GIOA Conference
March 2011 - Las Vegas
Callable Debt Workshop
Jim Zucco – Director Funding
Fannie Mae Treasury
1
1
1
To maintain our asset/liability match, Fannie Mae uses
option embedded debt along with actively rebalancing the
portfolio.
5
4
Years
3
2
1
Duration of MBS Component of Barclays Aggregate Fixed-Income Index
Fannie Mae Duration Gap
0
Jan-11
Nov-10
Sep-10
Jul-10
May-10
Mar-10
Jan-10
Nov-09
Sep-09
Jul-09
May-09
Mar-09
Jan-09
Nov-08
Sep-08
Jul-08
May-08
Mar-08
Jan-08
Nov-07
Sep-07
Jul-07
May-07
Mar-07
Jan-07
Nov-06
Sep-06
Jul-06
-1
Source: Fannie Mae, Barclays Capital
* As of January 31, 2011
2
2
2
Issued
Called
Feb-11
Dec-10
Oct-10
$ in billions
45
Aug-10
Jun-10
Apr-10
Feb-10
Dec-09
Oct-09
Aug-09
Jun-09
Apr-09
Feb-09
Dec-08
Oct-08
Aug-08
Jun-08
Apr-08
Feb-08
Dec-07
Oct-07
Aug-07
Jun-07
Apr-07
Feb-07
Dec-06
Oct-06
Aug-06
Jun-06
Apr-06
Feb-06
Monthly callable debt issuance activity
5 Year UST Yield
5.50
40
5.00
35
4.50
30
4.00
25
3.50
20
3.00
15
2.50
10
2.00
5
1.50
0
1.00
5 Yr UST
Source: Fannie Mae
3
3
3
Structural Features of Callable Debt
Maturity Date
The latest and final possible date at which the
security will be retired and principal will be
redeemed at par.
Fannie Mae issues callable debt instruments
with a variety of maturity dates along the yield
curve.
Lockout Period
The amount of time for which a callable
security cannot be called. For example, with
a 3 noncall 1-year (“3nc1”) debt security, the
security cannot be called for the first year.
During this time, only coupon payments are
made
Type of Call Feature
The type of call options embedded in a
callable security
Fannie Mae issues callable debt with lockout
periods of three months to as long as 10 years.
Fannie Mae callable debt issues incorporate one
of the following call features (after the lockout
date):
1)
American-style (continuous);
2)
European-style (one-time);
3)
Bermudan-style (only on a predetermined
schedule of dates);
4)
Canary-style (on a predetermined schedule
of dates until designated called period
ends).
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4
4
Fannie Mae’s flexible, responsive, and efficient reverse inquiry
process
1-5 minutes
Investor
Fannie Mae’s
Long Term
Funding Desk
Dealer
(~ 50 firms)
Customized Callable Debt
Security
Maturity
Lockout
Call Option
Coupon
1-year
to
30-years
3-months
to
10-years
European
Bermudan
American
Canary
Fixed-rate
Floating rate
Step-up
Float-to-fixed
5
5
5
Callable Medium-Term Notes (MTNs) Issuance by Call Feature
Callable MTN Issuance (in millions)
American Options*
Bermudan Options
European Options
Total Callable MTN Issuance
2007
$7,799
58,638
77,725
$144,162
2008
$8,341
47,593
96,601
$152,535
2009
$11,070
64,505
116,204
$191,778
2010
$5,740
161,070
142,381
$309,191
2011*
$350
11,583
12,630
$24,563
% American Options
% Bermudan Options
% European Options
5.4%
40.7%
53.9%
5.5%
31.2%
63.3%
5.8%
33.6%
60.6%
1.9%
52.1%
46.0%
1.4%
47.2%
51.4%
Average 5-Year UST Yield
4.42%
2.80%
2.20%
1.93%
2.11%
Issuance figures are limited to long term callable debt issuance.
