Freddie Mac gets paid to obstruct refinancings

By Felix Salmon
January 31, 2012
Jesse Eisinger and Chris Arnold have a really good story about Freddie Mac today, a company which is preventing mortgage refis at the same time as it's making enormous prop bets that homeowners are going to continue to find it hard to refinance.

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Jesse Eisinger and Chris Arnold have a really good story about Freddie Mac today, a company which is preventing mortgage refis at the same time as it’s making enormous prop bets that homeowners are going to continue to find it hard to refinance.

Back in September I noted that mortgage bonds are trading well above par just because investors are well aware that refis are hard to come by for many homeowners, and said that those investors were “taking unfair advantage of the fact that homeowners are locked into above-market mortgage rates”. What I never dreamed of was that the investors and the rule-setters were the same people — in this case, Freddie Mac.

But here’s what Freddie is doing. In the past two years, it’s bought $3.4 billion of hugely-risky “inverse-floater” notes — essentially bets that homeowners with above-market mortgage rates won’t be able to refinance to market rates. And then it turns around and implements rules which prevent homeowners like Jay and Bonnie Silverstein from refinancing. The Silversteins have made all their mortgage payments on their current home in full and on time, despite the fact that they’re paying an interest rate of 6.875%. They’d love to refinance to get that rate lowered, but Freddie Mac won’t let them — because of the way they sold their previous home.

The Freddie Mac rule certainly maximizes Freddie Mac’s income, but it’s dreadful and unfair public policy. At the same time, it’s also policy which is very much in line with the FHFA’s stance on principal reduction, or anything else which might help homeowners. Given the choice between extracting short-term cashflows from homeowners, on the one hand, and improving the all-over health of the housing market, on the other, the FHFA will always choose the former.

Check out the long-awaited letter from FHFA director Ed DeMarco, for instance, justifying the fact that he won’t allow Frannie or Freddie to do principal reductions. It’s basically a long list of tables with precious little annotation or explanation, but at heart it seems to be based on two ideas. The first is that if you reduce principal to 115% of the value of the home, that doesn’t help very much. Well, duh. The whole point of principal reduction is to give homeowners back some equity in their home, and if they’re still underwater, you’re not doing that. And the second reason is just that Frannie’s computer systems aren’t really set up for principal reductions:

Neither Enterprise can accommodate the new accounting and tracking of principal reduction without operationally challenging changes to the existing IT systems, which are outdated and inflexible. The team did not require the GSEs to provide FHFA with cost projections, but experience implementing the HAMP program suggests that each Enterprise would need substantial funds and would rely upon scarce personnel resources to make the necessary IT modifications.

This is pretty desperate stuff — “we don’t know what the IT costs might be, and we didn’t bother to try to find out, but trust us, they’d be substantial”. In the wake of ProPublica’s story today, I don’t trust the FHFA at all. It signed off on all of Freddie’s trades, and its actions are entirely consistent with a regulator perfectly happy with Frannie taking on massive bets at the expense of homeowners, just to try to make some extra money. Oh, and the chap at Freddie in charge of buying these inverse floaters is paid $2.5 million a year.

It’s all quite a disgusting spectacle, really. Matt Levine attempts some kind of defense of Freddie’s actions, based on the idea that the inverse floaters are just what’s left after Freddie sells off everything it can easily sell — but that’s not what actually happened. In fact, Freddie went out and bought these instruments, on the open market. It almost looks like inside trading: they’ll pay off handsomely, just so long as Freddie continues to make it hard for homeowners to refinance. Which means that refinancings in general, and principal reductions in particular, are still going to be rare to nonexistent going forwards. Which is bad for homeowners, bad for the housing market, and bad for the economy as a whole. Even if it’s good for Freddie’s prop book.


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This story is way off base. Inverse IO’s are not a bet against refinancing, but on volatility. Freddie by it’s very nature is mostly short volatility, so owning a some securities that are long this option makes sense, especially if that option is being mis-priced by the market. I understand that Freddie and Fannie are the new favorite whipping boy and much of that is deserved, but not in this case and the truth is that many in Congress who are expressing their “shock” & “outrage” don’t even understand what the security being discussed is.

Posted by Sechel | Report as abusive

Yves Smith has put up a detailed post earlier this morning on why this is so much nonsense.

