The giveaway was what they didn't say, or rather what was left out of the Non-Prosecution Agreement with the SEC. Usually, the deal includes a promise by the company to "sin no more," to stop making all those deceptive and misleading statements in its public filings. Not this time. Fannie Mae agreed to no such thing. Despite SEC claims that Fannie misled investors by underreporting the "true" exposure to subprime and Alt-A loans, despite unnamed sources claiming that the FBI is conducting a criminal investigation into the matter, Fannie never agreed to change the way that it calculates its subprime or Alt-A numbers in public financial disclosures. The company has in no way suggested that it will change the way it reports those numbers in the future. Nor has it suggested that it will amend any prior SEC filings. And the reason seems pretty obvious. The company wants to make sure that any financial disclosures continue to pass the laugh test.
And if the SEC's mission is to protect investors by compelling disclosures deemed by the agency to be necessary and appropriate, then, at least this time, it has forsaken that obligation.
As noted here before, as well as in Joe Nocera's column in The New York Times, the SEC's lawsuit against Fannie Mae executives depends entirely on how you define the words "subprime" and "Alt-A," two terms for which there are no precise, generally agreed upon, definitions in the marketplace. The SEC claims that these executives had the specific intent to deceive investors about the quality of Fannie's loan portfolio by deliberately understating Fannie's exposure to "subprime" and "Alt-A" loans. As explained previously, SEC's attempt to define "subprime" may not survive a motion to dismiss, because investors and judges read financial filings very carefully. They don't cherrypick from the text. They read entire documents for context and interpret the meaning of "subprime" accordingly.
The SEC's definition of "Alt-A" is so broad as to be virtually meaningless. It designates as "Alt-A" any loan with "reduced documentation," or "reduced and alternative documentation." But those are terms could mean almost anything. "Reduced documentation" can refer to a loan for which the borrower proves his income with a W2 for last year in addition to a 1040 for the previous year. Or "reduced documentation" can refer to a "stated income/stated asset" loan, otherwise known as a liar loan.
Numbers Provide A Reality Check
The difficulty in defining these terms raises the obvious question: If everyone has a slightly different definition for a loan category, and the definitions have changed over time, how can anyone communicate? Why do people find these words to be meaningful? The answer is simple and obvious.
Everyone--aside from shills for right wing think tanks--uses a definition that can be validated by loan performance. The categorizations are supposed to identify those loans that will perform significantly worse than the rest of the mortgage market, or significantly worse than the rest of a loan portfolio. That's the information investors seek out. That's how federal regulators, who gave no clear-cut definition of "subprime" loans, validate whether a subprime designation makes sense:
The average credit risk profile of [subprime] programs or portfolios will likely display significantly higher delinquency and/or loss rates than prime portfolios.
For example, the Mortgage Bankers Association shows a decade-long pattern wherein subprime loans, always a small percentage of the nationwide total, have serious delinquency rates several times higher than that of prime loans. In June 2008, the subprime segment represented about 12% of the overall mortgage market, but the subprime serious delinquency rate was six times that of prime loans.
The Federal Housing Finance Authority looks at it the same way; it compares subprime delinquency rates (using the MBA definition) with that of Fannie and Freddie. Invariably, subprime delinquencies are always six times higher.
LPS, which uses a different definition of subprime and Alt-A, shows the same pattern. The subprime and Alt-A categories represent small percentages of the nationwide total, but their rates of foreclosure are many times higher than that for prime loans or for overall market.
Moody's shows similar results in its July 15, 2011 report, "2005 -- 2008 US RMBS Surveillance Methodology." The ratings agency estimates that, for 2006-vintage private label securitizations, deals comprised of jumbo loans will lose, on average, 7.2% of the original loan balance. For subprime deals the loss rate is five times higher, or 37.6%. For Alt-A deals the loss rate is more than three times higher, at 25.3%. At the risk of belaboring the obvious, if you lumped together the jumbo loans and the Alt-A loans into one category, investors would get a misleading view of particular risk concentrations.