FundingNotes: Further Developments Regarding Fannie Mae

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Revised July 2001
Volume 6 • Issue 4
Fundingnotes is now available on Fannie Mae’s
website. Visit www.fanniemae.com, choosesm the “Debt Securities” option and select
“Fundingnotes Publications.” Fundingnotes is
also available at "FNM" on Bloomberg.undingnotesf
Monthly Report for Fannie Mae’s Investors and Dealers
Further Developments regarding Fannie Mae’s
®Subordinated Benchmark Notes
Fannie Mae has successfully issued two publicly traded and credit assessment institution (e.g. Standard & Poor’s or
externally rated Subordinated Benchmark Notes issues that Moody’s Investor Service); and (3) the credit quality of
have lead to the creation of a new, liquid class of fixed income Subordinated Benchmark Notes, as indicated by their credit
assets for investors. rating and the consequent low credit risk the debt presents to
investing banking organizations merit a 20 percent risk
The issuance of Subordinated Benchmark Notes is a result of weight.
one of the six voluntary initiatives made by Fannie Mae (in
conjunction with Freddie Mac) on October 19, 2000 to imple- Voluntary Initiatives
ment a series of financial operating and disclosure changes On October 19, 2000, Fannie Mae jointly announced with
designed to enhance capital adequacy, transparency and Freddie Mac and a bipartisan group of Members of Congress a
market discipline. As Franklin Raines, Fannie Mae’s Chair- set of six voluntary initiatives. Coupled with one of the
man, said in a speech at the Brookings ...

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Copyright ©2001 by Fannie Mae. No part of this document may be duplicated, reproduced, distributed or displayed in public in any manner or by any means
without the written permission of Fannie Mae. This document is for the private information of dealers in Fannie Mae securities (“Dealers”) and qualified sophisti-
cated institutional investors. Fannie Mae does not intend to solicit and is not soliciting any action with respect to any Fannie Mae security based upon this
document. This document does not constitute, and under no circumstances should it be used as, or considered to be, an offer to sell or a solicitation of an offer to
buy the securities or other instruments mentioned herein or derived from such securities or instruments. Fannie Mae expects Dealers to make every effort to assist
investors to consider and understand the risks of the securities or instruments mentioned herein. The securities or other instruments mentioned in this document
may not be eligible for sale in certain jurisdictions or to certain persons and may not be suitable for all types of investors. Opinions and estimates expressed herein
constitute our present judgment and are subject to change without notice. Such opinions or estimates should not be construed as either projections or predictions of
value, performance or results; nor as legal, tax, financial, or accounting advice. (See back cover.)
Revised July 2001
Volume 6 • Issue 4
Monthly Report for Fannie Mae’s Investors and Dealers
f
undingnotes
sm
continued
Further Developments regarding Fannie Mae’s
Subordinated Benchmark Notes
®
Fannie Mae has successfully issued two publicly traded and
externally rated Subordinated Benchmark Notes issues that
have lead to the creation of a new, liquid class of fixed income
assets for investors.
The issuance of Subordinated Benchmark Notes is a result of
one of the six voluntary initiatives made by Fannie Mae (in
conjunction with Freddie Mac) on October 19, 2000 to imple-
ment a series of financial operating and disclosure changes
designed to enhance capital adequacy, transparency and
market discipline. As Franklin Raines, Fannie Mae’s Chair-
man, said in a speech at the Brookings Institution in Decem-
ber 2000, “these commitments taken together put Fannie Mae
at the vanguard of safety and soundness protections, the kind
of advances that the G-7’s Basel Committee and others are
recommending for all major financial institutions.” Fannie
Mae now has perhaps the most comprehensive configuration
of protections against risk and loss of any financial institution
in the world. The concept of market discipline is a key
component in that configuration and Subordinated Bench-
mark Notes is the primary vehicle Fannie Mae is using to
enhance market discipline and serve as an independent
barometer of the company’s credit quality. When investors
evaluate Subordinated Benchmark Notes for investment
purposes it is important that they recognize that, just with
other securities issued by Fannie Mae, Subordinated Bench-
mark Notes are not guaranteed by the United States govern-
ment.
The U.S. banking regulatory agencies — the Office of the
Comptroller of the Currency, the Board of Governor’s of the
Federal Reserve System, the Federal Deposit Insurance
Corporation, and the Office of Thrift Supervision — have
assigned a 20 percent risk weighting to Fannie Mae’s Subordi-
nated Benchmark Notes. In a letter to Fannie Mae dated April
19, 2001, these agencies concluded that the Subordinated
Benchmark Notes warrant a 20 percent risk weight classifica-
tion for three reasons: (1) the agencies’ current risk-based
capital guidelines apply a 20 percent risk weight to the debt of
U.S. government-sponsored agencies, including Fannie Mae;
(2) a 20 percent risk weight is consistent with a proposed
revision to the Basel Capital Accord capital framework which
would assign a 20 percent risk weight to the securities of
commercial companies rated in one of the two highest invest-
ment-grade rating categories (e.g. AAA or AA) by an external
credit assessment institution (e.g. Standard & Poor’s or
Moody’s Investor Service); and (3) the credit quality of
Subordinated Benchmark Notes, as indicated by their credit
rating and the consequent low credit risk the debt presents to
investing banking organizations merit a 20 percent risk
weight.
Voluntary Initiatives
On October 19, 2000, Fannie Mae jointly announced with
Freddie Mac and a bipartisan group of Members of Congress a
set of six voluntary initiatives. Coupled with one of the
toughest capital and examination regimes of any financial
company in America (as a result of measures that Congress
enacted in 1992), the voluntary initiatives create an unparal-
leled, multi-layered approach to safeguarding its financial
strength. Fannie Mae implemented all of these voluntary
initiatives during the first quarter of this year and in several
cases has exceeded its commitments from October. The six
voluntary measures we have implemented place Fannie Mae
at the vanguard of risk management and disclosure practices
worldwide, with cutting-edge regulatory discipline bolstered
by cutting-edge market discipline. A review of those commit-
ments and the results of the implementation of each commit-
ment is described below (see
Figure 1
).
