Downfall
Part One
Subprime
âIf youâre not relevant, youâre unprofitable, and youâre not serving the mission.â
âDan Mudd, CEO of Fannie Mae, 2005â2008
The story of how Fannie and Freddie came to be put in conservatorship is one of petty personality conflicts, global political concerns, incompetent oversight, tremendously bad business decisions in the midst of a housing bubble the likes of which no one has ever seen beforeâand ultimately, the flawed model of Fannie and Freddie. There will probably never be a single version of the truth upon which everyone agrees. There are a number of people, including Tim Howard, chief financial officer of Fannie Mae from 1990 to 2004, and Franklin Raines, Fannieâs chief executive officer from 1999 to 2004, who claim that if the experienced senior management teams of both companies hadnât been pushed out at precisely the most dangerous time in historyâ2004, just when the mortgage market was becoming dangerously overheatedâit would all have been different. In Rainesâs view, Fannie and Freddie, which at the height of their power set and enforced the standards by which business was done, sat at the center of the housing finance world, holding it all together. âWhen the leadership of Fannie and Freddie were decapitated, it was like a pinwheel coming apart,â says Raines.
Itâs certainly true that in the mid-2000s, Fannie and Freddie were in tatters. A major scandal over complicated allegations about Fannie and Freddieâs accounting practicesâover the charge, essentially, that Raines, Howard, and other executives had manipulated their companiesâ results to maximize their own compensationâled to a vast, distracting reworking of both companies and, indeed, the decapitation of the leadership. A Fannie executive says that because the process was so onerousâthere were about 2,800 outside lawyers, accountants, and others hired to clean it up at a cost of over $1 billionâFannie never again had the same top executive team for a full year. And as this person puts it, âIt was a problem, not having a team that knew each other when the industry was going to hell.â
Itâs also clearly true that the industry was going to hell, thanks to the explosion in subprime lending. Subprime lending had first taken off in the 1990s. The mortgages were sold to Wall Street, not to Fannie and Freddie. Instead of guaranteeing the homeownerâs ability to pay, as Fannie and Freddie do, Wall Street paid the credit-rating agencies to assign ratings that were supposed to measure the risk of nonpayment. So-called private-label securities that were given triple Aâsâthe safest possible ratingâwere supposed to be as safe as Fannie and Freddie securities. Indeed, after much lobbying by the Federal Reserve, banks, and investment banks, the international body known as the Basel Committee, which assesses the riskiness of various securities for purposes of determining how much capital financial institutions must hold, ruled in 2001 that private-label securities rated triple-A and double-A were just as safe as the corresponding GSE securities. âThis action, as much as any other, opened the floodgates to the reckless private label securitization of the most toxic mortgage products,â noted Josh Rosner, managing director at research consultancy Graham Fisher, in a 2012 testimony to a congressional subcommittee.
Lending to people who couldnât afford traditional mortgages was supposed to increase homeownership, which, of course, was what politicians have long pushed for. But subprime lending was never truly about homeownership. In the 1990s, much of the business of the new breed of lenders was so-called cash-out refinancings, in which a borrower would refinance her mortgage into a bigger one, and take the difference in cash that could be spent on bills, or on home improvementsâreally, on anything. According to a 2000 joint study published by the Treasury and the Department of Housing and Urban Development, by 1999 a staggering 82 percent of subprime mortgages were refinancings; and in nearly 60 percent of those cases, the borrower pulled out cash, thereby adding to her debt burden. One could argue that refinancing worked to undermine, not strengthen, homeownership, by generating a lot of overextended homeowners who couldnât make their mortgage payments.
The first wave of subprime was too small to get most peopleâs attention. And at the end of the 1990s, many of the subprime lenders crashed and burned amid proliferating consumer complaints about abusive lending practices and the drying up of credit after the 1998 crisis in emerging economies. But within just a few years, subprime lending was back, and bigger than ever. An avalanche of companies was selling mortgage loans directly to Wall Street, bypassing Fannie and Freddie. Subprime mortgages rose from 8 percent of mortgage originations in 2003 to 20 percent in 2005. So-called Alt-A mortgagesâloans made to people with good credit who couldnât or wouldnât document their income, or with some other nontraditional feature, and thus considered more risky than âprimeâ loans and less risky than âsubprimeâ loansâalso exploded. By 2006, private-label issuance reached $1.15 trillion, and an astonishing 71 percent of the mortgages were either subprime or Alt-A, according to the Financial Crisis Inquiry Commission, which was tasked with investigating the causes of the 2008 crisis. According to analysis by Jason Thomas, now the director of research at the Carlyle Group, only about a third of subprime mortgages that were turned into securities between 2000 and 2007 were used to buy homes.
