an introduction to

callable debt SecuritieS

Table of ConTenTs

1 2 5 7

Introduction Characteristics of Callable Debt Fannie Mae Callable Debt Reverse Inquiry Process Yield Calculations for Fannie Mae Callables Analyzing the Components of Callable Debt Why Investors Buy Callable Debt Call Process Conclusion Glossary Figures

12 18 20 24 25 29

InTroduCTIon

annie Mae is a leader in the $11.5 trillion U.S. home mortgage market. The company furthers its housing mission by providing liquidity to the secondary mortgage market and promoting homeownership to low- and moderateincome families through portfolio purchases of mortgage loans and its MBS issuance. To fulfill its ongoing funding needs for the mortgage portfolio, Fannie Mae issues debt in domestic and global capital markets. Fannie Mae issues a variety of debt securities with maturities across the yield curve including short-term debt with maturities of one year or less and long-term debt with maturities of over one year. To effectively manage the interest rate and prepayment risks inherent in a mortgage portfolio, Fannie Mae issues noncallable and callable debt securities. Callable debt is one of the most important financial tools Fannie Mae uses to match the duration of its liabilities to that of its mortgage assets when mortgages prepay. By issuing callable debt, the company gains protection against declining interest rates that tend to cause the mortgage assets of the companys portfolio to prepay more quickly. Fannie Mae can then redeem the companys currently callable debt to match the liquidations of the companys mortgage assets, thus keeping the duration of the companys assets and liabilities closely in line. Callable debt securities also offer investors the opportunity to potentially earn enhanced returns in exchange for taking call risk or selling convexity. Fannie Mae takes very seriously its role in being a flexible, responsive and efficient issuer of callable debt securities and providing investors adequate information to facilitate trading and investment of these securities. The companys callable debt securities issued in the cash market have maturities ranging from one year to thirty years and call lockout periods ranging from three months to ten years or longer. Fannie Maes callable debt is brought to market mainly through a daily reverse inquiry process involving investors, dealers and Fannie Mae. Fannie Mae provides flexibility to investors seeking customized structures on a reverse inquiry basis based on a need for a specific coupon, maturity date, call date or call feature. Therefore, Fannie Mae issues a diverse group of callable securities with a variety of final maturities and call lockout periods resulting in securities with a wide range of duration and convexity profiles. Different types of investors are able to structure callable securities that match their investment criteria and interest rate outlooks. In 2009 and 2010, Fannie Mae issued approximately $191.8 billion and $309.3 billion, respectively, of callable securities.

Introduction

C e r l ne G s e CH o e H H a d aIC T e r IoT Is s e rf C a l l a b l e d e b T

CALLABLE D E B T FE A Tu R Es
Three main structural characteristics of Fannie Mae callable debt securities are the maturity date, the lockout period and the call feature. The maturity date of a callable debt instrument is the latest and final possible date at which the security will be retired and principal will be redeemed. Fannie Mae issues callable debt instruments with a variety of maturity dates along the yield curve. The lockout period refers to the amount of time for which a callable security cannot be called and only interest coupon payments are received by the security holder. For example, with a 10-year noncall 3-year (10nc3) debt security, the security cannot be called for the first three years. The call feature refers to the type of call option embedded in a callable security. Fannie Mae callable debt securities most often incorporate one of the following call features:
n

Fannie Mae issues callable debt instruments with a variety of maturity dates along the yield curve.

Fannie Mae issues continuously callable or American-style callable debt which can be called after an initial lockout period until maturity date. The investor is compensated for this continuous call feature by receiving a higher yield than on comparable maturity noncallable debt in exchange for allowing Fannie Mae the flexibility to call the security at any time after the lockout period, until the final maturity date, with the requisite amount of notice given to the investor. Fannie Mae issues callable debt with a one-time or European-style call feature. This call option can only be exercised by Fannie Mae on a single day at the end of the lockout period. European-style callable securities provide the investor an opportunity to obtain a greater spread over a typical Fannie Mae noncallable debt security of the same maturity while reducing the cash flow uncertainty of a continuous call structure. The spread of a European-style callable security will, however, be somewhat lower than an American-style callable security that has the same maturity and lockout period. Fannie Mae issues Bermudan-style callable debt securities which are callable only on a predetermined schedule of dates, usually on the coupon payment dates after the conclusion of the lockout period. Investors benefit from the increased predictability of cash flows. The spread of a Bermudan-style callable will typically be greater than the spread of a European-style callable, but less than that of an American-style callable with the same maturity and initial lockout period.

Characteristics of Callable Debt

Fannie Mae issues Canary-style callable debt securities which incorporate the call features of both Bermudan-style callables and European-style callables. Following its lockout period, a Canary-style callable becomes callable for a designated period of time during which Fannie Mae can call it back on a predetermined schedule of dates much like a Bermudan-style callable. However, once this designated call period concludes, the security is no longer callable. The spread of a Canary-style callable will be greater than the spread of a European-style callable, but less than that of a Bermudan-style callable with the same maturity and initial lockout period.

CALLABLE DEBT sTR uCT uRE s

In addition to straightforward, fixed-rate structures, Fannie Mae has the ability to issue callable floating-rate notes, callable step-up notes and callable zero-coupon notes.

Callable Floating-Rate Notes

Fannie Mae can issue callable floating-rate notes which have a coupon that is typically tied to a major benchmark index. Investors are able to customize a security with features such as size, interest rate benchmark index or maturity. There are several floating rate indices from which an investor can choose, including three-month Treasury Bills, Prime, Daily Fed Funds, one-month LIBOR, three-month LIBOR, Weekly Fed Funds and Weekly Constant Maturity Treasury. Depending upon the chosen index, various index reset and interest rate payment frequencies are available.

