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GSE Reform And A Conspiracy of Silence
By David Fiderer

Burying the One Legal End State Option
On January 4, 2011, 11 senior Treasury Department officials signed off on a ”GSE Transition
Plan and End State Framework," which was intended to serve as a draft for a report due to be
sent to Congress by the end of the month.

Brian Zakutansky, who today oversees mortgage-bond trading at Morgan Stanley, had drafted
the document, which reflected the input of others—including Jeffrey A. Goldstein, Under
Secretary of for Domestic Finance, James A. Millstein, Treasury’s Chief Restructuring Officer,
and Mary Miller, Assistant Secretary for Domestic Finance—who had convened to hammer out
the proposal at a pre-Chrismas meeting. The memo was to be reviewed by Treasury Secretary
Timothy Geithner.
Section 1074 of Dodd-Frank had directed Treasury to prepare a study to analyze different
options for, “Ending the Conservatorship of Fannie Mae, Freddie Mac, and Reforming the
Housing Finance System.” The options specified by statute included winding-down and
liquidating the companies, privatization of the companies, incorporating the GSEs’ functions into
a Federal agency, and breaking up Fannie and Freddie into smaller companies.
Whereas the internal memo discussed three possible “end state options.” Of those three, only
one, privatizing them—which in this context meant recapitalizing the companies and returning
them to private control— was authorized by law. Privatization end state was, "essentially the
path laid out under HERA [the Housing and Economic Recovery Act of 2008] and the Paulson
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Treasury when the GSEs were put into conservatorship in September 2008.” The advisable
scenario would be as follows:
After becoming adequately capitalized during the Transition, the GSEs would exit
conservatorship as private companies. Treasury converting its preferred into common
equity [would] be sold to the public over time (under legal review); the GSE's
existing common shareholders being substantially diluted. The companies continue to
guarantee a large share of mortgages, with PMI [private mortgage insurance]
companies and homeowners taking the first loss risk as they have done traditionally.
…[Furthermore], Dodd-Frank strengthens [the recapitalization] option through the
ability to designate the GSEs as SIFIs [Systemically Important Financial
Institutions], and thereby subject them to more rigorous prudential standards and
Fed supervision. GSEs/successor entities would maintain higher capital requirements
and investment restrictions as envisioned in Transition.
The other two end state options, which involved downsizing or revoking the GSEs’ corporate
charters, required new legislation, because the two companies operated under Congressional
charters.
But Geithner severely curtailed the discussion. According to his Report to Congress, “Path
Forward for Reforming America’s Housing Finance Market,” there is one, and only one, end
state option for the GSEs, which is to wind them down. The Report proposes three options for
housing finance reform:
1.   Wind down the GSEs and let the free market find price stability in housing finance;
2.   Wind down the GSEs and let a brand new insurance company offer an express government
guarantee on private mortgage portfolios, in excess of a first 10% loss assumed by private
investors; or
3.   Wind down the GSEs and allow the government to step in to finance mortgages in case the
market froze up, (which is arguably no different from the first option).
Henceforth, the idea that the GSEs might survive, or that they might be improved or
rehabilitated, was a verboten topic, never to be publicly acknowledged, much less discussed, by
anyone in the Obama Administration.

Rolling Out The Report At The Brookings Institution
The final report had a due date of January 31, 2011, about six weeks after the due date for the
final report of the Financial Crisis Inquiry Commission. But the FCIC Report was delivered late,
on January 27, 2011. And the final Treasury report was also delivered late, on February 11,
2011, at a day-long conference hosted by the Brookings Institution.
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The Brookings conference, and a number of other events on housing finance, had been scheduled
to coincide with release of of the Treasury and FCIC reports. NYU, the University of Maryland,
the House Financial Services Committee, the American Enterprise Institute, the Mercatus
Institute and others hosted panel discussions with housing finance experts who opined on the
future of the two government sponsored enterprises.
Though the internal memo prepared by Treasury officials was unique. None of the other articles
and books and slide presentations and prepared remarks and sworn testimony and public Q&A
sessions ever contemplated the future of Fannie and Freddie based on the law as it was currently
written. None of the other experts or institutions ever deigned to even consider the possibility
that the GSEs might survive by emerging out of conservatorship. Almost all of the other experts
argued forcefully that the GSE business model was a complete failure. A few noted that the
GSEs had some redeeming benefits. But most of the experts who shape conventional wisdom in
Washington fell into alignment like a flock of geese.

Brookings Institutionalized Conventional Wisdom
The day-long Brookings conference, “Restructuring the U.S. Residential Mortgage Market,”
opened with Geithner’s remarks. “Let me just lay out the basic pillars, the basic foundations, of
what we think is a credible reform plan,” he said. "The first, of course, is that we need to wind
down Fannie and Freddie.”

Afterwards, 23 experts addressed the Brookings audience. Almost all of them argued forcefully
that the GSE business model was a failure and must be abolished. They included professors from
Harvard, Wharton, Columbia, Berkeley, and NYU. They also included two economists from the
Federal Reserve, and former Fed Chairman Alan Greenspan.
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Brookings Senior Fellow Martin Neil Baily, who had organized the event, described the range
of opinions among the different speakers. “Some experts insisted that the GSEs had caused the
financial crisis, by buying securities backed by subprime or Alt-A mortgage loans,” he wrote.
“Others did not see Fannie and Freddie as the cause of a crisis, but agreed that their structure was
flawed, with government sponsorship and private ownership epitomizing the problem of the
public assumption of risk while rewards accrue to the private sector.” Consequently, “No one
proposed keeping Fannie and Freddie in anything close to their current form.”
Two Harvard economists David Scharfstein and Adi Sunderam, shed some light on how this
anti-GSE consensus came to evolve:
...Over the years, however, numerous policy analysts and economists, including Vern
McKinley, Peter Wallison, and [Columbia Prof.] Charles Calomiris have argued
forcefully for privatization, [which in this context means doing away with the GSEs and
affordable housing goals]. Their criticisms echo many of the same concerns in the
government reports, but they argue further that the two GSEs serve no useful public
purpose… More recently, Dwight Jaffee, an early critic of the GSEs, Edward Pinto, a
former Fannie Mae executive, and Alex Pollock, a long-time President of the Federal
Home Loan Bank of Chicago, itself a GSE, have argued for full privatization of Fannie
Mae and Freddie Mac. Given the immense cost to taxpayers from supporting Fannie and
Freddie through the recent crisis, the case for privatization appears to be a strong one.
Scharfstein and Sunderam failed to mention that Wallison, Calomiris, Pinto and Pollock all got
paid by the American Enterprise Institute. And that Wallison and Jaffee were paid by a Koch
Brothers think tank, the Mercatus Center. The American Enterprise Institute also receives
funding from the Koch brothers. Vern McKinley had also completed work for AEI and the Koch
Brothers’ Cato Institute.
Wallison, Pinto, Jaffee, Scharfstein, Sunderam, plus another Mercatus expert, NYU Prof..
Lawrence J. White, all spoke at the Brookings event.
Fortune reported on conference and how it embodied conventional wisdom in Washington:
Geithner's position enjoyed remarkably wide support from lawmakers, regulators, and
economists across the political spectrum. The prevailing—virtually universal—view was,
and still is, that the twin colossi of housing finance that stuck taxpayers with a $189
billion bailout bill after their collapse in 2008, that inflated the real estate bubble with
artificially cheap credit and hence helped sink the U.S. economy, should never, ever be
allowed to regain their former dominance.

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The Big Lie Emerges Out Of A Conspiracy Of Silence
The Brookings event, and many others like it, was remarkable because the experts made their
case against the GSEs using little more than doublespeak and insinuations. The intellectual void
becomes obvious when you focus what GSE critics refuse to talk about. You can read their
papers and presentations, plus other books, academic articles and op-eds, which all insist the
GSEs operated a failed business model. These authors simply ignore, or lie about, the critical
issues of mortgage lending: market liquidity, comparative loan performance, and risk
diversification.
Many of these experts insinuate falsehoods rather than stating them explicitly. Others are more
blunt. Invariably, their case against the GSE business model is predicated on three big lies, which
are easily disproved by fact checking. They are:
•   The GSEs faced collapse because of their liquidity problems, caused by the ambiguity of
the government’s implicit guarantee;
•   The GSEs’ underwriting standards, under affordable housing goals, were unsustainable;
and
•   The inherently flawed GSE business model of private gains and public losses forced to
taxpayers to bail out the companies, which, rather than benefiting the public, distorted the
mortgage markets.
The falsity of these claims should be obvious. It may not be obvious to the man on the street. But
it should be obvious to a junior analyst whose job it was to review the GSEs’ financial
disclosures and other government filings. It was always obvious that the GSEs never faced any
liquidity problems. It was always obvious that the GSEs’ loan performance was vastly superior
to anyone else’s, and that this superior loan performance benefited the pubic by stabilizing the
mortgage markets.
It was always obvious that the GSEs liquefied, and thereby saved, the mortgage markets and the
housing markets, which is a public benefit with a value that far exceeds the dollar amount of any
individual bailout. By way of contrast, the public bailed out Wall Street banks, which did almost
nothing the liquefy the mortgage markets from 2007 onward.
Moreover, it was always obvious that the financial crisis was caused by the collapsing values of
private label residential mortgage backed securitizations (PLS), and not by the GSEs. It was
always obvious that the GSEs attained a level of risk diversification that could not be matched by
anyone else. And it was always obvious that PLS cannot diversify the most important risk in real
estate, market timing.

