OFHEO’s James Lockhart Takes Cuomo to the Woodshed

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.

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  1. Anonymous

    Sorry, are GSEs government backed or sponsored? Questioning, of either would have different consequences. If sponsored then displaying to the public that poor due diligence of mortgages backing their paper could of course have a major effect on their value.

  2. Anonymous

    Granted that Cuomo’s use of “investment bank” for the agencies was not careful (“securitizers” would probably have been better), and making no claim as to his broader motives, of which I can’t even guess, I’m still not sure I see where what he said rated a five-alarm response from Lockhart. I guess the stress is going around these days.

    GSEs have govt. charters, but the backing for their debts is assumed, not legislated. As a practical matter the govt. would be vey unlikely to default. Here’s a pretty nice paper from the Atlanta Fed:


    It’s about FHLB, but also covers backing of other GSEs.

  3. Yves Smith

    Anon of 6:12 AM,

    Thanks for the link, but remember, the concern is about the reaction of the public at large. The stock prices of investment banks have been tumbling. They have already made $40 billion in writedowns and much larger writeoffs are expected. Investment bankers also pay themselves very handsomely, which will become more controversial as the search for the guilty widens.

    Anon of 5:42 AM,

    As 6:12’s comment shows, the answer to your question isn’t as straightforward as you might imagine. The Bloomberg article used the word “guarantee” while I didn’t, since the guarantee is not formal. See this article, which has this section in its abstract:

    This article provides the most comprehensive statutory analysis to date of the federal government’s implied guarantee of Fannie Mae and Freddie Mac’s financial obligations. Fannie and Freddie together have $4.45 trillion in mortgage-related obligations. The magnitude of their obligations can only be understood in comparison to the amount of outstanding U.S. government debt – $5.04 trillion. Given the ongoing meltdown of the residential mortgage market, it is important that the implied guarantee be understood for what it is, a contingent liability of the federal government.

    and this discussion from James Hamilton in a talk he made at the Fed’s Jackson Hole conference:

    This acquisition of mortgages was enabled by issuance of debt by the GSEs which currently amounts to about $1.5 trillion. Investors were willing to lend this money to Fannie and Freddie at terms more favorable than are available to other private companies, despite the fact that the net equity of the enterprises– about $70 billion last year– represents only 5% of their debt and only 1.5% of their combined debt plus mortgage guarantees. If I knew why investors were so willing to lend to the GSEs at such favorable terms, I think we’d have at least part of the answer to the puzzle.

    And I think the obvious answer is that investors were happy to lend to the GSEs because they thought that, despite the absence of explicit government guarantees, in practice the government would never allow them to default. And which part of the government is supposed to ensure this, exactly? The Federal Reserve comes to mind. I’m thinking that there exists a time path for short term interest rates that would guarantee a degree of real estate inflation such that the GSEs would not default. The creditors may have reasoned, “the Fed would never allow aggregate conditions to come to a point where Fannie or Freddie actually default.” And the Fed says, “oh yes we would.” And the market says, “oh no you wouldn’t.”

    It’s a game of chicken. And one thing that’s very clear to me is that this is not a game that the Fed wants to play, because the risk-takers are holding the ace card, which is the fact that, truth be told, the Fed does not want to see the GSEs default. None of us do. That would be an event with significant macroeconomic externalities that the Fed is very much committed to avoid.
    So even among people who have looked at this matter, opinion varies.

  4. Anonymous

    Why exactly does it reveal “a staggering level of ignorance” for me to move my funds (which are well in excess of FDIC limits) from Citibank to JP Morgan to have less default risk at the same yield?

  5. Yves Smith

    Anon of 9:34 AM,

    If you read the post, and clicked through on the link, the comment was about retail brokerage accounts. You are not exposed to default risk in a brokerage account. You are not a creditor. A broker acts as an agent and maintains a segregated account. The risks you are exposed to occur either if your broker embezzles, or if you give them discretion and they churn your account or put you in crappy investments that pay them high fees. As I said, fraud is easier to execute in a bull market than a bear market.

    The risk arises out of the current environment is that firms like Merrill have to cut bonuses to their brokers, who have nothing to do with the firm’s problems, and their good brokers leave. But again, brokers tend to take their accounts with them (although firms may have better contracts in place to impede that. I’m not current on that issue).

    If you had a brokerage account at Citi (as opposed to deposits in excess of FDIC limits) you proved my point.

  6. Anonymous

    Sound mortgage paper? I think, given the historic severity of the speculative mania in real estate during the last few years, that “sound” might be a bit strong. Tanta has another good post today about the Cuomo Lockhart exchange. She notes that the mortgage model of the GSE’s has far more risk than many think because the frontline weak lending practices were perpetrated by parties that supposedly support the solvency of the GSEs through put back provisions.