Callable step-up and step-down Notes

Fannie Mae has the ability to issue callable step-up and step-down notes which are variations of standard fixed-rate callable debt securities. They are structured with a coupon that increases or decreases to a specified rate on one or more predetermined dates, typically on interest payment dates. Fannie Mae callable step-up and step-down notes generally become eligible for redemption by Fannie Mae at the time of the first step-up or step-down.

Characteristics of Callable Debt

Callable Zero-Coupon Notes

Fannie Mae also issues zero-coupon callable debt securities. Zero-coupon notes are debt securities on which no coupon interest is paid to the investor. Rather, the security is purchased at a discounted dollar price and matures at par. If the option on a callable zero-coupon security is exercised, it is redeemed at a higher dollar price than the original issue price. The yield for a callable zero-coupon security is based on the difference between the original discounted price and the principal payment at the call date.

Characteristics of Callable Debt

fannIe Mae Callable debT reVerse InQuIrY ProCess

A variety of investors participate in the reverse-inquiry callable debt issuance process, attracted by the ease with which specific structures can be created to suit particular investor needs, market views, and specifications. Investors can structure callable debt securities designed to achieve certain coupon targets or purchase them based on relative value considerations. Frequently, investors have specific maturity date and call date requirements, and sometimes have preferences for specific call features (European-style, American-style, Bermudan-style, or Canary-style). Fannie Mae has the flexibility to structure callable debt to meet investor preferences and works closely with underwriters to price, provide feedback to and execute callable note structures with its dealer underwriters for investors. In addition, the reverse inquiry process enables investors to obtain the structure of their preference in an efficient and timely manner. Fannie Mae is able to issue callables with a wide variety of maturities and call dates because of the wide range of optionality that is acceptable for the companys asset/liability management needs. Since there is often no need to arrange a simultaneous interest rate swap converting the callable issue into a floating rate liability, it is more straightforward for dealers to underwrite Fannie Mae callables than the callables of other issuers. This results in more efficient pricing and quicker execution. Investors who have interest in specific callable structures typically have discussions with dealers as to the coupon targets, maturity, call date, and call feature parameters. Sometimes a reverse inquiry transaction is driven by a single investor, which is directed to Fannie Mae by one or more dealers. Alternatively, sometimes a transaction is structured for a larger size than any single investors interest. This is because the dealer observes a larger amount of general demand for that structure. Fannie Mae will in turn analyze the terms of the structure and give feedback to the dealer, and if appropriate, provide a price or spread level at which the transaction can be executed. The terms of a proposed structure are evaluated against internal benchmarks to enable Fannie Mae to reach a decision promptly. Fannie Mae attempts to provide the quickest possible feedback and turnaround to dealers in this respect.

The reverse inquiry process is kept as flexible as possible so as to enable investors to meet their needs for callable investments in the most fair and transparent manner.

Fannie Mae Callable Debt Reverse Inquiry Process

Fannie Mae may bring together several dealers to form a single, larger co-underwritten callable notes transaction if they have similar interests in a callable structure. Therefore, investors can obtain the benefit of better liquidity and tradeability from the larger issue size and broader dealer sponsorship of the transaction. Larger issues may qualify for inclusion in the broad bond indices, such as the Barclays Capital U.S. Aggregate Bond Index, which has a minimum outstanding size of $250 million for inclusion in the index. For these reasons, the funding group at Fannie Mae strongly encourages this type of coordination among its underwriting dealers. Fannie Mae issued approximately $309.3 billion callable medium-term notes (MTNs) in 2010 via the reverse inquiry process. As mentioned earlier, Fannie Mae is focused on the issuance of callable MTNs that are $250 million or larger issue sizes with multiple dealer underwriters. Therefore, figure 1 illustrates, of the total $309.3 billion callable MTNs, $69.7 billion were issued with at least two dealer underwriters and in 139 transactions.

FANNIE MA E C A L L A B L E D E B T I N C Lu D E D IN BOND IN D I C Es
Fannie Mae callable debt securities are included in most of the major domestic and international bond indices incorporating U.S. dollar high credit quality securities, such as those published by Citigroup, Barclays Capital, Bank of America Merrill Lynch, and others. This is of particular benefit to those investors who determine their allocations to various fixed-income asset classes in their portfolios based on the composition of an index.

Fannie Mae Callable Debt Reverse Inquiry Process

YIeld CalCulaTIons for fannIe Mae Callables

YIELD CALC uLATION s

When calculating the yield or internal rate of return (IRR) of a callable structure, there are three primary methods that an investor may use: yield-to-maturity, yield-to-call, and yield-to-worst. When making purchase decisions based upon yields, it is important to understand which of the three methods has been used in deriving the stated yield and how changes in the yield curve will affect the final yield performance of the security.

Yield-to-maturity
The yield-to-maturity calculation assumes that the debt security is not called and the investor holds the bond to its final maturity date. The yield is calculated from the cash flow at maturity and the periodic interest payments generated by the bond (reinvested at a rate equal to the bonds yield-to-maturity). When prevailing interest rates are higher than the coupon on the bond, it is assumed that the issuer will not call the bond. Under these circumstances, yields are commonly quoted using the yield-tomaturity method.

Yield-to-call
The yield-to-call calculation assumes that the bond is called on the next eligible call date. The yield is calculated from the cash flows of the coupon payments plus the cash flow of the redemption proceeds at the time of the call. When prevailing interest rates are lower than the interest rate on the issue, it is assumed that the issuer will call the security. Accordingly, in such circumstances, yields are sometimes quoted on a yieldto-call method.

Yield-to-worst
A more conservative alternative to the yield-to-call method is the yield-to-worst method. Many bonds are continuously callable after their first call date (American-style call feature). Because of the uncertainty of the call date, the yield-to-worst method was developed. To derive a yield-to-worst, a yield-to-call is calculated for the initial call date and each coupon payment thereafter. Additionally, a yield-to-maturity calculation is also performed. The yield-to-maturity calculation and all of the yield-to-call calculations are then reviewed with the lowest yield from the group designated as the yield-to-worst.