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It was always obvious that the GSE bailout never funded cash shortfalls or operating costs. It
was always obvious that the GSEs, because they do not originate loans, would not abet mortgage
fraud. GSE critics almost never examine the impact of fraud. Whereas it was always obvious
Wall Street’s originate-to-distribute model for PLS led to industrial scale mortgage fraud, which
triggered the crisis.
Do you think it was a coincidence that all these experts continued to ignore these salient issues,
even after the flaws in their analyses were identified by others? If you read enough of this antiGSE literature you eventually recognize that it’s all about dog wagging, reassigning blame for
the failures caused by PLS on to the GSEs. Ergo:
•   The moral hazard of the PLS originate-to-distribute model (which sells credit risk to The
greater fool) morphs into the moral hazard of the GSEs' implicit government guarantee1.
•   Wall Street's recklessness and incompetence morphs into the GSEs' "lack of free market
discipline."
•   The sudden collapse of the PLS market, which triggered instability throughout Wall
Street, morphs into the "systemic risk" of the GSEs and the phony pretext for a
government takeover.
Most importantly, the case against the GSEs is rooted in class bigotry. Which is how the
epidemic of predatory lending and fraud in the PLS market morphs into the GSEs' affordable
housing goals. The unspoken and unchallenged premise is that loans to middle and lower-income
borrowers must, by definition, be recklessly imprudent. Sometimes the bias is quite explicit. But
more often it's expressed in code, which says the GSEs are fatally flawed by their, "inherent
conflict between private ownership and a public mission," or their, "structural problems." It's all
nonsense, because the GSE business model, which buys and holds all credit risk, aligns the
interests of shareholders with its public mission, which is to finance loans that pay back
principal, interest and fees. Which explains why, for several decades now, GSE loan
performance has always been vastly superior to that of anyone else.
These GSE critics are like the sportswriter who ignores the league tables, or the lawyer who
never reads the fine print.
Over the past six years, additional information has come to light, which enables us to reconsider
earlier views of Fannie and Freddie. The GSEs’ initial losses proved to be a chimera. They were
caused by over-inflated non-cash accounting provisions that were subsequently reversed,
beginning in 2012. By the end of 2013 the GSEs had paid back every dollar extended by
taxpayers.

1

You can also substitute the, phrase perverse incentives for moral hazard.

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Moreover, lawsuits brought on behalf of Fannie and Freddie against 18 different banks, offer
definitive evidence that fraud in the PLS market had become institutionalized, and thereby
devastated housing finance.
And yet, these same housing experts show they have learned nothing. Then and now, these same
mortgage experts, the ones who seem impervious to empirical data, insist that the GSEs must be
abolished in favor of a new, untested system, which appears to double down of the failures of the
old PLS market. Senate bills like Corker-Warner or Johnson-Crapo and their progeny
proposals—including ”A More Promising Road Toward GSE Reform,” and “Toward a New
Secondary Mortgage Market ”— are predicated on a willful blindness to both the benefits of the
GSEs and the failures of PLS.
A closer examination of the Brookings event illuminates how two big lies about the GSEs—that
they faced liquidity crises and that their underwriting was unsustainable—became
institutionalized.

The Big Lie About The GSEs’ Liquidity
After Geithner spoke, two economists from the Federal Reserve, Diana Hancock and Wayne
Passmore, made the case for the second option proposed in the Report to Congress, whereby the
government would guarantee private securitizations against extraordinary losses, above an initial
first 10% loss amount that would be financed by private individuals.
Their basic idea was not exactly new. Fed Chair Ben Bernanke had first recommended it in at a
symposium jointly sponsored by UCLA and Berkeley in October 2008. In his prepared remarks,
titled, "The Future of Mortgage Finance,” Bernanke decreed that the future must not include the
GSE business model, which financed mortgages as a private corporation. He strongly hinted that
the only viable replacement would include a system with an explicit U.S. government guarantee.
He said:
[T]he recent legislation [HERA2] does not fully resolve the fundamental conflict between
private shareholders and public purpose that is the source of many concerns about the
GSEs. Considering some alternative forms for the GSEs (or for mortgage securitization
generally) during this "time out" thus seems worthwhile. Needless to say, however, even
if alternative organizational structures are considered for the future, the U.S.
government's strong and effective guarantee of the obligations issued under the current
GSE structure must be maintained. [Emphasis added.]
2

The Housing And Economic Recovery Act of 2008.

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Bernanke explained the GSEs’ “inherent conflict” with a made-up story:
[T]he existing GSE model involves an inherent conflict between the objectives of the
companies' private shareholders and the objectives of public policy. For example, the
GSEs were reluctant earlier this year to raise capital and to expand their operations,
even though this would have helped financial and macroeconomic stability at a time of
much-reduced mortgage availability. The GSEs' disinclination to support the mortgage
market was motivated by the fact that raising additional capital would have diluted the
values of the holdings of the existing private shareholders.
In fact, the GSEs did have plans to raise additional equity in the form of non-dilutive preferred
shares.
When Bernanke spoke in October 2008, the GSEs had not yet released their third quarter 2008
financials. According to their second quarter financials, they were more than adequately
capitalized. So Bernanke’s condemnation of the GSE business model was never based on any
empirical data or analysis. It reflected his ideological agenda..
"It would seem advisable to retain some means of providing government support to the mortgage
securitization process during times of turmoil," said Bernanke. "One possible approach,
suggested by Federal Reserve Board economists Diana Hancock and Wayne Passmore, is to
create a government bond insurer, analogous to the Federal Deposit Insurance Corporation."
(Note that Bernanke referred to the “mortgage securitization process,” which was a much
broader category than GSE securitization.)
A few hours later at the same event, Hancock and Passmore presented their idea to create a
government bond insurer for all securitizations3. From then on the idea, that mortgage
securitizations must benefit from an express government guarantee, became a shibboleth among
many GSE reformers.
Hancock and Passmore continued to develop their idea for a GSE alternative, and in August
2010 the Fed published their paper, "An Analysis of Government Guarantees and the
Functioning of Asset-Backed Securities Markets." They repackaged that paper for Brookings as
“Catastrophic Mortgage Insurance And The Reform Of Fannie Mae And Freddie Mac,” in
February 2011. The Brookings event included critiques of the paper by professors from
Berkeley and Columbia. So, prior to February 11, 2011 a number of people with advanced
3

The final version of their 2008 presentation was published in The B.E. Journal of Economic Analysis &
Policy in 2009.

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degrees and expertise in the subject had read Hancock and Passmore’s papers, which are
complete bunk.
The Fed econimsts’ thesis was that the GSEs were just like PLS, and that both were inherently
unstable. Consequently, an express government guarantee of all securitizations was necessary.
Passmore presented slides derived from their paper. "The GSE debt holders ran, given the
probability of substantial losses even with the credit guarantee,” he said “And that was because
capital was inadequate, values of the portfolio were opaque and they were unsecured."

There was no basis for these claims. None. Passmore and Hancock did not misspeak, or
exaggerate or embellish. They seem to have invented a story that suited their agenda.

In fact, those who had followed events leading up to the financial crisis might have wondered
where Passmore and Hancock came up with this scenario. Those who remembered the market
anxiety during August and September 2008 might have wondered why that had forgotten
headlines about a run on GSE bonds. A quick Internet search might have jogged their
recollections.

