November 20, 1998, p. 8
 

Fannie on Way to Creating Alternative Yield Curve

By JOSHUA BROCKMAN

     The term "yield curve"-as Wall Street and
fixed-income investors know it-may be changing
forever. At least that's the dream of Fannie Mae,
which this year started to build its own yield curve
when it launched a noncallable debt program.

     The U.S. government budget surplus created a
market opening for the quasi-governmental agency,
which is the largest buyer of mortgages on the
secondary market, and which dwarfs most private
companies. With the Treasury reducing issuance, Fannie
saw an opportunity to attract investors interested in
a large, liquid substitute for government debt.

     Now, with over $40.25 billion in noncallable
Benchmark notes issued to date, the program has given
the company a "worldwide premium position in global
markets," said James A. Johnson, chief executive
officer and chairman of Fannie, on Wednesday.

     Fannie securities are already being used as a
substitute for Treasury securities in risk management
and other investment strategies, Mr. Johnson said.

     "Benchmark notes for all their simplicity
-issuing large, liquid deals - are radical in that no
entity other than Treasury had ever tried to,
on a regular basis, issue large deals," said Linda
Knight, senior vice president and treasurer at Fannie
Mae. "We are very serious about building a yield
curve."

     Fannie uses the proceeds to fund mortgage
purchases for its portfolio, meaning the program has
contributed mightily to liquidity for U.S. mortgage
lenders, when other types of assets cannot be sold at
any price.

     And current market conditions have given Fannie
"tremendous opportunities to grow our book," Ms.
Knight said, with the difference between spreads on
the assets Fannie buys and the debt Fannie issues
as "positive as we have seen in the 1990s."

     Fannie Mae kicked off its program in January by
providing guidelines on how it intended to issue
notes: Each month it would come to market with a new
issue, reopen an existing issue, or pass.

     To date the company has brought eight new issues
to market and has reopened six other notes, including
notes with three-, five-, seven-, and 10-year
durations. The high number of reopenings was a result
of investor interest in larger deals, Ms. Knight said.

     "We need to have a whole range of securities, a
whole yield curve of agencies," said Larry Hill,
executive vice president for Investment Advisers Inc.,
a subsidiary of LLoyds TSB Group PLC in Minneapolis.

     Larger issues mean better trading for investors.
Investors similar to Mr. Hill, who has up to 10%, or
about $250 million, of his portfolio in agencies, feel
"more comfortable holding core positions in agencies
instead of just holding them all in Treasuries,"
because the program enables investors to get
"high-quality yield" at the same point on the yield
curve, he said.

     The type of notes Fannie issues is determined by
mortgage portfolio funding needs and demand from
investors. The program is most successful "if we can
meet the needs of the investor base and the needs of
the mortgage portfolio at the same time," Ms. Knight
said.

     Wall Street has played an active role in selling
Fannie's notes to investors and in providing the
Washington-based enterprise with details on primary
and secondary market trading.

     "On the one hand, we have given them something of
value: a large, liquid deal that sells well," Ms.Knight said.
"But they have added their commitment to trading the
security, to actively trade it with very tight bid offers."

     The dealer community also quickly established a
repo market, borrowing and repurchasing Fannie Mae
securities just as they would with Treasuries,
Ms.Knight said.

     Fixed-income executives on Wall Street say that
the key to Fannie maintaining the momentum of the
program is consistency through regular issues.

     "Wall Street is anxious to do business with
Fannie Mae, but Fannie Mae always listens and tries to
respond to dealer input," said Edward I. O'Brien Jr.,
senior vice president and manager of government agency
trading for Prudential Securities Inc.

     Investors and Wall Street dealers say that the
most active issues have been the five- and 10-year
notes. But to round out the yield curve, Fannie will
need to issue the two-year and 30-year notes,
investors said.

     The minimum investment is $10,000, but some Wall
Street dealers have seen purchases as high as $100
million.

     Margaret Danuser, a portfolio manager for
Founders Asset Management LLC, a mutual fund company
owned by Mellon Bank, said that she has actively
traded Benchmark notes in the five- and ten-year
sector, and that she regards the notes as a type of
"Treasury surrogate, which are very liquid."

     Benchmark notes are "an easier animal to deal
with," she said, because the issues are large and
liquid and have higher credit quality than other
spread products. The spread that is offered on these
securities over the Treasury also gives a "yield
boost," she said.

     But when problems racked the credit markets
during the past four months, noncallable issues were
not immune. And investors were so risk-averse that
they were only buying Treasuries, Ms. Danuser said.

     The notes "widened out significantly along with
any other spread-type product despite its credit
quality and liquidity," she said.

     In August, at the height of the credit crisis,
Fannie's 10-year note was as wide as 80 basis points
over the 10-year Treasury, she said. Earlier in
the summer its spread was 33 basis points over the
10-year Treasury, and at Wednesday's close it was 54
points over the 10-year.

     As with any promising program, Fannie has
competition.

     Fannie Mae's secondary-market rival Freddie Mac
also has a noncallable debt program. Freddie has
issued $16 billion of notes in its Reference note
program - $8 billion  with five-year maturities, $8
billion with 10-year.

     Freddie Mac said that it may reopen new and
previously issued notes by at least $1 billion up to
an individual bond limit of $10 billion. Freddie
also said it hopes to issue $40 billion of notes over
the next 12 months in bonds with terms between two and
10 years, depending on market conditions.

     And sources on Wall Street say that the Federal
Home Loan Bank System is putting together a program to
focus on noncallable notes that are five years and
shorter in duration.

     One fixed-income executive on Wall Street said
that these noncallable debt programs have also gained
momentum because the callable debt market has become
"a shadow of its former self" in the aftermath of
economic turmoil in Asia.

  Copyright (c) 1998 Joshua Brockman