Freddie Mac’s Conflict of Interest, and Why We Need Greater Accountability for Taxpayers

From "Stu's Views"

In the last week, NPR has run two separate stories of a very quiet but alarming problem: an enormous conflict off interest in the way that Freddie Mac,  the Federal Home Loan Mortgage Corporation, designed to help lower home ownership costs, invests/bets heavily against homeowners being able to refinance at lower rates.  The Federal Housing Finance Agency (FHFA), the government body set up to oversee Fannie Mae and Freddie Mac, issued a statement saying they’ve been researching the policy since last year, but Freddie Mac still has multi-billion dollar investments to these ends.  Also at issue is the enormous compensation the leaders of these taxpayer-owned organizations are giving themselves for this work, seemingly contradicting their public mission.  It’s a punch in the gut to hear that the administration is so lukewarm in its response to something that smells so much like corruption.  Scroll down for the blog posts from NPR with more.

‘Report Prompts Calls To End Freddie Mac’s Conflict Of Interest’
by Chris Arnold and Marilyn Geewax
NPR – January 30, 2012

…Freddie Mac, which has a public mission to help make home ownership affordable, also has placed multibillion-dollar bets against American homeowners being able to refinance to cheaper mortgages…

Freddie’s regulator, the Federal Housing Finance Agency (FHFA), late Monday issued a statement saying that last year, it began assessing Freddie Mac’s controversial investment strategy. In December, “Freddie Mac agreed that these transactions would not resume pending completion of the examination work,” it said. However, FHFA acknowledged that Freddie continues to hold $5 billion worth of the investments, known as inverse floaters. That figure was even higher than the $3.5 billion NPR and ProPublica had tracked down.

FHFA did not say when its examination of Freddie’s practice would be completed. It said only that FHFA already had “identified concerns” about the kinds of risks Freddie Mac was taking and “the controls” it had placed over its investments.

White House spokesman Jay Carney said at a press briefing that the Treasury Department is looking into the matter.

Sen. Johnny Isakson, R-Ga., told NPR that having a financial stake in blocking mortgage refinancings means Freddie Mac officials “would be in conflict with themselves, and that wouldn’t be the right thing to do.”…

Columbia University economist Chris Mayer has long been urging Congress and the White House to promote a large-scale refinancing strategy. He says that dropping the typical mortgage down to today’s rates could save each homeowner roughly $3,000 a year.

That would help the U.S. economy by “putting tens of billions of dollars back in consumers’ pockets, the equivalent of a very long-term tax cut,” Mayer said.

Not all economists agree. Anthony Sanders, an economist at George Mason University, said lowering mortgage payments wouldn’t be a quick cure for the housing crisis.

“That’s wishful thinking,” Sanders said. “The primary causes of mortgage default are job loss, or job curtailment, health problems where they get excessive bills, or believe it or not, divorce.”

Still, Sanders says Freddie Mac should not be structured in such a way that it has two goals: 1) to help make home ownership affordable and 2) to run up financial gains in its own portfolio through the use of risky investments — especially those that run counter to the interests of homeowners.

He says his email inbox has been getting filled with messages from other economists and policy experts reacting to the investigation into Freddie Mac’s investment strategies. “Everyone is in various degrees in rage,” Sanders said. His correspondents have been saying this is “a terrible public-policy debacle by Freddie Mac.”…

This is the conflict: Millions of homeowners wish they could refinance, but their lenders tell them they can’t qualify for today’s low rates because of tight rules. Freddie Mac is one of the gatekeepers with the power to set those rules, and lately, it has been saying no more often to homeowners.

“Freddie Mac prevented households from being able to take advantage of today’s mortgage rates — and then bet on it,” Alan Boyce told NPR. He is a former bond trader who has been involved in efforts to push for more refinancing of home loans.

