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The SEC hopes the District Court will ignore the fine print that exculpates the defendants.

Apparently, the SEC ignored the fine print, and hopes the U.S. District Court will do the same. Its lawsuit against Fannie Mae executives depends entirely on its shifting definitions of "subprime" and "Alt-A." The SEC alleges that these executives deliberately misled investors as to the size of Fannie's "subprime," and "Alt-A" exposures. But the SEC, in attempting to demonstrate an intention to deceive, cherrypicked facts in a rather misleading way.

Definitional Problems

Subprime and Alt-A are but two of numerous financial terms that have very fuzzy definitions. Generally speaking, financial jargon is extremely sloppy, which is why so financiers are  adept at bambozzling investors and regulators. So many words--"security," "default," "CDO," "market value," for example--have very different meanings when placed in different contexts.  And many words have meanings that evolve over time.  For instance, most people equate home equity loans with second lien loans taken out in addition to a first lien mortgage. But over time, the home equity loan category was also expanded to include subprime first lien mortgages.  Frank Fabozzi explains this phenomenon on page 313 of his book, Fixed income Analysis:

At one time, the [home equity] loan was typically a second lien on property that was already pledged to secure a first lien. In some cases, the lien was a third lien. In recent years, the character of the home equity loan has changed. Today, a home equity loan is often a first lien on property where the borrower has either and impaired credit history and/or the payment to income ratio is too high for the loan to qualify as a conforming loan [from the GSEs.]

Defining Subprime Mortgages

If you want to be precise about subprime mortgages, you need to distinguish between: (a) a subprime borrower, (b) a subprime loan product, and (c) the subprime market.  The SEC defines subprime loans as any loan made to a subprime borrower. Period. In its financial filings, Fannie Mae defined subprime loans as either: (a) a subprime loan product extended to a subprime borrower; or (b) a loan included in a mortgage pool held by a subprime securitization. By parsing its own definition, rather than referring to the complete definition used in Fannie’s financial filings, the SEC was able to contrive a narrative wherein Fannie “under-reported” its subprime exposure.  We see this in paragraphs 3 and 4 of the complaint:

3. For example, in a February 2007 public filing, Fannie Mae described subprime loans as loans "made to borrowers with weaker credit histories" and reported that 0.2%, or approximately $4.8 billion, of its Single Family credit book of business as of December 31, 2006, consisted of subprime mortgage loans or structured Fannie Mae Mortgage Backed Securities ("MBS") backed by subprime mortgage loans.

4. Fannie Mae did not disclose to investors that in calculating the Company's reported exposure to subprime loans, Fannie Mae did not include loan products specifically targeted by the Company towards borrowers with weaker credit histories, including Expanded Approval ("EA") loans. As of December 31, 2006, the amount of EA loans owned or securitized in the Company's single-family credit business was approximately $43.3 billion, yet none of these loans were included in the Company's disclosed subprime exposure.

The definitions require a bit more explication:

Subprime Borrower: In very simple terms, a subprime borrower is someone whose credit is impaired. The credit designation is usually based on a FICO score, which is not based on income. Each year in its 10-K Fannie disclosed the percent of loans with FICO scores below 620, which, for many players is a common cutoff point for "subprime." Again, the distinction is critical, because proponents of The Big Lie often resort to dog whistle rhetoric by equating loans to low income borrowers to loans to subprime borrowers.

Subprime Loan: A subprime loan is one that is underwritten with the expectation that the default rate will be very high, exponentially higher than the rest of the market, based on the belief that a higher interest rate will offset and losses from defaults. (See charts 3 and 4 in the MBA National Delinquency Survey.) The lender often takes little regard to the borrower’s ability to pay back the loan. Many prime borrowers took out subprime loans, because they were steered in that direction by mortgage brokers and by subprime lenders. Also, many prime borrowers wanted a bigger mortgage than they could afford, according to the debt-to-income standards of a prime loan, so they took out a subprime loan instead.