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“Fannie Mae, Freddie Mac debt funding smooth," said a Reuters headline on September 3, 2008.
"Fannie Mae and Freddie Mac drew solid demand for $5 billion of new securities on Wednesday
even as large overseas investors cut their exposure to the two troubled housing finance
companies. The latest sales “underscored their cooled expectations that a government rescue is
imminent,” wrote Alan Zibel of the Associated Press. “Investors are demanding a smaller
premium for Freddie Mac's debt than last month.” Two days after those stories came out, the
GSEs were notified about their imminent government takeover.
The truth was that the GSEs never faced a moment when they were unable to roll over their
unsecured debt. Market data confirms that there was never a moment when the market for such
obligations was not highly liquid. The GSEs never operated with less than 90-days liquidity. In
sum, there is zero hard evidence to support their thesis that the GSEs could not operate without
an express government guarantee.
To make their fictitious claims seem plausible, Hancock and Passmore invented a false
backstory, which mimicked the actual collapse of the PLS market. They referred to investors
who somehow failed to notice, until a market downturn, that GSE securities did not benefit from
an express federal guarantee. These imaginary investors realized too late that they didn’t know
how to value their investments because of inadequate financial disclosures.
In fact, investors would be hard pressed to find any other trillion-dollar financial institution that
offered as much detailed and comprehensive disclosure, on a monthly basis, as the GSEs. For
example, Fannie disclosed, in publicly disclosed monthly reports, precisely how it funded itself
with short-term debt and long-term debt. Review the months leading up to September 2008, And
you will see no reduction in Fannie’s access to the debt markets.4
Fannie and Freddie’s mission was to liquefy and stabilize mortgage markets amid failures by
private mortgage-market players. Fannie and Freddie performed that role–first, during the
savings-and-loan crises in the early and late-1980s, and later, in the wake of the financial crisis
that began with the collapse of the PLS market in 2007. In that sense, the GSEs functioned much
like the Federal Reserve or other central banks.
If the Passmore/Hancock version of reality had been true, and the GSEs had faced a genuine
liquidity crisis, the effects would almost certainly have been earth-shattering, far more
destabilizing than the collapse of Lehman or AIG. Most likely, the firms' problems would have
cascaded over into markets worldwide, causing disruption and mayhem. But that was not the
case. Passmore and Hancock were promoting a view of events that was not only at odds with
reality, but recklessly cataclysmic.
4

Fannie accesses the debt markets one day a week, on Wednesdays. Henceforth, months with five Wednesdays
show that it refinanced more debt than in months with four Wednesdays.

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But most people sitting in the audience at the Brookings Institute would have presumed that
Passmore and Hancock were telling the truth. In such a high-powered setting, who would dare
present such wild falsehoods, knowing his work would be critiqued by knowledgeable professors
from elite business schools? Who would allow himself to be embarrassed at an event broadcast
on C-SPAN, which featured appearances by their former boss, Federal Reserve Chairman Alan
Greenspan, Treasury Secretary Timothy Geithner, and a slew of other notables, including
academics from Harvard, Wharton, and NYU?
That is precisely the logic behind the Big Lie. The assumption is that no professional economist
would risk such damage to his reputation by making wild claims if they weren’t true.
No one at the event saw reason to question Hancock and Passmore’s fantasy, in part because it
seemed to confirm everyone’s initial bias. The gathering in the Falk Auditorium at the Brookings
headquarters in Washington was, in many respects, a celebration of groupthink.

Others Validate The Big Lie About GSE Liquidity
After Passmore and Hancock presented their paper, Berkeley Professor John Quigley and
Columbia Professor Christopher Mayer, offered their critiques. They, like the Fed economists,
overlooked the critical distinctions between GSE securitizations with PLS, and seemed to
conflate the two. They seemed unfazed by Hancock and Passmore’s imaginary run on the GSEs.

Repetition is part of The Big Lie technique, and others, Berkeley Professor Dwight Jaffee and
Wharton Professor Richard Herring, repeated Hancock and Passmore’s wild story. The two
professors were on hand to critique another paper5, which contradicted Passmore and Hancock’s
version of events. The second paper, by two Brookings economists, Karen Dynan and Ted
5

“The Government’s Role in the Housing Finance System: Where Do We Go from Here?” by two Brookings economists, Karen
Dynan and Ted Gayer.
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Gayer, said that the, “federal government decided to forestall any possibility of a run by placing
the GSEs into conservatorship.” [Emphasis added.] But instead of noting the difference, Jaffee
and Herring simply invoked the big lie told by the Fed economists.

Here’s how Jaffee put it:
The paper makes a very important point, which is that the actual failure of the
GSEs was because they couldn't roll over their bonds one morning. And that's
important to understand because there's been a lot of suggestion here that the
whole crisis is credit risk and that those of us who worried about interest rate risk
just missed the dilemma. It's actually not true. The GSEs had a terribly cash flow
mismatched portfolio with short term debt representing 50% of their
capitalization but with long term mortgages. Which is why one morning when the
market wouldn't buy their bonds they were basically out of business.
Nothing remotely like that ever happened. The line about, “terribly cash flow mismatched
portfolio with short term debt representing 50% of their capitalization but a with long term
mortgages,” isn’t true. On June 30, 2008, the last reporting date prior to conservatorship,
Fannie’s short-term debt totaled $240 billion, or about 27% of its total $885 billion
capitalization. Fannie’s long-term debt, $559 billion, far exceeded its $418 billion mortgage
portfolio held on its balance sheet

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Herring echoed this fantasy. “When the shock occurred,” he said, “people who thought they were
guaranteed [by the federal government on their GSE-issued debt] began to ask if they actually
were and without an explicit guarantee they ran.”

The Real Story Of The Crisis: PLS Liquidity Crises From 2007 Through
September 2008
Market stability is synonymous with liquidity. Every banker knows the difference between
liquidity and solvency. For a financial institution, liquidity–immediate access to cash–is like
oxygen; it can’t survive long without it. Solvency, on the other hand, is a much squishier
concept, it’s the product of professional judgements made by senior management once every
fiscal quarter. The financial crisis was defined by a succession of liquidity crises, which began in
early 2007 and escalated rapidly in September 2008.
A liquidity crisis is not unlike that famous scene from It’s A Wonderful Life, though with an
unhappy ending. It’s what happens when depositors, creditors or investors suddenly become
worried that a financial institution may be hiding some problem; so, because of their fears driven
by a lack of transparency, they rush to get their money out as soon as possible. In the nineteenth
century depositors would literally run to secure their place in line at a teller’s window in the hope
that they would not be left empty-handed.
For non-bank institutions that finance long-term assets with short-term borrowing, the strains can
be that much worse. As constituents of what has been called the shadow banking system, their
options are generally more limited. Non-deposit taking institutions have not historically had
access to the Fed’s discount window, where banks can pledge assets as collateral for immediate
liquidity. In the wake of Bear Stearns’ collapse, the Fed opened its discount window for the first
time to large brokerage firms. (There was a notable exception on, Sidewinder 15, 2008, the day
when Lehman went bankrupt. The Fed opened its discount window to all major brokerage firms,
save Lehman).

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In large measure, the financial crisis was defined by a succession of liquidity crises tied to PLS.
Those events began with the collapse of New Century and a few other subprime mortgage
lenders, which relied on investment banks to finance originations destined for the PLS market.
Things went downhill fast in the summer of 2007, when, almost immediately after the large
rating agencies began assigning long-overdue downgrades to subprime bonds, the PLS market
essentially seized up.
Over the subsequent 14 months, different entities with significant direct and indirect exposure to
PLS faced similar crises and many collapsed. Early victims included some hedge funds. Then
there was the $400 billion market for structured investment vehicles, or SIVs, followed by a few
German banks. Next came the broader asset-backed commercial paper, or ABCP, market. After
that, it was Bear Stearns, then Lehman and AIG.
Credit Default Swaps Remove Transparency: The near-collapse of all these institutions was
exacerbated by an inconvenient truth about modern credit markets: credit default swaps–in
essence, a type of insurance against default–had undermined, if not eliminated, transparency. No
corporate CFO, no banker in a loan workout meeting, no investor in a structured finance deal,
has any certainty about whom he may be dealing with. He doesn’t really know the creditors or
investors in any transaction, because of the possibility of a secret side deal, a credit default swap,
that transfers risk to any unknown party. The Big Short, the book and the movie, is about Wall
Street insiders who secretly bought credit default swaps to insure bonds they did not own,
because they were certain those bonds would fail.
It is true that mortgage loans played a key role in the unraveling of Wachovia and Washington
Mutual, but the rules of the game in those cases were clearly defined. Federal and state banking
laws laid out out a clear path for government regulators to step in and take over lenders that had
clearly gone bust.
Regardless, mortgage loans did not cause the crisis. PLS deserve the primary blame. Why?
Because the non-triple-A-rated tranches, which were subordinate to 95% of a debt-financed
capital structure, could be wiped out overnight. In fact, by September 2008, virtually all of them
were. In many cases, however, there had not yet been a payment default, because the principal
was not due to be repaid until maturity. But the net present values of those tranches under most
scenarios indicated that prospects for repayment were nonexistent.
Making matters worse was the fact that the deeply subordinated tranches were not broadly
distributed among institutional investors, potentially diffusing the fallout from the risk and
reality of defaults. Instead, the risk was concentrated at a relatively small number of firms,
including AIG, Citigroup, UBS, Merrill Lynch, MBIA and AMBAC. With aggregate exposure to
subprime collateralized debt obligations, or CDOs–structured bond portfolios that owned
different subordinated PLS bonds-–exceeding $250 billion, this group faced the specter of
insolvency, which would have had huge ripple effects.
There is no evidence to suggest that the downfall of any of these companies was in any way tied
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to GSE credit exposure, or to the GSE business model.
Hancock and Passmore’s slides suggest that they had reviewed and analyzed actual market data.
“GSE [unsecured corporate] debt holders ran,” says the slide, whereas,”Agency [GSE] MBS
[mortgage backed securitizations] holders did not run.” Ergo, “No GSE portfolio implies no runs
on GSEs.” In fact, their inference was based on nothing other than the story they invented out of
thin air.

