Opinion

Bethany McLean

Faith-based economic theory

Bethany McLean
Jan 25, 2012 17:36 UTC

The Republican candidates for president have some major differences in their policies and their personal lives. But they have one striking thing in common—they all say the federal government is responsible for the financial crisis. Even Newt Gingrich (pilloried for having been a Freddie Mac lobbyist) says: “The fix was put in by the federal government.”

The notion that the federal government, via the Community Reinvestment Act (CRA) and by pushing housing finance giants Fannie Mae and Freddie Mac to meet affordable housing goals, was responsible for the financial crisis has become Republican orthodoxy. This contention got a boost from a recent lawsuit the Securities and Exchange Commission (SEC) filed against six former executives at Fannie and Freddie, including two former CEOs. “Today’s announcement by the SEC proves what I have been saying all along—Fannie Mae and Freddie Mac played a leading role in the 2008 financial collapse that wreaked havoc on the U.S. economy,” said Congressman Scott Garrett, the New Jersey Republican who is chairman of the financial services subcommittee on capital markets and government-sponsored enterprises (GSEs).

But the SEC’s case doesn’t prove anything of the sort, and in fact, the theory that the GSEs are to blame for the crisis has been thoroughly discredited, again and again. The roots of this canard lie in an opposition—one that festered over decades—to the growing power of Fannie Mae, in particular, and its smaller sibling, Freddie Mac. This stance was both right and brave, and was mostly taken by a few Republicans and free-market economists—although even President Clinton’s Treasury Department took on Fannie and Freddie in the late 1990s. The funny thing, though, is that the complaint back then wasn’t that Fannie and Freddie were making housing too affordable. It was that their government-subsidized profits were accruing to private shareholders (correct), that they had far too much leverage (correct), that they posed a risk to taxpayers (correct), and what they did to make housing affordable didn’t justify the massive benefits they got from the government (also correct!). Indeed, in a 2004 book that recommended privatizing Fannie and Freddie, one of its authors, Peter Wallison, wrote, “Study after study has shown that Fannie Mae and Freddie Mac, despite full-throated claims about trillion-dollar commitments and the like, have failed to lead the private market in assisting the development and financing of affordable housing.”

When the bubble burst in the fall of 2008, Republicans immediately pinned the blame on Fannie and Freddie. John McCain, then running for president, called the companies “the match that started this forest fire.” This narrative picked up momentum when Wallison joined forces with Ed Pinto, Fannie’s chief credit officer until the late 1980s. According to Pinto’s research, at the time the market cratered, 27 million loans—half of all U.S. mortgages—were subprime. Of these, Pinto calculated that over 70 percent were touched by Fannie and Freddie—which took on that risk in order to satisfy their government-imposed affordable housing goals—or by some other government agency, or had been made by a large bank that was subject to the CRA. “Thus it is clear where the demand for these deficient mortgages came from,” Wallison wrote in a recent op-ed in The Wall Street Journal, which has enthusiastically pushed this point of view in its editorial section since the crisis erupted.

But Pinto’s numbers don’t hold up. The Financial Crisis Inquiry Commission (FCIC)—Wallison was one of its 10 commissioners— met with Pinto and analyzed his numbers, and concluded that while Fannie and Freddie played a role in the crisis and were deeply problematic institutions, they “were not a primary cause.” (Wallison issued a dissent.) The FCIC argued that Pinto overstated the number of risky loans, and as David Min, the associate director for financial markets policy at the Center for American Progress, has noted, Pinto’s number is far bigger than that of others—the nonpartisan Government Accountability Office estimated that from 2000 to 2007, there were only 14.5 million total nonprime loans originated; by the end of 2009, there were just 4.59 million such loans outstanding.

The disparity stems from the fact that Pinto defines risky loans far more broadly than most experts do. Min points out that the delinquency rates on what Pinto calls subprime are actually closer to prime loans than to real subprime loans. For instance, Pinto assumes that all loans made to people with credit scores below 660 were risky. But Fannie- and Freddie-backed loans in this category performed far better than the loans securitized by Wall Street. Data compiled by the FCIC for a subset of borrowers with scores below 660 shows that by the end of 2008, 6.2 percent of those GSE mortgages were seriously delinquent, versus 28.3 percent of non-GSE securitized mortgages.

