Fraud at Fannie and Freddie and its Impact on the 2008 Financial Crisis

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Fraud at Fannie and Freddie and its Impact on the 2008 Financial Crisis
Walker, Seth
Publication Date:


Subjects / Keywords:
Business executives ( jstor )
Financial risk ( jstor )
Home ownership ( jstor )
Investment risks ( jstor )
Loans ( jstor )
Mortgage loans ( jstor )
Political risk ( jstor )
Shareholders ( jstor )
Subprime loans ( jstor )
Taxpaying ( jstor )
Federal National Mortgage Association
Freddie Mac (Firm)
Undergraduate Honors Thesis


Abstract In December of 2011 the Securities and Exchange Commission charged former executive of Fannie Mae and Freddie Mac, the two largest holders and issuers of mortgaged backed securities, with fraud relating to the lack of disclosure of the risks that the companies were exposed to from sub-prime mortgages. Research and analysis shows that the implicit government guarantee provided to Fannie and Freddie, along with other advantages, lead to these two government sponsored entities dominating the secondary mortgage market. This guarantee, however, allowed shareholders to reap huge profits while United States Taxpayers assumed the risk posed by these investments because regulators wished to increase home ownership in the US. In looking at what affect proper disclosure would have played in averting the financial crisis, it is unlikely that the shareholders and regulators would have put pressure on management to avoid these risky mortgages. Ultimately, it is this ownership and regulatory structure that skews the secondary mortgage market and leaves US Taxpayers to pay hundreds of billions to cover the losses. ( en )
General Note:
Awarded Bachelor of Science in Accounting; Graduated May 8, 2012 with Highest Honors. Major: Accounting
General Note:
Advisor: Jennifer Wu Tucker
General Note:
Fisher School of Accounting

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University of Florida
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University of Florida
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Copyright Seth Walker. Permission granted to the University of Florida to digitize, archive and distribute this item for non-profit research and educational purposes. Any reuse of this item in excess of fair use or other copyright exemptions requires permission of the copyright holder.


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Page 1 of 14 Fraud at Fannie and Freddie and its Impact on the 2008 Financial Crisis By Seth Walker On December 16, 2011 the Securities and Exchange Commission (SEC) charged six former executives of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) with securities fraud. The complaint alleges that the executives knew of and approved financial statement s which contained materially misleading information in regards to the two Government Sponsored Enterprises (GSEs) subprime exposure ("SEC charges former," 2011) Given that the two enterprises accounted for roughly 41 percent of the entire mortgage market at the height of the housing bubble (Acharya, Viral V., Richardson, Matthew, Nieuwerburgh, Stijn Van & White, Lawrence J., 2011) it leads one to question what impact this lack of disclosure had on the financial crisis as a whole. To answer this question I will first look at Fannie Mae and Freddie Mac and their position in the mortgage market. Then summarize the claims made by the SEC which the two companies have accepted responsibility to (" SEC charges former," 2011) Last I will examine what impact these disclosures, if any, would have had to the operations of the GSEs and how this would have affected the mortgage industry leading up to the financial crisis. Fannie and Freddie and their roles in the market Fannie Mae and Freddie Mac both originated as non private government entities, respectively. Since then, as stated by the Congressional Budget Office (CBO) these companies have served as privately owne d financial institutions established by the government to fulfill a s three fold: 1) e stablishing an infrastructure for the