The first of the initiatives to be completed was the issuance of
publicly traded and externally rated subordinated debt.
Fannie Mae priced its first issue of Subordinated Benchmark
Notes in late January and its second in early May. The first
issue was a $1.5 billion 10-year maturity and was priced at a
spread of 22 basis points over our on-the-run 10-year senior
Benchmark Notes. The second issue was a $1.5 billion 5-year
issue that came to market at a spread of 18 basis points over
our on-the-run 5-year senior Benchmark Notes. Both securi-
ties are rated Aa2 by Moody’s and AA minus(AA-) by Standard
& Poor’s. Moody’s and Standard and Poor’s will rate each
subsequent issue of Subordinated Benchmark Notes.
Fannie Mae has committed to issue subordinated debt on at
least a semi-annual basis irrespective of the prevailing
market environment. Subordinated debt will be issued in such
an amount that the sum of total capital, net of certain
adjustments described below, and outstanding subordinated
debt will equal or exceed 4 percent of on balance sheet assets
Fundingnotes
is now available on Fannie Mae’s
website. Visit www.fanniemae.com, choose
the “Debt Securities” option and select
“Fundingnotes
Publications.”
Fundingnotes
is
also available at "FNM" <GO> on Bloomberg.
2
continued
Figure 1
As of March 31, 2001, Fannie Mae has delivered
on the six Voluntary Initiatives announced
in October 2000 putting Fannie Mae’s safety
and soundness protections at the forefront of
evolving world practices.
1 Committed to Periodic Issuance of Subordinated Debt
Issuance of rated and publicly traded subordinated debt that,
together with core capital, equals or exceeds 4% of on-balance-sheet
assets, after adjusting for capital required to support the off-
balance-sheet mortgage securities business and adding back the
allowance for losses.
This level of outstanding subordinated debt is
to be achieved by the end of a three-year phase in period.
Resulted in
Fannie Mae pricing two transactions to date; $1.5
billion of 10-year Subordinated Benchmark Notes on January
25, 2001 and $1.5 billion of 5-year Subordinated Benchmark
Notes on May 2, 2001.
Both are rated Aa2/AA-.
We also
committed to issue such Notes quarterly during 2001 and on at
least a semi-annual basis thereafter.
2 Committed to Liquidity Management and Contingency
Planning
— Maintain more than three months’ worth of liquidity
needs under an assumption that Fannie Mae has no access to the
public debt markets.
Resulted in
Fannie Mae announcing on March 12, 2001 that
we had met this commitment.
As of June 30, 2001 Fannie Mae’s
ratio of liquid assets to total assets was 8.0%, well above the
stipulated 5%. Our liquidity plan meets the 14 principles for
sound liquidity management set forth by the Basel Committee.
3 Committed to an Annual Public Disclosure of a Rating
Obtain and publicly disclose an annual rating from a nationally
recognized statistical rating organization that will assess the risk
to the government, or the independent financial strength, of Fannie
Mae.
Resulted in
S&P assigning a AA- “risk to the government”
rating to Fannie Mae on February 27, 2001.
The rating will be
maintained on a surveillance basis.
This rating according to
S&P, “refers to the inherent default risk of a federally-related
entity operating under its authorizing legislation, but without
assuming an infusion of cash from the government.”
4 Committed to New Credit Risk Disclosures
— Quarterly
public disclosure of the impact of an immediate 5 percent decline in
U.S. home prices.
Resulted in
Fannie Mae announcing the first quarterly
disclosure on March 26, 2001 that as of December 31, 2000, the
company’s net sensitivity of future credit losses, taking into
account the effect of credit enhancements, was $295 million.
As
of March 31, 2001 this value was $307 million.
This low level of
sensitivity to credit losses reflects the quality of our existing
book of business, the impact of our loss mitigation techniques,
and the effectiveness of our credit enhancement and risk-
sharing strategies.
5 Committed to New Interest Rate Disclosures
— Monthly
public disclosure of the effects of 50 basis point parallel shift and 25
basis point change in slope in the yield curve.
Resulted in
Fannie Mae going beyond the commitment made
in October by releasing the two primary measures of interest
rate risk that the company uses: portfolio net interest income at
risk and effective asset/liability duration gap. As of June 30,
2001, the company’s net interest income at risk from a 50 basis
point change in interest rates was 1.7% over the next one year
and 4.4% over the next four years. The company’s net interest
income at risk from a 25 basis point change in the slope of the
yield curve was 0.9% over the next one year and 2.2% over the
next four years.
The effective duration gap of Fannie Mae’s
mortgage portfolio was a plus 5 months, within the targeted
range of plus or minus six months.
6 Committed to Interim Risk-Based Capital Stress Tests
Pending final promulgation of a risk based capital standard by
OFHEO, implement a risk-based capital test based on the
parameters set forth in the Federal Housing Enterprises Financial
Safety and Soundness Act of 1992, and publicly disclose the test
outcome on a quarterly basis.
Resulted in
Fannie Mae having sufficient capital to pass our
interim version of the OFHEO risk-based capital test as of
December 31, 2000, and our capital cushion on that date was
between 10 - 30% of total capital.
This cushion has since grown
to exceed 30% as of March 31, 2001.
at the end of a three year phase-in period. For this purpose,
total capital will be adjusted downwards by an amount equal
to 0.45% times the net Mortgage Backed Securities outstand-
ing that are guaranteed but not owned by Fannie Mae.
Fannie Mae’s subordinated debt acts as a risk-absorbing layer
to supplement capital for the benefit of senior debt holders,
and also serve as a consistent and early market signal of
credit risk for investors. Fannie Mae has designed Subordi-
nated Benchmark Notes, described below in more detail,
under which each issue will at all times be publicly rated by
Moody’s Investors Service and Standard & Poor’s. The Notes
have been designed to create maximum secondary liquidity
for the benefit of investors and to ensure the effectiveness of
the program as an early warning system about market
perceptions of Fannie Mae’s financial strength.
