In an exhaustive study of Fannie Mae and Freddie Mac, British author Oonagh McDonald concludes that the two government-sponsored enterprises led the way in pushing down lending standards for the entire mortgage industry from the early 1990s onward. Their role was largely concealed from the public eye because they hid the ongoing erosion of lending standards in a black box underwriting system that was manipulated internally to approve loans for borrowers with bad credit and who could not be shown to be able to repay the loan. The banks and Wall Street followed their lead, according to Dr. McDonald.
When Fannie and Freddie moved deeper into subprime after 2000, it pushed private label securitizers of mortgages even deeper into the bad credit pool. Fannie and Freddie became the number one purchaser of private label securities, driving the growth of this market. When delinquencies rose, private label mortgage-backed securities (RMBS) and their associated collateralized debt obligations (CDOs) crashed in mid-2007. This set the stage for a liquidity squeeze on funding for investment banking firms as delinquencies continued to rise. As short-term lender confidence in investment banking sank, it precipitated the financial crisis of 2008. After investors began to flee from Fannie and Freddie, the federal government put them into conservatorship with explicit federal backing to preserve the flow of mortgage credit into a rapidly sinking housing market.
Note: Fannie Mae and Freddie Mac, published in hardcover in 2012, was published in a 432-page updated paperback edition in July 2013 and is available at Amazon.com and other online booksellers.
July 16, 2013
By Robert Stowe England
Dr. Oonagh Anne McDonald is a British academic, businesswoman and former Labour Party politician. Born in Stockton-on-Tees, County Durham, England, she grew up in London where she earned a master’s degree in philosophy in 1962 and a Ph.D. in philosophy in 1974 – both from King’s College, University of London.
McDonald was elected a Member of Parliament in 1976 for Thurrock, a borough in Essex County east of London. She was opposition spokesman on defense from 1981 to 1983 and then opposition spokesman on Treasury and civil service from 1983 to 1987, specializing in pensions, the City of London (the U.K.’s financial district) and financial institutions.
She heads her own regulatory and public policy consulting firm, Oonagh McDonald Consulting Ltd., based in London. McDonald has been a consultant on investment, banking and pension issues to a number of clients, including the United States Agency for International Development, the European Union, and the Asian Development Bank. She prepared a 2010 report on banking regulation for Deloitte LLP of the United Kingdom.
In 1998 she was awarded the title Commander of the Most Excellent Order of the British Empire (CBE) for services to financial regulation and business.
McDonald’s academic career includes ten years as a lecturer of philosophy at the University of Bristol from 1966 to 1976. She was Gwilym Gibbon Research Fellow at Nuffield College at the University of Oxford in 1988-1989. She edited the Journal of Financial Regulation & Compliance from 1999-2008.
McDonald has also held a number of directorships. She was previously a director of the United Kingdom Financial Services Authority (1993 to 1998). She is currently Complaints Commissioner for both ICE Futures Europe (since 2001) and ICE Clear Europe (since 2008) – both based in London.
McDonald is the author of Parliament at Work, 1989, and The Future of Whitehall, 1992. She is co-author with Kevin Keasey of The Future of Retail Banking in Europe: A View from the Top, 2002. Her latest work is Fannie Mae and Freddie Mac: Turning the American Dream Into a Nightmare, published last summer by Bloomsbury Publishing Plc of London.
Mind Over Market caught up with Dr. McDonald at her Paris consulting office recently and asked her about the findings in her latest book.
Q: What led you to take on the enormous task of researching and writing what is essentially a comprehensive history of Fannie Mae and Freddie Mac over the last two decades and a financial analysis of the fatal flaws in the U.S. housing policy and the consequences for global financial markets?
A: I was led into the project first by a good understanding of the U.K. housing market. Of course we have hot spots, which is not surprising, London in particular, because of a shortage of land for houses and therefore a shortage of housing. And so, with that background and an interest in what was going wrong, because 2008 hit a lot of us very hard. We couldn’t sell our properties. And that includes me. Naturally, I wanted to know what happened. I knew a little bit about Fannie Mae and Freddie Mac. But, once I started reading more, delving much more into the subject. Once I started delving more into market, not only did I begin to understand understood that huge damage that Fannie Mae and Freddie Mac had wrought, as well as the damage from the affordable housing ideology.
As I dug further and further into mortgage markets in the United States, including Fannie and Freddie as well, I just found found it almost an unbelievable story. It was just so fascinating because as I looked at one angle after another, I found it an almost unbelievable story. It opened up a new area. And I said to myself [about U.S. housing policy], ‘And you did that as well?’ It was just jaw dropping. A comprehensive history? I hope it is indeed, but an absolutely fascinating one to write. I enjoyed every minute of writing it.
Q: I guess part of your interest in the topic was that it had such a huge impact around the globe and not just inside the United States, as you indicated in the book.
