More than three years after their September 2008 government takeover, mortgage giants Fannie Mae and Freddie Mac are back in the news.
Just last week, the inspector general of the Federal Housing Finance Agency, which regulates the pair, reported that Fannie has had to ante up nearly $100 million to defend three former officials of the companies—including Fannie’s ex-CEO Franklin Raines—as a result of an accounting-fraud scandal that erupted in 2004. This of course, has become the U.S. taxpayer’s burden.
The allegations paint a picture of executives hell-bent on loading their companies with shaky loans to boost their bonuses.
Then there’s the fierce debate among conservatives and liberals over whether Fannie and Freddie were primarily responsible for the Great Recession by making home loans to low- and moderate-income folks who couldn’t afford the payments—or whether the culprit was Wall Street, which fueled the housing market by securitizing the risky subprime and alt-A (aka low-documentation or liar) loans that produced most of the mortgage defaults and credit losses. How about both?
OVERARCHING ALL OF THIS are two security-fraud complaints filed late last year by the Securities and Exchange Commission in the U.S. district court in Manhattan. The agency is charging, among others, Daniel Mudd, another former Fannie CEO, and Richard Syron, his counterpart at Freddie, with a variety of civil offenses connected to the 2008 collapse that pushed their companies into government conservatorship. The underlying motive for the alleged misdeeds was greed, the agency asserts. Both the companies’ stock prices and their executives’ bonuses were linked to financial results. The more mortgages processed, the better the reported numbers would be.
The complaints, backed by various statements of fact agreed to by Fannie and Freddie in accompanying non-prosecution agreements, paint a sordid picture of what went on at the two government-sponsored enterprises from 2005 until their collapse in September 2008.
The allegations, although couched in bloodless prose, paint a picture of executives hell-bent on loading up their companies with high-fee subprime and alt-A mortgage guarantees, while hiding from investors, regulators and even Congress the outsize risks involved. The effort allegedly involved shenanigans such as mislabeling mortgages as prime that clearly weren’t and systematically debauching decades-old credit standards for acceptable mortgages, such as an 80% loan-to-value maximum and a strong FICO credit score for borrowers.
Syron’s lawyer, Thomas Green of SidleyAustin LLP, called the charges against his client “senseless.” He added that, during Syron’s tenure, Freddie Mac had been scrupulous in “disclosing information about the character of all the loans in its single-family portfolio. There was no inadequate disclosure.” Daniel Mudd’s lawyer was unavailable for comment about the SEC case. But Mudd has said he didn’t attempt to mislead anyone and that the government had all the relevant information on Fannie’s loan book. Syron asserts that Freddie wasn’t the victim of wrongdoing, but rather of a once-in-a-century home-price collapse. They have apparently changed their tune from one of “We were only looking out for the shareholders.”
The complaints focus on Fannie and Freddie’s primary business: guaranteeing interest and principal payments on single-family home mortgages they buy from lenders throughout the U.S., and then repackage into “agency securities” sold to investors worldwide. The guarantee remains attached to individual mortgages throughout their lives in securitization. The two agencies’ single-family portfolios account for over half of their combined $5.3 trillion book of business.
The SEC alleges that mislabeling dramatically understated the extent of both companies’ exposure to subprime and alt-A mortgages. Fannie, for example, claimed in its second-quarter 2008 report, issued just a month before the company’s seizure, that its alt-A mortgages accounted for only $306 billion of its guarantee exposure, when the real number was $647 billion, the SEC says.
Fannie was able to fudge the number, contends the complaint, because it pre-arranged with many alt-A lenders to code only a certain percentage of their alt-A loans with that designation. When a lender screwed up, which the complaint claims happened occasionally, it would draw a rebuke from Fannie, which would accept the loans only after the lender dropped the alt-A tag. The SEC states that the company euphemistically referred to mislabeled mortgages as “lender-selected loans.”
ACCORDING TO THE SEC COMPLAINT, there were yawning gaps between Freddie’s reported and actual subprime and alt-A exposures. By the second quarter of 2008, Freddie was claiming in filings that subprime comprised an infinitesimal $2 billion to $6 billion, or less than 0.2%, of its total single-family book, when the real number was an estimated $244 billion, or 14%. Just before Freddie’s collapse, alt-A had grown to $541 billion, or 30% of the book, rather than the officially reported $188 billion, or 10%.
Bizarrely, the SEC reports, beginning perhaps in 2004, Freddie began to buy mortgages that had passed muster on Fannie’s automated underwriter system, Desktop Underwriter, instead of using its own Loan Prospector. The SEC alleges that Freddie preferred Underwriter because it generated more mortgage-purchase approvals as a result of its looser FICO credit and loan-to-value standards. By 2007, Freddie was getting more loans (31%) via Fannie’s system than its own (27%).
