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.
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.
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.
But no one ever did review those loans. One manager claimed his staff was "resource-constrained." Another said that a senior manager was "vehemently against looking at more loans" (p. 21). Freddie's managers seemed to want the issue to go away. One senior manager said he didn't think Freddie Mac "would recover enough from a more expansive loan review process" if they lost the business of Bank of America and other loan sellers.
After Freddie reached a tentative settlement with Bank of America, its internal auditors raised the same issue. Because the bank wanted to reach the settlement by the end of the year, however, there was no time to do a proper analysis, so Freddie produced an estimate based on an unrepresentative loan sample. Most revealingly, a senior management memorandum stated, "management made a deliberate decision not to consider changes to our sampling procedures" (p. 27, emphasis added).
The final twist in this story is that after the Bank of America settlement was signed, sealed, and delivered, Freddie essentially admitted the problem. The same senior manager who prepared the Freddie Mac estimate in 2010 admitted that "Freddie Mac could recover several billion additional dollars by changing its current loan review process" (p. 30).
Earlier this year, Freddie finally got around to analyzing those older mortgages. Not surprisingly, they found a greater share of defective loans than Freddie's senior management estimated in the Bank of America settlement.
IF NOT INCOMPETENCE, THEN CORRUPTION
This appears to be worse than incompetence. It appears to be something between cronyism and regulatory capture. The evidence suggests that Freddie Mac management wanted to give Bank of America a sweetheart deal. They swept concerns about their faulty loan review process under the rug. And they misled regulators about their process. Were good relations with Bank of America were worth more to Freddie than the money it could have gotten in a settlement? We don't know.
What we do know is that good relations with Bank of America are worth quite a bit to Freddie's executives. The money recovered in the settlement benefits all taxpayers. Since the Treasury Department is currently making good on Freddie's losses, any further losses from defective mortgages come out of our pockets. Sweetheart deals with the nation's largest banks don't help Americans, but they are good for the execs at Bank of America--and for execs at Freddie Mac who decide to look for work for big banks in the future...
And the band played on.
*The Countrywide portfolio was full of newly invented mortgages with extremely low teaser rates. With those loans, foreclosures tended to peak in the fourth year, when borrowers could no longer make their payments (sometimes because their incomes were inflated in the first place) and falling home prices prevented them from refinancing (sometimes because their appraisals were inflated in the first place).