Private sector loans, not Fannie or Freddie, triggered crisis
By David Goldstein and Kevin G. Hall | McClatchy Newspapers Posted on Sunday, October 12, 2008
WASHINGTON — As the economy worsens and Election Day approaches, a conservative campaign that blames the global financial crisis on a government push to make housing more affordable to lower-class Americans has taken off on talk radio and e-mail.
Commentators say that's what triggered the stock market meltdown and the freeze on credit. They've specifically targeted the mortgage finance giants Fannie Mae and Freddie Mac, which the federal government seized on Sept. 6, contending that lending to poor and minority Americans caused Fannie's and Freddie's financial problems.
Federal housing data reveal that the charges aren't true, and that the private sector, not the government or government-backed companies, was behind the soaring subprime lending at the core of the crisis.
Subprime lending offered high-cost loans to the weakest borrowers during the housing boom that lasted from 2001 to 2007. Subprime lending was at its height from 2004 to 2006.
Federal Reserve Board data show that:
-- More than 84 percent of the subprime mortgages in 2006 were issued by private lending institutions.
-- Private firms made nearly 83 percent of the subprime loans to low- and moderate-income borrowers that year.
-- Only one of the top 25 subprime lenders in 2006 was directly subject to the housing law that's being lambasted by conservative critics.
The "turmoil in financial markets clearly was triggered by a dramatic weakening of underwriting standards for U.S. subprime mortgages, beginning in late 2004 and extending into 2007," the President's Working Group on Financial Markets reported Friday.
Conservative critics claim that the Clinton administration pushed Fannie Mae and Freddie Mac to make home ownership more available to riskier borrowers with little concern for their ability to pay the mortgages.
"I don't remember a clarion call that said Fannie and Freddie are a disaster. Loaning to minorities and risky folks is a disaster," said Neil Cavuto of Fox News.
Fannie, the Federal National Mortgage Association, and Freddie, the Federal Home Loan Mortgage Corp., don't lend money, to minorities or anyone else, however. They purchase loans from the private lenders who actually underwrite the loans.
It's a process called securitization, and by passing on the loans, banks have more capital on hand so they can lend even more.
This much is true. In an effort to promote affordable home ownership for minorities and rural whites, the Department of Housing and Urban Development set targets for Fannie and Freddie in 1992 to purchase low-income loans for sale into the secondary market that eventually reached this number: 52 percent of loans given to low-to moderate-income families.
To be sure, encouraging lower-income Americans to become homeowners gave unsophisticated borrowers and unscrupulous lenders and mortgage brokers more chances to turn dreams of homeownership in nightmares.
But these loans, and those to low- and moderate-income families represent a small portion of overall lending. And at the height of the housing boom in 2005 and 2006, Republicans and their party's standard bearer, President Bush, didn't criticize any sort of lending, frequently boasting that they were presiding over the highest-ever rates of U.S. homeownership.
Between 2004 and 2006, when subprime lending was exploding, Fannie and Freddie went from holding a high of 48 percent of the subprime loans that were sold into the secondary market to holding about 24 percent, according to data from Inside Mortgage Finance, a specialty publication. One reason is that Fannie and Freddie were subject to tougher standards than many of the unregulated players in the private sector who weakened lending standards, most of whom have gone bankrupt or are now in deep trouble.
During those same explosive three years, private investment banks — not Fannie and Freddie — dominated the mortgage loans that were packaged and sold into the secondary mortgage market. In 2005 and 2006, the private sector securitized almost two thirds of all U.S. mortgages, supplanting Fannie and Freddie, according to a number of specialty publications that track this data.
In 1999, the year many critics charge that the Clinton administration pressured Fannie and Freddie, the private sector sold into the secondary market just 18 percent of all mortgages.
Fueled by low interest rates and cheap credit, home prices between 2001 and 2007 galloped beyond anything ever seen, and that fueled demand for mortgage-backed securities, the technical term for mortgages that are sold to a company, usually an investment bank, which then pools and sells them into the secondary mortgage market.
