Journal of Financial Economic Policy

The financial crisis: imperfect markets and imperfect regulation

Richard J. Buttimer
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Richard J. Buttimer, (2011),"The financial crisis: imperfect markets and imperfect regulation", Journal of
Financial Economic Policy, Vol. 3 Iss 1 pp. 12 - 32
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JFEP
3,1 The financial crisis: imperfect
markets and imperfect regulation
Richard J. Buttimer Jr
12 Department of Finance, Belk College of Business, UNC Charlotte,
Charlotte, North Carolina, USA

Abstract
Purpose – This paper seeks to examine the role that regulation and regulatory agencies played in the
creating of the subprime mortgage market, and the subsequent crash of the mortgage market. The paper
has two goals. First, it seeks to document the degree to which the US housing markets, and the US
housing finance market, were regulated prior to the crash. Second, it seeks to show that regulatory
bodies set policies which created both incentives and explicit requirements for Fannie Mae and
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Freddie Mac, as well as depository institutions, to enter the subprime market.

Design/methodology/approach – The paper examines the regulatory environment of the
subprime market. It uses regulatory filings and other documents as primary sources.
Findings – The popular perception that the subprime mortgage market arose because housing finance
was largely unregulated is incorrect. In point of fact, the housing finance market was very heavily
regulated. Indeed, the paper shows that the creation of the subprime market was a formal goal of the
federal government, and that federal regulatory agencies explicitly required participation by the
Government Sponsored Enterprises (GSEs).
Originality/value – The paper’s primary implication is that incentive conflicts within the US housing
finance system significantly contributed to the mortgage crisis. These incentive conflicts were not just
within private firms, but also extend to the GSEs and regulatory agencies. Regulatory agencies not only
failed to anticipate the crisis; they actively encouraged the policies which created it. As a result, the
primary focus of reform efforts should be on identifying and eliminating such conflicts.
Keywords Financial management, Mortgage companies, Mortgage default, Residential housing,
United States of America
Paper type Research paper

Journal of Financial Economic Policy
Vol. 3 No. 1, 2011
pp. 12-32
q Emerald Group Publishing Limited
1757-6385
DOI 10.1108/17576381111116795
I. Introduction
The global financial crisis is unprecedented in the era of modern finance. Its origination
in the US housing and mortgage finance markets and subsequent transmission into other
asset markets has exposed significant structural problems. The crisis has, in particular,
exposed the existence of serious information asymmetries in several markets, especially
with respect to securitization. It has also illustrated how poorly developed contracts
create difficulties for markets[1]. Many commentators have also noted egregious
unethical behavior on the part of lenders, brokers, and borrowers (Downs, 2008). One of
the major themes currently in the public consciousness is the notion that the subprime
debacle and the subsequent contagion to the rest of the economy were the result of free
markets run amok (Goodman, 2007; or Downs, 2007). Paraphrasing the old adage, the
idea seems to be that “for want of a regulation the economy was lost.” Indeed, a New York
Times editorial explicitly blamed the mortgage market collapse on a lack of federal
regulation (New York Times, 2008).
This paper examines the role that regulation and regulatory agencies played in the
creation of the subprime mortgage market, and its subsequent crash. It also examines the
difficulty that regulatory efforts face when dealing with so-called “black swan” events:
 events that happen so rarely planning for them is virtually impossible, but which have an The financial
extreme effect when they do occur[2]. In particular, this paper argues that the liquidity crisis
crisis portion of the meltdown is such an event and that “more” regulation would
not have been very likely to have prevented it. The paper has three goals. First, it seeks
to document the degree to which the US housing markets, and the US housing finance
market, were regulated prior to the crash. Second, it seeks to show that regulatory bodies
set policies which created both incentives and explicit requirements for Fannie Mae and 13
Freddie Mac, as well as depository institutions, to enter the subprime market, and that
these agencies did not fully appreciate the financial risks, and especially liquidity risk,
such entry entailed. Third, it discusses how the liquidity crisis of 2008 was a
“black-swan” type of event that caught both regulatory bodies and market participants
unawares.
The outline of the paper is as follows. Section II examines the evolution of the US
housing finance market and the reasons for the existence of Fannie Mae and Freddie Mac.
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Section III discusses the difficulties that extremely rare events place upon regulatory
bodies. Section IV examines the regulatory environment of the Government Sponsored
Enterprises (GSEs), in particular the basic approach that regulatory bodies took when
measuring financial risk at these firms. This section also examines the non-financial
regulations that the GSEs faced. The section also briefly examines how accounting rules
created a feedback loop which exacerbated liquidity problems once the market realized
that the housing sector had serious problems. Section V examines how housing finance
was regulated at depository institutions and at the concerns that their regulatory bodies
had about subprime mortgage lending. Section VII concludes the paper.

