All The Devils Are Here: Unmasking the Men Who Bankrupted the World (36 page)

In truth, the Treasury Department could have done something about the GSEs even without new legislation. During the early stages of Operation Noriega, Treasury had researched an obscure provision in a 1954 law that appeared to give the Treasury the right to limit the GSEs’ issuance of debt.
Treasury and the Justice Department concluded that Treasury did, indeed, have that right. By exercising it, they could have shut down the GSEs entirely. But they never tried. Even the Bush administration was afraid to see what would happen to the mortgage market without Fannie and Freddie.

Fannie’s new CEO was Daniel Mudd, a self-deprecating ex-Marine who had run General Electric’s Japanese operation before joining Fannie Mae in 2000. The son of the well-known television journalist Roger Mudd, the new chief executive could not have been more different from his three predecessors. He wasn’t a Democrat, a Washington power player, or a houser. He and Raines had never been close, and Mudd had thought about leaving the company because he didn’t like its “arrogant, defiant, my-way Fannie Mae,” as he later put it. When he became CEO, he embarked on a strategy of conciliation. “I thought for a very long time that it was our fault, because we were heavy-handed, because we had a propaganda machine,” he said. Though he tried to patch things up with the administration, no one in the White House would take his calls.

On the other hand, the White House was the least of Mudd’s problems. While Washington had been transfixed by the war between Fannie and the White House, something every bit as dramatic was taking place in the marketplace: Fannie’s stranglehold on the secondary mortgage market was weakening. And not just by a little. In 2003, Fannie Mae’s estimated market share for bonds backed by single-family housing was 45 percent. Just one year later, it dropped to 23.5 percent. As a 2005 internal presentation at Fannie Mae noted, with some alarm, “[P]rivate label volume surpassed Fannie Mae volume for the first time.”

There was no question about why this was happening: the subprime mortgage originators were starting to dominate the market. They didn’t need Fannie and Freddie to guarantee their loans—and for the most part didn’t want the GSEs mucking around in their business. The subprime originators sold their loans straight to Wall Street, which, unlike the GSEs, didn’t really care whether they could be paid back. “The subprime market needed the companies who created all the rules to go away,” says subprime entrepreneur Bill Dallas. “Fannie and Freddie were in the penalty box. They were gone.”

As Fannie’s market share dropped, the company’s investors grew restless—so restless that Fannie hired Citigroup to look at what Citi called “strategic
alternatives to maximize long-term Phineas [the code name the Citi team gave Fannie] shareholder value.” In a July 2005 presentation, Citi concluded that Fannie shouldn’t privatize, because its charter was its “core asset,” accounting for up to 50 percent of its current market capitalization. Among Citi’s key recommendations for increasing that market capitalization: Fannie should begin guaranteeing “non-conforming residential mortgages”—i.e., subprime.

Fannie’s relationship with its biggest customer, Countrywide, was also increasingly difficult. In some years, Countrywide generated a quarter of the loans purchased by Fannie; and the company had long supported certain key Mozilo causes, like low down payments. “The single defining quality of that relationship was the mutual dependence,” says one lobbyist. But now the balance was shifting, because Countrywide had other options. Unlike the pure subprime companies, Countrywide wanted Fannie in the subprime market. Countrywide originated so many loans that Mozilo wanted as many buyers as he could get, even Fannie. Besides, Countrywide liked the idea of having Fannie impose some order on the Wild West of subprime, with its insistence on sound underwriting standards. That would probably help Countrywide, with its long history of working hand in hand with the GSEs, and hurt the pure subprime companies like Ameriquest and New Century.

Instead, because Fannie wouldn’t buy riskier loans, its share of Countrywide’s business shrank. According to an internal Fannie Mae presentation, in mid-2002 Fannie bought more than 80 percent of Countrywide’s mortgages. By early 2005, that had shrunk to about 20 percent. “This trend is increasingly costing us business with our largest customer,” noted the presentation.

