Fannie and Freddie:

US agencies Fannie Mae and Freddie Mac are two of the most voracious users of interest rate hedging tools, especially swaptions and related instruments, which they use to hedge their vast mortgage portfolios. Naomi Humphries asks them about their main risk management concerns, and whether the derivatives markets are serving their hedging needs

What do you expect prepayment risk to be like in 2003? What are your expectations based on?

Peter Niculescu, executive vice-president of Fannie Mae’s mortgage portfolio business: Fannie Mae’s low-risk growth business model enables us to manage credit and interest rate risk inherent in our business through a wide range of economic and interest rate environments. Managing prepayment risk is something our disciplined risk managers do every day. While prepayments may continue to rise gradually as mortgage originators streamline the mortgage refinance process, we carefully monitor the prepayment environment and adjust accordingly.

Nazir Dossani, senior vice-president of investments, Freddie Mac: We expect prepayments to continue to be very fast, as they were in 2002 with interest rates remaining low. The key risk for mortgage investors, therefore, is extension risk if interest rates were to increase quickly. In such an environment, prepayments will slow and mortgage durations will extend dramatically.

What hedging tools have you used in the past year to manage the risk of your portfolio, especially prepayment or negative convexity risk? Do you see your use of these tools changing in the coming year?

Niculescu: Our conservative interest rate risk management strategies have been very successful and have produced very low interest rate sensitivity for our mortgage portfolio.

Fannie Mae uses plain vanilla derivatives solely to manage and reduce mortgage interest rate risk so that lenders can offer the consumer-preferred, 30-year, fixed-rate mortgages. We use derivatives – primarily interest rate swaps – to fund and balance our mortgage portfolio and to reduce the portfolio’s overall exposure to interest rate risk. Interest rate swaps allow us to find new and less expensive sources of funds and to create funding structures that enable the company to better manage its portfolio. We use swaps and options, as bullet and callable debt alternatives, to create interest rate protection such as interest rate caps and floors, and to diversify our funding base.

Fannie Mae’s use of derivatives changes with market conditions. For example, when market demand for callable debt increases, we increase our use of such debt to manage interest rate risk. When the market for callable debt is less strong, we increase derivatives for the same purpose.

Dossani: We use callable debt as well as derivatives (for example, swaptions) to hedge the prepayment risk inherent in mortgage investments. We also use plain vanilla swaps, Treasuries and other instruments to rebalance the portfolio on a continual basis as interest rates move, to keep our duration gap close to zero. Instruments such as swaps and swaptions are commonly used by risk managers, simple to understand and extremely liquid. We also structure and select investments to lower the amount of prepayment risk inherent in our assets. Although we are always looking for ways to better hedge interest rate risk, we do not expect to use any new types of derivatives next year.

Only a handful of dealers have dedicated industrial-strength swaptions trading operations. Is the Street serving your needs in terms of hedging products? If not, what more could it provide in terms of products, pricing, execution or liquidity?

Niculescu: Fannie Mae redistributes a large share of mortgage risk to risk-sharing partners fully able to handle it. These include double- and triple-A rated mortgage insurance companies, large, well-capitalised commercial and investment banks and a wide range of sophisticated financial institutions. The Street is only an intermediary to derivatives end-users. Investor and issuer demand is high in paying floating and in selling options, and the Street has done a good job of intermediating that flow. We expect that to continue.

Dossani: Wall Street provides sufficient liquidity to the swaptions and swap markets, as evidenced by the billions of dollars that trade every day. We expect price discovery and transparency to continue to improve as new investors and dealers enter the market. We also use the futures markets as needed to help us rebalance the portfolio. And, as we noted earlier, we use callable debt and asset selection strategies to actively manage risk, thus reducing our reliance on liquidity in the derivatives market. We are willing to accept the lower margins this conservative risk position implies.

Some derivatives dealers currently maintain large short-volatility positions. Do you have concerns about managing your derivatives counterparty risk due to this? Are you doing anything in response, for example changing your counterparty credit risk limits or hedging strategies?

Niculescu: No. Fannie Mae manages credit and interest rate risk on US mortgages, which are one of the safest assets in the world. Our collateralisation policies protect us against derivatives counterparty risk. Fannie Mae’s counterparties are of high quality, consisting of sophisticated financial institutions, the major commercial and investment banks in the country – along with US subsidiaries of major foreign banks – and double- and triple-A rated mortgage insurance companies.

Dossani: We actively monitor and manage our counterparty credit risk. We use state-of-the-art risk management practices, including a robust collateralisation process and a comprehensive approach to credit limits to further reduce exposure.

What other concerns do you have and what do you think will be the defining issues for managing your risk in 2003? Do you think the debate over implicit government credit support is likely to continue this year, and how do you respond to that?

Niculescu: We expect a strong mortgage market in 2003, making it very attractive throughout the year. In fact, we think mortgage debt outstanding will grow faster than the overall economy largely because of population growth driven by immigration. Fannie Mae will not, however, diverge from its low-risk growth posture if opportunities to grow are not present.

Fannie Mae receives no Federal subsidy and our debt is not government guaranteed. Investors value Fannie Mae debt and equity primarily because we’re a low-risk company and because we produce strong returns. Additionally, our financial safety and soundness regime and the transparency of our business operations are world class. Given our issuance of subordinated debt, the implementation of risk-based capital and our very strong ratings, the debate is really a moot point.

Dossani: From a market standpoint we expect the themes experienced in 2002 to continue. These include: relatively low interest rates, high prepayments, and high volatility due to economic and geo-political risk. Over time, however, the major prepayment risk will shift back from extension risk to call risk (fast prepayments shortening the duration of the mortgage markets) as prepayments and new mortgage activity lowers the mortgage rate on the universe of conforming mortgages. As for the debate over ‘implicit government support’, we believe there is strong bipartisan support for Freddie Mac and its role in the US housing finance system. We are integral to supporting US homeownership, which plays an indispensable role in our economy.