Monday, March 21, 2011

"Fannie and Freddie Investigations - Let the Chips Fall Where They May"

Sydney M. Williams

Thought of the Day
“Fannie and Freddie Investigations – Let the Chips Fall Where They May”
March 21, 2011

An article in the weekend edition of the Wall Street Journal, “Fannie and Freddie Probe Faces a Snag,” caught my attention.

A number of executives at the two GSE’s, including both companies former CEOs, Daniel Mudd of Fannie Mae and Richard Syron of Freddie Mac, have been served Wells Notices. (A Wells Notice indicates that the SEC staff is preparing to recommend civil charges against the person served, and provides that individual the opportunity to persuade regulators against such action.) The charges refer to the possibility (I would argue probability) that they (the management) failed to disclose the growing exposure to riskier mortgages between 2006 and 2007. The “snag” refers to the allegation by the defendants that any and all disclosures were reviewed by the firm’s regulator, the Federal Housing Finance Agency (FHFA.) The SEC must now prove that not only did the two agencies mislead investors, but they misled the agencies overseeing them, a difficult thing to prove in that David Felt, the former deputy general counsel of the FHFA said his agency had reviewed the disclosure issues and concluded, in January 2010, that they did not have sufficient evidence against any individuals.

The problem stems from the complicit and explicit role Congress played in perpetrating the collapse of the housing and mortgage markets. A principal culprit was the unintended consequence of the Community Reinvestment Act (CRA.)

The CRA is a federal law designed to encourage commercial and savings banks to help meet the needs of borrowers from all segments of their communities, including low income neighborhoods. The Act was passed in 1977. A number of changes were made to the Act in 1989 and throughout the 1990s. Attempts to rein in its influence failed in 2005. As Robert Rubin stated in 1995, the principal purpose of the Act was “to deal with the problems of the inner city and distressed rural communities.” In 1999, with the enactment of the Gramm-Leach-Bliley Bill that repealed the Glass-Steagall Act, any bank holding company wishing to be designated a financial holding institution would have to comply with the guidelines of the CRA. On signing Gramm Leach, President Clinton said, “that, as we expand the powers of the banks, we will expand the reach of the Community Reinvestment Act.” This Act abetted the proliferation of subprime mortgages.

In 2007, as the slide in the housing and mortgage markets were well underway, Federal Reserve Chairman Ben Bernanke suggested increasing the presence of Fannie and Freddie in the affordable housing market to help banks fulfill their CRA obligations by providing them with more opportunities to securitize CRA-related loans.

The point is that Congress, five administrations and myriad regulatory agencies aided and abetted the environment that led to speculation in housing, by encouraging those to buy houses who had limited ability to repay the loans and who were dependent on continuing rising prices. The relationship Congress had with the two GSEs, Fannie and Freddie, was truly symbiotic – the larger they became, the greater their donations to their benefactors in Washington. The victims were not only lower income home buyers, who had been sold a false promise – an Eldorado of ever rising prices, and taxpayers who had to step in to pick up the pieces, but investors who were lied to by managements operating behind the shield of regulators.

This is not to absolve banks for deceptive practices, nor mortgage brokers or real estate agents whose desire to book a transaction took priority over prudence. It is not to excuse consumers who came to expect annual increases in their home values as a reason to tap the improved value for ephemeral consumer items. There are very few people or groups who do not share some blame. But regulators and our elected officials in Washington were as guilty as anyone – and yet have been the least scrutinized and the least blamed.

Will investigations into misconduct at Fannie and Freddie grind to a halt because of the “snag” that any indictment might shed light on the role of regulators, which, in turn, could lead back to Congress? I hope not. A failure to persist will be a disservice to our system of democratic capitalism. Those who work hard, save and invest have been largely ignored, yet they are integral to our future well being. Increasingly, the demand by borrowers exceeds the ability of Americans who invest; so we have had to go offshore to find buyers of our bonds and assets. As risks to our system have become more apparent, we have, in the last several months, now become dependent on the Federal Reserve to purchase Treasuries – a form of debauching the currency. If they had not done so, interest rates would be considerably higher, negatively impacting our deficit, but at least providing a more realistic return to the elderly and the prudent, and a better reflector of embedded risks.

Capitalism, by definition, relies on adequate sources of capital. Very little that Congress or Washington has done over the past few years has appealed to that maxim. Congress is very good at spending money, especially on entitlements – Obamacare being the most recent and most egregious example – but they having shown little interest in increasing savings, despite the growing numbers who are approaching retirement age. Economic growth does not operate in a vacuum. It relies on investors and risk takers.

The investigations into Fannie and Freddie should continue; the chips should be allowed to fall where they may.

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