SEC Charges Reinforce Case for Eliminating Fannie Mae, Freddie Mac

David C. John / December 16, 2011

The misguided federal policy to concentrate the U.S. mortgage finance industry in two huge government-sponsored entities was underscored again this morning when the Securities and Exchange Commission (SEC) charged six former Fannie Mae and Freddie Mac executives with misleading investors and Congress about the amount of poor-credit-quality mortgages each entity held before they were taken over by U.S. regulators in September 2008.

The charges, if true, also make it clear that both Fannie and Freddie were acting as hedge funds that gambled on high-risk investments in addition to their congressionally mandated duties of underwriting and issuing mortgage-backed securities. Some of these high-risk purchases were actually required by federal government policies, but most of these assets were bought to regain market share and improve earnings.

The separate civil suits against Fannie Mae executives and Freddie Mac executives, which cover the period between December 6, 2006 and August 8, 2008, documents how both entities held far more risky subprime and Alt-A mortgages than they disclosed to investors. The six executives are accused of either making or assisting in the creation of misleading statements and quarterly 10-Q earnings disclosures at a time when investors in both firms were increasingly concerned about potential losses that would result from investments in mortgages made to borrowers with poor credit quality. The CEOs of both Fannie Mae and Freddie Mac are also charged with making similar misleading statements to Congress and in public speeches.

For instance, the SEC charges that during the period covered by the suits, Freddie Mac claimed that its Single Family Guarantee portfolio was exposed to between $2 billion and $6 billion in subprime or Alt-A mortgages. This equaled only 0.1–0.2 percent of the total. In reality, the suit says that internal company records show that the program was actually exposed to $141 billion (10 percent of the total) of these loans on December 31, 2006, and $244 billion (14 percent of the total) on June 30, 2008. During the same time, Freddie Mac sold four preferred stock issues totaling $7.5 billion.

Charges against the Fannie Mae executives outline a similar pattern of failing to disclose the company’s total exposure to risky, poor-quality mortgages. Fannie Mae executives are charged with failing to disclose its exposure to mortgages under two of its programs that together were about 12 times larger than the disclosed $4.8 billion of subprime loans or mortgage-backed securities backed by subprime loans. During the period of the suit, both Fannie Mae and Freddie Mac were attempting to regain market share they had lost to other types of issuers of mortgage-backed securities.

For policymakers, the suits reinforce several points:

1. First, both Fannie and Freddie show the dangers of allowing a crucial financial function to be filled by two massive government-subsidized entities. While at the time of the complaint, both were losing market share to other issuers of mortgage-backed securities, both had such weight in the market that they could pursue a risky investment strategy that helped to both collapse themselves and swamp their smaller competitors. The nation is still feeling the effects of their failure today. For the future, a reformed mortgage finance system should be spread among many different private participants so that none of them has the power to control such a significant proportion of the industry that its failure would require another massive government bailout.
2. Second, policies by both Congress and the executive branch that required both entities to meet certain goals in providing mortgages to moderate- and lower-income homebuyers only reinforced this risk. Elected officials saw Fannie Mae and Freddie Mac as ways to fulfill housing policies without any cost to the government. Instead, their decisions spectacularly backfired. Together with the poor management of their executives, these “free” policies ended up costing taxpayers hundreds of billions of dollars.
3. And third, it is not enough to talk of “privatizing” Fannie Mae and Freddie Mac. As the charges make clear, at the time they failed, both entities were private companies seeking to regain market share and increase earnings. While both had special privileges and specific housing policy responsibilities conferred by Congress, both were privately owned companies with publicly traded stock.

Today’s charges are another reminder why Fannie Mae and Freddie Mac must be gradually and responsibly phased out and replaced by a system of smaller private issuers of mortgage-backed securities. Any effort to restore them to their future position of dominating the market will result only in similar charges and taxpayer bailouts in the future.