A: Yes. I tell you the way in which I viewed it. Many have written about CDOs and credit default swaps. The way I viewed it was: stage one was the whole operation of the U.S. mortgage market and in particular the vast proportion of subprime loans. Stage two, which transferred the problem around the world, where so many banks bought either Fannie’s and Freddie’s own debt, but they issued or bought the CDOs or bought the credit default swaps, thinking they were dealing with triple-A rated [securities]. That was the way it was conveyed.
That led, of course, to the liquidity crisis or credit crunch. Then one bank would think, look at another, ‘How can I possibly trust you? I don’t know what you’ve got.’ So, you’re not going to lend to bank that you think doesn’t really have the assets-doesn’t have the assets of triple-A quality you thought they had; and, therefore you are going to lend them any money. That was the way in which it was transmitted.
And, so, when you come to Gillian Tett’s book, for example, Fool’s Gold, and The Big Short [by Michael Lewis] and other books like that, to me they are dealing with stage two of the crisis. I feel that in what I wrote, I went back to stage one.
Q: Yes, stage one, the fundamental causes of the crisis, was definitely neglected in the early books.
A: And it’s still being neglected by the regulators – because they started with the question of referring to the question too-big-to-fail and how they should deal with banks that are too-big-to-fail; whereas, the first question is: ‘Why did this happen in the first place?’ And there we are back to the basics of proper underwriting criteria and proper lending judgments.
Q: In the aftermath of the crisis, Washington seemed to have to done everything it could to avoid looking at the underlying fundamental causes.
A: Absolutely. Of course they would because I read very many of the Senate Banking Committee hearings and the Financial Services Committee hearings in the House of Representatives, where [former Democratic Representative] Barney Frank played a key role, and all they were concerned about – and frankly, this is pretty much on the Democratic side – was that mortgages should continue to be ‘cheap,’ owing to the presence of Fannie and Freddie, and that the number of minorities and people with low incomes buying their own homes should be increased.
Q: So, they didn’t really want to know and understand the fundamental causes of the crisis?
A: The certainly did not. And even the Financial Crisis Inquiry Commission carefully avoided such conclusions in spite of some of the evidence it collected. Right throughout the period that I covered, and particularly from the late 1990s onward, when representatives and groups of Senators introduced bills to try to control Fannie and Freddie, all of those were rejected and always with the same arguments, the ones I just cited.
Q: One by one you lay out the fundamental flaws with how the Enterprises conducted their business, concealed risky behavior, and built up a huge store of $2 trillion in risky loans – all without having to reveal it until the very end, when it was too late. While there are many causes for this, which single one do you consider the most important?
A: It gets very difficult because as your rightly say, there are a number of causes. I think it’s very difficult to pick out just one. But, I think we have to be very much aware of the context in which all these issues were viewed. And that was what I call the affordable housing ideology. Everyone had to pay lip service to that. If you look at [former Federal Reserve Board Chairman Alan] Greenspan’s speeches or testimony, they often start with what I regard as a ritual statement: ‘It was a good thing that credit was extended to those to whom it would have been denied in the past – or some such phrase.’
Q: How do you define the affordable housing ideology?
A: Let’s start with American dream of home ownership. As you know, many presidents throughout history have paid lip service to that idea. It was President Clinton who figured out how to make that American dream a reality for everybody – and at the same time cutting expenditure on public housing and low-cost rentals. Those two things come together in 1995 and not everyone notices that he cut public expenditure on public housing at the same time. To make the dream of home ownership a reality for everybody, homes had to be affordable. And they could only be affordable if banks would lend them the money. What President and Clinton and his Secretary of Housing Henry Cisneros did was to look for ways to reducing not really the cost of mortgages, although they would say that they had, but was the availability of mortgages.
Therefore, you had to tackle first of all the down payment. It could no longer be 20 percent. And the criteria for your flexible lending, a euphemism, was set out actually with a person who come in at the beginning and at the end. And that’s Richard Syron. When he was President of the Federal Reserve Bank of Boston, and gave us what I call the Boston Handbook, [Closing the Gap: A Guide to Equal Opportunity Lending, published in 1998], which sets out how you should approach lending to people who had no experience with mortgages and may not have a bank account and certainly not a credit rating. And if you go through that you can see what he demanded should be counted as income, for example, which could be unemployment benefits, alimony, child support, welfare income. You know if I in the U.K. mentioned any of that as sources of income to get a mortgage, every body would start about laughing. They can’t believe that was every written seriously or taken seriously. So, Richard Syron is there at the beginning as President of the Boston Fed and he comes at the end as chairman and chief executive of Freddie Mac.
This whole notion of lending to people with low incomes and the issue of fair lending to minorities and the way you achieve those goals I call an ideology because it was very hard for anyone to contradict it. Fannie and Freddie saw to that. So, if you contradicted it, as a representative in the House or as a Senator, or in any other key position, you are immediately vilified publicly, usually at Fannie and Freddie instigation, because you were trying to make mortgages more expensive for these poor people. So, that’s what I mean by the affordable housing ideology.