About 70 percent of all U.S. mortgages are in this secondary mortgage market, according to the Federal Reserve.
Conservative critics also blame the subprime lending mess on the Community Reinvestment Act, a 31-year-old law aimed at freeing credit for underserved neighborhoods.
Congress created the CRA in 1977 to reverse years of redlining and other restrictive banking practices that locked the poor, and especially minorities, out of homeownership and the tax breaks and wealth creation it affords. The CRA requires federally regulated and insured financial institutions to show that they're lending and investing in their communities.
Conservative columnist Charles Krauthammer wrote recently that while the goal of the CRA was admirable, "it led to tremendous pressure on Fannie Mae and Freddie Mac — who in turn pressured banks and other lenders — to extend mortgages to people who were borrowing over their heads. That's called subprime lending. It lies at the root of our current calamity."
Fannie and Freddie, however, didn't pressure lenders to sell them more loans; they struggled to keep pace with their private sector competitors. In fact, their regulator, the Office of Federal Housing Enterprise Oversight, imposed new restrictions in 2006 that led to Fannie and Freddie losing even more market share in the booming subprime market.
What's more, only commercial banks and thrifts must follow CRA rules. The investment banks don't, nor did the now-bankrupt non-bank lenders such as New Century Financial Corp. and Ameriquest that underwrote most of the subprime loans.
These private non-bank lenders enjoyed a regulatory gap, allowing them to be regulated by 50 different state banking supervisors instead of the federal government. And mortgage brokers, who also weren't subject to federal regulation or the CRA, originated most of the subprime loans.
In a speech last March, Janet Yellen, the president of the Federal Reserve Bank of San Francisco, debunked the notion that the push for affordable housing created today's problems.
"Most of the loans made by depository institutions examined under the CRA have not been higher-priced loans," she said. "The CRA has increased the volume of responsible lending to low- and moderate-income households."
In a book on the sub-prime lending collapse published in June 2007, the late Federal Reserve Governor Ed Gramlich wrote that only one-third of all CRA loans had interest rates high enough to be considered sub-prime and that to the pleasant surprise of commercial banks there were low default rates. Banks that participated in CRA lending had found, he wrote, "that this new lending is good business."
An angry mob of investors and taxpayers is assembling, and they want to see some executives' heads on pikes. The question for the courts will be, Who was just foolish with our money - and who was lying, cheating, and stealing?
Fuld takes full responsibility video javascript:cnnVideo('play','/video/news/2008/10/06/news.lehman.fuld.hearing.cnnmoney');
Three days that shook the world The most powerful people in American capitalism convened on September 12 to try and save Lehman Brothers. Three months later, it is clear that the egos, passions and prejudices of the participants in those meetings have reordered the American business landscape. .. http://money.cnn.com/galleries/2008/fortune/0812/gallery.threedays.fortune/index.html
(Fortune Magazine) -- In today's dire financial climate, what exactly should a CEO say when it's time to hold that quarterly earnings call with analysts and the media?
On the one hand, he could try refreshing candor and say, "Look, let's be honest. This sucker could go down." The problem with this approach is that it tends to ensure that the company will indeed go down - that afternoon. The stock price will plummet, lenders will call in their loans, banks and customers will freeze the company out, credit agencies will downgrade it, and soon our commendably honest CEO will notice a half-dozen satellite television trucks - those modern-day vultures - double-parked outside the lobby.
Or there's Plan B. The executive could exude confidence and willfully paint a disingenuously rosy picture featuring lots of gilded lilies. The problem with this tack is that, while it might get the company through a rough patch, the executive is certainly committing civil fraud, and if the company crashes and burns anyway, he may also go to prison.
It's no defense for an executive who bends the truth to say that he did so only to prevent a run-on-the-bank-type situation, says one criminal-defense lawyer. (The lawyer requests anonymity because in this climate, he notes, such an on-the-record statement might lose him some business opportunities.) Even if the executive thinks that short-sellers are spreading lies about his company, he can't respond in kind. If he does, this lawyer says, "he's betting the farm. He's betting his life."
