OIG Investigates Freddie Mac's Inverse Floater Investments

by devteam September 26th, 2012 | Share

Behind the public face of their business models Freddie MacrnFannie Mae produce, use, and invest in a variety of products to increase theirrnprofitability and minimize their risk. The various investment, funding, andrnhedging portfolios hold products of varying degrees of sophistication includingrnunsecuritized mortgages, collateralized mortgage obligations (CMOs),rnmortgage-backed securities (MBS),  privaternlabel and commercial mortgage-backed securities (PLMBS, CMBS).  The hedging portfolios of the two governmentrnsponsored enterprises (GSEs) alone are valued at an aggregate of more the $1.4rntrillion. </p

While generally profitable, some sections of the GSEs capitalrnmarkets business have lost tens of billions of dollars since the GSEs were put intornconservatorship under the Federal Housing Finance Agency (FHFA) in 2008.  Because of these losses the FHFA Office of InspectorrnGeneral (OIG) initiated a series of evaluations of FHFA’s oversight of the GSEs’rncapital market businesses.  On WednesdayrnOIG released the results of one evaluation, on FHFA’s oversight of Freddie Mac’srninvestment in reverse floaters.</p

CMOs structured and marketed by Freddie Mac are a family ofrnbonds.  Freddie Mac may tailor thesernproducts to the specific interests of investors and inverse floater investments</bare among the mortgage-related securities in which the Capital Markets Divisionrninvests. </p

Inverse floaters like a number of the mortgage-relatedrninvestments held by the company benefit from a low interest rate environment</awith limited prepayments. This characteristic creates a potential tensionrnbetween the Single-Family Credit Guarantee Business and the Capital MarketsrnDivision. </p

According to FHFA and Freddie Mac, as investor appetite forrnfloating-rate bonds increased in the spring of 2010, Freddie Mac capitalized onrnthe opportunity to charge a premium for structuring these bonds by carving themrnout of its securitized mortgages. In the process, it retained by-productrnvariable rate bonds known as inverse floaters. rnThe OIG report contains a very clear and interesting explanation ofrninverse floater investments which can be read here.  Suffice it to say that investors in theserninstruments benefit when interest rates fall and that Freddie Mac retained arngreat number of these instruments in its own portfolio.</p

In late January 2012, these inverse floaters became thernsubject of significant attention. It was asserted that, because the value ofrninverse floaters decreases when the underlying mortgages are refinanced,rnFreddie Mac could deliberately limit loan refinancings in order to protect thernvalue of its inverse floaters.</p

The OIG investigation uncovered no evidence that either FHFArnor Freddie Mac obstructed homeowners’ abilities to refinance their mortgages inrnan effort to influence the yields of the inverse floater retained by therncompany in its investment portfolio. OIG said that these floaters represent arnsmall portion of Freddie Mac’s capital markets portfolio and to the extent thatrntension exists between the company’s refinancing and investment policies , the “floatersrnare no more likely to adversely impact mortgage holders or discourage borrowerrnrefinancing that any of the mortgages or other assets that Freddie Mac holdsrnfor investment.”</p

Further, Freddie Mac has an ‘information wall” policy tornprevent its capital markets business from using non-public information to guidernits investments and OIG found no evidence that individuals at Freddie Mac hadrnbreached the information wall.</p

While FHFA and its predecessor the Office of Federal Housing Enterprise Oversight (OFHEO) werernaware of the inverse floater investments for at least ten years they did notrninvolve themselves in managing operations of the Capital Markets Division.  However FHFA did begin a formal supervisoryrnreview of Freddie Mac’s CMO business in April 2011.  Before the review was finished the mediarnpublished stories about the GSE’s retention of inverse floaters and FHFA made arnseries of public statements that could have been interpreted to imply that therncompany had abandoned the business in the spring of 2011 as part of a riskrnmanagement strategy.  According tornFreddie Mac, however, investor appetite for the floating-rate bonds evaporatedrnaround that time without specific action by Freddie Mac.  </p

OIG found that FHFA’s position (that Freddie Mac should be notrncreating or investing these vehicles) could have been communicated more clearly.rnIt also found that the public statement by FHFA emphasized its review ofrnFreddie Mac’s CMO business and noted that FHFA had reached an agreement withrnthe company regarding reverse floaters in December 2011 which does not appearrnto be the case.  That Freddie Macrnsuspended the inverse floater portion of its business was not the result of arncoordinated FHFA policy but rather the outcome of a broad examination ofrnFreddie Mac’s entire CMO business and several informal communications. </p

OIG made several recommendations resulting from itsrnevaluation.  FHFA should:</p

1.        rnContinue to monitor the GSE’s hedges and modelsrnto ensure its portfolio is hedged within its approved interest rate limits.</p

2.        rnConduct periodic reviews and tests of FreddiernMac’s information wall to confirm it is not trading on non-public information.</p

3.        rnInsure that supervisory policies are wellrnfounded and coordinated and that the Agency speaks with one voice.</p

4.        rnConfirm any new positions or any agreements withrnFreddie Mac promptly and in writing.</p

5.        rnEnsure that supervisory policies are based onrnthe work of Agency personal and not reactions to media or other publicrnscrutiny.</p

6.        rnExercise due diligence to ensure publicrnstatements accurately reflect all relevant facts before they are released.

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About the Author


Steven A Feinberg (@CPAsteve) of Appletree Business Services LLC, is a PASBA member accountant located in Londonderry, New Hampshire.

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