fcic final report, part 4, chapter 17, the unraveling - september 2008: the takeover of fannie mae...

8/7/2019 FCIC Final Report, Part 4, Chapter 17, The Unraveling - September 2008: The Takeover of Fannie Mae and Freddie

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17

SEPTEMBER 2008: THE TAKEOVER

OF FANNIE MAE AND FREDDIE MAC

CONTENTS

A good time to buy...........................................................................................

The only game in town....................................................................................

Its a time game . . . be cool...............................................................................

The idea strikes me as perverse .......................................................................

It will increase confdence................................................................................

Critical unsae and unsound practices ............................................................

They went rom zero to three with no warning in between .............................

The worst-run fnancial institution.................................................................

Wasnt done at my pay grade...........................................................................

From the all o until Fannie Mae and Freddie Mac were placed into conserva-

torship on September , , government ofcials struggled to strike the right bal-ance between the saety and soundness o the two government-sponsored enterprisesand their mission to support the mortgage market. The task was critical because themortgage market was quickly weakeninghome prices were declining, loan delin-quencies were rising, and, as a result, the values o mortgage securities were plum-meting. Lenders were more willing to renance borrowers into aordable mortgagesi these government-sponsored enterprises (GSEs) would purchase the new loans. Ithe GSEs bought more loans, that would stabilize the market, but it would also leavethe GSEs with more risk on their already-strained balance sheets.

The GSEs were highly leveragedowning and guaranteeing . trillion o mort-gages with capital o less than . When interviewed by the FCIC, ormer TreasurySecretary Henry Paulson acknowledged that ater he was brieed on the GSEs upontaking ofce in June , he believed that they were a disaster waiting to happen

and that one key problem was the legal denition o capital, which their regulatorlacked discretion to adjust; indeed, he said that some people reerred to it as bullsh*tcapital. Still, the GSEs kept buying more o the riskier mortgage loans and securi-ties, which by all constituted multiples o their reported capital. The GSEs


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F I N A N C I A L C R I S I S I N Q U I R Y C O M M I S S I O N RE P O R T

reported billions o dollars o net losses on these loans and securities, beginning inthe third quarter o .

But many in Treasury believed the country needed the GSEs to provide liquidityto the mortgage market by purchasing and guaranteeing loans and securities at atime when no one else would. Paulson told the FCIC that ater the housing marketdried up in the summer o , the key to getting through the crisis was to limit thedecline in housing, prevent oreclosures, and ensure continued mortgage unding, allo which required that the GSEs remain viable. However, there were constraints onhow many loans the GSEs could und; they and their regulators had agreed to porto-lio capslimits on the loans and securities they could hold on their booksand a capital surplus requirement.

So, even as each company reported billions o dollars in losses in and ,their regulator, the Ofce o Federal Housing Enterprise Oversight (OFHEO), loos-ened those constraints. From the all o , to the conservatorships, it was atightrope with no saety net, ormer OFHEO Director James Lockhart testied tothe FCIC. Unortunately, the balancing act ultimately ailed and both companieswere placed into conservatorship, costing the U.S. taxpayers billionso ar.

A GOOD TIME TO BUY

In an August , , letter to Lockhart, Fannie Mae CEO Daniel Mudd sought im-mediate relie rom the portolio caps required by the consent agreement executed inMay ollowing Fannies accounting scandal. We have witnessed growing evi-dence o turmoil in virtually all sectors o the housing nance market, Mudd wrote,and the immediate crisis in subprime is indicative o a serious liquidity event im-pacting the entire credit market, not just subprime. As demand or purchasing loansdried up, large lenders like Countrywide kept loans that they normally securitized,

and smaller lenders went under. A number o rms told Fannie that they would stopmaking loans i Fannie would not buy them.Mudd argued that a relaxed cap would let his company provide that liquidity. A

moderate, percent increase in the Fannie Mae portolio cap would provide us withexibility . . . and send a strong signal to the market that the GSEs are able to addressliquidity events beore they become crises. He maintained that the consent agree-ment allowed OFHEO to lit the cap to address market liquidity issues. Moreover,the company had largely corrected its accounting and internal control decienciesthe primary condition or removing the cap. Finally, he stressed that the GSEs char-ter required Fannie to provide liquidity and stability to the market. Ultimately,Mudd concluded, this request is about restoring market condence that the GSEscan ulll their stabilizing role in housing.

Fannie Mae executives also saw an opportunity to make money. Because there

was less competition, the GSEs could charge higher ees or guaranteeing securitiesand pay less or loans and securities they wanted to own, enabling them (in theory)to increase returns. Tom Lund, a longtime Fannie Mae executive who led the rmssingle-amily business, told the FCIC that the market moved in Fannie Maes avor a-


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S E P T E M B E R : T H E TA K EO VE R O F FA N N I E M A E A ND F R E D D I E M AC

ter August as competitors dropped out and prices o loans and securities ell.Lund told FCIC sta that ater the liquidity shock, Fannie had more comort

that the relationship between risk and price was correct. Robert Levin, the com-panys chie business ofcer, recalled, It was a good time to buy.

