naked capitalism

Normally, I have a pretty good feeling for the dynamics behind turf wars, but on this one, I freely admit to sticking my neck out, and welcome any reader insight.

As you probably know, the New York Attorney General Andrew Cuomo filed a suit against title insurer and appraiser eAppraiseIT, a unit of First American. The suit accuses the company of inflating home values as a result of pressure from its customer, Washington Mutual.

Now where this gets interesting, as discussed in a lengthy and very good post by Tanta at Calculated Risk, is that many of these WaMu mortgages were then sold to Fannie Mae and Freddie Mac. They don’t do their own due diligence, but they have gory provisions that, among other things, let them return the mortgage to sender if there was fraud. That means WaMu might have to eat a lot of mortgages that probably had low to no equity at the time of issuance, and now that housing is tanking, have good odds of having negative equity.

WaMu issued a testy press release that said, basically, “our hands are clean, the vendor did it,” and further notes:

WaMu has a very rigorous process regarding all repurchase requests and believes it is adequately reserved for such liabilities.

That is code for “we will fight Fannie and Freddie on this one, and will be OK even if we lose.” Somehow I doubt that. Tanta pointed out, that WaMu’s agreement with eAppraiseIT allows them to seek damages from them if the mortgage values were inflated. However, you can’t get blood from a turnip. If WaMu is successful in asserting its claim, the damages are likely to be well in excess of what eAppriaseIT can pay. And I am not lawyer, but if WaMu can be demonstrated to have been complicit in the fraud and profited from it, eAppraiseIT may be able to contest WaMu’s claims against them.

So this is already getting interesting and messy.

A new front was opened Thursday between the Office of Federal Housing Enterprise Oversight today, the body that supervises Fannie and Freddie, and Cuomo (hat tip Housing Wire).

What makes this development noteworthy is that Freddie Mac had initially signaled its intention to cooperate with Cuomo, but yesterday, the director of OFHEO, James Lockhart, issued what by bureaucratic standards is a stinging letter to Cuomo. And to add another twist, Lockhart may be the only guy in the Administration who is perceived to be highly competent, tough, and just about immune to pressure. So it’s reasonable to assume that he has legitimate grounds for going after Cuomo.

To give some of the letter’s high points: Lockhart says he believes that the AG “may not fully understand the difference between mortgages issued by government sponsored enterprises (GSEs) and those issued by other entities.” He is disappointed that the AG did not consult with his office first, points out that this is more a Federal than state matter, takes issue with Cuomo’s demand that Freddie and Fannie cease doing business with WaMu when WaMu has not been charged, and asks for a meeting ASAP.

Now at first, I thought this might be mainly about Cuomo following in Spitzer’s footsteps and playing the possible fraud for maximum media effect, rather than involving OFHEO and coming up with a joint approach. OFHEO has every reason to want to get to the bottom of this, but the public at large is likely not to understand that the GSEs don’t do due diligence, and may damage OFHEO’s and/or Freddie’s and Fannie’s’ reputation unfairly. I viewed this as a concern about institutional reputation (remember, Lockhart was brought in to clean up the GSEs).

But then I happened to see a Bloomberg story about a press conference Cuomo had on Wednesday, and now have another theory. While Lockhart may want to save OFHEO’s and the GSEs’ image, this motivation is likely secondary to a bigger and more pressing concern.

Consider Lockhart’s statement: Cuomo’s office “may not fully understand the difference between mortgages issued by government sponsored enterprises (GSEs) and those issued by other entities.” Now ponder this excerpt from the Bloomberg article:

New York Attorney General Andrew Cuomo subpoenaed Fannie Mae and Freddie Mac as he expanded his investigation into “widespread” collusion between real estate appraisers and lenders including Washington Mutual Inc…

The attorney general’s investigation calls into question the value of securities Fannie Mae and Freddie Mac have guaranteed from mortgages provided by lenders. Cuomo said he discovered a “pattern of collusion” between lenders and appraisers and that he’s targeting banks beyond Seattle-based Washington Mutual for potentially pressuring appraisers.

