Freddie Mac Halts Use of Derivatives Tied to High Interest Rates

Freddie Mac stopped making investments in derivatives known as inverse floaters last year after a regulatory exam raised questions about the mortgage company’s controls, the Federal Housing Finance Agency said.

An FHFA examination “identified concerns regarding the controls, including risk management, surrounding the inverse floaters,” the oversight agency said in a statement. “FHFA and Freddie Mac agreed that these transactions would not resume.”

FHFA, Freddie Mac’s regulator, released the statement in response to an article published yesterday by news organizations ProPublica and National Public Radio saying the company stood to profit from billions of dollars in positions that relied on homeowners remaining in mortgages with high interest rates.

Fannie Mae and Freddie Mac have cost U.S. taxpayers more than $150 billion in aid since 2008, when they were taken into conservatorship as they teetered on the brink of collapse after investing in risky mortgages.

Since then, the two government-sponsored enterprises have been under a mandate to improve their finances and reduce the burden on the U.S. Treasury. They have also faced political pressure to help troubled borrowers refinance into mortgages with lower rates.

The White House and some members of Congress are calling on the two companies to ease their rules to help avert home foreclosures. FHFA is independent of the federal government, and acting chairman Edward J. DeMarco has resisted policies that he says could add to the bailout and the costs to taxpayers.

Lawmakers React

Members of Congress, including California Senator Barbara Boxer, criticized the inverse floater transactions.

“Freddie should be taking every step to help borrowers refinance at today’s historically low rates -- not betting against their ability to do so,” Boxer, a Democrat, wrote yesterday in a letter to DeMarco.

The FHFA defended Freddie Mac in its statement yesterday, noting that just $5 billion of Freddie Mac’s $650 billion portfolio of retained investments is held as inverse floaters, the FHFA said.

Inverse floaters are a form of derivative known as a collateralized mortgage obligation. A CMO puts together mortgages and issues shares, or tranches. The underlying mortgages are collateral and provide principal and interest payments to investors.

With the inverse floaters, Freddie Mac was retaining tranches linked to the relatively high interest payments on the mortgages in the pool, and stood to lose if those mortgages were refinanced at lower rates.

Treasury Query

Treasury Department spokesman Anthony Coley said the FHFA statement came in response to a query by department officials based on the ProPublica and NPR report. No further investigation is planned by the Treasury, which does not have jurisdiction over Fannie Mae and Freddie Mac, Coley said.

The FHFA Office of Inspector General, the agency’s own auditor, will be looking at inverse floaters as part of an ongoing review of oversight of the mortgage firms’ market activity, Kristine Belisle, a spokeswoman for the inspector general, said in an e-mailed statement. “We currently have an open evaluation on capital markets, which encompasses this issue. We’ll know more when the evaluation is completed.”

Complex Derivatives

FHFA called on Freddie Mac to stop making the investments last year not because of concern about the impact on homeowners’ ability to refinance, but because of the complexity of the instruments, the agency said.

Freddie Mac’s ownership of inverse floaters “did not have any impact” on recent efforts to expand the reach of the administration’s main refinancing initiative, the Home Affordable Refinance Program, the FHFA said.

Fannie Mae and Freddie Mac have recently changed their rules to improve participation in HARP. After the initiative reached less than a quarter of the 4 million to 5 million homeowners projected by President Barack Obama, the White House pushed the companies for adjustments. The resulting changes, including lower fees and lessened risks for lenders, started in December.

“Refinancing is Freddie Mac’s bread and butter in today’s marketplace,” Freddie Mac said today in an e-mailed statement. “Refinancing mortgages was more than 78 percent of our business in 2011 and 80 percent of our business in 2009 and 2010. In three years we have refinanced an estimated 4.3 million mortgages totaling about $930 billion.”

Housing Revisions

The Obama administration also has announced revisions to the Home Affordable Modification Program, or HAMP, a program that provides incentives to lenders and servicers to reduce principal on mortgages for troubled borrowers. The revisions would pay Fannie Mae and Freddie Mac to forgive debt on homes that have lost value. The government-owned companies, citing cost to taxpayers, have a policy of not reducing principal. As a result, HAMP’s reach has been limited because the companies own or guarantee nearly half of U.S. home loans.

FHFA recently released an analysis “concluding that principal forgiveness did not provide benefits that were greater than principal forbearance”, DeMarco said in a written statement. In that analysis, DeMarco estimated that forgiving mortgage debt could cost the government-supported companies almost $100 billion.

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