There's no law against running a flawed business poorly. If there were, the Securities and Exchange Commission (SEC) would have far more to work with in going after former Fannie Mae and Freddie Mac bosses for misleading investors.

Federal investigations of the GSEs have been underway for several years on a notably modest scale. The Department of Justice looked into filing criminal charges but ultimately decided against doing so. Now comes the SEC's new bid to prove former execs misled investors or mismanaged the GSEs. Even if the SEC prevails with either charge, it isn't likely to recoup much financially. The SEC's potential fines are limited to the value of ill-gotten profits, and any judgments would likely be covered by insurance on Fannie and Freddie directors and officers.

So what's at stake? Primarily the potential to complicate the careers of former executives who presided over the GSEs' nosedives. Those in the SEC's sights include former Fannie chief executive Daniel Mudd, Freddie chief business officer Patricia Cook and Fannie Mae chief risk officer Enrico Dallavecchia. All three landed high-profile jobs following their dismissals and the GSEs' tumble into a form of government bailout known as conservatorship.

In terms of evidence, SEC's civil suits lay out compelling evidence that executives were downplaying their companies' exposure to subprime portfolios, even as they were increasing that very same exposure by hundreds of billions of dollars. Although Fannie and Freddie required bailouts to survive, those who oversaw them somehow managed to walk away without the same stigma that clings to those who led Countrywide Financial, Bear Stearns and Bank of America into disaster.

The SEC's case turns on the allegation that the executives used arbitrarily restrictive definitions of "subprime" and "Alt-A" to hide exposure to hundreds of billions of dollars in loans that looked, walked, quacked and defaulted like subprime and low-doc mortgages.

How those risky loans were acquired deserves more attention than it's received. Fannie acquired more than $43 billion worth of risky mortgage assets via a program called "Expanded Approval," which was explicitly designed for relatively high-risk borrowers and included a heightened guarantee fee to cover the risk.

The problem is that the relatively high G-fee still wasn't all that high; loans made through the Expanded Approval program were far cheaper than what the market generally charged for subprime risk. Yet as the SEC's suit makes clear, the "EA" borrowers ultimately performed worse than did many who took out loans that Fannie designated "subprime."

You'd think the discovery that Fannie was taking on subprime risk without commensurate reward would have led the mortgage giant to shut down the Expanded Approval channel. It didn't.
Three possibilities have been raised to explain Fannie's failure to shut its subprime, or higher risk, loan channel — that its executives were egged on by volume-based incentive payments, that they were under pressure to meet affordable housing goals or that they legitimately misjudged the loans' safety. What is certain in Fannie's case is that it expanded the Expanded Approval program to cover 100% loan-to-value originations just as the housing market was peaking in mid-2007. The GSE didn't pull the plug on new EA loans until August 2008, shortly before it entered conservatorship.

The narrative for Fannie's Alt-A loans is much the same as that of subprime, according to the SEC. Data shows that beginning in 2006 Fannie's holdings of low-doc loans not classified as Alt-A were performing just as poorly as its officially designated alternative products.

Given the product's deterioration, it's easy to understand why Fannie's leadership wouldn't want to disclose the loans to investors — it's harder, however, to come up with an explanation for why they continued guaranteeing them through 2008.

According to the SEC, Freddie Mac built — and disclosed — its subprime portfolio in much the same way. From 2006 on, the company's risk management staff informed top execs that Freddie's "Desktop Underwriter" program, software which allowed lenders to fast-track approval of Freddie Mac's guarantee, was producing large number of "defect loans, loans that are subprime-like, loans that have very low FICOs."

In a February 2007 presentation, the SEC alleges, the GSE's credit staff told Chief Exeuctive Richard Syron, Cook and Bisenius that Freddie "already purchase[s] subprime-like loans ... but with considerably lower fees[,]" — the same problem as in Fannie's Expanded Approval program.
Even as the company was publicly distancing itself from any connection to subprime, it was in the middle of a huge business push to ramp it up. Between 2007 and mid 2008, Freddie's subprime portfolio, as identified by the SEC, grew from $141 billion to $244 billion.

Again, the gist of the SEC's civil fraud claim is that Freddie executives failed to inform the company's investors of risks they knew they were incurring. In May of 2007, shortly before Cook and Syron gave speeches declaring that "Freddie had "basically no subprime exposure," the company's investor relations chief warned them that "We should reconsider making as sweeping a statement as 'we have basically no subprime exposure.'"

Even in the financial services industry, presiding over a major collapse is usually a serious obstacle to executives trying to repackage their careers elsewhere. Yet those formerly in Fannie's and Freddie's senior ranks seem to have gone on with their careers unscathed.

Donald Bisenius remained in a high-level position at Freddie Mac until April of this year. Patricia Cook is heading business for Green Tree Solutions, a specialty servicer hired by the GSEs to help borrowers avoid foreclosure. Until this month, Enrico Dallavecchia was the chief risk officer of PNC. And Daniel Mudd is chief executive officer of Fortress Investment Group, owner of Nationstar — another special servicer favored by Fannie Mae.

In the end, what the SEC may be fighting for is the contention that the executives charged are unfit to hold positions of corporate responsibility.

"Unless restrained and enjoined," warns the SEC, the executives "will continue to violate" securities laws. If the nation's chief securities regulator can make that allegation stick, it's likely to prove a career killer.

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