Warning level comparable to the 2002 Wall Street turmoil! Fannie Mae (FNMA.US) and Freddie Mac (FMCC.US) interest rate risk exposure surges.

Fannie Mae (FNMA.US) and Freddie Mac (FMCC.US) are taking on more interest rate risk in their rapidly expanding investment portfolios, with their key risk exposure indicators climbing to levels not seen on Wall Street in twenty years. Information disclosed by the two housing finance giants shows that their duration gap a measure of the degree to which assets, liabilities, and hedging tools offset each other has widened sharply in recent months, making their holdings more susceptible to interest rate fluctuations. Currently, the duration gap is close to a one-year high, meaning that for every 50 basis point increase in interest rates, Fannie Mae's investment portfolio value will decrease by approximately $1.2 billion, and Freddie Mac's losses will exceed $1.6 billion. A year ago, the estimated impact on both companies was minimal. This shift comes as the two government-backed enterprises have expanded their retained investment portfolios by over $135 billion in the past year as part of President Trump's efforts to lower housing costs by reducing the supply of mortgage-backed securities available for investors to purchase in the market, lowering bond yields, and thereby driving down mortgage rates. However, this strategy involves inherent trade-offs: as interest rates rise, the pace of homeowners' repayments or refinancing slows down, the duration of bonds lengthens, making them more vulnerable to subsequent interest rate changes. This puts Fannie Mae and Freddie Mac at greater risk exposure, unless they increase their hedging protection. The issue is that increasing hedging may contradict the goal of lowering borrowing costs. Hedging transactions may exert upward pressure on government bond yields, which are a key benchmark for mortgage rates. Fannie Mae and Freddie Mac stated that the expansion of the duration gap stems from their adjustment of some capital buffer investment strategies shifting funds from short-term investments to longer-term assets like MBS to achieve more stable returns. Market observers see another layer of intention: by preserving more unhedged space for new interest rate exposures, the two companies are avoiding trading activities that could raise mortgage rates. Oppenheimer & Co. strategist Richard Estabrook said, "In the early days of conservatorship, the 'two houses' were in a strict risk-control lockdown, perhaps overly cautious." He referred to the period when the government took over the two companies after the 2008 financial crisis. "Now they have evolved to a stage where they are being used more actively to advance policy goals." Trump has made lowering borrowing costs a core strategy to address the affordability of housing, with housing being a key political issue leading up to the midterm elections in November. With their vast mortgage investment portfolios, Fannie Mae and Freddie Mac are among the most direct policy tools of this administration to influence mortgage costs. This "rate-first" policy orientation was on full display on Wednesday the president suddenly abandoned signing a bipartisan housing bill passed by Congress, stating that lawmakers should first tighten voter qualification rules through a standalone bill. He believed that the housing bill, which included measures to restrict large institutional investors from buying single-family homes, and simplify regulations for prefab homes, was not as important as lowering interest rates. A spokesperson for Fannie Mae declined to comment, while Freddie Mac and the regulator for both companies, the Federal Housing Finance Agency (FHFA), did not respond to requests for comment. The last time Fannie Mae's duration gap reached such high levels, it caused unease among investors, and regulators were concerned about the risks facing taxpayers and conducted intensive reviews. However, the current concerns from market observers are relatively mild, as they point out that the capital buffer sizes of the two companies are more ample than before the financial crisis, and their investment portfolios are smaller. Fannie Mae and Freddie Mac typically manage interest rate risk through bond issuances and derivatives. As part of their retained investment portfolios rely on debt financing, rising interest rates will simultaneously reduce the value of their fixed-rate mortgage assets and liabilities, offsetting some impact. Subsequently, as interest rates and repayment expectations change, the two companies utilize swaps, swaptions, futures, and other instruments for precise matching. This is particularly important for mortgage bonds as interest rates drop, bond prepayment accelerates during refinancing, while rising... However, this balance is now changing. As the two companies shift more of their retained earnings (part of their capital buffer) towards long-term investments, they are keeping more of the new interest rate exposures unhedged rather than fully hedged. The benefit is that their sensitivity to interest rate changes is reduced. Using Freddie Mac as an example, according to filings, a 100 basis point decrease in interest rates will result in a $343 million reduction in interest income over the next year, lower than the $492 million reported a year ago. The cost, however, is a greater mark-to-market risk: a 100 basis point adverse change in the yield curve could lead to around $3.4 billion in losses, while a 50 basis point change would result in over $1.6 billion in losses. Scott Buchta, head of fixed income strategy at Brean Capital, said, "The issue is whether this risk is appropriate for an institution in conservatorship, and where are we headed? The scale of the investment portfolio is smaller than before but growing, and the risk exposure is expanding." The last time Fannie Mae's duration mismatch reached such a scale, the situation was quite the opposite. In 2002, a sudden drop in interest rates triggered a refinancing frenzy, with borrowers repaying ahead of schedule far exceeding expectations, causing Fannie Mae's asset duration to shorten faster than its debt and hedging tools could adjust. By August of that year, the duration gap had reduced to a negative 14 months. This disclosure shocked Wall Street. Fannie Mae's stock price declined, bond spreads widened, and regulators began investigating whether the core pillar of the U.S. mortgage market allowed interest rate risk exposure to deviate excessively. The company rushed to reassure investors, stating that they could close the mismatch gap by purchasing mortgages, repurchasing debt, and using derivatives. Long-term Treasury bonds strengthened as expectations that Fannie Mae would be forced to buy more bonds to rebalance increased. Today, market worries have greatly eased. Walt Schmidt, a strategist at FHN Financial, stated that the combined holdings of mortgage-backed securities by the two government-backed enterprises represent only about 2% of the $8.5 trillion U.S. agency MBS market, significantly lower than the approximately one-third market share in the early 2000s. Schmidt said, "The duration exposure that the 'two houses' are taking seems reasonable given the size of their investment portfolios, which are still much smaller than before." However, this strategy still carries risks. The resurgence of inflation concerns has led to a jump in interest rate expectations in recent weeks, potentially exposing Fannie Mae and Freddie Mac to greater loss risks. And this shift may not be over yet. Many market observers expect the holdings of the 'two houses' to continue growing, with potential sizes reaching $100 billion or even more, causing the duration gap to widen further. If the Trump administration pushes the two companies to buy more MBS, this trend will become even more pronounced. Brett Kozlowski, co-manager of GW&K Investment Management, which manages around $53 billion in assets, said, "The expansion of the duration gap is closely linked to the overall growth of the investment portfolio. As the 'two houses' have not yet completed their portfolio purchase plans, I speculate that the duration gap will continue to widen."