Monthly Archives: February 2011

Freddie Mac: Tone Deaf at the Top

By William K. Black

Freddie Mac made a terse announcement Wednesday in a securities filing about the resignation of its chief operating officer, Bruce Witherell. Freddie said that Witherell resigned “for personal reasons.” His departure was effective immediately and he received no termination benefits. He had been receiving several millions of dollars in annual compensation from Freddie. The Wall Street Journal reporter commented:
Efforts to attract and retain top managers at Freddie and its larger sibling, Fannie Mae, have been stymied by salary restrictions that are modest relative to comparable to private sector pay and by the fact that the firm’s federal overseers have effective veto rights over major decisions.
It is true that pay at Fannie and Freddie used to be even more criminogenic. According to the Los Angeles Times:
In 2007, then-Freddie Mac CEO Richard F. Syron had a base salary of $1.2 million and total compensation of $18.3 million, according to SEC filings. In the same year, Daniel Mudd, the chief executive of Fannie Mae, had a base salary of $987,000 and total compensation of $11.7 million.

Those were the days, when you could in a single year be made wealthy for destroying a company and causing scores of billions of dollars of losses to the taxpayers. The title of Akerlof & Romer’s famous 1993 article has never looked more prescient — “Looting: the Economic Underworld of Bankruptcy for Profit.”

I do not know why Witherell resigned. I hope he is not facing a family emergency. I write to ask why he was hired. Witherell’s principal experience was with Lehman. In particular, he was chief executive officer of Aurora Loan Services from 2003 to 2006. Lehman owned Aurora. Aurora specialized in purchasing and reselling “liar’s” loans.

I testified before the House Financial Services Committee on April 21, 2010 about Lehman and Aurora’s pervasive accounting fraud. A copy of that testimony can be found here.

The key point is that Aurora was a massive fraud — purchasing and selling often fraudulent mortgages. It is virtually certain that Freddie purchased material amounts of Aurora’s fraudulent mortgages (directly, or by purchasing collateralized debt obligations (CDOs) that were supposed to be backed by Aurora’s liar’s loans). As my colleague Randy Wray has emphasized, we need a new term for the toxic MBS (mortgage-backed securities) because they often weren’t backed by mortgages due to lender fraud.

The proverbial bottom line is that a global search for talent, after Fannie and Freddie’s second descent into accounting control fraud bankrupted both firms, Fannie and Freddie (with its regulators’ blessing, chose Witherell. (Heidrick & Struggles, which describes itself as the leading executive search firm, issued a press release praising itself for finding Witherell.) When Obama knew he had to clean up the Stygian Stables that were Fannie and Freddie — knew that their senior managers and their regulators had failed catastrophically — he left in charge the failed regulatory leadership team. The regulator team allowed Freddie to select as its COO one of the leaders in the creation of the liar’s loans that were the greatest single contributor to Freddie’s failure and the financial crisis. This was bizarre politics — the senior regulator Obama left in power until his voluntary resignation was a Republican chosen because he was George Bush’s close friend since their days together in prep school. It was even more insane regulatory policy.

Freddie (and Fannie) should be suing Aurora/Lehman for their frauds. Freddie and Fannie should be making thousands of criminal referrals against Aurora’s fraudulent loans. Witherell would be a key witness in the cases. Freddie placed him in impossible positions due to his conflicts of interest.

Aurora was notorious — why would anyone, much less Freddie, hire a top official from one of the firms most responsible for the frauds that destroyed Freddie and cost the taxpayers billions of dollars in losses? Is there anything that a business leader can do that disqualifies him from receiving millions of dollars annually — paid for by the taxpayers? It’s bad enough that our elites now loot with impunity. Do we really have to make them even richer?

Fannie and Freddie have no need to pay these high salaries to senior managers. It was the perverse executive compensation that drove the accounting control frauds at Fannie and Freddie — as the SEC explicitly charged. Executive compensation created the perverse managerial incentives that destroyed Fannie and Freddie. This was an unanticipated consequence of their privatization. Because Fannie and Freddie were privatized, their officers designed their compensation system in the same perverse manner as most firms (Bebchuk & Fried 2004). The mangers stood to gain enormous compensation if they inflated short-term accounting income, and as Akerlof & Romer famously observed, accounting fraud is a “sure thing.” Mr. Raines explained in response to a media question what was causing the repeated scandals at elite financial institutions:

We’ve had a terrible scandal on Wall Street. What is your view?
Investment banking is a business that’s so denominated in dollars that the temptations are great, so you have to have very strong rules. My experience is where there is a one-to-one relation between if I do X, money will hit my pocket, you tend to see people doing X a lot. You’ve got to be very careful about that. Don’t just say: “If you hit this revenue number, your bonus is going to be this.” It sets up an incentive that’s overwhelming. You wave enough money in front of people, and good people will do bad things.
If we are going to continue Fannie and Freddie’s existence then the business model they should follow is simple and requires modest executive pay. Fannie and Freddie should purchase only prime loans and it should promptly package those loans to form MBS and sell the MBS. This will minimize credit and interest rate risk. Fannie and Freddie can hedge the modest interest rate risk created by the “pipeline” of inventory without the need for any esoteric derivatives. The safe business turns out to be a simple business.

‘Reagan Made S&L Crisis Vastly Worse’: William Black Interviewed on The Real News

William Black was interviewed recently on the Real News regarding President Reagan’s role in the Savings and Loan Crisis.  For video and complete transcript click here.

Shmuel Rosner Paints U.S. Neocons as Likud’s Useful Idiots

(cross posted with the Huffington Post)  
The Jerusalem Post columnist Shmuel Rosner has written a revealing column: “Why Israel Hates the Egyptian Uprising.” His conclusion: “when Israel looks at the revolutionary forces in Egypt, it doesn’t see “change,” or “hope,” or “democracy,” or the “end of oppression.” It doesn’t see Egyptians rejoicing in anticipation of their new beginning. All Israel sees is trouble.”
But where Rosner is most interesting from an American perspective is in his description of the Israeli views of U.S. policy towards Egypt and the interaction with Israeli policies. Rosner tells us that Israelis’ view of Mideast policy makers is strictly dichotomous. Rosner accurately portrays the Israeli view as reflecting a consensus — policy views towards Israel’s Arab neighbors once held only by Israel’s ultra right wing parties now dominate all but its rapidly withering left. One branch of the dichotomy contains the philosophers who worry about democracy. They are fools, “wise-ass[es].” Israelis’ hold them in contempt and rightly ignore their consistently bad advice.

The alternative source of policy advice is to “learn from experience.” Experience teaches Israelis that everything that changes in the Mideast harms Israel — except Mubarak’s “cold peace.” Rosner believes that experience counsels Israelis to fear and reject Arab democracy and peace proposals.

So where do American presidents fit in this dichotomy? Well, the supreme success from this Israeli perspective is — President Carter. The Camp David Peace Accords with Mubarak’s assassinated predecessor Anwar Sadat resulted in the peace treaty with Egypt that Mubarak honored. That peace, even if cold, gave Israel the critical strategic advantage of not having to defend against a major conventional attack from its South (more precisely, it reduced the risk of such an attack and provided time for the IDF to mobilize to halt such an attack). The Israeli opponents of the Camp David Peace Accords were the settlers — the group that now purportedly exemplifies “learn from experience” under Rosner’s dichotomy. The settlers, the leading “pragmatists” (as Rosner terms the Israeli opponents of Arab democracy) sought to block the Camp David Peace Accords that Rosner now concludes were the greatest boon to Israeli security.

Under Rosner’s dichotomy, the naïve philosophers obsessed with democracy were George Bush and the U.S. neocons who eagerly launched a voluntary war against Iraq based on lies. Rosner writes to emphasize “that there’s no such thing as an Israeli neocon. The Israeli establishment never believed in promoting democracy in the Arab world, and it still doesn’t. It never much cared about Arab democracy, period.” Rosner thinks that Americans do not understand Israelis; that we had the absurd belief that Israel cared about democracy. Americans have many weaknesses in understanding other nations, but Rosner has picked an area in which Americans largely got it right. As Rosner opines, even among U.S. neocons, the most deluded segment of Americans about the Mideast, “most of them do” know that Israelis do not favor democracy. Quite the opposite — democracy and demographics are Jewish Israelis’ greatest fears because they know that Israeli Jews and Arab Muslims and Christians despise and fear each other. Even Israeli Jews and Arabs have sharply negative views of each other. Jewish demographics push Israel steadily to the right and towards the ultra-religious.

As Rosner pictures the relationship, Israelis originally viewed the neocons and Bush as useful idiots. All the talk of democracy was pure foolishness, but Likud originally believed that having America invade Iraq and provide ever greater military support to the IDF would prove exceptionally useful. Israelis came to doubt how useful the neocons policies were when they observed (1) the voluntary invasion of Iraq made Iran dominant in the region, (2) the wars in Iraq and Afghanistan weakened the U.S. military and greatly reduced its power to credibly project power elsewhere in the Mideast, and (3) the neocons’ Arab democracy ideas led to Hamas taking control of Gaza in relatively democratic elections. The neocons proved to be un-useful idiots to Israel under Rosner’s dichotomy.

As any reader of the Jerusalem Post would find “completely predictable,” the villain of Rosner’s piece is not President Bush, but President Obama. President Obama is the villain because he is like President Carter. Rosner cites Binyamin Ben Eliezer’s attack on Obama as proof of Obama’s pro-democracy folly — because Obama is purportedly risking the peace treaty that Carter negotiated over the opposition of Israel’s leading “pragmatists” — the settlers. Neither Ben Eliezer nor Rosner feel the need to inform the reader that Carter negotiated the treaty that provided the great strategic advantage to Israel and over 35 years of peace between Israel and Egypt.

[Mubarak] is now in danger of being toppled with the prodding and blessing of President Barack Obama and Secretary of State Hillary Clinton.
So, Israelis were stunned to wake up and discover that their American friend had abandoned Mubarak in favor of change. “The Americans brought disaster to the Middle East by calling for [Egyptian President Hosni] Mubarak to leave his country,” said Knesset Member Binyamin Ben Eliezer, a former defense minister and one of Israel’s most establishment-minded politicians. Right and left, coalition and opposition, all but a very few thought poorly of U.S. policy. Everyone felt that the Obama administration had once again been “naive,” or “hasty,” that it didn’t understand the region and didn’t understand the Arab mentality. Israelis were stunned–and somewhat frightened. After all, if Washington has dumped Mubarak, maybe peaceful Egypt is gone for good. And if the United States could desert such a valued strategic ally, maybe we’re next in line for the boot?
Of course, such fears are nonsense. Israel isn’t Egypt, and its ties with the United States run much stronger and deeper. It will not be abandoned with such haste, and anyway, why would anyone want to abandon Israel? Still, there’s something to these fears, because the Egyptian unrest emphasizes the extent to which American and Israeli interests in the Middle East can be different. The United States, for all its many faults, is a dreamer; and Israel is a cynical pragmatist.
The difficulty with all this Israeli pragmatism is that it isn’t pragmatic and it isn’t honest. Israelis demonize Carter because the Shah of Iran “lost” Iran while Carter was President. The Shah was a dying man who had lost the support of “his” people. His military was unwilling to murder thousands of citizen protesters to keep him in power. The U.S., to its credit, was unwilling to urge the Shah to murder thousands of Iranian protesters in the hopes that he could terrorize the population sufficiently to remain in power. Carter did not “lose” Iran, the U.S. did not lose Iran — the Shah lost Iran. The U.S. was not eager to force the Shah from office. The Carter administration, as with prior administrations, was quite willing to have friendly relationships with the autocratic Shah despite SAVAK’s depredations. The U.S.’ dealings with the Shah were always based on pragmatism. If he could stay in control without mass murder and remain friendly to the U.S. the U.S. would be happy to be his ally.

Once the Shah lost control of “his” nation the U.S. goals included arranging safe exile for the Shah (which the U.S. did at some substantial cost, including the seizure of our Embassy and staff). U.S. solicitude for the Shah was an act of pragmatism — we were showing our autocratic allies that even if they lost control and were in danger of being executed the U.S. would be willing to safeguard them and their families even when that would enrage the new government.

