To reiterate, ProPublica wrote that Freddie Mac kept (or “purchased”, though they really did neither) the IO coupon of newly purchased securities, called inverse floaters. These securities carried relatively steep interest rates, so it appeared that Freddie was aiming to discourage refinancing and place borrowers in “financial jail,” as one borrower put it.
Many bloggers, including me, responded “nonsense” .. there’s nothing wrong or strange about keeping the interest-only portion of newly issued securities; we weren’t even sure if anybody else would be interested in purchasing them.
What really happened is, like most issues affecting housing, more complicated, more sinister, and still entirely (as noted by Pro Publica) entirely legal. It’s arguably the type of deal Freddie was required to enter into under the 2008 Housing and Economic Recovery Act (HERA 2008), which mandates that the GSE’s minimize taxpayer losses.
Background: the GSE’s, Fannie Mae & Freddie Mac
Before explaining let’s review some basics. There are two Government Supported Enterprises, or GSE’s, related to housing, Fannie Mae and Freddie Mac. People who work with them refer to them as Fannie and Freddie, or FMFM though I shy away from the latter. They compete to purchase loans from banks. They do not lend directly to borrowers.
Fannie and Freddie were “private” companies until 2008. Because they were created by the US Government they were able to borrow money at lower rates than other private companies. Their prospectuses explicitly clarified the money they were raising was in no way backed by the US Government, though when they failed this explicit disclaimer was replaced by an “implied guarantee.”
When Fannie and Freddie began to collapse they were seized and back-stopped by the US Government.
There’s an irony that many sub-prime mortgage brokers made a rather explicit guarantee that, say, people could refinance before the interest rate on their adjustable mortgages exploded which were entirely ignored. At the same time, the explicit non-guarantee affecting Fannie and Freddie investors was cast as exactly the opposite.
Fannie and Freddie purchase mortgages from banks, bundle them into “pools,” add a guarantee to loans with less than 80-percent equity, then resell the bundled mortgages to investors. Sometimes they’ll sell only the interest only part of the loan, called IO, sometimes the principal only, called PO, and sometimes both.
At the same time they run what’s essentially an enormous hedge fund, purchasing many of the securities they themselves have guaranteed. That is, one half of the organization bundles mortgages into pools, guarantees them, then sells them to investors which often includes people working in the other half of the organization.
Fannie and Freddie collapsed at the end of the housing bubble and the government swooped-in to rescue them, keeping them “private” but putting them under government “conservatorship” run by regulator Edward DeMarco. To date, they’ve received over $182 billion of corporate welfare and the money keeps flowing.
As mentioned above, DeMarco is bound by HERA 2008; his job is to minimize the losses of the GSE’s to the American taxpayer while still retaining the aim of making houses affordable.
Fannie and Freddie, and DeMarco too, tend to make people’s blood boil across the political spectrum. Some of that is justified; for example, approval of multi-million bonuses for the CEO’s of the GSE’s, refusing to answer Freedom Of Information Act Requests, and ignoring the loan-level reporting requirements in HERA 2008 are indefensible.
But in other ways the conflicting goals of minimizing taxpayer losses — i.e., by making money, or at least losing the minimum possible — and making housing affordable put DeMarco in an impossible situation. For a more detail on how the US ended up in this position Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon by Gretchen Morgenson and Joshua Rosner is the best primer.
The Freddie Inverse Floaters Explained
Inverse floater are mortgage instruments that do best if the borrower does not refinance. I examined the 29 deals Pro Publica used as the basis to their story. What was not clear is that these were not new mortgages; Freddie took mortgages they already owned — that were purchased by their hedge-fund — and rewrote them into new instruments, keeping the interest paying pieces.
Despite that the new securities were created in 2010-2011, they involved $1.23 billion of mortgages written in 2009, $3.68 billion of mortgages written in 2008, $6.61 billion written in 2007 .. even $105 million written in 1995.
That is, Freddie essentially purchased usually old mortgages from themselves and remixed them into new securities where they benefited if borrowers could not refinance to lower interest rates.
Here is a spreadsheet detailing the Freddie Inverse Floaters & Related Instruments.
Freddie started to write these deals on March 1, 2010, though the majority — three times the prior volume — were written between Dec. 1, 2010 and April 1, 2011. That’s important because Freddie increased its “Post Settlement Delivery Fee,” — a junk fee that makes refinancing to a new GSE loan less affordable — on Nov. 22, 2010.
Altogether Freddie wrote $17.19 billion in inverse floaters — instruments where Freddie loses if borrowers refinance — or instruments that function similarly to inverse floaters.
These loans were at relatively high interest rates, most likely from the lowest credit borrowers. For example, the 2006 era loans carry an average interest rate of 6.65%, the 2007 era loans 6.52%, and the 2008 era loans 6.29%.
Principal and interest payments on a $350,000 30-year loan at 6.29% is $2,164/month. At 3% interest the same loan costs $1,476/month, or $689 dollars per month less, so there is an an appreciable difference. Over the life of the loan the higher interest costs a borrower $247,863 extra, money Freddie stands to gain at the expense of their borrowers.
As Pro Publica pointed out, correctly, Freddie stands to lose if people who took out these higher interest payments refinance to lower interest payments. Where they blew it was not breaking down the new instruments, the inverse floaters, into the years that the underlying mortgages came from.
Thanks to DeMarco’s thankless and somewhat schizophrenic mandate, it is not clear whether Freddie and the FHFA did anything wrong or whether the mandate itself — if not the GSE’s — needs to be revisited with the purpose of finally dismantling the GSE’s. Freddie Mac and a host of banker have defended the deals, though I suspect most bankers did not realize Freddie was remixing old loans, not new one’s.
