House of Cronies: Is Freddie Mac Incompetent or Corrupt?

It's becoming clear that Freddie Mac offered Bank of America a sweetheart deal in a case that suggests not only incompetence, but also something between cronyism and regulatory capture.

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Three years since the collapse of Lehman Brothers, we're not any closer to purging the rot at the heart of our financial-regulatory complex. Last December, Bank of America agreed to pay $1.35 billion to Freddie Mac for nearly 800,000 faulty mortgage loans that Freddie had bought from Countrywide, which has since been acquired by BofA. The full story, as told by the inspector general of the Federal Housing Finance Agency (i.e.: FHFA, Freddie's regulator), is a classic tale of institutional corruption.

The background is that Countrywide, then the country's largest originator of exotic mortgages, sold 787,000 loans to Freddie Mac. Under the terms of the sale, if it later turned out that some of those loans were defective, Freddie could sell them back to Countrywide for their full face value. Many of those loans were indeed defective due to inflated appraisals, fictional stated incomes, or other reasons.

By 2010, many of these mortgages had gone into foreclosure. This gave Freddie the option to sell the defective loans back to Bank of America, which then owned Countrywide. But proving that hundreds of thousands of loans were defective was a lot of work. Freddie only reviewed some of them, relying on a poor methodology that dramatically underestimated the number of defective mortgages. This increased losses to Freddie Mac -- losses that will eventually fall to Treasury and taxpayers.

SWEETHEART DEAL FOR BANK OF AMERICA

In its review, Freddie Mac focused on loans that defaulted within two years. But in the Countrywide portfolio, foreclosures tended to peak in the fourth year.*

And so you get this picture, from a 2011 report by Freddie's internal auditor. What you're seeing is that Freddie's review process (the black line) looked hardest at the bucket of loans containing 16% of total foreclosures. It mostly ignored the bucket containing 70% of the foreclosures. By comparison, this is a bit like searching for a lost salt shaker and spending more time looking on the roof than in the kitchen.

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We have reason to think Freddie was being willfully ignorant. An examiner at Freddie's regulator, the Federal Housing Finance Agency, warned that the majority of foreclosures were going uncounted in March 2010. Sure enough, in June 2011, regulators told Freddie that their review process was ignoring "over 93% of the year-to-date foreclosures from the 2005 and 2006."

Funky mortgage math designed to appease the big banks should sound familiar. Credit rating agencies gave AAA-ratings to huge tranches of mortgage-backed securities based on surreal models. This enabled them to earn fees from the investment banks sponsoring those offerings. In 2008, these quid pro quo arrangements contributed to the credit crash. You would think by 2010 people would have known better.

Perhaps they did.

WHAT DID FREDDIE KNOW?

This is when the story gets interesting. In June, a senior manager at Freddie Mac told the Federal Housing Finance Agency (FHFA) that he would review a sample of older loans, which showed a greater likelihood to end in foreclosure.

Presented by

James Kwak, an associate professor at the University of Connecticut School of Law, is co-author of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.
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James Kwak is an associate professor at the University of Connecticut School of Law and the co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. He blogs at The Baseline Scenario and tweets at @JamesYKwak.

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