Freddie Mac and Inverse Floaters

Or they structure a deal, sell off a floater, but don't place the inverse floater, so end up taking it down & absorbing/hedging it (or, in your example, using it as a hedge). Big deal.

I was trying to work through the ramifications of the mind-set of this 'journalism'. For example, what if I just loan money to struggling borrowers at a high-coupon, should I be chastised for 'betting against them' (because I lose duration if they refi)?

Puzzling article indeed.

Arnold, I think your being a bit unfair in your criticism of this story as "lousy journalism". As the old saying goes, a journalist is only as good as his sources. ProPublica spoke to, at the very least, an analyst at PIMCO, a former Freddie employee, a real-estate professor, and an FHFA official. Most important, they gave Freddie the chance to defend itself and received a bland bit of corporate speak in return. It's seems harsh for faulting journalists for failing to grasp the nuance of a strategy even Freddie itself didn't publicly defend.

Further, it allowed facts to get out in the open that experts like yourself can explain.

I don't think Freddie Mac is used to explaining investment decisions. There is nothing inherently bad about Inverse Floaters or any other form of mortgage backed security. The only relevant details are the price, the duration, and the quality of the collateral. If interest rates continue to remain rock bottom, as the Fed suggests, then these Inverse Floaters have a high return potential, so long as that return was not already baked into the price.

As you mentioned these Inverse Floaters surely offset the risk profile of one vanilla FRN mortgage in Freddie's portfolio.

@AngryKrugman

The source is not "an analyst at PIMCO" - he is a managing director and the head of MBS trading. He also expressed his surprise that Freddie Mac would be buying Inverse FRN even though they had some control over refi rules.

For any normal investment fund, an Inv FRN is a perfectly reasonable part of a portfolio. It would even be a smart move in Freddie Mac's case. The moral revulsion here is being misplaced, its not the investment that is unethical, it is the government sponsored enterprise.

Well, but as pointed out here, Pimco was not exactly a disinterested party to reach out to for comment on bets with embedded interest-rate risk:

http://www.forbes.com/sites/danielfisher/2012/01/30/freddie-mac-bets-against-refinancing-or-just-higher-rates/

From what I've read, Freddie purchased billions of dollars worth of inverse floaters -- these instruments are a protection against FALLIING SHORT TERM RATES These floaters are capped at zero, so there is no benefit from negative rates.

It is like being short 10,000 short Eurodollar put options.

Does anyone at Freddie seriously believe that their balance sheet is at risk if rates fall to zero (aren't they there already)

More likely, someone at BlackRock needed protection against rising rates and what better chumps than the taxpayer to sell it to them on the cheap.

Perhaps the more important takeaway here is that creating a for-profit entity created to serve some social purpose like increasing rates of home ownership is inevitably going to create conflicts between the for-profit and it's purported social purpose.

Either sell it or wind it down. Neither Pro Publica, NPR, nor anybody else will have anything to say about its investment decisions at that point.

I know something of inverse IO pricing, and it's strictly a bet that volatility is being mis-priced. It's not a bet on interest rates going up or down or prepays increasing or decreasing, since the security pays more interest if rates go down, but has a shorter life if prepays pick up. Freddie is mostly short volatility based on its business operation, so if it finds a way to cheaply purchase volatility it's mostly a good thing and is a partial hedge. I doubt most people in Congress who are currently expressing outrage even understand the securities involved or how they are created.

Freddie has more control over prepayments and refis than other market participants. Inverse floaters, at least by themselves, are sensitive to those risks. I think Freddie has more than enough incentive to manipulate the refi market for its own gain.

...but of course manipulating that market is sort of what Freddie does anyway. I think what this story highlights more than anything is not the absurdity of a mortgage lender purchasing inverse floaters, but the absurdity of an ostensibly independent firm having the mission and government backing that it does.

Tim, not really. It's the Fed that has been purchasing mortgages in the open market driving TBA prices, and while the mbs market is fairly large, basically four banks control the origination process so that any bank originating a loan and wishing to deliver it to Fannie or Freddie gives up roughly half the profit to those same large banks.
My gut feeling is that this story is a smear campaign aimed at Demarco for not wishing to go along with White House housing policy. The irony is that as conservator Demarco is following his mission as dictated by Congress.