Posted by Foppe | Report as abusive

Boo hoo for the Silversteins, who are cruelly being denied a chance to refinance at 4% just because they stopped paying their *other* mortgage just a few years ago. How dare Freddie demand a couple points of interest to protect itself from the risk that the Silversteins will stop paying their new mortgage too?

Posted by RogerNegotiator | Report as abusive

Anyone who holds a mortgage note makes more money when the note is not prepaid than when it is prepaid and refinanced at a new, lower rate, and Fannie and Freddie exist to hold mortgage notes. They may have engaged in trades that amplify their gains when this happens (and amplify their losses when it doesn’t), but I don’t see any ethical implications. They are in that market, they are going to have some position wrt prepayment, at most one might criticize their position as risky from a business perspective.

There is quite possibly an ethical problem with them also setting the prepayment rules, and doing so in order to make their position wrt prepayment pay off. (This would also be the case if they had taken the opposite position wrt prepayment and then changed the rules to make prepayment easier.) but all the noise seems to be about their “bet against America”, not the conflict of interest.

Posted by DCWright | Report as abusive

Shock horror, serial f*ckwit Eisinger gets yet ANOTHER story wrong? Do you just highlight the most idiotic stories he writes or is everything he write so utterly stupid. I doubt he could recognise a hedge if it walked up to him and beat him to death with his own paper.

Also what is your issue with people paying back debts? In topsy-turvey journo world, taking out a loan and paying it back early with exorbitant interest is evil but don’t bother paying it back at all and you are pure as the driven snow and deserve a gift from either the government and/or the people you took the loan from.

Posted by Danny_Black | Report as abusive

Steady on there, Felix. You might be in line for a coveted Sober Look Hype award! s-inverse-floater-is-hedge.html.

Posted by Greycap | Report as abusive

Felix, the fact that even Yves Smith saw through the Propublica populism is a sign that you missed something here: ropublicas-off-base-charges-about-freddi e-macs-mortgage-bets.html

more from Matt Levine at Dealbreaker: ac-profits-from-the-misery-of-american-h omeowners-so-that-banks-dont-have-to/

Posted by KidDynamite | Report as abusive

KidDynamite, I guess the original story was so egariously wrong that she had nothing to lose by not playing the screaming kill all the banksters harridan card for once.

Eisinger seems to always be embarassing bad. It is surely a sign of the state of journalism that this guy is not out on the sign asking for spare change let alone taken seriously. We have people like him to thank for the focus on prop trading, OTC derivatives and capital requirements rather than trying to remove some of the feedback loops and misaliged incentives in the wholesale repo and CP market that actually DID cause the financial crisis.

Posted by Danny_Black | Report as abusive

by the way, out “on the sign” is short for out on the street with a sign. Just like 1002% is short for 102% and CDFP is short for CSFP.

Posted by Danny_Black | Report as abusive

take a deep breath, Danny_black! you sound fired up this morning!

i was indeed shocked to see that post from Yves this morning. I don’t even read her stuff anymore, just browse the headlines in my Google Reader, but that one caught my eye.

Posted by KidDynamite | Report as abusive

Is a $3.4 billion interest-rates bet out of a $663 billion mortgage portfolio a strategy against homeowners?

Is it that difficult to think that forgiving mortgage debt to a priviledged few isn’t a good national policy?

77% of the mortgages purchases of last year were refinancings, so why do you insist that Freddie doesn’t allow refinancings?

Posted by GJOA | Report as abusive

Felix, here and elsewhere you’re essentially arguing that some combination of the government and banks should offer borrowers a mortgage where the interest rate floats down but not up while prepayment is entirely voluntary. Do you realize that if I had to offer this product, the initial interest rate would be higher than a standard fixed rate mortgage, and that in reality initial fixed interest rates were set to include some possibility of profit from falling rates (offsetting risk of default or rising interest rates), or are you not that economically literate?

Posted by najdorf | Report as abusive

najdorf, as long as property values are rising, and credit standards are constant, the standard mortgage product behaves exactly as you describe!

Seems the issue here is a default on some other loan? And they are now surprised that they are having trouble getting new loans? Maybe they can wait 2-4 years and then try again?

A couple other thoughts:
* If you buy a new house before you sell the old one, you can’t be picky on the sale price. The real estate market in 2005 was plenty hot to support a quick sale — they almost certainly got greedy.

* They retired? And they still had such a large mortgage on the old house that it was rapidly underwater? And so little savings that it was wiped out in just 2.5 years of paying a double mortgage? And they were STILL playing risky games like buying more before they sold? They gambled, they lost…

People like these make homebuyers everywhere look bad!

