The Central Fact that Folks Don’t Get about Fannie and Freddie’s Role in the Crisis

By William K. Black

Here’s the central thesis of the far right about Fannie Mae and Freddie Mac.  It is taken from the web site: The Neville Awards (as in Neville Chamberlain), which gives “awards” to Democrats for their cowardice and other mortal and venal sins.  This particular article claims that the damnably clever Democrats, while the Republicans controlled the Presidency, House, Senate, Supreme Court, and all the regulatory agencies, pulled off a deliberate plan to destroy the economy in order to elect Obama. “Obama, Fannie Mae & Freddie Mac – How the Democrats Brought Down the Economy in Time to Elect Obama.”

The author summarized his thesis in two sentences.  “Fan and Fred and the Problem of Narrative-The GSEs don’t fit the left’s story about how greedy bankers caused the financial crisis. That’s why they haven’t been reformed.”

Actually, Fannie and Freddie are perfect fits for the accurate narrative of what caused this financial crisis (and the Enron-era crisis and the S&L debacle) – epidemics of “accounting control fraud.”  The right has simply forgotten that Fannie and Freddie were controlled by “greedy bankers.”  Fannie and Freddie were privately owned and privately managed.  George Akerlof and Paul Romer explained their fraud scheme in their famous 1993 article (“Looting, the Economic Underworld of Bankruptcy for Profit”).   Crucially, they explained that accounting control fraud is a “sure thing.”  It will make the controlling officers wealthy and it will do so promptly.

The Bush administration’s regulators at the SEC and OFHEO (which regulated Fannie and Freddie in that era) explicitly charged that Fannie’s senior officers caused it to engage in accounting and securities fraud for the express purpose of maximizing those officer’s bonuses.  The relevant paragraphs of the 2006 SEC complaint against Fannie stated:

 22. Management’s decisions to book an amount significantly less than the total calculated catch-up amount and to institute the two accounting adjustments in the fourth quarter of 1998 resulted in the Company not only exceeding Wall Street expectations, but also hitting the earnings per share (“EPS’) target necessary to trigger maximum bonuses.

23. Under the Company’s Annual Incentive Pool (“AIP”) for 1998, an EPS figure of $3.13 would trigger minimum bonuses, an EPS figure of $3.18 would trigger the target bonus, and an EPS figure of $3.23 would trigger maximum bonuses.

24. Without these improper accounting adjustments, Fannie Mae’s management could have received substantially smaller bonuses (based on either a pool of only $17.3 million or only $8.6 million) or no bonuses at all. For example, prior to the 1lth-hour reversal of suspense items, EPS for the year was $3.2285. While this figure exceeded Wall Street estimates of $3.22, it fell short of the $3.23 EPS figure required to trigger maximum bonus payouts. After the $3.9 million reversal of suspense items, EPS for the year was $3.2309, which triggered a maximum AIP bonus pool for management totaling $27.1 million. If Fannie Mae had recorded the full catch-up amount as initially calculated, its EPS would have been $3.10 for year-end 1998, a figure below the minimum threshold for bonuses under the AIP.

25. By fraudulently failing to book the full amount of catch-up adjustment in the fourth quarter of 1998, Fannie Mae issued financial statements that were materially false and misleading. On January 14, 1999, Fannie Mae publicly issued its financial statements for the period ending December 3 1, 1998, which overstated pre-tax earnings by 4.3% and net interest income by 4.9%. Moreover, the Company failed to disclose that these figures had been intentionally manipulated to trigger management bonuses.

Similarly, the SEC has charged that Fannie and Freddie’s controlling officers caused the firms to make deceitful statements in violation of the securities laws during the ongoing crisis.