To recap: If private-sector loans performed far worse than loans touched by the government, how could the GSEs have led the race to the bottom?

Another problematic aspect to Pinto’s research is that he assumes the GSEs guaranteed risky loans solely to satisfy affordable housing goals. But many of the guaranteed loans didn’t qualify for affordable housing credits. The GSEs did all this business because they were losing market share to Wall Street—their share went from 57 percent in 2003 to 37 percent by 2006. As the housing bubble grew larger, they wanted to recapture their share and boost their profits.

Indeed, the SEC lawsuit specifically says Fannie and Freddie began to do more risky business not to meet their goals, but rather to recapture market share—and they began to do so aggressively in 2006, when the market was already peaking. So while the GSEs played a huge role in blowing the bubble bigger than it otherwise would have been—and the numbers in the SEC complaint are huge—they followed, rather than led, the private market.

It’s also very hard to look at what happened in the crisis and conclude that nothing went wrong in the private sector. Note that the other Republican members of the FCIC refused to sign on to Wallison’s dissent. Instead, they issued their own dissent. “Single-source explanations,” they said, were “too simplistic.”

Yet despite all that, the one-note Republican refrain hasn’t changed. The explanation is obvious: The “government sucks” rant polls well with conservatives. Mix in an urge to counter the equally simplistic story from the left—that the crisis was entirely the fault of greedy, unscrupulous bankers—and you get a strong resistance to the facts. Maybe there’s a deeper reason, too. For many, belief in the all-knowing market was (and is) almost a religion. This financial crisis challenged that faith by showing the market would indeed allow loans to be made that could never be paid back, and by showing that highly paid financial services executives aren’t gods, and that many of them are stupid and venal and all too human.

So maybe the Republican orthodoxy is understandable, but that doesn’t mean it isn’t scary. Of course, there’s the great line from Edmund Burke: “Those who do not know history are destined to repeat it.” Our housing market is a mess that threatens to drag down the entire economy, and whoever is president in 2013 needs to have a plan. Denying the facts is not a good start.

PHOTO: Republican presidential candidates (L-R) former U.S. Senator Rick Santorum (R-PA), former Massachusetts Governor Mitt Romney, former Speaker of the House Newt Gingrich and U.S Representative Ron Paul (R-TX) arrive on stage before the Republican presidential candidates debate in Tampa, Florida January 23, 2012.  REUTERS/Brian Snyder

COMMENT

The failure is larger than a partisan finger-pointing exercise. It is historical. The government did fail, because it did not fulfill its legal mandate under the securities laws of the 1930s to regulate all securities. It failed to enforce the basic rules. These securitizations were simply treated as traditionally exempt from securities scrutiny and oversight. The issue was obvious, but the relevant regulators regarded it as off their turf and out of their purview. The GSEs were a government program run as a monopoly. They had no rules, other than those they made themselves. The government is treated as if it needs no rules, because nothing the government does has to be economically rational. Government is simply assumed to be well motivated and benign—and often, it is. Whatever mistakes the government makes are by definition simply absorbed by the American people.

Originally, the GSEs had been run with integrity. To securitize home mortgage debt after the Great Depression was a good government program, particularly under conditions of the 1930s: diverse small local banks with limited portfolios of home and local commercial loans which, if combined, could be made overall safer, courtesy of government pooling. Government-backed finance for the little guy, structured to be safer by nationalizing it. FDR invented, by the way, the 30 year mortgage. The usual home mortgage at that time was 5 years to pay off, 50% down. (This datum comes from Raghuram Rajan’s Fault Lines.) Thus, there is nothing economically “natural” about the 30 year mortgage. FDR rationalized what was at that time an industry subject to local ups and downs, with a monopoly insurance plan. When the GSEs were later privatized (which happened not in the 80s “decade of greed,” but in 1968, in the effort to lay GSE liabilities off onto the private sector, due to the budget pressures of Vietnam and the Great Society), the need to inspect the integrity of the securities packaging process was just spaced out by Congress and all the rest of Washington.

