derivative Instruments.”
 
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 September 30, 2007. As indicated in Table 14, we recorded a net derivative asset of $1.8 billion as of September 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 $814.4 billion and $745.4 billion as of September 30, 2007 and December 31, 2006, respectively.


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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)
    155  
Fair value at date of termination of contracts settled during the period(4)
    42  
Periodic net cash contractual interest receipts
    (1,191 )
         
Total cash receipts, net
    (994 )
         
Income statement impact of recognized amounts:
       
Periodic net contractual interest income on interest rate swaps
    193  
Net change in fair value during the period
    (1,113 )
         
Derivatives fair value losses, net(5)
    (920 )
         
Net derivative asset as of September 30, 2007(2)
  $ 1,811  
         
 
 
(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 losses recognized in our condensed consolidated statements of income, excluding mortgage commitments.
 
The $1.9 billion decrease in the fair value of the net derivative asset was largely attributable to the decrease in the aggregate net fair value of our interest rate swaps due to the decrease in swap rates between December 31, 2006 and September 30, 2007. We present, by derivative instrument type, our risk management derivative activity for the nine months ended September 30, 2007, along with the stated maturities of our derivatives outstanding as of September 30, 2007, in Table 28 in “Risk Management—Interest Rate Risk Management and Other Market Risks.”
 
SUPPLEMENTAL NON-GAAP INFORMATION—FAIR VALUE BALANCE SHEETS
 
Our assets and liabilities consist predominately of financial instruments. The balance sheets presented in our condensed consolidated financial statements reflect some financial assets measured and reported at fair value while other financial assets, along with most of our financial liabilities, are measured and reported at historical cost. Each of the non-GAAP supplemental consolidated fair value balance sheets presented below in Table 15 reflects all of our assets and liabilities at estimated fair value. Estimated fair value is the amount at which an asset or liability could be exchanged between willing parties, other than in a forced or liquidation sale. The non-GAAP estimated fair value of our net assets (net of tax effect) is derived from our non-GAAP fair value balance sheet.
 
The non-GAAP supplemental consolidated fair value balance sheets and estimated fair value of our net assets are not defined terms within GAAP and may not be comparable to similarly titled measures reported by other companies. In addition, they are not intended as a substitute for amounts reported in our condensed consolidated financial statements prepared in accordance with GAAP. However, we routinely use fair value measures to make investment decisions and to measure, monitor and manage our risk because our assets and liabilities consist predominately of financial instruments. Management, particularly our Capital Markets group, uses this information to analyze changes in our assets and liabilities from period to period and understand how the overall value of the company is changing from period to period and to measure the performance of our capital markets investment activities. Accordingly, we believe that the non-GAAP supplemental consolidated fair value balance sheets and the fair value of our net assets are useful to investors because they provide consistency in the measurement and reporting of all of our assets and liabilities. We believe that the non-GAAP supplemental consolidated fair value balance sheets and the fair value of our net assets, when used in


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conjunction with our condensed consolidated financial statements prepared in accordance with GAAP, can serve as valuable incremental tools for investors to assess changes in our overall value over time relative to changes in market conditions.
 
Cautionary Language Relating to Supplemental Non-GAAP Financial Measures
 
In reviewing our supplemental non-GAAP consolidated fair value balance sheets, there are a number of important factors and limitations to consider. The presentation of some of the line items in our non-GAAP consolidated fair value balance sheets may differ from the presentation in our consolidated GAAP balance sheets, as we have disaggregated certain line items and aggregated certain other line items. We describe these differences in the notes to the non-GAAP consolidated fair value balance sheets. We believe this revised presentation, for purposes of analyzing our non-GAAP consolidated fair value balance sheets, provides greater transparency into the components of our balance sheet associated with our guaranty business activities and the components associated with our capital markets business activities, which is consistent with the way we manage risks and allocate revenues and expenses for segment reporting purposes.
 
