Freddie Mac Bets Against American Homeowners
by Jesse Eisinger, ProPublica and Chris Arnold, NPR News
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Freddie Mac,the taxpayer-owned mortgage giant, has placed multibillion-dollar bets that payoff if homeowners stay trapped in expensive mortgages with interest rates wellabove current rates.
Freddiebegan increasing these bets dramatically in late 2010, the same time that thecompany was making it harder for homeowners to get out of such high-interestmortgages.
No evidencehas emerged that these decisions were coordinated. The company is a keygatekeeper for home loans but says its traders are “walled off” from theofficials who have restricted homeowners from taking advantage of historicallylow interest rates by imposing higher fees and new rules.
Freddie’scharter calls for the company to make home loans more accessible. Its chiefexecutive, Charles Haldeman Jr., recently toldCongress that his company is “helping financially strapped families reducetheir mortgage costs through refinancing their mortgages.”
But the trades, uncovered for the firsttime in an investigation by ProPublica and NPR, give Freddiea powerful incentive to do the opposite, highlighting a conflict of interest atthe heart of the company. In addition to being an instrument of governmentpolicy dedicated to making home loans more accessible, Freddie also has giantinvestment portfolios and could lose substantial amounts of money if too manyborrowers refinance.
“We wereactually shocked they did this,” says Scott Simon, who as the head of the giantbond fund PIMCO’s mortgage-backed securities team is one of the world’s biggestmortgage bond traders. “It seemed so out of line with their mission.”
The trades“put them squarely against the homeowner,” he says.
Thosehomeowners have a lot at stake, too. Many of them could cut their interestpayments by thousands of dollars a year.
Freddie Mac,along with its cousin Fannie Mae, was bailed out in 2008 and is now owned bytaxpayers. The companies play a pivotal role in the mortgage business becausethey insure most home loans in the United States, making banks likelier tolend. The companies’ rules determine whether homeowners can get loans and onwhat terms.
The FederalHousing Finance Agency effectively serves as Freddie’s board of directors andis ultimately responsible for Freddie’s decisions. It is run by acting directorEdward DeMarco, who cannot be fired by the presidentexcept in extraordinary circumstances.
Freddie andthe FHFA repeatedly declined to comment on the specific transactions.
Freddie’smoves to limit refinancing affect not only individual homeowners but the entireeconomy. An expansive refinancing program could help millions of homeowners,some economists say. Such an effort would“help the economy and put tens of billions of dollars back in consumers’pockets, the equivalent of a very long-term tax cut,” says real-estateeconomist ChristopherMayer of the Columbia Business School. “Italso is likely to reduce foreclosures and benefit the U.S. government” becauseFreddie and Fannie, which guarantee most mortgages in the country, would havelower losses over the long run.
Freddie Mac’strades, while perfectly legal, came during a period when the company wassupposed to be reducing its investment portfolio, according to the terms of itsgovernment takeover agreement. But these trades escalate the risk of itsportfolio, because the securities Freddie has purchased are volatile and hardto sell, mortgage securities experts say.
The financialcrisis in 2008 was made worse when Wall Street traders made bets against theircustomers and the American public. Now, some see similar behavior, only thistime by traders at a government-owned company who are using leverage, whichincreases the potential profits but also the risk of big losses, and other WallStreet stratagems. “More than three years into the government takeover, we haveFreddie Mac pursuing highly levered, complicated transactions seemingly withthe purpose of trading against homeowners,” says Mayer. “These are the kinds ofthings that got us into trouble in the first place.”
‘We’re infinancial jail’
Freddie Mac isbetting against, among others, Jay and Bonnie Silverstein. The Silversteins live in an unfinished development ofcul-de-sacs and yellow stucco houses about 20 miles north of Philadelphia, in ahouse decorated with Bonnie’s orchids and their Rose Bowl parade pincollection. The developer went bankrupt, leaving orange plastic constructionfencing around some empty lots. The community clubhouse isn’t complete.
