Cleaning House: The Financial Crisis and the GSEs

By Edward Pinto 

Disclosures contained in SEC complaints show the need for further investigation of Fannie and Freddie’s characterization of subprime loans.

Late last week, the Securities and Exchange Commission charged the former executives of Fannie Mae and Freddie Mac with systematically misleading shareholders by grossly underestimating the levels of subprime and Alt-A loans in their single-family loan guaranty portfolios. Current management of Fannie and Freddie have agreed to cooperate with the SEC and to accept their findings, but they are not admitting wrongdoing for misleading investors about their firms’ exposure to troubled mortgages.


I have used new information from the complaints to update the totals contained in my related paper Government Housing Policies in the Lead-up to the Financial Crisis: A Forensic Study. Fannie and Freddie are now estimated to have had a combined $2 trillion in high-risk loans and securities, amounting to 42 percent of their total single-family mortgage guarantees and investments.
Fannie and Freddie entered into agreements accepting responsibility for misleading conduct discovered by the SEC, including:

1.    As of June 30, 2008, Freddie had $244 billion in subprime loans, while investors were told it had only $6 billion in subprime exposure.

a.    Freddie knew it was inadequately compensated for the risks it was taking. For example, it was taking on “subprime-like loans to help achieve [its] HUD goals” that were similar to private fixed-rate subprime, but the latter typically received “returns five to six times as great,” says the complaint.

b.    Freddie had concerns about risk layering on loans with an LTV >90% and a FICO <680. (Yet, in Freddie’s disclosures it only noted risk layering concerns on loans with an LTV >90% and a FICO <620. This is a major difference since only 10 percent of its loans fell into the LTV >90% and a FICO <620 category, while nearly half fell into the LTV >90% and a FICO <680 one.)

2.    As of June 30, 2008, Fannie had $641 billion in Alt-A loans (23 percent of its single-family loan guaranty portfolio), while investors were told it had less than half that amount ($306 billion, or 11 percent of its single-family loan guaranty portfolio).

3.    The SEC complaint disclosed that Freddie had a coding system to track “subprime,” “other-wise subprime,” and “subprime-like” loans in its loan guaranty portfolio even as it denied having any significant subprime exposure.

These suits are important because they demonstrate that Fannie and Freddie “told the world their subprime exposure was substantially smaller than it really was … and mislead the market about the amount of risk on the companies’ books,” said Robert Khuzami, director of the SEC’s Enforcement Division.

Why would Freddie and Fannie guarantee risky loans like subprime even though they were being inadequately compensated?

The government-sponsored enterprises also misled the world about the massive buildup of risk in the mortgage market as Fannie and Freddie, starting in 2001, accounted for about half of all outstanding single-family first mortgages. By mid-2008, more than 40 percent of their loans had risky characteristics. It was this unprecedented accumulation of weak and risky mortgages that precipitated the collapse of housing and mortgage markets and the ensuing financial crisis.
When the financial crisis hit in full force in 2008, approximately 27 million, or 49 percent, of the nation’s 55 million outstanding single-family first mortgage loans had high-risk characteristics, making them far more likely to default.
The SEC’s disclosure regarding Freddie’s coding system for subprime loans is particularly important. In 2010, I released Government Housing Policies in the Lead-up to the Financial Crisis: A Forensic Study, cataloguing research I began in 2008. One of my goals was to document the accumulation of non-traditional mortgages in the housing finance system, and to look behind Fannie and Freddie’s misleading disclosures and nomenclature to see actual risks.
The SEC’s disclosure debunks criticism leveled by David Min of the Center for American Progress and others against my analysis of the nature of the mortgage crisis. Min’s central objection was that I used “radically revised definitions for … subprime and Alt-A mortgages.”

By mid-2008, more than 40 percent of Fannie and Freddie loans had risky characteristics. It was this unprecedented accumulation of weak and risky mortgages that precipitated the collapse of housing and mortgage markets and the ensuing financial crisis.

In the Forensic Study, subprime loans were defined as those with a FICO score of less than 660. Min described this as a “radical definition” of subprime as it resulted in Freddie’s loan guaranty portfolio having $243.3 billion in subprime loans at June 30, 2008. It now turns out to be virtually identical to the subprime loan total of $244 billion that the SEC calculated. This should come as no surprise, as Freddie, in an August 1995 industry letter, set a 660 FICO as the score for an investment grade loan.¹
Interestingly, Fannie’s subprime loans, defined using the same <660 FICO definition, performed even worse than Freddie’s subprime loans.
Fannie’s risk exposures related to Alt-A loans (23 percent, based on SEC complaint), subprime loans (14.8 percent, based the Forensic Study definition), loans with LTVs >90% (10.4 percent, based on Fannie’s disclosure), and subprime and Alt-A private mortgage backed securities (2.4 percent, based on Fannie’s disclosure) totaled 43 percent of Fannie total single-family mortgage investments.² This percentage is even higher than the 39.5 percent estimate contained in my study.
The disclosures contained in the SEC complaints further validate the necessity to look behind Fannie and Freddie’s characterization of loans.
Why would Freddie and Fannie guarantee risky loans like subprime even though they were being inadequately compensated? The answer: these loans were necessary to meet affordable housing goals.

These suits demonstrate that Fannie and Freddie ‘told the world their subprime exposure was substantially smaller than it really was … and mislead the market about the amount of risk on the companies’ books.’

My American Enterprise Institute colleague Peter Wallison, in his Financial Crisis Inquiry Commission dissent, cited Fannie data showing loans with a FICO <660 that met the low- and moderate-income goal grew from 38 percent in 1996 to 56 percent in 2006. The percentage meeting the special affordable base goal grew from 12 percent in 1996 to 26 percent in 2006.
In a 2000 rulemaking, the Department of Housing and Urban Development pushed Fannie and Freddie “to play a significant role in the subprime market.” HUD went on to add “the line between what today is considered a subprime loan versus a prime loan will likely deteriorate, making expansion by the GSEs look more like an increase in the prime market … This melding of markets could occur even if many of the underlying characteristics of subprime borrowers and the market's (i.e., non-GSE participants) evaluation of the risks posed by these borrowers remain unchanged … Lending to credit-impaired borrowers will, in turn, increasingly make good business sense for the mortgage market.”
HUD nailed this one (except for the “good business” part). Was this mere prescience or an invitation to Fannie and Freddie to mislead investors?
Edward Pinto is a resident scholar at the American Enterprise Institute.