By William K. Black
(Cross-posted from Benzinga)
An important but fundamentally flawed debate aboutFannie and Freddie’s role in the ongoing crisis has raged since the SEC suedthe former senior managers of both entities for securities fraud. The WallStreet Journal and Peter Wallison (in the WSJ) have claimed that the suit vindicates their positions anddiscredits the Federal Crisis Inquiry Commission (FCIC). Joe Nocera, in his New York Times column, has thundered at the SEC and then Wallison,accusing him of “The Big Lie.” Nocera’scolumn is also interesting because it (implicitly) argues that the thesis of Reckless Endangerment is incorrect. His colleague Gretchen Morgenson and JoshuaRosner co-authored that book. I write toprovide yet another view, distinct from each of the sources.
There are two primary issues about Fannie andFreddie and the crisis discussed in the debate. First, why did Fannie and Freddie, relatively suddenly, change theirbusiness practices radically and begin purchasing large amounts of nonprimemortgages? Second, what role diddeclining mortgage credit quality that did not descend to the level of loansthat the industry described as “subprime” play in the Fannie and Freddiecrisis? The first issue is vastly moreimportant and this article focuses on it. (The short answer to the second question is: “The first issue, for everyone except theSEC, comes down to this question: did Fannie and Freddie’s controlling officers(eventually) cause them to buy large amounts of nonprime loans for the samereason their counterparts running Lehman, Bear Stearns and Merrill Lynch did(the higher nominal short-term yieldmaximized their current compensation) or because “the government” made them buythe loans?) (Lehman, Bear Stearns, andMerrill Lynch were not subject to any governmental requirements to purchase anycategory of nonprime loans.)
I show that Fannie and Freddie’s controllingofficers (eventually) caused them to buy huge amounts of nonprime loans for thehigher short-term nominal yield (though they knew that the actual yield wouldbe negative as soon as the housing bubble stalled). I exploit a “natural experiment” provided byliar’s loans – loans made without prudent underwriting of the borrower’scapacity to repay the loan. No governmentalentity ever required any lender, or any purchaser of loans (and that includesFannie and Freddie), to make liar’s loans. The mortgage industry’s anti-fraud experts, the FBI, and the bankingregulators all warned about liar’s loans producing an epidemic of fraud. If Fannie and Freddie purchased large amountsof liar’s loans, then their controlling managers did so because liar’s loans’higher short-term nominal yield maximized their near-term compensation – notbecause “the government” made them do so.
OFHEO, which was Fannie and Freddie’s regulatorduring the relevant period, had ample regulatory authority to prevent Fannieand Freddie from purchasing liar’s loans and its head, James B. Lockhart, was aGeorge Bush appointee and one of his oldest friends (from prep school). Lockhart had President Bush’s full supportand he was in no way intimidated by Barney Frank or Chris Dodd. Lockhart shared Bush’s anti-regulatorymindset, his inability to envision elite business leaders as felons, and hisstrong support for even the most perverse executive compensation systems. Lockhart was not “captured” by Fannie andFreddie. He was not a supporter ofeither entity. He and his seniorregulators that I met simply did not believe it was legitimate for thegovernment to regulate compensation or, absent proof that the business practicehad already produced large losses, Fannie and Freddie’s business strategy.
The, SEC complaint, takes the unique, naïve, anduntenable position that Fannie and Freddie bought very large amounts ofnonprime loans in order to increase market share. This position is exceptionally importantbecause it reveals the SEC’s unwillingness to take on even the most perverseexecutive compensation systems that are driving our recurrent, intensifyingfinancial crises. Suffice it to say thatthe documentary record at Fannie and Freddie is replete with evidence that thecontrolling officers drove the decision to adopt a new business plan ofpurchasing vast amounts of nonprime loans and that the reason for the plan wasto increase short-term nominal yields. Their risk people repeatedly warned them that the new plan could bedisastrous. High short-term yield producedextraordinary near-term compensation for Fannie and Freddie’s controlling officers,so it is no surprise that the CEOs’ decided in favor of the path that made themwealthy – and produced disaster for Fannie, Freddie, and the government.
