Opinion

Felix Salmon

Freddie Mac and the inverse floaters, cont.

By Felix Salmon
February 1, 2012

Jesse Eisinger is back with a follow-up to his original piece about Freddie Mac and the inverse floaters; he’s also left a long comment on this blog, responding to various criticisms of his story which appeared in the blogosphere.

There are two main pieces of new information in the update. The first is that the size of Freddie’s inverse-floater position is even greater than we previously thought — $5 billion, rather than $3.4 billion. And the second is that the FHFA forced Freddie to stop making these trades last month, before the original ProPublica piece appeared. Now the FHFA, under Ed DeMarco, is a highly obstructionist agency which will always protect Frannie’s short-term interests over the broader health of the housing market and American homeowners. If even the FHFA was expressing serious concerns about these deals, that’s very strong evidence that something fishy was going on.

To get a feel for the tenor of the debate, check out the official FHFA response to Eisinger’s story:

The inverse floater leaves Freddie Mac with a portion of the risk exposure it would have had if it simply held the entire set of mortgages on its balance sheet. The CMO structuring activity results in some portion of the mortgage cash flows being sold off and a smaller amount needing to be financed by Freddie Mac with debt securities. It also results in a more complex financing structure that requires specialized risk management processes.

And here’s Eisinger, in his comment on this blog:

[Freddie] 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.

I’m with Eisinger on this one. Let’s say you own a big house with a cottage in the back, which you’re renting out to tenants. And let’s say that you’ve been ordered to sell as many assets as you can. You can sell your property easily to homeowners who will be happy to take the rental income on the cottage. They know that the tenants can move out any time, so they won’t pay a huge premium for the cottage, but they will pay you extra for it.

Instead, you go to a very expensive lawyer and you carve your property up into two pieces. You then sell off the house, but hold on to the cottage yourself. You get less money for the house than you would have done if you’d simply sold the whole property. And what’s more, you now own a cottage, on its own, which is much harder to sell than either the house was, on its own, or the big house-plus-cottage property was before you split it into two.

The FHFA’s argument is, basically, “look, the cottage is smaller than the original property and the total risk associated with the cottage is, by definition, lower than the total risk associated with the cottage-plus-house original property. So we’re selling off assets, just like you asked.”

But this doesn’t make sense. Why go to the trouble of breaking the property up into constituent parts, at non-negligible expense, only to hold on to the more illiquid of those parts? If the sum of the parts were worth more than the whole, I could see it: breaking the property up makes sense if you sell the house to one person, the cottage to another person, and end up with more money than you could fetch for the property as a whole.

But that’s not what happened, because of the simple arbitrage in the markets: there are lots of traders out there happy to break up mortgage securities if doing so is profitable. There’s no need or reason for Freddie to start doing that itself.

It seems to me that Eisinger is right and that Freddie is violating the spirit of the Treasury’s instructions. Treasury wants Freddie to sell down and derisk its balance sheet. Freddie, in response, started selling down its balance sheet, but kept as much risk as it possibly could, in the form of inverse floaters.

And does anybody really believe that Fannie and Freddie should be taking on more risk, in relation to the size of their balance sheets? I’m sure that doing so is good for the annual bonuses of someone getting paid $2.5 million a year to run Freddie’s mortgage portfolio. But it’s unlikely to be a good idea for anybody else.

As for the now-famous Silversteins, the couple who aren’t being allowed to refinance their property — well, that addresses the one case where it does make sense for Freddie to be taking on this prepayment risk. And that’s the case where Freddie itself controls the rules as to whether or not homeowners are allowed to refinance.

To go back to that property with that cottage, suppose that if you sold the property with cottage attached, the new owner would have no control over whether or not the tenants in the cottage moved out. But you, the seller of the property, do have control over the tenants — you can force them to continue paying rent in a manner that the new owner can’t. In that case, it makes sense for you to hold on to the cottage, because it’s worth more to you than it is to anybody else.