The Anti-Predatory Distinction: Simply put, Fannie’s loans were subject to anti-predatory lending standards, whereas subprime loans were not. Which is why the vast majority of subprime loans have so many features—teaser interest rates fixed at no more than two-years, prepayment penalties, less-than-complete documentation—that were prohibited by the GSEs.  It’s worthwhile to recall how the GSE anti-predatory regulations came into effect. Around 2000, then HUD Secretary Andrew Cuomo was alarmed by the predatory practices concentrated in the subprime lending sector, so he encouraged the GSEs to compete in that retail market by offering loans to credit impaired borrowers who, upon closer examination, could be considered acceptable risks. Fannie's Expanded Approval program was offered as an alternative to a subprime loan product, because Fannie's underwriting standards were subject to predatory lending standards, whereas subprime lenders were not.  

Cuomo’s HUD devised new regulations based on the premise that, “mortgages with predatory features undermine homeownership by low-and moderate-income families in derogation of the GSEs’ Charter missions,” (65 FR 65069, Oct. 31, 2000). So that “Mortgages contrary to good lending practices,” were excluded from Affordable Housing Goals (65 FR 65085). HUD also said it would also exclude “B&C loans” (i.e. subprime loans) from its calculation of the size of the overall market. (65 FR 65090).

The new regulations specifically excluded loans with: (a) Excessive fees, (b) Prepayment penalties, (c) Single premium credit life insurance, or (d) Evidence that the lender did not adequately consider the borrower’s ability to make payments, plus any loans that the HUD secretary deemed to violate good lending practices.

And once again, proponents of The Big Lie, like the Cato Institute, falsely assert that Andrew Cuomo forced the GSEs to take on subprime loans, when in fact the opposite was true.

Any mortgage lender that originated an Expanded Authorization loan was liable for any violation of the anti-predatory rules:

Fannie Mae will perform monthly post purchase underwriting reviews on a discretionary basis to assess compliance with EA [Expanded Authorization] and EA with [Timely Payment Rewards] underwriting and eligibility requirements and requirements to prevent predatory lending practices. Mortgages that do not comply with the predatory lending requirements are subject to repurchase by the lender, regardless of whether the mortgages are performing mortgages, and the lender may be required to indemnify Fannie Mae for any and all losses resulting from any such noncompliance.

Former Fannie CEO Daniel Mudd alluded to the distinction in his February 2007 Congressional testimony:

Daniel Mudd: On the answer for Fannie Mae, on behalf of subprime, is that it's important to remember there is subprime and there is predatory. Subprime simply means--

Spencer Bachus. Oh, absolutely.

Daniel Mudd.--you have a credit blemish, and we think those  people are part of the market. It's less than 2.5 percent of our book. It's 80 percent insured. It's highly unsubordinated. We've been in it very carefully, consistent with some very strong anti-predatory lending guidelines we have.

Apparently, Mudd calculated the “less than 2.5 percent” by including 0.3% of the loan book that it characterized as subprime, plus 2.2% that were subprime securities.

Subprime Market: The subprime market generally refers mortgages by lenders that specialize in the subprime sector. But subprime mortgage securitizations may include loans that might ordinarily be characterized as prime. These otherwise prime loans are added to improve the overall risk profile of the portfolio, in order to attain a better credit rating.  This is another reason why the numbers can be somewhat fuzzy.

The Disconnect Between The SEC Definition and the Fannie Mae Definition of "Subprime"

Here's how Fannie described a subprime mortgage in its 2006 10-K:

"Subprime mortgage" generally refers to a mortgage loan made to a borrower with a weaker credit profile than that of a prime borrower. As a result of the weaker credit profile, subprime borrowers have a higher likelihood of default than prime borrowers. Subprime mortgage loans are often originated by lenders specializing in this type of business, using processes unique to subprime loans. In reporting our subprime exposure, we have classified mortgage loans as subprime if the mortgage loans are originated by one of these specialty lenders or, for the original or resecuritized private-label, mortgage-related securities that we hold in our portfolio, if the securities were labeled as subprime when sold...