Freddie officials repeatedly declined to comment on the specific transactions, but Freddie did say that its employees who make investment decisions are “walled off” from those who decide the rules for homeowners. No evidence to the contrary has emerged…

[NPR bios: Chris Arnold and Marilyn Geewax.] [Copyright 2012 National Public Radio]

Freddie Mac Betting Against Struggling Homeowners
by Chris Arnold
NPR – January 30, 2012

“We were actually shocked they did this,” says Scott Simon, who heads the mortgage-backed securities team at the giant bond trading and investment firm called PIMCO. “It seemed so out of line with their mission, out of line with what Congress wanted them to do.”

Freddie Mac, based in Northern Virginia, says its job is to purchase “loans from lenders to replenish their supply of funds so that they [the lenders] can make more mortgage loans to other borrowers.” That’s one reason why Freddie has a gigantic portfolio containing loans that generate income from mortgage payments. Critics say this investment portfolio has been allowed to grow far larger than necessary to further Freddie’s policy mission.

Plus, in 2010 and 2011, Freddie didn’t just hold a simple pile of loans. Instead, for hundreds of thousands of home loans, it used Wall Street alchemy to chop these loans up into complicated securities — slices of which were sold in financial markets.

This hypothetical example may help explain what happens:

1) Freddie Mac takes, say, $1 billion worth of home loans and packages them. With the help of a Wall Street banker, it can then slice off parts of the bundle to create different investment securities, some riskier than others. The slices could be set up so that, say, $900 million worth are relatively safe investments, based upon homeowners paying the principal on their mortgages.

2) But the one remaining slice, worth $100 million, is the riskiest part. Freddie retains that slice, known as an “inverse floater,” which receives all of the interest payments from the entire $1 billion worth of mortgages.

3) That riskiest investment pays out a lucrative stream of interest payments. But Freddie’s slice also has all the so-called “pre-payment risk” associated with that $1 billion worth of loans. So if lots of people “pre-pay” their old loans and refinance into new, cheaper ones, then Freddie Mac starts to lose money. If people can’t refinance, then Freddie wins because it continues to receive that flow of older, higher interest payments.

If the homeowner is unable to refinance, the Freddie Mac portfolio managers win, Simon says. “And if the homeowner can refinance, they lose.”…

In his State of the Union address, President Obama pushed for legislation to allow “every responsible homeowner the chance to save about $3,000 a year on their mortgage” by refinancing without what he called “red tape” or a “runaround from the banks.”

Columbia University economist Chris Mayer supports such an approach. “A widespread refinancing program would have many benefits — not only helping the economy and putting tens of billions of dollars back in consumers’ pockets, the equivalent of a very long-term tax cut,” he says.

“It also is likely to reduce foreclosures and benefit the U.S. government by having fewer losses that they have to pay,” Mayer adds.

In the long term, he says, allowing more Americans to refinance would help taxpayers as well as mortgage giants Freddie Mac and Fannie Mae, because they would suffer fewer losses related to foreclosures. These inverse floater trades, however, give Freddie Mac a short-term incentive to resist such so-called “mass re-fi” programs.

“If there was a mass re-fi program, the bets they made would get absolutely wiped out,” PIMCO’s Simon says. “The way these bets do the best is if the homeowner is barred from refinancing.”

Economists say that during the housing bubble, lending standards got too loose. Now many believe the pendulum has swung too far, making rules too tight.

…In a recent analysis of remedies for the stalled housing market, the Federal Reserve criticized Fannie and Freddie for the fees they have charged for refinancing. Such fees are “another possible reason for low rates of refinancing,” the Fed wrote, adding that the charges are “difficult to justify.”

Meanwhile, even though Freddie is a ward of the federal government, its top executives are highly compensated. The Freddie Mac official then in charge of its investment portfolio, Peter Federico, made $2.5 million in 2010, and had target compensation of $2.6 million for last year — the time period during which most of these inverse floater investments were made. ProPublica and NPR made numerous attempts to reach Federico. A woman who answered his home phone said he declined to comment.

[Copyright 2012 National Public Radio]