FAQs on Fannie Mae and Freddie Mac

What are Fannie Mae and Freddie Mac?
Fannie Mae and Freddie Mac are shareholder-owned companies whose objective is to make sure mortgage money is available for home buyers in America. They do not lend money directly to home buyers. Instead, they work with lenders, exclusively operating in the secondary mortgage market. They help to ensure that money for mortgages is available to home buyers in two ways. First, they purchase mortgages from lenders and hold those mortgages in their portfolio. The lenders, in turn can use that money to make more mortgages for more home buyers. Second, they issue what are known as Mortgage-Backed Securities (MBS) in exchange for pools of mortgages from lenders. These MBS provide the lenders with a more liquid asset to hold or sell.

In order to fund the mortgages they buy, Fannie Mae and Freddie Mac issue debt securities to investors. A significant part of their earnings is derived from the difference between the yield on the mortgages they hold and the cost of funds on their debt securities.

When Fannie Mae and Freddie Mac issue MBS, they guarantee that investors will receive timely principal and interest payments regardless of what happens to the underlying mortgages. In return for the guaranty, they earn a fee. These fees are another source of Fannie Mae and Freddie Mac's income.

What is the charter of Fannie Mae and Freddie Mac?
Fannie Mae and Freddie Mac are federally chartered corporations. Fannie Mae is a federally chartered and stockholder-owned corporation organized and existing under the Federal National Mortgage Association Charter Act whose purpose is to (1) provide stability in the secondary market for residential mortgages, (2) respond appropriately to the private capital market, (3) provide ongoing assistance to the secondary market for residential mortgages (including activities relating to mortgages on housing for low- and moderate-income families involving a reasonable economic return that may be less than the return earned on other activities) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing, and (4) promote access to mortgage credit throughout the nation (including central cities, rural areas and underserved areas) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing. Freddie Mac was chartered by Congress on July 24, 1970 under the Federal Home Loan Mortgage Corporation Act, with the same statutory purposes as Fannie Mae.

How do Fannie Mae, Freddie Mac and Ginnie Mae differ?
Freddie Mac and Fannie Mae have substantially similar charters, Congressional mandates and regulatory structures. Both Freddie Mac and Fannie Mae operate as publicly traded corporations. Ginnie Mae is a wholly-owned government corporation within the U.S. Department of Housing and Urban Development (HUD). Unlike Freddie Mac and Fannie Mae, Ginnie Mae's guarantee is backed by the full faith and credit of the U.S. government.

What does GSE stand for?
A GSE is a Government Sponsored Enterprise, and it is the unofficial designation of Freddie Mac, Fannie Mae (and others). The GSE status reflects the special relationship these organizations have with the US government.

What is the nature of the relationship between Fannie Mae, Freddie Mac and Ginnie Mae and the US Government?
The prospectuses for all of Fannie Mae's and Freddie Mac's debt offerings clearly state that the U.S. government does not back the company's debt instruments. Fannie Mae and Freddie Mac are not agencies of the Federal or any state government, nor do they receive any subsidy or appropriation from the government. Their securities are not backed by the full faith and credit of the United States government. Although born as government agencies, Fannie Mae and Freddie Mac are federally chartered corporations that are shareholder-owned, whose stock is traded on the New York Stock Exchange.

Fannie Mae and Freddie Mac are exempt from paying state and local income taxes. They are also exempt from filing with the Securities and Exchange Commission. Both companies have a line of credit with the US Treasury available to them in the amount of $2.25 billion. (Neither company has ever needed to take advantage of this line.) Each company has a board of directors, and a portion of those directors are appointed by the President of the United States.

Even though it is explicitly stated that the United States does not provide a full faith and credit backing to the debt securities or the MBS guaranty of Fannie Mae and Freddie Mac, the financial markets and rating agencies have interpreted the GSE status to mean that there is an implied government backing, and have priced their securities accordingly.