Moreover, as discussed in “Critical Accounting Policies—Fair Value of Financial Instruments,” when quoted market prices or observable market data are not available, we rely on internally developed models that may require management judgment and assumptions to estimate fair value. Differences in assumptions used in our models could result in significant changes in our estimates of fair value. In addition, the estimated fair value of our net assets is calculated as of a particular point in time based on our existing assets and liabilities and does not incorporate other factors that may have a significant impact on that value, most notably any value from future business activities in which we expect to engage. As a result, the estimated fair value of our net assets presented in our non-GAAP supplemental consolidated fair value balance sheets does not represent an estimate of our net realizable value, liquidation value or our market value as a whole. Amounts we ultimately realize from the disposition of assets or settlement of liabilities may vary significantly from the estimated fair values presented in our non-GAAP supplemental consolidated fair value balance sheets. Because temporary changes in market conditions can substantially affect the fair value of our net assets, we do not believe that short-term fluctuations in the fair value of our net assets attributable to mortgage-to-debt option-adjusted spreads (“OAS”) or changes in the fair value of our net guaranty assets are necessarily representative of the effectiveness of our investment strategy or the long-term underlying value of our business. We believe the long-term value of our business depends primarily on our ability to acquire new assets and funding at attractive prices, to effectively manage the risks of these assets and liabilities over time and to earn attractive returns on our guaranty business. However, we believe that assessing the factors that affect near-term changes in the estimated fair value of our net assets helps us evaluate our long-term value and assess whether temporary market factors have caused our net assets to become overvalued or undervalued relative to the level of risk and expected long-term fundamentals of our business.


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Table 15:  Non-GAAP Supplemental Consolidated Fair Value Balance Sheets
 
                                                 
    As of September 30, 2007     As of December 31, 2006  
    GAAP
                GAAP
             
    Carrying
    Fair Value
    Estimated
    Carrying
    Fair Value
    Estimated
 
    Value     Adjustment(1)     Fair Value     Value     Adjustment(1)     Fair Value  
    (Dollars in millions)  
 
Assets:
                                               
Cash and cash equivalents
  $ 4,976     $     $ 4,976 (2)   $ 3,972     $     $ 3,972 (2)
Federal funds sold and securities purchased under agreements to resell
    8,349       2       8,351 (2)     12,681             12,681 (2)
Trading securities
    48,683             48,683 (2)     11,514             11,514 (2)
Available-for-sale securities
    315,012             315,012 (2)     378,598             378,598 (2)
Mortgage loans:
                                               
Mortgage loans held for sale
    5,053       21       5,074 (3)     4,868       (88 )     4,780 (3)
Mortgage loans held for investment, net of allowance for loan losses
    394,550       (3,601 )     390,949 (3)     378,687       (2,821 )     375,866 (3)
Guaranty assets of mortgage loans held in portfolio
          4,105       4,105 (3)(4)           3,669       3,669 (3)(4)
Guaranty obligations of mortgage loans held in portfolio
          (5,299 )     (5,299 )(3)(4)           (2,831 )     (2,831 )(3)(4)
                                                 
Total mortgage loans
    399,603       (4,774 )     394,829 (2)(3)     383,555       (2,071 )     381,484 (2)(3)
Advances to lenders
    11,738       (122 )     11,616 (2)     6,163       (152 )     6,011 (2)
Derivative assets at fair value
    3,172             3,172 (2)     4,931             4,931 (2)
Guaranty assets and buy-ups
    10,332       4,212       14,544 (2)(4)     8,523       3,737       12,260 (2)(4)
                                                 
Total financial assets
    801,865       (682 )     801,183 (2)     809,937       1,514       811,451 (2)
Master servicing assets and credit enhancements
    1,668       1,752       3,420 (4)(5)     1,624       1,063       2,687 (4)(5)
Other assets
    36,250       2,901       39,151 (5)(6)     32,375       (948 )     31,427 (5)(6)
                                                 
Total assets
  $ 839,783     $ 3,971     $ 843,754     $ 843,936     $ 1,629     $ 845,565  
                                                 
