Fannie and Freddie Accounting Probes

Beginning in 2003, Fannie and Freddie executive compensation mechanism caused accounting probes forcing the two agencies to withdraw from the housing market during a period of record volumes of mortgage lending. Separate investigations conducted by OFHEO found that Fannie and Freddie exceeded their risk-based capital requirement by $22.2 billion and $26.2 billion, respectively. Fannie and Freddie reached settlements with the OFHEO. Fannie  and Freddie also reached agreements with the Securities and Exchange Commission (SEC). In a final agreement with the Department of Justice (DOJ) Fannie “voluntarily” limit its growth and restrict the expansion of mortgage investments.

In the absence of competition from Fannie and Freddie, Wall Street-supported “originate-to-distribute models” allocated large quantities of subprime mortgage products into a sector of the housing market with little federal supervision or governmental oversight. A sentiment best expressed by David Faber, CNBC financial reporter, and author of the book “And then the Roof Caved.” According to Faber, Wall Street rushed into the vacuum created by the absence of Fannie and Freddie in 2003-2005.

“It was Wall Street that took their market share and became the leader.”

“It was Wall Street that encouraged mortgage originations of every kind to lower their standards by providing an endless supply of new capital to fund their mortgages.” “It was Wall Street that found willing buyers for U.S. mortgages around the globe in order to keep funding their mortgage market. It was Wall Street.”

As reported by the FCIC:

“As the scandals unfolded, subprime private label mortgage-backed securities issued by Wall Street increased from $87 billion in 2001 to $465 billion in 2005; the value of Alt-A mortgage backed securities increased from $11 billion to $332 billion. Starting in 2001 for Freddie and 2002 for Fannie, the GSEs—particularly Freddie—became buyers in the market. While private investors always brought the most, the GSEs purchased 10.5% of the private-issued subprime mortgage-backed securities in 2001…The GSEs almost always brought the safest, triple-A-rated tranches.”

In their book 13 Bankers, MIT’s Sloan School of Management Professor Simon Johnson and his coauthor James Kwak of the Baseline Scenario note:

“The common indictment of Fannie and Freddie charges that Democrats in Congress, trying to expand homeownership among the poor and minorities, pushed the GSEs to buy more and more subprime loans, pumping up subprime lending and housing prices in the process. (The implication, of course, is that the financial crisis was causes by government intervention in the market.) There is a grain of truth to this story. The targets set by HUD in both the Clinton and Bush administrations [mandated affordable housing goals]…The riskiest mortgages, however—the ones that pushed the housing bubble to dizzying heights—were simply off-limits to Fannie and Freddie…regulatory constraints prevented them from plunging too far into subprime lending…

Fannie and Freddie could not have pushed mortgage lenders into the most extreme forms of subprime lending, because those were precisely the loans they could not buy. They created demand fro conforming mortgages, which were precisely what the aggressive subprime lenders were not selling.”

In All The Devils are Here, Bethany McLean, who co-authored a best selling text on the Enron scandal, and Joe Nocera, business columnist for The New York Times, wrote:

Many conservative critics of the GSEs would come to see [increasing the affordable housing goals] as the capitulation of Fannie and Freddie to the Clinton affordable housing drive. That wasn’t really true. The real reason Fannie was willing to finally move into riskier territory was the same reason Countrywide did: profits. Subprime was taking off—and the GSEs were sitting on the sidelines…In the end, though, it didn’t really matter whether Fannie and Freddie moved into riskier mortgages quickly or slowly, reluctantly or gleefully. What matters was that they entered this new market at all. In so doing, they gave their imprimatur to what had previously been an entirely separate universe. A line that had once been absolute was now blurring.

Next Page: The Role of the Bush Administration Homeownership Policy