Today's crisis has placed under the forensic microscope scores of reassuring assertions made by CEOs and CFOs during earnings calls or "investor day" gatherings or breezy, on-camera flirtations with Maria Bartiromo that have proved, sometimes within hours, breathtakingly off the mark. Were the officials honestly relying on flawed business models - or lying through their teeth?
It's not just the Securities and Exchange Commission, New York State attorney general Andrew Cuomo, and hordes of civil plaintiffs lawyers who want to find out. According to understated disclosures in SEC filings or newspaper reports, federal criminal prosecutors in Manhattan, Brooklyn, Newark, Los Angeles, San Francisco, Seattle, and Alexandria, Va., are all poring over e-mails and other records right now trying to answer that question in regard to high-level officers at such formerly blue-chip companies as Lehman Brothers, AIG, Washington Mutual, Countrywide Financial, Fannie Mae, and Freddie Mac.
To be clear, we're not talking here about sensational, not conceivably legal, out-and-out Ponzi schemes, like the $50 billion one that former Nasdaq chairman Bernard L. Madoff has been arrested for, or brazen forgery and criminal impersonation, like the $100 million spree that glitzy New York litigator Marc S . Dreier has been accused of. Crimes like those typically have only one of two defenses: (a) "It wasn't me," or (b) "Okay, it was me, but I was sleepwalking on Ambien at the time." This article is, rather, about an entirely different category of accusation. The probes being discussed here concern statements that ultimately proved incorrect, but which reasonable, straight-faced people can, and vigorously do, contend were honest when made.
The level of fury surrounding these inquiries is of a different order from what we saw with, say, the backdating scandals or the Enron and WorldCom failures. Today's credit collapse has already vaporized about $9 trillion in investment capital, while ripping another trillion in assorted bailout money from the pockets of enraged taxpayers - also sometimes known as "jurors."
So there's an angry mob with pitchforks assembling, and they want to see some heads on pikes. While former Enron CEO Jeff Skilling could at least try to have his case transferred out of Enron-devastated Houston, the credit-crisis targets will have no such card to play. This time the corporate shenanigans have wrecked the globe. "This is the ugliest enforcement environment I've ever seen in my professional career," says one criminal- defense lawyer, who also asks for anonymity.
"People are hot," observes John Dowd, who heads the white-collar unit of Akin Gump Strauss Hauer & Feld. "It can get toxic pretty quickly."
People have a right to be angry, but anger is not the best frame of mind in which to mete out due process. Here, the process that is due requires distinguishing foolish mistakes from lies and fraud - a line that can get surprisingly fine. To the chagrin of John Q. Public, there will be serious defenses in most of these cases.
To begin with, bad business models - even business models that in retrospect look like prescriptions for disaster - are not crimes as long as they are fully disclosed to investors. And the fact that lenders were hawking outlandishly risky mortgages to people who were terrible credit risks was, in fact, no secret in America: It was bipartisan national policy. The fact that exotic mortgages (like "pick a payment option" AR Ms and "Alt-A" loans with no documentation of the buyer's assets or income) were then being packaged into complex derivative securities - some rated AAA by Moody's, S &P, and Fitch - was not just well known but also hailed as ingenious by some of the putatively best financial minds in the country.
If CEOs did not foresee the imminent train wreck that, looking back, seems so inevitable, neither did former Federal Reserve chairman and erstwhile "maestro" Alan Greenspan, who has recently, if self-servingly, termed our predicament a "once-in-a-century credit tsunami."
Accordingly, Carl "Chip" Loewenson Jr., cohead of Morrison & Foerster's white-collar defense unit in New York City, sees an impending collision of two powerful opposing forces. "No one - not Fannie, not Freddie, not Lehman, not AIG, not [SEC chairman Christopher] Cox, not [Federal Reserve chairman Ben] Bernanke - thought it would get as bad as it has gotten," he says. "This weighs against proving criminal intent.