Each of the discussions (and that includes the SECcomplaints) is faulty because it proceeds as if Fannie and Freddie suddenlybegan engaging in accounting and securities fraud late in the crisis. That is objectively false. The SEC (and eventually Fannie and Freddie’sregulator – then OFHEO, now called FHFA) documented that Fannie and Freddie hadlong engaged in accounting and securities fraud – no later than the beginningof the decade that would eventually produce the crisis. The SEC detected Freddie’s and then Fannie’sfrauds in 1983. Indeed, the SECexplicitly charged that Fannie’s senior managers caused it to commit accountingfraud for the purpose of maximizing their executive compensation. I was an expert witness for OFHEO againstRaines, et al. in the agency’s enforcement action arising from this earlierfraud. The SEC and OFHEO’s actions ledto Freddie appointing a new CEO in December 2003 (Richard Syron, the mostsenior defendant in the new SEC suit arising from Freddie’s operations) andFannie appointing a new CEO in December 2004 (Mr. Mudd, Fannie’s COO during itsendemic accounting fraud from 2000-20003). Mudd is the most senior defendant in the SEC suit arising from Fannie’soperations.
One of the delightful acts of unintentionalself-parody arising from the crisis is that when the Business Roundtable (the100 largest U.S. corporations), eventually decided that they needed aspokesperson to respond to the Enron-era epidemic of “accounting controlfraud,” they selected Frank Raines (Fannie’s CEO). BusinessWeek dutifully asked Raines why the fraud epidemic occurred. Raines responded:
“Don’t just say: ‘Ifyou hit this revenue number, your bonus is going to be this.’ It sets up anincentive that’s overwhelming. You wave enough money in front of people, andgood people will do bad things.”
Raines knew of what he spoke, for his predecessorsand he had devised such a bonus system (tied largely to, non-GAAP, earnings pershare (EPS) targets purportedly designed to be “stretch” goals). Fannie’s compensation system produced exactlythe perverse results that Raines predicted and explained to Business Week.
“By now every one ofyou must have 6.46 [EPS] branded in your brains. You must be able to say it in your sleep, youmust be able to recite it forwards and backwards, you must have a raging firein your belly that burns away all doubts, you must live, breath and dream 6.46,you must be obsessed on 6.46…. Afterall, thanks to Frank, we all have a lot of money riding on it…. We must do this with a fiery determination,not on some days, not on most days but day in and day out, give it your best,not 50%, not 75%, not 100%, but 150%.”
“Remember, Frank hasgiven us an opportunity to earn not just our salaries, benefits, raises,ESPP, but substantially over and above if we make 6.46. So it is our moral obligation to givewell above our 100% and if we do this, we would have made tangiblecontributions to Frank’s goals.” (Mr.Rajappa, head of Fannie’s internal audit, emphasis in original.)
I call internal audit the anti-canary. Miners took canaries into coal mines becausethe birds are more susceptible than humans to carbon dioxide and monoxide. If the canary loses consciousness the humanscan survive by exiting the mine. Internal audit is supposed to the least susceptible unit in a firm. The mantra of internal audit is“independence” from the senior managers. If internal audit is suborned by executive compensation then the rot ispervasive in other units. In consideringthe import of Rajappa’s speech to his internal audit troops, consider the factthat it was a written speech and that Rajappa provided the text to Raines – andgot favorable suggestions to make it even stronger. Raines knew and approved of the fact that therot at Fannie was pervasive.
A word about “stretch goals.” Consider this exceptionally naïve passagefrom a Nordic banker (Nyberg) recently asked to write a report on the failedIrish banks. He is discussing earningtargets that maximized executive compensation.
