The Federal Housing Finance Agency's (FHFA) Office of the Inspector General (OIG) has issued a white paper detailing how FHFA manages the interest rate risk faced by the two government sponsored enterprises (GSEs) Freddie Mac and Fannie Mae and the Federal Home Loan Banks (FHLBanks) it regulates.  OIG did the study because the three entities face considerable risk of lose from fluctuations in prevailing interests rates; an increase in rates of one percentage point could subject the GSEs to a loss of nearly $2 billion in the fair value of their assets.  Such losses could limit the ability of the Department of the Treasury to recover some of the financial assistance it has provided to the GSEs during their conservatorships.

The white paper:

  1. Defines interest rate risk,
  2. Identifies strategies by which such risk may be managed,
  3. Traces the Enterprises' historical exposure to interest rate risk and their management thereof,
  4. Describes recent efforts to limit the GSEs' interest rate risks,
  5. Discusses the GSEs' ongoing interest rate risk management challenges, and
  6. Sets forth the issues and challenges the FHLBanks face in managing interest rate risk.

Credit risk, such as the risk that a mortgage will not be repaid, was one cause of the billions of dollars in losses suffered by the GSEs since 2007 but interest rate risk has also posed substantial financial challenges. Prior to 2008, the Enterprises and some FHLBanks adopted business strategies that involved large interest rate risk exposures and did not always effectively manage these risks. When the financial crisis struck in 2007 the Enterprises and some FHLBanks faced considerable financial deterioration and operational challenges resulting from interest rate and related risks.

Financial institutions that hold mortgage assets in their investment portfolios, such as the GSEs, face two general interest rate risks.  When rates rise, they face extension risk, i.e., they risk being "stuck" with a portfolio of super low rates in a rising rate environment.  Second, when rates fall, they face prepayment risk, i.e., that borrowers will refinance their loans causing a decline in the institutions' revenue and income.

Prepayments may increase in a falling interest rate environment, causing financial firms, such as the GSEs, to forfeit a significant portion of the gains they would otherwise expect to derive from holding above-market rate mortgage assets. A wave of such mortgage refinancings would be expected to significantly reduce the revenues and profits generated by the firm's mortgage portfolio.

There is also some risk that a financial firm's capacity to fund its operations and remain solvent could be jeopardized by prepayments associated with falling mortgage interest rates.  Suppose that a hypothetical firm finances the purchase of its mortgage assets with relatively longer-term debt on which the firm would likely be required to make a correspondingly higher interest rate payment. If the firm's mortgage assets prepay due to declining interest rates, then, assuming a significant volume of refinancing, the yield from such investments is no longer sufficient to cover the cost of the debt associated with the loans that remain in its portfolio. This, in turn, could cause the firm to experience a funding crisis, particularly if its capital levels are low.

The housing GSEs can employ several strategies and tools to mitigate the interest rate risks discussed above.  They have the option of issuing relatively more MBS to investors, transferring the interest rate risk associated with the MBS. 

FHLBanks are not authorized to issue their own MBS and, therefore, cannot use them to manage interest rate risk and consequently retain all risk associated with mortgage assets that they elect to purchase and hold in their portfolios.

The housing GSEs employ derivatives, financial instruments that act like insurance policies, to manage the interest rate and prepayment risks associated with their mortgage assets by transferring these risks to their counterparties, such as investment and commercial banks.  In general, derivatives permit the GSEs to manage - or "hedge" - the risk that their short-term borrowing costs will increase relative to the yield on their longer term mortgage assets, or that declining mortgage interest rates will increase borrower prepayments.

The housing GSEs employ derivatives in two ways:

  • Using interest rate swaps to trade the fixed-rate interest payments characteristic of mortgage loans for floating-rate interest payments that correspond more closely to their short-term borrowing costs. If short-term interest rates rise, then the GSEs gain additional cash flow from floating-rate interest payments under the swaps.
  • Issuing callable debt and buying call options in the capital markets. In the event of a decline in rates, the GSEs can redeem their callable debt at lower rates to match the declining rate of their mortgage investments. Call options on interest rate swaps, commonly known as "swaptions," offer the same general protection.

