With the word "derivatives" recently getting a lot of bad press, Fannie Mae's and Freddie Mac's use of these instruments have come under increased scrutiny not only by the different trade groups who have long established crusades against the two agencies but also by their regulators.

The Office of Federal Housing Enterprise Oversight (OFHEO), safety and soundness regulator for Fannie Mae and Freddie Mac, recently announced it has formed a Working Group on Derivatives to monitor the GSEs' derivative activities, said sources at OFHEO.

Although OFHEO's examination staff has been monitoring the GSEs' use of derivatives for more than six years, OFHEO's Director, Armando Falcon, Jr., said through a spokesman that the Group was established last month "to formalize and bring together the various disciplines within the regulatory agency - the examination, legal, policy and risk-based capital experts."

"We have a team of examiners who are constantly looking at what the Enterprises do in terms of their usage of these derivatives," said G. Scott Calhoun, OFHEO's Chief Examiner. "Having established that, I can state that we are comfortable with their use of derivatives. We think that they use derivatives prudently, manage the risk well and they use them to manage their interest rate risk."

Calhoun added that by establishing this Working Group OFHEO is taking "a more holistic look at the environment in which this type of risk management is happening." Calhoun said it is "a way to make sure that the regulator is considering all of the salient factors that would constitute a risk to Fannie and Freddie in terms of the derivatives market."

"We are poring over the individual transactions," Calhoun said, adding that they "continuously evaluate the GSEs' strategies and practices."

As indicated earlier, the agency is also closely looking at events that would impact GSE derivative activities such as the consolidation over the last several years in the financial services sector of companies that are active in derivatives trading.

Questions raised

There have been some questions raised by representatives of trade groups known for having anti-GSE leanings about Fannie's and Freddie's hedging activities

Peter Wallison, a fellow at the American Enterprise Institute, is questioning why, as indicated by Fannie's 2000 financial statements, the firm was hedging their interest rate risk with derivatives that had a value of about $320 billion while the firm has assets worth about $700 billion.

"How can they be hedging an interest-rate risk for $700 billion in assets with only $320 billion in notional amount of derivatives," asked Wallison.

Experts say that the discrepancy is caused by the fact that there is no parallel way to report the firm's use of derivatives relative to the amount of its assets.

Swings in equity

There have been recent questions as well about swings in the GSEs' shareholder equity.

According to analysts, this is caused by the fact that Fannie and Freddie use held to maturity accounting for their MBS portfolios. This means the agencies do not really mark to market their securities portfolios.

However, it is required under FASB 133 that companies must market a derivatives position if it is not tied directly to an individual security or cashflow. Because the GSEs hedge their entire portfolio and not individual bonds, they must mark to market the derivatives portfolios that hedge the MBS portfolios. In other words, accounting standards force them to mark to market the hedge but not the assets being hedged.

The discrepancy cited in their financial statements result because they are marking to market only one side of the trade, or the hedge. If Fannie lost $4.5 billion on its derivatives hedge, for instance, it has a commensurate gain in its securities portfolio. However, the gains on bond holdings never show up in the financials because they cannot mark their bond holdings to market.

Sources say that this accounting effect is a major problem with FASB 133. In some circumstances, this is actually causing some financial institutions not to hedge to avoid the accounting headaches. In this sense, FAS 133 is increasing risk in the system and not reducing it.

"The irony is institutions like Fannie and Freddie that use derivatives to hedge their positions in aggregate end up introducing big variations in earnings and shareholder equity from employing risk reducing strategies," said an analyst. "They use derivatives to reduce risk, but have more earnings variability. While other institutions may choose not to hedge and have bigger risks, but more stable earnings."

Why not higher than triple-A?

AEI's Wallison also questioned the diversification of Fannie's counterparties as well as why these counterparties are mostly rated only single-A and not higher.

Representatives from both Fannie and Freddie said that although they do make use of single-A rated counterparties, they ensure that they require from these counterparties full collateralization of their exposure. Aside from these, other sources confirmed that Fannie uses 21 or 22 counterparties, while Freddie is also said to be using a similar number.

"Our counterparties are broad, deep and are of high-quality," said McCarson. "Not only that but all our agreements are highly-collateralized to the point that although last year our exposure was $533 billion notional, our actual exposure was actually only $150 million, which is less than a week's worth of our revenues."

This conservative approach is mirrored in Freddie Mac's spokesperson Sharon Mchale statement.

"We use derivatives for the sole purpose of managing interest rate risk, and not to speculate," Mchale said. "It's actually because we are very conservative and disciplined in managing interest rate risks that we use derivatives because of their powerful ability to reduce interest-rate exposure."

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.