Freddie Mac Bets Against Its Own

“More than three years into the government takeover, we have Freddie Mac pursuing highly levered, complicated transactions seemingly with the purpose of trading against homeowners. These are the kinds of things that got us in trouble in the first place.”

Christopher Mayer, Columbia Business School

Freddie Mac is at it again. The taxpayer-owned mega mortgage conglomerate has continued and increased bets that pay off if its borrowers remain in expensive mortgages featuring interest rates well above current rates. Through the last quarter of 2011, Fannie and Freddie had received over $169 billion worth of taxpayer funds.

Key contributing factors to the 2008 financial crisis were the “bets” that Wall Street made against its own clients. Now, some analysts are seeing this similar trend, not within a private company, but by government-owned Freddie Mac.

Freddie’s trades are completely legal; however they increased during the time when the company was supposed to reduce its investment portfolio (per the terms of the government takeover agreement.) Conversely, the company increased the overall risk of its portfolio, as the company continued to purchase risky and volatile securities. Not surprisingly, these bets rose dramatically towards the end of 2010, as Freddie made regulations more and more stringent for homeowner refinance and modification.

Freddie Mac states that its traders are separated from the officials who work with its customers individually. However, one could certainly reason that Freddie still however one could reason that an inherent conflict of interest exists.

The investments work like this: an individual mortgage is pooled with other Freddie mortgages. These mortgages make securities in two categories- one backed by principal is looked at a “safer” investment; the other, known as an inverse floater, is backed mostly by interest payments on mortgages. As such, the higher the interest rate, the higher the return. However, due to the fluctuating market and current low interest rates, the inverse floater is a much riskier investment.

In 2010 and 2011, Freddie’s purchases of inverse floater securities rose considerably- this presents two issues. Number one, if the borrowers go into default (which is more likely for loans fixed at higher interest rates), Freddie covers the entirety of the principal, as the insurer of the loan. Secondly, if the borrower refinances, the investment fails, as a new loan is originated, and Freddie loses out on the interest rate payments over the projected life of the loan.

In practicality, Freddie restricts refinance and modification in various ways. First of all, Freddie has tightened its lending restrictions considerably, making it much more difficult for borrower to qualify for new mortgages and refinanced loans. One restriction that harms many borrowers is Freddie’s refusal to refinance if the borrower has had a shorts sale or foreclosure within the last 2 to 4 years.

Another practical consideration that shouldn’t be minimized is the failure of Freddie’s execution of the Obama administration’s Making Homes Affordable Programs. One source states that only 4.6% of applicants ever obtain a permanent HAMP modification and, as of those, 60% later fail generally because there is no principal reduction component. The Homes Affordable Refinance Program (HARP) was supposed to have aided four to five million home owners with a streamlined refinance of their existing mortgage, but has been a dismal failure (actual figures as to approvals through the program have not been released.)

Finally, as Freddie was purchasing an increasingly portfolio of inverse floater portions, it was also raising its fees on new loan origination and refinance. The Federal Reserve has criticized Fannie and Freddie for the increase in fees, stating that the fees are “another possible reason for low rates of refinancing” and are “difficult to justify.”

Freddie Mac’s policy is set by the Federal Housing Finance Agency which basically serves as their Board of Directors. Freddie’s reluctance to refinance affects individual homeowners- but also the economy as a whole. A large-scale refinance program (which incorporates & allows underwater homeowners to refinance as well) could not only stimulate the economy by putting more money in borrower’s pockets, but may also discourage defaults, both of necessity and by default.

Tiffany N. Ballenger, Esq.

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