Jan. 30: Read the update to this article, “Bets Against Homeowners Must Stop, Freddie Mac Was Told.” This story is not subject to our Creative Commons license.This story was co-published with NPR News.
Freddie Mac,
the taxpayer-owned mortgage giant, has placed multibillion-dollar bets that pay
off 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.
No evidence
has emerged that these decisions were coordinated. The company is a key
gatekeeper for home loans but says its traders are “walled off” from the
officials who have restricted homeowners from taking advantage of historically
low interest rates by imposing higher fees and new rules.
Freddie’s
charter calls for the company to make home loans more accessible. Its chief
executive, Charles Haldeman Jr., recently told
Congress that his company is “helping financially strapped families reduce
their mortgage costs through refinancing their mortgages.”
But the trades, uncovered for the first
time in an investigation by ProPublica and NPR, give Freddie
a powerful incentive to do the opposite, highlighting a conflict of interest at
the heart of the company. In addition to being an instrument of government
policy dedicated to making home loans more accessible, Freddie also has giant
investment portfolios and could lose substantial amounts of money if too many
borrowers refinance.
“We were
actually shocked they did this,” says Scott Simon, who as the head of the giant
bond fund PIMCO’s mortgage-backed securities team is one of the world’s biggest
mortgage bond traders. “It seemed so out of line with their mission.”
The trades
“put them squarely against the homeowner,” he says.
Those
homeowners have a lot at stake, too. Many of them could cut their interest
payments by thousands of dollars a year.
Freddie Mac,
along with its cousin Fannie Mae, was bailed out in 2008 and is now owned by
taxpayers. The companies play a pivotal role in the mortgage business because
they insure most home loans in the United States, making banks likelier to
lend. The companies’ rules determine whether homeowners can get loans and on
what terms.
The Federal
Housing Finance Agency effectively serves as Freddie’s board of directors and
is ultimately responsible for Freddie’s decisions. It is run by acting director
Edward DeMarco, who cannot be fired by the president
except in extraordinary circumstances.
Freddie and
the FHFA repeatedly declined to comment on the specific transactions.
Freddie’s
moves to limit refinancing affect not only individual homeowners but the entire
economy. An expansive refinancing program could help millions of homeowners,
some economists say. Such an effort would
“help the economy and put tens of billions of dollars back in consumers’
pockets, the equivalent of a very long-term tax cut,” says real-estate
economist Christopher
Mayer of the Columbia Business School. “It
also is likely to reduce foreclosures and benefit the U.S. government” because
Freddie and Fannie, which guarantee most mortgages in the country, would have
lower losses over the long run.
Freddie Mac’s
trades, while perfectly legal, came during a period when the company was
supposed to be reducing its investment portfolio, according to the terms of its
government takeover agreement. But these trades escalate the risk of its
portfolio, because the securities Freddie has purchased are volatile and hard
to sell, mortgage securities experts say.
The financial
crisis in 2008 was made worse when Wall Street traders made bets against their
customers and the American public. Now, some see similar behavior, only this
time by traders at a government-owned company who are using leverage, which
increases the potential profits but also the risk of big losses, and other Wall
Street stratagems. “More than three years into the government takeover, we have
Freddie Mac pursuing highly levered, complicated transactions seemingly with
the purpose of trading against homeowners,” says Mayer. “These are the kinds of
things that got us into trouble in the first place.”
‘We’re in
financial jail’
Freddie Mac is
betting against, among others, Jay and Bonnie Silverstein. The Silversteins live in an unfinished development of
cul-de-sacs and yellow stucco houses about 20 miles north of Philadelphia, in a
house decorated with Bonnie’s orchids and their Rose Bowl parade pin
collection. The developer went bankrupt, leaving orange plastic construction
fencing around some empty lots. The community clubhouse isn’t complete.
The Silversteins have a 30-year fixed mortgage with an interest
rate of 6.875 percent, much higher than the going rate of less than 4
percent. They have borrowed from
family members and are living paycheck to paycheck. If they could refinance,
they would save about $500 a month. He says the extra money would help them pay
back some of their family members and visit their grandchildren more often.