As sole securitizer, the GSEs would never have lent to deadbeats. But there was no such restraint on private market securitizers. The government’s debt securities packaging technique — which amounted to cranking paper out of word processing — was now normalized and blindly handed off to financial firms to simply emulate. Banks themselves were now also no longer local small lenders eking out a small profit on lending to well scrutinized debtors, but highly aggregated volume sales fee generators, soon to be on digital steroids, and also, by that time, all rolled up over a long series of mergers and acquisitions into a vast cartel. Banking itself emulated government, in size and aggregation structure. There was no antitrust scrutiny in the 80s. For other reasons antitrust was under a cloud. This too had the effect of extending the originally limited government guarantee to the little guy against his home, to all of finance. The original limitation had been based on the early segregated nature of banks’ very function and structure, an industry structure originally enforced by Glass Steagall. The fact of Glass Steagall itself should have suggested to Congress that it held significance to the overall structure of the law. But Congress isn’t capable of that kind of deep thinking. They respond to the immediacies of campaign self-promotion, and lobbying.

Even government officials using Other People’s Money have the “skin in the game” of a sense of responsibility to the public, and whatever native smarts they may have. But privatizing the GSEs eliminated even this pillar of restraint and accountability. Meanwhile the private sector could also con its new buyers by pointing to debt securitizations’ long, apparently safe track record in the hands of the government. The world simply assumes the integrity of our markets. By long habit, the SEC didn’t notice the lack of arms’ length market scrutiny in the debt securities packaging process. Though, it should have. When entrepreneurs form a company, and do business, then seek capital to expand, entering into debt agreements or seeking to sell equity securities to people, in its nature this is scrutinized by lenders and VCs. The government’s word processing technique of taking debt off banks’ hands and bundling it into securities to resell, has no such nature. But securities law certainly requires some such rigorous process of transparency, scrutiny, and arms’ length negotiation.

Wall Street lawyers did not miss this, by the way. They knew, but weren’t telling. They served their clients, the banks, whose interest was to land all this business, and devil take the hindmost. The lawyers got to look the other way, collect big fees for themselves, and whistle Dixie. They also knew the government would in effect be on the hook. By the 80s all of elite law was full of this type of speculative thinking. The government itself was also specifically advised of its duty to subject all such securities to the full monte of regulatory oversight. It ignored it out of the bureaucrat’s instinct to ignore anything that seems to fall between stools. That is why Republicans are right to blame government, even if they get most of the details wrong. By long habit, Washington “trusts” Wall Street to guide it. But here, government was conned by Wall Street. Too much money was at stake. Government should not have been so stupid, but it was.

The American people rely on the government to do the basics. The basics are to enforce the antitrust and the securities laws. Instead, the government indulges in convoluted bread and circuses: massive self promotions, clamorous issuance of “new” laws that do nothing but confuse and trip up all the existing law. In this, government ignored all the basics. We have much to fear because if they cannot get the basics right, none of the rest matters. In a meta-sense Republicans are very right to warn against the piling on of feckless government promises.

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A tale of two SEC cases

Bethany McLean
Jan 17, 2012 23:20 UTC

Juries are sometimes told that in the eyes of the law, all Americans are created equal. But if that’s the case, then why does the Securities and Exchange Commission’s treatment of former top Fannie and Freddie executives seem to be so much harsher than its treatment of Citigroup and its senior people for what appear to be similar infractions?

Recall that on Dec. 16, the SEC charged six former executives at mortgage giants Fannie Mae and Freddie Mac with fraud for not properly disclosing the companies’ exposure to risky mortgages. In Fannie’s case, the SEC alleges that former CEO Dan Mudd and two other executives made a series of “materially false and misleading public disclosures.” The SEC says, for instance, that at the end of 2006, Fannie didn’t include $43.3 billion of so-called expanded approval mortgages in its subprime exposure and $201 billion of mortgages with reduced documentation in its Alt-A exposure. In Freddie’s case, the SEC alleges that while former CEO Dick Syron and two other executives told investors it had “basically no” subprime exposure, they weren’t including $141 billion in loans (as of the end of 2006) that they internally described as “subprime” or “subprime like.”