Source: Fannie Mae, Bloomberg
* As of February 28, 2011
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6
6
Callable MTN Issuance by Maturity Bucket
$350
100%
90%
$300
80%
60%
$200
50%
$150
40%
30%
($ billions)
$250
70%
$100
20%
$50
10%
$0
0%
2007
2008
2-year
2009
3-year
5-year
2010
10+ years
2011*
Total issuance
Source: Fannie Mae
* As of February 28, 2011
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7
7
Callable MTN Issuance by Lockout Period
(in millions)
85%
91%
94%
99%
100%
100%
80%
80%
60%
60%
37%
30%
40%
40%
20%
20%
0%
0%
2006
Source: Fannie Mae
2007
2008
2009
2010
2011*
Less than or equal to 3-months lockout
Greater than 3-months to 1-year lockout
Greater than 1-year lockout
Noncall periods one year or less as a percent of total callable issuance
* As of February 28, 2011
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8
8
Fannie Mae is focused on the issuance of callable MTNs that
are $250 million or larger issue sizes with multiple dealer
underwriters*
Total Issuance
Number of Transactions
$80
160
$69.7
$70
139
94
$35.0
$24.7
$30
56
46
40
$20
$10
9
$4.8
YT
D
20
11
20
10
20
09
20
11
YT
D
20
10
20
09
20
08
20
07
20
08
0
$0
20
06
75
80
$29.8
20
07
$40
120
$49.5
$50
20
06
($ in billions)
$60
* Callable MTNs from January 1, 2011 to February 28, 2011, three callable issues were $1 billion or larger in size totaling $3 billion.
Source: Fannie Mae
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9
9
Callable notes outstanding varies over time but is relative to
overall assets held on balance sheet
Y/E Balance
(Blns)
1,000
40%
905
Projected Balances – 10% Reduction
787
800
727
724
789
773
729
724
35%
656
590
600
531
30%
400
249
250
275
267
218
227
229
212
200
190
171
154
0
25%
20%
2004
2005
2006
Mortgage Portfolio
2007
2008
2009
Callable Debt
2010
2011
2012
2013
2014
Callables % of Assets (RHS)
Source: Fannie Mae
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10
10
Through a combination of lockout and maturity, Fannie Mae
issues different structures that offer a variety of risk profiles
Duration and convexity profiles for the most common
European-style callable debt structures
0.5
2NC1
2NC6m
-1
3NC6m
15NC5
10NC3
7NC2
10NC2
5NC1
-1.5
10NC4
7NC3
5NC2
3NC1
-0.5
Convexity
7NC4
5NC3
0
7NC1
5NC6m
-2
-2.5
10NC6m
-3
-3.5
0
1
2
3
4
5
6
7
8
9
Duration
Source: Fannie Mae
11
11
11
How do we value and price callable debt?
From our perspective, a five year maturity where we have the
ability to call the note in one year with four years remaining.
Hence, valuation components are two fold:
* Our bullet cost of funds, one to five years.
* Cost of the option that allows us to call a four year bond,
one year forward. This is where it gets more
complicated……
12
12
12
Bullet and callable spreads for 5 Y bullet and new issue 5nc1Y
1X callable note
5Y Bullet and 5nc1Y 1X Spreads
75
Spread (BPs)
65
Callable Spread
55
45
Bullet Spread
Call Spread
35
25
15
2/8/10
5/4/10
7/29/10
10/25/10
1/20/11
Callable spreads are driven by those two factors, 5 Y bullet spreads and the
value of the call option.
Source: Fannie Mae
13
13
13
No market for options on Agency rates…..we utilize option
pricing on swap rates as the two markets are highly correlated
5Y Agency and Swap Correlation and Vol Ratios *
120%
Correlation
Correlation %
110%
Ratio Realized
(Agy/Swap)
100%
90%
80%
1/12/05
* 100 day moving average
1/12/06
1/11/07
1/10/08
1/12/09
1/12/10
1/10/11
Source: Fannie Mae
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14
Option terminology….
5nc1 Y Example….
Black (Yield) vol: Market quoted implied
volatility used to translate volatility to price
Forward Rate…. As implied by current yield
curve. Volatility quote is based on the strike
set at the forward.
Normal (BP) vol: Yield volatility multiplied by
the forward rate. A measure that
“normalizes” yield volatility with level of
rates.
Implied volatility sets the expected range of
future rates. The higher the volatility
assumption, the wider the expected range.
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15
The Call Spread is dictated by the volatility assumption that is
used to value the embedded option.
5nc1Y 1X Call Spread to 5Y Bullets
vs Implied Vol
45
140
120
35
100
Vol (BPs)
Cpn Spread (BPs)
Call Spread
1x4 BP Vol (RHS)
25
80
15
2/8/10
60
5/4/10
7/29/10
10/25/10
1/20/11
Source: Fannie Mae
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Calculating the par priced, callable bond coupon is an iterative
process. The coupon (strike) where the value of the high
coupon bullet is offset by the value of the option.