The new, tougher housing goals of the Bush administration also ratcheted up the pressure. How was Fannie going to achieve those goals without adding subprime mortgages to its books? The products it had carefully tailored for low-income borrowers were no longer appealing in a world where those borrowers could get much bigger mortgages from a subprime originator by making up their income. But Fannie couldn’t just dive headlong into the subprime market. Its systems weren’t able to gauge the risk of subprime mortgages. “[W]e are not even close to having proper control processes for credit, market, and operation risks,” wrote the company’s chief credit officer, Enrico Dallavecchia, in an e-mail. The irony was painful: HUD had increased and toughened Fannie’s housing goals at the precise moment when the market was willing to make loans—often terrible loans that quickly soured, to
be sure—to any low-income person who wanted one. “The difference between what the market produced and what we had to produce grew bigger and bigger,” says a former Fannie executive.

“All these voices on the outside were saying, ‘You are not relevant,’ ” Mudd later recalled. “And you have an obligation to be relevant.”

Fannie’s traditional arrogance soon gave way to angst; Mudd would later say that going to work felt like “a choice between poking my eye out and cutting off a finger.” Fannie’s internal struggles were on vivid display at a getaway for executives in the summer of 2005. In a slideshow entitled “Facing Strategic Crossroads,” the first question Fannie asked itself was “Is the housing market overheated?” The next question: “Does Fannie Mae have an obligation to protect consumers?” Executives debated whether the new dominance of subprime products was a permanent change or a temporary phenomenon. The presentation went on to lay out the two “stark choices” Fannie faced. One was to “stay the course,” which meant staying away from subprime lending and seeing continued market share declines. The other: “Meet the market where the market is.” Which meant subprime. The presentation concluded on a plaintive note. “Is there an opportunity to drive the market back to the thirty-year FRM [fixed-rate mortgage]?”

Although the company vowed at the meeting to stay the course, in truth it had already begun to stray. First the GSEs bought for their portfolios the safest subprime securities in the marketplace: the triple-A-rated tranches of residential mortgage-backed securities. (Neither GSE ever bought CDOs.) They’d begun buying these securities in the earlier part of the decade because they offered decent yields. But when the housing goals became harder to fulfill, the triple-A tranches provided an easy way to meet their mission numbers. Eventually, the Street began designing a special GSE tranche that was packed with loans that satisfied the affordable housing requirements. And HUD allowed the GSEs to count these purchases toward their goals.

Over time, Fannie and Freddie became two of the world’s largest purchasers of triple-A tranches. In the peak year of 2004, the GSEs bought about $175 billion in triple-As, or 44 percent of the market. While there were plenty of buyers for triple-A-rated securities, the very size of the GSEs’ purchase undoubtedly helped inflate the housing bubble.

Putting triple-A subprime securities on its books was, like some of Fannie’s other methods of meeting its housing goals, a stupid pet trick. It didn’t help low-income Americans buy homes. Because the GSEs weren’t determining which loans they would buy, they lost the opportunity to enforce any standards on the lenders. And, as housing advocate Judy Kennedy points out, putting subprime securities on its books was a perversion of its affordable housing mission. From the government’s perspective, GSEs existed to buy up loans to poor and middle-income borrowers—even if that came at the expense of its profits. By buying Wall Street’s securities, the GSEs were able to earn more of a return on their affordable housing investments, rather than less.

Fannie and Freddie turned out to be almost as clueless as your average investor. They, too, relied on the rating agencies, although Fannie did so with a tiny bit of caution. (“Although we invest almost exclusively in triple-A-rated securities, there is a concern that rating agencies may not be properly assessing the risk in these securities,” noted a Fannie internal document in the spring of 2005.) Not enough caution, however. After the crisis, HUD would report that the value of the Wall Street–created securities owned by Fannie and Freddie fell as much as 90 percent from the time of purchase.