"On the other hand," Loewenson continues, "there is a long populist tradition in our country that insists on finding villains in any economic downturn."
The job of the prosecutors is not to ferret out the root causes of what went wrong with the economy. That's a task for historians. The prosecutors are to look for unambiguous, intentional wrongdoing - and since a lay jury will be the official scorer here, the simpler the wrongdoing, the better. While it might be true, for instance, that investors were misled by the way companies handled mark-to-market accounting of derivatives, a prosecutor who makes that the centerpiece of his case will end up with a swearing contest between opposing accounting experts - a morass in front of a jury.
So prosecutors will keep it simple. "The kinds of things that get our attention," says Benton Campbell, the U.S. Attorney for the Eastern District of New York, in an interview, "are fundamentally very familiar: lying, cheating, and stealing."
Let's start with lying, which brings us back to those earnings conferences that executives face every three months, the handling of which gets trickier as the company's prospects get dicier.
The poster boy for criminally false upbeat statements during a crisis is Ken Lay, the founder and chairman of Enron. Lay resumed control of the company late in the game, after Skilling abruptly resigned as CEO in August 2001, less than four months before Enron's bankruptcy filing, when the company's goose was already pretty well cooked. Lay was convicted almost exclusively for his preposterous happy talk during those final days: "The balance sheet is strong." "The third quarter is looking great." "Enron stock is an incredible bargain at current prices." (Lay's convictions were overturned automatically when he died before his appeal could be heard.)"
Though a jury found that Lay crossed the line, lawyers disagree about where that line is. If you ask a class-action lawyer, he'll tell you it's not a complicated issue. "When you speak, you need to tell the whole truth," says Gerald Silk of Bernstein Litowitz Berger & Grossmann.
But if you ask a lawyer who advises corporations, you'll get a very different answer. "The reality is, you've put your finger on one of the most difficult situations that will come up in counseling executives of corporations," says one who does that for a living and insists on anonymity. "You can't lie," he says. "You're trapped between serving the best interests of shareholders and the legal requirement not to lie. You need to thread the needle." (Now you see why he wants anonymity.)"
Continuing down U.S. Attorney Campbell's list of sins, after lying we come to cheating and stealing, rubrics that comfortably embrace insider trading, another crime that's easy for jurors to understand. Though Lay wasn't charged with insider trading, prosecutors did highlight that he had been, without disclosure, selling $24 million of his Enron stock at the same time he was urging investors and employees to buy. Yes, the sales were "involuntary" in that they were required to meet margin calls, but the government does not consider such sales as fundamentally different from any others. They are still voluntary in the sense that the investor could theoretically post cash or other collateral if he really wanted to keep the stock badly enough. The SEC is, in fact, currently scrutinizing whether certain CEOs made margin-call sales of company stock without disclosing inside information, according to a person in a position to know.
In addition, once prosecutors subpoena documents and e-mails from a company, they may stumble across other easy-to-prove crimes - "pickoffs," one former prosecutor calls them. (Lay was convicted, for instance, of four felonies for having used personal bank loans, which he paid back on time, for purposes the banks hadn't anticipated - a transgression not known to have ever been prosecuted criminally before then.) An easy-to-prove standby charge is obstruction of justice, if the target is believed to have destroyed documents or lied to investigators. (Think of tech bubble inflater Frank Quattrone, Enron enabler Arthur Andersen, or ImClone stock dumper Martha Stewart. Quattrone's and Arthur Andersen's convictions were overturned on appeal, but each defendant had suffered plenty by then.)"
Finally, there is at least one criminal investigation underway that does not concern either executives' questionable statements or insider trading. Attorney general Cuomo and the Manhattan U.S. Attorney's office have publicly announced that they are working jointly on a broad inquiry into allegedly manipulative or fictitious trading in credit default swaps. Based on the documents being sought, prosecutors appear to hypothesize that short-sellers, perhaps with assistance from bank or brokerage officials, faked trades in these instruments to artificially signal to the market widespread panic over a company's condition when, in fact, such sentiments had not existed before the manipulative trading itself.
