Monday, June 01, 2009

Speaking of Duration Mismatch

I wonder if we are setting ourselves up for another set of problems for Fannie and Freddie. They are purchasing large number of mortgages with 5 percent interest rates; so long as the yield curve remains steeply sloped, this is OK. But if short term rates rise to 5 percent, the GSEs and investors in their MBS who are borrowing short will be in trouble.

The problem is that the GSE disclosures are not very helpful. They look at the effect of changes in interest rates and the slope of the yield curve on value, but the changes are quite small. They also disclose how much of their debt is one year and how much is longer than one year, but again, one year is not that helpful a cut-off point. It is possible that everything is fine from a duration perspective, but with so much current focus on credit issues (and just getting through the next year), we may be taking our eye off the ball on interest rate risk.


Anonymous said...

Both Freddie and Fannie disclose duration positions as well as mkt value sensitivities to changes in rates (parallel and slope chg). Doesn't that tell you all you need to know? The GSEs actively hedge interest rate risk (or at least they used to). I would worry much more about the banks who don't hedge it as closely.

Richard K. Green said...

The disclosres involve small changes in rates (50 bp change in rates and 25 bp change in the slope of the yiled curve). With rates at record lows (and the slope of the yield curve at something like a record high), I don't know if it is possible to develop a meaningful disclosure.

Duration measures are first derivative measures, so as interest rates change a lot, they become less accurate at predicting changes in values.

As I said, everything may be fine. But we used to worry about interest rate risk a lot more, and we need to continue to do so. The comment about banks was spot on.

Richard K. Green said...

I meant "disclosures," of course.

Anonymous said...

With the risk of hyper inflation growing, today's mortgage rates are a potential disaster for anyone holding the bonds.

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