Hancock and Passmore’s Big Lie About GSE Failures
To create the illusion that the GSEs are unstable the same way that PLS market is unstable, and
to add a veneer of gravitas, Hancock and Passmore concocted a familiar recurring history in their
opening paragraph:
Mortgage securitization has been tried several times in the United States and each time it
has failed amid a credit bust. In what is now a familiar recurring history, during the
credit boom, underwriting standards are violated and guarantees are inadequately
funded; subsequently, defaults increase and investors in mortgage-backed securities
attempt to dump their investments. Ex post, the securitizers are taken to task for the
methods they used to originate and sell bonds and for not looking out for the interests of
bondholders. In the most severe cases, a federal emergency response to a mortgage crisis
is mounted. In effect, the government is “on the hook” to provide catastrophic insurance
ex post when securitization markets go awry.
In footnotes, the authors refer to collapse of the farm mortgage debenture movement in the
1880s, and to the collapse of securities developed by mortgage guarantee companies and real
estate bond houses in the 1920s. Those tiny little markets are hardly relevant to the 21st century.
Financial panics were recurring phenomena in the United States prior to the establishment of the
three Federal Reserve in 1913 and New Deal reforms in the 1930s6. They had not occurred again
until 2008, after many New Deal reforms had been gutted or hollowed out.
And then the PLS market failed in the summer of 2007. But GSE securitizations and the GSE
debt markets never failed. To state otherwise is to lie. Moreover, the authors’ insinuation, that
the GSEs were, “not looking out for the interests of bondholders,” is nonsensical, since the GSEs
guarantee the credit risk on all securitizations.
Which brings us the difference between GSE mortgage securitizations and PLS. It can be
6

Prior to establishment of the Federal Home Loan Bank in 1932, there was no secondary source of liquidity for

mortgage loans. Following New Deal reforms-–which included the standardization of the long-term fixed rate
amortizing residential mortgage, and Federal securities laws that madated full disclosure and prohibition of
manipulative schemes-–there were no similar financial panics, until 2008. The recent panic was caused by the
gutting or hollowing out of New Deal reforms.

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distilled into one little word, non-recourse. Though the broader implications are profound.
People versus Machines: The GSEs, like all corporations, manage risk because they are
managed by human beings who adapt to changing circumstances. The GSEs, like every bank,
continually monitor and rebalance credit risks to avoid excessive concentrations measured by
geography, borrower profile, loan-to-value ratios and private mortgage insurers. Prior to
conservatorship, the GSEs never sold off credit risk. They only sold off the interest rate risk
embedded in GSE securitizations. Fannie and Freddie guaranteed the mortgages they transferred
into securitized pools. Each company managed credit risk globally as single multi-trillion
mortgage book.
The concept of ongoing risk management is antithetical to PLS, which is predicated on the
notion that every static mortgage pool in liquidation must stand or fail on its own. The idea is
that an investment banker can assemble a dumb machine, a trust holding mortgage pool that is
sufficiently robust so that all investors recover principal and interest. There are no do-overs after
a PLS deal closes.
Of course, different borrowers prepay at different rates. Which is why the risk diversification
within a single PLS portfolio continually changes, quite often for the worse. As a general rule,
borrowers with robust home equity tend to refinance when mortgage rates go down. Borrowers
with deteriorating home equity have fewer, if any, refinancing options; so they stay put. And
once a PLS mortgage pool performs materially worse than expected, the prospects for recovery
are negligible, because every static mortgage pool goes through a death spiral. Each month the
size of the pool of mortgages generating income, used to offset credit losses, shrinks.
All real estate is unique and every mortgage pool is unique. Investors in GSE securitizations
know they hold unique collateral, which makes them structurally senior to GSE corporate
bondholders. But these investors also rely heavily on corporate guarantees, which offset the
biggest risk in real estate finance, market timing. If a mortgage pool is financed at the peak of the
market, or if a single pool happens to be packed with a bunch of lemons, the investor need not
worry about recovering principal and interest, thanks to the corporate guarantee.
Because the credit profiles of all GSE securitizations are virtually fungible, the market for those
debt instruments has always been extremely liquid and deep. Such market confidence was also
derived from the GSEs' unmatched excellence in credit underwriting; Fannie's annual credit
losses from 1971 through 2007 averaged below four basis points.
PLS deals have always been defined by their wide variability in performance for reasons should
be obvious. Housing is cyclical. Market timing is the biggest driver in debt recovery, as revealed
by all loan performance data segmented by vintage. For PLS investors, timing is everything. This
lack of fungibility explains the sudden shutdown of the PLS market in the summer of 2007. Nine
years later, PLS remain a drop in the bucket of new originations.
You Can’t Ignore Subordination: We know exactly which PLS investors got wiped out. They

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were the ones holding the subordinate tranches, the ones that assumed the first 10% loss in a
static mortgage pool. And if you know how the net present values of these mortgage pools are
calculated, you know that the monthly NPVs of the subordinate tranches are highly volatile.
especially in the early years, when the mortgage pool is larger and generates more interest
income. And yet the Hancock/Passmore proposal sought to transform a $10 trillion credit
market so that, going forward, these deeply subordinated PLS tranches would be the new center
of gravity for the private markets.
The GSE business model was not about buying and selling small pieces of individual mortgage
pools; it was about financing housing across the country. Since management’s first priority is to
preserve the value of its outstanding loans and guarantees, it has a strong incentive to liquefy the
mortgage markets during downturns, when other private players, faced with failure, shut down
their credit windows. Anyone who failed to recognize the essential role played by the GSEs in
stabilizing the market in the wake of the last housing crash must have not been paying attention.
The private market for those deeply subordinated PLS tranches, the ones rated below triple-A,
were not actively traded on a standalone basis. The vast majority of these subordinated bonds
were bundled into portfolios held by structured finance CDOs, created by people who ignored
basic issues of risk diversification, who failed to grasp the impact of subordination, and who
failed to recognize the differences between human beings and dumb machines.
Moody's, Standard & Poor's and Fitch assumed that default correlations for corporations are just
like default correlations for structured finance deals. Again, corporations are run by human
beings who adapt differently to economic downturns; and those differences are reflected in
corporate default correlations.
Structured finance deals don't respond differently to downturns because they don't respond. And
though every PLS mortgage pool is unique, every PLS deal is structured around a cash flow
waterfall, which guarantees that credit problems, wherever they are located, shall always be
borne by the most subordinated tranches. Common sense tells you that, during a real estate
slump, the deeply subordinated tranches of different PLS deals will all be hammered in a similar
way. Hence the CDO portfolios, packed with hundreds of different subordinated PLS tranches,
weren't really diversified at all.
And it got worse, because relative handful of major institutions--AIG, MBIA, Merrill Lynch,
UBS, and others—deluded themselves into thinking that a diversified CDO portfolio, holding
dozens of different triple-A rated tranches of different CDOs, meant it was unlikely that the
different CDOs would all perform in pretty much the same way.
Time is money. If you’ve ever done a net present value calculation, you know it doesn’t take
much tweaking in the first few years’ cash flows to change a positive outcome into a negative
outcome. The impact of subordination on the non-triple-A tranches was to rapidly accelerate the
timeframe in which they got wiped out.

