Government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac are chartered for the purpose of advancing the economy by ensuring the smooth and transparent flow of credit between borrowers and lenders. Home ownership has always been a strong aspect of the American dream, and both Fannie and Freddie essentially exist to keep the dream alive by acting as facilitators and intermediaries, which is why it is baffling to to think that these GSEs would resort to cunning financial maneuvers to boost their profits at the expense of embattled homeowners. That's exactly what a recent investigation by a public media concern and an independent news organization revealed.
An inquiry into the practices of mortgage loan GSEs conducted by the National Public Radio and independent journalism organization ProPublica has revealed that, on more than one occasion, Freddie Mac has engaged in profitable financial strategies that essentially amounted to betting against the possibility of American homeowners refinancing at lower rates. The multi-billion dollar trades involved financial instruments known as mortgage-backed securities, the same instruments that are believed to have been a major factor in precipitating the global financial crisis and the subprime mortgage meltdown in 2008. The U.S. government eventually placed both home mortgage GSEs under conservatorship, and thus Fannie and Freddie are now owned by taxpayers.
The trades in question are lucrative and legal, but nonetheless controversial. They work on the concept of leverage; increasing the potential of realizing immediate gains, but also raising the exposure of a securities portfolio to financial risk. The way these investments work is as follows: When a mortgage company GSE guarantees a home loan, it essentially purchases that loan from an originating entity that usually continues to service it. These mortgage loans are then bundled into securities that are further divided into portions that are supported by the principal amounts of the home loans and by the interest payments made by the borrowers. Securities backed by the principal amount of mortgages offer a relatively lower rate of return, but are nevertheless attractive to investors who eschew volatility in the markets. Securities backed by the interest paid on mortgages are far more lucrative, but carry a substantial amount of risk. In 2010 and 2011, Freddie Mac chose to purchase billions of dollars worth of securities backed by high interest payments, also known as inverse floaters.
A GSE conducting the above-described trades is essentially betting that homeowners will not be able to refinance into lower rates, thereby realizing higher profits. The current credit and underwriting guidelines make it nearly impossible for many borrowers to refinance their mortgages, something that increases the rate of return in a mortgage securities portfolio, but also increases financial risk since borrowers are more likely to default on high-interest home loans. Should economic conditions worsen, thereby increasing the incidence of mortgage defaults, Freddie would be in a tight spot in regards to its mortgage securities portfolio. It isn't clear whether the home mortgage GSE has a contingency plan or hedge strategy in place to avoid losses in case of massive defaults.