II. Evolution of the GSEs

The US housing finance system, and its accompanying regulatory framework,
evolved over a long period of time. The two largest entities in this system, Fannie Mae
and Freddie Mac, are unique and have no other analog in the US economy[3]. Their
development and evolution mirror the evolution of the US housing finance system in the
modern era. To understand how the system failed with the subprime crisis and the
subsequent liquidity crisis, one must first understand how and why these entities came to
exist in the first place. This story also explains how the federal government came to have
such a major role in the regulation of housing finance.
Prior to the Great Depression, the housing finance system in the US was largely
local in nature, and so was its regulation. Laws which prevented interstate, intrastate,
and in some cases even branch, banking had the effect of forcing mortgage lending to be
done at the state or local level, and hence most regulation was also at the local level.
Financial institutions managed interest rate and credit risk primarily by limiting the
term of mortgage loans; the typical home loan had a five-year term to coincide with
the short-term nature of the deposits which funded them. Because of the short-terms of
mortgages, amortizing loans were not practical, and therefore borrowers typically
took out interest-only loans. This resulted in borrowers having either to pay off a large
balloon note after five years, or to refinance into a new five-year note at maturity.
In addition, lenders typically required very large down payments; down payments of
one-half of the house value were not uncommon.
Whenever a local bank faced a funding crisis it was forced to stop lending, including
mortgage lending for both purchases and refinancing. Borrowers with maturing
 JFEP mortgages were unable to get refinancing and faced foreclosure. Further, these borrowers
3,1 found that they were unable to sell at prices that made default non-optimal because
potential buyers were also unable to get financing. As a result, default became relatively
common and there were significant concerns about resulting political instability. During
the Great Depression, credit crises occurred throughout the US over a relatively long
period of time, and home loss due to foreclosure induced by an inability to get financing of
14 maturing mortgages was relatively common[4].
Even before the inauguration of FDR and the launching of the New Deal the federal
government was beginning to become involved much more deeply in the US housing
finance system. In 1932, Congress created the Federal Home Loan Bank system to
provide financing and liquidity for what eventually became the savings and loan system.
The most sweeping changes, however, occurred with the introduction of the New Deal.
One of President Roosevelt’s first goals was to create a finance system which
would allow homeowner to obtain fully amortizing loans. In order for this to be practical,
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loan terms had to extend to at least 20 years. Lenders were concerned with issuing
such long-term loans because of both credit risk and the inherent maturity mismatch
that they created. To help address credit risk, Congress in 1934 created the Federal
Housing Administration as an agency to provide mortgage insurance on privately
issued mortgages[5]. The 1933 Glass-Steagall act authorized the Federal Reserve to
implement Regulation Q capping bank funding costs and attempting to render the
maturity mismatch moot. From that moment forward the federal government has been
deeply involved with the US mortgage finance system, and has ever since maintained a
very strong regulatory presence in that market.
Even after these first regulatory steps, however, financial institutions continued
to face serious liquidity problems throughout the 1930s. In an attempt alleviate
this liquidity problem, Congress in 1938 established the Federal National Mortgage
Association (FNMA, or Fannie Mae) for the purpose of creating a secondary market
in home mortgages. In its original form Fannie Mae was a part of the federal government.
It was originally tasked with direct purchasing of mortgages from lending institutions.
Its ultimate purpose, however, was to create a secondary market through which
financial institutions could trade mortgages in order to enhance the liquidity of the
mortgage marketplace.
Fannie Mae was not particularly successful in establishing a truly national secondary
market for mortgages, but it did establish the de facto national standards for fixed-rate
mortgages. This infrastructure was instrumental in the later evolution of the national
mortgage market. In particular, Fannie Mae established the notion that the monthly
payment amount should be fixed and that the loan should amortize over the life of
the loan. These standards also nominally placed both interest rate risk and housing price
risk on the shoulders of the borrower, although the borrower’s right to prepay and their
ability to default effectively transfers much, but not all, of this risk to the lender. Fannie
Mae also standardized contractual language, the security interest, and other loan terms.
In 1965 the federal government created a new cabinet agency, the US Department of
Housing and Urban Development. This agency became the primary agency responsible
for all federal housing programs and policy. FHA, FNMA, and certain other programs,
were placed under the auspices of HUD, although they continued to have their own
identities within HUD. Financial oversight of both agencies, however, was the
responsibility of the Secretary of Housing and Urban Development.
 In 1968, FNMA was partially privatized. It was designated as a GSE, a status it The financial
still retains. This status means that the firm is owned by shareholders, but that the crisis
federal government has significant control over the leadership and policies of the firm.
In particular, the CEO and one-third of the board of directors are appointed by the
President of the United States and subject to Congressional confirmation. Further, the
federal government has the right to require the GSE to undertake certain mission that
are in the public interest, even if they are not necessarily profit-maximizing for, or even in 15
the interests of, the shareholders.
The conversion of Fannie Mae to GSE status came with a renewed mandate for it to
make a secondary market for mortgage loans. At the same time, the federal government
created a new agency within HUD called the Government National Mortgage Association
(GNMA, or Ginnie Mae) which was tasked with creating and maintaining a secondary
market for FHA-insured loans. Financial oversight of these two entities primarily rested
with HUD. In fact, Fannie Mae’s charter specifically exempted it from many of the
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securities regulations that the SEC placed on other private firms.

In 1970 Congress created another GSE, the Federal Home Loan Mortgage Corporation
(FHLMC, or Freddie Mac), to compete with Fannie Mae. Freddie Mac was originally
placed under the regulatory mandate of the Federal Home Loan Bank Board, but in 1990
