Washington – The Securities and Exchange Commission announced a dramatic lawsuit on Friday alleging that six former top executives of mortgage finance titans Fannie Mae and Freddie Mac committed fraud by authorizing misleading statements about their balance sheets.
Fannie and Freddie were congressionally chartered private companies with implicit government backing until they were put into government receivership by the Bush administration in September 2008.
That move came at the start of a global financial crisis that has proved to be the worst since the Great Depression. The financial crisis was triggered by excessive subprime mortgages given to the weakest borrowers, and former Fannie and Freddie executives now stand accused of deliberately misleading about their exposure to these subprime loans.
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“Fannie Mae and Freddie Mac executives told the world that their exposure was substantially smaller than it really was,” Robert Khuzami, director of the SEC's enforcement division, said in a statement “These material misstatements occurred during a time of acute investor interest in financial institutions' exposure to subprime loans, and misled the market about the amount of risk on the company's books. All individuals, regardless of their rank or position, will be held accountable for perpetrating half-truths or misrepresentation about matters materially important to the interest of our country's investors.”
In Friday's statement, the SEC said Fannie Mae and Freddie Mac had each entered into a non-prosecution agreement with the SEC, accepting responsibility without dispute for the actions of their former executives. It frees the agencies from costly and embarrassing civil prosecution.
The securities fraud charges were lodged in the U.S. District Court for the Southern District of New York. In one complaint, fraud charges were leveled against former Fannie Mae CEO Daniel Mudd, his former chief risk officer, Enrico Dallavecchia, and Thomas Lund, the former executive vice president for Fannie's single-family mortgage business.
In the second complaint, in the same court and against Freddie Mac, the SEC alleged fraud by former CEO and Chairman Richard Syron, former Executive Vice President and Chief Business Officer Patricia Cook, and Donald Bisenius, the former executive vice president for Freddie's single-family guarantee business.
The SEC is seeking unspecified financial penalties, return of ill-gotten gains with interest and a bar against the executives serving as officers or directors of companies. That's a big potential hit on Mudd, who is now CEO of the investment firm Fortress Investment Group.
In a blistering response Friday, Mudd — the son of legendary television newsman Roger Mudd — said politics was behind the SEC action.
“Every piece of material data about loans held by Fannie Mae was known to the United States government and to the investing public. The SEC is wrong, and I look forward to a court where fairness and reason — not politics — is the standard for justice,” he said In a statement issued through the law firm DLA Piper LLP.
Syron, through an attorney, said the case was without merit and fatally flawed.
“The SEC has ignored the fact that the term 'subprime' had no uniform definition in the market and that the federal government itself refused to define the term and bring clarity to the industry and the market,” said the statement of Sidley Austin LLP, representing Syron.
The SEC alleged Fannie executives engaged in fraud when they withheld information and abetted others in providing misleading information to investors about subprime exposure between December 2006 and August 2008. The alleged fraud for Freddie Mac executives occurred between March 2007 and August 2008. The agency alleges both mortgage finance giants said they had limited exposure to subprime loans in the billions, but actually had exposure in the tens and even hundreds of billions.
Aside from masking its true exposure to subprime loans on its books, the SEC alleged, Fannie executives also made misrepresentations about exposure to Alt-A loans, which were one step up the credit quality ladder from subprime loans.
“The misleading disclosures were made as Fannie Mae's executives were seeking to increase the company's market share through increased purchases of subprime and Alt-A loans, and gave false comfort to investors,” the SEC alleged Friday.
The SEC's Khuzami is under fire for a recent decision by a federal judge on Nov. 28 to reject his $285 million settlement with Citibank on similar charges of malfeasance involving the sale of a $1 billion collateralized debt obligation, a complex security backed by shaky subprime mortgages that soaked investors.
The Citi settlement was considerably lower than the $550 million Goldman Sachs paid to settle similar complaints against its collateralized debt obligation sales to investors. U.S. District Judge Jed Rakoff called the fines on Citi “pocket change,” tossed out the settlement and ordered a July trial. The SEC announced Thursday it would appeal.
Fannie and Freddie together own or back more than half of the nation's mortgage debt. Fannie Mae was created in 1938 to boost home ownership after the Great Depression, while Freddie Mac was created in 1970 to provide more competition.
The two bundle mortgages together and offer them to investors as mortgage bonds in a secondary market. This gets home loans off of the books of banks, allowing them to continue lending. For decades, the bonds — called agency mortgage-backed securities — were plain-vanilla investments that central banks and investors bought without incident.
From the late 1990s forward, Wall Street investment banks aggressively got into the business of packaging mortgages into bonds — called private-label mortgage-backed securities. By 2006 they had effectively halved Fannie and Freddie's share of the secondary market thanks to subprime loans.
Data from the Federal Reserve shows that more than 84 percent of the subprime mortgages in 2006 were issued by private lenders, routed mostly to Wall Street firms, who bundled them into private mortgage bonds. Data from the specialty publication Inside Mortgage Finance showed that in 2005 and 2006, the height of the boom years, Wall Street firms bundled two-thirds of new mortgages, supplanting Fannie and Freddie.
But shortly before the financial crisis, Fannie and Freddie tried to recover some of that lost ground, loosening what had been tighter standards than those applied by Wall Street. And that's where the SEC complaints were focused.