<font size="3" color="blue"><b>Derivatives Risk Casts Long Shadow Over Freddie, Fannie</b></font>
By Peter Eavis
Senior Columnist
Originally posted at 1:10 PM ET 7/10/01 on RealMoney.com
<a href="http://www.thestreet.com/comment/detox/1486090.html" target="web">thestreet.com Link</a>
Consider it Fannie Mae (FNM:NYSE - news - commentary) and Freddie Mac's (FRE:NYSE - news - commentary) biggest nightmare.
Last week, a large U.S.-focused mortgage company said it was booking nearly half a billion dollars in losses because it made a series of bum bets with derivatives, the complex financial instruments that companies use to hedge risks.
The firm in question is HomeSide Lending, which is owned by National Australia Bank (NAB:NYSE - news - commentary). HomeSide took a $450 million pretax provision to cover a writedown in the value of what are called mortgage servicing rights. Essentially, HomeSide buys from mortgage lenders the rights to collect and administer payments made by mortgage borrowers. It collects a fee for doing the servicing.
HomeSide got into trouble because, as key interest rates have fallen this year, more borrowers have prepaid their mortgages than anticipated. This reduces revenue from the servicing rights because loans to which the company held rights have been refinanced out of existence. HomeSide normally hedges against the prepayment risk with derivatives, but this time these instruments didn't give the necessary protection. The company explained: "Extreme volatility in the U.S. interest rate markets has adversely impacted HomeSide's United States hedging positions."
Enter Fannie and Freddie, two of the most loved financial stocks. They also hedge against prepayment risk, with specially constructed bonds and derivatives. For the most part, they've repeatedly gotten their bets right. But over the past 10 years, both institutions have massively changed their business plans to carry much more risk on their own balance sheets. As a result, any hedging failure could crush earnings.
<b>Undiversifying</b>
Fannie and Freddie have two main businesses. Originally, their revenue streams were dominated by the fees they got from providing guarantees on mortgages that were bundled into mortgage-backed bonds.
<center><font color="blue"></b>Overload?</b>
Fannie and Freddie's retained mortgages
<img src="http://www.thestreet.com/comment/detox/1485009.gif">
Source: Fannie Mae, Freddie Mac, Detox</font></center>
But now most of their revenues come from mortgages that they buy and keep on their books. They make money when the interest paid on these retained mortgages is greater than the interest that Fannie and Freddie pay out on the borrowings they make to finance the mortgage purchases.
Fannie and Freddie have managed to do this trade on such a large scale because they enjoy below-market financing costs. How so?
First, bond investors believe the government would step in to shore up these companies if they ever got into trouble. As a result, the interest rates on Fannie and Freddie bonds are lower than those on large banks' borrowings. Second, the government has given Fannie and Freddie substantial operating advantages over other lenders, like low capital requirements, tax and regulatory exemptions, and (untapped) credit lines with the U.S. Treasury. (Though privately owned, Fannie and Freddie were established by the federal government and operate under government charters.)
Low-cost funding has enabled explosive growth. Freddie's retained mortgage portfolio has grown fivefold since 1994, going from $73 billion in 1994 to $386 billion in 2000. From $221 billion in 1994, Fannie's soared 175% to $607 billion in 2000. Net interest income on the retained portfolio accounted for nearly two-thirds of revenues at Freddie last year, up from just over half in 1996. At Fannie, that share has gone from 73% in 1996 to 81% in 2000.
<b>Spreads Like Butter</b>
So how does the prepayment issue affect Fannie and Freddie -- and how could it be their undoing? A large wave of prepayments can potentially harm them because they lose higher-interest mortgages as borrowers refinance to gain advantage from lower rates. Fannie and Freddie have to make sure that they can quickly bring down their own borrowing costs so that they can maintain the profit margin, or spread, between their interest income from retained mortgages and their interest expense.
They do this by using derivatives. They also issue callable bonds that can be bought back before maturity, thus freeing Fannie and Freddie from paying higher interest rates and allowing them to issue replacement debt at the lower rates. However, this means they have to get their derivatives bets right and make sure to issue the right amount of callable debt.
Too little callable debt means the profit spread gets squeezed. In 1998, when mortgage prepayments were rampant, Fannie's interest costs went up more quickly than interest income, resulting in a meager 4% revenue increase from its retained mortgages. Freddie fared much better in that year.
The prepayment boom didn't appear to harm either institution in the first quarter, and analysts don't see any damage in the second quarter or the remainder of this year.
But it would be wrong to relax. Fannie and Freddie look very much like huge hedge funds that are continuously betting on prepayment risk. Like other large hedge funds, they may get it right for years and then have one terrible year. After all, until last week, National Australia Bank had a sterling reputation for risk management.
<b>Pay Me Now...</b>
And there are other risks at Fannie and Freddie. If interest rates go up quickly, borrowers will be less likely to prepay. In that scenario, Fannie and Freddie may end up having to roll over their own debt at higher interest rates without getting a sufficient increase in interest income from their retained mortgages. Moreover, the torrid growth in the retained portfolios may have masked problems from investors that would surface in a slower economic environment.
One other factor clouding Fannie and Freddie's outlook is the coming collapse of the current housing bubble. Single family home sales are near record highs, and prices of such homes increased at an annualized 10% in the first five months of 2001 as interest rates have fallen and spurred refinancing.
That sort of appreciation is unsustainable -- and so is Fannie and Freddie's government-sponsored business model.
