Everyone’s housing market profits were fictitious
By Maureen Tkacik
The opinions expressed are her own.
Also read part one of this series, How Ed DeMarco finally cried fraud.
A big clue something had become dysfunctional at Fannie Mae and Freddie Mac came in the first week of 2011, when the government mortgage market makers announced the terms of a settlement agreement theyâd reached with Bank of America, and were immediately pilloried for extending the bank another âbackdoorÂ bailoutâ by the likes of Maxine Waters and the American Enterprise Institute.
By the end of January an internal investigation had convened, all other settlement negotiations had been suspended, and Edward J. DeMarco, the acting Fannie/Freddie overseer pending the confirmation of his replacement, found himself suddenly faced with the challenge of replacing himself as congressional Republicans vowed to stonewall Obamaâs pick. Part one of this series traced DeMarcoâs unlikely conversion in 2011 from coddler of banks to unyielding litigator of bank fraud. Itâs a rare shift in Washington, where âcorruptionâ is a process thatâs practically synonymous with âaging.â Whatâs often forgotten when bureaucrats fail as spectacularly as they have at Fannie and Freddie is the critical roles played by cluelessness, incuriosity, faulty reasoning and fraudulent economic logic as well.
Consider what the inspector general learned about the corporate procedures for pursuing âputbackâ claims in place at Freddie Mac. While purchase contracts entitle the GSEs to force banks to buy back any delinquent loan in which it finds evidence of fraud, Freddie restricted examiners to screening only mortgages which had defaulted within two years of origination, a tiny sliver of total foreclosures comprising less than one-tenth of defaults from the years 2004 to 2007âthe vintage of the Countrywide loans. When one of DeMarcoâs deputies noticed this apparent oversight and began warning executives that “Freddie could passively be absorbing billions of dollars of losses” merely by refusing to glance at 90% of their files, the enterprise âŚ chose to absorb the losses, repeatedly resorting to a boilerplate argument justifying the two-year policy holding that:
loans that had demonstrated a consistent payment history over the first two years following origination and then defaulted in later yearsâŚlikely did so for a reason such as loss of employment, which is unrelated to [fraud].
The deputy spent six or so months attempting to politely introduce his colleagues to the concept of the âteaser rate.â Perhaps, he writes in one email, Freddie was failing to take into account that âfrom 2005 through 2007 there was a substantial increase in non-traditional mortgage products [which] frequently featured âteaserâ rates initially resulting in low paymentsâ which would âincrease dramatically two, three, or five years after originationâ when ârates reset and/or the repayment of principal beganââthus rendering virtually any deliberate fraud essentially âinvisibleâ for the first few years of the life of the loan.
The examiner, though, was either himself mistaken, or trying to be polite, because those dates are off by a few important years. As he might have gleaned from the companyâs annual survey of adjustable rate mortgage trends, a 28-year-old Freddie Mac tradition available online, the âsubstantial increase in non-traditional mortgage productsâ began well before 2005; what changed in 2005 is that housing prices in the hottest markets finally, slowly began to edge down a bit, meaning that each passing month was rendering increasing numbers of borrowers âunderwaterâ on their loans.
But when Freddie executives attempted to get themselves off the hook by blaming plummeting housing values for the uptick in foreclosures, the inspector general shoots them down in a fascinating footnote (emphasis mine):
Freddie Mac staff advised FHFA-OIG that they disagree with the senior examinerâs causation hypothesis. Alternatively, they attribute the reversed pattern of foreclosures shown in Figure 3 to falling home prices leading to negative equity or âunderwaterâ mortgages.Â However, causation is irrelevant to the issue in controversy. Regardless of the cause of these defaults, the search for representations and warranties defects is the point of the loan review process; and if the search does not begin, then the defects will not be found.
Causation is irrelevant to the issue in controversy?
Pretty bold statement for a professional investigator! If only it didnât so elegantly articulate the widespread attitude of the political establishment toward the crisis itself: We get it, we get it, âitâs the economy stupid etc.â so do yourselves a favor and stop nagging us with demands for truth and justice while weâre trying to pass this freaking jobs billâŚ But imagine if someone involved here had paused to contemplate the irrelevant just briefly, pondering the methodology with which one might calculate the likelihood that a particular defaulted loan conforms withâŚ
- Foreclosure Causation Hypothesis A: Borrower can afford to make mortgage payment of X but defaults when faced with a payment of 2X after the introductory teaser rate expires
- Foreclosure Causation Hypothesis B: Borrowerâs mortgage balance is now 2X the value of his house.
âŚonly to think, Holy Cow, what if it turns out that each causation hypothesis might also serve as a causation hypothesis for the other causation hypothesis? That is, what if the âteaser rateâ enabled so many Americans to pay the mortgage on houses they couldnât otherwise afford that housing prices kept rising artificially, in turn enabling borrowers to refinance their loans just before their payments were scheduled to balloon? That is of course, the central dynamic of the post-2001 housing market: people buying houses they could not afford with the help of kickbacks that collectively, over time, wound up rendering the whole housing market (artificially) unaffordable to just about everyone — unless you used one of those new mortgage products.
In the absence of any underlying economic fundamentals that might plausibly justify an unprecedented expansion of homeownership in an era of total wage stagnation, obscene gas prices and the whole litany of other hardships the 99% endured throughout the Bush Administration, it is a Ponzi scheme. Fannie and Freddie knew this.
