Arnold Kling  

Freddie Mac: My Chapter

A Guy in the Wrong Profession... Subsidies...

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.

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CATEGORIES: Business Economics

COMMENTS (12 to date)
Brad Hutchings writes:

How much do you think that Freddie's and Fanny's purchasing of high risk loans contributed to the expansion of the housing bubble? In other words, in a noble attempt to make housing more affordable, did they actually make it less affordable by making credit too easy and driving up prices? Is that basically a repeat of the multi-family fiasco?

James A. Donald writes:

That your risk assessment models will die because of events suggesting that they are correct is part of a widespread pattern of intellectual deterioration, manifest in global warming theory, string theory, postmodernism, and fields too numerous to mention. The stupids are taking charge, and standards are being adjusted to accommodate them.

The motto of the royal society was “Nullius in verba”, which means “Take no one’s word for it”. This motto was reinterpreted to accommodate the “evidence” for global warming. Most science journals have condition of publication that authors must comply with any reasonable request by other researchers for materials, methods, or data necessary to verify the conclusion of the article, which condition has not yet been enforced against the global warmers.

The equivalents are happening in finance and a thousand other fields. Risk models that show that lending to poor people with low payments is safe are happy happy happy, so reality must accommodate.

Tom Hanna writes:

My recollection is that Syron became CEO as serious accounting irregularities and other problems were coming to light. There was a lot of pressure on at the time to eliminate Freddie's special privileges and some of the criticism stemmed from the idea that Freddie wasn't living up to its charter. That, combined with Syron's mandate to reform the organization from within probably made the shift from financially conservative loans to more low income lending inevitable. Not to say that you're wrong on the economics, just that it was less about efficiency than about politics, internal and external.

Arnold Kling writes:

A couple of points about the accounting irregularities.

1. They caused Freddie to understate it's earnings in the near term, by postponing recording gains on hedges. The thinking was that this matched the treatment of the underlying securities being hedged.

2. As of current accounting standards, they would not be irregularities. The accounting profession now takes the view that there is no one right approach for treating the type of financial hedging Freddie was engaged in, and Freddie's approach is among those now considered acceptable.

See my essay, The Risk Disclosure Problem.

Arnold Kling writes:

It's really hard to say. The bubble was financed primarily by paper issued by Wall Street folks who were new to the game of packaging mortgages into securities. But Freddie and Fannie bought some of that paper, in effect subsidizing their inexperienced competitors.

Had Freddie and Fannie taken the opposite view, then Wall Street might not have been able to find other takers. But even if they had, and the bubble would have inflated without Freddie and Fannie, if Freddie and Fannie had stuck to low-risk lending they would today not be needing any government bailout. Most of their losses are coming from stuff they should have stayed away from.

Freddie Mac was the company that knew better, at least in the older corporate culture.

Jeff writes:

Very illuminating.

Jed writes:

Kling misstates both the allegations in the accounting securities class action case and the relevant accounting standards applied today. The allegations were that Freddie Mac intentionally manipulated its earning to cause investors to perceive its earnings stream as more stable than it actually was and bid up the stock accordingly. The fact that earnings were, as Kling points out, "front ended" over a period of several years reflected the rapid growth in the retained portfolio and a multi-year trend in interest rates -- conditions the market knew were not stable and management must have known were not sustainable. The stability of Freddie's earnings as these trends slowed or ended was initially a surprise to investors. But "Steady Freddie" was a market misperception sustained only by a program of "hedge" trading that was allegedly driven by the desire to achieve a particular earnings result. If that allegation were true, no current accounting convention would permit such transactions to be recorded as hedges because the intent of those trades was not to actually hedge risk. Ultimately, Freddie Mac agreed to pay a settlement of over $400 million dollars -- which does not seem like a mere "go away you pesky attorneys settlement" -- it was one of the largest securities class action settlements in history. To me, it seems exceedingly doubtful the company would have done so unless senior management knowingly engaged in fraud.

76s writes:


Sounds like you're conflating Fannie Mae with Freddie Mac.

In any event, I disagree with your perspective.

Both GSEs faced the vindictive rath of a rogue federal agency (OFHEO) that, for a variety of complex political and personal reasons, acted as an instrument of conservative "free market" ideologues who wanted to destroy FNM/FRE by any means at their disposal.

Chet Foster writes:

This is an excellent article by Arnold, but it tells only part of the story.