was also brought in under HUD’s regulatory mandate. Freddie Mac’s federal charter is
nearly identical to Fannie Mae’s, and the two companies have always been similar in
both operations and their economics.

III. Regulation in the presence of extreme events

Most regulatory bodies are fundamentally risk managers. Their raison d’être is to
prevent some bad consequence within their sphere of regulation from affecting the
public at large. In essence they seek to prevent the actions of their regulated entities from
imposing costs (i.e. negative externalities) on others. In some contexts, such as in
aviation or nuclear power, the regulatory body seeks to prevent a bad physical outcome
for the public. For most financial regulatory bodies the potentially bad outcome is a
financial loss so large that the public loses confidence in the financial system. As a risk
manager, the regulatory body seeks to identify, quantify and then ultimately manage the
risk for which they have responsibility. Like other entities, however, they have limited
resources and must deploy those resources where they will be most beneficial. They
must also frame their risk-management view in a way that either meshes with the
understanding of risk within the regulated industry or which defines risk in a new way
and leads the industry.
Financial regulatory bodies have largely embraced the financial risk paradigm that
was developed in the financial economics literature over the past thirty years. In this
paradigm risk is most commonly defined as the standard deviation of returns.
Implicitly, this measure of risk assumes that return follow a normal distribution[6]. That
view is not without critique, however, as some researchers have documented that
returns for many investments do not follow a normal distribution. There is a large
sub-literature within the financial econometrics literature that shows that stock returns
in particular have “fatter” tails than what the normal distribution would imply (Jansen
and de Vries, 1991).
If returns are not normally distributed, risk measures built upon the assumption of
normality will not reflect the full degree of risk in an investment. Risk management and
 JFEP mitigation plans built around those measures will at best be only partially effective
3,1 and at worst ineffective. As Taleb (2007) argued, the real danger lies in the potential for
catastrophic events to lie in the extreme tails of the return distribution. That is, that there
could be the possibility of an event occurring that is very rare, but that should it occur
would cause the entity bearing that risk, such as a company or the economy as a whole,
to collapse. He refers to these events as “black swan” events.
16 Although this is a problem that any risk manager, even those in the private sector,
must consider, it is an especially difficult problem for the regulator. This is because the
risks which they are charged with controlling are systemic risks, and those are precisely
the rare, extreme events that show up in the tails of distributions[7]. They also tend to be
the types of events that when they do occur are highly disruptive not to just one firm but
to the entire economy. The burden of the regulator is to identify those risks before hand
and then have in place a plan for dealing with them when they do occur. This is, of course,
an extraordinarily difficult task – the rarity of the events means that they are usually
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without precedent and it is notoriously difficult to develop and implement a plan for an
unknown, and potentially unknowable, risk.
Indeed, one could argue the regulator must actually be concerned with two different
types of “black swan” events. The first type is the event which is known to be able to
happen, but which occurs so infrequently that any empirical estimation of its probability
of occurrence would be zero. In essence this type of event is fundamentally a mistake in
probability estimation. Given unlimited resources one could have identified, measured,
and managed the risk. The second type is the truly unfathomable event, i.e. the event
which is so far outside of one’s experience that nobody could foresee it. An example of
such an event might be the discovery of the New World and the subsequent change in the
economic order of Europe. With this type of event no amount of effort could discover the
risk before it manifests itself.
In some sense, however, these are two sides of the same coin. With the first type of
event, the regulator could with unlimited resources presumably quantify the risk.
The difficulty is that regulatory bodies do face limited resources, and this forces them to
prioritize risks. Those risks that fall below a threshold level of probability of occurrence
and severity must be ignored. The regulator understands that the risks exist; they just
recognize that they cannot do anything about them without reducing efforts on higher
priority risks[8]. With the second type of event, since it is unfathomable the regulator
has no hope of measuring or managing the risk. Yet, the regulator does understand
that unfathomable risks do exist and that they do occasionally occur. In essence they
know that there will be future unfathomable events, and they also know that they have,
implicitly, underestimated their probability of occurrence. Observationally, the outcome
of the two are the same – an event that “comes out of nowhere” to bite the regulator, the
regulated entity, and the economy as a whole[9].
The economic collapse of 2008 is such an event. The initial shock was a downturn in
the housing market which triggered a series of defaults on subprime mortgages[10].
As the depth and scope of the problem became clearer through late 2007 and into 2008,
liquidity in the secondary mortgage markets, especially for the non-GSE issued securities,
dried up as the marketplace as a whole began to question what the returns on those assets
would eventually be. This made it difficult for firms to sell assets to raise capital when
they needed to do so. Essentially, the risk management plans of firms assumed liquidity
in the markets, but when the time came to execute the plan, the liquidity was not there.
 This liquidity crisis – which reached critical levels in late 2008 – was the “black swan” The financial
of the financial crisis. crisis
In some sense this was the type of black swan event in which the risk is known
but underestimated. As previously discussed, liquidity was a primary motivation
for creating the secondary mortgage markets in the first place, so it was a known risk.
Further, financial economic theory and the sub-specialty of risk management explicitly
assume liquidity in capital markets. This is embodied in the seminal papers in the field, 17
Markowitz (1952), Lintner (1965), Black and Scholes (1973), Merton (1973), and others.
So it is was not the case that the importance of liquidity was not known, but rather the
presumption in the markets and with regulatory bodies was that the risk of a loss of
liquidity risk very low. The key to the notion of the perceived “Great Moderation” was
that central banks had figured out how to contain, among other things, liquidity risk.