“I don’t believe it’s just about Washington Mutual,” Cuomo said at a press conference in Manhattan today. “I believe it’s widespread. I believe it’s the rule not the exception. And we’re investigating Fannie Mae and Freddie Mac and other investment banks as to the underlying practices that have allowed this to go on for so long.”

No wonder Lockhart is ripshit. I would be too. Cuomo astoundingly called the GSEs investment banks, and as the article points out, raises doubts about the value of their even though they are government backed. Huh? That is likely the basis for Lockhart’s “you may not understand remark.”

The last thing the securities market needs is doubts being cast on the creditworthiness of Freddie’s and Fannies’ paper. This is a country in which roughly 70% of the public thinks Osama bin Laden had something to do with Saddam Hussein’s regime. Most people don’t read or listen closely.

Recall also that in August, many retail investors were pulling cash out of money market funds and putting them into Treasuries out of concern over subrprime exposure. By all accounts, only a portion of the investors withdrawing funds bothered to call to find out whether their fund did indeed own any subprime related paper (quite a few funds, like Vanguard’s, did not).

Similarly, anecdotal evidence suggests that demand for bank certificates of deposit is high, again revealing serious investor worry about credit quality. And a story on TheStreet.com (hat tip Michael Panzner) says retail customers are “scrambling” to withdraw funds from brokerage firms. That one I find disturbing, not because I am a great lover of retail brokers, but because it reveals a staggering level of ignorance among investors. Brokerage firms are fiduciaries. If your broker or firm were going to commit fraud, it’s a lot easier to pull off in a rising market than a falling one. One area of legitimate concern is the money market fund they use for their sweeps, but per above, that can be investigated, and money market holdings can be moved into other assets.

While investors have legitimate reasons to worry, the fear is becoming indiscriminate. The last thing that we need now is for relatively sound mortgage paper to become tainted in investors’ eyes. That is likely the reason for Lockhart’s salvo.

Update 11/9, 7:30 PM: A like minded post, “OFHEO to Andrew Cuomo: Point that thing someplace else,” from Accrued Interest. He goes though Lockhart’s letter and inserts what he think Lockhart really meant to say, and adds these observations:

First, I think Lockhart glosses over reality when he says that the GSEs have no incentive to inflate loan appraisals. On one hand, that’s true, because it increases their loss potential. But on the other hand, I suspect this practice is pretty pervasive. And I’m betting in most cases its the appraiser tacks on an extra 8% to the value or something on that order. Even if the GSE sees that in their random check, a number like 8% might be considered within the error range. Of course, if it were really a random error, then half the loans would be slightly undervalued and the over half overvalued. Something tells me this wasn’t the case.

I’d also argue that this could only apply to refinanced loans. Valuing a purchase loan at the price the purchaser just paid is called “mark to market” even if the purchaser vastly overpaid. And if an appraiser grossly overvalues a property off a purchase, that would be too obvious for anyone to ignore.

Now, if WaMu or anyone else was actually fraudulent in any step of underwriting MBS securities, that should be punishable. But this is extremely different than Elliot Spitzer’s crusade against bad street research, which occurred around the time of the dot.com bust. While I thought Spitzer was entirely self-serving in his actions, and I thought street research had little to do with either the internet boom or subsequent bust, I still didn’t give a damn what happened to the brokerages. They were, in fact, pushing bad research, and so they got what they deserved.

Here, there is potential damage to the overall banking system, with dire consequences for tax payers. The fact is that if something happens to Fannie or Freddie, we’ll have little choice but to bail them out. And if any bank goes bust, tax payers will at least have to bail out the depositors.

I think what will happen here is that the Federal government will conduct a probe of WaMu, and probably other banks. They’ll undoubted find that some appraisals were overstated. But they’ll also conclude that there was no mandate from management to overstate home values. Therefore proceedings will turn into minor fines at the corporate level.

Someone like Henry Paulson understands the danger here. Ben Bernanke does too. The U.S. economy is like a car with two wheels hanging off a large cliff. Hopefully we can carefully put the car in reverse and carefully back away from the abyss. We really don’t need Cuomo jumping up and down on the hood, thanks.

Accrued Interest tells us he owns Fannie Mae and Freddie Mac debt and MBS, and some of his client accounts hold WaMu (ouch). I don’t.