Fannie Mae currently expects to issue $12 - $15 billion of
Subordinated Benchmark Notes over the three year phase-in
period stipulated in the voluntary commitment. The weighted-
average maturity of outstanding subordinated debt issues will
be at least five years following the three-year phase-in period.
Fannie Mae has made a firm commitment to bring at least
one new issue or reopening of Subordinated Benchmark Notes
to market in each quarter during 2001. Subsequently, the
company will issue at least semi-annually and possibly more
frequently. Subordinated debt will not detract in any way
from our commitment to bring to market large, liquid senior
Benchmark Securities
SM
according to the issuance calendar
that the company published in September 2000 for the
calendar year 2001.
The second voluntary initiative was fulfilled in February
when Fannie Mae obtained and disclosed a standalone “risk
to the government rating” of AA- from Standard & Poor’s. This
rating measures our inherent credit quality. No U.S. commer-
cial bank holding company or thrift institution has an S&P
rating higher than AA-. Fannie Mae went beyond the October
19 commitment by seeking this rating on a surveillance basis,
which means that S&P will continually monitor its rating
during the year and may change it if our financial condition
changes. This “risk to the government” rating does not apply
to any security that Fannie Mae issues.
The third voluntary commitment Fannie Mae implemented
related to the company’s liquidity. Fannie Mae announced in
February that it met this commitment by putting in place a
contingency plan to ensure that the company could meet its
obligations for at least three months without access to the
new issue debt markets. Fannie Mae also announced that the
company is maintaining at least 5 percent of its on-balance
sheet assets in the form of high-quality, liquid, non-mortgage
securities. Fannie Mae exceeded the October commitment by
disclosing that its ratio of such assets to on-balance sheet
assets was 8.0 percent as of June 30, 2001. Fannie Mae
further announced that its liquidity management meets the
14 principles of sound liquidity management set forth by the
Basel Committee on Banking Supervision in February 2000.
Fourth, pending final promulgation of a risk-based capital
standard by the Office of Federal Housing Enterprise Over-
sight, our safety and soundness regulator, Fannie Mae
committed to implement an interim version of the risk-based
capital stress test detailed in the Federal Housing Enterprises
Financial Safety and Soundness Act of 1992. We also commit-
ted to publicly disclose the test outcome each quarter. As of
March 31, 2001, the company passed its internal interim risk-
based capital test with a capital cushion that exceeded 30
3
continued
percent of total capital. Fannie Mae intends to manage its
risk so that the cushion between total capital and calculated
risk-based capital is at least 10 percent of total capital.
Fifth, Fannie Mae has initiated public disclosure of credit risk
sensitivity analyses on a quarterly basis that will show the
expected financial impact of an immediate 5 percent decline
in the value of all single-family properties securing mortgages
owned or guaranteed by Fannie Mae. Following this decline,
home prices are assumed to increase at the same long-run
rate projected by the company’s credit pricing models. We are
showing our credit loss sensitivities both with and without the
effective credit enhancements. As of March 31, 2001, Fannie
Mae’s net sensitivity to future credit losses was $307 million
taking into account the effect of credit enhancements and
$1.061 billion without the effect of credit enhancements.
Fannie Mae’s low level of net credit loss sensitivity is due to a
combination of factors including the quality of the existing
book of business, the impact of loss mitigation techniques, and
the effectiveness of credit enhancement and risk-sharing
strategies.
Finally, Fannie Mae has initiated public disclosure of two
primary measures of interest rate risk the company uses in
managing its mortgage portfolio business. These are portfolio
net interest income at risk and the effective asset/liability
duration gap. The portfolio net interest income at risk
measure discloses the sensitivity of Fannie Mae’s net interest
income to an immediate 50 basis point shift in interest rates
and a 25 basis point change in the slope of the yield curve.
Fannie Mae generally expects its net income at risk to remain
within a range of 1 percent to 5 percent of baseline income. As
of June 30, 2001, the company’s net interest income at risk
from a 50 basis point change in interest rates was 1.7 percent
over the next year and 4.4 percent over each of the next four
years. The company’s net interest income at risk from a 25
basis point change in the slope of the yield curve was 0.9
percent over the next one-year and 2.0 percent over the next
four years.
Fannie Mae is supplementing its net interest income at risk
disclosure with monthly disclosure of the company’s effective
asset/liability duration gap. At the end of June, the effective
duration of our assets was 5 months longer than the effective
duration of our liabilities. Fannie Mae has a target range for
its effective duration gap of plus or minus six months. The
disclosure of effective asset/liability duration gap exceeds the
commitment the company announced last October.
The company’s interest rate risk disclosures follow the
recommendations of the new Basel Accord and the January
11, 2001 report of the Federal Reserve’s Working Group on
Public Disclosure, a private sector body established by the
Federal Reserve and chaired by Walter V. Shipley, former
chairman of Chase Manhattan Bank. Both recommend that
risk disclosures be consistent with internal risk management
practices. As noted above, net interest income at risk and
duration gap are the primary portfolio risk measures used at
Fannie Mae. Basel further proposes that disclosures incorpo-
rate expected future activity, and that sophisticated disclo-
sures use multiple simulations of interest rates. Fannie Mae’s
net interest income at risk measure incorporates future
activity in line with the company’s one- and four-year busi-
ness projections, and both net interest income at risk and
duration gap are calculated using at least three hundred
interest rate paths. Furthermore, both the credit risk and
interest rate risk disclosures meet or exceed the current best
practices of financial institutions.
No financial company in the world will tell investors and
policymakers more about its financial condition than Fannie
Mae does. Our new disclosures reinforce the fact that Fannie
Mae is one of the safest, soundest financial institutions in the
world. If there is any question or concern about how Fannie
Mae is doing, there are now several ways to find out. Inves-
tors can look at our supervision exams, our capital levels, our
regular stress test results, our external rating reports, our
monthly and quarterly reports on how the economy is affect-
ing our business, or changes in the value of our subordinated
debt.
