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.