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ProPublica’s Off Base Charges About Freddie Mac’s Mortgage “Bets”

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A new ProPublica story, “Freddie Mac Betting Against Struggling Homeowners,” treats the fact that Freddie Mac retains the riskiest tranche of its mortgage bond offering, known as inverse floaters, as heinous and evidence of scheming against suffering borrowers.

The storyline in this piece is neat, plausible, and utterly wrong. And my e-mail traffic indicates that people who are reasonably finance savvy but don’t know the mortgage bond space have bought the uninformed and conspiratorial ProPublica thesis hook, line, and sinker.

We need to get into a bit of detail to explain what is wrong with the ProPublica account. The structuring of Freddie and Fannie bonds is to deal with interest rate risk (remember, there is no credit risk since the bonds are guaranteed by the GSEs). This is well established technology, dating back to the early 1980s.

The undesirable feature of mortgages is their prepayment risk. Every country ex the US has features in mortgages that restrict or prohibit prepayment risk (the most common is having mortgages be floating rather than fixed rate). Prepayments are very unattractive to bond investors, since the time you are happiest as a fixed income investor is when interest rates fall, since your bonds go up in value. But if you hold a simple mortgage pass-through, the bond will disappear due to prepayments.

So the structuring of a CMO (collaterlialized mortgage obligation) creates a series of normal looking bonds from the cash flows from mortgage securities: some fixed interest rate bonds of various maturities (created at a lower interest rate than the yield on the mortgages) and one medium-term maturity fixed rate bond which is then decomposed into a floating rate bond and an “inverse floater” which consists only of the inverse of the interest rate payments on the floating rate note (for instance, if the coupon on the bond from which it was decomposed was 6% and the rate on the floater is Libor + 8 basis points, or .08%, the inverse floater would pay at 6% – (Libor + .08%).

There are some dirty little secrets of inverse floaters. The first is that because the other parts of the deal are very to extremely easy to sell, various features of the deal structure are tweaked to favor the inverse floater, plus the other components are often sold at premiums, meaning some additional cash flow can be diverted to the inverse floater. This is useful because the inverse floater is colloquially called “toxic waste.” It is very difficult to sell and usually retained by the originator because it is hard to explain, hard to model, and has widely divergent payouts depending on what interest rates and prepayments do.

The second dirty secret is that all the feature tweaking makes inverse floaters a good bet on average. On a $100 million bond deal, you might expect $2 million of the value to be in the inverse floater. All the eagerness of the other buyers for the other pieces means you can probably rejigger terms during the deal structuring for it to be expected to be worth $3 million. If you are smart and disciplined, you book it at $2 million, so that if things work out, you look like a hero. and if events pan out otherwise, you look like less of a goat.

Now let’s turn to the bizarre ProPublica piece. It starts with the wrongheaded premise that retaining the inverse floater is unusual and a sign that Freddie is “betting against homeowners.” Now it is true that owning an inverse floater means that you are happier when mortgages don’t prepay. But the GSEs in general don’t want homeowners to prepay. Yet another dirty secret of the mortgage business is that it is the MOST creditworthy investors who refi to take advantage of lower rates, over and over again. The weaker ones don’t because they can’t (the credit mania period of 2004-2007 was an exception to this long standing pattern).

In addition, it is not clear what Freddie’s net position is. Both Freddie and Fannie have a long standing practice of hedging their prepayment risk. Their hedging activities are so massive as to have macroeconomic impact. They are “pro cyclical” meaning they tend exaggerate interest rate moves, pushing them down faster when they are falling and forcing the higher when they are rising. Greenspan was concerned about the distortions caused by the GSE’s hedging in 2003 and was relieved when the Freddie and Fannie accounting scandals led to them having their loan growth restricted, since it kept a big problem from getting even bigger. John Dizard of the Financial Times discussed this problem in early 2008:

The core problem for the housing GSEs is, and has been, the prepayment option embedded in US fixed-rate mortgages. That has meant that the term of the GSE assets extends or contracts depending on whether homeowners can refinance at an advantageous rate. However, most of the long-term debt on the liability side of the GSE balance sheets has a fixed term. So the GSEs must more or less continually offset this imbalance between the average maturity of their assets and liabilities through the derivatives market, specifically the interest rate swap market. Otherwise the mark-to-market losses would overwhelm their small equity bases.

So ProPublica misses completely that the GSEs have long been engaged in a massive program of interest rate hedging.

The implication is that it is meaningless to look at the inverse floaters in isolation; you’d need to look at the composition of all of Freddie’s exposures to reach any conclusions as to what sorts of wagers, if any, they are taking. Looking at one position in isolation is meaningless.

And if you read the article carefully you can see even with its cherry-picking, ProPublica’s case is weak. It tries to argue that the inverse floaters “raise concerns” and represent “a conflict of interest.” It argues that Freddie is refusing to refinance high interest rate loans to help the performance of its inverse floaters. Yet look at the language:

Freddie Mac set out to make gains for its own investment portfolio by using complex mortgage securities that brought in more money for Freddie Mac when homeowners in higher interest-rate loans were unable to qualify for a refinancing.

First, any “bet” on refinancing would be made in Freddie’s treasury department, which is separate from its business side (ProPublica includes this notion in the story as the rebuttal from Freddie, and I’ve worked with enough financial firm treasury units to find that credible).

And look at the sort of “evidence” that ProPublica uses to try to argue that Freddie is being unfair:

Jay and Bonnie Silverstein describe themselves as truly stuck in a bad mortgage. They live in an unfinished development of yellow stucco houses north of Philadelphia. The developer went bankrupt.

The Silversteins bought this home before the housing market crashed, and then couldn’t sell their old house. They now say that buying a new home before selling the old one was a mistake — a painful one. Stuck with two mortgages, they started to get behind on their payments on the old house.

“It wound up taking us years to sell that house, so we had two homes and two mortgages for two-and-a-half years,” Jay Silverstein says. “It burned up my 401(k) and drained us.”

Jay Silverstein has a modest pension, and they haven’t missed a mortgage payment on their current home. Still, they are struggling. They could make the monthly payment on their new home if they could just refinance — down from their current interest rate of near 7 percent to today’s rates below 4 percent. That could save them roughly $500 a month.

“You know, we’re living paycheck to paycheck,” he says. A lower rate “might go a long way toward helping us.”

I hate to sound heartless, but their credit recored would clearly show that they have defaulted on their mortgages on their old home. They are NOT a candidate for a refi. They MIGHT be a candidate for a principal mod (which is what banks traditionally did for underwater but potentially salvageable borrowers). The ProPublica reporting here is completely disingenuous.

Even if the allegation in the ProPublica article is correct, that the GSEs have positioned themselves to be betting on a lower than normal rate of refis, based on the weak credit condition of GSE borrowers, the evidence they present says the causality runs the other way: that based on GSE standards, a bunch of borrowers who would normally refi can’t because their credit condition has deteriorated. And the GSEs have positioned their book accordingly.