Fannie and Freddie also benefited from the extraction of home equity. No one distinguished between a mortgage made to purchase a home and a refinancing, in part because no one foresaw the waves of refinancing that the falling interest rates of the 1990s and 2000s would bring. Between 2004 and 2007, homeowners cashed out approximately $966 billion in home equity from Freddie Macâbacked loans, according to a Government Accountability Office report. In 2006, cash-out refinances accounted for nearly 30 percent of all refinances at Freddie Mac.
Even so, as the private market boomed, Fannie and Freddie were rapidly becoming irrelevant. Their market share fell from 57 percent in 2003 to 42 percent in 2004 and to 37 percent in 2006, according to data gathered by the Financial Crisis Inquiry Commission. Why? The private market was leaving them behind. A 2005 internal presentation at Fannie Mae noted, with some alarm, âPrivate label volume surpassed Fannie Mae volume for the first time.â As an executive from a major subprime lending company called New Century told Congress in early 2004, subprime lenders were necessary to the economy, because they provided credit to âcustomers who do not satisfy the stricter credit, documentation or other underwriting standards prescribed by Fannie Mae and Freddie Mac.â He went on to point out that while over 40 percent of New Centuryâs loans were made to borrowers who didnât have to verify their income, Fannie and Freddie âhave more stringent income documentation guidelines.â He also continued, âFor refinance transactions, Fannie Mae and Freddie Mac do not generally permit a borrower to exceed a 90 percent loan-to-value ratio on a cash-out refinance loan. We and other nonprime lenders allow borrowers to take out more cash.â
But even before Raines, Brendsel, and other top executives were forced out, Fannie and Freddie had embraced their enemy in a subterranean and deeply perverse way, and one that only mega-institutions with a dual mandate of making profits and satisfying a government mandate would have done. They began buying what were supposedly the safest part of Wall Streetâs private-label securitiesâthose that were rated triple-Aâas investments that they would own on their own balance sheets, and they did so in huge volumes that only institutions of their size could handle. It was actually Freddie, which in most things followed Fannie, that dove into this business first, and bought much more. According to an Atlanta Federal Reserve working paper, Freddie and Fannie together purchased 3.8 percent of subprime issuance in 2001, 11.9 percent in 2002, 34.7 percent in 2003, 38.9 percent in 2004, and 28.9 percent in 2005, tapering to about 25 percent in 2006 and 2007. By the end of 2007, the two companies together held more than $313 billion in private-label mortgage-backed securities, according to a 2009 Government Accountability Office report. Most of it was owned by Freddie.
One reason Fannie and Freddie encouraged the very business that was threatening their existence was that the private-label mortgage-backed securities were, at first, profitable investments. Another reason was that they talkedâor âconned,â according to Judy Kennedy, the former president of the National Association of Affordable Housing Lendersâthe Department of Housing and Urban Development into allowing these loans to count toward the congressionally mandated goals to provide affordable housing that Fannie and Freddie had had to meet since 1992. (Fannie initially didnât think these loans qualified for the goals, says one former employee, but soon began using them for the same reason.) Wall Street even began designing a special product just for Fannie and Freddie that was packed with loans that satisfied the goals.
But buying what would turn out to be Wall Streetâs fatally flawed securities wasnât the only bad decision Fannie and Freddie made. Dan Mudd, who replaced Franklin Raines as Fannieâs CEO in 2005, was a Republican former Marine who had worked at General Electric before joining Fannie in 2000. He found himself under immense pressure to win back the market share Fannie was losing in the business of turning mortgages into securities. (It was a similar story over at Freddie Mac.) So both companies also began guaranteeing the risk that the homeowner wonât payâknown as credit riskâon huge quantities of those risky Alt-A loans. In this, Fannie took the lead, purchasing a stunning $350 billion of these loans between 2005 and 2007, stamping them with its guarantee, and turning them into securities. In a presentation for a 2005 executive retreat, Tom Lund, who was then the head of Fannieâs single-family business, put it this way: âWe face two stark choices: stay the course [or] meet the market where the market is.â According to an interview with staff of the Financial Crisis Inquiry Commission, Lund went on to say that if Fannie Mae stayed the course, it would maintain its credit discipline, protect the quality of its book, preserve capital, and be able to speak publicly about its concerns over the declining quality of mortgages. However, he said, Fannie would also face lower volumes and revenues, continued declines in market share, lower earnings, and a weakening of key customer relationships. It was simply a matter of relevance, Dan Mudd later told the FCIC. âIf youâre not relevant, youâre unprofitable, and youâre not serving the mission,â he said. âAnd there was danger to profitability. Iâm speaking more long term than in any given quarter or any given year. So this was a real strategic rethinking.â âIt was very interesting to me how market shareâdriven both Fannie and Freddie were,â says a former executive. âIt was how they measured themselves.â
It wasnât done without trepidation. A former executive says that Lund, who complained that Fannie didnât have the capability or the infrastructure to deal with riskier mortgages, would sit in meetings shaking his head, saying, âI do not know how banks are pricing these.â Lund also worried that by his calculations, as much as 35 percent of all home purchases were second homes, which indicated that widespread speculation was going on. In May 2005, he gave a speech to a mortgage industry group where he argued that the proliferation of nontraditional mortgage products had created risk layering, by which he meant loans that might combine, say, a very small down payment with a borrower who wouldnât document her income. (Even when Fannie began guaranteeing those massive quantities of risky Alt-A loans, the company tried to pick the best ones and avoid guaranteeing mortgages with layered risk.)
