Monthly Report for Fannie Mae s Investors and Dealers. Fannie Mae s Callable Note Reverse Inquiry Process

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1 February 2000 Volume 5 Issue 2 fundingnotes sm Fundingnotes is now available on Fannie Mae s website. Visit choose the Debt Securities option and select Fundingnotes Publications. Fundingnotes is also available at "FNM" <GO> on Bloomberg. Monthly Report for Fannie Mae s Investors and Dealers Fannie Mae s Callable Note Reverse Inquiry Process Fannie Mae issues a large number of callable notes through its Universal Debt Facility program in response to investor demand for specific structures. This issuance is to be distinguished from Fannie Mae s Callable Benchmark Note program for which four American-style callable structures are reserved 10NC3 year, 10NC5 year, 5NC2 year and 5NC3 year (although this last structure has yet to be issued as a Callable Benchmark Note and therefore continues to be issued in the callable notes format). Prior to 2000 and the introduction of the Universal Debt Facility, these callable notes used to be issued through Fannie Mae s Medium Term Notes (MTNs) program. In 2000, Fannie Mae simplified its documentation for all debt transactions into one single Universal Debt Facility. All of Fannie Mae s debt programs including short-term Discount Notes, Benchmark Bills, Benchmark Notes and Benchmark Bonds, Callable Benchmark Notes, other bullet and callable notes, and foreign currency denominated debt - are consolidated into this Facility. As a result all issues that were formerly referred to as Medium Term Notes will henceforward be referred to merely as callable notes or bullet notes (or as other callable or bullet notes). Fannie Mae s callable notes issues in 1999 other than Callable Benchmark Notes amounted to over $63 billion or roughly 45% of all long term debt funding. From this it can be seen that issuance of callable notes is a very important source of funding for Fannie Mae. In fact, Fannie Mae initiated the agency callable market in1987 in order to better manage its asset-liability interest rate risk. Through the issuance of callable notes, Fannie Mae is able to offset the risk of prepayments in its mortgage asset portfolio, the principal of which typically prepays when interest rates decline. A large variety of investors participate in the callable note market, attracted by the ease with which specific structures can be created to suit investor demand. Certain investors choose callables structured to reach coupon targets, while others buy them based on total return expectations. Frequently, investors have specific maturity date and call date requirements as well, and sometimes have preferences for European-style (one time call) or Bermudan-style (callable on interest payment dates only) call options. Fannie Mae is flexible in its ability to structure callable debt and works diligently with underwriters to price, provide feedback for and execute callable note structures with its underwriters for the benefit of investors. In 1999, Fannie Mae began to provide dealers the flexibility to underwrite smaller sized callable notes offerings so as to satisfy demand from investors seeking specialized structures. Callable notes versus Callable Benchmark Notes In 1999 Fannie Mae made the decision to separate callable issuance into two categories. The first is the category of callable notes in which investors are primarily interested in yield and structure, and to a lesser extent in secondary market liquidity. The second is the category of Callable Benchmark Notes in which investors are concerned with liquidity to as great an extent as yield and structure. As a result, Fannie Mae has been prepared to issue small size transactions in the first category while issuing only large amounts, $500 million and greater, in the Callable Benchmark Notes category. Certain fixed income investors are primarily interested in liquidity in the assets that they buy, because they expect to trade in and out of different sectors of the bond market based on their perceptions of relative value. The Callable Benchmark Note program is designed to appeal to such investors, who might trade into and out of callables based on their valuation relative to mortgages or bullet Benchmark Notes, or as a vehicle to trade interest rate volatility. On the other hand, another major class of fixed income investors is interested in callables for a slightly different set of reasons and might be less interested in secondary trading and more interested in the yield or return enhancement potential of callables. For such investors, the ability to choose and tailor the structure is more important than having a large issue size to maximize secondary liquidity. Callable notes are ideal for this latter class of investor because of the flexibility of the structuring process in terms of maturity, call date, call feature and issue size. Small specific pockets of demand can be satisfied through callable notes in a manner distinct from Callable Benchmark Notes, with their defined structures and large issue sizes. Issuance of callable debt structures during 1999 As shown in Figure 1, during 1999 Fannie Mae issued about $71.3 billion in 659 callable notes and bonds issues with maturities from 1.5 years to 20 years. The lockouts ranged from three months to five years, although the structures with shorter lockouts, i.e., three or six months were comparatively small in volume, at $6.7 billion or roughly 10% of the overall continued Copyright 2000 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 sophisticated 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.)