IV. Regulation of the GSEs

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a. Financial regulation of Fannie and Freddie

The modern housing finance era began with the widespread introduction of amortizing
mortgages in the 1930’s, and was completed with the partial privatization of Fannie Mae
and the creation of Freddie Mac in the late 1960’s and early 1970’s. Fannie Mae and
Freddie Mac developed the market for the mortgage pass-through security[11]. Under
this system, Fannie and Freddie purchased loans which met their credit-worthiness
guidelines, transferred ownership of these loans into trusts, and then sold proportional
claims to the monthly cash flows of these mortgages[12]. Fannie and Freddie guaranteed
the timely repayment of principal associated with these Mortgage Backed Securities
(MBS), and they charged a fee for providing this guarantee. MBS purchasers liked this
guarantee because it effectively transformed borrower default into a prepayment[13].
Beyond this guarantee, however, Fannie and Freddie had no financial interest in the
MBS, and no liability for its performance. Once Fannie or Freddie placed a loan into an
MBS pool, that loan was no longer an asset on the balance sheet of the firm.
It is worth noting that the GSE’s guarantee program was, in essence, a short put
position on the national housing market[14]. As shown by numerous academic studies
(Epperson et al., 1985; Hilliard et al., 1998; Ambrose and Buttimer, 2000), a necessary
condition for large numbers of borrowers to default is for house prices to fall below the
value of the underlying mortgages. Essentially if house prices fall sufficiently, borrowers
can “sell” the house back to the lender in return for not making the mortgage payments[15].
While there is legitimate debate as to whether there are other necessary conditions,
so-called trigger-events, that are also required the academic literature shows that the
primary condition is a decline in house price. Indeed, it was not until home prices in certain
markets, notably California, Florida, Arizona, and Nevada, began to fall that subprime
defaults became substantial. When viewed this way, it is easy to see why the GSEs were
originally required by Congress to only purchase loans with large down payments (at least
20 percent) or that carried either FHA or private mortgage insurance[16].
The Fannie/Freddie MBS program was extremely successful. By the early 1990’s the
vast majority of eligible loans were securitized through this system. Around this time,
Fannie and Freddie began to expand significantly the number of mortgages that they
did not securitize. These loans, known as the investment, or retained, portfolios, were
held on the balance sheets of Fannie and Freddie. The firms were holding these loans
as an investment and were taking all of the risks associated with holding mortgages.
 JFEP The risks in these holdings are substantially greater, and different, from the risks
3,1 inherent in their normal guarantee business. One such risk would be the risk of the
mortgage price rising or falling because of a change in market interest rates. These
portfolios eventually grew into a combined size of approximately $1.5 trillion (Lockhart,
2008)[17].
There was substantial debate about these investment portfolios prior to the financial
18 crisis. Many academics argued that these portfolios were a type of “regulatory
arbitrage” that simply allowed the managers and shareholders of the GSEs to use their
government-endowed funding advantage to buy large mortgage holdings (Quigley,
2006; or Jaffee, 2005). Others, such as Roll (2003) and Miller and Pearce (2006), argued
that these portfolios were really just an alternative way of “securitizing” the mortgages.
They argued that, there was a segment of the investing population that did not want to
directly bear prepayment risk. By issuing non-callable corporate debt and using the
proceeds to purchase mortgages for the investment portfolio, this allowed the GSEs to
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expand their purchase activity and to increase the availability of mortgages. This, they
argued, meant the GSE funding advantage flowed to consumers even when the loans
were not directly securitized.
During the late 1980’s and early 1990’s, the increasing size and scope of Fannie
and Freddie led Congress to determine that it was appropriate to form a dedicated
financial regulatory body. In 1992, Congress created the Office of Federal Housing
Enterprise Oversight (OFHEO). OFHEO was an independent regulatory agency that
was housed administratively within HUD, but which reported directly to Congress.
OFHEO’s primary mandate was to ensure that Fannie and Freddie were operated in a
safe and sound manner. To this end OFHEO conducted detailed on-site examinations of
both Fannie and Freddie[18].
OFHEO was also tasked with developing a risk-based capital adequacy test (a “stress
test”) for Fannie and Freddie. This stress test was supposed to ensure that Fannie and
Freddie had sufficient capital to be able to withstand depression-era default levels
coupled with extreme shifts upward and downward in interest rates. OFHEO began
applying these risk-based capital rules in 1999, and ran them quarterly thereafter.
Initially, OFHEO found both Fannie and Freddie to be adequately capitalized[19].
In the third quarter of 2004, OFHEO found Fannie to be undercapitalized. By the first
quarter of 2005, OFHEO found Fannie Mae to once again be adequately capitalized.
During late 2007, OFHEO re-categorized Fannie Mae as being inadequately capitalized
during the first three quarters of 2002, and for all of 2003 and 2004[20]. As late as March
31, 2009 OFHEO classified Fannie Mae and Freddie Mac as being adequately
capitalized[21]. Despite this, on September 7, 2008 the firm’s capital positions had
deteriorated to the point that they had to be placed into federal conservatorship.
Why did the OFHEO stress test not indicate hat Fannie and Freddie were in trouble
sooner? There is still much debate about this, but there are two reasonable and
non-mutually exclusive explanations. The first is that a collapse in confidence in the
mortgage market occurred very rapidly. It may well be the case that Fannie and Freddie
were adequately capitalized in March of 2008, but that the rapid decline in market
conditions eroded their capital within four months.
The OFHEO capital adequacy tests were primarily designed to ensure that the GSE’s
could honor their guarantee obligations on their MBS, and so primarily focused on the
default risks that they bore. Although the stress tests did include the retained portfolios
 of the firms, the focus of the stress test, as mandated by Congress, was on the economic The financial
performance on the loans. That is, they were geared to measure the risk of loans going crisis
into default. The test was not geared toward a collapse in liquidity, i.e. a decrease in the
market price of mortgages that was disproportional to changes in defaults or
delinquencies. This is exactly what happened to the general mortgage and fixed-income
markets in the summer and early autumn of 2008.
Again, this failure to include liquidity risk was not because the risk was unknown, but 19
rather because it was perceived as being of much lower magnitude than the direct risk
that the firms faced from mortgage default. That is, it was a risk that was known, but
which was given effectively zero probability because resource constrained regulators
had to focus on risks which were perceived to be of more importance. In this sense the
liquidity crisis affected the GSEs as the first type black swan event.
No discussion of the financial regulation of Fannie Mae and Freddie Mac can be
complete without at least a brief mention of the accounting scandals of the early 2000’s.
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Although not central to their ultimate collapse, the discovery of accounting irregularities
brought about a significant amount of regulatory oversight to the firms during
the mid-2000s. OFHEO conducted “Special Examinations” of both Freddie and Fannie
during 2003 and 2006, respectively. In other words, the collapse of the GSEs happened not
in a regulatory vacuum, but rather at a time when they were under enhanced regulatory
scrutiny.
Beginning in the late 1990’s, both Fannie and Freddie engaged in accounting
practices that were not in compliance with generally accepted accounting practices
(GAAP), the accounting standard used by private firms in the USA. In both cases, the
purpose of these irregular practices was to reduce the volatility of earnings for the firms.
In essence they allowed the firms to transfer high earnings in one period to future periods
that had lower earnings. This sent an improper signal to investors that the firms were
less risky than they really were.
The compensation of the executive leadership at both firms was directly tied to
meeting earning per share targets. The accounting irregularities directly affected the
reported earnings per share. OFHEO found that at Fannie Mae, as a “direct result, senior
management knowingly and purposefully used accounting maneuvers to achieve
earning goals to increase their own compensation” (OFHEO, 2006, p. 4). At Freddie Mac
OFHEO found that the executive compensation scheme being tied to earning per share
“contributed to the improper accounting and management practices of the Enterprise”
(OFHEO, 2003, p. iv).
Because of these accounting scandals, Fannie Mae and Freddie Mac were both
under extraordinary regulatory and political scrutiny for years. Indeed, Wallison and
Calomiris (2008) argue that the primary reason that the GSEs accelerated their entry into
the subprime market after 2004 was because of political pressure to do so relating to
these accounting scandals. Further, the relationship between Fannie Mae and OFHEO in
particular became particularly adversarial with OFHEO publicly accusing Fannie of
using political connections to hamper its regulatory investigation (OFHEO, 2006, p. 3).
Given this climate, it is unlikely that OFHEO would have been inclined to take any
information about risk from Fannie or Freddie at face value. OFHEO had every incentive
to be especially diligent at finding and measuring risk at these institutions. Further, the
political winds had shifted such that OFHEO would have the ability to get virtually any
 JFEP information that it wanted form Fannie or Freddie. Yet despite this, both firms
3,1 eventually failed four months after having been found to be adequately capitalized.
Both firms failed not just because of the direct losses they suffered from defaulted
loans, but also because the market for virtually all fixed income instruments simply
ceased to function[22]. Their risk management plans, and the capital adequacy tests that
OFHEO used to measure risk, did not contemplate such an event. Both OFHEO and the
20 GSEs focused their risk management efforts on what was universally considered to be
the biggest risk that the GSEs undertook: the risk that defaults would supersede their
ability to make whole MBS investors. The risk of a major liquidity crisis was considered
so small that no regulatory agency or major financial institution was actively planning
for it. There are certain risks which, while real, are either simply too unlikely to justify
spending significant regulatory resources to monitor, or are so hard to fathom that they
are simply missed. This creates the conditions for the emergence of a “black swan” of the
first type – i.e. a risk which is known but given low managerial/regulatory priority.
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OFHEO, like any other economic entity, had to decide how to deploy most effectively
the scarce resources that it controlled. It simply would not be possible to model every
potential risk, no matter how small, that entities as large as Fannie and Freddie bear.
OFHEO spent the majority of their resources monitoring the widely acknowledged
default risk which Fannie and Freddie bore, and, when the accounting scandals arose,
they invested additional resources to ensure that those scandals were resolved. It seems
extremely unlikely that had OFHEO had more resources that they would have devoted
the issue of a collapse in market liquidity. In other words, the problem was not that there
was not enough regulation; the problem was that under no reasonable level of resourcing
would this risk have been given any priority. There are simply some financial risks that
a prior are so remote that even highly effective regulators would leave unmonitored.