What follows is an overview of some of the companies that prosecutors are known to be looking at and some of the likely problem areas relating to each. In most cases, the questionable statements highlighted here have already become the focus of civil shareholder suits alleging fraud.
Bear Stearns
A likely template for the prosecutions to come was set last June, with the indictment of Ralph Cioffi and Matthew Tannin, the founder and portfolio manager, respectively, of two Bear Stearns hedge funds that had collapsed 12 months earlier. (Cioffi and Tannin have pleaded not guilty, and their attorneys declined to comment on the case.)"
Cioffi and Tannin lost $1.4 billion of their clients' money by making the bad business decision to invest it in a highly leveraged portfolio of instruments called CDO-squareds, which were backed in part by subprime mortgages. But losing money is not a crime. Cioffi and Tannin were charged with making false statements in the final months of the funds' demise. The indictment alleges, for instance, gaping discrepancies between the men's reassuring public statements to investors (e.g., "We're very comfortable with exactly where we are," on April 25, 2007) and their despairing private e-mails days earlier (e.g., "If we believe the [internal report is] A NYWHERE CLOSE to accurate I think we should close the funds now," on April 22, 2007)
Nevertheless, many observers of the Bear Stearns prosecution are skeptical that the charges will hold up when the e-mails are presented in context. People change their minds rapidly and radically during any crisis, as they consult others and learn additional facts. These observers are even more dubious that the funds' investors were in the dark about risk. Cioffi and Tannin ran a hedge fund, after all, meaning that their investors had to be, by law, supersophisticated.
Plaintiffs class-action lawyers claim that Bear's problems should not end there. Two months after the hedge funds collapsed, CEO James E. Cayne assured investors that "the balance sheet, capital base, and liquidity profile have never been stronger. Bear Stearns' risk exposures to high-profile sectors are moderate and well controlled." Seven months later the company sought emergency funding from the Federal Reserve and was quickly sold to J.P. Morgan Chase (JPM, Fortune 500).
Of course, as the world has seen, a lot can change in seven months, so it will be hard to prove that Cayne did not believe what he was saying. A tougher case is presented by his successor, Alan Schwartz, who was saying much the same thing as late as the morning of March 12, 2008, just 36 hours before seeking emergency funding. "Our liquidity and balance sheet are strong," Schwartz told CNBC's David Faber. "We don't see any pressure on our liquidity, let alone a liquidity crisis."
Although federal prosecutors in Brooklyn were asking some questions immediately after the company's collapse, there does not appear to be any active criminal inquiry. Counsel for Schwartz declined to comment, as did U.S. Attorney Campbell.
AIG
On Sept. 16, 2008, AIG was saved from bankruptcy by a taxpayer-funded bailout. It is currently being propped up with federal loan commitments and investments potentially totaling $150 billion. It acknowledges being under scrutiny by the U.S. Department of Justice and the SEC and says it's cooperating fully.
Though AIG's core (and heavily regulated) insurance businesses are healthy, the company appears to have been sunk by its small, formerly lucrative financial products unit. This group, headed by Joseph Cassano, effectively insured the holders of certain bonds against default by writing contracts known as credit default swaps. In particular, it insured the safest "super-senior" tranches of collateral debt obligations (CDOs), which, though backed in part by subprime mortgages, were originally considered very safe by credit-rating agencies and rated AA .
In August 2007, a month after those agencies downgraded hundreds of CDOs, Cassano spoke to investors in a conference call. "It is hard for us, without being flippant," he said, "to even see a scenario ... within any kind of realm of reason that would see us losing $1 in any of these transactions."