<i>Fair use principals apply!</i>
By Peter Eavis
Senior Columnist
Originally posted at 1:10 PM ET 7/10/01 on RealMoney.com
<a href="http://www.thestreet.com/comment/detox/1486090.html" target="web">thestreet.com Link</a>
Consider it Fannie Mae (FNM:NYSE - news - commentary) and Freddie Mac's (FRE:NYSE - news - commentary) biggest nightmare.
Last week, a large U.S.-focused mortgage company said it was booking nearly half a billion dollars in losses because it made a series of bum bets with derivatives, the complex financial instruments that companies use to hedge risks.
The firm in question is HomeSide Lending, which is owned by National Australia Bank (NAB:NYSE - news - commentary). HomeSide took a $450 million pretax provision to cover a writedown in the value of what are called mortgage servicing rights. Essentially, HomeSide buys from mortgage lenders the rights to collect and administer payments made by mortgage borrowers. It collects a fee for doing the servicing.
HomeSide got into trouble because, as key interest rates have fallen this year, more borrowers have prepaid their mortgages than anticipated. This reduces revenue from the servicing rights because loans to which the company held rights have been refinanced out of existence. HomeSide normally hedges against the prepayment risk with derivatives, but this time these instruments didn't give the necessary protection. The company explained: "Extreme volatility in the U.S. interest rate markets has adversely impacted HomeSide's United States hedging positions."
Enter Fannie and Freddie, two of the most loved financial stocks. They also hedge against prepayment risk, with specially constructed bonds and derivatives. For the most part, they've repeatedly gotten their bets right. But over the past 10 years, both institutions have massively changed their business plans to carry much more risk on their own balance sheets. As a result, any hedging failure could crush earnings.
<b>Undiversifying</b>
Fannie and Freddie have two main businesses. Originally, their revenue streams were dominated by the fees they got from providing guarantees on mortgages that were bundled into mortgage-backed bonds.
<center><font color="blue"></b>Overload?</b>
Fannie and Freddie's retained mortgages
<img src="http://www.thestreet.com/comment/detox/1485009.gif">
Source: Fannie Mae, Freddie Mac, Detox</font></center>
But now most of their revenues come from mortgages that they buy and keep on their books. They make money when the interest paid on these retained mortgages is greater than the interest that Fannie and Freddie pay out on the borrowings they make to finance the mortgage purchases.
Fannie and Freddie have managed to do this trade on such a large scale because they enjoy below-market financing costs. How so?
First, bond investors believe the government would step in to shore up these companies if they ever got into trouble. As a result, the interest rates on Fannie and Freddie bonds are lower than those on large banks' borrowings. Second, the government has given Fannie and Freddie substantial operating advantages over other lenders, like low capital requirements, tax and regulatory exemptions, and (untapped) credit lines with the U.S. Treasury. (Though privately owned, Fannie and Freddie were established by the federal government and operate under government charters.)
Low-cost funding has enabled explosive growth. Freddie's retained mortgage portfolio has grown fivefold since 1994, going from $73 billion in 1994 to $386 billion in 2000. From $221 billion in 1994, Fannie's soared 175% to $607 billion in 2000. Net interest income on the retained portfolio accounted for nearly two-thirds of revenues at Freddie last year, up from just over half in 1996. At Fannie, that share has gone from 73% in 1996 to 81% in 2000.
<b>Spreads Like Butter</b>
So how does the prepayment issue affect Fannie and Freddie -- and how could it be their undoing? A large wave of prepayments can potentially harm them because they lose higher-interest mortgages as borrowers refinance to gain advantage from lower rates. Fannie and Freddie have to make sure that they can quickly bring down their own borrowing costs so that they can maintain the profit margin, or spread, between their interest income from retained mortgages and their interest expense.
They do this by using derivatives. They also issue callable bonds that can be bought back before maturity, thus freeing Fannie and Freddie from paying higher interest rates and allowing them to issue replacement debt at the lower rates. However, this means they have to get their derivatives bets right and make sure to issue the right amount of callable debt.
Too little callable debt means the profit spread gets squeezed. In 1998, when mortgage prepayments were rampant, Fannie's interest costs went up more quickly than interest income, resulting in a meager 4% revenue increase from its retained mortgages. Freddie fared much better in that year.
The prepayment boom didn't appear to harm either institution in the first quarter, and analysts don't see any damage in the second quarter or the remainder of this year.
But it would be wrong to relax. Fannie and Freddie look very much like huge hedge funds that are continuously betting on prepayment risk. Like other large hedge funds, they may get it right for years and then have one terrible year. After all, until last week, National Australia Bank had a sterling reputation for risk management.
<b>Pay Me Now...</b>
And there are other risks at Fannie and Freddie. If interest rates go up quickly, borrowers will be less likely to prepay. In that scenario, Fannie and Freddie may end up having to roll over their own debt at higher interest rates without getting a sufficient increase in interest income from their retained mortgages. Moreover, the torrid growth in the retained portfolios may have masked problems from investors that would surface in a slower economic environment.
One other factor clouding Fannie and Freddie's outlook is the coming collapse of the current housing bubble. Single family home sales are near record highs, and prices of such homes increased at an annualized 10% in the first five months of 2001 as interest rates have fallen and spurred refinancing.
That sort of appreciation is unsustainable -- and so is Fannie and Freddie's government-sponsored business model.
<i>Fair use principals apply!</i>