By Jerry Knight Monday, September 23, 2002; Page E01
Today's record-low mortgage rates are saving homeowners hundreds of dollars a month in house payments. Everybody loves those 6 percent rates.
Everybody but the stockholders of Fannie Mae, the nation's biggest mortgage lender.
Shares of Fannie Mae took their worst single-day hit in four years Tuesday after the giant Washington-based, government-chartered mortgage company revealed that falling interest rates are making its business more risky.
The shares continued to fall after Merrill Lynch & Co. analyst Michael R. Hughes did the unthinkable: downgrading Fannie Mae stock to "neutral." Until then Fannie earned straight "buys" from Wall Street, just like its sibling rival across the Potomac in McLean, Freddie Mac.
Freddie Mac has kept its 100 percent "buy" ratings and has suffered less in the stock market than Fannie. Since Sept. 9, when both stocks hit a little peak, Fannie Mae shares have fallen 15.8 percent, or $12.12 a share, and Freddie Mac stock is off 9.5 percent, or $6.15 a share. Fannie Mae closed Friday at $64.60 a share, Freddie Mac at $58.55.
The result has been a massive loss of shareholder value for investors in Washington's two biggest financial institutions. The market value of Fannie Mae's stock has fallen by more than $10 billion, while Freddie Mac's shareholders are $4 billion poorer.
All because of a yardstick of risk that is so obscure most Washington investors have never heard of it.
Duration gap. You know what that is, don't you?
Peter Niculescu, Fannie Mae's senior vice president for portfolio strategy explains what it means at Fannie Mae, which borrows money by selling bonds worldwide and uses the cash to buy up financial institutions' mortgage loans all over America.
"We try to match our assets [the mortgages] so they pay off at the same time as our debts [the bonds]," he said.
Fannie Mae does not want to buy a 30-year mortgage using money that it borrows by issuing 10-year bonds. If it did that, when the bonds come due, there wouldn't be enough money to pay them off.
The mismatch between the life of the mortgage and the life of the bond is what financial folks call a duration gap. It is considered a crucial measure of how much risk Fannie Mae faces because of falling interest rates.
A duration gap is what did in the savings and loan industry a decade ago. The S&Ls made 30-year mortgage loans using money in passbook savings accounts that could be withdrawn at any time. When interest rates shot up, savers wanted to withdraw from their passbook accounts so they could reinvest their money at higher rates. The S&Ls couldn't pay up because the money was tied up in mortgages.
That's one kind of duration gap. Fannie has the opposite problem. Because so many people are refinancing, mortgages are being paid off before the matching bonds come due. When a homeowner pays off an old high-rate mortgage, of course, Fannie can use the cash to buy a new mortgage. But the new mortgage carries a much lower rate, too low in many cases to cover the interest due on Fannie's bonds.
When that happens, Fannie's profits shrink, which makes its stock worth less. The more people refinance, the more Fannie gets squeezed.
Avoiding that squeeze by matching up the life of their mortgages and the life of the bonds is tricky. People take out 30-year mortgages, but most of them don't keep their houses that long. They move, they refinance.
"When interest rates move significantly, our assets [mortgages] will either pay off sooner or pay off more slowly," depending on whether rates go up or down, Niculescu said. "With the sharp drop in mortgage rates, we believe many mortgage holders will refinance and if rates fall even further, many more mortgages will refinance."
Because of the recent decline in rates, Fannie Mae figures its mortgages are going to pay off an average of 14 months sooner than its bonds. In financial lingo, that's a duration gap of 14 months, much worse than the six months that is Fannie Mae's target.
Calculating that number when you are balancing hundreds of billions worth of mortgages with an equal amount of bonds is a math problem that challenges PhDs. You need to compare the interest rate on every one of the mortgages with the rates available today and guess who's going to refinance. Then you have to look at the housing market to estimate who's going to sell their house. Then you have to look at hundreds of possible scenarios for what could happen to interest rates next month, next year or several years from now.
