By Numerian Posted by Michael Collins

Citizens carry the load for bad loans by Wall Street

In a February regulatory filing with the SEC, Fannie Mae and Freddie Mac, now owned by the federal government, say they intend to return $21 billion in home mortgages to banks in 2010. Four commercial banks now dominate the home mortgage market: Citigroup, JP Morgan Chase, Bank of America, and Wells Fargo, and they will receive the bulk of these repurchases. Since the banks sold these mortgages to these agencies for full value, they must buy them back at full value, but at least one bank, JP Morgan Chase, says these mortgages will then be immediately written down by 50%.

Fannie and Freddie have already written off $200 billion in losses on their mortgage portfolio, and late last year they had a $400 billion cap on losses removed by the Treasury, meaning the losses could be unlimited. These losses have been localized in the agencies’ mortgage-backed securities portfolios, built up around 2006-2007 at the height of the housing boom, and consisting of thousands of “non-qualifying” mortgages that Fannie and Freddie based on their own policies would not normally have purchased as individual mortgages. The mortgages now being returned to the banks are in fact qualifying mortgages – the supposed cream of the crop sold individually to the agencies by the banks, but now that Fannie and Freddie are looking at each of these mortgages carefully, they are finding the documentation riddled with errors, fraudulent income claims, over-stated appraisals, and serious omissions. Banks “represent and warrant” that all mortgages sold to the agencies are in compliance with high standards, and must buy them back if they are proven otherwise.

The banks do not accept these repurchases willingly. They sit down with Fannie and Freddie and go through each repurchase request one by one. The agencies already have a leg up in the process; they have copies of all the documentation, and they have sent analysts looking at comparable property valuations at the time the mortgage was made. Most of the mortgages were made in 2006, 2007, and 2008, with far less problems occurring in the 2009 vintages once the recession hit. All of these mortgages are in default or heading to default, and property values have plummeted in so many cases that there is no way the government or the banks can recover full value on the loans. Hence the large write-downs. Still, in this review process banks are able to decline half of the repurchase requests, forcing the government to absorb the losses.

That means that not all of the intended $21 billion in repurchases will be dumped on the banks. If only $10 billion is successfully passed back to the banks for false representations and warranties, and half of this is written off, each of the four big banks will be facing $1 billion at least in losses. This is double what they experienced last year in repurchase losses, and the number should be heading higher for the next few years.

Banks are forced to go along with this process and play nice with Fannie and Freddie, because they are the only game in town. They bought at least three-quarters of all mortgages originated in 2009, and up to 90% of the market is supported by them if you count their guaranties as well. The banks themselves aren’t in the business of holding on to mortgages for 30 years; they are into trading, getting in and out of a mortgage as fast as possible to collect fees and stick someone else with the credit risk. Besides, the banks don’t have the capital to support a book of mortgages held to maturity.

Paul Miller, an analyst at FBR Capital Markets in Arlington, Virginia, commented on the position the banks are in. “It’s a fine line you’re walking, because the government’s trying to recapitalize the banks, not put them in bankruptcy, and then here’s Fannie and Freddie putting more pressure on the banks through these buybacks …If it becomes too big of an issue, the banks are going to complain to Congress, and they’re going to stop it.”

Since Fannie and Freddie are now owned by the taxpayers, the question boils down to whether the banks or the taxpayers should pay for the shoddy and often illegal processes that were used to book mortgages at the height of the bubble. And it needs to be remembered that we are only talking about the best mortgages here – the ones that qualified for Fannie and Freddie’s strict standards. The real garbage was being put together and peddled by Wall Street through the securitization process. These were the sub-prime and Alt-A mortgages, the pick-a-payment disasters sold by Washington Mutual, the no-income no-documentation loans favored by Countrywide. Who is holding on to these loans, which have had much higher default rates than those owned by Fannie and Freddie?

The answer is – you are. You bought $1.2 trillion of these loans, packaged by the thousands into hundreds of different mortgage-backed securities, and now sitting on the balance sheet of the Federal Reserve Bank. They were purchased as part of a program called quantitative easing, which did what it was supposed to do; it kept mortgage rates down at record lows as the Fed drained the market of the stuff nobody wanted. Quantitative easing is now coming to an end, and we shall see whether mortgage rates can remain as low as they have been.

In the meantime, throughout 2008 and 2009 the big banks which owned hundreds of billions each of these securities managed to stanch the bleeding on their own balance sheets by getting the mark to market accounting rules suspended. This gave them time to pawn the securities off on to the Fed, at what price we don’t know because the Fed insists this is all secret information that would damage the market if it were made public.

If the Fed were in a talkative mood it would probably tell you the great majority of these securities are performing perfectly well and will likely do so until maturity. But even if only 10% of the portfolio is impaired, that is $100 billion in losses, and if the good mortgages in default are worth only 50% of their original value, think how much higher the losses must be on $1.2 trillion of garbage. The mighty Fed, which has the power to print money, doesn’t have the power to absorb losses on its balance sheet, because it has no capital other than what the Treasury gives it through taxpayer dollars. The losses, in other words, ultimately will find their way back to you and me. We will know this is beginning to happen when the Fed misses its usual annual dividend payment to the Treasury and starts asking, very, very quietly, for its own bailout.

What you can count on is that, between the Treasury and the Fed and the administration, very little will be said about this situation. As much as possible will be done to keep this out of the public eye and away from the hands of Congress. This might explain why there is no mention that Fannie and Freddie, who are now sitting on a prosecutors wet dream of information about criminal behavior in the mortgage market, are sending any of their files over to the Justice Department. The Attorney General seems to have no interest in this gold mine of prosecutable information, and no task force of lawyers and FBI agents has been set up in Washington to look into this cesspool of fraud, deceit, malfeasance, bribery, and theft, involving billions and billions of dollars.

Nobody in Washington wants these sorts of investigations. The biggest banks in the country would have to be subpoenaed, along with Goldman Sachs and Morgan Stanley for their role in issuing securities that were obviously fraudulent. Moody’s and Standard & Poor’s would have to answer for their grossly negligent and misleading Aaa ratings stamped on these securities. The founders and owners of dozens of bankrupt mortgage broking firms would need to be tracked down and brought to justice, along with thousands of corrupt attorneys, bribed appraisers, and duplicitous real estate agents.

This is, however, exactly what was done during the 1980’s Savings & Loan crisis. Hundreds of criminal convictions were obtained after years of hard work involving an army of prosecutors, agents, analysts, and lawyers. Back then, the government, including the Congress, was zealous that justice be done. What has happened 25 years later to America’s criminal justice system, needed now more than ever when the damage done to the country is many magnitudes greater?

When the government, as the dispenser of justice, turns a blind eye to the most outrageous and now well-documented fraud of the past century, the government itself is corrupt to its very core. That is the only explanation we can as taxpayers come up with when no one in Washington is willing to stop the stench that is wafting across the Potomac all over this country.

For more details on the Fannie and Freddie repurchase program, see this Bloomberg story.

Originally pulblished in The Agonist