Posted by TFF | Report as abusive

“They’d love to refinance to get that rate lowered, but Freddie Mac won’t let them”

No, it is not true that Freddie won’t “let them” do so. Freddie won’t itself provide the financing for them to do so. If a 3rd-party would refinance their mortgage, Freddie would take the money, as it is contractually obligated to do. To the extent that there is anything nefarious or unfair happening here – I tend to agree with Danny Black and Kid Dynamite and the sources to which they link that there is not, but I’m no expert on how the GSE’s manage their portfolios – it’s an argument for why we need a genuinely competitive housing finance market rather than one dominated by the decisions of two subsidized GSE’s.

Also, regarding Felix (and others) piling on Ed DeMarco, he is actually trying to do his job as mandated. His legislative mandate is to try to recover value from Freddie and Fannie, not support the housing market. If Congress thinks that he should do the latter, pass legislation saying so.

Posted by realist50 | Report as abusive

TFF – insightful of you to point out those details. Reading between the lines, it makes one wonder if they were trying to flip their prior house, or had extracted and spent the equity (as it sure doesn’t sound like they saved any equity). Philly is not part of the Case-Shiller Index, but a local group pulls together its own indices. Anyone selling in 2005 who had owned their house for at least a couple years should have built substantial equity - hiladelphia-house-prices-currently-back- to-2003-levels/

Posted by realist50 | Report as abusive

DeMarco needs to go. Impeach him? His entire role is unconstitutional – violating the doctrine of separation of powers. His current position – get Congress to give me new marching orders – is not a position properly taken by anyone with executive branch authority over hundreds of billions in government assets. Why the country has an executive branch with a President is so folks like DeMarco can be fired if they insist on promoting their fiefdoms over the good of the US. Maybe the Boies and Olson team can get a suit filed to have the DeMarco statute narrowed (so DeMarco takes orders from Obama) or ruled unconstitutional.

Posted by cwanda | Report as abusive

cwanda, in what way exactly is he not acting in US interests? Because he is not falling over himself to lend more money to people who don’t honour their loans? Because he is working to return the hundreds of billions of dollars of cash the US government pumped into Frannie?

Posted by Danny_Black | Report as abusive

realist50, journalism 101. Find some people whose life has been “ruined” by the never ending search for profits. Need to fire up that outrage, if it requires fabricating a story about a hedge and throwing in a couple of property speculators who are a bad credit risk and so cannot refinance and some tenuous link with a rich finance guy [boo, hiss] then it is not like integrity or honesty or even cursory knowledge is even a base requirement for working in journalism these days…. Propublica got dem pageviews to sell.

Posted by Danny_Black | Report as abusive

This is pure supposition, but this strikes me as a smear campaign against Demarco for not advancing administration housing policy. And ironically as conservator, he’s doing exactly what he should be doing.

Posted by Sechel | Report as abusive

I think I know how this will end. What if the goverment used fannie and freddie to make loans directly. They did something similar with student loans.

They could then openly use the GSE’s as a tool to dial up or down the economy just like the fed uses short term interest rates. Want to slow things down when the economy is a little too hot… up the required down payment by a point or two. Want to heat the economy up when things are slow… let people re-fi with no cash out up to 95% LTV.

The trick is they will have to reduce the default rates by making all fed backed home loans full recourse and bankrupcy proof like fed student loans are. Fall behind and they garnish wages… withhold tax refunds… even a peice of social security payments if it goes that far. It would still be a good deal for the 90% of consumers who pay their bills. Based on the 10 year T-bill they could probably offer a 3% 30 year home loan to someone who had good credit and 50% equity.

Posted by y2kurtus | Report as abusive

y2kurtus, the federal student loans have produced a whole industry of no-value for-profit colleges designed specifically to feed off them. Would direct mortgages be any better?

Posted by TFF | Report as abusive

We are glad to see that our Freddie Mac story has sparked a lot of discussion.

We wanted to respond to some of the critiques.

First, though some bloggers see nothing wrong with these trades, the FHFA did. They had them stopped. And there is a lot we still don’t know from the agency’s statement. Why did the agency stop the trades? What were its concerns about Freddie’s risk management? In all the critiques, we have seen little engagement with this FHFA statement, which essentially confirms our story, while saying that Freddie had an even greater amount of inverse floaters than we had reported.