“Targets that wereintended to be demanding through the pursuit of sound policies and prudentspread of risk were easily achieved through volume lending to the propertysector.” (Nyberg 2011: 30)
The bonus targets, of course, were not “intended tobe demanding through the pursuit of sound policies.” The senior managers chose stretch goals,impossible to reach through prudent lending, because such goals were “easilyachieved” by ignoring asset quality (which they proceeded to do). As George Akerlof and Paul Romer aptlyobserved in their 1993 article (“Looting: the Economic Underworld of Bankruptcyfor Profit”), accounting control fraud is a “sure thing.” Whether one is in Ireland or the U.S., thefraud recipe for a lender (or loan purchaser) has four ingredients.
- Growlike crazy
- Bymaking (or buying) exceptionally bad loans at a premium yield, while
- Employingextreme leverage, and
- Providinggrossly inadequate allowances for loan and lease losses (ALLL)
Indeed, Ireland provides a superb natural experimentthat helps us determine why banks make or purchase exceptionally bad loans withgrossly deficient underwriting and trivial ALLL. The fraud recipe is so perverse because it ismathematically guaranteed to produce record (albeit fictional) short-termreported income, huge compensation, and catastrophic losses. If a material number of banks (or a smallnumber of very large banks) follows the same fraud recipe in an asset categoryit will hyper-inflate a bubble in that asset. Accounting control frauds often lend into teeth of a glut.
Ireland is so useful because it had no equivalent ofa Community Reinvestment Act (CRA) and no material secondary market (noequivalent of Fannie and Freddie – hence, no requirements to purchase a subsetof below median-income home mortgages). Nevertheless, its real estate bubble was roughly twice as large (inrelative terms) as the U.S. bubble and it had twin bubbles in commercial andresidential real estate. Its banksexhibited a collapse of loan quality driven by perverse executivecompensation. Irish bank CEOs followedthe same fraud recipe as Lehman, Merrill Lynch, Countrywide, WaMu, Fannie,Freddie and their ilk and produced the same catastrophic losses.
“All of the covered [failed]banks regularly and materially deviated from their formal policies in order tofacilitate rapid and significant property lending growth. In some banks, creditpolicies were revised to accommodate exceptions, to be followed by furtherexceptions to this new policy, thereby continuing the cycle.”
“Occasionally,management and boards clearly mandated changes to credit criteria. However, inmost banks, changes just steadily evolved to enable earnings growth targets tobe met by increased lending.” (Nyberg 2011: 34)
“The associated risksappeared relevant to management and boards only to the extent that growthtargets were not seriously compromised.” (Nyberg 2011: 49)
That’s right; let nothing get in the way of makingit simple to meet the bonus target – even though doing so will destroy thebank.
Fannie and Freddie’s accounting frauds in theearlier part of the decade, however, followed a different recipe. Their managers’ were then “skimmers” insteadof “looters.” We should not be too kindto them. Their earlier accounting fraudrecipe put Fannie and Freddie (and therefore the government) at risk of lossand their phony (“dynamic”) hedging posed a systemic risk. Fannie and Freddie’s original fraud schemesought to maximize the senior managers’ income by taking substantial interestrate risk. This required Fannie andFreddie to grow their portfolios massively.
“[F]rom 1998 to 2003,Freddie Mac’s retained portfolio grew at an annual average rate of about 21percent. Over the same period of time, Fannie Mae’s mortgage holdings increasedby an annual average rate of 17 percent. By 2003, Freddie Mac’s retainedportfolio ($661 billion) was about 72 percent as large as Fannie Mae’s ($920billion.)”
The Rise and Fall of Fannie Mae and Freddie Mac: LessonsLearned and Options for Reform. Richard K. Green and Ann B. Schnare (November19, 2009: p. 18).
Fannie and Freddie’s controlling officers made theopposite bet on the direction of interest rates. Fannie lost its bet, so it hid it losses bycalling them “hedges.” This accountingfraud turned Fannie’s real losses into fake profits, maximizing the officers’bonuses. This bit of accounting andsecurities fraud caused the SEC to required Fannie to restate its financialstatements and recognize millions of dollars in losses. Naturally, Fannie’s officers did not giveback their bonuses. Freddie won its beton interest rates and, after recognizing enough income to maximize currentexecutive bonuses, it created “cookie jar” loss reserves so that it could drawon them if it failed to meet the targets that maximized future bonuses. The SEC was not amused and required Freddieto restate its financial statements.