The GSEs also began buying, guaranteeing, and selling those not-quite-subprime Alt-A mortgages. Fannie executives insist that they never bought or guaranteed more than a few billion dollars worth of loans they considered subprime. They never guaranteed loans with layered risks, for instance. But many of the borderline loans they guaranteed would certainly be categorized as subprime by others in the marketplace. To this day, former Fannie Mae executives will insist that they chose the securities they guaranteed more carefully than others. And maybe they did; after the crisis, Fannie and Freddie defenders would point out that in every mortgage category, from prime to Alt-A to subprime, the GSEs’ loans defaulted at rates below the national average.

But just as with the purchase of triple-A securities, guaranteeing Alt-A loans had little to do with housing goals and everything to do with profits and market share. They were simply more profitable than guaranteeing thirty-year fixed loans. “We were lured into it by the big margins,” says a former executive. Both companies got warnings about the true state of market—Fannie from the outside and Freddie from the inside. Michelle Leigh, a vice president at IndyMac, later claimed in a lawsuit that she tried to warn Fannie about the Alt-A loans it was buying from IndyMac, which were riddled with problems. Fannie didn’t respond, and increased its purchases of loans from the company, according to the lawsuit.

Over at Freddie, chief credit officer David Andrukonis warned the company’s new CEO, Dick Syron, the former chairman of the Boston Federal
Reserve, about the riskiness of no-income, no-asset loans. (They were called NINA loans.) “Freddie Mac should withdraw from the NINA market as soon as practical,” Andrukonis wrote in the fall of 2004. “Today’s NINA appears to target borrowers who would have trouble qualifying for a mortgage if their financial position were adequately disclosed.” He added, “What better way to highlight our sense of mission than to walk away from profitable business because it hurts the borrowers we are trying to serve?”

Between 2005 and 2007, about one in five mortgages Fannie and Freddie purchased or insured was Alt-A or subprime, according to a study by Jason Thomas. By the end of 2007, Fannie Mae had $350 billion in Alt-A exposure and another $166 billion in exposure to mortgages that it defined as subprime or whose recipients had FICO scores of less than 620. Freddie had $205 billion in Alt-A exposure and $173 billion in exposure to subprime or sub-620 FICO scores. Thomas calculates that that meant the GSEs owned about 23 percent of the subprime mortgage-backed securities outstanding at that time and a whopping 58 percent of the total Alt-A mortgages outstanding.

There was no worse time to accumulate exposure to Alt-A and subprime loans than the 2005 to 2007 time period. Some critics would later point to these massive purchases in an effort to blame the entire crisis on Fannie and Freddie. But as Thomas points out, it’s precisely because they were so late to the party that their losses would be so immense.

Another irony is that, in the end, OFHEO, despite its brief stance as an aggressive regulator, failed as miserably as the GSEs. As Raines would later point out, “Fannie and Freddie succumbed to the pressure, and they did so right in front of OFHEO.” After the accounting scandal, OFHEO had examiners in Fannie’s offices on a full-time basis. There was very little that Fannie Mae did that OFHEO didn’t know about. OFHEO’s 2006 report to Congress had a cover letter that read in part, “OFHEO is working with the Enterprises to provide guidance on subprime … mortgages.” OFHEO had the right to suspend the affordable housing goals if the agency felt they threatened the GSEs’ capital position. At any moment along the way, OFHEO could have stopped the GSEs from buying risky loans by citing “safety and soundness” concerns. But it didn’t. Like the other regulators who were charged with looking after the health of the financial system, OFHEO simply didn’t appreciate the credit risk until it was too late.

The last, and most painful, irony is that the two longtime rival armies in the securitization market—the investment banks and the GSEs—would end up magnifying each other’s sins rather than keeping each other in check.
Without the GSEs’ buying power, the private market would never have been as big as it got. And without Wall Street, there never would have been all those bad mortgages for the GSEs to binge on.