Freddie Didn’t Bet Against Homeowners, It Gambled With Taxpayer Money

This is one of the last places you will find me defending Freddie Mac, but as much as I would like to pile on to the recent story that Freddie “bet against homeowners” the reality is that the nature of the story completely misses the point: Freddie gambled with taxpayer money.

It all started yesterday with a story from ProPublica, who normally does great work, and NPR claiming:

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.

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

The problem with this story can be best communicated in the form of a Jeopardy question (I’ll take Really Simple Finance Concepts for $2,000)…

Answer: A bet that pays off if homeowners stay trapped in expensive mortgages with interest rates well above current rates.

Question: What is a… mortgage.

Yes, in fact, all mortgage investments are worth more at higher interest rates. All mortgage investments lose value if they get refinanced, and thus prepaid. Finance 101 teaches that if interest rates go down, then investors in mortgages with fixed-rates make money. If people refinance those mortgages, then the investors lose money.

So why all the news stories (beyond the banality of news cycle driven journalism)? What exactly did Freddie do? Well, The New York Times writes it one way:

Beginning in 2010, Freddie bought several billion dollars’ worth of “inverse floater” securities — essentially the interest-paying portion of a bundle of mortgages — for its investment portfolio while selling the far less risky principal portion. Fannie and Freddie are supposed to be decreasing the size of their investment portfolios.

To read this you would think that Freddie never before made investments with interest-rate risk, and that their portfolio was growing. In fact, almost every mortgage Freddie Mac owns has interest-rate risk—since almost every mortgage investment everywhere has interest rate risk. Furthermore, their total portfolio decreased 4% in 2010 and 4.1% in 2011. This is much slower then they should be reducing their portfolios, and it reflects how the government is trying to use the GSEs to help homeowners, but the point is that the story framed by the New York Times is misleading.

Here is a more clear way of understanding what they did:

Freddie creates a security (MBS) backed by mortgages it guarantees which was divided into two parts. The larger portion, backed by principal, was fairly low risk, paid a low return and was sold to investors. The smaller portion, backed by interest payments on the mortgages, was riskier, and paid a higher return determined by the interest rates on the underlying loans. This portion, called an inverse floater, was retained by Freddie Mac.

In 2010 and 2011 Freddie Mac’s purchase (retention) of these inverse floaters rose dramatically, from a total of 12 purchased in 2008 and 2009 to 29. Most of the mortgages backing these floaters had interest rates of 6.5 to 7 percent.

In structuring these transactions, Freddie Mac sells off most of the value of the MBS but does not reduce its risk because it still guarantees the underlying mortgages and must pay the entire value in the case of default. The floaters, stripped of the real value of the underlying principal, are also now harder and possibly more expensive to sell, and as Freddie gets paid the difference between the interest rates on the loans and the current interest rate, if rates rise, the value of the floaters falls.

So, the reality remains that the conflict of interest inherent in holding an investment that makes more money when less prepayments occurs for both inverse floaters as well as any standard mortgage. Even if all you are getting is the interest stream then a prepayment wipes out all of the investment where as a prepaid whole mortgage investment would get the principal back. The thing is, though, that Freddie already got the principal back so on net the investment is not a substantially greater conflict of interest.

What is different though about inverse floaters is that they carry more risk. That part of the story above should not be missed. So even though the portfolio had decreased in quantity, the risk profile of the portfolio contained riskier investments. Freddie Mac in effect reduced the refinancing risks for buyers of its MBS, and took on a disproportionate amount of refinancing risk itself. That is gambling with taxpayer money to help out mortgage investors. So the Federal Housing Finance Agency, Freddie Mac’s regulator, asked Freddie to stop at some point last year.

In a statement released late yesterday, FHFA noted it had “concerns regarding the controls, including risk management, surrounding the inverse floaters” given that the investment strategy was putting taxpayer money on the line (every three months the Treasury Department covers all net losses for Fannie and Freddie as an ongoing bailout).