Q: Former Fannie Mae Chairman Jim Johnson is a major figure in your book. To what extent to you believe he is responsible for the way Congress decided to grant the Enterprises their valuable charters that ultimately made them black boxes, extremely powerful, a systemic threat, and ultimately able to engage in massive accounting fraud without detection?
A: I think, as you know, he was chairman and chief executive of Fannie Mae from 1991 onwards to 1998. Previously he had been a consultant to Fannie Mae. I think he was an extremely astute politician. I think looking at the ways in which Fannie and Freddie could operate. I think he saw them as frankly a money making machine [for senior management] and strongly influenced the ways in which the details for the charters were passed as legislation. I think it was money and position that drove it and he exploited the options at his disposal. He was chairman of the Kennedy Center, for example, at the same time he ran Fannie Mae. That’s a very nice thing to be able to do is to invite members of the relevant Congressional committees to front row seats at the opera or whatever. People love that. And so, it’s that sort of the thing. You’re one of the crowd and they say an extremely powerful man. But, of course he didn’t earn as much in terms of numbers but probably as much in terms of values as his successor Franklin Raines did. [Raines earned more that $100 million during his tenure at Fannie Mae.]
Q: The charter contained so many provisions that really insulated Fannie and Freddie from any scrutiny.
A: Exactly. First of all, they had capital level. You should never have a single percentage in legislation of that kind, which in this case actually puts into a percentage the amount of their capital. Of course, he made very sure that the Office of Federal Housing Enterprise Oversight (OFHEO), their first regulator, was particularly weak. It was too small. Of course they had be part of the federal budget for funds [and be approved by Congress] for the funds that were given to them to regulate. They never had enough staff and they never had enough staff with skills. OFHEO embarrassed itself before the accounting irregularities emerged. I thin it was about Freddie Mac that OFHEO said to Congress that their finances were perfectly satisfactory, not those precise words but words to that effect.
Q: And that was just before the scandal broke.
Q: In your book you state that subprime was an integral of Fannie and Freddie loan purchases from the mid-1990s.
A: Yes. In the mid to late 1990s, from the start what they would offer something called a mortgage product. But, it wasn’t really their own product. It was a characteristic of loans that they would buy. The loans that they would buy included first of only, loans with only a 3 percent deposit. That was Flex97 was Fannie’s first one like that. Then they moved on to expanded credit. Freddie Mac introduced Freddie Mac Gold as their first one, with a very low down payment, and also with the proviso early on that the down payment, even though it was only 3 percent, could be provided by families lending them the money, grants from employers or from a not-for-profits. So, you really didn’t have to put down 3 percent yourself. There were various ways you could fudge the 3 percent.
Q: This was not then recognized as a subprime mortgage product they were purchasing.
A: No, that’s the problem you see which marks this throughout. That’s why the book goes so much detail because that’s important to explain. They defined at the stage that subprime loans were higher priced loans or loan offered by lenders who described themselves as subprime lenders. Those were the only two characteristics [they recognized as subprime]. But, they tended to focus on the price of the loan [to define subprime.]
Q: The view that subprime is defined primarily by being a higher priced loans comes from the affordable housing ideology, since that is the view, is it not, of affordable housing advocates?
A: Exactly. That’s their big mistake. Nobody else would define a subprime loan in that fashion. And eventually, although the Office of the Comptroller of the Currency laid out the characteristics of subprime loan fairly early on, the actual agreement as to what characterized a subprime loan from the regulators point of view didn’t come about very late in the game, in about 2007. What they were looking at was the wrong thing. What they were looking was wrong thing. Looking at details of loan.
Subprime lending refers to the borrower, the characteristics of the borrower is what you look at, which includes whether or not he can pay a deposit of at least 10 percent. Typically in America it is 20 percent, as you know, for traditional loans. You should be looking at their credit history and at their debt-to-income ratio. And you go into that further with income – can they actually afford this loan – usually by considering stability of employment, for example. And the source of the loan has to be stable income from employment. But, I suppose there are occasions when somebody has sufficient private income from investments.
So, these are the characteristics, you see. Nobody focused much on the borrower but they focused on the price of the loan, and the price of the loan is not the point. And then, of course, not only did they disregard the characteristics of the borrower. But, to attract such borrowers, they introduced teaser loans, which you had a lower rate for 2 or 3 years. But, then, of course, your loan was going to be revamped, so interest rates would be higher, more than you would expect to be able to pay. The other category of subprime loans, by the bye, is no doc or low doc loans. So, it’s stated income. They only thing you’d know about that was loan to value.
Now, the other problem was the government statistics that were connected [to the subprime lending issue]. I read endless analyses by the Federal Reserve Bank to say what the proportion of subprime lending was, with all sorts of regressive models imposed on that. The problem is they didn’t have the right data. The Home Mortgage Disclosure Act (HMDA) statistics were really primarily concerned with ethnicity and gender of the borrowers.
