FNM, you have a problem!
This is a good one......
In other news, Fannie Mae revealed last week that their duration gap has plunged to a negative 14 months. Which begs the question, "What's a duration gap?" Having seen how inaccurately it has been explained in the press, all I can say to my former finance students is "I feel your pain." The following discussion is going to gloss over a few details, like call features, modified duration, convexity, and inverse floaters, but here is the basic idea:
As you can read in the Prospectus of the Hussman Strategic Total Return Fund, the price of a debt security is just the present value of the future payments that the security will deliver to investors. The "duration" of a fixed income security is the average date at which it makes those payments, weighted by their present values. So for example, the duration of a 10-year zero coupon bond is simply 10 years (100% of the payment stream is received in year 10). In contrast, the duration of a 10-year, 6% coupon bond priced at par is just 7.8 years. The coupon bond has a shorter duration because part of its payment stream is received as coupon payments much earlier than its 10 year maturity date, and these coupon payments shorten the bond's duration.
Importantly, duration measures not only the "average" date at which a bond makes its payments; it also measures the price sensitivity of a bond to interest rate changes. So now things get interesting. To an approximation, a bond with a duration of 10 years will fluctuate about 10% in price based on a 1% (100 basis point) change in interest rates, while a bond with a duration of say 4 years will fluctuate only about 4% in price on that same 1% change in rates.
So here's the payoff. The duration gap of a financial company is equal to the duration of assets minus the duration of liabilities. For Fannie Mae to have a duration gap of -14 months means that the duration of liabilities exceeds the duration of their assets by 14 months. This is because Fannie Mae makes mortgage loans, and as interest rates have declined, more and more individuals have refinanced or shortened their borrowing horizons. So these mortgages (assets of Fannie Mae) are now substantially shorter in duration than Fannie's liabilities. Since -14 months is -1.17 years, this means that a 1% drop in interest rates would cause Fannie Mae's loan portfolio to lose about 1.17% in value. Now, that doesn't sound like a lot. Until you realize that Fannie Mae has leveraged its equity 40-to-1 (the highest leverage ratio in its history), and that its annual return on this portfolio is just 0.65%.
In short, a further drop in interest rates of even 0.50% here would cause an overall portfolio loss equal to about (1.17 x .50 x a leverage factor of 40 =) 23% of Fannie Mae's book value, or equivalently, about (1.17 x .50 / .65 = ) 90% of Fannie Mae's annual earnings. Accordingly, Fannie Mae appears to be scrambling to buy long-term Treasury bonds (thereby lengthening the duration of its assets) in an attempt to shore up its duration gap. This is no small problem, and is behind the substantial plunge in long-term Treasury interest rates we've seen in recent weeks.
... Thus explaining my comment last year that I don't understand why Fannie Mae trades without a substantial haircut for risk. As I've written many times, there are three features common to nearly every financial debacle: 1) extreme leverage, 2) a mismatch between assets and liabilities, and 3) lack of disclosure. In this regard, it's difficult to exclude Fannie Mae from concern. We don't own any stock in the company. And while I have no concern over the debt quality of Fannie Mae's bonds, we don't own them either, because even tiny changes in risk premiums demanded by investors can generate meaningful price fluctuation.
http://hsgfx:reciprocal@www.hussman.com/hussman/members/updates/latest.htm
larry |
