It attributed the widening of the duration gap to a surge in mortgage refinancing levels during the past few months as US mortgage rates have hit record lows. “Rates are low enough that virtually everyone with a mortgage can refinance,” said an analyst at a major US bank.
Unlike traditional government bonds, mortgage bonds have negative convexity, due to an option embedded within them. Decreasing interest rates offer mortgage holders the opportunity to exercise this option and refinance their mortgages at lower levels, which in turn serves to lower the duration of agencies' mortgage assets.
The reduction of Fannie Mae's duration gap this month has been all the more noteworthy, according to George Oomman, chief strategist for fixed-income derivatives at Credit Suisse First Boston in New York, given the rally in the fixed-income markets over the past few months, which has presented greater refinancing opportunites for mortgage holders.
"The move from minus 14 to minus 10 months is noteworthy given the recent market rally," said Oomman.
Analysts believe Fannie Mae has improved its position through a combination of methods, including reducing its fixed swap positions, either through cancelling existing swaps or by receiving fixed, and buying treasuries and mortgage assets. Cancelling existing swap transactions would allow it another benefit, as the cost of terminating swaps could be amortised over the life of the swaps, essentially making near-term earnings appear more favourable.
Despite yesterday’s early monthly announcement, analysts still expressed reservations about Fannie’s hedging programme. While Fannie Mae’s duration gap has fallen significantly outside its target of plus or minus six months, Freddie Mac, the other major government-sponsored mortgage enterprise in the US, has reported a maximum one-month duration gap over the past year.
The two US mortgage agencies are active players in the US swaps market, although analysts believe Freddie Mac to be the more aggressive in its hedging activity. Fannie Mae’s notional derivatives exposure stood at $594.5 billion at the end of June, while Freddie Mac reported a total derivatives exposure of $1.1 trillion. An analyst at Freddie Mac said that, unlike Fannie, it had not found it difficult to manage duration in the current environment.
“It would take a tremendous lack of vigilance on our part to get to that figure,” said the official, who requested anonymity.
Fannie Mae found itself in a similar situation in October 2001, when its duration gap widened to 10 months. The mortgage agency was able to reverse this the following month, though, after interest rates shot up, allowing it to better match its asset/liability cashflows using its treasury holdings. With the US Federal Reserve more likely to ease interest rates in the coming months, it seems highly unlikely that the company will see a repeat of this favourable situation.
“They have worse risk management than Freddie, which has positioned itself to be better hedged in all interest rate environments,” claimed an analyst at a major US investment bank.
Fannie Mae refused to comment any further on the matter.