Over the last week there has been a lot of press and associated discussion over Freddie Mac’s use of CMO inverse floaters and whether they incent Freddie Mac to slow its efforts to refinance struggling homeowners. Freddie has also been experimenting with a new
debt financing structure, the Mortgage Linked Amortizing Note (MLAN) which some also feel may be taking a bet against homeowners seeking to refinance. The subject of an American Banker Op-ed piece on this issue appeared today in which I outline how these derivatives are important instruments for hedging interest rate risk exposure at the GSE and that the size of the inverse floater position at $5 billion, relative to Freddie’s $655 billion retained portfolio is insufficient for the agency to have risked taking enormous reputation risk.
Moreover, the MLAN provides a useful way of better matching the duration of the mortgage asset with its liability and lessens the reliance on accurate prepayment forecasting. However, much has been speculated on Freddie’s derivatives activities as the reason for such poor refinance results to date. As a control group the fact that Fannie has not followed in using these types of derivatives (at least not to this author’s knowledge) and their poor refinance results would suggest that perhaps derivatives are not the reason for the underwhelming results today and we should be looking at a different but more plausible cause; namely poor program design and execution. CMO inverse floaters and MLANs certainly may capture our attention as potentially sinister financial instruments of mass destruction as one oracle suggests, but in this case, it really looks like some are searching for an answer to a problem that has a much simpler explanation.