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Fannie Freddie Lawsuit and Risk Arbitrage
...To understand how casual Fannie and Freddie were about credit risk, consider the two types of activity they engage in. One, they buy and pool mortgages, issuing securities backed by these pools, a process called securitization. They’ve been doing this longer and on greater scale than anyone else—by comparison Wall Street was a newcomer to the business.

Two, they buy such securities, whether issued by themselves or others. The lawsuits just filed concern this second type of activity, the purchase of readymade mortgage securities. The main accusation is that materials pertaining to certain securities the defendants sold from 2005 to 2007 contained wrong or deficient information, “unbeknownst” to Fannie and Freddie.

At the time they bought these securities, Fannie and Freddie were competing furiously with the same banks for mortgages to securitize—-and earn fees on. They were buying mortgages as they had for decades, but now they faced growing pressure from banks seeking lucrative securitization business. This led to all-around lowering of underwriting standards and the rise of higher-risk mortgages, the race to the bottom described in Guaranteed to Fail.

Being both suppliers and buyers in the mortgage security market on a gigantic scale, Fannie and Freddie were uniquely positioned. Because they bought mortgages to securitize, they too were lowering standards and taking higher risks. For the reality underlying the securities to be “unbeknownst” to them, they had to willfully avoid knowing it. Even if they did not do the analysis themselves, they could have easily asked for third-party reports—-which existed at the time and are presented as evidence in the cases. That the GSEs were complicit does not exonerate the banks’ shoddy work, but it does show how we got to the current mess.

Fannie and Freddie appeared to mint money because government backing gave them easy and cheap capital, plus they had special tax breaks and low capital requirements. The government guarantee was initially explicit—they were was created as federal bureaucracies, as the “F” in their names indicates. Then it became implicit until the 2008 crisis made it explicit again. It was always assumed. Their extraordinarily low capital requirement meant GSEs leveraged more than adventurous hedge funds.
Lobbying and public relations made sure they retained the full panoply of special privileges. This was managing the political risk, which they appear to have done superbly and still do—-note their victim status in the lawsuits and mainstream media coverage thereof. Ensuring political protection meant that managing credit risk was less crucial....