Liabilities:
                                               
Federal funds purchased and securities sold under agreements to repurchase
  $ 1,645     $ 2     $ 1,647 (2)   $ 700     $     $ 700 (2)
Short-term debt
    153,146       199       153,345 (2)     165,810       (63 )     165,747 (2)
Long-term debt
    608,619       10,316       618,935 (2)     601,236       5,358       606,594 (2)
Derivative liabilities at fair value
    1,336             1,336 (2)     1,184             1,184 (2)
Guaranty obligations
    14,322       1,771       16,093 (2)     11,145       (2,960 )     8,185 (2)
                                                 
Total financial liabilities
    779,068       12,288       791,356 (2)     780,075       2,335       782,410 (2)
Other liabilities
    20,672       (2,572 )     18,100 (7)     22,219       (2,101 )     20,118 (7)
                                                 
Total liabilities
    799,740       9,716       809,456       802,294       234       802,528  
Minority interests in consolidated subsidiaries
    121             121       136             136  
Stockholders’ Equity:
                                               
Preferred
    9,008       (287 )     8,721 (8)     9,108       (90 )     9,018 (8)
Common
    30,914       (5,458 )     25,456 (9)     32,398       1,485       33,883 (9)
                                                 
Total stockholders’ equity/non-GAAP fair value of net assets
  $ 39,922     $ (5,745 )   $ 34,177     $ 41,506     $ 1,395     $ 42,901  
                                                 
Total liabilities and stockholders’ equity
  $ 839,783     $ 3,971     $ 843,754     $ 843,936     $ 1,629     $ 845,565  
                                                 


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Explanation and Reconciliation of Non-GAAP Measures to GAAP Measures
 
(1) Each of the amounts listed as a “fair value adjustment” represents the difference between the carrying value included in our GAAP condensed consolidated balance sheets and our best judgment of the estimated fair value of the listed asset or liability.
 
(2) We determined the estimated fair value of these financial instruments in accordance with the fair value guidelines outlined in SFAS No. 107, Disclosures about Fair Value of Financial Instruments (“SFAS 107”), as described in “Notes to Condensed Consolidated Financial Statements—Note 15, Fair Value of Financial Instruments.” In Note 15, we also disclose the carrying value and estimated fair value of our total financial assets and total financial liabilities as well as discuss the methodologies and assumptions we use in estimating the fair value of our financial instruments.
 
(3) We have separately presented the estimated fair value of “Mortgage loans held for sale,” “Mortgage loans held for investment, net of allowance for loan losses,” “Guaranty assets of mortgage loans held in portfolio” and “Guaranty obligations of mortgage loans held in portfolio.” These combined line items together represent total mortgage loans reported in our GAAP condensed consolidated balance sheets. This presentation provides transparency into the components of the fair value of our mortgage loans associated with our guaranty business activities and the components of our capital markets business activities, which is consistent with the way we manage risks and allocate revenues and expenses for segment reporting purposes. While the carrying values and estimated fair values of the individual line items may differ from the amounts presented in Note 15, the combined amounts together equal the carrying value and estimated fair value amounts of total mortgage loans in Note 15.
 
(4) In our GAAP condensed consolidated balance sheets, we report the guaranty assets associated with our outstanding Fannie Mae MBS and other guaranties as a separate line item and include buy-ups, master servicing assets and credit enhancements associated with our guaranty assets in “Other assets.” The GAAP carrying value of our guaranty assets reflects only those guaranty arrangements entered into subsequent to our adoption of FIN No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FIN No. 34) (“FIN 45”), on January 1, 2003. On a GAAP basis, our guaranty assets totaled $9.4 billion and $7.7 billion as of September 30, 2007 and December 31, 2006, respectively. The associated buy-ups totaled $894 million and $831 million as of September 30, 2007 and December 31, 2006, respectively. In our non-GAAP supplemental consolidated fair value balance sheets, we also disclose the estimated guaranty assets and obligations related to mortgage loans held in our portfolio. The aggregate estimated fair value of the guaranty asset-related components totaled $16.8 billion as of September 30, 2007, compared with $15.8 billion as of December 31, 2006. These components represent the sum of the following line items in this table: (i) Guaranty assets of mortgage loans held in portfolio; (ii) Guaranty obligations of mortgage loans held in portfolio, (iii) Guaranty assets and buy-ups; and (iv) Master servicing assets and credit enhancements.
 
