Fannie and Freddie's pass

By Peter J. Wallison

No one wants to excuse the managers and regulators of financial companies from responsibility for the financial crisis. But it is too easy to assign blame and walk away without doing the serious work of finding out what really happened.

The Securities and Exchange Commission is reportedly considering an enforcement action against Daniel Mudd and Richard Syron, who were the chief executives of Fannie Mae and Freddie Mac, respectively, before the two government-sponsored enterprises collapsed. If, as news reports suggest, Fannie and Freddie failed to fully disclose potential subprime mortgage losses, the implications would extend beyond a violation of securities laws. There would also be important implications about the causes of the financial crisis and the thoroughness of the Financial Crisis Inquiry Commission.

The commission's majority blamed the crisis on financial executives who failed to understand or didn't care about the risks they were taking. Regulators didn't do their jobs either, according to the commission.

The suggestion is that the crisis was caused by private greed and regulators' indolence or lack of authority. The remedy implied is tighter regulation, and the now-notorious Dodd-Frank Act is the result.

Yet the commission, headed by Phil Angelides, a former Democratic candidate for governor of California, and Bill Thomas, a former Republican congressman from that state, never investigated what information about Fannie and Freddie's loans was available at the time, or why investors and regulators continued to believe that mortgage-backed securities were safe.

With the SEC's impending enforcement action, we are getting close to the truth.

Under legislation adopted in 1992, Fannie and Freddie were required to meet affordable-housing goals when they bought loans from mortgage originators. Initially, the goals required that 30 percent of all mortgage acquisitions be classified as affordable - that is, made to borrowers who were at or below their region's median income.

Over succeeding years, the goals were increased. By 2007, 55 percent of the mortgages they acquired had to be considered affordable.

It's possible to find prime borrowers at that income level, but not when more than half of all loans had to meet this test, and especially when the companies were competing for loans with the Federal Housing Administration, insured banks, and savings and loan associations with similar requirements.

By 2008, Fannie and Freddie held or had guaranteed 12 million loans that were made to borrowers with credit scores below 660 - a common definition of a subprime loan - or were risky for other reasons. By then, 27 million loans, or half of all U.S. mortgages, were subprime or otherwise risky. When the housing bubble began to deflate, these loans started defaulting at unprecedented rates, dragging down housing prices and the financial companies holding securities backed by them.

For many years, Fannie Mae defined subprime mortgages as loans that it bought from subprime lenders, not by credit score. This had the effect of making its investment holdings seem less risky. In 2007, for example, it estimated its subprime exposure at about 0.3 percent of its single-family mortgages. But loans to borrowers with credit scores of less than 660 actually made up 18 percent of its single-family holdings.

Fannie's and Freddie's reports might have lulled analysts and risk managers into believing that if the housing bubble collapsed, the damage would be limited because the number of risky loans was small. We now know the damage was severe. Had those 12 million Fannie Mae and Freddie Mac loans been prime instead of subprime, delinquencies and defaults probably would have been around 2 percent, not almost nine times higher.

In writing my dissent from the commission's majority, I searched widely for examples of anyone - academic researcher, credit rating analyst, or housing market expert - who knew before 2008 that half of all mortgages in the financial system were subprime or otherwise risky, or that Fannie and Freddie had contributed almost half of that total.

The commission had a chance to investigate the risks that Fannie and Freddie were taking and why the information available was so deficient. But this would have required it to examine losses caused by government housing policy. Angelides refused to do so. Instead, Fannie and Freddie's contribution to the crisis was called "marginal" in the commission's report.

As a result, the American people and Congress received a distorted picture of the causes of the financial crisis, not the thorough investigation they deserved.