By filing a civil fraud suit in mid-December against former executives of Fannie Mae and Freddie Mac, the Securities and Exchange Commission (SEC) took an action that has benefits far beyond bringing justice for investors. Among other things, it ruined the holidays of some of the nation’s most prominent liberal commentators by exposing the flaws of their narrative blaming the “unfettered free market” for the housing meltdown.
The American Prospect’s Robert Kuttner and The New York Times’s Joe Nocera spent part of their winter breaks attacking the SEC and lashing out at long-time critics of the government-sponsored entities (GSEs) who were vindicated by the SEC suit. “The SEC does Wall Street’s bidding,” screams the headline of Kuttner’s December 23 column. For his part, Nocera continued his long-running jeremiad against American Enterprise Institute fellow Peter Wallison, called the SEC’s case “weak” and charged that it was brought “in part for political reasons.” He then asked, “How better to curry favor with House Republicans than to go after former Fannie and Freddie executives?”
Never mind that the SEC, which like all other “independent” agencies is run by a 3-2 majority from the president’s party, has done the left’s bidding on issues from the “proxy access” rule that empowers union pension funds in shareholder battles (recently struck down by a federal appeals court) to mandated disclosure of companies’ alleged risk to the climate. The commission is even fighting modest bipartisan attempts in Congress to pare back the crushing Sarbanes-Oxley accounting mandates for smaller public companies.
But its lawsuit against the Fannie and Freddie executives does show that this SEC has a scintilla of integrity when it comes to its core mission of protecting investors from fraud. But even this scintilla is too much for big-government ideologues. And in that regard, they are right to be fearful of the SEC’s findings. Those findings shatter the narrative the GSEs’ apologists have settled on: that Fannie and Freddie did buy some subprime mortgage securities that they shouldn’t have bought, but only after the big, bad private sector forced them to do so in order to keep market share.
“Fannie and Freddie got into subprime mortgages, with great trepidation, only in 2005 and 2006, and only because they were losing so much market share to Wall Street,” Nocera proclaimed late last month. “The reality is that Fannie and Freddie followed the private sector off the cliff instead of the other way around.”
Yet mounting evidence, now supported by the SEC lawsuit, shows that Fannie and Freddie led, rather than followed, the private sector into the subprime market, hiding their footprints from investors and regulators. Wallison and his AEI colleague Edward Pinto, Fannie’s former chief credit officer, analyzed the GSEs’ portfolios and found that, beginning in the mid-1990s, Fannie and Freddie misclassified millions of subprime loans as “prime.” Mortgages with no down payment requirements, credit scores below 660 and/or lack of income verification were all tossed into the GSEs’ “prime” mortgage basket.
Wallison and others note that much of these purchases stemmed from “affordable housing” quotas on the GSEs from the Housing and Community Development Act of 1992, which Rep. Barney Frank (D-MA) strongly supported. In The Wall Street Journal, Wallison writes that these quotas requiring purchases of loans from borrowers at or below the median incomes of their communities rose from an initial 30 percent to 40% in 1996, 50% in 2000 and 55% in 2007.
Fannie and Freddie hid the extent of these massive purchases of subprime loans, according to Wallison, Pinto and the SEC. This misled not just the GSEs’ shareholders but the entire market about the true number of bad mortgages in the system, blinding investors and regulators to the degree of systemic risk the GSEs had created. “These material misstatements occurred during a time of acute investor interest in financial institutions’ exposure to subprime loans, and misled the market about the amount of risk on the company’s books,” Robert Khuzami, the director of the SEC’s Enforcement Division, stated in a press release.
According to the SEC suit, Freddie Mac reported its 2006 exposure to subprime loans as between $2 billion and $6 billion, when in fact the company “internally recognized” between $140 billion and $244 billion of its mortgages as (in Freddie’s own language) “subprime,” “otherwise subprime” or “subprime-like.” The SEC alleges similar deception at Fannie and notes its alliance that began in 1999 with the now-notorious Countrywide Financial, with which Fannie developed a reduced documentation loan program the firms called “Fast and Easy.” Nocera’s New York Times colleague Gretchen Morgenson also details the partnership between Fannie and Countrywide in “Reckless Endangerment,” her acclaimed new book.
Of course, according to Kuttner, Morgenson is just another player in the conservative conspiracy to blame big government for the housing crisis. “It is bewildering that they would echo the right-wing narrative and stretch their story to attribute the financial collapse to Fannie Mae’s work to broaden homeownership, much less to the government’s effort to remedy discrimination in mortgage lending,” he writes.
What’s really bewildering is why — after they’ve shown that protecting investors and the financial system is less important to them than protecting big-government entities — anyone listens to the recommendations of people like Kuttner and Nocera.