oversight

FHFA's Oversight of Freddie Mac's Investment in Inverse Floaters

Published by the Federal Housing Finance Agency, Office of Inspector General on 2012-09-26.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

           FEDERAL HOUSING FINANCE AGENCY
             OFFICE OF INSPECTOR GENERAL

           FEDERAL HOUSING FINANCE AGENCY
             OFFICE OF INSPECTOR GENERAL

        FHFA’s Oversight of Freddie Mac’s Investment in
                       Inverse Floaters




Evaluation Report: EVL-2012-009          DATED: September 26, 2012


EVALUATION REPORT: EVAL-2012-XX             DATED: Month XX, 2012
                                                    AT A GLANCE
                                            title
               FHFA’s Oversight of Freddie Mac’s Investment in Inverse Floaters

Why FHFA-OIG Did This Evaluation                                       What FHFA-OIG Found
                                                                    title
                                                                    title
                                                                       FHFA-OIG uncovered no evidence that FHFA or Freddie Mac
The Federal National Mortgage Association (Fannie Mae)
and the Federal Home Loan Mortgage Corporation (Freddie                obstructed homeowners’ abilities to refinance their mortgages in
Mac) (collectively, the Enterprises) manage investment,                an effort to influence the yields of the inverse floating-rate bonds
funding, and hedging portfolios valued at more than                    that the Enterprise retained in its investment portfolio.
$1.4 trillion. These capital markets businesses encompass a            Inverse floaters represent a small portion of Freddie Mac’s capital
diverse range of sophisticated financial products. Although            markets portfolio. To the extent that a tension exists between
generally profitable, certain sectors of the Enterprises’              Freddie Mac’s refinancing and investment policies, inverse
capital markets businesses have lost tens of billions of dollars       floaters are no more likely to adversely impact mortgage holders
since the Enterprises entered into conservatorships overseen           or discourage borrower refinancing than any of the mortgages or
by the Federal Housing Finance Agency (FHFA or Agency)                 other assets that Freddie Mac holds for investment.
in September 2008. For this reason, the FHFA Office of                 Further, Freddie Mac has an “information wall” policy to prevent
Inspector General (FHFA-OIG) initiated a series of                     its capital markets business from using non-public information to
evaluations relating to FHFA’s supervision of the                      guide its investments. The information wall applies to non-public
Enterprises’ capital markets businesses.                               information about homeowner refinancing. In interviews with
Among other capital markets activities, Freddie Mac                    FHFA and Freddie Mac employees, FHFA-OIG found no
structures and markets a family of bonds known as                      evidence that individuals at Freddie Mac have violated the
collateralized mortgage obligations (CMOs). Freddie Mac                information wall.
may tailor these products to the specific interests of investors.      FHFA began a process of reviewing Freddie Mac’s CMO business
According to FHFA and Freddie Mac, as investor appetite                in the spring of 2011, identified critical concerns, and issued
for floating-rate bonds increased in the spring of 2010,               findings in April 2012. FHFA-OIG found that FHFA’s position
Freddie Mac capitalized on the opportunity to charge a                 on inverse floaters could have been communicated more clearly.
premium for structuring these bonds by carving them out                Its public statements were ambiguous regarding when and how
of its securitized mortgages. In the process, it retained              Freddie Mac stopped engaging in inverse floater transactions.
by-product variable rate bonds known as inverse floaters.              Furthermore, to the extent FHFA communicated a recommendation
                                                                       or attempted to reach or confirm an agreement with Freddie Mac
In late January 2012, these inverse floaters became the                specifically focused on inverse floaters, that communication or
subject of significant attention. It was asserted that, because        agreement could have been more clearly articulated.
the value of inverse floaters decreases when the underlying
mortgages are refinanced, Freddie Mac could deliberately               What FHFA-OIG Recommends
limit loan refinancings in order to protect the value of its           FHFA-OIG recommends that FHFA: (1) conduct periodic tests
inverse floaters.                                                      of Freddie Mac’s information wall; (2) monitor Freddie Mac’s
                                                                       hedges and models to ensure Freddie Mac remains oriented in
On January 31, 2012, Senator Robert Menendez requested
                                                                       a net flat position; (3) ensure supervisory polices are well-founded,
that FHFA-OIG examine Freddie Mac’s use of inverse of
                                                                       coordinated, and communicated in writing; and (4) exercise care
floaters.
                                                                       to ensure public statements include all relevant facts.



Evaluation Report: EVL-2012-009                                                                      Dated: September 26, 2012
TABLE OF CONTENTS
TABLE OF CONTENTS ................................................................................................................ 3
ABBREVIATIONS ........................................................................................................................ 5
PREFACE ....................................................................................................................................... 6
BACKGROUND ............................................................................................................................ 7
      About Inverse Floaters ............................................................................................................. 7
             Mortgage Securitization: The Core of the Enterprises’ Businesses ................................ 7
             Mortgage Investments Come with Risk ........................................................................... 9
             CMOs Provide Investors the Opportunity to Manage Risk: Floaters and
             Inverse Floaters, Two Sides of the Same CMO Coin .................................................... 11
             Freddie Mac’s Rationale for Structuring and Selling Floaters and Inverse
             Floaters ........................................................................................................................... 13
             Fundamentals of Inverse Floaters Are Not Substantially Different from
             Mortgages ....................................................................................................................... 15
                    Interest and Prepayment Risk Hedging ................................................................... 16
                    Interest Rate and Prepayment Risk Are Hedged to Net Flat ................................... 17
      Freddie Mac’s Information Wall ........................................................................................... 18
      FHFA’s Role in Freddie Mac’s Inverse Floater Business ..................................................... 20
             Freddie Mac’s Structuring of Inverse Floaters Ended Because of Market
             Conditions....................................................................................................................... 20
             FHFA’s Review of Freddie Mac’s CMO Business Begins in April 2011 ..................... 21
             FHFA’s Communications with Freddie Mac Regarding CMOs .................................... 21
             FHFA Confirms a Specific Agreement with Freddie Mac Regarding Inverse
             Floaters ........................................................................................................................... 23
             FHFA Concludes Its Review of Freddie Mac’s CMO Business in April 2012 ............. 24
FINDINGS .................................................................................................................................... 25
RECOMMENDATIONS .............................................................................................................. 26
OBJECTIVE, SCOPE, AND METHODOLOGY ........................................................................ 27
APPENDIX A: FHFA’S COMMENTS ON FINDINGS AND
RECOMMENDATIONS .............................................................................................................. 28
          Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                                        3
APPENDIX B: FHFA-OIG’S RESPONSE TO FHFA’S COMMENTS .................................... 32
ADDITIONAL INFORMATION AND COPIES ........................................................................ 33




       Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                     4
ABBREVIATIONS
Capital Markets Division .................................................. Investments & Capital Markets Division
CFO .............................................................................................................. Chief Financial Officer
CMO ........................................................................................ Collateralized Mortgage Obligation
Enterprises.......................................................................................... Fannie Mae and Freddie Mac
Fannie Mae......................................................................... Federal National Mortgage Association
FHFA or Agency.......................................................................... Federal Housing Finance Agency
FHFA-OIG ...................................... Federal Housing Finance Agency Office of Inspector General
Freddie Mac .................................................................. Federal Home Loan Mortgage Corporation
HARP .................................................................................... Home Affordable Refinance Program
MBS ....................................................................................................... Mortgage-Backed Security
PLMBS ............................................................................ Private Label Mortgage-Backed Security
SEC ....................................................................................... Securities and Exchange Commission




         Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                                    5
                                  Federal Housing Finance Agency
                                    Office of Inspector General
                                          Washington, DC



                                          PREFACE
FHFA-OIG was established by the Housing and Economic Recovery Act of 2008, which
amended the Inspector General Act of 1978. FHFA-OIG is authorized to conduct audits,
investigations, and other studies of the programs and operations of FHFA; to recommend
policies that promote economy and efficiency in the administration of such programs and
operations; and to prevent and detect fraud and abuse in them. This report assesses FHFA’s
oversight of Freddie Mac’s structuring and retention of inverse floaters, in the context of FHFA-
OIG’s commitment to prioritize projects related to FHFA’s conservatorships and oversight of
Fannie Mae and Freddie Mac.

This report was written principally by Investigative Counsel Charlie Divine and David P. Bloch,
Director, Division of Mortgage, Investments, and Risk Analysis. Investigative Counsel
Christopher Poor and Senior Policy Advisor Timothy Lee also contributed to the report. FHFA-
OIG appreciates the assistance of FHFA and Enterprise staff in completing this report. It has
been distributed to Congress, the Office of Management and Budget, and others and will be
posted on FHFA-OIG’s website, www.fhfaoig.gov.




George Grob
Deputy Inspector General for Evaluations




       Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                     6
BACKGROUND
Fannie Mae’s and Freddie Mac’s combined capital markets businesses, which include their
funding, hedging, and investment activities, manage more than $1.4 trillion of assets. Their
capital markets portfolios share certain characteristics with a hedge fund and, like a hedge fund,
they can sustain significant financial losses. Accordingly, although the Enterprises’ capital
markets businesses have generally been profitable, certain elements have incurred tens of billions
of dollars in losses since the Enterprises entered into conservatorships overseen by FHFA in
September 2008. Thus, FHFA-OIG launched an evaluation of the Enterprises’ capital markets
businesses in November 2011.

On January 31, 2012, Senator Robert Menendez requested that FHFA-OIG examine Freddie
Mac’s use of a financial instrument known as an “inverse floater.” An inverse floater is one of
many financial products in Freddie Mac’s capital markets portfolio. Interest in inverse floaters
has grown since January, with media articles, congressional inquiries, and interviews and
congressional testimony from the FHFA Acting Director.1 Despite the persistent attention
focused on Freddie Mac’s inverse floaters, the role of the investment in the Enterprise’s portfolio
has not been discussed at length. This report is intended—in the context of FHFA-OIG’s
ongoing work in evaluating the Enterprises’ capital markets businesses—to explain inverse
floaters, provide clarity regarding their use, and evaluate FHFA’s role with regard to them.

About Inverse Floaters

Mortgage Securitization: The Core of the Enterprises’ Businesses

Freddie Mac is a government-sponsored enterprise that provides liquidity to the mortgage
finance system. Through its Single-Family Credit Guarantee Business, Freddie Mac stands
ready to purchase home mortgage loans in bulk, providing mortgage lenders a reliable
mechanism to obtain the funds needed for further lending. Freddie Mac can hold the mortgages
it buys in its portfolio or, more commonly, package them into securities that are sold to investors.
The proceeds of such sales, in turn, fund additional purchases of loans on the secondary market.

Freddie Mac, through its Investments & Capital Markets Division (Capital Markets Division),
invests in mortgage-related securities guaranteed by Freddie Mac and other financial institutions.
Freddie Mac’s inverse floater investments are among the mortgage-related securities in which
the Capital Markets Division invests. As discussed in greater detail below, inverse floaters, like


1
 The FHFA Acting Director testified on February 28, 2012, before the Senate Committee on Banking, Housing and
Urban Affairs.


       Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                      7
a number of the mortgage-related investments held by the Capital Markets Division, benefit from
a low interest rate environment with limited prepayments. This characteristic of certain
investments creates a potential tension between the Single-Family Credit Guarantee Business
and the Capital Markets Division, as FHFA-OIG has previously discussed.2

Mortgages can be securitized in various forms, the most basic
                                                                          Trustee
of which is a pass-through securitization, also known as a
                                                                          The Trustee is an entity that
mortgage-backed security (MBS). As illustrated below, in a                serves as the custodian of funds
pass-through security, homeowners’ payments of principal                  from homeowners and is the
and interest pass through the trustee to the securitization               official representative of MBS
                                                                          bond holders.
investors, also called bond holders. In a standard MBS,
homeowners’ payments of principal and interest are allocated
to bond holders on a pro rata basis.




Mortgages can also be securitized in more sophisticated
instruments known as CMOs. CMO investors are divided                      Tranches
                                                                          Tranches divide a securitization
into different classes or tranches, with distinctive rights to            into distinct classes. Each class
certain portions of the payments on the underlying mortgage               has its own payment structure
loans. For example, in a simple CMO structure, like the one               and rights to the underlying
in the following illustration, the first tranche receives                 investment pool. A single CMO
                                                                          can have more than a dozen
payments before the second tranche and payments flow like a
                                                                          tranches.
waterfall through to the last tranche.




2
 See FHFA-OIG, FHFA-OIG’s Current Assessment of FHFA’s Conservatorships of Fannie Mae and Freddie Mac,
at pp. 28-30 (March 2012) (WPR-2012-001) (online at http://www.fhfaoig.gov/Content/Files/WPR-2012-001.pdf).


       Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                     8
Tranches can also be used to allocate specific payments from homeowners. For example, in an
often used CMO structure, certain investors receive only interest payments by homeowners
while other investors receive payments derived solely from payments of principal. As discussed
below, inverse floaters can constitute one or more tranches in a CMO.

Mortgage Investments Come with Risk

Mortgage investments, including inverse floaters, carry numerous risks; the most prominent of
these risks are credit risk, interest rate risk, and prepayment risk.

Credit risk is the risk of financial loss to investors stemming from borrowers failing to make
scheduled mortgage payments in full and on time. The Enterprises accept credit risk as part of
their mission and business model. A significant portion of the Enterprises’ businesses centers on
indemnifying mortgage loan owners and MBS investors against credit risk in return for a
guarantee fee. As a result, the Enterprises bear the risk that homeowners will default on their
mortgages. Ultimately, a mortgage holder’s default may lead Fannie Mae or Freddie Mac to
foreclose and sell the property. If the property is sold for less than the outstanding mortgage
principal, the Enterprise incurs the loss. For example, if Freddie Mac guarantees a $100
mortgage, the homeowner defaults, and Freddie Mac has to foreclose, then Freddie Mac risks not
recovering the full $100 pursuant to its guarantee. Thus, if Freddie Mac sells the foreclosed
home for $90, Freddie Mac will suffer a $10 or 10% loss.3




3
 Under the specific terms of the applicable guarantee, Freddie Mac may also be responsible for accrued interest
payments, thus potentially increasing the Enterprise’s loss.


        Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                         9
Interest rate risk is the risk of               $103
financial loss to investors stemming            $102
from movements of interest rates                $101




                                            Market Value
over time. As an illustration,
                                                $100
consider a $100 bond at a 5% fixed
                                                 $99
interest rate with a single interest
                                                 $98
payment due in one year. An
investor who buys the bond today                 $97
for $100 can expect to receive $105              $96
at the end of the year—$100 in                               3%              5%          7%
principal and $5 in interest. If                                        Interest Rate
prevailing interest rates drop to 3%, then a second investor who purchases a similar bond on the
same terms, except at the current interest rate, would expect to receive $103 at the end of the
year—$100 in principal and $3 in interest. The original investor, who holds a 5% asset at a time
when investors will accept a 3% annual return on a comparable bond, can expect to sell the bond
for an amount greater than the original $100 purchase price. The original investor can expect
other investors will be prepared to buy the 5% bond for $101.94 because at that price the
purchaser will still receive a 3% (i.e., $3.06) net return on the investment. The 3% return is the
same return the purchaser could have obtained by buying a newly issued $100 bond at the
current interest rate of 3%.

The converse is also true. If rates were instead to rise to 7%, the original investor would possess
a 5% asset at a time when investors expect a 7% annual return. Accordingly, the price of the
bond would fall below its $100 face value, to $98.13, in order to compensate any prospective
purchaser and provide a competitive return.

Investors who purchase mortgages similarly face interest rate risk. A mortgage investment is
similar to a bond investment in that the investor expects to receive principal and interest for the
life of the mortgage. In the United States, most mortgages are issued at a fixed-rate of interest
(for example, 5% per year) that is charged for the life of the loan. The interest rate risk thus
continues throughout the life of the mortgage. Hence, domestic home mortgages, which are
conventionally originated for terms of 30 years, can experience sharp swings in value as interest
rates fluctuate over that long period.

For the purposes of this discussion, it is essential to note that even if full and timely principal and
interest payments are guaranteed—as they are with Enterprise-guaranteed MBS—significant risk
of financial loss to investors still exists due to interest rate risk. To limit interest rate risk,
investors can purchase, from a variety of sources, bonds that pay a floating interest rate that
resets at regular intervals to match the current interest rate. Floating-rate bonds minimize
interest rate risk.

       Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                           10
Prepayment risk is the risk of financial loss to investors stemming from mortgage prepayments
and is related to interest rate risk. Domestic mortgage loans typically provide borrowers the right
to terminate their obligations at any time by repaying in full the outstanding principal balance of
their mortgages. When interest rates fall, homeowners may take the opportunity to refinance
existing high interest rate mortgages. For example, if a homeowner holds a $100 mortgage with
a 5% interest rate, assuming the option is available, the homeowner will likely seek to refinance
if interest rates fall to 3%. In a falling interest rate environment, prepayment rates may increase
and result in mortgage investors forfeiting a significant portion of the gains they would otherwise
expect from holding above-market rate mortgage loans. For example, if the homeowner
refinances his or her 5% interest rate mortgage loan and returns the investor’s $100 in principal,
but the prevailing interest rates have dropped to 3%, then the investor (i.e., the owner of the paid-
off mortgage loan) will likely earn only a 3% return if he or she chooses to reinvest the $100 in
new mortgage loans. The net result is the investor loses the opportunity to earn an additional 2%
with each interest payment. Accordingly, investors in mortgage loans inherently stand to lose
less in a low interest rate environment with low prepayment rates.

CMOs Provide Investors the Opportunity to Manage Risk: Floaters and Inverse Floaters, Two
Sides of the Same CMO Coin

CMOs provide investors the opportunity to invest in mortgage-related assets and manage the
degree of interest rate and prepayment risk to which they are exposed. CMOs, therefore, allow
the Enterprises to sell MBS to a wider range of investors by offering a “menu” of alternatives
tailored to their investment strategy preferences.

Floating-rate bonds are one category of products popular
                                                                         Floating-Rate Bonds
with many investors. They prefer floating-rate investments
                                                                         Floating-rate bonds pay a variable
because their value is less vulnerable to interest rate                  interest rate that fluctuates with
fluctuations than fixed-rate investments. As illustrated                 the market. Over time, as interest
below, Freddie Mac can create a tranche of a CMO with                    rates change as measured by
floating-rate bonds by splitting the pooled homeowners’                  an index such as LIBOR, the
                                                                         interest rate paid by the floating-
mortgage payments. Floating-rate bonds are created by                    rate bond also changes.
assigning investors a portion of the pooled homeowners’
                                                                         LIBOR
mortgage payments corresponding to the prevailing interest               LIBOR is the London Interbank
rate. Inverse floaters are essentially the rights to the                 Offered Rate, which is the interest
remainder of the homeowners’ mortgage payments after                     rate banks charge each other for
payments due to the floating-rate bonds are subtracted (i.e.,            short-term loans. LIBOR is
                                                                         frequently used as the base for
should interest rates fall, the difference between the currently
                                                                         resetting rates on floating-rate
prevailing interest rate and the higher rate at which the                securities.
underlying mortgage pool was originated is allocated to the
inverse floater investors).

       Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                    11
The inverse floater, then, is a by-product or residual of Freddie Mac’s structuring and selling
floating-rate CMO products. Since the commencement of the conservatorship, Freddie Mac has
generally retained the residual inverse floaters.

The example discussed here and in the table below provides an illustration of the connection
between floating and inverse floating-rate bonds. For this example, assume there are ten $100
fixed-rate mortgages with a combined outstanding balance of $1,000 and an aggregate 5%
interest rate. Setting aside credit and other risks, these ten mortgages will pay 5% in interest per
year or $50. Freddie Mac could structure the ten mortgages in a manner that reflects fluctuations
in market interest rates by creating a simple CMO in which the combined pool is split into two
tranches of $500 each: one $500 tranche structured as floating-rate bonds and the other as
inverse floating-rate bonds. If market interest rates do not fluctuate and remain at 5% through
the life of the CMO, floating and inverse floating-rate investors would each receive an equal and
proportionate share of interest payments (in this case, $25 each).

However, market interest rates generally do not remain static but, instead, will fluctuate above
and below the 5% interest rate over the life of the bonds. Regardless of the change in market
interest rates, the interest payments from homeowners remain constant because they have fixed-
rate mortgages. Assuming each homeowner pays what he or she owes, the total amount of
interest payments remitted to the CMO is approximately $50 annually (5% of $1,000).4 But,
how the annual payment of $50 is allocated to investors of the floating-rate and inverse floating-
rate bonds depends on the prevailing interest rate. As shown in the table below, if prevailing
interest rates rise above 5% to 7%, then the floating-rate bond investors receive an amount
4
  Over the years, as the homeowners pay down the mortgage principal, interest payments would decrease. For
simplicity, however, assume in this example that the aggregate interest payments remain at $50.


        Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                      12
greater than their $25 proportionate share (i.e., $35) and the inverse floating-rate investors
receive less than $25 (i.e., $15). On the other hand, if interest rates fall to 3%, then the floating-
rate bond investors receive only $15, a loss of $10. At the same time the inverse floating-rate
bond investors gain 2% or $10. In other words, an inverse floater investor makes more money if
interest rates fall and loses money if interest rates rise.


                             Aggregate Return on $500                Aggregate Return on $500
       Interest Rate           Floating-Rate Bonds                  Inverse Floating-Rate Bonds
            5%                 $25              5%                     $25               5%
            3%                 $15              3%                     $35               7%
            7%                 $35              7%                     $15               3%


The foregoing is merely for illustration; the structure of CMOs involving floating-rate and
inverse floating-rate bond pairs can vary in any number of ways. For example, the CMO
structure often includes a leverage element, which results in any change in interest rates
potentially having a far more dramatic impact on the return of the inverse floating-rate bonds.

Freddie Mac’s Rationale for Structuring and Selling Floaters and Inverse Floaters

Freddie Mac has been in the business of structuring CMOs for decades, and inverse floaters have
been a part of that business since at least 1994. According to Freddie Mac, its CMO process
typically starts with what are known as “reverse inquiries.” In a reverse inquiry, a dealer, usually
an investment banker representing a customer, reaches out to Freddie Mac to ascertain its
willingness to structure a deal to specifications sought by the customer. According to executives
currently with Freddie Mac, the inverse floaters created after the Enterprise entered
conservatorship arose in response to reverse inquiries for floating-rate securities, and were a by-
product of transactions resulting from those inquiries.

Consistent with the reality of fluctuating investor demand, the following chart shows that inverse
floater activity has varied over time.




       Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                    13
         Total Number of Inverse Floater Deals Either Structured and Retained or Purchased by
                                    Freddie Mac (1995 – Present)5

                                   30
                                                                                            September 2008
                                   25
    No. of Inverse Floater Deals




                                   20

                                   15

                                   10

                                    5

                                    0




As of December 31, 2011, Freddie Mac’s retained investment portfolio had a balance of $653
billion, of which inverse floaters represented less than $5 billion, which is less than 1%.6

According to interviews with both FHFA and Freddie Mac executives, Freddie Mac’s decision to
issue or invest in CMO securities is principally driven by market dynamics and investor appetite.
Investors who prefer high-quality, stable-value floating-rate CMOs are at times willing to pay
Freddie Mac relatively higher prices for such assets. Depending on market conditions, dividing
an MBS into a floating-rate and inverse floater CMO pair can be more profitable for Freddie
Mac when investors are willing to pay a premium for floating-rate bonds. Both FHFA and
Freddie Mac employees suggested that such a premium was available starting in the spring of
2010 through the spring of 2011.

According to Freddie Mac executives, Enterprise traders’ standard practice for evaluating inverse
floater deals starts with analyzing the proposed structure with internal models. The Enterprise
executes a deal only if: (1) the floating-rate bonds provide Freddie Mac a premium; and (2)
Freddie Mac is comfortable holding the inverse floating-rate bonds. Freddie Mac is comfortable
if, after subtracting the price of the floating-rate CMO from that of the underlying portfolio of
5
  Data provided by Freddie Mac. According to the data provided, Freddie Mac retained more than 92% of all
inverse floater deals that it structured.
6
    The less than $5 billion in inverse floaters were structured from approximately $30 billion in underlying collateral.


                                   Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                                                14
mortgage assets, Freddie Mac is left with an inverse floater
                                                                   Liquid assets are cash and other
at a more favorable price than would be otherwise
                                                                   assets that can be converted
possible. In essence, such a “relative value strategy,” if         easily into cash.
properly executed, permits Freddie Mac to improve the
return on its mortgage investments. It is critical, however, that Freddie Mac is comfortable with
holding the inverse floaters because they are difficult to sell and accordingly are considered less
liquid.

Another potential benefit of Freddie Mac’s structuring inverse floating-rate bonds and selling the
matching floating-rate bonds is the reduction of mortgage assets on its balance sheet. For
example, if Freddie Mac packages ten $100 mortgages in a CMO with a $500 floating-rate
tranche and a $500 inverse floating-rate tranche, and then sells the floating-rate tranche, Freddie
Mac has reduced the mortgage assets on its balance sheet by $500. Such a reduction in the size
of Freddie Mac’s balance sheet is consistent with Section 5.7 of Freddie Mac’s Amended and
Restated Senior Preferred Stock Purchase Agreement with Treasury, which requires Freddie Mac
to reduce the aggregate amount of its mortgage assets each year.7

Fundamentals of Inverse Floaters Are Not Substantially Different from Mortgages

Creating and holding inverse floaters does not substantially change Freddie Mac’s position in
the market because inverse floaters derive their economics from the underlying mortgage
investments. In effect, by holding inverse floaters, Freddie Mac retains the risks of its
fundamental business—particularly, interest rate and prepayment risk—albeit in a smaller, more
concentrated form. The risk is not transformed or magnified relative to the risk already
associated with the loans structured in the inverse floater. In other words, Freddie Mac’s
structuring does not change the total amount of risk. In certain instances, Freddie Mac’s
structuring and subsequent retention of inverse floaters may result in Freddie Mac retaining
nearly all of the risk associated with the underlying mortgages, but the structuring itself does not
magnify that risk.



7
  FHFA-OIG interviewed a number of Freddie Mac and FHFA employees to understand Freddie Mac’s rationale for
creating inverse floating-rate bonds. According to the majority of those interviewed, a reduction in mortgage assets
was not Freddie Mac’s motivation in creating inverse floaters. Nevertheless, Freddie Mac’s most recent annual
filing with the Securities and Exchange Commission notes that a reduction in mortgage assets is a justification for
creating inverse floating-rate securities: “We create inverse floating-rate securities ... and sell tranches that are in
demand by investors to reduce our asset balance, while conserving value for the taxpayer.” Read in isolation,
Freddie Mac’s statement is not consistent with certain information the Enterprise and FHFA provided to FHFA-
OIG. Nevertheless, no matter the intention, the aggregate value of mortgage assets held by Freddie Mac is reduced.
However, Freddie Mac’s use of leverage in creating inverse floating-rate bonds may diminish the benefits of
reducing mortgage assets because the use of leverage may concentrate a disproportionate amount of the underlying
collateral’s interest and prepayment risk in the portion retained by Freddie Mac.


        Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                          15
Indeed, holding inverse floaters is, in many aspects, fundamentally no different than holding any
number of other assets that Freddie Mac and Fannie Mae retain. The Enterprises own a number
of assets in their portfolios, including:

          Unsecuritized mortgages
          CMO instruments (e.g., inverse floaters, floating-rate securities, interest-only
           securities)
          Agency MBS
          Private label mortgage-backed securities (PLMBS)
          Commercial MBS
          Hedging instruments such as options, interest rate swaps, swaptions, foreign-currency
           swaps, and credit derivatives.