ProPublica is not necessarily wrong to say that Freddie has a conflict of interest, but it is hardly a secret: it is between minimizing losses to taxpayers and saving struggling borrowers. It is fair to question whether it is balancing those interests correctly. Critics allege that the GSEs are taking very aggressive measures to maximize their short term profits in order to deliver lower losses to taxpayers, and that in turn is leading to policies that a lot of critics are deeming to be short-sighted. For instance, New York Fed president William Dudley said in a speech earlier this month an analysis by his staff showed that taxpayers would get better returns longer term from having the GSEs do more principal mods, and we’ve separately argued multiple times that principal reductions are in many cases better solutions than foreclosures (which the GSEs have been pursing aggressively) or refis (which typically offer lesser payment relief and still leave most borrowers underwater).

So that begs the question: why does one Scott Simon from PIMCO charge, at the top of the article, that he was “shocked” that Freddie was engaging in the well established, common practice of retaining inverse floaters, and seemed stunningly unaware of the fact that the GSEs have always engaged in hedging strategies to manage their prepayment risk? One is forced to conclude that he either does not know this space or has some reason to run a disinformation campaign. We’ve heard that the Administration is deeply frustrated with FHFA head DeMarco’s resistance to slowing foreclosures and taking other measures to throw the GSEs’ full weight behind saving the housing market. And the people who have the most to lose from the GSEs doing more refis are not the holders of inverse floaters, but the holders of high coupon Fannie and Freddie bonds from 2006 to 2009. So perhaps Pimco has decided to do the Administration a favor by supporting an anti-GSE line, or perhaps has shorted those high coupon bonds, anticipating that the GSEs would be made to step in to rescue the housing market, and are upping the pressure to make that trade works out.

But no matter what the explanation is, ProPublica does not have a smoking gun, and it’s embarrassing to see them get this one so wrong.

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77 comments

  1. Chris

    A very nice job here. When I heard NPR run this story today, something didn’t smell right.

    Once again the traditional media gets it wrong. And I’m sure lots of blogs ran with the story, and piled on. Thanks for being objective.

    1. JamesW

      Well articulated and deconstructed, Madam Y.

      The reporting claimed Freddie was making the wifi’s more difficult, but it was never clearly explained how they were doing so.

  2. LeonovaBalletRusse

    PIMCO “has perhaps shorted those high coupon bonds, in anticipation …”

    YVES, you are a super sleuth, you are Sherlock Holmes. Now, does the ProPublica piece serve PIMCO’s bottom line if they have indeed shorted those high coupon bonds, if it will nudge the “administration” to act in favor of PIMCOs purpose?

    When, in 2009, the new administration in Greece made an announcement that caused PIMCO to dump not only Greece sovereign debt, but also that of Portugal and Spain all at once, without warning, and quickly? Was PIMCO short the sovereign debt of the three countries, or were they the beneficiaries of *derivatives insurance* before they dumped? Is PIMCO just lucky always?

    Follow the *inside straight* money, YVES, the global money and DNA.

    1. MyLessThanPrimeBeef

      It sounds like someone is setting himself up so as to be able to claim later he’s doing God’s work of helping those in need.

  3. kravitz

    ProPublica has an update of their story. Doesn’t address Yves concerns, but kinda explains why they ran the piece

    Bets Against Homeowners Must Stop, Freddie Mac Was Told
    http://www.propublica.org/article/bets-against-homeowners-must-stop-freddie-mac-was-told

    Freddie Mac agreed last month to stop making new bets against American homeowners after its regulator, the Federal Housing Finance Agency, raised concerns, according to a statement the agency issued late Monday.

    1. kravitz

      And make sure you check out the FHFA response on the original piece. Which basically agrees with Yves.

      “FHFA Statement on Freddie Mac Refinance Story”

        1. kravitz

          American Banker

          Claims that Freddie Mac ‘Bets Against Homeowners’ Are Bunk
          http://www.americanbanker.com/bankthink/Claims-Freddie-Mac-Bets-Against-Homeowners-Bunk-1046239-1.html

          “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.”

  4. Rob

    As always, enlightening. When I read this piece on ProPublica, I was pretty sure that this was SOP but thanks for filling in the details. I feel guilty doing this but “Quelle surprise”….

  5. Mark P.

    This level of expertise is why I read this blog and it’s unfortunate it wasn’t available to the ProPublica folks — one can easily see why the journalists responsible, lacking such knowledge, came to the mistaken conclusions they did.

  6. publius

    The bigger question is why does Freddie still hold a gigantic portfolio composed of Fannie and Freddie-guaranteed MBS? What does this gigantic MBS portfolio have to do with their guarantee business, which was supposed to be their raison d’etre?

    These portfolios should be liquidated ASAP. Now would be a great time while the Fed is propping up MBS prices.

    1. Yves Smith Post author

      They are an insurance company.

      Insurance companies take premiums and invest them until they think they need to make payments on claims.

      If they didn’t invest them, they’d have to hold their proceeds in cash, which means they’d have to charge even higher premiums to make up for the lack of investment income. That would make mortgages more expensive and housing even cheaper.

      1. Tim

        Excellent reporting. I think the question of the day is actually – what are the GSEs? As long as their mission is vague and obfuscated, the Obama Admin and other pols will use them as off-balance sheet political tools to hide the true costs of politically popular actions. The problem with this is that the goals are not accomplished (housing availability, principal mods etc.) and the costs are huge when they finally emerge.

        Low income subsidies, principal mods etc. are worthwhile and should be provided and accounted for properly.

      2. publius

        How many other insurance companies that your know of invest in debt guaranteed by themselves? Why don’t you ask your friend Tom Adams what FGIC invested in. I can tell you they were not buying muni debt that they themselves guaranteed.

        Their guaranty business itself is pretty well hedged against prepayments, since volume picks up when refinances do, so the size of the guaranty portfolio grows and shrinks only due to the overall size of the mortgage market and the GSE’s share of it.

        The reason those MBS portfolios grew was simple – to juice profits, and thus bonuses.

        1. Yves Smith Post author

          They didn’t invest in debt guaranteed by themselves.

          The MBS portfolios they had and that blew them up were private label securitizations. Now I agree that was stupid, as in doubling their housing market bets, but it was not “investing in their own debt”

          1. JamesW

            But was it anymore fundamentally “stupid” than when S&P rated 95% of securitizations triple-A?

            http://hsgac.senate.gov/public/_files/Financial_Crisis/FinancialCrisisReport.pdf

            p. 31 on document/p. 38 in pdf file:

            From 2004 through the first half of 2007, Moody’s and S&P provided AAA ratings to a majority of the RMBS and CDO securities issued in the United States, sometimes providing AAA ratings to as much as 95% of a securitization. Beginning in July 2007, however, Moody’s and S&P issued hundreds and then thousands of downgrades of RMBS and CDO ratings, the first mass downgrades in U.S. history. By 2010, analysts had determined that over 90% of the AAA ratings issued to RMBS securities originated in 2006 and 2007 had been downgraded to junk status.

          2. Fiver

            Have to agree with James (comment below) that “stupid” doesn’t quite work when everyone in the housing game KNEW there was a tidal wave of fraud – how many times has Bill Black noted that the FBI told the world so as early as 2004.

