It’s always good fun to get upset about something of the form “X bet against Y,” and the financial markets offer a whole range of opportunities to do so. Everything is a bet against something, and if that something is sympathetic and/or you, you can go get enjoyably pissed at whoever is doing the betting. Today ProPublica reports on a nasty-sounding Freddie Mac bet against America and freedom and the 30-year fixed-rate mortgage with no prepayment penalty:
Freddie Mac, the taxpayer-owned mortgage giant, has placed multibillion-dollar bets that pay off if homeowners stay trapped in expensive mortgages with interest rates well above current rates.
Freddie began increasing these bets dramatically in late 2010, the same time that the company was making it harder for homeowners to get out of such high-interest mortgages.
Now, a “bet that pays off if homeowners stay trapped in expensive mortgages with interest rates well above current rates” is called a … what’s the word? … oh, right. A “mortgage.” A feature of our life here on earth is that banks make money when people stay in their fixed-rate mortgages when rates go down, and lose money when people refinance those mortgages.*
Okay but in fairness those aren’t Freddie’s “bets,” not exactly. Their bets against not only the housing market but also specifically a couple named the Silversteins, who “live in an unfinished development of cul-de-sacs and yellow stucco houses about 20 miles north of Philadelphia, in a house decorated with Bonnie’s orchids and their Rose Bowl parade pin collection,” look like this:
Here’s how Freddie Mac’s trades profit from the Silversteins staying in “financial jail.” The couple’s mortgage is sitting in a big pile of other mortgages, most of which are also guaranteed by Freddie and have high interest rates. Those mortgages underpin securities that get divided into two basic categories.
One portion is backed mainly by principal, pays a low return, and was sold to investors who wanted a safe place to park their money. The other part, the inverse floater, is backed mainly by the interest payments on the mortgages, such as the high rate that the Silversteins pay. So this portion of the security can pay a much higher return, and this is what Freddie retained.
In 2010 and ’11, Freddie purchased $3.4 billion worth of inverse floater portions — their value based mostly on interest payments on $19.5 billion in mortgage-backed securities, according to prospectuses for the deals. They covered tens of thousands of homeowners. Most of the mortgages backing these transactions have high rates of about 6.5 percent to 7 percent, according to the deal documents.
Between late 2010 and early 2011, Freddie Mac’s purchases of inverse floater securities rose dramatically. Freddie purchased inverse floater portions of 29 deals in 2010 and 2011, with 26 bought between October 2010 and April 2011. That compares with seven for all of 2009 and five in 2008.
In these transactions, Freddie has sold off most of the principal, but it hasn’t reduced its risk.
Okay, that is actually pretty interesting. But let’s leave the Silversteins out of it for a sec and talk about what these trades are. I think they look like this:
(1) Banks write 30-year fixed mortgages.
(2) Banks sell mortgages to Freddie.
(3) Freddie slices off the credit risk of these mortgages and puts it in Freddie’s special credit-risk-keeping place, which is called a “guarantee,” because no one else wants that credit risk.
(4) Freddie now has a pile of mortgagy-looking cash flows with no credit risk, but with interest rate and refinancing risk.**
(5) Freddie then slices off a good hefty chunk of the refinancing risk (and some interest rate risk***) and puts it in its special refi-(and-rates)-risk-keeping place, which is called “inverse floaters,” because [reason goes here].
(6) Freddie now has a pile of cash flows with no credit risk, much less refinancing risk, and less interest rate risk (and, like, what, are rates going to go lower)?
(7) Freddie now sells to investors a delightful pile of, um, at a first approximation fixed-rate fixed-maturity U.S. government bonds.
(8) People seem to like U.S. government bonds! So that goes swimmingly.
Seem fair? The important point is that you don’t need to get hung up on structural details like “inverse floaters” in step (5). All you need to know is that Freddie is taking a disproportionate amount of refinancing risk on the mortgages it guarantees and packages, which means that the buyers of those packaged mortgages are getting disproportionately less refinancing risk.
Now let’s fill in the reason in step (5). One possible reason might be “Freddie has the ability to change its rules to make it harder for the Silversteins to refinance, so it thinks it has the best ability to outperform market expectations on refinancing risk, so it hangs on to that risk itself because it believes it’s being overpaid for taking the risk.” This is the view that ProPublica takes and it’s pretty plausible because Freddie apparently did change its rules to make it harder to refinance, tightening its credit checks to exclude borrowers who have a recent short sale. That’s at least awkward given Freddie’s whole role as, whatever, government guarantor of homeownership. Here’s a related take:
When Freddie and Fannie’s huge investment portfolios profit, it helps reduce the potential burden on taxpayers. That’s been a priority for FHFA under Edward DeMarco’s leadership. At the same time, Fannie and Freddie could, by easing the way for homeowners to lower their payments, help heal the housing market. That’s the priority for the White House. As such, Freddie Mae made “a direct bet against the administration’s public policy effort,” Christopher Mayer, professor of housing finance at Columbia University, tells me.
When it comes to refinancing, “there’s always been this lingering question — why aren’t the GSEs doing more? Everyone says it’s because of their portfolio, ” said Mayer, who’s been a proponent of mass refinancing through Fannie and Freddie. He points out that Freddie, in recent months, had tighter rules for refinancing than its counterpart Freddie. “Now we know why,” Mayer says.