A primary goal of the GSEs' strategies is to limit interest rate risk through a process that is known as "net- flat" hedging which is intended to minimize the potential for loss or gain if interest rates rise or fall.  They continually monitor key measures of interest rate risk, such as duration and convexity, to help ensure that interest rate risks associated with retained mortgage portfolios are mitigated.  

The GSEs periodically readjust their derivative and callable debt positions to respond to changes in interest rates and maintain a net- flat hedge of their retained mortgage portfolios.

Duration gap is the difference between the sensitivity to changes in market interest rates of the GSEs' interest-yielding assets, such as retained mortgage portfolios, and their liabilities, such as GSE-issued debt securities, as well as derivatives. The duration gap is usually expressed as a period of time, in this case months and a duration gap of "zero," indicates equally matched durations for assets and liabilities and generally low risk.  The GSEs use a variety of hedging techniques to achieve a duration gap of zero.

Convexity is the principal measurement of prepayment risk. Mortgage-related assets are said to have negative convexity; that is, due to prepayment risk, the GSEs' mortgage asset prices may not rise as much in a declining interest rate environment as might otherwise be expected. In such an environment, prepayments can reduce expected revenue and profits from mortgage assets, impairing their value.

Derivatives are essential to the management of interest rate risk, but there are costs and risks associated with their use.  These include increased expenses and increased counterparty risks.

From the late 1990s through 2008, the GSEs rapidly increased the size of their retained mortgage asset portfolios, and did so relative to the amount of MBS they issued to investors.  This involved significant risk and was driven more by profit opportunities enabled by the federal government's implicit financial support rather than market fundamentals. Regulatory concluded that the GSEs often failed to manage the risks associated with their large mortgage portfolios. Moreover, financial market fears that the Enterprises would be unable to repay the large debt incurred to fund the growth of their retained mortgage portfolios contributed to the decision to place them into conservatorships in September 2008.

Pre-conservatorship the GSEs also dramatically increased their use of derivatives.  As shown in Figure 9 below, the "notional value" of the Enterprises' derivative contracts was below $300 billion in 1997 before increasing rapidly to $2.2 trillion by 2003.  After falling to $1.4 trillion in 2005, the notional value of the Enterprises' derivatives contracts rose again to nearly $2.6 trillion by 2008.

In 2006, OFHEO, FHFA's predecessor imposed caps on the growth of the GSEs' mortgage portfolios due to its concerns about their safety and soundness because of credit risks, interest rate, and operational risks. However, OFHEO lifted the growth caps on March 1, 2008, when it determined that the GSEs had made progress in complying with the terms of established supervisory requirements.

FHFA examined the GSEs later than year and found they had set "aggressive" interest rate risk limits and had violated those limits 11 times in 2008 alone. FHFA also stated that Fannie Mae's interest rate risk positions were excessive and that both GSEs were unable to assess adequately and report on their interest rate risk exposures, and faced increasing risks that counterparties would be unable to meet the obligations under their derivative contracts.

Credit related losses, and not interest rate risk was the primary reason that Fannie Mae and Freddie Mac were placed into conservatorship in September 2008 but the decision was informed, by the financial markets' perceptions about the GSEs' ability to repay their short-term debt as their traditionally low borrowing costs rose amidst concern about their credit risks.  According to FHFA, the crisis in 2008 was so severe that the GSEs were forced to fund their day-to-day operations with very short-term debt, e.g., debt with maturities ranging from overnight to less than one year, increasing their exposure to "roll- over risk," i.e., that lenders would cut off their short-term credit and they would default on their obligations.  

Post conservancy FHFA and Treasury have moved to significantly reduce the size of the GSEs' portfolios and thereby limit their interest rate and prepayment risks. Under the terms of their initial agreement with Treasury and its subsequent revisions the GSE's are required to reduce their portfolios originally by 10 percent annually and now by 15 percent  to reach a maximum size of $250 billion each (or $500 billion combined) by 2018. Figure 10, below, shows the actual and projected declines in the Enterprises' retained mortgage portfolios pursuant to the revised PSPAs.

