The Republican members of the Financial Crisis Inquiry Commission have conducted a preemptive strike.
They issued a report arguing that the problem with Fannie and Freddie was regulation and politics and that Fannie and Freddie are responsible for the U.S. financial crisis – so regulation is the great evil.
This subdivides into four arguments: the Community Reinvestment Act (CRA), Congress’ rejection of an administration proposal to give OFHEO greater supervisory powers, specifically, the power to place Fannie and Freddie in receivership, the ability of Fannie and Freddie to borrow due to their status as Government-Sponsored Enterprises (GSEs), and the rules on Fannie and Freddie making a rising percentage of their loans to those with below median income.
The CRA argument fails on multiple levels. The CRA became law in 1977 so it is a poor candidate to explain the rise of a crisis a quarter-century later. Its enforcement did become slightly stronger under the Clinton administration, but it became far weaker under the Bush administration. If the CRA caused banks to make more bad home loans, then bad loans should have fallen this decade as enforcement efforts fell.
Most nonprime loans were made by entities that are not federally insured – and not subject to the CRA. The uninsured lenders made nonprime loans for the same reason that insured banks made the loans – doing so guaranteed the creation of record short-term income and executive compensation. When, for example, we (OTS’ West Region) used our supervisory powers in the early 1990s to stop a sharp rise in the issuance of liar’s loans by a number of S&Ls based in California, Long Beach Savings responded by giving up its charter and federal deposit insurance so that it could become a mortgage banking firm. Long Beach changed its name to Ameriquest and became the nation’s most infamous predatory lender specializing in making nonprime loans.
Ameriquest changed its charter so that it was not subject to the CRA – as part of a deliberate strategy to expand massively its nonprime lending. The CRA does not require a lender to make a bad loan. The nonprime lenders made liar’s loans which inflated the borrower’s purported income, which could make a loan that could have received credit under the CRA appear not to do so. If the CRA drove increased liar’s loans then lenders and their agents should have falsified the income disclosures on liar’s loans’ applications by reporting reduced income. In reality, lenders and their agents used liar’s loans to inflate substantially the borrower’s income.
President Bush did propose legislation to strengthen OFHEO’s supervisory powers and Congress declined to pass the bill. The defeat of the bill, however, played no role in the crisis. Moreover, while more Congressional Democrats than Republicans opposed the bill, it was a bipartisan coalition that killed the bill. (I would have voted for the bill and I am a critic of Fannie and Freddie.) The bill proved to be irrelevant because (1) OFHEO already had ample statutory authority to prevent Fannie and Freddie from purchasing liar’s loans’ paper and uncreditworthy subprime loans, and (2) the Bush administration did not foresee the nonprime loan crisis or the housing bubble and it did not rein in Fannie and Freddie’s purchase of nonprime mortgage paper.
The Bush administration, the Fed, and Peter Wallison did not identify, warn against, and seek to pop the housing bubble. They did not identify and warn against nonprime lending. Instead, they encouraged nonprime loans and ignored the warnings of the State attorneys general, consumer advocates, the FBI, and the mortgage industry’s own anti-fraud experts of the growing epidemic of fraud brought on by liar’s loans. They did not warn against the dangers of Fannie and Freddie purchasing nonprime paper. Instead, they encouraged them to do so. OFHEO and Lockhart did not identify nonprime paper as a serious risk. The bill proposed by President Bush would not have limited Fannie and Freddie’s purchase of nonprime paper. If the bill had become law Lockhart would not have used it to restrain Fannie and Freddie’s purchase of nonprime paper – a restraint he already had authority to impose.
The systemic risk that Wallison, the Fed, and Lockhart focused on arose from Fannie and Freddie purporting to use “dynamic hedging” to hedge their interest rate risk created by their rapid portfolio growth. The critics’ concerns about interest rate risk and dynamic hedging were valid. Very large dynamic hedging can cause systemic risks – but that particular concern did not contribute to this crisis. (Moreover, OFHEO already had the authority to prevent Fannie and Freddie from engaging in purported dynamic hedging. OFHEO used that existing authority to order extensive changes to Fannie and Freddie’s conventional purported hedging practices. I use the word “purported” because Fannie and Freddie were recurrent accounting control frauds. One of the ways in which they committed accounting fraud was to make misrepresentations about their hedging operations.)
Fannie and Freddie did not have explicit federal guarantees. They were privately-owned corporations. The markets, however, considered them to be “too big to fail.” The markets assumed that it was highly likely that the Treasury would prevent defaults on MBS issued by Fannie and Freddie. Fannie and Freddie did have unique features, but the “too big to fail” aspect was, as we have seen, far from unique. Some critics argue that if Fannie and Freddie were never created then the current crisis could not have occurred or at least would have been far smaller.
The argument is that Fannie and Freddie had the unique ability to borrow large amounts of funds while being insolvent due to their holdings of uncreditworthy nonprime paper. The problem with this assertion is that most of the “too big to fail” banks (investment and commercial) were major purchasers of nonprime paper and they too were in reality insolvent because of their (unrecognised) losses on that nonprime paper. Fannie and Freddie came later to the nonprime paper party than many of its peers.
Fannie and Freddie did have unique rules ratcheting up the proportion of their loans that should be made to lenders with below median incomes. Americans are relatively wealthy, so it is not sound to conflate “below median” with “poor” or “low income.” Fannie and Freddie could comply with some of the goals by purchasing prime mortgage loans made primarily to middle-income Americans. There were no penalties if Fannie or Freddie failed to meet the affordable housing goals. The goals were complex (there were three subsets) and they increased over time. Fannie and Freddie did not always meet the goals. They often purchased a lower percentage of “affordable” loans than the mortgage industry originated. As to some of the goals, however, Fannie and Freddie often exceeded the goal. The overall numbers, therefore, do not establish that the affordable housing goals drove Fannie and Freddie’s mortgage purchase decisions.
