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How Fannie Operates



The short answer to this question in my mind is, not very much. Oh, of course Fannie Mae (FNM:NYSE) has an official role in our financial system: to buy mortgages from other lenders. Fannie Mae is indirectly subsidized by the government (in the form of implicit guarantees of solvency, which in effect makes its borrowing costs low) so that the prices it pays for these mortgages leaves these other lenders (banks, mortgage companies, etc.) with a nice profit. This has the effect of making mortgages cheaper than a "normal" market would otherwise provide. People who otherwise would not qualify for a mortgage or could not afford one because of the higher price are able to buy a house.

Some cynics might cry that a subsidized market such as this is not sustainable because the risk for reward is out of kilter: the cash flows generated are at the expense of too high risk, and eventually default rates will eat Fannie or completely wipe it out. I will leave it to you to ponder this question, for it is not my point.

A hedge fund basically tries to identify spreads (differences between highly correlated assets that offer a profit margin), lever those spreads, and then mitigate extraneous risks.

This is what Fannie Mae does. There are spreads between mortgage rates and interest rates. Fannie Mae creates liabilities by borrowing money (by issuing bonds) and creates assets by buying mortgages. We estimate that Fannie levers these spreads by about 62 times.

Besides default risk on mortgages, Fannie has another risk to mitigate that most people do not understand: pre-payment risk. When interest rates drop precipitously, people pay off their old mortgages and get new ones. If this happens quickly, Fannie is left without assets against its liabilities; in essence, it is no longer earning any spreads. In order to hedge this when it occurs, Fannie goes out and buys government bonds. The spread is not nearly as high as when it is earning mortgage rates, but it is better than nothing.

Now notice when Fannie buys government bonds to affect this hedge: when interest rates drop quickly (i.e. when bond prices rise). So Fannie is buying bonds aggressively when bond prices go up. Fannie must also sell them when rates rise and bond prices go down (to unwind this hedge). This is called duration risk by the analysts, a very sanguine term for being short options on interest rates. For those of you who are watching the bond market, have you been wondering who has been buying all those government bonds like crazy lately?

I have illustrated that Fannie is basically a hedge fund and that its main strategy is short gamma in the government bond market: The more volatile the government bond market, the more Fannie has to hedge, and the less money it makes (selling bonds low and buying them high causes losses). With Fannie's balance sheet being in the trillions of dollars caused by leverage equal to or greater than that employed by Long Term Capital Management, and Fannie's equity options trading around 25% (it has been lower) implied volatilities, I have been a buyer of volatility.

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