Subordinated debt as a barometer of safety and
soundness and a tool promoting market discipline
Direct “market discipline” is exerted when an issuer’s cost of
issuing a debt instrument increases with its risk profile. The
issuer is dissuaded from taking excessive risks because it will
have to pay higher funding costs. Fannie Mae and Freddie
Mac found in discussions last year that policymakers view the
issuance of subordinated debt as a valuable tool to promote
market discipline. Issuance of subordinated debt promotes
market discipline because investors must conduct indepen-
dent reviews and consistently monitor Fannie Mae’s risk
profile, capital positions, creditworthiness and financial
health. Unlike equity holders who may have a prospect of
higher returns from greater risk, the subordinated debt
holders will not gain anything and could suffer losses if
Fannie Mae were to take excessive risks. The issuance of
subordinated debt strengthens the position of senior debt-
holders relative to equity holders. Fannie Mae’s issuance of
subordinated debt creates a powerful tool that investors may
use to monitor risk management and capital adequacy, in
conjunction with regular disclosures of interest rate and credit
risk exposures and the stringent stress test based capital
standard to which the company adheres.
Many financial regulators support subordinated debt as an
important way to crystallize the views of thousands of market
participants into a clear descriptor - the yield or spread of a
company’s subordinated debt over risk-free yields - of the
market’s view of a company’s risk position and potential for
loss. Some proponents of subordinated debt have suggested
that financial institutions should be required to issue a
certain amount of it and the Financial Laws Modernization
Act mandates a study of such a requirement. Under the
proposal made by the Bank for International Settlements for
a new capital adequacy framework for financial institutions,
market discipline is one of the “three pillars” set forth as
promoting better financial risk management, along with
improved capital standards and enhanced risk–based supervi-
sion. The Federal Reserve also has endorsed the concept of
increased market discipline as a means to ensure stringent
risk management by financial institutions. Federal Reserve
Chairman Alan Greenspan has noted that:
“The great advantage of…subordinated debentures is that it
[has] something of the nature…of a canary in a mine, that
if…the credit capacity of these institutions seems to be eroding
at the edges, it is very much more likely to show up in the
prices of liabilities which are not insured and have no collat-
eral behind them.”
Testimony before the Senate Banking Committee,
January 26, 2000.
Investors must gather information about Fannie Mae’s risks
and then incorporate that information into their decisions to
buy subordinated debt. Fannie Mae is relying on investors to
4
continued
analyze their risks on Subordinated Benchmark Notes based
on the components making up the financial safety and
soundness of Fannie Mae. Investors who purchase our
subordinated debt should pay close attention to our financial,
credit and capital positions.
One feature of Fannie Mae’s Subordinated Benchmark Notes
that promotes market discipline and distinguishes it from
other types of subordinated debt is the introduction of triggers
to defer interest payments. The terms of Fannie Mae’s
Subordinated Benchmark Notes, as stipulated in the volun-
tary commitments, call for interest deferral under the follow-
ing defined conditions of financial stress:
1) Fannie Mae’s core capital falls below 125% of critical
capital levels; or
2) (a) Fannie Mae’s core capital falls below minimum capital
levels,
and,
(b) pursuant to the company’s request, the
Secretary of the Treasury exercises his or her discretionary
authority to purchase the company’s obligations under
Section 304(c) of the company’s Charter Act.
A more detailed discussion of the capital definitions and
related issues is provided in a later section of this publication.
Unlike other subordinated debt issues, neither of the two
triggers can be set in motion arbitrarily by Fannie Mae or a
regulator, nor can the interest deferral be delayed by Fannie
Mae or by any other party if the defined conditions occur.
Required and regular issuance of subordinated debt further
promotes market discipline. Regular issuance provides
potential investors with ongoing information about safety and
soundness and alerts them to any excessive risk taking
because they continually get fresh updates on the health of
the issuer. Fannie Mae Subordinated Benchmark Notes will
be issued quarterly in 2001 and at least semi-annually in
successive years. This regular issuance pattern encourages
Fannie Mae to maintain a relatively stable risk profile on a
consistent basis. Another component of market discipline that
has been incorporated into the program is that the subordi-
nated debt securities are issued in a competitive, public
market in large size to investors representing a variety of
investor segments. Minimum initial new issue size is $1
billion, and through reopenings it is possible that Fannie Mae
will grow outstanding issues to $1.5 billion or larger. Most
dealers have been trading Subordinated Benchmark Notes on
their agency trading desks. Fannie Mae also has encouraged
dealers to take additional steps to promote liquidity in the
subordinated debt market. These features taken together –
the interest deferral trigger, regular issuance in large sizes,
and an actively traded and liquid secondary market – enhance
the role of Fannie Mae Subordinated Benchmark Notes as an
appropriate and effective barometer of Fannie Mae’s success
at risk management.
Investors should be aware that subordinated debt is treated
strictly as debt on Fannie Mae’s balance sheet. The subordi-
nated debt is not equity nor is it convertible to equity. It is
also not regulatory core capital. Due to its subordinate
position, this debt will serve as a risk-absorbing supplement
to core capital. Fannie Mae’s core capital requirement will
remain unchanged. Fannie Mae Subordinated Benchmark
Notes may be thought of as “economic” capital rather than
regulatory capital.
Although there are other instruments that Fannie Mae could
issue to enhance its capital position, subordinated debt was
selected as the best alternative to assure investors, regulators
and other outside parties that the company is fully committed
to the principle of market discipline by frequently issuing and
repricing supplemental capital. Two other alternative instru-
ments are preferred stock and convertible debt. In our
opinion, both of these instruments are less appropriate than
subordinated debt for the purpose of promoting market
discipline. The market for preferred stock is not as liquid or
homogeneous as the market for non-callable subordinated
debt that is investment grade.