It is fantasy, not pragmatism, to believe that Carter had some magic button he could have pressed that would have kept the Shah in power. What was Carter supposed to do? Instruct SAVAK to launch a dirty war of torturing, disappearing, and murdering the Shah’s political opponents? Instruct Iran’s military to turn automatic weapons on the crowds? Assassinate Khomeini? Fly in the ready brigade of the AirCav? To do what? The Shah was a weak, dying, and hated man. Any of these options were almost certain to fail, they would make us hated with a passion, and they would betray everything that makes America a great nation. Does Israel want the U.S. to adopt Assad’s “Hama rules”? (When Haffez al-Assad was faced with revolt in Hama, Syria’s fourth largest city, in 1982, he responded by destroying much of the city and murdering thousands of “his” citizens. The terror “worked” — the revolt was crushed.)

Israel has, for 37 years, had the ability to follow Hama rules because of its decisive military power. It has refused to do so for moral and pragmatic reasons. It should not criticize the U.S. for refusing to descend to a depth of depravity and anti-pragmatic stupidity that Israel wisely refuses to plumb.

The conventional wisdom in Israel about the situation in Egypt today, and the U.S. response to it is fantasy posing as pragmatism. Under the Israeli rewrite of history, the U.S. was eager to push democracy in Egypt and too naïve to understand that the Muslim Brotherhood would come to power and destroy the Camp David Peace Accords with Israel. In the real world, the Obama administration consistently emphasized its support for President Mubarak and refused to criticize him for his consistent denial of democratic rights to the Egyptian people. When the mass protests began recently in Egypt, Obama and Secretary of State Clinton responded by emphasizing their support for him and cautioning against the protests.

What changed the U.S. policy response was that it became clear that Mubarak had lost control of Egypt. The U.S. had no good choices from either the U.S. or the Israeli perspective. Pragmatism means recognizing the limits of one’s power and options and not assuming that there is some “silver bullet” solution that makes difficulties disappear.

The U.S. did not urge Mubarak to conduct a peaceful transition of power until it was clear that he had lost control of Egypt. Rosner’s language choices are all slanted to make Obama the villain. Consider the sentence he uses to begin the critical discussion.

[Mubarak] is now in danger of being toppled with the prodding and blessing of President Barack Obama and Secretary of State Hillary Clinton.
The sentence may be literally true, but it is also deliberately misleading. It would be far more accurate to state that Mubarak has lost control of Egypt because Egyptians no longer respect or fear him. President Obama and Secretary of State Hillary Clinton, after supporting Mubarak for their entire terms in office, finally decided (pragmatically) that even with their continued support Mubarak could not regain control of Egypt without engaging in a campaign of terror against Egyptians. That option was unacceptable to the U.S. on pragmatic and moral grounds. (It may have been unacceptable to Mubarak and the Egyptian Army on the same grounds.)

The U.S. was pragmatic, not naïve, in deciding that it could not keep Mubarak in power. Obama’s dominant policy goal was to attempt to influence the transition in order to maximize the chances that the successor government would continue to honor the Camp David Peace Accords with Israel. No good deed goes unpunished.

Consider also Rosner’s subtle slanting of this passage.

[I]f Washington has dumped Mubarak, maybe peaceful Egypt is gone for good. And if the United States could desert such a valued strategic ally, maybe we’re next in line for the boot?
Rosner conflates the head of state with the nation. The U.S. did not “desert” anyone, and it certainly did not desert Egypt. Our alliance is with Egypt. We never allied with Mubarak against the Egyptian people. We never promised to keep Mubarak in power regardless of the will of Egyptians.

The U.S. remains Egypt’s closest ally. That alliance is not hostile to Israel, indeed, it was essential to attain Egypt’s willingness to enter into the peace accords with Israel — which Rosner and Ben Eliezer agree is the most favorable event for Israel in over 30 years. U.S. taxpayers have provided tens of billions of dollars in aid to Egypt and Israel as part of our broader agreements to support the Camp David accords. Even in the Great Recession the American people have continued this aid without complaint.

The Egyptian people “dumped Mubarak.” If, and only if, Mubarak’s successor repudiates the Camp David Peace Accords, the U.S. will cease its aid to Egypt. Rosner is even more disingenuous in his claims that Israelis are worried that because we have not urged Mubarak to respond to the protestors with terror, Israel may be “next in line for the boot.”

Rosner then adds this bit of faux reassurance to Israelis.

Of course, such fears are nonsense. Israel isn’t Egypt, and its ties with the United States run much stronger and deeper. It will not be abandoned with such haste, and anyway, why would anyone want to abandon Israel? Still, there’s something to these fears….
Because U.S. ties with Israel are “stronger and deeper” than our ties with Egypt we will not “abandon” Israel “with such haste.” The fears he first describes as “nonsense” end up being somehow sensible. Again, he implicitly conflates the head of state with the nation. Consider a hypothetical that makes clear the absurdity of this reasoning. Assume that a future Israeli Prime Minister has a strong majority in the Knesset. The PM has been a good friend of the U.S. and our President and Secretary of State have strongly supported him for years. The PM is indicted because there is compelling evidence that he extorted kickbacks from contractors, but the MKs continue to support his government. Seven hundred thousand Israelis protest in Tel Aviv demanding that the PM resign and that new elections be held. The protests continue and lead to general strike that paralyzes the Israeli economy and endangers the IDF’s ability to mobilize reserves. The U.S. President states that he believes that the PM should call new elections within the month and, for the good of Israel, resign. Israelis might criticize the U.S. President’s comments as an interference in Israeli internal affairs, but it would be insane to claim that the President was “abandon[ing]” either the Israeli PM or Israel. The U.S. never promises to keep a particular Israeli PM in power against the will of the Israeli people. The U.S. alliance is with Israel and it is not dependent on the identity of Israel’s PM.

Wallison and the three “des” – Deregulation, Desupervision and De Facto Decriminalization

By William K. Black

Peter Wallison dissented from the Commission’s finding that deregulation played a material role in the crisis. Here are the key excerpts.
Deregulation or lax regulation. Explanations that rely on lack of regulation or deregulation as a cause of the financial crisis are also deficient. First, no significant deregulation of financial institutions occurred in the last 30 years [p. 445].
Moreover, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) substantially increased the regulation of banks and savings and loan institutions (S&Ls) after the S&L debacle in the late 1980s and early 1990s, and it is noteworthy that FDICIA—the most stringent bank regulation since the adoption of deposit insurance—failed to prevent the financial crisis [p. 446].
The shadow banking business. The large investment banks—Bear, Lehman, Merrill, Goldman Sachs and Morgan Stanley—all encountered difficulty in the financial crisis, and the Commission majority’s report lays much of the blame for this at the door of the Securities and Exchange Commission (SEC) for failing adequately to supervise them. It is true that the SEC’s supervisory process was weak, but many banks and S&Ls—stringently regulated under FDICIA—also failed. This casts doubt on the claim that if investment banks had been regulated like commercial banks—or had been able to offer insured deposits like commercial banks—they would not have encountered financial difficulties [p. 446].
The Commission report and the dissents do not distinguish between the three “des” – deregulation, desupervision, and de facto decriminalization. Deregulation occurs when one reduces, removes, or blocks rules or laws or authorizes entities to engage in new, unregulated activities. Desupervision occurs when the rules remain in place but they are not enforced or are enforced more ineffectively. De facto decriminalization means that enforcement of the criminal laws becomes uncommon in the relevant industries. These three regulatory concepts are often interrelated. The three “des” can produce intensely criminogenic environments that produce epidemics of accounting control fraud. In finance, the central task of financial regulators is to serve as the regulatory “cops on the beat.” When firms gain a competitive advantage by committing fraud, “private market discipline” becomes perverse and creates a “Gresham’s” dynamic that can cause unethical firms and officials to drive their honest competitors out of the marketplace. The combination of the three “des” was so criminogenic that it generated an unprecedented level of accounting control fraud, which in turn produced unprecedented levels of “echo” fraud epidemics. The combination drove the crisis in the U.S. and several other nations.

Wallison discusses only one example of deregulation – the repeal of the Glass-Steagall Act. I show that his claim that “no significant deregulation of financial institutions occurred in the last 30 years” is false.

I do not discuss here in detail the enormous S&L deregulation and desupervision that occurred at the federal and state level that occurred in 1982-83 and made possible the second phase of the S&L debacle – then the worst financial scandal in U.S. history. The first phase of the debacle was caused by interest rate risk. It, ultimately, cost the taxpayers roughly $25 billion to resolve. The second phase of the debacle was driven by the epidemic of accounting control fraud by S&Ls. Deregulation and desupervision in 1981-1983 created the criminogenic environment that allowed that epidemic of fraud. I have written about it extensively in my staff reports to the National Commission on Financial Institution Reform, Recovery and Enforcement and my book: The Best Way to Rob a Bank is to Own One. Akerlof & Romer (1993) used the second phase of the debacle as an exemplar of the title of their article – “Looting: the Economic Underworld of Bankruptcy for Profit.” The criminologists Calavita, Pontell, and Tillman discuss the fraud epidemic in their book – Big Money Crime. Airbrushing the deregulation and desupervision that permitted the second phase of the S&L debacle out of history is necessary to Wallison’s central task – defending his disastrous lobbying for decades for financial deregulation. We will see that the S&L deregulation and desupervision are not alone in disappearing from Wallison’s rewrite of history.

I will also not discuss in detail the enormous desupervision that occurred at the SEC that permitted the Enron-era frauds. The budget and staffing of the SEC were kept relatively flat while its workload grew enormously. The percentage of fillings it reviewed declined to five percent. Congressional Republicans consistently sought to cut the SEC’s budget and staffing levels in the 1990s. Criminologists refer to the result as a “systems capacity” problem. (see here and here)

As SEC enforcement director Robert Khuzami emphasizes, the SEC must serve as the regulatory “cops on the beat.” The staff and budgetary limits rendered the SEC incapable of performing its primary statutory mission.

In sum, Wallison’s history excludes the deregulation and desupervision that permitted the two massive financial crises that preceded the current crisis. We will see that Wallison also ignores the major acts of deregulation, desupervison and de facto decriminalization that made possible the current crisis.


This column addresses the role of deregulation in allowing the current crisis. I break the discussion in to three subsets: deregulation by legislation, deregulation by rule changes, and an odd hybrid – the SEC’s Consolidated Supervised Entities (CSE) program.

Deregulation by Legislation

Gramm-Leach-Bliley (1989) repeals the Glass-Steagall Act and Reduces CRA Examination

The repeal of Glass-Steagall demonstrates the complexity of what deregulation can mean. The banking regulatory agencies were extremely hostile to the Glass-Steagall Act. They eviscerated the Act by adopting rules and interpretations that created so many exceptions to Act’s separation of “banking and commerce” that the separation was rendered ineffective. The federal regulators also did not enforce the remaining provisions of the Act vigorously even before it was repealed in 1999. The combination of deregulation and desupervision by the banking regulators so gutted the Act that its formal repeal by the Gramm-Leach-Bliley Act in 1999 had little practical effect.

Wallison refers to a modest regulatory strengthening of the CRA rules in 1995, but he does not inform the reader that the GLB Act reduced the frequency of examinations of smaller and rural banks under the Community Reinvestment Act (CRA) and sought to discourage alleged extortion by housing activist organizations (e.g., ACORN) by requiring the disclosure of any agreements they made with banks not to challenge mergers. Senators Dodd and Schumer led the group of Democrats that successfully pushed these anti-CRA provisions on a reluctant White House because the Democrats were so eager to repeal Glass-Steagall. (see here)
Wallison does not disclose this deregulatory aspect of the GLB Act because it falsified his claim that the CRA caused the crisis.

If there is doubt that these lessons are important, consider the ongoing efforts to amend the Community Reinvestment Act of 1977 (CRA). Late in the last session of the 111th Congress, a group of Democratic congress members introduced HR 6334. This bill, which was lauded by House Financial Services Committee Chairman Barney Frank as his “top priority” in the lame duck session of that Congress, would have extended the CRA to all “U.S. nonbank financial companies,” and thus would apply, to even more of the national economy, the same government social policy mandates responsible for the mortgage meltdown and the financial crisis [p. 443].
There are many crippling flaws in Wallison’s claim that the CRA was “responsible for the … crisis.” Here, I note only the fact that the timing and direction of regulatory changes falsify his claim that the CRA was responsible for the crisis. The obvious problem is that the CRA had been in effect since 1977 – so one must assume a fictional latency effect of 15 years, a period that included two recessions, before the CRA suddenly became toxic. The recessions should have exposed any toxic aspects of the CRA long before the current crisis. The less obvious problem is that the CRA was weakened, not strengthened, after 1999. This refutes Wallison’s assertion that the CRA was “responsible for the … crisis.” As I will explain, the statutory weakening of the CRA in 1999 was compounded by other forms of deregulation and desupervision during the run-up to the crisis in 2001-2007.

