Search

Threat Of Rising Rates Poses Funding Risks For GSEs And Banks

by devteam March 12th, 2013 | Share

The Federal Housing Finance Agency’s (FHFA)rnOffice of the Inspector General (OIG) has issued a white paper detailing howrnFHFA manages the interest rate risk faced by the two government sponsoredrnenterprises (GSEs) Freddie Mac and Fannie Mae and the Federal Home Loan Banksrn(FHLBanks) it regulates.  OIG did thernstudy because the three entities face considerable risk of lose fromrnfluctuations in prevailing interests rates; an increase in rates of onernpercentage point could subject the GSEs to a loss of nearly $2 billion in thernfair value of their assets.  Such lossesrncould limit the ability of the Department of the Treasury to recover some ofrnthe financial assistance it has provided to the GSEs during theirrnconservatorships. </p

The white paper:</p<ol

  • Defines interest rate risk,</li
  • Identifies strategies by which such risk may be managed,</li
  • Traces the Enterprises’ historical exposure to interest rate risk and their management thereof, </li
  • Describes recent efforts tornlimit the GSEs’ interest rate risks, </li
  • Discusses the GSEs’rnongoing interest rate risk management challenges, and </li
  • Sets forth the issues and challenges the FHLBanks face inrnmanaging interest rate risk.</li</ol

    Credit risk, such as the risk that a mortgage willrnnot be repaid, wasrnone cause of the billions of dollars in losses suffered by the GSEs since 2007rnbut interest rate risk</bhas alsornposed substantial financial challenges. Prior to 2008, the Enterprises and some FHLBanks adopted business strategies that involved large interest rate risk exposures and did not alwaysrneffectively manage these risks. When the financial crisis struck in 2007 the Enterprises andrnsome FHLBanks faced considerable financial deterioration and operational challenges resulting from interest rate and related risks.rn</p

    Financial institutions that hold mortgage assets in theirrninvestment portfolios, such as the GSEs, face two generalrninterest 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, whenrnrates fall, they face prepayment risk, i.e., that borrowers will refinance their loans causing a decline in the institutions’ revenue and income.</p

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

    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 assetsrnwith 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 volumernof refinancing, the yield from such investments is no longer sufficient torncover the cost of the debt associated with the loans that remainrnin its portfolio. This, in turn, could cause the firm tornexperience a funding crisis, particularly if its capital levels are low.</p

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

    FHLBanks are not authorized to issuerntheir 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.</p

    The housing GSEs employ derivatives, financial instruments that act likerninsurance 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 GSEsrnto manage – or “hedge” – the risk that their short-term borrowing costs willrnincreasernrelative to the yield on their longer term mortgage assets, or that declining mortgage interest ratesrnwill increase borrower prepayments.</p

    The housing GSEs employ derivatives in two ways:rn</p<ul class="unIndentedList"<liUsing interest rate swaps to trade the fixed-rate interest payments characteristic of mortgagernloans for floating-rate interest paymentsrnthat 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.</li<liIssuing callable debt and buying call options in the capital markets. In the event ofrna 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 raternswaps, commonly known as "swaptions,"rnoffer the same general protection.</li</ul

    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 thernpotential for loss or gain if interest rates rise or fall.  Theyrncontinually monitorrnkey measures of interestrnraternrisk, such as duration and convexity, to help ensurernthat interest rate risks associated with retained mortgage portfolios are mitigated.  </p

    The GSEs periodically readjust their derivativernand callable debt positions tornrespondrnto changes in interest rates and maintainrna net- flat hedge ofrntheir retainedrnmortgage portfolios.</p

    Duration gap is the difference between the sensitivity to changes in market interestrnrates 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 arnduration gap of “zero,” indicates equally matched durations for assets andrnliabilities and generally low risk.  The GSEs use a variety of hedgingrntechniques to achieve a duration gap of zero. </p

    Convexity is the principal measurement of prepayment risk. Mortgage-relatedrnassets 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.</p

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

    From the late 1990s through 2008, the GSEs rapidly increased the size of their retained mortgage asset portfolios, and did so relativernto the amount of MBS they issuedrnto investors.  This involved significant risk andrnwas driven more by profitrnopportunities 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 ofrntheir retained mortgage portfoliosrncontributed to the decision to place them into conservatorshipsrnin September 2008.</p<p</p

    Pre-conservatorshiprnthernGSEs 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 increasingrnrapidly 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.</p

    </h3

    In 2006, OFHEO, FHFA’s predecessor imposed capsrnon the growth of the GSEs’ mortgage portfolios due to its concerns about theirrnsafety and soundnessrnbecause of credit risks, interest rate, and operational risks. However, OFHEO lifted therngrowth caps on March 1, 2008, when it determined that thernGSEs had made progress in complying with the terms of established supervisoryrnrequirements.</p

    FHFA examined the GSEs later than year and found they had set “aggressive” interest rate risk limits and had violated those limitsrn11 times in 2008 alone. FHFA also stated that Fannie Mae’s interest rate risk positions werernexcessive 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.</p