          3. Yves Smith Post author

            Fiver,

            First the GSE invested in higher quality mortgages. The fraud was in subprime. It really was a very different market

            Second, what people knew about and ignored was the bubble. They assumed even if they made some bad loans, they could always grab the house to be made whole.

          4. Procopius

            Weren’t Fannie and Freddie either forced or “strongly encouraged” by the Congress to help the Fed and/or the Treasury out by buying a bunch of those OTC derivatives? The Mark to Your Opium Dreams ones that were believed to be worth about 3 cents on the dollar if buyers could be found? And were marked to approximately face value?

  7. Jeff N

    Yves, where do you learn all this stuff? I didn’t even know what GSE stood for until I wikipedia’ed it! :)

  8. Paul Tioxon

    http://www.reuters.com/article/2012/01/30/us-propublica-idUSTRE80T1J420120130

    Mon Jan 30, 2012 1:46pm EST

    NEW YORK (TheWrap.com) – Digital publisher Open Road has partnered with award-winning journalistic outfit ProPublica to release a series of e-books, the two companies announced Monday.

    Well, this seems to be a hot topic to kick off a new money making venture for the smart money set to read from their ipads, kindles etc etc.

    Hopefully, the degrading practices of models and movie starlets forced to wear near naked skin tight outfits on red carpets will be exposed in their next shocking report: “Skin Traffickers How the Media Makes You Want to Look Using Sex To Sell.” Complete with shocking e-photos not suitable for the dying family friendly newspaper industry.

    Upcoming titles, how to get the best deal in negative amortizations mortgages based on libor plus what ever yield spread premium yr mortgage broker can lure you into.

  9. Thorstein

    Yves,

    You and ProPublica both essentially denounced Magnetar. ProPublica is still pressing the same indictment, only this time they’ve substituted Freddie Mac for Magnetar. In their indictment of Freddie & Magnetar, ProPublica thinks they’ve exposed something nefarious by revealing that the equity tranche buyer/owner — Freddie and/or Magnetar — does NOT have the same motives or expectations as the senior tranche holders.

    That’s the crime, in their view. I think they are wrong — about both Freddie Mac and Magnetar.

    But your post ripping on PP’s Freddie takedown makes me wonder if you’ve altered your views of the Magnetar trade, which you describe this way in “Econned”:

    “Whether you like the results or not, [Magnetar's] novel use of an arcane instrument was exceptionally clever. If the world had been spared their cunning, the insanity of 2006–2007 would have been less extreme and the unwinding milder.”

    Wouldn’t your dissection of ProPublica’s reading of Freddie Mac’s actions also largely apply to your own takedown of Magnetar too?

    Have you changed your view of Magnetar’s “exceptionally clever” trade? Or are you exacting a little revenge upon ProPublica for having gained a good deal of glory — and a Pulitzer Prize too (sigh) — for their report on Magnetar with hardly an acknowledgment for your detailed analysis of the same story?

    (If only ProPublica would publish a long expose about the (near) criminal exploits of their benefactors: Herbert & Marion Sandler of Golden West Financial Corporation.)

    I detect a whiff of change in your view of the “exceptionally clever” Magnetar trade. Is it undergoing revision?

    1. Yves Smith Post author

      This is nothing like Magnetar. Magnetar was a levered short bet.

      This is normal construction of CMOs. This is how the business has been done since at LEAST the 1980s. This is utterly normal, not secret, not controversial. There is a piece left that most of the time no one wants to buy. You tweak the rest of the deal terms as much as you can to make it less toxic. And it IS routinely described as “toxic waste”. Inverse floaters were what blew up KIdder Peabody, for instance. Mismanaging the risk of inverse floaters was what ended Larry Fink’s (now head of Blackrock) career at First Boston. His bad experience with the retained tranches is why he is such a fiend about risk management at Blackrock.

      And as I ASLO indicated, Freddie and Fannie has LONG engaged in interest rate hedging. They HAVE to, as DIzard explained. You can’t determine anything about how they are positioned by looking at a single trade. So you and I have NO IDEA of what view they are taking by looking at this activity in isolation.

  10. Conscience of a Conservative

    Susan, I know something of Inverse-Io pricing and the activity that is alleged. First Inverse IO’s are a volatility play and by holding on to them Freddie beleived that VOL was being mispriced, or to say it another way, they were simultaneously betting against the forward curve and that prepays would come in slower than consensus. Second as you alluded to the inverse floater is what remains after pricing a floater, and again what most likely occured was an attempt to profit from mis-priced securities; Freddie does not control prices in the cmo market, they merely respond to them. Freddie Mac is correct in saying its traders are walled off, this is nothing more than a decision to retain what it considers the cheap parts of a CMO. What’s most surprising in the article is that a senoir PIMCO executive claims he didn’t understand the practice which has been widely known in the industry for years. The NPR/Pro-publica sory is just pure garbage and displays a lack of knowledge for the subject matter.

  11. Blissex

    «The Silversteins bought this home before the housing market crashed, and then couldn’t sell their old house. They now say that buying a new home before selling the old one was a mistake — a painful one.»

    So these are highly leverage property speculators who hoped to ride a bubble to MAKE MONEY FAST and then they discovered that they were greatest fools, and there were no more suckers onto which flip their speculative property. No more retirement made of cruises on luxury ships.

    «“It burned up my 401(k) and drained us.”
    Jay Silverstein has a modest pension, and they haven’t missed a mortgage payment on their current home. Still, they are struggling. They could make the monthly payment on their new home if they could just refinance — down from their current interest rate of near 7 percent to today’s rates below 4 percent. That could save them roughly $500 a month.
    »

    That’s the same as saying that they want the interest cost to be halved. Their numbers are pretty easy to figure: $500 monthly difference between 4% and 7% implies a $270,000 loan over 30 years, with around $1,300/month on 4% and $1,800/month on 7%.

    That means cutting the interest cost (on top of the $270,000 capital repayment) from $380,000 to $190,000.

    If paying $380,000 interest on a $270,000 property looked like a MAKE MONEY FAST idea before the price crash, then a saving of $190,000 on a $270,000 loan almost surely means BIG TAX-FREE PROFITS because the $270,000 property is unlikely to have declined to $80,000.

    In other words they want the highly leveraged speculation for which they happily borrowed at 7% (smug in their certainty that it was a one way bet to tax-free capital gains and wealth for a luxurious retirement) to be retroactively made a huge tax-free gain regardless of any loss in value of their property.

    Because they want the house price crash to be erased for them, by being given 30 years of tax-free mortgage welfare of $500/month.

    Without being a Tea Party person, I can see why Nardelli’s Rant got so much resonance.

    But then What about the banks who are getting many years of interest rate welfare with 0.25% Fed money to lend at 7% (or 4%) so they can “rebuild their balance sheets” as Greenspan put it so apporvingly?

    1. Bayer Beed

      Who was on the other side of the Silverstein’s abhorrent, immoral attempt to game the hustle and commit financial rape, adultery and money based buggary? Oh that’s right – even smarter a-holes.
      Oh well, perhaps Ma and Pa Silverstein should suck it up and find a tunnel or some Port Authority labyrinth where they can think long and hard about their housing crimes.