I prepared the chart below by searching the FFIEC data base for CRA rating by date of the CRA examination.(see FFIEC website here)

The chart confirms a number of points that anyone who has ever been a financial regulator after the passage of the CRA in1977 knows. CRA ratings have long been like Lake Woebegon’s children: they’re virtually all above average. Fewer than ten banks get rated as a serious problem – and even they get treated with kid gloves. Examine the data for 1999 and 2000. The examiners discover seven serious CRA problems in 1999 – slightly above one-tenth of one percent of the banks examined. That CRA rating “substantial noncompliance” triggered a requirement for annual CRA reexaminations of the non-magnificent seven and should have led to immediate enforcement actions. Clinton was President and had appointed each of the regulatory leaders. By 2000 the regulators appointed by Clinton (who Wallison seeks repeatedly to cast as the villains) acted so aggressively against the seven that the 2000 exams revealed that there were still seven awful banks. It’s not like banks were failing frequently in this period and requiring the regulators’ attention to be paid solely to “safety and soundness.” The claim that banks lived in fear of the CRA and that the CRA drove their lending decisions is pure fiction. Banks routinely got satisfactory or outstanding ratings by making good loans. Banks had to try hard to get poor ratings and even the tiny minority that did so rarely faced any meaningful sanction.

The data in the chart also show that the statutory deregulation, reducing CRA examination frequency, was significant. The number of annual CRA examinations in the 2000s was typically well under one-half of the number of CRA examinations in 1995. Wallison is deliberately disingenuous in stopping his discussion of CRA changes in 1995. Both statutory and regulatory deregulation of the CRA occurred after that date. (My next column will also discuss the desupervision of CRA compliance that occurred during the 2000s.) The CRA, and its enforcement, became weaker as the mortgage fraud epidemic surged. That (further) falsifies Wallison’s claims that the CRA was “responsible for the … crisis.”

Statutory changes that allowed the creation of “private label” MBS

The SEC, Department of the Treasury, and OFHEO (which regulated Fannie and Freddie) created a joint task force, which issued: A Staff Report of the Task Force on Mortgage-Backed Securities Disclosure in January 2003.

The Task Force report explained two key statutory changes that made possible the rise of private label

A number of regulatory and tax constraints initially impeded private entities from expanding into the MBS market created by the GSEs and Ginnie Mae.
1. Secondary Mortgage Market Enhancement Act of 1984
Many of the regulatory constraints affecting private entities were removed in 1984 with the passage of the Secondary Mortgage Market Enhancement Act of 1984 (“SMMEA”). SMMEA was intended to encourage private sector participation in the secondary mortgage market by, among other things, relaxing certain regulatory burdens that affected the ability of private-label issuers to sell their MBS.14 For example, SMMEA allowed state and federally regulated financial institutions to invest in privately issued mortgage related securities.
2. Effect of Tax Laws on MBS Markets
Tax law constraints also affected the types of MBS that could be sold. Until the passage of the Tax Reform Act of 1986 (“1986 Tax Act”), which recognized the Real Estate Mortgage Investment Conduit (“REMIC”) structure with its beneficial tax treatment, most MBS were sold as “pass-through” securities. As discussed below, pass-through securities pay an investor principal and interest received from payments on the mortgage loans that are the assets of the trust. The payments on the mortgage loans are passed through the trust to the investors as they are made.
Before 1986, the effect of the limitation on activity of grantor trusts under the tax laws restricted the use of trusts with multiple classes of securities with differing payment characteristics. In the multi-class structure, the principal and interest payments are not just passed through pro rata as paid to all investors, but rather are divided into varying payment streams to create classes with different expected maturities, different levels of seniority or subordination or other differing characteristics. Prior to 1986, the tax law treated these multi-class trusts as associations taxable as corporations, and distributions would have been taxable at the trust level and also at the trust investor level. This “double taxation” made multi-class structures generally unfeasible.
The 1986 Tax Act eliminated the double taxation for multi-class vehicles structured as REMICs. With the advent of the REMIC, more complex structures with multiple classes were developed which divided up the payment streams on the mortgage loans that were collateral for the securities repayment obligations to investors.
The statutory changes that allowed the creation of an extensive private label MBS system were major contributors to the crisis. Wallison has particularly compelling reasons for seeking to blot the deregulation that led to the rise of private label MBS out of existence. As I explained in a prior column, Wallison praised the role of private label MBS, praised its provision of subprime loans, and derided Fannie and Freddie for failing to make as many loans to less wealthy Americans as their private label competitors did.
The existence and business practices of the private label competitors refute Wallison’s claims. The private label competitors were not subject to affordable housing goals. If they securitized toxic CDOs (and they did), and if they did so before Fannie and Freddie became the dominant purchaser of toxic CDOs (and they did), then Wallison’s claim that Fannie and Freddie’s affordable housing goals caused the crisis fails yet again.

As late as October 2006, the view from the mortgage industry was that the private label MBS issuers were dominant and likely to remain dominant over Fannie and Freddie precisely because the private label issuers were far more aggressive than Fannie and Freddie in making far riskier loans to less wealthy Americans. Here’s how the Mortgage Bankers Association’s (MBA) trade magazine explained the role of Fannie and Freddie vis-a-vis Fannie and Freddie.

The rise of private label: innovative mortgage products, enthusiastic investor support and consumer demand for new affordable loans have all come together to give extraordinary new power to the private mortgage-backed securities market. This has left the private sector setting the rules once largely dictated by Fannie Mae, Freddie Mac and FHA.
A change in the mortgage-backed securities (MBS) market that began more than two years ago appears to have completely reshuffled the industry’s deck of cards. Now, issuers of private-label residential MBS are holding the aces that were once held by the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. Once a junior–but powerful–player in the market, private-label residential mortgage-backed securities (RMBS) are now the leading force driving product innovation and the net overall volume of mortgage origination. Further, it appears that the new dominant role for private-label RMBS may be here to stay.
Product innovation has resulted from two developments, the first is mortgage consumers looking for new low-payment mortgages to help them afford rising home prices. The other is the growing willingness of investors to fund the new types of mortgage products that lenders have developed to meet this need.
Mortgages that offer low monthly payment options often do not amortize the principal balance on the loan, and may even negatively amortize. These products–interest-only (IO) mortgages and option adjustable-rate mortgages (option ARMs)–are the primary generators of gains in market share for private-label issuers.
There are also new nontraditional mortgage products that amortize, but extend the amortization term from the current 30 years to 40 and even 50 years in an effort to bring down the monthly payment.
The expectation that private-label issuers are likely to retain their dominant position was the consensus view of the [MBA’s] Council to Shape Change, a blue-ribbon mortgage industry panel of 19 experts that published its findings in August.
The council, echoing what other market observers have said, cited the lag in product innovation as “the most important factor” holding the agencies back. “Most of the business now considered alt-A used to be prime business and would have fallen in the GSEs’ sweet spot,” the report states.
Another factor in the market shift has been the ability of mortgage originators to increasingly securitize their own production. With this new capability, originators have been able to “adversely select the GSEs, feeding only product that lenders cannot advantageously securitize themselves,” the council’s report notes.
Also, due to sharply rising home prices and the limits on the size of loans they can purchase, Fannie Mae and Freddie Mac are a minimal presence in states such as California, the nation’s largest mortgage market.
To get a sense of the dramatic nature of the shift in market share, a few numbers help tell the story. As recently as 2003, the agencies issued 76 percent or $2.13 trillion of the year’s $2.72 trillion in mortgage-backed securities, according to data compiled by Inside Mortgage Finance (see Figure 1). These numbers include Fannie Mae, Freddie Mac and Ginnie Mae securitizations.
In 2003, the non-agency or private-label RMBS was only 24 percent or $586 billion. Most of these were jumbo prime mortgages. The ground began to shift in the second half of 2004 as the refi boom subsided and interest rates began to rise, and home-price appreciation raced ahead at double-digit rates–prompting the introduction of a flurry of new affordability products.
By year-end 2004, agency RMBS issuance represented $1.02 trillion, while the non-agency piece had risen to $864 billion out of a total of $1.88 trillion, according to Inside Mortgage Finance (see Figure 2).
In 2005, the private-label RMBS surged into the dominant position, with $1.19 trillion or 55 percent of the $2.16 trillion in securities issued, while the agencies issued $966 billion (see Figure 3).
By the first half of 2006, the private-label share has strengthened still more to 57 percent or $577 billion, according to Inside Mortgage Finance. Agency issues totaled $439 billion of the $1.12 trillion market.

Note the comprehensive refutation of Wallison’s thesis provided by the findings of the MBA study. The MBA was an opponent of Fannie and Freddie because it believed that they acted to reduce yields on home loans. The MBA was overjoyed that Fannie and Freddie were losing market share. The MBA attributed Fannie and Freddie’s loss of market dominance to the private label issuers’ far greater willingness to make extreme risk loans to less wealthy Americans. The MBA explained that it was investors’ growing willingness to purchase toxic MBS issued by private label firms that was driving the rapid growth of the private label firms. The MBA study did not find that Fannie and Freddie were the investors purchasing the private label issuers’ toxic MBS. Douglas Holtz-Eakin, later appointed by the Republican Congressional leadership as an FCIC Commissioner, was one of the consultants to the MBA’s Council to Shape Change.

Wallison ignores the passage of the Commodities Futures Modernization Act of 2000

The Commodities Futures Modernization Act of 2000 created two regulatory black holes. Enron exploited one to help create the California energy crisis of 2001. The Act also created a massive regulatory black hole with regard to credit default swaps (CDS). Wallison does not mention the passage of the CFMA. He concedes that AIG took crippling losses from its CDS exposure but dismisses it as an “outlier” (p. 447).

Deregulation by Rule

Wallison fails to mention the major acts of deregulation by rule or interpretation that made substantial contributions to the crisis. I discuss four examples of this form of deregulation.

Rules Reducing Underwriting and Recordkeeping Requirements

On December 31, 1992, the Office of Thrift Supervision (OTS), and its sister federal banking agencies, adopted the Real Estate Lending Standards Rule (RELS), 12 CFR § 560.100-101. The OTS’ prior standard required minimum underwriting demonstrating that the borrower could repay the loan and that the collateral value was adequate to repay the loan in the event that the borrower did not pay. The OTS’ rule was of tremendous value in allowing the OTS to take effective supervisory and enforcement actions and the Justice Department’s fraud prosecutions. The OTS rules also required contemporaneous documentation of that the borrower had conducted the required underwriting. The joint agency standards, however, allowed the lender to establish its underwriting standards and its documentation standards. The result was a very substantial deregulation and impaired ability to supervise, take enforcement actions, and prosecute frauds.

Basel II Reduces Capital Requirements

Wallison mentions the Basel II deregulation only once in passing, without seeming to realize that it refutes his claim that there was no important deregulation in 30 years.

Beginning in 2002, for example, the Basel regulations provided that mortgages held in the form of MBS—presumably because of their superior liquidity compared to whole mortgages—required a bank to hold only 1.6 percent risk-based capital, while whole mortgages required risk-based capital backing of four percent [p. 476].
As weak as U.S. banking regulators were during the crisis, they had great concerns about Basel II’s deregulation and limited it. The Shadow Financial Regulatory Committee expressed similar concerns. Europe, unfortunately, bought into Basel II’s deregulation whole hog, which explains why their banks’ reported leverage was far higher than U.S. banks. (One must always remember that banks’ actual leverage is often dramatically greater than reported leverage.)

Rules and Interpretations Preempting State Laws and Rules

Wallison ignores deregulation via preemption even though it was a major aspect of deregulation in the current crisis. It is particularly understandable that Wallison does not acknowledge preemption because he favored federal regulators’ preemption of state efforts against predatory lending in his capacity as a member of the anti-regulatory and self-selected “Shadow Financial Regulatory Committee.” Statement No. 195 of the Shadow Financial Regulatory Committee on Predatory Lending and Federal Preemption of State Laws (September 22, 2003); Statement No. 186 of the Shadow Financial Regulatory Committee on State and Federal Securities Market Regulation (calling for federal preemption of then NY Attorney General Spitzer’s actions against securities firms) (February 24, 2003).

The federal agencies actually competed to be the most aggressive preemptors. The competition in laxity added greatly to the desupervision that will be the subject of my next column, but it also produced deregulation at the state level. The Commission report makes this plain.

