I've said that I think that someone should write a book about Freddie Mac. Here is my chapter.
I came to Freddie Mac as a senior economist in the Financial Research Department in 1986. The department was headed by Peter Lloyd-Davies, who knew me from when we overlapped at the Fed.
Peter hired Chet Foster and Bob Van Order, two former HUD economists, who had developed the option-theoretic model of mortgage defaults and prepayments. The default model said that the probability of mortgage defaults increases as the borrower's equity in the home goes negative. To implement the model, you have to specify a probability distribution for the path of future house prices.
Chet and Bob scorned the corporate lifestyle. Bob had an old, torn purple smoking jacket that he preferred to the standard coat and tie.
Leland Brendsel, the CEO of Freddie Mac, loved Financial Research. After regular hours, he would often wander down to talk with Chet or Bob or Peter or Ann Dougherty (another ex-HUD economist). I was rarely around for Brendsel's visits, because I liked to come in early in the morning and leave while it was still afternoon.
If Chet and Bob were the mad scientists, I was like a platoon leader. "All right, here's what we're gonna do. We're going to take these explosives that Chet and Bob have created, plant them under the multifamily division...and blow them to BITS!!!"
I was very combative when I was at Freddie. I took on the multifamily division (more on that shortly), I took on some of the financial analysts in Henry Cassidy's Corporate Finance section, and I took on the Information Systems division. At one point, Ann said, "We're going to have a rule that Arnold is not allowed to write memos on Fridays." At another point, Bob said, "We need to get Arnold laid." Peter or somebody should have taken me aside and told me that I could not go around alienating everyone if I wanted to be successful.
Freddie Mac buys mortgages and sells securities. The mortgages can default. But Freddie Mac insulates the securities from mortgage defaults by absorbing the default losses itself. Typically, these losses are small, because Freddie buys loans where the borrower puts down 20 percent. With that large a down payment, it takes a drop in the value of the house of more than 20 percent to make the borrower's equity go negative.
The Foster-Van Order model was used to produce estimates of default costs and capital charges for the mortgages that Freddie Mac was guaranteeing. The default cost is the average amount that Freddie will lose because of its guarantee. The average is low, because the probability of a severe decline in house prices is low.
The capital charge starts with the assumption that there will be a severe decline in house prices. We calculated how much capital we would need to be able to absorb the mortgage losses under that scenario. We called this the stress test.
Based on the stress test, we included a capital charge in the fee we charged for providing our guarantee. This capital charge varied considerably by the type of loan. High-risk loans, such as loans to investors who did not occupy the homes or loans with low borrower down payments, had enormous capital charges, so that Freddie Mac was not competitive in buying those loans. Low-risk loans, meaning loans to owner-occupants putting 20 percent down, had low capital charges, less than the capital requirements for banks to hold those loans. That meant we were very competitive in that market.
Multifamily loans were high risk. However, Freddie Mac, as a government-sponsored enterprise (at that time, it was an agency under the Federal Home Loan Bank Board), was expected to provide funds to support low-income housing. The multifamily division guaranteed mortgages on apartment buildings, which were occupied by many low-income renters.
The capital charges that we came up with for multifamily drove the division crazy, because they were so high. The capital charges made it very difficult for the division to compete for business, and their management howled about it. In an important meeting between Chief Financial Officer David Glenn and the entire Financial Research department, Glenn challenged us to justify whether we had the authority to dictate the pricing of multifamily loans, given the adverse impact it was having on our purchases.
In theory, the battle between Financial Research and Multifamily could have gone either way. In practice, Multifamily blew itself up. It turned out that their risk controls were terrible. They were lending money to slumlords who were quite happy to take the cash, let the properties rot, and hand the keys to Freddie Mac to clean up the mess. The default rates on the loans were much worse than our models predicted, and the losses nearly cost Brendsel and Glenn their jobs.
The multifamily fiasco had several long-term consequences. It raised the prestige of the Foster-Van Order model within the company. Over the next decade, many other economists were hired, and the Foster-Van Order approach to default and capital costs became deeply embedded in the corporate culture, with Brendsel, Glenn, Cassidy and others in senior management well attuned to it.
The multifamily fiasco also affected how senior management handled the trade-off between making loans to support low-income housing vs. doing what was best for the financial health of Freddie Mac. After the multifamily debacle, Freddie Mac's policy was to focus on financial health and minimize the support for low-income housing.
This was the risk management culture that Richard Syron inherited when he became Freddie Mac's CEO in 2003. Syron wanted to do more for low-income housing, and he did not trust the people that he found at Freddie Mac. As we now know, there was a blow-up between Syron and Freddie Mac's Chief Risk Officer over loans with low down payments. The Chief Risk Officer argued that such loans were bad for borrowers, bad for Freddie Mac, and bad for the country. Syron fired him.
In theory, Syron might have been correct. It could have been the case that the Freddie Mac holdovers he inherited were too conservative in the types of loans they were willing to buy. It could be that the policy of minimizing low-income lending and maximizing financial health was the wrong way to deal with the trade-off.
In practice, Syron's timing was awful. He pushed Freddie Mac into high risk loans just as the real estate bubble was in its final few years. He then compounded this mistake by ignoring those at Freddie Mac who said that if the company was going to take these risks, then it had to raise more capital.
I am not an attorney. However, I suspect that the warnings that Syron received about the high-risk loans may make him vulnerable, given the Sarbanes-Oxley law, on issues of disclosure.
Finally, there was the press release featured prominently on Freddie Mac's web site where senior management denied receiving warnings and lashed out at the former Chief Risk Officer. This struck me--and other current and former employees with whom I have spoken--as nasty, clumsy, and untenable. It lacked credibility and undermined what had been Syron's reputation as a straight shooter.
I was "present at the creation" of Freddie Mac's risk management culture--all of those people who had absorbed the Foster-Van Order approach to pricing mortgage default risk. That was the culture that Syron rejected. I was proud to be part of that culture, and I would have felt hurt no matter how Syron's new policy turned out. But the new policy drove Freddie Mac to the brink of bankruptcy, if not beyond. As a result, I believe that the risk-assessment models that we so proudly developed will die along with the company.