The Federal Housing Finance Agency (FHFA) will file several lawsuits against a number of large banks, seeking to recoup money lost by Fannie Mae and Freddie Mac in the housing crash. "The suits will argue the banks, which assembled the mortgages and marketed them as securities to investors, failed to perform the due diligence required under securities law and missed evidence that borrowers’ incomes were inflated or falsified."SourceOn principle, sweeping Federal action against poor banking practices is a good thing. However, I'm not hopeful that this action will meaningfully change bank practices. Lawsuits are by definition reactionary and are not an effective method to change bank behavior (even if they are the executive's only option in the face of weak regulation). More broadly, I'm skeptical about the claim that Fannie and Freddie are owed billions of dollars.The FHFA wants compensation for losses on mortgage backed securities (MBSs), including (somewhat absurdly) for losses on "private-label [not packaged by Fannie or Freddie] securities that were backed by subprime and other risky loans but were rated as safe AAA investments by the ratings agencies." As noted by the Levin Committee report on the crisis, ratings agencies were paid by the banks they serviced, creating a "race to the bottom" for ratings standards. Even so, many of the assets the FHFA is seeking compensation for had the blessing of the highest creditworthiness score—higher than the U.S. government enjoys at the moment. I find it unlikely that banks will be forced to pay billions of dollars to Fannie and Freddie, simply because the industry (however wrongfully) considered these good assets at the time. While deceptive practices abounded and banks failed to do their homework (and should have to pay), the system in place prevented any kind of reasonable check on banks. So the FHFA demand amounts to claiming that banks should have volunteered to stop churning out these AAA assets that Fannie and Freddie were buying for incredible prices. This is at best a misapplication of hindsight.I've compiled two simple charts showing total amount owed by homeowners to Fannie and Freddie, along with the share of that debt held by third parties but legally guaranteed by the two agencies. It's important to note that S&P sees their "on- and off-balance-sheet guaranteed mortgage portfolio as bearing equal credit risk"—not that I would trust S&P on risk, but the point is a sensible one: a guarantee is a guarantee.Source: Freddie Mac official data: see here, here, and here; search for "selected financial data"Source: Fannie Mae official data: see here and here; search for "selected financial data"We can see two main things from these charts: balance sheets expanded almost exponentially leading up to the crisis; and the number of loans kept off-book remained well above half through the expansion. Before January 1, 2010, Fannie and Freddie "were not required to reserve capital against potential losses" on off-book mortgages that they legally guaranteed. Thus they could shift MBSs off their balance sheets for the purposes of holding less collateral. This was a nice accounting trick that helped conceal the extent of the entire economy's exposure to MBSs while making sure that Fannie and Freddie had too little cash on hand. It also led to confusing situations like the "total mortgage assets" effectively excluding trillions in off-book liabilities.Looking at Fannie Mae's 2010 financial statement (p74), we can see that changes in accounting rules had a huge effect on the balance sheet of the company: in 2009, there were $2.5 trillion in "Unconsolidated Fannie Mae MBS, held by third parties." In 2010 there were $21 billion, or 0.0876% of the previous year's number. Fannie didn't get rid of these assets—they were shifted to another category. The "total mortgage assets" category—comprising about a quarter of mortgage assets before 2010—jumped from $769 billion to $3.1 trillion between '09 and '10. Basically Fannie moved nearly every security on-book overnight, holding capital against the risk. This is the way the system should have worked from the start.To come back to the FHFA charge, there was a lot of shady dealing by banks leading up to the '08 crash. In fact, most of what the FHFA charges against banks is probably true, but the idea of asking for compensation because AAA assets went bad strikes me as the wrong response to the problem. Rather, we need a meaningful overhaul to the ratings system, with the ratings agencies paid by a third party (perhaps the government) rather than by the companies they service. Dodd-Frank unfortunately doesn't address this well. We also need a clearer set of accounting standards concerning these derivative assets, especially with respect to rules about balance-sheet valuation. The recent agreement by Goldman Sachs to write down mortgages and review fraudulent lending practices (all as a concession to the Federal Reserve) is proof of this brokenness. Without at least these basic changes, we aren't incorporating lessons from the crisis in a way that makes the financial system more sustainable over the long term.
read more: Lawsuits Aren't Regulation