Between 2000 and 2006, a period during which median household income moved almost suspiciously in alignment with the consumer price indexâboth gained about 17%âthe mortgage behemothâs âconformingâ loan limits rose 65%, from $252,000 to $417,000 in average markets and $340,000 to 625,000 in designated âhigh costâ areasâand even those caps drastically understated the housing bubble, which drove housing prices up more than 100% in many markets. A full 40% of mortgages originated in 2004 were ARMs, the highest share since 1994âwhen fixed rates were much higher. It wasnât merely a bubble, although you wonât even find that word in the IG report. Fraud was ubiquitous throughout the process, top to bottom, year after year upon year. More than ten million foreclosure filings into the bust, nearly a quarter of outstanding mortgages are still underwater.
Given the crappy hand the proverbial 99% have been dealt here, it is obvious now and has been for a few years what Fannie and Freddie, as federal taxpayer-capitalized entities which own or guarantee half of all outstanding mortgages in America, must do: avoid foreclosures wherever possible by enacting massive mortgage relief programs, find ways to lure owner-occupants to hard-hit areas and deter would-be slumlords from dragging down property values further, and more generally do whatever possible to preserve the value of its assets.
But on many separate occasions, they have chosen to do the opposite. Reviewing thousands of local Fannie Mae real estate transactions, the recent Detroit Free-Press investigation portrayed an institution seemingly hellbent on foreclosing and liquidating properties en masse to big investors as quickly as possible, even when banks and borrowers were in the midst of ironing out some sort of deal that would ostensibly work out better for both parties, then selling off the properties in secret transactions from which local househunters complained of being âshut out.â As one local housing expert lamented: âEven the worst slum landlord understands that basic concept. Why wouldnât you take the $10,000 from the homeowner? But they will take $2,000 or $3,000 from an investor?â It didnât make sense. âIt has really seemedâŚpunitive,â says series author Jennifer Dixon. âLike they really want to punish people for falling behind on their mortgages.â
Alan White, a Valparaiso University law professor and expert on housing policy and the foreclosure epidemic, agrees: âFannie has said their average recovery rate on a foreclosure is 50%, so if the homeowner can cough up anything more, it only makes business sense to offer them a modification, but the idea is that this would somehow create unthinkable âmoral hazard.â There is definitely a sort of anti-borrower ideology driving a lot of it. But I also think theyâre in a hurry to clear their books and get these loans off the balance sheet while taxpayers are footing the bill.â
White was reluctant to indict DeMarco for his policies, however; like many of the other nine mortgage finance âexpertsâ I consulted to figure out what the hell theyâd done with taxpayersâ $180 billion and counting, White blamed DeMarcoâs ânarrow interpretation of his mandateâ as a guardian of taxpayer dollars, for his failure to grasp the economics of achieving that mandate.
Burning down the houses
In the worst of the crisis, the economics of post-bubble Washington lacked even the typical slumlordâs grounding in reality. Because causation was irrelevant to the handling the crisis, naturally the first guy former Treasury Secretary Hank Paulson called for advice when he realized heâd have to nationalize the mortgage giants in the summer of 2008 was, according to Andrew Ross Sorkinâs Too Big To Fail, the Madoff of macroeconomics himself, Alan Greenspan. The former Fed chairman suggested a course of action so bizarre it turned out portentous: Fannie and Freddie ought to use their bailout money to buy up vacant homes in bulk and burn them; a million would probably do the trick.
Paulson reportedly nixed this idea âwith a laughâ; the book dismisses it as a ârhetorical flourish befitting [Greenspanâs] supply-and-demand mind-set.â But the wily financier Bill Gross, whose bond fund PIMCO employed Greenspan as a consultant, endorsed it the next month in a letter to investors. The schemeâs obvious drawback was of course, the universal refrain at the time went, âpolitically impossible.â The robo-foreclosure industrial scale eviction frenzy that actually transpired wasnât any more politically correct than setting a few ZIP codes on fire, however, and it was about equally stupid, akin to dealing with the aftermath of Madoff by ordering a hit out on every one of his victims, letting a few die and informing the rest that youâll happily call off their assassinations as soon as they recruit five new high net worth âinvestorsâ who have somehow never heard of Madoff.
But what should we expect from Greenspan, a guy whose legacy, mission statement and unifying theory all boil down to the one consistent conviction he ever stooped to plain English to voice: that thereâs no need for laws against fraud. If Greenspan were in charge, Madoff would be in Fiji or Uzbekistan with a dozen bodyguards, and there would be nothing the government could do about it. And thatâs much closer to reality than most people realize, because Greenspanâs bankrupt nonsense ideology still saturates every debate, policy decision, news update and barroom conversation that happens in Washington, cutting off the relationship between public servants and the public, not unlike the way effective cult leaders convince members to fear their families.
In any Ponzi scheme, everyone is a little bit culpable, but on the spectrum of negligent naivete, trusting that housing prices would continue to rise forever is arguably a lot more forgivable than trusting an unlicensed mutual fund that claims with no documentation to be delivering a steady unchanging 10% annual return. Which is why in any Ponzi scheme, you differentiate the victims from the unwitting accomplices by determining who lost and who profited from the arrangement. There was so much fraud in the mortgage crisis that no oneâs earnings were truly earned, and everyoneâs profits were fictitious. And yet one group has walked away with billions, and the other have lost their homes.
My hope is that by this point DeMarco is familiar enough with the contentions of the eighteen lawsuits heâs filed to comprehend the magnitude of the malefaction at work here, and, understanding that his previous notions of causation of the issue in controversy were misguided, change his agency’s role in it. But he’ll probably get replaced, first.
Also read part one of this series,Â How Ed DeMarco finally cried fraud.