2 volume of callables. Callable Benchmark Notes issuance during 1999 totaled $8.1 billion in four transactions; therefore, issuance of callable notes totalled $63.2 billion. Some of the other very active categories of callable notes in 1999 were 3NC1 years and 5NC1 years. Somewhat smaller in total amount, though still important, were some other structures with one and two year lockouts, such as the 4NC1 years, 7NC1 years, 7NC2 years, 10NC1 years and 10NC2 years. Figure 1 Fannie Mae responds to reverse inquiry in a wide range of callable structures Year to Date Maturity/Call Par Amount (# Issues) 1.5NC.50 $50,000,000 (1) 2NC.25 $80,000,000 (2) 2NC.50 $2,150,000,000 (23) 2NC1 $9,915,000,000 (94) 2.5NC.50 $100,000,000 (1) 2.5NC1 $400,000,000 (2) 2.5NC1.50 $500,000,000 (2) 3NC.25 $285,000,000 (5) 3NC.50 $1,935,000,000 (15) 3NC.75 $200,000,000 (1) 3NC1 $9,785,000,000 (82) 3NC2 $250,000,000 (3) 3.5NC.25 $100,000,000 (1) 3.5NC1.5 $25,000,000 (1) 4NC1 $1,120,000,000 (13) 4NC2 $175,000,000 (5) 5NC.25 $1,050,000,000 (2) 5NC.50 $900,000,000 (8) 5NC1 $9,740,000,000 (112) 5NC1.5 $50,000,000 (1) As of December 31, 1999 Source: Fannie Mae 1999 Callable Debt Issuance Total $71,258,500 (659) 1999 Year to Date Maturity/Call Par Amount (# Issues) 5NC2 $6,450,000,000 (58) 5NC2 * $3,300,000,000 (2) 5NC3 $1,625,000,000 (13) 5.5NC1 $390,000,000 (4) 6NC1 $65,000,000 (4) 7NC1 $1,870,000,000 (27) 7NC2 $1,095,000,000 (16) 7NC3 $230,000,000 (4) 7.5NC1 $15,000,000 (1) 8.5NC1 $30,000,000 (2) 10NC1 $1,290,000,000 (6) 10NC2 $2,880,000,000 (31) 10NC3 $4,930,000,000 (48) 10NC3 * $3,300,000,000 (1) 10NC5 $1,625,000,000 (13) 10NC5 * $1,500,000,000 (1) 15NC1 $728,000,000 (31) 15NC3 $135,500,000 (9) 15NC5 $690,000,000 (12) 20NC1 $300,000,000 (2) *Callable Benchmark Notes Program Figure 1 shows that there was some limited issuance during 1999 of callable notes that were not Callable Benchmark Notes in the reserved structures, i.e., currently 5NC2 years, 10NC3 years and 10NC5 years. This was either issuance that occurred before the advent of the Callable Benchmark Notes program or issuance of European-style callables within those structures. It should be noted that as a matter of policy, Fannie Mae will continue to issue European-style callables within these maturity and call parameters outside the Callable Benchmark Notes program. As mentioned earlier, Fannie Mae issues 5NC3 year structures as callable notes, since although the structure is technically included in the Callable Benchmark Notes program, they have not yet been introduced into that program. It is also worth noting the wide variety of callables that Fannie Mae issued in The range of maturities and lockouts is substantially more diverse even than those discussed above. Investors have been able to purchase callables with maturities, as long as 15 or 20 years, well outside the more standard two to ten year range. These longer maturities with one to two year call lockouts are popular as ways to pick up yield, particularly when investors have a stong view that interest rates will decline and that the issue is likely to be redeemed on its call date. The shorter maturities are an attractive way to pick up yield for a limited amount of extension risk when investors have the view that rates are likely to be stable or fall. The average issue size of callable notes issued during 1999 was $96.4 million, while the range of actual issue sizes was from $15 million to $500 million. On occasion, Fannie Mae issued in sizes as small as $15 million either to satisfy specific investor demand or for a retail transaction. Thus investor demand of limited amounts was also satisfied at the same time as deals with larger sizes targeted to foster secondary liquidity were issued. As mentioned above, in 1999 Fannie Mae was able to offer dealers the flexibility of underwriting smaller transactions because of its conscious policy of bifurcating its callable issuance into smaller, flexible structure callable notes and larger, more liquid, Callable Benchmark Notes. Structuring callables for yield or return enhancement Investors buy callable notes for a several different though related reasons. Most commonly, the goal is to enhance yield or return by taking a specific view of future interest rates. In a declining interest rate scenario, investors expect their issues to be called, so they buy callables to maximize the yield to the call date. In a stable interest rate scenario and an upward sloping yield curve investors may also expect their investments to be called, and therefore buy callables to enjoy a high yield up to the call date. Some investors buy European callables when they have the view that interest rates will be higher on the call date so that their issue will not be called. Because of the yield advantage of the callable, they expect to outperform bullets that have similar maturity dates. In