b. Non-financial regulation of Fannie and Freddie

One of the advantages that GSE status holds for Fannie and Freddie is that the credit
markets assumed they had the backing of the federal government, although until 2008
this backing was implicit[23]. This implicit backing allowed the GSEs to borrow at rates
substantially below that of other financial institutions. Typically they were able to
borrow at rates of only 15-30 basis points higher than Treasury rates when AA rated
financial institutions were borrowing at closer to 100 basis points above Treasury.
In return for this preferential borrowing ability, Fannie and Freddie are required to carry
out missions that are deemed to be in the public interest that would not traditionally be
expected of private firms.
After 1992, regulation of the GSEs was bifurcated with OFHEO becoming the
primary financial regulatory agency and with HUD retaining other regulatory authority.
One area in particular in which HUD had explicit regulatory authority was in the
promulgation of and compliance with the affordable housing goals. These goals are set
by HUD, in compliance with mandates from Congress, to ensure that housing is broadly
available and affordable to all Americans.
In 1999, HUD promulgated affordable housing goals for the period 2000-2004 which
substantially increased the number of affordable home mortgages which Fannie and
Freddie were required to purchase. The affordable housing goals essentially created two
categories of loans that Fannie and Freddie were required to purchase. The first were those
that came from traditionally underserved geographic regions, i.e. those that came from
 geographic regions with high concentrations of minority and low-income households[24]. The financial
The second were loans made to borrowers with incomes substantially below the area crisis
median income.
By definition, the majority of loans which counted toward the GSEs meeting the
Affordable Housing Goals did not meet their normal conforming loan guidelines, i.e. they
were either subprime or Alt-A[25]. To be clear, in order to meet the Affordable Housing
Goals, Fannie and Freddie were required to purchase subprime mortgages[26]. Indeed, 21
after the promulgation of the 1999 rule Fannie and Freddie greatly increased their
purchase of subprime mortgages. In 2004, HUD finalized the 2005-2008 Housing Goals.
As part of that process, HUD subjected the proposed rules to public comment and then
published responses to those comments. That response and analysis was published as a
final rule in the Federal Register on November 2, 2004 (HUD, 2004, pp. 63579-63886).
HUD’s 2005-2008 housing goals required Fannie and Freddie to significantly
increase their purchase of loans from underserved regions and low-income borrowers.
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In its Final Rule, HUD specifically addressed the impact that this would have on the
subprime market and on the participation of Fannie and Freddie in that market. HUD
noted that “neither GSE was supportive of the higher goal levels for 2005-2008”
(HUD, 2004, p. 63582). Further, HUD noted that both “GSE’s indicated that they would
need to increase their purchase of subprime loans to meet the higher goals” (HUD, 2004,
p. 63600). Tellingly, HUD also acknowledged that “Freddie Mac stated that the increased
affordable housing goals created tension in its business practices between meeting the
goals and conducting responsible lending practices” (HUD, 2004, p. 63600).
In its analysis, HUD ultimately concluded that the benefits to lower income and
traditionally underserved borrowers outweighed the potential financial risks to the
GSEs. The analysis noted that Fannie and Freddie were, at the time, profitable, had large
cash reserves, and were also among the largest companies in the US based on this HUD
concluded that Fannie and Freddie “have the ability to lead the industry in making
mortgage credit available for low- and moderate-income families” (HUD, 2004, p. 63742).
Further, HUD concluded that “the goals raised minimal, if any, safety and soundness
concerns” (HUD, 2004). Interestingly, the goals only mandated what the GSEs had to
purchase, which effectively limited the scope of the goals to focusing on the origination
of loans. The goals did not set standards or requirements for the long-term performance
of the loans.
The implication from the Final Rule is that HUD felt that Fannie and Freddie were too
large to have been much affected by the risks associated with subprime. This, of course,
gets at the gist of the problem. HUD, with the best of intentions, was more concerned
about meeting the public purpose of increasing home availability and affordability than
the financial performance of Fannie and Freddie. In some sense, HUD had a binary
definition of success or failure: the rule would have been successful if Fannie and Freddie
had met the affordable housing goals and had stayed solvent. If this had brought
about a reduction in the rate of return on GSE stocks from say 15 percent to 10 percent,
or even from 15 percent to 1 percent, the program would still have been “successful” from
a regulatory standpoint[27]. A shareholder, of course, would have had a very different
definition of success: they would measure degrees of success based on how well the
firm’s stock performed.
Compounding the problem was that Freddie and Fannie did not use their standard
business model to purchase the subprime loans. Instead of directly purchasing subprime
 JFEP loans, securitizing them as Fannie or Freddie MBS and selling those bonds
3,1 into the secondary market, Fannie and Freddie primarily purchased subprime loans
through the CDO market. That is, they purchased subprime loans which had already
been securitized by banks or other issuers[28]. This did allow Fannie and Freddie to
capture all of the returns (i.e. profits) on those securities, and certainly the two GSEs
were eager to earn those returns. It did, however, have two profound implications for the
22 riskiness of the firms. First, by keeping the subprime loans on their books, it put the
shareholders of Fannie and Freddie in a first-loss position for these assets. Had they
wished to do so, the shareholders had no way of removing these assets from the firm.
Indeed, because of the affordable housing goals, the shareholders did not even have the
option to not engage in the business if they felt the risks were too high. Thus, Congress
essentially mandated that the shareholders (both common and preferred) of Fannie and
Freddie bear the primary risk of what is essentially a major national housing goal. This
was, of course, the deal that shareholders entered into when they bought Fannie or
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Freddie stock, but still one has to question whether it is wise public policy to put that
type of risk on such a narrow segment of the population[29].
The only practical way for the firm to reduce this exposure was through the
credit-derivatives market. The difficulty was that Fannie and Freddie’s positions were
so large that finding counterparties that were willing to take on the risk was difficult.
Further, the size of the Fannie and Freddie subprime portfolios were so large that any
attempt to hedge the majority of their exposure through the credit derivatives markets
would have moved those markets and probably prevented the GSEs from truly hedging
these risks anyway. An alternative approach for the GSEs would have been not to reduce
their exposure, but rather to mitigate it. One way to have done this would have been to
increase their capital holdings to offset to potential for the enhanced risk.
The second implication of keeping these loans on their balance sheet was that it
exposed Fannie and Freddie to a type of risk that they generally had not faced and which
they had no special ability to manage: liquidity risk. Had the loans been securitized by
the GSEs and sold into the secondary market, changes in the market price of the
underlying mortgages that were driven by a decrease in market liquidity would not have
had a direct effect on Fannie or Freddie[30]. By keeping these mortgages on their books,
Fannie and Freddie retained direct exposure to price changes in the assets, and took on
much greater liquidity risk. When the market meltdown occurred and liquidity became
an issue, credit spreads increased and these assets lost value.
To see this, consider that as of June 30, 2008 Fannie Mae had, according to
OFHEO’s successor agency the Federal Housing Finance Agency (FHFA), a minimum
capital requirement of $37.525 billion and $46.964 in core capital, resulting in surplus
capital of $9.43 billion. Freddie, also according to FHFA, had a minimum capital
requirement of $34.451 billion and core capital of $37.128 billion resulting in surplus
capital of $2.676 billion[31]. The two enterprises held roughly $178 billion in “private label”
mortgage securities, the vast majority of which were subprime or “Alt-A” mortgages. For
the quarter ending June 30, 2008, Freddie Mac reported an “impairment” of nearly $1 billion
in its available for sale portfolio, and stated that “$826 million was related to non-agency
mortgage-related securities backed by subprime or Alt-A and other loans”[32]. For the
quarter ending September 30, 2008 Freddie Mac reported an additional loss of $9.1 billion
due to additional impairments on the firm’s available for sale portfolio[33]. Freddie Mac
did not explicitly state the amount of this loss that was explicitly attributable
 to its subprime/Alt-A portfolio, but there is no reason to believe that it was not The financial
proportional with the losses reported in June. This would place the losses due to crisis
subprime/Alt-A to be on the order of $7.5 billion. Fannie Mae reported smaller, but still
significant losses on its subprime/Alt-A holdings, with losses of $1.8 billion for the third
quarter of 2008. Fannie Mae also reported an increase in its provision for credit losses of
$9.4 billion, and noted much of this increase was in response to “Alt-A” loans in its
guaranty portfolio[34]. This collapse in value was a major factor in the failure of both 23
Fannie and Freddie and their entry into conservatorship. While there were other
contributing factors, including some losses in their conforming portfolios, the extreme
negative performance, both in terms of credit and liquidity, of the non-conforming
portfolio was a primary cause of their demise.
The bifurcation of GSE regulation did not help. The OFHEO mandate to monitor the
safety and soundness of the GSEs was not required to mesh closely enough with HUD’s
mandate to ensure that the GSEs provide affordable housing finance. Although HUD did
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consult with OFHEO with respect to the effect that the new housing goals would have,
this was of secondary interest to HUD. Further, HUD does not appear to have explicitly
considered how the expanded program would affect GSE liquidity risk. OFHEO was
required to certify whether the GSEs met their capital requirements as of a specific date, but
they were not required to forecast how proposed HUD regulations would affect future
valuations. That is, OFHEO does not appear to have published analyses for the GSEs
financial health under alternative scenarios in which the housing goals did and did not exist.

