Fannie and Freddie took huge losses, but was it their own fault or were big banks fraudulent?
Instead of waning, big banks' mortgage troubles continue to grow. First, the state attorneys general sued banks over their faulty foreclosure procedures. Reports have indicated that the damages could amount to as much as $17 billion. Then, private investors began to sue banks, claiming that banks misrepresented the mortgages that they purchased indirectly through securities. Now we learn that the government is preparing to sue the big banks for a similar reason. This latest government lawsuits raise a number of questions.
First, here are the basics of the lawsuits, via the Nelson Schwartz at the New York Times:
The suits will argue the banks, which assembled the mortgages and marketed them as securities to investors, failed to perform the due diligence required under securities law and missed evidence that borrowers' incomes were inflated or falsified. When many borrowers were unable to pay their mortgages, the securities backed by the mortgages quickly lost value.
Fannie and Freddie lost more than $30 billion, in part as a result of the deals, losses that were borne mostly by taxpayers.
We can expect the details to arrive as soon as today or Tuesday, according to the reports.
Today is September 2, 2011. The mortgage market's woes began to become clear in early 2007. If Fannie and Freddie were misled by the banks, what took them so long to realize it? Does it really take four-plus years to discover that lots of the mortgages going bad were misrepresented by the banks? Wouldn't that be the first thing you checked when you realized that the loans weren't performing as you anticipated?
Think about it: let's say you've got a pool of loans with statistics indicating that the average income of the borrowers is sufficient to support the average mortgage size, according to all historical models. If huge losses begin to hit, wouldn't you worry that something fishy is going on immediately? Would it take you a couple of years to get around to checking on the data?
This might cast some doubt on the validity of the lawsuit. But if it is legitimate, we should all be left wondering why it took so long for Fannie and Freddie to arrive at the revelation that the banks misled them.
How Mismanaged Were Fannie and Freddie?
That first question also brings up another: just how poorly run were these government-sponsored mortgage companies? Didn't they have had periodic audits to find and prevent the sort of fraud they're accusing the banks of? Wouldn't they have wanted to perform some of the due diligence that they accuse the banks of ignoring themselves? After all, Fannie and Freddie aren't just typical investors: they were the titans of the mortgage market, facing trillions of dollars in mortgage exposure. Surely, they would have had a little extra leverage to ensure that the loans they bought or backed had the characteristics that the banks claimed.
Indeed, had such measures been in place, perhaps the mortgage bubble wouldn't have been so severe. If processes had existed at Fannie and Freddie to ensure better due diligence, then perhaps they would have realized banks were originating worse mortgages than investors believed in, say, 2005 or 2006. The mortgage madness could have ended much sooner. Having this knowledge in 2011 might relieve a small portion of taxpayers' losses, but it won't reverse the economic destruction that the housing bubble caused by creating the financial crisis.
This lawsuit appears to demonstrate just how haphazard and rushed the mortgage financing process really was. If Fannie and Freddie had neither the time nor procedures in place to ensure the quality of the mortgages they effectively purchased, then regular investors never stood a chance.
How Significant Will the Lawsuits Be?
Next, what's the potential magnitude of these lawsuits? The Times article implies that they might be large, but not catastrophically massive. I'm not sure what the mention of Fannie and Freddie's $30 billion in mortgage losses refers too. Their total losses are far, far greater. So this appears to be some estimate of the mortgage losses that were relevant to this particular lawsuit. If that's the case, then presumably, damages wouldn't be much more than $30 billion. Since such a case would probably be settled, the remedy to the government will likely be even smaller.