The clauses above--"using processes unique to subprime loans," and "if the mortgage loans are originated by one of these specialty lenders"-- clearly exclude Fannie's Enhanced Authorization Program from its definition of "subprime." First, "processes unique to subprime lenders," refers to processes other than those used by Fannie for underwriting Enhanced Authorization Loans. In addition, EA loans are not ordinarily offered by subprime lenders; they are all processed through Fannie's standard underwriting system, Desktop Underwriter, which is used primarily for prime borrowers. Specialty subprime lenders do not rely on Desktop Underwriter, they target consumers for higher priced loans.  

And in CEO Daniel Mudd's 2006 letter to shareholders:

Affordability products: To provide an alternative to risky subprime products, we have purchased or guaranteed more than $53 billion this year in Fannie Mae loan products with low down payments, flexible amortization schedules, and other features.

Consequently, the SEC doesn't have much, if any case, in arguing that certain Fannie executives had the specific intent to deceive investors by excluding Expanded Authorization loans, and My Community Mortgage loans in its calculation of subprime exposure.

Yet that's what the SEC alleges:

115. Fannie Mae's Single Family mortgage credit book of business consisted of approximately $43.3 billion worth of EA loans and $13.8 billion worth of MCM loans as of December 31, 2006, more than 12 times greater than the 0.2% ($4.8 billion) disclosed as "subprime mortgage loans or structured Fannie Mae MBS back by subprime loans" as of December 31, 2006.
116. Nothing in Fannie Mae's public disclosures alerted investors that this much larger volume of loans matched the Company's description of subprime loans but were not included in the reported quantitative number.

It's hard to see how the SEC could get very far with that charge.

Next time: How the SEC used shifting definitions of "reduced documentation" or "reduced and alternative documentation" to measure Alt-A exposure.

Tue Dec 20, 2011 at 6:36 AM PT: Nice to see that Joe Nocera at the NY Times identified the same problems with the SEC case today.

Originally posted to Been There 1963 on Mon Dec 19, 2011 at 08:24 AM PST.

Also republished by Community Spotlight.

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Comment Preferences

  •  Well written (13+ / 0-)

    And accurate.  I, too, don't understand why the SEC thinks they can go after Fannie and Freddy this way.  They had the most (or at least some of the most) stringent underwriting standards for both loans and securities.

    It is the other companies that should be gone after.  The ones that are privately owned.  The ones that paid for their AAA ratings.

    Thank you for your diary.

    If you want to know the real answer: Just ask a Mom.

    by tacklelady on Mon Dec 19, 2011 at 08:56:32 AM PST

    •  Unfortunately, I consider this SEC prosecution (2+ / 0-)
      Recommended by:
      J M F, theano

      as analogous to the Obama administration's decision to ignore the science regarding Plan B contraception and young women - it's a political decision designed to make Obama look better to those proverbial "independents."

      From my readings on the situation, I think the SEC and the DOJ could make much stronger cases against the bankers and private mortgage originators as culprits in the mortgage melt-down. But right now, that would be "politically incorrect" - so I think the calculation goes.

      Courage is contagious. - Daniel Ellsberg

      by semiot on Tue Dec 20, 2011 at 04:44:01 AM PST

      [ Parent ]

  •  Much as I'd like to nail the gamblers I (5+ / 0-)
    Recommended by:
    Loge, bnasley, DRo, semiot, Matt Z

    figured that they have battalions of lawyers telling them what cleared off regulations and legal exceptions would allow them to get away with. Who is going to jail?  .. probably those who slipped over the line of what was permissable in the free for all. Which wasn't very much.

    Machines should have licensed operators who have to follow safety regulations and have fully empowered machine police with real laws to go after miscreants. Banks & corporations are money making machines. I think they even call not going for the profit 'failing fiduciary trust'.  They need to be forced back to more measured approaches to that profit making that do not carry high risk of damaging the society they exist in when they blow up... because nothing is guaranteed to never blow up. Even great race car drivers have boo boos.

