Last week a few articles were forwarded to me about the misconduct of government sponsored enterprises (GSEs) – specifically Freddie Mac. However, when you look closer you should come up with a different conclusion.
On January 30, ProPublica and NPR released Jesse Eisinger’s article, Freddie Mac bets against American Homeowners.
And it states:
“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.”
In late 2010, Freddie Mac, according to the ProPublica story, started to retain a greater number of “inverse floaters,” an instrument created when mortgage pools are turned into collateralized mortgage obligations.
ProPublica contended that Freddie Mac’s use of inverse floaters represented a conflict of interests because it would lose money from the hedges if borrowers refinanced to a lower rate mortgage. They implied Freddie could abuse its influence in the housing market to prevent lower-interest refinancing programs, which are better for borrowers.
And from the title and the harsh language you come up with the idea that Freddie Mac is out to get you America. I think once you get a quick overview of what a collateralized mortgage obligation and how they usually work, I think you’ll see the change in their portfolio was the result of a numbers game and not the actions of “Big Brother.”
Hold the jokes…
In a nutshell, Freddie Mac purchases and bundles mortgages into pools of mortgages, then sells the expected mortgage payments to investors in the form of bond-like securities.
This process was and still is a vital component of today’s mortgage market, or most other credit markets for that matter, since securitization frees up capital that can then be used to make more mortgages.
These bundles of mortgages are called collateralized mortgage obligations (CMOs), which are securities issued by the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corp. (Freddie Mac), or the Government National Mortgage Association (Ginnie Mae).
So the structuring of a CMO creates a series of tranches from the cash flows from mortgage securities.
In structured finance of this sort, a “tranche” is one of a number of related securities offered as part of the same transaction. In other words, after you put all the mortgages together, you then slice it into pieces and sell those pieces depending on how risky the tranche. Remember, the set-up of Freddie and Fannie bonds is to tackle interest rate risk. GSEs are guaranteed in regards to principal.
Your tranches will usually look like this: some fixed-interest rate tranche of various maturities (created at a lower interest rate than the yield on the mortgages) and one medium-term maturity fixed-rate tranche, 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.
The undesirable feature of a mortgaged-backed security is their prepayment risk. People repay when they refinance. You’re paying off an existing loan to gain another one at a better rate. Prepayments are very unattractive to bond investors, since the time you’re 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 can disappear due to prepayments.
Both Freddie and Fannie have a long standing practice of hedging their prepayment risk.
Moreover, the inverse floater is the portion of the CMO that is most exposed to prepayment risk. Given the uncertainty about government intervention in the mortgage market, investors in both straight pass-throughs and in CMOs would be more leery than usual of taking prepayment risk.
The article tried to argue that the increase in the last two years of inverse floaters on Freddie’s books were a sign of the GSE positioning itself to bet against homeowners. But they didn’t tell the story of an increase in Freddie’s CMO issuance during this period – it appears the increase in inverse floaters was due to an increase in mortgage funding.
I think what Freddie tried to do was keep the “refinancing risk” to itself, and since Freddie controls the levers and can obstruct refis, it can package securities that are attractively low-risk for investors while retaining the high-risk stuff and “game” the risk-management for its own benefit.
Is this evil? No. Can this be done in a different manner? Yes. But this style of risk management isn’t out to harm Americans. Innovative finance is complex and hard to explain. I believe that Freddie Mac’s inability to explain the subject matter is at the heart of the misunderstanding and maybe with a little more due diligence on the part of ProPublica and NPR, this would all be a moot point.
Good Investing,
Jason Jenkins
Article by Investment U