Ginnie Mae is a wholly-owned government corporation within the U.S. Department of Housing and Urban Development (HUD). Unlike Freddie Mac and Fannie Mae, Ginnie Mae's guarantee is backed by the full faith and credit of the U.S. government.

How are Fannie Mae and Freddie Mac regulated?
The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 created a regulatory oversight structure for Fannie Mae and Freddie Mac to monitor their housing mission and their safety and soundness. HUD has oversight responsibilities for the housing mission of the agencies. Safety and soundness regulation is vested in the Office of Federal Housing Enterprise Oversight (OFHEO). Organizationally, OFHEO is located within HUD, but operates independently of the Secretary of HUD as it implements, monitors and enforces capital standards for Fannie Mae and Freddie Mac. This arrangement is similar to how the Office of Comptroller of the Currency (OCC) operates within the U.S. Department of the Treasury. Congress is currently evaluating the oversight agency for the GSEs.

What is the likelihood of Fannie Mae and Freddie Mac losing their GSE status?
It is unclear exactly what this would mean. Perhaps it would mean that Fannie Mae and Freddie Mac would have to pay state and local taxes, the $2.25 billion line of credit would be taken away, all of their securities would have to registered with the SEC, they would no longer have to accept political appointees to their boards, or all of the above.

It is also unclear exactly what would precipitate this type of change. Regardless, it is unlikely that the special relationship enjoyed by Fannie Mae and Freddie Mac would be severed. The companies have come to play a very important role in the housing market through their execution of their charter and in the financial markets by virtue of their size. A change in status would undoubtedly roil both markets, an outcome that would most likely be far worse than whatever ill it purported to correct. Congress continually monitors and evaluates the GSEs and their relationship to the US government.

Freddie Mac has thought about this issue and made the following disclosure in its 2001 Information Statement. "Elimination or modification of our various exemptions, new or additional fees or substantive regulation of our business activities, alteration or elimination of our relationship to the federal government or any significant amendments to the Freddie Mac Act or other federal legislation bearing on the corporation could require or cause us to change the nature and/or extent of our business activities, and could adversely affect the scope of our activities, financial condition and results of operations. Any amendments to the Freddie Mac Act or modification of our relationship to the federal government, including assessment of user fees or oversight fees, repeal of our exemptions or any modification of the present tax treatment of mortgage interest payments, would require legislation to be passed by Congress and signed by the President. Legislation that adversely affects the corporation or its shareholders, if challenged, would be subject to judicial review to ensure its conformity with the requirements of the United States Constitution (including the Fifth Amendment's ban on uncompensated takings of property)."

To what risks are Fannie Mae and Freddie Mac exposed, and how do they manage them?
Fannie Mae and Freddie Mac have indisputable strong points. Due to the implied backing of the United States government, they enjoy virtually unlimited access to the capital markets at funding costs that are below market. Together they dominate their market. They pay no local taxes, only national. Their credit experience has been terrific. They are adept at public and governmental relations. Each has enjoyed tremendous growth and profitability.

These results do not come without risk. The risks to which the companies are exposed include credit risk, interest rate risk, derivatives-related risk, market-related risk, operational risk and political risk. The agencies' primary exposure to credit risk is associated with the mortgages in its total mortgage portfolio, the risk that borrowers do not pay the amounts due or default on their mortgage, which could potentially result in a loss. The companies manage this risk through sound underwriting and quality control, obtaining credit enhancements on higher risk mortgages and mitigating losses through early action. The companies are also subject to credit risk from institutional counterparties to the extent they do not fulfill their contractual obligations, primarily related to mortgage services, mortgage insurers and reinsurers and other mortgage guarantors. The companies manage this risk through strict guidelines on the choice of institutional counterparties, use of credit enhancements, strong documentation and contracts and ongoing analysis and oversight.