Yield Calculations For Fannie Mae Callables

PRICING FR A M E W O R K O P T I O N - A D Ju s T E D s P R E A D (OA s) ANAL Ys I s

Callable debt is usually priced and evaluated using an OAS framework similar to that used for other option-embedded securities with cash flows that are sensitive to changes in interest rates. Because a callable debt security consists of a bullet component and a call option component, OAS provides investors with a methodology to analyze a callable debt security by factoring out the yield premium associated with the call option. The OAS of a callable debt security is expressed as a spread over a noncallable yield curve such as Fannie Maes noncallable Benchmark Notes yield curve, the Treasury yield curve, or the interest rate swaps curve. The OAS analysis framework is based on a forward rate curve derived from the noncallable yield curve employed, volatility assumptions, and the current security price. An OAS model generates the average spread over the forward curve under a number of possible future interest rate paths. For many fixed-income investors, OAS is one of the more useful measurements for assessing value in a callable debt security. Investors also compare the OAS of a callable debt security to the option-adjusted or bullet spreads of other fixed-income securities in analyzing investment decisions and relative value. To calculate an OAS that most accurately captures the value of a callable debt security, investors must incorporate their views with respect to future interest rate volatility. Volatility represents the amount of interest rate fluctuation that is expected over a given period of time. The expectation of future rate volatility may be influenced, or determined in part, from historical measures of volatility. A more detailed discussion of the measurement and impact of interest rate volatility as it relates to Fannie Mae callable debt is provided later in this section. Meanwhile, Bloomberg offers an easy and effective method for calculating the OAS of a specific callable debt security. Investors with access to Bloomberg terminals can analyze option-adjusted spreads through the OAS1 screen by entering a yield curve, implied volatility and price, and setting the Calculate box to O for OAS. The price or volatility can be calculated instead of the OAS just as easily by plugging in the remaining two parameters and changing the Calculate box accordingly. Any standard OAS calculator will return a value for implied volatility, price, or the OAS, given the other two parameters and the yield curve as inputs. These values are quickly accessible and easy to interpret, with no assumption on prepayments or other models for cash flows.

Yield Calculations For Fannie Mae Callables

BLOOMBERG AOA s sCREEN F O R C A L L A B L E MEDIuM-TERM NOTE s

Securities Industry and Financial Markets Association (SIFMA) guidelines were introduced in late 2003 for pricing and trading European-style callable U.S. agency debt securities. Fannie Mae believes this development further enhances the transparency and liquidity of callable debt securities in both the primary and secondary markets. The SIFMA guidelines incorporate skew into the volatility assumption and recommend the use of the Black Scholes model as the OAS-to-price calculation convention. The volatility skew adjustment corrects the value of those options that are not at-the-money. Bloombergs AOAS screen incorporates the SIFMA guidelines and enables investors to value Fannie Mae callable debt securities relative to an up-to-theminute Fannie Mae constant maturity yield curve derived from a live noncallable Benchmark Securities yield curve. The guidelines recommend the use of a single credit issuer specific constant maturity curve, and the relevant swaption volatility to price the callable bond on an OAS basis. For example, in analyzing a Fannie Mae callable debt security, Fannie Maes noncallable Benchmark Securities constant maturity yield curve should be used. The criteria is limited to callable securities that have European-style (one-time) call options, and are callable at par only on the call date. Also, they are only callable on a coupon date. To perform analyses on these securities, investors may change several of the variables while in AOAS, including the Yield Curve, At-the-money Volatility, OAS, Price, and Settlement Date. Only the Skew Adjusted Volatility and the Forward Strike rate may not be over ridden. Additionally, AOAS requires that the investor enter either an OAS or Price to solve for the other, i.e. enter OAS to solve for Price and vice versa. The securitys CUSIP may be used to bring the security into AOAS for analysis by typing the Fannie Mae CUSIP number <CORP> AOAS <GO>. Please see figure 2.

Yield Calculations For Fannie Mae Callables

Details of each variable are provided below:

The Constant Maturity Yield Curve: The default constant maturity yield curve in AOAS for Fannie Maes callable debt is Fannie Maes noncallable Benchmark Securities constant maturity yield curve. For other agencies European callable notes, the default yield curve is typically their respective bullet yield curve or, alternatively, the swaps curve. The maturities defining the curve include 3-months, 6-months, 1-year, 2-years, 3-years, 4-years, 5-years, 7-years, 10-years, 20-years and 30-years. The entire Benchmark Securities yield curve is fed to Bloombergs AOAS screen, except for the 20-year maturity yield. In the case of the 20-year maturity yield, Bloomberg will use a straight-line interpolation between 10-year and 30-year bullet Benchmark yields. The yields provided on Bloombergs AOAS screen are populated by using the average bid-side yields from contributing broker-dealers for Fannie Mae Benchmark Notes. These yields are then designated to corresponding maturity points on Fannie Maes constant maturity yield curve and are continually updated throughout the business day. Yields may be refreshed within the AOAS screen by selecting the refresh button on the bottom-right of the screen. The underlying securities that make up the constant maturity yield curve may be viewed in Bloomberg by typing AGPX <GO>. The column labeled Adjust shows the constant maturity adjustment spreads. The adjustment spreads are calculated by subtracting the constant maturity yield from the actual yield for the same maturity point. The constant maturity calculation used for AOAS has been recommended by the SIFMA. Investors can also use the AOAS screen to evaluate a security with the swaps curve or the constant maturity Treasury curve by substituting these curves for the Benchmark Securities default yield curve. at-the-money Volatility: Within the AOAS screen, the default volatility will be the mid-market at-the-money volatility for a comparable European-style option as quoted by the inter-dealer brokerage firm Tullett & Prebon. The Tullett & Prebon swaption volatilities are found in Bloomberg by typing TTSV <GO> 1 <GO> 2 <GO>, for United States Dollar Swaption Volatilities or on the Reuters iCap page 19902. The Tullett & Prebon swaption volatilities are updated throughout the day and fed directly into Bloomberg. Investors may override the default volatility assumption that appears in AOAS by changing it to any desired value.

