Freddie Mac Didn’t Set Out to Profit from Homeowners Trapped in High-Rate Mortgages

Mortgage
giant Freddie Mac did not keep homeowners trapped in high-interest loans in
order to boost profits on billions of dollars’ worth of complex financial bets
it had made. That’s the conclusion reached in a report released today by the inspector general that
oversees the agency in charge of Freddie Mac.

Last
January, ProPublica and NPR reported that Freddie had dramatically expanded
its holdings of mortgage-backed securities that would profit if homeowners stayed
in their existing high-interest-rate loans. At the same time, the company had
taken steps that made it harder for homeowners to refinance at lower interest
rates. Our report stated that there was no evidence of a coordinated attempt to
bet against homeowners’ ability to refinance. The inspector general’s report concludes
that there was none.

But the
inspector general left a key stone unturned: It did not independently evaluate
the firewall within Freddie Mac designed to keep Freddie’s investment arm from
profiting from insider information about the mortgage giant’s plans to tighten
or loosen homeowners’ access to credit. Instead, the inspector general relied
on the word of employees it interviewed and conducted no further investigation.
It also reported that the agency that oversees Freddie has not tested the
firewall’s integrity.

Freddie Mac
and its sister company Fannie Mae were bailed out by taxpayers after the
financial crisis and are now controlled by the Federal Housing Finance Agency. Freddie
and Fannie guarantee most of the mortgages in the U.S., and they have a mission to make home loans more affordable. But Freddie also has a massive
investment portfolio and has to protect against losses. Sometimes, those two
goals can conflict.  

Beginning in
2010, Freddie Mac expanded its portfolio of a particular kind of
mortgage-backed security known as an “inverse floater.” The company offered investors
a relatively safe bond with a floating interest rate. It then kept on its books
what is called an “inverse floater,” which pays out the highest returns if
borrowers stay in their mortgages. When interest rates dropped (as they did
during that period), Freddie Mac stood to profit on its inverse floaters,
because the rates being paid by the pool of borrowers were higher than the
prevailing market rates. Inverse floaters lose that advantage the more that homeowners
in the pool refinance at the lower rates. 

The report
says that Freddie’s investment wing increased its holdings in inverse floaters
merely because investors were demanding the floating rate bonds linked to them
— not because of any strategy to exploit homeowners trapped in
high-interest-rate mortgages.

Freddie Mac
has an  “information wall” designed
to separate the employees running Freddie Mac’s investment strategy from those designing
and carrying out its policies that impact the mortgage market, such as programs
aimed at helping people refinance or making it more difficult for them to do so.
The inspector general’s report says that it found “no evidence” that the wall
had been breached.

Yet, the
inspector general noted that FHFA has not conducted any independent testing of
Freddie’s information wall. And the inspector general limited its own
investigation of the wall to interviewing Freddie executives and FHFA officials
and reviewing policy documents. The inspector general “did not independently
evaluate the efficacy of Freddie Mac’s information wall policy,” the report
states.

The report emphasizes
that there are indeed “tensions between policies aimed at homeowners
refinancing and Freddie Mac’s retained investments.” But it says that such
tensions are not unique to inverse floaters but are “inherent throughout
[Freddie and Fannie’s] various business lines.”

At the end
of 2011, Freddie held about $5 billion worth of inverse floaters, according to
the report, or less than one percent of its $653 billion investment portfolio.

The report
also notes that the company hedges to balance its interest-rate risk, meaning
that it places many different bets so that no matter whether interest rates
rise or fall, its investments will be close to “net flat” — stay roughly
the same, recording neither large profits nor large losses. Freddie does not
try to balance the risk of each individual investment, but rather hedges “on
its portfolio as a whole.”   The report explains:

The
inspector general did not independently evaluate Freddie’s hedging strategies. When
ProPublica and NPR first reported on these deals, it was unclear what kind of
hedging, if any, Freddie Mac had performed.

The company
is also supposed to be reducing its investment portfolio as part of the terms
of its government bailout. In a footnote, the inspector general’s report
mentions that Freddie Mac told the Securities and Exchange Commission that
selling the floating rate securities was a way to reduce its balance sheet. But
most Freddie and FHFA officials interviewed by the inspector general said that
reducing its balance sheet was not
the motivation for Freddie to create inverse floaters, even if that was the
result.

Separately, the
way Freddie structured the inverse floaters leaves Freddie with nearly all of
the risk of the assets that no longer show up on its balance sheet. The reason:
As the guarantor of the mortgages that back the securities, Freddie is already
on the hook if the homeowner defaults. With inverse floaters, it also retains
the risks that homeowners might refinance and that overall interest rates might
rise. Indeed, independent analysts told ProPublica and NPR in January that
Freddie may actually have increased its risk, because inverse floaters are
illiquid and hard to sell.

In its
written response to the inspector general’s report, the FHFA did not address Freddie Mac’s
statements to the SEC. When contacted by ProPublica, an FHFA spokesperson
declined to comment.

The report
said that FHFA issued misleading statements to the public on when it ordered
Freddie to stop creating inverse floaters. According to the report, in the
spring of 2011, the FHFA began a review of Freddie Mac’s mortgage securities
operation, in large part to determine whether the company held too many complex
and risky mortgage products, including inverse floaters.

But an
executive at Freddie didn’t suspend inverse floaters and certain other complex
securities deals until January 6, and FHFA didn’t explicitly order Freddie Mac
to stop selling inverse floaters until January 30, 2012, after ProPublica’s story was published. In fact, according to the
report, that day marked “the first time that FHFA’s senior leadership met to
discuss the Agency’s position with respect to inverse floaters.”

By then,
however, Freddie had long since stopped selling floating rate securities —
not because of any order from FHFA but because the market for them dried up in
spring 2011 when Federal Reserve chairman Ben Bernanke indicated that interest
rates would remain low for at least another year.

That’s not
how FHFA described what happened after our story broke. In a statement released in response to ProPublica
and NPR’s reports, the agency said that staff met with Freddie in December 2011
and came to an agreement then to suspend inverse floater trades. The inspector
general’s report concludes that statement was misleading: “prior to January
2012, neither Freddie Mac nor FHFA made a decision to halt Freddie Mac’s
creation and investment in inverse floaters; the market for reciprocal floating
rate bonds simply disappeared. Had the market reappeared and Freddie Mac found
the economics were again profitable, [Freddie] would have been free to
structure floating-rate and inverse floating-rate investments.”

In a response
to the report, the FHFA disputed the inspector general’s reading of the public
statement, saying that it did not claim “that there was a specific,
well-articulated FHFA policy and agreement” in December. The agency also
emphasized that it did not take a position on inverse floaters only in reaction
to media reports. While acknowledging that “the key stakeholders” had met
together for the first time on January 30th, the day ProPublica and
NPR released their original stories, the FHFA emphasizes that it had been in
communication with Freddie on inverse floaters over the previous year.

The inspector general’s report was requested by Senator Robert Menendez,
D-NJ, last
January, after our story brought the issue to light.