Several bloggers, even the critics, have also agreed with the central premise of the story: That Freddie (like Fannie) has an enormous conflict of interest between helping homeowners and maintaining the value of its investment portfolios. With these trades, we wrote, Freddie exacerbated that conflict.

Naked Capitalism’s Susan Webber (who writes under the nom de plume Yves Smith) says we have the “wrongheaded premise that retaining the inverse floater is unusual.” We flat out never said that. Quite the contrary, we wrote that these kinds of securitizations have been around for decades — hardly an indication that “retaining the inverse floater is unusual.”

The point that Webber misses is this: Freddie’s retention of inverse floaters ramped up dramatically in late 2010 through spring 2011. 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.

It’s not the retention of the floater that’s unusual (a word we didn’t use). It’s the dramatic increase in these deals by Freddie Mac that is noteworthy.

Some people have raised the point that there is a difference if Freddie “retained” these inverse floaters instead of “bought” them. But we reported that Freddie retained these positions and the graphic, though simplified, says the same.

Our story says this:

“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. (Our emphasis)”

Naked Capitalism goes wrong when she discusses how hard it is to sell inverse floaters. Yes, it’s hard. But that’s not what Freddie started with. It started with mortgage-backed securities.

It could have sold MBS on its portfolio outright and rid itself of the prepayment risk. The market for simple MBS with a government guarantee attached is liquid and deep – and certainly was then, in late 2010 and early 2011 when Freddie’s inverse floater bets ramped up.

Instead Freddie had the securitization structured, then retained the inverse floater portions. In other words, Freddie undertook transactions in which it retained a piece of a newly created deal that has basically the same risk profile as the original holdings. And what Freddie retained carried new risks: liquidity and LIBOR risks. Freddie engaged in reverse alchemy: it turned a position of gold into lead.

Moreover, these trades didn’t happen in a vacuum. Freddie is under a mandate to sell down its portfolio. Implicit in that mandate is that Freddie reduce its risk. In these trades, Freddie sells something notionally, so that the assets on its balance sheet fall, but it keeps most of the risk — and adds new risk. That raises the question of whether it is subverting the spirit, if not the letter, of its agreement with the U.S. Treasury. In Freddie’s defense, as we reported, its portfolio is “well below the cap of $729 billion required by its government takeover agreement.”

As for the point that Freddie has a large portfolio and we cannot know what other risks are there, or how it’s being managed, that strikes us as a bizarre defense. The company retained these positions. Its now-smaller portfolio is now even more levered to prepayments because of these inverse floaters.

As always, we welcome any and all responses from Freddie that clarify these matters. All others are speculating.

Regardless of the portfolio’s overall size, Freddie essentially placed $5 billion in bets that homeowners wouldn’t prepay through deals involving a much larger pool of mortgages worth more than $20 billion. We’re talking about tens of thousands of home loans wrapped up in these investments. We raise the question: Is that an appropriate bet for a government-run company to be making, especially when it is a gate-keeper on refi eligibility?

As far as the argument that perhaps these inverse floaters were used to hedge other risks in Freddie’s portfolio, bond traders we spoke with say that Freddie could have easily bought options or swaptions to hedge its prepayment and/or interest rate risk. Entering into inverse floaters as a hedge – or to offset a hedge – seemed to these traders to be cumbersome and expensive for Freddie. One said comparing inverse floaters to hedging tools is not just apples and oranges – it’s more like apples and cars. They just have nothing to do with each other.

Finally, some people, such as Matt DeBord, seem to have missed a big point about the Silversteins, the homeowners we profiled in our story. Yes, they did a short sale and have worse credit for that. If they applied for a new loan, a lender should evaluate that.

But this is a refi. Freddie – which means you and I as taxpayers – owns the credit risk. The government guarantees their mortgage already. There seems to be little reason why borrowers who are current on their mortgages shouldn’t have easier access to refinancings, especially when that would only reduce their credit risk to the insurer – in other words, to the taxpayer.

But Freddie did inhibit refinancings and did have an incentive to inhibit them: its short-term profits on the inverse floaters. As we reported, no evidence has emerged that Freddie’s decisions to limit access to refinancings were coordinated with its decisions to retain the inverse floaters, and Freddie denies that they were coordinated.

We welcome more discussion of this. Thanks to the people who have commented on our story.