Q: So, the laws that existed and led to collection of data on mortgage loans, did not really allow the regulators to know how much subprime lending was taking place? Apparently, the regulators did not set out on their own to collect data they would expect to tell them about subprime lending. Instead, Congress decided what data should be collected and they identified the wrong kind of data to collect and which could not allow one to track subprime lending.
A: No – because everybody focused on the wrong things. They focused on how it can increase home ownership among minorities and people on lower incomes. These were the issues that dominated, whereas they should have had a proper set of statistics that continually showed you (a) the nature of the borrower and (b) 3 months, 6 months in delinquencies and then foreclosures. That’s what our figures do in the U.K.
Q: At a special meeting of the Federal Open Market Committee in June 2005 that focused on the housing bubble, the committee members were told by Fed economists that Fannie and Freddie, for example, did not engage in buying subprime loans and specially, they did not purchase interest only (IO) mortgages. However, at the time, they were heavily involved in buying IO loans.
A: That’s what I realized, you see. Like you, I looked at the minutes of particular meetings and I read the analyses of the Fed’s economists. Then I went back and read what it was that the HMDA was collecting. When you read what they were collecting, you realized all their analyses had to be wrong. You can introduce whatever sophisticated models you wish, but if you haven’t got raw data [that is relevant] you haven’t got the raw data. That’s the end of it. And you have to have the right data.
Q: When the banking regulators decided to come up with guidance on nontraditional lending, as they called it, they did not issue the final guidance until December 2006, when the housing bubble was over. They were very late to the game.
A: As you know, to issue regulations, the four regulatory authorities had to agree and publish together. Then of course you not only had to agree to it, you had to enforce it. And there’s no indication in any thing I read, that that’s what they were enforcing because they didn’t have the proper regulations behind them. And then there’s the question of who was regulating what. Mortgage brokers – who was regulating those? That’s at the state level and they were regulated inadequately. That was a real problem. Nobody was looking at the loans that were being made and the kinds of loans that Fannie and Freddie bought through their black box underwriting system.
Q: Why is it such a problem that Fannie and Freddie never disclosed how they approved loans with their automated underwriting systems?
A: First of all, they were able and continually did plead that this was commercial information, the way in which the automated underwriting systems operated. By the end of the 1990s they were able to assess loans and give you an answer on whether or not they were going to buy the loan in 4 minutes.
Q: Four minutes?
A: Yes, it took four minutes to accept or reject a loan.
Q: And, of curse, know one really know what on earth they considered in making that decision.
A: No, because they said they wouldn’t reveal it. They said it was proprietary information.
Q: Is that a legitimate defense on their part?
A: It seemed to be what everyone accepted. But, remember, there was further confusion that could be made. Particularly Franklin Raines would always refer to loans that “conformed to their standards.” That’s actually quite important because it threw the dust in people’s eyes. Conforming simply meant that it was below the limits of the size of the mortgage balance, which had been laid down for Fannie and Freddie. That’s all ‘conforming’ meant.
Q: People probably thought that in their charter they were required to make mostly prime loans, but you point out in the book that nothing in their charter really indicated that.
A: Certainly not way back then in 1992 [when the charter was defined] would anyone consider subprime loans.
Q: The assumption in Washington among politicians and policy makers was that Fannie and Freddie were involved only in prime mortgages. The Enterprises cultivated the view, too?
A: Yes, of course and they did that by describing the loans as conforming within our standards, said in a suitable tone of voice. And, of course, remember that lenders who used the automatic underwriting systems got a reduction in guarantee fees they had to pay Fannie and Freddie when they bought the loans. So, you weren’t going to quibble too much. You got the loan off your books and you had to pay less because you used the automated underwriting.
And in the case of Countrywide, in particular, James Johnson did a deal with Countrywide around 1993 and that deal meant because Countrywide gave great impetus to subprime lending – I refer to a lecture Angelo Mozilo gave at Harvard quite early on – they had a volume reduction. So other people could pay at least 23 basis points, but Countrywide paid only 13 basis points.
Q: And that was for the guarantee fee?
A: Yes. That’s right. They were mutually dependent. Countrywide kept producing loans for Fannie Mae to buy. And because they kept doing that, using the underwriting system, the got probably a better deal than anyone else.
And, of course, the other important piece of evidence concerning the nature of the black box came from Thomas Lund, who was head of the single family mortgage division at Fannie for several years. He was indicted by the SEC [in December 2011]. I had long suspected [that Fannie and Freddie tampered with the credit rating of borrowers within their underwriting system to get more loans approved], but I couldn’t find any evidence, and I wasn’t going to use this until I did find it. Then I found it in his interview for the Federal Crisis Inquiry Commission, in which he said they ordered the credit quality of the loan that they were buying, whenever it suited them. “Whenever it suited them” is, of course, my addition.
Q: What did Lund mean when he said the ordered the credit quality of the loan they were going to purchase?