Fannie and Freddie’s managers bought enormous amounts of endemically fraudulent liar’s loans for the same reasons that the investment banks did – it maximized their bonuses.  For a fraudulent purchaser of loans, the “recipe” for optimizing looting has four ingredients:

  1. Grow like crazy by
  2. Purchasing crappy loans at a premium yield
  3. While employing extreme leverage, and
  4. Providing only grossly inadequate allowances for loan and lease losses (ALLL)

There are two things that were obviously special about Fannie and Freddie.  First, Fannie and Freddie initially (Freddie: 1998 – 2003; Fannie: 1998 – 2004) followed a different accounting fraud strategy (and used opposite tactics in implementing that strategy) that was designed to “skim” profits rather than to loot.  The strategy was to take serious interest risk by rapidly growing their portfolio of loans.  Fannie and Freddie normally buy mortgages, repackage them as mortgage backed securities (MBS), and sell the MBS to others.  Fannie and Freddie began to keep huge amounts of loans rather than selling them through MBS (or even “purchasing” their own MBS from themselves).  The idea was to gamble on interest rate risk.  If they won the bet the managers would get rich through bonuses.  If they lost the bet they would commit accounting fraud to hide the losses and get rich through bonuses.  Fannie bet that interest rates would increase.  Freddie bet they would fall.  Rates fell.  Fannie used accounting fraud to hide the real losses in order to maximize their bonuses.   Freddie committed accounting fraud to hide its (real) profits in the form of “cookie jar reserves” that it could draw on (illegally) in future time periods in order to claim profits (fictionally earned in that quarter) in order to report sufficient profit to maximize their bonuses.

Second, when the SEC and OFHEO discovered their initial accounting fraud schemes in 2003 (Freddie) and 2004 (Fannie) it led to OFHEO, in 2005 and 2006, severely restricting how much they could grow their portfolio.  Fannie and Freddie could no longer use their initial fraud strategy, so their managers shifted to a variant of the looting recipe.  They could no longer grow “like crazy,” but they could ensure that a dramatically increased share of the mortgages they caused Fannie and Freddie to purchase would have premium, nominal yields.  (The real yield, of course, was sharply negative, but if one ignores the inevitable losses and provides only a trivial ALLL the nominal yield was certain to surge quickly under this looting strategy.  It is no coincidence that Fannie and Freddie begin their massive purchases of nonprime loans after their original fraud strategy was blocked.

Conservatives, of course, assume that Fannie and Freddie must have sharply increased their purchase of nonprime loans beginning around 2005 because of their “affordable housing” requirements.  The investment banks, which had purchased hundreds of billions of dollars of liar’s loans and subprime paper, were never subject to the Community Reinvestment Act (CRA) or any other affordable housing goal.  They purchased nonprime paper because of its yield and grotesquely inflated credit rating.  Indeed, they often purchased their own collateralized debt obligation (CDO) securities because doing so was a “sure thing” that was guaranteed to maximize reported (albeit fictional) near-term income and the officers’ bonuses.  The investment banks’ controlling officers became wealthy by causing “their” investment banks to purchase massive amounts of nonprime paper without any affordable housing goals – so it should be no surprise that Fannie and Freddie’s controlling officers eventually mimicked their fraud strategy.

Indeed, we can exploit a “natural experiment” to test the rival hypotheses (accounting control fraud v. the affordable housing goals).  No governmental entity ever required or recommended that a lender, investment banker, or Fannie and Freddie make or purchase liar’s loans.  The opposite is true.  The federal and state governments criticized liar’s loans and warned against them.  In the Fannie and Freddie context we can make even stronger statements that Fannie and Freddie’s managers (eventually) directed the purchase of massive amounts of liar’s loans because of their high nominal yield rather than affordable housing goals.  The Financial Crisis Inquiry Commission (FCIC) found.

Overall, while the mortgages behind the subprime mortgage–backed securities were often issued to borrowers that could help Fannie and Freddie fulfill their goals, the mortgages behind the Alt-A securities were not. Alt-A mortgages were not generally extended to lower-income borrowers, and the regulations prohibited mortgages to borrowers with unstated income levels—a hallmark of Alt-A loans—from counting toward affordability goals.  [Robert] Levin [Fannie’s chief business officer] told the FCIC that they believed that the purchase of Alt-A securities “did not have a net positive effect on Fannie Mae’s housing goals.”  Instead, they had to be offset with more mortgages for low- and moderate income borrowers to meet the goals.  (FCIC 2010: 125)

Fannie and Freddie commonly could not count the liar’s loans they purchased toward their affordable housing goals.

The other point is that the reason that liar’s loans proliferated was to allow the lenders to pretend that the borrower had sufficient income to repay the loan by inflating the borrower’s reported income.  The famous mortgage industry study [PDF version] of liar’s loans found that 90% of the loan packages inflated the borrowers by at least 5% and that 60% of the loan packages inflated the borrower’s income by more than 50 percent.