    Credit related losses, and not interest rate risk was the primary reason that Fannie Mae and Freddie Mac were placed into conservatorshiprnin September 2008 but the decision was informed, by the financial markets’rnperceptionsrnabout the GSEs’ ability to repay their short-term debtrnas their traditionally low borrowing costs rose amidst concern about their credit risks.  According to FHFA, the crisis in 2008rnwasrnso severe that the GSEsrnwere forced to fund their day-to-dayrnoperations with very short-term debt, e.g., debt with maturities ranging from overnight to lessrnthan one year, increasing their exposure to “roll-rnover risk,” i.e., that lenders would cut off their short-term credit and they would default on their obligations.  </p

    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 theirrninitial agreement with Treasury and its subsequent revisions the GSE’s arernrequired to reduce their portfolios originally by 10 percent annually and nowrnby 15 percent  to reach a maximum size of $250 billionrneach (or $500 billionrncombined) by 2018.rnFigure 10, below, shows the actual and projected declines inrnthe Enterprises’rnretained mortgage portfolios pursuant to the revised PSPAs.</p

    </p

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

    Although the GSEs’ overall interest rate risks are expected to declinernalong with their retained portfolios,rnsignificant challenges remainrndue 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.</p

    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,rndistressed assets,rnsuch as non-performing whole mortgages or distressed privaternlabel MBS (PLMBS) may be more difficult to sell for a variety of reasons.  There has been a shift in the composition of thernGSEs’ retained mortgage portfoliosrnto more illiquid assets over the past several yearsrnincluding a significant decline in readily marketable MBS from 2009 to 2012, and a significant increase in thernrelative proportion of whole loans in both Fannie Mae’s and Freddie Mac’s portfolios. rnMoreover, distressed whole loans, i.e., those that are delinquent or modified, accountedrnfor 60% of Fannie Mae’s whole mortgages and 50% ofrnFreddie Mac’s asrnof June 30, 2012.</p

    </p

    These distressed assetsrnpresent two riskrnmanagement challenges,rnfirst that the challenge is likely to be long term.  The second involves “modelrnrisk“, i.e. the mortgage assets are less likely to be prepaid in a manner that is consistent with the historical performance record usedrnas a basis for the GSEs’ computer models.rnThe GSEs may be unable to employ themrnto 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.</p

    While the GSEs have revised existing models, FHFA has call this arnstop-gap measure and said the GSEs must develop improvedrnmodels that better reflect the risks ofrnportfolios with elevated levels of distressed assets. rnFHFA has also found that the GSEs face human capital risks because of turnover of keyrnpersonnel responsible for interest rate risk management. </p

    From the late 1990s through 2008, some FHLBanks adoptedrnbusiness strategies that were, inrnsome respects, similar to thosernof the GSEs. Specifically, several FHLBanks rapidly increased the size of their mortgage asset portfolios and didrnnot 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,rnface ongoing interest rate risk management responsibilities and challenges.</p

    Beginning in the late 1990s, some FHLBanks began to increase the size of their mortgage assetrnportfolios by purchasing mortgages directlyrnfromrntheir members to hold on their balance sheets.rn Then, during the housing boom years of 2005 through 2007,rnseveral FHLBanks purchased larger amounts of PLMBS, partly to offset the loss of revenue and interest income associatedrnwith the decreasing demand for advances from member institutions.</p

    Because they do not havernauthority to issue MBS some FHLBanks had to use derivatives and other strategies tornmitigate the interest risk rate associated with their mortgage assets. rnThe inability to adequately manage interest rate risks led to severalrnoccasions then regulators issued enforcement agreements or put limits on one orrnmore Banks’ activities.  </p

    FHFA has reported somernimprovements in FHLBank interest rate exposure and risk management.  However, going forward, several continuernto face challenges in managingrnrate risks associated inrntheir large mortgage asset portfolios. As shown in below, seven FHLBanks’ mortgage asset portfoliosrnare greater than 25% of their total assets. FHFA has expressed concern over the fact that certain assetsrnin these portfolios, such as PLMBS and MBS,rnwhich are classified as “non-core” missionrnactivities, do not materially contribute to thernFHLBanks’ housing missionrnand, over thernyears, have increased risksrnwithin the FHLBankrnSystem. </p

    </h3

    Moreover, the FHLBanks face model risk challenges that are, in some respects, similar to thosernfaced by the GSEs Inrnparticular, modeled prepaymentsrnhave been much greater than actual prepayments. Consequently, the FHLBanks may face challenges in usingrnderivatives to hedge effectively against the prepayment risks associated with their mortgage asset portfolios.

    All Content Copyright © 2003 – 2009 Brown House Media, Inc. All Rights Reserved.nReproduction in any form without permission of MortgageNewsDaily.com is prohibited.

  • About the Author

    devteam

    Steven A Feinberg (@CPAsteve) of Appletree Business Services LLC, is a PASBA member accountant located in Londonderry, New Hampshire.

    See all blogs
    Share

    Comments

    Leave a Comment

    Leave a Reply

    Latest Articles

    Real Estate Investors Skip Paying Loans While Raising Billions

    By John Gittelsohn August 24, 2020, 4:00 AM PDT Some of the largest real estate investors are walking away from Read More...

    Late-Stage Delinquencies are Surging

    Aug 21 2020, 11:59AM Like the report from Black Knight earlier today, the second quarter National Delinquency Survey from the Read More...

    Published by the Federal Reserve Bank of San Francisco

    It was recently published by the Federal Reserve Bank of San Francisco, which is about as official as you can Read More...