OIG Investigates Freddie Mac's Inverse Floater Investments

Behind the public face of their business models Freddie Mac Fannie Mae produce, use, and invest in a variety of products to increase their profitability and minimize their risk. The various investment, funding, and hedging portfolios hold products of varying degrees of sophistication including unsecuritized mortgages, collateralized mortgage obligations (CMOs), mortgage-backed securities (MBS),  private label and commercial mortgage-backed securities (PLMBS, CMBS).  The hedging portfolios of the two government sponsored enterprises (GSEs) alone are valued at an aggregate of more the $1.4 trillion.

While generally profitable, some sections of the GSEs capital markets business have lost tens of billions of dollars since the GSEs were put into conservatorship under the Federal Housing Finance Agency (FHFA) in 2008.  Because of these losses the FHFA Office of Inspector General (OIG) initiated a series of evaluations of FHFA's oversight of the GSEs' capital market businesses.  On Wednesday OIG released the results of one evaluation, on FHFA's oversight of Freddie Mac's investment in reverse floaters.

CMOs structured and marketed by Freddie Mac are a family of bonds.  Freddie Mac may tailor these products to the specific interests of investors and inverse floater investments are among the mortgage-related securities in which the Capital Markets Division invests.

Inverse floaters like a number of the mortgage-related investments held by the company benefit from a low interest rate environment with limited prepayments. This characteristic creates a potential tension between the Single-Family Credit Guarantee Business and the Capital Markets Division.

According to FHFA and Freddie Mac, as investor appetite for floating-rate bonds increased in the spring of 2010, Freddie Mac capitalized on the opportunity to charge a premium for structuring these bonds by carving them out of its securitized mortgages. In the process, it retained by-product variable rate bonds known as inverse floaters.  The OIG report contains a very clear and interesting explanation of inverse floater investments which can be read here.  Suffice it to say that investors in these instruments benefit when interest rates fall and that Freddie Mac retained a great number of these instruments in its own portfolio.

In late January 2012, these inverse floaters became the subject of significant attention. It was asserted that, because the value of inverse floaters decreases when the underlying mortgages are refinanced, Freddie Mac could deliberately limit loan refinancings in order to protect the value of its inverse floaters.

The OIG investigation uncovered no evidence that either FHFA or Freddie Mac obstructed homeowners' abilities to refinance their mortgages in an effort to influence the yields of the inverse floater retained by the company in its investment portfolio. OIG said that these floaters represent a small portion of Freddie Mac's capital markets portfolio and to the extent that tension exists between the company's refinancing and investment policies , the "floaters are no more likely to adversely impact mortgage holders or discourage borrower refinancing that any of the mortgages or other assets that Freddie Mac holds for investment."

Further, Freddie Mac has an 'information wall" policy to prevent its capital markets business from using non-public information to guide its investments and OIG found no evidence that individuals at Freddie Mac had breached the information wall.

While FHFA and its predecessor the Office of Federal Housing Enterprise Oversight (OFHEO) were aware of the inverse floater investments for at least ten years they did not involve themselves in managing operations of the Capital Markets Division.  However FHFA did begin a formal supervisory review of Freddie Mac's CMO business in April 2011.  Before the review was finished the media published stories about the GSE's retention of inverse floaters and FHFA made a series of public statements that could have been interpreted to imply that the company had abandoned the business in the spring of 2011 as part of a risk management strategy.  According to Freddie Mac, however, investor appetite for the floating-rate bonds evaporated around that time without specific action by Freddie Mac. 

OIG found that FHFA's position (that Freddie Mac should be not creating or investing these vehicles) could have been communicated more clearly. It also found that the public statement by FHFA emphasized its review of Freddie Mac's CMO business and noted that FHFA had reached an agreement with the company regarding reverse floaters in December 2011 which does not appear to be the case.  That Freddie Mac suspended the inverse floater portion of its business was not the result of a coordinated FHFA policy but rather the outcome of a broad examination of Freddie Mac's entire CMO business and several informal communications.

OIG made several recommendations resulting from its evaluation.  FHFA should:

1.         Continue to monitor the GSE's hedges and models to ensure its portfolio is hedged within its approved interest rate limits.

2.         Conduct periodic reviews and tests of Freddie Mac's information wall to confirm it is not trading on non-public information.

3.         Insure that supervisory policies are well founded and coordinated and that the Agency speaks with one voice.

4.         Confirm any new positions or any agreements with Freddie Mac promptly and in writing.

5.         Ensure that supervisory policies are based on the work of Agency personal and not reactions to media or other public scrutiny.

6.         Exercise due diligence to ensure public statements accurately reflect all relevant facts before they are released.