Many of those assets (e.g., mortgages, PLMBS, Agency MBS, and CMO instruments), like
inverse floaters, are potentially premium assets. In the mortgage context, a premium asset is a
mortgage-backed product with an interest rate greater than an investor could obtain on the
market. If market interest rates rise above the interest rate on a mortgage-backed asset, the asset
loses value and is no longer considered a premium asset. For example, at a time when the
prevailing interest rate is 3%, Freddie Mac may hold billions of dollars of assets that pay an
interest rate greater than 5%. Those assets are considered premium. If at some point the
prevailing interest rate increases to 6%, those same assets will no longer be considered premium.

Freddie Mac purchases and retains potentially premium assets as part of its hedging, funding,
securitization, and guarantee business. As a result, contrary to the notion that inverse floaters are
unique in that they give rise to tensions between policies aimed at homeowner refinancing and
Freddie Mac’s CMOs, that tension is inherent throughout the Enterprises’ various business lines.

Hedging Offsets Significant Gains in Inverse Floaters

Freddie Mac manages interest rate and prepayment risk in its retained portfolio investments,
including inverse floaters, by hedging. Hedging occurs when an investment is made to offset the
risk of adverse price movements in an asset. In most instances, the “hedge” consists of taking an
offsetting or counter position in a related security.

       Interest and Prepayment Risk Hedging
Both Enterprises use hedging strategies in an effort to reduce or eliminate the prospect of interest
rate and prepayment risk driven price volatility in their portfolios, which include inverse floaters.



       Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                    16
Hedging Interest Rate Risk. As discussed above, the value
                                                                     Interest Rate Swaps
of the Enterprises’ portfolio of mortgage-related investments        Interest rate swaps are a form of
will tend to fall as interest rates rise and to rise as interest     derivative in which two counter-
rates fall. Thus, as part of their risk management strategy, the     parties agree to exchange interest
Enterprises will invest in financial products, such as interest      payments on a predetermined
                                                                     amount of principal for an
rate swaps, that tend to offset the change in value as interest      agreed-upon period. One
rates fluctuate. By contracting to receive floating or fixed-        counterparty pays the other
rate payments on a set amount, the Enterprises can effectively       counterparty a floating-rate of
offset interest rate-driven changes in the value of their core       interest, typically based on an
                                                                     index such as LIBOR. In return,
mortgage holdings. For example, if Freddie Mac’s portfolio
                                                                     the other pays a fixed-rate of
is situated such that an increase in interest rates from 5% to       interest for the life of the swap.
7% would yield a $100 loss, Freddie Mac can invest in
interest rate swaps that would return a $100 profit from the same increase in interest rates, thus
leaving Freddie Mac in a neutral position with respect to interest rates, minus the cost of the
hedge. It is important to note that because the future direction of interest rates is unpredictable,
Freddie Mac reduces interest rate risk by taking offsetting positions in both directions.

Hedging Prepayment Risk. The value of the Enterprises’
                                                                     Swaptions
portfolio of mortgage-related investments is also sensitive to       A swaption is an option to enter
unexpected changes in prepayments. As mortgage rates fall,           into an interest rate swap.
homeowners refinance mortgages more aggressively, and the
Enterprises may lose the premium on their investments. Conversely, if—as mortgage rates
rise—homeowners refinance at an unexpectedly slow pace, then the Enterprises may lose the
opportunity to reinvest the proceeds at higher rates. In either case, the Enterprises can offset the
inherent risk of loss from borrower prepayment rights by purchasing options and swaptions. In
the same way that interest rate swaps provide Freddie Mac the opportunity to offset losses due to
changing interest rates, options and swaptions, if properly executed, could allow Freddie Mac to
offset losses due to unexpectedly fast or slow homeowner prepayments.

        Interest Rate and Prepayment Risk Are Hedged to Net Flat
The value of inverse floaters rises as interest rates decrease. However, as interest rates fall,
prepayment risk increases because homeowners will likely seek to refinance their mortgages.
Homeowner refinancing prematurely retires the mortgages underlying the inverse floaters thus
wiping out potentially high interest collections. Accordingly, viewed in isolation, with regard to
inverse floaters, Freddie Mac stands to benefit most from a low interest rate environment with
minimal prepayments.

However, according to executives at Freddie Mac and FHFA, the Enterprise attempts to hedge
interest rate and prepayment risk in its retained portfolio, including inverse floaters, to “net flat,”
meaning the portfolio consists of offsetting positive and negative positions. Freddie Mac hedges

       Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                    17
interest rate risk on a macro level, which means the Enterprise positions its portfolio as a whole
rather than hedges individual micro positions or individual trades. Put another way, according to
Freddie Mac, its interest rate hedges are designed to eliminate risk, not to generate profit. It is
important to note that if achieved, a perfect hedge, for example a position on an option,
completely offsets a position on the underlying asset. Thus, while perfect hedges work to
eliminate risk, they simultaneously eliminate the potential for a benefit from changes in the
market. In the context of inverse floaters, although Freddie Mac may on one hand benefit from a
trend of low interest rates and reduced prepayments by homeowners, on the other hand, Freddie
Mac’s other investments may equally suffer from such a trend. Thus, the end result, if perfectly
hedged on interest rates, is that Freddie Mac’s overall position will remain the same regardless of
prepayments.

Implementing a perfect hedge of a portfolio as large and diversified as Freddie Mac’s is difficult.
Freddie Mac’s Capital Markets Division utilizes internal financial models to ascertain its position
at the end of each day and to implement correcting hedges. Freddie Mac has set limits on how
far from a net flat position it can be on any given day. Freddie Mac tracks and compares the
performance of its hedging strategy to those self-imposed limits, then reports its performance on
an aggregate monthly basis in publicly available Securities and Exchange Commission (SEC)
filings.8 FHFA-OIG reviewed the aggregate monthly data reported by Freddie Mac and
confirmed that the Enterprise reported that it operated within its limits each month since at least
March 2009. Still, although it operates within the limits it sets, Freddie Mac will typically be
positioned such that, even after hedging, an increase in prevailing interest rates will be
detrimental to some degree to the total value of its portfolio.

Inherent in any macro hedging strategy, specifically Freddie Mac’s, is the risk that the models
used to ascertain the current position and the required hedge are flawed. Freddie Mac’s self-
imposed limits are similarly based on Freddie Mac’s own models and assumptions and utilize
Freddie Mac’s own internal data. FHFA-OIG did not independently analyze Freddie Mac’s
models or assumptions or verify Freddie Mac’s self-reported data in SEC filings.

Freddie Mac’s Information Wall

On an institutional level, potential exists for a conflict of interest between Freddie Mac’s Single-
Family Credit Guarantee Business, which purchases and securitizes residential mortgages, and
its Capital Markets Division, which trades CMO structured products. That potential exists
because the Single-Family Credit Guarantee Business has access to material non-public
information such as loan-level detail about borrowers seeking to refinance at lower interest rates.
In the absence of safeguards, the Capital Markets Division theoretically could misuse such data
8
    E.g., Freddie Mac, Form 8-K (April 25, 2012), incorporating by reference, Monthly Volume Summary.


          Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                        18
to its advantage and discourage or interfere with refinancing efforts. This issue is particularly
sensitive given that Freddie Mac is capable of impacting homeowner refinancing through
programs such as the Home Affordable Refinance Program (HARP), which provides certain
underwater homeowners the opportunity to refinance.9

To combat misuse of material non-public information, Freddie Mac has an “information wall”
policy. Freddie Mac’s information wall policy:

            Provides examples of various types of material                   In the context of Freddie Mac’s
             non-public information and a definition of who at                information wall, a restricted
             Freddie Mac is a restricted person;                              person is someone whose job
                                                                              responsibilities at Freddie Mac
            Specifies actions Freddie Mac employees must                     include purchasing and selling
             undertake to comply with the policy; and                         mortgage securities in the
                                                                              market.
            Defines the steps employees must take if they
             believe there is/has been a violation of the policy.

Based upon interviews with FHFA officials and Freddie Mac executives as well as a review of
Freddie Mac’s information wall policy, FHFA-OIG has found no evidence of collusion between
the Capital Markets Division and Single-Family Credit Guarantee Business that would: (1)
discourage borrowers from refinancing at lower interest rates; or (2) prevent or otherwise
obstruct a homeowner from seeking more favorable mortgage terms. Further, an FHFA official
from the Division of Examination Programs and Support who examines Freddie Mac’s Capital
Markets Division told FHFA-OIG that she is not aware of any breaches to Freddie Mac’s
information wall. However, FHFA acknowledged that it does not conduct any independent
testing because it implements a risk-based supervision policy, and it has not encountered any
indications that there is a high risk of any violation of Freddie Mac’s information wall policy.10




9
  This tension is illustrated by the value of conducting a prudent risk analysis of the impact of any new program
proposal on the Enterprise’s various businesses. According to documents reviewed by FHFA-OIG, Freddie Mac
analyzed the impact of changes to HARP on its retained investment portfolio. However, FHFA-OIG found no
documentation indicating that Freddie Mac planned to manipulate or obstruct HARP through the use of inverse
floaters. Further, FHFA issued a statement regarding inverse floaters on January 30, 2012, which notes: “Freddie
Mac’s retained portfolio investment in inverse floaters did not have any impact on the recent changes to [HARP]. In
evaluating changes to HARP, FHFA specifically directed both Enterprises not to consider changes in their own
investment income as part of the HARP evaluation process.”
10
  FHFA-OIG did not independently evaluate the efficacy of Freddie Mac’s information wall policy in connection
with this evaluation.


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FHFA’s Role in Freddie Mac’s Inverse Floater Business

FHFA and its predecessor, the Office of Federal Housing Enterprise Oversight, have known
about Freddie Mac’s inverse floater business for at least 10 years. However, FHFA does not
maintain a transactional role or manage the trading operations of Freddie Mac’s Capital Markets
Division. Further, although FHFA is aware of and monitors Freddie Mac’s CMO business, it
does not pre-approve Freddie Mac’s trades. FHFA also does not approve individual CMO
structured transactions, including those that involve inverse floaters.

Nevertheless, FHFA began a formal supervisory review of Freddie Mac’s CMO business,
including inverse floaters, in April 2011. Before FHFA completed its review of Freddie Mac’s
CMO business, on January 30, 2012, the media published stories drawing attention to Freddie
Mac’s retention of inverse floaters. After January 30, 2012, FHFA completed its review of
Freddie Mac’s CMO business and identified critical concerns. FHFA-OIG found FHFA’s
review robust, but it also found that FHFA’s communications lacked clarity: first to Freddie
Mac before January 30, 2012, and second, to the public on and after January 30, 2012.

Freddie Mac’s Structuring of Inverse Floaters Ended Because of Market Conditions

After the media reports regarding inverse floaters surfaced in late January and February 2012,
FHFA made a series of public statements that could have been interpreted to imply that Freddie
Mac abandoned its inverse floater business in the spring of 2011 as part of a risk management
strategy. For example, one FHFA statement indicated:

       [I]n spring 2011 Freddie Mac suspended its CMO structuring activities where it
       retained less liquid securities, like inverse floaters, until further notice. (FHFA
       Acting Director, Letter to Senator Mark Warner (May 21, 2012).)

According to Freddie Mac, however, investor appetite for floating-rate bonds evaporated by the
spring of 2011, without specific action by Freddie Mac. The demand for Freddie Mac-sponsored
floating-rate bonds increased in 2010 as investors sought protection from potentially fluctuating
interest rates. In order to meet market demand, Freddie Mac created floating-rate CMOs and
retained the corresponding illiquid inverse floaters. Demand for floating-rate bonds decreased in
the spring of 2011 after the Chairman of the Federal Reserve Board of Governors stated that a
stabilized low interest rate environment would continue for at least another year. Without
investor demand (i.e., without investors willing to pay a premium for floating-rate bonds), the
economics of creating floating and inverse-floating CMOs was no longer attractive to Freddie
Mac and no further deals were executed.

In other words, prior to January 2012, neither Freddie Mac nor FHFA made a decision to halt
Freddie Mac’s creation and investment in inverse floaters; the market for reciprocal floating rate

       Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                    20
bonds simply disappeared. Had the market reappeared and Freddie Mac found the economics
were again profitable, the Enterprise would have been free to structure floating-rate and inverse
floating-rate CMOs.

FHFA’s Review of Freddie Mac’s CMO Business Begins in April 2011

FHFA’s Market Risk Branch, Division of Examination Programs and Support, began an
examination of Freddie Mac’s CMO activity in April 2011, roughly around the same time that
Freddie Mac stopped structuring inverse floater deals. The timing of the examination and the
decline in inverse floater deals appears to be coincidental. According to FHFA executives and
documents provided to FHFA-OIG, the examination was initiated not because FHFA was
concerned that CMO structuring potentially placed Freddie Mac at odds with homeowners.
Instead, FHFA commenced the examination because it was concerned that: (1) Freddie Mac
lacked the requisite expertise in the CMO market after the departure of key personnel;
(2) Freddie Mac’s retention of illiquid CMO instruments like inverse floaters and interest-only
securities increased risk and complicated the process of winding down Freddie Mac’s retained
portfolio; and (3) Freddie Mac’s retained CMO products were highly leveraged. The Market
Risk Branch’s work continued throughout 2011 and into 2012 with the fieldwork coincidentally
culminating on the same day the media stories were released, January 30, 2012.

FHFA’s work with respect to Freddie Mac’s CMO business was not limited to the Market Risk
Branch. FHFA’s Office of the Chief Accountant also began work in the area in late November
2011, when the Chief Accountant sent Freddie Mac’s Chief Financial Officer (CFO) an email
inquiring about Freddie Mac’s business purpose for retaining interest-only securities and inverse
floaters. FHFA’s Chief Accountant and Freddie Mac’s CFO had related discussions through
December 14, 2011, when the CFO responded with a letter. Those discussions focused on CMO
structuring generally, not specifically on inverse floaters.

FHFA’s Communications with Freddie Mac Regarding CMOs

As FHFA’s Market Risk Branch began the final stages of its review of Freddie Mac’s CMO
business in December 2011, the Agency’s communications with Freddie Mac became
decentralized, with multiple individuals and departments engaging with various Freddie Mac
personnel. As a result, FHFA-OIG found an absence of a clear and consistent understanding
among Freddie Mac and FHFA personnel interviewed regarding FHFA’s position with respect to
Freddie Mac’s CMO business and inverse floaters.