But brokers
have told the Silversteins that they cannot
refinance, thanks to a Freddie Mac rule.
The Silversteins used to live in a larger house 15 minutes from
their current place, in a more upscale development. They had always planned to
downsize as they approached retirement. In 2005, they made the mistake of
buying their new house before selling the larger one. As the housing market
plummeted, they couldn’t sell their old house, so they carried two mortgages
for 2½ years, wiping out their savings and 401(k). “It
just drained us,” Jay Silverstein says.
Finally, they
were advised to try a short sale, in which the house is sold for less than the
value of the underlying mortgage. They stopped making payments on the big house
for it to go through. The sale was finally completed in 2009.
Such debacles
hurt a borrower’s credit rating. But Bonnie has a solid job at a doctor’s
office, and Jay has a pension from working for more than two decades for
Johnson & Johnson. They say they haven’t missed a payment on their current
mortgage.
But the Silversteins haven’t been able to get their refi. Freddie Mac won’t insure a new loan for people who
had a short sale in the last two to four years, depending on their financial
condition. While the company’s previous rules prohibited some short sales, in
October 2010 the company changed its criteria to include all short sales. It is
unclear whether the Silverstein mortgage would have been barred from a short
sale under the previous Freddie rules.
Short-term,
Freddie’s trades benefit from the high-interest mortgage in which the Silversteins are trapped. But in the long run, Freddie
could benefit if the Silversteins refinanced to a
more affordable loan. Freddie guarantees the Silversteins’
mortgage, so if the couple defaults, Freddie — and the taxpayers who own
the company — are on the hook. Getting the Silversteins
into a more affordable mortgage would make a default less likely.
If millions of
homeowners like the Silversteins default, the economy
would be harmed. But if they switch to loans with lower interest rates, they
would have more money to spend, which could boost the economy.
“We’re in
financial jail,” says Jay, “and we’ve never been there before.”
How Freddie’s
investments work
Here’s how
Freddie Mac’s trades profit from the Silversteins
staying in “financial jail.” The couple’s mortgage is sitting in a big pile of
other mortgages, most of which are also guaranteed by Freddie and have high
interest rates. Those mortgages underpin securities that get divided into two
basic categories.
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.
In 2010 and ’11,
Freddie purchased $3.4 billion worth of inverse floater portions — their
value based mostly on interest payments on $19.5 billion in mortgage-backed
securities, according to prospectuses for the deals. They covered tens of
thousands of homeowners. Most of the mortgages backing these transactions have
high rates of about 6.5 percent to 7 percent, according to the deal documents.
Between late
2010 and early 2011, Freddie Mac’s purchases of inverse floater securities rose
dramatically. 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.
In these
transactions, Freddie has sold off most of the principal, but it hasn’t reduced
its risk.
First, if
borrowers default, Freddie pays the entire value of the mortgages underpinning
the securities, because it insures the loans.
It’s also a
big problem if people like the Silversteins refinance
their mortgages. That’s because a refi is a new loan;
the borrower pays off the first loan early, stopping the interest payments.
Since the security Freddie owns is backed mainly by those interest payments,
Freddie loses.
And these
inverse floaters burden Freddie with entirely new risks. With these deals,
Freddie has taken mortgage-backed securities that are easy to sell and traded
them for ones that are harder and possibly more expensive to offload, according
to mortgage market experts.
The inverse
floaters carry another risk. Freddie gets paid the difference between the high
mortgages rates, such as the Silversteins are paying,
and a key global interest rate that right now is very low. If that rate rises,
Freddie’s profits will fall.
It is unclear
what kinds of hedging, if any, Freddie has done to offset its risks.
At the end of
2011, Freddie’s portfolio of mortgages was just over $663 billion, down more
than 6 percent from the previous year. But that $43 billion drop in the
portfolio overstates the risk reduction, because the company retained risk
through the inverse floaters. The company is well below the cap of $729 billion
required by its government takeover agreement.