Here is the crazy thing – the SEC, OFHEO, andDepartment of Justice all failed to demand that Fannie and Freddie end theirperverse executive compensation system that made the executives wealthy throughfraud and put the entities and the government at risk. The Bush White House took no action and madeno criticism of the compensation system. The Congress (both parties) made no criticism of the compensationsystems. Remember, we had seen theseperverse compensation systems blow up the S&L industry and the Enron-eraaccounting control frauds.
OFHEO even allowed Mr. Mudd, Fannie’s COO during theperiod of its extensive accounting and securities fraud, to replace Raines’ asCEO in December 2004. None of this wasdue to any weakness in OFHEO’s regulatory powers. The problem was an unwillingness toregulate. The unwillingness wasideological. OFHEO’s senior managers didnot consider it legitimate to regulate executive compensation or to blockFannie’s choice of its new CEO. The newSEC suit names Mudd as a defendant.
OFHEO had its maximum leverage over Fannie andFreddie when the SEC discovered their accounting and securities frauds and itsown examinations confirmed those frauds in the middle of the criticaldecade. OFHEO used its leverage to fightthe last war – ensuring that Fannie and Freddie did not take excessive interestrate risk. It sharply limited the amountthat Fannie and Freddie could grow their portfolios and cracked down on hedgingabuses. Unfortunately, the first ofthese actions, while completely appropriate, helps explain the new accountingand securities fraud that are (or should be in a better complaint andprosecution) the subject of the new SEC action.
By December 2004, the SEC and OFHEO had forced outFannie and Freddie’s controlling managers who led the accounting control fraudsin the first part of the decade, but they left in place Fannie and Freddie’sexceptionally perverse executive compensation systems that promised that thenew senior officers could attain vast wealth if they could cause Fannie andFreddie to report high, short-term profits. Their old scam, interest rate risk plus hedge/cookie jar accountingfraud could no longer be used when Fannie and Freddie’s new controllingofficers took power. There was only onealternative means of creating (fictional) outsized reported profits. They could not grow their portfoliosignificantly, but OFHEO failed to require them to divest those portfolios –and those portfolios were massive because of the earlier fraud scheme.
In 2005, Fannie and Freddie’s new controllingofficers led them into an orgy of purchasing nonprime loans (liar’s loans,subprime loans, and subprime liar’s loans) – the loans sure to generate thelargest short-term nominal yield. This had the intended effect on thecontrolling officers’ executive compensation. Fannie and Freddie’s controlling officers increasingly moved prime loansout of portfolio by securitizing and selling them. Their portfolios increasingly became litteredwith nonprime loans. Fannie andFreddie’s controlling officers followed the classic recipe for looters usingaccounting control fraud. The differencebetween Fannie and Freddie and some of its counterparts is that Fannie andFreddie’s risk and (some) underwriting officers mounted considerably greateropposition to the fraud recipe than many other accounting control frauds. This explains why Fannie and Freddie’s losses(relative to the amount of nonprime loans they purchased) were smaller thanmany of their counterparts.
It is only by taking into account Fannie andFreddie’s earlier accounting fraud and the SEC and OFHEO’s reactions to thosefrauds that one can understand why Fannie and Freddie made radical changes intheir purchase of nonprime loans in 2005. It is only by taking into account the (moderately) superior professionalculture of its risk professionals that one can understand why their losses werenot far worse (given the enormous amounts of nonprime loans they purchased from2005-2007). Wallison implicitly assumesthat if Fannie and Freddie had not purchased these nonprime loans theircompetitors would not have done so. Thatassumption is extraordinary and requires heavy proof. Wallison provides none. It was Fannie and Freddie’s competitors whopurchased the same nonprime loans so eagerly in 1998-2004 that they evisceratedFannie and Freddie’s once dominant market share in the secondary market formortgage loans. Fannie and Freddie’scombined share of the secondary market fell from well over 90% in 1990 to underone-half by 2004. Indeed, many of Fannieand Freddie’s losses come from investing in or guaranteeing the financialderivatives issued by its competitors where the underlying asset was nonprimeassets, particularly liar’s loans and subprime liar’s loans.
