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.
This observation was triggered by news last week that the U.S. Securities and Exchange Commission is considering an enforcement action against Daniel Mudd and Richard Syron, 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 the potential subprime mortgage losses, the implications would extend beyond a violation of securities laws. It would also have important implications for the causes of the financial crisis and the thoroughness of the work of the Financial Crisis Inquiry Commission.
The commission’s majority report 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 conclusion to draw from this is that the crisis was caused by private greed and the indolence or lack of authority of regulators. The remedy implied by this narrative was tighter regulation, and the now-notorious Dodd-Frank Act was 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 had to be classified as affordable -- that is, made to borrowers who were at or below median income in the areas where they lived.
Over succeeding years the goals were increased so that, by 2007, 55 percent of all mortgages the two companies acquired had to be made to borrowers at or below median income.
Competing for Loans
It’s possible to find prime borrowers at this income level. But not when more than half of all loans had to meet this test, and especially when the companies were competing for the same loans with the Federal Housing Administration, and insured banks, and savings and loan associations with similar requirements under the Community Reinvestment Act.
By 2008, Fannie and Freddie held or had guaranteed 12 million loans that were made to borrowers with FICO credit scores below 660 -- a common definition of a subprime loan -- or were otherwise risky because they had no or very low down payments and other deficiencies. 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 these mortgages.
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 its 2007 10-K annual report, for example, the company estimated its subprime exposure at about 0.3 percent of its single-family mortgages. Tables deeper inside the report showed loans with FICO credit scores of less than 660 were 18 percent of the company’s single-family holdings.
The significance of this for the financial crisis is that Fannie 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 report, 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. I found none.
The commission had a chance to investigate the risks that Fannie and Freddie were taking and why the information available in the market was so deficient. But this would have required the commission to examine the losses caused by government housing policy. Angelides refused to do so. Instead, Fannie and Freddie’s contribution to the housing 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.
(Peter J. Wallison, the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute, was a member of the Financial Crisis Inquiry Commission and dissented from its majority report. The opinions expressed are his own.)
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