Saturday, October 04, 2008

Don't blame the quants: Fannie edition

This article in the Times gives some details about the collapse of Fannie Mae. It's pretty clear that the quants at Fannie knew they were undercharging for risky loans, and that senior management knowingly pushed the firm into dangerous territory.

Fannie's business: repackaging mortgages into collateralized securities. But it operated under political pressure to help low-income buyers achieve home ownership and under financial pressure to compete with investment banks getting aggressively into the mortgage securitization business.

NYTimes: ...When Mr. Mudd arrived at Fannie eight years ago, it was beginning a dramatic expansion that, at its peak, had it buying 40 percent of all domestic mortgages.

...So Fannie constructed a vast network of computer programs and mathematical formulas that analyzed its millions of daily transactions and ranked borrowers according to their risk.

Those computer programs seemingly turned Fannie into a divining rod, capable of separating pools of similar-seeming borrowers into safe and risky bets. The riskier the loan, the more Fannie charged to handle it. In theory, those high fees would offset any losses.

With that self-assurance, the company announced in 2000 that it would buy $2 trillion in loans from low-income, minority and risky borrowers by 2010.

All this helped supercharge Fannie’s stock price and rewarded top executives with tens of millions of dollars. Mr. Raines received about $90 million between 1998 and 2004, while Mr. Howard was paid about $30.8 million, according to regulators. Mr. Mudd collected more than $10 million in his first four years at Fannie.

Take aggressive risks, or "get out of the company":

...But Fannie’s computer systems could not fully analyze many of the risky loans that customers, investors and lawmakers wanted Mr. Mudd to buy. Many of them — like balloon-rate mortgages or mortgages that did not require paperwork — were so new that dangerous bets could not be identified, according to company executives.

Even so, Fannie began buying huge numbers of riskier loans.

In one meeting, according to two people present, Mr. Mudd told employees to “get aggressive on risk-taking, or get out of the company.”

In the interview, Mr. Mudd said he did not recall that conversation and that he always stressed taking only prudent risks.

Employees, however, say they got a different message.

“Everybody understood that we were now buying loans that we would have previously rejected, and that the models were telling us that we were charging way too little,” said a former senior Fannie executive. “But our mandate was to stay relevant and to serve low-income borrowers. So that’s what we did.”

I complained about Frankin Raines, who embroiled Fannie in a derivatives accounting scandal, back in 2004-5.

Mr. Raines and Mr. Howard, who kept most of their millions, are living well. Mr. Raines has improved his golf game. Mr. Howard divides his time between large homes outside Washington and Cancun, Mexico, where his staff is learning how to cook American meals.


Anonymous said...


Sounds like Raines was acting at best in a dangerous manner. Given that he is one of Obama's advisors do you have any thoughts? Does it not make you question Obama's judgment? I did not see a word on the issue of integrity. You can be so objective when your guy is neck deep in filth of corruption. I guess it's ok if its not Palin or McCain.

Steve Hsu said...

If you look back on the blog I did plenty of complaining about Raines when no one else seemed to know or care. I don't know how close Raines is to Obama. If Obama were to appoint Raines to a key poisition in his administration I would certainly consider it ill-advised.

Raines is really a Clinton guy, so I'm not sure who he supported earlier in the campaign.

This article claims the McCain ads trying to link Raines to Obama are based on flimsy evidence:

The Obama campaign issued a statement by Raines on Thursday night insisting, "I am not an advisor to Barack Obama, nor have I provided his campaign with advice on housing or economic matters." Obama spokesman Bill Burton went a little further, saying in an e-mail that the campaign had "neither sought nor received" advice from Raines "on any matter."

So what evidence does the McCain campaign have for the supposed Obama-Raines connection? It is pretty flimsy, but it is not made up completely out of whole cloth. McCain spokesman Brian Rogers points to three items in the Washington Post in July and August. It turns out that the three items (including an editorial) all rely on the same single conversation, between Raines and a Washington Post business reporter, Anita Huslin, who wrote a profile of the discredited Fannie Mae boss that appeared July 16. The profile reported that Raines, who retired from Fannie Mae four years ago, had "taken calls from Barack Obama's presidential campaign seeking his advice on mortgage and housing policy matters."

Since this has now become a campaign issue, I asked Huslin to provide the exact circumstances of that passage. She said that she was chatting with Raines during the photo shoot, and asked "if he was engaged at all with the Democrats' quest for the White House. He said that he had gotten a couple of calls from the Obama campaign. I asked him about what, and he said, 'Oh, general housing, economy issues.' ('Not mortgage/foreclosure meltdown or Fannie-specific?' I asked, and he said 'no.')"

Steve Hsu said...

From the same article:


The McCain campaign is clearly exaggerating wildly in attempting to depict Raines as a close adviser to Obama on "housing and mortgage policy." If we are to believe Raines, he did have a couple of telephone conversations with someone in the Obama campaign. But that hardly makes him an adviser to the candidate himself -- and certainly not in the way depicted in the McCain video release.

Anonymous said...

If their business model was to repackage and sell these loans, I would think that there would be pension funds, New York dentists and the like who would be in trouble.

Either they guaranteed a large percentage of these (bought insurance to cover this risk?) or they kept them as investments.

I've never really understood how or why these banks had all this inventory.

Can you explain it?

Anonymous said...

Raines is barely connected to Obama - and rather ironic considering the head of McCain's campaign, Rick Davis and his chief of staff were both working for Fannie in one way or another. Davis' company was being paid $15k a month for undefined work - in other words, they were buying access to McCain. But I digress.

Once again we learn of a CEO that pushed the envelope in order to make short term gains. This, to me, continues to be the problem with our system - there is no real downside for these guys. So they get fired. No one takes away the millions they've already made. And the corporation says "you owe nothing to the world, just improve the stock price".

Now I'm a firm capitalist, and a trader, so I have no interest in removing the good capitalist incentives that help drive people to succeed, but I really wish we could find a way to deal with this issue. Sadly, I think as long as boards of directors are mainly rubber stamps, there will be little improvement in the future.

Steve Hsu said...

My understanding is that when Fannie securitizes the mortgages it is on the hook for the defaults -- i.e., Fannie sells bonds that are backed by mortgage income, but Fannie is itself guaranteeing the interest on the bond. That's why the government had to intervene -- the PBOC, for example, holds a ton of Fannie paper and leaned on Paulson to make sure it would continue to be good.

Re: the CEO agency problem, that's why there should be clawbacks, or very carefully negotiated employment agreements for senior execs. This is related to the fact that most boards are beholden to the CEO and not the shareholders, primarily.

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