FHFA Sues SIFIs on Behalf of GSEs

The mouthful of a headline I wrote for this blog post is about as complicated and headache deriving as the issue it references itself.

Last Friday, the Federal Housing Finance Agency—the regulator for Fannie Mae and Freddie Mac—filed lawsuits against 17 banks and charged them with knowingly selling toxic debt to the government-sponsored enterprises during the housing bubble. The FHFA lawsuit alleges that Fannie and Freddie did their part by setting good standards for what mortgage characteristics it would accept when buying mortgage-backed securities, but that the big banks (or, as we now know many of them, the “systemically important financial institutions” or SIFIs) misrepresented what was in the securities.

The banks, as the WSJ notes, are likely to respond that

Fannie and Freddie knew that the loans were risky and that losses were due to underlying economic conditions, not faulty underwriting. “It will become clear that the plaintiffs knew as much as the defendants about the quality of these loan portfolios,” says Andrew Sandler, co-chairman of BuckleySandler LLP, a law firm representing banks in litigation and regulatory enforcement actions.

In short, this legal battle is going boil down to this…

FHFA: The banks lied!
SIFIs: The GSEs were big boys.
FHFA: The banks knew they were selling crap!
SIFIs: The GSEs were more than capable of looking at what they were buying and deciding if they wanted to buy it or not.

As I somewhat incoherently tried to elucidate last Friday on RT, they can both be right (see video here, FHFA conversation starts at minute 7).

In instances where it can be proven that banks defrauded the GSEs, we should see justice served. FHFA should have the right to sue. Though, we should not lose sight of the fact that in many of these transactions, the GSEs knew full well what they were doing—in that they knew they were buying risky crap, but they didn’t care, not that they knew they were helping to bring down the financial system. You can’t really blame banks for selling dog crap to someone who wanted to buy dog crap.

Thus, it is not a straightforward battle.

But there is yet another layer here, while justice being served is a delightful treat, FHFA and the taxpayers need to get on the same page about what this lawsuit seeks to accomplish.

We will only survive as an economy and nation with rule of law, so fraud should be punished. In fact, that is about the only real deterrent to future thoughtless behavior. Extracting a pound of flesh is much more likely to force banks to think carefully about their use of capital than using some arbitrary one-size-fits-all risk-based capital requirement settle by a distant Basel committee.

That being said, this lawsuit does not fix the housing market. It won’t come close to repaying the taxpayers for their $160+ billion (so far) bailout of the GSEs. It won’t encourage more lending to homebuyers. It won’t lower prices to where buyers will start to surge forward with demand. It will just be a battle on the sidelines with the goal of influencing future activity at stake. And we need to be aware of that so as to not get all filled with righteous indignation and try to sake and pillage the banks for crimes that they did not commit along with whatever fraud they did perpetrate.