FHFA Answers Conflict of Interest Charges against Freddie Mac

The Federal Housing Finance Agency (FHFA) issued a statement late Monday refuting a story from ProPublic and NPR that a complicated investment strategy utilized by Freddie Mac had influenced it to discourage refinancing of some of its mortgages.  FHFA confirmed that the investments using Collateralized Mortgage Obligations (CMOs) exist but said they did not impact refinancing decisions and that their use has ended. (the NPR Story)

Freddie Mac's charter calls for it to make home loans more accessible, both to purchase and refinance their homes but the ProPublica story, written by Jesse Eisinger (ProPublica) and Chris Arnold (NPR) charged that the CMO trades "give Freddie a powerful incentive to do the opposite, highlighting a conflict of interest at the heart of the company. In addition to being an instrument of government policy dedicated to making home loans more accessible, Freddie also has giant investment portfolios and could lose substantial amounts of money if too many borrowers refinance."

Here, in a nutshell, is what the story (we are quoting from an "updated" version) says Freddie has been doing.  

Freddie creates a security (MBS) backed by mortgages it guarantees which was divided into two parts.  The larger portion, backed by principal, was fairly low risk, paid a low return and was sold to investors.  The smaller portion, backed by interest payments on the mortgages, was riskier, and paid a higher return determined by the interest rates on the underlying loans.  This portion, called an inverse floater, was retained by Freddie Mac.

In 2010 and 2011 Freddie Mac's purchase (retention) of these inverse floaters rose dramatically, from a total of 12 purchased in 2008 and 2009 to 29.  Most of the mortgages backing these floaters had interest rates of 6.5 to 7 percent.

In structuring these transactions, Freddie Mac sells off most of the value of the MBS but does not reduce its risk because it still guarantees the underlying mortgages and must pay the entire value in the case of default.  The floaters, stripped of the real value of the underlying principal, are also now harder and possibly more expensive to sell, and as Freddie gets paid the difference between the interest rates on the loans and the current interest rate, if rates rise, the value of the floaters falls. 

While Freddie, under its agreement with the Treasury Department, has reduced the size of its portfolio by 6 percent between 2010 and 2011, "that $43 billion drop in the portfolio overstates the risk reduction because the company retained risk through the inverse floaters."

Since the real value of the floater is the high rate of interest being paid by the mortgagee, if large numbers pay off their loans the floater loses value.  Thus, the article charges, Freddie has tried to deter prospective refinancers by tightening its underwriting guidelines and raising prices.  It cites, as its sole example of tightened standards that in October 2010 the company changed a rule that had prohibited financing for persons who had engaged in some short sales to prohibiting financing for persons who had engaged in any short sale, but it also quotes critics who charge that the Home Affordable Refinance Program (HARP) could be reaching "millions more people if Fannie (Mae) and Freddie implemented the program more effectively."

It has discouraged refinancing by raising fees.  During Thanksgiving week in 2010, the article contends, Freddie quietly announced it was raising post-settlement delivery fees.  In November 2011, FHFA announced that the GSEs were eliminating or reducing some fees but the Federal Reserve said that "more might be done."

If Freddie Mac has limited refinancing, the article says, it also affected the whole economy which might benefit from billions of dollars of discretionary income generated through lower mortgage payments.  Refinancing might also reduce foreclosures and limit the losses the GSEs suffer through defaults of their guaranteed loans.

The authors say there is no evidence that decisions about trades and decisions about refinancing were coordinated.  "The company is a key gatekeeper for home loans but says its traders are "walled off" from the officials who have restricted homeowners from taking advantage of historically low interest rates by imposing higher fees and new rules."

ProPublica/NPR says that the floater trades "raise questions about the FHFA's oversight of Fannie and Freddie" as a regulator but, as conservator it also acts as the board of directors and shareholders and has emphasized that its main goal is to limit taxpayer losses.  This has frustrated the administration because FHFA has made preserving the companies' assets a priority over helping homeowners.  The President tried to replace acting director Edward J. DeMarco, but Congress refused to confirm his nominee. 

The authors conclude by saying that FHFA knew about the inverse floater trades before they were approached about the story but officials declined to comment on whether the FHFA knew about them as Freddie was conducting them or whether the FHFA had explicitly approved them."

The FHFA statement said that Freddie Mac has historically used CMOs as a tool to manage its retained portfolio and to address issues associated with security performance.  The inverse floaters were used to finance mortgages sold to Freddie through its cash window and to sell mortgages out of its portfolio "in response to market demand and to shrink its own portfolio."  The inverse floater essentially leaves Freddie with a portion of the risk exposure it would have had if it had kept the entire mortgage on its balance sheet and also results in a more complex financing structure that requires specialized risk management processes.  (Full FHFA Statement)

The agency said that for several reasons Freddie's retention of inverse floaters ended in 2011 and only $5 billion is held in the company's $650 billion retained portfolio.  Later that year FHFA staff identified concerns about the floaters and the company agreed that these transactions would not resume pending completing of the agency examination.

These investments FHFA said did not have any impact on the recent changes to HARP.  In evaluating changes, FHFA specifically directed both Freddie and Fannie not to consider changes in their own investment income in the HARP evaluation process and now that the HARP changes are in place the refinance process is between borrowers and loan originators and servicers, not Freddie Mac.