10

Yield Calculations For Fannie Mae Callables

skew adjusted Volatility: The at-the-money volatility input in the AOAS model is adjusted for skew resulting in a Skew Adjusted Volatility that more accurately reflects current market conditions. The at-the-money volatility input in AOAS is adjusted according to a normalized adjustment factor developed by Blyth and Uglum of Morgan Stanley. The Skew Adjusted Volatility figure that is displayed in AOAS cannot be overridden but may be turned off as indicated by Use Skew Adj Vol field. However, the skew variable may be changed manually but is defaulted, per SIFMA guidelines, to 1.00. Any change in the skew variable (from 1.00) will result in a different calculated skew adjusted volatility. forward strike: The Forward Strike rate shown in AOAS is implied from the Benchmark Securities yield curve and is also adjusted up and down by the OAS assumption. The forward yield is implied by the current yield curve for the period beginning on the exercise date and ending on the maturity date of the underlying swap. The Forward Strike rate that is displayed in AOAS is not a variable that can be overridden. settlement date: The settlement date for a new issue defaults to the appropriate date at the announcement of each issue. For a new issue, Fannie Mae will input the settlement date. For outstanding issues or reopenings, the default settlement date in Bloomberg will need to be verified by the investor. The SIFMA guidelines recommend that the settlement date is not to be greater than three days. oas and Price: The OAS of callable debt securities will be priced on an OAS basis relative to the noncallable Benchmark Securities yield curve. An investor can input an OAS at which a specific transaction is being marketed or an OAS at which an investor is interested in buying or selling a callable debt security to get the corresponding dollar price. Conversely, the desired dollar price of a callable debt security may be entered to obtain the corresponding OAS. The assumption for the above calculation is that the volatility being used has been set to a desired value but the default volatility is the European swaption volatility. It is also possible for the user to calculate an implied volatility using the AOAS screen for a given price and OAS level.

Yield Calculations For Fannie Mae Callables

11

analYzInG THe CoMPonenTs of Callable debT

By analyzing its components, investors are able to assess the value of callable debt. To illustrate this point, we use a par-priced, new issue 5 non-call 2-year (5nc2) Fannie Mae European-style callable debt security, which has a five-year maturity, two-year lockout, after which it is redeemable at par, as the example in the following discussion. Similar explanations and analogies can be made for other callable structures that Fannie Mae issues. An investment in a par-priced 5nc2 callable new issue can be thought of as the purchase of a 5-year bullet with a coupon equal to the callables coupon (5-year bullet component) and the simultaneous sale of an option to call a 3-year bullet two years from issue date (call option component). Note that the option is being sold on a forward bond. The investor has sold Fannie Mae an option to redeem a three-year bond two years from now. The value of the callable is the difference in the value between these two components:
Price5nc2 callable = Price5-year bullet PriceCall option

KEY POINT s O N T H E Y I E L D C uR V E
The value of the 5-year bullet component depends on the Fannie Mae 5-year bullet yield. The call option embedded in a European-style 5nc2 callable depends on the value of a forward asset, e.g., a 3-year bond beginning in 2 years (termed for convenience a 5/2 forward). The value of the 5/2 forward is in turn derived from the yields of a 5-year bullet and a 2-year bullet. This analysis of the key points on the yield curve can also be used for callable debt with an American-style call feature. The value of the option depends partly on the 5/2 forward, but because it has a continuous call option, other points on the curve must also be analyzed. Thus, the value of the American-style call option would also depend on the 5/3 forward, the 5/4 forward, and all other forward points within the 2- to 5-year call window.

12

Analyzing the Components of Callable Debt

D uRATION AND CONVEXITY C H A R A C T E R Is T I C s

The effective duration of a callable debt security falls between the effective durations of bullets maturing on the call date and the maturity date of the callable debt security, respectively. As yields decline, the duration of a callable debt security shortens and approaches the duration to call. As yields rise, the duration lengthens and approaches the duration at maturity. Although lower yields result in higher prices for fixed-income securities, with callable debt securities, the percentage price change will be less than for equal duration bullets in a falling interest rate environment due to the increased likelihood of the bond being called. This characteristic of a callable debt security is known as negative convexity. These negative convexity characteristics are also found in most mortgage securities and some types of asset-backed securities that have embedded options. Fannie Mae typically issues callable debt securities with various effective durations and convexities. Fannie Mae also offers a diverse variety of structures in terms of maturities, call lockouts, and resulting durations and convexities to investors. figure 3 illustrates the convexity and duration profiles for several of Fannie Maes most commonly issued European-style callable debt structures.

Fannie Mae also offers a diverse variety of structures in terms of maturities, call lockouts, and resulting durations and convexities to investors.

