SEC Sues Fannie and Freddie Executives… Finally

Like Ricky Martin’s 2010 truth of the year, the SEC has finally come around to doing what everyone knew they had to do, and filled suit against the former heads of Fannie Mae and Freddie Mac for lying to investors and leading the mortgage community into thinking they were stable institutions. It was as obvious as Livin’ La Vida Loca.

Anyone who looked closely act GSE activities at the time would have known they were lying. But millions trusted them, and as a result hundreds of millions more have been impacted by the GSEs contributing to the build up of toxic debt in the financial system and household balance sheets, which in turn exacerbated the financial crisis, which spilled over into Main Street and still haunts the economy to today. Perhaps, with the law suits against Fannie and Freddie justice will finally be served.

Don’t quite hold your breath though. While Judge Dred has recently pushed back hard against the SEC ands its infamous “non admittance of guilt” settlements, these cases could still be swept under the rug. Consider that, in an ironic twist of fate, the SEC has just agreed on a settlement agreement with Fannie and Freddie themselves, as companies. The civil charges against the GSEs are not being disputed by the companies and the GSEs are “accepting responsibility” but “without admitting or denying wrongdoing.” The GSEs don’t have to pay a fine, but instead are planning to cooperate in the SEC litigation against the former GSE executives.

Let your mind wrap around that for a second before blood starts to trickle down from your ears. The GSEs are saying: “Okay, we won’t deny that we did a lot of bad stuff, misled investors, leveraged our tacit government backstop to make huge bets that paid off in compensation in the near term but destroyed our companies, our creditors, and American homeowners in the process. But if you don’t make us admit to any of that, or pay any restitution, we’ll help you sue the guys who used to run the joints—which we would do for legal reasons anyway.” Thank you American justice system.

Theoretically this could be a sign that the SEC doesn’t want to wrestle with the companies right now, in conservatorship, and they’d prefer to get the guys who helped perpetrate the mess. But giving the SEC the benefit of the doubt is not something they’ve earned recently.

Anyway, here is the background on the two suits filed by the SEC. There is one each against the companies:

  • The suit against Fannie targets Daniel H. Mudd (CEO from 2005-2008), Enrico Dallavecchia (Chief Risk Officer from 2006 to 2008), and Thomas A. Lund (EVP from 2005 to 2009). Why Lund was allowed to stay as an EVP until June of 2009 just blows my mind—until I force myself to stop thinking rationally.
  • The law suit against Freddie targets Richard F. Syron (CEO from 2003 to 2008), Patricia L. Cook (Chief Business Officer 2004 to 2008), and Donald· J. Bisenius (SVP for Credit Policy and Portfolio Management starting in 2003, and according to BusinessWeek he still works for Freddie Mac).
  • Since the lawsuit is focused just on lies told between December 2006 and August 2008, guys like Jim Johnson—godfather of Fannie Mae’s transformation from market distorter to mafia machine in Washington—and Franklin Raines are being let off the hook.

The suits specifically accuse the six executives making false and misleading statements about GSE exposure, and specifically used accounting and definition tricks related to subprime mortgages. Ed Pinto, over at AEI, has done a lot of work to point out how accurately defining categories for mortgages in the GSE realm is important for understanding their role in the crisis—i.e., if you defined subprime loans really narrowly, then you could argue the GSEs were not involved in the subprime mess that banks got caught up in and so the GSEs really didn’t play a big part in the financial crisis. This is also known as politics in Washington. (Click here and here for some of Ed’s detailed analysis.)

Here are some of the SEC’s accusations against Fannie Mae:

…in a February 2007 public filing, Fannie Mae described subprime loans as loans “made to borrowers with weaker credit histories” and reported that 0.2%, or approximately $4.8 billion, of its Single Family credit book of business as of December 31, 2006, consisted of subprime mortgage loans or structured Fannie Mae Mortgage Backed Securities (“MBS”) backed by subprime mortgage loans.

Fannie Mae did not disclose to investors that in calculating the Company’s reported exposure to subprime loans, Fannie Mae did not include loan products specifically targeted by the Company towards borrowers with weaker credit histories, including Expanded Approval (“EA”) loans. As of December 31, 2006, the amount ofEA loans owned or securitized in the Company’s single-family credit business was approximately $43.3 billion, yet none of these loans were included in the Company’s disclosed subprime exposure.

Fannie Mae’s exclusion of loans such as EA from its subprime disclosures was particularly misleading because EA loans were exactly the type of loans that investors would reasonably believe Fannie Mae included when calculating its exposure to subprime loans. In fact, the Company identified EA as its “most significant initiative to serve credit impaired borrowers” in response to regulatory requests for information on its subprime loans. In addition, all of the Defendants knew that EA loans had higher average serious delinquency rates, higher credit losses, and lower average credit scores than the loans Fannie Mae included when calculating its disclosed subprime loan exposure.

In a November 2007 public filing, Fannie Mae described subprime loans as a loan to a borrower with a “weaker credit profile than that of a prime borrower,” classified mortgage loans as “subprime” if the mortgage loans were originated by a “specialty” subprime lender or a “subprime division of a large lender,” and again represented that only 0.2%, or approximately $4.8 billion, of its Single Family credit book of business consisted of subprime mortgage loans or structured Fannie Mae MBS backed by subprime mortgage loans as of both March 31, 2007, and June 30, 2007.

Fannie Mae did not tell investors that in calculating the Company’s exposure to subprime loans reported in this filing, Fannie Mae again did not include at least $43 billion of EA loans, included loans from only fifteen loan originators of the approximately 210 lenders listed on the HUD Subprime Lender list, and did not even have the capacity to track whether loans were originated by a subprime division of a large lender.

(HT: Zerohedge)

Read the Journal’s coverage of the story here.

See Reason’s Fannie & Freddie coverage here.