(5) The line items “Master servicing assets and credit enhancements” and “Other assets” together consist of the assets presented on the following five line items in our GAAP condensed consolidated balance sheets: (i) Accrued interest receivable; (ii) Acquired property, net; (iii) Deferred tax assets; (iv) Partnership investments; and (v) Other assets. The carrying value of these items in our GAAP condensed consolidated balance sheets together totaled $38.8 billion and $34.8 billion as of September 30, 2007 and December 31, 2006, respectively. We deduct the carrying value of the buy-ups associated with our guaranty obligation, which totaled $894 million and $831 million as of September 30, 2007 and December 31, 2006, respectively, from “Other assets” reported in our GAAP condensed consolidated balance sheets because buy-ups are a financial instrument that we combine with guaranty assets in our SFAS 107 disclosure in Note 15. We have estimated the fair value of master servicing assets and credit enhancements based on our fair value methodologies discussed in Note 15.
 
(6) With the exception of partnership investments and deferred tax assets, the GAAP carrying values of other assets generally approximate fair value. While we have included partnership investments at their carrying value in each of the non-GAAP supplemental consolidated fair value balance sheets, the fair values of these items are generally different from their GAAP carrying values, potentially materially. For example, our LIHTC partnership investments had a carrying value of $8.0 billion and an estimated fair value of $9.1 billion as of September 30, 2007. We assume that other deferred assets, consisting primarily of prepaid expenses, have no fair value. We adjust the GAAP-basis deferred income taxes for purposes of each of our non-GAAP supplemental consolidated fair value balance sheets to include estimated income taxes on the difference between our non-GAAP supplemental consolidated fair value balance sheets net assets, including deferred taxes from the GAAP condensed consolidated balance sheets, and our GAAP condensed consolidated balance sheets stockholders’ equity. Because our adjusted deferred income taxes are a net asset in each year, the amounts are included in our non-GAAP fair value balance sheets as a component of other assets.
 
(7) The line item “Other liabilities” consists of the liabilities presented on the following four line items in our GAAP condensed consolidated balance sheets: (i) Accrued interest payable; (ii) Reserve for guaranty losses; (iii) Partnership liabilities; and (iv) Other liabilities. The carrying value of these items in our GAAP condensed consolidated balance sheets together totaled $20.7 billion and $22.2 billion as of September 30, 2007 and December 31, 2006, respectively. The GAAP carrying values of these other liabilities generally approximate fair value. We assume that deferred liabilities, such as deferred debt issuance costs, have no fair value.


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(8) “Preferred stockholders’ equity” is reflected in our non-GAAP supplemental consolidated fair value balance sheets at the estimated fair value amount.
 
(9) “Common stockholders’ equity” consists of the stockholders’ equity components presented on the following five line items in our GAAP condensed consolidated balance sheets: (i) Common stock; (ii) Additional paid-in capital; (iii) Retained earnings; (iv) Accumulated other comprehensive loss; and (v) Treasury stock, at cost. “Common stockholders’ equity” is the residual of the excess of the estimated fair value of total assets over the estimated fair value of total liabilities, after taking into consideration preferred stockholders’ equity and minority interest in consolidated subsidiaries.
 
Changes in Non-GAAP Estimated Fair Value of Net Assets
 
Table 16 summarizes the change in the estimated fair value of our net assets for the first nine months of 2007.
 