a rising yield curve scenario, investors may choose to buy callables to outperform bullets of the same maturity. This is because they expect the callables not to be called and, therefore, to outperform bullets of the same maturity. Some investors have specific coupon targets at the same time as they have rate views in mind when they buy callables so that they structure callables to suit their views. Often such investors may wait for Treasury rates to rise to a certain level before they want to make their investment in callables. Underwriters keep these target levels in mind and approach Fannie Mae when the target yield level is reached. Investors who are very confidently bullish on future yields may choose to maximize the yield to the call date by having the longest possible maturity date and a relatively short time to first call. In most cases, extending the maturity achieves the goal of maximizing the coupon and hence yield. Shortening the call lockout period minimizes the investors call protection, thus also the yield of the security. Investors who are bullish to neutral on the future level of yields may prefer to be more cautious in terms of either maturity or call or both. For such investors an intermediate or short maturity may be most appropriate. Alternatively, a longer call lockout period may be most desirable. Bearish investors may choose to buy a European-style callable note, taking the view that it will not be called because of higher rates, and will thus convert to a bullet after the call date. In this way they are able to pick up the extra spread over a bullet of the same maturity for taking the one-time call risk. Certain investors have a preference for Bermudan-style callables based on the greater certainty of cashflows from such a structure. Bermudan-style callables are callable only on the interest payment dates and thus, if they are not called on any given interest payment date, the investor can be certain of receiving the coupon at least until the next coupon date which may be six months away. This kind of cashflow 2 continued

3 assurance is important to certain investors from an operational perspective. Finally, investors who are restricted to investing in short maturities may prefer to invest in 2NC1 years or 3NC1 years, or even in short maturity issues with 3-month or 6-month lockouts. The reverse inquiry process Fannie Mae has developed a flexible mechanism for the reverse inquiry process for callable notes that enables investors to obtain the structure that they want efficiently and at the best possible price. Fannie Mae has an ongoing need for callable debt funding because these liabilities allow us to manage the risk of prepayments on its mortgage asset portfolio. 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 asset/liability management purposes. Fannie Mae does not typically swap out of the optionality of the callables it issues to a floating LIBOR basis, but instead retains the optionality for asset/liability management purposes. Because there is usually no need to arrange a simultaneous interest rate swap converting the callable issue into a floating rate liability, it is simpler for dealers to underwrite Fannie Mae callables than the callables of other agency issuers. Fannie Mae has instituted a process under which it provides a list of callables on a daily basis to several dealers on which it receives pricing indications. Underwriters provide their indications based on the interest that they are in turn seeing from investors in the different structures. Based on these pricing indications, Fannie Mae may choose to issue a specific structure that meets its funding criteria through the dealers with the best quotations. In this situation, Fannie Mae would approach the dealer or dealers with the best quotations with the size and other terms of a proposed issuance in that structure, and through further negotiation conclude the underwriting. Alternatively, if investors have specific interest in a certain structure, the dealer involved will reflect this to Fannie Mae. Fannie Mae will in turn analyze the terms of the structure and give feedback to the dealer as to whether or not it is prepared to act, and if appropriate, with a price or spread level at which the transaction can be executed. Fannie Mae attempts to provide the swiftest possible feedback on particular structures in which investors have interest. The terms of a proposed structure are quickly evaluated against internal benchmarks to enable Fannie Mae to reach a decision in a prompt manner. 