In a sense, Cassano's prognostication was not as far off as one would think. Even today very few CDO tranches insured by AIG FP have actually stopped paying as anticipated. But what Cassano and AIG were not disclosing - and at that stage might not themselves have appreciated - was that if market confidence in the CDOs fell sufficiently, AIG could be forced to post billions of dollars in cash collateral to protect the counterparties to its credit default swaps. It would also face writedowns in the value of its credit default swap portfolio, causing huge quarterly losses, sending the company's stock price lower, threatening its own credit rating, and making it harder for the company to raise new capital. Thus, even without cash losses, the unit's portfolio could start the company on a downward spiral to oblivion.
The question that civil plaintiffs lawyers are homing in on - and, it stands to reason, that government investigators would also look at - is precisely when AIG's officers began to appreciate that risk and whether they made sufficient disclosure at that point. Thus, while Cassano's statement above, 13 months before the bailout, might have been defensible, as time passed it might have become less so. Corporate officials have an ongoing duty to update old information that "remains alive in the marketplace," if an investor might reasonably rely on it.
Based on documents made public at an Oct. 7 hearing before the House Committee on Oversight and Government Reform, supplemented by additional disclosures in a New York Times article of Sept. 28 and a Wall Street Journal article of Oct. 31, the timeline looks like this:
In early September 2007, AIG internal auditor Joseph St. Denis learned that AIG had received a multibillion-dollar collateral call on its credit default swaps, according to a letter he wrote to the House oversight committee this past October. Alarmed, St. Denis sought more information about the valuation of the credit default swaps. In late September 2007, Cassano allegedly refused him access to it, saying, "I have deliberately excluded you from the valuation of [the swaps in question] because I was concerned that you would pollute the process," according to St. Denis's letter.
St. Denis resigned. As collateral calls continued, Cassano's unit concluded that writedowns were necessary on the swaps portfolio. But there was no accepted way to assign value to the novel and illiquid instruments.
In its third-quarter earnings statement AIG reported a modest loss attributable to the swaps write-downs. It also acknowledged - without quantification, to be sure - that it was having some differences of opinion with counterparties about how much collateral it needed to be posting for those swaps.
Then, on Nov. 29, a PricewaterhouseCoopers partner addressed AIG's audit committee, with AIG CEO Martin Sullivan present, and related certain concerns the auditor had about possible "material weaknesses" in the accounting valuation process AIG's financial products unit was using.
Just six days later both Sullivan and Cassano addressed investors at New York's Metropolitan Club, giving an in-depth, generally reassuring presentation about AIG's credit default swaps portfolio. Sullivan stressed that AIG "has accurately identified all areas of exposure to the U.S. residential housing market," that "we are confident in our marks and the reasonableness of our valuation methods," that "we have ... a high degree of certainty in what we have booked to date," and that "AIG's exposure levels are manageable."
Cassano also spoke, saying, "We are highly confident that we will have no realized losses on these portfolios during the life of these portfolios." There was no explicit warning about the dire impact that the collateral calls and unrealized losses might have in themselves. Still, Cassano did give a detailed presentation of the valuation methodology his unit was using to price the portfolio for purposes of the write-downs.
Two months later, on Feb. 11, AIG disclosed in an SEC filing that its outside auditor was declaring that there were "material weaknesses" in that valuation process. A bout two weeks after that, AIG issued its results for the last quarter of 2007 using a different valuation technique. It resulted in a $5.3 billion net loss, driven in large part by more than $11 billion in write-downs on its credit default swaps portfolio. The rest, as they say, is history.
A spokesman for AIG declined to comment, and lawyers for Cassano and Sullivan did not respond to detailed messages seeking comment.
Lehman Brothers
Lehman's parent company filed for Chapter 11 protection on Sept. 15, 2008, the largest bankruptcy in history. Officials of the company are now under scrutiny by federal prosecutors in Brooklyn, Manhattan, and Newark.
