Meet Wall Street Refugees Running Bonds at Freddie Mac

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Freddie Mac's Investment Holdings

Freddie Mac's Investment Holdings

Way up in a Manhattan skyscraper, a band of Wall Street refugees is quietly staking billions of dollars on the American mortgage machine.

Their pedigrees are A-list: Citigroup Inc., Bank of America Corp., Credit Suisse Group AG. Their job is to prowl for an edge in the $6 trillion market for home-loan securities, a place where, just seven years ago, greed and hubris collided in the worst financial crisis since the Great Depression.

It might sound like some high-flying hedge fund, but it’s not.

It’s Freddie Mac, the taxpayer-backed mortgage giant that collapsed in 2008, along with its larger cousin, Fannie Mae. Today, after multibillion-dollar bailouts, both effectively are still wards of the state.

Which is why what’s happening inside Freddie Mac might come as a surprise. With little fanfare, the company has recruited traders from major banks and empowered some to place new wagers.

Chief Executive Officer Don Layton says the goals include greasing the mortgage market, where Freddie Mac and Fannie Mae still play pivotal roles. But the activity also presents something else: an opportunity to boost profits.

No one is saying Freddie Mac is taking the kind of risks it took during the subprime era. But given the fiasco of 2008, when the two government-sponsored enterprises were placed under federal conservatorships, some outsiders are concerned the company may be unnecessarily gambling with taxpayer money.

Bearing Risk

“If things work out like they’re supposed to, the money goes to the taxpayers, as well as the people who are getting paid the salaries and bonuses,” said Jay Brinkmann, formerly the chief economist of the Mortgage Bankers Association.

But if the new traders make a mistake or markets move in surprising ways, “ultimately, that risk is held by the taxpayers,” said Brinkmann, now a financial-services consultant.

Even as Freddie Mac and Fannie Mae are pushed to expand in their main business of insuring mortgage bonds to support the housing market, they’re supposed to be unwinding their investment books to reduce the danger of a future blowup. At Freddie Mac, the new hires are indeed helping the company do that, including in ways that Fannie Mae hasn’t.

But company disclosures, bond-offering documents and other data show Freddie Mac is also taking new risks.

‘Smart Guys’

In December, for instance, its holdings of mortgage securities and loans jumped by $6.4 billion to $408 billion. They similarly rose during three other months over the past two years. At Fannie Mae, holdings consistently dropped each month.

Layton, 64, likes to emphasize how his new traders are focused largely on unwinding old bets. But he says his team is also trading and holding onto slices of assets it’s meant to be shrinking.

The former JPMorgan Chase & Co. vice chairman who became Freddie Mac’s CEO in 2012 says his company needs “smart guys” to do things like stepping into the market for its bonds from time to time to ensure it stays liquid.

“You need to make sure that the core mortgage securities, your issues, are traded well,” Layton said via e-mail. “Over time, our securities will trade at lower rates because we’re providing a bid at times. All of this is good for the market, good for the borrowers and good for the lenders.”

Returning Profits

It may be working. Last year, the discount at which some Freddie Mac mortgage bonds trade to similar Fannie Mae notes shrunk to an average of about 0.2 cent on the dollar from 0.3 cent in 2012, according to data compiled by Bloomberg.

The companies have given the government little reason to complain, each returning about $20 billion more than they got in their bailouts. The Treasury is essentially taking all of the companies’ profits under the rescue pacts, an arrangement their shareholders have been seeking to end.

The firms’ overseer, the Federal Housing Finance Agency, said in a statement that it’s fine for Freddie Mac to be occasionally buying bonds to ensure a liquid market. It also notes the company had to cope with a brain drain in its capital markets division after the crisis, something Fannie Mae didn’t face to the same degree.

So who are Layton’s smart guys? Since July 2013, Freddie Mac’s investment and capital markets division has been led by Michael Hutchins, who ran global fixed income at UBS Group AG before helping to start an internal UBS hedge fund.