When data for the month of August were fed into Fannie Mae's secret formula, the answer that came out last week was a 14-month duration gap.
That same day, Freddie Mac reported that its duration gap was just one month, a much safer number that had not gone up at all despite the big drop in interest rates.
The comparison renewed sibling rivalries and rapidly deteriorated into a he said-she said snit. "They don't calculate it the same way we do," Fannie sniffed. "No, but when we do it their way, it is still just one month," Freddie huffed.
Neutral observers like analyst Paul Miller of Friedman, Billings, Ramsey Group in Arlington said the duration gap illustrates the contrasting strategies Fannie and Freddie use to handle the risk of volatile interest rates.
"At Fannie, the theory is that they can manage themselves through this volatility. Freddie doesn't want to take any risk," he said. "Freddie hedges much more tightly."
"We are and always have been very conservative when it comes to risk management," Freddie Mac spokeswoman Sharon McHale said. "We hedge, basically, all the [interest-rate] risk out of our portfolio."
Fannie and Freddie try to protect themselves against interest-rate changes in two ways.
They issue bonds that are "callable," which means Fannie and Freddie might sell 10-year bonds, but have the option to pay them off sooner. Callable bonds carry higher interest rates to compensate investors for the risk of early repayment.
Both lenders also hedge their interest-rate risk by using complex deals called "derivatives." They pay Wall Street firms to set up custom-tailored transactions designed to produce gains that offset any losses caused by interest-rate changes.
Hedging costs money. The higher cost of eliminating almost all interest-rate risk is one reason why Freddie Mac, over the years, has earned smaller profit margins than Fannie Mae, Miller added.
Miller believes Fannie's widening duration gap will shrink over the coming months. Along with 10 other analysts last week, he reaffirmed his "buy" rating on the stock.
Bond market maven James Bianco, president of Bianco Research of Chicago, said the duration gap issue "has been a disaster for them in the bond market this week. The bonds have had an equally bad week as the stock."
In the bond market, a change of a few pennies in the value of a $1,000 bond issued by a company as solid as Fannie Mae is a big deal, explained Bianco, whose firm sells advice to big bond market investors.
Over the years, he said, bond buyers have favored Fannie Mae over Freddie Mac and have been willing to lend money to Fannie for slightly less than Freddie. Last week, for the first time, the tables turned. On Friday, the interest rate was 2.57 percent on Freddie Mac's three-year notes and 2.585 percent on an identical Fannie Mae note.
"What's happened to them is that they've gotten hit by the '100-year flood' in the bond market," Bianco said. "The 100-year flood is super-low interest rates."
Bianco thinks Fannie Mae's computer models to predict how the mortgage business will be affected by changes in interest rates -- and what to do about it -- didn't account for rates this low. "For years and years, their models have worked very well. Now they're finding that when you get to extreme interest rates, all the assumptions you make about what a homeowner does are out the window."
The average interest rate on 30-year, fixed-rate mortgages fell to 6.05 percent last week, the lowest in 40 years.
If Fannie's financial problems get serious, they could become the taxpayers' problems, said Karen Shaw Petrou, managing partner of Federal Financial Analytics, a Washington consulting firm. Fannie and Freddie have unique federal charters that allow them to turn to the U.S. Treasury for help if they get in trouble.
No one sees that happening at this point, but tighter monitoring of Fannie Mae was ordered last week by the Office of Federal Housing Enterprise Oversight, the obscure federal agency that must ensure Fannie and Freddie do not get into financial trouble that will require a government bailout.
Armando Falcon Jr., director of the oversight office, ordered Fannie to begin filing weekly reports on its exposure to interest-rate risks and what is being done about it.
The ties Fannie and Freddie have with the federal government have been a back-burner political issue for years, but the issue is suddenly heating up along with the interest-rate problem.
More on that in next week's Washington Investing column.
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