And that’s what Eisinger was alleging in his original piece. That the only reason it makes sense for Freddie to do these complex trades which leave it with significant holdings of inverse floaters, is that Freddie actually controls whether or not people like the Silversteins are able to refinance and thus prepay their mortgage. And because Freddie has that control, inverse floaters are worth more to Freddie than they are on the open market.

Basically, Freddie can’t have it both ways. Either it is preventing the likes of the Silversteins from refinancing so that it can maximize the value of its inverse floaters or it has no particular reason to carve up its mortgage securities and retain an illiquid inverse-floater tranche. Which is it to be?

Comments
16 comments so far | RSS Comments RSS

1st. Fannie and Freddie have a stabilizing role in the housing market contemplated in their charters, therefore they can’t sell their portfolio and stop purchasing mortgages.

2nd. “breaking the property up” is a common practice in the securitization market. Fannie and Freddie offload their risks selling the different tranches (slices) of a structured product.

Both ProPublica and you show a stunning lack of knowledge about basic securitization operations and interest-risk hedge operations.

Posted by GJOA | Report as abusive
 
 

When you are in a hole stop digging. Ok for Eisinger, he doesnt have any credibility with anyone except the idiot class but I assume you value your credibility.

Posted by Danny_Black | Report as abusive
 

“Freddie, in response, started selling down its balance sheet, but kept as much risk as it possibly could, in the form of inverse floaters.”

I don’t understand enough about the details of finance to know exactly what is being discussed, but there are situations in which including a risky asset in your portfolio can REDUCE risk. If the value of that asset moves contrary to other assets you hold, then the combination is less risky than either alone.

For example, an uncovered CDS is a very risky gamble. It is a pure bet on default, with no underlying assets at all. But a bondholder might buy a CDS as protection against loss.

Might these “inverse floaters” act contrary to other aspects of Freddie’s holdings?

Posted by TFF | Report as abusive
 

The market might, in fact, be crazy enough that they get more money for just selling the house, because no one wants to deal with the crazy tenants. And the GSE says, hey, I know how to deal with the tenants.

The whole mortgage market is built on crazy ways to carve things up so the individual parts are worth more to certain investors than the original. Otherwise everyone would just buy the pass-through cow, and not the filet.

Sounds to me like someone is making political hay/power play out of business risks/power plays. Which is a good reason to get GSEs out of the whole business.

Posted by Curmudgeonly | Report as abusive
 

When I see bankers loading up on risk, I assume they’re being compensated on a mark-to-model scheme that allows risks to be ignored (or at least underpriced).

Posted by JayCM | Report as abusive
 

So nothing has changed.

Posted by alwayslearning | Report as abusive
 

I’m in a similar boat to TFF – this particular corner of finance is not my area of expertise. Danny Black and Yves Smith both seem to understand it much better than Eisenger, though, and the couple he found in PA was clearly a red herring sob story with no demonstrated connection to his story.

What I do see is this -

(1) At 9/30/11 (latest 10-Q), Freddie’s consolidated balance sheet had $2.2 trillion (that’s with a T) of assets. Just its book of trading and available for sale securities is $272 billion.

(2) The position in question is $5 billion of inverse floaters;

(3) The very nature of the GSE’s business is to buy mortgages, then slice and dice various risks – credit risk, prepayment risk correlated to interest rates falling, also interest rate risk of long-term fixed rate loans losing value when rates rise. Through securitization and hedges, Freddie retains some of this risk and offloads some of it to others;

(4) As part of (3), since at least the ’80′s mortgage bonds have been diced into interest only and principal only components, with prepayment risk being a big driver (I’m remembering Liar’s Poker for this one);

(5) We’re being asked by Mr. Eisinger to look at a $5 billion position in isolation, and assess its impact on Freddie’s risk profile and decision-making process with respect to refinancing. Again, that compares to $2.2 trillion in assets, a $650 billion retained portfolio (mentioned by the FHFA in its comment) or a $272 billion portfolio of trading and available for sale securities. His story had the sensational headline, “Freddie Mac Bets Against American Homeowners”. Not sure how that’s true since I think that Freddie is long American homeowners somewhere between $650 billion and $2.2 trillion;

(5) The FHFA has told Freddie, “Don’t keep adding to that $5 billion inverse floater position when structuring CMO’s in the future. We don’t think that you are managing that risk well.” Seems fair enough if FHFA’s staff is competent, since they can see the granular detail of Freddie’s portfolio;

So, is my takeaway to be that Freddie’s risk management isn’t great on at least 1% of its retained mortgage portfolio? Perhaps I already realized that based on the $150 billion f’ing dollars that the 2 GSE’s have received from the Treasury.

