WASHINGTON - Three years ago Linda Knight, the treasurer of Fannie Mae, began looking for a way to increase its use of callable debt in its business of buying home mortgages and packaging them into securities.
She wanted to use the debt, which can be redeemed at a set price before it matures, to hedge against interest rate declines. Because homeowners can pay off their mortgages early to refinance at lower rates, Fannie must adjust its debt equally to reduce its interest costs and maintain its profit margins.
Though using such debt made sense for the nation's largest buyer of home mortgages, Ms. Knight knew that investors found the bonds harder to trade and value than standard, noncallable ones. In addition, the pricing models in use at the time relied on snapshots of market volatility.
That left sellers and buyers working with instantly outdated information, said Ms. Knight, who has been with Fannie for 20 years and its treasurer for the past decade.
"Given the importance of callable debt to Fannie Mae's hedging strategy, the question was: How do we get more transparency and attract as broad a range of investor as possible?" she said.
Ms. Knight, who arranges Fannie's bond sales and plans hedges for $800 billion of debt, collaborated with Bloomberg LP and TradeWeb LLC, the biggest online bond-trading platforms, to create standards for pricing Fannie's callable debt. The result is a function on Bloomberg terminals that incorporates TradeWeb's government bond prices, current Fannie yield curves, and real-time changes in market volatility.
Interest in Fannie's callable debt is growing. "The biggest accounts are starting to get involved," said Beth Hammack, the head of agency debt at Goldman Sachs Group Inc.
From July 2001 to November 2002 the government-sponsored enterprise sold $30.3 billion of its large, benchmark callable-note issues, which form the basis of most secondary-market trading.
Before Fannie issues callable debt, Ms. Knight's staff calculates a likely price level and spread. Wall Street underwriters use that data to develop their own models and present the offering to their customers. After receiving feedback from underwriters on what investors think of the deal, Ms. Knight and her team review printouts showing different scenarios and then set the bond issue's final price and structure.
Last year Fannie took advantage of falling rates with its callable debt. As the yield on 10-year Treasuries fell below 4% in September, from 5.16% at the start of the year, the GSE redeemed the bonds it had sold when rates were higher and issued callable debt at lower rates.
Its ability to call bonds helped it weather the impact of the fastest quarterly interest rate drop in two decades, according to Scott Graham, the head of agency debt trading at RBS Greenwich Capital, a unit of Royal Bank of Scotland Group PLC.
In the third quarter investors who perceived unwanted risk from record home refinancings sold Fannie's stock and bonds until they were persuaded that its hedging strategies were working.
The GSE also hedges interest rate swings with swaps and options.
Fannie shares fell to a two-year-low of $59.54 on Sept. 30, from $76.72 on Sept. 9. After the GSE reassured the markets that there was less chance of a mismatch between its assets and liabilities, the stock rebounded, to $71.89 by Oct. 18,.
Fannie sold about $130 billion of callable debt issues in the first 11 months of last year - almost six times as much as it sold in all of 2000. About 25% of the benchmark issues have been sold in Asia.
