The Myth of Fannie Mae, Freddie Mac, Barney Frank, the Housing Bubble and the Recession
The Office of Federal Housing Enterprise Oversight (OFHEO) was an agency within theDepartment of Housing and Urban Development of the United States of America. It was charged with ensuring the capital adequacy and financial safety and soundness of two government sponsored enterprises—the Federal National Mortgage Association (Fannie Mae) and theFederal Home Loan Mortgage Corporation (Freddie Mac). It was established by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992.
OFHEO was managed by a Director, appointed by the President and ratified by the Senate. The final Director was James B. Lockhart III, assuming the position during a time of crisis as Acting Director April 28, 2006, when nominated, confirmed to the post on June 15, and sworn in June 26, 2006. The previous Director was Armando Falcon, Jr, confirmed September 29, 1999, and forced to resign February 4, 2003, over the release of critical oversight reports However, the White House withdrew the nomination of his successor and he served as Director beyond the end of his term as provided by law.
On July 30, 2008, the Housing and Economic Recovery Act of 2008 combined OFHEO and the Federal Housing Finance Board (FHFB) to form the new Federal Housing Finance Agency (FHFA). OHFEO director James B. Lockhart III oversaw the agency at its conception, but departed after less than a year.
OFHEO also published the house price index.
Within three weeks of his appointment in May 2006, Lockhart published a report detailing the numerous missteps by Fannie Mae’s previous management and signed a consent agreement that restated Fannie Mae’s extra 30% capital requirement and capped the growth of its investment portfolios for the first time. In a joint press conference with the SEC Chairman, Chris Cox, Lockhart announced a $400 million fine. Shortly thereafter, he obtained Freddie Mac’s voluntary agreement to likewise cap the growth of their portfolio.
We now know the tale in 2006 and 2004 was a LIE:
Fannie Mae "Accounting Scandal" Discredited In Court
After eight years of litigation, the plaintiffs came away with nothing. No damages awarded, no trial, nothing other than a summary verdict against them because, the judge ruled, no evidence of any substance had been uncovered and presented.
It was not as if plaintiffs' attorneys had left any stone unturned in their quest for any kind of evidence to prove that three former Fannie Mae executives had committed securities fraud. "The volume of information exchanged in discovery was enormous," wrote Judge Richard Leon. "The parties produced nearly 67 million pages of documents, deposed 123 fact witnesses, and engaged 35 expert witnesses." And then, in a gentle swipe at Fannie Mae's regulator, he noted how, "The discovery process was unnecessarily prolonged by OFHEO's repeated and stubborn assertion of privileges that had to be litigated up to the Court of Appeals."
It was kind of pathetic really, hundreds of millions of dollars in legal fees wasted in a fruitless search for something as elusive as the Treasure of Sierra Madre, or Saddam's nuclear weapons lab. But it was also obvious that the plaintiffs' lawyers, representing pension funds that held Fannie Mae stock in the early 2000s, were deluding themselves. Any competent lawyer could have seen, from the onset, that the case would go nowhere. I figured out in about an hour, after casually perusing some public documents two years ago.
Fannie's "Accounting Fraud" = Saddam's WMD
"The narrative of plaintiffs' securities fraud claims against [the former Fannie executives] not surprisingly, flows directly from an OFHEO investigation of Fannie Mae," wrote Judge Leon. Apparently the plaintiffs had a hard time believing that the Chairman of the S.E.C., and the Director of the Office of Federal Housing Enterprise Oversight would deceive the Courts, Congress and the public with their patently bogus allegations of securities fraud. After all, Fannie Mae settled with the government for $400 million! Former Fannie executives agreed to millions in clawbacks of their bonuses! Where there's smoke there's fire! There must be something there!
Except the government's deception was really, really obvious. Remember how, 10 years ago, U.N. inspectors eviscerated U.S. "intelligence," on WMD in Iraq, and the Bush Administration, which refused to consider the substance of the inspectors' findings, kept saying there was WMD and invaded anyway? The Bush Administration pulled the same kind of stunt when it accused Fannie Mae of committing securities fraud, even after the written record showed that such a fraud was virtually impossible.
Judge Richard Leon's rulings provide full exoneration of former CEO Franklin Raines, former CFO Timothy Howard and former Controller Leanne Spencer. The Judge was not asked to rule on the original charges brought by SEC Chairman Christopher Cox, and OFHEO Director James Lockhart, but it's impossible to read his decisions without making the obvious inference, that the charges brought by the government were a sham, which is why the government stonewalled for years thereafter. It's a felony to lie to or deceive Congress, and the statute of limitations for indicting Cox and Lockhart has probably passed.
Why The Case For Fraud Would Never Hold Up
Which is why it's all but impossible to make a case for fraud if the defendant relies on the company's outside auditor, KPMG, which had reviewed the relevant accounting and knowingly signed off on it. And then the regulator, the OFHEO, reviewed the relevant accounting and knowingly signed off on it, before assuring Fannie's Board that Fannie's accounting is proper. Also, if the matter is fully disclosed in contemporaneous S.E.C. filings, then the defendant is pretty much inoculated from charges of fraud. The coup de grace was the release of Fannie Mae's restated financials, which showed that the alleged "$11 billion loss" had disappeared.
If you looked at the substance of the government's case, or rather, the absence of substance, it was obvious that the allegations of securities fraud had been fabricated out of thin air, that all of the characterizations about financial manipulation were flimsy at best.