Posted by realist50 | Report as abusive
 

Alternate framework – don’t bother with these complicated details, just let me know the impact on Warren Buffett and his secretary. Isn’t that the new standard to evaluate public policy decisions?

Posted by realist50 | Report as abusive
 

realist50 at 12:56 gets to it in point five–buying Inverse Floaters should be a bad hedging tool for Freddie, given their business. Eisinger gets that correct.

Credit where due: FHFA looked at what they were doing, managed to do a bit of math, and told them to stop doing it.

The question, being obscured by the magnitudes (which are irrelevant if Freddie is indeed turning over its portfolio at a reasonable pace), is whether there is anything in the $5B linked to specific Freddie mortgages/tranches. Are they all jumbos? Owned by John (well, Cindy) McCain? In areas that have recovered, such as DC? Are they the only ARMs issued by Freddie in a period? Are they all ARMs without MI?

If it’s a hedge–or (more likely) a limited, data-driven bet on a portfolio of characteristics–then there really is no there there and it may well be (not the way to bet, but certainly possible) that FHFA was wrong to tell Freddie to stop.

The claim that needs to be substantiated is that there is something related to the Inverse Floaters that affects the way Freddie manages that portion of their portfolio. Haven’t seen that yet.

Posted by klhoughton | Report as abusive
 

realist50, thank you and luckily this area seems just obscure enough that no one noticed my idiotic mistake when i said inverse floaters are bets on interest rates rising when of course they are the polar 180 degree opposite.

klhoughton, my understanding of what is being discussed is that the inverse floaters are what was left after securitising and sell the other components off. It also appears that it was 29 deals with a total value of 20bn which means they did a flurry of relatively small deals.

For this to be a real story, one would have to look up the mortgages underlying those deals and see if there has been active interference to prevent those deals being refinanced and that that interference led to a material gain on the bonds. I would be relatively certain the answer to both those questions is no.

Posted by Danny_Black | Report as abusive
 

Felix I’m having a hard time getting my head around this:

“Now the FHFA, under Ed DeMarco, is a highly obstructionist agency which will always protect Frannie’s short-term interests over the broader health of the housing market and American homeowners.”

Fannie and Freddie as currently opperated exist solely to transfer wealth from the US treasury to borrowers. Their loans are currently at LEAST 100 basis points under the market. They are losing money as fast as the goverment will allow them to. We’re in for over 100 billion at this point aren’t we? What more do people want?

This inverse floater issue is small potatoes… fannie and freddie are making a little bit of money because they know which loans can’t refi due to rules their goverment overseers set. Why shouldn’t they make millions off the inverse floaters to very partially offset the many billions they lose enhancing the credit rating of 5 trillion dollars worth of home loans from BBB- to AA+.

Posted by y2kurtus | Report as abusive
 

@y2k who said, ”
This inverse floater issue is small potatoes… fannie and freddie are making a little bit of money because they know which loans can’t refi due to rules their goverment overseers set. Why shouldn’t they make millions off the inverse floaters to very partially offset the many billions they lose enhancing the credit rating of 5 trillion dollars worth of home loans from BBB- to AA+.”

So the conflict of interest, even for a Government held agency, is OK? really? So when should anyone intervene … after another crisis? Were CDOs not once small potatoes, until crooks realized that they could make a killing dicing them into obscurity so that now refinancing is done to obscure that there never was a proper note or securitization in the first place?