Page 2 of 14 secondary mortgage market; 2) p roviding stability and ongoing assistance to that market, whi ch includes promoting ho meownership through subsidies fo r low and moderate income households ; 3) i ncreasing liquidity to mortgage investments to promote access to mortgage credit. The GSEs accomplish their public objectives by purchasing and holding mortgages from mortgage lenders and by pooling purchased mortgages, guaranteeing them, and selling them as mo rtgage backed securities (MBSs) ( CBO, 2010). Their GSE status stems from their unique regulatory structure. While their shares are publically t raded on the New York Stock Exchange, they were, until recently, heavily regulated by the Office of Federal Housing Enterprise Oversight (in 2008 they were placed into conservatorship of the Federal Housing Finance Agency). These regulations include th e in ability to issue mortgages and permission from the S ecretary of T reasury in order to issue debt (Wallison, Peter J. & Ely, Bert, 2000). As quasi governmental entities, Fannie and Freddie enjoy a number of benefits not privileged to their private sector co mpet illion line of credit with the Treasury, they are exempt from state and local income taxes along with the requirement to register their securities with the SEC and their debt securities can serve as eligible collateral for of are eligible for open market transactions by the Federal Reserve and for investment in insured banks (Wallison, Peter J. & Ely, Bert, 2000). Essentially t he debt that they issue is treated in the same manner as Treasury S ecurities and only carries a 20 percent risk weighting requirement for their securities under Basel I. This re quirement is well below the 100 percent requirement of private companies (CBO, 2010).


Page 3 of 14 With these enormous advantages over private companies, the GSEs enjoyed belief that their investments in Fannie and Freddie were guaranteed by the government. This prospectuses for GSE debt are required by law to stipulate that such instruments are not backed by the full faith and worldwide have concluded that our government will (Wallison, Peter J. & Ely, Bert, 2000). As one would expect, this implicit guarantee allowed the GSEs to issue debt at a near risk free rate and operate at a lower average costs of capital. This Fannie and Freddie with a powe rful vehicle for achieving profits that are virtually guaranteed through the rapid growth of sector competitors cannot meet (Wallison, Peter J. & Ely, Bert, 2000). This resulted in an unprecedented return on equity of 30 percent which dwarfs the 15 percent averaged by their (Wallison, Peter J. & Ely, Bert, 2000). This subsidy awarded to the GSEs is nearly impossible to value because it is in the form of an implicit guarantee rather than a cash outlay. However, in 2003 the CBO estimated that the total subsidies e njoyed by Fann ie and Freddie were around $20 b illion, of which only $13 b illion was passed through to the borrowers, while the other $7 billion went straight to GSE shareholders. This taxpayer funded subsidy meant that Fannie and Freddie could take risk s a t


Page 4 of 14 nearly no cost to themselves, leading to high profits in good times, and high costs to taxpayers when everything fell apart (CBO, 2010). All of these advantages enabled the GSEs to dominate the secondary mortgage market. At their peak in 2003 Fannie and Freddie accounted for roughly 70 percent of the issuances for MBSs (CBO, 2010). Consider though, that they cannot compete for V eterans A ffairs (VA) and Federal Housing Authority (FHA) loans which constitute around 11 percent of the market and jumbo loans which constitute an estimated 15 percent That then allows the GSEs to compete in around 74 percent of the total residential market, of which they held a 60 percent total market share in 2007 as the market was beginning to crash (Wallison, Peter J. & Ely, Bert, 2000). Private companies reacted to their inability to compete with the mortgage giants by focusing on the portion of the market in which Fannie and Freddie were not allowed to compete. This sector includes jumbo mortgages and mortgages in whi ch Fannie and Freddie could not purchase because they were too risky, the Alt A and subprime mortgages (CBO, 2010) In 2001, non prime originations accounted for only 14 percent of the total mortgage market. In ueled by low interest rates causing investors to seek out riskier investments for higher yields, private companies began purchasing, packaging, and selling large amounts of below prime mortgages and reaped huge profits in doing so. By 2006, the non prime share of originations incre ased to 48 percent (Acharya, Viral V., Richardson, Matthew, Nieuwerburgh, Stijn Van & White, Lawrence J., 2011). Fannie and Freddie would not, however, sit idly by while private companies profited on the housing boom and subprime gold rush. The two lower ed their lending standards, in part to