For example, on December 15, 2011, teams from FHFA and Freddie Mac met to discuss the
preliminary results of a market risk governance examination. Neither the examination nor the
agenda for the meeting was in any way related to Freddie Mac’s CMO structuring business.
Nevertheless, a senior FHFA executive in attendance raised several concerns regarding Freddie

       Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                    21
Mac’s CMO business. According to the senior FHFA executive, he gave his views on a number
of CMO structuring topics, including hidden leverage in CMO products, floating-rate securities,
and interest-only securities. In interviews with FHFA-OIG, the senior FHFA executive
described his comments as an admonition to Freddie Mac to “knock-off” deals involving illiquid
CMO structures, which he believed included inverse floaters and interest-only securities.
However, Freddie Mac attendees of the December 15, 2011, meeting interviewed by FHFA-OIG
said that they did not believe that inverse floaters were prohibited, nor was there an explicit
instruction to cease illiquid CMO structuring.

FHFA did not send a written confirmation of the referenced admonition. Further, the substance
of the December 15 meeting was not widely shared within FHFA until after circulation of the
media reports about inverse floaters on January 30, 2012. Indeed, the senior official most
responsible for monitoring Freddie Mac’s CMO business did not learn of the substance of the
December 15 meeting until after public attention surged in late January 2012. In addition, none
of the FHFA and Freddie Mac individuals involved in previous discussions regarding CMO
structuring attended the December 15 meeting. Moreover, at the time of the meeting, FHFA’s
Market Risk Branch was still reviewing Freddie Mac’s CMO business, and FHFA’s management
had not yet formulated an opinion with respect to such business.

Compounding the confusion surrounding the message delivered by the senior FHFA executive at
the December 15 meeting, on December 16, 2011, Freddie Mac’s CFO asked FHFA’s Chief
Accountant if FHFA was directing Freddie Mac to stop CMO structuring. The Chief Accountant
responded no. As a result, as of December 16, FHFA had not formally directed Freddie Mac to
cease creating inverse floaters; Freddie Mac had not agreed to refrain from creating inverse
floaters or other illiquid CMO transactions; and there was apparent uncertainty at Freddie Mac
with respect to FHFA’s position on Freddie Mac’s CMO business.

On the other hand, despite the confusion and seemingly inconsistent messages, FHFA apparently
was successful in causing Freddie Mac to reconsider its CMO business prior to the January 30,
2012, media reports. On January 6, 2012, the head of Freddie Mac’s Capital Markets Division
sent an email to his staff instructing them to suspend structured sales of certain categories of
investment products such as inverse floaters. The head of Freddie Mac’s Capital Markets
Division then forwarded the email to the individual leading the Market Risk Branch’s
examination. In interviews with FHFA-OIG, the head of Freddie Mac’s Capital Markets
Division did not recall why he suspended Freddie Mac’s structuring of these products. Freddie
Mac’s CFO suggested to FHFA-OIG that the January 6 suspension was a result of several
factors, including his correspondence with FHFA’s Chief Accountant, the December 15 meeting,
and the general tenor of the Market Risk Branch’s review of Freddie Mac’s CMO business.




      Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                   22
FHFA Confirms a Specific Agreement with Freddie Mac Regarding Inverse Floaters

After media reports surfaced on January 30, 2012, FHFA took a step it described as not typical
and issued a press release on inverse floaters because, in its own words, “the circumstances ...
require[d] some clarification.” Regarding FHFA’s involvement in Freddie Mac’s inverse floater
business, the press release stated:

        FHFA supervision staff informed Freddie Mac in December [2011] of its
        preliminary examination findings and FHFA and Freddie Mac agreed that those
        transactions would not resume pending completion of the examination work.

FHFA’s statement legitimately highlights its proactive review of Freddie Mac’s CMO business.
However, a specific, well-articulated FHFA policy and agreement between FHFA and Freddie
Mac regarding inverse floaters was not in place in December 2011, as implied by FHFA’s press
release.

The same day that media stories were published (i.e., January 30, 2012), FHFA sought to
formalize an agreement with Freddie Mac regarding inverse floaters. Several FHFA senior
executives have confirmed that FHFA’s senior management met early in the afternoon of
January 30, to discuss the stories. The January 30 meeting was the first time FHFA’s senior
leadership met to discuss the Agency’s position with respect to inverse floaters. FHFA then
drafted its press release; a senior official with the Division of Enterprise Regulation called
Freddie Mac’s CFO to confirm that FHFA and Freddie Mac had reached an agreement regarding
inverse floaters; and the same senior official emailed Freddie Mac’s CFO a letter confirming the
agreement.11 Thus, a specific agreement with regard to inverse floaters was reached and
recorded on January 30, not December 2011 as implied by FHFA’s press release.

Although the statement FHFA released on January 30 notes that the agency reached an
agreement with Freddie Mac regarding inverse floaters in December 2011, FHFA-OIG did not
find evidence of such an agreement in December. The earliest record found is the January 6
email sent by the head of Freddie Mac’s Capital Markets Division that is discussed above.
Freddie Mac’s January 6 email may have been the product of a chain of events precipitated by
comments at the December 15 meeting, but those comments were neither the result of an
agreement between FHFA and Freddie Mac nor a formal FHFA policy. Further, a December
2011 agreement would have predated FHFA’s Market Risk Branch completing its fieldwork on
January 30, 2012. A December 2011 agreement would also predate the FHFA executives
responsible for supervising Freddie Mac’s CMO business settling on a course of action. The

11
  There is some debate regarding whether FHFA first confirmed the agreement with Freddie Mac or released the
January 30 statement that references an agreement with Freddie Mac.


        Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                      23
FHFA executive responsible for making that decision told FHFA-OIG that he did not settle on a
course of action until January 30. Yet, the record suggests that FHFA’s statements at the
December 15 meeting did convey to Freddie Mac, FHFA’s concerns about the CMO business.

FHFA Concludes Its Review of Freddie Mac’s CMO Business in April 2012

FHFA did not issue its formal findings regarding Freddie Mac’s CMO business until several
months after the initial publicity regarding inverse floaters. FHFA’s Market Risk Branch
completed its review of Freddie Mac’s CMO activity on April 2, 2012, and provided Freddie
Mac a letter detailing the Agency’s findings. Although the final letter does not address Freddie
Mac’s retention of inverse floating-rate bonds, it does discuss the CMO business in detail. The
letter concludes that Freddie Mac’s retained mortgage investment portfolio, including CMO
assets, represents a critical concern for three reasons:

       1. The need to clarify risk tolerances, corporate objectives, and goals associated
          with management of the retained mortgage portfolio, including CMO
          structuring;

       2. The need for improved risk management oversight of the large volume of
          illiquid assets and CMO structuring activities; and

       3. Significant key person dependencies within the Capital Markets Division.

FHFA also requested that Freddie Mac address several issues of concern, including: clarifying
goals and objectives associated with its CMO structuring activities; instructing Freddie Mac’s
Board of Directors to evaluate the CMO business and determine if CMO structuring is in the best
interests of the taxpayer or creates undue headline or reputational risk; and addressing staffing
concerns.