Why does deja vu not bring on feelings of impending doom, yet merely evoke an “it’s ok it is small potatoes” response from a banker? Is that how your own community bank does business? (you have written in the past that it doesn’t, I know, but how can this small potatoes remark mean anything other than a lack of integrity?)

@Danny_Black, I was laughing in the previous article and this one, being you never really know much more than others … but use your own brand of mud tossing tactics to elevate your past from Bankster to benevolent gentleman banker who didn’t abuse the system… and do so by smearing anyone who dares to try to unearth the hucksters, past or present?

*Rolls eyes* that so many listen to you, being you are a former bankster so know “all about” what really went on to cause the crisis. It was all those filthy, greedy home owners fault for buying the property in the first place, right Danny? Look no further, is always your motto… as I read in your last replies in the previous Fannie and Freddie article.

You want to look up mortgages to get the “real” story? Perhaps check with MERS? OOOPS sorry but there is no info there being MERS is a cover for improper securitization and fraudulent practice. Look up the past mortgage and their notes? OOOPS, many notes were destroyed, and so were millions of mortgages and original documents destroyed and “missing” by shady bank and servicer practices. All of that was resolved though, wasn’t it? Nope? ooopps!

Perhaps you want to ask a county clerk? Ooops, sorry there was no proper registry of that mortgage. It was, however, resold 20 times and so cannot be traced. Perhaps check with the bank officials who signed the mortgages? Oops, that was done by robo signers, not officals! Oops, 9 of 10 of the mortgage holders are no longer in business anyway so Fannie and Freddie hold most of the mortgages! Well! Let’s check with them as surely they will know! Ooops I am getting a deja vu moment!

But like Danny would like us to think, does any of that matter? (nope, but really, isn’t all of that above THE REAL story behind the mortgage crisis that is never ending) This is simply another complicated and obscure instrument of finance and if anyone ever tries to figure it or end the trades, the Quants will be called in to obscure it all even more or design new instruments!

Who cares if the home owners and the taxpayers are the ones who are ultimately at risk, as what matters is that Fannie and Freddie get back in shape, by any means possible, to obscure the past and get on with business, as they are too danged big to fail!

Besides, we wouldn’t want to get in the way of the millions of dollars that the person who buys the floaters (He obviously deserves the 2.5 million salary for dealing with small potato risk!)

Posted by youniquelikeme | Report as abusive
 

Danny_Black, it has become quite obvious that you hide behind insults.

Although you are a retired bankster who feels he deserves respect people should realize that it is elitists, like you, who would “pooh pooh” the criticism of the greedy/crooks involved in the economic crisis, who are perpetuating it.

The conflict of interest is the real story. That such financial pariahs would still be taking on risk is the real story. That any one would be paid 2.5 million to manage this conflict of interest is a real story. The mortgages behind the financial crisis and that housing is still used as bets and sliced and diced to obscurity is the real story.

Posted by youniquelikeme | Report as abusive
 

youniquelikeme, say something intelligent and I will engage with it. However, I suspect pigs will fly first.

Posted by Danny_Black | Report as abusive
 

Danny_Black, you seem to be a brash know-it-all; an unapologetic insulting cretin. Perhaps you might actually make some intelligent comments yourself, and not suggest that one, including the SEC, might actually be able to look at anyone’s mortgage and see what has actually transpired being that is what is being hidden in the shell game.

A forensic analyst took over a year to audit ONE mortgage to find all the layers of fraud and illegalities and there are layers of opaqueness deliberately designed to ensure one might never be able to get the true background, but go ahead and suggest it might be done.

Deny it all you wish, but the housing market will never stabilize nor become healthy, as long as past problems are not fixed, and mortgages are used as pawns to the detriment of all homeowners and the economy.

While in England and as a former banker, do you live in a flat or a home? Do you even have a mortgage? I know a favourite comment I get from my English friends is that ONLY bankers can afford a home in England. I suppose that may be where your distaste of anyone beneath you owning one might come from…

PS: you need not engage.

Posted by youniquelikeme | Report as abusive
 

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