Affordable housing goals generally count loans made to borrower’s with below median income.  Inflating the borrower’s true income dramatically would be an irrational strategy for honest lenders subject to the CRA and for Fannie and Freddie’s if they were honest and interested in meeting affordable housing goals by purchasing fraudulent liar’s loans that were sure to cause them catastrophic losses.  Making or purchasing liar’s loans is suicidal for an honest firm – and is a terrible means of trying to meet CRA or affordable housing goals.

OFHEO, Fannie and Freddie’s regulator, had ample authority to prohibit Fannie and Freddie from purchasing liar’s loans.  During Fannie and Freddie huge upsurge in purchasing nonprime loans OFHEO was run initially by Armando Falcon (who resigned on April 5, 2005) – a Clinton appointee who became famous for his disgust for Fannie and Freddie’s leadership and standing up to those leaders.  He received bipartisan praise for his work.

The Washington Post article explains why Falcon’s successor, James Lockhart III, had unprecedented leverage to require Fannie and Freddie to take any actions he felt necessary.  Lockhart was one of President Bush’s earliest friends (from prep school).  Neither Falcon nor Lockhart took any effective action to prevent Fannie and Freddie’s dramatic increase in the purchase of fraudulent liar’s loans.  In fairness to Falcon, at the time he left office Fannie and Freddie did not hold enormous amounts of liar’s loans.  The vast bulk of Fannie and Freddie’s purchase of fraudulent liar’s loans occurred after Falcon stepped down.

The morass that distracts Republicans and Democrats when they debate Fannie and Freddie is what turned out to be a deeply misleading definitional exercise by Edward Pinto, a deeply conservative researcher.   Pinto was correct that Fannie and Freddie’s loan standards (which created the platinum standard for the industry back when Fannie and Freddie still had partially public leadership) made “conforming” lending to homeowners exceptionally safe for lenders.  He was correct in identifying that well before Fannie and Freddie began to purchase enormous amounts of liar’s loans around 2005 those platinum standards began to erode.  This occurred as Fannie and Freddie became wholly dominated by their privatized senior officers and those officers’ bonus programs became larger and tied to relatively short-term reported earnings.

Where Pinto proved incorrect was in labeling virtually all such less than platinum loans as equivalent to subprime loans.  Under Pinto’s unique definition of nonprime an enormous share of all loans purchased by Fannie and Freddie were nonprime from a very early date.  FCIC compared the performance of the Pinto-defined “subprime” loans to loans the financial markets generally considered subprime and liar’s loans.

 The FCIC undertook an extensive examination of the relative performance of mortgages purchased or guaranteed by the GSEs, those securitized in the private market, and those insured by the Federal Housing Administration or Veterans Administration (see figure 11.3). The analysis was conducted using roughly 25 million mortgages outstanding at the end of each year from 2006 through 2009. The data contained mortgages in four groups—loans that were sold into private label securitizations labeled subprime by issuers (labeled SUB), loans sold into private label Alt-A securitizations (ALT), loans either purchased or guaranteed by the GSEs (GSE), and loans guaranteed by the Federal Housing Administration or Veterans Administration (FHA) (FCIC 2010: 216).

The comparison falsified Pinto’s claims that the slightly less pure “prime” loans that Fannie purchased well before the crisis would perform like the loans that the financial markets viewed as subprime or liar’s loans.

 In 2008, the respective average delinquency rates for the non-GSE and GSE loans were 28.3 and 6.2% (FCIC 2010: 219).

The great bulk of the loans from earlier “vintages” that Pinto labeled “subprime” loans did not perform remotely as poorly as the very large group of clearly subprime and liar’s loans that Fannie and Freddie began to purchase in staggering amounts in 2005-2007.  Indeed, even the loans purchased by Fannie and Freddie that the markets generally considered to be subprime or liar’s loans performed far better than subprime and liar’s loans purchased by entities other than Fannie and Freddie (primarily investment banks).