On August , OFHEOs Lockhart notied Fannie that increasing the portoliocap would be premature but the regulator would keep the request under activeconsideration. Lockhart wrote that he would not authorize changes, because Fanniecould still guarantee mortgages even i it couldnt buy them and because Fannie re-mained a signicant supervisory concern. In addition, Lockhart noted that Fanniecould not prudently address the problems in the subprime and Alt-A mortgage mar-ket, and the companys charter did not permit it to address problems in the marketor jumbo loans (mortgages larger than the GSEs loan limit). Although there hadbeen progress in dealing with the accounting and internal control deciencies, he ob-served, much work remained. Fannie still had not led nancial statements or or , a particularly troubling issue in unsettled markets.

As Lockhart testied to the FCIC, It became clear by August that the tur-moil was too big or the Enterprises [the GSEs] to solve in a sae and sound manner.He was worried that ewer controls would mean more losses. They were ulllingtheir mission, Lockhart told the FCIC, but they had no power to do more in a saeand sound manner. I their mission is to provide stability and lessen market turmoil,there was nothing in their capital structure that would allow them to do so.

Lockhart had worried about the nancial stability o the two GSEs and aboutOFHEOs ability to regulate the behemoths rom the day he became director in May, and he advocated or more regulatory powers or his largely toothless agency.Lockhart pushed or the power to increase capital requirements and to limit growth,and he sought authority over mission goals set by the Department o Housing andUrban Development, as well as litigation authority independent o the Department o

Justice. His shopping list also included the authority to put Fannie and Freddie intoreceivership, a power held by bank regulators over banks, and to liquidate the GSEs inecessary. As it stood, OFHEO had the authority to place the GSEs in conservator-shipin eect, to orce a government takeoverbut because it lacked unding to op-erate the GSEs as conservator, that authority was impracticable. The GSEs woulddeteriorate even urther beore Lockhart secured the powers he sought.

THE ONLY GAME IN TOWN

But Fannie and Freddie were the only game in town once the housing market driedup in the summer o , Paulson told the FCIC. And by the spring o , [theGSEs,] more than anyone, were the engine we needed to get through the problem.

Few doubted Fannie and Freddie were needed to support the struggling housing

market. The question was how to do so saely.

Purchasing and guaranteeing riskymortgage-backed securities helped make money available or borrowers, but it couldalso result in urther losses or the two huge companies later on. Theres a real trade-o, Lockhart said in late a trade-o made all the more difcult by the state o


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the GSEs balance sheets. The value o risky loans and securities was swampingtheir reported capital. By the end o , guaranteed and portolio mortgages with

FICO scores less than exceeded reported capital at Fannie Mae by more thanseven to one; Alt-A loans and securities, by more than six to one. Loans or whichborrowers did not provide ull documentation amounted to more than ten times re-ported capital.

In mid-September, OFHEO relented and marginally loosened the GSEs portoliocap, rom about billion to billion. It allowed Fannie to increase the amounto mortgage loans and securities it owned by per yeara power that Freddie al-ready had under its agreement with OFHEO. OFHEO ruled out more dramatic in-creases because the remediation process is not yet nished, many saety andsoundness issues are not yet resolved, and the criteria in the Fannie Mae consentagreement and Freddie Macs voluntary agreement have not been met.

As the year progressed, Fannie and Freddie became increasingly important to themortgage market. By the ourth quarter o , they were purchasing o newmortgages, nearly twice the level. With trillion in mortgages resting on ra-zor-thin capital, the GSEs were doomed i the market did not stabilize. According toLockhart, a withdrawal by Freddie Mac and Fannie Mae or even a drop in con-dence in the Enterprises would have created a sel-ullling credit crisis.

In early October, Senator Charles Schumer and Representative Barney Frank in-troduced similar bills to temporarily lit portolio limits on the GSEs by percent,or approximately billion, most o which would be designated or renancingsubprime loans. The measures, which Federal Reserve Chairman Ben Bernankecalled ill advised, were not enacted.

In November, Fannie and Freddie reported third-quarter losses o . billion and billion, respectively. At the end o December , Fannie reported that it had billion o capital to absorb potential losses on billion o assets and . trillion

o guarantees on mortgage-backed securities; i losses exceeded ., it would beinsolvent. Freddie would be insolvent i losses exceeded .. Moreover, there wereserious questions about the validity o their reported capital.

ITS A TIME GAME . . . BE CO OL

In the rst quarter, real gross domestic product ell . at an annual rate, reectingin part the rst decline in consumer spending since the early s. The unemploy-ment rate averaged in the rst three months o , up rom a low o . inspring o . As the Fed continued to cut interest rates, the economy was sinkingurther into recession. In February, Congress passed the Economic Stimulus Act,which raised the limits on the size o mortgages that Fannie and Freddie could pur-chase, among other measures.