The Comptroller of the Currency took the same line [as the OTS] on the national banks that it regulated, offering preemption as an inducement to use a national bank charter. In a speech, before the final OCC rules were passed, Comptroller John D. Hawke Jr. pointed to “national banks’ immunity from many state laws” as “a significant benefit of the national charter—a benefit that the OCC has fought hard over the years to preserve.” In an interview that year, Hawke explained that the potential loss of regulatory market share for the OCC “was a matter of concern” [p. 112].
Note that the strident efforts that federally insured banks and S&Ls made to preempt state efforts to prevent predatory loans by non-insured affiliates further demonstrates that banks and S&Ls made nonprime loans for the purpose of maximizing short-term reported income – not because of the CRA. They were eager to expand their fraudulent liar’s loans and feared State enforcement efforts against such lending.

Rules Further Reducing the Scope of the CRA

In addition to the statutory deregulation of CRA provisions wrought by adoption of the Gramm-Leach-Bliley Act in 1999, the federal regulatory agencies further reduced enforcement of the CRA by rule in 2004 and 2005 by expanding the definition of small banks from $250 million in assets to those with assets up to $1 billion. The rule changes reduced substantially the amount of information on loans the banks now considered small would have to provide and make public and reduced CRA examination frequency for many banks.

A Hybrid: the SEC’s Consolidated Supervised Entity (CSE) Program

There are regulatory actions that do not fall neatly into any category. The SEC, for example, created a regulatory structure for the purpose of blocking regulation. The context was that the European Union (EU) issued its Financial Conglomerates Directive was going to regulate the largest U.S. investment banks – unless they were regulated by the U.S. on a “consolidated supervision” basis. The SEC rushed to create a regulatory structure that the investment banks could voluntarily opt into – the Consolidated Supervised Entities (CSEs). The SEC’s CSE program was a sham. The SEC was supposed to act in an unprecedented capacity as a safety and soundness regulator (in addition to its role as a regulator of disclosures) over five of the largest, most complex financial institutions in the world. The SEC had no expertise and no systems that would allow it to succeed. But the Sec didn’t even try, its CSE program was a sham designed to block EU regulation of the largest investment banks. Each of the largest U.S. investment banks promptly volunteered to be regulated by the SEC’s CSE program. (The OTS, the weakest of the weak banking regulators, entered the competition in laxity with the SEC – and lost decisively. Each of the large investment banks voluntarily joined the CSE program. When an agency makes it clear that it will be a clearly weaker regulator than the OTS during the 2000s one knows that the agency has attained the status of flagrantly farcical.) The CSE program was so understaffed that it had three employees assigned to supervising Lehman. The CSE program was faux regulation. It created a de facto regulatory black hole for the largest investment banks that effectively reduced the investment banks’ capital requirements. The Commission report discusses the CSE program (pp. 150-155), the Republican dissents do not.


The three “des” – deregulation, desupervision and de facto decriminalization are the defining regulatory characteristics that, along with the perverse incentives of modern executive compensation and the ability of accounting control frauds to suborn purported “controls” (credit rating agencies, auditors, and appraisers) created the criminogenic environment that produced the epidemics of fraud that drove the current crisis. Wallison is correct that federal banking regulation law was made tougher in 1989 and 1991. On the SEC front, Sarbanes-Oxley attempted to toughen the securities laws. Each of those attempted positive statutory actions was overwhelmed by the rampant desupervision. Wallison is incorrect in claiming that there has been no significant financial deregulation in the last 30 years. There has been very little desirable financial deregulation in the last 30 years, but there has been extensive, destructive deregulation. Deregulation played a major role in the S&L debacle and the current crisis.

Wallison Reinvents History – and His Own Positions on the Causes of the Crisis

By William K. Black

(Cross-posted with Benzinga)

The big news in U.S. regulation last week was the release of the Financial Crisis Inquiry Commission reports. (There’s a major article in the New York Times about Kabul Bank that supports warnings made in my earlier column on that scandal.) The Commission report and the two dissents discuss some of the most important topics in financial regulation, so I will devote a series of columns to the reports, beginning with the dissent of the nation’s leading anti-regulator – Peter Wallison. Wallison’s passion, for forty years, has been financial deregulation and desupervision. The Republican Congressional leadership appointed him to the Commission to serve as apologist-in-chief for the deregulation and desupervison that made the crisis possible.
We’ll explore Wallison’s dissent in greater detail in future columns, but this overview column addresses his three primary arguments: Fannie and Freddie are the Great Satans, they caused the crisis because of demands politicians put on it to purchase the subprime loans that caused the crisis, and all of this was compounded by the Fed’s easy money policies.

This column discusses Wallison’s views on the first two subjects while the crisis was developing. Wallison is well-known for his long-standing criticisms of Fannie and Freddie, but most people do not know the nature of those criticisms. Wallison praised subprime mortgage loan and complained that Fannie and Freddie purchased too few subprime loans. Wallison (correctly) explained that Fannie and Freddie’s CEOs acted to maximize their wealth – not to fulfill any public purpose involving affordable housing. He also explained that they used accounting abuses to make themselves wealthy. He predicted that low capital costs would increase economic growth. Wallison’s prior views contradict his current claims. Aspects of Wallison’s prior views were correct. They support the conclusion that Fannie and Freddie were accounting control frauds.

Wallison’s Ode to Low Interest Rates

Testimony before the Subcommittee on Securities of the Senate Committee on Banking, Housing and Urban Affairs
By Peter J. Wallison
Senate Committee on Banking, Housing, and Urban Affairs
(July 19, 2000)

If capital costs are low, more capital will be available for companies that need it, capital will be allocated more efficiently, we will have faster and broader-based economic growth, and the welfare of all Americans will be enhanced.
(Parenthetically, Wallison’s July 19, 2000 Senate testimony disputed the claim that there was a high tech bubble – even as the bubble was collapsing.)

Wallison’s Ode to Subprime Lending

Wallison and his AEI colleague Charles Calomiris co-chaired AEI’s project on financial market deregulation . They were also members of the Shadow Financial Regulatory Committee (a self-selected group of deregulatory scholars and practitioners associated with AEI).

Statement of the Shadow Financial Regulatory Committee on Predatory Lending
December 3, 2001. Statement No. 173

The Federal Reserve is in the process of drafting detailed regulations dealing with alleged problems of so-called “predatory lending” in the subprime mortgage market, and the Congress is considering actions to curb various alleged abuses in this type of lending.
Because much of what is classified as predatory lending involves loans to low-income, minority, and higher-risk borrowers, a central principle that should guide legislation and regulation in this area is the desirability of preserving access to subprime mortgage credit for such borrowers, who are most at risk of losing access to this market in the wake of misguided and punitive regulations. The democratization of consumer finance that has occurred over the past decade has created new opportunities for low-income consumers. This is now threatened by chilling effects that inappropriate regulations and laws might have on the supply of subprime credit to these consumers.
Subprime credit to low-income consumers necessarily entails higher interest rates. As recent evidence of increasing loan defaults demonstrates, this line of business is risky, and institutions will only be willing to provide such credit if interest rates are sufficiently high relative to risks and other costs of servicing consumers. One of the risks that must be borne by intermediaries is regulatory risk. Laws or regulations that place lenders at greater risk of legal liability for having entered into a loan agreement (for example, state and municipal statutes that penalize refinancings that could be deemed contrary to the interests of the borrower) generally will reduce the supply of beneficial lending as well as predatory lending. Illegal lending, however, would not be reduced; indeed, it would be encouraged.
Wallison Criticized Fannie & Freddie for Making too Few Loans to the Less Wealthy

Wallison’s critique of Fannie and Freddie emphasized their failure to make more subprime loans and loans to minorities.

H.R. 3703 and its Effects on Government Sponsored Enterprises
By Peter J. Wallison
House Subcommittee on Capital Markets
(September 06, 2000)

The GSE form–at least as it is embodied in Fannie Mae and Freddie Mac–contains an inherent contradiction. It is a shareholder-owned company, with the fiduciary obligation to maximize profits, and a government-chartered and empowered agency with a public mission. It should be obvious that it cannot achieve both objectives. If it maximizes profits, it will fail to perform its government mission to its full potential. If it performs its government mission fully, it will fail to maximize profits.
[T]he incentives of their managements [are] to increase their own compensation.
This has direct consequences in the real world. Since 1992, Fannie and Freddie have had an obligation to assist in financing affordable and low income housing. Obviously, doing so would be costly, and would thus reduce their profitability. Studies now show that their performance in financing low income housing—especially in minority areas—is far worse than that of ordinary banks. In other words, despite the fact that Fannie and Freddie receive subsidies to perform a government mission—in this case support of low income housing—their need for and incentives to retain a high level of profitability is an obstacle to their performance.

The Public Trust of a GSE
By Peter J. Wallison
2002 Federal Home Loan Bank Directors Conference
(November 14, 2002)

Other GSEs–and here I am thinking specifically of Fannie Mae and Freddie Mac–while they hold a government charter, are much closer to the business corporation model. They have actual shareholders, are listed on a securities exchange, and in terms of the way they present themselves to the financial markets are profit-maximizing entities. Although five of their directors are appointed by the president, I am told that these directors are advised by counsel for Fannie and Freddie that their duty of loyalty runs to the corporation and its shareholders and not to any stakeholder or any government mission.
[T]he subsidy realized by Fannie and Freddie is the worst kind of corporate welfare–a transfer of wealth from the taxpayers to both the generally well off (Fannie and Freddie’s investors) and the genuinely wealthy (Fannie and Freddie’s managements).
We understand from the rules of corporate governance that the directors of corporations like Fannie Mae and Freddie Mac are expected to serve the interests of the corporation and the shareholders by seeing to the maximization of profits. The fact that they have a government mission is irrelevant–as is, we are told, the fact that some of them are appointed by the president. So, in a quite literal sense the directors of Fannie and Freddie face a conflict between the government mission of their corporations and their duty to maximize profits for shareholders. Any claim that they are discharging a public trust is an illusion. To the degree that they do anything less than maximizing profits it is to maintain their valuable franchise by reducing their political risk, not because they are voluntarily fulfilling some public trust. It can’t be otherwise; they are legally bound to a duty only to the corporation and its shareholders.
This is very clearly seen in Fannie and Freddie’s activities in affordable and minority housing. Study after study has shown that they are doing less for those who are underserved in the housing market than banks and thrifts. Not only do they buy fewer mortgages than are originated in minority communities, the ones they buy tend to be seasoned and thus less risky. Despite Fannie’s claims about trillion dollar commitments, they are meeting their affordable and minority housing obligations by slipping through loopholes in the loosely written and enforced HUD regulations in this area.
In other words, two companies that are immensely profitable and claim to have a government mission, are doing as little as they can get away with for those who most need assistance–while swamping the airwaves with advertising that they are putting people in homes. This should be no surprise, since their incentives push them in this direction. As shareholder-owned companies, they are maximizing their profits–as they must–while doing just enough to avoid the criticism that might result in the loss of the government support that enables them to earn these profits.
Wallison dismisses the concept that Fannie and Freddie’s senior managers (the “genuinely wealthy”) even consider the public interest – their “government mission is irrelevant” to their decision-making. He explains that Fannie and Freddie’s leaders act like fully private CEOs.

Fannie Mae and Freddie Mac
By Peter J. Wallison
House Subcommittee on Commerce, Trade and Consumer Protection
(July 22, 2003)

Fannie and Freddie suggest that they provide special assistance to minority families hoping to become homeowners. And if they did this disproportionately–that is, helped minorities or low income borrowers more than they helped middle class borrowers–that would be a powerful argument for preserving their current status.
But they do not do this. Instead, according to a study by Jonathan Brown of Essential Information, a Nader-related group, Fannie and Freddie buy proportionately fewer conventional conforming loans that banks make in minority areas than they buy in middle class white areas. Other studies have shown that the automated underwriting systems that Fannie and Freddie use to select the mortgages they will buy approve fewer minority homebuyers than similar automated underwriting systems used by mortgage insurers.
The sad fact is that Fannie and Freddie–two government sponsored enterprises that have a government housing-related mission–do less for minority housing than ordinary commercial banks. Studies have repeatedly shown that banks and other loan originators make more loans to minority borrowers than Fannie and Freddie will buy. That in itself should be a scandal, together with the fact that both companies seek through their soft-focus advertising to create the impression that they are actually using their government benefits for the disadvantaged in our society.
Wallison’s verbal assault on Fannie and Freddie was vigorous. He viewed their failure to make more loans to minorities to be a “sad fact” and a “scandal.”

