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Unraveling the Freddie-Fannie Tangle

The taxpayer-backed mortgage giants, Freddie Mac and Fannie Mae, play a huge and growing role in the economy yet are riven by conflicts of interest and clashing goals. We examined the problems and solutions.

The taxpayer-backed mortgage giants, Freddie Mac and Fannie Mae, play a huge and growing role in the economy yet are riven by conflicts of interest and clashing goals. (Pablo Martinez Monsivais/AP Photo)

In the aftermath of the financial crisis, American taxpayers poured $187.5 billion into two huge but poorly understood companies: Freddie Mac and Fannie Mae. Now controlled by the government, the companies play an even larger role in the economy than they did before the crisis and their bailout, but they are riven by conflicts of interest and clashing goals. Are they private companies, only out to increase their profits, or are they instruments of government policy, dedicated to keeping home ownership available?

ProPublica has focused on the tensions within Freddie Mac and Fannie Mae, as well as those besetting their regulator, the Federal Housing Finance Agency (FHFA).

NPR's Chris Arnold and ProPublica revealed that Freddie Mac had placed multibillion-dollar bets that pay off only 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 scoop, "Freddie Mac Bets Against American Homeowners," caused an immediate firestorm. As countless media outlets picked up the story, multiple senators criticized the company and wrote to Edward DeMarco, the acting head of the FHFA, calling for an investigation into the transactions and the company's activities.

The FHFA responded, saying it had told Freddie not to make any more transactions in the kind of securities at issue, called inverse floaters. The agency said it had "identified concerns regarding the controls, including risk management, surrounding the inverse floaters." The agency did not specify those "concerns," but said Freddie agreed in December that "these transactions would not resume pending completion of [FHFA's] examination work." The statement also said that Freddie had ceased making the deals earlier in 2011 but did not explain why.

In response to a letter Sen. Robert Casey, D-Pa., sent to DeMarco, the regulator expanded on its reasons for shutting down the transactions a few days later, saying that "the risk associated with these transactions is inconsistent with FHFA's goals of having Freddie Mac reduce its risk profile and avoid unnecessary complexity that requires specialized risk management practices."

In September, the inspector general of FHFA concluded that there was no deliberate or coordinated effort by Freddie Mac to keep homeowners trapped in high-interest mortgages in order to profit from trades pegged to those rates. A firewall is supposed to separate Freddie employees who make trades from those who set policy for homeowners. In its investigation, the inspector general found no evidence that the firewall had been breached — but conceded it had not independently evaluated the integrity of the firewall but instead relied on interviews with employees who said no one had violated the wall.

Penetrating Freddie's boardroom, ProPublica exposed the internal debates over the company's refi programs. Many economists were pushing for mass refis, because they said they would reduce foreclosures and boost the economy. But some Freddie board members feared they would cut into company profits. In closed door meetings, two Republican-leaning board members and at least one executive resisted a mass refi policy for an additional reason: They regarded it as a backdoor economic stimulus.

In a recent explainer, we looked at how with little discussion or planning, we have nationalized the American mortgage market and what the ramifications of that are. Before the financial crisis, the federal government backed roughly 30 percent of mortgages. Now, the government is backing about 90 percent of new mortgages, with Fannie and Freddie backing the lion's share. What do we do about Fannie Mac and Freddie Mac? Should the government keep insuring so many mortgages? And how do we resolve the conflicts of interest and competing goals that beset Freddie and Fannie? A bipartisan centrist consensus is forming to solve the problem by heading down a path that offers the least resistance but could be the most dangerous: returning to what existed before the housing market imploded.

ProPublica also focused on the FHFA, which regulates Fannie and Freddie, and DeMarco, its acting head. A coalition of progressive groups, housing advocates, Democrats and, later, the White House pushed DeMarco to allow Fannie and Freddie to cut the size of mortgage balances, known as principal reduction. Many economists argue that such debt relief is the key for helping people get back on their feet and the economy going again.

The fight over principal reduction highlights the conflicting goals at Fannie and Freddie. DeMarco has remained steadfastly opposed to principal reductions, arguing that they would be too costly — both to the companies' profit margins and to the taxpayers, whom Freddie and Fannie are still paying back. Critics say DeMarco is putting the Fannie and Freddie's financial interests above struggling homeowners'. His opposition to principal reduction has stymied White House plans to encourage mass write-downs, because Fannie and Freddie together own or guarantee half of the country's mortgages.

As part of its revamped refinancing effort, Home Affordable Refinance Program (HARP), the Treasury Department agreed to supplement Fannie and Freddie to write down principal. In a Propublica/NPR scoop, we revealed that Fannie and Freddie ran the numbers and determined that principal reductions would actually be profitable for the companies, undercutting DeMarco's stated reason for opposing them.