How Freddie
tightened credit
Restricting
credit for people who have done short sales isn’t the only way that Freddie Mac
and Fannie Mae have tightened their lending criteria in the wake of the
financial crisis, making it harder for borrowers to get housing loans.
Some
tightening is justified because, in the years leading up to the financial
crisis, Freddie and Fannie were too willing to insure mortgages taken out by
people who couldn’t afford them.
In a statement, Freddie
contends it is “actively supporting
efforts for borrowers to realize the benefits of refinancing their mortgages to
lower rates.”
The company said in a statement: “During the first
three quarters of 2011, we refinanced more than $170 billion in mortgages,
helping nearly 835,000 borrowers save an average of $2,500 in interest payments
during the next year.” As part of that effort, the company is participating in
an Obama administration plan, called the Home Affordable Refinance Program, or
HARP. But critics say HARP could be reaching millions more people if Fannie and
Freddie implemented the program more effectively.
Indeed, just
as it was escalating its inverse floater deals, it was also introducing new
fees on borrowers, including those wanting to refinance. During Thanksgiving
week in 2010, Freddie quietly announced that it was raising charges, called
post-settlement delivery fees.
In a recent
white paper on remedies for the stalled housing market, the Federal Reserve
criticized Fannie and Freddie for the fees they have charged for refinancing.
Such fees are “another possible reason for low rates of refinancing” and are
“difficult to justify,” the Fed wrote.
A
former Freddie employee, who spoke on condition he not be named, was even
blunter: “Generally, it makes no sense whatsoever” for Freddie “to restrict
refinancing” from expensive loans to ones borrowers can more easily pay, since
the company remains on the hook if homeowners default.
In November,
the FHFA announced that Fannie and Freddie were eliminating or reducing some
fees. The Fed, however, said that “more might be done.”
The regulator
as owner
The trades
raise questions about the FHFA’s oversight of Fannie and Freddie. But the FHFA
is not just a regulator. With the two companies in government conservatorship,
the FHFA now plays the role of their board of directors and shareholders,
responsible for the companies’ major decisions.
Under acting
director DeMarco, the FHFA has emphasized that its
main goal is to limit taxpayer losses by managing the two companies’ giant
investment portfolios to make profits. To cover their previous losses and
ongoing operations, Fannie and Freddie already had received $169 billion from
taxpayers through the third quarter of last year.
The FHFA has
frustrated the administration because the agency has made preserving the value
of the companies’ investment portfolios a priority over helping homeowners in
expensive mortgages. In 2010, President Barack Obama nominated a permanent
replacement for acting director DeMarco, but
Republicans in Congress blocked him. Obama has not nominated anyone else to
replace DeMarco.
Even though Freddie is a ward of the state, top executives are highly compensated. Peter Federico, who was in charge of the company’s investment portfolio when most of these leveraged investments were made, earned $2.5 million in 2010. He left the company in May 2011.
One of
Federico’s responsibilities — tied to his bonuses — was to “support and provide
liquidity and stability in the mortgage market,” according to Freddie’s annual
filing with the Securities and Exchange Commission. Mortgage experts contend
that the inverse floater trades don’t further that goal.
ProPublica and
NPR made numerous attempts to reach Federico. A woman who answered his home
phone said he declined to comment.
The FHFA knew
about the trades before ProPublica and NPR approached the regulatory agency
about them, according to an FHFA official. The FHFA has the power to approve
and disapprove trades, though it doesn’t involve itself in day-to-day
decisions. The official declined to comment on whether the FHFA knew about them
as Freddie was conducting them or whether the FHFA had explicitly approved
them.
Liz Day of ProPublica contributed to this story.
Correction Feb. 3, 2012: Peter Federico, who was in charge of Freddie Mac’s investment portfolio, left the company in May 2011. A previous version of this story incorrectly said he still held that position.
