ENGINES OF DESTRUCTION / BARRON´S EDITORIAL COMMENTARY ( HIGHLY RECOMMENDED READING )

MONDAY, DECEMBER 21, 2009


EDITORIAL COMMENTARY


Engines of Destruction


By THOMAS G. DONLAN

Amid the loan-delinquency pileup, Fannie Mae and Freddie Mac need a smackdown.

AS A HEARING OF THE HOUSE Oversight and Government Reform Committee opened a year ago to consider "The Role of Fannie Mae and Freddie Mac in the Financial Crisis," then-Chairman Henry Waxman, Democrat of California, rendered the verdict in advance of the testimony:

"The CEOs of Fannie and Freddie made reckless bets that led to the downfall of their companies. Their actions could cost taxpayers hundreds of billions of dollars, but it is a myth to say they were the originators of the subprime crisis. Fundamentally, they were following the market, not leading it."

Waxman exonerated the real culprit: "It is also a myth to blame the nation's affordable-housing goals. The bulk of Fannie and Freddie's credit losses are the result of their purchases of Alt-A loans and securities. Because many of these risky loans lack full documentation of income, they did not help the companies meet their affordable housing goals." (Alt-A usually means loans that are between prime and subprime.)

Testimony and documents presented at the hearing that day would show that the two housing-finance corporations had worked hard to expand the mortgage market into a higher-risk zone -- and that many of the risky loans did help Fannie and Freddie meet their affordable-housing goals.

The American Nightmare

The new administration of President Barack Obama has been far more interested in bailing out borrowers and lenders than in placing blame where it belongs. It continues to rely on Fannie and Freddie to sustain the U.S. mortgage market, when it should be liquidating their portfolios and reducing the risk to taxpayers.

Delinquency rates on mortgages held by Fannie and Freddie have recently reached new highs, further bloating a system that everyone should have admitted was broken before the financial crisis began.

A bipartisan effort to extend the so-called American dream -- to put more and more people into homes they could not afford -- is at fault. Fannie and Freddie were perfect instruments for this effort, even though they were nominally private corporations. They had the ambiguous status of government-sponsored enterprises. They benefitted from low capital requirements, shadowy financial reporting and privileged access to U.S. Treasury credit.

Investors were warned on every prospectus that repayment of money lent to Fannie and Freddie was not guaranteed by the full faith and credit of the U.S. The investors knew better: Fannie and Freddie were too big and too important to the U.S. economy to be allowed to fail. If they exploded, the government would pick up the pieces, as indeed it did on Sept. 7, 2008, when it placed the two behemoths into "conservatorship" and injected $200 billion of capital, so they could withstand losses from their bad loans and still pay back their investors in the private debt markets.

The $200 billion may not be enough; losses are still piling up, and critical analysts -- such as Fannie's former chief credit officer, Ed Pinto -- say the losses may top $400 billion within a few years.

Funny Money

The testimony and e-mails put on the record with Waxman's committee last December show that lending to people who should not borrow became the stock-in-trade of Fannie and Freddie after 2003, due to pressure from the mortgage market, the Department of Housing and Urban Development and Congress. To satisfy the affordable-housing goals, the two companies changed their policies to buy loans made without documentation of income or assets -- often called "no-doc" loans and better dubbed "liar loans."

Fannie and Freddie reported many such loans as good credits satisfying affordable-housing goals.

Fannie CEO Daniel Mudd had been told in 2005 that the company faced a grim choice, either to "maintain [Fannie's] strong credit discipline and protect the quality of our book," or to buy subprime, no-doc and other dubious mortgages and "accept higher risk and higher volatility."

Freddie's chief risk officer had warned then-CEO Richard Syron in 2004 that Freddie was facilitating "predatory lending" with its heavy purchases of no-doc loans. The company cut his budget. At Fannie, a risk officer who raised similar objections was fired.

Fannie and Freddie securitized risky loans and distributed them to investors around the world, helping to bring the financial system near the brink of disaster.

Keeping Score

The mortgage crisis already has been laid at the doors of executives at Fannie and Freddie, who were eager to keep their institutions as highly leveraged as possible. Their generous pay was pegged to short-term performance, so it depended on high returns from tiny amounts of equity.

Less well understood is the thing Congressman Waxman denied: the connection between Fannie's and Freddie's low-capital and easy-credit policies and the long-standing bipartisan effort to make housing more affordable for low-income buyers.

The link was the accounting scandals that had enveloped Fannie and Freddie early in the decade. After they demonstrated they would cook the books to keep profits and bonuses high, Fannie and Freddie had become vulnerable to the critics who called for them to increase their capital. For protection, executives and their lobbyists turned to Congress, arguing that leverage let them do more for the lawmakers' pet causes. Democrats were eager to help the urban and rural poor get homes cheaply financed; Republicans believed the moral character of the poor could be improved by home ownership.

By the end of 2008, Fannie and Freddie held $1.6 trillion in subprime and other risky mortgages, a class they had emphatically avoided only a decade earlier.

A year later, they're taking federal money into another high-stakes game of musical chairs. Their delinquency rates have been climbing all year. Nearly 5% of Fannie Mae mortgages were more than 60 days past due at the end of September.

Unless Fannie and Freddie are wound down, they will lend until the next disaster. Americans may have learned that banks that are too big to fail are simply too big, but they haven't learned that government-sponsored enterprises are too political to succeed.

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