Freddie Mac didn’t set out to profit from homeowners trapped in high-rate mortgages

Federal watchdog in the US says the mortgage giant had no coordinated plan to bet against homeowners, though Freddie Mac held billions of dollars of investments that paid off if borrowers stayed stuck in high-interest loans

Mortgage giant Freddie Mac did not keep homeowners trapped in high-interest loans in order to boost profits on billions of dollars’ worth of complex financial bets it had made. That’s the conclusion reached in a report released today by the inspector general that oversees the agency in charge of Freddie Mac.


Last January, ProPublica and NPR reported that Freddie had dramatically expanded its holdings of mortgage-backed securities that would profit if homeowners stayed in their existing high-interest-rate loans. At the same time, the company had taken steps that made it harder for homeowners to refinance at lower interest rates. Our report stated that there was no evidence of a coordinated attempt to bet against homeowners’ ability to refinance. The inspector general’s report concludes that there was none.


But the inspector general left a key stone unturned: It did not independently evaluate the firewall within Freddie Mac designed to keep Freddie’s investment arm from profiting from insider information about the mortgage giant’s plans to tighten or loosen homeowners’ access to credit. Instead, the inspector general relied on the word of employees it interviewed and conducted no further investigation. It also reported that the agency that oversees Freddie has not tested the firewall’s integrity.

Freddie Mac and its sister company Fannie Mae were bailed out by taxpayers after the financial crisis and are now controlled by the Federal Housing Finance Agency. Freddie and Fannie guarantee most of the mortgages in the U.S., and they have a mission to make home loans more affordable. But Freddie also has a massive investment portfolio and has to protect against losses. Sometimes, those two goals can conflict.


Beginning in 2010, Freddie Mac expanded its portfolio of a particular kind of mortgage-backed security known as an “inverse floater.” The company offered investors a relatively safe bond with a floating interest rate. It then kept on its books what is called an “inverse floater,” which pays out the highest returns if borrowers stay in their mortgages. When interest rates dropped (as they did during that period), Freddie Mac stood to profit on its inverse floaters, because the rates being paid by the pool of borrowers were higher than the prevailing market rates. Inverse floaters lose that advantage the more that homeowners in the pool refinance at the lower rates. 

The report says that Freddie’s investment wing increased its holdings in inverse floaters merely because investors were demanding the floating rate bonds linked to them — not because of any strategy to exploit homeowners trapped in high-interest-rate mortgages.

Freddie Mac has an  “information wall” designed to separate the employees running Freddie Mac’s investment strategy from those designing and carrying out its policies that impact the mortgage market, such as programs aimed at helping people refinance or making it more difficult for them to do so. The inspector general’s report says that it found “no evidence” that the wall had been breached.

Yet, the inspector general noted that FHFA has not conducted any independent testing of Freddie’s information wall. And the inspector general limited its own investigation of the wall to interviewing Freddie executives and FHFA officials and reviewing policy documents. The inspector general “did not independently evaluate the efficacy of Freddie Mac’s information wall policy,” the report states.

The report emphasizes that there are indeed “tensions between policies aimed at homeowners refinancing and Freddie Mac’s retained investments.” But it says that such tensions are not unique to inverse floaters but are “inherent throughout [Freddie and Fannie’s] various business lines.”

At the end of 2011, Freddie held about $5 billion worth of inverse floaters, according to the report, or less than one percent of its $653 billion investment portfolio.

The report also notes that the company hedges to balance its interest-rate risk, meaning that it places many different bets so that no matter whether interest rates rise or fall, its investments will be close to “net flat” — stay roughly the same, recording neither large profits nor large losses. Freddie does not try to balance the risk of each individual investment, but rather hedges “on its portfolio as a whole.”   The report explains:

In the context of inverse floaters, although Freddie Mac may on the one hand benefit from a trend of low interest rates and reduced prepayments by homeowners, on the other hand, Freddie Mac’s other investments may equally suffer from such a trend. Thus, the end result, if perfectly hedged on interest rates, is that Freddie Mac’s overall position will remain the same regardless of prepayments. 

The inspector general did not independently evaluate Freddie’s hedging strategies. When ProPublica and NPR first reported on these deals, it was unclear what kind of hedging, if any, Freddie Mac had performed.

The company is also supposed to be reducing its investment portfolio as part of the terms of its government bailout. In a footnote, the inspector general’s report mentions that Freddie Mac told the Securities and Exchange Commission that selling the floating rate securities was a way to reduce its balance sheet. But most Freddie and FHFA officials interviewed by the inspector general said that reducing its balance sheet was not the motivation for Freddie to create inverse floaters, even if that was the result.


Separately, the way Freddie structured the inverse floaters leaves Freddie with nearly all of the risk of the assets that no longer show up on its balance sheet. The reason: As the guarantor of the mortgages that back the securities, Freddie is already on the hook if the homeowner defaults. With inverse floaters, it also retains the risks that homeowners might refinance and that overall interest rates might rise. Indeed, independent analysts told ProPublica and NPR in January that Freddie may actually have increased its risk, because inverse floaters are illiquid and hard to sell.

In its written response to the inspector general’s report, the FHFA did not address Freddie Mac's statements to the SEC. When contacted by ProPublica, an FHFA spokesperson declined to comment.

