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The Bottom Line Problem with Fannie Mae



Most pundits think rising mortgage debt is a good thing for Fannie Mae (FNM:NYSE) and the other GSE's: more loans, more revenues, and therefore, more profits. This sounds right, but things don't work that way in the world of derivatives (which FNM is inextricably tied to).

I have explained how and why the GSE's must hedge and re-hedge their duration risk by trading government bonds: they must buy bonds as the price rises and sell bonds as it declines. As the size of their transactions rises (as a function of the size of mortgage debt), it follows that these companies actually create the higher volatility in the bond market that they so much fear. This is the nature of gamma: it is directly affected by supply and demand.

For example, in 1996 if FNM is analyzing their duration position after a certain move in interest rates (bond prices) decides it must buy $25 million in bonds, the same move in 2003 would cause them to buy $50 million in bonds. Unless the government bond market (floatable debt) has risen commensurately, it follows this doubling of the necessary transaction will move the market more (increase volatility). In fact, the total outstanding amount of government bonds has remained fairly constant at around $3.7 trillion (total federal debt has actually increased during this time from $5 trillion to $6.7 trillion, but by way of infamous government accounting, the Clinton administration swapped out a chunk of this to Social Security). So the overall negative bond gamma for the GSE's has basically doubled, while the market in which they hedge this gamma has remained the same.

So as the size of the mortgage business has grown it has ironically created a box for these companies: it has caused higher volatility in the government bond market, which has increased costs and reduced profits.

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