There is a delicious irony associated with the government’s suit against 17 major banks for selling securities backed by subprime loans to the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac.
Fannie and Freddie bought these securities because government housing policies required them to do so. Beginning in 1992, Congress established what were called “affordable housing” goals for Fannie and Freddie, requiring them to purchase mortgages that were made to borrowers at or below the median income in the areas where they lived. Initially, this quota was set at 30 percent, but over time (and through the Clinton and Bush administrations) the Department of Housing and Urban Development (HUD) increased the quota to 55 percent and added “subgoals” for loans to borrowers at or below 80 percent and 60 percent of median income.
It is of course possible to find prime loans among low income borrowers, but not if more than half of all loans the GSEs acquired had to be made to these borrowers. Accordingly, in order to meet these government quotas, Fannie and Freddie resorted to buying mortgage-backed securities based on subprime loans. This involved taking additional risks, since subprime loans were low quality because the borrowers generally had blemished credit records, but these loans were the most likely to meet the affordable housing goals. Wall Street and other firms made up pools of loans specifically to meet the GSEs’ requirements, and eventually Fannie and Freddie became the largest purchasers of the mortgage-backed securities issued against these pools of low-quality loans.
Moreover, in order to certify to HUD that they had met the quotas in any year, Fannie and Freddie had to know the percentage of loans in each pool that contributed to meeting the affordable housing goals and subgoals. It is likely, then, that in defending themselves in this suit, the banks will point out how much information the GSEs had about the loans they were buying, and hence that they assumed the risk.
Indeed, the GSEs were well aware of the additional risks they were assuming in buying subprime loans in order to comply with government requirements. For example, here is a statement in Fannie Mae’s 2006 10-K:
[W]e have made, and continue to make, significant adjustments to our mortgage loan sourcing and purchase strategies in an effort to meet HUD’s increased housing goals and new subgoals. These strategies include entering into some purchase and securitization transactions with lower expected economic returns than our typical transactions. We have also relaxed some of our underwriting criteria to obtain goals-qualifying mortgage loans and increased our investments in higher-risk mortgage loan products that are more likely to serve the borrowers targeted by HUD’s goals and subgoals, which could increase our credit losses. [emphasis supplied]
In effect, then, the government is suing 17 banks for helping Fannie and Freddie meet the government’s own affordable housing quotas.