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Fannie Mae and Freddie Mac are at risk of losingbillions as a result of fluctuations in interest rates, according to a ""white paper"":http://origin.www.fhfaoig.gov/Content/Files/WPR-2013-01.pdf from the ""Federal Housing Finance Agency (FHFA) Office of Inspector General (OIG)"":http://fhfaoig.gov/.
[IMAGE]The white paper explained two types of interest rate risks. One is if the interest rate on short-term debt used to finance the purchase of mortgage assets increases and another is from prepayment risk, which could lead to a decline in how much the GSEs earn on their mortgage assets.
According to the OIG's paper, an increase of just 1 percentage point in interest rates could cause the GSEs to lose nearly $2 billion in the fair value of their assets.
To protect against interest rate risks, the OIG offered its own suggestions.
One strategy to mitigate interest rate risks is to issue more mortgage-backed securities (MBS) to investors, such as investment banks, according to the white paper. This transfers the interest rate risk associated with the MBS to investors.
The GSEs can also use derivatives, which act as a form of insurance and provide financial protection for when rates fluctuate.
[COLUMN_BREAK]To illustrate how derivatives reduce losses, the white paper examined data from the GSEs, which showed that at the end of 2011, a one percentage point increase in interest rates would have resulted in a combined loss of about $7.9 billion if derivatives were not employed to manage risks. With derivatives, exposure was reduced to $1.7 billion.
According to the white paper, the GSEs portfolios more than tripled after rising to $481 billion in 1997 to $1.6 trillion in 2008, which therefore substantially increased the GSEs' interest rate risk.
During that time, the Office of Federal Housing Enterprise Oversight (OFHEO), which FHFA replaced in 2008, determined the GSEs did not have the capacity, such as information systems and personnel, to successfully manage risks associated with the portfolios.
Since then, FHFA and Treasury have made efforts to reduce the size of the GSEs' portfolios to limit risks. Under the terms of the ""Preferred Stock Purchase Agreements"":http://www.treasury.gov/press-center/press-releases/Pages/tg1684.aspx (PSPAs), the GSEs are required to wind down their portfolios until they reach $250 billion for a combined total of $500 billion. They were first required to reduce their portfolios at an annual rate of 10 percent each year, but this was later changed to 15 percent.
As of the end of 2011, the GSEs' portfolios were valued at $1.3 trillion, according to the paper.
Thus, despite the efforts, the OIG stated interest rate risk still remains high.
One particular challenge for the GSEs is in how distressed mortgage assets will be handled.
Distressed assets are expected to remain in the GSEs' portfolios for a longer time, and may even mature in the portfolios, unless they are sold at a reduced price.
In addition, with distressed mortgage assets, FHFA noted it's more difficult to estimate how the assets will respond to interest rate changes, and so it is also difficult to use derivatives to hedge effectively against the risk of prepayment.