Although the scheduled reductions in the mortgage portfolios will likely reduce the associated interest rate risk over time, the portfolios are still large and considerable interest rate risks remain, classified in FHFA's 2011 examinations as a "significant concern."

Although the GSEs' overall interest rate risks are expected to decline along with their retained portfolios, significant challenges remain due to the relatively higher proportion of illiquid assets and the relatively new interest rate challenges (e.g., model risk) that they present. Moreover, the GSEs continue to face human capital risks.

FHFA has observed that as the GSEs most efficiently comply with the mandated portfolio reductions they sell performing assets that are readily marketable, such as their own MBS. On the other hand, distressed assets, such as non-performing whole mortgages or distressed private label MBS (PLMBS) may be more difficult to sell for a variety of reasons.  There has been a shift in the composition of the GSEs' retained mortgage portfolios to more illiquid assets over the past several years including a significant decline in readily marketable MBS from 2009 to 2012, and a significant increase in the relative proportion of whole loans in both Fannie Mae's and Freddie Mac's portfolios.  Moreover, distressed whole loans, i.e., those that are delinquent or modified, accounted for 60% of Fannie Mae's whole mortgages and 50% of Freddie Mac's as of June 30, 2012.

These distressed assets present two risk management challenges, first that the challenge is likely to be long term.  The second involves "model risk", i.e. the mortgage assets are less likely to be prepaid in a manner that is consistent with the historical performance record used as a basis for the GSEs' computer models. The GSEs may be unable to employ them to reliably estimate things such as the speed at which mortgages will be prepaid and, thus, employ derivatives to hedge effectively against the risk of prepayment.

While the GSEs have revised existing models, FHFA has call this a stop-gap measure and said the GSEs must develop improved models that better reflect the risks of portfolios with elevated levels of distressed assets.  FHFA has also found that the GSEs face human capital risks because of turnover of key personnel responsible for interest rate risk management.

From the late 1990s through 2008, some FHLBanks adopted business strategies that were, in some respects, similar to those of the GSEs. Specifically, several FHLBanks rapidly increased the size of their mortgage asset portfolios and did not always manage the associated interest rate risks effectively. Indeed, one FHLBank faced a severe financial crisis in early 2009 due, in part, to adverse interest rate movements. Although FHFA has recently observed improvements in the FHLBanks' ability to manage their interest rate risks, several continue to maintain large mortgage asset portfolios and, thus, face ongoing interest rate risk management responsibilities and challenges.

Beginning in the late 1990s, some FHLBanks began to increase the size of their mortgage asset portfolios by purchasing mortgages directly from their members to hold on their balance sheets.  Then, during the housing boom years of 2005 through 2007, several FHLBanks purchased larger amounts of PLMBS, partly to offset the loss of revenue and interest income associated with the decreasing demand for advances from member institutions.

Because they do not have authority to issue MBS some FHLBanks had to use derivatives and other strategies to mitigate the interest risk rate associated with their mortgage assets.  The inability to adequately manage interest rate risks led to several occasions then regulators issued enforcement agreements or put limits on one or more Banks' activities. 

FHFA has reported some improvements in FHLBank interest rate exposure and risk management.  However, going forward, several continue to face challenges in managing rate risks associated in their large mortgage asset portfolios. As shown in below, seven FHLBanks' mortgage asset portfolios are greater than 25% of their total assets. FHFA has expressed concern over the fact that certain assets in these portfolios, such as PLMBS and MBS, which are classified as "non-core" mission activities, do not materially contribute to the FHLBanks' housing mission and, over the years, have increased risks within the FHLBank System.

Moreover, the FHLBanks face model risk challenges that are, in some respects, similar to those faced by the GSEs In particular, modeled prepayments have been much greater than actual prepayments. Consequently, the FHLBanks may face challenges in using derivatives to hedge effectively against the prepayment risks associated with their mortgage asset portfolios.