Did Freddie bet against homeowners? ProPublica says yes. The blogosphere says no.

February 3, 2012

On Monday, ProPublica, an independent non-profit investigative journalism outfit, published an inflammatory story against Freddie Mac, the government sponsored enterprise that facilitates the secondary mortgage market.  (Freddie was taken over from shareholders and placed into conservatorship in 2008.  It is currently being overseen by an independent agency called the FHFA.)

The ProPublica piece charged that Freddie took out investments which allowed the agency to profit from its own risk management policies that can prevent homeowners from refinancing into lower interest rate loans.  The investment vehicle in question is called an ‘inverse floater’, an instrument whose coupon rate is inversely tied to an interest rate.

The article suffers from a set of deeply contradictory assumptions. The authors expect Freddie to create liquidity, while minimizing its own risk exposure.  But Freddie’s very purpose in these markets is to deal with the prepayment (refinancing) risk associated to changes in interest rate, so that, in the words of blogger Matt Levine, “the banks don’t have to”. As Yves Smith points out “the GSEs have always engaged in hedging strategies to manage their prepayment risk”.

The most puzzling part of the article, however, is not in the technical argument which was rehashed in detail on several financial blogs, but rather the article’s prominent feature of the following quote: “We were actually shocked they did this,” says Scott Simon, who as the head of the giant bond fund PIMCO’s mortgage-backed securities team is one of the world’s biggest mortgage bond traders. “It seemed so out of line with their mission.””

Someone at the world’s largest bond investment company is expression shock (a moral sentiment of outrage) at another company’s investment strategy? Really? (Yves Smith wonders whether PIMCO has shorted the high yield coupon bonds that stand to loose the most if there is a wave of refinancing).

Freddie Mac has a difficult mission because it suffers, by definition, from a conflict of interest. It is supposed to make loans available to American consumers while at the same time maximizing return for its owners – at the moment, American taxpayers.  Seeking for fraud and corruption in how Freddie operates overlooks basic tensions in how the government and private capital have been draw together to funnel money into U.S. homeownership.  These deeply rooted tensions are part of how the system – for better or for worse – functions, and not, as journalists, politicians and pundits perpetually try to show, evidence that it is somehow working incorrectly.

The original ProPublica story is here.

A weak defence of the story by Felix Salmon on Reuters, here.

A detailed reply by Yves Smith of Naked Capitalism, here.

Further reply by Michael Olenick on Naked Capitalism, here.

Reply by Matt Levine at Dealbreaker, here.

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