A: Well if someone came in with a low credit quality for their loan, they then changed it to something higher.
Q: So, the borrower’s credit score could be raised several points if that is what was needed by Fannie Mae to approve the purchase of the loan?
A: Yes. I think that one thinks that if you are not an IT [Information Technology] expert, here you are with an automated underwriting system and that’s been set up properly and you will go though its processes. And what perhaps the rest of us don’t think about is that you can “fix” it. You can keep altering the system. And that’s really what they did. That piece of evidence is a piece most people missed. And I think it’s very important.
Q: And by “fix” systems, you don’t mean that you can repair it.
A: No, it’s “fiddle with” or “distort” the systems.
Q: Then Fannie and Freddie accelerated the purchase of subprime loans after 1990, which is against the narrative that some have put forward that they were late to the game of subprime. Indeed, your book argues that they were really early to the game.
A: Yes. If you look at James Johnson’s $1 trillion commitment [in 1996] to housing for minorities, etc., and if you look at how they describe them as loan products, but, of course, they were not. They were the kinds of loans they were prepared to accept. They had already introduced these loans with very low down payments of 3 percent and then less, and then expanded credit, which meant lower credit of various kinds. They were already doing that. And the relationship with Countrywide started I think in about 1993.
Q: So, you can trace the origins of the subprime to the period from 1993 to 1996 – and Fannie and Freddie were leading the way?
A: Exactly. You know, other people, other lenders – those who introduced adjustable rate mortgages in the 1980s about the same time as we did in the U.K. – most of the traditional lenders were still looking at a 20 percent deposits.
Q: In the early 1990s there were subprime lenders in the private sector, but they required a large down payment and they charged a higher interest rate to cover the risk.
A: Yes, I agree. Most lenders were moving away from the 30-year year [fixed-rate] mortgages with 20 percent deposits, mortgages that seem to be venerated by consumer organizations in the U.S. and I’m not sure I understand why. But, certainly Fannie and Freddie followed that route during the 1990s. Then with the introduction of their automated underwriting system, they were able to dominate the field. So I don’t accept the narrative [that Fannie and Freddie were followers, not leaders in driving subprime.] Not only were Fannie and Freddie weakly regulated – OFHEO didn’t know half of what they were up to – but also your banking regulators were not looking at the dangers of subprime lending either.
Q: How import was President Bill Clinton’s National Homeownership Policy in 1995?
A: I know people dismiss it. But I think it was important because two things happened at the same time. Clinton was pushing for the politically popular notion for increasing homeownership by 8 million families, and particularly among ethnic minorities, blacks and Hispanics. That’s one aspect of it. The other aspect was the way in which you had to have an outstanding rating [under the Community Reinvestment Act] for lending to low-income groups and minorities and your rating was publicly stated.
That brought in some of the community organizations that would hector you and complain about you publicly and even, in the case of someone like ACORN, invade a bank branch. It could make it very difficult for people to conduct business. So, you had those problems. But the real thing was that it took effect at the same time as the Riegel Neal Act, which allowed interstate banking for the first time. So, that led to a spate of mergers and acquisitions and I put in the book some indication of the extent of the mergers and acquisitions lasting from 1998 to 2001. You couldn’t merge with or acquire with another bank unless your regulator approved of your rating for lending to minorities – the CRA rating. No wonder banks started to increase their lending. Many of them entered into partnership with various [non-profit advocacy] organizations in various states. And they promises that they made were actually very extensive promises, running into trillions of dollars.
Q: The National Community Reinvestment Coalition reported there were $4.5 trillion in commitments made as of 2007 and you indicate that most of them followed through in actually meeting those commitments.
A: Well, they followed through. But, by the time you get to 2007, you’ll find that a number of banks that made those sorts of commitments either had collapsed or had merged with other banks.
Q: You write about how Washington failed to understand the link between promoting flexible underwriting and the rise of predatory lending. Did HUD fail as a regulator of the affordable housing goals in ignoring this problem?
A: Yes, I think they did because they saw that once again it was their commitment to the affordable housing ideology as a goals setter. What they had to be concerned with was how many of these loans to low and moderate income and minority families did they actually make – that was HUD’s concern.
Q: So they didn’t consider that these could be predatory loans?
A: No, they didn’t. Remember that house prices continued to rise to May 2006. It was then the market began to falter, partly because delinquencies and foreclosures began to increase. But, much of this was hidden by continued rise in house prices. So, nothing seemed to be going wrong because people were paying their mortgages. The values of homes were rising.
Q: And the same thing seemed to apply to Congress. They could not see that by embracing this flexibility lending and affordable housing ideology they were in fact encouraging predatory lending.