Page 5 of 14 subprime market. Much of their activity in the subprime market involved the purchasing of subprime mortgage backed securities is sued by private companies. In fact, combined, the two percent of all newly issued mortgage backed securities. Additionally, direct purchase of subprime loans has historically been around 15 18 percent for both companies which le ft the firms exposed to roughly 65 percent of all sub prime loans In terms of the mortgage market as a whole, while Fannie and Freddie did not directly issue many of the and liquidity for these risky investments (Calabria, Mark, 2011). The Lack of Disclosure financial statements released between December 2006 and August 2008. They allege that once Fannie Mae be gan to report its exposure to subprime loans in 2007, loans ed exposure was less than $4.8 b illion, or .2 percent of its Single Family loans. However, the SEC claims tha t their exposure was actually in the realm of $48 billion because management excluded from their total all loans which were specifically targeted towards weaker borrowers under their Expanded Approval (EA) policy (" SEC charges former," 2011). The SEC also less risky but still none prime Alt A loans. Alt A loans are loans made with lower or alternative documentation requirements. Because management only disclosed loans if the lender had classified them as Alt A, they reported only an 11 percent exposure while their alleged actual


Page 6 of 14 exposure was around 18 percent Indeed, the company itself provided guidelines to sellers on coding designations in order to classify the loan as Lender Select ed, which carried the same risk as an Alt A Loan but allowed management to not disclose their risk to these loans (" SEC charges former," 2011). The charges against Freddie Mac executives span from March 23, 2007 to August 6, 2008. The allegations i risk to subprime loans. While management disclosed that the firm held between $2 billiion and $6 billion of subprime loans or .1 percent to .2 percent the SEC alleges that their actual expo sure grew from $141 billion (10 percent ) to $244 billion (14 percent ) between December 2006 and June 2008. This misstatement could possibly be because management failed to disclose loans ( SEC charges former," 2011). Impact While the SEC allegations only span from 2006 to 2008, the two firms were not held to the same reporting requirements as other companies. It was not until 2007, when investor interest in credit risk increased that they began to report their risk exposure. However, it is safe to assume that had the disclosure been required earlier, manage ment would still have hid the exposure from their investors and their regulators. In order to understand the impact of these miss tatements on the financial crisis, we need to look at the users of this information who might have changed the operations and behavior of management


Page 7 of 14 First had shareholders known of the risk to which the GSEs were exposed, would they have acted differently by causing the mortgage companies to decrease their overall risk to non prime loans and mortgage backed securities? The answer is a bsolutely not. Given the implicit guarantee the government placed on Fannie and Freddie, a guarantee that they would never go under, shareholders would have no reason to be concerned with the level of risk which the companies were exposed to. Had shareholders been exposed to risk in the same manner as a normal corporation, then the increase in risk of the cor poration would lead to an increase in cost of equity and an increase in cost of debt. This incentivizes less risky behavior. However, because shareholders believed that the US taxpayer would be responsible for any major losses the companies incurred, the risk exposure. and US treasury rates, we see about a .3 percent spread in 2007. In 2010, after the f irms had been placed into conservatorship and the fed announced that they would be buying the agency debt issued by the GSEs, the spread dips down to around .15 percent The small spread and the even smaller change that occurred after the government annou nced that they would explicitly guarantee Fannie and Freddie serves as proof that the market understood that their investments were always nearly as safe as government debt (CBO, 2010). This implicit guarantee allowed the two GSEs to grow at rates of nearly 12 percent by 1999 As Peter J Wallison and Bert Ely pointed out in their book Nationalizing Mortgage Risk (Wallison,


Page 8 of 14 Peter J. & Ely, Bert, 2000) Meaning that at some point in order to susta in growth and profitability to shareholders, the company would eventually have to branch out into subprime markets. This is almost exactly what happened, and shareholders would have applauded the increased risk exposure because it would enable them to con tinue to reap huge profits at no risk to themselves regulator, the federal government. Had the risk been properly disclosed, it is highl y unlikely that the regulators wo uld have reigned in the mortgage giants. Given the close relationship of Fann ie and Freddie management with C ongress and their public mission to promote affordable housing Congress as well is unlikely to have adjusted the course of the mortgage giants in the years leading up to the crisis. To begin, the cozy relationship between the GSEs and their regulators is unsettling at best and borders on frightening. As Ralph Nader described in 2001, the bipartisan revolving door between Fannie, Freddie, and Wash ington paints a grim picture as to inner workings between the regulator and the companies they should be regulating. One example would be Franklin Raines, who from 1991 1996 served as a vice president at Fannie Mae, then served as Director of Management a nd Budget at the Clinton Administration, then became Chief Executive Officer of Fannie Mae. Additionally, the GSEs extensive lobby practices and campaign contributions demonstrate this close relationship. The Center for Responsive Politics reported that in 1998 that Fannie and Freddie spent $5.55 and $2.16 million respectively on lobbying (Wallison, Peter J., 2001).