The market for convertible debt is also more limited than the
market for highly rated subordinated debt. Limited liquidity
in this market makes it less likely that convertible debt would
be effective as an early warning signal of financial weakness
or distress. If Fannie Mae’s Subordinated Benchmark Notes
were convertible into equity after a trigger event, Fannie
Mae’s ability to raise additional capital by issuing stock would
be compromised. In addition, the pricing of convertible debt is
often affected by factors relating to the stock market, and
these factors may at times cause convertible debt prices to
behave quite differently than prices or spreads of the
company’s straight debt securities. Should this happen, the
market signal given by convertible debt prices will most likely
not be conveying a useful indication about the market percep-
tions of Fannie Mae’s safety and soundness.
Fannie Mae Subordinated Benchmark Notes
Fannie Mae’s Subordinated Benchmark Notes incorporate
some of the hallmark features of Benchmark Notes
®
and
Benchmark Bonds
SM
, which are consistency, liquidity, and
transparency. As our experience over the last three years has
taught us, our investors greatly benefit from these features.
Subordinated Benchmark Notes are brought to market
consistently through a traditional syndicate underwriting
structure similar to that of Benchmark Notes and Bonds. For
each transaction, Fannie Mae will appoint two or three lead
managers, several more co-managers and a selling group of
dealers.
New issues of Subordinated Benchmark Notes are typically
announced a few days before pricing. Cashflow, date conven-
tion, settlement and other aspects of Subordinated Bench-
mark Notes are consistent with those of Fannie Mae’s senior
Benchmark Notes and Bonds. Subordinated Benchmark Notes
settle through the Federal Reserve’s book-entry system.
Fannie Mae lists Subordinated Benchmark Notes on the
Luxembourg Stock Exchange.
Fannie Mae expects to issue quarterly during 2001, the first
year of the initiative, and at least semi-annually thereafter,
with a minimum issue size of $1 billion. From time to time in
order to enhance liquidity, Fannie Mae may also reopen an
existing Subordinated Benchmark Notes issue. Fannie Mae
currently expects that individual issues size could ultimately
be $1.5 billion or larger. Subordinated Benchmark Notes will
be issued over a three-year phase-in period in such a manner
that the weighted-average maturity of outstanding Subordi-
nated Benchmark Notes will be at least five years.
It is Fannie Mae’s intention to fashion some form of yield
curve in these securities. Our intent is to facilitate as much
liquidity in Subordinated Benchmark Notes as possible, given
the parameters of the program. Fannie Mae expects to issue
$12 to $15 billion in Subordinated Benchmark Notes over the
first three years, and that the weighted average maturity of
outstanding Subordinated Benchmark notes will be at least
five years at the end of the three-year phase-in period. We
may issue Subordinated Benchmark Notes in maturities from
5
continued
3- to 30-years to achieve these goals, with the maturity of
each issue being decided as we bring it to market. Given our
volume and average maturity objectives, we expect that there
will be a liquid secondary market at several points on the
yield curve, although we may not be able to issue enough
Subordinated Benchmark Notes for there to be liquidity at all
points on the curve.
Subordinated Benchmark Notes are independently rated and
are included in major dealer fixed-income indices. Our web-
based Benchmark Automated Syndication System (BASS),
which captures distribution information directly from under-
writers during the book-building process is used in the
distribution process of Subordinated Benchmark Notes. The
latest announcements, pricing information and other informa-
tion releases about upcoming and past Subordinated Bench-
mark Notes issues is available from the Debt Securities
section of Fannie Mae’s web-site
www.fanniemae.com
.
Unlike senior Benchmark Notes and Bonds, Subordinated
Benchmark Notes are not strip eligible, and so cannot be
stripped into single payment securities by investors.
Review of Fannie Mae’s First Two Subordinated
Benchmark Notes Issues
Fannie Mae’s first Subordinated Benchmark Notes transac-
tion was priced on January 25, 2001. The issue is $1.5 billion
of a 10-year maturity with a coupon of 6.25%. It was priced at
a spread of 22 basis points over our on-the-run, senior 10-year
Benchmark Notes. The initial issue was placed with over 175
investors at the time of pricing. Participating institutions
included fund managers, insurance companies, pension funds,
commercial banks, corporations and state and local govern-
ments. With respect to geographical distribution, 88% was
placed in the United States, 9% in Europe, 1% in Asia and 2%
in other areas.
Figure 2
provides a break down of the new
issue distribution on both a geographic and investor segment
basis.
Fannie Mae’s second Subordinated Benchmark Notes transac-
tion was priced on May 2, 2001. The issue is $1.5 billion of a
5-year maturity with a coupon of 5.50%. It was priced at a
spread of 18 basis points over our on-the-run, senior 5-year
Benchmark Notes. The second issue was placed with over 140
investors at the time of pricing. Participating institutions
included fund managers, insurance companies, pension funds,
commercial banks, corporations and state and local govern-
ments. With respect to geographical distribution, 83% was
placed in the United States, 15% in Europe and 2% in other
areas.
Figure 3
provides a break down of the second issue
distribution on both a geographic and investor segment basis.
Since pricing, 10-year Subordinated Benchmark Notes have
traded at a spread of between 18 and 29 basis points over
their relevant Benchmark security and 5-year Subordinated
Benchmark Notes have traded at a spread of between 17 and
22 basis points over their relevant Benchmark security. That
is a higher spread to senior debt than the subordinated debt of
many high-quality commercial banks, and it demonstrates
that investors do believe that subordinated debt is in a
different risk category from our senior debt. Our dealers have
reported trading in the secondary market, and that the bid/
offer spread has typically been between 1 and 2 basis points.
Trigger mechanism and various capital levels
As mentioned earlier, the critical feature distinguishing
Fannie Mae’s new Subordinated Benchmark Notes from other
more traditional bank-issued subordinated debt is the use of
two interest deferral triggers. These triggers (defined earlier)
result in interest deferral under defined conditions for up to
five years, though not exceeding the maturity of the issue.