The push to get OFHEO to loosen requirements on the GSEs also continued.Schumer pressed OFHEO to justiy or lower the capital surcharge; such a strin-gent requirement, he wrote Lockhart on February , hampered Fannies ability toprovide nancing to homeowners.


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Two days later, Fannie CEO Mudd reported losses in the ourth quarter o ,acknowledging that Fannie was working through the toughest housing and mort-

gage markets in a generation. The company had issued . billion o preerredstock, had completed all requirements o the consent agreement with OFHEO,and was discussing with OFHEO the possibility o reducing the capital surplusrequirement. The next day, Freddie also reported losses and said the company hadraised billion o preerred stock.

As both companies had led current nancial statements by this time, ullling acondition o liting the restrictions imposed by the consent agreements, Lockhart an-nounced that OFHEO would remove the portolio caps on March , . He alsosaid OFHEO would consider gradually lowering the capital surplus require-ment, because both companies had made progress in satisying their consent agree-ments and had recently raised capital through preerred stock oerings. Mudd toldthe FCIC that he sought relie rom the capital surplus requirement because he didnot want to ace urther regulatory discipline i Fannie ell short o required capitallevels.

On February , , the day ater OFHEO lited the growth limits, a New YorkFed analyst noted to Treasury that the capital surcharge was a constraint thatprevented the GSEs rom providing additional liquidity to the secondary mortgagemarket.

Calls to ease the surcharge also came rom the marketplace. Mike Farrell, theCEO o Annaly Capital Management, warned Treasury Undersecretary Robert Steelthat a crisis loomed in the credit markets that only the GSEs could solve. We be-lieve that we are nearing a tipping point; . . . lack o transparency on pricing or vir-tually every asset class and a dearth o buyers oreshadowed worse news, Farrellwrote. Removing the capital surcharge and passing legislation to overhaul the GSEswould make it possible or them to provide more stability, he said. Farrell recog-nized that the GSEs might believe their return on capital would be insufcient, butcontended that they will have to get past that and ocus on ullling their charters,because the big picture is that right now whatever is best or the economy and thenancial security o America trumps the ROI [return on investment] or Fannie andFreddie shareholders.

Days beore Bear Stearns collapsed, Steel reported to Mudd that he had encour-aging conversations with Senator Richard Shelby, the ranking member o the SenateCommittee on Banking, Housing, and Urban Aairs, and Representative Frank,chairman o the House Financial Services Committee, about the possibility o GSEreorm legislation and capital relie or the GSEs. He intended to speak with SenateBanking Committee Chairman Christopher Dodd. Condent that the governmentdesperately needed the GSEs to back up the mortgage market, Mudd proposed aneasier trade. I regulators would eliminate the surcharge, Fannie Mae would agree to

raise new capital.

In a March email to Fannie chie business ofcer Levin, Muddsuggested that the capital surplus requirement might be reduced without anytrade: Its a time game . . . whether they need us more . . . or i we hit the capital wallrst. Be cool.


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On the next day, March , Treasury and White House ofcials received additionalinormation about Fannies condition. The White House economist Jason Thomas

sent Steel an email enclosing an alarming analysis: it claimed that in reporting its nancial results, Fannie was masking its insolvency through raudulent ac-counting practices. The analysis, which resembled one oered in a March Barronsarticle, stated:

Any realistic assessment o Fannie Maes capital position would showthe company is currently insolvent. Accounting raud has resulted inseveral asset categories (non-agency securities, deerred tax assets, low-income partnership investment) being overstated, while the guaranteeobligation liability is understated. These accounting shenanigans add upto tens o billions o exaggerated net worth.

Yet, the impact o a tsunami o mortgage deaults has yet to runthrough Fannies income statement and urther annihilate its capital.Such grim results are a logical consequence o Fannies dual mandate toserve the housing market while maximizing shareholder returns. In try-ing to do both, Fannie has done neither well. With shareholder capitaldepleted, a government seizure o the company is inevitable.

Given the turmoil o the Bear Stearns crisis, Paulson said he wanted to increasecondence in the mortgage market by having Fannie and Freddie raise capital. Steeltold him that Treasury, OFHEO, and the Fed were preparing plans to relax the GSEscapital surcharges in exchange or assurances that the companies would raise capital.

On March , , Steel also reported to his Treasury colleagues that WilliamDudley, then executive vice president o the New York Fed, wanted to harden theimplicit government guarantee o Freddie and Fannie. Steel wrote that Dudley

leaned on me hard to make the guarantee explicit in conjunction with dialing backthe surcharge and attempting to raise new capital, and Steel worried about how thismight aect the ederal governments balance sheet: I do not like that and it has notbeen part o my conversation with anyone else. I view that as a very signicant move,way above my pay grade to double the size o the U.S. debt in one ell swoop.