Page 9 of 14 evidence that the disclosed risk would not just be ignored but accepted as a product of achieving an ownership society in America. In 1993 the Department of Housing and Urban Development (HUD) through the Federal Housing Enterprises Financial Safety and Soundness Act created a series of targets for the two companies to hit in order to increase home ownership. In 2004 the targets were further increased after reports surfa ced that Fannie and (Acharya, Viral V., Richardson, Matthew, Nieuwerburgh, Stijn Van & White, Lawrence J., 2011). These targets meant that the HUD was asking Fannie and F reddie to take on more risk in order to support affordable housing. This, in turn, allowed Fannie and Freddie to lower their lending Dan Mudd who would later go on to become the ch (" SEC charges former," 2011). This pattern filtered into the halls of congress, where countless calls for additional regulation and oversight of the two firms were ignored by both sides of the aisle. In 2003 Treasury Secretary John Snow warned that there was no system in place to handle how large and complex the GSEs had become. He was ignored (Acharya, Viral V., Richardson, Matthew, Nieuwerburgh, Stijn Van & White, Lawrence J., 2011). As late as 2005, when the Federal Housing Enterprise Regulatory Reform Act of 2005 was introduced to the senate, congressmen warned of the coming crisis associated with the mortgage giants. It was never brought up for a


Page 10 of 14 vote. President Bush went as far as to ask other banks and the Federal Housing Administration to lower their lending standards to allow for more home ownership (Woods Jr., Thomas, 2009). However, the comes from Representative Barney Frank who stated in 2003 that "I do think I do not want the same kin d of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing." He would later chair the H ouse Finance Committee. Clearly, Congress and others in government had no problem with the US Taxpayer assuming the risk of the mortgage giants in order to support affordable housing. Conclusion Clearly, Fannie Mae and Freddie Mac had a significant role in the lead up to the financial crisis. Their government support, topped with an implicit guarantee, allowed these two companies to dominate the markets in which they operated and push private companies into the riskier fringes of the secondary mortgage m arket. And the housing market skyrocketed on top of sub prime loans the GSEs followed suit. N ow, six executives are being charged with fraud, the first major indictment to come out of the crisis. W hile the misstatements were clear and material, it seem s that the masters of Fannie Mae and Freddie Mac would have been more than willing to allow the company to t ake on additional risk that is, t he shareholder s, for larger risk free profits and the regulators for political or social gain. It would appear t hen that while some may tout the SEC indictments as justice for executives who were key players in the run up to the crisis, it is clear that the public private nature of these two companies plays a larger role in their actions than any accounting disclosu re ever could.


Page 11 of 14 The future of the companies remains unclear. To date, the government has given Fannie and Freddie bailouts totaling $150 billion, the largest government rescue of the 2008 financial crisis and one of the few which has yet to be at least pa rtially repaid. In fact, cash infusions are expected to continue through 2014 totaling over $250 billion and the Obama administration has shown interest in scaling down the two mortgage giants to decrease the rket (Smith 2012) public mission it becomes even clearer that the companies are no longer necessary In terms of their goal of establishing an infrastructure and liquidity for secondary mortgages they have done so but are no lo nger necessary Private companies issue and purchase secondary mortgages and mortgage backed securities and do so without incurring risk to taxpayers. In fact, there is nothing unique about Fannie and Freddie that makes them necessary for the existence a nd efficiency of the secondary mortgage market, save for their implicate government guarantee. In fact, the private commercial mortgage backed securities market has revived itself without any form of government guarantee (Lea and Sanders 2011) If the co mmercial MBS market can exists without government entities, why are they necessary for a functioning residential MBS market? Their second goal of providing stability to the housing market has proven to be utterly non existent and to a degree detrimental The two companies did more to promote the housing bubble, exten d credit to non credit worthy borrowers, and over saturate the entire American housing market than any other firm in the industry. In fact, the presence of quasi governmental entities has do ne more to destabilize the housing market than most of us realize. In addition, how much have Fannie and Freddie really done to promote affordable housing?