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Too Big To Fail means, among other things, too big to fail quickly. The financial crisis was
caused, not by mortgage loans, which deteriorate gradually over an extended period, but by
deeply subordinated mortgage securities, which got wiped out as soon as home prices started
falling. (Notwithstanding delayed announcements of rating downgrades.)
The Big Short And The Financial Crisis Were About Subordination: You know who
overlooked the dangers of subordination? Not the GSEs, but the companies who relied on the
rating agencies, which pushed fanciful notions about risk diversification in CDOs. In spite of
evidence to the contrary, the rating agencies asserted that they could accurately measure the
safety of a single portfolio packed with deeply subordinated triple-B tranches of different private
mortgage deals. Using their own flawed logic, the rating agencies proclaimed the dominant
senior chunk of a triple-B RMBS portfolio to be super safe, ergo rated triple-A.
Ordinarily, the triple-B corporate bonds in a big portfolio will not all deteriorate in tandem, and
they will not all deteriorate very rapidly. That’s because people, the professional managers who
run corporations, have different ways of adapting to changing circumstances. Structured finance
deals do the opposite; they are designed to operate like dumb machines. Also, outside of
structured finance and possibly banks, there are no triple-B bonds subordinate to 90% of a capital
structure with near-zero equity.
Executives who relied on triple-A ratings for senior tranches in structured finance CDOs — at
AIG, Citigroup, Merrill Lynch, UBS, MBIA, AMBAC — acquired over $250 billion in risk
exposure to portfolios packed with deeply subordinated mortgage bonds. Because their CDO risk
exposures got hammered so quickly, six huge financial firms faced the specter of liquidity crises
and insolvency. And the U.S. government, by announcing its decision to let Lehman abruptly
collapse, signaled to everyone else that all bets are off. Panic ensued.
The severe subordinated risk concentrations among major banks and insurance companies had
nothing to do with the GSEs, or with affordable housing goals.
Yet proponents of "GSE reform" seem to ignore the issues of risk diversification and
subordination altogether. Which is why their common template for transforming housing
finance–to replace the GSEs with a system of federal guarantees on PLS deals, save for the first
10% loss assumed by private investors –is fatally flawed. This template is still promoted by a
litany of mortgage experts, including some senior Obama Administration officials.

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The Big Lie About GSE Credit Underwriting

The Brookings event took place exactly two weeks after release of the Final Report of the
Financial Crisis Inquiry Commission, which was beset by a vitriolic schism between one
commissioner and nine others. In his scathing dissent, commissioner Peter Wallison excoriated
the FCIC for not embracing the research of his colleague at the American Enterprise Institute,
mortgage expert Edward Pinto. The release of the Report and Wallison’s dissent were widely
covered by the financial media. Pinto addressed the Brookings audience early in the day;
Wallison presented the last paper of the event. It’s hard to believe that the audience was unaware
of the FCIC backstory that shrouded their presentations. Pinto alluded to the dispute in his
remarks:
The major cause of the housing crisis and the financial crisis that resulted was an
accumulation of an unprecedented number of weak or nontraditional mortgages in the
U.S. financial system. During the 15 year period after the passage of the Act [mandating
affordable housing goals], trillions of dollars would first buoy and capsize the housing
market. When the financial crisis hit in 2008, approximately 27 million, or 49% of our
nation's 55 million outstanding first mortgage loans had high risk characteristics and
were far more likely to default. Some have questioned my calculations in this area. The
mortgage industry led by Fannie and Freddie practiced something I think many many in
this audience can appreciate. The world's most incredible example of grade inflation. We
took what were a loans. There was a definition of a loan back in 1990s. The community
groups talked about it. That definition was changed over time. Much like the frog in the
frog of water that started boiling very slowly, as that definition changed over time, people
got more and more comfortable, but it also buoyed the market and created its own
problems. My methodology is very straightforward and well documented.
Pinto, a former Fannie Mae executive who left the firm in 1989, had emerged out of obscurity on
December 9, 2008, when he testified before Congress. The next day, a front-page story at The
New York Times began: “Fannie Mae and Freddie Mac engaged in ‘an orgy of junk mortgage
development’ that turned the two mortgage-finance giants into vast repositories of subprime and
similarly risky loans, a former Fannie executive testified Tuesday."
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Pinto said, "There are now approximately 25 million subprime and Alt-A loans outstanding
[44% of the US total of 55 million], with an unpaid principal of about $4.5 trillion…While
Fannie Mae and Freddie Mac may deny it, there can be no doubt that they now own or guarantee
$1.6 trillion in subprime, Alt-A, and other default-prone loans and securities.”
Pinto’s claims seemed shocking and alarming. Industry professionals had been relying on data
from the Mortgage Bankers Association and Loan Processing Services, which both showed the
problems were concentrated in a small niche segment of the total mortgage market. The MBA
calculated that 12% of all mortgages were subprime, whereas LPS calculated that subprime, AltA and Option-ARM loans together represented something close to 15% of the national total. The
revelation that 44% of all loans were of comparable risk, and that a third of all GSE loans were
“default-prone,” seemed ominous. Pinto had devised his own risk categories, which were much
bigger than the “self-designated” subprime and Alt-A categories used by anyone else.
Soon thereafter, Pinto recalculated his numbers and decided that there were 27 million subprimeequivalent mortgages outstanding as of June 30, 2008, about half of the nationwide total. Pinto’s
“27 million subprime loan” mantra would be regularly repeated in the op-ed pages of The Wall
Street Journal mostly by his AEI colleague, a former official in the Reagan Administration, Peter
Wallison, one of AEI’s resident experts on financial markets and regulation, had been appointed
as one of the Republican commissioners on the FCIC. His was the final paper at the Brookings
event, and it was based primarily on Pinto’s findings.
In reality, that "orgy of junk loan development" at Fannie and Freddie produced the best retail
loan performance in U.S. history. From 1993 through 2007, Fannie’s annual credit losses
averaged 2.7 basis points. The GSEs', “vast repositories of subprime and similarly risky loans,"
performed at a level that was far superior to that of any other segment of the market. Losses were
disproportionately worse during the crisis years, 2008 through 2011, when Fannie's average
annual loss rate was 52 basis points. Freddie’s results were comparable.
By way of contrast, during the 1991–2007 period, commercial banks' average annual loss rate on
single family mortgages was about 15 basis points. During the 2008-2011 period, annual losses
were 184 basis points.
An FHFA study that compared, on an apples-to-apples basis, GSEs loan originations with those
for private label securitizations. The study segmented loans four ways, by ARMs-versus-fixedrate, as well as by vintage, by FICO score and by loan-to-value ratio. In almost every one of
1800 different comparisons covering years 2001 through 2008, GSE loan performance was
exponentially better. On average, GSE fixed-rate loans performed four times better, and GSE
ARMs performed five times better.

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Indeed, there is no data anywhere to cast doubt on the superior loan performance of the GSEs.
Year after year, decade after decade, before, during and after the housing crash, GSE loan
performance has consistently been two-to-six times better than that of any other segment of the
market. The numbers are irrefutable, and they show that the entire case against GSE
underwriting standards, and their role in the financial crisis, is based on social stereotyping,
smoke and mirrors, and little else.
Which was a problem for Pinto in the spring and summer of 2010, when he was interviewed by
FCIC staffers. They kept asking him one simple question: How do you reconcile your risk
categories with loan performance? How can you assess risk if you ignore data on delinquency,
foreclosures and loss severity? Pinto had no answer. He had no answer then; he has no answer
today. Instead, he offered up a series of tangents and non-sequiturs, lengthy studies filled with
half-lies and distortions, all used to distract away from the one essential question that defines
capitalism: Which loans pay back and which ones don’t?