-Jesse Eisinger

Posted by JesseEisinger | Report as abusive

Firstly, I note you that keep switching from the size in these trades but when claiming that freddie ramped up the trades you suddenly go from size of trades to number of trades. This is something you have form for, for instance with the CDO [non]“story”. Are these lots of small trades vs a few large ones? What was the investment background to such trades?

Secondly, inverse floaters are not a direct bet on prepayment, they are a leveraged bet that interest rates are not going down and probably going up. There is – or at was – a relatively well understood statistical correlations between interest rates moves and prepays for ***PRIME*** borrowers – which the sop story you picked are not. A brief look at what was going on in the world between autumn 2010 and spring 2011 might offer a simpler reason to bet that in the mid term rates might go up. There was the bailout of Ireland, there was austerity passed for Portugal and Greece, US economy was doing well, the “Worlds largest market(TM)” seemed to booming, there was stability in the Middle East and also operation TWIST was ongoing at the time( from recollection, at EXACTLY the same time in question ). All of that came to an end around the same time the FHFA intervened – according to you.

Thirdly, you claim a causual link between the couple you interviewed and this trade. Was there mortgage part of that block? Can you show that actually Frannie stood to make money by “blocking their refi”? Or did you just go out, find the nearest refi sop story and fabricate a link?

Fourthly, while the context is important is because you don’t know what the counterbalancing risks are in the portfolio.

Fifthly, so your suggestion is that Freddie, rather than simply selling over most of the transaction and getting cash – yummy – should KEEP the transactions and spend MORE cash getting a swaption, which will either be custom and so cost alot of money and be illiquid. Or it will be vanilla, have basis risk and roll-over risk. Not to mention Frannie now have counterparty exposure whereas before before they didn’t. All to get the same risk profile?

As said before, I don’t usually read your crap because what i have read is obviously crap – you compete with the Bloomberg FED team for consistently worst financial “journalist” in the world – and maybe I am missing out on all the insightful, nuanced stories you write showing a deep understanding of the subject and an uncompromising commitment to fact checking but somehow I doubt it.

Posted by Danny_Black | Report as abusive

Again, I have to say how disappointed I am at this column and the original source story. Freddie Mac is long major credit exposure in mortgages. That certain mortgages are not refinance able or obtainable is a credit story and Freddie Mac has acted very responsibly in applying prudent lending standards post crisis. That interest rates are declining is government policy and comes from the Federal Reserve. That a wall off trading desk held on to or purchased some exposure to inverse IO’s is not a scandal but merely a judgment that these securities were mis-priced by the market and offered value. This was not inside information, but something every market participant had the opportunity of doing simply by comparing the inverse to the floater and the fixed, or by running an OAS, applying scenario analysis or looking at interest rate floor pricing. Perhaps Eisinger believes Freddie should refinance everyone and ignore any/all risk guidelines, but the we all know that would lead to huge tax payer losses. The sole legitimate discussion is whether Freddie & Fannie should have post-conservator any retained portfolio.

Posted by Sechel | Report as abusive

For 5 years we paid extra on our mortgage with Taylor, Bean, & Whitaker. As a small business owner for 25 years, that was our lame attempt at planning for our retirement. With our good credit history, it was a fluke that we were handed over to sub-prime predators, Ocwen Loan Servicing after the Feds shut down Taylor Bean. Experiencing the abuse of power the cocky Ocwen heaped on top of us, makes sense now. Our paying down our principle was money out of Freddie Mac’s pocket.

Taylor Bean did us no harm. In fact, in April 2009, they sent us a notice saying that our good payment history made us eligible for an interest reduction through a HASP refinance.

When Ocwen took over, all they wanted was for us to apply for HAMP, and then they went to work making sure we had no other alternative. We finally did apply last February because it became our only choice. We were approved, but Ocwen added unjustified fees to our refinanced balance, so our extra Taylor Bean curtailment payments were for nothing.

The .5% reduction to our payment in 2009 would have added $2,400 a year to our budget. How much better would we all be right now if everyone would have gotten that courtesy?

I’m a fighter, not a whiner, but sometimes I let myself feel sorry for a few minutes. It’s not fair that we consumers had to go through such abuse.

I use my website to do most my whining. I’ve posted documents to back up my story as well:

Posted by RobinBrownDavis | Report as abusive

RobinBrownDavis, sorry to say whatever agro you had has nothing to do with this story. The author simply didn’t understand what he was writting. If it makes you feel any better this is apparently normal for him.

Posted by Danny_Black | Report as abusive