The report said that FHFA issued misleading statements to the public on when it ordered Freddie to stop creating inverse floaters. According to the report, in the spring of 2011, the FHFA began a review of Freddie Mac’s mortgage securities operation, in large part to determine whether the company held too many complex and risky mortgage products, including inverse floaters.

But an executive at Freddie didn’t suspend inverse floaters and certain other complex securities deals until January 6, and FHFA didn’t explicitly order Freddie Mac to stop selling inverse floaters until January 30, 2012, after ProPublica’s story was published. In fact, according to the report, that day marked “the first time that FHFA’s senior leadership met to discuss the Agency’s position with respect to inverse floaters.”

By then, however, Freddie had long since stopped selling floating rate securities — not because of any order from FHFA but because the market for them dried up in spring 2011 when Federal Reserve chairman Ben Bernanke indicated that interest rates would remain low for at least another year.

That’s not how FHFA described what happened after our story broke. In a statement released in response to ProPublica and NPR’s reports, the agency said that staff met with Freddie in December 2011 and came to an agreement then to suspend inverse floater trades. The inspector general’s report concludes that statement was misleading: “prior to January 2012, neither Freddie Mac nor FHFA made a decision to halt Freddie Mac’s creation and investment in inverse floaters; the market for reciprocal floating rate bonds simply disappeared. Had the market reappeared and Freddie Mac found the economics were again profitable, [Freddie] would have been free to structure floating-rate and inverse floating-rate investments.”


In a response to the report, the FHFA disputed the inspector general’s reading of the public statement, saying that it did not claim “that there was a specific, well-articulated FHFA policy and agreement” in December. The agency also emphasized that it did not take a position on inverse floaters only in reaction to media reports. While acknowledging that “the key stakeholders” had met together for the first time on January 30th, the day ProPublica and NPR released their original stories, the FHFA emphasizes that it had been in communication with Freddie on inverse floaters over the previous year.

The inspector general’s report was requested by Senator Robert Menendez, D-NJ, last January, after our story brought the issue to light.




Cabinet to soon take proposal to hike insurance FDI

Finance Minister Chidambaram is keen on getting Cabinet approval on raising FDI cap in insurance sector and it should soon go to the Cabinet


New Delhi: The Union Cabinet is likely to soon take up the proposal of hiking foreign investment limit in the insurance sector in India to 49%, from 26% at present, reports PTI.


"The Finance Minister is keen on getting Cabinet approval on raising FDI cap in insurance sector. It should go to the Cabinet soon," a source said.


Foreign Direct Investment (FDI) in the insurance sector is capped at 26%. With the government taking policy reform initiatives earlier this month, especially allowing FDI in multi-brand retail and aviation sectors, there are expectation that the limit in the insurance sector may also be raised.


The government, sources said, is assessing political implications of the move.


Earlier this week, Insurance Regulatory and Development Authority (IRDA) Chairman J Hari Narayan had said that the industry needs big investments for growth in the coming years and will welcome hike in FDI cap.


The government had taken a couple of reform decisions in the past couple of weeks to pep up investment climate. But the decision led to political uncertainty with Trinamool Congress, a key ally of the UPA, quitting the government.


Following pressure from key allies, the government in May this year had postponed a decision on raising the FDI limit in the insurance sector to 49%.


The Insurance Bill, which was tabled in Rajya Sabha in 2008, proposed to increase the FDI limit in the insurance sector to 49%, but Parliamentary Standing Committee on Finance wanted it to be retained at the current level of 26%.


SEBI imposes Rs12 lakh fine on two for synchronised trade in Era Construction

Both Ghelani and Rathod executed synchronised trades in the scrip of Era Construction and indulged in creation of artificial volume in 2004

Mumbai: Market regulator Securities and Exchange Board of India (SEBI) has imposed a total penalty of Rs12 lakh on two entities for alleged fraudulent trading in the shares of erstwhile Era Constructions, reports PTI.
"...impose a penalty of Rs 2 lakh on Vijay Rathod...impose a penalty of Rs 10 lakh on Tejash Ghelani," Securities and Exchange Board of India (SEBI) said in two separate orders.
It further said that monetary penalties were imposed "... for the violation of the provisions of regulations... of SEBI (prohibition of fraudulent and unfair trade practices relating to securities market)  Regulations, 2003," the regulator said today.
Probe carried out by SEBI observed a spurt in price and volume in the scrip of Era Constructions (India) Ltd during the period from 17 March 2004 to 12 November 2004.
Subsequently, the company has changed its name to Era Infra Engineering Ltd in 2008.
"...noticee (Ghelani and Rathod) had executed synchronised trades in the scrip of Era and indulged in creation of artificial volume during the investigation period," SEBI said in its orders.
SEBI noted that Ghelani carried out synchronised trades for a volume of 4.67 lakh shares with a total value of Rs2.92 crore, while Rathod was indulged in synchronised trades for a 1.03 lakh scrips with a valuation of Rs66.25 lakh.
The regulator said the two entities had carried out numerous trades in Era Constructions' scrip on a daily basis for several trading days and the traded quantities were also high.
The fact that such transactions took place repeatedly over a period of time reinstates the non-genuine nature of such trades.


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