In their heyday, before being seized, Fannie and Freddie embraced pell-mell growth. And why not? Shareholders wanted growth and the higher stock prices that it typically fuels, and that’s what earned the managers big bucks from stretch-goal bonuses and the like. Periodic genuflection to the companies’ supposed social mission—cheap mortgages for all deserving Americans regardless of income status—camouflaged greed.
By 2007, Freddie Mac was well along toward its ultimate plunge over a cliff, but its stock (ticker: FMCC) was doing great, trading near $65 at one point. Fannie’s shares (FNMA) also were in the 60s for part of that year. Now, both fetch less than 40 cents a share in over-the-counter trading.
Also in 2007, Freddie CEO Richard Syron got almost $20 million in compensation, according to an SEC filing—a $1.2 million salary, $3.45 million in bonuses, $770,000 in other compensation, plus stock and options worth $14.3 million at the time of their grant. To be sure, the stock and options ultimately were smoked in Freddie’s collapse into federal conservatorship. Syron also received a car and driver for commuting, a free home-security system and $100,000 to pay his legal fees in negotiating his contract.
For a time in the 1990s and early in the present millennium, rising home ownership ensured smart growth for Fannie and Freddie. The two government-sponsored enterprises’ retained-investment portfolios grew to $1.7 trillion, combined, as they bought more mortgages and other paper to capitalize on the handsome spread between their rock-bottom cost of funds (debt implicitly guaranteed by Uncle Sam) and the yield on their investments.
BUT THAT GAME ENDED IN 2004, when their regulators accused them of hiding gains and losses on their interest-rate hedges, to mask their financial results’ volatility. Several senior officers of the companies, including Franklin Raines, ultimately were forced to walk the plank. And, later that year, Raines and two others were named in a class-action suit that accused them of having used bogus accounting to produce larger bonuses for themselves. The departures ushered in the Syron and Mudd eras, setting the stage for the much bigger debacle that was to follow, four years later.
The 2004 incident concluded with the companies’ being hit with surcharges on their capital by federal regulators and enjoined to stop expanding their retained portfolios.
To keep growing, the Mudd and Syron regimes plunged into the subprime and alt-A guarantee business, which threw off substantially higher guarantee fees than prime loans. Fannie and Freddie argue that this helped them meet their affordable-housing goals for low- and moderate-income borrowers. They also assert that Wall Street’s origination and securitization machines were stealing the march on them in the fast-growing subprime and alt-A markets, and that they had to compete to stay relevant. The rising risk this entailed, the SEC contends, was obscured by the underreporting of their actual exposure.
A Bush administration official, who had a ringside seat to the GSE collapse in 2008, recalled recently that both the White House and Treasury woke up to the unfolding disaster only in the summer of that year. This person says that the White House was particularly miffed at Syron (“a real empty suit”) and Freddie’s board (“a bunch of incompetents”) who refused to raise more capital, as they had agreed to in March. Fannie, on the other hand, honored its agreement by selling preferred stock.
MUDD, HOWEVER, INSPIRED MORE confidence among the Bush officials, this person says. Whereas Syron reportedly cut a somewhat buffoonish figure by insisting on being called Dr. Syron in recognition of his Ph.D. in economics, Mudd was a CEO out of central casting. He had much of the gravitas of his father, former network anchor Roger Mudd. Tall and articulate, he had been a decorated Marine officer. He worked at the Defense Department and GE Capital before joining Fannie in 2000 as its chief operating officer. After Franklin Raines, his boss, was sacked as a result of the 2004 accounting scandal, Mudd smoothly slid into the CEO position late that year. In the end, his charisma didn’t matter.
Fannie’s mortgage-default rate has consistently topped Freddie’s since the seizure. Freddie has cost U.S. taxpayers $72.2 Billion in capital injections; Fannie, $112 Billion. A total of $184.2 Billion. If found guilty, shouldn’t these guys be in prison for the rest of their lives?
The SEC is seeking disgorgement from Mudd, Syron and four other executives of what the agency considers the fruits of their misconduct. Effectively, this applies to only the bonuses they received in their last three years or so at the GSEs. For Mudd and Syron, the hit probably wouldn’t exceed $10 million each. The SEC also wants to bar any of the six defendants from serving as an officer or director of a public company. That’s all? That’s it?
In January, Mudd, 53, resigned as CEO and a director of the hedge-fund company Fortress Investment Group. He had gone on leave from the company just days after the SEC filed its action in December.
Typically, the SEC prefers to settle cases like these, rather than stretch its limited resources by going to trial. The defendants sign a consent decree that carries no finding of guilt, innocence or liability. In this case, this means that any monetary penalties would be paid by Fannie and Freddie’s directors-and-officers liability policies, rather than by the executives themselves.