THE IDEA STRIKES ME AS PERVERSE

Regulators at OFHEO and the Treasury huddled with GSE executives to discuss low-ering capital requirements i the GSEs would raise more capital. The entire mort-gage market was at risk, Lockhart told the FCIC. The pushing and tuggingcontinued. Paulson told the FCIC that personal commitments rom Mudd and Fred-die Mac CEO Richard Syron to raise capital cinched the deal. Just days earlier, on

March , Syron had announced in a quarterly call to investors that his companywould not raise new capital. Fannie and Freddie executives prepared a drat press re-lease beore a discussion with Lockhart and Steel. It announced a reduction in thecapital surcharge rom to . Lockhart was not pleased; the drat lacked a com-


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mitment to raise additional capital, stating instead that the GSEs planned to raise itover time as needed. It looked as i the GSEs were making the deal with their n-

gers crossed. In an email to Steel and the CEOs o both entities, Lockhart wrote: Theidea strikes me as perverse, and I assume it would seem perverse to the markets thata regulator would agree to allow a regulatee to increase its very high mortgage creditrisk leverage (not to mention increasing interest rate risk) without any new capital.The initial negotiations had the GSEs raising o capital or each o reduction inthe surplus. Lockhart wrote in rustration, We seem to have gone rom to rightthrough to to now to .

Despite Lockharts reservations, OFHEO announced the deal, unaltered in anymaterial way, on March . OFHEO agreed to ease the capital restraint rom to; Fannie and Freddie pledged to begin the process to raise signicant capital,giving no concrete commitment. Paulson told the FCIC that the agreement, whichincluded a promise to raise capital, was a no-brainer, and that he had no memory oLockhart ever having called it perverse.

The market analyst Joshua Rosner panned the deal. We view any reduction [incapital] as a comment not only on the GSEs but on the burgeoning panic in Wash-ington, he wrote. I this action results in the destabilizing o the GSEs, OFHEOwill go rom being the only regulator that prevented its charges rom getting intotrouble, to a textbook example o why regulators should be shielded rom outsidepolitical pressure.

Fannie would keep its promise by raising . billion in preerred stock. Freddiereneged. Executive Vice President Donald Bisenius oered two reasons why, in hind-sight, Fannie Mae did not raise additional capital. First was protecting the assets oexisting shareholders. Im sure [Fannies] investors are not very happy, Bisenius toldthe FCIC. Part two is . . . i you actually undamentally believe you have enough cap-ital to withstand even a airly signicant downturn in house prices, you wouldnt

raise capital.

Similarly, CEO Syron spoke o the downside o raising capital on August , :Raising a lot more capital at these kinds o prices could be quite dilutive to ourshareholders, so we have to balance the interest o our shareholders. But Lockhartsaw it dierently; in his view, Syrons public comments put a good ace on Freddiesinability to raise capital. He speculated that Syron was masking a dierent concern:lawsuits. [Syron] was getting advice rom his attorneys about the high risk o raisingcapital beore releasing [quarterly earnings] . . . and our lawyers could not disagreebecause we know about their accounting issues, Lockhart told the FCIC.

IT WILL INCREASE CONFIDENCE

In May, the two companies announced urther losses in the rst quarter. Even as the

situation deteriorated, on June OFHEO rewarded Fannie Mae or raising . bil-lion in new capital by urther lowering the capital surcharge, rom to . InJune, Fannies stock ell ; Freddies, . The price o protection on million inFannies debt through credit deault swaps jumped to , in June, up rom


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, in May; between and , it had typically been about ,. In Au-gust, they both reported more losses or the second quarter.

Even ater both Fannie and Freddie became public companies owned by share-holders, they had continued to possess an asset that is hard to quantiy: the implicitull aith and credit o the U.S. government. The government worried that it couldnot let the . trillion GSEs ail, because they were the only source o liquidity in themortgage market and because their ailure would cause losses to owners o their debtand their guaranteed mortgage securities. Uncle Sam had rescued GSEs beore. Itbailed out Fannie when double-digit ination wrecked its balance sheet in the earlys, and it came through in the mid-s or another GSE in duress, the FarmCredit System. In the mid-s, even a GSE-type organization, the Financing Cor-poration, was given a helping hand.

As the market grappled with the undamental question o whether Fannie andFreddie would be backed by the government, the yield on the GSEs long-term bondsrose. The dierence between the rate that the GSEs paid on their debt and rates onTreasuriesa premium that reects investors assessment o riskwidened in to one-hal a percentage point. That was low compared with the same gure or otherpublicly traded companies, but high or the ultra-sae GSEs. By June , the spreadhad risen over the level; by September , just beore regulators parachutedin, the spread had nearly doubled rom its level to just under , making itmore difcult and costly or the GSEs to und their operations. On the other hand,the prices o Fannie Mae mortgagebacked securities actually increased slightly overthis time period, while the prices o private-label mortgagebacked securities dra-matically declined. For example, the price o the FNCI indexan index o Fanniemortgagebacked securities with an average coupon o increased rom inJanuary to on September , , two days prior to the conservatorship. Asanother example, the price o the FNCI indexFannie securities with an average

coupon o increased rom to during the same time period.In July and August , Fannie suered a liquidity squeeze, because it was un-able to borrow against its own securities to raise sufcient cash in the repo market.Its stock price dove to less than a share. Fannie asked the Fed or help. A senioradviser in the Federal Reserve Boards Division o Banking Supervision and Regula-tion gave the FCIC a bleak account o the situation at the two GSEs and noted thatliquidity was just becoming so essential, so the Federal Reserve agreed to help pro-

vide it.