    Fear is the Mind Killer

    by boophus on Mon Dec 19, 2011 at 09:23:26 AM PST

  •  Okay. I'll bite. (12+ / 0-)

    I don't quite get where this diary is going.

    The entire lawsuit is largely a set of violations related to public filings made by, and attested to by the individual corporate officers named in the suit - Sarbanes-Oxley for example.

    They stated exactly the definition of subprime borrowers that Fannie actually put in the relevant filings. That very definition does, as the SEC states, include borrowers under EA and MCM. I can't see how it doesn't. It also includes borrowers that were approved via Countrywide via its Clues system.

    However, the Officers and Directors of Fannie did not add in the total amount of those loans in the category of subprime even though the very definition they supplied would require otherwise.

    Whether there are other definitions of subprime and usage in other contexts is irrelevant. It only matters exactly what definition Fannie stated in its filings and whether or not those filings were accurate or not.

    It doesn't even matter what any of these executives might have said elsewhere in the media or even to Congress in hearings.

    In allegation 72 of the complaint:

    When Fannie Mae first reported its quantitative exposure to subprime loans in a filing with the Commission on February 27, 2007, the Company broadly defined subprime as loans to "borrowers with weaker credit histories." EA and MCM loans fell squarely within this definition, but were not included in the accompanying quantification of Fannie Mae's subprime exposure.

    It was Fannie's board and these executives that made the filing with that definition yet did not include the numbers from EA and MCM in the subprime bucket. Either the borrowers approved under those programs met the definition of borrowers with weaker credit histories or they didn't.

    The SEC alleges, based on other facts in other allegations, that borrowers under EA and MCM met that definition and should have been disclosed. Had Fannie issued a filing with a more restrictive definition then perhaps this lawsuit wouldn't exist.

    This can be seen in allegation 85 concerning a 12b-25b filing:

    Four days later on February 27, 2007, in a Form 12b-25 filing with the
    Commission, the Company disclosed the following regarding Fannie Mae's subprime exposure:
    Although there is no uniform definition for sub-prime . .. loans across the mortgage industry... sub-prime loans typically are made to borrowers with weaker credit histories ... We estimate that approximately 0.2% of our singlefamily mortgage credit book of business as of December 3J, 2006 consisted of sub-prime mortgage loans or structured Fannie Mae MBS backed by sub-prime mortgage loans ... We estimate that approximately 2% of our single-family mortgage credit book of business as of December 31, 2006 consisted of privatelabel mortgage-related securities backed by sub-prime mortgage loans and, to a lesser extent, resecuritizations of private-label mortgage-related securities backed by sub-prime mortgage loans. (Emphasis added.)

    However, they didn't and investors in Fannie Mae - the stockholders and debt holders NOT the buyers of certificates to Fannie MBS - had only that filing statement to rely on. The allegation is that these executives materially misled those investors and these executives materially benefited in terms of bonuses and salary by doing so.

    I am not sure what the relevance is of other definitions existing for subprime or even Alt-A for that matter because it only matters what definition the company used in the filing.

    This isn't as if the SEC is inventing its own definition and then trying to apply it. It using the definition that Fannie supplied in its filings and applying it.

    The whole case comes down to whether or not loans made under EA and MCM met the definition supplied by the company and whether the defendants knowingly excluded them from that definition. It doesn't matter, for example, whether or not EA or MCM were ever designated (offiicially or therwise) as "subprime" programs or not. It doesn't matter what prior HUD officials said or not. The only thing that matters is the definition provided in the filing.

    Why would you expect a defense based on (essentially) the investors should have been aware of the existence of other definitions or prior statements outside of regulatory filings is going to fly?

  •  Interesting. (11+ / 0-)

    A simple explanation could be that Fannie and Freddie are the new ACORN.