Nevertheless, DeMarco subsequently decided against doing them, citing risks that such reductions would cause other homeowners to voluntarily default on their mortgages.

Because FHFA is an independent regulator, the White House can't simply fire DeMarco over a policy dispute. As an acting director, DeMarco could have been replaced by a new Obama appointee, but the administration's initial pick withdrew himself from consideration as Senate Republicans signaled they would oppose him. The Wall Street Journal recently reported that the White House hopes to have a new nominee early next year.

Richard Careaga

Jan. 2, 2013, 4:46 p.m.

The focus on interest rates hides the reality that for too many borrowers in too many communities it doesn’t matter how low interest rates are because their unpaid balances are too high due to the unsustainable growth of prices during the run-up to the crash. A mortgage at 0% per year is too high on a balance of $400,000 on a property now worth $200,000. Allowing borrowers to escape into a lower interest rate loan won’t fix the problem.

It’s important to understand how inverse floaters work as part of a mortgage backed deal and how Freddie expected to profit by them.

For an adjustable rate mortgage loan, the borrower pays interest based on a fixed interest rate, called the “margin” and a variable interest rate, called the “index.” The margin is supposed to represent a risk adjusted profit for the investor and the index is a stand-in for the investor’s cost of funds. One of the common indices was LIBOR, the now-famous London Interbank Offered Rate. (LIBOR was manipulated by one or more of the banks that were supposed to be reporting actual prices; luckily, the manipulations benefited homeowners by driving the LIBOR index lower than it would otherwise have been.)

LIBOR, along with other interest rates, have fallen steadily since the crash. The 6-month LIBOR rate, a commonly used index, has been as low as about 0.5% in the past few months. To translate into concrete terms, the cost to borrow $1,000,000 for six months at that rate would be only $2,500.

LIBOR cannot, of course, go lower than zero, which means that if the economy and money markets return to something like modern history, LIBOR would go up. Freddie asked itself: how can we profit is LIBOR goes up?

Because of its charters, Freddie is limited, for the most part, in permitted investments that derive payments from mortgage loans on residential properties in amounts that the GSEs are authorized to fund directly. This would lead it to look at outstanding mortgage backed backed by pools of conforming (i.e., within the Freddie loan limit) adjustable rate mortgage loans indexed to LIBOR. However, not just any security would do. It needed leverage.

The LIBOR floater and the LIBOR inverse floater. These bear interest equal to the net interest on a pool of LIBOR based loans (in a simplified example). As LIBOR goes up and down, the total net interest goes up and down. The interesting part is how that net interest is divvied up between the floater and the inverse floater. Through financial alchemy, the answer is that the floater goes up and down slowly and the inverse floater goes up and down quickly. That is, the inverse floater is leveraged and the floater thus gets more stability.

From an investment perspective the floater is “safer” in that it is less sensitive to changes in LIBOR and the inverse floater is “riskier” in that it’s value will change dramatically if LIBOR goes up or down. In the past, inverse floater risk has resulted in some fireworks, such as the Orange County, California bankruptcy. In the recent environment, however, the downside has been very limited because LIBOR could not get much lower than it already was, but could go much higher, allowing Freddie to rake in the big bucks.

Is the Freddie’s gain the borrower’s loss? Yes and no. Yes, in the sense that the GSEs can only profit if LIBOR goes up and, if LIBOR goes up, the borrower’s payment will go up. No, in the sense that whether Freddie owns inverse floaters has no effect on whether LIBOR goes up.

Is it unreasonable to expect LIBOR to go up? We’ll have to see. The Japanese experience shows that interest rates can remain extremely low for very long times. If LIBOR goes up and, at the same time, the economy improves and that improvement were to be translated into higher earned income, borrowers may not be in necessarily a worse condition than they are at today’s strangely low rates.

This is a problem we used to know how to solve. In bankruptcy, a homeowner with a $200,000 property, other assets worth, say $20,000 and a $400,000 mortgage was once able to get relief. The mortgage debt would be secured to the amount of the property value, $200,000, and the remaining $200,000 would be unsecured and the lender would share in the non-exempt assets in proportion to its unsecured debt along with other creditors, such as credit card companies. We can’t do this any more for owner-occupied homes because when the bankruptcy code underwent its last major revision, a lobbyist raised a hand to say that we shouldn’t let homeowners do this because it would encourage irresponsible borrowing and Congress said “OK” without giving it much thought or without considering the corresponding risk of irresponsible lending and investing. Perversely, bankruptcy remains an option for the flippers and other speculators who didn’t manage to bail early enough.

