Freddie and Fannie Cannot Solve the Mortgage Mess

James Lockhart heads up the Office of Federal Housing Enterprise Oversight (OFHEO). The OFHEO provides regulatory oversight to Freddie Mac and Freddie Mae and is supposed to stop these government chartered entities from reckless behavior. Given the history of these two agency's track record of all sorts of inept and fraudulent deeds, including cooking the books to the tune of billions of dollars, serious adult supervision seems wise.

Freddie Mae manipulated earnings and was caught in a massive accounting fraud that took place between 1998 and 2002.

In 2006 the Washington Post reported the following:

"Fannie Mae engaged in "extensive financial fraud" over six years by doctoring earnings so executives could collect hundreds of millions of dollars in bonuses, federal officials said yesterday in a report that portrayed a company determined to play by its own rules.

Regulators at the Securities and Exchange Commission and the Office of Federal Housing Enterprise Oversight, in announcing a settlement with Fannie Mae that includes $400 million in penalties, provided the most detailed picture yet of what went wrong at the congressionally chartered firm.

[SEC and OFHEO] portray the District-based mortgage funding giant -- a linchpin of the nation's housing market -- as governed by a weak board of directors, which failed to install basic internal controls and instead let itself be dominated and left uninformed by chief executive Franklin Raines and Chief Financial Officer J. Timothy Howard, who both were later ousted.

The result was a company whose managers engaged in one questionable maneuver after another..."

Fisher Investments republished an article from Bloomberg yesterday that smugly downplayed the problems at Freddie and Fannie. The article points out that the losses are just small fraction of the their total loan portfolios. It also states that the capital requirements of the firms are arbitrary and can be changed. Senator Charles Shummer has strongly pushed for raising the limits on the amount of loans that Freddie and Fannie can purchase.

But here is the problem. Freddie and Fannie have a history of fraud and reckless behavior. Congress has still not passed legislation to reform these entities. They are leveraged 50 to 1. They are already operating under capital standards that are much less rigorous than banks. Neither firm is fully in compliance with the consent degree that was agreed to as a result of all the shenanigans, although Fannie is farther along than Freddie. To pick up for the loss of liquidity in the mortgage market Freddie and Fannie are already buying 60% of the conforming mortgages in the U.S., up from 40% last year.

Ben Bernake suggested that the limits be raised on the size of loans that can be purchased by Freddie and Fannie to include so-called jumbo loans. This is also a terrible idea. The management teams reconstituted after the fraud are thin. Freddie and Fannie do not have any experience with jumbo loans and no models for risk management of these mortgages. They already have their hands full doing what they know correctly - providing liquidity for standard, conforming loans. Again, let's be clear that neither firm has even been able to get into compliance with the consent decrees with the SEC and OFHEO.

Allowing these firms to take on even more capital risk without the appropriate reforms seems like a very bad idea.