For the last three years, since the housing bubble burst, the Securities and Exchange Commission has been investigating the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac). Fannie and Freddie, after all, were the biggest players in the mortgage lending and securitization business, and there's a lot of sentiment that they deserve a hefty share of blame for encouraging the financial industry's voracious appetite for mortgage loans, no matter how deficiently underwritten. The problem for regulators hoping to hold Fannie and Freddie accountable, though, is that the previously quasi-private agencies went into public conservatorship in 2008. Any SEC suit against Fannie and Freddie would essentially be one wing of the U.S. government seeking damages against another.
But the people who ran Fannie and Freddie in the run-up to the mortgage meltdown were another story. About nine months ago the SEC issued Wells notices to top Fannie and Freddie executives. I've heard there was virtually no give-and-take between regulators and defense lawyers for the executives after initial defense responses. So it was a disappointment but not a big surprise to the defendants when, on Friday, the SEC sued three former top officials from both Fannie and Freddie. (Here's the SEC's complaint against Richard Syron, Patricia Cook, and Donald Bisenius of Freddie Mac; and here's the complaint against former Fannie Mae execs Daniel Mudd, Enrico Dallavecchia, and Thomas Lund.) The SEC complaints charge two defendants in each case with full-on securities fraud (the third official in each complaint faces aiding and abetting claims) for allegedly misleading investors about their agencies' exposure to subprime mortgages. In the Freddie complaint, the SEC asserts that the agency claimed only $2 to $6 billion of its single-family guaranteed mortgages were considered subprime loans, when, in fact, $140 billion to $244 billion in loans fit that classification. Fannie allegedly reported $4.8 billion in exposure when its subprime lending exceeded $40 billion.
There are a few points to keep in mind about the Fannie and Freddie suits. First, the allegations all center on disclosures. There's no accusation of accounting manipulation or more obvious fraudulent acts. Yet four of the defendants are accused of intentionally defrauding investors -- partly because Fannie and Freddie were not registered entities during the entire period of alleged wrongdoing, which means the execs couldn't be accused of negligence. That's a high bar, in which the agency has to show the defense acted with fraudulent intent. Second, the former Fannie and Freddie executives -- unlike the Citigroup executives who agreed to an administrative settlement in the bank's 2010 subprime exposure agreement with the SEC -- had no leverage because the SEC wasn't also negotiating with their employer. There was little reason for financial regulators to reign in aggressive allegations, especially because there's a strong public-relations incentive for the SEC to charge senior executives of agencies that ended up in such severe straits that they had to be placed in receivership, with taxpayers bearing the burden of management's overly risky strategy.
But if you parse the SEC's complaints, you'll see the weaknesses in the agency's cases. Let's start with which sector of Fannie and Freddie's business the allegations involve. The government-sponsored entities, as they're known, bought lots of subprime loans for the portfolios they securitized and resold as mortgage-backed notes. But that's not where the SEC accusations lie. The SEC asserts that the Fannie and Freddie officials misrepresented subprime exposure in the mortgage-guarantee business, in which the agencies offered government backing for individual mortgage loans.
Both Fannie and Freddie had, at least in theory, strict guidelines on these guaranteed loans, in which they required mortgage lenders to assure, for instance, that borrowers met income requirements. Fannie and Freddie also bought guaranteed loans from prime lenders, not traditional subprime lenders.
It's unquestionably true that as Wall Street's hunger for mortgages to securitize encouraged prime lenders to abandon their own underwriting standards, Fannie and Freddie backed ever-shakier loans, as their internal controls noted. But were loans by prime lenders who purported to meet underwriting guidelines "subprime" loans for disclosure purposes?
The SEC says they were. The Freddie Mac complaint cites a glossary of terms the agency presented to its own board: "There is no longer a clear-cut distinction between prime and subprime mortgages as the mortgage market has evolved," the glossary said, but Freddie officials relied on the old definitions -- that subprime exposure came from loans originated by subprime lenders -- in investor disclosures. Similarly, the complaint against Fannie cites a 2008 10Q in which Fannie Mae admitted that more of its traditional guaranteed mortgages resembled subprime loans, but it was not classifying them as such because they didn't meet Fannie's definition of subprime loans. (Nor, for that matter, the definition the Treasury Department promulgated in 2007.)
Both Fannie Mae and Freddie Mac -- even as they declined to reclassify loans as "subprime" and failed to disclose that increased exposure to investors -- did disclose reams of information about the loans they guaranteed. Expect their lawyers to argue that investors were fully apprised of the increasingly risky nature of the mortgages the GSEs were backing.
In other words, the case will turn on how Fannie Mae and Freddie Mac defined subprime loans, and whether executives committed fraud when they did not revise internal definitions to reflect the changing mortgage market. (The complaints are filled with phrases like "subprime-like" and "otherwise subprime.") From what I hear, the defendants are vowing to fight the SEC all the way to trial (where, OTC has reported, the agency has a decidedly mixed track record). The agency will also have to face formidable defense teams. Here's the lineup: Thomas Green of Sidley Austin for former Freddie CEO Richard Syron; Steven Salky of Zuckerman Spaeder for former Freddie Chief Business Officer Patricia Cook; Walter RIcciardi of Paul, Weiss, Rifkind, Wharton & Garrison for former Freddie Executive Vice-President Donald Bisenius; James Wareham of DLA Piper for Fannie Mae CEO Daniel Mudd; Laurie Miller of Nixon Peabody for Chief Risk Officer Enrico Dallavecchia; and Michael Levy of Bingham McCutchen for Executive Vice-President Thomas Lund.
(Reporting by Alison Frankel)
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(A previous version of this story stated that Fannie Mae and Freddie Mac went into public receivership in 2008. The agencies went into public conservatorship.)