When complexity counts

Mortgage lending is the big risk management story of 2003. Last month, Freddie Mac restated its profits for 2000, 2001 and 2002, reducing them by $5 billion. Most of this was down to the restatement of its derivatives positions, but we don’t know how much of that huge anomaly was due to accounting errors, and how much was down to the federal mortgage lender’s management of volatile interest rates.

We can be fairly certain, however, that the Office of Federal Housing Enterprise Oversight – which in August asked for the resignation of Greg Parseghian, the chief executive of Freddie Mac – will demand more changes as a result of its continuing investigation into risk management in the mortgage market. Anything that cramps the activities of Freddie Mac and its larger sibling Fannie Mae, which for years have played a dominant role as customers in the swaps market, will have an effect on derivatives dealers – especially as investment banks have been fingered as accessories in the mis-accounting. The fear must be that regulators will rein in the agencies’ ability to actively manage increasingly large amounts of debt.

The irony is that the US mortgage agencies have a reputation for being both sophisticated and, at the same time, conservative risk managers. They have been at the leading edge of credit and interest rate risk management for many years. Furthermore, those risk management skills have demonstrably been put to very good use in providing liquidity to end-customers in the mortgage chain, who have benefited from the world’s most competitive market for home loans.

As our cover story proves (page 22), some of the largest primary lenders in the US market could take a lesson from the agencies. Unlike Freddie Mac and Fannie Mae, they have been reluctant to make extensive use of options, preferring to rely on rebalancing swaps positions dynamically. But it’s in times of extreme volatility – when hedges are needed most – that the dynamic approach is most likely to fail.

Sure enough, those lenders came unstuck when rates volatility spiked in July and August this year and exposed the dangerous implicit bet that some had taken with their hedges: that rates would stay low.

But while many mortgage hedgers – including National City, Washington Mutual and Chase Home Finance – experienced significant problems in managing their mortgage risk, California-based Countrywide Financial didn’t. As our story reveals, Countrywide has long believed that it needed more than just plain vanilla swaps and futures to hedge negative convexity. Without its more elaborate derivative hedges and sophisticated risk management, it would have been just one of the herd rushing to adjust its hedges when rates rose.

We have another story on mortgage lenders on page 49, where we take a look at the UK building societies and how they are dealing with the challenge of Basel II, regulators’ proposed new Accord on bank regulatory capital.