Price/Yield relationship for a Callable debt security and a noncallable debt security
Price

Negative Convexity Segment of a Callable Debt Security

100

Positive Convexity of a Noncallable Debt Security

Yield

Analyzing the Components of Callable Debt

13

IMPACT OF N E G A T I V E C O N V E X I T Y O N FANNIE MA E C A L L A B L Es
Convexity is a feature of fixed-income securities that has a direct impact on a securitys performance and is useful for comparing bonds. If two bonds offer the same duration and yield but one exhibits greater convexity, changes in interest rates will affect each bond differently. The price of a bond with negative convexity is less affected by movements in interest rates than a bond that displays positive convexity or does not have option embedded features. Comparing two securities with the same final maturity, a callable security with a shorter lockout period would have greater negative convexity. For example, for a 5 non-call 3-year security, the longest possible maturity is 5 years and the shortest possible maturity is 3 years. As rates increase, the price-yield behavior of the callable security approaches that of a 5-year bullet because the call options value decreases as the yield moves higher. Conversely, if rates decline, this callable bond would exhibit negative convexity in that the security behaves more like a 3-year bullet rather than a 5-year bullet because the likelihood of the security being called increases. A 5 non-call 1-year security would exhibit negative convexity as well, but this bond would behave more like a 1-year bullet as yields fall. The price sensitivity for a 1-year bullet would be less than the price sensitivity for a 3-year bullet for the same change in yield. Therefore, as the yield falls on the 5 non-call 1-year security, it would exhibit greater negative convexity than would the 5 non-call 3-year security. The length of the lockout period also impacts the performance of callable debt securities. If investors accept shorter lockout periods they typically obtain higher yields because they are exposed to the risk that their securities could be called for a longer period of time. Since the value of a callable debt security is impacted by the value of the call option, the length of the lockout option affects the convexity profile of the security. It is important to point out that negative convexity is a characteristic of callable debt that the investor has the ability to alter by using Fannie Maes reverse inquiry process.

14

Analyzing the Components of Callable Debt

IMPACT OF INTERE sT RATE V O L A T I L I T Y O N FANNIE MAE CALLABLE s

Interest rate volatility is a market variable that has a significant impact on the initial pricing and returns of Fannie Mae callable debt. Expectations of future interest rate volatility, often referred to as implied volatility, result in changes in the valuation of the embedded option. For example, expectations of higher future volatility will imply higher yields for all callable debt. Alternatively, expectations of lower volatility imply the opposite. Many investors base their predictions of future interest rate volatility on their perspective of historical interest rate volatility. In addition, forecasts on the fundamental health of the economy can be of value in developing predictions of future interest rate volatility. A commonly used measure of volatility for Fannie Mae callable debt (particularly European or one-time callables) is the volatility for a corresponding swaption in the over-the-counter derivatives market. Investors often buy a callable security because they believe that actual future realized volatility will be lower than that implied by the price/yield at which they are able to purchase the security. In this way the level of implied volatility at the time of buying a callable security can be a key relative value indicator for an investor.

IMPACT OF YIELD C uRVE CH A N G Es A N D R E sH A P I N Gs ON FANNIE MAE CALLABLE s

The initial pricing and future returns of Fannie Mae callable debt are also determined in part by the initial yield curve and changes in the yield curve over time. The returns of callable debt in a variety of hypothetical future curve shift scenarios (e.g., parallel, flattening, and steepening) are described below. The key points on the yield curve that affect callable debt securities are those corresponding to a securitys call and maturity dates. For instance, the Fannie Mae 5nc2 callable debt security would be affected most significantly by 5-year and 2-year yields. The investor could obtain from some combination of 5-year and 2-year bullets an average effective duration equal to the option-adjusted duration of the 5nc2 callable debt security. As a result, the investor in a 5nc2 callable debt security can be thought to have synthetic long positions in 2-year and 5-year bullets. This position is often referred to as a synthetic barbell.

Analyzing the Components of Callable Debt

15

Impact of the shape of the initial yield curve on new issue pricing
The nominal spread of a 5nc2 callable debt security over the 5-year U.S. Treasury yield increases and declines for two main reasons. One reason is due to changes in perceived interest rate volatility, as explained above, and the other is the slope of the yield curve between the 2- and 5-year points. The value of the 5nc2 callable debt security is equal to the value of the 5-year bullet minus the value of the call option. A steep yield curve implies that expected future yield levels are higher than current levels. Because a call option is less likely to be exercised in a high interest rate environment, a steeper yield curve between 2 and 5 years makes the call option embedded in a 5nc2 callable debt security less valuable and, therefore, results in a lower nominal spread for the 5nc2 callable debt security. Conversely, a flatter curve results in a more valuable call option and a higher nominal spread for the 5nc2 callable debt security. Accordingly, investors typically demand higher nominal spreads for callables in flat yield curves when the call option is more valuable and lower spreads in steep yield curves when the call option is less valuable.

Impact of various changes in yield curve on total returns

Interest rates and the yield curve can be expected to change over time through parallel, flattening, and steepening shifts as well as other more complex types of yield curve changes.

16

Analyzing the Components of Callable Debt

Impact of yield curve changes on the performance of premium and discount callables
A callable debt securitys sensitivity to changes in market variables depends on whether the call option is in-the-money, at-the-money, or out-of-the-money. Investors can determine whether a call option is trading at a premium or a discount by comparing the coupon of the callable to the par forward rate implied by Fannie Maes bullet curve. For example, the coupon of a 5nc1 would be compared to the 1-year into 4-year par forward rate. For a premium callable, which has a coupon that is higher than the implied forward rate, the embedded option is in-the-money. Consequently, the premium callable will most likely trade on a yield-to-call basis due to the likelihood that it will be called. For a discount callable, which trades below par, the embedded call option is out-of-the-money and will generally trade like a bullet to maturity. The more a premium callable moves into the money, the more it trades like a bullet with a maturity comparable to its lockout period. Conversely, the more a discount callable moves out-of-the-money, the more it trades like a bullet with a maturity equal to its final maturity. These characteristics of premium and discount callables make their prices less sensitive to changes in market variables. At-the-money callables, which trade at or near par, exhibit the most sensitivity to changes in interest rates and volatility because there is more uncertainty associated with the embedded call option.