    You imply that the securities market needs certainty about credit quality and that no one should be looking under the rug at the GSEs. I think the opposite: awareness of risk is what this market needs. I know that this means higher interest rates, lower asset prices, BKs/insolvencies and most likely recession, but the oft lauded risk mitigating financial innovation of recent years was really a ruse based on the idea that risk could be offloaded to systemic irrelevance when in fact it could not and in reality was always there and still is. The problem we have is that risk is not priced in to a variety of asset prices. Going back to the assumption that risk can be avoided or endlessly offloaded is the last thing we need. Every investment is always risky, even sovereign debt (just ask foreign holders of garbage, err I mean, dollar denominated sovereign debt.) The awakening of concern, or “fear” if you prefer, and curious delving into risk exposure are the only good things that have happened to the markets in years. A generation of investors who think that they can avoid all risk and that if they make mistakes the government will bail them out is the cadre we now have to finance the global economy and support innovation, do you really think that they’ll get things right? When I work with someone I want it to be someone who knows they are taking risks and carefully examines and prepares for those risks, not someone who assures me they’ve offloaded it to some third party or that some provident big brother will come to save us from our folly. Certainly I agree that degrees and types of risk should be differentiated, but the naïve perception of riskless ventures and unquestionably sound credit must end.


  7. Anonymous


    Love your posts, but I do have a bit of nitpicking on this one.

    Your Bloomberg quote indicates that the investigation itself calls into question the value of Fannie and Freddie’s securities, not that Cuomo did so. I don’t think it’s fair to accuse Cuomo of fomenting panic.

    The problem is that in the current environment where AAA rated assets may not just fall in value but end up being worth nothing (which seems to be a possibility for some CDO cubed and maybe even squared products), any regulator doing his job right can’t help but add to the worries.

  8. Yves Smith

    Anon of 1:30 PM,

    With all due respect (I am going to sound unduly cranky because I have to run to a meeting and don’t have time to craft my tone, so don’t take offense) I did not say that the investigation calls into question the value of Fannie’s and Freddie’s securities. The Bloomberg piece did, which leads me to believe, not having seen the full transcript of the Cuomo press announcement, that he made a few more derogatory statements. And even if he didn’t go beyond the investment bank comparison, that alone is pretty bad.

    I am objecting to Cuomo putting Fannie and Freddie’s paper in the same category as privately issued mortgage paper. Per the comments above, it enjoys government backing. Now it is fair to argue that taxpayers might wind up footing the bill, but that is not what Cuomo was saying. His comments could cause concern among uninformed investors. That is what I believe Lockhart objected to, and I think his views are reasonable.

    And Cuomo is not a regulator. Lockhart is.

  9. Doug MacKenzie

    Yves, it seems somwhat out of character for this blog to be concerned about not creating a panic.
    I know there are a number of people including Peter Schiff that have warned about the possible collapse of Fannie Mae and Freddy Mac.

    “raises doubts about the value of their even though they are government backed”

    Well, a lot of things that I would never touch have been government backed. How long ago was it that Russia defaulted on its commitments?

    “Now it is fair to argue that taxpayers might wind up footing the bill”

    What makes you assume that the taxpayers are capable of footing the bill for a collapse? Last I checked, they were borrowing about 2 billion a day just to make ends meet, while bridges are collapsing and tax revenues on the municipal, state and federal levels are all declining. Not to mention that the American taxpaers are clearly over extended in terms of mortgage debt, credit card debt, auto debt, student loan debt etc, etc,
    What is most worrying to international observers like myself is the “sweep it under the rug” “speak no evil” response to these problems. That kind of response is dishonest and is a very big reason why the aggegate creditworthiness of all things American is declining in the eyes of the rest of the world.

  10. James I. Hymas

    You are not exposed to default risk in a brokerage account. You are not a creditor. A broker acts as an agent and maintains a segregated account.

    Does this apply to the free cash balances as well? I am not familiar with American rules – and my knowledge of Canadian rules may well be out of date – but I believe that in Canada the cash in a brokerage account is treated as a loan to the brokerage and may be used in the course of their business. The securities must be segregated, and the cash in registered accounts (our answer to 401(k)) must be segregated, but not excess cash held in an ordinary margin or cash account.

    Investors are protected by the Canadian Investor Protection Fund but, while the fund size is certainly adequate to take care of the small shops, it would be instantly swamped if one of the big firms were to require support.

    What is most worrying to international observers like myself is the “sweep it under the rug” “speak no evil” response to these problems.

    Lockhart has been pushing for better capitalization of the GSEs for some time and achieved considerable support – except in congress.

    I don’t think anybody in this particular drama wants to sweep anything under the rug – but authority must be coupled with responsibility. Cuomo has issued orders to the GSEs:

    Knowing this, Fannie Mae and Freddie Mac cannot afford to continue buying Washington Mutual mortgages unless they are sure these loans are based on reliable and independent appraisals.”

    Such an order exceeds his mandate, as Lockhart so admirably points out:

    Your demand that two federally-chartered and federally-regulated Enterprises cease doing business with a major federally-charterd bank, which you have not charged or subpoenaed, unless certain conditions stipulated by you are met.

    The regulators – and in this particular case, the NY AG – are entirely too fond of throwing their weight around and using the threat of extended, messy investigation in lieu of actual court proceedings.

    It’s not quite corrupt, but it’s not quite clean government either.

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