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 reflected directly to Fannie Mae by the dealer. This could occur if the investor s interest was for an amount of $25 million or more and if the dealer did not have interest for the structure from other investors. Alternatively, sometimes the transaction is structured for a larger size than any single investor s interest and this is because the dealer observes a larger amount of demand for that structure. On occasion, Fannie Mae may bring together several dealers if they have similar interests in callable structures to form a single, larger co-underwritten callable notes transaction. In this way, investors can obtain the benefit of better liquidity and tradability from the larger deal size and the broader dealer sponsorship of the transaction. At the same time, larger issues qualify for inclusion in the broad bond indexes, such as Lehman s Aggregate Bond Index, which has a minimum size requirement of $150 million for an issue to be included in the index. For these reasons, the funding group at Fannie Mae strongly encourages this type of coordination among its underwriting dealers. In addition, Fannie Mae reopens callable notes issues whenever possible to grow their outstanding sizes. For example, if a dealer finds investor interest in a 5NC2 callable notes transaction, and Fannie Mae had recently issued another 5NC2 transaction with similar terms, Fannie Mae will make an effort to reopen the existing issue. As a result of the reopening, the liquidity of the outstanding issue is enhanced and its size may be increased to the point that it is included in the broad bond indexes. Typically, the minimum size that Fannie Mae is prepared to entertain for a callable notes underwriting is $25 million, although occasionally smaller transactions have been issued. The minimum size for a Callable Benchmark Notes transaction is $500 million. 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 s approach to the market for callable notes is to seek out funding that suits its asset/liability management needs and at the same time enables the widest participation by investors. Fannie Mae callables have a larger share of the agency component of the Lehman Aggregate Index than all other issuers combined. Lehman Aggregate Index 1/31/00 ABS 1.30% Corporates 21.66% Agency 9.35% MBS 33.93% US Treasury 32.34% Source: Lehman Brothers Figure 2 CMBS 1.42% Other Agency Callables 12.32% Agency Component of Lehman Aggregate Index 1/31/00 Other Agency Bullets 43.91% Fannie Mae Bullets 28.02% Fannie Mae Callables 15.75% Fannie Mae callable notes in the broad bond indexes The larger issue sizes of much of Fannie Mae s callable issuance means that these issues are included in the agency components of the broad bond indexes such as the Lehman Brothers Bond Index, which has a minimum issue size requirement of $150 million. Figure 2 illustrates the breakdown of the agency component of the Lehman Index. It shows that Fannie Mae s callables have the largest weighting of all issuers callables in the agency sector. This high level of representation can be attributed to Fannie Mae s efforts to structure callable notes in larger issue sizes so as to qualify for inclusion in the index. In addition, over the last several years, the share of corporate callables in Lehman s index has declined steadily. For instance, Lehman s analysts pointed out recently that the percentage of callables in Lehman s Corporate Bond Index has declined from 22.4% in 1995 to 9.4% in 2000 (February 14, 2000 Relative Value). With this decline in the amount of corporate callables outstanding, investors seeking the yield enhancement that callables provide, increasingly find their needs served by agency callables. continued 3

4 Conclusion Fannie Mae s reverse inquiry process for callable notes has been in place for a number of years. In 1999, Fannie Mae made the conscious decision to pursue liquidity conscious investors through its Callable Benchmark Note program, and to separately focus on investors who desire flexibility of structure and yield through its issuance of callable notes. Callable notes remains a key source of funding for Fannie Mae as can be seen from the fact that of the $71 billion in callables issued during 2000, about $63 billion was issued as callable notes and the balance as Callable Benchmark Notes. Callable notes issuance is highly flexible in terms of enabling investors to achieve yield targets in conjunction with maturity and call date requirements. At the same time callable notes transactions are structured in sizes of as little as $25 million and as much as $ million. Fannie Mae s portfolio needs for callables make it possible to offer this flexibility to investors. Fannie Mae works with its dealers to assess the market demand for different structures and issues callable notes in response to specific investor demand as well as to broader based demand. Fannie Mae responds swiftly to investor reverse inquiry regarding callable notes by providing timely feedback to the dealer involved. Since Fannie Mae issues callables for its asset-liability management needs, there is typically no need for arranging