In summary, FHFA’s April 2, 2012, letter provided the analysis and findings that were
preempted by the events that started with the December 15 meeting and culminated with the
January 30 agreement.




       Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                    24
FINDINGS

     1. Inverse Floaters Likely Do Not Adversely Impact Mortgage Holders.
FHFA-OIG uncovered no evidence that Freddie Mac: (1) obstructed refinancing efforts of
homeowners to influence yields on inverse floating rate securities in its investment portfolio; or
(2) retained inverse floating rate securities to position itself to benefit from a decrease in interest
rates or in prepayments from homeowners.12 Further, contrary to the notion that inverse floaters
are unique in that they give rise to tensions between policies aimed at homeowner refinancing
and Freddie Mac’s retained investments, that tension is inherent in the Enterprise’s various
business lines.

Further, Freddie Mac endeavors to maintain a net flat interest rate risk position, meaning that
theoretically profits derived from inverse floaters are offset, in large part, by losses elsewhere in
the portfolio.

Finally, FHFA-OIG found no support for the contention that Freddie Mac’s Capital Markets
Division acted on non-public information regarding HARP or any other program in deciding to
retain inverse floating rate bonds. However, FHFA has not conducted any reviews or tests to
ensure that Freddie Mac’s Capital Markets Division traders are not violating or circumventing
Freddie Mac’s information wall policy.


     2. FHFA’s Position on Inverse Floaters Could Have Been Communicated
        More Clearly.
FHFA began a process of reviewing Freddie Mac’s CMO business in the spring of 2011,
identified critical concerns, and issued written findings in April 2012. To the extent FHFA
communicated a recommendation or attempted to confirm an agreement with Freddie Mac
specifically focused on inverse floaters prior to public attention surging, that communication or
confirmation could have been clearer and more consistent. Nevertheless, FHFA’s basic message
was received insofar as Freddie Mac itself took affirmative steps to halt structuring illiquid CMO
structures, which included inverse floaters, in early January 2012.

Regarding FHFA’s public statement, the Agency’s press release was not as clear as it could have
been concerning when and how Freddie Mac stopped engaging in inverse floater transactions.
For example, the press release emphasized FHFA’s review of Freddie Mac’s CMO business and


12
  Rather, according to Freddie Mac and FHFA, the Enterprise reacted to market requests for floating rate bonds and
retained the reciprocal illiquid investment where practical.


        Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                       25
noted that FHFA had reached an agreement with Freddie Mac regarding inverse floaters in
December 2011. This does not appear to be the case. It is clear that starting early in 2011 FHFA
engaged in ongoing discussions with Freddie Mac about limiting and managing certain CMO
assets. Further, as early as November 2011, discussions focusing on inverse floaters had
commenced. As noted above, those discussions ultimately led to Freddie Mac’s suspending a
portion of its CMO business related to inverse floaters in early January 2012. It is equally clear,
however, that this was not the result of a coordinated FHFA policy focused on inverse floaters
but instead was the outcome of a broader examination of Freddie Mac’s entire CMO business
and several informal communications. Ultimately, FHFA and Freddie Mac did not come to a
specific agreement regarding inverse floaters until after public attention surged in late January
2012, as opposed to December 2011 as implied by FHFA’s press release.




RECOMMENDATIONS
   1. FHFA should continue to monitor Freddie Mac’s hedges and models to ensure the
      Enterprise’s portfolio is hedged within its approved interest rate limits.

   2. FHFA should conduct periodic reviews and tests of Freddie Mac’s information wall to
      confirm that the Enterprise is not trading on non-public information.

   3. FHFA should ensure that supervisory policies are well-founded and coordinated and that
      the Agency speaks with one voice.

          If FHFA is going to take a position, or believes it has come to an agreement with
           Freddie Mac regarding a particular investment product, it should confirm its position
           or the agreement in writing as soon as practical. Written communication will avoid
           the confusion that occurred with respect to inverse floaters.
          FHFA should also ensure that supervisory policies are based on the robust work of
           Agency personnel and not reactions to media or other public scrutiny.

   4. Prior to issuing any public statement FHFA should exercise due diligence to ensure
      statements accurately reflect all relevant facts.




       Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                    26
OBJECTIVE, SCOPE, AND METHODOLOGY
The objective of this evaluation was to assess FHFA’s oversight of Freddie Mac’s structuring
and retention of inverse floaters. It does not address the broader tension that might exist between
homeowner refinancing policies, such as HARP, and Freddie Mac’s investment business.

To achieve its objectives, FHFA-OIG interviewed FHFA officials with knowledge of Freddie
Mac’s capital markets business, including those responsible for monitoring and examining the
business, as well as FHFA employees with relevant knowledge about FHFA’s public statements
regarding inverse floaters. FHFA-OIG also interviewed current Freddie Mac and Fannie Mae
employees with knowledge of the Enterprises’ CMO businesses. FHFA-OIG also reviewed
materials related to Freddie Mac’s capital markets business including, but not limited to, deal
documents, risk-monitoring documents, SEC filings, internal FHFA documents, and Freddie
Mac’s information wall policy. FHFA-OIG did not conduct an independent test of Freddie
Mac’s information wall. Finally, FHFA-OIG reviewed technical publications and securities
industry publications addressing, among other things, CMO structuring and the CMO market.

This evaluation was conducted under the authority of the Inspector General Act and is in
accordance with the Quality Standards for Inspection and Evaluation (January 2012), which was
promulgated by the Council of the Inspectors General on Integrity and Efficiency. These
standards require FHFA-OIG to plan and perform an evaluation that obtains evidence sufficient
to provide reasonable bases to support the findings and recommendations made herein. FHFA-
OIG believes that the findings and recommendations discussed in this report meet these
standards.

The performance period for this evaluation was from February 2012 to September 2012.




       Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                    27
APPENDIX A: FHFA’S COMMENTS ON
FINDINGS AND RECOMMENDATIONS




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                                               28
Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
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Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
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Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                             31
APPENDIX B: FHFA-OIG’S RESPONSE TO
FHFA’S COMMENTS
FHFA-OIG appreciates FHFA’s comments and agreement with the report’s recommendations.




      Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                   32
ADDITIONAL INFORMATION AND COPIES


For additional copies of this report:

       Call the Office of Inspector General (FHFA-OIG) at: 202-730-0880

       Fax your request to: 202-318-0239

       Visit the FHFA-OIG website at: www.fhfaoig.gov



To report alleged fraud, waste, abuse, mismanagement, or any other kind of criminal or
noncriminal misconduct relative to FHFA’s programs or operations:

       Call our Hotline at: 1-800-793-7724

       Fax your written complaint directly to: 202-318-0358

       E-mail us at: oighotline@fhfaoig.gov

       Write to us at: FHFA Office of Inspector General
                       Attn: Office of Investigation – Hotline
                       400 Seventh Street, S.W.
                       Washington, DC 20024




       Federal Housing Finance Agency Office of Inspector General • EVL-2012-009 • September 26, 2012
                                                    33