Table 16:  Non-GAAP Estimated Fair Value of Net Assets (Net of Tax Effect)
 
         
    (Dollars in millions)  
 
Balance as of December 31, 2006
  $ 42,901  
Capital transactions:(1)
       
Common dividends, common share repurchases and issuances, net
    (1,279 )
Preferred dividends, redemptions and issuances
    (472 )
         
Capital transactions, net
    (1,751 )
Change in estimated fair value of net assets, excluding capital transactions
    (6,973 )
         
Decrease in estimated fair value of net assets, net
    (8,724 )
         
Balance as of September 30, 2007(2)
  $ 34,177  
         
 
(1) Represents net capital transactions, which are reflected in the condensed consolidated statements of changes in stockholders’ equity.
 
(2) Represents estimated fair value of net assets (net of tax effect) presented in Table 15: Non-GAAP Supplemental Consolidated Fair Value Balance Sheets.
 
Summary of Fair Value Results
 
The estimated fair value of our net assets decreased by $8.7 billion to $34.2 billion as of September 30, 2007, from $42.9 billion as of December 31, 2006. The $8.7 billion decrease included the effect of a reduction of $1.8 billion attributable to capital transactions, consisting primarily of payments of $1.1 billion for the redemption of preferred stock and $1.7 billion for dividends to holders of our common and preferred stock, which were partially offset by proceeds of $1.0 billion from the issuance of preferred stock.
 
Excluding the effect of capital transactions, we experienced a $7.0 billion decrease in the estimated fair value of our net assets for the first nine months of 2007. The primary factors affecting the fair value of our net assets for the first nine months of 2007 included the benefit from the economic income generated by our businesses, which was more than offset by a decrease in value resulting from the decline in home prices and wider mortgage-to-debt OAS. We expect periodic fluctuations in the estimated fair value of our net assets due to our business activities, as well as due to changes in market conditions, including changes in interest rates, changes in relative spreads between our mortgage assets and debt, and changes in implied volatility. Below we provide selected market information in Table 17 and discuss how changes in market conditions have contributed to the significant decrease in the estimated fair value of our net assets.


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Table 17:  Selected Market Information(1)
 
                         
    As of        
    September 30,
    December 31,
       
    2007     2006     Change  
 
10-year U.S. Treasury note yield
    4.59 %     4.70 %     (0.11 )%
Implied volatility(2)
    17.20 %     15.70 %     1.50 %
30-year Fannie Mae MBS par coupon rate
    5.97 %     5.79 %     0.18 %
Lehman U.S. MBS Index OAS (in basis points) over LIBOR yield curve
    21.4 bp     (2.7 ) bp     24.1 bp
Lehman U.S. Agency Debt Index OAS (in basis points) over LIBOR yield curve
    (18.8 ) bp     (13.8 )bp     (5.0 ) bp
 
 
(1) Information obtained from Lehman Live, Lehman POINT and Bloomberg.
 
(2) Implied volatility for an interest rate swaption with a 3-year option on a 10-year final maturity.
 
Estimated Impact of Changes in Market Conditions on Fair Value Results
 
For the first nine months of 2007, we experienced a decrease in the fair value of our net guaranty assets, including related deferred tax assets, of $4.5 billion. This fair value change does not include the impact of the economic earnings of the guaranty business during the period. The decline is primarily due to a substantial increase in the estimated fair value of our guaranty obligations attributable to the decline in the home prices and the market’s expectation of future home price declines. This increase more than offset an increase in the fair value of our guaranty assets that resulted from growth in our guaranty book of business.
 
We estimate that the significant widening of mortgage-to-debt spreads during the first nine months of 2007 caused a decline of approximately $4.5 billion to $5.0 billion in the fair value of our net portfolio. As displayed in Table 17 above, the Lehman U.S. MBS index, which primarily includes 30-year and 15-year mortgages, reflected a significant widening of OAS during the first nine months of 2007. The OAS on securities held by us that are not in the index, such as AAA-rated 10-year commercial mortgage-backed securities and AAA-rated private-label mortgage-related securities, widened even more dramatically, resulting in an overall decrease in the fair value of our mortgage assets. Debt OAS based on the Lehman U.S. Agency Debt Index to the London Interbank Offered Rate (“LIBOR”) tightened by 5 basis points to minus 18.8 basis points as of September 30, 2007, resulting in an increase in the fair value of our debt. Our economic earnings from our portfolio investments resulted in an increase in fair value of our net assets that partially offset the decrease that resulted from the change in market conditions.


