One of the most contentious points of the "what caused the housing bubble" debate is the role of Fannie Mae and Freddie Mac. On the one side you have the argument that the GSEs contributed to establishing the concept of MBS, that they lowered lending standards and led the market into toxic investments, and that their loan definitions created a mask over the true nature of underlying collateral value in MBS and CDOs. On the other side you have the argument that the GSE market share actually fell in the early 2000s and that it wasn't until 2005ish that the GSEs really began to jump in the game, long after it was destined to failure by Wall Street.
Sorting out the exact role of the GSEs is important because it 1) influences how we view them today and what their future role should be, a decision that will dramatically influence the housing market for the coming decades; 2) has a profound impact on the balance of blame between private sector and public sector for the causes of the bubble and subsequent financial crisis; 3) weighs heavily on the debate about the virtue of public policies promoting homeownership.
As the Wall Street Journal pointed out just before Christmas, the SEC lawsuit against six former GSE executives is a gift as it will contribute greatly to possibly settling this debate about the GSE role in the bubble and crisis. They write in a Review & Outlook:
The SEC also shows how Fannie led private lenders into the subprime market. In July 1999, Fannie and Angelo Mozilo's Countrywide Home Loans entered "an alliance agreement" that included "a reduced documentation loan program called the 'internet loan,'" later called the "Fast and Easy" loan. As the SEC notes, "by the mid-2000s, other mortgage lenders developed similar reduced documentation loan programs, such as Mortgage Express and PaperSaver—many of which Fannie Mae acquired in ever-increasing volumes."
Mr. Mozilo and Fannie essentially were business partners in the subprime business. Countrywide found the customers, while Fannie provided the taxpayer-backed capital. And the rest of the industry followed.
As Fannie expanded its subprime loan purchases and guarantees, the SEC alleges that executives hid the risk from investors. Consider Fannie's Expanded Approval/Timely Payment Rewards (EA) loans, which the company described to regulators as its "most significant initiative to serve credit-impaired borrowers."
By December 31, 2006, Fannie owned or securitized some $43.3 billion of these loans, which, according to the SEC, had "higher average serious delinquency rates, higher credit losses, and lower average credit scores" than Fannie's disclosed subprime loans. By June 30, 2008, Fannie had $60 billion in EA loans and $41.7 billion in another risky program called "My Community Mortgage," but it only publicly reported an $8 billion exposure.
The SEC says Fannie executives also failed to disclose the company's total exposure to risky "Alt-A" loans, sometimes called "liar loans," which required less documentation than traditional subprime loans. Fannie created a special category called "Lender Selected" loans and it gave lenders "coding designations" to separate these Alt-A loans from those Fannie had publicly disclosed. By June 30, 2008, Fannie said its Alt-A exposure was 11% of its portfolio, when it was closer to 23%—a $341 billion difference.
All the while, Fannie executives worked to calm growing fears about subprime while receiving internal reports about the company's risk exposure. In February 2007, Chief Risk Officer Enrico Dallavecchia told investors that Fannie's subprime exposure was "immaterial." At a March 2007 Congressional hearing, CEO Daniel Mudd testified that "we see it as part of our mission and our charter to make safe mortgages available to people who don't have perfect credit," adding that Fannie's subprime exposure was "relatively minimal." The Freddie record is similarly incriminating.
Also before Christmas, in an email, AEI's Ed Pinto wrote that the "new information contained in the complaints along with figures from my paper 'Government Housing Policies in the Lead-up to the Financial Crisis: A Forensic Study,' Fannie and Freddie are estimated to have had a combined exposure of $2 trillion in high risk loans and securities. This was equal to 42% of their total single-family mortgage guarantees and investments."
He notes that the major admissions include:
- By June 30, 2008 Freddie had $244 billion in subprime loans, while investors were told it had only $6 billion in subprime exposure.
- Freddie knew it was inadequately compensated for the risks it was taking.
- Freddie had concerns about risk layering on loans with an LTV >90% and a FICO <680.
- By June 30, 2008 Fannie had $641 billion in Alt-A loans (23% of its single-family loan guaranty portfolio), while investors were told it had less than half that amount or $306 billion (11%).
- While it is well known that Freddie started acquiring subprime loans to meet affordable housing goals at least as far back as 1997, the complaint disclosed that Freddie had a coding system to track “subprime”, “other-wise subprime” and “subprime-like” loans in its loan guaranty portfolio even as it denied having any significant subprime exposure.
Pinto further notes that "These suits are important because they confirm Fannie and Freddie 'told the world their subprime exposure was substantially smaller than it really was….and mislead the market about the amount of risk on the companies’ books.' Equally, if not more important, is that they mislead the world about the massive buildup of risk in the mortgage market as Fannie and Freddie accounted for about half of all outstanding single family first mortgages from 2001 on. By mid-2008 more than 40% of their loans had risky characteristics. It was this unprecedented accumulation of weak and risky mortgages that precipitated the collapse of housing and mortgage markets and the ensuing financial crisis. When the financial crisis hit in full force in 2008, approximately 27 million or 49% of the nation’s 55 million outstanding single-family first mortgage loans had high risk characteristics, making them far more likely to default."
The SEC has a horid track record for settling these types of cases out of court, but here's hoping that doesn't happen this time around. Having the matter discussed in the open light of court would be incredibly helpful for understanding our past so we can properly assess our future.
Also see my take on the lawsuits from earlier in December.