      1. Blissex

        «Who was on the other side of the Silverstein’s abhorrent, immoral attempt to game the hustle and commit financial rape, adultery and money based buggary? Oh that’s right – even smarter a-holes.»

        That’s the usual right-wing speculator-friendly propaganda.

        Asset speculation is not a victimless bet, or a bet whose victims are heroes of finance.

        On then other side of petty property speculators’ dream of work-free tax-free luxury there are poorer people when the speculators succeed, and pensioners when the speculators fail.

        Because someone who borrows $270,000 to purchase an asset with the hope of getting a $1,000,000-4,000,000 capital gain in 30 years has not created once cent of wealth as new value, they haven’t built or produced anything; they have just redistributed $4,000,000 to themselves from people who own no property or less property.

        Asset speculation is pure upwards redistribution with no economic content (and it is actually economically destructive, because it turns to rent-seeking capitals that could have been invested in income producing wealth like infrastructure or factories or research).

        And if their dream of work-free tax-free capital gains fails, the creditors who lose ultimately are mostly pension funds or life assurance companies like AIG. The snakes, the heroes of finance, are there only to ferry pension and insurance fund money to speculators for a huge cut.

        «Oh well, perhaps Ma and Pa Silverstein should suck it up and find a tunnel or some Port Authority labyrinth where they can think long and hard about their housing crimes.»

        Objecting to making property speculation a risk-free not just work-free and tax-free rent extraction activity by giving retroactive discounts on prices paid to speculators is not the same as demanding that the speculators be cast in the gutter, however much they deserve it on just desserts grounds.

        After all they still got their Social Security, they still got their future Romneycare or Medicare (and let me add that the Silversteins probably belong to a class that hates hates hates the idea that parasitical darkskins get “free” Social Security, Medicaid, unemployment, money).

        There is a safety net and it is for failed property speculators too, even if their failed plan was to redistribute income upwards to themselves by making poorer people’s house rents and prices higher and higher and higher.

        1. liberal

          Because someone who borrows $270,000 to purchase an asset with the hope of getting a $1,000,000-4,000,000 capital gain in 30 years has not created once cent of wealth as new value, they haven’t built or produced anything; they have just redistributed $4,000,000 to themselves from people who own no property or less property.

          Or, as someone figured out a couple centuries ago:

          Landlords grow rich in their sleep without working, risking or economizing. The increase in the value of land, arising as it does from the efforts of an entire community, should belong to the community and not the individual who might hold title.

    2. Blissex

      To get bitter renters to really seethe at the bottomless greed of bubble loving heartless speculators, some more numbers.

      Warning: all figures below slightly rounded (and some sarcasm in the text).

      If someone borrowed at 7% on what looks like $270-280,000 for a total interest cost of $380,000, or a total repayment cost of around $650,000 after 30 years.

      Assuming that their $270,000 speculation would grow incessantly (house prices never go down! it is a safe bet!) at the expected 10%/year compound nominal (just 3% above the 7% borrowing rate!), the $270,000 magically turn into $4,700,000 for a BIG TAX-FREE PROFIT of around $4,000,000. How’s that for risk-free speculation?

      At a break-even rate of nominal house price increase of merely 7% the $270,000 turn into $2,050,000 for a totally ordinary TAX-FREE PROFIT of around $1,400,000.

      And even if a socialist government keeps house prices down so they grow only at 4% nominal, the initial $270,000 turn into around $880,000 for a TINY TAX-FREE PROFIT of only $230,000.

      Now let’s look at return on investment: assuming that there was an initial downpayment of $30,000 (a very conservative 10% of a total property price of $300,000), despite overly prudent 10-times leverage we have a TAX-FREE return on investment over 30 years of 15,200% (after 10%/y house appreciation), 5,400% (after 7%/y house appreciation) or 1,000% (after 4%/y house appreciation).

      That’s why the Silverstein were happy to borrow at 7%: it was a fantastic deal anyhow. And risk free, because house prices never go down.

      That’s why the ownership society of GWB and many others was the solution to all of America’s problems: the only thing that Americans need to do to be rich is to just keep building houses and selling them to each other for ever higher prices! :-)

      Let’s also look at one scenario with a Silverstein-like refinance from 7% to 4%.

      Let’s imagine the same purchase price of $300,000 with an investment of 10% or $30,000 and let’s imagine that because of socialism caused lack of confidence house prices halve, so the $300,000 house halves to $150,000 in the first 5 years, and let’s imagine that the price grows again at 4%/y for the next 25.

      Then the house will appreciate to $490,000, and if the rate on the $270,000 mortgage is still 7% for a total cost of $650,00 there is a loss of $160,000 wiping out the $30,000 investment and more.

      But if the rate on the $270,000 mortgage gets reduced to 4%, the total cost of the mortgage comes down to $460,000 resulting in a tiny profit of $30,000 or mostly a wash if some years of 7% interest have already been paid.

      If they get lucky and house prices grow by 7% nominal instead of 4% for those 25 years, they make a capital gain of $500,000 tax-free, for a total return on their $30,000 investment over 30 years of a mere 1,600%.

      If the figures above are roughly those for the Silversteins, all they want is for that $500/month for 30 years of mortage interest TAX-FREE WELFARE to give them a largely risk free option: if their speculative property halves in price and then its price grows slowly, they break even, if things get better than that, they still get a MASSIVE TAX-FREE UPSIDE.

      That’s right folks! The GSEs should retroactively halve the borrowing costs of property owners, courtesy of the public purse, to give property speculators a big chance again at MASSIVE TAX-FREE CAPITAL GAINS, or at least erase their losses.

      That’s how America should be: trillions for ensuring that clever deserving property speculators get risk-free tax-free returns, and for their enablers in the finance industry, not a penny for the exploitative parasites who can’t get a job after nearly two years of unemployment.

      1. diptherio

        This couple lived in both houses, which to me means that they were not speculators or house-flippers. They were simply trying to move. The sense of injustice in their story stems from the fact that they have been injured by a market collapse they had nothing to do with, and are now receiving no help from the government who stepped in to save the ones who created the problem. If the couple made a bad assumption, it was only that the housing market wouldn’t suddenly nosedive. They now have a default on their record, but under normal circumstances they would have not had one. The actions of others caused the situation in which they had to short-sell their previous residence, and now they’re financial pariahs.

        1. Blissex

          «This couple lived in both houses, which to me means that they were not speculators or house-flippers.»

          Ah really? Borrowing $270,000 at 7% to make a highly leveraged bet on land prices is not speculation? Do you invest in stocks at 10 times leverage with 7% loans? Not so long ago investment banks, that is professional speculators, were 10 times leveraged, and they surely did not speculate with a 7% cost of funds.

          That some people lived in one of the houses they bought simply means that their speculative capital gains would have been tax-free. In the USA, the UK and other countries it has been a popular strategy for small-scale speculators: buy a small house, live in in for a few years, get the tax-free capital gain, sell it, buy a bigger house, live in it, get a bigger tax-free capital gain, and so on. The sky is the limit. House prices just go up and up. :-)

          «They were simply trying to move. The sense of injustice in their story stems from the fact that they have been injured by a market collapse they had nothing to do with,»

          The sense of crass entitlement here is just fabulous. Being a property owner of two houses after a failed go at speculation is an injustice to be redressed with a retroactive discount on the price paid? Worth $6,000 a year of tax-free welfare for 30 years?