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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 18 summarizes our debt activity for the three and nine months ended September 30, 2007 and 2006.
 
Table 18:  Debt Activity
 
                                 
    For the
    For the
 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2007     2006     2007     2006  
    (Dollars in millions)  
 
Issued during the period:(1)
                               
Short-term:(2)
                               
Amount(3)
  $ 341,033     $ 432,575     $ 1,124,200     $ 1,715,094  
Weighted average interest rate
    4.91 %     5.16 %     5.07 %     4.78 %
Long-term:
                               
Amount(3)
  $ 37,462     $ 40,833     $ 150,753     $ 140,046  
Weighted average interest rate
    5.58 %     5.73 %     5.57 %     5.52 %
Total issued:
                               
Amount(3)
  $ 378,495     $ 473,408     $ 1,274,953     $ 1,855,140  
Weighted average interest rate
    4.98 %     5.21 %     5.13 %     4.84 %
Redeemed during the period:(1)(4)
                               
Short-term:(2)
                               
Amount(3)
  $ 351,130     $ 455,380     $ 1,135,352     $ 1,735,420  
Weighted average interest rate
    4.97 %     5.08 %     5.07 %     4.68 %
Long-term:
                               
Amount(3)
  $ 45,725     $ 43,339     $ 142,973     $ 119,899  
Weighted average interest rate
    4.68 %     4.15 %     4.58 %     3.73 %
Total redeemed:
                               
Amount(3)
  $ 396,855     $ 498,719     $ 1,278,325     $ 1,855,319  
Weighted average interest rate
    4.93 %     5.00 %     5.02 %     4.62 %
 
 
(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 September 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 nine 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 September 30, 2007, refer to “Consolidated Balance Sheet Analysis—Debt Instruments.”


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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 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 19 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 19 also sets forth our “risk to the government” rating and our “Bank Financial Strength Rating” as of November 8, 2007.
 
Table 19:  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.
 
Nine Months Ended September 30, 2007.  Our cash and cash equivalents of $4.5 billion as of September 30, 2007 increased by $1.2 billion from December 31, 2006. We generated cash flows from operating activities of


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$16.9 billion, largely attributable to net cash provided from trading securities. We also generated cash flows from investing activities of $746 million, attributable to funds provided from a reduction in federal funds sold and securities purchased under agreements to resell. These cash flows were partially offset by net cash used in financing activities of $16.5 billion, as amounts paid to extinguish debt exceeded the proceeds from the issuance of debt.
 
Nine Months Ended September 30, 2006.  Our cash and cash equivalents of $3.1 billion as of September 30, 2006 increased by $259 million from December 31, 2005. We generated cash flows from operating activities of $25.6 billion, largely attributable to net cash provided from trading securities. These cash flows were partially offset by net cash used in financing activities of $20.5 billion, as amounts paid to extinguish debt exceeded the proceeds from the issuance of debt, and net cash used in investing activities of $4.9 billion, attributable to an increase in federal funds sold and securities purchased under agreements to resell.
 
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 20 displays our regulatory capital classification measures as of September 30, 2007 and December 31, 2006, with the exception of our statutory risk-based capital measure and related total capital measure, which have been provided as of June 30, 2007 (the most recent date for which our statutory risk-based capital measure is available) and December 31, 2006. The regulatory capital classification measures as of September 30, 2007 provided in the table below represent amounts that will be resubmitted to OFHEO for its certification and are subject to its review and approval. They do not represent OFHEO’s announced capital classification measures.