I will begin the explanation in this column of why Wallison’s lack of understanding of accounting fraud leads him to err in his view that Fannie and Freddie’s senior managers were acting to fulfill their fiduciary duties to the shareholders. (It’s an odd error for a man whose normal premise is wealth maximization. As with “public choice” theory, the neoclassical prediction should be that the CEO will act to maximize his wealth – not the shareholders’ wealth. Term it “CEO choice theory.”) Wallison does not understand that Fannie and Freddie’s controlling officers would come to see that purchasing large amounts of “liar’s” and subprime loans was an ideal strategy for short-term wealth maximization. Nonprime mortgage loans made it easy for Fannie and Freddie’s senior officers to supply the first two ingredients in the four-part recipe by which lenders (and purchasers of loans) that are accounting control frauds maximize short-term accounting income.

1. Extreme growth

2. Through making bad loans at premium yields

3. With extreme leverage, and

4. Providing only trivial loss reserves

As Akerlof & Romer (1993) explained, accounting fraud is a “sure thing.” A lender that follows the recipe is guaranteed to report record income in the short-term, which translates to making the senior officers wealthy. The SEC’s complaint against Freddie’s senior managers stated that the reason they caused Freddie to engage in accounting fraud was to maximize their compensation. Fannie and Freddie’s CEOs eventually came to see that there was no conflict between their desire to become personally wealthier and purchasing bad loans with high nominal yields (and real losses).

Wallison is correct, however, that it was only after Fannie and Freddie’s use of an alternative accounting fraud scheme based on rapid growth and taking serious interest rate risk was discovered by the SEC and ordered terminated by OFHEO that Fannie and Freddie vastly increased their purchase of nonprime loans and MBS. Fannie and Freddie were late to the nonprime party – the giant investment and commercial banks were the leaders in securitizing toxic mortgages to form toxic collateralized debt obligations (CDOs).

Wallison Welcomed a Federal Crackdown on Fannie and Freddie

The Public Trust of a GSE
By Peter J. Wallison
2002 Federal Home Loan Bank Directors Conference
(November 14, 2002)

In part, I blame HUD for letting Fannie and Freddie get away with this. Over both Republican and Democratic administrations, HUD has failed to adopt regulations that would require Fannie Mae and Freddie Mac to use a significant portion of the profits they derive from their government support to add appreciably to the housing finance resources available to low-income families. This is in part because the HUD regulations establish a single broad category for low and moderate income families–allowing Fannie and Freddie to meet their requirements through the purchase primarily of moderate income mortgages–and also define underserved areas so broadly that Fannie and Freddie are not compelled to purchase many of the mortgages that banks and thrifts make in meeting their CRA obligations. In a memorable demonstration at an AEI conference two years ago, Jonathan Brown of Essential Information showed aerial views of Chicago neighborhoods with overlays for areas where Fannie and Freddie were and were not purchasing mortgages. Brown’s overlays showed clearly that the low income and minority areas of Chicago were being bypassed by Fannie Mae and Freddie Mac.

To be sure, the jury is still out on the Bush administration’s stewardship of HUD. In a June speech, the President identified increasing home ownership for minorities as a key goal of his administration. In October, he hosted a conference on minority home ownership, where he proposed a $200 million fund to provide up to 40,000 minority families with downpayment assistance. An amount of this size would be a fraction of what Fannie and Freddie earn each year through their government support. It may well be that HUD, in vigorously pursuing all avenues to advance the President’s program will seek to tap this source in some significant way. I hope so, but it remains to be seen. Only then, albeit under duress, will Fannie and Freddie be in any sense fulfilling the public trust of a GSE.

HUD’s Affordable Housing Regulations
By Peter J. Wallison
AEI event on HUD’s housing regulations
(September 13, 2004)

In recent years, study after study has shown that Fannie Mae and Freddie Mac are failing to do even as much as banks and S&Ls in providing financing for affordable housing, including minority and low income housing. After studying the issue for years, HUD has finally proposed regulations that would tighten the definitions of such terms as “low and moderate income,” “underserved areas,” and “very low income families.” Then HUD set a goal that required Fannie and Freddie to devote increasing percentages of their total business to assisting families in the affected groups to become home owners.
In the regulations we will be considering in this conference, HUD is making a valiant effort to bring the activities of Fannie and Freddie into alignment with their statutory mission and with their advertising claims..
Wallison “blame[d]” HUD for not cracking down on Fannie and Freddie’s relatively small purchases of loans to poorer minorities. He noted with relief that HUD had “finally” decided to crack down after reviewing “years” of “study after study” demonstrating that Fannie and Freddie purchased fewer nonprime loans than did the large banks. Wallison called HUD’s new effort “valiant. He wrote “I hope so” in reference to the possibility that President Bush would compel Fannie and Freddie to increase greatly their provision of affordable housing loans.

Are Fannie Mae and Freddie Mac Meeting Their Obligations?
By Peter J. Wallison
AEI event on Fannie Mae & Freddie Mac
(June 09, 2003)

Introduction by Peter J. Wallison at 6/9/2003 “Are Fannie Mae and Freddie Mac Meeting Their Obligations?” event.

Now, I want to be clear about what the problem is. In reality, Fannie and Freddie are not charged by statute with responsibility for increasing minority housing
Wallison’s Recognition that only Fannie and Freddie’s Actions Mattered

Wallison repeatedly emphasized that Fannie and Freddie’s CEOs were wealth-maximizers who used affordable housing as propaganda to cover-up their self-interested behavior.

HUD’s Affordable Housing Regulations
By Peter J. Wallison
AEI event on HUD’s housing regulations
(September 13, 2004)

[I]t is doubtful that any set of regulations and any enforcement would be successful in driving these companies in a direction they do not want to go. That is the subtext of the discussion today.
There is a cottage industry in former Fannie and Freddie officers trying to claim that they were forced to purchase bad loans by the government to help poorer Americans. Wallison never believed it then, but he purports to believe it now when it is useful to his historical revisionism.

Wallison was Concerned about Fannie and Freddie’s Interest Rate Risk, not Credit Risk

Fannie Mae and Freddie Mac
By Peter J. Wallison
House Subcommittee on Commerce, Trade and Consumer Protection
(July 22, 2003)

Wallison gave this testimony in the context of the SEC’s exposure of Fannie and Freddie’s accounting fraud. The scheme was to take substantial interest rate risk. Freddie bet that rates would fall and Fannie bet they would rise – they fell. If the gamble worked the firm would report record profits and maximize the officers’ bonuses. Indeed, Freddie’s profits were so large that it (unlawfully) created “cookie jar” reserves that it could draw on in lean quarters to “hit the number” and maximize executive bonuses. Fannie unlawfully hid the losses on its interest rate bets by improperly calling them hedges. Wallison’s emphasis was always on Fannie and Freddie’s interest rate risk. In order to optimize the accounting scam, Fannie and Freddie had to grow rapidly by holding loans and MBS in portfolio so that they could take much larger interest rate bets. When Fannie and Freddie sell MBS they transfer the interest rate risk to the purchaser.

These are two very different ways of performing their functions, and have very different consequences. When Fannie and Freddie create pools of mortgages and sell MBS backed by these pools, they are guaranteeing that investors will receive a stream of revenue derived from the interest and principal paid into the pools by homeowners paying off their mortgages. In this case, Fannie and Freddie are taking only credit risk–the risk that homeowners will not meet their mortgage obligations. This is not a very significant risk, especially today, when losses on mortgage pools have been running at 1 or 2 basis points.
However, buying and holding mortgages or MBS is an entirely different story. In that case, Fannie and Freddie must take interest rate risk in addition to credit risk. Interest rate risk–that rates will rise or fall–is a far greater risk than credit risk, and requires Fannie and Freddie to buy derivatives of various kinds to protect themselves against the vicissitudes of the credit markets. To put this in perspective, it was interest rate risk that caused the failure of the S&Ls.
Wallison’s incomplete Understanding of Accounting Control Fraud

Wallison gets many of the elements of control fraud correct, but he comes from such a warped perspective when it comes to accounting fraud that he never quite gets it. The irony is that Franklin Raines, Fannie’s CEO during much of the time that Wallison was focused on Fannie and Freddie, could have taught Wallison everything he needed to know. In response to the Enron-era accounting control frauds the Business Roundtable made Raines its spokesperson on fraud and integrity. Business Week interviewed him on May 19, 2003.

We’ve had a terrible scandal on Wall Street. What is your view?

Investment banking is a business that’s so denominated in dollars that the temptations are great, so you have to have very strong rules. My experience is where there is a one-to-one relation between if I do X, money will hit my pocket, you tend to see people doing X a lot. You’ve got to be very careful about that. Don’t just say: “If you hit this revenue number, your bonus is going to be this.” It sets up an incentive that’s overwhelming. You wave enough money in front of people, and good people will do bad things.
Wallison’s description of accounting control fraud at Fannie and Freddie is confusing. He could not seem to believe that the GSEs were in grave danger because of their leaders and business practices.

Fannie Mae and Freddie Mac
By Peter J. Wallison
House Subcommittee on Commerce, Trade and Consumer Protection
(July 22, 2003)

It is important to recognize the significance of the accounting problems at Freddie Mac–not because these problems are especially severe, but because they were a surprise and seem to arise from something so routine. From press accounts, it appears that Freddie attempted over many years to manage its earnings by manipulating the valuation of its derivatives. This is known as managing earnings, and its objective is to create a smooth upward curve. Freddie Mac was so good at this that it was nicknamed “Steady Freddie” on the Street. Some attention is now also being paid to Fannie Mae’s financial reports, which, despite the vicissitudes of the mortgage market, interest rates and the economy generally, also showed the same smooth upward curve. Managing earnings is very easy to do under Generally Accepted Accounting Principles (GAAP)–so easy that many companies are suspected of doing it.
Wallison’s use of the word “routine” is simultaneously accurate and enormously disturbing. He is correct that many of our most elite corporations deliberately manipulate their financial statements. It is disturbing that Wallison does not find that alarming and does not understand how much damage it causes. He actually believes that it is lawful to manipulate the earnings and it does not appear he believes it raises any moral issues.
The fact is that GAAP financials are highly malleable, and should not be considered an index of the financial condition or prospects of companies. Because the principal constituents of a GAAP earnings statement are predictions about the future–what losses will be suffered on a portfolio of receivables, what reserves should be established for future claims–bottom line financial results reflect simply the judgments of management rather than a true picture of the company’s financial condition.
Again, this passage has some basis in reality and is disturbing both for what it says about business elites and the nation’s leading apologist for those elites. Yes, GAAP statements are exceptionally “malleable” if the senior officers choose to act like a blacksmith and hammer them into the shapes that the CEO desires. The fact that reserves require judgments about the likelihood of future events does not mean, as Wallison appears to believe, that the CEO and CFO can put in whatever number will maximize their bonuses. And if he does think it means that then he should be working feverishly to end it.
Because of the uncertainties associated with GAAP, it is not correct to believe that Fannie Mae and Freddie Mac are financially strong companies simply because they are producing earnings or have strong-looking balance sheets. It’s likely that they are both profitable and financially strong, but we really can’t know for sure. A demonstration of this is the fact that OFHEO–Fannie and Freddie’s regulator–was not aware of the true extent of the company’s financial problems until advised of them one day before they were announced. If their regulator could not find their financial problems, how is the general public–or Congress–supposed to do it?
This passage contains a critical understanding. Fannie and Freddie’s managers could – at will – produce financial statements that made them look exceptionally profitable even when they were in fact suffering losses. Moreover, they could get a clean opinion from a top tier audit firm and they could deceive their regulator. Taken together, that meant that if the senior officers were wealth-maximizers they could easily find accounting control fraud to be their optimal strategy. Wallison seemed to understand that the frauds came from the top.
But in relying on regulation we are again deluding ourselves. Occasionally, regulators stumble upon things like bad accounting, but in most cases they are in the dark until someone tells them about the problem. Thus, I don’t blame OFHEO, or believe that it is a weak or incompetent regulator because it failed to uncover or understand the gravity of the accounting problems at Freddie. This is what we should expect from any regulator, because it is the most likely outcome. Regulators work in the bowels of the organizations they regulate, but the big decisions–the ones that can really cause the losses at a company–are made at the top level, where regulators generally have no regular access.
Wallison missed the fact that competent regulators always focus on the CEO. The Bush administration had overwhelmingly appointed regulatory leaders on the basis of their anti-regulatory dogma, so Wallison didn’t have many effective role models.
Until June of this year, when Freddie Mac dismissed its top three officers and announced that it would have to do a considerably bigger financial cleanup than we initially thought necessary, it was possible to say that both Fannie and Freddie were in strong financial condition and that there was no prospect of a bailout. Since then, however, there has been much more scrutiny of the financial statements of both companies, and at least some observers have pointed out that while Freddie might have been more profitable than it reported during the three years ending in 2002, Fannie Mae might actually have lost money, or made no profits, last year. That is not what Fannie reported, which was of course another huge annual increase in profitability. The problem is, because of the malleable nature of Generally Accepted Accounting Principles (GAAP), we don’t really know how these complicated companies are doing.
Despite these concerns about Fannie and Freddie’s accounting fraud, Wallison did not see credit risk as serious.

