Fannie Freddie Lawsuit and Risk Arbitrage

by Chidem Kurdas

Last week the Federal Housing Finance Agency filed suits against 17 major banks and mortgage businesses for misleading Fannie Mae and Freddie Mac regarding the risks of mortgage securities sold to these government-sponsored enterprises.  Though it targets banks, the litigation shows the mode of operation of Fannie and Freddie.

This development is best understood against the background provided by a revealing new book,  Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance, by V. Acharya, M. Richardson, S. van Nieuwerburgh and L. White, professors at New York University’s Stern School of Business. Here’s a quote taken from a decade-old American Enterprise Institute compilation of warnings regarding GSEs from free marketers and left-wingers alike. This is from a Fannie Mae executive:

“We’re not casual about managing our political risk.” 

By contrast, they were casual about managing their credit risk, resulting in immense losses once housing prices turned downward.

To understand how casual Fannie and Freddie were about credit risk, consider the two types of activity they engage in. One, they buy and pool mortgages, issuing securities backed by these pools, a process called securitization. They’ve been doing this longer and on greater scale than anyone else—by comparison Wall Street was a newcomer to the business.  

Two, they buy such securities, whether issued by themselves or others. The lawsuits just filed concern this second type of activity, the purchase of readymade mortgage securities. The main accusation is that materials pertaining to certain securities the defendants sold from 2005 to 2007 contained wrong or deficient information, “unbeknownst” to Fannie and Freddie. 

At the time they bought these securities, Fannie and Freddie were competing furiously with the same banks for mortgages to securitize—-and earn fees on. They were buying mortgages as they had for decades, but now they faced growing pressure from banks seeking lucrative securitization business. This led to all-around lowering of underwriting standards and the rise of higher-risk mortgages, the race to the bottom described in Guaranteed to Fail

Being both suppliers and buyers in the mortgage security market on a gigantic scale, Fannie and Freddie were uniquely positioned. Because they bought mortgages to securitize, they too were lowering standards and taking higher risks. For the reality underlying the securities to be “unbeknownst” to them, they had to willfully avoid knowing it. Even if they did not do the analysis themselves, they could have easily asked for third-party reports—-which existed at the time and are presented as evidence in the cases. That the GSEs were complicit does not exonerate the banks’ shoddy work, but it does show how we got to the current mess. 

Fannie and Freddie appeared to mint money because government backing gave them easy and cheap capital, plus they had special tax breaks and low capital requirements. The government guarantee was initially explicit—they were was created as federal bureaucracies, as the “F” in their names indicates. Then it became implicit until the 2008 crisis made it explicit again. It was always assumed. Their extraordinarily low capital requirement meant GSEs leveraged more than adventurous hedge funds.

Lobbying and public relations made sure they retained the full panoply of special privileges. This was managing the political risk, which they appear to have done superbly and still do—-note their victim status in the lawsuits and mainstream media coverage thereof. Ensuring political protection meant that managing credit risk was less crucial.   

The Fannie-Freddie model of arbitraging risks, of combining political protection with high financial risk, was the archetype of too-big-to-fail.  Professor Acharya and his colleagues argue that large complex financial institutions – like the ones being sued – emerged as another embodiment of this model, differing only in degree: too-big-to-fail banks and GSEs made similar leveraged bets on mortgages, with implicit government backing.

But in court they face each other as plaintiff and defendants.

While getting money from banks may look like a way of lightening the burden on the federal budget since taxpayers continue to pay for GSE losses, in fact it will likely reduce banks’ taxes by increasing their legal costs. And there are various other effects. Anticipation of the lawsuits brought down stocks on Friday, with Bank of America in particular losing some 8%. Shareholder losses will percolate through pensions and retirement accounts.

6 thoughts on “Fannie Freddie Lawsuit and Risk Arbitrage

  1. Very good posting by Chidem, who understands the dynamics of how housing finance worked. Fan & Fred inherently faced interest-rate risk. Whe they started holding securities, which was no part of their mission, they also took on credit risk.

  2. Jerry O’Driscoll–
    You point to a key question: What is or what should be their mission? I did not include in the post above the other aspect of their mission: Congressional mandates to go easy on credit standards.

  3. The lawsuits certainly had a market effect. The downward pull on the shares of the banks sued appears to have persisted yesterday. There’s some recovery today.

  4. @Chidem,

    Their statutory mission was to promote and support housing finance. Guaranteeing mortgage-backed securities did that. Holding securities on their own account leveraged taxpayer guarantees to run up their profits by taking on credit risk.

  5. Jerry, yes, they certainly did that. But doesn’t guaranteeing mortgage securities also involve a significant risk? I grant you, Fannie & Freddie losses would have been less if they had not bought securities. But the insurance they provided would have still distorted the market and, once the bubble collapsed, resulted in a big bill to the taxpayer.

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