Other financial institutions who have issued securities with a
deferral provision typically do not specify exactly what has to
happen for the deferral to be triggered, whereas investors in
Subordinated Debt Notes can evaluate how likely a deferral is
by monitoring Fannie Mae’s capital levels. For these reasons,
Subordinated Benchmark Notes will result in clearer market
discipline.
Figure 4
provides definitions of the different measures of
regulatory capital that are relevant to the new issues of
subordinated debt. Recent capital levels for the company are
also provided in Figure 4.
Fannie Mae’s core capital stood at $21.482 billion on March
31, 2001. With regard to the first trigger, since Fannie Mae’s
critical capital requirement was $10.712 billion on March 31,
core capital exceeded critical capital by $10.770 billion, and
was equivalent to 200% of the critical capital level. Further,
Figure 2
Distribution of Fannie Mae’s
10-Year Subordinated Benchmark Notes
®
.
Other
2%
Europe
9
%
Asia
1
%
U.S.
88%
Comm.
Banks
7%
Found./
Non-profits
1%
Insurance
Cos. 19%
Corp./
Pensions
5
%
State &
Local
Govt's
4%
Retail
1%
Fund
Managers
63%
Subordinated
Benchmark
Notes
Size/Cusip
Lead-Managers
Co-Managers
Pricing Date &
Spread
10-year
6.250%
2/1/11
$1.5 billion
31359MGT4
Goldman Sachs
Morgan Stanley
Salomon Smith
Barney
Bear Stearns
Blaylock
CSFB
JP Morgan
Lehman Brothers
Merrill Lynch
January 25, 2001
+22 bp vs.
Benchmark Notes
6.625% due
11/15/10
By Region
By Investor Type
O ther
2%
Europe
15%
U.S.
83%
By Region
By Investor Type
Comm.
Banks
7%
Found./
Non-profits
1%
Insurance
Cos. 19%
Corp./
Pensions
5%
State &
Local
Govt's
4%
Retail
3%
Fund
Managers
61%
Subordinated
Benchmark
Notes
Size/Cusip
Lead-Managers
Co-Managers
Pricing Date &
Spread
5-year
5.500%
5/2/06
$1.5 billion
31359MHX4
Lehman Brothers
Morgan Stanley
Salomon Smith
Barney
Bear Stearns
CSFB
Goldman Sachs
JP Morgan
Merrill Lynch
Utendahl
May 2, 2001
+18 bp vs.
Benchmark Notes
5.500% due
2/15/06
Figure 3
Distribution of Fannie Mae’s
5-Year Subordinated Benchmark Notes
®
.
6
continued
deferral ceasing, or (ii) the given issue maturing, or (iii) the
maximum five year period of deferral for the given issue
having elapsed, all missed interest will be due and payable
along with interest on the missed payments compounded at
the coupon rate of the particular issue.
Interest deferral would cease if none of the conditions that
trigger interest deferral continue to hold. Therefore, as soon as
Fannie Mae is no longer required to defer interest under the
terms described above and has repaid all obligations, if any,
purchased by the Secretary of the Treasury as described
above, Fannie Mae will be required to pay all deferred interest
on outstanding Subordinated Benchmark Notes and interest
thereon. If interest ceases to be deferred on any one issue of
Subordinated Benchmark Notes in this way, interest will also
cease to be deferred on all other outstanding issues of Subordi-
nated Benchmark Notes.
The securities will not contain any provision to allow holders
to accelerate the maturity of the securities if Fannie Mae does
not pay after a five year deferral. Therefore, holders will have
the right only to institute a judicial proceeding to collect
amounts then due and unpaid – i.e., the accrued interest and
compounded interest thereon. Holders would then need to
institute additional judicial proceedings for future payments
of interest and principal that become due and unpaid. This is
consistent with the structure of Fannie Mae’s senior debt
securities.
Since Fannie Mae will pay the deferred interest, if any, along
with compounded interest, the duration of the security will be
lengthened as a result of the interest deferral.
Priority of Payment
Subordinated Benchmark Notes are unsecured and subordi-
nated and rank junior in priority of payment to all of our
“Senior Liabilities.” “Senior Liabilities” means all existing and
future liabilities of Fannie Mae, other than liabilities that by
their terms expressly rank equal with or junior to Subordi-
nated Benchmark Notes. Senior Liabilities include, but are
not limited to, senior debt obligations issued under section
304(b) of the Charter Act, liabilities in respect of our guaran-
tees on mortgage-backed securities and our outstanding 9%
Capital Debentures due 2019 and our Zero Coupon Capital
Debentures due 2019. Senior Liabilities also include any
liabilities related to the $773.836 billion of outstanding
mortgage-backed securities at that date on which Fannie Mae
Figure 4
Definitions of various types of capital relating to
interest deferral feature of Subordinated
Benchmark Notes
®
• Issuance will be in an amount such that, following the three-year
phase-in period, the sum of core capital, loss allowances, and
outstanding subordinated debt will equal or exceed 4 percent of on-
balance sheet assets, after setting aside capital sufficient to support
off-balance sheet mortgage backed securities.
• At March 31, 2001, Fannie Mae’s core capital was $21.482 billion,
our minimum capital was $21.033 billion and our critical capital was
$10.712 billion.
• “Core capital” is the sum of:
- the stated value of our outstanding common stock,
- the stated value of our non-cumulative perpetual preferred stock,
- paid-in capital, and
- retained earnings.
• “Minimum capital” is the sum of:
- 2.50% of on-balance sheet assets,
- 0.45% of net mortgage-backed securities outstanding, and
- 0.45% of other outstanding balance sheet items, which may be
adjusted by OFHEO in certain circumstances.
• “Critical Capital” is the sum of:
- 1.25% of on-balance sheet assets,
- 0.25% of net mortgage-backed securities outstanding, and
- 0.25% of other off-balance sheet obligations, which may be adjusted
by OFHEO under certain circumstances.
core capital was $8.092 billion higher than the trigger level of
125% of critical capital.
