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.
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.