On July , the Federal Reserve Board in Washington authorized the New YorkFed to extend emergency loans to the GSEs should such lending prove necessary . . .to promote the availability o home mortgage credit during a period o stress in -nancial markets. Fannie and Freddie would never tap the Fed or that unding.

Also on July , Treasury laid out a three-part legislative plan to strengthen the

GSEs by temporarily increasing their lines o credit with the Treasury, authorizingTreasury to inject capital into the GSEs, and replacing OFHEO with the new FederalHousing Finance Agency (FHFA), with the power to place the GSEs into receiver-ship. Paulson told the Senate that regulators needed a bazooka at their disposal.


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You are not likely to take it out, Paulson told legislators. I just say that by havingsomething that is unspecied, it will increase condence. And by increasing con-

dence it will greatly reduce the likelihood it will ever be used. Fannies Mudd andFreddies Syron praised the plan.

At the end o July, Congress passed the Housing and Economic Recovery Act(HERA) o , giving Paulson his bazookathe ability to extend secured lines ocredit to the GSEs, to purchase their mortgage securities, and to inject capital. The-page bill also strengthened regulation o the GSEs by creating FHFA, an inde-pendent ederal agency, as their primary regulator, with expanded authority overFannies and Freddies portolios, capital levels, and compensation. In addition, thebill raised the ederal debt ceiling by billion to . trillion, providing unds tooperate the GSEs i they were placed into conservatorship.

Ater the Federal Reserve Board consented in mid-July to urnish emergencyloans, Fed sta and representatives o the Ofce o the Comptroller o the Currency(OCC), along with Morgan Stanley, which acted as an adviser to Treasury, initiated areview o the GSEs. Timothy Clark, who oversaw the weeklong review or the Fed,told the FCIC that it was the rst time they ever had access to inormation rom theGSEs. He said that previously, The GSEs [saw] the Fed as public enemy numberone. . . . There was a battle between us and them. Clark added, We would deal withOFHEO, which was also very guarded. So we did not have access to ino until theywanted unding rom us. Although Fed and OCC personnel were at the GSEs andconerring with executives, Mudd told the FCIC that he did not know o the agenciesinvolvement until their enterprises were both in conservatorship.

The Fed and the OCC discovered that the problems were worse than their suspi-cions and reports rom FHFA had led them to believe. According to Clark, the Fedound that the GSEs were signicantly underreserved, with huge potential losses,and their operations were unsae and unsound. The OCC rejected the orecasting

methodologies on which Fannie and Freddie relied. Using its own metrics, it oundinsufcient reserves or uture losses and identied signicant problems in credit andrisk management. Kevin Bailey, the OCC deputy comptroller or regulatory policy,told the FCIC that Fannies loan loss orecasting was problematic, and that its loanlosses thereore were understated. He added that Fannie had overvalued its deerredtax assetsbecause without uture prots, deerred tax assets had no value.

Loss projections calculated by Morgan Stanley substantiated the Feds and OCCsndings. Morgan Stanley concluded that Fannies loss projection methodology wasawed, and resulted in the company substantially understating losses. Nearly all othe loss projections calculated by Morgan Stanley showed that Fannie would all be-low its regulatory capital requirement. Fannies projections did not.

All told, the litany o understatements and shortalls led the OCCs Bailey to arm conclusion. I the GSEs were not insolvent at the time, they were almost there,

he told the FCIC.

Regulators also learned that Fannie was not charging o loans un-til they were delinquent or two years, a head-in-the-sand approach. Banks are re-quired to charge o loans once they are days delinquent. For these and numerousother errors and awed methodologies, Fannie and Freddie earned rebukes. Given


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the role o the GSEs and their market dominance, the OCC report said, they shouldbe industry leaders with respect to eective and proactive risk management, produc-

tive analysis, and comprehensive reporting. Instead they appear to signicantly lagthe industry in all respects.

CRITICAL UNSAFE AND UNSOUND PRACTICES

Paulson told the FCIC that although he learned o the Fed and OCC ndings by Au-gust , it took him three weeks to convince Lockhart and FHFA that there was a cap-ital shortall, that the GSEs were not viable, and that they should be placed undergovernment control. On August , FHFA inormed both Mudd and Syron that theirrms were adequately capitalized under the regulations, a judgment based on nan-cial inormation that was certied and represented as true and correct by [GSE] man-agement. But FHFA also emphasized that it was seriously concerned about thecurrent level o Fannie Maes capital i the housing market decline continued.