The Silversteins have a 30-year fixed mortgage with an interestrate of 6.875 percent, much higher than the going rate of less than 4percent. They have borrowed fromfamily members and are living paycheck to paycheck. If they could refinance,they would save about $500 a month. He says the extra money would help them payback some of their family members and visit their grandchildren more often.
But brokershave told the Silversteins that they cannotrefinance, thanks to a Freddie Mac rule.
The Silversteins used to live in a larger house 15 minutes fromtheir current place, in a more upscale development. They had always planned todownsize as they approached retirement. In 2005, they made the mistake ofbuying their new house before selling the larger one. As the housing marketplummeted, they couldn’t sell their old house, so they carried two mortgagesfor 2½ years, wiping out their savings and 401(k). “Itjust drained us,” Jay Silverstein says.
Finally, theywere advised to try a short sale, in which the house is sold for less than thevalue of the underlying mortgage. They stopped making payments on the big housefor it to go through. The sale was finally completed in 2009.
Such debacleshurt a borrower’s credit rating. But Bonnie has a solid job at a doctor’soffice, and Jay has a pension from working for more than two decades forJohnson & Johnson. They say they haven’t missed a payment on their currentmortgage.
But the Silversteins haven’t been able to get their refi. Freddie Mac won’t insure a new loan for people whohad a short sale in the last two to four years, depending on their financialcondition. While the company’s previous rules prohibited some short sales, inOctober 2010 the company changed its criteria to include all short sales. It isunclear whether the Silverstein mortgage would have been barred from a shortsale under the previous Freddie rules.
Short-term,Freddie’s trades benefit from the high-interest mortgage in which the Silversteins are trapped. But in the long run, Freddiecould benefit if the Silversteins refinanced to amore affordable loan. Freddie guarantees the Silversteins’mortgage, so if the couple defaults, Freddie — and the taxpayers who ownthe company — are on the hook. Getting the Silversteinsinto a more affordable mortgage would make a default less likely.
If millions ofhomeowners like the Silversteins default, the economywould be harmed. But if they switch to loans with lower interest rates, theywould have more money to spend, which could boost the economy.
“We’re infinancial jail,” says Jay, “and we’ve never been there before.”
How Freddie’sinvestments work
Here’s howFreddie Mac’s trades profit from the Silversteinsstaying in “financial jail.” The couple’s mortgage is sitting in a big pile ofother mortgages, most of which are also guaranteed by Freddie and have highinterest rates. Those mortgages underpin securities that get divided into twobasic categories.
Graphic by Jeff Larson. Sources: prospectuses for the deals, reporting by ProPublica and NPR
One portion isbacked mainly by principal, pays a low return, and was sold to investors whowanted 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 highrate that the Silversteins pay. So this portion ofthe 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 — theirvalue based mostly on interest payments on $19.5 billion in mortgage-backedsecurities, according to prospectuses for the deals. They covered tens ofthousands of homeowners. Most of the mortgages backing these transactions havehigh rates of about 6.5 percent to 7 percent, according to the deal documents.
Between late2010 and early 2011, Freddie Mac’s purchases of inverse floater securities rosedramatically. Freddie purchased inverse floater portions of 29 deals in 2010and 2011, with 26 bought between October 2010 and April 2011. That compareswith seven for all of 2009 and five in 2008.
In thesetransactions, Freddie has sold off most of the principal, but it hasn’t reducedits risk.
First, ifborrowers default, Freddie pays the entire value of the mortgages underpinningthe securities, because it insures the loans.
It’s also abig problem if people like the Silversteins refinancetheir 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.
And theseinverse floaters burden Freddie with entirely new risks. With these deals,Freddie has taken mortgage-backed securities that are easy to sell and tradedthem for ones that are harder and possibly more expensive to offload, accordingto mortgage market experts.
The inversefloaters carry another risk. Freddie gets paid the difference between the highmortgages rates, such as the Silversteins are paying,and a key global interest rate that right now is very low. If that rate rises,Freddie’s profits will fall.
