In the battle for investors' hearts and minds,

Fannie Mae

won an importantskirmish Tuesday, although the war is far from over.

The firm reported that its duration gap fell to 10months in September vs. 14 months in August. At 2:32p.m. EDT, Fannie Mae shares were up 4.9%, outpacingmajor averages, which were solidly higher after initially struggling to digest another round of uninspiring economic data.

Fannie Mae's main business -- and itscongressional mandate -- is to purchase mortgages fromprimary lenders in order to support the housingmarket. Because of its implied government backing,Fannie Mae is able to borrow at advantageous rates,and generates the bulk of its profit from the spreadbetween the yield on its $747 billion mortgageportfolio and the cost of its debt, or agencysecurities.

Record refinancing activity this year hasdiminished the average life of its mortgage portfolio,creating a mismatch between its assets andliabilities, known as its duration gap.

A duration gap of 10 months for September is stilloutside Fannie Mae's target of six months or less andlarger than the nine months reported for July. But thefirm's ability to reduce its gap from 14 months inAugust brought relief to shareholders. Fannie Mae'sduration gap announcement on Sept. 16 raised a

host of concerns aboutthe company's earnings prospects and risk exposure.

Clearly, Fannie Mae was concerned about thetorrent of negative coverage its August duration gapnews unleashed, and sought to pre-empt concern aboutthe September number by releasing it earlier thanexpected.

"Due to the greatly heightened interest in thisnumber currently, we are electing to release ourSeptember 30 duration gap ahead of our normalschedule," Fannie Mae CFO Timothy Howard said in thefirm's statement. "Future duration gap releases willfollow the mid-month schedule."

Other measures of Fannie's monthly performancewill be released with the firm's regularly scheduledthird-quarter results midmonth, Howard said. Noofficial release date has yet been set.

Dealing With Duration

Janis Smith, a spokeswoman for the firm, saidFannie Mae reduced its duration gap through acombination of hedging activity, loan purchases,issuance of short-term securities and a buyback oflonger-term debt. Smith would not comment specificallyon what the firm had been buying, although wireservices reported Fannie repurchased $846 million ofits benchmark notes due to mature in 2009 and 2012 onSept. 24.

"We can't give a road map

because obviously itcould have a market impact," she said.

Many fixed-income players believe Fannie Mae wasbuying long-dated Treasury securities, or theirequivalents, in an effort to reduce its duration gap.

Jim Bianco, president of Bianco Research in Barrington, Ill., estimated the firm had to buy the equivalent of $60 billion of 10-year Treasuries to move the duration gap to 10 months from 14 months.

The expectation Fannie Mae's need for long-dated securities will now be diminished was cited as one reason for weakness in Treasuries Tuesday.

The price of the benchmark 10-year note was latelydown 29/32 to 105 17/32, its yield rising to 3.70%, despite aweaker-than-expected Institute for Supply Management's factory index report for September and a larger-than-expected drop in construction spending in August.

Weak economic data are usually beneficial toTreasuries, because faster growth is associated withhigher inflation, which erodes the value of futureinterest payments. The fact Fannie Mae's internalduration gap needs could cause big movements in theU.S. Treasury market is one critique levied againstthe firm.

"Their activity explains why

10-year Treasury yields fell so much in September," Bianco said. "Yes, rates would have gone down anyway but they wouldn't have gone down 54 basis points."

Bianco, an increasingly vocal critic of Fannie Mae, suggested Tuesday's earlier-than-expected duration gap announcement suggests the firm is "managing actively to reporting dates" and wondered why the firm didn't release other measures of monthly performance. Fannie Mae's Smith countered that the firm released the duration-gap information sooner than normal because of the "inordinate amount of attention" it has received. "We didn't want market activity to be based on speculative, potentially erroneous information," she said.

Nevertheless, "10

months is still a big number," Bianco said, and suggests Fannie Mae is "still actively making a bet that interest rates are going to rise to close the gap."

Fundamentally, Bianco agrees that rates are most likely to rise, which would alleviate many of Fannie Mae's problems (although create them for others.) However, "I'm concerned that the market is shooting at Fannie Mae, knowing these guys are making a bet on rising rates," he said, again alluding to when Long Term Capital Management was under pressure in 1998. "If the market thinks they got Fannie Mae on the run, it might encourage people to keep buying Treasuries, knowing they can sell their positions to Fannie or its dealers," which keeps the cycle of lower rates causing Fannie to buy --- again causing lower rates.

The Show Must Go On

As noted previously, some other of Fannie's staunchest critics dismiss the

comparisons of Fannie Mae to Long TermCapital. The allusion is also somewhat ironic, according to Doug Noland, financial markets strategist at David Tice & Associates in Dallas, given his belief Fannie Mae played a large role in the Fed-engineered bailout when the hedge fund imploded.

Tice & Associates is short Fannie Mae, but Nolandsaid it's not a large position in the firm's $375million

(BEARX) - Get Report

Prudent Bear fund, which is up74% year to date and 35% in the past year, accordingto Morningstar.

"To me this duration-gap issue is not the key part of what's going on

but a symptom of the unfolding problem," Noland said in an interview late last week. "The issue is they are so big and

because of this whole credit boom, institutions have to aggressively create credit to keep housing prices levitated."

The problem, Noland contended on Web site, is that the growth ofmortgage credit "adds to the amount of risk that mustbe mitigated by dynamic market trading strategies," orhedging activity, at a time when there's a "shrinkingpool of players willing or able to accept marketrisk."

With a derivatives portfolio of approximately $600billion, Fannie Mae is one of the largest customers ofderivatives in the world. Notably,

J.P. Morgan

(JPM) - Get Report

, by far the largestderivatives dealer, is having some

troubles of its own.

If J.P. Morgan retrenches from the derivatives market either becauseof an internal decision or external pressures, such asanother credit-rating downgrade, Fannie Mae (andothers) might have difficulty finding othercounterparties.

"If 25% of J.P. Morgan's derivatives business hasto be scaled down, maybe 80% is going to be absorbedby other participants," mused David Hendler, ananalyst at CreditSights, an independent, fixed-incomeresearch firm. For the remainder, derivativescustomers are not going to find dealers eager to takethe other side of trades, and are either going to haveto scale back their usage or pay more for it, heforecast. "The whole market has become more sensitizedto credit risk."

In a

speechlast Wednesday,

Federal Reserve

Chairman AlanGreenspan lauded the use of derivatives as a "majorcontributor to the dispersion of risk in recentdecades."

But one man's "dispersion of risk" is another's"potent brew for a financial accident," to useNoland's term. Notably, fiascos such as OrangeCounty, Calif., in 1994 and Long Term Capital Managementin 1998 were exacerbated by, if not due to, the misuseof derivatives.

The bottom line being that while Fannie Mae issuedsome legitimate good news this morning, it's a stretchto say the risks surrounding this company -- and, becauseof its size, the broader market -- have been eliminated.

Aaron L. Task writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.