“Private labelsecurities accounted for 56 percent of Fannie Mae’s total mortgage-relatedsecurity purchases from 2004 through 2006, and 54 percent for Freddie Mac. (SeeExhibit 4.) Most of these purchases involved securities backed by subprime orAlt-A mortgages. (See Exhibit 9.) In 2006, the GSEs’ purchases of suchsecurities represented 9.8 percent of the total volume of subprime and Alt-Aoriginations made within the year.” (Green & Shnare 2009: 23)
“Alt-A” is one of the many euphemisms for liar’sloans. The term is a double lie. It purports that the loans are prime quality(“A” grade) and it purports that the loans are underwritten through “alternative”means. In reality, the capacity of theborrower to repay the loan was not underwritten. Typically, the lenders and their agentsfraudulently inflated the borrower’s income.
Fannie (which predated Freddie), created the conceptand standard of the “prime” home loan decades ago when it was an independentgovernment agency before it was privatized. When it was a government agency, it was the principal source ofdesirable market discipline ensuring high mortgage quality. Nonprime home loans include three primarycategories – liar’s loans (loans made without prudent underwriting of theborrower’s capacity to repay the loan), subprime (loans made to borrowers withknown, serious credit defects), and subprime liar’s loans (combining bothproblems). One of the easy tests ofcompetence is to find whether a writer knows so little that he believes thatsubprime and liar’s loans are dichotomous. Credit Suisse reports that, by 2006, 49% of the loans called “subprime” werealso liar’s loans.
Prior to 2005, nonprime loans were soldoverwhelmingly to large investment banks. These banks were not subject to any governmental requirements topurchase such loans. The investmentbanks purchased the nonprime loans because doing so maximized their controllingofficers’ compensation. Fannie andFreddie lost enormous market share because of this competition.
The indisputable fact that it was the non-regulatedsector (mortgage banks, mortgage brokers, investment banks, and non-bankaffiliates that led the epidemic making and purchasing fraudulent nonprimeloans has not prevented multiple, major analytical failures about the role thatFannie and Freddie played in the crisis. The historical quibble is that Fannie and Freddie reduced their loanpurchase standards well before 2005. That is true, but it does not explain why Fannie and Freddie sufferedhuge losses on nonprime loans. Fannieand Freddie’s definition of “prime” created an exceptionally safe standard inwhich credit losses were minimal. It waspossible to reduce that standard without creating a criminogenic environmentand the data review by FCIC demonstrates that the loans that Wallison haslumped together (relying on Pinto’s work) and labeled “subprime” are extremelydisparate.
Fannie’s original definition of “prime” wasequivalent to an A+. The loans that themortgage industry called “subprime” were a C-. Liar’s loans were a D-. Subprimeliar’s loans were an F. There is a largerange in credit quality between the original definition of prime and loans theindustry called “subprime.” FCIC showedthat the loans that Pinto (but not the industry) classified as “subprime” haddramatically lower default rates than the loans that the industry classified assubprime. As Charles Calomiris, one ofFannie and Freddie’s most virulent critics has emphasized, the proof as to whois correct in this argument about categorization rests on the performance ofthe loans. The loans at Fannie andFreddie that Pinto (but not the industry) termed subprime performed far betterthan the loans the industry termed subprime.
Nocera’s December 23, 2011 column calls Pinto andWallison’s work a “big lie” because it categorizes loans that Fannie andFreddie would not have considered “prime” (circa 1982) as “subprime” even whenthese loans were not considered “subprime” by the industry (circa 2006).