    They have long been the whipping boy of the rights attempt to explain the entire housing crisis as the result of Barney Frank, the Community Re-Investment Act (of 1977!) and Fannie and Freddie "forcing" banks to make loans "to people who shouldn't buy houses" or, even worse, "people who don't deserve to own houses" being code for . . . . .. oh, you figure it out. Like I said, the new ACORN.

    Although, I have to say, I was pretty pissed off myself at discovering that Newt was being paid 30K a month as a lob. . .I mean historian for Freddie Mac for his  strategic counsel. Actually, he was paid to craft ways to fend off attacks from the right, who hate Fannie and Freddie.

    Read here

    Looking at this in a larger context, one might want to remember that it is a goal of the right and our own Treasury Department to get the GSE's out of the mortgage market and to privatize all but a very small percentage of the housing finance sector, while also eliminating the mortgage interest tax deduction and requiring 20% down payments -  all of which would limit the ability of home ownership to just a small fraction of Americans.

    Because, with the new austerity and all,it's much better for HUD to focus on us being a nation of renters. Home ownership will just have to go the way of Medicare and Social Security. Oh well. Owning a home is just a big headache, really. They're doing us a favor. Much easier to rent from the giant housing conglomerates they are planning to sell all the vacant houses to.

    Think I'm kidding? Please read Reforming America's Housing Finance Market a joint report to Congress last February by the Treasury Department and HUD.  

    Poor Fannie and Freddie. They will be in the Morgue of Programs for Public Benefit soon, in the drawers right under the Public Option

    “Human kindness has never weakened the stamina or softened the fiber of a free people. A nation does not have to be cruel to be tough.” FDR

    by Phoebe Loosinhouse on Mon Dec 19, 2011 at 10:20:16 AM PST

  •  We're confusing three separate issues. (11+ / 0-)

    That's up from the usual two, so I guess the inflation bugaboo has come back--alert the Fed!  Anyway, in no particular order:

    1) Have Fannie and Freddie been the object of bad-faith attacks by conservatives who blame lending to racial minorities for our economic problems?  Yes, of course.  Conservatives are racists.  Duh.

    2) Is it probable that the defendants in this case have a legally credible defense, as you've suggested in the diary?  Sure, that's what they paid lawyers for at the time, and what they're paying for now.

    3) Are the defendants absolutely vile and disgusting people, who had absolutely no interest in the stated social purpose of Freddie and Fannie?  Were they frausters and looters disguised as quasi-governmental bankers?  Let me return to my first answer: duh.

    But nobody's buying flowers from the flower lady.

    by Rich in PA on Mon Dec 19, 2011 at 10:33:33 AM PST

  •  It's all about the mortgage insurance (2+ / 0-)
    Recommended by:
    semiot, J M F

    not the mortgages. I have yet to see a detailed or credible explanation of where it went.

    Whoever underwrote these loans is doing a great job of staying under the radar, IMO.

  •  Holy Crap, Fannie and Freddie Apologists (0+ / 0-)

    because they "have long been a target of the right".

     Is it possible that the criminal executives who were running the GSEs at the time lied to investors and broke the Sarbanes- Oxley law complete with a 10 year prison sentence? Sure it does, or "duh". ?

    If the SEC has filed a complaint specifically against executives mentioning no criminal punishment as part of the agreement,  is the SEC doing what it has done for every bad actor in this whole mucked up crisis? Well, Hell yes.

    They did it with Bank of America, Citibank, JP Morgan and Goldman Sachs. Slaps on the wrists. Write a check from the stockholders checkbook or in some cases taxpayers . That means it's all done.No Criminal Prosecution. Lets not get hung up on those confounding finance terms when all we have here is a massive case of looting where the criminals don't go to jail.

    Put another way; if I rob a bank or even lie on a Loan App, I'm going to prison for a minimum of five years. If  bad actors in bank rob me, their shareholders pay the fines that the porn engorged SEC  and the banks agrees to pay   while not admitting guilt or innocence.If they rob investors by signing off on falsified financial statements, under Sarbanes-Oxley they go to jail for 10 years. Seen any go to jail yet  for securities fraud, mortgage fraud or fraudulent financial statements?