Page 12 of 14 (Sanders 2005) While estimates range anywhere from $6.76 billion to $9.25 billion (Sanders 2005) it is clear that these benefits pale in comparison to the roughly $250 billion that it is expected to cost taxpayers to keep these companies operating. Additionally, while the driving force behind expansion of the two firms was to increase home ownershi p in the US, at best they increased home ownership from 66 percent to 70 percent (Lea and Sanders 2011) Clearly, the costs far outweigh any benefit these companies provide to promoting home ownership. After over 50 years, it is time to remove the federa l government from the mortgage market. Fannie Mae and Freddie Mac have become to o large, complex, and burdensome to be properly regulated and their benefits are inconsequential when compared to their cost. Some have argued that it is impossible to unrave l these two firms, considering that they currently control around 90 percent of the secondary mortgage market. However, plans have been submitted which would unwind the giants and allow for a functioning secondary mortgage market without US T axpayer assum ption of risk. One such plan put forth by Michael Lea and Anthony Sanders at George Mason University call for a five year process of dissolving Fannie and Freddie. They argue that less government will create greater competition within the mortgage indust ry and will help to create more diversity in the market place. By moving away from the thirty year fixed model risk would be spread more evenly between lenders and borrowers and would help prevent another meltdown as seen in 2008 (Lea and Sanders 2011) Indeed, they estimate that without Fannie and Freddie, interest rates would only increase between 40 and 100 basis points, or .4 percent to 1 percent a small price for homebuyers and a huge benefit to US T axpayers (Lea and Sanders 2011) In fact, other s tudies


Page 13 of 14 percent (Sanders 2005). to push borrowers into homes they cannot afford and then leave taxpayers to cover the losses. In short, a gradual phase out of government intervention in the secondary mortgage market is necessary to promote stability in the market and shift risk away from taxpayers and onto investors. The small benefit provided by Fannie Mae and Freddie Mac is no longer enough to make up for the hundreds of billions they cost taxpayers. By simply analyzing who uses the s we find that private profit, political forces, and public risk are a remedy for cre ating the worst economic downturn since the great depression. The strange mixture of the government and private industry has been proven to be failed experiment and the US T axpayers should no longer be forced to pay for a dying model.


Page 14 of 14 Bibliography 1. Achar ya, Viral V. Richardson, Matthew, Nieuwerburgh, Stijn Van, & White, Lawrence J., (2011). Guaranteed to fail Princeton, NJ: Princeton University Press. 2. Congressional Budget Office, (2010). Fannie mae, freddie mac,and the federal role in the secondary mortgage market (Pub. No. 4021) 3. Calabria, Mark. Cato Institute, (2011). Fannie, freddie, and the subprime mortgage market (No. 120) 4. Michael, Lea, and Anthony Sanders. "The Future of Fannie Mae and Freddie Mac." (2011): n. page. Web. 22 Apr. 2012. . 5. Sanders, Anthony. "Measuring the Benefits of Fannie Mae and Freddie Mac to Consumers: Between De Minimis and Small." (2005): n. page. Web. 22 Apr. 2012. . 6. SEC charges former fannie mae and freddie mac executives with securities fraud (2011, December 16). Retrieved from ht tp:// 267.htm 7. Smith, Gina. "Fannie Mae Wants Another Bailout." Wallstreet Cheat 29 02 2012, n. pag. Web. 22 Apr. 2012. . 8. Wallison, Peter J. ( 2001). Serving two masters yet out of control Washing, D.C.: The AEI Press. 9. Wallison, Peter J. & Ely, Bert, (2000). Nationalizing mortgage risk Washing, D.C.: The AEI Press. 10. Woods Jr., Thomas, E. (2009). Metldown: A free market look at why the stock market collapsed, the economy tanked, and the government bailouts will make things worse Washington, DC: Regnery Publishing, Inc.