          Why didn’t certain petty speculators decide to rent while they were trying to sell their previous house? Was that being terrified of missing out on a fantastic tax-free capital gains opportunity?

          Why ever did they decide to borrow $270,000 at 7% instead of renting? Why is the government responsible for that decision?

          If you buy $270,000 worth of lottery tickets with a 7% loan, should the government give you $6,000 per year of tax-free welfare for 30 years to compensate you if you don’t win the $1m or the $4m prize?

          «and are now receiving no help from the government»

          Really? What about Social Security, Medicare, unemployment extensions? Or is the help you want $6,000 tax-free welfare handouts for 30 years on top of that? To end up owning 2 properties without debt?

          «who stepped in to save the ones who created the problem.»

          The Silverstein problem was created by the Silverstein’s greedy decision to speculate on high leverage at 7% into a “one-way” bet on house prices.

          The government stepped in to save those big banks who could blackmail the rest of the country with a massive economic collapse. Small time speculators can only blackmail the rest of the country with their own economic collapse.

          As to injury and injustice and government help, what about all the poor (largely dark skinned) people who could not afford a $270,000 speculation at 7%, and don’t own speculative property, and saw their rents increase and their chances to ever buy a house decrease as the speculation by petty rentiers drove house prices up and up, fueled by 7% loans? Who saw their living standard fall and taxes rise and public services worsen as petty (and big) rentiers redistribute income upwards to themselves via tax-free or Romney-style low-tax capital gains?

          What about all the people who have lost their miserably paid jobs because the failure of that speculation, should they get too $6,000/y of tax-free welfare for 30 years even if they don’t own any property?

          «If the couple made a bad assumption, it was only that the housing market wouldn’t suddenly nosedive. They now have a default on their record, but under normal circumstances they would have not had one.»

          Hahahaha! So «normal circumstances» are that investments «wouldn’t suddenly nosedive», and if they do the government should give you free tax-free money to make you whole again? One way bets are the new normal? What do you think house speculators are, like bankers?

          And what about that 7%? Wasn’t that an assumption that house prices would be zooming up for 30 years at faster than 7%? Is that just «normal circumstances» again?

          Arguments like these make me sympathize with Old School Mellon and his “liquidate homeowners” and “purge the rottenness out of the system” line, except that I would anyhow put a safety line in place to ensure that the purging bad deals and bad decisions does not result in purging people too.

          But human sympathy for speculators, small or big, should not extend to sympathy for speculation deals. Give the Silverstein Social Security, medicare, social housing, but don’t give them a retroactive discount on their bad bet.

          1. LD

            That is one of the best liberal rants I have ever read in regards to housing speculators and their heinous impacts to society. Thank you. It should be published far and wide.

            Furthermore, from Yves’ analysis of the piece, especially about the PIMCO involvement, and then PP holding up the Silverstein example as a kosher reminder of this, reeks of stench. (BTW-this PP piece is making the “liberal” rounds everywhere. Disgusting Orwellian disconnect, once again.)

          2. PL_2

            Lot of air in your comment. Hello, homeownership is _nearly always_ a heavily leverage bet on appreciation keeping up with interest payments. Hello, _any borrowing_ is a bet that the value received will exceed interest payments.

            A) There would be no foreclosures if the housing market had not crashed — homeowners would just sell the home in a ‘normal’ market.

            B) No homeowner crashed the housing market.

            C) Therefore, no homeowner is to blame for a foreclosure (within rational limits.)

  12. Blissex

    «However, most of the long-term debt on the liability side of the GSE balance sheets has a fixed term. So the GSEs must more or less continually offset this imbalance between the average maturity of their assets and liabilities through the derivatives market, specifically the interest rate swap market. Otherwise the mark-to-market losses would overwhelm their small equity bases.»

    This is a worrying statement, because if the problem is a «small equity base» the solution is to raise equity, not to pay dearly for what is regulatory arbitrage of insuring aganst maturity/rate risk and thus turning a risky investment against a risk-free one, in the usual one-trick pony of modern finance of manufacturing AAA assets that don’t require risk capital.

    Because either the potential «mark-to-market losses» don’t happen, and then the GSEs have paid expensively to dress up their accounts for lower volatility so that they can work with very little capital, and give themselves huge bonuses, or they do happen, and then someone else like AIG will take the hit, again expensively. And we do know what is going to happen, and how much more frequent are “hundred year” events.

    1. Blissex

      «

      The core problem for the housing GSEs is, and has been, the prepayment option embedded in US fixed-rate mortgages. That has meant that the term of the GSE assets extends or contracts depending on whether homeowners can refinance at an advantageous rate. However, most of the long-term debt on the liability side of the GSE balance sheets has a fixed term. So the GSEs must more or less continually offset this imbalance between the average maturity of their assets and liabilities through the derivatives market, specifically the interest rate swap market. Otherwise the mark-to-market losses would overwhelm their small equity bases.

      So ProPublica misses completely that the GSEs have long been engaged in a massive program of interest rate hedging.»

      I have just noticed here that while the quote from John Dizard is very misleading, the comment by Yves Smith is correct and quite different.

      John Dizard seems to argue that the GSE problem is «imbalance between the average maturity of their assets and liabilities» but that by itself would mean much, maturities are not a big deal because typically house mortgages are prepaid with money from other mortgages and it makes very little difference whether a borrower who has a 30 year mortgage pays it off with another 30 year mortgage both of them typically end up with the GSEs.

      What matters and where the risk lies is that the new mortgage may pay a lot lower interest rate. When a borrower prepays a mortgage with cash from another mortgage, the vital detail is that the new mortgage is cheaper. So if the GSE has funded the a 6% mortage with 5.5% borrowing, and effectively the mortgage gets replaced with one with similar maturity but at 4%, the GSE is going to lose a lot of money.

      This is implied in John Dizard mentioning the «interest rate swap market» even if apparently it does not make sense because he described the issue as maturities, to the point where he writes «most of the long-term debt on the liability side of the GSE balance sheets has a fixed term» where the issue is not that the liabilities are fixed term, but fixed interest rate.

      This seems obfuscation to me, just as describing the resulting losses as «mark-to-market» as if they were just a temporary or accounting matter, while of course they are not, because borrowers are not going to refinance to a higher rate when market rates go up again (borrowers have the option to «mark-to-market» their rates downward only), and lending at 4% while borrowing at 5.5% results in a certain loss.

  13. Helen Kellermann

    ‘I don’t mean to sound heartless, but here’s how the grift really works ProPublica, hmmph!’

  14. Chris2

    Many of these posts ignore the fact that Freddie Mac is not a normal financial firm. Freddie Mac, along with Fannie Mae, control about 70% of mortgage originations and set their own credit standards. So Freddie Mac has partial CONTROL of prepayments. The analogy to a normal firm that is a price taker in the market is not right. And Freddie Mac has different mandates than a private firm.