At $21.482 billion, Fannie Mae’s core capital exceeded
minimum capital by $448 million as of March 31, 2001. Two
factors should be noted here. First, Fannie Mae manages the
difference between the core and minimum capital levels by
increasing and decreasing investments in its Liquid Invest-
ment Portfolio (high quality short term investments typically
of less than one year to maturity) to utilize or release core
capital as needed, and by share repurchases in case of excess
core capital. Also, the second trigger is activated only if core
capital is less than minimum capital
and
the Secretary of
Treasury purchases Fannie Mae’s debt at the company’s
request. Fannie Mae has never requested such purchases and
the Treasury has never undertaken such purchases at its own
discretion.
Figure 5
illustrates the margins by which Fannie
Mae’s core capital has exceeded minimum and critical capital
requirements over the last several years. Core capital has
been close to double the value or more than critical capital
and has exceeded minimum capital at all times.
Fannie Mae, like any other financial institution, has some
ability to manage its capital levels in times of financial stress,
particularly in terms of utilizing or reducing excess capital.
However, the trigger for Fannie Mae Subordinated Bench-
mark Notes relies much less on management discretion than
does the trigger of interest deferral for typical bank capital
securities.
In the event of interest deferral being triggered, it would
simultaneously be triggered for all outstanding Subordinated
Benchmark Notes. In addition, dividend payments on out-
standing equity and preferred stock would be suspended.
Interest deferral for an issue will occur for a maximum of five
years, but will not extend beyond the stated maturity of the
issue. Once interest deferral is triggered, no interest pay-
ments will be made until the requirement for interest deferral
ceases. Upon the earliest of (i) the requirement for interest
Differences between Core and Critical Capital levels
211.29%
203.96%
200.34%
200.54%
196.68%
216.86%
195.86%
$5,586
$6,883
$7,265
$7,602
$10,490
$10,770
$8,749
185.00%
190.00%
195.00%
200.00%
205.00%
210.00%
215.00%
220.00%
1995
1996
1997
1998
1999
2000
1Q2001
% Difference
$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
$ Difference
$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
$14,000
$16,000
$18,000
$20,000
$22,000
1 9 9 5
1996
1 9 9 7
1998
1999
2000
2001
Core over Minimum
Minimum over Critical
Critical Capital
Figure 5
Subordinated Benchmark Notes
®
provide an added
layer of protection to senior debt holders.
As of March 31, 2001
7
continued
guarantees timely payment of principal and interest (which
excludes mortgage-backed securities held by us in portfolio at
that date). Fannie Mae cannot make any payments of princi-
pal or interest on the Subordinated Benchmark Notes if the
company defaults on any Senior Liabilities. On June 30, 2001
Fannie Mae had outstanding total liabilities of $717.720
billion, $714.720 billion of which constitute Senior Liabilities.
The two outstanding subordinated debt securities referred to
above are a $6.75 billion (book value $1.093 billion as of June
30, 2001) zero coupon issue maturing on October 9, 2019 and
a $250 million 9.00% coupon issue maturing on February 1,
2019. The zero coupon was issued in 1984 and the 9.00%
coupon was issued in 1989.
Investors will have four public credit rating
viewpoints for Fannie Mae
Each issue of Subordinated Benchmark Notes will at all times
be publicly rated by Moody’s Investor Service and Standard &
Poor’s. With the annual publication of the new risk to the
government or independent financial strength ratings of
Fannie Mae mentioned earlier as one of our voluntary
commitments, investors will have available to them four
published ratings of our credit standing, each from a different
angle:
• First, our senior unsecured debt is currently rated Aaa by
Moody’s and AAA by Standard & Poor’s. This debt has
always been rated at these levels at all times that a rating
has actually been assigned to it.
• Second, our preferred stock is currently rated “aa3” by
Moody’s.
• Third, each issue of subordinated debt will be rated by
both Moody’s and Standard & Poor’s. The first two transac-
tions were rated Aa2 by Moody’s, and AA- by Standard &
Poor’s.
• Finally, Fannie Mae has obtained and disclosed a “risk to
the government” of AA- by Standard & Poor’s.
Inclusion in Major Fixed-Income Indices
Fannie Mae’s Subordinated Benchmark Notes are included in
many of the major dealer international and domestic fixed-
income indices. Lehman Brothers includes outstanding
Subordinated Benchmark Notes in the agency component of
their Global Aggregate Bond Index and their U.S. Aggregate
Bond Index. Merrill Lynch includes Subordinated Benchmark
Notes in the agency component of their Global Broad Market
Index and their U.S. Broad Market Index. Salomon Smith
Barney also includes the Subordinated Benchmark Notes in
the agency component of their World Broad Investment-Grade
Bond Index and their U.S. Broad Investment-Grade Bond
Index.
As of June 30, 2001 the market value of the agency sector in
Lehman Brothers’ Global Aggregate Bond Market Index stood
at 11.03%, with Fannie Mae comprising 41.28% of the agency
sector. The outstanding par amount of all Fannie Mae’s senior
bullet Benchmark Notes was $224 billion. Very little subordi-
nated agency debt exists apart from Fannie Mae’s and Freddie
Mac’s issuances in 2001. As noted above, Fannie Mae’s
projected issuance over the next three years will be in the
range of $12 to $15 billion. Therefore, the vast majority of
agency debt in the agency indexes will continue to be the
senior unsecured debt of Fannie Mae and other agency
issuers.
Unchanged status for senior unsecured debt
Fannie Mae’s senior unsecured debt is currently rated Aaa by
Moody’s and AAA by Standard & Poor’s. In addition, Fannie
Mae’s commitments with respect to issuing Subordinated
Benchmark Notes will not in any way affect the previously
stated commitments to issue senior Benchmark Securities
according to the calendar for 2001 that was published in
September 2000. As detailed in the calendar release, Fannie
Mae will issue Benchmark Notes and Bonds in maturities of
two-, three-, five-, ten- and thirty-years, and Benchmark Bills
in maturities of three- and six-months and one-year.