U.S. Attorney Campbell's office, in Brooklyn, is scrutinizing statements that Lehman executives CEO Dick Fuld Jr. and then-CFO Ian Lowitt made in an emergency conference call to preannounce third-quarter earnings on Sept. 10, 2008, just five days before the bankruptcy filing, according to a person familiar with the situation. The call was convened after word had leaked out the day before that talks between Lehman and the Korean Development Bank about a possible investment had broken down. Among other things, Fuld assured investors that "we are on the right track to put these last two quarters behind us," while Lowitt stressed, "Our liquidity pool also remains strong at $42 billion." The question today is essentially, How does $42 billion vanish in five days, and did Lehman officers know then of any harbingers of doom that they weren't sharing?
The Manhattan federal prosecutor's office, meanwhile, is focused on whether Lehman was overvaluing its commercial real estate holdings shortly before bankruptcy (even though it had already marked them down significantly), according to a person familiar with the situation. The former head of Lehman's global real estate group, Mark Walsh, is therefore among the executives coming under the microscope.
In Newark the U.S. Attorney's office, together with New Jersey state regulators, is looking at a major capital-raising effort Lehman launched in June 2008, just three months before bankruptcy, when it issued $4 billion in common stock and $2 billion in preferred. Among the big investors was the fund that provides pensions for New Jersey's state and municipal employees, which invested $180 million, of which it has already lost at least $115.5 million.
It is not unusual for corporate officers to meet officers of big investors personally before such capital raisings, so any oral representations made to fund officials will presumably be closely scrutinized, as will all the SEC filings and conference call statements prior to the filing, including statements by CEO Fuld, then-CFO Erin Callan, and Callan's predecessor, Christopher O'Meara, who was then chief risk officer.
A spokesperson for Lehman Brothers said the company is cooperating fully, but otherwise declined to comment. Attorneys for Fuld and Walsh declined to comment, while a lawyer for Callan did not answer detailed messages seeking comment. Lowitt and O'Meara could not be reached.
Fannie and Freddie
Both Fannie Mae (FNM, Fortune 500) (the Federal National Mortgage Association) and Freddie Mac (FRE, Fortune 500) (the Federal Home Loan Mortgage Corp.) were placed into conservatorship on Sept. 7, 2008, in what was then the largest federal bailout in history. Each has since acknowledged that it is under investigation by federal prosecutors and the SEC, and says it is cooperating fully. Though it is still unclear what the focus of the probes is, the companies' former CEOs, Daniel Mudd and Richard Syron, have been accused of fraud in civil suits for making reassuring statements, which proved ill founded, about their companies' capitalization levels.
Civil lawyers alleging fraud have also been incensed by Fannie Mae's preferred stock offering in May 2008 - just four months before it was seized - because Fannie assured investors then that it was more than adequately capitalized, and provided only very perfunctory, opaque warnings about an accounting rule change that the Federal Accounting Standards Board had proposed in April. It wasn't until July 7, two months after the offering, that bank analysts at Lehman published a report explaining that the change, if adopted, would bring $2.27 trillion in mortgage-backed securities onto Fannie's balance sheet for the first time, meaning that Fannie would need to add $46 billion to meet its capital requirements - an unattainable sum.
Though the analysts predicted that Fannie would "probably" get an exemption from the rule before it took effect, the damage was done, as it fueled the perception that Fannie (and Freddie too, which would need $29 billion in additional capital under the rule change) was already insolvent and was being sustained only by an accounting mirage.
Fannie's stock fell about 20% that day and lost more than half its value over the ensuing week. A t the end of that month Congress gave the Treasury Department authority to seize Fannie and Freddie if necessary. Two months later the Treasury did.
Spokespeople for Fannie Mae and Freddie Mac declined to comment, as did counsel for Mudd. Syron did not return phone messages. The mortgage originators
Needless to say, several of the subprime or low-documentation mortgage originators - ground zero for today's crisis - are reportedly under criminal and SEC scrutiny, including New Century Financial Corp., American Home Mortgage Investment, Countrywide Financial Corp., Golden West Financial, and Washington Mutual. In the civil shareholder suits that have already been filed against them, their officers have generally stressed that they genuinely believed their companies were advancing the noble goal, actively promoted by both the Clinton and Bush administrations, of making the American dream of homeownership a reality for less-well-off citizens. They were overtaken, they insist, by seismic market forces whose speed, breadth, and severity nobody foresaw, and which have already caused the failures of more than 300 lending institutions since 2006.