A: Both houses briefly discuss predatory lending in about 2000. But, that never got anywhere. They just talked about it. Some of the states tried to bring in anti-predatory lending legislation. Fannie and Freddie were on to that and strongly opposed that. So, that kind of petered out. There was a big burst of anxiety about predatory lending and then in just disappeared from the page. And then what you get is the focus still on any action being taken to restrict Fannie and Freddie would force up the price of mortgages. And you know how intensive that lobby was and the millions they spent, the kind of protests they were able to organize against individual representatives and senators when there was a big burst of anxiety about predatory lending and then it disappears from the page. I’ve covered all that in book.
Q: You detailed the enormous cost of all the lobbying by Fannie and Freddie.
A: Not just cost of the lobbying but also the partnership offices throughout the country gave them a terrific means of attacking representatives or senators who didn’t tow the line on supporting Fannie and Freddie.
Q: It never occurred to Congress that Fannie and Freddie were in fact promoting predatory lending by the defining the types of loan products they said they wanted to buy?
A: They didn’t see that because they were absolutely focused on the increases in numbers of designated groups being able to buy their own homes.
Q: They, as you report, the strongest friends of Fannie and Freddie in Congress would engage in stinging attacks on anyone who dared question anything the Enterprises did.
A: Yes. You had to be pretty tough and pretty determined to seek to introduce the number of bills that they did [to reform Fannie and Freddie.]
Q: One thing that struck me from your book was the anecdote about Fannie Mae spent $2 million in 2005 to hire the consulting firm of DCI in Washington, D.C. to successfully persuade many of the Republicans backing a GSE reform bill by Nebraska Republican Senator Chuck Hagel to abandon their support. [See pages 273-274.)
A: That’s what happened. You see it is just amazing the efforts they went to. And, of course, they went to such efforts because, you know, the whole of their accounting and governance procedures were all designed for earnings management – to hit particular targets on which their bonuses were based, obviously for the most senior executives but also for executives at other levels.
Q: Even though the accounting crisis in the early 2000s bared on the earnings management that was going on at Fannie and Freddie, members of didn’t seem to fully appreciate what they had learned. They didn’t seem to understand the significance of that.
A: No, they didn’t. You do find that most of them don’t read the reports and don’t even read perhaps the Congressional Research Service that they have.
Q: But, they held hearings on the accounting scandals that were attended by members of the relevant committees.
A: Yes, that’s right. But, whether they had read the papers [is another thing]. I quote in the book [Massachusetts Democratic Representative] Barney Frank famously dismissing the hedge accounting issues as a kind of alchemy and not relevant. But, actually, when you go through accounting irregularity accounting reports, which I think are very good – I love to read all the emails. Deloitte Touche did [OFHEO’s forensic audit of Fannie Mae] and sometimes I do work with Deloitte in London and so I know what a huge amount of work was involved in that they had to go through millions of papers. Anyway, it was quite clear that it wasn’t just a question of hedge fund accounting – that was part of it – but the governance issues and the whole management of Fannie and Freddie was at best incompetent and at worst thoroughly dishonest. Everything was done to keep that the return on equity steady to keep the shareholder buying.
Q: The huge accounting scandals and crisis arose and passed and no reform was enacted.
Q: In any normal situation, scandals of this magnitude would lead to reform.
A: Exactly. I know. Well, you think how quickly after Enron that Congress enacted the Sarbanes-Oxley Act.
Q: You describe OFHEO as ultimately a regulator that could not measure up to the task of conducting proper oversight of the safety and soundness of the Enterprises and unable to preventing accounting fraud and other abuses. Why was that the case?
A: I think it was really for two reasons. One [was in] the way in which they were set up. And secondly, because they were starved of finances. They had too small a staff and completely lacked the kind of technical expertise that they would have required to understand financial accounts. That was a situation James Johnson deliberately brought about.
Q: Was that because of Johnson’s key role in designing the legislation that set up the regulation of Fannie and Freddie – the Federal Housing Enterprises Financial Safety and Soundness Act of 1992?
A: Yes, exactly.
Q: In your book you essentially agree with the estimates of risky lending by the Enterprises made by Ed Pinto, former chief credit officer of Fannie Mae, in his 2011 forensic study. He estimated there were $1.8 trillion in subprime and Alternative-A loans held by the Enterprises on the eve of financial crisis of 2008. He also estimated that 26.7 million of the universe of 55 million mortgages that can be classified as risky or subprime were loans were tied to federal government policy. Why is this of significance to the financial crisis of 2008?
A: Bearing in mind that your mortgage-backed securities (MBS) and CDOs incorporating mortgage-backed securities and your credit default swaps were much more risky than they were thought to have been. Suppose, say, that subprime mortgages were only 5 percent of the total mortgages. Such a small percentage going into delinquency and foreclosures – that I think could have been a risk that would have been pretty easily handled by banks. But the fact you’re getting to nearly half of outstanding mortgages means that there were far, far riskier loans involved in the various derivatives products than anybody had expected.