Fannies prospects or increasing capital grew gloomier. Fannie inormed Treasuryon August and repeatedly told FHFAthat raising capital was ineasible andthat the company was expecting additional losses. Even Fannies base-case earningsorecast pointed to substantial pressure on solvency, and a stressed orecast indi-cated that capital resources will continue to decline.

By September , Lockhart and FHFA agreed with Treasury that the GSEs neededto be placed into conservatorship. That day, Syron and Mudd received blisteringmidyear reviews rom FHFA. The opening paragraph o each letter inormed theCEOs that their companies had been downgraded to critical concerns, and that thecritical unsae and unsound practices and conditions that gave rise to the Enterprisesexisting condition, the deterioration in overall asset quality and signicant earningslosses experienced through June , as well as orecasted uture losses, likely re-

quire recapitalization o the Enterprise.

A bad situation was expected to worsen.The -page report sent to Fannie identied sweeping concerns, including ail-ures by the board and senior management, a signicant drop in the quality o mort-gages and securities owned or guaranteed by the GSE, insufcient reserves, thealmost exclusive reliance on short-term unding, and the inability to raise additionalcapital. FHFA admonished management and the board or their imprudent deci-sions to purchase or guarantee higher risk mortgage products. The letter aultedFannie or purchasing high-risk loans to increase market share, raise revenue andmeet housing goals, and or attempting to increase market share by competing withWall Street rms that purchased lower-quality securities. FHFA, noting a conictbetween prudent credit risk management and corporate business objectives, oundthat these purchases o higher-risk loans were predicated on the relaxing o under-writing and eligibility standards. Using models that underestimated this risk, the

GSE then charged ees even lower than what its own decient models suggestedwere appropriate. FHFA determined that these lower ees were charged because o-cus was improperly placed on market share and competing with Wall Street and[Freddie Mac].


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Even ater internal reports pointed to market problems, Fannie kept buying andguaranteeing riskier loan products, FHFA said. Despite signs in the latter hal o

and o emerging problems, management continued activity in risky pro-grams, and maintained its higher eligibility program or Alt-A loans without estab-lishing limits. The company also bought private-label securities backed by Alt-Aand subprime loans. Losses were likely to be higher than the GSEs had estimated,FHFA ound.

FHFA also noted increasing questions and concerns regarding Fannies account-ing. The models it used to orecast losses had not been independently validated orupdated or several years. FHFA judged that in an up-to-date model, estimated losseswould likely show a material increase. In addition, Fannie had overvalued its de-erred tax assets. Applying more reasonable projections o uture perormance, FHFAound this benet to be signicantly overstated.

The -page report delivered to Freddie included similarly harsh assessments othat GSEs saety and soundness, but more severe criticisms o its management andboard. In particular, the report noted a signicant lack o market condence, whichhad eliminated the ability to raise capital. FHFA, or its part, lost condence in theBoard o Directors and the executive management team, holding them accountableor losses stemming rom a series o ill-advised and poorly executed decisions andother serious misjudgments. According to the regulator, they thereore could not berelied on, particularly in light o their widespread ailures to resolve regulatory issuesand address criticisms. In addition, FHFA said that Freddies ailure to raise capitaldespite its assurances invite[d] the conclusion that the board and CEO had not ne-gotiated in good aith about the capital surcharge reduction.

As in its assessment o Fannie, FHFA ound that Freddies unsae and unsoundpractices included the purchase and guarantee o higher-risk loan products in and in a declining market. Even ater being told by the regulator in that its

purchases o subprime private-label securities had outpaced its risk management abil-ities, Freddie bought billion o subprime securities in each subsequent quarter.FHFA also ound that aggressive accounting cast doubt on Freddies reported

earnings and capital. Despite clear signals that losses on mortgage assets were likely,Freddie waited to record write-downs until the regulator threatened to issue a ceaseand desist order. Even then, one write-down was reversed just prior to the issuanceo the second quarter nancial statements. The regulator concluded that risingdelinquencies and credit losses would result in a substantial dissipation o earningsand capital.

THEY WENT FROM ZERO

TO THREE WITH NO WARNING IN BETWEEN

Mudd told the FCIC that its regulator had never beore communicated the kind ocriticisms leveled in the September letter. He said the regulators chronicling o thesituation then was inconsistent with what you would consider better regulatorypractice to belike, rst warning: x it; second warning: x it; third warning: youre


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out o here. Instead, they went rom zero to three with no warning in between. Areview o the examination reports and other documents provided by FHFA to the

FCIC largely supports Mudds view on this specic point. While OFHEOs examina-tion reports noted concerns about increasing credit risk and slow remediation o de-ciencies required by the May consent agreement, they do not include thesweeping criticisms contained in the September letter.