The problems will arise where the executives tried to distinguish their companies from the pack by highlighting their allegedly superior underwriting techniques, higher-quality portfolios, early anticipation of the downturn, or other purported advantages that proved to be insufficient at best and fictitious at worst. Some officials, like CEO Angelo Mozilo of Countrywide Financial, portrayed the growing market turmoil as an opportunity: "This will be great for Countrywide at the end of the day," Mozilo told CNBC's Bartiromo in March 2007, "because all the irrational competitors will be gone."
In all these cases, prosecutors and the SEC will likely be scrutinizing the executives' stock sales as the crisis played out, looking for both insider trading and evidence of the executives' true state of mind. Civil plaintiffs accuse Countrywide's officers, for instance, of selling $848 million in stock during the year and a half before the company's sale to Bank of America (BAC, Fortune 500) in January 2008, including $474 million worth sold by CEO Mozilo alone. In a particularly unseemly twist, most of the stock was allegedly sold back to the company itself as part of a $2.4 billion buyback program initiated in October 2006. (Neither Mozilo's counsel nor the Countrywide press office responded to detailed inquiries.)"
How does it all play out? Criminality is about deviance, so the more widespread undesirable conduct turns out to have been, the more difficult it becomes to treat it as criminal. The collapse of the Bear Stearns hedge funds in July 2007 was shocking, as was the demise of their parent company eight months later. Likewise, Fannie's, Freddie's, Lehman's, and AIG's failures were all stunners. But by the time Washington Mutual fell, indignation was beginning to flag. It does not appear that the subsequent near collapses of Wachovia and Citigroup (C, Fortune 500) - each once unimaginable in itself - has yet triggered any criminal scrutiny at all (although Golden West, which Wachovia bought in 2006, is reportedly being looked at).
Fairly or unfairly, those who came under scrutiny first - because their companies failed first - are likely to experience the greatest pressure. The reference point here is former CEO Greg Reyes at Brocade, who was convicted and sentenced to prison for backdating. Brocade came under criminal investigation in late 2005 after a disgruntled employee dropped a dime on it, well before the Wall Street Journal revealed, in March 2006, just how widespread options backdating was. ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ INSERT: Judges Overturn Backdating Conviction By MICHAEL J. de la MERCED .. August 18, 2009
Citing misconduct by prosecutors, a federal appeals court on Tuesday overturned the conviction of the former chief executive of Brocade Communications Systems on charges related to the illegal backdating of stock options.
Gregory L. Reyes, the former chief executive of Brocade Communications Systems, and Stephanie Jensen, a human resources executive.
The court ordered a new trial for Gregory L. Reyes, the former chief executive................... http://www.nytimes.com/2009/08/19/technology/companies/19options.html ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Though it later became difficult to distinguish what had happened at Brocade from what had happened at, say, Apple or Pixar, the latter companies appear to have been permitted to resolve their problems entirely through civil channels. (In addition, as the breadth of a scandal spreads, simple issues of investigatory manpower arise. Criminal cases are time-consuming to prepare, and, as the New York Times reported in October, the FBI just doesn't have enough agents to simultaneously fight terrorism and form a dozen company-specific investigatory battalions, each on the scale of the mighty Enron Task Force.)"
Undoubtedly a few out-and-out scoundrels will be exposed, and they will be convicted criminally. Most of these situations, however, will be handled civilly, by the SEC and plaintiffs lawyers, which is as it should be. And then, inevitably, there will be the sadder, closer calls. Some executives may have made misleading statements under trying circumstances - ones that had far graver consequences than anyone ever imagined, but that were misleading nonetheless. It may turn out that one of the many risks that these financial wizards mispriced was the risk of lying and getting caught.
News 
Market Data 
Discover 
AI
