Last Monday Fannie Mae announced that its portfolio duration gap decreased to negative 14 months on August 31 from negative nine months at the end of July. The GSE said the gap is the lowest level seen since fall 1997.

Two days later, Freddie Mac released its monthly interest-rate risk sensitivity disclosure as part of its Monthly Volume Summary report. In direct contrast to Fannie, Freddie revealed that its duration gap averaged approximately zero months for August, which is unchanged from July.

Aside from causing inevitable, and somewhat unfavorable, comparisons to archrival Freddie, Fannie Mae's short-term duration gap also raised concerns from a credit perspective.

"Some investors are (we think wrongly) concerned that a large duration gap impedes the credit health of Fannie Mae," said Deutsche Bank researchers in a report released before Fannie's announcement. "Others are simply worried that a string of duration gap numbers outside Fannie Mae's self-imposed six-month band will trigger regulatory or Congress jawboning about the gap. Any Agency spread widening in such a scenario would be a buying opportunity, in our opinion."

Most Street research last week viewed Fannie's 14-month duration gap as a good thing for MBS. UBS Warburg analysts called it a positive technical indicating that Fannie is probably going to be a heavy buyer in coming months.

Merrill Lynch researchers echoed this by saying, "We expect the gap and future paydowns to leave Fannie in a position to be active buyers of mortgages in the coming weeks."

However, some researchers warned that if interest rates hold steady or decline further, it may take longer for Fannie to bring the duration gap to within plus/minus six months.

A question of modeling?

Though many view Fannie's duration gap as a credit risk issue, some experts say that this might just be a question of modeling, and that the actual risk may be overstated, or less than is currently implied.

"Fannie Mae's reported duration gap is the model duration of its assets minus the duration on its liabilities (i.e. debt)," explained David Montano, head of mortgage research at JPMorgan. "But the duration of its liabilities is not model dependent and we argue that their model might be estimating durations that are too short, based on where the market is trading especially for very high premiums."

Montano noted in a report that Fannie's duration gap is based on model durations (OAD) for mortgages. He added that premium mortgages have been trading longer than most model OADs, as models have not taken into account factors like originator capacity constraints and the widening between primary and secondary rates, which make mortgages trade longer than the models imply.

The Freddie differential

Modeling issues may also account for the differences in Fannie's and Freddie's reported duration gaps. "It is possible that some of the difference between them could be due to differences in duration calculations on the asset side," Montano said.

Representatives from Fannie Mae have concurred with this statement. "Our number and the Freddie Mac number are not comparable," Fannie stated in a Q&A released with the August financial report. "Our duration gap is the simple difference between our asset durations and our liability durations. The duration number Freddie Mac cited was an estimate derived from their own internal measure of market value sensitivity, whose components are not known."

Because of the difference in results, there has been a lot of speculation in the market about Freddie being a much better manager of risk than Fannie. Different analysts said that Freddie Mac is generally viewed to be better hedged than Fannie Mae.

"I think Fannie thought that a 3.8% ten-year was a relatively improbable event and they were not fully hedged for that," said a senior mortgage analyst last Wednesday. "Freddie, on the other hand, was fully hedged for rates this low and Freddie might have done more derivative hedges in the interest derivatives market."

Experts say it's quite difficult to really know who is better positioned from the information that is made available. Many would say it's really a matter of two very different portfolio management styles.

"While we think both organizations want to grow their respective portfolios when it is more favorable to do so - optimal funding mix versus a basket of cheap mortgage assets - it appears from the numbers that each agency has its own strategy as to how it enters the market for mortgage product," said Kevin Jackson, a senior analyst from RBC Dain Rauscher.

He noted a possible reason for the difference in the duration gaps of the two GSEs is that, compared to Fannie, assets are not running off Freddie's portfolio as fast as current refinance volume suggests. Freddie's total retained portfolio liquidations as a percent of their total retained portfolio balance is only 16% year to date, in contrast to Fannie's 19%. He also said that the two agencies have their own models and assumptions, and use different prepayment analysis. Again, Fannie and Freddie may have different opinions on how to optimize asset/liability mix.

"The extent to which each agency picks the correct funding blend versus a particular asset will affect how their portfolio's duration gap drifts positive or negative," said Jackson.

What is Fannie to do?

In the same Q&A mentioned above, Fannie said it intends to rebalance quickly, but in a manner and at a pace that would not make undue demands on the market.

JPMorgan equity analysts stated that on the liability side Fannie is shortening the duration of its funding by "converting long-term debt into shorter maturities through the termination of swaps and options, issuing primarily short-term debt to fund growth, and buying additional hedging." Meanwhile, on the asset side, they said Fannie is buying longer duration assets, including lower-coupon mortgages for its retained portfolio, Treasurys and other securities.

MBS analysts think that Fannie's options are rather limited. "Basically, they can't issue all callable debt," said the senior mortgage analyst. "There is a market for their straight bullet maturities so they can't offset the callability of mortgages by issuing lots of callable debt. The market would choke on it at some point."

Fannie is also caught in a dilemma because traditionally it has not purchased passthroughs above par. However, with virtually the entire MBS market at a premium, Fannie either has to adjust its portfolio guidelines or sit this refinancing cycle through, placing its cash in other assets.

The senior mortgage analyst noted that a lot of Fannie's 6s, 7s and 7.5s will be paying off in the next few months, and Fannie is looking to plow its money "into longer duration stuff like 5.5s that would help their duration gap."

He added that this creates additional demand for 30-year 5.5s. Aside from buying 5.5s, he noted that Fannie could also be buying duration elsewhere, such as Treasurys, futures or swaps.

"It's probable that Fannie's activities are at least a small force in holding long rates down, lower than they would otherwise be."

In a related development, Armando Falcon, director of the Office of Federal Housing Enterprise Oversight (OFHEO), said he had met with senior Fannie Mae officials and is requiring weekly reports from OFHEO examiners on Fannie's exposure to interest rate risk. He also stated that he instructed the GSE to keep regulators apprised of any challenges that have to do with returning its interest rate risk measure to more acceptable levels. These statements were made in a letter sent to Reps. Richard Baker (R., La.) and Paul Kanjorski (D., Pa.) last Monday.

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