By some accounts, the driving forces in the US rates markets before the financial crisis were not big investment banks or name-brand hedge funds. It was Fannie Mae and Freddie Mac.
The two government-sponsored enterprises (GSEs) buy qualifying mortgages made to US homebuyers, freeing up bank balance sheets to continue lending, and bundle them as mortgage-backed securities (MBSs) with a credit guarantee. Investors bought up the bonds, but the entities retained or purchased many bonds and mortgages for their own books.
Most importantly, they hedged their risk in large size. Using interest rate derivatives and Treasuries, the two minimised the difference between the expected lifespans of their mortgage holdings and their liabilities, including the callable debt they issued. At their peak before the financial crisis, Fannie and Freddie held more than $1 trillion of MBSs in their retained portfolio, accounting for roughly a third of the market.
“In those early years, the biggest number in the market was not payroll or inflation or GDP. The biggest number was the monthly GSE duration gap,” says Harley Bassman, managing partner at Simplify Asset Management.
I don’t think it’s really going to have any impact on the Treasury market. There’s not enough hedging there to cause a big convexity move
Walt Schmidt, FHN Financial
Since the financial crisis and their takeover by the US government, the GSEs have slimmed down their MBS holdings, allowing banks and the Federal Reserve to step in as significant buyers. But neither of those hedged their portfolios like the GSEs had, so the MBS buying-rates hedging cycle disappeared.
When Donald Trump pointed last month to a $200 billion cash pile at the GSEs and instructed “representatives” to buy the same amount of mortgage bonds, it raised the possibility that the market might eventually see the GSEs push around the rates market. Federal Housing Finance Agency (FHFA) director Bill Pulte clarified that the GSEs would be the ones buying.
But Fannie and Freddie – the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation – are no longer the giants they once were, and it is unlikely the announced buying will have much impact on rates markets.
“We expect the MBS market to grow by $200 billion this year, so if they do $200 billion, they’ll take out 100% of net supply. That’s going to have an impact on spreads. I don’t think it’s really going to have any impact on the Treasury market. There’s not enough hedging there to cause a big convexity move,” says Walt Schmidt, who manages the mortgage strategies group at FHN Financial.
The sentiment was echoed by the Barclays MBS research team in a note last month: “To the extent that GSEs hedge vol, unlike most MBS investors, we could see a slight uptick in implied vols, but that may be difficult to separate from macro impacts.”
Still, it’s possible Fannie and Freddie will look to hedge, and their flows may add a familiar dynamic to rates markets, even if it’s less noticeable than it once was.
“The duration mismatch between GSE debt with their mortgage assets will likely be hedged by paying fixed in SOFR swap[s], and these flows naturally push swap spread[s] wider,” strategists at Deutsche Bank wrote last month.
The GSEs hold fewer mortgages in their retained portfolios than their $225 billion limits allow. In December, filings show the two portfolios totalled $272 billion.
The figure is up $93 billion, or 52%, from May’s holdings, suggesting that president Trump may have been instructing the agencies to do something they had already started. Pulte later said the FHFA gave the GSEs “flexibility to go beyond their previous caps, but the combined incremental total MBS buy will not exceed $200 billion”.
The December figures make for the largest retained portfolio in years but account for 3% of the outstanding market. The Fed, meanwhile, held more than $2 trillion at the end of December while commercial banks held $2.7 trillion. The two together represent roughly half the market.
The announced purchases may simply make up for the Fed’s ongoing balance sheet runoff, which it restarted in 2022 and led to roughly $200 billion in declining holdings last year.
(Never mind) the duration gap
Fannie and Freddie’s hedging activity focused mainly on managing a mortgage portfolio’s negative convexity, the relationship that sees rates and bond duration move together. Falling rates increases the likelihood that homeowners will refinance and take higher-coupon bonds out of the market, meaning the duration of MBSs declines.
The duo would fund their mortgage purchases by issuing callable debt and hedge with derivatives to manage their interest rate risk and the duration gap between their assets and liabilities.
“They’d buy mortgage bonds. They would then short Treasuries, short futures, and pay fixed on swaps to offset the duration, and they would buy swaptions. That’s how you got big volatility in those years as Fannie and Freddie were manoeuvring these trillion-dollar portfolios up and down,” says Bassman.
The process creates a vicious cycle – falling rates means buying Treasuries, which pushes rates lower and forces additional purchases. Hedge funds and dealers monitoring the GSE’s duration mismatch would look to trade ahead of them, adding to the market’s flows.
“They’re gone now, so there’s no one who must buy or sell the market, because there’s no duration gap to manage,” says Bassman.
Even if the GSEs were to increase their holdings and hedge their exposure, refinancing risk is relatively low for much of today’s market where many homeowners borrowed at rates significantly below those currently available.
“Nearly half the country is sitting on a 3% mortgage or less and with current mortgage rates in the sixes, we would need a tremendous rally to move them. But the longer we remain at these rate levels and continue to issue higher rate mortgages, the more we increase the refinance exposure of the overall market,” says Tom Mansley, head of MBS strategy at GAM Investments.
Editing by Lukas Becker
date: 2026-02-09 04:35:00