Reformers of Fannie Mae and Freddie Mac Forget That Money Talks, BS Walks

“It’s not the crime; it’s the coverup,” became a journalistic cliche because the coverup always has many more plot twists. The 13-year saga of the conservatorship of Fannie Mae and Freddie Mac is filled with litigious plot twists, which reflect the government’s efforts to cover up its decision making. Scrutinized with the benefit of hindsight, those actions may or may not have constituted crimes. But they are certainly discredited by any economic measure. Which is why officials are still reluctant to address the obvious question, “Why are Fannie and Freddie still in conservatorship?” Any answer invites other, more awkward questions, such as, “Why was there a net worth sweep?” Or, “Why were they placed in conservatorship in 2008?”

To unravel the saga of the two government sponsored enterprises, remember two truisms. First, there’s Wall Street’s favorite rhyme: Money talks, bullshit walks. The determinative evidence is not what people say; it’s the hard financial data. As Lewis Ranieri put it, “Mortgages are math.” Second: First impressions are lasting impressions. The entire case against the GSEs, all of it, is based on first impressions that were debunked over time, but endure as BS claims that are repeated endlessly.

Big picture math: The primary first impression was the shock of the September 2008 meltdown, in which a multitude of Wall Street giants faced liquidity crises. That impression was reinforced by $250 billion in accounting losses reported by the GSEs subsequent to the government takeover in September 2008. But those non-cash provisions proved to be wildly over inflated, and in 2012–2013 accounting reversals generated $200 billion in profits to pay down the entire $188 billion “bailout.” Which raises a question of why they’re still in conservatorship. In retrospect, if accountants had guesstimated credit losses with great accuracy, the government bailout would have approximated zero. And the GSEs never faced any liquidity problems. Which raises a question of what kind of reform is necessary to protect the taxpayer. It also raises a question of why they were placed in conservatorship in the first place.

We know why the GSEs remain in conservatorship eight years after the government was repaid. In 2012 the government declared that the companies’ equity shall never materially exceed zero. All their income shall be swept into the coffers of the U.S. Treasury. Fannie and Freddie shall not return to the status quo ante because their “failure” played a major role in the financial crisis and the housing crash. “Reflecting a consensus across almost the entire political spectrum, Treasury repeatedly stated it would not approve an exit that has the GSEs going back to the pre-conservatorship status quo, since the failure of the two companies made clear that significant structural reforms were required,” wrote Don Layton, the former CEO of Freddie Mac, last month. If that’s the consensus opinion, it’s unmitigated bullshit.

Defining the term: BS, as Princeton Philosophy Professor Harry Frankfurt explained in his bestseller, On Bullshit, is different from a flat out lie. It’s verbal noise used to distract from the essential truth of a situation. The BS artist always excludes the critical fact that nullifies his message. Critical facts, which were excluded to obscure the truth about the financial crisis, show up in the basic math of the mortgage markets. The case against the GSEs is a distraction away from the fatal flaws of private label securitizations. Those who pushed out fraudulent private label transactions seek to abolish or cripple the GSEs as a way to resuscitate private label deals, which are otherwise unsustainable.

Credit losses and liquidity: If you judge the GSEs by the standards of capitalism, their track record is unassailable. Capitalism is about getting your money back plus something extra, and capitalism is about competition. Which is why you can never ignore comparative loan performance. GSE loan performance has always been exponentially superior to that of every other segment of the market. Anyone who tells you otherwise is lying.

Moreover, financial institutions fail when they lose liquidity, which is cash or credit to cover immediate cash obligations. Unlike the Wall Street titans that faced collapse in 2008, the GSEs never had liquidity problems, ever. Anyone who tells you otherwise is lying.

A capitalist should find it quite a coincidence that none of the esteemed GSE critics ever discuss comparative loan performance. A few notable GSE critics, such as Wayne Passmore and Diana Hancock from the Federal Reserve, made references to liquidity. They flat out lied at a Brookings conference and said that there was a run on GSE corporate securities, which was never remotely true.

So a chasm divides the GSEs and Wall Street in terms of loan performance and liquidity. But Wall Street behemoths faced collapse in September 2008 because of their exposures to mortgage loans; so it follows their problems must have been enmeshed with the two biggest mortgage lenders, Fannie and Freddie, right? That must have been why Treasury Secretary Hank Paulson placed them in conservatorship, right? That was certainly a plausible first impression. But now that the numbers are in, we can certify that it’s BS.

You follow the money to see where it was lost and how it was lost. Of about $1 trillion in total mortgage losses, the majority was lost by private label securitizations (plus synthetic CDOs), which represented only 20% of the total market. The private label loss rate was six times that of the GSEs. And all of the losses in private label securitizations were concentrated in the subordinate tranches. Almost all the private label tranches rated below triple-A recovered zero principal.

And we know the overwhelming majority of private label losses were tied to fraud. The GSEs held over $200 billion in triple-A private label bonds bought from 18 banks, which were sued after a review of hundreds of thousands of individual loan files in hundreds of different deals that all showed large percentages with fraudulent claims about owner occupancy and loan-to-value ratios, plus other deceptions. All 18 banks settled or lost in court for billions.