That fund, Dillon Read, collapsed in 2007, when its bets on subprime securities went wrong. The fund’s holdings led to billions of dollars in writedowns for the Swiss bank following Hutchins’ departure that year, after which others at the bank managed the trades.

Market Pioneer

Then there is Vadim Khazatsky, who helped pioneer the mortgage securities market at Salomon Brothers during the 1980s, lending his name to a still popular type of bond known as very accurately defined maturity tranches, or VADMs. He spent more than 20 years at Salomon and Citigroup, which later subsumed it.

Another senior hire, Lee Godfrey, started his career in mortgage bonds at Salomon in 1993. He later headed a team at Bank of America and then oversaw various mortgage and structured-finance businesses at Credit Suisse.

Others include Kevin Cheng, who departed Citigroup in June; John Wang, also formerly of Citigroup; Eliot Deutsch, who worked for Citigroup and BNP Paribas SA; and Craig Grabowski, who left Bank of America’s Merrill Lynch unit in June.

Manhattan Digs

Some team members are based in Freddie Mac’s headquarters in McLean, Virginia, while others work out of offices in the MetLife Building in Midtown Manhattan. Freddie Mac declined to disclose the employees’ compensation. In 2011, the median cash pay for senior vice presidents at Fannie Mae and Freddie Mac was $723,500, according to a report by the FHFA’s inspector general. The median for vice presidents was $388,000.

While a variety of factors affect the size of the companies’ portfolios, Freddie Mac’s trading of mortgage bonds also helps explain why holdings of its own securities grew by $6.4 billion in August. Still, its investment portfolio was more than $60 billion below a $470 billion cap for the end of 2014, a limit tied to mandates for Fannie Mae and Freddie Mac to reduce their holdings by at least 15 percent annually to $250 billion.

Former Federal Reserve Chairman Alan Greenspan said in an e-mail that it wouldn’t be a good idea to allow the firm to be “producing income by borrowing at Freddie Mac’s subsidized rate” -- echoing his criticism of the two government-sponsored enterprises before the subprime crisis.

‘Runs Counter’

“They need to be unwinding the portfolios as soon as they can,” Clifford Rossi, an executive-in-residence at the University of Maryland’s Robert H. Smith School of Business who’s worked at both, said in December. “To get an organization staffed up for the purposes of ongoing trading activity runs counter to the intent. I have a real problem with that.”

Layton said Freddie Mac isn’t buying anything that’s illiquid and not making large bets on interest rates. With its “legacy” assets, he wants to mitigate dangers for taxpayers without selling assets on the cheap. And the riskiest investments have in fact rebounded in value since the crisis, helping Fannie Mae and Freddie Mac to start to shed more after contributing to the U.S. turning profits on their bailouts.

“We think it has gone very well indeed,” Layton said.

His company has been using a bit of financial slicing and dicing as part of the effort. Homeowners who fell behind on their mortgages but have now caught up are having their loans bundled into new Freddie-guaranteed securities. Freddie is then packaging those bonds into collateralized mortgage obligations with various levels of risk and cherry picking parts it wants.

Outflanking Banks

The firm, in retaining select pieces of those CMOs and others with potentially concentrated risks, is outflanking Wall Street banks that might have otherwise gotten potentially lucrative investments to sell.

“If they choose to do it in a manner that’s slightly more profitable to them, that doesn’t run afoul of what they’ve been told to do,” said Laurie Goodman, director of the Urban Institute’s Housing Finance Policy Center. “They’re only helping their bottom lines.”

Given their spectacular collapses, Fannie Mae and Freddie have plenty of doubters. To Josh Rosner, an analyst at research firm Graham Fisher & Co., Freddie Mac’s trading strategy underscores the dangers of leaving these companies in limbo without any capital buffers.

“The bigger issue it highlights is that if something goes wrong, the Treasury is on the hook,” he said.

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