    While IO inverse floaters are not exotic instruments for the mortgage market, apparently Freddie only started using them in scale only in October 2010. This was the same month that Freddie began tightening credit for refis, first by limiting rules on who could qualify, including short sales, and later by imposing new fees in November 2010 to further restrict refis. Fannie Mae did not set the same restrictions at the same time. At a minimum, this is an odd coincidence. The fact that Freddie Mac later tightened credit relative to Fannie Mae under Harp 2.0 in November 2011 is another odd coincidence after Freddie did inverse io floaters against at least $20 billion of underlying mortgages. 

    The FHFA statement appears to ignore the fact that the inverse io floaters are highly leveraged…the value of these securities depends more on how many mortgages are underlying the securities than the claim of how much the inverse io floaters are worth. The deals ProPublica and NPR highlighted we’re levered about 6:1.

    Freddie is under a mandate to reduce risk and move towards winding down its portfolio. It is also under a mandate to ensure a stable, liquid, and efficient mortgage market.  Instead of selling straight MBS, they created highly structured, highly levered MBS that will be impossible to sell later–who would buy inverse io floaters from Freddie when Freddie could later do a mass refi and wipe them out? It is a long known fact in the industry (supported by acadmic studies) that the GSEs used their knowledge of specific mortgages to pursue higher profits while trading. Gse bonds trade with a healthy lemons premium. In the deals coverd by ProPublica and NPR, Freddie Mac is taking more mortgage risk relative to just selling an equivalent amount of MBS (a violation of their mandate to wind down their portfolio and reduce risk on their balance sheet), making themselves harder to unwind, and accentuating information problems that make the MBS market less liquid and efficient.

    Almost every commentator who wonders why the GSEs are not doing more refis comes to the same conclusion…it must be to protect their portfolio of high rate mortgages.  If not, the GSEs strictly win with large refis due to possibly lower defaults when borrowers have lower payments.  Not sure why some commentators are willing to cut the Freddie Mac a break when they do deals that retain all the prepayment risk and also control lending standards.

  15. Conscience of a conservative

    This strikes me as nothing more than smear campaign to discredit Demarco, who has so far been a thorn in the administration’s housing goals.

    1. Julie

      Exactly! DeMarco is insisting on playing by the rules as spelled out by Congress for the GSE conservation. Is it semi-heroic that he is unwilling to do off-the-books mortgage mods to help out with Obama’s reelection campaign when Obama is unwilling himself to spend the political capital to do so honestly and directly.

      Obama and Timmy G are trying to continue the same shenanigans that got the GSEs and the US housing markets in trouble in the first place.

      1. Robert Weiler

        I didn’t hear Obama propose any ‘off books’ loan modifications and it’s hard to see how one could be more honest and direct than announcing their intentions during the State Of The Union address with the full Congress in attendance. This Obama sure needs a lesson in how to do things under the table. What got the GSE’s in trouble was being under capitalized and from previously credit worthy borrowers being unable to service their mortgages when they became unemployed. With access to the US Treasury, the former is no longer a problem, and the later should become less of a problem if current borrowers can pay a lower interest rate and if the money ‘freed up’ reduces unemployment enough to create more home owners. It sure is terrible that keeping people in their homes and reducing unemployment will improve Obama’s re-election chances, but I guess you’ve got to take the bad with the good.

        1. Fiver

          “This Obama sure needs a lesson in how to do things under the table.”

          That’s right. Obama has made it perfectly clear that it’s way past time crimes ranging from fraud to Presidential murder-by-writ came out from the dark and were performed in broad daylight, so that the Law could quite clearly be seen to be relegated to the trash bin and various perpetrators receive the royal “let’s all move on…” treatment. That he leaves out the “….so they can lard their asses with the spoils” is just good manners.

  16. dcblogger

    I thought that the NPR piece was too good to be true, that NPR was waking up to its responsibilities.

    When covering up and hushing press scrutiny won’t work, the next step is to deflect attention.

  17. Peter Pan

    Yves, I suspect your post is too late but it is appreciated.

    When I first read this NPR/ProPublica piece my first thought was: WTF? They’re hedging risk! This is nothing new!

    Unfortunately, this is another example of misinformation/disinformation that is picked up by the national Nightly News and broadcast into the flash memory of the programmable roboton zombie sheeple that rely on the national news media. So, now it’s a big shit storm that will require congressional inquiries and political finger pointing as to fault. Look for the Tea Party to make an even bigger deal out of it.

  18. Brian

    Let’s ignore that Freddie Mac has written policy to their servicers (for loans they can’t prove a note or deed exists) to lie to each and every court and claim the servicer owns the loan to the court, thus has every right to act. Standing is claimed knowing it is based upon perjury by all. That is fraud, correct?
    Let’s ignore the fact that they also provided money as lender, but not of record, and yet aren’t mentioned in the transaction on deed or note. This means the note was created knowing it was false by the originator and Freddie Mac. Does this void the note under UCC 3-9?
    Let’s forget that the FDIC is an accomplice to the false claims of Freddie and JPMorgan regarding Washington Mutual, knowing the FDIC was the receiver and that Chase never had an interest. Yet is claiming to be owner of paper that can’t exist with the FDIC, Freddie Mac, and Chase each claiming to be owner.
    Let’s ignore that the friends of Angelo bought silence from an entire government to keep this scheme swinging until Chase blew the whistle trying to protect themselves from fraud charged by Deutsche Bank.
    Pick a crime, any crime. Why protect one aspect of a criminal organization by minimizing their bets against the people that own the company, us.

  19. Andrew Burday

    First, two or three typos:

    “the inverse floater would pay at 6% – (Libor = .08%)” – the last term should be Libor + 0.08%, right?

    “their credit recored would clearly show that they have defaulted on their mortgages on their new home” – “record”, and unless I completely misunderstood, the couple defaulted on the mortgage on the old home.

    More substantively, thanks for posting this. It’s very helpful to those of us who have no background in finance and are trying to understand the issues. One substantive question: why decompose the medium-term bond into a floater and an inverse floater? This would appear to have no economic payoff at all. The post says that the inverse floater is usually priced lower than its economic value, because investors don’t understand and fear that kind of instrument. That hints that the floater may be correspondingly overpriced. Is that the reason for the decomposition: so the originator can hold an overvalued instrument and sell an overpriced one? If so, that’s a little skeevy. If that’s not the reason, what is?

    Finally, readers like me who have know a little bit about recent financial history but not much about the real detail have encountered inverse floaters in at least one other notorious context. They were one of the main instruments that led to the bankruptcy of Orange County in the mid-90s. OC used inverse floaters to bet that interest rates would stay low following the early 90s recession. Instead, Greenspan briefly got the inflation willies and pushed rates up.

    Yves, I hope you’ll have a chance to get to the question about decomposing the medium-term bond.

    1. Blissex

      «Readers like me who have know a little bit about recent financial history but not much about the real detail have encountered inverse floaters in at least one other notorious context. They were one of the main instruments that led to the bankruptcy of Orange County in the mid-90s. OC used inverse floaters to bet that interest rates would stay low following the early 90s recession. Instead, Greenspan briefly got the inflation willies and pushed rates up.»