Appreciate Richard Careaga comments. It is an interesting lesson, but one with too much detail.

If I may, I’ll try to be simpler.

Mortgage lenders, be they banks or Fannie Mae, borrow short and lend long. Anytime that rates go up the spread between cost to borrow and revenue from lending is squeezed and can even become negative.

Some years back we had the FSLIC (Savings & Loans) fiasco. The Feds, under regulation “W” had limited the interest banks could charge to 5% and the encouraged the S&Ls; to make long term loans. People started to move their deposits to the newly created money market funds that were paying higher interest. The banks had to pay CD rates that were higher than their morrtgage income.

We are headed for the same problem. Everyone thinks that they are smart by encouraging refinancing of mortgages at lower rates. Eventually with the government printing fiat, inflation will rise and the Feds will be forced to fight it with higher rates of interest.

If you think we had bank bailouts before, just wait and see what is coming down the road.

Only a corrupt journalist dares to repeat old news that had been categorically refuted by the Inspector General of the FHFA.
I will further investigate this journalist and ProPublica.

Richard Careaga, adding to what you have noted, my neighborhood changed dramatically, it became like a 3rd world war. I felt like I could not leave my home for fear, nor stay in my home for fear. What a dilemia. I belonged to a neighborhood watch group, talked to the mayor and those in charge and in the end moved. They can have my house, I’d rather be alive. The thugs and thieves have become more brazen, going into homes during the day even when people are home and killing or shooting more people during their criminal behavior. My voice felt on deaf ears. At least now I’m not in the middle of that. PS my Bank didn’t care about my safety.

I read this, then went back and read the supposedly scandalous earlier article about FHLMC betting against homeowners.  First of all, the instruments described are “Interest-Only securities (aka “IO’s”),” not “Inverse floaters.”  That may not seem like a big deal to most, but it’s such a basic and glaring error to anybody familiar with MBS that for me it immediately suggested to me that whoever wrote these articles didn’t know what they were talking about.

Whether Freddie’s ownership of IO’s is cause for a scandal depends on what Freddie was trying to do with them.  IO’s have a legitimate use as a hedging instrument.  If they were being used to offset other positions in lieu of alternatives like interest rate swaps, then this whole “scandal” is totally overblown.  If they were used to speculate on the direction of interest rates (something FH should not be doing), or they were owned in concert with preventing the thousands of people in the underlying MBS from refinancing, then that’s a real issue.  I didn’t see any proof of that in either article. 

Believe me, I’m no apologist for the GSE’s, but my guess is that the Freddie traders buying these things were clueless about what was going on in the rest of the company.  One could argue that Freddie’s risk management capabilities were poor, and that the firm had no business dealing with them because they can be incredibly risky and sometimes illiquid, and have blown up in the past.  I just don’t buy the conspiracy idea, which would require a higher degree of competence than this company has ever displayed, and I didn’t see any convincing proof in the articles.

Richard Careaga

Jan. 4, 2013, 3:45 p.m.

@L aside from a small quibble (floaters and inverse floaters are a particular type of I/o mbs), I agree with you: the guys on a trading desk have a very narrow focus that probably doesn’t include thinking much about how things might appear to the public.

@G. Hat, I think the situation of being caught up in the inevitable side effects of this scale of foreclosure represents one of the neglected tragedies of the crash: it was much like the panicked exit to a theatre file that tramples everyone. By lenders all trying to get out first, they trampled each other and left homeowners not in default amidst the ruins. This is sometimes called “the tragedy of the commons.”

Richard - Thanks for acknowledging, but I must quibble with your quibble.  IO’s and inverse floaters are both mortgage derivative securities, but in the industry it is understood that IO’s are instruments that pay only interest and no principal, while inverse floaters are instruments that pay both principal and interest.  What is true is that “IO’s” and “Inverse IO’s” are both I/O MBS, and each do (usually) benefit when homeowners can’t or don’t refinance.  Inverse floaters, in contrast, typically benefit from fast prepayments (because they are purchased at a discount to par), so Freddie would actually be incentivized to encourage refinancing if that was the instrument they held.

I worked as an MBS strategist on Wall Street for some time, so I unfortunately know more about this stuff than a person should.  I otherwise love the stories you guys have done on the banks and other credit crisis-related issues and look forward to more good work.

This is more of an opinion piece than an article.  You are trying to drive the reader to agree with your opinion by not too subtle use of language.  Terrible.  I’ve read some very good articles here. This is not one of them.

This article is part of an ongoing investigation:
Freddie Mac

Freddie Mac

The taxpayer-owned mortgage giant made investments that profited if borrowers stayed stuck in high-interest loans while making it harder for them to get out of those loans.

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