ProPublica and NPR reported on Monday that government-sponsored entity Freddie Mac had invested billions of dollars in so-called "inverse floaters," an exotic form of interest rate hedge that pays off if borrowers become unable to refinance. For an entity with a mandate to support the housing market, and which is being kept on life support with taxpayer money, a headline that declares "Freddie Mac Bets Against American Homeowners" is obviously a bit challenging to explain away.
The ProPublica/NPR report performed a public service in raising the question of why Freddie is continuing to engage in complex derivatives trades as a ward of the state. Where it goes astray is in implying that for Freddie and its conservator, the Federal Housing Finance Agency, the hedges represent some sort of nefarious conflict of interest that undermines their mission of supporting the housing market.
In its story, ProPublica/NPR claims that Freddie Mac tightened its credit standards and restricted borrowers from refinancing out of high interest rate mortgages specifically to reduce losses from prepayments on its $650 billion investment portfolio. The implication is that, instead of aiding borrowers by allowing them to refinance, Freddie gave priority to its own P&L and the desire to limit taxpayer losses. The inverse floaters, according to this line of thinking, were merely a tool in putting its bottom line ahead of mom-and-pop homeowners.
The FHFA, Freddie's regulator, issued a rare public response Monday, saying that it had ordered Freddie to unwind the complex trades in December-but that even so the inverse floaters "did not have any impact," on Freddie's credit decisions, including those related to the Home Affordable Refinance Program. The FHFA further disclosed that the total value of Freddie's inverse floaters was $5 billion. That's a mere 1% of Freddie's retained portfolio. The trades represent such a small percentage of the GSE's holdings as to raise serious doubts about whether they were meaningful enough to influence Freddie's refinancing standards. Moreover, there is no evidence to suggest that Freddie's traders had any input on home financing policies.
A more logical incentive for the GSE to carry out the trades is its mandate to cut the size of its portfolios by 10%. The complex derivatives actually helped fulfill that mission. Purchasing inverse floaters allows Freddie to sell off less-risky portions of its portfolio while hedging the risks inherent in the remaining bits, which are troubled and hard-to-sell.
"They need to protect against interest rate risk and they needed to tighten underwriting standards, but to suggest they're betting against homeowners is a giant stretch," says David C. Stephens, the CFO of United Capital Markets in Greenwood Village, Colo.
More broadly, the FHFA in particular has become a football in a political game that has it bouncing between conflicting dual mandates: support a stable and liquid housing market; and minimize taxpayer costs by preserving assets.
Christopher J. Mayer, a real estate professor at Columbia Business School, who is an advocate of mass refinancings, notes that Freddie added loan-level pricing adjustments and tightened rules on short sales "at around the same time" that it started trading in the inverse floaters. Freddie changed its credit standards to control the outcome of prepayment speeds, he says.
"What is the explanation for the restrictive policy on refinancing?" Mayer asks. "When conserving and preserving assets go against one of the mandates, how do you deal with that? That's the tension."
It's also notable that Freddie has not pursued a restrictive policy regarding refinancings. Over the past three years it has, in fact, refinanced 4.3 million homes with a total value of nearly $1 trillion. Moreover, refinancings made up 78% of its loan purchases last year.
While loosening refinancing guidelines would certainly allow more borrowers to benefit, it also would saddle the GSEs with additional credit risk, higher defaults and more losses to taxpayers. For those pushing the government to be as generous in bailing out homeowners as it was in bailing out banks, of course, that doesn't resonate quite like the sound of "betting against Americans."
Kate Berry is a reporter covering consumer finance for American Banker. The views expressed are her own.
Kenneth: Thank you for pointing out the typo. I think your reaction underscores a problem that's bigger than the $5B of inverse floaters. As long as Fannie and Freddie are in the limbo of conservatorship, they've got these two mandates that often conflict: A) the social policy one (supporting the housing market) versus B) the fiscal policy objective (saving money for taxpayers, who are already in the hole). Bundling these mortgages into CMOs served the purpose of shrinking Freddie's portfolio (because it's easier to sell the portions that have been cleansed of prepayment risk), which you could argue is good for objective B over the long term, even if Freddie was left with the dodgiest bits. But then keeping the floater piece can be construed as "betting against" homeowners, and it looks especially bad that the the same company was simultaneously tightening guidelines (not good for objective A), even though one hand probably didn't know what the other was doing. Conversely, if Fannie or Freddie were to loosen credit guidelines or grant more relief to troubled borrowers (good for objective A), you'd read about it on the WSJ editorial page -- the government's throwing good money after bad, subsidizing a favored sector, etc. So you can always zoom in on some aspect of a GSE's business and say it's working against one mission or the other. Stories like ProPublica's will be coming out until the ultimate fate of the GSEs is resolved. Marc Hochstein, Executive Editor, American Banker