As discussed earlier, the new Subordinated Benchmark Notes
will support the existing senior unsecured debt (in addition to
the Capital Debenture issues maturing 2019). As a result of
the issuance of the new subordinated debt, the level of support
enjoyed by senior debt-holders will increase substantially
from the current level of $21.482 billion of regulatory core
capital and the book value (as June 30, 2001) of $4.343 billion
of existing subordinated debt.
Potential investors in Fannie Mae Subordinated
Benchmark Notes
Subordinated Benchmark Notes have been distributed to
many traditional as well as non-traditional investors in the
company’s senior Benchmark Notes and Bonds. Many high-
grade corporate bond investors such as insurance companies,
money managers, and pension funds have been attracted to
the Fannie Mae Subordinated Benchmark Notes. In particu-
lar, corporate bond investors who fear under-performance of
certain credit sectors, due to a slowing economy and the
possibility of declining earnings, may choose to move assets
into Fannie Mae Subordinated Benchmark Notes as an
alternative strategy. In addition, those investors that desire
exposure to credit with solely U.S. domestic operations may
find the Subordinated Benchmark Notes an attractive
investment vehicle. Fannie Mae encourages the maintenance
of a liquid secondary market in these securities, so that total
rate of return oriented investors can easily trade them with a
number of dealer counterparties when they see opportunities
to buy or sell these securities.
Commercial banks are also participants in the Subordinated
Benchmark Notes program since they can hold the subordi-
nated debt without regard to limitations generally applicable
to investment securities. Additionally, Fannie Mae Subordi-
nated Benchmark Notes are eligible as collateral for borrow-
ing from the Federal Reserve Discount Window.
Pension funds and fund managers that manage pension
assets have also expressed interest in the Subordinated
Benchmark Notes since they are ERISA eligible.
Life insurance companies have also been attracted to the
Subordinated Benchmark Notes since the National Associa-
tion of Insurance Commissioners (NAIC) has provided
guidance that Subordinated Benchmark Notes should receive
a preliminary NAIC-1 designation.
Traditional agency debt investors are also thought to be active
participants in Subordinated Benchmark Notes since many of
the leading index providers have included our subordinated
debt in the agency component of their widely followed fixed-
income indices.
Information Sources
The Universal Debt Facility Offering Circular has been
amended to incorporate Subordinated Benchmark Notes.
Appendix C of the Offering Circular contains a summary
description of our Subordinated Benchmark Notes. We will
offer any issue of Subordinated Benchmark Notes through the
Offering Circular and a supplement that will contain detailed
information about the issue.
8
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PAID
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Permit No. 8560
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s Office
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Fundingnotes
is published Monthly by
Fannie Mae’s Debt Marketing Group
Editors:
Hasan Latif
(202) 752-5659
Michael Kenney
(202) 752-2859
Toll-free Help line:
(888) BONDHLP
Website:
http://www.fanniemae.com
E-mail:
debt_marketing@fanniemae.com
f
undingnotes
sm
This document is based upon information and assumptions (including financial, statistical or historical data and computations based upon such data) that we
consider reliable and reasonable, but we do not represent that such information, assumptions, data or computations are accurate or complete, or appropriate or
useful in any particular context, including the context of any investment decision, and it should not be relied upon as such. In addition, we do not undertake to
update any information, data, or computations contained herein, or to communicate any change in the opinions and estimates expressed herein. No representation
is made that any strategy, performance or result illustrated herein can or will be achieved or duplicated. The effect of factors other than those assumed, including
factors not mentioned, considered or foreseen, by themselves or in conjunction with other factors, could produce dramatically different performance or results.
Fannie Mae is the issuer of certain securities and instruments mentioned herein and Fannie Mae or its employees may from time to time have long or short
positions in, and buy or sell or engage in other transactions, as principal, with respect to or relating to such securities or instruments. Fannie Mae securities are
more fully described in applicable offering circulars, prospectuses, or supplements thereto (such applicable offering circulars, prospectuses and supplements, the
“Offering Documentation”), which discuss certain investment risks and contain a more complete description of such securities. All statements made herein are
qualified in their entirety by reference to the Offering Documentation. An offering only may be made through delivery of the Offering Documentation. Investors
considering purchasing a Fannie Mae security should consult their own financial and legal advisors for information about such security, the risks and investment
considerations arising from an investment in such security, the appropriate tools to analyze such investment, and the suitability of such investment in each
investor’s particular circumstances. The Debt Securities, together with interest thereon, are not guaranteed by the United States and do not constitute a debt or
obligation of the United States or of any agency or instrumentality thereof other than Fannie Mae.
A key information resource pertaining to Fannie Mae Subordi-
nated Benchmark Notes is our web site,
http://
www.fanniemae.com/markets/debt/subordinated_debt/
index.html
.
Visit the Subordinated Benchmark Notes Web Site
for the most current information on Fannie Mae
Subordinated Benchmark Notes®
At this site, you will find the most recent developments,
offering circulars, press releases and other related informa-
tion on the Subordinated Benchmark Notes as well as on
specific transactions.
New issue pricing and distribution information on past issues
of Subordinated Benchmark Notes is also available on Fannie
Mae’s BASS web-page which is accessible from Fannie Mae’s
Debt Securities web-site,
http://www.fanniemae.com/markets/
debt/index.html
.
Conclusion
Fannie Mae is committed to being a leader among the premier
financial institutions in the world in terms of risk manage-
ment practices that adhere to an extremely high level of
safety and soundness. With the company’s implementation of
six voluntary safety and soundness commitments, Fannie
Mae now perhaps has the most comprehensive configuration
of protections against risk and loss of any financial institution
in the world. The concept of market discipline is a key
component in that configuration and Subordinated Bench-
mark Notes are the primary vehicle Fannie Mae is using to
enhance market discipline.
www.fanniemae.com/markets/debt/subordinated_debt/current_events.html