Wallison realized that shareholders could not exert effective private market discipline over accounting control frauds. He also knew that the CEO could suborn the internal and external controls and turn them into his most valuable fraud allies.

The Significance of Enron
By Peter J. Wallison
Le Centre Francais sur les Etats-Unis
(May 15, 2002)

[T]he Enron collapse called into question the most fundamental beliefs of investors in the United States about how their interests were protected. It is important to keep in mind that investors in public companies have relatively little control over how their funds are used by the company’s management. Investors’ willingness to purchase equity shares depends on a belief that management will hold to explicit or implicit promises about how the company will be operated, and in the most general sense this promise is that the company will be operated for the benefit of the shareholders and not the management. To assure that management is observing this commitment, investors rely on several “gatekeepers” or monitors–a belief in the efficacy of corporate governance, in the diligence and honesty of accountants, in the quality of Generally Accepted Accounting Principles (GAAP) as in force in the United States, and in the expertise of securities analysts at the major brokerage firms.
All these monitors failed in this case, and failed spectacularly.
Under these circumstances, when the management of an issuer engages in fraudulent or manipulative practices in connection with the company’s disclosures of financial information, and these practices are not caught by the board of directors, by the accountants or by the analysts, there are essentially no safeguards for investors. Since this is what happened in Enron, where a high quality board, a major accounting firm, and virtually all sell-side securities analysts failed entirely to understand or stop a management fraud that was going on right in front of them, it is no wonder that US investors are nervous about whether the safeguards they have been relying on are truly useful. That, in my view, is the true significance of Enron, and accounts for the extraordinary attention this particular fraud has received.
Why did all these controls fail simultaneously? Because the CEO can use his ability to hire, fire, promote, and compensate to create perverse incentives and drive a powerful “Gresham’s” dynamic that will select for the least ethical. Again, Fannie would have provided Wallison the perfect example.

Unfortunately, Raines’ insights the risk of good people doing bad things stemmed from his implementation of an executive compensation system that gave huge bonuses if Fannie reached the “stretch” goal of $6.46 EPS. Raines knew that the unit that should have been most resistant to this “overwhelming” financial incentive, Fannie Mae’s Internal Audit department, had succumbed to it. Mr. Rajappa, its head, instructed his internal auditors in a formal address in 2000 (and provided the text to Raines, who praised it):

By now every one of you must have 6.46 [the earnings per share bonus target] branded in your brains. You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breath and dream 6.46, you must be obsessed on 6.46…. After all, thanks to Frank [Raines], 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 has given 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 give well above our 100% and if we do this, we would have made tangible contributions to Frank’s goals [emphasis in original]. (Office of Federal Housing Enterprise Oversight, 2006, p. 4)
Internal audit is the “anti-canary” in the corporate “mines”; by the time it is suborned every other unit is corrupted.

Unfortunately, accounting control fraud would so rock Wallison’s anti-regulatory dogma that he keeps stepping back from his ability to even recognize (much less condemn) frauds by business elites as a common problem.

Poor Diagnosis; Poor Prescription
The Error at the Heart of the Sarbanes-Oxley Act
By Peter J. Wallison
AEI Event on Audited Earnings
(January 23, 2003)

GAAP and all other methods of financial reporting, including International Accounting Standards, are inherently malleable, and results can be easily adjusted by corporate managements to meet predetermined targets. It is possible, perfectly legally and within the rules of GAAP, to produce audited income statements showing results that are highly variable simply by changing predictions about the future–for example, by increasing or decreasing reserves, or depreciation rates.
During that period, the earnings of public companies grew steadily from year to year, frequently hitting to the penny the forecast for quarterly earnings per share made by the sell-side analysts.
This was possible because, wholly legally, companies could hit earnings targets by adjusting one or more of the variable elements involved in the preparation of financial statements under GAAP. This gave rise to claims that companies were engaged in “earnings management,” but to no effective cure. In fact, what seems to have been occurring was a game in which analysts and investors were testing the quality of a company’s stated earnings by determining whether management could hit its targets. If it could, that meant that the company’s earnings were probably growing, although not necessarily as stated. If it could not, that was a signal that the company had run out of ways of adjusting its results to produce earnings growth, and that in turn suggested that its earnings had really fallen quite dramatically. It was because of this that we saw the strange market phenomenon in which companies that missed their earnings targets by a penny or two saw 20 or 30 percent declines in their share prices.
Since there is no “correct” statement of income, and corporate managements were and are in a position to show earnings results within a broad range, smoothing earnings so that they grow gradually over time is not necessarily dishonest, and it is certainly rational. The problem then is not dishonest managements–although there are some–it is excessive reliance on a financial disclosure mechanism–Generally Accepted Accounting Principles–that inherently permits a variety of outcomes.
Let us review the bidding as Wallison describes it. CEOs are able to choose which “earnings” to report from a “broad range” of values. If actual income is negative or too low to maximize the CEO’s bonus he will, typically, reduce the provision of loss reserves (for a bank, the ALLL) to be able to transmute a loss into a gain. The CEO picks which earnings to report to maximize his compensation. A CEO that does this “is not dishonest.” Indeed, he is “certainly rational.”

Wallison is channeling Gregory Mankiw’s (President Bush’s Chairman of the Council of Economic Advisors) infamous remark as discussant after hearing George Akerlof and Paul Romer present their paper “Looting: the Economic Underworld of Bankruptcy for Profit” (1993) (“it would be irrational for operators of the savings and loans not to loot”).

Wallison is a lawyer, and he is read primarily by other lawyers and senior corporate officials. In criminology, we refer to what he and Mankiw did as “neutralization.” It’s designed to render the criminal and immoral acceptable. Neutralization increases crime. In a word: no. It is dishonest to report false loss reserves in order to make your bonus. It frequently constitutes looting. It typically requires the CEO to commit multiple felonies.

Again, more importantly, if Wallison believes what he is saying then he should study philosophy and ethics and work every day to undue the corrupt culture his anti-regulatory policies have created. His dissent doubts the ethics of subprime borrowers. If he believes what he says about CEOs and CFOs he should place his ethical focus at the top of the food chain.

The key point is that the Republican leadership knew exactly what it would get when it appointed Wallison to the Financial Crisis Inquiry Commission. He was there because he would have to repudiate his entire career before he could ever join in a bipartisan report. The tragic effect is that by trying to discredit the staff’s findings Wallison has most benefited the CEOs who have been able to commit fraud with impunity. His apologia for their “rational” “not dishonest” accounting manipulations marks a new low point in his anti-regulatory zeal. He now defends fraudulent CEOs, those he aptly calls the “genuinely wealthy,” and claims that they should be able to manipulate the accounting to maximize their bonuses. America needed a unanimous Commission willing to write that Wallison’s homo economicus concept of morality is depraved and is producing recurrent, intensifying crises. As authors of the book Moral Markets (a very pro-market volume) emphasize – homo economicus is a sociopath.

William Black Interviewed on The Real News

William Black was interviewed on The Real News recently.  For video and complete transcript click here.

Wallison is far too Kind to Fannie and Freddie

By William K. Black

It is easy to understand why Commissioner Wallison’s lengthy dissent to the report of the Financial Crisis Inquiry Commission has received such poor reviews.  The first page of his dissent [p. 443] insults Congress, President Obama, former Congressman Rahm, the Democratic Commissioners, the Commission’s staff, and Democratic Congressmen in 1977, particularly Representative Frank.  His dissent is partisan and unprofessional.  It is also long.

Despite those defects, however, Wallison has the virtue of emphasizing the key fact about the crisis that is most often misunderstood.  The conventional economic wisdom starts with the effort to explain a mystery – how could such a relatively small number of subprime loans have caused the Great Recession?  Wallison’s dissent stresses that there were in fact enormous numbers of nonprime loans.  The data on nonprime loans demonstrate several other points

  • Most of the nonprime loans were fraudulent “liar’s” loans
  • The industry knew that such loans caused staggering losses
  • Fannie, Freddie, large commercial banks, and large investment banks frequently purchased large amounts of liar’s loans and CDOs backed by liar’s loans
  • The share of total loans composed of nonprime loans grew rapidly in 2004-2007 – despite urgent, stark warnings from the FBI and the mortgage banking industry’s own anti-fraud experts that mortgage fraud was “epidemic” and would cause an “economic crisis” (FBI September 2004) and that liar’s loans were “an open invitation to fraudsters” with a fraud incidence of 90 percent (MARI 2006).  “Eighth Periodic Mortgage Fraud Case Report to Mortgage Bankers Association” (April 2006).  The nonprime lenders (and purchasers) ignored the warnings – the rapid growth of nonprime loans continued until the secondary market in nonprime loans collapsed.
  • Fannie, Freddie, and other large, publicly-traded holders of nonprime loans and CDOs commonly did not disclose honestly these holdings
  • The holders of nonprime loans and CDOs reduced their general provisions for loan losses as their portfolios of nonprime loans increased

Wallison ignores these facts, however, because they refute his overall theory of the crisis. Wallison chastises the Democratic members of the Commission for not giving more attention to the work of Edward Pinto, a lawyer who is Wallison’s colleague at AEI.  

One glaring example will illustrate the Commission’s lack of objectivity.  In March 2010, Edward Pinto, a resident fellow at the American Enterprise Institute (AEI) who had served as chief credit officer at Fannie Mae, provided to the Commission staff a 70-page, fully sourced memorandum on the number of subprime and other high risk mortgages in the financial system immediately before the financial crisis. In that memorandum, Pinto recorded that he had found over 25 million such mortgages (his later work showed that there were approximately 27 million). Since there are about 55 million mortgages in the U.S., Pinto’s research indicated that, as the financial crisis began, half of all U.S. mortgages were of inferior quality and liable to default when housing prices were no longer rising [p. 448].

The Commission report criticizes Pinto’s classifications.  It finds that delinquency rates on loans held by Fannie and Freddie that Pinto argues are equivalent in risk to nonprime loans are far lower than for nonprime loans held by non-GSEs [p. 219].  As the Commission concluded, this suggests that Pinto classified too many of the loans in Fannie and Freddie’s portfolio as nonprime.  The other Republican Commissioners do not cite Pinto’s work.  Pinto’s claim that nonprime loans were enormous would falsify the other Republican Commissioners’ principal argument in their dissent.  The Commission staff reviewed and responded substantively to Pinto’s work in the report – it is Wallison’s Republican colleagues who ignored Pinto.

