Financial Reform Overlooks Fannie Mae

[BRIEFING.COM - Robert V. Green] The financial reform bill agreement reached by the House and Senate conference committee on Thursday, June 24, 2010, is one of the most major and broad sweeping changes in the financial industry in history. The most striking aspect of this bill, however, is the complete absence of any regulation of Fannie Mae and Freddie Mac. Instead of recognizing the principal role that the agencies played, the motivation behind the bill attempts to demonize unnamed "companies" that created the subprime mortgage mess. Fannie and Freddie were two of the biggest of these "villainous companies."

The Financial Reform Bill

The Financial Reform Bill is broad reaching and covers many aspects of the industry, including regulations on the hedge fund industry for the first time. In addition, new regulations for banks and derivative securities will limit the amount of risk that financial institutions can assume.

For the most part, these changes appear to be beneficial in the long term, particularly the trend back towards separation of commercial banks and investment banks.

However, the most striking aspect of this legislation is how it completely avoids any discussion of the GSEs chartered by Congress, principally Fannie Mae, whose mortgage purchasing activities were the root cause of the financial crisis.

What the Bill Says About Mortgage-Backed Securities

The bill institutes new requirements on how mortgage-backed securities (MBS) can be created. The biggest change is that issuers of MBS will have to retain a minimum of 5% of the credit risk associated with the underlying assets. Exactly how this 5% of risk will be retained is not clear at the moment.

There is an exception to this "skin in the game" rule, where underlying assets meet certain defined standards. The exact details of this loophole are not known at this moment, as the resolution reached by the joint-committee has yet to be actually written into law.

Why Change Securitization Rules?

The motivation for the new regulations on securitization of mortgages was best expressed by the U.S. Senate Banking Committee's "Summary: Restoring American Financial Stability" dated May 28, 2010:

Companies that sell products like mortgage-backed securities are required to retain a portion of the risk to ensure they won't sell garbage to investors, because they have to keep some of it for themse

Why Change Is Needed: Companies made risky investments, such as selling mortgages to people they knew could not afford to pay them, and then packaged those investments together, called asset-backed securities, and sold them to investors who didn't understand the risk they were taking. For the company that made, packaged and sold the loan, it wasn't important if the loans were never repaid as long as they were able to sell the loan at a profit before problems started.

This led to the subprime mortgage mess that helped to bring down the economy.

The irony of this statement is that the dominant player in the mortgage industry, including the subprime sector, was Fannie Mae, a "company" controlled by the U.S. government through mandates issued by the Department of Housing and Urban Development (HUD).

Fannie Mae never originated mortgages, but it did purchase mortgages from originators and then packaged those mortgages into "asset-backed securities." As such it could clearly be called one of the players for whom the word "companies" applies.

Fannie Mae and Freddie Mac never originated mortgages.

Both agencies purchased individual mortgages from originators and then either held those mortgages in their portfolios or packaged them into MBS securities that are then sold to investors.

The types of individual mortgages that Fannie Mae was legally allowed to purchase were subject to defined rules to ensure credit-worthiness. These types of loans are called conforming loans.

However, Fannie Mae and Freddie Mac also provide a service called guarantee services, where the agencies, in essence, provide insurance on a pool of mortgages.

These "insured" pools of mortgages were not subject to the same types of rules as conforming loans.

Both Fannie Mae and Freddie Mac began to provide guarantee services for pools of riskier mortgages such as Alt-A and subprime mortgages from originators in large quantities starting in 2005 and peaking in 2007.

It was these "insured" pools of mortgages that were at the root of the housing problem, and by ripple effect, the financial crisis.

Fannie Mae's Lender Swap Transactions
An illustration of how Fannie Mae facilitated the subprime mortgage market can be seen by examining the operation of what Fannie Mae called a "lender swap transaction." In a lender swap transaction, an outside company originates individual mortgages and pools a large number of them into a single MBS security.

In the swap agreement with Fannie Mae, that lender then submits the pool of mortgages to Fannie Mae in exchange for a Fannie Mae issued MBS, which is backed by the same loans. Fannie Mae then would take the pool of loans provided to it and place those loans in a trust fund, which was in essence an off-balance sheet asset.

Each MBS involved in the lender swap transaction was placed in a separate and distinct trust, with Fannie Mae as the trustee. As principal and interest payments were made on the loans by the mortgage borrowers, the originating lender submitted those payments to the Fannie Mae trust fund, retaining a portion of the payments for themselves.

Fannie Mae would then take the income stream from the trust, retaining a portion for themselves. The remainder would then be used to the make the interest payments on the Fannie Mae MBS that was issued in exchange for the pool of loans that now reside in the trust. For the lender, the swap transaction allowed a pool of subprime mortgages to be exchanged for a Fannie Mae MBS, which carried the implied credit and backing of the U.S. government.

