Fed Takeover of Freddie and Fannie May Provide Temporary Stability, But Is it Just a Band-Aid?

Posted on September 10, 2008 by Isaac Gradman

By now, most have heard the news that the Federal Government stepped in on Sunday to exercise the authority granted to it by Congress in July to bail out government sponsored enterprises (GSEs) Freddie Mac and Fannie Mae. The major features of the move include the ouster of the two companies’ chief executive officers, the acquisition by the Treasury of $1 billion of the companies’ preferred stock and a pledge of up to $200 billion more, and the placing of the companies in conservatorship (a type of federally-managed bankruptcy) with management control placed into the hands of the Federal Housing Finance Agency.

This report in the Silicon Valley Business Journal discusses the potential impact of the takeover on interest rates and taxpayer dollars. Government officials, such as those quoted in this fascinating MSN article, have hailed the move as providing necessary stability to a volatile market and keeping mortgages affordable. Others are questioning whether this will be enough to balance out the markets, especially given the cost (see Seattle Times article here).

Though few can argue that the stability of the mortgage markets is a worthy goal, I find the takeover troubling for a variety of reasons. Fannie Mae was created as a government agency in the late 1930s expressly to provide liquidity to the mortgage market. It was later converted into a private corporation in 1970, at the same time that Freddie Mac was created to provide competition to Fannie’s monopoly, to establish a secondary market to purchase mortgages and repackage them as securities. Since then, these organizations have existed as quasi-governmental entities in the murky ether between public and private. This uncertainty about what exactly these organizations are and who they represent has often led to an increase rather than a decrease in volatility in the mortgage markets.

This has been especially true in recent months as speculation about Freddie and Fannie’s fate swirled around Wall Street. If these are governmental agencies, then they should be supported by the full faith and credit of the United States Government. If they are private corporations, then they should fail. Instead, we have seen them handled with hesitancy, and with a bailout that many say has come too late.

But the status of these organizations is really a secondary question to the one that nobody seems to want to address – is the stated purpose of Freddie and Fannie a goal the U.S. Government, or anyone for that matter, should promote? Namely, do we really want to artificially inject liquidity into the mortgage market? This entire subprime crisis, and the broader credit crisis it has spawned, can be fairly attributed to an excess of liquidity in the mortgage market. This and the process of securitization, by which each player in the chain (borrower to broker to lender to investment bank to investor) could pass on the risk of a mortgage to the next, created a market in which anyone who could fog a mirror could get a loan. Was this a good thing? Nobody cared if a given borrower could really repay a loan because the secondary market’s appetite for these loans was voracious. Did this ultimately result in either a stable or a liquid market?

This takeover is therefore all the more troubling because it seems only to prop up the misguided policy at the heart of this crisis. Returning to the stated goals of government officials, it’s clear that injecting liquidity into the mortgage market was again one of the foremost drivers behind this move. But, nobody stopped to ask whether keeping mortgages affordable for all who want them is a good thing. Maybe borrowers who cannot afford nice homes should settle for more modest homes or (gasp) rent until they can afford them. What a novel concept!

It seems to me that the goal should be a mortgage market that accurately reflects the value of real estate and the available financing, not one that treats home ownership as a Constitutional right.

Posted in broader credit crisis, causes of the crisis, education, Fannie Mae, Freddie Mac, legislation, lenders, liquidity, mortgage market, securitization, stability, subprime, takeover | 1 Comment

Borrowers Will Be Borrowers

Posted on August 27, 2008 by Isaac Gradman

Despite the increased attention directed at mortgage fraud since the collapse of the subprime market, fraud continues to be a major issue in newly-originated loans, reports the Mortgage Asset Research Institute (MARI). The study showed a 42% increase in in reported incidents of fraud in loans originated during the first quarter compared to a year ago.

This almost certainly has more to do with lenders beginning to actually investigate and report fraud on the part of borrowers (as opposed to encouraging it), than with an uptick in borrowers lying on their applications. Certainly, borrowers should bear a large degree of responsibility for the current subprime mess, as many lied about their income, employment, or intentions to secure loans they could not actually afford or profit by purchasing and then “flipping” or renting out properties they represented would be their homes.

But, this study illustrates that there will always be some borrowers who attempt to game the system for their own benefit. Only in an atmosphere of deregulation and encouragement by the lenders, markets and investors could these practices flourish and become the norm. This counsels in favor of stricter regulation of lending practices, criminal penalties for mortgage fraud, and more prescient investing by Wall St. and the ultimate investors to create the proper incentives for lenders to filter out fraud in its inception.

Indeed, MARI concluded in its Quarterly Fraud Report, “[a]s lenders pursue higher-quality loans for the market, the priority should be on identifying poor quality at the earliest possible point in the process — and at the lowest possible cost. In MARI’s view, the origination and prefunding processes offer the largest and least expensive opportunities to assure funding of higher-quality loans. How a lender accepts or rejects a loan application at the front door is often all a criminal needs to see how much further he or she may push through the loan process.”

Posted in borrower fraud, incentives, MARI, mortgage fraud, overstated income, regulation, subprime | Leave a comment

Indiana Piles On

Posted on August 27, 2008 by Isaac Gradman

Indiana Attorney General Steve Carter has brought a lawsuit against Countrywide Financial Corp., making it the latest of a half dozen states going after the nation’s former number one mortgage lender for improper lending practices (see Reuters article here). This suit focuses on Countrywide misleading borrowers about the rates and fees associated with their loans and encouraging its brokers to steer borrowers into riskier and ultimately more costly mortgages.