FHFA did not ask Freddie to “stop betting against homeonwers” as a ProPublica and NPR story falsely reported last night. In fact, FHFA explicitly clarified that the investments had no bearing on recent changes, announced last fall, to the Home Affordable Refinance Program, in which Freddie maintained stricter controls than Fannie on homeowners who owed less than 80 percent of their homes’ value.

In one sense the Freddie bet with taxpayer money was small. FHFA pointed out that only $5 billion of Freddie’s $650 billion portfolio was held in inverse floaters. But a $5 billion bet with taxpayer money is still a problem.

So what does this story boil down to?

The story amounts to a big to-do in educating America that mortgage investment makes the most money when people pay higher interest rates. The same as every other type of lending.

The story highlights the need to address Fannie and Freddie, who have been in conservatorship for over three years now. At the very least we should be forcing the GSEs to sell off their investment units and just be securitizers in the near-term—though Congress and the White House have been too cowardly to even discuss that.

The story amounts to paraded evidence that a private company seeking to make money might have some conflicts of interest if it also has a mission to fulfill some kind of social obligation (the essence of the government-sponsored enterprise model). Not really a newsflash there either, and we can avoid these conflicts of interest by getting rid of the two companies operating with the conflict of interest built right into their mission, but again, Capitol Hill seems to be primarily focused on their Bert Lahr impressions these days.

The story is NOT evidence of any kind of collusion at Freddie Mac that they purposely have made refinancing difficult in order for their special inverse floater investment to cash in—THAT would have been a story. But Jesse Eisinger and Chris Arnold, the Pro-Publica and NPR writers who “broke” this story, reported that:

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.

Unfortunately, the way that story came out looks like it was just another tool for pushing an agenda for increased refis and forced principal modifications. The battle has raged for a while now: FHFA says that principal modifications would hurt taxpayers by causing losses at the GSEs and any other parties invested in mortgages or providing insurance for mortgages. The White House says it wants to fulfill a social mission and modify mortgages to address the massive negative equity problem. The Federal Reserve says that it thinks taxpayers may come out ahead with principal mods if the benefit to homeowners is greater on net than the losses to taxpayers generally… but that really shouldn’t be a bet left to the Fed to make.

Who were the economists criticizing Freddie for “betting against homeowners” in the lead story yesterday? NPR relied on Alan Boyce, a former bond trader who co-wrote a paper outlining a streamlined mortgage refinance program, and Christopher Mayer, who co-wrote the Boyce paper and is co-author of another detailed paper considered by the White House for how to pursue a principal modification program. Talk about conflict of interest.

Boyce said, “Freddie Mac prevented households from being able to take advantage of today’s mortgage rates — and then bet on it.” Ironically, this quote is from a NPR article that explicitly notes there is zero evidence to suggest this actually happened. But worse, Mr. Boyce knows that any mortgage investment owned by Freddie Mac with interest-rate risk would lose value on a prepayment, and he ignores that they too should be classified as “betting against homeowners” under his logic.

PIMCO’s Scott Simon says he is “shocked” that Freddie did this because the trades “put them squarely against the homeowner.” Really Mr. Simon? As the head of a team that deals in mortgage-backed securities, then he invests all the time in mortgage products that are “against the homeowner” because most mortgage investments have interest-rate risk. That is kind of the point. You make a loan and collect the principal plus interest in return. Or, in the case of PIMCO or Freddie Mac, you buy the rights to getting the mortgage principal repaid plus the interest. If you buy the payment stream on a 30-year fixed-rate mortgage that has 6.5% interest payments on it, but five years after the mortgage was made it gets prepaid (either because of a refinance or home sale), then you lose out on those other 25 years of 6.5% interest payments.

That is basic mortgage investing.

The reality is that homeowners move roughly every 7 to 8 years, meaning that most mortgages are going to get prepaid eventually. The bet is that the mortgages you invest in will hold out for longer than others. Because there is a time factor involved.

As long as the government wants Freddie to help support homeownership, it is going to face the conflict of needing to make money from taxpaying homeowners as well as make what they pay for homeownership lower.