Where were the losses? So we know precisely why AIG, Lehman Brothers, Citigroup, Merrill Lynch and other Wall Street titans faced collapse in September 2008. Together they indirectly held hundreds of billions in deeply subordinated private label bonds that were wiped out. Those deeply subordinated bonds were encased in structured portfolios called CDOs, which were originally acquired because of their triple-A ratings. Wall Street institutions lost more money on $400 billion in CDOs than the GSEs lost on $5 trillion in mortgage loans. Analysts at those companies certainly knew how to calculate net present values, which showed how those CDOs holding subordinated bonds got wiped out long before September 2008. In his famous public letter dated January 30, 2008, hedge fund manager Bill Ackman, using Credit Suisse’s calculations, showed that subprime and Alt-A bonds rated single-A and below had already lost 90% of their value. (An executive summary encapsulating the entire financial crisis is that financiers were susceptible to the same false first impression; they could not believe they could lose much money on CDO bonds rated triple-A.)

So what did the GSEs have to do with the problems afflicting Wall Street? Almost nothing. The GSEs don’t originate mortgages, and, unlike private label deals, GSE securitizations don’t sell off credit risk. Which means any suggestion that GSE underwriting standards contributed to the epidemic of private label fraud is complete bullshit. True, the GSEs purchased the most senior triple-A tranches of private label deals, which, before the housing crash, had average lives of less than one year. As any financially literate person will attest, the critical path to selling off a securitization was not the senior slices representing short-term triple-A risk.

The GSE business model is to preserve liquidity in the mortgage markets whenever other players, such as the Wall Street banks, withdraw. Meaning the GSEs only helped, never harmed, the Wall Street banks.

Any other involvement with the crisis? Investors got spooked when the government placed Fannie and Freddie in conservatorship. But that was because the Treasury Secretary Paulson reversed his signals. Six months before September 2008, the government upended longstanding policy to effectively bail out Bear Stearns and give brokerage firms access to the Fed’s discount window, where they could pledge private label bonds as collateral. It also gave the GSEs a vote of confidence, which enabled Fannie to raise billions in new preferred stock. But in September 2008 the government summarily wiped out the preferred shares of the GSEs, which were both solvent and liquid. Days later it pushed Lehman into bankruptcy by cutting off access to the Fed’s discount window. Financiers saw that all bets were off and panicked. But none of the fallout can be attributed to the GSEs’ practices or their management.

But what about the housing crash that began before September 2008 and persisted for years thereafter? Surely Fannie and Freddie are at the center of that debacle, right? No. That problem was, once again, caused by the fatal flaws of private label deals. All loan workouts are labor intensive, and for distressed mortgages financed by the GSEs, there’s one only party in charge of preserving the value of his collateral. But it doesn’t work that way at all with private label deals. The responsibility is outsourced to a loan servicer, who has no skin in the game and often finds it more convenient to expedite a costly foreclosure rather than explore any forbearance. Senior bondholders want quick payouts which benefit them at the expense of the subordinate investors. Others have written about the epidemic of fraud in the foreclosure industry.

Reform what? The foregoing raises the obvious question to any proponent of GSE reform: Reform what? What went wrong that can be improved upon? The obvious answer is that the GSEs didn’t have enough equity to withstand a collapse in home prices caused by private label fraud. That’s it. No one can cite any example of housing finance anywhere in the United States that’s superior to the track record of the GSEs. There’s no history, no data that anyone can point to, only untested ideas. (You can go down a rabbit hole reading a library of books and articles by scholars at elite universities who claim that the GSE business model is fatally flawed and private label securitizations are an essential component of housing finance. They all conflate the problems caused by private label deals with the issues affecting the GSEs, which is like conflating oxycontin with Tylenol. All of it is BS.)

Circling back to the original question, why are the GSEs still in conservatorship? The obvious answer is the net worth sweep. There never was any rational explanation for draining the GSEs of all equity, other than to prevent them from restoring capital before Congress changed or nullified their charters. That was the plan in August 2012, when the net worth sweep was imposed. Back then, the Obama Administration held the quaint belief that Congress was willing to engage in the heavy lifting of passing transformative economic regulation. Years later, after the gradual realization that those days are long gone, the conservator has been willing to temporarily suspend net worth sweep, now that $300 billion in equity has been drained from the companies.

So what now? There is no clearly articulated plan to “reform” the GSEs, other than to encourage them to build equity, which is a clear repudiation of an eight-year policy. And to do whatever is necessary to preempt any reexamination of how regulators treated Fannie and Freddie before and after the 2008 crisis. Avoiding awkward disclosures probably takes priority over pleasing the only constituency eager to end the conservatorship, the private preferred and common shareholders. They, like the GSEs, seem to be hobbled by false first impressions about who and what caused the financial crisis. Indeed, these false first impressions have framed judicial reasoning for the past eight years.

The foregoing only scratches the surface in covering the legacy of malfeasance at the GSE regulator, once called the Office of Federal Housing Enterprise Oversight and now called the Federal Housing Finance Agency. There’s been a reluctance to pull all the pieces together for fear of sounding like a conspiracy theorist. More to come.