Analyzing the Components of Callable Debt

17

WHY InVesTors buY Callable debT

Investors buy callable debt for several different, though related, reasons. Most often, the goal is to enhance yield or returns in a high credit quality security by taking a specific view on future interest rates or volatility. Callable debt securities enable investors to sell interest rate options if they cannot participate in oTC derivatives. Many investors are not able to participate in the OTC options market and, therefore, invest in Fannie Mae callable debt as a way to sell options that they would not be able to do otherwise. The variety of structures that Fannie Mae issues make it possible for these investors to use callables for this purpose. Callable debt securities generally have historically provided higher yields than noncallable debt securities maturing on either the call date or the maturity date. The incremental spread offered by callables over comparable maturity bullet securities leads to a greater yield at maturity because of the call option embedded in the callable security. However, even in the event the security is called before the maturity date, the investment will often provide a greater yield than a bullet maturing on the call date. Investors buy callables to take advantage of high oas levels. As mentioned earlier, given that a callable debt security consists of a bullet component and a call option component, OAS provides an investor with a methodology to analyze a callable debt security by factoring out the yield premium associated with the call option. The OAS of a callable debt security is expressed as a spread over a noncallable yield curve such as Fannie Maes noncallable Benchmark Notes yield curve, the Treasury yield curve, or the interest rate swaps curve. Investors gain from the alternative OAS levelsrelative to Fannie Mae noncallable securities or other corporate securities. Investors can have exposure to the volatility of callables. When implied volatility reaches historically high levels, investors may invest in agency callables if they expect a reduction in implied volatility levels. The call option on callable debt is much easier to analyze than the prepayment behavior of mortgage-related securities. Fannie Maes economic decision to call its securities is an efficient and uniform call decision that is generally based on the level of interest rates and where Fannie Mae can issue similar duration debt at a lower option-adjusted spread. In addition, given the stated final maturity date of a callable debt security, there is no extension risk with callable debt.
18 Why Investors Buy Callable Debt

For mortgage securities, investors must evaluate much more complicated and uncertain call decisions requiring prepayment forecasts, many of which differ substantially among investors even for mortgage loans of similar characteristics. These prepayment models usually include a host of economic as well as noneconomic factors, and have historically differed substantially from actual prepayment experience. Therefore, many investors have found the more predictable nature of the call decision along with the structural benefits and attractive spreads of Fannie Mae callable debt to be an appealing alternative to mortgage related securities. fannie Mae callable debt has historically provided attractive yields in both steepening and flattening yield curve environments. In a rising yield curve scenario, investors may choose to buy callables to outperform noncallable securities of the same maturity. This is because they expect the callables not to be called and, therefore, to outperform noncallable securities of the same maturity. In a stable or declining interest rate scenario, or an upward sloping yield curve, investors may expect their investments to be called, and therefore buy callables to receive a higher yield up to the call date versus a bullet security. Indexed investors purchase agency bullet and callable debt to match the share of these securities in major fixed-income indices. Agency debt is a sizable component of the major fixed-income indices. Many indexed investors include callable agency debt in their portfolios to potentially match or outperform their benchmark fixed-income index. fannie Mae has the flexibility to structure callable debt with coupon payments to meet investors specific needs. Most often, securities are issued with semiannual coupon payments, but the frequency of coupon payments can be structured to occur monthly, quarterly and annually. Fannie Mae also offers the greatest diversity of agency callable debt in terms of maturity dates, lockout periods, call features and interest payment dates.

Why Investors Buy Callable Debt

19

Call ProCess

As discussed, the callable debt redemption policy for Fannie Mae callable debt typically has one of four call features: europeanthe issue can be called on only one, pre-determined date. bermudanthe issue is usually callable only on a pre-determined schedule of dates. americanthe issue can be called on the initial call date or any time thereafter until maturity. Canarythe issue is callable for a designated period of time on a pre-determined schedule of dates. Once the designated call period concludes, the issue is no longer callable.

Fannie Maes callable redemption policy is transparent and relatively easy to understand.

When a Fannie Mae callable debt issue has reached its call or redemption date, Fannie Mae generally can call the issue in whole or in part. As a matter of practice, Fannie Mae generally calls its securities issues in whole. Fannie Maes callable redemption policy is transparent and relatively easy to understand. It is in the companys interest that investors of Fannie Maes callable debt clearly understand why and how Fannie Mae callable debt is redeemed. Fannie Maes economic decision to call its securities is an efficient and uniform call decision based on the level of interest rates. For instance, in an environment of falling interest rates, callable securities that have passed their lockout period are more likely to have the call option exercised. Below is an example of the process Fannie Mae uses to determine whether or not to call a debt security that has entered its call period. An investor relying on this description should be able to develop a good idea of whether or not a security will be called, though perfect accuracy in such predictions cannot be assured. Predicting the call decision requires knowledge of the current level of yields and spreads for callable and noncallable Fannie Mae debt. Fannie Mae performs a theoretical calculation employing a hypothetical par-priced currently callable security. If the yield of the hypothetical issue is lower than the yield of the outstanding issue, the implication is that the outstanding issue could be called. The yield for this security is calculated using option-adjusted spread models. The theoretical yield-saving calculations are made by referring to the prevailing yield curve, so that an investor using the same process should be able to deduce as to the likelihood that the callable debt security will be called. This yield would be compared to the yield of the outstanding callable that is a candidate for redemption, with the latter yield being calculated assuming a price equal to its call price, typically at par.