All the confusion, the conflicts of interest, and the grey areas of morality, point to the need to dismantle the GSE’s and push tirelessly to restart the private secondary market, which has essentially vaporized since the financial crisis.
As long as government continues to dominate the lending business, especially with such a conflicted and emotionally charged mandate, the private market — and the discipline putting one’s own money on the line inspires — will never return.
Over the weekend I had a conversation with Alan Boyce, a seasoned bond trader and mortgage expert, who persuasively argued that computer programs inadvertently helped trigger the housing crisis and continue to substantively depress the market.
Alan’s hypothesis is that banks programmed their mortgage pricing systems to be either market leaders — “competitive” is the term he used — or second-tier more conservative followers.
You can see those systems work in real-time to this day. Log onto a myriad of websites for mortgage pricing information, enter some basic information or even your social security number, and computers will instantly and accurately churn out their best quotes. Mortgage brokers use essentially those same systems.
As the “competitive” mortgage companies — many who engaged in both prime and sub-prime lending — began to fail, he argues, systems at other banks automatically responded by ratcheting up their own prices. This cycle continued on a slower but just as deadly trajectory as the 1987 quant market meltdown, where the S&P shed 20% of its value in one day.
Volumes declined, leading to the end of an ever-decreasing number of sub-prime players, which led to higher prices from fewer competitors.
Finally the fiercely competitive players were wiped out, leaving nothing but the more conservative banks. However, these banks had programmed their systems to come in second; they did not want to be market leaders.
As each system tried to push behind the pricing of the others pricing increased dramatically, becoming almost entirely divorced from the underlying cost of capital.
Rates rose and volume dropped in a self-sustaining cycle that eventually crashed the market and, unlike the 1987 crash, has been neither noticed nor corrected to this day.
There are many side-effects, some that the public has noticed and some that we haven’t.
One of the worst is a dramatic increase in mortgage profitability, at the expense of both borrowers, the housing market, and the overall economy.
Boyce notes that mortgage profitability has increased about 600% since the height of the bubble. He convincingly argues originators and the GSE’s enjoy an essential monopoly and the inevitable pricing power that comes from being king.
I’ve never heard much discussion about whether banks and the GSE’s are behaving like Enron energy traders who didn’t flinch at flipping off electricity to entire neighborhoods when their pricing demands weren’t met, but the notion doesn’t seem far-fetched.
On one hand, the GSE’s have a mandate under the 2008 HERA law to minimize losses. On the other, that doesn’t mean that they’re allowed to fix prices. I don’t know if any of their myriad of exemptions includes immunity from price-collusion, but seeing that the government created two GSE’s on purpose that seems unlikely.
Indeed, the GSE’s absolutely used to compete fiercely. Competition is what led Fannie to adopt a “strategic relationship” with Countrywide in 1999, and served as the partial impetus for Freddie to purchase the doubly-pledged Taylor, Bean, and Whitaker loans throughout the bubble years.
Boyce didn’t raise the question but I will: now that the private secondary market has all but evaporated is there either inadvertent or overt price gauging between the GSE’s under the guise of risk management?
Boyce cites some compelling figures from September, 2011. He examines a hypothetical borrower with a 739 FICO score and a 75.01 loan-to-value (LTV) ratio: reasonably strong credit and just over 25% equity in their house.
That intuitively sounds like a strong borrower to me but apparently they will pay a .25 points “Adverse Market Delivery Condition” (AMDC) charge, a .5 points “Loan Level Pricing Adjustment” (LLPA), and another .5 points penalty in the bond market. After all the pricing math this person, with reasonably strong credit and a sizable equity cushion, will be offered a loan at 4.5% for money so cheap that the government is essentially paid to lend it.
Leave the same equity cushion but drop that borrowers score to 699, which is still high given our economic climate, and the costs skyrocket. The market hasn’t changed so the AMDC remains at .25 points but the LLPAs jumps to 1.75 points and the bond pricing to 5.5%. For paying a credit-card payment late, once, months before, that same borrower now faces a 6% mortgage rate.
On a $300,000 30-year fixed mortgage for $300,000 the 739 FICO score borrower will have a $1,520.06 P&I payment; the borrower with the 699 FICO score will pay $1,798.65 per month. Those forty FICO points will cost the borrower an extra $278.60 per month, $100 thousand more — a third of the initial loan amount — over the life of the loan.
Charging an extra $6.96 per month per FICO point does seem like an unreasonably steep pricing premium.
Boyce served a stint as a senior executive on the secondary market desk at perennial bad-boy Countrywide. On one hand that obviously serves as a taint on anybody’s reputation, but on the other hand almost anybody who knows what they’re talking about in the mortgage field was involved to some extent with one or more of the sub-prime lenders.
While it’s reasonable to contextualize the motivations of those who were involved in the market during those days it can also become counterproductive because so much institutional knowledge is tied up in their collective conscience.
In any event, Boyce’s figures speak for themselves, and those figures paint an ugly portrait for the ongoing health of the housing market as well as the overall economy that inevitably follows this vital market.
Returning to those automated pricing systems, the government should explore whether bankers accidentally discovered they can jack up mortgage prices to rates that might be as unreasonably high now as they were unreasonably low during the bubble.
As we approach what seems like the tenth final deadline for the AG settlement we can continue playing the blame game endlessly while families are thrown to the street and our economy sits rotting like unpicked fruit on a tree. But at some point — and I suspect we’re past that point — this becomes counterproductive if not outright harmful.
Let’s figure out first what went wrong, what we can do about it now, which elements are blocking the way to a stable market and how to quickly but responsibly repair them, and what’s most likely to restart the private market. Financially responsible American’s deserve to obtain or refinance their mortgages and it’s up to our government and banking system to make that happen.