an accompanying interest rate swap, further speeding up the pricing and underwriting process of its callable notes issuance. Noteworthy Transactions In February, in accordance with its calendar, Fannie Mae issued $3 billion of 5-year Benchmark Notes with a 7.125% coupon maturing February 15, The issue was priced at 50.5 bp over the 5-year Treasury yield and the lead underwriters were Bear Stearns, Lehman Brothers and Merrill Lynch. Placement was widespread with the following geographic breakdown: US 73%, Asia 15%, Europe 12%. The institutional breakdown was: fund managers 51%, commercial banks 15%, central banks 11%, insurance 8%, corporate pension funds 5%, retail 5%, state & local 3% and non-profits 2%. Also in keeping with its newly revised calendar, in February Fannie Mae issued $2.5 billion of 30-year Benchmark Bonds with a 7.125% coupon maturing in 15, Including the Exchange amount (see below) a total of $4.82 billion of this issue is now outstanding. The issue was priced at 82.5 bp over the 30-year Treasury yield and the lead underwriters were Bear Stearns, Lehman Brothers and Merrill Lynch. Placement was widespread with the geographic breakdown as follows: US 83%, Europe 14%, Other 3%. The institutional breakdown was: fund managers 61%, commercial banks 9%, corporate pension funds 8%, state & local 7%, insurance 5%, retail 5%, central banks 3%, non-profits 2%. On February 3, Fannie Mae announced its third Benchmark debt exchange in conjunction with its offering of a new issue % 30-year Benchmark Bond. The exchange settled on February 15, 2000 with Fannie Mae offering to exchange 22 debt issues totaling $4.25 billion with maturities ranging from 2025 to Final tendered amount was $2.675 billion with at least some of all 22 issues exchanged for $2.32 billion of the new 30-year Benchmark Bonds. The participation level for the exchange was 63%, the highest level for any Benchmark Securities Debt Exchange to date. Merrill Lynch and Bear Stearns were dealer managers of the exchange. A distinctive feature of the exchange was that it incorporated a comprehensive Internet strategy by Fannie Mae and the dealer managers of the Exchange. Nearly 100% of the completed letters of transmittal submitted to the Exchange Agent was submitted through the Internet demonstrating the efficiency impact of this innovation. Treasurer s Office 3900 Wisconsin Avenue, NW Washington, DC First Class U.S. Postage PAID Washington, DC Permit No fundingnotes sm Fundingnotes is published Monthly by Fannie Mae s Debt Marketing Group Editors: Hasan Latif (202) Michael Kenney (202) Toll-free Help line: (888) BONDHLP Website: debt_marketing@fanniemae.com 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.

5 Fannie Mae Debt Securities Index Report ( 2000) In a poor month for the bond market, agencies and Fannie Mae debt performed aproximately in line with the market. The Fannie Mae 1-3 Year Index was the bright spot in an otherwise lackluster performance in the market, and this sector outperformed all major sectors of the broad sectors % of Big Last 3 mos Last 6 mos December % of Big of Agg December Last 3 mos Last mos Last 6 mos Last mos Salomon Brothers Fannie Mae Index: Years Years Years Years Callable Noncallable Globals Agency: Callable Noncallable Globals Salomon Broad Index*: Treasury GSE** Corporate Mortgage * Components of Broad (BIG) Index: Treasury, GSE, Corporate, Mortgage ** Includes U.S. Agencies *** Includes World Bank global issues Lehman Brothers Fannie Mae Index: Years Years Callable Noncallable Globals Agency: Callable Noncallable Globals*** Lehman Aggregate Index: Government** Corporate MBS CMBS ABS This data has been compiled from reports supplied by Salomon Brothers and Lehman Brothers and is reproduced here with their permission. The indexes are constructed according to rules developed by these firms and the index values are calculated by them. Summary Breakdown Of Fannie Mae 2000 Debt Issuance Year-to-Date Includes all settled fixed rate debt issues with maturities greater than one year (360 days). Fixed rate US dollar and foreign currency global debt is included in the bullet and callable breakdowns below as well as listed separately. Variable rate debt is not included in totals. Fannie Mae Fixed Rate Bullet Debt Year to Date Maturity/Call Par Amount (# Issues) Par Amount (# Issues) 2 Years* $ 4,000,000,000 (1) $ 4,000,000,000 (1) 10 Years* $ 6,000,000,000 (1) $ 6,000,000,000 (1) Total $10,000,000,000 (2) $10,000,000,000 (2) * Benchmark Securities Programs Year to Date Maturity/Call Par Amount (# Issues) Par Amount (# Issues) 4NC2 $ 30,000,000 (1) $ 30,000,000 (1) 5NC1 $ 390,000,000 (5) $ 390,000,000 (5) 10NC1 $ 15,000,000 (1) $ 15,000,000 (1) 10NC3 $ 50,000,000 (2) $ 50,000,000 (2) 15NC1 60,000,000 (3) $ 60,000,000 (3) Total 545,000,000 (12) $ 545,000,000 (12) * Callable Benchmark Note Program