Regulator Rumble: SEC Going After Fannie and Freddie Execs

The Securities and Exchange Commission is finally taking on the biggest bailout recipients of them all: Fannie Mae and Freddie Mac. How could things go so horribly wrong -- resulting in a still-growing $150 billion bill to taxpayers -- without any shenanigans? Perhaps Fannie and Freddie executives misled investors, who provided funding for mortgages of worse quality than the companies led on. But since the firms' disclosures were approved by the Federal Housing Finance Authority, the suit sets up a clash of regulators.

Zachary A. Goldfarb and David S. Hilzenrath at the Washington post report on the SEC's move to target Fannie and Freddie execs. Their article only provides a glimpse at what they're being accused of, however:

The allegations are slightly different for both the companies. One of the chief allegations against Fannie executives is that it characterized mortgage loans as "prime" -- meaning high-quality -- when they should have been classified in a more risky category of loans.

In theory, this should be quite easy to prove. If you know the characteristics of the mortgages in Fannie and Freddie's portfolio, then you can pretty easily determine if the disclosures matched up with the loans. What were the borrower credit scores, loan-to-value ratios, incomes, mortgage types, etc? If you know these characteristics, then you can quickly toss them into prime or subprime buckets. But this simplicity raises a question: if investors were misled in this easy-to-determine way, wouldn't they have figured it out by now and successfully sued the firms?

And perhaps more importantly, why would the FHFA have signed off on those disclosures? The article says:

In the years relevant to the SEC case, Fannie and Freddie routinely submitted their financial disclosures to FHFA's predecessor agency before releasing them to the public.

Now this might not matter if Fannie and Freddie also misled the FHFA. After all, if the information provided to the regulator failed to reveal key facts, then the FHFA wouldn't have known that a disclosure was misleading. But according to the article, the FHFA is standing by Fannie and Freddie, saying that the disclosures were sufficient.

Ultimately, it sounds like this may spark a regulator versus regulator dispute. If the SEC doesn't believe a disclosure is sufficient and the FHFA does, who is right? Since the SEC is in charge of ensuring that disclosures contain all material information, the subject falls under its jurisdiction. So it may proceed with lawsuits despite the FHFA's objections. But it could be difficult to convince a jury that these executives misled investors with another federal regulator in their corner.