There are some gray areas in the SEC’s case. Start with the fact that there is no single definition of what constitutes a subprime or Alt-A loan, or as Mudd said in a speech in the fall of 2007, “the vague, prosaic titles that pass for market data — ‘subprime,’ ‘Alt A,’ ‘A minus’ — mean different things to the beholders.” In Fannie’s 2006 10(k), Mudd noted that apart from what Fannie was defining as subprime or Alt-A, the company also had “certain products and loan attributes [that] are often associated with a greater degree of credit risk,” like loans with low FICO scores or high loan-to-value ratios. And in a letter to shareholders in 2006, Mudd noted that “to provide an alternative to risky subprime products, we have purchased or guaranteed more than $53 billion in Fannie Mae loan products with low down payments, flexible amortization schedules, and other features.” These are the very holdings that the SEC says should have been disclosed as subprime exposure.

The SEC’s case on the Alt-A mortgages is equally tricky. As blogger David Fiderer points out, “reduced documentation” can refer to a loan for which the borrower proves his income with a W-2 for last year in addition to a 1040 for the previous year. Or “reduced documentation” can refer to a “stated income/stated asset” loan, otherwise known as a liar loan.” As of September 2008, the default rate on the loans that the SEC says Fannie should have labeled Alt-A was less than a third of the default rate on those Fannie did call Alt-A. In other words, you could argue that if Fannie had mixed those two groups of loans together, thereby lowering the reported default rate, the company could have been criticized — or possibly even sued — for making the default rate on its Alt-A loans look artificially low.

Be that as it may, the SEC, which has been under fire for not being aggressive enough, brought its charges. “Fannie Mae and Freddie Mac executives told the world that their subprime exposure was substantially smaller than it really was,” said Robert Khuzami, director of the SEC’s Enforcement Division, in the press release. “These material misstatements occurred during a time of acute investor interest in financial institutions’ exposure to subprime loans … all individuals, regardless of their rank or position, will be held accountable for perpetuating half-truths or misrepresentations about matters materially important to the interest of our country’s investors.”

The companies themselves entered into non-prosecution agreements and agreed to cooperate with the SEC’s litigation against the former executives. (The SEC said it “considered the unique circumstances presented by the companies’ current status,” meaning that because the companies were wards of the state following the government takeover in the fall of 2008, it wasn’t in taxpayers’ best interests to go after them.) The SEC didn’t charge any of the more junior employees who were presumably involved in the actual drafting of the disclosures. But the SEC is throwing the book at the former executives, charging them with securities fraud — its most serious charge — and seeking financial penalties plus a bar on any of the six serving as an officer or director of a publicly traded company. It’s one of the harshest treatments of big corporate executives in the aftermath of the financial crisis.

Just weeks earlier, a judge in New York had thrown a wrench in another SEC proceeding. Judge Jed Rakoff refused to approve a settlement in which Citigroup (or rather, its shareholders) would have paid $285 million to settle SEC charges that the bank misled investors when it sold a $1 billion subprime CDO, made itself a profit of about $160 million and cost investors about $700 million. The charge involved only negligence, not fraud. In his rejection of the settlement, Rakoff wrote: “If the allegations of the Complaint are true, then Citigroup is getting a very good deal; even if they are untrue, it is a mild and modest cost of doing business.” Separately, the SEC filed a complaint against a former Citigroup employee named Brian Stoker, who the SEC describes as “primarily responsible” for the deal’s marketing documents. Stoker was charged with fraud — but Stoker was a relatively junior guy.

That attempted settlement, though, isn’t the only deal the SEC has cut with Citigroup. In 2010, Citigroup’s shareholders paid $75 million to settle charges that Citigroup — get this — misled investors over its exposure to risky mortgages. According to the SEC, Citi repeatedly told investors that its exposure was only $13 billion and declining, when in reality it was more than $50 billion and not declining. Citi neither admitted nor denied the charges, as was the standard convenience afforded to companies until Judge Rakoff began to derail the settlement machine.