FCIC Backstory
The chasm between Pinto’s predictions and actual results spoke for itself. FCIC staffers—who
carefully reviewed all of Pinto's submissions and met with him nine times—failed to see how his
work could offer useful insights.
But Peter Wallison was furious that FCIC staffers were unwilling to embrace Pinto’s thesis. He
issued a not-so-veiled threat to his FCIC colleagues:
I don’t like being told that I disagree with everything. I believe that I disagree
with the things that are wrong and my point of view is valid and entitled to be
heard....You should know that I have no compunction about filing a separate
statement if I am not persuaded by data, by facts that have been tested and are not
subject to dispute. Many of the statements I heard and read today are part of
conventional wisdom; that in itself does not recommend them to me. I heard that
we should accept the point of view of “experts” as evidence, as in a trial. As we
all should know, in a trial each side can select its experts. All the experts I have
ever suggested for the Commission’s hearings have been rejected or ignored.
There is a price to pay for that.
At the time, few if any of the FCIC commissioners appreciated the broader consequences of
Wallison’s declaration of war. From their perspective, the matter concerned one study, which
was touted by two not-so-well-known scholars from a conservative think tank.
In fact, there was much more at stake beyond Pinto’s and Wallison’s reputations. Pinto’s
findings had been cited in books and papers written by professors at the University of Chicago,
Columbia University, Berkeley and NYU. Four of the speakers at the at the Brookings event,
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three professors plus Wallison, had all relied on Pinto’s analysis to determine that the GSE
business model was destined to fail.
Wallison Defames His Colleagues: Peter Wallison wanted nothing to do with the FCIC Report.
He would write his own scathing dissent to challenge the legitimacy of the entire endeavor. But
he did not say that the FCIC misinterpreted Pinto’s work, or that it failed to recognize its merits.
He would not concede anything to do with the reality of what happened, and thereby prompt an
examination of opposing views. Instead, he invoked the Big Lie technique, by making harsh
accusations that were discredited in the actual Report. He writes in his dissent:
Any objective investigation of the causes of the financial crisis would have looked
carefully at this research [by Pinto], exposed it to the members of the
Commission, taken Pinto’s testimony, and tested the accuracy of Pinto’s research.
But the Commission took none of these steps. Pinto’s research was never made
available to the other members of the FCIC, or even to the commissioners who
were members of the subcommittee charged with considering the role of housing
policy in the financial crisis.
Accordingly, the Commission majority’s report ignores hypotheses about the
causes of the financial crisis that any objective investigation would have
considered, while focusing solely on theories that have political currency but far
less plausibility.
You don’t need to read the entire Report. Just go to the online version and do a word search for
“Pinto,” which brings you to page 219 of the Report and its detailed analysis of Pinto’s work. It
proves that Wallison’s accusation is a lie. The key paragraph:
Importantly, as the FCIC review shows, the GSE loans classified as subprime or Alt-A in
Pinto’s analysis did not perform nearly as poorly as loans in non-agency sub-prime or
Alt-A securities. These differences suggest that grouping all of these loans together is
misleading. In direct contrast to Pinto’s claim, GSE mortgages with some riskier
characteristics such as high loan-to-value ratios are not at all equivalent to those
mortgages in securitizations labeled subprime and Alt-A by issuers. The performance
data assembled and analyzed by the FCIC show that non-GSE securitized loans
experienced much higher rates of delinquency than did the GSE loans with similar
characteristics.
The FCIC Report was highly anticipated and considered a very big deal. Anyone who read the
Report could see how it highlighted both the fatal flaws in Pinto’s analysis, and the evidence that

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Wallison’s dissent was predicated on a lie. Wallison’s dissent was not materially different from
the paper he presented at Brookings that day
Pinto and Wallison's conceit, like that of Hancock and Passmore, was to conflate the problems of
PLS with the very different issues affecting the GSEs. Hancock and Passmore used the word
“securitization” to fabricate a false equivalency between two very different types of mortgage
financing. Pinto and Wallison used the word “subprime,” to conflate the worst-performing sector
of the PLS market with GSE affordable housing goals.
But Pinto was no outlier. Nothing in the other speakers’ presentations or papers shows any
evidence that they reviewed loan performance in the context of the rest of the market.
And there is no indication that the speakers chose to examine the GSEs’ liquidity in September
2008.
A few graphics, below, illustrate the collective silence. The 1st and 3rd slides were prepared by
Brookings economists Karen Dynan and Ted Gayer, highlight points in their paper presented at
the conference. “Fannie Mae and Freddie Mac created significant problems that contributed to
the financial crisis,” they wrote. “The GSEs’ pre-crisis activities also left the taxpayers with an
enormous burden.” They show how delinquency rates began to spike in the latter part of 2008,
two years after the housing bubble began to deflate.

But look at GSE delinquencies in comparison to the rest of the market, as measured by the
National Delinquency Survey published by the Mortgage Bankers Association. The lower
delinquency rates are only half the story. The loss severity rate on post-2008 GSE defaults,
about 30+%, was about half that seen in PLS.
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Over the last 20 years, GSE delinquency rates have closely tracked the delinquency rate for
Prime Fixed Rate mortgages.
One reason that the GSEs showed better loan performance is that, to a large extent, they avoided
the worst of the real estate bubble. Look at the trajectory of home price appreciation, as
presented by Dynan and Gayer. And then look at the graph prepared by Trust Company of the
West, which follows. The TCW graph compares home price appreciation for homes financed by
the GSEs with the commonly-used Case-Shiller Index.

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Social Stereotyping As A Substitute For Data
The GSEs are mandated to serve middle and lower income borrowers and underserved areas.
What GSE critics insinuate, but rarely say, is that loans to lower income borrowers must be
recklessly imprudent. And those recklessly imprudent loans must have caused the inevitable
collapse of the GSEs. And since the GSEs were so much larger than anyone else, they must have
poisoned the well of housing finance. As the Steve Carell character says near the end of the
movie The Big Short, “The banks would blame it on immigrants and poor people.”
Such is the thesis of Pinto, Wallison, and several other speakers at the Bookings event. Two
speakers, NYU professors and collaborators, Lawrence White and Viral Acharya, plugged their
new book, co-written with two other NYU profs, Stijn Van Nieuwerburgh and Matthew

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Richardson. Guaranteed To Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage
Finance, relies heavily on the work of Edward Pinto.
The 1992 Act Changed Everything: The book’s thesis is that the GSE business model is fatally
flawed and destined to fail because of affordable housing goals, which were imposed on the two
companies by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992
(FHEFSSA). They, like Pinto, insist that the FHEFSSA presaged doom. And they, like Pinto, use
inflammatory and misleading rhetoric to obscure their rejection of empirical data. They liken
passage of the FHEFSSA to Julius Caesar’s decision to cross the Rubicon:
The Rubicon River marks the boundary between the province of Gaul and Italy. It was
Roman law that no general could cross this boundary southward towards Rome with his
army, lest the general be mistaken for instigating a coup d'etat. On January 10, 49 BC,
Julius Caesar did just that, stating the infamous words "alea jacta est" (the die is cast).
And history was forever changed…
The entry of Fannie and Freddie into high-risk mortgages had a similar effect... the GSEs
had crossed their own Rubicon in the mid-1990s after the passage of the FHEFSSA. The
moment that the GSEs lowered their underwriting standards, there was no turning back,
and as soon as housing prices started falling, their fate was sealed.
The GSEs’ fate was sealed? Caesar’s decision to cross the Rubicon triggered a four-year civil
war. After he returned to Rome with Cleopatra, Caesar crowned himself emperor. Soon
thereafter, he was assassinated and a second civil war commenced. By then, the Roman republic
was definitely over.
Whereas the FHEFSSA triggered no great tumult. From 1993 through 2007, Fannie’s average
annual credit losses were 2.7 basis points. By June 30, 2007, one year after the real estate bubble
began to deflate, the GSEs' serious delinquency rates were no higher than they were during the
height of the bubble. By June 2007 hundreds, if not thousands, of investment-grade PLS bonds
were deeply underwater, effectively wiped out, before the rating agencies began to downgrade
them in July 2007. By year-end 2007, Fannie's realized loss rate on its mortgages was five basis
points, a fraction of what it was in the 1980s. By year-end 2007, the average realized loss rate on
subprime PLS was more than 70 times higher, according to Moody’s. As of year-end 2013, the
GSEs' realized losses on loans booked before 2008 was about 3%. For PLS, the realized losses
were more than seven times higher, about 23%.
Yet four NYU professors insisted there was no turning back, no opportunity for the type of midcourse correction observed in any other company. Because we all know that loans extended
under affordable housing goals to those people are, by definition, foolhardy. Which is why GSE
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failure was inevitable in 2008, when, for the first time ever, Freddie reported an annual loss. The
Financial Times, which gave the book a laudatory review, was not so coy. It called affordable
housing goals, “the government’s euphemism for ethnic minority neighbourhoods.”
Sometimes the social stereotyping subtle, conveyed in coded language such as that used by Hank
Paulson when he announced that the GSEs had been placed in conservatorship on September 7,
2008. "There is a consensus today that these enterprises pose a systemic risk and they cannot
continue in their current form," he said. "Because the GSEs are Congressionally-chartered, only
Congress can address the inherent conflict of attempting to serve both shareholders and a public
mission."
What systemic risk? Paulson didn’t say. But it was clear that the inherent conflict was about
affordable housing goals. That inherent conflict about a public mission is ubiquitous in modern
life. Every public utility, every private hospital, every military contractor, every privatized
prison, faces an "inherent conflict of attempting to serve both shareholders and a public
mission." A utility can boost profits by cutting back on grid maintenance; a hospital may
discharge Medicaid patients prematurely. Because these inherent conflicts show up in myriad
and subtle ways, Congress created regulators to continually oversee and limit those companies'
operations. The GSEs are overseen by FHFA, by HUD, and by the SEC.
As for the GSEs, this much-touted inherent conflict is illusory. If a GSE takes shortcuts in its
underwriting standards, the company and its shareholders pay the price in credit losses. The
GSEs’ policy toward all credit risk was buy-and-hold, an approach that is antithetical to the
originate-to-distribute model of Wall Street and PLS.
Again, this supposed conflict never stopped the GSEs from attaining the best loan performance
numbers anywhere. The concept, which insinuates that the GSEs forsook prudent credit
standards to meet affordable housing standards, is nothing more than a rhetorical sleight of hand.
It is used to distract away from the inherent conflict that is central to the originate-to-distribute
model of PLS, which enabled bankers to sell off dodgy credit risk to the greater fool.
Paulson and Geithner often use vague terms that blur critical distinctions—between regulatory
capital and “economic” capital, between a business model and management performance,
between liquidity and solvency. They insinuate all sorts of things that do not withstand scrutiny.
But often the social stereotyping is overt and shameless, as it was with Richard Herring’s tirade
against the GSEs, which is packed with falsehoods and distortions:

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[The issue is] the incoherence of having a private institution with a public purpose.7 The
conflict, of course, is in disavowing a government guarantee which had been done
repeatedly while at the same time providing a line of credit from the Treasury, exemption
from state and local taxes, classifying the issues as government securities and risk
weighting them in that way, exempting.... them from SEC disclosure requirements8 so
they're even more opaque than banks9 Permitting portfolios to grow to 13% of GDP
which is emphatically too big too fail and then a presenting a net subsidy which seems to
range from 20 to 45 basis points if you look simply at their funding advantage10
There had been a real corrupting impact of this public purpose that has been built into
it11 and it has been bipartisan12. If you give politicians the option to do something that
appears to be good at no cost, which, they tend to view guarantees and off balance sheet
financing of all sorts, they will do.it13
And in 1992 Congress authorized HUD to set quotas for the purchase of affordable loans
and as we've already heard they wrote 30% of affordable home purchases to 55% in
2007. So It really got out of hand it was uncontrollable and it was irresistible. And it was
absolutely predictable.
Also, I think they've done a very nice job of explaining the fundamental mistake of
subsidizing interest rates rather than equity.
It's actually foolhardy to push unqualified homebuyers14—which usually means they have
volatile incomes or perhaps none at all15 into a situation where they have a subsidized
interest rate but no equity interest16 so that whenever their income falls as it undoubtedly

7

The GSEs were consistently profitable, had the best loan performance in American history and repeatedly saved
housing finance in the wake of private market failures.
8
The GSEs were subject to SEC disclosure requirements; which Herring woke have known if he had ever read a
GSE financial disclosure. How rhetoric demonstrates that he never bothered.
9
The scope of GSE public disclosures far exceeds those of banks; Herring dissembled to the point of fraud.
10
The “funding advantage” is a fiction devised in a series of Fed studies by Wayne Passmore. The fatal flaw in
Passmore’s “studies” is that he cherry picks his data.
11
What evidence of corruption? In providing stability in the housing markets? Here we see Herring projecting the
fatal flaws of PLS, which embodied the corruption of Wall Street’s originate-to-distribute model, on to the GSEs.
12
Again, the “corruption” is unsubstantiated and is nothing more than a pretentious form of class bigotry.
13
The problem with Herring’s snide insinuation is that mortgage loans, unlike virtually all other forms of
government debt, are self liquidating. Every loan is repaid by scheduled amortization, by refinancing, or from
proceeds of a property sale.
14
The GSEs were subject to anti-predatory regulations that did not apply to PLS.
15
Here we see class bigotry at work. Low income, does not translate into volatile income. He accuses the GSEs of
extending credit to borrowers irrespective of income, which is a lie.
16
The GSEs cannot assume direct credit risk on mortgages with an LTV higher than 80%. It’s against the law.

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will), they are in very grave danger of being evicted and we are living with but
horrendous consequences of that now.17
It also of course has led to a real over investment in the housing sector18 and it made in
the end the GSEs the principal buyers of subprime securities19. And since they weren't
very discerning20, the supply got sloppier and sloppier21.
Those of us who studied financial institutions for a long time, this is really a tale of moral
hazard22. You have hugely undercapitalized institutions that are implicitly guaranteed
and weakly regulated23they are encouraged to buy risky assets24 and took increasing
credit and liquidity shocks25. These are as old as banking itself. They were basically
financing very illiquid long term assets26 with short-term paper27 and that makes you
incredibly vulnerable to a run28 which is something that people have commented on, but I
think there's no reason to try to perpetuate that structure.
When the shock occurred29, of course what happened is the flaw in constructive
ambiguity arose30, as it always does, and people who thought they were guaranteed31
began to ask if they actually were32 and without an explicit guarantee they ran33.
The economists have typically been very skeptical of GSEs. The benefits are very few to
anyone but the shareholders and managers34. Less than half the taxpayer subsidy at most
generous estimates have flowed through to borrowers35.

17

The GSEs were subject to anti-predatory lending rules, which prohibited lands to borrowers who couldn’t afford
them.
18
The doubling in mortgage debt, from $5 trillion to $10 trillion from 2001 to 2006, was tied to home equity
extraction.
19
The GSEs only bought the most senior triple-A tranches, which had average lives of one year or less.
20
The GSEs only bought the most senior triple-A tranches, which had average lives of one year or less.
21
The critical path for selling PLS deals was the subordinated tranches, which is why the comment is wry off the
mark.
22
He’s projecting the moral hazard of originate-to-distribute for PLS on to the GSEs, which retained credit risk.
23
The GSEs’s regulators were very intrusive and proactive,,; but they were also incompetent and corrupt.
24
“Risky,” devoid of context, is a meaningless term.
25
A lie, pure and simple.
26
False, GSE securitizations were and are highly liquid.
27
False, long-term assets were financed with long-term debt.
28
Nothing like a run ever occurred.
29
GSE liquidity was never affected by a shock.
30
He’s perfecting his own ideological biases on to a non-event.
31
He’s repeating a lie.
32
He’s repeating a lie
33
He’s repeating a lie
34
He ignores the GSEs role in liquefying markets.
35
He relies on dubious studies by Wayne Passmore.

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But I would argue that the true cost is even larger. It really has led to a corruption of the
political process36. It's probably the most powerful lobby in Washington37and led to the
whole destabilization of the financial system38. Surely this is a model that is fatally
flawed.
By making baseless accusations of moral hazard and corruption at the GSEs, Herring reassigns
blame for the institutionalized moral hazard and corruption that defined the PLS market.

PLS Fraud Went Viral
Nowhere in Guaranteed to Fail, or in the texts of any of the papers presented at the Brookings
event, will you find the word, “fraud.” Wallison, in his FCIC dissent, simply dismissed the
evidence of pervasive fraud gathered by the Commission. Other speakers at the Brookings event
basically ignored the issue altogether.
You can’t blame mortgage fraud on Fannie or Freddie because the two companies don’t originate
mortgages; they merely finance home loans that meet their criteria. Yet an abundance of
evidence showed that the GSEs were victims of fraud and that fraud had become institutionalized
in PLS during the bubble years.
How bad was the fraud in PLS? The Federal Reserve Bank of New York found that, in the
bubble states at the peak of the market, "almost half of purchase mortgage originations were
associated with investors. In part by apparently misreporting their intentions to occupy the
property, investors took on more leverage, contributing to higher rates of default." Fitch
reviewed the documentation of a small sample of subprime loans in default in late 2007, and
found some kind of misrepresentation in almost every file. In early 2007, before home prices
began to tank, BasePoint Analytics found that 70% of early payment defaults were tied to
mortgage fraud.
Investors in PLS bonds are not able to review every loan file. Nor is it practicable for bulk
purchasers of mortgage loans to do so. Which is why bother bond investors and loan purchasers
rely on standard representations and warranties in purchase contracts as a substitute for due
diligence. Reps and warrants – which traditionally claim that no document in connection with the
transaction contains untrue statements of material fact – have been used as the primary source of
legal comfort that the seller stands behind the purported accuracy of loan files in a pool of 2,000
mortgages.
Consider what U.S. Bank, N.A., a trustee of one Countrywide PLS deal, HarborView Mortgage
Loan Trust 2005-10, uncovered after it hired an underwriting consultant to review some
36

Dog whistle language.
Shills for Wall Street project their own corruption on the GSEs.
38
A bald faced lie.
37

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nonperforming loans. The consultant looked at a small but meaningful sample, 786 loans out of
total pool of 4,484 mortgages, and found that two-thirds of the loan sample, 520 out of 786,
contained one or more breaches of representations and warranties. About 90% of those breaches
involved fraud or violations of Countrywide's underwriting guidelines.
The definitive review of fraud in the PLS market was performed by outside outside counsel hired
by FHFA to review the loan files of mortgages held in triple-A tranches of PLS held by Fannie
and Freddie.
For each one of hundreds of different PLS deals sold by 18 different banks, counsel reviewed a
minimum of 1,000 loan files to test for homeowner occupancy and loan-to-value at the time of
the loan closing. To test the veracity of the banks' statements, the FHFA had reviews conducted
for 1,000 files in each loan group. So, for instance, the JPMorgan complaint involved reviews
of about 122,000 loan files. No easy, or inexpensive, task. The total review, of hundreds of
thousands of different loan files, may be the most comprehensive study of RMBS collateral
anywhere.

