Arnold Kling  

Freddie Mac--victim, villain, or savior?

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If You'd Listened to Me, You'd... Am I a heterodox Keynesian?...

The New York Times reports,


Freddie Mac, the big mortgage finance company, posted a $2 billion loss for the third quarter and warned that it might not have enough capital on hand to cover the mandatory reserves for its mortgage commitments.

...Freddie’s misfortune is particularly rattling because the company is considered something of a backstop for the lending industry.


Over ten years ago, I worked for Freddie Mac. Freddie Mac received its charter from the government, and the charter said that we were to buy "investment-quality loans." When I was there, we took this to mean loans where either the borrower made a down payment of 20 percent or the borrower made a down payment of 10 percent and private mortgage insurance covered another 10 percent in case of default.

In the article, I detect an attempt to spin Freddie Mac as a victim of a "crisis" that was outside of its control. However, somebody should look into whether or not the loans in Freddie Mac's portfolio that are defaulting were truly of investment quality. If instead it turns out that Freddie is suffering from defaults on subprime loans, then my view would be that Freddie's executives are villains, not victims. If any company should have had the institutional memory, know-how, and clarity of mission to avoid buying junk loans, it would be Freddie.

If the politicians want to change Freddie's charter to make it the savior of sub-prime mortgage borrowers, then they may do so. That is part of the political risk that Freddie Mac's shareholders face. (I am no longer a shareholder, except insofar as the stock is included in the S&P 500 index and I own mutual funds that track that index).

But I think there is a lot to be said for sticking to the original charter. From a public policy perspective, I think we are better off with Freddie Mac doing less fishing in subprime waters, not more.

UPDATE: A commenter raises the issue of whether accounting losses exceed actual losses in the current subprime crisis. That is, suppose that only $3 million of default losses are likely to occur on a $50 million pool of subprime loans, but because of loss of confidence, the market price of the pool drops to $40 million. Using mark-to-market accounting, the holders of the pool take a loss of $10 million, not $3 million.

My view is that the holders in fact should record a $10 million loss, and then if they hold the pool they can record a gain in subsequent years. It's much better to take write-downs too much, too soon than too little, too late.


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COMMENTS (6 to date)
Barkley Rosser writes:

Arnold,

We already went through a major round of scandalizing and firings at Freddie Mac due to shambolic accounting that was discovered. To what extent has that been fixed so that this new problem is a strictly separate and brand new, as it were, problem?

Arnold Kling writes:

The accounting at Freddie Mac was fine. It caused them to understate earnings for a while. But the "scandal" did manage to wipe out top management, and the new management turned the company into a nonprofit.

Sleepine writes:

A technical comment, Arnold, to one whose grasp of economics and overall political-economic lucidity I have long admired. Freddie Mac's Charter does not require it to limit its mortgage guarantee or purchase activities to "investment quality" loans. The Charter requires it to purchase only those loans that meet generally the purchase standards of private institutional mortgage investors. As we know, private institutional mortgage investors will purchase mortgages of any quality -- at a price. The Charter standard thus is one of marketability -- not intrinsic investment quality (although the Seller/Servicer Guide does speak of purchasing only "investment quality" loans, that is a voluntary contractual standard that can and has been waived from time to time).

The marketability standard is not an altogether inappropriate standard for an institution chartered, first and foremost, not so much to provide subsidies to low-income families who simply lack the financial wherewithal to purchase a home in the first place, but to ensure that the market for housing finance enjoys a continuity of liquidity that other financial market sectors will not necessarily enjoy (whether this is a good or bad thing is another matter, but it is not an illegitimate social choice for a polity to make).

I believe that 10 years ago, the loans that are the subject of so much controversy today would not have been made -- they certainly would never have found their way into the portfolio of Freddie Mac, which managed that portfolio with a conservatism regarding credit risk altogether appropriate for a government-sponsored enterprise. Candidly, it is not altogether clear that the present management team abandoned that risk conservatism regarding credit. Freddie's purchase of subprime mortgages is, as is well known, mostly in the form of structured senior-subordinate securities in which the subordination (that will absorb credit losses before they hit Freddie Mac) is very, very substantial. Significantly, Freddie Mac never invested in CDOs regardless of their ratings -- cognizant of the phony credit protection offered by the subordinate securities in front of even the highest-rated CDOs. Much of today's so-called "credit losses" are the artifices of an arcane and, I'd say, substantively irrational accounting system that forces "realization" of "losses" that have nothing to do with real world losses but everything to do with a snapshot of a market that is hysterical, illiquid and therefore mispriced.

A heterodox Keynesian is likely found of his aphorism about scribblings and scribblers. What would Adam Smith think, though, of the dominion of pea-brained accountants over our capital markets?

Barbara Ann Jackson writes:

Perhaps the most critical element of the Nationwide Foreclosure Crisis is the problem of fraudulent foreclosures. In almost all instances where fraudulent foreclosures are being accomplished, MORTGAGE LENDERS benefit by becoming enabled to FLIP the fraudulently obtained foreclosed property.

