Some affordable-housing advocacy groups are holding Freddie Mac's feet to the fire over its investment in about 70 very-high-rate home loans.
The secondary-market agency bought the loans - inadvertently, it says - as it began to experiment in the subprime market.
The groups said the purchases proved that Freddie and rival Fannie Mae should be kept out of that market, because their purchases would inevitably spur abusive lending.
"Fannie and Freddie will be giving billions of dollars to companies that abuse and exploit lower-income and minority neighborhoods," warned William Brennan, director of one of the groups, the Home Defense Program of the Atlanta Legal Aid Society.
The tactic highlights a strategy that has become more prevalent among activists and government agencies alike as the financial industry consolidates: holding the biggest corporations responsible for the actions of their subsidiaries and clients.
Such thinking can put financial institutions in unexpected fixes, as happened when Bear, Stearns & Co. came under fire over its role as a clearing broker for the now-bankrupt A.R. Baron & Co. Bear Stearns ultimately paid $38.5 million to the Securities and Exchange Commission to settle fraud charges.
Last summer protesters picketed subprime lending offices that Citigroup Inc. had acquired, taking the company to task for failing to make low-rate Citibank mortgages available to customers who applied for loans at the subprime units. And the New York alternative newspaper The Village Voice reports that activists are considering an action against Citigroup's retail businesses to protest the role of its corporate unit in financing projects that allegedly damage the environment.
The furor over the Freddie and Fannie, its larger rival in the secondary market, centers on expansion into the subprime sector, which they say fits with their mission to broaden homeownership. Critics contend that the government-sponsored enterprises are really motivated by potential profits, and that their presence will only predatory lending by injecting fresh capital into a flawed market. This, the critics say, will ultimately saddle the two companies with more risk than they can handle if the economy turns down.
The loans the Freddie Mac bought are considered high-cost loans, and therefore subject to restriction under the Home Owner Equity Protection Act of 1993.
They are "the worst kind of subprime loans," said Mr. Brennan of the Atlanta Legal Aid Society. "They are almost by definition abusive."
Mortgages are tagged as Home Owner Equity Protection Act loans if they carry interests rate at least 10 percentage points over Treasury rates of the same maturity, or if closing costs exceed 8% of the loan amount. The 1994 act sought to control abusive lending by sharply restricting the terms that can accompany such loans.
"We are concerned that with GSEs in the subprime market, they will serve to strip wealth, not build it," said Peter Skillern, executive director of the Community Reinvestment Association of North Carolina. "We have appealed to HUD to not grant any credit for affordable housing goals with loans that prepayment penalties, single-premium credit life insurance, excessive origination fees, or loans from lenders that are not in compliance with fair-housing laws."
David O. Beim, a professor at Columbia Business School, said that Bear Stearns' responsibilities in the Baron case were clear but that Fannie's and Freddie's in preventing predatory lending were more ambiguous.
"The problem with predatory lending is how you define it," he said. "Aren't banks allowed to charge more for lending to higher risk [customers]?"
But there is little ambiguity from the GSEs' regulator on the issue.
"This is a safety and soundness issue for us," said Armondo Falcon, director of the Office of Federal Housing Enterprise Oversight. "We think any relationship that they maintain with a lender that engages in predatory lending practices represents a serious issue. As part of the examination program we do try to identify loans that fall into that category, and if we see them we would expect [the GSEs] to reassess their relationships."
He said it should be possible for Fannie and Freddie to weed out bad loans through automation.
Freddie Mac spokeswoman Sharon McHale said the company never wanted to purchase the Home Owner Equity Protection Act loans; they just "slipped through," she said.
Freddie identified them only after they were acquired in pilot programs in the subprime sector, Ms. McHale said.
"When we got tabs on predatory lending, we went back and looked at our portfolio to make sure we didn't have any of these loans, and identified them as something we wanted to stay out of," she said.
A Fannie Mae spokesman dismissed the fears as unwarranted, saying his company will take a leadership role in preventing predatory, developing its own procedures and working on a set of lending principles to bar the lending.
"We will make sure we have all the safeguards in place," the Fannie Mae spokesman said. "We want to do everything we can to eliminate abusive practices, and that is why we are making sure our own house is in order and plan to work industrywide to enforce good principles."
Faith Schwartz, director of national alternative markets for Freddie, said that "predatory lending really hasn't been defined by anyone." But she said Freddie Mac has set guidelines for what it would and would not buy, and that it would insist on warranties from the companies it buys from.
Both GSEs argue that their efforts will benefit borrowers who qualify for conventional loans but often receive subprime rates. The Fannie spokesman said that many of these borrowers are minorities, immigrants, lower-income people, or women.
A Freddie Mac spokesman said: "The notion that we would fuel predatory lending is at odds with reality. We are able to bring some borrowers into the conventional arena and reach out to borrowers who are not."
Freddie Mac has guaranteed the principal and interest on a number of bond issues by subprime lenders. According to the newsletter Asset-Backed Alert, Freddie invested $875 million in this business in 1997, $1.5 billion in 1998, and $5.8 billion in 1999, dealing with larger and larger issues.
The deals were done in the name of studying the subprime sector to gauge its risks and to understand it, a spokesman said. They involved B and C loans, though the loans were credit-enhanced so that Freddie did not incur risk, the Freddie Mac spokesman said.
Critics worry that purchasing subprime loans makes the GSEs vulnerable to massive foreclosures when the economy turns down. Mr. Brennan argued that because the average subprime borrower is already strapped by the draconian conditions of his loan, a faltering economy will quickly drag him down.
Fannie and Freddie maintain that the risk is small, because their strategies are aimed at drawing in borrowers that nearly qualify for conventional loans. "We have no intention or ability to underwrite C and D loans," said the Fannie spokesman. "We are highly focused on groups such as minorities and women that are disproportionately represented in the group that is being over charged."
Mr. Falcon, of the housing enterprise oversight office, which sets minimum capital levels and risk-based capital levels for the GSEs, said it remains to be seen whether the activity poses excessive risk.
"We have to see what happens in practice," he said. "It's one thing to say they are getting into subprime lending, but it is another to look at the loans they buy, assess the loans' characteristics, look at the way the GSE's plan to manage risk, and then make sure they hold adequate capital against that risk."
He added, "Subprime loans can have a lot risk built in, but if they are well-managed they may not require higher capital."
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