We trust the regulators of the financial system to see problems and act to stop them. So why didnât the regulators put a stop to what was happening? During this period, an obscure federal agency, the Office of Federal Housing Enterprise Oversight (it was a casualty of the financial crisis and no longer exists), had responsibility for Fannie and Freddie. OFHEO understood that Fannie and Freddie were moving aggressively into the subprime mortgage market. Its March 2007 report noted that Fannieâs new initiative to purchase higher-risk products included a plan to capture 20 percent of the subprime market by 2011. But OFHEO viewed this as a positive development, or at least as not alarming. Jim Lockhart, a Yale fraternity buddy of President George W. Bushâs who had worked as the deputy commissioner of the Social Security Administration when there was much talk of privatizing Social Security, and who then became the chairman of OFHEO in 2006, later told the FCIC that there was so much focus on cleaning up the accounting and watching interest rate risk (changes in interest rates can cause big losses for those who own mortgages) that âcredit risk was not emphasized as much as it should have been.â
As for the Federal Reserve, which also has responsibility for the financial system, its powerful chairman from 1987 to 2006, Alan Greenspan, was long opposed to the power in the mortgage market that Fannie and Freddie wielded. Tim Howard, Fannie Maeâs former CFO, would later charge that that was one reason no one tried to rein in the private market. âFollowing the lead of Fed chairman Alan Greenspan, [the Fed and the Treasury] actively were seeking to substitute free market principles, mechanisms and disciplines for government involvement and regulation wherever they could . . . subprime mortgages were the private market alternatives to loans financed by the GSEs,â Howard wrote in a 2013 book titled The Mortgage Wars: Inside Fannie Mae, Big-Money Politics, and the Collapse of the American Dream. Later, many people would pat themselves on the back for identifying the GSEs as a disaster waiting to happen. But itâs actually hard to find one person who identified the real cause of the problem. It was credit riskâthe chance that homeowners wonât be able to payâand it would soon engulf the global financial system.
The Bazooka
âIf youâve got a bazooka, and people know youâve got it, you may not have to take it out.â
âHank Paulson, Secretary of the Treasury, 2006â2009
In the summer of 2007, German Landesbankenâregional German banksâbegan to warn about losses due to heavy investments in U.S. private-label mortgage securities. Many would eventually need costly bailouts by the German government. Fannie and Freddie saw the trouble emerging in the mortgage marketsâhow could they not?âbut they saw it as an opportunity not to pull back, but to win back the market share they had lost to Wall Street. âOur business modelâinvesting in and guaranteeing mortgagesâis a good one, so good that others want to âtake us out,ââ stated Fannie Mae in its strategic plan for 2007 to 2011. By the end of August 2007, Fannieâs stock, which had dropped to a low of $48 in the spring of 2005, was almost back to its 2004 peak of $70. By the first quarter of 2008, Fannie and Freddie were guaranteeing 80 percent of all U.S. mortgages, double their market share from two years earlier. As a result, Fannie and Freddie exploded in size, from $3.6 trillion in debt and mortgage-backed securities outstanding in 2006 to $4.9 trillion in 2007 and to $5.2 trillion in the summer of 2008. To back that up, they held just a comparative sliver of capitalâ$84 billion.
Few people saw that the bottom was about to fall out. Many politicians were pushing Fannie and Freddie to do more to support the softening housing market. âSome of us who have helped Fannie and Freddie in the past ought to jawbone them to do it,â Chuck Schumer, the Democratic New York Senator, said. And even those who didnât like the GSEs saw that they n...