THERE is a volcano rumbling in the US, with many praying it does not erupt. Concerned observers of the accounting troubles at mortgage financier Fannie Mae include both the International Monetary Fund and the Federal Reserve Bank.

The Reserve Bank of Australia is also keeping an eye on developments.

Fannie Mae, a statutory corporation enjoying a US government guarantee, has a balance sheet of a little over $US1 trillion ($1.37 trillion), which is about 75 per cent larger than the entire Australian GDP.

The organisation buys mortgages from retail banks and other household mortgage providers and then packages them into tradeable mortgage-backed securities.

The standard US mortgage has a fixed rate with a 30-year term. Mortgage holders have the right to refinance their mortgages when interest rates fall.

At the moment, with interest rates rising, anyone financing long-term loans with short-term debt will be out of the money.

However, Fannie Mae covers the risks of rates moving, and of mortgage holders refinancing, by using derivatives markets.

For the past month, an accounting scandal has been developing, with the regulator accusing Fannie Mae of manipulating the way it accounts for derivatives in order to smooth earnings and pay executive bonuses.

The company has been defending its practices, and it is not yet clear that any restatement of its accounts will seriously erode its capital, or standing in the market.

However, the sheer scale of Fannie Mae – and of the mortgage securities market, for which it is the biggest originator – is cause for nervousness.

The US housing market has been booming, much like the housing markets in Australia and Britain, and Fannie Mae has grown with it.

Fannie Mae’s new mortgages soared by 55percent last year to $US573 billion.

The Wall Street Journal quoted one of the governors of the Federal Reserve, Susan Bies, saying that if anything happened to Fannie Mae – and it’s twin, Freddie Mac, which has a similar business and is also government-guaranteed – the impact would be felt in mortgage markets across the country.

“What I worry about is that these organisations have gotten so large and have such aggressive growth plans,” she said.

Any problem would be like the widespread collapse of North America’s version of building societies, “savings and loans”, which occurred in the 1980s, she said, with taxpayers bearing the cost.

Fannie Mae has many enemies in US financial markets because of its access to a government guarantee.

The American Enterprise Institute and the Cato Institute have called for it to be privatised, and some see the hand of AEI and Cato behind the attacks on its practices.

But the accounting troubles at Fannie Mae have had little impact on the value of its mortgage securities, suggesting the market does not see serious problems.

However, the rocks of malpractice are usually exposed when the tide in financial markets goes out.

Enron and Worldcom were exposed as the IT bubble burst, and entrepreneurs such as Mike Milken in the US and Alan Bond in Australia were exposed by the 1987 crash.

In the case of mortgage markets, the change has been the new direction in interest rates, with the yield curve shifting from historically steep, with low short rates and high long rates, to relatively flat.

This change is putting the hedging strategies of those involved in financing the US mortgage market to the test.

Some banking regulators contend that the risks in Fannie Mae have been known for such a long time that they are likely to have been covered.

They suggest the biggest problems in the mortgage market are more likely to emerge from left field.

The biggest buyer of Fannie Mae’s interest rate risk has been a group of five Wall Street investment banks.

They have been covering that risk in the US government treasuries market.

However, the scale of the mortgage market is now so big that there is concern any disruption could flow to interest rates more broadly.

The IMF recently warned that the hedging of mortgage securities by Fannie Mae and Freddie Mac could make US interest rates more volatile as they hedged against expected interest rate rises.

The Reserve Bank’s recent review of financial market stability also highlighted the potential for extreme market volatility as a result of investors using the bond market to hedge interest rate risk associated with US mortgage-backed securities.