I have serious concerns about Pinto’s work attempting to quantify nonprime loans and I believe his work on the Community Reinvestment Act (CRA) is very poor – but I also think he raises a critical question about the number of nonprime loans.  Pinto’s attempt to quantify the number of liar’s and subprime loans and the amount of those loans held by Fannie and Freddie, was an impossible task given the data available to him.  The data available to him – to all of us – are exceptionally poor.  
First, there never was an official definition of any of the three major classes of mortgage loans – prime, subprime, and “alt a” (aka stated income, NINJA, or liar’s loan).  Second, the categories are not exclusive, i.e., large numbers of liar’s loans were also subprime.  Third, the classification of loans by the FDIC and the OTS in its data base is false.  The data base classifies loans based on FICO score and treats subprime and liar’s loans as mutually exclusive categories.  Fourth, the firms holding nonprime loans had powerful incentives to misclassify the assets as “prime” loans.  Fannie, Freddie, and Lehman all called their liar’s loans “prime” loans in their financial reports.  Fifth, the information provided with nonprime loans the loans was frequently false, e.g., the borrower’s income and the value of the home were often inflated.  Sixth, FICO scores are inherently unreliable as a means of underwriting home mortgage lending.  A borrower could “rent” a straw’s FICO score or “improve” his FICO score.  A FICO score does not demonstrate that a borrower is capable of repayment.  Seventh, loan quality can vary greatly within a category.  A subprime loan with effective credit enhancements (admittedly, uncommon) was far less risky than a subprime loan with a simultaneous second lien loan purportedly secured by the same home. 
It appears that Pinto fell into some of these methodological traps.  He seems to have assumed that subprime loans could not also be liar’s loans.  Credit Suisse’s survey of 2006 originations found that “roughly 50% of all subprime borrowers in the past two years have provided limited documentation regarding their incomes.”  “Mortgage Liquidity du Jour: Underestimated no More.” (March 12, 2007).  Credit Suisse reported that “stated income” (aka: liar’s loans) constituted 49% of new mortgage originations in 2006.  The 49% figure is inconsistent with Pinto’s estimate that nonprime loans constitute 49% of total mortgages outstanding, but it represents an enormous expansion of nonprime lending that hyper-inflated the real estate bubble.  It also represents a staggering amount of incidence of mortgage fraud, since mortgage fraud was common in subprime loans and endemic in liar’s loans (see my testimony before the Commission and subsequent columns on that subject).   
Credit Suisse explained that alt-a loans, the most common form of liar’s loans, did not simply become vastly more common, but also became far more likely to default because of the nature of their loan terms.
While credit risk in this segment is often downplayed given the better credit profile of Alt-A borrowers relative to subprime borrowers (i.e. better FICO scores, lower CLTVs), we believe that the significant growth in this segment resulting from its exposure to exotic mortgages leaves the Alt-A mortgage market particularly susceptible….
[S]tated income loans represented a staggering 81% of total Alt-A purchase originations in 2006, up significantly from 64% just two years earlier. These loans are also sheepishly referred to as “liar loans” by many in the industry due to the propensity for borrowers to exaggerate their income on loan applications. In addition, the combined loan to value on Alt-A purchase originations was 88% in 2006, with 55% of homebuyers taking out simultaneous seconds (piggybacks) at the time of purchase. Investors and second home buyers represented approximately 22% of Alt-A purchase originations last year, which is the largest non-owner occupied share among the various segments of the mortgage market. Adding to the risk is the fact that 1-year hybrid ARMs represented approximately 28% of Alt-A purchase originations in 2006, setting the stage for considerable reset risk. The average loan size of Alt-A mortgages backing MBS in 2006 was roughly $287,700, while the average FICO score of an Alt-A borrower last year was 717.

Note the average loan size and FICO score for Alt-A borrowers – these were typically not loans to working class homeowners with known credit defects.  Lenders and their agents (principally loan brokers) routinely inflated the borrowers’ “stated income” – making it even less likely that the loans would be considered to be made to below median-income borrowers

The same Credit Suisse report explained why so many liar’s loans were being made and what effect the loans were having on the size of the particular housing bubbles.

[M]any of the states that had the greatest share of Alt-A mortgages in 2005 have also served as the primary growth engines for the major homebuilders in recent years. We estimate that Nevada, California, Arizona, Florida and Virginia had the greatest share of Alt-A originations in 2006. These five states are also the top five EBIT [Earnings Before Interest and Tax] generators for our homebuilding universe, representing roughly 75% of total operating profit in 2005. In a survey of our private homebuilders, our contacts confirmed that the Alt-A market is a significant portion of their overall business, representing 18% of home sales, on average, in 2006. In addition, our builder contacts specifically operating in Nevada (30% Alt-A share), California (28%) Florida (27%), and Arizona (20%) confirm that those states have an above average concentration of Alt-A loans of the overall mortgage pie, in-line with our state-by-state estimates. A few builders out west indicated that Alt-A represents up to 90% of their overall business. Suffice to say, any credit tightening in this segment of the market will likely have a negative impact on homebuilder profits.
Pinto was correct to try to estimate the total number of nonprime loans originated by year and who held the loans.  (His failure to look intensively at the purchases and holdings of nonprime mortgages – and their timing – by U.S. investment banks and foreign parties (neither of which was subject to the CRA) was analytically unsound – an unfortunate result of his holy war against Fannie and Freddie and the CRA.)  Pinto could not conduct a real investigation of Fannie and Freddie.  He looked at their financial statements and accompanying disclosures and publicly available information about Fannie and Freddie. 
The Federal Housing Finance Agency (FHFA), however, could find out the truth about Fannie and Freddie’s portfolio.  The FHFA, and the nation, have an urgent need to find the true condition of Fannie and Freddie and what caused their catastrophic failures.  This would be true even if they had no ability to “put” the fraudulent loans back to the sellers.  The fact that Fannie and Freddie have the ability to put the fraudulent loans back to the sellers means that conducting the factual investigations should be Fannie and Freddie’s dominant priority.
On January 12, 2010, Eliot Spitzer, Frank Partnoy, and I wrote a short open letter to the Commission “10 Questions the Financial Crisis Commission Must Ask.”  
We stressed that AIG, Fannie, and Freddie (each of which the public (in)effectively owns) were the treasure trove essential to the success of the Commission’s investigation.
The FCIC has not used subpoena authority or voluntary requests for information to obtain the background information essential in order to hold a real investigative hearing. In particular, it has not obtained AIG (and Fannie and Freddie’s) emails and other critical internal documents such as their financial models, internal accounting records, and loss reserve data that are readily available and vital to understand what caused the crisis. Any aircraft crash investigator knows how critical it is to find the “black box” that records the information that is typically essential to finding the cause. In the financial context, these AIG, Fannie & Freddie emails and internal accounting and risk records are the “black box” that any competent investigator would demand to review.

Fannie and Freddie’s “internal accounting records”, “financial models”, and “loss reserve data”, collectively, are precisely what the Commission needed to conduct a reliable study of Fannie and Freddie’s actual nonprime holdings.  The fact that Fannie and Freddie’s senior officers have not conducted such a study tells us that they need to be replaced.  The fact that the FHFA’s senior leaders did not require that Fannie and Freddie’s leaders to provide such a study tells us that FHFA’s senior leaders needed to be replaced.  If the FHFA did not trust Fannie and Freddie’s leaders to conduct the study then the FHFA should have replaced the leaders and conducted their own study.  Similarly, FCIC should have required Fannie, Freddie, and/or the FHFA to provide reliable data on their nonprime loans. 
So what did Pinto say about liar’s loans – the loans that according to the data were increasingly used to finance home buyers and speculators and hyper-inflate the bubble?  He testified before House on December 9, 2008 [page references are from a copy of his testimony on AEI’s website]:

[T]he Alt-A or “liar” loan is generally not classified as subprime, because the FICO score of the borrower was generally above 660, but this loan was the favorite of the real estate speculator, and are currently defaulting at rates approaching those of subprime loans [p. 2].

Pinto knew the loans were fraudulent, for he called them “liar” loans.  He knew that they were “the favorite of the real estate speculator.”  These were not loans to borrowers with below median incomes.  Loans to speculators don’t qualify for affordable housing goals.  Inflating the borrower’s income is the last thing lenders would do if the goal of the loan was to qualify for affordable housing goals.  Pinto also knew what fraudulent loans inherently cause – catastrophic losses.  Pinto also testified that Fannie and Freddie purchased huge amounts of liar’s loans – but deceptively classified the great bulk of them as “prime” loans – which would be insane if the purpose of purchasing the loans was to help Fannie and Freddie meet affordable housing goals.  Pinto testified that Fannie and Freddie purported to justify this deception by simply adopting the seller of the loans misclassification of the loan as “prime” [p. 3].   But that would be insane if the lenders were making the loans to qualify for affordable housing treatment.   Pinto notes that Freddie knew from prior loss experience that making large amounts of nonprime loans would cause severe losses [p. 3]. 

Pinto estimated that Fannie and Freddie held “34% of all the subprime loans and 60% of all Alt-A loans outstanding” [p. 7].  Pinto seems to have treated subprime loans as non-liar’s loans, but that is clearly incorrect.  I cited Credit Suisse’s finding that by 2005 and 2006, half of all subprime loans were also stated income (liar’s loans).  The presence of such large amounts of Alt-A loans is one of the demonstrations that Pinto, Wallison, and the Republican Commissioners’ “Primer” are flat out wrong to claim that it was affordable housing goals that drove Fannie and Freddie’s CEOs’ decisions to purchase loans they knew would cause the firms to fail.  That claim doesn’t pass any logic test.  One of its unobvious flaws is that no one was making Fannie and Freddie buy liar’s loans.  For the reasons I’ve explained, and Pinto admits, Fannie and Freddie actions with respect to liar’s loans were the opposite of what they would have been if they were trying to demonstrate that the loans were made for affordable housing purposes.  This is the best, indeed the only, evidence Pinto cites to show a link between liar’s loans and the HUD goals:

“The Alt-A business makes a contribution to our HUD goals.” Internal Freddie Mac email from Mike May to Dick Syron, dated October 6, 2004.  FMACOO13694

Yes, some Alt-A loans doubtless did count toward the HUD goals.  But massive amounts did not.  According to Pinto’s numbers, Fannie and Freddie’s CEOs deliberately purchased extraordinary amounts of Alt-A loans that they knew would not qualify for affordable housing goals and would cause massive losses that would destroy Fannie and Freddie.  Pinto’s theory is that absent the HUD goals Fannie and Freddie would not have purchased liar’s loans.  His data refute his theory.   Moreover, Fannie and Freddie acted to minimize the number of liar’s loans that would qualify by (1) buying loans with grossly inflated “stated income” and (2) misclassifying the loans as prime.  Pinto’s grand conspiracy theory is that Fannie and Freddie created the HUD goals to protect itself from President Bush.  Pinto claims that Fannie and Freddie sought to emphasize at all times their critical role in aiding affordable housing.  But why did they misclassify their loans so that they would appear to make dramatically fewer (Pinto says only one-quarter the reality) nonprime loans to less wealthy Americans if their brilliant political strategy was to do the opposite?  Pinto’s data falsify his, and Wallison’s, claims view that the housing goals warped Fannie and Freddie into the Great Satans. 

I have emphasized that we, the West Region of OTS, used our normal supervisory powers to kill an earlier wave of liar’s loans being made by California S&Ls in 1990-1991.  Pinto adds to this point by noting that:  “In the early-1990s Fannie and Freddie publicly announced they were no longer buying low doc/no doc loans because they were too risky” [p. 9].  This confirms the point we’ve long made – it didn’t require any genius on our part to kill liar’s loans.  Bankers have known for hundreds of years that making large liar’s loans creates intense “adverse selection” and guarantees catastrophic losses.  That is further proof that the Commission report got one of its central points correct – this crisis could have been stopped.  We, and Fannie and Freddie, proved that in the early 1990s by preventing exactly this crisis – the beginnings of an epidemic of liar’s loans

Pinto then testified about an even more complicated conspiracy theory

By the early part of this decade, the GSEs realized that the private sector was beating them in terms of share and, default risk notwithstanding, these subprime and Alt-A loans were to affordable housing “goal rich” to ignore [p. 11].

Pinto’s conspiracy theory and English usage are convoluted, but after several readings I interpret his argument as follows: 

1.     The mortgage bankers, mortgage brokers, investment banks, and commercial bank affiliates (not subject to affordable housing goals and virtually unregulated at the federal level – collectively, the Shadow Banking System) dominated subprime and liar’s loans
2.     As the Shadow banking investment banks rapidly increased the primary and secondary market in nonprime loans, Fannie and Freddie lost market share
3.     Therefore, Fannie and Freddie convinced Congress to increase their affordable housing goals in order to increase their political power.  They sought to meet their affordable housing goals by purchasing large amounts of subprime and liar’s loans [p. 11].

Wallison’s theories about Fannie and Freddie causing the crisis have been inconsistent over time and are logically incoherent for many reasons.  I’ll make a broader response in future columns, but I’ll make only a few points here. 

  • The California S&Ls that began to do large amounts of liar’s loans in 1990-1991 did not do so because of the CRA or any other form of affordable housing goal.  They did it because they were accounting control frauds following the four-part recipe for creating stellar short-term reported income and maximizing their CEOs’ compensation.  By making liar’s loans to those who would often be unable to repay their loans, both S&Ls were able to grow rapidly by making loans at premium yields.  This, along with providing only trivial loss reserves and extreme leverage, produced a “sure thing” (Akerlof & Romer 1993) of very high reported profits in the short-term.
  • When Long Beach Savings and Guardian Savings did large numbers of liar’s loans we (OTS-West Region) did not praise them for CRA performance – we took enforcement actions against their senior managers.
  • Long Beach Savings and Guardian Savings’ CEOs responded by starting mortgage banking firms precisely because they would no longer be subject to OTS-West Region’s jurisdiction.  As mortgage bankers, they had no CRA or affordable housing obligations or guidelines, yet they increased enormously the number of nonprime loans they made.  Again, they were maximizing short-term reported accounting income.  Long Beach became Ameriquest – notorious for its nonprime lending abuses.
  • The Shadow Banking participants that made large amounts of subprime loans in the late 1990s were not subject to the CRA and made the loans for the same reason as Long Beach.
  • The Shadow Banking participants that started the secondary market in nonprime mortgage loans were not subject to the CRA and created the market to achieve high reported accounting income and executive compensation. 
  • The Shadow Bank system did not pose an economic threat to Fannie and Freddie.  Losing market share to a competitor that will fail – and liar’s loans guarantee that mortgage lenders will fail – is a good thing for an honest competitor. 
  • If Fannie and Freddie’s controlling officers were honest, the Pinto/Wallison conspiracy theory makes no sense, for it would be suicidal. 
  • If Fannie and Freddie were accounting control frauds, then their behavior in going heavily into nonprime was a “sure thing” that was highly profitable for its senior managers.   

