Steering Clear of Risk Has Costs as Well as Benefits.

When you examine the 800-pound gorillas of the mortgage industry, Fannie Mae and Freddie Mac, they look a lot alike. But when it comes to managing interest rate risk, Freddie Mac seems to be the more conservative of the two giants.

Fannie Mae took some heat last August for letting its "duration gap" extend to negative 14 months, indicating that its mortgages were prepaying faster than its debt was expected to repay. Fannie Mae took steps to reduce the duration gap in the following months, but advised investors that it does not hedge all of its interest rate risk. Investors were warned that the duration gap was likely to move beyond the target range of plus or minus six months from time to time.

Freddie Mac, on the other hand, was quick to point out that its duration gap was nearly zero at the time, and remained within a narrow range throughout last year, despite the unexpected downward trend in interest rates.

But there is a price to pay for such aggressive hedging, as Freddie Mac's 2002 earnings report makes clear. Freddie Mac reported excellent results, as one would expect from a year when residential mortgage originations surged to a record $2.5 trillion.

But it also announced that its new accountant, PricewaterhouseCoopers, is requiring changes that will require Freddie Mac to restate its earnings for prior periods. The issue affects the timing of gains, and Freddie Mac will apparently be required to restate past earnings upwards, essentially stealing earnings that would have been saved for future periods under the previous accounting procedure.

The issue, Freddie Mac executives explained during a conference call with investors and analysts, reflects the question of when gains should be recognized with ...