Tuesday, August 26, 2008

Joe Nocera (NYT): Fannie and Freddie's Expensive Scam

Joe Nocera of the NYT exposes the scam conducted by Fanny and Freddie whose officers were warned off sub prime loans in good time but chose to continue buying them since they assumed correctly that they would be bailed out if they failed, and since CEO's multi million dollar salaries were unaffected if not enlarged. Repeatedly in public testimony they cynically used the excuse of their alleged mission to maintain low cost housing loans as a cover for their reckless malfeasance.

Are they really too big to fail or is it simply a case (surprise surprise) of the Bush administration protecting Wall St and hedge funds and other investors?


New York Times
August 23, 2008
Talking Business
A Mission Goes Off Course
Whenever the mortgage finance giants, Fannie Mae and Freddie Mac, find themselves in a tough spot — and boy, are they in a tough spot now! — they always seem to find a way to blame their problems on “the mission.” “We exist to expand affordable housing,” says Fannie Mae on its Web site, and although it also lists its other mission — providing liquidity for the American housing market — it is the former that has long been the companies’ trump card.

That mission of creating affordable housing is the reason that Alan Greenspan, the former Federal Reserve chairman, could testify, year after year, that Fannie and Freddie had become so large, and took so much risk, that they could one day damage the nation’s financial system — only to be utterly ignored by the same members of Congress who otherwise hung on his every word.

The mission is why Representative Barney Frank, the powerful, and usually clear-eyed, chairman of the House Financial Services Committee, will defend Fannie and Freddie even now, when their misdeeds are so clear. The mission is why the two companies were able to run roughshod over their regulator for years, and why the Bush administration was unable to rein them in, even after an accounting scandal.

Read more:



Ronald said...

S wrote:


I think the issue is slightly more complicated than your note suggests.

Don't get me wrong. I think the abuses that the Times article lays out are genuine. For years Freddie and Fannie have played a cynical game with taxpayers' money, i.e., wrapping themselves in the flag of affordable housing while feathering their own nests to a considerable degree.

But the flip side is that The Wall Street Journal crowd has been trying to drive a stake through both GSEs for years, arguing that they represented "unfair" competition for the banking/housing industry. In no small measure, Fannie and Freddie adopted the mantle of affordable housing as a partial defense against those attacks.

And I don't think that the market for underlying mortgage paper would have become fairer, cheaper, or more transparent in their absence. I believe that to some degree, the presence of Fannie and Freddie as buyers for mortgage debt helped keep those markets intensely competitive, which meant that US home buyers benefited from low borrowing costs.

But that's a separate issue from what to do about the GSEs now that they are so troubled. I am completely sympathetic with the idea that equity investors in the GSEs should suffer. Unlike the buyers of Fannie or Freddie's debt, they have no argument that they have any entitlement to a government bailout. Any plan that leaves them any prospect of recovery is nothing more than crony capitalism at its worst. I would argue that the recent Bear Stearns deal actually over-compensated the former Bear stockholders. By any measure, the Bear was insolvent when JPMorgan took it over; it had run out of cash and couldn't satisfy its liabilities. So $10/share was a total windfall to them and the Bush Administration sat by and let that happen, which it could have prevented.

But the issue is more complex with the Fannie and Freddie bondholders. To be sure, there are investors who have bought into these issues in recent weeks at discount prices, betting on a government bailout and hoping that they will profit thereby. Like the equity investors, these buyers deserve little sympathy. But what of bondholders who bought into deals several years ago, when the subprime problems weren't prominent, and the issue of Fannie and Freddie's cupidity was less obvious? They may well represent genuinely innocent investors.

So if one were going to devise a solution that made bondholders bear some of the pain for management's errors, you'd have to find a way to separate the apparent profiteers from investors who showed no evidence of bad intentions in buying the debt. As a practical matter, that's a very messy and difficult undertaking, unless you simply draw a line in the sand and treat creditors differently based on the time of their investment. But treating similarly situated creditors in a disparate manner is quite contrary to our bankruptcy laws, and any such plan would be the target of instant (and by no means frivolous) litigation.

Then there's the broader issue of the implicit guarantee for the debt of these GSEs. Allowing defaults on Fannie and Freddie's debt would be viewed in large measure as a US default on sovereign debt, especially after Paulson said he wouldn't allow that to happen. The consequences for the US dollar and our economy are sufficiently grave that I think that's a bridge we all should be quite wary of even approaching, let alone crossing.

To recap, I would wipe out the equity in the GSEs, but I wouldn't let the debt default.


Ronald said...

Ronald responded:
Thanks S.
Very helpful. I gather you don't take issue either with Nocera's point that they kept buying sub prime mortgages even after they were warned off.
(Should that be sufficient to prosecute them?)
S replied:
I agree with Nocera that both Fannie and Freddie kept buying subprime debtlong past the time when it was clear that such purchases were imprudent. For the reasons that I said in my prior note, I think both management teams should be jettisoned, and without the benefit of expensive golden parachutes. They both clearly abused the trust and the implicit government guarantees they held, and they should be accountable. I'm not certain, however, that they engaged in any criminal conduct that would give rise to a prosecution, however. In general, stupidity and even greed are not crimes. But I'm not a criminal lawyer, and if there are violations of the law, I'm completely OK with prosecuting. By analogy, two Bear Stearns executives ran a couple of hedge funds that also invested in subprime mortgage securities. The funds eventually became insolvent and this spring the government brought criminal charges against the two executives based on very traditional securities fraud theories. Based on what I read in those complaints, the government has outlined valid charges against the two of them, and those prosecutions look entirely appropriate. So if it turns out that individuals within Fannie's and Freddie's management engaged in criminal misconduct, I am supportive of prosecutions. But nothing I have read so far suggests criminal violations.