Homeowners in 'financial jail,' and Freddie Mac profits

Because of a Freddie Mac rule, Bonnie and Jay Silverstein of Bucks County say they're in "financial jail" - unable to refinance their home loan and save about $500 a month. And according to a disturbing story by the nonprofit Pro Publica and NPR, Freddie Mac itself profits from keeping them there - because the mortgage giant made a Wall Street-style bet against the likelihood of refinancings.

"Freddie Mac Bets Against American Homeowners" tells a complicated story, and acknowledges that there's no clear coordination between Freddie Mac's refi rules and its ability to profit when homeowners are stymied. But the Silversteins' story is one being played out all across the country, in various forms. And the damage from the housing bubble won't be healed until we deal with consequences such as these:

The Silversteins have a 30-year fixed mortgage with an interest rate of 6.875 percent, much higher than the going rate of less than 4 percent. They have borrowed from family members and are living paycheck to paycheck. If they could refinance, they would save about $500 a month. He says the extra money would help them pay back some of their family members and visit their grandchildren more often.

But brokers have told the Silversteins that they cannot refinance, thanks to a Freddie Mac rule.

The Silversteins used to live in a larger house 15 minutes from their current place, in a more upscale development. They had always planned to downsize as they approached retirement. In 2005, they made the mistake of buying their new house before selling the larger one. As the housing market plummeted, they couldn’t sell their old house, so they carried two mortgages for 2½ years, wiping out their savings and 401(k). “It just drained us,” Jay Silverstein says.

Finally, they were advised to try a short sale, in which the house is sold for less than the value of the underlying mortgage. They stopped making payments on the big house for it to go through. The sale was finally completed in 2009.

Such debacles hurt a borrower’s credit rating. But Bonnie has a solid job at a doctor’s office, and Jay has a pension from working for more than two decades for Johnson & Johnson. They say they haven’t missed a payment on their current mortgage.

But the Silversteins haven't been able to get their refi. Freddie Mac won’t insure a new loan for people who had a short sale in the last two to four years, depending on their financial condition.

There are reasons, of course, for such underwriting standards - even if they're ill-advised in the context of a national housing debacle that economist Mark Zandi says will eventually cost 10 million families their homes.   Zandi also did a great job recently of debunking the myth that Freddie Mac and Fannie Mae are to blame for the bubble itself.

But it's another aspect of Freddie Mac's recent business that has piqued Pro Pubica's interest, for good reason:

Freddie Mac, the taxpayer-owned mortgage giant, has placed multibillion-dollar bets that pay off if homeowners stay trapped in expensive mortgages with interest rates well above current rates.

... The trades, uncovered for the first time in an investigation by ProPublica and NPR, give Freddie a powerful incentive to do the opposite, highlighting a conflict of interest at the heart of the company. In addition to being an instrument of government policy dedicated to making home loans more accessible, Freddie also has giant investment portfolios and could lose substantial amounts of money if too many borrowers refinance.

"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.”

The trades “put them squarely against the homeowner,” he says.

Those homeowners have a lot at stake, too. Many of them could cut their interest payments by thousands of dollars a year.

Excerpts can't do justice to this great story.  Among other things, it's a vivid illustration of the inherent conflict between the role of a government agency designed to promote home ownership by helping lower its costs and the role of a Wall Street financial firm, which is to maximize returns.

There's nothing inherently wrong with either goal - the goal of maximizing returns is essential to market economics. But in this case, it's hard to see how the two motives can co-exist in the same enterprise.