Fannie, Freddie boost risk to levels that once shook Wall Street

Fannie Mae and Freddie Mac are taking on more interest-rate risk in their rapidly growing investment portfolios, driving a key gauge of their exposure to levels that rattled Wall Street two decades ago.

Disclosures from the housing-finance giants show their duration gaps — a measure of how closely assets, liabilities and hedges offset one another — have widened sharply in recent months, leaving their holdings more exposed to rate swings. With the gaps now at roughly one year, a half-percentage point increase in rates would reduce the value of Fannie Mae's portfolio by about $1.2 billion and Freddie Mac's by more than $1.6 billion. Twelve months earlier, the estimated impact at both firms was minor.

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The shift comes as the government-backed companies have added more than $135 billion to their retained portfolios over the past year, part of President Donald Trump's push to ease housing costs by shrinking the supply of mortgage-backed securities available to investors. That can lower yields on the bonds and help drive mortgage rates down.

But the strategy carries a tradeoff: When rates rise, homeowners are slower to repay or refinance their loans, extending the life of the bonds and making them more vulnerable to further rate moves. That leaves Fannie Mae and Freddie Mac with more risk unless they add protection. 

The problem is that adding that protection can work against the goal of lowering borrowing costs. Hedging trades can put upward pressure on Treasury yields, which feed into home-loan rates.

Fannie Mae and Freddie Mac have said the wider duration gaps stem from a shift in how they invest some of their capital cushions, moving money out of short-dated investments and into longer-term assets like MBS to generate steadier income. Market watchers see another benefit: by leaving more of that added rate exposure unhedged, the companies avoid trades that could lift mortgage rates.

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"In the early years of conservatorship the GSEs were in a sort of lockdown with strong risk oversight, maybe even excessively so," said Richard Estabrook, a strategist at Oppenheimer & Co., referring to the period after the 2008 financial crisis when the government took control of the two companies. "Now they've evolved to the point where they're being more actively used to advance policy goals."

Trump has embraced lowering borrowing costs as a strategy to address home affordability, a key political issue heading into November's midterm elections. With their vast mortgage portfolios, Fannie Mae and Freddie Mac are among the administration's most direct tools for influencing home-loan costs.

That rate-first approach was on display Wednesday, when the president abruptly scrapped plans to sign a bipartisan housing bill passed by Congress and said lawmakers should first pass separate legislation tightening voter-eligibility rules. The housing measure, which would take steps including curbing large institutional investors' ownership of single-family homes and streamlining rules around factory-built housing, was less important than lower rates, he said. 

A spokesperson for Fannie Mae declined to comment, while representatives for Freddie Mac and the Federal Housing Finance Agency, which oversees the two companies, didn't respond to requests for comment. 

When Fannie Mae's duration gap last climbed this high, it unsettled investors and drew intense scrutiny from regulators worried taxpayers could be exposed to losses. This time, market observers are less alarmed, pointing to the companies' larger capital buffers and smaller investment portfolios than before the financial crisis.

Fannie Mae and Freddie Mac typically manage rate risk through bond issuance and derivatives. Because their retained portfolios are funded in part via debt, a rise in rates can reduce the value of both their fixed-rate mortgage assets and liabilities, offsetting part of the hit.

They then use swaps, swaptions, futures and other instruments to fine-tune the match as rates and repayment expectations shift. That's especially important for mortgage bonds, which can pay off faster when falling rates spur refinancings and extend when rising rates keep borrowers in place.

But now, that balance is shifting. As the companies move more of their retained earnings, part of their capital cushion, into longer-term investments, they're leaving more of the added rate exposure in their portfolios unhedged rather than fully offsetting it.

The upside is less earnings sensitivity to rate moves. For Freddie Mac, a 1 percentage point decline in rates would cut coupon income by $343 million over the next year, down from $492 million a year earlier, according to filings. The tradeoff is bigger mark-to-market risk: an adverse 1 percentage point shift in the yield curve would result in about $3.4 billion in losses, while a half-point move would cost over $1.6 billion.

"The question is, for institutions in conservatorship, how appropriate is this risk for their balance sheets, and where are we headed?" said Scott Buchta, head of fixed-income strategy at Brean Capital. "The portfolios are smaller than they used to be but they're growing and the risk exposure is expanding."

The last time Fannie Mae's duration mismatch was this large, it was running in the opposite direction. In 2002, plunging rates unleashed a refinancing wave that caused borrowers to pay off mortgages far faster than expected, shortening the life of Fannie Mae's assets more quickly than its debt and hedges could keep up. By August of that year, the gap had reached minus 14 months.

The disclosure shook Wall Street. Fannie Mae's shares fell, its debt spreads widened and regulators began probing whether one of the central pillars of the US mortgage market had allowed its rate exposure to drift too far. The company raced to reassure investors, saying it had tools to shrink the mismatch through a mix of mortgage purchases, debt buybacks and derivatives. Longer-term Treasuries rallied on the expectation that Fannie Mae would need to buy more of the securities to rebalance.

Today, concern is more muted. The government-sponsored enterprises' combined mortgage-bond holdings make up only around 2% of the approximately $8.5 trillion US agency MBS market, well below their roughly one-third share in the early 2000s, according to Walt Schmidt, a strategist at FHN Financial.

"The amount of duration the GSEs have taken on seems reasonable relative to the size of the investment portfolio, which is still far smaller than it was," Schmidt said.

Still, the strategy carries risk. A jump in rate expectations in recent weeks, fueled by renewed inflation concerns, could leave Fannie Mae and Freddie Mac more exposed to losses.

And the shift may not be over. Many market watchers expect Fannie Mae and Freddie Mac's holdings to keep growing, potentially by $100 billion or more, with duration gaps widening alongside them. That's especially true if the Trump administration pushes the firms to buy even more mortgage-backed securities.

"The duration gap widening has aligned closely with the growth in the size of the overall portfolios," said Brett Kozlowski, who helps oversee $53 billion at GW&K Investment Management. "And since the GSEs aren't done buying yet for the portfolios, my best guess is that the gap will keep widening too."