5 Question Raised by the Government's Coming Mortgage Lawsuits

Fannie and Freddie took huge losses, but was it their own fault or were big banks fraudulent?

Fannie and Freddie took huge losses, but was it their own fault or were big banks fraudulent?

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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.

Why Now?

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.

In the context of Fannie and Freddie's nearly $170 billion loss tab already picked up by taxpayers, even $30 billion isn't much. In the context of 12 big banks, however, it could be -- depending on how it is divided up among them. Presumably, the biggest loser here would be Bank of America, since it is responsible for the mortgages created by Countrywide, which the bank acquired in 2008. In a vacuum, lawsuits of this size shouldn't lead to another financial crisis. But they aren't in a vacuum. As other investors file similar suits, uncertainty may again begin to cloud the financial sector and begin to worry the market.

Should These Lawsuits Surprise Us?

We've been hearing for a while that the federal government is trying to go relatively easy on the banks, since it fears that putting additional stress on them could lead to another financial crisis, given their fragile condition. And the last thing an economy where hiring is barely growing or stagnant needs is a financial crisis. Does that make these lawsuits surprising?

If you follow the political dynamics at play here, then the lawsuits aren't all that shocking. The interests of Fannie and Freddie, and consequently the Federal Housing Finance Authority, are currently aligned with taxpayers. They want their loss to be a small as possible so that they might have a shot at survival. As a result, their actions sometimes conflict with the federal government's broader policies aimed at economic stability and recovery.

But doesn't the government control Fannie and Freddie? Not exactly: the government technically owns the firms, but the Treasury can't coerce the FHFA. This has been made clear through mortgage modifications. Although the Treasury would love for the FHFA to pursue them more aggressively, the FHFA refuses to even participate in principal reductions, largely viewed as the most effective method of modification. So even if the Obama administration doesn't want to see big lawsuits launched against the banks, the FHFA could bring them anyway.

Are the Lawsuits Good or Bad for Taxpayers?

And what about those taxpayers: are they better off with or without these lawsuits? On one hand, if the suits succeed, the size of Fannie and Freddie's bailout will be reduced. On the other hand, if the lawsuits are too large, then they could play a part in triggering another financial crisis. That would endanger economic stability and make a double dip recession inevitable. If unemployment were to begin ticking up again towards 15%, $30 billion or so in taxpayers losses might not seem like such a bad alternative.

Ultimately, it depends on how this all shakes out. If the lawsuits end up saving taxpayers a few billion here or there, then that would be great. Economic stability probably won't be significantly affected in that situation. But if a financial crisis is a real danger here, then the federal government may lean on the FHFA to go easy on the banks.

Would such a strategy be morally reprehensible on the part of the federal government? Perhaps, but as some of the above questions begin to show, Fannie and Freddie weren't pure victims here. Even if banks weren't totally clear on the quality of the mortgages they sold, Fannie and Freddie should have been more careful. Did banks really manage to execute a grand conspiracy, in unison, to defraud these companies by intentionally and deeply obscuring the truth? If not, then Fannie and Freddie deserve some of the blame for their recklessness in purchasing these mortgage securities in the first place.

Image Credit: REUTERS/Jason Reed