One begins to wonder when the mounting pressure on Countrywide from this flood of litigation will begin to spur Bank of America to take action. BofA has said publicly that it will not guarantee Countrywide’s debts (e.g. here and here). But news last month that BofA transferred Countrywide’s liabilities into a subsidiary, Red Oak, which was then renamed to Countrywide Financial Corp., fueled speculation that those liabilities would indeed be assumed. Analysts from independent researcher CreditSights, Inc., after reviewing a BofA regulatory filing that showed how it was handling Countrywide’s debts, stated that, “[o]ur view continues to be that B of A will ultimately honor the outstanding indebtedness from (old) Countrywide, based on our discussion with the company following this filing, as well as our prior analysis.” (see story here)

Regardless, there’s no denying that BofA’s acquisition increases its overall credit and litigation risk, and that what was hailed as a steal of a deal is beginning to look like a sucker’s bet.

Posted in acquisitions, Attorneys General, banks, BofA, Complaints, Countrywide, lenders, liabilities, litigation, predatory lending, subprime | Leave a comment

Countrywide Sued by New Mexico Pension and Investment Funds

Posted on August 20, 2008 by Isaac Gradman

The Chicago Times reports that Countrywide has been sued on behalf of New Mexico’s state Investment Council, the Educational Retirement Board and the Public Employees Retirement Association for both conning homeowners into mortgages they could not afford and duping investors about the value and safety of securities backed by these shaky mortgages. The allegations as to Countrywide’s lending practices should sound familiar – they are similar to those alleged in recent suits by California, Florida, Illinois, Connecticut and the City of San Diego (see prior posting here). But the allegations regarding Countrywide’s issuance of securities are relatively new. As additional allegations surface about what was going down at the country’s former number one lender, it will be interesting to see whether Bank of America steps forward to take some responsibility for the debts of its new acquisition or if, as is more likely, Countrywide sags under the mounting pressure of its liabilities and goes the way of New Century and IndyMac. Stay tuned…

Posted in acquisitions, Countrywide, IndyMac, lenders, litigation, New Century, predatory lending, securities | Leave a comment

California Legislature Reaches Compromise on Subprime Reform Bill

Posted on August 20, 2008 by Isaac Gradman
The L.A. Times reports that the California has reached a compromise with consumer and lending groups on a bill that would guard against some of the practices that contributed to the subprime crisis. The bill, an amended version of AB 1830 introduced by Assemblyman Ted Lieu (D-Torrance), contains measures that would bar pick-a-payment loans to subprime borrowers, limit the size and duration of prepayment penalties on subprime loans and prohibit brokers from steering subprime borrowers into costlier loans than they qualified for. The bill would also forbid lenders from paying brokers more when they persuaded people to take loans with prepayment penalties or higher interest rates, an issue that has come up in state suits against Countrywide, among others. The measure also increases access to the courts for victims of predatory lending by allowing California regulators to enforce both federal lending laws and state rules.

While the bill does address some of the abusive practices that encouraged volume lending and lax underwriting, there is still much work to be done. For one, while the bill includes a provision that would require mortgage brokers to place their customers’ financial interests ahead of their own for all lending, the bill focuses primarily on subprime loans. While this category of loans has received the most attention in the media as the harbinger of the current credit crisis, the problems by no means are limited to these loans. As we have seen, the delinquency and foreclosure rates among so-called Alt-A loans have skyrocketed (for reports regarding this category of loans, see here and here), and I expect to see major problems with this and other categories of non-subprime loans down the road.

Moreover, there is good reason to think that these abusive lending practices have not been limited to residential home mortgages alone. In an interesting profile by the New York Times of Nouriel Roubini, who predicted the current subprime crises back in 2006, Roubini opines that:

“Reckless people have deluded themselves that this was a subprime crisis… But we have problems with credit-card debt, student-loan debt, auto loans, commercial real estate loans, home-equity loans, corporate debt and loans that financed leveraged buyouts.” All of these forms of debt, he argues, suffer from some or all of the same traits that first surfaced in the housing market: shoddy underwriting, securitization, negligence on the part of the credit-rating agencies and lax government oversight. “We have a subprime financial system,” he said, “not a subprime mortgage market.”

Though Roubini has been criticized as an eternal pessimist, he has been largely vindicated by his numerous accurate predictions regarding the U.S. housing and financial markets. Plus, his reasoning makes sense: given an environment where lax underwriting was encouraged and responsibility was passed off to the next buyer in a securitization chain, there’s no reason to think that lenders were incentivized to care whether borrowers were actually capable of repaying their loans. And by no means are the abuses limited to lenders or banks; the borrowers themselves have been responsible for a significant amount of reckless or fraudulent borrowing which must be curtailed through improved financial education and legal reform. Though AB 1830 is a good start, it will take a much broader overhaul of the entire credit system to address the fact that Americans as a whole are staggering under the weight of their debts.

Posted in Alt-A, broader credit crisis, Countrywide, education, incentives, legislation, lenders, predatory lending, ratings agencies, subprime | Leave a comment