Fannie Mae, Freddie Mac Touch Off Swaps Scrap

By SCOTT PATTERSON
The regulator of Fannie Mae and Freddie Mac is on the cusp of making big changes to the market for interest-rate swaps, in a move that could potentially cut into Wall Street firms' revenues and generate new business for some firms that run exchanges.


The Federal Housing Finance Agency, which oversees the government-owned mortgage giants, expects them to start using a clearinghouse to trade the swaps by year's end, according to people familiar with the matter.


The impending change away from private "over-the-counter" contracts has generated behind-the-scenes meetings among officials at Fannie and Freddie, the banks that now command their business and the exchanges that want it, according to the people. Each camp is posturing to protect its interests amid the shift.

Fannie and Freddie are among the biggest buyers of interest-rate swaps. The swaps are two-way derivative contracts in which one party pays a fixed rate in exchange for a rate that floats along with the market.

For years, the mortgage firms have purchased the swaps from Wall Street banks to hedge their huge mortgage portfolios against rate swings. The banks, such as Goldman Sachs Group Inc. and J.P. Morgan Chase & Co., make money by structuring the deals and selling them to clients.

With so-called central clearing, banks play a similar role but operate under the umbrella of a clearinghouse that guarantees the trade for both parties in case one side defaults. The guarantee is something that many felt was badly missing during the financial crisis. Then, markets seized up amid fears that some firms would falter and be unable to make good on their swap trades.

Officials at the FHFA have said they are hoping a clearinghouse will give them more information about prevailing market prices and also will help regulators gauge when firms are accumulating excessive risk.

The move to central clearing is a step short of what some critics of the opaque derivatives market have pushed for this past year: trading on a public exchange. While a clearinghouse will provide a backstop for trades, the market will remain an exclusive club because the clearinghouse is expected to be open only to brokerage firms that become members.

Still, if a large percentage of trading volume gravitates toward central clearing, the playing field for swaps brokerage and trading could open to other firms besides now-dominant banks.

Incumbents would still make money by brokering the deals, but with more competition and transparency, their margins might shrink.

"The FHFA will write the new rules" on interest-rate-swap trading and clearing, said Richard Repetto, an analyst who tracks exchanges at Sandler O'Neill & Partners LP.

Goldman Sachs Chief Executive Lloyd Blankfein has said the bank favors a clearinghouse. In a September speech, he said clearing of derivatives would "do more to enhance price discovery and reduce systemic risk than perhaps any specific rule or regulation."

An effort to move swaps and other derivative financial contracts to clearinghouses has been among the bigger pushes for changes in market structure since the financial crisis. That is because the woes of firms like Lehman Brothers Holdings Inc. and American International Group Inc. made regulators wary about contracts struck out of their sight. But like many other efforts to change the status quo in markets, so far regulation requiring a move to clearinghouses hasn't gotten very far.

Fannie's and Freddie's regulator seems intent on changing course regardless of the political winds. Martha Tirinnanzi, chairman of the FHFA's clearinghouse working group, said at an industry conference in March that Fannie Mae and Freddie Mac are "going to central clearing" even if current legislation that includes clearing mandates doesn't pass.

There were $342 trillion of interest-rate swaps outstanding as of June 2009, according to the Bank for International Settlements. Fannie Mae and Freddie Mac have more than $2 trillion of interest-rate swaps on their books, according to public securities filings. Market experts say that share, while under 1%, is among the biggest if not the biggest held by any participant.
A number of exchanges are now vying for Fannie's and Freddie's clearing business, including Nasdaq OMX Group Inc. and CME Group Inc.

J.P. Morgan officials favor the use of a London-based clearinghouse, LCH.Clearnet Group Ltd., according to people familiar with the matter. LCH, in which several U.S. banks including J.P. Morgan are stakeholders, has been the most active clearer of the derivatives, according to firm data.



Meanwhile, in recent months, the agency has been running tests with the International Derivatives Clearing Group, or IDCG, a clearinghouse operator majority-owned by Nasdaq. It also has been testing the systems of LCH.Clearnet and CME.



The FHFA is likely to select more than one exchange, according to a person familiar with the matter.



Some see the IDCG as a front-runner, since its clearing system has been operational since early 2009. A number of large brokerage firms have signed on to its platform, including Newedge USA LLC and MF Global Holdings Ltd.



The CME, meanwhile, has had some trouble getting its rate-swap system operational, according to people familiar with the matter. If the FHFA moves forward with its plans before the CME is ready, other exchanges could benefit from a first-mover advantage, Mr. Repetto says.



The FHFA may choose not to give much business to LCH.Clearnet, some market insiders say, because the firm is based in the U.K., which has different bankruptcy laws than the U.S.

—Sarah N. Lynch

contributed to this article.


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Freddie Using IRW to Adjust Funding Mix

We generally use interest-rate swaps to mitigate contractual funding mismatches between our assets and liabilities. We also use swaptions and other option-based derivatives to adjust the contractual terms of our debt funding in response to changes in the expected lives of our investments in mortgage-related assets. As market conditions dictate, we take rebalancing actions to keep our interest-rate risk exposure within management-set limits. In a declining interest-rate environment, we typically enter into receive-fixed interest rate swaps or purchase Treasury-based derivatives to shorten the duration of our funding to offset the declining duration of our mortgage assets. In a rising interest-rate environment, we typically enter into pay-fixed interest rate swaps or sell Treasury-based derivatives in order to lengthen the duration of our funding to offset the increasing duration of our mortgage assets.