The faults in these were beginning to appear and that undermined confidence. And as you know, those CDOs in particular, as well as Fannie and Freddie’s own debt and MBS were distributed throughout the world. That’s really why they went into conservatorship in September 2008 because [Treasury Secretary Hank] Paulson was under huge pressure from foreign banks and from central banks, particularly in Asia, to protect bondholders at the expense of shareholders. So, that’s why the size of the subprime market is important. Not only was it much, much larger than anyone thought at the time, but it also meant you really had no idea of the risk you had taken on in buying MBS and in buying CDOs that should not have been tripled-A rated.
Q: The Securities and Exchange Commission opened wide a window in the black box of risky lending at the Enterprises when in December 2011 they announced they were bringing charges against six former executives of Fannie and Freddie. Why is the development so important and what does it tell us about the Enterprises?
A: Well, I think it tells you the truth about the Enterprises. If you bear in mind particular what I said about Thomas Lund [at Fannie Mae, one of the six executives charged by the SEC]. I’ve wrote an article actually for the City A.M, a free newspaper that circulates in the City of London [in response to the fact that] the U.S. Attorney General for the Southern District of New York] issued a complaint [October 24] against Bank of America because they fraudulently sold subprime loans to Fannie and Freddie, who then, of course, appear as the two “innocents abroad” I’ve called them [in my op-ed in City A.M.].
Q: Of course, you do not really think that was not the case.
A: But that’s how they look. But, they were actually buying these loans, so how could you possible say that [they are the innocent parties]? You will recall that Bank of America bought Countrywide, [the source of the loans in the case], and wished to God they hadn’t.
Q: Of course it was not Bank of America who originated the loans.
A: Right. But, how can you say fraudulently sold them when you should rightly say most of the must business was done by Countrywide and it is well known and established that Countrywide and Fannie Mae were in a partnership for many years and it was reaffirmed in 2006.
Q: Aren’t these loans that Fannie Mae bought from Countrywide the loans that they wanted? Fannie set the terms and approved them in their underwriting system.
A: Yes, they did. And as I told you, they reduced the cost of guarantee fees to get more business from Countrywide. Of course, in the book I refer to the friends of Angelo [Mozilo], co-founder and former chairman of Countrywide. [California Republican Representative Darrell] Issa, chairman of the House on Oversight and Government Reform, has published a lot of evidence about [the extent to which the Friends of Angelo program operated in Washington, D.C. to benefit well-placed members of Congress and others with low cost mortgages.]
Q: You quote approvingly testimony by Julia Gordon of the Center for Responsible Lending, which she gave in February 2011 to Congress, stating that federal housing programs, in the end, created more pain and suffering than anything else on those it has sought to help. How do you measure the harm done?
A: It’s difficult to measure unless you went through and toted it up – the numbers of people who [have been put into] foreclosure because of the loans that they took out – or, of course, the problem of no-recourse loans. People in Europe I have to say just roar laughing when I mention to them such loans – or look at me as if I had grown two heads.
[A lot of] mortgages are still underwater and most of them are still paying. If you don’t have to move for any family reason or employment reasons, you might as well sit it out. Some are only now 5 percent underwater. It depends of course where you are.
I don’t think you could count up numbers. But, I think more pain and suffering. Just use your imagination. You struggled to buy your home and it is a home and it’s yours and all the emotional feelings that go with that. You furnished it. You’ve made it your own. It’s the first home that you or any other members of your family ever had – certainly your parents or grandparents. And, then it’s all taken away from you. So, you’ve lost all that money and you’ve lost your home. Well, we can easily imagine what that means. That’s why I put it in. I thought she had expressed it quite well. I thought it was good for Congress to hear it, so they that would hopefully begin to understand the enormity of what they had done. But, of course, what they have done, some of them is to shift the blame to Wall Street.
Q: Do you wonder if members of Congress actually realize what they have done? Or, is it that they know the harm they have done and they are trying to deflect the outrage?
A: I would offer they are trying to deflect [the outrage]. They ought to have known that if you lend money to people you now can’t pay it back, that this is going to end in tears. It may not be your tears – but in other people’s tears.
Q: You do point out that some of the statements that were made by people like Barney Frank, who presented himself as deeply knowledgeable on financial markets, really did not understand some of what was going on.
A: He didn’t understand most of it. As you know, I was an MP [Member of Parliament], so I do understand the politics of these things. Although it’s in somewhat a different context, there’s a sense that the politics are all the same. And when I read all of his statements, as well as the statements, questions and the views expressed by so many members of his committee, it was just distressing that they refused to see what they had done.
And yes, they will shift the blame to Wall Street. People generally don’t like banks and so bank bashing is a very popular diversionary sport for politicians. So, that’s why I include that testimony [from Julia Gordon] because I wanted to make it clear you can’t do it like this. And, and if you do, you cause people to suffer and you should understand that. And there are other ways of doing it – of helping people have homes, as [Treasury Secretary Timothy] Geithner said actually. He referred to affordable rented homes suitably located, as well as to people buying their own homes when he did his first white paper [in February 2011] on what to do with Fannie and Freddie.
