Yesterday's NPR/ProPublica story about Freddie Mac's refusal to refinance mortgages so that it can make more money on some high-risk parts of its investment portfolio has divided the blogosphere. As I noted yesterday, Matt Levine at Dealbreaker thinks that Freddie was absorbing a refinancing risk that it would find difficult to pass on to investors. Felix Salmon at Reuters disagrees and disagrees profoundly, basically saying that we should call a duck a duck and conclude the Freddie was putting its own returns above the needs of homeowners.
Arnold Kling thinks not, dismissing the idea that Freddie was engaged in pure speculation:
The authors describe this as only being bad. It is bad for homeowners because it reduces Freddie's incentive to refinance loans. It is bad for Freddie Mac because it means taking on more risk from these instruments.
There is another possibility. In its normal course of business, Freddie Mac buys mortgages and issues debt, giving it a duration mismatch. These inverse floaters seem to have negative duration, which helps to offset that mismatch.
The article does not discuss the duration issue at all. Instead, it acts as if inverse floaters were a pure speculative play by Freddie Mac, which I think is unlikely to be the motivation.
At Forbes, Daniel Fisher argues that Freddie wasn't betting against refinancing (because it could control the refinancing terms), but rather mitigating its short-term interest-rate risk (a theory that I found initially plausible when digging into this yesterday, given what "inverse floaters" are meant to be used for):
I find it hard to believe Freddie Mac’s relatively small investment in inverse floaters — $4.3 billion out of a $663 billion portfolio — led it to adopt policies that made it difficult for homeowners to refinance. Stranger things have happened, I suppose. It would be interesting to hear how those derivatives actually performed between early 2011 and today.
Soberlook, meanwhile, delves into the intricacies of the actual financial engineering involved, building on Matt Levine's first crack at the problem yesterday. He concludes that for Freddie, it was indeed taxpayers versus borrowers (and pointedly those two could often be the same). And the taxpayers won this round:
It is true that Freddie has a responsibility to the mortgage borrowers. However it has a bigger responsibility to the tax payers who own the organization. And that responsibility includes managing the portfolio risk as a fiduciary. The interest-only securities are not hurting the borrowers, yet they capture some of the revenue back to the taxpayer. According to CBO, the US Treasury spent some $300 billion to prop up the GSEs. Shouldn't the taxpayers have the right to get some of this money back?
The Federal Housing Finance Agency — the government entity that is now running Freddie Mac and its sibling, Fannie Mae, since they were taken over after the financial crisis — issued a statement, explaining why it bought inverse floaters:
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 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.
There aren't enough specifics here to really draw conclusions, but the FHFA statement/explanation matches up with Levine's thinking, as well as with some other bloggers. Basically, Freddie was using a mash-up of refinancing-risk hedging and interest-rate hedging, while simultaneously trying to reduce the size of its balance sheet. That's your "specialized risk management process" for you.
To Felix's point, however, it does appear as though Freddie was hanging some homeowners out to dry. That said, it also seems pretty clear that ProPublica really missed the mark on how Freddie manages its portfolio. Naked Capitalism dismantles the whole thing — and doesn't hold back:
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).
Here's what bothers me about this entire dustup. The NPR/ProPublica story was built around a couple, the Silversteins, who can't refinance after they did a short sale on a previous home. Theirs is a sad tale, but from the outside, with even a modest understanding of how borrowers are evaluated for creditworthiness, you'd have to conclude that they aren't good refi candidates.
Furthermore, at the heart of the whole scandal, allegedly, is the purchase of inverse floaters, which ProPublica failed to explain, apart from characterizing them as risky. And so in a 24-hour period, it's been left up to the blogosphere to vet the story and do the real heavy lifting. I don't get it. Jesse Eisenger, the ProPublica reporter, knows what he's talking about — he's a veteran of financial media. He went on KPCC's "The Patt Morrison Show" to lay it all out and got asked a bunch of same questions that the bloggers are asking by another guest, Ted Frank from the Manhattan Institute.
That said, you can understand why ProPublica wouldn't want to delve too deeply into all this. It's fairly complex and it doesn't in the end make Freddie look like a force of pure evil, but rather a quasi-governmental entity that's in a kind of limbo state. In other words, ProPublica scrubbed the gray. I mean, it wasn't a bad story — it's obviously set off a debate, and it highlights Freddie's potential conflict of interest — but it left out a lot of important detail when painting the Freddie picture.
Freddie doesn't come out of this looking good. And it still wouldn't have if ProPublica had covered the financial side more comprehensively.