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Fatal Flaws In The Case Against Fannie Mae Execs, Part 1

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Apparently, the SEC ignored the fine print, and hopes the U.S. District Court will do the same. Its lawsuit against Fannie Mae executives depends entirely on its shifting definitions of "subprime" and "Alt-A." The SEC alleges that these executives deliberately misled investors as to the size of Fannie's "subprime," and "Alt-A" exposures. But the SEC, in attempting to demonstrate an intention to deceive, cherrypicked facts in a rather misleading way.

Definitional Problems

Subprime and Alt-A are but two of numerous financial terms that have very fuzzy definitions. Generally speaking, financial jargon is extremely sloppy, which is why so financiers are  adept at bambozzling investors and regulators. So many words--"security," "default," "CDO," "market value," for example--have very different meanings when placed in different contexts.  And many words have meanings that evolve over time.  For instance, most people equate home equity loans with second lien loans taken out in addition to a first lien mortgage. But over time, the home equity loan category was also expanded to include subprime first lien mortgages.  Frank Fabozzi explains this phenomenon on page 313 of his book, Fixed income Analysis:

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At one time, the [home equity] loan was typically a second lien on property that was already pledged to secure a first lien. In some cases, the lien was a third lien. In recent years, the character of the home equity loan has changed. Today, a home equity loan is often a first lien on property where the borrower has either and impaired credit history and/or the payment to income ratio is too high for the loan to qualify as a conforming loan [from the GSEs.]

Defining Subprime Mortgages

If you want to be precise about subprime mortgages, you need to distinguish between: (a) a subprime borrower, (b) a subprime loan product, and (c) the subprime market.  The SEC defines subprime loans as any loan made to a subprime borrower. Period. In its financial filings, Fannie Mae defined subprime loans as either: (a) a subprime loan product extended to a subprime borrower; or (b) a loan included in a mortgage pool held by a subprime securitization. By parsing its own definition, rather than referring to the complete definition used in Fannie's financial filings, the SEC was able to contrive a narrative wherein Fannie "under-reported" its subprime exposure.  We see this in paragraphs 3 and 4 of the complaint:

3. For example, in a February 2007 public filing, Fannie Mae described subprime loans as loans "made to borrowers with weaker credit histories" and reported that 0.2%, or approximately $4.8 billion, of its Single Family credit book of business as of December 31, 2006, consisted of subprime mortgage loans or structured Fannie Mae Mortgage Backed Securities ("MBS") backed by subprime mortgage loans.

4. Fannie Mae did not disclose to investors that in calculating the Company's reported exposure to subprime loans, Fannie Mae did not include loan products specifically targeted by the Company towards borrowers with weaker credit histories, including Expanded Approval ("EA") loans. As of December 31, 2006, the amount of EA loans owned or securitized in the Company's single-family credit business was approximately $43.3 billion, yet none of these loans were included in the Company's disclosed subprime exposure.

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The definitions require a bit more explication:

Subprime Borrower: In very simple terms, a subprime borrower is someone whose credit is impaired. The credit designation is usually based on a FICO score, which is not based on income. Each year in its 10-K Fannie disclosed the percent of loans with FICO scores below 620, which, for many players is a common cutoff point for "subprime." Again, the distinction is critical, because proponents of The Big Lie often resort to dog whistle rhetoric by equating loans to low income borrowers to loans to subprime borrowers.

Subprime Loan: A subprime loan is one that is underwritten with the expectation that the default rate will be very high, exponentially higher than the rest of the market, based on the belief that a higher interest rate will offset and losses from defaults. (See charts 3 and 4 in the MBA National Delinquency Survey.) The lender often takes little regard to the borrower's ability to pay back the loan. Many prime borrowers took out subprime loans, because they were steered in that direction by mortgage brokers and by subprime lenders. Also, many prime borrowers wanted a bigger mortgage than they could afford, according to the debt-to-income standards of a prime loan, so they took out a subprime loan instead.

The Anti-Predatory Distinction: Simply put, Fannie's loans were subject to anti-predatory lending standards, whereas subprime loans were not. Which is why the vast majority of subprime loans have so many features--teaser interest rates fixed at no more than two-years, prepayment penalties, less-than-complete documentation--that were prohibited by the GSEs.  It's worthwhile to recall how the GSE anti-predatory regulations came into effect. Around 2000, then HUD Secretary Andrew Cuomo was alarmed by the predatory practices concentrated in the subprime lending sector, so he encouraged the GSEs to compete in that retail market by offering loans to credit impaired borrowers who, upon closer examination, could be considered acceptable risks. Fannie's Expanded Approval program was offered as an alternative to a subprime loan product, because Fannie's underwriting standards were subject to predatory lending standards, whereas subprime lenders were not.  

Cuomo's HUD devised new regulations based on the premise that, "mortgages with predatory features undermine homeownership by low-and moderate-income families in derogation of the GSEs' Charter missions," (65 FR 65069, Oct. 31, 2000). So that "Mortgages contrary to good lending practices," were excluded from Affordable Housing Goals (65 FR 65085). HUD also said it would also exclude "B&C loans" (i.e. subprime loans) from its calculation of the size of the overall market. (65 FR 65090).

The new regulations specifically excluded loans with: (a) Excessive fees, (b) Prepayment penalties, (c) Single premium credit life insurance, or (d) Evidence that the lender did not adequately consider the borrower's ability to make payments, plus any loans that the HUD secretary deemed to violate good lending practices.

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And once again, proponents of The Big Lie, like the Cato Institute, falsely assert that Andrew Cuomo forced the GSEs to take on subprime loans, when in fact the opposite was true.

Any mortgage lender that originated an Expanded Authorization loan was liable for any violation of the anti-predatory rules:

Fannie Mae will perform monthly post purchase underwriting reviews on a discretionary basis to assess compliance with EA [Expanded Authorization] and EA with [Timely Payment Rewards] underwriting and eligibility requirements and requirements to prevent predatory lending practices. Mortgages that do not comply with the predatory lending requirements are subject to repurchase by the lender, regardless of whether the mortgages are performing mortgages, and the lender may be required to indemnify Fannie Mae for any and all losses resulting from any such noncompliance.

Former Fannie CEO Daniel Mudd alluded to the distinction in his February 2007 Congressional testimony:

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For over 20 years, David has been a banker covering the energy industry for several global banks in New York. Currently, he is working on several journalism projects dealing with corporate and political corruption that, so far, have escaped serious (more...)

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