This is unduly harsh. Pinto and Wallison (and Joshua Rosner andGretchen Morgenson) are correct that the credit quality of some loansconsidered prime deteriorated for over a decade. The real problem is the authors’ lack ofconsistency. At root, their point isthat differences matter. Specifically,they argue that making nonprime loans is far riskier than making primeloans. The same logic, however, requiresthem to evaluate whether differences matter withinthe vast category that they created and labeled as “subprime.” They failed to conduct this evaluation. The FCIC conducted one aspect of theevaluation and found that the differences within the Pinto/Wallison categoryhad enormous consequences for relative performance. The bulk of Fannie and Freddie’s loans thatfall within Pinto/Wallison’s unique and far broader categorization of“subprime” loans perform far better (have much lower default rates) than thenarrower, commonly used categorization of subprime.
Second, all the authors advancing this meme failedto evaluate the difference between liar’s loans and non-liar’s loans for thepurpose of their real thesis – “the government” caused the crisis by forcingFannie and Freddie to purchase bad loans. This argument has many factual weaknesses, but one fatal weakness is thefact that there was never any governmental requirement for Fannie and Freddieto purchase liar’s loans. This providesa natural experiment that allows us to test, and reject, the thesis that Fannieand Freddie purchased bad loans because of governmental mandates. The CEOs of Fannie and Freddie caused them tobuy vast amounts of liar’s loans because the higher nominal yield maximizednear-term executive compensation. TheCEOs of Fannie and Freddie acted like the CEOs of Bear Stearns, Lehman, andMerrill Lynch and they did so for the same reasons and with the same fatalconsequences. Akerlof and Romer capturedthe dynamic in the title of their article (“Looting: the Economic Underworld ofBankruptcy for Profit”). The firm fails,but the CEO walks away wealthy because accounting control fraud is a “surething.”
Remember, the FBI has already warned (in September2004) and the mortgage industry’s own anti-fraud unit (MARI) has warned inearly 2006, respectively, that an “epidemic” of mortgage fraud will produce afinancial “crisis” if it is not stopped and that liar’s loans are 90%fraudulent. No honest, financiallysophisticated entity would make or purchase liar’s loans (or CDOs backed byliar’s loans) knowing these facts. Yet,several of the leading investment banks, hundreds of mortgage bankers, WaMu,Countrywide, IndyMac, and Fannie and Freddie rushed to make or purchase endemicallyfraudulent mortgage paper. This would beirrational for any honest CEO, but it would be optimal for a CEO directing anaccounting control fraud. Fannie andFreddie’s losses on liar’s loans paper are extreme – and note that the authorsof the study make the common error of assuming that liar’s loans and subprimeloans are dichotomous. If one examinedseparately the losses on Fannie and Freddie’s subprime liar’s loans (and CDOswhere such loans were the bulk of the underlying) the losses would be catastrophic.
“In 2008, for example,Alt-A mortgages represented just 9.7 percent of Fannie Mae’s book, butaccounted for almost 40 percent of the company’s credit losses. The experienceat Freddie Mac tells a similar story: the serious delinquency rate on FreddieMac’s Alt-A book (which is 8 percent of the portfolio) is more than three timeshigher than the total portfolio’s rate.” (Green & Schnare 2009: 24).
Sadly, the SEC fails to exploit this naturalexperiment involving liar’s loans. Indeed, the SEC complaint appears to have been drafted by someone sopoorly informed that he believes that liar’s loans and subprime loans aredichotomous categories. Nocera is alsocritical of the SEC complaint, but his criticism arises from his erroneousbelief that the complaint rests on Pinto and Wallison’s unique categorizationof “subprime” loans. Nocera is guilty ofwhat he accuses Pinto and Wallison of doing, writing “I still maintain that theS.E.C.’s charges are weak, and that the agency brought the case in part forpolitical reasons: how better to curry favor with House Republicans than to goafter former Fannie and Freddie executives?” This is a strong charge requiring at least some proof, but Noceraprovides no support.
