Jesse Eisinger is back with a follow-up to his original piece about Freddie Mac (FMCC.OB) and the inverse floaters; he’s also left a long comment on this blog, responding to various criticisms of his story which appeared in the blogosphere.
There are two main pieces of new information in the update. The first is that the size of Freddie’s inverse-floater position is even greater than we previously thought — $5 billion, rather than $3.4 billion. And the second is that the FHFA forced Freddie to stop making these trades last month, before the original ProPublica piece appeared. Now the FHFA, under Ed DeMarco, is a highly obstructionist agency which will always protect Frannie’s short-term interests over the broader health of the housing market and American homeowners. If even the FHFA was expressing serious concerns about these deals, that’s very strong evidence that something fishy was going on.
To get a feel for the tenor of the debate, check out the official FHFA response to Eisinger’s story:
The inverse floater leaves Freddie Mac with a portion of the risk exposure it would have had if it simply held the entire set of mortgages on its balance sheet. The CMO structuring activity results in some portion of the mortgage cash flows being sold off and a smaller amount needing to be financed by Freddie Mac with debt securities. It also results in a more complex financing structure that requires specialized risk management processes.
And here’s Eisinger, in his comment on this blog:
[Freddie] could have sold MBS on its portfolio outright and rid itself of the prepayment risk. The market for simple MBS with a government guarantee attached is liquid and deep – and certainly was then, in late 2010 and early 2011 when Freddie’s inverse floater bets ramped up.
Instead Freddie had the securitization structured, then retained the inverse floater portions. In other words, Freddie undertook transactions in which it retained a piece of a newly created deal that has basically the same risk profile as the original holdings. And what Freddie retained carried new risks: liquidity and LIBOR risks. Freddie engaged in reverse alchemy: it turned a position of gold into lead.
Moreover, these trades didn’t happen in a vacuum. Freddie is under a mandate to sell down its portfolio. Implicit in that mandate is that Freddie reduce its risk. In these trades, Freddie sells something notionally, so that the assets on its balance sheet fall, but it keeps most of the risk — and adds new risk. That raises the question of whether it is subverting the spirit, if not the letter, of its agreement with the U.S. Treasury.
I’m with Eisinger on this one. Let’s say you own a big house with a cottage in the back, which you’re renting out to tenants. And let’s say that you’ve been ordered to sell as many assets as you can. You can sell your property easily to homeowners who will be happy to take the rental income on the cottage. They know that the tenants can move out any time, so they won’t pay a huge premium for the cottage, but they will pay you extra for it.
Instead, you go to a very expensive lawyer and you carve your property up into two pieces. You then sell off the house, but hold on to the cottage yourself. You get less money for the house than you would have done if you’d simply sold the whole property. And what’s more, you now own a cottage, on its own, which is much harder to sell than either the house was, on its own, or the big house-plus-cottage property was before you split it into two.
The FHFA’s argument is, basically, “look, the cottage is smaller than the original property and the total risk associated with the cottage is, by definition, lower than the total risk associated with the cottage-plus-house original property. So we’re selling off assets, just like you asked.”
But this doesn’t make sense. Why go to the trouble of breaking the property up into constituent parts, at non-negligible expense, only to hold on to the more illiquid of those parts? If the sum of the parts were worth more than the whole, I could see it: breaking the property up makes sense if you sell the house to one person, the cottage to another person, and end up with more money than you could fetch for the property as a whole.
But that’s not what happened, because of the simple arbitrage in the markets: there are lots of traders out there happy to break up mortgage securities if doing so is profitable. There’s no need or reason for Freddie to start doing that itself.
It seems to me that Eisinger is right and that Freddie is violating the spirit of the Treasury’s instructions. Treasury wants Freddie to sell down and derisk its balance sheet. Freddie, in response, started selling down its balance sheet, but kept as much risk as it possibly could, in the form of inverse floaters.
And does anybody really believe that Fannie (FNMA.OB) and Freddie should be taking on more risk, in relation to the size of their balance sheets? I’m sure that doing so is good for the annual bonuses of someone getting paid $2.5 million a year to run Freddie’s mortgage portfolio. But it’s unlikely to be a good idea for anybody else.
As for the now-famous Silversteins, the couple who aren’t being allowed to refinance their property — well, that addresses the one case where it does make sense for Freddie to be taking on this prepayment risk. And that’s the case where Freddie itself controls the rules as to whether or not homeowners are allowed to refinance.
To go back to that property with that cottage, suppose that if you sold the property with cottage attached, the new owner would have no control over whether or not the tenants in the cottage moved out. But you, the seller of the property, do have control over the tenants — you can force them to continue paying rent in a manner that the new owner can’t. In that case, it makes sense for you to hold on to the cottage, because it’s worth more to you than it is to anybody else.
And that’s what Eisinger was alleging in his original piece. That the only reason it makes sense for Freddie to do these complex trades which leave it with significant holdings of inverse floaters, is that Freddie actually controls whether or not people like the Silversteins are able to refinance and thus prepay their mortgage. And because Freddie has that control, inverse floaters are worth more to Freddie than they are on the open market.
Basically, Freddie can’t have it both ways. Either it is preventing the likes of the Silversteins from refinancing so that it can maximize the value of its inverse floaters or it has no particular reason to carve up its mortgage securities and retain an illiquid inverse-floater tranche. Which is it to be?