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GIOA Conference March 2011 - Las Vegas Callable Debt Workshop

GIOA Conference March 2011 - Las Vegas Callable Debt Workshop. Jim Zucco – Director Funding Fannie Mae Treasury. To maintain our asset/liability match, Fannie Mae uses option embedded debt along with actively rebalancing the portfolio. .

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GIOA Conference March 2011 - Las Vegas Callable Debt Workshop

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  1. GIOA Conference March 2011 - Las Vegas Callable Debt Workshop Jim Zucco – Director Funding Fannie Mae Treasury

  2. To maintain our asset/liability match, Fannie Mae uses option embedded debt along with actively rebalancing the portfolio. Duration of MBS Component of Barclays Aggregate Fixed-Income Index Fannie Mae Duration Gap Source: Fannie Mae, Barclays Capital * As of January 31, 2011

  3. Monthly callable debt issuance activity Source: Fannie Mae

  4. 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. 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 instruments • with a variety of maturity dates along the yield • curve. • 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): • American-style (continuous); • European-style (one-time); • Bermudan-style (only on a predetermined schedule of dates); • Canary-style (on a predetermined schedule of dates until designated called period ends).

  5. Fannie Mae’s flexible, responsive, and efficient reverse inquiry process 1-5 minutes Fannie Mae’s Long Term Funding Desk Investor Dealer (~ 50 firms) Customized Callable Debt Security Maturity 1-year to 30-years Lockout 3-months to 10-years Call Option European Bermudan American Canary Coupon Fixed-rate Floating rate Step-up Float-to-fixed

  6. Callable Medium-Term Notes (MTNs) Issuance by Call Feature Source: Fannie Mae, Bloomberg * As of February 28, 2011

  7. Callable MTN Issuance by Maturity Bucket Source: Fannie Mae * As of February 28, 2011

  8. Callable MTN Issuance by Lockout Period (in millions) 2011* Source: Fannie Mae * As of February 28, 2011

  9. 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 * 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

  10. Callable notes outstanding varies over time but is relative to overall assets held on balance sheet Y/E Balance (Blns) Projected Balances – 10% Reduction Source: Fannie Mae

  11. Through a combination of lockout and maturity, Fannie Mae issues different structures that offer a variety of risk profiles Source: Fannie Mae

  12. 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……

  13. Bullet and callable spreads for 5 Y bullet and new issue 5nc1Y 1X callable note Callable spreads are driven by those two factors, 5 Y bullet spreads and the value of the call option. Source: Fannie Mae

  14. No market for options on Agency rates…..we utilize option pricing on swap rates as the two markets are highly correlated Source: Fannie Mae

  15. Option terminology….Black (Yield) vol: Market quoted implied volatility used to translate volatility to priceNormal (BP) vol: Yield volatility multiplied by the forward rate. A measure that “normalizes” yield volatility with level of rates. 5nc1 Y Example….Forward Rate…. As implied by current yield curve. Volatility quote is based on the strike set at the forward.Implied volatility sets the expected range of future rates. The higher the volatility assumption, the wider the expected range.

  16. The Call Spread is dictated by the volatility assumption that is used to value the embedded option. Source: Fannie Mae

  17. 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) Source: Fannie Mae

  18. The relationship of the callable coupon to the forward rate (“Moneyness”) is driven by shape of the curve. Source: Fannie Mae

  19. “Moneyness” can dictate the overall risk profile of the callable note….duration measure. Source: Fannie Mae

  20. “Moneyness” can dictate the overall risk profile of the callable note….convexity measure. Source: Fannie Mae

  21. 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

  22. Different sectors of the volatility surface reflect the market’s view on future rates and monetary policy. Source: Barclays Capital

  23. Implied volatility levels fluctuate with rate levels though the relationship has reversed since 2009. Source: Barclays Capital

  24. The volatility on strikes that are not ATM can vary. Below is 1x4 normal volatility with strikes +/- 200 bps. 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

  25. Will a bond be called? European, fixed rate note… AssumptionsDiscounting curve: I252 (Fannie Mae Benchmarks) via AOASCall price: Par (100)Settlement: Call DateVolatility assumption: ZeroCall decision: Positive (negative) OAS – bond is called (extends) Source: Bloomberg

  26. Will a bond be called? Bermudan, step-up….. AssumptionsDiscounting curve: I252 (Fannie Mae Benchmarks) via AOASCall price: Par (100)Settlement: Next Call DateVolatility assumption: Volatility surface – Bloomberg Model HCall decision: Positive (negative) OAS – bond is called (extends) Source: Bloomberg

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