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FCIC Final Report, Part 4, Chapter 17, The Unraveling - September 2008: The Takeover of Fannie Mae and Freddie Mac

FCIC Final Report, Part 4, Chapter 17, The Unraveling - September 2008: The Takeover of Fannie Mae and Freddie Mac

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
17
SEPTEMBER 2008: THE TAKEOVEROF FANNIE MAE AND FREDDIE MAC
CONTENTS
A good time to buy”...........................................................................................“The only game in town”....................................................................................“It’s a time game . . . be cool”...............................................................................“The idea strikes me as perverse” .......................................................................“It will increase confdence”................................................................................“Critical unsae and unsound practices” ............................................................“They went rom zero to three with no warning in between” .............................“The worst-run fnancial institution.................................................................“Wasn’t done at my pay grade”...........................................................................
From the all o  until Fannie Mae and Freddie Mac were placed into conserva-torship on September , , government ofcials struggled to strike the right bal-ance between the saety and soundness o the two government-sponsored enterprisesand their mission to support the mortgage market. The task was critical because themortgage market was quickly weakening—home prices were declining, loan delin-quencies were rising, and, as a result, the values o mortgage securities were plum-meting. Lenders were more willing to renance borrowers into aordable mortgagesi these government-sponsored enterprises (GSEs) would purchase the new loans. I the GSEs bought more loans, that would stabilize the market, but it would also leavethe GSEs with more risk on their already-strained balance sheets.The GSEs were highly leveraged—owning and guaranteeing . trillion o mort-gages with capital o less than . When interviewed by the FCIC, ormer Treasury Secretary Henry Paulson acknowledged that ater he was brieed on the GSEs upontaking ofce in June , he believed that they were “a disaster waiting to happen”and that one key problem was the legal denition o capital, which their regulatorlacked discretion to adjust; indeed, he said that some people reerred to it as “bullsh*tcapital.”
Still, the GSEs kept buying more o the riskier mortgage loans and securi-ties, which by all  constituted multiples o their reported capital. The GSEs
 
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reported billions o dollars o net losses on these loans and securities, beginning inthe third quarter o .But many in Treasury believed the country needed the GSEs to provide liquidity to the mortgage market by purchasing and guaranteeing loans and securities at atime when no one else would. Paulson told the FCIC that ater the housing marketdried up in the summer o , the key to getting through the crisis was to limit thedecline in housing, prevent oreclosures, and ensure continued mortgage unding, allo which required that the GSEs remain viable.
However, there were constraints onhow many loans the GSEs could und; they and their regulators had agreed to porto-lio caps—limits on the loans and securities they could hold on their books—and a capital surplus requirement.So, even as each company reported billions o dollars in losses in  and ,their regulator, the Ofce o Federal Housing Enterprise Oversight (OFHEO), loos-ened those constraints. “From the all o , to the conservatorships, it was atightrope with no saety net,” ormer OFHEO Director James Lockhart testied tothe FCIC.
Unortunately, the balancing act ultimately ailed and both companieswere placed into conservatorship, costing the U.S. taxpayers  billion—so ar.
A GOOD TIME TO BUY”
In an August , , letter to Lockhart, Fannie Mae CEO Daniel Mudd sought im-mediate relie rom the portolio caps required by the consent agreement executed inMay  ollowing Fannie’s accounting scandal. “We have witnessed growing evi-dence o turmoil in virtually all sectors o the housing nance market,” Mudd wrote,and “the immediate crisis in subprime is indicative o a serious liquidity event im-pacting the entire credit market, not just subprime.”
As demand or purchasing loansdried up, large lenders like Countrywide kept loans that they normally securitized,and smaller lenders went under. A number o rms told Fannie that they would stopmaking loans i Fannie would not buy them.Mudd argued that a relaxed cap would let his company provide that liquidity. “Amoderate,  percent increase in the Fannie Mae portolio cap would provide us withexibility . . . and send a strong signal to the market that the GSEs are able to addressliquidity events beore they become crises.” He maintained that the consent agree-ment allowed OFHEO to lit the cap to address “market liquidity issues.” Moreover,the company had largely corrected its accounting and internal control deciencies—the primary condition or removing the cap. Finally, he stressed that the GSEs’ char-ter required Fannie to provide liquidity and stability to the market. “Ultimately,”Mudd concluded, “this request is about restoring market condence that the GSEscan ulll their stabilizing role in housing.”
Fannie Mae executives also saw an opportunity to make money. Because therewas less competition, the GSEs could charge higher ees or guaranteeing securitiesand pay less or loans and securities they wanted to own, enabling them (in theory)to increase returns.
Tom Lund, a longtime Fannie Mae executive who led the rm’ssingle-amily business, told the FCIC that the market moved in Fannie Mae’s avor a-
 
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
ter August  as competitors dropped out and prices o loans and securities ell.Lund told FCIC sta that ater the  liquidity shock, Fannie had “more comortthat the relationship between risk and price was correct.”
Robert Levin, the com-pany’s chie business ofcer, recalled, “It was a good time to buy.”
On August , OFHEO’s Lockhart notied Fannie that increasing the portoliocap would be “premature” but the regulator would keep the request under “activeconsideration.” Lockhart wrote that he would not authorize changes, because Fanniecould still guarantee mortgages even i it couldn’t buy them and because Fannie re-mained a “signicant supervisory concern.” In addition, Lockhart noted that Fanniecould not prudently address the problems in the subprime and Alt-A mortgage mar-ket, and the company’s charter did not permit it to address problems in the marketor jumbo loans (mortgages larger than the GSEs’ loan limit).
Although there hadbeen progress in dealing with the accounting and internal control deciencies, he ob-served, much work remained. Fannie still had not led nancial statements or or , “a particularly troubling issue in unsettled markets.”

As Lockhart testied to the FCIC, “It became clear by August  that the tur-moil was too big or the Enterprises [the GSEs] to solve in a sae and sound manner.”He was worried that ewer controls would mean more losses. “They were ulllingtheir mission,” Lockhart told the FCIC, “but they had no power to do more in a saeand sound manner. I their mission is to provide stability and lessen market turmoil,there was nothing in their capital structure” that would allow them to do so.

Lockhart had worried about the nancial stability o the two GSEs and aboutOFHEO’s ability to regulate the behemoths rom the day he became director in May , and he advocated or more regulatory powers or his largely toothless agency.Lockhart pushed or the power to increase capital requirements and to limit growth,and he sought authority over mission goals set by the Department o Housing andUrban Development, as well as litigation authority independent o the Department o Justice. His shopping list also included the authority to put Fannie and Freddie intoreceivership, a power held by bank regulators over banks, and to liquidate the GSEs i necessary. As it stood, OFHEO had the authority to place the GSEs in conservator-ship—in eect, to orce a government takeover—but because it lacked unding to op-erate the GSEs as conservator, that authority was impracticable. The GSEs woulddeteriorate even urther beore Lockhart secured the powers he sought.

“THE ONLY GAME IN TOWN”
But Fannie and Freddie were “the only game in town” once the housing market driedup in the summer o , Paulson told the FCIC. And by the spring o , “[theGSEs,] more than anyone, were the engine we needed to get through the problem.”

Few doubted Fannie and Freddie were needed to support the struggling housingmarket. The question was how to do so saely.

Purchasing and guaranteeing risky mortgage-backed securities helped make money available or borrowers, but it couldalso result in urther losses or the two huge companies later on. “There’s a real trade-o,” Lockhart said in late —a trade-o made all the more difcult by the state o 

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