Freddie Mac, complex derivatives, and one huge conflict of interest

There have been many news reports lately describing the difficulty homeowners have had in refinancing their mortgages. Many decry the strict requirements imposed on them by Fannie Mae and Freddie Mac, the massive taxpayer-owned-but-ostensibly-nongovernmental mortgage financing firms. Well today, NPR and ProPublica are reporting that Freddie Mac bet billions that many homeowners would not be able to refinance their mortgages.

Now that's a conflict of interest. Other outlets have begun to report the story as well, for example see this ABC article and this Washington Post article.

The article says the bet was on inverse floaters:

In 2010 and '11, 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 for the deals. They covered tens of thousands of homeowners. Most of the mortgages backing these transactions have high rates of about 6.5 percent to 7 percent, according to the deal documents. 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, such as the high rate that the Silversteins pay. So this portion of the security can pay a much higher return, and this is what Freddie retained.

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 people like the Silversteins 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.

The article also claims Freddie "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." But clearly, the investment side must have known that the amount of refinances and prepayments would be low enough to make this position profitable. As others have reported, this position could be a hedge against the high sensitivity to interest rate fluctuations.

The taxpayer owned company with great power over whether or not a significant portion of US homeowners have the ability to refinance their mortgages has been making investments that are profitable precisely when homeowners are not able to refinance their mortgages. If Freddie Mac had taken the other side of the bet, their investment strategy would at least be consistent with their stated mission of 'making home possible'.

At the very least, this position does not bode well for Freddie Mac's credibility or shareholder transparency. In general, Freddie Mac can't be both a profit-maximizing corporation and a special purpose entity with a specific governmental policy initiative. Examples like this show that one goal must be exclusive to the other.

We'll be watching this one very closely.