Should We Cheer The FHFA Lawsuit?

By: John Downs | Thu, Sep 8, 2011
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Tonight, the NFL season will begin. One of the best aspects of this national spectacle is the fierce competition of evenly matched teams, any one of which can beat, on "any given Sunday," any of the league's best teams. While Americans admire league parity in football, they have come to despise the tiered structure that the government has created in the financial services arena. Many Americans blame Big Finance for the recession, and as a result, many have expressed outrage that the biggest offenders have cordoned off into a league of "Too Big To Fail" (TBTF) banks that operate with greater protections and more favorable access to capital than smaller competitors. Given this mindset, many Americans see politicians as scrappy hometown heroes squaring off against the bigger, better-funded Titans of Wall Street.

The dominance of this narrative explains the largely positive public reaction that greeted last Friday's announcement of Federal Housing Finance Agency (FHFA) lawsuits filed against seventeen banks and financial institutions for $200 billion in subprime loan losses. The victims of the alleged fraud? Fannie Mae and Freddie Mac, and therefore the taxpayers.

The suits claim that Fannie and Freddie, then two of the largest investment bodies in the world, had been ruthlessly hoodwinked by bankers into buying low-quality, and potentially fraudulent, mortgage-backed securities. In exchange for fees and commissions, big banks and loan companies stuck the taxpayers with a mountain of bad debt.

In a statement released following the announcement of the lawsuits, Bank of America said that when Fannie and Freddie bought these collateralized mortgage obligations (CMOs), "[t]hey claimed to understand the risks inherent in investing in subprime securities." Some defenders of the lawsuit insist that Fannie and Freddie's share of the blame is irrelevant, since the taxpayers are now the shareholders of these institutions, and the government's responsibility is to recoup these costs. In other words, even if Fannie and Freddie weren't on our team before, they are now.

In reality, American taxpayers have always been on the hook for Fannie and Freddie. These government-sponsored-enterprises (GSEs) were products of the New Deal and Great Society and always enjoyed favor with the federal government. They always had the implicit promise of a bailout if anything went wrong. This is like giving a hot-shot rookie a guaranteed lifetime multi-million dollar contract, and then, after the rookie fails to live up to expectations, suing the drug dealers and groupies for "ruining his career." Any General Manager of a football team that made a habit of throwing money at players with no accountability to performance would be fired quickly, but, in Washington, they are rewarded.

The affinity between Washington and these GSEs was obvious years before their outright nationalization in the summer of 2008. Senator Harry Reid (D) rejected GSE reform throughout the housing boom on the grounds that "we cannot pass legislation that could limit Americans from owning homes and potentially harm our economy in the process." Senator Chris Dodd (R) threatened to filibuster a major reform of GSEs in 2005. Have we ever seen politicians so protective of an institution that was not essentially an arm of the government? Fannie and Freddie also enjoyed tax and regulatory advantages, but, more importantly, they knew that if anything went terribly wrong, they would be bailed out by the loving politicians they had spent millions lobbying. It was in this context that the Fannie Mae CEO told his employees to "get aggressive on risk taking" even as his enterprise was leveraged more than 60 to 1.

In football, a Hail Mary pass usually falls incomplete and tempers a coach's enthusiasm for "going for it all." But in Washington, where the ref can always be relied on to throw a flag for pass interference, why not throw for the end zone every time? The government did just that by specifically subsidizing subprime mortgages in the first place. It wasn't just Democrats. The Bush administration made widespread home ownership a high priority, even for those who couldn't realistically keep up with their mortgages. By the peak of the housing boom, the Federal Housing Administration was backing loans with down payments as low as 3.5% and it is still doing so on loans of more than half a million dollars for "low-income" Americans.

Here's the real kicker: the Federal Reserve kept interest rates artificially low from 2001 onward with the specific goal of propping up a housing bubble. As a result, the mortgage sector expanded unsustainably, and the volatility of derivatives like CMOs was vastly exacerbated by the underlying problem of too much easy credit. As a classic example of the business cycle identified by Nobel Prize winner Friedrich Hayek, the boom of the last decade eventually went bust.

Most of the banks and financial entities being targeted by the lawsuit have also been long-time recipients of government support and Federal Reserve favoritism. The irresponsibility that flourished on Wall Street did not come about in a vacuum - underlying the easy credit was the unspoken guarantee that Uncle Sam would come to the rescue if reckless lending threatened to bring down the system. And that's exactly what happened in late 2008.

To see the ultimate absurdity of the government's position, all one need to do is ask, "where will the money come from if the lawsuit prevails?" It will either be bailout money that had previously been offered to the banks by government, or it will come out of banks' operating expenses, meaning these "solvent" banks will be one step closer to another slew of bailouts. Taxpayers will also be forced to pay for the government's lawyers and the trials themselves.

In this system, taxpayers are forced to foot the bill no matter who wins or loses. Imagine if football worked that way. If all points scored always were credited to the away team, would the home team even bother to suit up? The problem with the FHFA lawsuit, like all these Washington games, is that unbeknownst to the spectators, both teams are playing on the same side - and so is the ref.

 


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John Downs

Author: John Downs

John Downs
Assistant Branch Manager/Investment Consultant
Euro Pacific Capital, Inc.

John Downs

Mr. Downs comes to Euro Pacific Capital as a real estate investor and mortgage industry insider, where he most recently founded and operated a multi-state wholesale lender. His firsthand "inside the bubble" experience validates the predictions that Peter Schiff has espoused for years. Mr. Downs was a student-athlete at the University of California Davis, where he graduated with degrees in History and Political science. Mr. Downs is an avid student of government monetary and economic policy, the Federal Reserve banking system, and the implications for your investments.

A licensed California Real Estate Broker, he is nearing completion of his Certified Financial Planner designation and studying for his Chartered Financial Analyst exam. He presently holds FINRA Series 7, 24 and 66 licenses.

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