There are excellent ways of teasing out whether Fannie and Freddie’s mortgage purchase decisions were driven by a search for yield in order to maximise their controlling officers’ compensation (which is what the SEC investigators had found earlier in the decade) or by the goals. Liar’s loans are the best way to determine the controlling officers’ motivations. The lenders and their agents used the absence of underwriting that is the defining element of a “liar’s loan” to substantially inflate the borrowers’ income without leaving a clear paper trail of their fraud. In 2006, the Mortgage Asset Research Institute (MARI) explained in its Eighth Annual report to industry about mortgage fraud:
“Stated income and reduced documentation loans speed up the approval process, but they are open invitations to fraudsters. It appears that many members of the industry have little historical appreciation for the havoc created by low-doc/no-doc products that were the rage in the early 1990s. Those loans produced hundreds of millions of dollars in losses for their users.”
“One of MARI’s customers recently reviewed a sample of 100 stated income loans upon which they had IRS Forms 4506. When the stated incomes were compared to the IRS figures, the resulting differences were dramatic. 90 per cent of the stated incomes were exaggerated by 5% or more. More disturbingly, almost 60% of the stated amounts were exaggerated by more than 50%. These results suggest that the stated income loan deserves the nickname used by many in the industry, the “liar’s loan.””
It was also common for liar’s loans to have seriously inflated appraisals. This lowered the reported loan-to-value (LTV) ratio and increased the loan’s sales value. Appraisal fraud also leads to unusually severe losses upon default. It was lenders and their agents who deliberately created the perverse incentives (Gresham’s dynamic) that produced the “echo” epidemic of appraisal fraud. (The borrower can rarely induce the appraiser to inflate the valuation.) An honest secured lender would never cause, or permit, appraised values to be inflated. Widespread appraisal fraud is a superb “marker” for identifying lenders engaged in accounting control fraud.
Note that a similar point applied to Fannie and Freddie. They were exposed to severe losses if appraisals were inflated – and published reports had established that there was an epidemic of appraisal fraud. Fannie and Freddie, if they were run by honest managers, would have reviewed a sample of the appraisals prior to purchasing mortgage paper. Had they done so, however, they would have found that fraud was so pervasive in nonprime lending that they could not purchase the product. The result was that financial participants dealing in nonprime paper adopted the financial version of “don’t ask; don’t tell.” That approach would allow Fannie and Freddie’s officers to report high income and obtain large bonuses in the short-term, but it would also doom Fannie and Freddie.
Fannie and Freddie’s attainment of the affordable housing goals was measured, in the context of liar’s loans, by “stated income.” Lenders and their agents engaged in pervasive, large inflation of those incomes because that deceit would increase the price the lender could obtain when he sold the loan. Buying liar’s loans would simultaneously (1) massively increase Fannie and Freddie’s losses and, (2) reduce their reported compliance with the affordability guidelines by making it appear that Fannie and Freddie were buying mortgages made to those with higher incomes. That would be a significantly insane strategy for Fannie and Freddie’s senior officers to follow if they were honest and making their business decisions based on a felt need to comply with the affordability guidelines.
We don’t know the total dollar amount of liar’s loan paper that Fannie and Freddie purchased, but we know that it is enormous. (The fact that we do not know tells us a great deal about the continuing weakness in the regulation of Fannie and Freddie). In the Fannie report I reviewed they falsely reported that their liar’s loans were “prime” loans. Fannie and Freddie’s huge purchases of liar’s loans and the efforts to mislead their investors and OFHEO about the extent of their purchases of liar’s loans only make sense if their controlling officers were following their recurrent strategy, the one laid out in the title of Akerlof & Romer’s 1993 article – “Looting: the Economic Underworld of Bankruptcy for Profit.” Fannie and Freddie’s controlling officers repeatedly wanted a “sure thing.” Purchasing high yield liar’s loan paper maximized their compensation and let them walk away rich.
If Fannie and Freddie had purchased only subprime mortgage paper to lower income borrowers we would have had more difficulty discerning whether they did so because of the guidelines or the yield. The huge portfolio of liar’s loan paper, however, makes no sense if they were running an honest financial institution subject to affordable housing guidelines. No honest CEO would purchase vast amounts of loans that were “an open invitation to fraudsters” and were sure to produce losses so catastrophic that they would cause Fannie and Freddie to fail. Fannie and Freddie’s CEOs had been warned by the FBI, MARI, and their own staff about the epidemic of mortgage fraud. Making liar’s loans made it harder for Fannie and Freddie to meet the affordable housing goals. Why would an honest CEO overpay massively to acquire pervasively fraudulent assets that frequently did not count towards the affordable housing goals?
Fannie and Freddie caused such horrific losses because they were private institutions run by officers who obtained a “sure thing” – great wealth through booking high yield in the near term without establishing meaningful loss reserves. OFHEO and the SEC had blocked Fannie and Freddie’s prior accounting scam (abusive hedge accounting) and limited Fannie and Freddie’s growth. Fannie and Freddie’s officers’ optimal remaining strategy, given OFHEO’s imposition of a constraint on growth, was to maximise reported short-term accounting income by purchasing very high (nominal) yield mortgage paper and not provide adequate loss reserves. Liar’s loans offered the best nominal yield (many subprime loans are also liar’s loans). Fannie and Freddie’s officers profited through the quintessentially private sector method of looting a corporation – executive compensation based on short-term, fictional, reported income followed by catastrophic losses and insolvency.
Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.
Business Insider Emails & Alerts
Site highlights each day to your inbox.