Who's More to Blame: The SEC or Fannie and Freddie?

Join the Fool as we assess blame for this financial meltdown -- March Madness bracket style! Below is one of eight first matchups you can vote on … enjoy!  

The Case for the Securities and Exchange Commission, by Eric Bleeker
I have to admit, the SEC is probably coming into this tournament as a 16-seed. It’s like East Tennessee State in the NCAA tournament, just happy to be playing with the big boys. It seems an unlikely choice to win “The Big Financial Dance” when set against magnets of criticism such as Congress, Ben Bernanke, and Wall Street’s greed.

However, the SEC has more than enough complicity in this mess to make the bold claim that it’s most to blame for the current crisis.

Don’t believe me? My guess is that Harry Markopolos does. Markopolos is the man who warned the SEC five times that Madoff was running a Ponzi scheme. He sent the SEC letters demonstrating that there weren’t high enough options volumes for Madoff to possibly execute his split strike options strategy. Markopolos describes the SEC as “untrained in finance … lawyers without any financial industry experience.”

Jim Cramer seems to be of the same opinion as Mr. Markopolos. In a video from 2006 that was unearthed last week, he appeared downright dismissive of the agency: "You can't foment. That's a violation ... But you do it anyway because the SEC doesn't understand it."

The way I see it, the SEC is a government organization with a useful purpose -- it’s just that they don’t have any clue how to do their jobs. Also, to make matters even worse, the agency helped create the situation of over-leveraged banks that caused repeated failures and the resulting lack of confidence that has crushed our financial system. In 2004, the SEC altered its net capital rule to allow five banks -- Bear Stearns (now a part of JPMorgan (NYSE: JPM  ) ), Lehman Brothers, Merrill Lynch (now a part of Bank of America), Goldman Sachs (NYSE: GS  ) , and Morgan Stanley (NYSE: MS  ) -- to triple the amount of leverage they employed from 12-to-1 to as much as 40-to-1. Notice a pattern with those five banks? Yup, three of them don’t exist anymore.

So, while the Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) combo is a fine choice, I wouldn’t call it the biggest culprit in the credit crisis. That’s because Fannie wasn’t the root cause of the crisis – rather, that honor goes to the various government programs to spur continued housing development. Fannie was under tremendous pressure from the U.S. Department of Housing and Urban Development (HUD) to get more “affordable” loans to low-income borrowers. I say, for mortgages, blame Congress and HUD. As far as the financial implosion, blame the SEC -- they changed the leverage rules at the root of the crisis. How many banks would have collapsed if they were only at a 12-to-1 leverage ratio? Not as many, and our taxpayer tab for rescuing them wouldn’t be nearly so large.

The case for Fannie Mae and Freddie Mac, by David Williamson
Fannie Mae and Freddie Mac were set up to fail. They were tasked with the governmental goal of increasing homeownership while at the same time maximizing profits for shareholders, deftly combining the impractical idealism of Washington with the naked greed of Wall Street.

Coming off an accounting scandal in 2004 that cost executives at Fannie, including Franklin Raines, more than $30 million, Fannie and Freddie found themselves in the midst of a housing boom that made residential homebuilders such as Pulte Homes (NYSE: PHM  ) and Lennar Corp. (NYSE: LEN  ) increasingly influential. They were also watching their market share shrink in favor of the the Wall Streeters that were making a fortune on subprime mortgages. So, after years of relaxing qualifications for the loans they purchased -- fueling the start of the housing bubble to begin with -- Fannie and Freddie got greedy.

With the implicit financial guarantee of the U.S. government behind them, the two quasi-governmental institutions dove head-first into the subprime business in a plan that would either make the executives lavishly rich or leave the U.S. taxpayer holding the bill. And indeed, the taxpayers now own an almost 80% equity stake in companies that would otherwise be worthless. Fannie and Freddie have almost $170 billion combined in subprime exposure, and they’ve received government pledges for hundreds of billions in aid. Let’s hope gratuity is included on this tab.

The Security and Exchange Commission’s Ponzi and leverage oversights are nothing more than a sideshow, the bearded lady or the lobster boy, to the three-ring circus that is the global credit crisis.

Did the SEC fail miserably at regulating Wall Street and protecting a handful of investors from crooked hedge funds? Undoubtedly. But did it control almost half of the national mortgage market and make risky bets to the tune of hundreds of billions of dollars, only to put the losses on the American public when those bets came up snake eyes? No, that was Fannie and Freddie, the real guilty party here.

Check out the Fool’s entire 2009 March Madness bracket here.

Eric Bleeker -- unlike his counterpart, David Williamson -- isn’t evil personified. David Williamson -- unlike his counterpart, Eric Bleeker -- is taking the high road ... in public. Remember these facts when you’re voting. Neither owns shares of any companies mentioned in this article. JPMorgan Chase is a former Motley Fool Income Investor recommendation. The Fool has a disclosure policy.


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  • Report this Comment On March 17, 2009, at 12:54 PM, pondee619 wrote:

    "Who's More to Blame" How is this constructive?

  • Report this Comment On March 17, 2009, at 1:00 PM, marylandgu101 wrote:

    I would point out that in spite of the manifest pressures on Fannie and Freddie to enter the subprime market; they should take less of the blame because 1. as you pointed out in the article Wall Street created the huge subprime market first and 2. Fannie and Freddie's share of the subprime market was distinctly smaller that the Wall Street share ( investment banks, hedge funds, insurance companies etc). 3. The rating agencies that allowed Wall Street to chop these loans up into hundreds of pieces combine them and sell at investment grade securities can also take their share of blame. I'm not letting Fannie and Freddie out of the blame game just that they were late to this party and played smaller albeit significant role.

  • Report this Comment On March 17, 2009, at 1:04 PM, NewJerichoMan wrote:

    Unconvincing argument about F&F.

    The article quotes $170B in subprime exposure for F&F. When considering that the companies hold/own over $5.2T (some estimates up to $5.5T), that amounts to just over 3% of their mortgages.

    No formal definition of subprime but it's usually equates to poor credit and high LTV ratios. Another thing that goes hand-in-hand with high LTV is mortgage insurance or "credit enhancements"; i.e. F&F are either being made whole on their delinquent loans, or getting a substantial portion of it.

    Plus, one can't even compare the subprime mortgages that F&F vs. private label securities. As of December 2008, Fannie's seriously delinquent rate:

    Non-credit enhanced lots = 1.4%

    Credit enhanced loans = 6.42%

    Overall seriously delinquent rate = 2.42%.

    Freddie (as of December 2008)

    Non-credit enhanced lots = 1.26%

    Credit enhanced loans = 4.31%

    Overall seriously delinquent rate = 1.98%.

    It is quoted in various media sources, that 1 in 8, or approximately 12% of loans are at least 30 days late or in foreclosure. Data from the Mortgage Bankers Association also has quoted that 48% of homeowners who have subprime, adjustable-rate mortgages are behind on their payments or in foreclosure.

    It is clear a lot of improvident loans were made but the vast majority were are NOT held or guaranteed by F&F.

    Later,

    David

  • Report this Comment On March 17, 2009, at 2:03 PM, travelerjdh wrote:

    I believe the lawmakers in Congress who repeteadly for the last 15 years blocked any attempt to regulate Fannie & Freddie are the real responsible for this crisis and is obvious to me that was self-interest as they were "developing" their own states through the building of houses, sales, flipping and profit making by erveryone involved.

    No one who understand banking can otherwise justify running a financial entity with the kind of leverage and lack of regulations that were apparent in these two cases.

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