Fannie Mae 2001 Annual Report Download - page 29

Interest Rate Risk Management
Fannie Mae is exposed to interest rate risk because changes
in interest rates may affect mortgage portfolio cash flows in a
way that will adversely affect earnings or long-term value.
Fannie Mae’s interest rate risk is concentrated primarily in its
mortgage portfolio, where exposure to changes in interest
rates is managed to achieve stable earnings growth and a
competitive return on equity over time.
Fannie Mae’s overall objective in managing interest rate risk is to
deliver consistent earnings growth and target returns on capital in
a wide range of interest rate environments. Central elements of
Fannie Mae’s approach to managing interest rate risk include:
(1) investing in assets and issuing liabilities that perform similarly
in different interest rate environments, (2) assessing the sensitivity
of portfolio profitability and risk to changes in interest rates, and
(3) taking rebalancing actions in the context of a well-defined risk
management process.
(1) Funding of mortgage assets with liabilities that have
similar cash flow patterns through time and across
different interest rate paths.
To achieve the desired liability durations, Fannie Mae issues
debt across a broad spectrum of final maturities. Because the
durations of mortgage assets change as interest rates change,
callable debt and interest rate derivatives are frequently used
to alter the durations of liabilities. The duration of callable
debt, like that of a mortgage, shortens when interest rates
decrease and lengthens when interest rates increase.
Fannie Mae also uses derivative financial instruments,
including interest rate swaps and other derivatives with
embedded interest rate options, to achieve its desired liability
structure and to better match the prepayment risk of the
mortgage portfolio. These instruments are close substitutes
for callable and noncallable debt.
(2) Regularly assessing the portfolio’s exposure to
changes in interest rates using a diverse set of
analyses and measures.
Because the assets in Fannie Mae’s mortgage portfolio are
not perfectly matched with the liabilities funding those
assets, the portfolio’s projected performance changes with
movements in interest rates. Fannie Mae uses various
analyses and measures—including net interest income at risk,
duration and convexity analysis, portfolio value analyses, and
stress testing—to project the portfolio’s future performance.
Risk measures and assumptions are regularly evaluated and
modeling tools are enhanced as management deems
appropriate. Net interest income at risk, duration, convexity,
and portfolio value analyses all provide key information
about risk across a wide range of interest rates. Because
future events may not be consistent with recent experience,
Fannie Mae has constructed a further series of tests using
highly stressful assumptions of changes in interest rates.
Using stochastic interest rate simulations based on historical
interest rate volatility, Fannie Mae projects portfolio net
interest income over a wide range of interest rate
environments, including specific rising and falling interest
rate paths. Stochastic simulations generate probability
distributions of future interest rates based on historic
behavior. These analyses generally include assumptions
about new business activity to provide a more realistic
assessment of possible portfolio performance. Fannie Mae
also regularly conducts narrower assessments of interest rate
risk by analyzing the interest rate sensitivity of only the
existing mortgage portfolio (assuming no new business).
The duration and convexity of the portfolio, along with net
interest income and portfolio value-at-risk analyses, are the
primary risk assessment tools used to analyze the existing
portfolio. The portfolio duration gap—the difference
between the durations of portfolio assets and liabilities—
summarizes for management the extent to which estimated
cash flows for assets and liabilities are matched, on average,
through time and across interest rate scenarios. A positive
duration gap indicates more of an exposure to rising interest
rates, and a negative duration gap indicates more of an
exposure to declining interest rates. The portfolio’s
convexity—or the difference between the duration
sensitivities of the portfolio’s assets and liabilities—provides
management with information on how quickly and by how
much the portfolio’s duration gap will change in different
interest rate environments. Management regularly monitors
the portfolio’s duration and convexity under current market
conditions and for a series of hypothetical interest rate
shocks. In addition, management tracks the portfolio’s long-
term value and the amount of value that is at risk over a broad
range of potential interest rate scenarios.
Many of the projections of mortgage cash flows depend on
prepayment models. While Fannie Mae is highly confident
in the quality of these models, management recognizes that
the models are based on historical patterns that may not
continue in the future. The models contain many
assumptions, including some regarding the refinanceability
of mortgages and relocation rates. Other assumptions are
implicit in the projections of interest rates and include
projections of the shape of the yield curve and volatility.
Fannie Mae constructs “worst-case” assumptions of dramatic
changes in interest rates, combined with substantial adverse
changes in prepayments, volatility, and the shape of the yield
curve. The stress tests provide extreme measures of potential
risk in highly improbable environments and contribute to
the evaluation of risk strategies.
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