Let's go through what a plaintiff needs to prove, and then go through the documents that showed that the allegations by the S.E.C. and OFHEO were bogus. To prevail in a case of securities fraud (what the lawyers call a 10(b)(5) violation) you need to prove six elements:
(1) a material misrepresentation or omission by the defendant;
(2) "scienter" [or in plain English, that a person knew of, or showed reckless disregard for, the material misrepresentation] ;
(3) a connection between the misrepresentation or omission and the purchase or sale of a security;
(4) reliance upon the misrepresentation or omission;
(5) economic loss; and
(6) loss causation.
Smoking Guns That Demolish The Government's Case
Here's a list summarizing the key documents or events, with further explanation below:
1) Rudman Investigation: In February 2006, a year-long independent investigation, led by former Senator Warren Rudman, then a partner at Paul Weiss Rifkind, virtually inoculated top Fannie executives from any allegation of scienter;
2) OFHEO Report: A May 2006 OFHEO report, which excoriated Fannie's accounting, also conceded that KPMG had signed off on what was being done. The OFHEO based its claims on its own interpretation of accounting rules, not that of an outside accountant.
3) S.E.C. Complaint: The June 2006 S.E.C. complaint complaint against Fannie Mae alleged securities fraud, but failed to lay out facts establishing all six necessary elements.
4) Cox/Lockhart Testimony: On June 15, 2006 Cox and Lockhart appeared before Congress and alleged that Fannie had "concealed" an "$11 billion loss," and offered testimony that was, to put it charitably, highly misleading, or more bluntly, dishonest.
5) Fannie's Restated Financials: When Fannie Mae released its restated financials in December 2006, it became obvious how the OFHEO and the S.E.C. had divined the so-called "$11 billion reduction in capital," which had always been hiding in plain sight. In order to show the "loss," on the books, accountants had to increase equity by $10.4 billion, so net equity increased by $4 billion. When restated, the financial reports showed that every financial metric--earnings, cash flow, equity--improved.
In an nutshell, any financial analyst of reasonable competence could have figured out what was going on, based on the original financial statements filed under Raines' watch. The FAS 133 adjustments were fully disclosed as adjustments to equity. (See fuller discussion here.)
6) OFHEO Administrative Charges: Afterwards, on December 18, 2006, the OFHEO sued the three former Fannie executives for committing accounting fraud. Since the lawsuits constituted "administrative charges," the adjudication of the matter was, to my knowledge, something unique in Anglo Saxon law. The complaint was signed by OFHEO Director James Lockhart, who was also designated to make the final ruling on the matter. (The Administrative judge heard evidence, but he merely made a recommendation; Lockhart was the final decider.) From the start, the OFHEO stonewalled about disclosure of any of its relevant records.
7) Frivolous Motions: The private lawsuit, initially filed in 2004, was relentlessly besieged by frivolous motions filed by a non-party, the OFHEO, which insulted everyone's intelligence by its refusal to hand over key documents and its demands to keep everything under seal. These tactics should have been a tipoff of what the OFHEO was trying to hide. See also here, here, and here.
If you read Judge Richard Leon's decisions--here, here, and here--it becomes obvious that nothing drawn from the OFHEO and S.E.C. investigations could withstand scrutiny. What are the chances that the Inspector General of OFHEO's successor agency, the Federal Housing Finance Agency, would ever investigate the waste, fraud and abuse that resulted from the government's attempts to conceal Lockhart's dirty laundry? I wouldn't bet on it.
One other little detail that may not have much to do with anything. James Lockhart was George W. Bush's buddy at prep school and college.
Top Dems Break With Treasury Over Fannie, Freddie Losses
In Thursday's remarks Greenspan seemed to side Fannie and Freddie's competitors.
"The strong belief of investors in the implicit government backing of the GSEs does not by itself create problems of safety and soundness for the GSEs but it does create systemic risks for the U.S. financial system as the GSEs become very large," he said.
Over the past few years Greenspan has moved from some gentle nudging of Fannie Mae and Freddie Mac to Thursday's outright criticism. In particular, he singled out Fannie's and Freddie's giant portfolios of mortgage-backed securities as being too risky to back up the mortgage finance system in the event of a crisis, and argued that only ultra-safe, ultra-conservative U.S. Treasury bonds would do the trick.
"Indeed, only such highly liquid portfolios would be consistent with (government-sponsored enterprises') mission of providing primary mortgage market liquidity during a crisis, particularly a financial crisis," Greenspan said.
The outcome of this debate has important implications for consumers. In the short-term, if Congress reins in Fannie and Freddie by putting stricter limits on the size of the portfolios they can build, the amount of mortgage financing they can issue, and the kinds of securities they can hold in, this could -- all else being equal -- mean their cost of borrowing would rise and the cost of home mortgage loans could go up, resulting higher mortgage rates for home buyers.
In the longer run, if such a move were to make Fannie's and Freddie's investment base less risky, it could mean that the U.S. financial system would be able to weather storms such as a recession or a big pullback in the housing market without any kind of meltdown.
NOTE: the year is 2005 and Greenspan is firmly behind PLS and not fannie and freddie. He thinks the PLS is the way to go and is angry at fannie for not opening up to more loose standards.
At the same time that Greenspan was speaking, Fannie Mae was deemed "adequately capitalized" as of March 31 by its chief regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), with a projected surplus over its minimum capital requirements sufficient to absorb the uncertain impact of accounting errors on its capital.
OFHEO, which oversees both Fannie Mae (Research) and Freddie Mac (Research), had classified Fannie as "significantly undercapitalized" as of Dec. 31. By law, the regulator classifies Fannie and Freddie as adequately capitalized, undercapitalized, significantly undercapitalized or critically undercapitalized.
Fannie Mae and Freddie Mac were victims, not culprits
Posted by: Aaron Pressman on September 26, 2008