Explaining Southern California's economy

Freddie Mac scandal: What the heck is an 'inverse floater?'

While Sales Of Existing Homes Rise In July, Prices Continue To Fall

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A recent ProPublica/NPR report on Freddie May refusing to refinance mortgages for struggling homeowners shows that the market is still coming to terms with new ways of measuring risk.

This morning, NPR and ProPublica fired a broadside at the government side of the embattled mortgage market, with a report on how Freddie Mac is refusing to refinance loans, reportedly because Freddie has developed a financial derivative that would suffer if interest rates on loans were lowered. Here's a sampling, and please note that there's something called an "inverse floater" at the core of the alleged problem. The Silversteins are a couple who have been unable to refinance their mortgage after doing a short sale on another property:

Here's how Freddie Mac’s trades profit from the Silversteins staying in “financial jail.” The couple’s mortgage is sitting in a big pile of other mortgages, most of which are also guaranteed by Freddie and have high interest rates. Those mortgages underpin securities that get divided into two basic categories.

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.

In 2010 and '11, Freddie purchased $3.4 billion worth of inverse floater portions — their value based mostly on interest payments on $19.5 billion in mortgage-backed securities, according to prospectuses for the deals. They covered tens of thousands of homeowners. Most of the mortgages backing these transactions have high rates of about 6.5 percent to 7 percent, according to the deal documents.

Between late 2010 and early 2011, Freddie Mac’s purchases of inverse floater securities rose dramatically. 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.

In these transactions, Freddie has sold off most of the principal, but it hasn’t reduced its risk.

First, if borrowers default, Freddie pays the entire value of the mortgages underpinning the securities, because it insures the loans.

It’s also a big problem if people like the Silversteins refinance their mortgages. That’s because a refi is a new loan; the borrower pays off the first loan early, stopping the interest payments. Since the security Freddie owns is backed mainly by those interest payments, Freddie loses.

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