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Table 20:  Regulatory Capital Measures
 
                 
    As of  
    September 30,
    December 31,
 
    2007(1)     2006  
    (Dollars in millions)  
 
Core capital(2)
  $ 41,713     $ 41,950  
Statutory minimum capital(3)
    30,303       29,359  
                 
Surplus of core capital over required minimum capital
  $ 11,410     $ 12,591  
                 
Surplus of core capital percentage over required minimum capital(4)
    37.7 %     42.9 %
                 
Core capital(2)
  $ 41,713     $ 41,950  
OFHEO-directed minimum capital(5)
    39,393       38,166  
                 
Surplus of core capital over OFHEO-directed minimum capital
  $ 2,319     $ 3,784  
                 
Surplus of core capital percentage over OFHEO-directed minimum capital(6)
    5.9 %     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)
  $ 41,713     $ 41,950  
Statutory critical capital(10)
    15,682       15,149  
                 
Surplus of core capital over required critical capital
  $ 26,031     $ 26,801  
                 
Surplus of core capital percentage over required critical capital(11)
    166.0 %     176.9 %
 
 
  (1) Statutory risk-based capital and total capital measures have been provided as of June 30, 2007 (the most recent date for which the statutory risk-based capital measure is available) and December 31, 2006. The regulatory capital classification measures as of September 30, 2007 provided in this table represent estimates that will be resubmitted to OFHEO for its certification.
 
  (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 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.


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(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).
 
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 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.


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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.
 
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


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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 21 presents a summary of our on- and off-balance sheet Fannie Mae MBS and other guaranties as of September 30, 2007 and December 31, 2006.
 
Table 21:  On- and Off-Balance Sheet MBS and Other Guaranty Arrangements
 
                 
    As of  
    September 30,
    December 31,
 
    2007     2006  
    (Dollars in millions)  
 
Fannie Mae MBS and other guaranties outstanding(1)
  $ 2,214,180     $ 1,996,941  
Less: Fannie Mae MBS held in portfolio(2)
    175,290       199,644  
                 
Fannie Mae MBS held by third parties and other guaranties
  $ 2,038,890     $ 1,797,297  
                 
 
 
(1) Includes $35.5 billion and $19.7 billion in unpaid principal balance of other guaranties as of September 30, 2007 and December 31, 2006, respectively. Excludes $99.1 billion and $105.6 billion in unpaid principal balance of consolidated Fannie Mae MBS as of September 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 September 30, 2007, we had a recorded investment in LIHTC partnerships of $8.0 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.”
 
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 22 displays the composition of our entire mortgage credit book of business, which consists of both on- and off-balance sheet arrangements, as of September 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 September 30, 2007 and December 31, 2006.


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Table 22:  Composition of Mortgage Credit Book of Business
 
                                                         
    As of September 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)
  $ 298,854     $ 23,101     $ 76,606     $ 859     $ 375,460     $ 23,960          
Fannie Mae MBS
    172,518       2,246       312       214       172,830       2,460          
Agency mortgage-related securities(7)
    30,898       1,723             50       30,898       1,773          
Mortgage revenue bonds
    3,186       2,896       7,616       2,458       10,802       5,354          
Other mortgage-related securities(8)
    80,692       968       23,350       31       104,042       999          
                                                         
Total mortgage portfolio
    586,148       30,934       107,884       3,612       694,032       34,546          
Fannie Mae MBS held by third parties(9)
    1,948,986       15,467       37,780       1,149       1,986,766       16,616          
Other credit guaranties(10)
    18,638             16,810       60       35,448       60          
                                                         
Mortgage credit book of business
  $ 2,553,772     $ 46,401     $ 162,474     $ 4,821     $ 2,716,246     $ 51,222          
                                                         
Guaranty book of business(11)
  $ 2,438,996     $ 40,814     $ 131,508     $ 2,282     $ 2,570,504     $ 43,096          
                                                         
 
                                                         
    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 September 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-


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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 September 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 September 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 78% and 84% of our total multifamily mortgage credit book as of September 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 $100.0 billion and $105.5 billion as of September 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.
 