Q: And, on that point, you state in your book that Fannie and Freddie “must be phased out of existence” and steps taken to make sure they are never reconstitute. Why is doing anything less so wrong?
A: As you know, Fannie and Freddie are making a profit, which Geithner [last year] rightly granted a way of paying back towards what they are being bailed out with taxpayers money. I think the problem, first of all, is that you don’t actually need them. No European country or advanced country has anything like this to support the mortgage market. Fannie Mae is left over from the 1930s – although Freddie Mac was brought into being much later. It’s a left-over entity and [in the book] I quote from [former Fed Chairman Alan] Greenspan as well to support that contention. [Fannie Mae was needed back then] when banks were small and fragmented and could not provide more loans just on the basis of bank deposits. Now, of course, the situation has completely changed. Securitization has been introduced. But, I guess those of us who are outside [of the U.S.] are little puzzled. When you study the history of it, you can see why they are still there – but, apart from that, we can’t see the necessity for securitization to be through the purchase of loans by two bodies like this. The point is you can just securitize the loans on the package to other banks – either within country and outside it. That’s the way in which we do it.
And I think particularly in the current circumstances, whilst they are still there and continue to make a profit, I think the temptation would be to use them for similar purposes all over again.
Q: And then history would repeat itself.
A: A repeat performance, yes. That’s what really worries me. The simple argument [against keeping them] is that they are not needed. If the do exist, then the temptation may be to use them for somewhat similar purposes.
Q: Steps were taken last fall  to make them pay down their portfolios faster. And now, all of their profits go to Treasury. Are those two steps in the right direction?
A: Yes they are. What happens if Obama gets a new set of advisers and housing becomes an issue again?
Q: You write, “It is simply not possible, however desirable, for everyone to own their own home. The American experience over the 13 years from 1996 to 2008 amply demonstrated that. For once, the lessons of history should be surely learnt.” That is a very emphatic declaration you make at the end of the book.
A: Yes. I think it’s emphatic partly because it isn’t possible for everybody to own their own home. They just do not have the money or enough money, and are not capable of earning enough or their earnings are only intermittent – if you are an actor or you work as a builder or something like that. You don’t have consistent income or you don’t have enough income.
I do see a need to provide housing, which would have to be rented housing. We find this [to be true that some people can only be renters] in the U.K. and most other countries, too, for a variety of reasons: people simply can’t own their own homes for a variety of reasons. They don’t have enough money. You have to look at hopefully a good quality rental situation. I don’t object to social housing or public housing. And, I do think others can do shared equity, where you pay rent, and part of the rent goes toward the purchase of part of the value of the property.
Q: That’s something the people in America might want to consider.
A: Yes, I think so. Then you can sell your property and take the capital with you, which you can then put on deposit on some other property.
Q: And the person who invested in the shared equity would take some of the gain.
A: Yes, that’s right. I think we just have to look and be aware that there are other things that can be done. We also have to remember that Clinton introduced this clever idea [of promoting home ownership] because at the same time he cut expenditures on public housing.
Q: Now, of course we want to see a private system. You talk about what that private securitization seems needs. And we should be thinking about that. It should be safe and sound.
A: One of Clinton’s last acts was to sign the Commodity Futures Modernization Act, which meant that derivatives were not regulated, although that’s beginning to change. I think what we need is better regulated banks, properly regulated banks, better regulated derivatives and properly keeping checks on lending so lending is done with proper criteria. In a funny way, I sometimes think that regulators are always discussing liquidity and what regulatory capital should consist of and what model you should use, because all of that is intellectually challenging and fascinating. But what they need to do is to get back to is basics. One of primary function of banks is to lend money. Banks must be sure they lend money properly and carefully.
Q: And yet bank supervisors did not prove to be capable of proper prudential oversight of bank lending in the years leading up to the crisis. They failed that test.
A: They failed that test because they didn’t understand what the problem was. There was political pressure on them not to see the problem. They had to refocus their attention on whether or not money being lent to specific groups.
Q: There was never the courage to point out pitfalls and dangers of that approach.
A: From what I have seen, your regulatory structures in the U.S. are a total mess. The bank examiner approach is better, as is attending to basics like lending. I think [bank supervisors and examiners] should be looking at lending because it’s basic. Most bank failures are caused by [bad] lending.
Q: Bank management should also be focused on the quality of lending – and not just the regulators, don’t you think?
A: Absolutely, yes. The should set out to make criteria for what you think is
sufficient debt-to-income ratios, loan-to value, and credit quality. When you look at lending taking place under CRA, you are talking of low to moderate income where the income could be 50 percent of the median income for that area and for very low incomes, at 30 percent of the media. So, you’re talking about very low incomes indeed. Look at the definition – they are extremely low incomes. They aren’t going to have [financial] cushions if they suddenly lose their jobs. Counseling them until they are blue in the face is not going to create money to put down.
Q: Thank you for discussing your book and best of luck with the paperback edition.
A: Thank you.