FHFA Sues Banks to Recover Housing Bond Losses: Less Than Meets the Eye?

News reports say that the Federal Housing Finance Agency (FHFA) will sue about 12 major banks in order to recover some of the losses that Fannie Mae and Freddie Mac sustained on mortgage-backed securities the banks issued.

The suits will seek to make the banks repay a share of about $30 billion in losses from securities that Fannie Mae and Freddie Mac bought before they essentially failed and the FHFA took them into conservatorship in September 2008.

Since any recovered money would reduce the over $150 billion the taxpayers have already spent on bailing out the two housing giants, this should be good news. However, the FHFA should not start counting the money it plans to recover quite yet. The suits are being filed now because the statute of limitations expires next week, and the burden of proof that the FHFA will have to meet will be high.

The FHFA is expected to charge that the 12 or so banks should have known that the mortgages that had been packaged into the securities that Fannie Mae and Freddie Mac bought were riskier than advertised. It claims that the banks failed to adequately check the quality of the mortgages before either selling them to packagers who combined mortgages into mortgage-backed securities or packaging them into securities themselves.

It is true that this happened far too often, and especially so in the year or two just before the housing bubble burst in 2008. There was a huge demand for high quality mortgage-backed securities across the world and not nearly enough quality home buyers. Some issuers took any step possible to create securities that appeared to be higher quality than they actually were. In doing so, some mortgage bankers clearly lent money to people who did not have anywhere close to the income necessary to repay the mortgages, and in some cases, borrowers were tricked into mortgages they could not understand.

However, most of the worst mortgages were made by other types of mortgage lenders, and not by the banks being sued. And government involvement in the mortgage market also bears a significant amount of blame for the 2008 crisis. The FHFA lawsuit is following an old legal practice of suing the deep pockets who might be able to either pay significant damages or settle out of court to avoid costly litigation.

In late 2008, the entire mortgage-backed securities market collapsed in part because buyers and sellers could not tell which bonds were backed by good quality mortgages and which were backed by poor quality ones. It will be very difficult for the courts to tell how much of the losses Fannie Mae and Freddie Mac suffered were caused by careless banks and how much were caused by the general market collapse.

Further, it will be hard to say whether the banks being sued issued securities or made mortgages that were worse than those made by other lenders. This is especially true since the securities were rated by one or more of the credit ratings agencies, which might have been expected to catch some or all of the errors when they examined the bonds.

In short, this is not a black-and-white question of going after “bad” banks, and we should not assume that those being sued are actually guilty until after a court rules. It would also be a mistake to assume that those 12 were any worse than dozens of other lenders who are not being sued because they have since gone out of business. Regulators have a history of going after deep pockets, and the burden will be on them to prove that they have a case.

Source material can be found at this site.

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