For Fannie Mae, the much higher interest rate payment stream from the swapped pool of mortgages made for an extremely profitable arrangement. In these prearranged swap agreements, Fannie Mae did not have to create the pool of mortgages themselves, as they had to do with individual mortgages they purchased.

Nor did they have to sell the packaged MBS on the market as they did with their own MBS packaged securities. The swap agreements represented fast arrangements of "flipping" a pool of mortgages acquired from a lender into a Fannie Mae MBS that was instantly "sold" back to that very same lender.

The lender could then take this Fannie Mae branded MBS and either hold it, sell it, combine it with other mortgage pools to create new securities, or divide the MBS into new "tranche" securities that could be sold at the retail level. In essence, Fannie Mae could be viewed as having "laundered" a pool of subprime mortgages into a Fannie Mae MBS, with the full credit rating of other Fannie Mae MBS securities.

Scale Of Fannie Mae's Subprime and Alt-A Guarantees
The scale of Fannie Mae's involvement in the Alt-A and subprime market was extremely large. A Washington Post article published in June 2008 estimated that Fannie Mae and Freddie Mac purchases of subprime loans totaled 49% of the entire subprime market in 2003, 44% in 2004, 33% in 2005, and 20% in 2006. According to Fannie Mae's 2007 10-K, the total volume of Alt-A and subprime mortgages held in these separate MBS trusts, but guaranteed by Fannie Mae was $318 billion.

In December 2008, former Fannie Mae CEO Franklin Raines testified at the House Committee On Oversight And Government Reform hearing regarding Fannie Mae and Freddie Mac. Mr. Raines testified that $17 billion of the $18 billion loss recorded by Fannie Mae in the first three quarters of 2008 was attributable to the guarantees standing by Fannie Mae issued MBS. Mr. Raines further testified that the losses were attributable "in large part to Fannie Mae's guaranteeing of certain high risk loans, largely so-called 'Alt-A' loans and, to a lesser extent, subprime loans."

In other words, Mr. Raines, the former CEO of Fannie Mae (1999-2004), places the blame for Fannie Mae's losses directly upon their assumption of risk on non-traditional loans. The Senate Committee on Banking, Housing, and Urban Affairs places the blame on "companies."

The Unnamed "Companies"
The largest originator of home mortgages was Countrywide Financial. Countrywide was also one of the largest originators of Alt-A mortgages and the top servicer of subprime mortgages. As such Countrywide is often viewed as one of the companies at the heart of the housing crisis. It seems reasonable to assume that the "companies" referred to in the Senate Housing Committee's Summary of the Financial Reform would include, and perhaps be directly aimed at, companies like Countrywide Financial.

The irony of this is that Countrywide was Fannie Mae's largest customer. In 2007, Countrywide accounted for 28% of Fannie Mae's single-family business volume. When combined with Bank of America, which acquired Countrywide, the two companies accounted for 32% of Fannie Mae's business in 2007.

Exactly what percentage of loans provided to Fannie Mae from Countrywide were Alt-A or subprime loans is not readily available. It seems reasonable, however, to assume that as one of the largest Alt-A originators and the servicer of subprime loans, Countrywide, as Fannie Mae's largest customer, also transferred these loans, through sales or swaps, to Fannie Mae's portfolio or into Fannie Mae MBS trusts. With this view, it is hard to blame Countrywide for issuing loans where, as the Senate Committee stated, "it wasn't important if the loans were never repaid as long [since] they were able to sell the loan at a profit before problems started." Countrywide was selling those loans to Fannie Mae, a federally chartered and directed company. The government created the very buyer that enabled firms such as Countrywide to avoid assuming the risk.

The Great Shortfall of the Financial Reform Bill
With the above understanding of Fannie Mae's involvement in the housing crisis, including the "subprime" mess referred to by the Senate Committee, it seem incredulous that the broad sweeping financial reform bill says absolutely nothing about reforming Fannie Mae and Freddie Mac. Is it fair to focus on "companies" such as Countrywide in the financial reform bill without also focusing on the primary enabler of Countrywide's practices: Fannie Mae?

An optimistic view might hope that the reformation of Fannie Mae and Freddie Mac will occur in a separate action by Congress. However, with the near complete absence of any posturing by either the House or Senate Committee's charged with reforming the financial system, such optimism seems unrealistic. If reformation of Fannie Mae and Freddie Mac were truly important to Congress, statements from someone would likely be made now. Fannie Mae was explicitly exempted from a variety of already existing financial regulations.

For example, while banks were required to hold 4% of capital against outstanding mortgages, Fannie Mae needed only a 2.5% capital reserve. What is the likelihood that Fannie Mae will eventually be exempt from the requirements imposed on other financial firms? We can only speculate. In conclusion, while we think that many aspects of the coming financial reform bill will be positive, without dramatic reformation of Fannie Mae and Freddie Mac, the impact will be deeply diminished.

Comments may be emailed to the author, Robert V. Green, at aheadofthecurve@briefing.com