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Just look at some of the 122 residential mortgage-backed securitizations referenced in the lawsuit
against JPMorgan. Every one of those deals was sold with the claim that the pool had zero

mortgages with a loan-to-value in excess of 100%. But the opposite was true. At the time of
closing, all 122 deals held a material number of mortgages that exceeded the value of the
property.

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The uniformity is striking, as can be seen in similar tables in the Goldman Sachs complaint the
Merrill Lynch complaint the Royal Bank of Scotland complaint and in tables in a dozen other
lawsuits filed by FHFA on behalf of Fannie Mae and Freddie Mac.
It's hard to summarize the damning evidence set forth all 18 lawsuits, but a quick glimpse at
those tables gives you a sense of a widespread disregard for accuracy in S.E.C. filings.
Those numbers understate the magnitude of the problem. They reflect, for the most part, only
first lien LTVs, and not simultaneous 2nd lien debt, which also encumbered the collateral. (Many
of these deals had small percentages, usually 5% or less, of 2nd lien loans, for which the
combined LTV was used in the complaints' calculations.)
For instance, the prospectus for J.P. Morgan Mortgage Acquisition Corp. 2006-CH2 , which
financed only first-lien mortgages, stated there were zero mortgages with an LTV in excess of
100%. In fact, a subsequent review showed that 20% had mortgages that exceeded the value of
the collateral. Allstate Insurance conducted another review of the JPMAC 2006-CH2 loan files,
and found that 44% of the mortgages had CLTVs that exceeded the property values. As you
would expect, underwater mortgages perform poorly when home prices start sliding.
Moreover, FHFA’s lawyers presented an abundance of evidence that the underwriting banks
seriously overstated the percentages of owner occupancy in each mortgage pool. And, the
plaintiffs allege, there was an abundance of other evidence that banks simply disregarded their
stated credit standards.

Willful Blindness About Alan Greenspan’s Legacy
Long before the housing crash, there was an abundance of evidence that mortgage fraud had
gone viral in the subprime sector, as detailed in a report prepared by the Clinton Administration
and released on April 12, 2000. Five weeks later, May 24, 2000, Rep. James Leach, the
Republican Chair of the House Banking and Financial Services Committee, convened a hearing
and posed a question that that answered itself. He prefaced his question, with the legislative
history of the Home Ownership and Equity Protection Act of 1994:
Congress six years ago passed a law which was very strong in its sense of purpose in
outlawing predatory lending in effect. And then, because Congress felt that the subtleties
of this were beyond the Congress, we gave two federal regulators, most specifically the
Federal Reserve Board of the United States, the authority to make definitions and to
move in this direction…Just to go back to this law, what we said and we gave particularly
to the Fed:

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"The Board by regulation or order shall prohibit acts or practices in connection with
mortgage loans that the Board finds to be unfair, deceptive or designed to evade the
provisions of this law." I'm paraphrasing partially at the end. "And in connection with
refinance of a mortgage loan that the Board finds to be associated with abusive lending
practices or that are otherwise not in the interest of the borrower."
So the question becomes if there is a problem out there: If Congress has given very strong
authority to regulators and the Federal Reserve, are regulators and the Federal Reserve
AWOL?
Indeed Alan Greenspan’s Fed was AWOL according to the FCIC Report, which made headlines.
“Fed takes a flogging in FCIC report,” reported Fortune on January 27, 2011. “The report argues
that the U.S. central bank failed to stem the flow of toxic mortgages,” reported MarketWatch. As
the FCIC wrote, “More than 30 years of deregulation and reliance on self-regulation by financial
institutions, championed by former Federal Reserve chairman Alan Greenspan and others…had
stripped away key safeguards, which could have helped avoid catastrophe.” As the keynote
speaker at the Brookings event, Greenspan was given a platform to respond to the FCIC’s
conclusions. But neither he nor his questioners brought up the topic. It seemed as if the FCIC,
like the legal status of the GSEs, like the GSE’s liquidity, and like the GSEs’ loan performance
in the context of the broader market, was a verboten topic.

Brookings And The Echo Chamber For GSE Abolition
The Brookings event was the most prestigious in a series of events and publications, which were
scheduled to precede or follow release of the FCIC Report, to provide media platforms for
mortgage experts who gave substantially identical arguments for abolishing the GSEs.
The Great American Bank Robbery preceded the FCIC Report by 10 days. Published on January
17, 2011, the book was written by Paul Sperry, who, before he became a fellow at the Hoover
Institution, was Washington Bureau Chief of WorldNetDaily. Sperry trashed the FCIC for being
politically biased. To illustrate how the GSEs and affordable housing goals had caused the crisis,
Sperry offered Pinto's numbers in graphic form39.

39

Wallison used a chart with the same numbers in his FCIC dissent and in his paper for Brookings. The same chart
would show up later in other books written by Wallison, and in Black Box Casino by Robert England and in Fannie
Mae and Freddie Mac: Turning the American Dream into a Nightmare by Oonaugh McDonald, who devoted 1,400
words to describe Pinto’s methodology.  

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Pinto’s message was amplified three days later, on January 20, 2011, when Rep. Jeb Hensarling
(R-TX), hosted an event to promote a new white paper, “Four Principles to End Housing
Bailouts and Eliminate the GSEs,” written by Peter Wallison, Alex Pollock, and Ed Pinto.
Wallison repeated his message on January 25th at an AEI event titled, “What Should Replace The
GSEs?” And on February 9, 2011 Pollock testified at a House hearing on GSE Reform, at which
“Four Principles to End Housing Bailouts and Eliminate the GSEs,” was entered into the record.
Also in Washington, on January 24th, NYU and the University of Maryland jointly sponsored a
conference titled, “The GSEs, Housing & the Economy.” Speakers advovating GSE abolition
included Dwight Jaffee, plus NYU Profs. Lawrence J White and Matthew Richardson, who also
touted their book, Guaranteed To Fail, which cited the research of Wallison, Pinto, Pollock and
Jaffee.

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Though marketed as an academic book by an academic publisher, Princeton University Press,
Guaranteed To Fail is more like a political tract that makes its case with inflammatory rhetoric
as a substitute for evidence. They describe Fannie and a Freddie as a "ticking time bomb," a
"monster" created by "Dr. Frankenstein.” The GSEs are also called “the Devil's Cigarette
Lighter," as well as "King Kong," and "Godzilla." The companies sparked a "Gold Rush," which
precipitated "Falling Off A Cliff," and "The End of Days.” They claim the GSEs are "the largest
hedge fund on the planet,” and, apparently, the only hedge funds on the planet that took buy and
hold position on all credit risk.
On February 11, 2011, the same day that Treasury released its report to Congress, BlackRock
published a nice glossy document, "Getting Housing Finance Back On Track." which evaluated
Treasury's three proposals. Of those three, BlackRock preferred the one advocated by Hancock
and Passmore, which was a "continuous catastrophic reinsurance program guaranteed by the
Federal Government that would be used to back primary guarantees sourced solely with
significant private capital." Moreover, wrote BlackRock, "the tone of the Report leads us to
believe that [this option] is the one favored most by the Treasury and the US Department of
Housing and Urban Development (HUD)."
A few weeks later, on March 2011, the Koch Brothers Mercatus Center presented, "Five
Proposals for a New Housing Finance System in the United States." Three of those proposals
came from experts who spoke at Brookings–Peter Wallison, Lawrence White and Dwight
Jaffee–and all of the proposals advocated abolition of the GSEs.

END PART 1

GSE Reform And A Conspiracy Of Silence

David Fiderer