Nocera (and Wallison) miss entirely the key aspectof the SEC complaint that refutes Wallison’s thesis that Fannie and Freddiebought bad loans because “the government” made them buy bad loans. Wallison’s facially implausible claim is thatFannie and Freddie were weak political actors forced by crazed Democrats topurchase suicidal loans in order to subsidize poorer minorities that supportDemocrats. Fannie and Freddie wereexceptionally powerful political entities with strong support from bothparties, e.g., Newt Gingrich, but ignore this aspect of unreality solely forthe purpose of testing the internal logic of Wallison’s hypothesis. Wallison’s claim is that Fannie and Freddiewere so weak politically that they were forced to take on suicidal loans inorder to curry political favor with the Democrats. If that were true, then Fannie and Freddieshould have consistently been leading the purchase of subprime loans from 1993on (which was when HOEPA became law). Inreality, Fannie and Freddie lost tremendous market share because they(generally) refused to purchase loans the industry categorized as subprimeuntil roughly 2005. Their rivals, theinvestment banks (who were not subject to any affordable housing mandates),rushed to purchase massive amounts of these subprime loans. That is the conventional (compelling) reasonto reject Wallison’s thesis. I haveadded another reason – Fannie and Freddie would never have purchased liar’sloans under Wallison’s thesis because “the government” never compelled them topurchase liar’s loans and doing so would be suicidal.
The SEC complaint adds an additional reason whyWallison’s thesis fails. UnderWallison’s thesis Fannie and Freddie should have been exaggerating the amountof subprime loans they were making in order to curry favor with the despicableDemocrats. But the SEC complaint (andWallison and Pinto’s own work) prove that Fannie and Freddie did theopposite. Fannie and Freddie’scontrolling managers consistently cooked their financial statements andfinancial disclosures to make it appear that Fannie and Freddie purchased vastly fewer subprime loans than theyactually purchased. (They did the samething with their liar’s loans – for the same reasons.) Nocera (incorrectly) assumes that the SECcomplaint relies on Pinto/Wallison’s unique, ultra-broad categorization of“subprime” loans, but Fannie and Freddie’s documents show that they understatedboth the number of liar’s loans and subprime loans they purchased (ascategorized by conventional industry norms). This makes perfect sense for managers running an accounting control fraud,but it makes no sense under Wallison’s thesis.
We need to be blunt about the source of Wallison’sthesis. Wallison is one of the leadingarchitects of the global financial crisis in his capacity as AEI’s long-timeco-director of their financial deregulation program. He pushed the criminogenic three “de’s”: deregulation, desupervision, and de facto decriminalization. He criticized Fannie and Freddie for notmaking greater amounts of nonprime loans. He is desperately seeking to escape accountability for his major role increating a global crisis. He is anideologue who would have been fired by AEI had he supported financialreregulation. His thesis that the crisiswas really caused by the government forcing the politically powerless Fannieand Freddie to make suicidal loans is a desperate effort to save himself andhis ideology.
Wallison’s thesis cannot survive the laughtest. It requires that, for over adecade in which the Republicans had control over the Congress and/or the WhiteHouse Fannie and Freddie’s CEOs knew they were purchasing loans that wouldeventually prove catastrophic for Fannie and Freddie, the lenders (loan salesto Fannie and Freddie are made with recourse back to the seller), and for the(poorer minorities) purchasing the homes. No one at Fannie and Freddie leaks this to the Republican Congress orthe Bush White House even though such leaks would have (under Wallison’sthesis) provided the mother of all Democrat-bashing congressional hearings. No one at OFHEO, including Bush’s old friend,and strong Republican, James Lockhart (the guy running OFHEO), informs Bushthat Fannie and Freddie are headed for catastrophe because the Democrats haveforced them to purchase suicidal loans to poorer minorities (i.e., the base ofthe Democratic Party).
