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Freddie Mac bets against struggling homeowners

January 31st, 2012 12:59 PM by Lehel S.

 

Freddie Mac, the taxpayer-owned mortgage giant, has placed multibillion-dollar bets that pay off if homeowners stay trapped in expensive mortgages with interest rates well above current rates. The trades give Freddie a powerful incentive to do the opposite of its charter — to make home loans more accessible — highlighting a conflict of interest at the heart of the company.

Freddie began increasing these bets dramatically in late 2010, the same time the company was making it harder for homeowners to get out of such high-interest mortgages.

No evidence has emerged that these decisions were coordinated. The company is a key gatekeeper for home loans but says its traders are "walled off" from the officials who have restricted homeowners from taking advantage of historically low interest rates by imposing higher fees and new rules.

Freddie's charter calls for the company to make home loans more accessible. Its chief executive, Charles Haldeman Jr., recently told Congress his company is "helping financially strapped families reduce their mortgage costs through refinancing their mortgages."

But the trades, uncovered in an investigation by ProPublica and NPR, give Freddie a powerful incentive to do the opposite, highlighting a conflict of interest at the heart of the company.

In addition to being an instrument of government policy dedicated to making home loans more accessible, Freddie also has giant investment portfolios and could lose substantial amounts of money if too many borrowers refinance.

"We were actually shocked they did this," says Scott Simon, who, as the head of the giant bond fund PIMCO's mortgage-backed securities team, is one of the world's biggest mortgage bond traders. "It seemed so out of line with their mission."

The trades "put them squarely against the homeowner," he says.

Those homeowners have a lot at stake. Many of them could cut their interest payments by thousands of dollars a year.

Freddie Mac (short for Federal Home Loan Mortgage Corporation), along with its cousin Fannie Mae (Federal National Mortgage Association), was bailed out in 2008 and is now owned by taxpayers.

The companies play a pivotal role in the mortgage business because they insure most home loans in the United States, making banks likelier to lend. Their rules determine whether homeowners can get loans and on what terms.

The Federal Housing Finance Agency (FHFA) effectively serves as Freddie's board of directors and is ultimately responsible for Freddie's decisions. It is run by acting director Edward DeMarco, who cannot be fired by the president except in extraordinary circumstances.

Freddie repeatedly declined to comment on the specific transactions. Late Monday, the FHFA said that last year it asked Freddie to stop making bets against homeowners. The agency also said that the value of the bets was $5 billion.

In addition, the agency said that it had "identified concerns regarding the controls, including risk management, surrounding the inverse floaters," as the investments at issue are known. The agency did not specify its concerns.

Separately, White House spokesman Jay Carney said in a briefing that the Department of the Treasury was "looking into" Freddie's investments.

Freddie's moves to limit refinancing affect not only individual homeowners but the entire economy. An expansive refinancing program could help millions of homeowners, some economists say.

Such an effort would "help the economy and put tens of billions of dollars back in consumers' pockets, the equivalent of a very long-term tax cut," says economist Christopher Mayer of the Columbia Business School. "It also is likely to reduce foreclosures and benefit the U.S. government" because Freddie and Fannie would have lower losses over the long run.

Freddie Mac's trades, while legal, occurred when the company was supposed to be reducing its investment portfolio, according to the terms of its government takeover agreement. But these trades escalate the risk of its portfolio, because the securities Freddie has purchased are volatile and hard to sell, mortgage-securities experts say.

The financial crisis in 2008 was made worse when Wall Street traders made bets against their customers and the public.

Now, some see similar behavior, only this time by traders at a government-owned company who are using leverage, which increases the potential profits but also the risk of big losses, and other Wall Street stratagems.

"More than three years into the government takeover, we have Freddie Mac pursuing highly levered, complicated transactions seemingly with the purpose of trading against homeowners," says Mayer. "These are the kinds of things that got us into trouble in the first place."

Here's how Freddie Mac's trades profit from homeowners unable to refinance. The mortgage sits in a big pile of other mortgages, most of which are also guaranteed by Freddie and have high interest rates. Those mortgages underpin securities divided into two basic categories.

One portion is backed mainly by principal, pays a low return and was sold to investors who wanted a safe place to park their money.

The other part, the inverse floater, is backed mainly by the interest payments on the mortgages. So this portion of the security can pay a much higher return, and this is what Freddie retained.

In 2010 and 2011, Freddie purchased $3.4 billion worth of inverse floater portions — their value based mostly on interest payments on $19.5 billion in mortgage-backed securities, according to prospectuses. They covered tens of thousands of homeowners. Most of the mortgages backing these transactions have high rates of about 6.5 to 7 percent, according to the deal documents.

Between late 2010 and early 2011, Freddie Mac's purchases of inverse floater securities rose dramatically. Freddie purchased inverse floater portions of 29 deals in 2010 and 2011, with 26 bought between October 2010 and April 2011. That compares with seven for all of 2009 and five in 2008.

In these transactions, Freddie has sold off most of the principal, but it hasn't reduced its risk.

First, if borrowers default, Freddie pays the entire value of the mortgages underpinning the securities, because it insures the loans.

It's also a big problem if homeowners refinance their mortgages. That's because a refi is a new loan; the borrower pays off the first loan early, stopping the interest payments. Since the security Freddie owns is backed mainly by those interest payments, Freddie loses.

And these inverse floaters burden Freddie with entirely new risks. With these deals, Freddie has taken mortgage-backed securities that are easy to sell and traded them for ones that are harder and possibly more expensive to offload, according to mortgage-market experts.

The inverse floaters carry another risk. Freddie gets paid the difference between the high mortgages rates and a key global interest rate that right now is very low. If that rate rises, Freddie's profits will fall.

It is unclear what kinds of hedging, if any, Freddie has done to offset its risks.

At the end of 2011, Freddie's portfolio of mortgages was just over $663 billion, down more than 6 percent from the previous year. But that $43 billion drop in the portfolio overstates the risk reduction, because the company retained risk through the inverse floaters.

The company is well below the cap of $729 billion required by its government takeover agreement.

Posted in:General
Posted by Lehel S. on January 31st, 2012 12:59 PM

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