Fannie Regulators Exacerbated the Bubble

Today’s mea culpa by finance executives includes the puppets in the Fannie/Freddie disaster ($127B and counting). In 2005 the chief regulator of Fannie and Freddie was addressed an accounting mini-scandal related to bonuses. They were basically moving earnings around to hit triggers, so their executives could receive their multi-million dollar bonuses. As Fannie Mae (FNM) and Freddie Mac (FRE) are filled with political hacks (Jamie Gorelick, Bill Syron, Franklin Raines), these are the prime sinecures of top Administration bureaucrats, and Congress appreciates the incentive this provides their minions. Ex-congressman are known to get lucrative consulting contracts with them. And all of this is subsidized by the U.S. taxpayer.

The government support provided to Fannie and Freddie is supposed to be used to expand home ownership for lower income Americans, as if that could be done at a profit by our wise bureaucrats. What do they think, bankers hate minorities more than they like making money? I’m sure there might exist such bankers, though I must say I never have met one, and am confident they are about as representative of bankers as the KKK is of America (I’m sure many on the far-Left would say–exactly! One and the same!).

Anyway, here is the chief regulator discussing the risks in Fannie, at just about the time seeds were being sown via reckless lending to people who could only afford the mortgages if their collateral increased in value:

Mr. FALCON: I think the guaranteed side of their business where they purchase qualifying affordable housing goal type mortgages, that does continue, and it is proceeding at a healthy pace. Despite the problems the company has with their accounting issues and internal control problems, that side of the business remains sound. So I can give you some comfort there, that while we are having to take some supervisory actions with the company to make sure that they continue to be as aggressive in fulfilling their mission as possible, when we get these other issues addressed properly over time, it will not deter them from continuing their guarantee side of their business.

I have always looked at our responsibility at OFHEO as part housing mission. A company that is experiencing severe financial difficulties is going to constrain the amount of work it can do in fulfilling its mission, and so the greater extent to which we can make sure that the company does not get into any kind of trouble

makes sure that there is no interruption in their ability to continue to fulfill the mission and innovate. With a fully authorized, well-resourced regulator, I think here would be a good safeguard to make sure that there are not unnecessary interruptions in the company’s business as a result of safety and soundness problems.

If you read this document, you will find nothing related to Alt-A mortgages, underwriting standards, the bread-and-butter basics of credit. No one cared. As Falcon states, everything’s sound.

Worse, he clearly shows his hand by highlighting his objective is subservient to his mission’, that clearing ‘unnecessary interruptions’ in that mission was essential. What is the mission? Making home ownership ‘more affordable’. The intermediate goal being “purchase qualifying affordable housing goal type mortgages”. What is the goal? Increase home ownership, specifically in historically underserved (ie, black and latino) communities.

These are the regulators. They should have been focused on the viability of these GSEs as going concerns, but instead, all they really cared about was fighting fires of the past, and fulfilling its eleemosynary pretext for creating a crony-capitalist monopoly to pay off obedient bureaucrats who help them maintain their power. The circle is complete. If only everyone could work for a powerful monopoly, it seems, life would be great.

Today the old Fannie chief uses the ‘everyone was doing it‘ excuse, a perennial because its

Executives decided that new, riskier loans were “not a fad, but a growing and permanent change” that the companies couldn’t ignore, Mr. Mudd said in his testimony. Faced with the prospect of becoming irrelevant as private lenders fueled by Wall Street took over a larger share of the market, the company opted to strike a “middle course” by trying to offer less risky versions of loans.

Gee, benchmarking to guage risk, I should write a book! Risk, as I have argued, is a deviation of what ‘everyone else’ is doing. So, by not going with the flow, they felt they weren’t taking more risk. Of course, the private label mortgage guarantors justified their increased subprime exposure by pointing to Freddie and Fannie’s greater subprime portfolio, and on the primrose path we went to Armageddon. This is the mechanism for endogenous bubbles, where large players increase their exposure into previously risky areas, but don’t notice it because each player thinks they are actually reducing their risk by playing catch-up in some new paradigm.

About Eric Falkenstein 136 Articles

Eric Falkenstein is an economist who specializes in quantitative issues in finance: risk management, long/short equity investing, default modeling, etc.

Eric received his Ph.D. in Economics from Northwestern University , 1994 and his B.A. in Economics from Washington University in St. Louis, 1987

He is the author of the 2009 book Finding Alpha.

Visit: Eric Falkenstein's Website

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