The FHFA’s sweeping lawsuits against 17 banks, filed Friday afternoon, seem to be largely like a case of case of brother-versus-brother, with the government turning against the very banks it has spent billions of dollars bailing out.
But a more apt metaphor for the FHFA’s lawsuit against the banks may be like something out of Law & Order: co-conspirators breaking down under cross-examination of who’s really at fault for the mortgage crisis.
The truth is, it took many players to take down the housing market. Homeowners, lured by low rates, rushed to buy homes they couldn’t completely afford. Mortgage lenders handed out no-documentation mortgage loans and many mortgage servicers robosigned them. The government forced Fannie Mae and Freddie Mac to guarantee low-income loans that later became the backbone of the subprime housing market. Fannie Mae and Freddie Mac then bought mortgage loans – about 50% of the residential mortgages generated each year, CNBC noted – for the purpose of selling them to banks, which would bundle them. Banks certainly didn’t cover themselves in glory, packaging mortgages they knew were terrible. The ratings agencies – which slapped a AAA rating on these monstrosities, making them as creditworthy as bonds from the US Treasury – fueled the boom by allowing everyone to look the other way.
The FHFA’s lawsuit charges that the banks knew they were bundling terrible mortgages and did it anyway. There is very little question that this is true. Even worse, even after the crisis banks have helped drag down the housing market, as the Consumers’ Union’s Norma Garcia pointed out to me yesterday, because banks have welched on their side of the taxpayer bailouts: they were supposed to help prevent unnecessary foreclosures and ease lending to consumers, which the banks have not done.
But the lawsuit ignores what is also true: Fannie and Freddie did the exact same thing they’re accusing the banks of doing.
I did a story for Marketplace on the lawsuits yesterday before they were filed but I took a wider view, examining what most Americans are curious about: yes, there’s a lot of anger, but what is the proper punishment for banks? And can we really find redress four years after the fact, or should we be trying to fix what we can in the mortgage market?
I regret I didn’t have time to get into a major aspect of this lawsuit that seemed obvious to me, but seemed to have been buried in most of the news coverage: Fannie and Freddie were enormously influential firms who guaranteed mortgages and put the government’s imprimatur of strength on them. If there were any two firms who should have known how bad these mortgages were, Fannie and Freddie were certainly among them. As analyst Christopher Whalen says in this month’s Housing Wire – I’m paraphrasing – “Everyone who is mad at Wall Street for the mortgage crisis forgets that Fannie and Freddie were part of Wall Street.”
In other words, if you ask why banks would make loans or buy mortgages to lenders who couldn’t make their payments – and you know the answer is shoddy practices in the service of profits – you also have to ask why Fannie Mae and Freddie Mac would guarantee — with the backing of the U.S. government– the principal and interest payments on many of the subprime mortgages they themselves took on.
Chip MacDonald is a Jones Day banking lawyer. You would expect him to speak in favor of banks, which are, after all, his clients. But he made an excellent point in our conversation yesterday: “Fannie Mae and Freddie Mac were sophisticated about the mortgage market. In many ways, Fannie and Freddie were the mortgage market. They set the rules and standards everyone else used.”
And there is evidence that Fannie and Freddie were well aware of the trouble they were getting themselves into. A 2008 congressional hearing on the role of Fannie and Freddie in the housing crisis turned up this gem:
One key document is a confidential presentation from the files of Fannie Mae’s CEO, Daniel Mudd. According to this document, the company faced a strategic crossroads in June 2005. The document states, ”We face two stark choices: one, stay the course; or, two, meet the market where the market is.” Staying the course meant focusing predominantly on more secure, prime and fixed-rate mortgages. The presentation explained that this option would ”maintain our strong credit discipline and protect the quality of our book.”
But, according to the confidential presentation, the real revenue opportunity was in buying subprime and other alternative mortgages. To pursue this course, the company would have to ”accept higher risk and higher volatility of earnings.” This presentation
recognized that homes were being utilized like an ATM. It acknowledged that investing in subprime and alternative mortgages would mean higher credit losses and increased exposure to unknown risks, but the lure of additional profits proved to be too great.
Let’s take that again: “investing in subprime and alternative mortgages would mean higher credit losses and increased exposure to unknown risks, but the lure of additional profits proved to be too great.”
That’s about Fannie and Freddie, but the same sentence could apply to the banks and the mortgage lenders and the ratings agencies. They all shared, essentially, the same motivation.
The FHFA’s lawsuit is more likely to be about so-called “private-label” mortgage-backed securities. That means the bundles of mortgage securities that Fannie and Freddie did not themselves guarantee. By 2006 – as the quote above shows – Fannie and Freddie were feeling insecure about banks outpacing them in dominating the mortgage market and finding more profitability in it.
(This Federal Reserve paper, which Cate Long pointed out on Twitter, shows that banks far outpaced Fannie and Freddie in the residential mortgage market in 2004-2006)
Even with this as the backdrop, however – and many thanks for Housing Wire CEO Paul Jackson for pointing it out – Fannie and Freddie were not wide-eyed, unsophisticated buyers. As giant players – and now dominators – of the market, they knew mortgages and due diligence on mortgages better than anyone on Wall Street or anywhere else.
So why a lawsuit? It’s about money, of course. Here’s one way that money matters: It’s about who will have to take the losses on all those bad mortgages, as Ernie Patrikis, a former Federal Reserve general counsel now with White & Case, mentioned to me yesterday.
But another way that money matters is this: Three years into the mortgage crisis, we’ve seen how bailouts don’t work for everybody. The banks took their money from the government and thrived. Fannie Mae and Freddie Mac took their money from the government and….now need more money from the government. Just last month, Fannie Mae asked for another $5.1 billion from taxpayers. . A giant lawsuit against the same banks they worked with? Well, that could help Fannie and Freddie look like the innocent victims and make their point for another bailout.
But when it comes to the mortgage crisis, it’s going to be hard for Fannie and Freddie to plausibly argue that they were victims. They were accomplices.
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