Monday, January 30, 2012
Freddie Mac, a taxpayer-owned mortgage company, is supposed to make homeownership easier. One thing that makes owning a home more affordable is getting a cheaper mortgage.
But Freddie Mac has invested billions of dollars betting that U.S. homeowners won't be able to refinance their mortgages at today's lower rates, according to an investigation by NPR and ProPublica, an independent, nonprofit newsroom.
These investments, while legal, raise concerns about a conflict of interest within Freddie Mac.
"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, formally called the Federal Home Loan Mortgage Corp., was chartered by Congress in 1970. On its website, it says it has "a public mission to stabilize the nation's residential mortgage markets and expand opportunities for homeownership." The company is owned by U.S. taxpayers and overseen by a regulator, the Federal Housing Finance Agency (FHFA).
In December, Freddie's chief executive, Charles Haldeman, assured Congress his company is "helping financially strapped families reduce their mortgage costs through refinancing their mortgages."
But public documents show that in 2010 and 2011, Freddie Mac set out to make gains for its own investment portfolio by using complex mortgage securities that brought in more money for Freddie Mac when homeowners in higher interest-rate loans were unable to qualify for a refinancing.
Those trades "put them squarely against the homeowner," PIMCO's Simon says.
Freddie Mac's trades came at a time when mortgage rates were falling to record lows. 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.
That raises concerns among some industry insiders who see a conflict: Freddie Mac's own financial health improves when homeowners can't refinance.
Simply put, "Freddie Mac prevented households from being able to take advantage of today's mortgage rates — and then bet on it," says Alan Boyce, a former bond trader who has been involved in efforts to push for more refinancing of home loans.
Freddie and FHFA 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.
When Homeowners Lose, Freddie Mac Wins
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."
Refinancing A Path To Recovery
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."
In a written statement, Freddie said it "is actively supporting efforts for borrowers to realize the benefits of refinancing their mortgages to lower rates." It also says it refinanced loans for hundreds of thousands of borrowers just last year.
Fannie and Freddie have taken part in an existing federal program known as "HARP" to help Americans refinance, but many economists say far more homeowners would benefit if Fannie and Freddie were to implement the program more aggressively.
Stuck In 'Financial Jail'
Some homeowners believe the current re-fi game is stacked against them.
Jay and Bonnie Silverstein describe themselves as truly stuck in a bad mortgage. They live in an unfinished development of yellow stucco houses north of Philadelphia. The developer went bankrupt.
The Silversteins bought this home before the housing market crashed, and then couldn't sell their old house. They now say that buying a new home before selling the old one was a mistake — a painful one. Stuck with two mortgages, they started to get behind on their payments on the old house.
"It wound up taking us years to sell that house, so we had two homes and two mortgages for two-and-a-half years," Jay Silverstein says. "It burned up my 401(k) and drained us."
Jay Silverstein has a modest pension, and they haven't missed a mortgage payment on their current home. Still, they are struggling. They could make the monthly payment on their new home if they could just refinance — down from their current interest rate of near 7 percent to today's rates below 4 percent. That could save them roughly $500 a month.
"You know, we're living paycheck to paycheck," he says. A lower rate "might go a long way toward helping us."
But that's the problem — getting approved for a refinancing. Here's why: After the housing market crashed, the Silversteins' old house had to be sold for less than the mortgage was worth. That's known as a short sale.
Freddie Mac has been tightening lending restrictions, and one of its restrictions blocks people with a short sale in their past from refinancing for up to four years following that short sale. So the Silversteins are stranded by the rule.
"We're in financial jail," Jay says. "We've never been there before."
Tight For Homeowners, But Elsewhere, Money Still Flows
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.
The short-sale restriction may be a good example. For a home purchase, such a rule may be prudent, but allowing people with existing loans to refinance actually lowers the risk that they may default by giving them more affordable mortgage payments.
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.