Ongoing concern about how interest rate fluctuations could impact Fannie Mae and Freddie Mac prompted the Office of the Inspector General for the Federal Housing Finance Agency to audit the FHFA's oversight of these risks.
According to the OIG white paper, the U.S. Department of Treasury as well as the FHFA have taken several steps to limit the government-sponsored enterprises' interest rate risks by requiring both to substantially downsize their mortgage asset portfolios. However, interest rate risk is still a major concern because the GSEs' portfolios contain $1.3 trillion in assets.
"Moreover, the increasingly illiquid nature of the GSEs' mortgage asset portfolios presents new challenges in terms of limiting potential losses due to fluctuations in interest rates," the white paper reported.
Another obstacle is that both Fannie Mae and Freddie Mac have a problem recruiting and retaining experienced interest-rate risk staff.
For example, the FHFA noted in its 2011 examinations that one of the GSE’s witnessed the departure of a key executive responsible for interest rate risk management, while the other noted that there had been considerable "attrition in its risk-modeling unit."
Financial institutions such as Fannie Mae and Freddie Mac face two general interest rate risks, including incurring losses if the rate of interest paid on the short-term debt used to finance the purchase of mortgage rises to the level of interest earned on the assets or if the interest earned on the mortgage assets falls, leading to prepayment risk, the paper explained.
Going forward, the government-sponsored enterprises can manage interest rate risk by employing several strategies and tools to mitigate the interest rate risks.
Specifically, the Enterprises have the option of issuing relatively more mortgage-backed securities to investors such as investment banks, which transfers to the investors the interest-rate risk associated with the bond, the OIG stated.
Additionally, the GSEs can employ derivatives – financial instruments that act as an insurance policy – providing the holder with financial compensation when those interest rates fall or rise, the white paper explained.
"In general, the GSEs employ derivatives and other tools, such as asset selection and debt issuances, as part of an overall risk management strategy that is intended to reduce the potential that they will incur losses caused by fluctuations in interest rates," the OIG report said. "Employing derivatives to manage interest rate risk in this way can be a complex undertaking that entails costs and risks."
While derivatives are critical to the management of interest rate risks, the OIG elaborated that employing derivatives requires a comprehensive understanding of the instruments within the derivatives as well as the business of the GSEs.
For instance, a failure to properly employ derivatives to manage interest-rate risk may cause significant financial losses.