Can a government-sponsored enterprise (GSE) that is supposed to be a benefit to homeownership make investments against a homeowner’s ability to refinance? According to a report this week from National Public Radio, that’s the gist of one of Freddie Mac’s investment strategies.
NPR and ProPublica jointly reported that Freddie Mac made multibillion-dollar investments called “inverse floaters” — complex mortgage securities that make money if homeowners with higher interest rates stay at those rates. Essentially, they are bets against refinances. These are legal investments, but NPR and ProPublica raise concerns about the obvious conflict of interest that exists for an entity that has "a public mission to stabilize the nation's residential mortgage markets and expand opportunities for homeownership,” according to the Freddie Mac website.
The Federal Housing Finance Agency (FHFA), which regulates Freddie Mac, stated that Freddie has historically used “collateralized mortgage obligations” (CMOs) as a tool to manage its retained portfolio and to address issues associated with security performance — one of which are the inverse floaters. Inverse floaters, it said, were used to finance mortgages being sold to Freddie Mac through its cash window (typically used by smaller loan originators), to sell mortgages out of Freddie Mac’s own portfolio in response to market demand and to shrink its own portfolio.
“Essentially, 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 FHFA stated. “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.”
Such an investment might be risky with mortgage rates at enticingly low levels and with President Obama seemingly intent on creating programs that help homeowners refinance, but for one of the entities charged with creating its own refinancing criteria, it might not be as risky. The issue has caused (yet another) backlash against the GSE.
Here is a hypothetical example from NPR.org that illustrates part of the strategy:
“1) Freddie Mac takes, say, $1 billion worth of home loans and packages them. With the help of a Wall Street banker, it can then slice off parts of the bundle to create different investment securities, some riskier than others. The slices could be set up so that, say, $900 million worth are relatively safe investments, based upon homeowners paying the principal on their mortgages.
2) But the one remaining slice, worth $100 million, is the riskiest part. Freddie retains that slice, known as an "inverse floater," which receives all of the interest payments from the entire $1 billion worth of mortgages.
3) That riskiest investment pays out a lucrative stream of interest payments. But Freddie's slice also has all the so-called "pre-payment risk" associated with that $1 billion worth of loans. So if lots of people "pre-pay" their old loans and refinance into new, cheaper ones, then Freddie Mac starts to lose money. If people can't refinance, then Freddie wins because it continues to receive that flow of older, higher interest payments.”
The FHFA noted that Freddie’s use of inverse floaters ceased in 2011 and that of the $650 billion in Freddie’s retained portfolio, $5 billion is held as inverse floaters. A further assessment by FHFA staff later in 2011 identified concerns regarding the controls, including risk management, surrounding the inverse floaters.
“FHFA supervision staff informed Freddie Mac in December of its preliminary examination findings and FHFA and Freddie Mac agreed that these transactions would not resume pending completion of the examination work,” the regulator stated.