In Louisiana, cronyism and judicial corruption are the salient reasons why unlawful foreclosures are sanctioned. Further, in Louisiana, 2 particular mortgage companies which benefit from fraudulent foreclosures are WELLS FARGO and FREDDIE MAC! The Louisiana Division of the U.S. JUSTICE DEPARTMENT, as well as various legislators have repeatedly been informed about foreclosure improprieties. However, it appears that cover ups are granted to these mortgagors.

In certain instances in New Orleans (from whence I became displaced due to Katrina) the creditor was initially no better off than defaulted borrowers from fraudulent foreclosures because the tangible proceeds went to the collector. Lenders often needed to wait for fraudulent property flippings in order to reap some benefit.

Furthermore, when borrowers sued for unfair debt collection practices, the collector got to make more $$ out of the deal by protracting litigations, and thereby reaping more billable hourly fees while allowing the lender / the creditor to believe the borrower caused the legal costs! As such, it is NOT HARD to conceive that $$ which should have been paid to INVESTORS went to collectors and to (knowingly or unknowingly) association-in-fact" members of real estate fraud schemes who got a slice of the foreclosure pie. Prior to Katrina, such was (and likely still is) the norm. Moreover, in far too many cases, the mortgage creditor probably GOT NOTHING FROM the foreclosure -not even the property!! In the meantime, Investors in Securities would have no clue when books are cooked to mislead Investors to believe the market was productive rather than fraudulently flipped real estate which in turn create legal expenses when those frauds are challenged in court.

However, despite a property owner's entitlement to CHALLENGE CONTRARY-TO-LAW loss of his / her home, most such owners LACK consumer and legal knowledge; the Court System is REFRACTORY; and there is a SHORTAGE of attorneys with acumen to pursue this area of Consumer Law! (Sometimes attorneys do advise the filing of bankruptcy cases as the best option;
but not often are adversary proceedings brought within those cases for redress of foreclosure fraud.)

Also, too often it goes overlooked that when Mortgage Lenders negligently DISREGARD unlawful and abusive conduct of debt collectors, NOT ONLY are distressed borrowers often subjected to tyranny and injustice, but the lenders and indirectly, Investors could become made liable for various Torts -including "Conversion" of real estate and other violations of Consumer Law. Thus, the current foreclosure epidemic compels a focused look at the total foreclosure process.

Lastly, Investors need to become more astute about how mortgage servicers' misdeeds hurts borrowers as well as siphons incalculable amounts of money from what Investors should reap. (See "Limiting Abuse and Opportunism By Mortgage Servicers," AND "Private Property Rights Deferred: Has Predatory Mortgage Servicing Destroyed The American Dream" by Rawle Andrews, Jr., Esq.,and Leroy Jones, Jr., J.D. The document can be found at
http://www.msfraud.org/index.html.)

**Here's a few links for my site with more clarity on these issues, as well as Prima Facie proof of what I've written:

"ILLEGAL REAL ESTATE FLIPPING..."
http://www.lawgrace.org/2007/06/21/illegal-real-estate-flipping-unfair-enrichment-etc/

"No One Should Be Required. . ."
http://www.lawgrace.org/2007/05/22/no-one-should-be-required-to-be-a-law-abiding-citizen-if-the-manifest-illegal-conduct-of-attorney-herschel-c-adcock-jr-remain-ignored/

Commenter writes:

The comment above mine doesn't mention Freddie Mac one time, but it has a lot of CAPS in it, so I can tell it's IMPORTANT for us to READ.

Sleepine writes:

Arnold:

I agree, in general, with your point "that the holders in fact should record a $10 million loss, and then if they hold the pool they can record a gain in subsequent years. It's much better to take write-downs too much, too soon than too little, too late."

The difficulty in applying this general principle at a moment of severely constrained market liquidity -- and particularly to enterprises chartered by Congress with a stated purpose of continuous enhancement of the liquidity of mortgage investments -- is that the application of this sound accounting generality undermines the ability of the institution to do what it was created to do. In times of severe liquidity stress -- like the present -- leveraged institutional investors seek to de-leverage as rapidly as is feasible (leading to the much decried risk of "asset fire sales" justifying the government's clumsy attempt to bail out firms running SIVs with a super-SIV). Lots of good work on this, especially some papers by Prof. Hyun Song Shin available on the Internet / SSRN. Similarly, this instantaneous "mark-to-market" requirement accelerates the need to de-leverage and investors' flight to the exits. If you accept the notion that market liquidity has some public good aspects that can result in its systematic under-provision by purely private providers who can't possibly capture all the externalities of genral market liquidity provision, then liquidity needs to come from somewhere else. The Fed's generalized and unbfocused infusions of liquidity have to date availed little, and continuing down that oath raises the ugly specter of building inflation and inflationary expectations into the economy. One might wish to look, under those circumstances and subject to market-based regulatory oversight (e.g., monitor CDS spreads on GSE debt or sub debt-- much more accurate measures of credit risk than those debt spreads themselves), to Freddie and Fannie for more focused and disciplined injections of mortgage market liquidity.

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