Pinto’s testimony goes on to explain how Fannie and Freddie’s senior managers acted in a manner that is sane only if the firms were control frauds.  As early as 1999 [p. 11]:

“Freddie Mac has found that 65% of its fraud cases involve loans produced by third-party originators [For 1999 OHFEO reported that third-party originators, ie. brokers, had a 26% market share with the GSEs.]….  Independent mortgage brokers account for 32% of the fraud cases’ while banks are the remaining 3%. The majority of the fraud – 60% — comes from defective loans.”

Pinto finds other behavior by Fannie and Freddie’s senior management irrational – which it would be for an honest firm.

Adding to this bias in favor of mortgage broker and mortgage banker sourced business was the fact that Fannie and Freddie offered its best pricing to its largest (and riskiest) customers, (i.e. Countrywide, Indy Mac) while offering much worse pricing to customers, i.e. community banks, with proven track records of delivering high quality loans done the traditional way [p.12].”
Countrywide and IndyMac, of course, offered higher yielding loans for sale to Fannie and Freddie than did the community banks.  That maximized Fannie and Freddie’s reported (albeit fictional) income and their senior executives’ compensation.  The National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) understood this dynamic because it understood the recipes for accounting fraud.  Lending to the uncreditworthy allows exceptional growth while charging a higher interest rate.  The combination maximizes accounting income.  As James Pierce, Executive Director of the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) explained:
Accounting abuses also provided the ultimate perverse incentive:  it paid to seek out bad loans because only those who had no intention of repaying would be willing to offer the high loan fees and interest required for the best looting.  It was rational for operators to drive their institutions ever deeper into insolvency as they looted them [NCFIRRE 1993, pp. 10-11].
(Parenthetically, the Commission report and dissents do not appear to cite any of NCFIRRE’s findings.  Wallison quotes the famous warning about those that fail to learn the lessons of the past, but doesn’t follow the advice.)
Pinto understands that Fannie and Freddie were engaged in accounting fraud.
[A]fter their accounting scandals in 2003 and 2004, they were afraid of new and stricter regulation. By ramping up their affordable housing lending, they showed their supporters in Congress that they could be major sources of affordable housing financing.
This was not a failure of the free market. It is a failure of Congress and the ill-conceived regulatory regime it implemented [p. 13].
Pinto and Wallison know that Fannie and Freddie engaged in accounting control fraud in the early 2000s.  (I was an expert witness for OFHEO in its enforcement action against Fannie’s former CEO, Franklin Raines.)  Pinto and Wallison know that the SEC charged that the reason they engaged in the accounting fraud was to enrich their senior officers.  They know that Fannie and Freddie were caught at the fraud and the fraud scheme they were using – very rapid growth of portfolio in order to take interest rate risk (with losses hidden by abusive hedge accounting) – was ended just before Fannie and Freddie decided to purchase far greater amounts of nonprime loans, particularly liar’s loans.  Pinto and Wallison know that OFHEO restricted Fannie and Freddie’s growth.  Fannie and Freddie’s controlling officers, were they to renew the accounting control fraud, would have to find a way to increase yield sharply without growing the portfolio rapidly.  The obvious answer was to purchase much higher yielding loans – nonprime loans – and provide only trivial allowances for loan losses.  Pinto and Wallison, however, cannot even conceive that Fannie and Freddie’s senior managers might renew their accounting fraud. 
As to Pinto’s claim that Fannie and Freddie do not represent a failure of the “free market,” it turns out that he answers that point nicely in one of his attached exhibits.  Pinto writes that Fannie and Freddie’s response to efforts to regulate them:
[W]as crony capitalism at its worst. The mere fact that Congress continued to remain opposed to real reform after both Fannie and Freddie experienced massive accounting scandals in the early part of this decade is proof positive. Fannie and Freddie had gotten so powerful that they felt that they should be able to dictate the terms of their own reform to Congress or block the reforms if they did not like them.
Amen.  When private corporations like Fannie and Freddie become enormous they do gain extraordinary political as well as economic power.  This is the American version of “crony capitalism at its worst.”  We need to get rid of the systemically dangerous institutions (SDIs) that loot with impunity and we need to prosecute the senior officers leading the accounting fraud, including the senior officers of Fannie and Freddie.  Why aren’t Pinto and Wallison calling for those prosecutions?  Pinto is correct, we don’t have “free enterprise” in broad sectors of our economy and the results have been horrific.
Wallison and Charles Calomiris (long time co-directors of AEI’s financial deregulation project) advanced this same self-bondage theory of Fannie and Freddie’s actions in a September 2008 paper entitled:  The Last Trillion-Dollar Commitment: The Destruction of Fannie Mae and Freddie Mac.
The central problem was their dependence on Congress for continued political support in the wake of accounting scandals in 2003 and 2004. To curry favor with Congress, they sought substantial increases in their support of affordable housing, primarily by investing in risky and substandard mortgages between 2005 and 2007.
There’s a much simpler explanation, one that doesn’t require ornate conspiracies or irrational actions by Fannie and Freddie’s CEOs – Fannie and Freddie renewed their accounting control fraud and enriched their senior officers.  After all, Wallison and Calomiris complain bitterly about the weak response to Fannie and Freddie’s accounting control frauds, decrying “GSE immunity to accounting scandal….”  They claim that the decisive break in Fannie and Freddie’s prior behavior of largely standing by while the Shadow Banking sector made over a trillion dollars in nonprime loans was reaction to the discovery of their accounting control fraud.
Instead, it seems likely that the event responsible for the GSEs’ change in direction and culture was the accounting scandal that each of them encountered in 2003 and 2004.
That makes sense.  OFHEO responded to those frauds not by cleaning house, but by the selective removal of a few of the most senior officers.  The corrupt cultures and the executive compensation systems that created the perverse incentives to engage in accounting control fraud remained in place.  What changed was that OFHEO added two operational constraints – it restricted the growth of the portfolio and it continued to look closely at interest rate risk and hedging.  Fannie and Freddie, therefore, could not continue to use their prior accounting scam – extreme growth, the deliberate exposure to serious interest rate risk, and abusive hedge accounting.  There was one obvious way left to dramatically inflate yield – purchase nonprime loans and CDOs with high nominal yields and provide only trivial allowances for loan losses.  Fannie and Freddie could seek much greater yields without substantial growth if they took the enough lower yield mortgages and MBS that they had been holding in portfolio and sold them.  They could quickly substitute higher yield nonprime mortgages and CDOs for the lower yield paper that they ran off.  The net effect would show only modest growth but a significant increase in yield.
Wallison and Calomiris quote an article paraphrasing James Lockhart, Fannie and Freddie’s senior regulator as testifying that his agency recognized that Fannie and Freddie were greatly increasing their credit risk, but “the companies increased their exposure to risks in 2006 and 2007 despite the regulator’s warnings.”  Note that the regulator was, regardless of HUD guidelines, discouraging Fannie and Freddie from making additional nonprime loans.  James Lockhart was President Bush’s friend from childhood (they met in an elite prep school).  He had the President’s confidence and support.  Because Fannie and Freddie had just been caught in acts of repeated, severe fraud he had exceptional regulatory leverage over Fannie and Freddie.  He had ample regulatory authority to order Fannie and Freddie to cease increasing their credit risk and to reduce it.  Lockhart declined to use that authority.  He also declined to bring the fraud allegations to hearing against Franklin Raines (Lockhart settled for such small sums that Raines walked away wealthy).  Lockhart shared the fundamental anti-regulatory philosophy of President Bush – that’s why President Bush appointed him.  Still, as weak as the agency was made by the anti-regulatory dogma, it was superior in at least warning about Fannie and Freddie’s credit risk at a time when Wallison and Greenspan were focused entirely on fighting the last war – interest rate risk.
Why, if honest, would Fannie and Freddie’s CEOs have them function in a manner that would maximize short-term (fictional) reported income (and compensation) but cause catastrophic losses in the longer-term?  As Pinto and Wallison emphasize, Fannie and Freddie had plentiful experience demonstrating that liar’s loans were suicidal.  Further, why did they rely so heavily on liar’s loans – and cover up three-quarters of their non-prime loans through deceptive accounting – if the purpose was to meet self-imposed HUD requirements?  Wallison and Calomiris explicitly charge that Fannie and Freddie’s senior managers followed a deliberate strategy of accounting deception in order to dramatically understate how many nonprime loans they were making.  If they believe that Fannie and Freddie’s controlling officers engaged in accounting deception, why can they not even conceive that those managers would engage in a form of accounting deception that guaranteed that it would make them exceptionally wealthy within a year or two?  Wallison and Calomiris understand that the strategy of buying large amounts of nonprime loan created substantial (fictional) reported income from 2004-2008.
From the perspective of their 2008 collapse, this may seem to have been unwise, but in the context of the time, it was a shrewd decision. It provided the GSEs with the potential for continuing their growth and delivered enormous short-term profits. Those profits were transferred to stockholders in huge dividend payments over the past three years (Fannie and Freddie paid a combined $4.1 billion in dividends last year alone) and to managers in lucrative salaries and bonuses.
But perhaps I am too kind.  It may be that Wallison and Calomiris are so unaware of accounting control fraud that they do not understand that the “enormous short-term profits” were fictional.  They were the product of accounting fraud – a “sure thing.”  Had Fannie and Freddie established appropriate allowances for losses on loans this toxic they would have reported losses at the time they purchased the loans.  Wallison and Calomiris have described a classic accounting control fraud.  They have given a classic example of why Akerlof and Romer entitled their 1993 article “Looting: the Economic Underworld of Bankruptcy for Profit.” 
Although Fannie and Freddie were building huge exposures to subprime mortgages from 2005 to 2007, they adopted accounting practices that made it difficult to detect the size of those exposures.
Similarly, the New York Times reported.
Charles W. Calomiris, a finance professor at Columbia, testified that nobody saw the crisis coming because the two mortgage giants “adopted accounting practices that masked their subprime and Alt-A lending,”
Wallison needs to man up and learn to call powerful business leaders frauds.  Wallison’s lengthy dissent does not use the words “liar’s” loan, crime or criminal.  He uses the word “fraud” once, and the way he uses it is revealing.
Predatory lending. The Commission’s report also blames predatory lending for the large build-up of subprime and other high risk mortgages in the financial system. This might be a plausible explanation if there were evidence that predatory lending was so widespread as to have produced the volume of high risk loans that were actually originated. In predatory lending, unscrupulous lenders take advantage of unwitting borrowers. This undoubtedly occurred, but it also appears that many people who received high risk loans were predatory borrowers, or engaged in mortgage fraud, because they took advantage of low mortgage underwriting standards to benefit from mortgages they knew they could not pay unless rising housing prices enabled them to sell or refinance. The Commission was never able to shed any light on the extent to which predatory lending occurred. Substantial portions of the Commission majority’s report describe abusive activities by some lenders and mortgage brokers, but without giving any indication of how many such loans were originated [p. 447].
Only borrowers warrant the “f” word.  I have written extensively as to why it was overwhelmingly lenders and their agents that put the lies in “liar’s” loans. 
The “CYA” efforts get intense after a crisis.  As a lagniappe, I leave you with this gem I came across researching this column.  At the same conference that Wallison conducted to showcase Pinto’s work, Jay Brinkman the Mortgage Bankers Association’s (MBA) Chief Economists presented (his slides are available on AEI’s site).  Brinkman captures the essence of the MBA.  It’s his last slide, with the title “Credit Failures of the GSEs.”
Individual lenders cannot drive credit decisions and credit pricing.  That was and is the role of the GSEs, but they failed….
When I sat on a bank credit committee we believed that making credit decisions was the core of lending and that the adequacy of the price relative to the risk was always a critical consideration as to whether we should approve the loan.  “They failed.”  It’ll look good as a business motto over the entrance to the MBA headquarters – the new one after they strategically defaulted on the old one (shortly after they opined that any homeowner that strategically defaulted was a moral degenerate).