A positive answer to life after the refi boom can be found in a number of new tests and techniques, say Fannie Mae and Freddie Mac. but some analysts say that while the new methods of gauging interest rate risk are solid, no plan is fail-safe.

"A sharp rise in interest rates probably won't hurt Fannie or Freddie significantly, and the securitization strategy is one of the biggest reasons." said Ed Golding, director of policy and planning at Freddie Mac. "Ninety percent of the mortgages we see immediately go out to be securitized or Remic-ed, so the risk isn't really with us as much as it is with the investor."

Other factors that may keep the GSEs safe in the face of rising interest, Golding said, are the advent of long-term callable debt. the institutional capability of tracking and understanding interest rates the GSEs' improved analytical skills and management and control techniques. Still, some wonder what would happen if higher rates cut them off from their customers.

"The question is that if there's a drop in volume as a result of higher rates. does it mean we're going to shrink up and blow away?" Golding said. "The answer is obviously no. [Business] will dry up, but so will our run-off rate. If we ran a strategy where we funded primarily with short-term debt. we would care a lot if (rates) went from 4% up to 12%. That's not the case. We also have a lot of 10-year callable debt in our portfolio, so we're fairly well immunized from changes in interest rates. It's part of our strategy."

Fannie Mae said they were also prepared to weather a rise in interest rates.

The primary mortgage market sees an annual net of 11% a year, according to Kevin Hawkins, a Fannie Mae spokesman. The secondary market has traditionally seen growth at twice that of the primary market. Despite the drawbacks of the business, including prepayments and interest rate risk, "we have the environment to make it grow, with or without refis."

Improving the system was vital when Fannie Mae fell on hard times in the early '80s following a sharp rise in interest rates caused by the U.S. embargo of Middle Eastern oil and a generally sluggish economy.

"At the time, Fannie was just a gigantic thrift and ... had 30-year mortgages backed by short-term debt. Then rates went up and 30-year mortgages stayed where they were. They were trapped," said Gary Cordon, a secondary market analyst for PaineWebber.

The financial damage to Fannie was extensive, Gordon said. Although the agency didn't actually have negative net worth, it was severely beaten and lost money for a couple of years.

Gordon said the agency nearly eliminated the risk over the course of the next 10 years by working down the mismatch between asset maturities and liability maturities, and by buying adjustable-rate loans and creating callable debt, which allows it to have short-term debt when rates are declining and long-term debt when rates are rising.

New government-sponsored enterprise legislation enacted in October also requires both Fannie and Freddie to maintain enough capital to withstand an immediate, lasting 600 basis point rise in interest rates. The GSE test is intensive and dynamic, Golding said. If rates shot up to 12%. the test threshold would change accordingly. Once at 12%. the new test would prepare the GSEs for another interest rate shock, this time at 18%. That, as well as a battery of other tests, will keep the GSEs in good shape when rates begin their inevitable climb.

"You want people to be ever-vigilant because interest rate risk will creep back into a financial institution's system," Golding said. "But a 600 basis point stress test is extremely valuable. There are minimal risks, but if people are vigilant, it's fall-safe," Golding said. "We have the advantage of a good regulatory system, which gets you to as low a level of risk you can get. It's not backward looking, like many tests--it's always looking forward."

Should rates rise sharply again, Gordon said, both agencies are likely to handle it well.

"It shouldn't be anything close to what happened last time." Gordon said. "They would have much longer debt maturities, so the problem would take much longer to hit. Having callable debt is a great help, as well, but it's not perfect protection. Eventually their interest margin would start to narrow, but to really have an impact, it would probably take two or three years."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.