20

Call Process

Callable debt securities Called

Call style CusIP settle date 2/18/10 2/18/10 5/18/10 amount Called $100M $100M $100M Coupon Maturity date 8/18/15 2/18/15 5/18/20 Call date structure

Comparable fannie Mae debt

Tsy spread (bps) usT5 +28 usT5 +46 usT10 +116 structure Yield

European Bermudan American

3136FJ4N8 3136FJ2Y6 3136FMTE4

3.10% 3.05% 5.00%

8/18/10 8/18/10 8/18/10

5.5nc0.5 5nc0.5 10nc0.25

5-year bullet

1.88%

4.5nc0.25 Bermudan 2.06% 9.75nc1-day American 4.09%

As stated earlier, Fannie Mae generally exercises the call option strictly on economic grounds. If the current interest rate environment supports issuing callable debt at lower coupons than existing outstanding callable debt, Fannie Mae will call the higher coupon outstanding callable debt and replace the outstanding issue with a new issue that has similar characteristics to the old issue. In practice, Fannie Mae may replace callable debt that has been called with new debt, either callable or noncallable, that differs in maturity or call lockout period. Such a difference between the new and old issues may be dictated by Fannie Maes current asset/liability management needs, by relative value considerations relating to the funding alternatives available or by investor demand. Occasionally, outstanding callable debt that is called may not be refunded at all, particularly if mortgage liquidations are high, and there is no need to replace the debt. When Fannie Mae determines that the issue should be called, it gives notice in the manner set forth in the terms of the securities. The time between when notice of a call is given and when redemption of principal occurs is 10 calendar days. It is Fannie Maes general practice to redeem principal on a business day (as defined in the terms of the applicable securities). An exception is that if the interest payment date is on a non-business day, and the call date of a callable debt security falls on this same non-business day, then the bond may be called on that day. Following standard industry practice, the redemption payment is made on the subsequent business day. Interest on the principal amount redeemed is paid up until the date fixed for the redemption. If payment is delayed because the date fixed for redemption is not a business day, additional interest on the principal amount redeemed is not payable as a result of the delay. Of course, the terms of any particular issue of securities are governed by the applicable documents establishing such terms, and may differ from the above information.

Call Process

21

FANNIE MA E s W E B s I T E
Fannie Mae provides numerous tools and information resources for callable debt investors on its web site. The companys web site provides the most accessible means to monitor the call status of the callable debt securities in which they have invested or obtain legal disclosures such as the Universal Debt Facility Offering Circular or Pricing Supplements. Fannie Maes web site also provides two reports, that are updated daily, which detail the companys callable debt securities issued and callable debt securities outstanding.

Call Monitor
The Call Monitor allows investors to retrieve information on recently called securities or to view currently callable securities. The Call Monitor allows market participants to examine Fannie Maes recent call activity. Using the Call Monitor, debt investors can view recently called securities for the trailing three months as well as debt securities that are currently in their call period on any particular day. Call Monitor is available on the Fannie Mae web site under Debt Securities => Call Monitor.

universal Debt Facility Offering Circular

The Offering Circular for Fannie Maes Universal Debt Facility outlines the general terms of Fannie Mae debt securities. The Offering Circular includes extensive information on Fannie Mae debt securities including a general description of funding programs, risk factors, clearance and settlement procedures, and distribution methods. The Offering Circular is located on the Fannie Mae web site under Debt Securities => Debt Tools and Resources => Fannie Maes Universal Debt Facility.

22

Call Process

Pricing supplements
In addition to the Universal Debt Facility Offering Circular, debt investors should also refer to pricing supplements for specific issues of Fannie Mae debt securities in which they invest. Fannie Mae discloses detailed information on individual debt securities through these pricing supplements. Certain securities terms such as payment dates, maturity dates, payment currency, principal amounts and interest specifications are included in the pricing supplements. The supplements also provide identification numbers, listing applications, pricing dates, settlement dates and dealer underwriting commitments. Pricing supplements for outstanding noncallable and callable debt securities can be retrieved on the Fannie Mae web site by going to Debt Securities => Debt Tools and Resources => Document Search. Agency market participants can locate specific pricing supplements by CUSIP number.

Call Process

23

ConClusIon

annie Mae offers a wide variety of high quality callable debt securities with maturities ranging from one year to thirty years and call lockout periods ranging from three months to ten years or longer. Investors purchase these securities to receive enhanced yields relative to noncallable securities in exchange for taking the risk that the securities may be called by Fannie Mae prior to their maturity date. Investors may buy these securities specifically as a way to take a view on interest rate volatility, i.e., if they expect future interest rate volatility to be low they might buy callables that are priced at higher implied interest rate volatility levels. Investors may buy Fannie Mae callable debt securities in order to benefit from a specific view of how the yield curve shape may change in the future. For instance, investors who believe that the yield curve may flatten may buy a callable security to enhance returns relative to barbell or bullet portfolios of duration similar to that of the callable. Fannie Mae callable securities are most often issued as callable notes through a reverse inquiry process. Most of the investor segments active in Fannie Mae senior noncallable debt securities are also active in callable notes. Commercial banks, fund managers, central banks and state and local authorities are particularly active participants in this type of security. Fannie Mae is committed to providing its investors with a diverse array of callable debt structures through its issuance initiatives on an ongoing basis. The company is committed to innovation in the market for callable debt and works diligently to incorporate the needs of its investors and make enhancements to its callable debt issuance activities.

24

Conclusion

GlossarY

american-style Call feature: The call option may be exercised on any business day after an initial lockout period. This type of call feature is also referred to as a continuous call. aoas (agency option-adjusted spread): A new model for pricing and analyzing callable debt securities with European calls. AOAS refers to the yield premium over an agency yield curve instead of the more traditionally employed Treasury or interest rate swaps yield curves. bermudan-style Call feature: The call option may be exercised semiannually on the coupon payment dates after an initial lockout period. This type of call feature is sometimes referred to as a discrete call. Callable debt: A debt security whose issuer has the right to redeem the security prior to its stated maturity date at a price established at the time of issuance, on or after a specified date. Fannie Mae callable debt securities are always redeemed at par. Call feature: The type of call option embedded in a callable security (i.e., American, Bermudan, Canary or European). Call option: An option granting the holder the right to buy the underlying asset on (or before) a specified date at a specified (strike) price. Call risk: The risk to an investor that a given callable debt security will be redeemed prior to its final maturity date, thus affecting expected cash flows and consequently the yield on the security. Canary-style Call feature: A call feature that combines a Bermudan-style call option and a European-style call option. Convexity: A volatility measure for bonds used in conjunction with modified duration in order to measure how the bonds price will change as interest rates change. It is equal to the negative of the second derivative of the bonds price relative to its yield, divided by its price. For example, since a noncallable bonds duration usually increases as interest rates decrease, its convexity is positive.