      Ahhhh Orange County and the appropriately named Mr. Citron, what a beautiful story :-).

      They have become a model for all counties and other local governments (especially Republic ones), and for something much bigger than inverse floaters

      The Orange County model was to bet their funds, mostly pension funds, on highly speculative leveraged instruments, to generate capital gains that would allow the County to substantially cut taxes, and then when the leverage speculation would blow up, to slash spending to repay the loans fueling the leverage. That is, the Norquist strategy.

      There is this fantastic article by some Fed researchers:

      http://macroblog.typepad.com/macroblog/2011/10/state-and-local-fiscal-fortunes-follow-the-money-collected.html

      that shows that overall USA local government funds are in highly leveraged stock market investments, where once they were more properly in Treasuries. Until the recent crash the huge capital gains on these levered stocks allowed many local governments to cut taxes. Now the strategy is to cut instead the pensions and other spending that the investments were meant for, because taxes cannot be raised again.

      That Orange County invested in highly volatile speculative trades like inverse floaters was a feature, not an issue.

      1. LeonovaBalletRusse

        Blissex, as George Carlin said: “They don’t give a F%#K about you. They don’t care about you at ALL! at all, at all. And now they’re after your Pensions, your Social Security.”

        This putsch went into high gear under The Decider’s first term, but he failed at Fuehrer, true to his performance record. He could smirk and flip the bird, tho’.

        “AMERICAN DYNASTY” by Kevin Phillips.

  20. Susan the other

    Over my head. My only thought was how wrong I have been to assume that volatility, aka free markets, were the life blood of capitalism. I guess Bernanke must be thinking the same thing with his new interest rate transparency and betting rules.

  21. Arnold Layne

    I generally think ProPublica and NPR have done a decent job on reporting on the mortgage crisis, BUT…Let’s just remember the little game being played at and by ProPublica.

    They got their money from…Herb and Marion Sandler, former owners of GOLDEN WEST MORTGAGE, one of the original proponents of the Option ARM. GWM sold to Wachovia pre-crisis and Herb walked a way with a bundle. THose loans were the principal reason the Wachovia failed and needed to be bailed out by the feds and Wells Fargo.

    Why is this important? In an environment in which journalists are losing their jobs everyday, Herb has found a way to fund them while they do investigative journalism–it’s one of the few places doing it now. Would any journalist look behind the curtain at Golden West Mortgage and the role of Herb and his firm if the journalist was EVER worried about losing his/her job? Of course not. The journalists have been effectively neutralized.

    “Nothing to see here. Everybody keep moving. OH, look at Freddie. Oh, see what Fannie and Countrywide and BofA and GOldman Sachs have done? Nothing to see over here behind our curtain though.”

  22. Jesse Eisinger

    We are glad to see that our Freddie Mac story has sparked a lot of discussion.

    We wanted to respond to some of the critiques.

    First, though some bloggers see nothing wrong with these trades, the FHFA did. They had them stopped. And there is a lot we still don’t know from the agency’s statement. Why did the agency stop the trades? What were its concerns about Freddie’s risk management? In all the critiques, we have seen little engagement with this FHFA statement, which essentially confirms our story, while saying that Freddie had an even greater amount of inverse floaters than we had reported.

    Several bloggers, even the critics, have also agreed with the central premise of the story: That Freddie (like Fannie) has an enormous conflict of interest between helping homeowners and maintaining the value of its investment portfolios. With these trades, we wrote, Freddie exacerbated that conflict.

    Naked Capitalism’s Susan Webber (who writes under the nom de plume Yves Smith) says we have the “wrongheaded premise that retaining the inverse floater is unusual.” We flat out never said that. Quite the contrary, we wrote that these kinds of securitizations have been around for decades — hardly an indication that “retaining the inverse floater is unusual.”

    The point that Webber misses is this: Freddie’s retention of inverse floaters ramped up dramatically in late 2010 through spring 2011. 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.

    It’s not the retention of the floater that’s unusual (a word we didn’t use). It’s the dramatic increase in these deals by Freddie Mac that is noteworthy.

    Some people have raised the point that there is a difference if Freddie “retained” these inverse floaters instead of “bought” them. But we reported that Freddie retained these positions and the graphic, though simplified, says the same.

    Our story says this:

    “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. (Our emphasis)”

    Naked Capitalism goes wrong when she discusses how hard it is to sell inverse floaters. Yes, it’s hard. But that’s not what Freddie started with. It started with mortgage-backed securities.

    It could have sold MBS on its portfolio outright and rid itself of the prepayment risk. The market for simple MBS with a government guarantee attached is liquid and deep – and certainly was then, in late 2010 and early 2011 when Freddie’s inverse floater bets ramped up.

    Instead Freddie had the securitization structured, then retained the inverse floater portions. In other words, Freddie undertook transactions in which it retained a piece of a newly created deal that has basically the same risk profile as the original holdings. And what Freddie retained carried new risks: liquidity and LIBOR risks. Freddie engaged in reverse alchemy: it turned a position of gold into lead.

    Moreover, these trades didn’t happen in a vacuum. Freddie is under a mandate to sell down its portfolio. Implicit in that mandate is that Freddie reduce its risk. In these trades, Freddie sells something notionally, so that the assets on its balance sheet fall, but it keeps most of the risk — and adds new risk. That raises the question of whether it is subverting the spirit, if not the letter, of its agreement with the U.S. Treasury. In Freddie’s defense, as we reported, its portfolio is “well below the cap of $729 billion required by its government takeover agreement.”

    As for the point that Freddie has a large portfolio and we cannot know what other risks are there, or how it’s being managed, that strikes us as a bizarre defense. The company retained these positions. Its now-smaller portfolio is now even more levered to prepayments because of these inverse floaters.

    As always, we welcome any and all responses from Freddie that clarify these matters. All others are speculating.

    Regardless of the portfolio’s overall size, Freddie essentially placed $5 billion in bets that homeowners wouldn’t prepay through deals involving a much larger pool of mortgages worth more than $20 billion. We’re talking about tens of thousands of home loans wrapped up in these investments. We raise the question: Is that an appropriate bet for a government-run company to be making, especially when it is a gate-keeper on refi eligibility?

    As far as the argument that perhaps these inverse floaters were used to hedge other risks in Freddie’s portfolio, bond traders we spoke with say that Freddie could have easily bought options or swaptions to hedge its prepayment and/or interest rate risk. Entering into inverse floaters as a hedge – or to offset a hedge – seemed to these traders to be cumbersome and expensive for Freddie. One said comparing inverse floaters to hedging tools is not just apples and oranges – it’s more like apples and cars. They just have nothing to do with each other.

    Finally, some people, such as Matt DeBord, seem to have missed a big point about the Silversteins, the homeowners we profiled in our story. Yes, they did a short sale and have worse credit for that. If they applied for a new loan, a lender should evaluate that.