It is unclearwhat kinds of hedging, if any, Freddie has done to offset its risks.
At the end of2011, Freddie’s portfolio of mortgages was just over $663 billion, down morethan 6 percent from the previous year. But that $43 billion drop in theportfolio overstates the risk reduction, because the company retained riskthrough the inverse floaters. The company is well below the cap of $729 billionrequired by its government takeover agreement.
How Freddietightened credit
Restrictingcredit for people who have done short sales isn’t the only way that Freddie Macand Fannie Mae have tightened their lending criteria in the wake of thefinancial crisis, making it harder for borrowers to get housing loans.
Sometightening is justified because, in the years leading up to the financialcrisis, Freddie and Fannie were too willing to insure mortgages taken out bypeople who couldn’t afford them.
In a statement, Freddiecontends it is “actively supportingefforts for borrowers to realize the benefits of refinancing their mortgages tolower rates.”
The company said in a statement: “During the firstthree quarters of 2011, we refinanced more than $170 billion in mortgages,helping nearly 835,000 borrowers save an average of $2,500 in interest paymentsduring the next year.” As part of that effort, the company is participating inan Obama administration plan, called the Home Affordable Refinance Program, orHARP. But critics say HARP could be reaching millions more people if Fannie andFreddie implemented the program more effectively.
Indeed, justas it was escalating its inverse floater deals, it was also introducing newfees on borrowers, including those wanting to refinance. During Thanksgivingweek in 2010, Freddie quietly announced that it was raising charges, calledpost-settlement delivery fees.
In a recentwhite paper on remedies for the stalled housing market, the Federal Reservecriticized Fannie and Freddie for the fees they have charged for refinancing.Such fees are “another possible reason for low rates of refinancing” and are“difficult to justify,” the Fed wrote.
Aformer Freddie employee, who spoke on condition he not be named, was evenblunter: “Generally, it makes no sense whatsoever” for Freddie “to restrictrefinancing” from expensive loans to ones borrowers can more easily pay, sincethe company remains on the hook if homeowners default.
In November,the FHFA announced that Fannie and Freddie were eliminating or reducing somefees. The Fed, however, said that “more might be done.”
The regulatoras owner
The tradesraise questions about the FHFA’s oversight of Fannie and Freddie. But the FHFAis not just a regulator. With the two companies in government conservatorship,the FHFA now plays the role of their board of directors and shareholders,responsible for the companies’ major decisions.
Under actingdirector DeMarco, the FHFA has emphasized that itsmain goal is to limit taxpayer losses by managing the two companies’ giantinvestment portfolios to make profits. To cover their previous losses andongoing operations, Fannie and Freddie already had received $169 billion fromtaxpayers through the third quarter of last year.
The FHFA hasfrustrated the administration because the agency has made preserving the valueof the companies’ investment portfolios a priority over helping homeowners inexpensive mortgages. In 2010, President Barack Obama nominated a permanentreplacement for acting director DeMarco, butRepublicans in Congress blocked him. Obama has not nominated anyone else toreplace DeMarco.
Even thoughFreddie is a ward of the state, top executives are highly compensated. PeterFederico, who’s in charge of the company’s investment portfolio, made $2.5million in 2010, and he had target compensation of $2.6 million for last year,when most of these leveraged investments were made.
One ofFederico’s responsibilities — tied to his bonuses — is to “support and provideliquidity and stability in the mortgage market,” according to Freddie’s annualfiling with the Securities and Exchange Commission. Mortgage experts contendthat the inverse floater trades don’t further that goal.
ProPublica andNPR made numerous attempts to reach Federico. A woman who answered his homephone said he declined to comment.
The FHFA knewabout the trades before ProPublica and NPR approached the regulatory agencyabout them, according to an FHFA official. The FHFA has the power to approveand disapprove trades, though it doesn’t involve itself in day-to-daydecisions. The official declined to comment on whether the FHFA knew about themas Freddie was conducting them or whether the FHFA had explicitly approvedthem.
Liz Day of ProPublica contributed to this story.