Freddie Benefits from Rate Risk Success

As government officials prepare to revamp oversight of the government-sponsored enterprises, their big worry is that with huge mortgage portfolios on their balance sheets, Fannie Mae and Freddie Mac could be vulnerable to a shock from unexpected interest rate movements.

And it's easy to see why some people are concerned. In its first half financial report, Freddie Mac reported that the notional amounts of its total derivative portfolio totaled $705 billion, with a fair value of almost $8.5 billion. That derivative portfolio is lower than it was a year ago, but it still presents a financial management challenge.

At the moment, Freddie Mac's interest rate risk management seems both vigilant and successful. But that doesn't mean that hedge accounting rules are clarifying things much, since many of the derivatives do not qualify for hedge accounting relationships.

Just take a look at Freddie Mac's recently released financial results for the first half of this year.

In the company's official announcement, Freddie Mac's chief operating officer, Eugene McQuade, said the company managed to keep both interest rate risk and credit risk "at very low levels" while increasing market share in the first half of this year.

But he said that accounting rules pertaining to interest rate risk management continue to distort Freddie Mac's financial picture, noting that only part of the company's balance sheet is "marked" to fair value each quarter. In fact, Freddie Mac said the decline in net income it reported in the first half of this year, compared to last year, in part, reflects losses in derivative instruments that do not qualify for hedge accounting relationships. Freddie Mac contends that the derivatives "continue to be an effective component of our risk management activities."

To illustrate, Freddie Mac reported $747 million of losses on derivative securities during the first six months of this year, in addition to $71 million of hedge accounting losses. That created an overall loss in "non-interest income" for the mortgage secondary market giant.

Freddie Mac prefers that investors and analysts look at "pure fair value," as chief financial officer Martin Baumann said in a conference call to discuss the results. That puts all assets and liabilities into view without regard to hedge accounting rules.

Freddie Mac measures interest rate exposure through its "portfolio market value sensitivity" and duration gap. Both essentially weigh the duration of assets against liabilities in the event of a change in interest rates. For the first six months of 2005, portfolio market value sensitivity averaged 1%, Freddie Mac said. The duration gap averaged zero months during that time period.

Mr. Baumann pointed out in a conference call with investors and analysts, if rates edge up as projected in the second half of this year, that could generate some recapture of non-interest income and offset a lower margin in net interest margin.

"You haven't seen that yet in the first half of the year. You will see that in the full year."

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