Fannie, Freddie Cut Derivative Use in ’04

Fannie Mae and Freddie Mac, the biggest buyers of U.S. residential mortgages, reduced the amount of derivatives on their books by about a third last year, their federal regulator said Wednesday.

The so-called notional amount of derivatives outstanding at Fannie Mae dropped 33% to $722.9 billion at the end of last year, while Freddie Mac’s fell 31% to $756.8 billion, according to the annual report of the Office of Federal Housing Enterprise Oversight.

Derivatives are contracts whose values are derived from underlying financial assets such as bonds, stocks, commodities or currencies. A derivative’s notional amount is the value of the underlying asset.

Freddie Mac’s use of derivatives such as interest-rate swaps fell last year as it purchased more floating-rate mortgages that require less hedging than fixed-rate loans do, Chief Executive Martin Baumann said in March in discussing 2004 earnings. The company also increased the use of callable debt to fund its mortgage portfolio, he said.

Fannie Mae spokeswoman Janis Smith declined to comment on the company’s derivatives.

Freddie Mac and Fannie Mae hold charters from Congress to provide financing for home mortgages. The companies make most of their profit on the difference between their costs to borrow in the bond market and the returns on mortgages they buy from lenders. They also earn fees from lenders for guaranteeing the payments on loans that are packaged into mortgage bonds.

Both companies have slowed the growth of their combined $1.5-trillion portfolios since 2003 as competition for mortgage bonds has bid up prices and cut returns relative to borrowing costs. Fannie Mae has cut its portfolio by $61.3 billion since October.

The two companies use derivatives and issue debt with call options attached, to hedge against changes in the value of their mortgage holdings.

Falling interest rates can reduce the value of a pool of mortgages as more homeowners refinance their loans, reducing the flow of interest payments made to the mortgage holders.

In addition, as rates fall, the value of mortgage debt tends to rise above 100 cents on the dollar, setting investors up for losses because the principal is returned to them at face value.

Accounting errors at the government-chartered companies have fueled a push in Congress to create a stronger regulator with the powers to increase capital standards, approve new financing programs and cut their mortgage portfolios to ward off risks to the financial markets.

The Federal Reserve last month also recommended that banks and other sellers of interest-rate options conduct tests of their ability to withstand shocks including the possible failure of mortgage companies Fannie Mae and Freddie Mac.