c. Mark-to-market accounting
The advent of mark-to-market accounting further magnified the liquidity risk
that Fannie and Freddie bore. This accounting system requires that assets be marked
to the current fair market value of the asset at each quarter. For most assets, such as
mortgages, the accounting rule requires assets to be marked at their traded value on
the valuation date. If trades are not available, then indicative quotes from dealers and
brokers could be used to form an opinion of fair value. Mark-to-market accounting began
to be implemented during the late 1990’s and early 2000’s. The theory was that by
marking financial assets and liabilities at their current market value investors would be
better able to determine the true value of firms and securities of firms. The fundamental
assumption of this system, however, was that the market prices would be readily
available and observable. That is, the combination of regulatory agencies and private
sector accounting standards groups did not build into the system a mechanism for
dealing with a market in which there was no liquidity.
The creators of the mark to market accounting rules never envisioned a scenario
of extreme illiquidity such as that which came to pass in the mortgage markets. When
the subprime market began to collapse in 2007, virtually all trading dried up, so firms
marking to market had to rely on indicative quotes. The dealers providing the quotes
could not observe traded prices, and so where highly uncertain as to where to set their
indicative quotes. Thus, they had an incentive to provide extremely low quotes on all
mortgage instruments[35]. The dealers wanted to make sure that if any counterparty did
ask to trade at those prices, that there would be no chance of the dealers having overpaid
for the asset. Basically they quoted prices that were designed to discourage trades[36].
Since these were the only quotes available, however, market participants, including
Fannie and Freddie, had to use them for marking their portfolios to market. This, in turn,
 JFEP increased concerns about the viability of Fannie and Freddie, and resulted in even lower
3,1 quoted prices.
This feedback loop that formed severed the normal relationship between observed
“market” prices and economic value. Loan values were “written down” when credit
spreads went up, even though the borrower was still making all of their scheduled
payments and there was every indication that they were going to continue doing so in the
24 future. That is, it is certainly the case that many of the loans which have been “written
down” are still performing. Under older accounting rules, these loans would still be held
at their initial principal value. Indeed, it is arguable that many mortgage instruments
were marked down on accounting statements at prices which were far below their
real economic value. This is one reason that many in both industry and government
have called for either a suspension of the mark-to-market accounting system or at least
an easing of it during times of severe illiquidity[37]. It is difficult to see, however, how
such a suspension could be implemented while maintaining orderly markets. Still, the
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accounting standards organizations continue to try to figure out how to implement mark
to market accounting in markets that are normally liquid but which occasionally have
significant impairment in liquidity, but to date no satisfactory system exists[38].
It is also worth noting that under the accounting rules in place prior to the advent of
mark-to-market accounting, loans held on Fannie and Freddie’s balance sheet would
have been held at their purchase price unless there was actual performance impairment,
i.e. if there was a default. This might well have preserved Fannie and Freddie’s capital
base, since the majority of loans they hold are still performing[39].
While Fannie Mae and Freddie Mac are the two biggest entities in the US housing
finance system, there are, of course, other institutions which are involved. Most notably
depository institutions such as banks and thrifts are involved both as mortgage
originator and as mortgage investors. The regulation of these firms is the focus of the
next section.

V. Regulation of housing finance at depository institutions

Fannie Mae and Freddie Mac had a relatively monolithic regulatory structure. Their
financial regulator was OFHEO, and they were subject to non-financial regulation from
HUD. Depository institutions, however, are regulated by a myriad of agencies. This
reflects the fractured nature of the US banking system in which some institutions are
federally chartered, some are state chartered, some belong to the Federal Reserve
System, and some do not.
As is the case with the GSE’s, HUD has some non-financial regulatory authority
over depository institutions relating to compliance with federal fair housing laws.
Specifically, the Real Estate Settlement Procedures Act is a consumer-oriented law that
required mortgage originators to disclose to borrowers loan information in a consistent
manner. This act, among others, authorized HUD to require lenders, including depository
institution, to submit information on loans and borrower demographics to demonstrate
compliance with various federal equal opportunity lending laws. HUD dose not, however,
have safety and soundness responsibility over financial institutions. That responsibility
lies with the myriad of state and federal banking regulatory bodies.
Federally charted financial institutions are regulated by several financial regulatory
bodies. The primary responsibility for daily safety and soundness oversight has rested
with four entities, the Office of the Comptroller of the Currency (OCC), the Office
 of Thrift Supervision (OTS), the Federal Deposit Insurance Corporation (FDIC), The financial
and the Federal Reserve. The OCC is part of the Treasury Department and is responsible crisis
for chartering, regulating and supervising all national banks. The OTS was also part of
the Treasury and was the primary regulator for federally chartered thrifts and thrift
holding companies[40]. The FDIC is an independent federal agency which is responsible
for insuring deposits held in US banks and thrifts. It is also the primary bank regulator
for those state-chartered banks which are not part of the Federal Reserve System. The 25
FDIC conducts its own examination of financial institutions to determine their viability.
The Federal Reserve has primary supervisory responsibility for state-chartered banks
which are members of the Federal Reserve System.
Federal banking regulatory agencies were aware of the risks posed by subprime
lending. On March 3, 1999, the OCC, OTS, FDIC, and Federal Reserve issued a
formal document “Interagency Guidance on Subprime Lending” that provided guidance
to regulated institutions on subprime lending. The cover letter to this document, OCC
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Bulletin 99-10, notes “the higher risk associated with subprime lending” and states that
“the OCC expects banks to fully understand the risks involved, exercise increased risk
management, and provide appropriate managerial, staffing and capital support”
(Office of the Comptroller of the Currency, 1999).
The Interagency Guidance document further asserted that “due to the high-risk
nature of sub-prime lending, examiners will carefully evaluate this activity during
regular and special examinations” (Board of Governors of the Federal Reserve System,
Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and
Office of Thrift Supervision, 1999). Institutions were alerted that bank examiners would
specifically look at whether institutions had adequate financial and managerial capacity
to conduct subprime lending operations during these examinations (Board of Governors
of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the
Comptroller of the Currency, and Office of Thrift Supervision, 1999).
For the largest US banks, the money-center banks with federal charters,
the OCC maintained a continual presence. Although full examinations only occurred
at specified intervals, examiners typically had on-site offices and rotated through
different components of the institution to constantly monitor the health of the institution.
This close scrutiny was in place specifically because of the systemic risk that these
institutions presented to the economy. It is difficult to envision, as a practical matter,
how there could be greater supervisory oversight than what existed at those institutions.
A financial institution can face two distinct types of mortgage risk. The first is the
risk that organizations with large originating operations face. This risk is that they may
commit large sums of cash into originating whole loans, particularly non-conforming
whole loans, and find that the secondary market loses its appetite for those loans. This
results in the firm being unable to sell the loans to replenish its capital. This is at least
partially what happened to the large subprime originators such as IndyMac and WaMu.
The second risk comes from holding large position in loans – even securitized loans –
which subsequently perform poorly and become illiquid. This would be more similar to
the problems that Fannie and Freddie faced with their subprime CDOs. Firms such as
JP Morgan and Bear Stearns, neither of which had particularly large origination
businesses faced this risk[41].
The regulatory bodies had a number of methods at their disposal for evaluating the
riskiness of an institution’s mortgage-related activities. Some of these methods looked
 JFEP at operational issues, such as how underwriting was performed, how identities were
3,1 checked, and how cash was physically disbursed. Other methods were much more
similar to the “stress test” that OFHEO used with the GSEs. In particular, all assets of a
financial institution were rated for riskiness. Assets in each risk tier were then
aggregated and the assets in riskier categories incurred a higher capital charge than
assets in less risky tiers.
26 Generally Fannie/Freddie conforming MBS were treated as being a very low-risk
investment, while unsecuritized loans were treated as being in the highest risk category.
This provided a strong incentive for institutions to sell the conforming loans they
originated to the GSEs and purchase MBS for investments. This also explains why financial
institutions in general wanted to securitize and sell subprime mortgages. As unsecuritized
whole loans, these subprime products were very costly from a regulatory capital standpoint.
Ultimately, a financial institution must prove that it has adequate capital to be
considered safe and sound. This is primarily done both through risk-based capital tiers,
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but also through stress testing. Because of the diversified nature of depository
institutions, the scenarios used are not as specifically directed at housing as in the case of
the GSEs. That said, the basic idea is the same. The institution must demonstrate that it
has adequate capital to withstand both normal operations and a significant downtown in
the economy. Despite all of this, some of the largest depository institutions in the country
failed. Names such as Countrywide, IndyMac, Wachovia, and Washington Mutual were
done in by the credit crisis, despite their generally having met their regulatory capital
requirements in the period immediately before the crisis began.
Regulatory bodies assigned to depository institutions understood that mortgages
and mortgage-related products were major sources of risk. Even more importantly,
the regulatory bodies understood that subprime loans represented a significant increase
in risk to the financial institutions. They had access to management, to their data, and
to their risk models, yet, they were caught as unawares when the crisis hit as were the
market participants. As was the case with the OFHEO stress tests, the stress tests used
in these financial institutions generally did not consider the implications of a systemic
loss of liquidity in the financial system.
As noted above, the guidance given to the regulated institutions and to the on-site
regulators focused on the increased operational and credit risks associated with
subprime loans. The regulatory bodies devoted virtually no time or effort to considering
the effects that a severe liquidity crisis would have on the regulated institutions. Once
again, this was because the risk was viewed as being too small to be worth the costs of
directly regulating. It was a black swan event where the regulatory bodies implicitly set
the joint probability of a simultaneous housing bust and a liquidity crisis at zero when in
fact the probability was somewhat higher.
Given all of this, it is a mistake to argue that, it was a lack of regulation that allowed
the crisis to promulgate through the financial system. One might realistically argue that
it was a lack of effective regulation, but given resource constraints it is difficult to believe
that a more effective regulatory environment could have been implemented. Financial
institutions must take risk in order to function, and regulators must allow them to take
such risks. Bearing risk, even properly priced risk, necessarily implies that these firms will
occasionally lose. The fact that such losses happen does not mean that there was a lack of
regulation or that additional regulation would have resulted in a different outcome. Indeed,
the only way to guarantee no losses is to impose regulation that prevents institutions from
 taking risk, but doing so would mean the collapse of the market for risk and a major decline The financial
in innovation and risk-taking in society. crisis