    But this is a refi. Freddie – which means you and I as taxpayers – owns the credit risk. The government guarantees their mortgage already. There seems to be little reason why borrowers who are current on their mortgages shouldn’t have easier access to refinancings, especially when that would only reduce their credit risk to the insurer – in other words, to the taxpayer.

    But Freddie did inhibit refinancings and did have an incentive to inhibit them: its short-term profits on the inverse floaters. As we reported, no evidence has emerged that Freddie’s decisions to limit access to refinancings were coordinated with its decisions to retain the inverse floaters, and Freddie denies that they were coordinated.

    We welcome more discussion of this. Thanks to the people who have commented on our story.

    -Jesse Eisinger

    1. RalphR

      Wow, Eisenger just tries to bluster past Yves. Not very convincing. Misses the critical point that you can’t tell anything by looking at these positions by themselves. You have to look at the whole book of exposures. Also misses that if anything the trading desk was probably positioning itself to take advantage of market trends (difficulty in qualifying for refis) or just pure interest rate market conditions (Conscience of a Conservative’s point above, that this was really a bet on vol).

    2. Foppe

      I don’t see a need to address the substantive claims/counters offered by Eisinger here, but what fascinates me most about this reply is the paragraph dedicated to ‘exposing’ the person behind the pen name. Is it that these ‘investigative journalists’ simply can’t help themselves, no matter how uninteresting the object of investigation, or what?

      1. reprobate

        Yes, it come off as either pretentiousness or an effort to discredit Yves (she’s a woman! she’s hiding behind a pen name!)

  23. Robert Waldmann

    I may have fallen for the ProPublia story. I certainly am enthusiastic about anything which weakens DeMarco. However, I don’t find this post entirely convincing. You note that Freddie’s approach is common practice. You conclude that it is therefore not grosdly unethical. This follows if one assumes that the normal practice of the financial services industry is not grossly unethical. Huh ? I have long had the impression that you thought nuch of it is grossly unethical.

    I certainly think standard practice is grossly unethical. Off topic I consider it outrageous that firms which trade on their own account provide investment advice. The conflict of interests is gross and obvious. Also, I think the people who listen to that advice are idiots.

    To return to the topic, the fact that we have accepted for decades that a firm ( now publicly owned) can bet on the volume of refinancing and determine that volume doesn’t mean that we aren’t fools to allow such a clear conflict of interests to exist.

    Here the victims( if any) are the investors who bought the principal repayment only part. If Freddie did indeed change the rules (adding refi fees) after selling those securities, then, it seems to me that this is close to fraud. The fact that they (and Fannie) have done things like this for decades does not make them OK. I think the question must be what serves the public interest. This question is not answered by noting that they have long done something, or that it is currently legal. Should it be ?

    1. Yves Smith Post author

      With all due respect, you don’t appear to understand the argument.

      Tranching mortgages into CMOs is really really old technology. Despite Eisenger’s attempts to argue it’s sus, It allows for Fannie and Freddie to fund mortgages at a cheaper price. This HELPS taxpayers and borrowers.

      I’m surprised they aren’t doing the overwhelming majority of their deals this way. I don’t find a higher volume in 2010 to be odd; I find the fact that they had a lower volume before then to be odd. I wonder if that has something to do with QE, as in with the Fed as a big buyer, why bother structuring the deals, they could just sell them to the Fed trading desk.

      You are ALSO missing the point that this is one position in isolation. It’s like screaming that, say, if I own stock in Citi and have bought an even bigger put against it, you look at only the stock and not the put and declare me to be a bank shill talking my own book if I run a not-negative story about banks. With a company running a massive interest rate hedging operation, you can’t conclude anything from looking at one position. That is a REALLY BASIC principle of risk management.

      Finally, in really large firm, Treasury (as in trading) decision NEVER influence the business side. I’ve worked with lots of Treasury units. Why? Business decisions take time (weeks, months) to decide and implement. Any trading unit can change its position in a day or over a period of days if it is a really big change in your book. Treasury units work within parameters set by the business side because the business side is more rigid, not vice versa. And on a practical level, the lending guys and the Treasury guys have nothing to do with each other. Their reporting lines don’t converge below the CEO.

      1. Fiver

        All these varied means of financial “innovation” to produce “efficiencies” or mitigate “risk” strike me as simply 1001 ways to siphon money out of the stream without getting wet. Slicing and dicing, wandering up and down yield curves with a magnifying glass, bury this turd, flaunt that zircon, I’d be asking why F & F ought not to have the simplest, most straight-forward of “business” models and practices. In fact, I’d suggest that is Mistake #1, i.e., running these outfits as if they should be state-of-the-art business “players” in an environment where all their myriad “partners” in the “business” are out to screw the government for every cent possible, AND, because of 2 decades of revolving door syndrome, far too many senior people over time at F & F are inclined at bare minimum to “see things” the same way (note the bias is NOT one that views a public trust as sacrosanct). Government is NOT a business.

        There was nothing wrong with the financial mechanics used 50 years ago re financing mortgages. What was wrong was the lack of income for far, far too many people. The GSE’s are a FAILED political/economic response. Policy should’ve been aimed at jobs and incomes – STILL should be. Or, if for some strange reason (a lie for instance)that was deemed impossible, GSE’s should’ve been 100% government providing the financing at cost (+ risk reasonably adduced) with an EXPLICIT public policy goal re quality of housing backed by a known amount of taxpayer funding to make it happen. It is the hallmark of “liberals” in money (and some other) matters to attempt to have it both ways – keep the wealthy private sector happy and the public happy at the same time – thus the Original Can Kick and the genesis of the PPP.

        The only way it ever did work, to the extent that it did, was in ancient times, say, 40 years ago, when the lines between government and the private sector were far, far less permeable, and the amounts of public money diverted to wealthy players, outright looted or stuck on the tab for future victims to pay was in relative terms seemingly inconsequential compared to what goes on in the muck of today’s swamp.

        Nobody’s going to want to be standing where all the cans land a couple years or so down the road. That’s when we’re going to wish we hedged by arranging passage across the Styx.

      2. Fiver

        Yves,

        This was intended as a general comment, not a response to your response to Mr. Waldmann. I quicked once too click. And no, I am not drunk.

      3. Conscience of a Conservative

        Eisinger is off base and sensationalistic. By virtue of the title the attempt is to paint it as scandalous and similar to Abacus CDO’s. As confirmation he points to Freddie ending the practice, but there’s a good reason why they ended it, and that is simply to take the issue off the table and limit the issue as a p.r. tool.

        With regards to Eisinger’s argument that other hedges were available, the response is two fold first why not use the cheapest hedge, and second that while the inverse IO is long vol and not short, it wasn’t so much a pure hedge as a
        pricing arb. Susan is right in that higher REMIC prices help fund cheaper mortgages.

        To the discussion that they ramped up the activity , the truth is that they probably believed these securities were continuing to offer value, so they bought more of them.

        The only point in the discuss that has some validity is whether Freddie should have any retained portfolio at all, in mortgage form, pool form or at the tranche level. Since they are no longer a share-holder owned company but under conservatorship, it could be argued that this activity was no longer appropriate under its current charter. Eisinger loses this point due to his sensationalism of this issue and phrasing it as betting against the home owner.

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