Fannie, Freddie Knew About Risks, Ignored Them

This post first appeared on Minyanville and Cirios Real Estate.

Unprecedented. Unpredictable. Unparalleled. Extraordinary.

These are the adjectives offered by mortgage industry executives defending their relative innocence in the collapse of the housing industry. Conditions, they argue, deteriorated so rapidly and in such unpredictable ways they couldn't possibly batten down the hatches fast enough.

As it turns out, that's not exactly true.

The Washington Post reports that chief executive offers at both Fannie Mae (FNM) and Freddie Mac (FRE) ignored warnings about their firms' exposure to risky loans. The findings of the House Committee on Oversight and Government Reform are being discussed today on Capitol Hill.

At Freddie, an internal report explicitly warned that certain types of loans might default at a higher rate than expected if borrowers' true financial positions were to be made known. Furthermore -- and troubling insofar as these firms and their Washington backers actively pushed these risky loans on low income immigrant communities -- senior executives were told many such mortgages could be particularly harmful for non-English-speaking homeowners, since many didn't fully understand the confusing loan terms.

At Fannie, no smoking gun was produced, but the oversight committee discovered what it called an "underground" effort to actively buy subprime loans.

For their part, former Fannie CEO Daniel Mudd and deposed Freddie chief Richard Syron are directing the blame elsewhere - not surprising, given their well-documented penchant for obfuscation and finger-pointing. To Mudd and Syron, responsibility for the crash lies squarely at the feet of regulators and Congress: One was asleep at the wheel while bad loans ran rampant through industry as a whole; the other all but forced lenders to give out loans to under-qualified borrowers under the auspice of the Community Reinvestment Act, or CRA.

The CRA, introduced in the late 1970s but used by the Clinton administration to support the now-maligned American dream of home ownership, aims to give low-income borrowers equal access to cheap mortgages and other banking services. Think of it as reverse "red-lining," which is the outlawed practice of refusing to lend in certain neighborhoods that may be perceived as riskier than others.

Homeownership rates -- not to mention political backslapping -- surged as the housing market boomed, even as borrowers became increasingly exposed to predatory lending and risky loans. Wall Street and banks like Bank of America (BAC), Citigroup (C) and JPMorgan (JPM) saw loan portfolios balloon as low interest rates, securitization and an influx of foreign money fueled the red-hot market.

A lucky few managed to sell at the top; the rest are now left holding the bag, with everything tenuously held together by an ad-hoc glue of taxpayer money and a ballooning national debt.

And while we now know how the story ends, the future, as they say, has yet to be written.

Mortgage regulations, as much as they've been tweaked since the crisis began, will undergo an even further-reaching overhaul by the time we emerge on the other side of this mess. Along with the rest the financial industry, laws regarding borrowing and lending are slated for massive changes in the coming years.

Regulators could choose to punish the industry and homeowners alike with oppressive rules and regulations, which will will push up interest rates and prolong the housing market's eventual recovery. It will, however, do little to punish those actually responsible, since most have either lost their jobs or are living high off their spoils. Sadly, we appear well along this path.

The other option, however politically inexpedient it may be, is to once and for all remove the government crutch from the mortgage industry and let the free market determine interest rates, borrowing terms, and home prices.

To be clear, this is not to advocate lawless cowboy lending, but simple, prudent rules that protect borrower and lender alike without home loan subsidies in the form of artificially low interest rates.

At the center of any responsible regulatory regime is a realignment of incentives. The current system still rewards housing-market actors like real-estate agents and mortgage brokers for encouraging borrowers to make bad decisions. The higher a buyer's price, the more an agent is paid; the more the terms of the loan favor the bank, the more a mortgage broker stands to profit. This needs to change.

And until it does, as George Santayana said, "Those who cannot remember the past are condemned to repeat it."