Monday, January 30, 2012

Freddie Mac's "inverse floater" allowed more loan origination

Everybody is up in arms today about the Propublica story discussing Freddie Mac "betting against the borrowers" (hat tip Mike Konczal). The structured securities Freddie holds tend to be the "interest-only" component of a pool of mortgages. As long as borrowers in the pool keep paying, the holder of these securities receives cash. The more borrowers refinance, the less interest income is left in the pool. A holder of these securities therefore does not want borrowers to refinance and instead just keep paying as long as possible. How diabolical!
NPR: “We were actually shocked they did this,” says Scott Simon, who as the head of the giant bond fund PIMCO’s mortgage-backed securities team is one of the world’s biggest mortgage bond traders. “It seemed so out of line with their mission.”
And more...
Daniel Fisher (Forbes): ... I don’t get it. Freddie Mac did something potentially risky, but it was based on the reasonable assumption that interest rates can’t go much lower, but neither will they rise dramatically. According to the ProPublica story, Freddie bought $3.4 billion in “inverse floaters,” which are mortgage-backed bonds based on the interest payments from homeowners. As ProPublica points out, those securities can lose value when homeowners refinance or “prepay” in mortgage-banking terms. When that happens, investors get the principal portion of the mortgage back to reinvest but the stream of interest payments ends forever.
Freddie holds a massive portfolio of mortgages. Many of these borrowers have negative equity, can't refinance, and therefore pay higher coupon. Freddie can leverage that excess coupon stream via the interest-only securities and generate extra revenue with little capital.

Freddie holds both floaters and inverse floaters (much larger book of inverse floaters than floaters.)  Both are interest-only securities, but inverse floaters tend to be more stable. As rates rise, the coupon decreases, but there is more cash available to pay the coupon because prepayments stop.

With rising rates, Freddie's big mortgage portfolio will fall in value because mortgage durations will extend, paying lower than market coupon (negative convexity). Interest-only securities would do reasonably well because any remaining refinancing in the pool of mortgages will stop and the coupon revenue will extend. These positions therefore will be providing some offset to the mark to market losses in the main book in a rising rate environment. If rates keep rising however, the inverse floaters will indeed get hurt because they will receive an increasingly lower portion of the interest pool. But typically mortgage portfolio managers use interest rate swaps to offset some of that risk.

In a falling rate environment the coupon in the interest-only pool will be reduced due to some prepay, but a big chunk will keep paying because of the borrowers' inability to refinance. The interest-only securities will drop in value but still be reasonably stable, particularly the inverse floaters. Freddie's main mortgage portfolio on the other hand should go up in value because it will be paying above market rates with refinancing speeds contained.

What happens however if the Obama administration launches some sort of a mortgage principal forgiveness program? The probability of this event is remote because many of these troubled borrowers also have home equity loans. It would be legally difficult to force a principal reduction on the "1st lien" mortgages, while "2nd lien" (home equity - often with a different lender) is still outstanding (hat tip Greg Merrill). 2nd lien loans will therefore have to be sorted out before such a program can be effective (and legal). Even if it does happen, it will definitely hurt the interest-only paper, but should be net positive for their main mortgage portfolio because it will reduce default rates.

It is also important to note that Freddie retained many of these positions from the secularization transactions in which it sold pools of mortgages. Often there simply weren't many "natural" investors in inverse floaters. But this securitization process gave Freddie more balance sheet to originate new loans.

Securitization of mortgage pools ("Gold Collateral" refers to pools of mortgages in Freddie's deals called Gold MACS)

It is true that Freddie has a responsibility to the mortgage borrowers. However it has a bigger responsibility to the tax payers who own the organization. And that responsibility includes managing the portfolio risk as a fiduciary. The interest-only securities are not hurting the borrowers, yet they capture some of the revenue back to the taxpayer. According to CBO, the US Treasury spent some $300 billion to prop up the GSEs. Shouldn't the taxpayers have the right to get some of this money back?
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