As for that public policy effort, if you didn’t know, there’s gonna be mass refinancing. Or not. I mean, probably not. But supposedly “The program will give every responsible homeowner the chance to save about $3,000 a year on their mortgage by refinancing at historically low interest rates. No more red tape. No more runaround from the banks.” So you could see Freddie’s red-tape-and-runaround, and its financial incentives to keep up said runaround, being somewhat awkies.
Now I could characterize step (5) a little differently if I wanted to. I could say that Freddie may have kept the refinancing risk because it was the hardest to sell. Why might it be hard to sell? Well, refinancing risk is often sort of quantifiable based on past experience, etc. – but it gets harder to quantify when politicians want to push refinancing, and when mortgage-market practices and policies are (maybe!) being changed to facilitate that. In that environment, especially where many of those maybe-changing policies are Freddie Mac’s policies, buying refinancing risk from Freddie becomes less appealing for a private investor. If I stump up a million bucks for fixed-rate Freddie mortgages at 6%, and the next day Freddie says “everyone gets a free refinancing!,” Freddie has cost me a lot of money.
Given that sort of moral-hazard-and-adverse-selection situation, you could see why it would be less attractive for an investor to take refinancing risk off of Freddie’s hands. And that might push down the price for buying that risk – making Freddie, as the actor with the most clarity into the housing market and coming regulatory changes, the only player who might think that it’s worth it.
That’s not exactly a different explanation from ProPublica’s. It’s just a question of whether you emphasize Freddie’s nefarious demand for that risk – “ooh, let’s manipulate the mortgage rules to make ourselves money on refinancing risk!” – or everyone else’s lack of demand for it – “let’s stay the hell away from refinancing risk because mass mortgage modification is maybe coming.” Either one could end up with Freddie holding relatively more I/O inverse floaters from its deals than it did in the past. But one sounds evil and the other sounds … well, less evil. But maybe stupid? Like, part of your job at Freddie is to manage risk, and building up all of the refinancing risk in the world in your book just because no one else wants it at the price you offer, while your political bosses are pushing mass refinancings, sounds kind of dumb. Unless you go do stupid-evil things like make refinancing harder.
One related point is that the refinancing risk has to go somewhere. You can give it to the banks which originate the loans, or to Freddie which packages the loans, or to investors who ultimately buy the loans. Leaving the refinancing risk in the mortgages diffuses it more, so there’s not just one entity – Freddie – with kajillions of dollars of refinancing risk. Same, by the way, for credit risk – making banks or investors responsible for defaulted loans spreads out the risk; making Freddie responsible for them concentrates it in one place. (Two places. Fannie Mae too.)
What is the effect of concentrating the risks? Well, on the one hand, you get Freddie, in its creepy dual role of profit-seeking mortgage investor and tool of government policy, doing creepy dual things like talking nicely about refinancing and modification while also seeking to avoid actual refinancings and principal writedowns that would cost it money. So that’s bad. On the other hand, that’s relatively – relatively – easy to put a stop to. As a tool of government policy mostly owned by the government, Freddie really is subject to direct government orders in the way that JPMorgan isn’t quite.
My bet, though, is that reducing the refinancing risk held by the private sector will make mass refinancing easier. Freddie and Fannie, God knows, do a lot of lobbying, and they apparently have big incentives to oppose refinancing. But those incentives exist because JPMorgan and Bank of America and Pimco and pension funds all have reduced incentives to oppose refinancing. Mass refinancing will cost the private sector $1 less for every $1 more it will cost Fannie/Freddie. And Fannie/Freddie at this point are unpopular government-owned punching bags that lose so much money that a few billion more will hardly be noticed. Whereas banks and investors are trying to stay profitable and are less politically toxic than Frannie.
In other words, if I ran the government and I wanted to create a mass mortgage refinancing program, I would worry about banks and investors revolting over the losses they’d take on refinancing, where by “revolting” I mean “mounting a lobbying and PR and financial campaign to stop it.” And the way I might prevent that revolt would be by subsidizing those private sector refinancing losses. And this might be the way I’d do it.
Freddie Mac Bets Against American Homeowners [ProPublica]
* You write a fixed-rate 30-year mortgage and it has a present value of zero, or some profit margin, whatever. Rates go down and now it has an above-market interest rate. What is its present value? Well, something like [(change in rates) x (duration of mortgage)]. If it’s easily and frictionlessly prepayable, the duration gets very short and its value is zero or zero-ish. If it’s a pain in the ass to prepay, the value is positive, and gets bigger the more rates drop and the harder it is to prepay. It’s a bet that pays off if homeowners stay trapped in fixed-rate mortgages with rates above market rates.
** Really “prepayment risk,” which is the more general/normal term, but let’s stick with “refinancing risk” here to emphasize what people are actually worried about politically and such.
*** Random update: It’s worth saying that the IO inverse floaters are also/mainly a rates play. I’m focusing on the prepayment risk because that’s what’s newsworthy, and certainly they soak up a lot of prepayment risk.