Notes on the House hearing held yesterday re: Fannie, Freddie, and the mortgage meltdown

Notes: House Oversight & Government Reform Committee Hearing 12/9/2008:

Committee Chairman – Henry Waxman D – CA, Edolphus Towns D-NY sitting in today

Darrell ISSA R-CA Ranking Member

Definitions: subprime is defined as mortgages with a 660 FICO or below
AltA mortgages are typically “no doc” “stated income” mortgages, “liar loans” and other high risk factors
GSE = Government Sponsored Enterprises

To Testify: Pinto, Kling, Calomiris, Stanton…. see below

Edward Pinto – Chief Credit Officer for Fannie Mae until 1989

There are 25 million subprime and AltA mortgages representing 4.5 trillion unpaid dollars in the country. This represents 44% of all mortgage loans by count in the USA
The GSEs became insolvent while being allowed to operate on a 75 to 1 leverage ratio which makes Lehman Bros. practices look conservative in comparison.
The GSEs own 1.6 trillion in subprime and AltA outstanding which equals one third of their risk portfolio

From 2005 – 2007

The GSEs were responsible for 34% of all subprime loans, 59% of AltA
These 10.5 million non prime loans are 8 times more likely to default than traditional “conforming” mortgages
5.7 million subprime, 3.3 AltA,1.5 million additional high risk factor mortgages
these 10.5 million non prime loans do not include 3 million FHA obligations

AltA mortgages, or so called “liar loans”, with zero down payment, represent about 1 million of the GSE’s total

1 million GSEs had no down payment, help meet their housing goals based on “target” neighborhoods
20 % of these mortgages made to investors, not homesteaders, mostly for rental or flip

Default performance of Fannie and Freddie subprime and AltA portfolio::

2005 8%
2007 40%

2005 to 2007 they bought 1 trillion dollars of “junk” mortgages

Fannie and Freddie enabled thinly capitalized mortgage brokers and non depository banks, who did not have to meet the same capital requirements, to take over the mortgage origination business Depository banks, which have more stringent capital requirements and regulation than the GSEs. Of course, they couldn’t compete for this business with Fannie and Freddie. The GSEs grew at the expense of regulated depository banks.

2004 Raines and Syron went to a meeting of mortgage originators and announced they would wrest back the AltA and subprime market from Wall Street

The announced their new EZ approval practice trying to meet 2005 HUD targets which meant 55% of their loans should qualify as affordable housing loans inluding 28% to low income borrowers.

By ramping up their EZ lending they pursuaded their supporters in Congress that they were doing what they were supposed to be doing.

Arnold Kling – Senior Economist Fannie Mae until 1994

He thinks both the Industry executives, the regulators, AND the market were fooled, so it’s no one’s fault. After saying he doesn’t think a lack of regulation played a role, he then talked in detail about the “perverse” incentives in bank capital requirements encouraged unsound lending practices and caused excessive securitization. A depository bank could originate low risk mortgages, exchange their low risk mortgage for for mortgage securities, and lessen their capital requirements in doing so. This also increased their risk as the securities were much riskier than the low risk loans they originated in the first place. A high risk mortgage held by a bank would require a greater capital requirment, but when that risky mortgage is laundered through Wall street, it can come back into the bank as a AAA security. He believes all the players in the mortgage business should all have to use the same capital standards. To encourage home ownership he recommends against trying to artificially create cheap mortgages and easy approval as it has been proven to be a cruel joke on the same people Congress was trying to help.

Charles Calomiris – Columbia University

GSEs hold 1.6 trillion in subprime mortgages which is half of the non FHA exposure to subprime

They willingly engaged in practices that they KNEW were not in the best interest of the subprime borrower. Their risk managers saw the losses coming and warned management. WHY did they ignore the warnings of their own internal experts? The affordable housing mandate to the GSEs. There existed a quid pro quo between elements of the government and the GSEs based on the implicit mission of “affordable housing” and favorable treatment of the GSEs by the government. Short term goal oriented compensation reinforced this deal.

They chose to relax underwriting standards to achieve their affordable housing mandate.

Had they not decided to enter the subprime and AltA market so agressively the crisis would have been at least 50% less than actually experienced.

The GSEs were the market makers. From 2003 to 2005 subrpime and AltA lending tripled as a result of the GSEs getting aggressive in this area.

They continued to buy these toxic mortgages aggressively even after signs of severe problems emerged.

The GSEs adopted accounting practices that masked the problem by subtly redefining subprime and AltA.

Thomas Stanton – Johns Hopkins

Regulators were overwhelmed by political influence.

3 Points

1. They didn’t cause it, just exacerbated it

2. They should be in “receivership” and shareholders removed. Once that takes place, the next government can use the GSEs for their original purpose. They are currently in “conservatership.”

3. Should not be restored as private companies operating with pervasive federal backing.

The biggest mistakes made by the GSEs involves their resistance to oversight and reasonable capital standards. They doubled in size every five years. The combination of private ownership and government backing made them a compelling poilitical force. they selected their leaders based on their political connections, not on their ability to run massive complex financial companies. They funded over 40% of all mortgages which gave them market and political power. They achieved this by avoiding capital structure requirements put on conventional depository banks and by ever more risky lending practices.

By themselves they DID NOT cause the housing bubble or the proliferation of subprime and AltA mortgages. Stanton’s Law, “Risk will migrate to the area where government is least equipped to deal with it.” The flow of the capital markets sent the most toxic of mortages to where the capital requirements were the least and federal supervision was weak. This same phenomenon sent trillions of dollars of toxic mortgages to commercial and investment banks where supervision was weak at best.

HUD established the recent goals for “affordable housing” under the Bush administration. The low income housing goals DID NOT cause the problem. The low income housing mandate only required that a certain number of mortgages be made where “the financial return is somewhat less than normal mortgages.” The GSEs received no appropriations to make losing mortgages. HUD was precluded by law from imposing rules and goals that would cause them to fall below a standard of profitability. The leaders of the GSEs engaged in lending practices to achieve HUD goals that exceeded all common sense for political reasons and reasons of short term compensation, read bonuses. HUD kept ratcheting up the goals and the GSEs kept striving to beat them. Political favors AND bonuses were attached to the goals. It got so bad there was a time when Fannie “rented” some low income mortgages from another lender at the end of a year to meet the HUD goal and trigger the bonuses. HUD didn’t audit the quality of the mortgages they were doing to achieve the goals. HUD was only concerned that they were “low income.”

Too many AltA mortgages went to investors and speculators, not homesteaders, perhaps 20%. Everyone who took out a mortgage was NOT a victim. Many were perpetrators of fraud. Many were just plain stupid. The main victims are the people who do everything right and are victimized by the collapse of their home equity. Most of the victims didn’t even enter the mortgage market during the boom years. Who is going to help them?

The GSEs bought mortgages of undocumented aliens. No legitimate ID was required. Foreign investors bought the securities sight unseen.

According to Pinto we are facing a 2nd and 3rd wave of defaults. In eighteen months we will have more in outstanding mortgage balances than we will have in home value in the USA…. in other words, we will be upside down as a country in our houses.

The taxpayers own 77% of the mortgage liability in the USA. It is ludicrous for the government to try to bail out mortgage holders from Washington. Trying to do that would cost more in adminstration than could be expected in benefit. There are other ways to do it. There isn’t enough time or space here to itemize all of the ideas that were put forth.