Two days ater their two companies were designated critical concerns, Mudd atFannie and Syron at Freddie aced a government takeover. On September , FHFAActing Deputy Director Chris Dickerson sent separate memos to Lockhart recom-mending that FHFA be appointed conservator or each GSE.

Still, conservatorship was not a oregone conclusion. Paulson, Lockhart, andBernanke met with Mudd, Syron, and their boards to persuade them to cede con-trol. Essentially the GSEs aced a Hobsons choice: take the horse oered or none atall. They had to voluntarily agree to a consent agreement, Lockhart told the FCIC.The alternative, a hostile action, invited trouble and nasty lawsuits, he noted. So wemade a . . . very strong case so the board o directors did not have a choice. Paulsonreminded the GSEs that he had authority to inject capital, but he would not do so un-less they were in conservatorship.

Mudd was stunned and angry, according to Paulson. Tom Lund, who ran Fan-nie Maes single-amily business, told the FCIC that conservatorship came as a sur-prise to everyone. Levin told the FCIC that he never saw a government seizurecoming. He never imagined, he said, that Fannie Mae was or might become insol-

vent. Interviewed in , Mudd told the FCIC: I did not think in any way it wasair or the government to have been in a position o being in the chorus or the com-pany to add capital, and then to inject itsel in the capital structure. The conserva-torship memoranda reiterated all the damning evidence presented in the letters twodays earlier. Losses at Fannie Mae or the year were estimated to be between bil-

lion and billion.

Freddie Macs memorandum diered only in the details. Itslosses, recorded at billion in the rst six months o , were projected to end upbetween and billion by the end o the year.

Although the boards had a choice, the only realistic option was assent. We were go-ing to agree to go in a conservatorship anyway, Syron told the FCIC. There was a veryclear message that the [September ] letter was there as a mechanism to bring about aresult. Mudd agreed, observing that the purpose o the letter was really to orce con-servatorship. The boards o both companies voted to accept conservatorship.

Both CEOs were ousted, but the undamental problems persisted. As promised,the Treasury was prepared to take two direct steps to support solvency. First, it wouldbuy up to billion o senior preerred stock rom the GSEs and extend themshort-term secured loans. In addition, it pledged to buy GSE mortgagebacked secu-rities rom Wall Street rms and others until the end o . Up ront, Treasury

bought rom each GSE billion in preerred stock with a dividend. Each GSEalso gave Treasury warrants to purchase common stock representing . o sharesoutstanding. Existing common and preerred shareholders were eectively wipedout. The decline in value o the preerred stock caused losses at many banks that held


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these securities, contributing to the ailure o institutions and to the downgradingo to less than well capitalized by their regulators.

Paulson told the FCIC that he was naive enough to believe that the action wouldhalt the crisis because it would put a oor under the housing market decline, andprovide condence to the market. He realized he was wrong on the next day, when,as he told the FCIC, Lehman started to go. Former Treasury Assistant SecretaryNeel Kashkari agreed. We thought that ater we stabilized Fannie and Freddie thatwe bought ourselves some time. Maybe a month, maybe three months. But they weresuch proound interventions, stabilizing such a huge part o the nancial markets,that would buy us some time. We were surprised that Lehman then happened a weeklater, that Lehman had to be taken over or it would go into bankruptcy.

The rms ailure was a huge event and increased the magnitude o the crisis, ac-cording to Fed Governor Kevin Warsh and New York Fed General Counsel Tom Bax-ter. Warsh also told the FCIC that the events surrounding the GSE takeover led to amassive, underreported, underappreciated jolt to the system. Then, according toWarsh, when the market grasped that it had misunderstood the risks associated withthe GSEs, and that the government could have conceivably let them ail, it caused in-

vestors to panic about the value o every asset, to reassess every portolio.

FHFA Director Lockhart described the decision to put the GSEs into conservator-ship in the context o Lehmans ailure. Given that the investment banks balancesheet was about one-th the size o Fannie Maes, he elt that the allout romLehmans bankruptcy would have paled in comparison to a GSE ailure. He said,What happened ater Lehman would have been very small compared to these .trillion institutions ailing. Major holders o GSE securities included the Chineseand Russian central banks, which, between them, owned more than hal a trilliondollars o these securities, and U.S. nancial rms and investment unds had evenmore extensive holdings. A Fed study concluded that U.S. banks owned more

than trillion in GSE debt and securitiesmore than o the banks Tier cap-ital and o their total assets at the time.

Testiying beore the FCIC, Mudd claimed that ailure was all but inevitable. In, the companies had no reuge rom the twin shocks o a housing crisis ollowedby a nancial crisis, he said. A monoline GSE structure asked to perorm multipletasks cannot withstand a multiyear home price decline on a national scale, evenwithout the accompanying global nancial turmoil. The model allowed a balance obusiness and mission when home prices were rising. When prices crashed ar beyondthe realm o historical experience, it became The Pit and the Pendulum, a choice be-tween horrible alternatives.