There is probably gray in the Citi complaint as well, but at least on the surface, it’s harder to find. The allegedly undisclosed exposure consisted of “super senior” tranches of subprime mortgage-backed securities (the stuff that was supposed to be really safe, but wasn’t) and “liquidity puts” (which required Citi itself to buy outstanding commercial paper that was backed by subprime mortgage-backed securities if the paper couldn’t be sold to investors). According to the SEC’s complaints, Citi executives didn’t feel they had to disclose these exposures because they felt the risk of default was low. Yet by the fall of 2007, Citi had had to buy “substantially all” of the $25 billion in commercial paper and had started taking losses on the super-seniors. Even then, Citi still didn’t disclose its exposure, but rather bundled these losses in with others. According to the SEC, “senior management was aware” that the super-senior tranches were a source of the losses, but the company “nevertheless continued to exclude” the additional exposure. Only on Nov. 4, 2007, did Citi issue a press release in which it acknowledged the existence of this junk — and the after-tax losses of $5 billion to $7 billion it would have to take as a result of all of its subprime exposure.

In its own press release announcing the settlement, the SEC summed it up this way: “Even as late as fall 2007, as the mortgage market was rapidly deteriorating, Citigroup boasted of superior risk management skills in reducing its subprime exposure to approximately $13 billion. In fact, billions more in CDO and other subprime exposure sat on its books undisclosed to investors,” said Khuzami. “The rules of financial disclosure are simple — if you choose to speak, speak in full and not in half-truths.” Added Scott Friestad, the associate director of the SEC’s Enforcement Division: “Citigroup’s improper disclosures came at a critical time when investors were clamoring for details about Wall Street firms’ exposure to subprime securities.”

In addition to the fine paid by Citi’s shareholders, the SEC gave two executives, Citi’s former CFO, Gary Crittenden, and its former head of investor relations, Arthur Tildesley, light slaps on the wrist for their roles in causing Citigroup to make the misleading statements. Crittenden and Tildesley agreed to “cease and desist” from anymore violations of the securities laws, and they paid $100,000 and $80,000, respectively. That’s a far cry from being charged with fraud and being barred from serving as an officer or director of a publicly traded company. Neither man admitted or denied the charges. Tildesley continued to work at Citi.

The SEC doesn’t comment on enforcement cases. But it might be worth noting that the Citi charges came at the end of a settlement process, whereas the charges against the Fannie and Freddie executives might be just the beginning of a process that could end in something far less extreme than fraud charges. Nor is the SEC a monolithic agency, meaning that there may not be any coordination between the teams in charge of each case. And there could, of course, be differences between the cases that can’t be gleaned from the surface of the complaints.

Still, given the leniency seemingly accorded Citigroup’s people, it’s hardly surprising that some would charge that Citi received special treatment. In fact, the SEC’s Office of the Inspector General investigated an anonymous complaint that there were “serious problems with special access and preferential treatment” in the Citi affair. While the OIG did not find that that was the case, its redacted report still offers insight into the vagaries of the SEC’s process.

Most notably, Tildesley had agreed to settle to a lesser charge of fraud than that faced by the former Fannie and Freddie executives — but it was still fraud. Crittenden, however, wouldn’t settle. After SEC officials had meetings not just with Crittenden and Citi’s lawyers but even one in which Dick Parsons, Citigroup’s then-chairman, “made a personal pitch,” the SEC agreed to the slap on the wrist for Crittenden. So Tildesley’s settlement was changed to match Crittenden’s. The SEC enforcement staff had notified other individuals that it planned to recommend charges against them, the report said, but their identities are blacked out, and the non-redacted text doesn’t explain why those individuals weren’t charged. But an unidentified SEC official testified that Citigroup was “trying to use whatever leverage they had … to get us to … lay off the individuals.”

These days, Fannie and Freddie, far from having any “leverage,” are political punching bags. And they deserve to be punched: The companies were disasters. In the wake of a crisis the magnitude of the one we experienced, it’s also probably better that the SEC is too aggressive, rather than not aggressive enough. But above all, the SEC has a duty to be fair. Which means making sure that there can’t even be the perception that a company’s “leverage” influences the treatment accorded its employees.

COMMENT

The box on the Reuters front page asks: “Why is the SEC throwing the book at former Fannie and Freddie executives for misstating their companies’ subprime exposure, but letting Citigroup officials off with only a slap on the wrist for doing the same thing?”

Answer: In government enforcement decisions involving economic regulation, it’s just about always the small fish that get fried.

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