In the 1980s Freddie Mac had a marketing campaign "The Gnomes Know," touting their expertise in mortgage markets. Now the Federal Housing Finance Agency has filed a $200 billion lawsuit against 17 of the nation's largest mortgage lenders arguing that during the subprime lending debacle of the last decade the gnomes didn't know!
The lawsuits all relate to publicly offered private label subprime mortgage backed securities purchased by Fannie and Freddie mostly from 2005 through 2007. They purchased mostly senior investment grade securities because these not only qualified towards their housing "mission" goals required by HUD's "mission regulator," but also because the Office of Federal Housing Enterprise Oversight, FHFA's predecessor prudential regulator, required only 20% as much capital as for whole loan purchases.
On the one hand, the individual lawsuits are boilerplate securities fraud, i.e., the investments didn't pan out, the investors made the investments based entirely on the representations in the prospectus, these representations proved to be false and misleading, and had the investors known they would not have made them. Implicit is that the subsequent losses are due entirely to this misinformation. Making the lenders pay up will improve Fannie Mae and Freddie Mac balance sheets and reduce taxpayer losses, generally a good thing.
On the other hand, the magnitude of the losses, the number of firms sued, and the fact that the lawsuits were filed by the regulator of Fannie Mae and Freddie Mac all have potentially large consequences for the future of the secondary mortgage market.
Other deposit-financed investors received the same regulatory capital inducement to purchase these securities, and in addition relied on Fannie and Freddie as the lead investor whose expertise was long touted by politicians and regulators, so if Fannie and Freddie were mislead then these investors were doubly mislead. Fannie and Freddie purchased about 40% of all investment grade private label securities, enabling subprime during the peak of the lending debacle.
Among these other investors are the very banks that FHFA is suing.
The root of the problem is the incentive conflicts between borrowers, loan officers and investors. Mortgage portfolio lenders address these up front in their internal policies and procedures, and over time in staff meetings and with management directives. Mortgage capital markets require a much more extensive and formal system of legal agreements between unrelated parties, with court intervention an ultimate threat to be used sparingly as that is hardly conducive to a productive ongoing business relationship.
Implicit in the size and scope of the lawsuits is the allegation of a systemic fraud, i.e. that not a few but most of the loans made by most of the major lenders violated the stated underwriting guidelines. The courts will likely spend years determining the legal merits of theses lawsuits.
But it is hard to believe from what's been disclosed in the subprime aftermath that the gnomes didn't know a lot more about the risks than the FHFA court filings indicate, that their motives were the same as those of any investor, or that the named defendants are necessarily the most culpable.
Fannie and Freddie wanted to invest in these securities to meet their mission goals, and more accurate disclosure would have inhibited that.
If the gnomes truly didn't know, Fannie and Freddie stockholders may be wondering how their CEOs at the time, who received hundreds of millions of dollars in compensation, could have been so naïve or arguably incompetent not to smell a rat. But management has successfully rebuffed disgorgement of past compensation.
Maybe stockholders relied on mission regulators, whose mission requirements were imposed on well over half of Fannie's and Freddie's portfolio, to set reasonable goals consistent with lending prudence, or on prudential regulators, whose capital requirements implied that these securities were as close to risk-free as it gets, to ask the right questions of management.
But the mission regulator at the time has since denied that subsequent losses had anything to do with lending goals, inaccurately blaming management's profit-seeking greed during the subprime lending debacle, while the prudential regulator has accurately blamed politicians for tying their hands.
The defaulting borrowers claim to have been prey rather than predator, a politically sanctioned and often rewarded viewpoint. Fannie and Freddie balance sheets are a potential black hole sucking in Treasury financing and taxpayers are undisputedly blameless, so politicians have generally attempted to deflect all blame — and their regulators the cost — back to the lenders and "Wall Street."
But if the robo-signing lawsuits are any indication, these lawsuits are about ex post blame and loss-shifting that goes well beyond the immediate consequences of the allegations. These FHFA lawsuits may strengthen Fannie Mae and Freddie Mac balance sheets, but to what end? Widespread ex post loss shifting not directly related to contract "violations" and not anticipated up front is an abuse of the legal process that will likely stifle future securitization.
Moreover, loss-shifting to too-big-too-fail universal banks shifts the burden to their customers — both savers and borrowers — in the short run, (e.g., by paying depositors a negative real rate of return to invest in Treasury bills) and taxpayers in the longer run (e.g. by shifting the burden from one federal regulator, the FHFA, to another, the FDIC.)
While it is certainly appropriate to pursue such cases on the merits in liquidation, this option has been off the table for months as the Obama Administration has exploited their off balance sheet status to allow them to totally dominate mortgage lending, and doesn't seem inclined to change this policy any time soon. Are they attempting to rebuild Fannie and Freddie balance sheets so that they can be maintained as the centerpiece of U.S. housing finance?
A recent BankThink piece attributed the VA's lower default rate to directly servicing the loans they guarantee. ("Why is VA's Mortgage Program Succeeding Where Others Fail?") The implicit suggestion was that the incentive conflicts such as those at the center of these lawsuits could be removed if Fannie and Freddie serviced their own loans.
But why stop there? B of A is now ready and willing to sell them the Countrywide retail origination network. And think of all the cross-selling opportunities provided by the government takeover of the student loan market. Come to think of it, there may well be synergies in dealing with defaults as well!
The courts may subsequently reject the loss-shifting, concluding that the gnomes knew after all, but by then the crony capitalist system may be too well entrenched.
Kevin Villani was senior vice president and chief economist at Freddie Mac from 1982 to 1985.