GSEs Face Questions about Impact of Hedging Moves

They are highly regarded by Wall Street rating agencies and stock analysts. They have consistently produced double-digit earnings growth. And so far, neither Fannie Mae nor Freddie Mac has ever cost the taxpayers a dime in the form of a bailout. Moreover, because there is no explicit federal guarantee on the obligations of Fannie Mae and Freddie Mac, the taxpayers are not obligated to bail them out even if they were to fail. (The much-discussed "implicit" guarantee amounts to nothing. Being guaranteed is like being pregnant ither you are or you aren't).

To top it off, virtually everyone acknowledges that the government-sponsored enterprises make credit for buying and owning a home cheaper and more widely available than it otherwise would be.

So why are so many people up in arms about the GSEs?

The reason, in a nutshell, is their growing retained portfolios. Fannie Mae and Freddie Mac have some of the best hedging expertise in the world, no doubt. But anyone who recalls the early days of the thrift crisis knows that trying to manage the interest rate risk inherent on a portfolio of 30-year mortgage loans is not an easy job.

The GSEs face a few other areas of concern in addition to the effectiveness of their own hedging strategies, which handled this summer's interest rate swings remarkably well, according to data published by the agencies.

For one, there is growing concern in the capital markets that the heavy reliance on Treasury securities to hedge mortgage portfolios could distort the market for those assets. If huge agencies like Fannie Mae and Freddie Mac have to flood the market with either purchases or sales to rebalance their positions in response to an interest rate move, will the pricing of those assets be affected? Some have argued that the agencies may inadvertently have put upward pressure on interest rates this summer because of their rebalancing needs.

The size of the MBS market, representing 35% of the fixed-income debt (compared to 22% for Treasuries) according to Lehman Brothers, helps to illustrate the problem.

Another concern is "counterparty" risk. When the agencies enter into option-based contracts or swap agreements, what if at the end of the day, when a rate movement triggers a reciprocal transaction, the counterparty to the deal cannot deliver?

Fannie Mae and Freddie Mac say that collateral arrangements with highly rated counterparties reduces the risk of a counterparty failure on a transaction.

They also dispute the notion that their hedging strategies could disrupt the market for Treasury securities (though Fannie Mae, it should be noted, has started to rely on more option-based debt offerings as a larger part of its interest rate risk management program).

In a recent webcast with investors, Fannie Mae's chief financial officer, Timothy Howard, has indicated that Fannie Mae expects to grow its retained portfolio further, picking up market share as other buyers of mortgage assets (commercial banks, namely) decide to sell them in favor of other assets. And he said there is no evidence that the GSEs have distorted Treasury prices because of their hedging moves. Fannie Mae has a diverse hedging strategy and deals with many business partners, making it easier for the agency to conduct its hedging strategy without affecting the market, he said.

"We are very conscious of the potential impact that our rebalance has on all of our counterparties," Mr. Howard told investors.

He said it is in Fannie Mae's long-term financial interest to be a low-risk company, so that policymakers and debt markets continue to have confidence in the enterprise.

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