The thesis also requires that, knowing of the comingcatastrophe, Fannie and Freddie’s controlling officers, for over 15 years,decided to provide only trivial accounting allowances for the inevitablecatastrophic losses – even though GAAP would mandate that they provide massiveallowances in such circumstances and even though the controlling officers’failure to do so could be prosecuted as securities fraud. The failure to provide massive allowancesmakes no sense under the Wallison thesis, but it is the standard “fourthingredient” for an accounting control fraud. Had Fannie and Freddie’s controlling officers appropriate allowances forlosses their financial reports would have shown the truth – that the actuallong-term yield on liar’s loans was negative. Fannie and Freddie would have reportedsubstantial losses from 2005 on had they established the allowances required byGAAP, which would have eliminated their bonuses.
The WallStreet Journal editorial on the SEC complaints against Fannie and Freddieclaims that FCIC should be embarrassed that it ignored the key role that Fannieand Freddie played in the crisis. Wallisonhas a new piece in The Atlantic inwhich he claims “the government” caused the crisis.
If one had to pick one person in the private sectormost responsible for causing the global financial crisis it would beWallison. As I explained, he is theperson, who with the aid of industry funding, who has pushed the longest andthe hardest for the three “de’s.” It wasthe three “de’s” combined with modern executive and professional compensationthat created the intensely criminogenic environments that have caused ourrecurrent, intensifying crises. He complainedduring the build-up to the crisis that Fannie and Freddie weren’t purchasingmore affordable housing loans. He nowclaims that it was Fannie and Freddie’s purchase of affordable housing loansthat caused the crisis. He ignores themassive accounting control fraud epidemics and resulting crises that hispolicies generate. Upon reading thatFannie and Freddie’s controlling officers purchased the loans as part of afraud, he asserts that the suit (which refutes his claims) proves hisclaims.
Placing Wallison on FCIC was like placing the Don’s consigliere on a panel that is supposedto investigate the mafia. What wasWallison going to say as a FCIC member? “Mea Culpa, I’ve been wrongfor a quarter-century about everything important and I have come to admit thatderegulation, desupervision, and de factodecriminalization are disastrous.” There was a reason no other Republican appointee to FCIC was willing tosign on to Wallison’s dissent. Hisdissent is a screed that is devoted to protecting his theoclassical economicideology. FCIC did not ignore Pinto’swork, it refuted its analytics. Wallison’s real complaint is that FCIC took Pinto’s work seriouslyenough to do the analytical work that Pinto and Wallison should have done todetermine whether Pinto’s unique categorization of “subprime” produced acategory of loans with similar (terrible) performance results. What Wallison cannot forgive the FCIC staffand other commissioners for is that they did treat his claims seriously despitehis obvious self-interest and the logical inconsistency of his claims. It was taking his claims seriously andevaluating his data that he failed to evaluate that put the final nail in thecoffin of his claims. Wallison and Pintohave had a year to point out any data errors in FCIC’s demonstration that theloans Pinto categorized as “subprime” had greatly superior loan performancecompared to loans the industry categorized as “subprime.”
There is no point criticizing the Wall Street Journal’s editorialstaff. They know that FCIC concludedthat Fannie and Freddie played a major role in the crisis. FCIC was correct that Fannie and Freddie werelate to the party in terms of purchasing the loans and CDOs that eventuallycaused the catastrophic losses. Thequestion was why Fannie and Freddie suddenly began to buy enormous amounts oflargely fraudulent nonprime paper in 2005. They did so, as the repeated investigations have found, for the samereason that Fannie and Freddie engaged in accounting control fraud earlier inthe decade – it makes the controlling officers wealthy. It is a “sure thing.” What I have added is the relevant time lineexplaining the role that Fannie and Freddie’s earlier accounting controlfrauds, and the modest sanctions levied by the SEC and OFHEO, played inexplaining why they went so heavily into fraudulent nonprime paper around 2005.
Wallison has been conspicuously silent indemanding that elite CEO frauds that drove this crisis be prosecuted. I ask him, and I ask reporters who discussany story with him, whether he will now demand that we end the de facto decriminalization of thefraudulent CEOs who drive our financial crises and become wealthy through theirfrauds. Does Wallison believe thatFannie and Freddie’s controlling officers would be a good place to beginprosecuting?
Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.
Follow him on Twitter: @WilliamKBlack