VI. Summary and conclusion

Many commentators from across the political spectrum have called for greater oversight
and regulation of the financial industry. A representative characterization of the 27
subprime market is that made by Senator Schumer of New York: “the subprime market is
the Wild West of mortgage loans”[42]. That is, the perception is that subprime arose, and
ultimate brought down the entire economy, due to a lack of regulatory oversight and little
or no consumer protections. Yet a careful examination reveals that virtually all housing
and financial regulatory bodies understood that subprime was a growing area, that it
was much riskier than conventional lending, and that it had the potential to go very
wrong. It simply is not correct to assert that the development of the subprime market
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occurred without the knowledge and consent of virtually every major regulatory body.
Indeed, at least one regulatory body, HUD, specifically encouraged the development of
the subprime market and mandated that Fannie Mae and Freddie Mac become the
predominant purchasers and holders of those loans.
While the exposure of subprime loans, and hence subprime investors, to housing
prices was known, what neither regulatory bodies nor market participants foresaw was
the degree to which a collapse in that market would lead to a general meltdown of the
entire financial system and a lack of confidence in any asset. They also did not see that
this would create a feedback loop – as liquidity in the credit markets dried up, it would
become impossible to implement the various risk management plans that firms had in
place, and so the firm’s positions deteriorated even more rapidly. As the market realized
that lack of liquidity was preventing firms from being able to offload risk, the perception
became that all financial firms were, in effect, becoming riskier at precisely the same
time that the market’s appetite for risk was diminishing. Thus, the contagion spread
through the entire system. This could have been ameliorated had the firms had greater
capital reserves, but without an appreciation for the risk of a liquidity crisis it would
have been very hard a priori to determine the adequate capital level.
The liquidity portion of the crisis illustrates a major problem faced by any financial
regulator, the difficulty of dealing with so-called “black swan” events. This is the event
that is extremely rare but extremely detrimental when it does happen. That is, it is an
event that is so rare that under the standard empirically based statistical tools of risk
management it would essentially be assigned a zero probability of occurring, yet, when
it does occur its results are calamitous. The difficulty for the regulatory body is that
these are the “systematic” risks – the risks that are so large only government, through
the regulatory system, can manage.
Success, the saying goes, has many fathers, but failure is an orphan. The failure
of the subprime market and the subsequent meltdown of the US and world economy
is certainly one of the biggest economic debacles of all time. It is tempting, easy,
and even emotionally satisfying to place all of the blame for the failure on the managers
of the firms involved, and to assume that additional regulatory oversight might have
prevented the calamity. Doing so, without fully acknowledging the degree to which the
regulatory bodies contributed to the disaster, either through acts of commission or
omission, however, is naı̈ve and runs the risk of repeating the problem in the future.
 JFEP Notes
3,1 1. Ellis (2008) examines various market factors that contributed to the housing meltdown in the
USA. Ashcraft and Schuerman (2008) provide an extensive look at frictions within the
securitization process which compounded the housing meltdown.
2. The phrase “black swan” was popularized in the book The Black Swan by Nicolas Taleb (2007).
3. Technically there are other GSEs, such as Farmer Mac, but none have the visibility or scale
28 of Fannie Mae and Freddie Mac.
4. Not all foreclosures were the result of credit crunches. With a national unemployment rate
that peaked at near 25 percent, many borrowers lost the ability to support a mortgage and
were forced to either sell their properties or default on their loans.
5. See Thomas, http://mysite.verizon.net/hudhistory/hud_history.pdf, for an excellent history
of the origins and evolution of HUD and federal housing policy.
6. One can calculate a standard deviation for data from a non-normal distribution, but the
theoretical reasons for assuming that this is a reasonable measure of risk break down when
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the distribution is not normal.