    I mean they didn't appoint two two of  the sharpest white collar criminal  defenders in Washington; Assistant AG and AG for nothing. Imagine the Criminal Defense Lawyer who also ran the much heralded Guns and Cash program to Mexico prosecuting bankers for criminal acts? That's why the SEC is bringing civil charges against selected executives, so the Assistant AG can say "Ok, they are punished". The taxpayers will pay their fine and Fannie and Freddie will keep doing business just as the other Banks have been doing.

    Your making this corruption thing too complicated. The SEC is a easy way out of jail.

    Uniformed people on the left, please don't worry about the right with F&F, because if they get too close that could open up a can a whoop-ass on their banker friends in Wall Street who sold them all kinds of fraudulent shit, that the bankers at F&F knowingly bought so they could"compete".

    This whole diary sucks. Please don't go there with part two. Well, if your getting paid like the last few diarists I saw, please step right up. Everyone needs to get paid to do something.

    Joined Oct 16th 2011 eh? Yep, that's about right. How many bucks does anyone want to put on this diarist that it will be gone no later than 10/30/2012 if it lasts that long.

    •  Real hard to get five years... (0+ / 0-)

      ...for lying on a mortgage app and submitting it to a lender.  If you write "this is a stickup" on the false app and commit that bank robbery with it, you can get your five years.

  •  The diarist is right about one thing. I was doing (10+ / 0-)

    real estate law in the first part of the last decade in no small part in minority communities, and saw many borrowers who had perfectly decent credit ratings steered to mortgage brokers rather than banks, in no small part by recommendations by those they knew who had also been steered there. The number of major banks in that quite large but minority community was very small and the brokers made it seem that there was nothing wrong with their mortgages, with the odd terms because they argued it was simply a cheaper way to get basically the same loan. And argued it to people who were not familiar with what larger banks were offering because they were not offerign them in that community and most were not in that community for any reason. It was billed as loans offered to minority community members because the big guys wouldn't do it because of racism, and the like. So there were solvent professionals and the like who also got the subprime market terms, not because they were appropriate but because the brokers were pushing them and got paid a greater commission for every loan in stinko form which they booked, having no dealings thereafter with the borrowers.

    •  Single female steered by broker CR WAS 750 av. (7+ / 0-)

      It's gone now...that credit rating. I was absolutely steered. This was in 2001. I didn't even know there was such a thing as sub prime. I had never even heard the term. I was turned down at 5 major banks...(wells fargo, bank of america, american national, first national...) They all said I needed a better income to debt ratio. So I spent a year paying down my credit cards...then went back when my landlord decided to sell the house I had been living in for 7 years. When I went back to two banks...they told me that because I was a single female I could not qualify for a "normal" loan.

      That is not legal the last I knew but they both said the same thing. It's as if this WAS a conspiracy. Like the bankers were all in. I didn't want a high interest rate, and I wanted a 30 year mortgage, no weird stuff. A real estate agent I knew, steered me to a broker. The broker's wrote the loan at 9.75...which was better than the 12 and 13 percent I was offered at the time. There was no way I should have been in a sub prime loan. They said I needed two incomes.

      They never used the term "sub prime". They called it "high interest".

      And it's been one illegal fraudulent behavior after the next, ever since...GMAC! We bailed em tax money and now...they have my house!

  •  WTF? (0+ / 0-)

    From the diary:

    The SEC defines subprime loans as any loan made to a subprime borrower. Period. In its financial filings, Fannie Mae defined subprime loans as either: (a) a subprime loan product extended to a subprime borrower; or (b) a loan included in a mortgage pool held by a subprime securitization. By parsing its own definition, rather than referring to the complete definition used in Fannie’s financial filings, the SEC was able to contrive a narrative wherein Fannie “under-reported” its subprime exposure.(emphasis added)

    Are you under the impression that those being regulated are supposed to write the definitions of the words used in the regulation? I think I would come out better financially if the IRS would agree to use my definitions; what an idea!

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