THE WORSTRUN FINANCIAL INSTITUTION

When interviewed by the FCIC, FHFA ofcials were very critical o Fannies manage-ment. John Kerr, the FHFA examiner (and an OCC veteran) in charge o Fannie ex-aminations, minced no words. He labeled Fannie the worst-run nancialinstitution he had seen in his years as a bank regulator. Scott Smith, who became


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associate director at FHFA ater that agency replaced OFHEO, concurred; in his view,Fannies orecasting capabilities were not particularly well thought out, and lacked a

variety o stress scenarios. Both ofcials noted Fannies weak orecasting models,which included hundreds o market simulations but scarcely any that contemplateddeclines in house prices. To Austin Kelly, an OFHEO examination specialist, therewas no relying on Fannies numbers, because their processes were a bowl ospaghetti. Kerr and a colleague said that that they were struck that Fannie Mae, amultitrillion-dollar company, employed unsophisticated technology: it was less tech-savvy than the average community bank.

Nonetheless, OFHEOs communications with Fannie prior to September didnot ully reect these criticisms. FHFA ofcials conceded that they had made mis-takes in their oversight o Fannie and Freddie. They paid too much attention to x-ing operational problems and did not react to Fannies increasing credit risk.Lockhart told the FCIC that more resources should have been dedicated to assessingcredit risk o their mortgage assets and guarantees. Current FHFA Acting DirectorEdward DeMarco told the FCIC that it would not pass the reasonable person testto deny that OFHEO took its eye o the ball by not paying sufcient attention tocredit risk and instead ocused on operational risk, accounting and lack o auditedresults.

To Mudd and others, OFHEOs mistakes were not surprising. Mudd told theFCIC that the regulators skill levels were developing but below average. HenryCisneros, a ormer housing and urban development secretary, expressed a similar

view. OFHEO, Cisneros told the FCIC, was puny compared to what Fannie Maeand Freddie Mac could muster in their intelligence, their Ivy League educations, theirrocket scientists in their place, their lobbyists, their ability to work the Hill.

The costs o the bailouts have been enormous and are expected to increase. FromJanuary , , through the third quarter o , the two companies lost bil-

lion, wiping out billion o combined capital that they had reported at the end o and the billion o capital raised by Fannie in . Treasury narrowed thegap with billion in support. FHFA has estimated that costs through willrange rom billion to billion. The Congressional Budget Ofce has pro-

jected that the economic cost o the GSEs downall, including the total nancialcost o government support as well as actual dollar outlays, could reach billionby .

WASNT DONE AT MY PAY GRADE

Fannies two most senior executives were asked at an FCIC hearing how their chartercould have been changed to make the company more sound, and to avoid the multi-billion-dollar bailout. Mudd, who made approximately million rom to

, testied that the thing that would have made the institution more sound orhave produced a dierent outcome would have been or it to have become over timea more normal nancial institution able to diversiy, able to allocate capital, able to be


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COMMISSION CONCLUSIONS ON CHAPTER 17

The Commission concludes that the business model o Fannie Mae and FreddieMac (the GSEs), as private-sector, publicly traded, prot-making companies withimplicit government backing and a public mission, was undamentally awed. Wend that the risky practices o Fannie Maethe Commissions case study in this

areaparticularly rom on, led to its all: practices undertaken to meet WallStreets expectations or growth, to regain market share, and to ensure generouscompensation or its employees. Aordable housing goals imposed by the De-partment o Housing and Urban Development (HUD) did contribute marginallyto these practices. The GSEs justied their activities, in part, on the broad andsustained public policy support or homeownership. Risky lending and securiti-zation resulted in signicant losses at Fannie Mae, which, combined with its ex-cessive leverage permitted by law, led to the companys ailure.

Corporate governance, including risk management, ailed at the GSEs in partbecause o skewed compensation methodologies. The Ofce o Federal HousingEnterprise Oversight (OFHEO) lacked the authority and capacity to adequatelyregulate the GSEs. The GSEs exercised considerable political power and were suc-cessully able to resist legislation and regulatory actions that would have strength-

ened oversight o them and restricted their risk-taking activities.In early , the decision by the ederal government and the GSEs to increase

the GSEs mortgage activities and risk to support the collapsing mortgage marketwas made despite the unsound nancial condition o the institutions. While theseactions provided support to the mortgage market, they led to increased losses atthe GSEs, which were ultimately borne by taxpayers, and reected the conictednature o the GSEs dual mandate.

GSE mortgage securities essentially maintained their value throughout thecrisis and did not contribute to the signicant nancial rm losses that were cen-tral to the nancial crisis.

long or short in the market, able to operate internationally. And i the trade or thatwould have been, you know, a cut in the so-called implicit ties with the government, I

think that would havethat would have been a better solution. Chie Business O-cer Levin, who received approximately million rom to , answeredonly that making such decisions wasnt done at my pay grade.


fcic final report, part 4, chapter 17, the unraveling - september 2008: the takeover of fannie mae...

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