Freddie Mac's Silly Boo Boo

We are told today that Freddie Mac has some $3.4 billions in derivatives called "inverse floaters" that profit if homeowners do not refinance out of high interest rate mortgages. At the same time that Freddie Mac was accumulating its holdings of inverse floaters, it was tightening requirements for refinancings, thus either wittingly or unwittingly increasing its chances of profiting from its inverse floaters.

The contradiction between Freddie's investment in inverse floaters and its mission of fostering affordable housing for Americans is obvious. Freddie's regulator, the Federal Housing Finance Agency, has been pushing Freddie and Fannie Mae to limit the extent to which they receive taxpayer subsidies. Seeking investment gains has been one way of pursuing that goal. That may be why Freddie took a flyer with the inverse floaters.

While details remain scarce, it appears from news reports that these inverse floaters are interest only strips--investments that paying the holder (Freddie, in this case) the interest payments from a large pool of mortgages. Refinancings of these mortgages mean that interest payments from the pooled mortgages would stop (while interest payments on the new, refinanced mortgages would go to whoever holds the right to those payments, not to the strip). So the more the old mortgages in the pool are refinanced, the greater the likelihood of Freddie losing money on the strip. Inverse floaters are likely to be volatile in value if interest rates change, and probably aren't very liquid because they're risky.

Refinancings increase as interest rates drop. By investing in the inverse floaters, Freddie was in effect speculating on the direction of interest rates. If rates dropped, the inverse floaters would lose money. If rates rose, the inverse floaters could rise in value (although higher mortgage rates would detract from the value of the stream of interest payments, which would be detrimental to the value of the inverse floaters). These inverse floaters may have been a bet on largely stable interest rates.

The silly thing about all this is that Freddie was speculating on the direction of interest rates in volatile investments that would be an embarrassment if the financial press found out about them. After being nationalized in 2008, Freddie should have become greatly sensitized to the need to look good while doing good. These inverse floaters could produce outsized losses if refinancings pick up. Taxpayers might then be called on to provide more subsidies to Freddie, not fewer. And not because Freddie took losses trying to make homes more affordable for America but because it was betting homes wouldn't become more affordable.

It's entirely possible that Freddie's traders have an explanation for the inverse portfolios that sounded pretty good when they talked among themselves. But from a public relations standpoint, the inverse floaters are silly, at best. The true problem is that Freddie and Fannie have too many conflicting goals, attempt to fulfill too many differing expectations, and are simply too big. There are some pretty good arguments that the biggest banks should be broken up into smaller, not too big to fail pieces. All of those arguments apply a fortiori to Freddie and Fannie.