25

Glossary

Credit risk: The possibility that the issuer or another party may have its credit rating downgraded by a rating agency; may experience changes in the markets perception of its creditworthiness; or may default on its financial obligations to the investor. duration: The weighted average maturity of the present values of the securitys cash flows. It is used as a measure of the sensitivity of the value of a security to changes in interest rates. The greater the duration of a security, the greater its percentage price volatility. european-style Call feature: The call option may be exercised on a single date at the conclusion of the initial lockout period. Historic Volatility (realized Volatility): A statistical measure of a securitys past price movements. It is calculated by using the market price of the option and solving for volatility. Implied Volatility: A measure of a securitys expected volatility as reflected by the market price of the traded options on that security. The theoretical price of an option is a function of the underlying price, strike price, historical volatility of the underlying, the risk-free rate, and time to expiration. Implied volatility appears in several option pricing models, including the Black-Scholes Option Pricing Model. Interest rate risk: The risk that the value of a bond will depreciate in response to an increase in interest rates. An inverse relationship exists between bond prices and yields for fixed-income securities. In a rising interest rate environment, bond prices will decrease and in a declining interest rate environment, bond prices will increase. lockout Period: A time interval, usually early in the life of a security, when a call, conversion feature, or some other provision is not operative. A callable security cannot be called during this period of time. Maturity date: The date on which the life of a financial instrument ends through cash or physical settlement or expiration with no value.

Glossary

26

option: The right to buy or sell an asset at a specified price on, before, or after a specified date. option-adjusted spread (oas): A reference tool for comparing alternative debt securities that contain embedded options. OAS refers to the yield premium over comparable U.S. Treasury securities that a callable debt security would have if it were noncallablethat is, if the value of the embedded option in the callable debt security were removed from the value of the debt security. repo (repurchase agreement): An agreement between a seller of securities and a buyer, whereby the seller agrees to repurchase the securities at an agreed upon price and at a stated time. reverse Inquiry: A method of initiating issuance of debt securities whereby an investor consults with a broker/dealer and then the broker/dealer approaches an issuer with a proposal for a specific security issuance that will meet the investors needs. spread: Typically, in the context of pricing debt securities, the difference in percentage or basis points between the yield of a non-U.S. Treasury debt security being priced and the yield of a comparable U.S. Treasury security. Also refers generally to the difference in yields or coupons between any two debt securities. Usually noted in basis points. Volatility: The relative rate at which the price of a security moves up and down. Volatility is found by calculating the annualized standard deviation of daily change in price. Yield: The annual rate of return on an investment, expressed as a percentage. Yield calculation for notes and bonds is based on the coupon rate, length of time to maturity, and market price, assuming the coupon paid over the life of the security is reinvested at the same rate. Yield Curve: A curve that illustrates the relationship between yields and maturities for a set of similar bonds at a given point in time.

27

Glossary

Yield-to-Call: The internal rate of return on a callable bond in the event that the bond was redeemed by the issuer on the next available call date. Yield-to-Maturity: The internal rate of return on a callable bond or a fixed rate security if the bond was held until the maturity date. Yield-to-Worst: The lowest of all yield-to-calls or the yield-to-maturity.

We deal in one asset type residential mortgages and manage two types of risk on that asset interest rate and credit risk.

Glossary

28

figure 1.
Fannie Mae is focused on the issuance of callable MTNs that are $250 million or larger issue sizes with multiple dealer underwriters*.

To T al Issu a N c e
80 $69.7 160

N uM b e r o F T r aN s a cT I oN s

70

140

139

60 $49.5

120

50

Number of Transactions

100

$ in billions

40 $29.8 $24.7 20

80

75

30

60 46 40

56

10

20

0
2007 2008 2009 2010

0
2007 2008 2009 2010

*Callable MTNs with at least two dealer underwriters

As of December 31, 2010

29

Figures

figure 2.
bloomberg aoas screen Fannie Mae 4Nc1 european-style callable Note evaluated relative to the Noncallable benchmark curve
resulting dollar price resulting OAS up-to-date relevant mid-market european swaption volatility imported from Tullett Prebon

The noncallable Benchmark Securities yield curve and associated constant maturity yield adjustment spreads are fannie Mae Benchmark Securities yield curve provided by Bloomberg Agency Composite AgPX spreads.

This exhibit is the SIFMA pricing model as it appears on Bloomberg using Fannie Maes recently issued 1.200% 4 noncall 1-year European-style callable note due November 3, 2014.
30 Figures

figure 3.
Duration and convexity profiles for the most common european-style callable debt structures.

0 5NC3 -0.3 2NC1 -0.6 co N v e xI Ty 3NC1 -0.9 5NC1 -1.2 7NC2 5NC2 7NC3 10NC3 7NC4 10NC4 15NC5

10NC2

-1.5

7NC1

-1.8

6
D u r aT Io N

10

12

14

Source: Fannie Mae As of December 31, 2010

31 Figures

DIsCLAIME R
Fannie Mae securities are more fully described in applicable offering circular, prospectuses, or supplements thereto (such applicable offering circular, 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 investors 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.

Our Business Is The American Dream At Fannie Mae, we are in the American Dream business. Our Mission is to tear down barriers, lower costs, and increase the opportunities for homeownership and affordable rental housing for all Americans. Because having a safe place to call home strengthens families, communities and our nation as a whole.

3900 Wisconsin Avenue, NW Washington, DC 20016-2892 http://www.fanniemae.com

2011, Fannie Mae

www.fanniemae.com