The non-profit investigative journalism organization ProPublica, in cooperation with National Public Radio, published a story yesterday revealing that Freddie Mac, the government-owned mortgage financier, has recently been purchasing derivatives that would make the company money “if homeowners stay trapped in expensive mortgages with interest rates well above current rates.” The story, titled “Freddie Mac Bets Against American Homeowners” argues that these derivative purchases are unethical because they give Freddie Mac “a powerful incentive” not to help homeowners refinance at today’s historically low rates. The article states that “no evidence has emerged that these two decisions were coordinated,” but it does imply that there is something wrong with Freddie tightening its lending standards and then attempting to profit off the knowledge that these standards would be tighter.
So have these well-respected news organizations uncovered more corruption in government and Wall Street chicanery aimed at fleecing unsuspecting homeowners? The short answer is no. Conflict of interest is inherent and largely unavoidable in the government’s conservatorship of Fannie and Freddie, and the seemingly contradictory actions described in the article were very likely a natural outgrowth of that conflict and probably each taken in good faith — not a conspiracy to manipulate the housing market for short term gain.
The article reports that in 2010 and 2011 Freddie Mac purchased about $3.4 billion dollars worth of “inverse floaters,” a kind of mortgage-backed derivative that pays holders the interest from a pool of mortgages minus a benchmark interest rate. Interest rates are now low, of course, and many of the mortgages underlying the derivatives pay much higher rates than they would if they were issued now, so the investments are paying off handsomely. (High coupon – low rate = good return.)
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These securities are very risky, however, because they can lose value if interest rates go up or down. If rates go up, of course, the return goes down. And if interest rates go down, many homeowners will choose to refinance, which can also crush the value of the inverse floater. (When you refinance, you essentially pay back the old mortgage and take out a new one at a lower rate — at which point interest payments on the old mortgage stops.) Purchasing these investments, in other words, was a bet that 1) interest rates would remain low; and 2) homeowners would not refinance in great numbers.
The problem is that such a bet seems to run counter to the interests of the millions of American homeowners who would benefit by refinancing at lower rates — but who have been prevented from doing so by high lending standards set… by Freddie Mac itself. Freddie Mac is making money, argues Pro Publica, by keeping homeowners in “financial jail.” What’s more, it implies that Freddie could be actively maintaining unreasonably high lending standards, and preventing refis, in order to protect these investments. The article does note that no evidence of this collusion has been unearthed, but the accusation of a “conflict of interest” implies that Freddie’s institutional interests lie in preventing refinancing, and that these tight lending standards are an unfair abuse of homeowners who wish to refinance.
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But let’s remember that loose lending standards were one of the primary causes of the housing crisis — and that, until very recently, it had been the explicit policy of the Obama Administration to guide Freddie Mac and Fannie Mae towards tighter lending standards and smaller balance sheets. Both of these actions, by their very nature, make it more difficult for people to take out mortgages. In fact, right around the time Freddie Mac was supposedly buying these derivatives, the Department of Housing and Urban Development issued a report to Congress stating that Freddie and Fannie had been and would continue to oversee the tightening of lending standards:
“Since Fannie Mae and Freddie Mac were placed into conservatorship, the FHFA has monitored their business operations closely and strengthened underwriting standards, reducing risk to the American taxpayers.”
In addition, the decision to purchase the derivatives appears to have been reasonable independent of any kind of collusion or inside knowledge about lending standards. It was public knowledge that lending standards were being tightened; and because most experts expected higher, not lower, rates, most people assumed everybody who was able to refinance already had. Thus, the refi risk was deemed low. So the only real ‘bet’ was that interest rates would stay low, which they have. As Daniel Fisher argues in a recent issue of Forbes, these “inverse floaters” were really just a smart investment made by employees charged with helping to strengthen Freddie’s balance sheet. In fact, one could argue that by not buying these securities, Freddie would be shirking their responsibility to its stockholders – otherwise known as the American taxpayer.
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The real issue, then, isn’t conspiracy or other abuses of power, but the glaring conflict of interest that’s built into the conservatorship of Fannie Mae and Freddie Mac. In the past several months, some economists, the Federal Reserve, and President Obama have come out in favor of using government conservatorship of Fannie Mae and Freddie Mac as a tool to stabilize the housing market and stimulate the economy, an endeavor that’s likely to cost these government-owned entities serious money, at least in the short term. Yet one of the mandates of the government’s takeover of the GSEs is to not increase costs to the American taxpayer. It is becoming increasingly clear that these two goals are in opposition to each other.