7. Financial regulators do, of course, also concern themselves with the more mundane everyday
risks, but they are the only entity that has responsibility for considering the industry-wide or
economy-wide risks that.
8. This presumes the regulator cannot either garner more resources or reduce the cost of
managing the higher priority risks.
9. The distinction between the two types of events may well be important within the political
arena. One may well be able to garner sympathy more easily if an event was unfathomable
than if it were a risk that was too remote to monitor.
10. In this context, “sub-prime” is shorthand to include loans that did not meet the credit standards
normally used by the GSE’s and prime Jumbo lenders. This would include true sub-prime
(i.e. FICO score , 620) mortgages, Alt-A mortgages, and low-doc/no-doc mortgages.
11. The first pass-through was actually a GNMA insured security. Even as early as the
mid-1970’s, however, Fannie and Freddie were issuing significantly larger volumes of MBS
than the GNMA system. It was the success of Fannie and Freddie in developing these
instruments which convinced Wall Street that other types of assets could be securitized.
12. See DeGennaro (2008) for an overview of Fannie/Freddie securities.
13. Loans which are more than 90 days delinquent are bought out of the MBS pool. See Buttimer
and Lin (2005) for a more complete description of this process.
14. A put is an option under which the holder of the option has the right, but not the obligation,
to sell an asset to the writer of the option at a given price. The writer of the option is said to
be “short” the put.
15. This is, of course, not strictly true in states which allow a lender to sue a defaulted borrower
for any shortfall between the loan balance and the amount the house sells for at auction.
About ten states, notably including California, prohibit such deficiency judgments. In those
states, the “put option” framework is highly apt. Even in states that do allow deficiency
judgments, however, borrowers with few assets are rarely sued after the house is sold.
16. Congress set eligibility requirements for the loans which Fannie and Freddie could
guarantee. The loans had to be of “investment grade” per the charters of both corporations.
This standard, although not formally defined in their charter, were understood to encompass
a loan to value ratio of less than 80 percent (or to have default insurance), and for the
borrower to meet certain credit and debt-to-income standards.
 17. As of December 2008, the investment portfolios for Fannie and Freddie were approximately The financial
$1.5 trillion. In contrast, MBS issued by the GSEs totaled $3.8 trillion (Lockhart, 2008).
crisis
18. After the mortgage crisis, OFHEO was merged into the newly formed Federal Housing
Finance Authority. FHFA now has the regulatory responsibilities previously held by
OFHEO.
19. For example, OFHEO noted in a press release on January 22, 1999 that both Fannie and
Freddie were adequately capitalized as of September 30, 1998. 29
20. Press Release, OFHEO, March 30, 2007. The reason for this re-categorization was a material
misrepresentation in Fannie Mae’s financial statements during that period. When Fannie
eventually issued revised statements, OFHEO reclassified it as being inadequately capitalized.
21. Press release OFHEO, June 9, 2008.
22. There is obviously some endogeneity as the imminent failure of the GSEs further depressed
the fixed income markets.
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23. Fannie and Freddie have always had a small, explicit line of credit with the US Treasury.
This line of credit was a signal to the capital markets that the US Government considered
Fannie and Freddie too important to fail. The federal government did not, however, have an
explicit legal obligation to back the debt of Fannie and Freddie. After placing Fannie and
Freddie into receivership, however, the backing of the federal government became explicit.
24. Note that technically loans in these geographic regions that were made to high-income
individuals would still count toward meeting the goal.
25. Technically a subprime loan was one in which either the borrower’s credit score was lower than
the normal standard of 620, or in which their debt-to-income ratio was higher than normal.
An “Alt-A” loan was a loan made to a person with credit score above 620, but which somehow
violated other conforming loan standards. This was most often caused by the borrower not
being able to fully document all of the income that they were listing on the loan. Despite these
differences, “Alt-A” loans are usually lumped into the more generic term “subprime”.
26. Again, in this context “subprime” is used generically and includes “Alt-A” loans. Mayer et al.
(2009), provide a thorough overview of the credit and borrower characteristics of subprime
and Alt-A loans.
27. These returns refer only to the returns earned by persons that owned shares prior to any
change in the rules. Once the new rules were known, the market price of the stock would
adjust so that the expected return on the stock was consistent with the risk of the stock.
28. It is not at all clear that the GSEs could have purchased “whole” subprime loans and securitized
them as Fannie/Freddie MBS. The GSE charters explicitly required the agencies to only
purchase loans that met “institutional investor” purchase standards. By purchasing “AAA”
rated tranches of subprime CDOs, Fannie and Freddie met that requirement. It is not clear
whether “whole” subprime loans would have met that standard, as there is a diversity of
opinion among current and former employees of the agencies and of OFHEO as to this issue.
29. A significant portion of the preferred stock was held by foreign governments. This
effectively transferred the risk out of the country – and may have reduced the total net
housing finance exposure in the country.
30. If the price changes were due to defaults, Fannie and Freddie would have had direct
exposure because they would have to buy defaulted loans out of the pools they guaranteed.
Fannie and Freddie would have had no liability, however, for a price decline due to, say,
a generalized increase in market credit spreads. Indeed, a price decline because of an increase
in expected prepayments would have actually improved Fannie and Freddie’s fiscal position
because it would have reduced the default risk that they faced.
 JFEP 31. Source: Federal Housing Finance Agency table, available at: www.fhfa.gov/webfiles/417/
2Q2008MinCap.pdf
3,1
32. Press release, Freddie Mac, August 6, 2008, available at: www.freddiemac.com/news/
archives/investors/2008/2q08er.html
33. Press release, Freddie Mac, November 14, 2008, available at: www.freddiemac.com/news/
archives/investors/2008/3q08er.html
30 34. Form 10-Q, November 11, 2008, Fannie Mae, p. 56.
35. A more technically correct way of saying this is that they dramatically raised the credit
spreads that used when pricing these loans.
36. This is an extreme example of the dealers trying to avoid a “winners curse”.
37. See, for example, the comments by Ben Bernanke to the Council of Foreign Relations, March
10, 2009.
38. The SEC and accounting standards boards have implemented short-term rules under which
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“fire sale” and other distressed trades or quotes including those stemming from liquidity
crises, maybe ignored for accounting purposes. They continue to work on a permanent
solution. Cannata and Quagliariello (2009) examine whether mark-to-market accounting
interacted with the Basel II capital adequacy standards at commercial banks to increase the
effects of the crisis. They argue that the combination probably did create some excess
volatility in asset prices, especially with respect to downward valuation revisions.
39. According to Lockhart (2008), only about 23 percent of all subprime loans are “seriously
delinquent”, although about 34 percent of subprime ARMs are. In contrast, only about
2 percent of Fannie Mae and Freddie Mac conforming loans are delinquent.
40. OTS is currently being subsumed into the OCC.
41. These risks are not, of course, mutually exclusive, and many large financial institutions were
hurt by both risks during the crisis.
42. Press release, Senator Charles Schumer, March 25, 2007.

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Corresponding author
Richard J. Buttimer Jr can be contacted at: buttimer@uncc.edu

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