  (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.


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Single-Family
 
Table 23 provides information on the product distribution of our conventional single-family business volumes for the three months ended September 30, 2007 and 2006, and our conventional single-family mortgage credit book of business as of September 30, 2007 and December 31, 2006.
 
Table 23:   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
       
    September 30,     As of  
                September 30,
    December 31,
 
    2007     2006     2007     2006  
 
Fixed-rate:
                               
Long-term
    74 %     69 %     70 %     68 %
Intermediate-term
    5       7       15       18  
Interest-only
    9       6       3       1  
                                 
Total fixed-rate
    88       82       88       87  
Adjustable-rate:
                               
Interest-only
    7       9       5       4  
Negative-amortizing
    1       4       1       2  
Other ARMs
    4       5       6       7  
                                 
Total adjustable-rate
    12       18       12       13  
                                 
Total
    100 %     100 %     100 %     100 %
                                 
 
 
(1) As noted in Table 22 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 23 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 third quarter of 2007, as compared with the third quarter of 2006.
 
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 mortgage loans to us have classified the loans as Alt-A based on documentation or other product features. As of September 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. 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.


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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 0.3% of our total single-family mortgage credit book of business as of September 30, 2007 consisted of subprime mortgage loans or Fannie Mae MBS backed by subprime mortgage loans. 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 $106.2 billion in non-Fannie Mae structured mortgage-related securities in our investment portfolio as of September 30, 2007. Of this amount, $76.2 billion consisted of private-label mortgage-related securities backed by subprime or Alt-A mortgage loans. As of September 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 $42.4 billion in private-label mortgage-related securities backed by subprime mortgage loans. We also guaranteed approximately $6.2 billion in resecuritized subprime mortgage-related securities as of September 30, 2007. Approximately $18.6 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 September 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. For our private-label mortgage-related securities backed by subprime loans that were rated AAA at acquisition, the weighted average credit enhancement, which is predominantly in the form of subordination, is 32%. 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-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


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of the unrealized 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 721, 71% and 59%, respectively, as of September 30, 2007, as compared with 721, 70% and 55% , respectively, as of December 31, 2006. 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, up from 10% as of December 31, 2006.
 
Multifamily
 
As of September 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 24 below compares the serious delinquency rates for all conventional single-family loans and multifamily loans with credit enhancements and without credit enhancements.


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Table 24:  Serious Delinquency Rates
 
                                                         
    September 30, 2007     December 31, 2006     September 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 %     1.14 %     17 %     1.01 %     17 %     0.94 %        
Northeast
    19       0.79       19       0.67       19       0.62          
Southeast
    25       0.88       24       0.68       24       0.64          
Southwest
    16       0.69       16       0.69       16       0.69          
West
    23       0.33       24       0.20       24       0.17          
                                                         
Total conventional single-family loans
    100 %     0.78 %     100 %     0.65 %     100 %     0.61 %        
                                                         
Conventional single-family loans:
                                                       
Credit enhanced
    20 %     2.18 %     19 %     1.81 %     19 %     1.74 %        
Non-credit enhanced
    80       0.43       81       0.37       81       0.35          
                                                         
Total conventional single-family loans
    100 %     0.78 %     100 %     0.65 %     100 %     0.61 %        
                                                         
Multifamily loans:
                                                       
Credit enhanced
    89 %     0.08 %     96 %     0.07 %     96 %     0.13 %        
Non-credit enhanced
    11       0.11       4       0.35       4       0.12          
                                                         
Total multifamily loans
    100 %     0.08 %     100 %     0.08 %     100 %     0.12 %        
                                                         
 
 
(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 September 30, 2007 from our rate as of September 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. 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


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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 decline in our multifamily serious delinquency rate as of September 30, 2007 from our rate as of September 30, 2006 was due primarily to payoffs and the resolution of problems associated with loans secured by properties affected by Hurricane Katrina.
 
Foreclosure and REO Activity
 
Foreclosure and real estate owned (“REO”) activity affec