Interest rate risk is the risk that changes in the level of interest rates or changes in the shape of the yield curve could adversely affect the market value and earnings of the agencies. The primary manifestation of this exposure is in the uncertainty as to when borrowers will pay the outstanding principal balance of their mortgages. A mortgage borrower has the option of prepaying, and the exercise of this option is very sensitive to changes in interest rates. The agencies typically will employ several strategies to manage interest rate risk, including actively adjusting their funding mix to match assets, investing in assets that are less sensitive to prepayment risk, and entering into derivatives transactions to obtain low-cost financing, reduce risk and protect market value. Derivatives are used to hedge prepayment options embedded in retained mortgages, foreign currency exposure, existing long-term fixed-rate debt and forecasted debt issuance. The primary derivative-related risk that the agencies incur is counterparty credit risk resulting from credit exposure to derivative counterparties.

Market-related risks that the agencies are exposed to include the risk of fluctuations in the value of their mortgage portfolio, volatility risk, liquidity risk and foreign currency risk. Each of these risks is monitored and managed in different ways, through the use of derivatives and asset-based strategies. The operational risk to the agencies is similar to the risk faced by any large institution, and is mitigated by strong management controls.

The political risk faced by the agencies is the risk that Congress decides it is in the best interests of the country and the agencies' shareholders and debtholders to change its relationship. There is almost constant debate over the nature of this relationship and what responsibilities inure to the agencies in exchange for its benefits. Fannie Mae and Freddie Mac manage this risk through aggressive public relations, lobbying and trying to manage their businesses as transparently as possible.

Is there a housing bubble and, if so, how would one affect the underlying mortgages in your fund?
In some local markets there has been rapid price appreciation. Rising home prices make it possible for larger loans to be made against the same property. The risk a decline in prices would pose to underlying mortgages is that the value of the home could fall below the value of the mortgage. In the event of a default on the mortgage, there would be a loss for the mortgageholder.

For holders of a portfolio of mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae, any defaults or delinquencies result in zero loss: the credit risk is borne by the agencies, and the holders are made whole and paid 100 cents on the dollar. In addition, a large portfolio of mortgage-backed securities offers geographical diversification which mitigates any exposure to local problem areas.

In any event, holders of MBS are protected by the secured structure of mortgage-backed securities. The MBS holder has multiple levels of protection. Besides the implied guarantee of Treasury, the MBS holder is secured-protected by the actual loan-to-value rating of the home, mortgage insurance, the income verification and maintenance of the homeowner, property/casualty and life insurance, the rights of foreclosure and the settlement process, and the reduction in principal amount from monthly amortization.

Is the continued scrutiny of Fannie Mae and Freddie Mac a positive or negative?
Fannie Mae and Freddie Mac most likely believe that this scrutiny is a negative in that it is costly to manage and may result in a change in operations. However, scrutiny that results in policies that ensure the safe and sound operations of Fannie Mae and Freddie Mac, and therefore the American financial system, can't be a bad thing.

Can you explain the importance of Fannie Mae and Freddie Mac to the growth of the U.S. economy?
A report that came out in the Spring of 2002 showed that fully one-half of 2002's 1.2% gain in real GDP growth was due to housing activity. Inarguably, the activities of Fannie Mae and Freddie Mac in executing their charter, combined with the current low rate environment, have been a key component of the housing market strength. It would not be too far a stretch to suggest that the agencies' activities are central to this growth.

The work of the agencies would not be possible without a willing and accommodative credit market. Moreover, there are huge institutional notional exposures to Fannie and Freddie in the form of off-balance-sheet contingencies, like swap counterparties, mortgage servicers, primary market originators, and mortgage insurance companies. As the biggest issuer of mortgage-backed securities and corporate securities in the world, the biggest buyer and hedger of the securities in the world and, not least, the source of liquidity for more than 75% of conventional and conforming home mortgages extended in this country. It could be argued that Fannie Mae and Freddie Mac are about as central to the American capital markets as the Treasury Department.

