Steering Clear of Risk Has Costs as Well as Benefits

When you examine the 800-pound gorillas of the mortgage industry, Fannie Mae and Freddie Mac, they look a lot alike. But when it comes to managing interest rate risk, Freddie Mac seems to be the more conservative of the two giants.

Fannie Mae took some heat last August for letting its "duration gap" extend to negative 14 months, indicating that its mortgages were prepaying faster than its debt was expected to repay. Fannie Mae took steps to reduce the duration gap in the following months, but advised investors that it does not hedge all of its interest rate risk. Investors were warned that the duration gap was likely to move beyond the target range of plus or minus six months from time to time.

Freddie Mac, on the other hand, was quick to point out that its duration gap was nearly zero at the time, and remained within a narrow range throughout last year, despite the unexpected downward trend in interest rates.

But there is a price to pay for such aggressive hedging, as Freddie Mac's 2002 earnings report makes clear. Freddie Mac reported excellent results, as one would expect from a year when residential mortgage originations surged to a record $2.5 trillion.

But it also announced that its new accountant, PricewaterhouseCoopers, is requiring changes that will require Freddie Mac to restate its earnings for prior periods. The issue affects the timing of gains, and Freddie Mac will apparently be required to restate past earnings upwards, essentially stealing earnings that would have been saved for future periods under the previous accounting procedure.

The issue, Freddie Mac executives explained during a conference call with investors and analysts, reflects the question of when gains should be recognized with regard to treasury securities used for hedging purposes. Re-securitized mortgage loans also contributed to the accounting snafu.

But while the expected restatement may have put a damper on investor enthusiasm for Freddie Mac's stock last month, CEO Leland Brendsel insists that the company's business remains fundamentally safe and strong, and the numbers suggest he is right.

Not only did Freddie Mac report record earnings, but its measures of interest rate risk reveal an institution that is well insulated from potential shocks in the interest rate environment.

Joseph Amato, Freddie Mac's vice president of finance, said Freddie Mac's hedging strategy combines disciplined rebalancing and a high level of optionality.

"We hedge a significant portion of the options risk in our retained portfolio by buying mortgage securities with less repayment risk, such s CMOs, and by using callable debt and option-based derivatives. We also monitor our portfolio daily and actively rebalance to maintain our low-risk profile," he said during the company's conference call.

However, he said Freddie Mac is not perfectly hedged. As a result, investors should expect some change in Freddie Mac's measurements of risk, such as its duration gap and its "portfolio market value sensitivity" measures, as interest rates move. Freddie Mac's PMVS numbers have consistently been "in the single digits," he said. Its duration gap remained within a range of plus or minus one month all year during 2002.

However, he said the magnitude and volatility of these changes should be mitigated by the low-risk profile of Freddie Mac's business and its constant rebalancing of its hedge strategy.

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