The Big Risk of Fannie & Freddie's Big Profit

Matthew C. Klein writes for Bloomberg View about the economy and financial markets. He previously wrote for the Economist magazine and its economics blog, Free Exchange.
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Fannie Mae and Freddie Mac, the U.S. government-owned mortgage-finance giants, are finally back in the black. The two companies earned a combined net income of $28.2 billion in 2012 -- their most profitable year ever.

Fannie and Freddie will probably enjoy several more banner years now that they seem to have finished working through their portfolios of toxic subprime securities. Almost all of those profits will go to the U.S. Treasury, which would allow lawmakers to claim credit for reducing the budget deficit without having to raise taxes or cut spending.

Despite the recent good news, abandoning reforms of the companies would be a mistake. Today's big profits may not persist once interest rates start to rise. Policymakers should focus on fixing the mortgage giants so that taxpayers won't ever be on the hook for their losses again.

Right now, Fannie and Freddie are profiting from the relatively wide spread between the borrowing costs that the companies pay to fund themselves and the yields on the mortgages they own. Sooner or later, however, their funding costs will rise from today's low levels. The yields on new mortgages would also rise, of course, but that wouldn't help them with their existing portfolio of long-term loans. After all, borrowers are quick to refinance when rates go down, but almost never do so when rates rise. This mismatch could create large losses.

Fannie's and Freddie's regulator, the Federal Housing Finance Agency, is aware of these risks, although it isn't clear what, if anything, it's doing about them. Last month, the FHFA's inspector general published a white paper explaining how the companies could use interest-rate swaps to protect themselves.

Interestingly, the paper suggests that Fannie and Freddie are not fully hedging their portfolios. (Fannie and Freddie both report that they are shielded from small changes in interest rates.) In fact, the regulators believe that "considerable interest rate risks remain" despite Fannie's and Freddie's efforts to sell off their mortgages in securities to investors. One problem is that there has been "considerable attrition" in the units charged with modeling and hedging these risks.

It's in the nature of hedges that they dampen swings in earnings in both directions. We can't know for sure, but I wonder how much of last year's record profits can be attributed to excessive interest-rate risk. That could affect their earnings in the future. Never forget that the companies managed to lose more than $257 billion because they took too much risk to inflate their earnings. It would be a real shame if that were happening again.

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