How does the disclosure about Fannie Mae's duration gap affect investors in mortgage-backed securities?
On September 16, 2002, Fannie Mae released its monthly summary of activity in its mortgage portfolio, including mortgage commitments, purchases and sales, portfolio growth rate, net interest margin, delinquencies and duration gap. The headline piece of data emanating from this release was that the company's duration gap had widened to a negative 14 months on August 31, reflecting the recent sharp decline in mortgage rates. Fannie Mae's duration gap measures the difference, in months, between the durations of the assets and the liabilities in its mortgage portfolio. The target for the duration gap, established by management, is to be within a band of plus or minus 6 months. On October 1, Fannie Mae rushed out to the market the news that its September duration gap had narrowed slightly to 10 months. Since then, Fannie Mae has reported that its duration gap has stayed within its target band.

It is not unusual for Fannie Mae's duration gap to be outside of this band; over the past dozen years the duration gap has been outside the target range one-third of the time. Nor is it unusual for the duration gap to turn negative during periods of high refinancing. What is noteworthy about the recent disclosure is that with the September data point, it had been three months in a row that the company had a duration gap outside of its target band.

On a company-specific level, this condition suggested that the wave of refinancing had resulted in a substantial shortening of the duration of Fannie Mae's assets relative to is liabilities. Since Fannie Mae generates a significant portion of its revenues through the spread between what it pays on its liabilities and what it earns on its assets, a refi-induced shortening of the duration of its assets will lower their yield and may end up squeezing net interest margins. Going forward, Fannie Mae will endeavor to bring its duration gap to within its target band through the use of interest rate derivatives or by some combination of extending the duration of their assets-through the purchase of longer-duration assets like Treasurys, corporates or different types of mortgage assets-and shortening the duration of their liabilities-through calling its longer duration debt or issuing shorter-term liabilities. These efforts may also result in lower margins. In other words, while Fannie Mae may see earnings pressure going forward, it is in no serious danger of seeing its ability to operate threatened.

On a more general level, the refinancing wave affects all investors in mortgage-backed securities, and in much the same way that it affects Fannie Mae. The question is one of degree and the extent to which the investor's strategy is flexible enough to perform in various interest rate environments. Our position on the news coming out of Fannie Mae solely relates to this general condition. We manage our portfolio so that it can maintain NAV stability and generate income for investors in up or down markets. As such, we manage the interest rate risk in our portfolio with a strategy that is substantially different from Fannie Mae: Our portfolio is largely adjustable-rate and floating-rate mortgage-backed securities, financed with short-duration reverse repurchase agreements. Thus, we have minimal duration mismatch. In other words, generally as our assets reset up or down, so will our liabilities.

The last point to make on this issue has to do with the risk in investing in Fannie Mae. While the agency's interest rate risk may pose challenges to the valuation of its common stock, let us emphasize that we don't invest in Fannie Mae stock. We invest in mortgage-backed securities wrapped with guarantees as to payment of principal and interest by Fannie Mae, Freddie Mac and Ginnie Mae. Despite the fact that Fannie and Freddie's commitment to pay under the guarantee is pari passu with the obligation to its corporate bondholders, the MBS holder has multiple levels of protection. Besides the implied guarantee of Treasury, the MBS holder is secured-protected by the actual loan-to-value rating of the home, mortgage insurance, the income verification and maintenance of the homeowner, property/casualty and life insurance, the rights of foreclosure and the settlement process, and the reduction in principal amount from monthly amortization. Furthermore, geographical diversification protects the MBS investor. In short, unlike unsecured investments, ours are secured and, at that, secured by a basic element of human existence.

Has the accounting restatement at Freddie Mac and Fannie Mae affected the market for our portfolio securities?
The accounting restatement and related newspaper headlines and regulatory scrutiny created a firestorm of publicity surrounding the GSEs and their operations- past, present and future. While the issue has been volatile, the market for the agencies' debt securities has not. The trading of their mortgage-backed securities and debentures has stayed relatively constant on a spread-to-Treasurys basis. The bond market is comfortable with the credit of the Agencies debt securities even as the news continues to raise questions. The same cannot be said for the companies' public stock. But we must emphasize that in our strategy we do not invest in the public stock of Fannie Mae and Freddie Mac.

January 15, 2004