5nc1Y 1X Callable Pricing (as of 3/3rd)
Market Information
Coupon
Bullet
Price
Option
Value
Callable
Price
Duration
Convex
YTM
YTC
1 Year Agy
0.31%
3.25%
102.9
(2.0)
101.5
2.6
(1.18)
2.93%
1.75%
4 Year Agy
2.00%
3.00%
102.3
(1.5)
100.8
3.0
(1.22)
2.82%
2.16%
5 Year Agy
2.51%
2.72%
101.0
(1.0)
100.0
3.3
(1.17)
2.72%
2.72%
1x4 Forward
3.09%
2.50%
99.9
(0.7)
99.3
3.7
(1.06)
2.66%
3.26%
ATM Vol
112.6 BPs
2.25%
98.8
(0.4)
98.3
4.0
(0.86)
2.61%
3.96%
Black Vol
36.4%
Source: Fannie Mae
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The relationship of the callable coupon to the forward rate
(“Moneyness”) is driven by shape of the curve.
0
20
(10)
30
(20)
40
(30)
50
(40)
60
(50)
70
(60)
2/8/10
80
5/4/10
7/29/10
10/25/10
Callable Cpn vs
Forward
Curve (BPs - invert)
Moneyness (BPs)
5nc1Y 1X "Moneyness" and 1x4Y Forward Rate
1x4Y Forward vs
5Y (RHS)
1/20/11
Source: Fannie Mae
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18
18
“Moneyness” can dictate the overall risk profile of the callable
note….duration measure.
0
2.8
(10)
2.9
(20)
3
(30)
3.1
(40)
3.2
(50)
3.3
(60)
2/8/10
3.4
5/4/10
7/29/10
10/25/10
Callable Cpn vs
Forward
Duration (invert)
BPs
5nc1Y 1X Duration vs "Moneyness"
Duration (RHS)
1/20/11
Source: Fannie Mae
19
19
19
“Moneyness” can dictate the overall risk profile of the callable
note….convexity measure.
5nc1Y 1X Convexity vs "Moneyness"
0
Callable Cpn vs
Forward
-2
(20)
-1.5
(30)
(40)
-1
Convex (invert)
Moneyness (BPs)
(10)
Convexity (RHS)
(50)
(60)
2/8/10
-0.5
5/4/10
7/29/10
10/25/10
1/20/11
Source: Fannie Mae
20
20
20
Bermudan pricing is the same process, the only difference is
the use of a volatility surface instead of a single volatility
assumption.
The Bermudan volatility for a 5nc1Y is 32.1% compared to 36.4% for the 1X callable.
However, the Bermudan coupon is still 6 BPs higher than the 1X bond.
Source: Fannie Mae
21
21
21
Different sectors of the volatility surface reflect the market’s
view on future rates and monetary policy.
Source: Barclays Capital
22
22
22
Implied volatility levels fluctuate with rate levels though the
relationship has reversed since 2009.
Source: Barclays Capital
23
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23
The volatility on strikes that are not ATM can vary. Below is 1x4
normal volatility with strikes +/- 200 bps.
1x4 Swaption Vol Across Strikes
Normal Vol (BPs)
200
150
100
81
84
88
92
95
99
104
108
112
117
121
126
130
135
140
144
149
Lognormal
(Constant
Yield vol)
Market
Normal
50
0
-200
-150
-100
-50
ATM
50
100
150
200
Strike
The difference between the ATM volatility and the one used for varying strikes is referred to
as “skew”. Right now, high (low) strikes trade at a higher (lower) implied volatility
compared to the ATM. AOAS is set to normal volatility.
Source: Fannie Mae
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Will a bond be called? European, fixed rate note…
Assumptions
Discounting curve:
Call price:
Settlement:
Volatility assumption:
Call decision:
I252 (Fannie Mae Benchmarks) via AOAS
Par (100)
Call Date
Zero
Positive (negative) OAS – bond is called (extends)
Source: Bloomberg
25
25
25
Will a bond be called? Bermudan, step-up…..
Assumptions
Discounting curve:
Call price:
Settlement:
Volatility assumption:
Call decision:
I252 (Fannie Mae Benchmarks) via AOAS
Par (100)
Next Call Date
Volatility surface – Bloomberg Model H
Positive (negative) OAS – bond is called (extends)
Source: Bloomberg
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