I explained that Fannie and Freddie had two obvious differences from investment banks in the pattern of their purchase of nonprime loans.  Those differences arose from their initial fraud scheme that relied on taking interest rate risk and the resultant crackdown by OFHEO.  The FCIC studies indicate a more subtle difference must also have been present.  The pattern of Fannie and Freddie experiencing far smaller losses from nonprime loans can only have occurred because Fannie and Freddie’s underwriting standards and practices remained considerably less awful than the investment banks’ wholly farcical underwriting standards and practices.  The FCIC studies confirmed that nonprime loans purchased by Fannie and Freddie were far less likely to have as many “layered risks” as loans purchased by the investment banks (FCIC 2010: 219).

Because Fannie and Freddie were subject to affordable housing goals and the investment banks were not the pattern should have been the opposite if the hypothesis that the goals caused the crisis were correct.  The FCIC studies were so devastating that Pinto’s patron, Peter Wallison, was unable to convince any Republican to join his FCIC dissent that sought to blame the crisis on politicians imposing affordable housing goals on Fannie and Freddie.

(A technical note:  it appears that Pinto and FCIC treated the categories “subprime” and liar’s loans as mutually exclusive.  That is incorrect.  There is broad agreement that by 2006 roughly half of all the loans called “subprime” by the markets were also liar’s loans.  Had FCIC studied two categories – subprime liar’s loans and non-subprime liar’s loans – their already devastating refutation of Pinto’s claims would have been even stronger.)

Fannie and Freddie’s superior loan performance relative to the investment banks did not mean that their purchase of liar’s loans was a success.  It was a disaster.  The losses, as a percentage matter, were far lower than the investment banks but Fannie and Freddie are among the largest financial entities in the world and like investment banks that employed Special Investment Vehicles to take much of their debt off their publicly disclosed financial statements, their leverage is extraordinary.  The loans nonprime loans (as the market, not Pinto, conventionally defined the category) suffered losses that swamped Fannie and Freddie’s capital and rendered them massively insolvent.

The central point that Republicans and Democrats miss is that Fannie and Freddie were private.  They had no express federal guarantee.  They failed because, like the failed investment banks, they were looted by greedy bankers – their own officers.  It was their controlling officers who structured the perverse compensation incentives that made accounting control fraud a “sure thing.”  The identification of some of their employees with the public interest reduced, not increased, their losses compared to investment bankers who deride the entire concept of the public interest.  Many of Fannie and Freddie’s employees and even some their important officers identified sufficiently with the public interest that they resisted the total destruction of underwriting.  That reduced the Fannie and Freddie bailout by hundreds of billions of dollars.

Fannie and Freddie were bailed out not because they were the “government” but because they were considered systemically dangerous institutions (SDIs).  A financial institution is bailed out not because it is the “government” but because it is an SDI.  Citicorp’s general creditors have been bailed out by governmental interventions three times not because it is the government but because it is an SDI.  It is true that we do not call Citicorp a Government Sponsored Enterprise (GSE) – but we should, because that is the truth.  All the SDIs are in fact GSEs.  Perhaps if we follow Camus’ advice and begin to call a pestilence by its correct name we can get past some of the silly partisan debates and stop the plague.  Any “too big to fail” financial institution poses a systemic risk to the global economy, makes “free” markets impossible, and poses a grave threat to democracy.  Let’s (1) begin to call them SDIs – and GSEs, (2) forbid them to grow, (3) order them to shrink within five years to the point that they no longer pose a systemic risk (which will also make them far more efficient), and (4) regulate them ultra-intensively until they shrink.

5 Responses to The Central Fact that Folks Don’t Get about Fannie and Freddie’s Role in the Crisis

  1. This is brilliant.

  2. Bill,

    A credit to the citizenry and the field of economics. If I had known of you 17 years ago I would have aspired to study under you at UMKC. Frequent articles of yours give a former economics nerd turned lawyer the info he needs to keep his passion alive for public policy and demonstarted that the field of economics is not devoid of brilliant and independent minded professionals who’s goal is not neo-liberal hegemony but the common good. thank you sir.

  3. There was also a great piece by Ritholtz called The Big Lie that examined this.

    http://www.ritholtz.com/blog/2011/11/examining-the-big-lie-how-the-facts-of-the-economic-crisis-stack-up/

    Mr Black, however, is in a class of his own.

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