First, the accounting system. Freddie started as a Federal agency that did not have much to do. It was set up as a secondary market for S&Ls. At that time S&Ls were not much interested in selling loans. The accounting system was the typical government accounting system, done by folks that did not have a sound understanding of mortgage risk and related accounting practice. Freddie knew that the accounting system was not good. But fixing it was a huge problem. When Syron took over at Freddie Mac, it was estimated that it would cost something like $500 million to fix, and Wall Street analysts I talked to thought that it would take a lot more. Imagine going to the Board and asking for $500 million!

One thing that irks me is the requirement that Fannie And Freddie are required to make specified proportions of their purchases in lower income and minority areas. This more than anything else has created this mortgage market disaster. The mortgage market is one of the most competitive markets in the country. We have National Banks, commercial banks, S&Ls, finance companies, Credit Unions, mortgage bankers, and mortgage brokers (I am sure I have left some out) all competing for the last nickel on the table. I live in a small town in Texas (pop. 8,911) and we have 6 Banks, a credit union and a mortgage broker. In such a market everyone should be able to get a loan as long as the property and borrower are reasonable risks.

Leland and David were truly fine people to work for and exceptionally competent. It was a sad day for Freddie Mac when these gentlemen were forced to leave.

Bob Van Order writes:

Nice article Arnold. Mostly right. However, I did wear a tie with my smoking jacket. What am I to conclude about your recent relative mellowness?

On some other points:

On the bubble I think the feedback goes both ways, but mostly it came out of the subprime market. The really big surge in house prices was after 2003 or so, which was when the Fannie Freddie share of purchases fell sharply.

The declining share may have had something to do with the risk profile after 2005.

I think the price decline is most of the story, but not all, re defaults. They also did a lot of Alt-A in the last few years (currently about 10% of book). These have high downpayments and high credit scores, but are performing lousy. They are tough to evaluate because some are in securities with subordination ahead of them and insurance. As far I I know all of the subprime is in senior pieces of securities, but the senior pieces are at risk. The problem there is more a liquidity one--noone wants to buy even senior pieces. These will take losses, but not as much as the market discount suggests. Unfortunately neither accounting equity or mark to market equity are very accurate.

That's why I like the stress tests.


Jed writes:

Apologies to the blog-owner, but I wanted to clarify my previous comment in response to the post by 76s: I can't comment as to what politics may or may not have motivated OFHEO to produce the original OFHEO report that stimulated the class-action litigations, but having read many of the court pleadings in the Freddie Mac case, I can say that the plaintiffs allegations were that many of the transactions that Freddie Mac accounted for as hedges lacked a proper business purpose and were entered into solely for the purpose of reducing its then-current period accounting earnings and shifting those earnings to later periods. I can also say with certitude, that under past or present accounting standards, transactions lacking a proper business purpose can never be accounted for as hedges.

I also recall that late in the case when things must not have been looking good for the defendants, David Glenn, a "truly fine person to work for" filed papers claiming personal immunity from the anti-fraud provisions of the Securities and Exchange Act on account of the fact that Freddie Mac was a Congressionally chartered entity. Freddie Mac made no such claim in its own defense. I believe Glenn's claim was rejected in court.

Judy Naiman writes:

Reading Arnold's piece and the postings by Bob Van Order and Chet Foster brings back a lot of memories. Bob, you did wear a tie, but it was always the same one that you kept at the ready when you had to go to a meeting.
After leaving Freddie, I spent some time at OFHEO, the struggling GSE regulator. By this time (1996-2000)there was virtually no federal housing policy other than making Freddie Mac and Fannie Mae buy loans that met the various affordable housing goals. There was a lot of political pressure then and subsequently to make them buy more and more loans serving low and very low income housing needs. The goals were ratcheted up. There was little other federal policy for this segment of the housing market. In addition, the mortgage insurers and big mortgage bankers saw Fannie and Freddie as competitors not partners and sought to rein them in. There were many who thought the GSEs had gotten too big, too rich. Then you had Wall Street which could no longer get rich on the internet tech wave and saw real opportunity in the mortgage market. They promoted the origination of loans that they then securitized and ignored years of Freddie and Fannie experience in developing underwriting standards and understanding default risk.
These are only a few of the factors contributing to the current mortgage market mess. Every playerin every aspect of this industry is culpable.

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