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Stop Calling Fannie and Freddie 'Sophisticated Investors'

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CNBC

One of the more ridiculous complaints about the Federal Housing Finance Agency's lawsuits against 17 banks is that Fannie Mae and Freddie Mac were "sophisticated investors" who knew or should have known about the quality of the mortgages underlying the securities they were buying.

Fannie and Freddie were not sophisticated purchasers under any reasonable definition of the term. And there's no way they could have known that the mortgage securities they bought from Wall Street were stuffed with low-quality mortgages.

The lack of sophistication of Fannie and Freddie was on display throughout the last decade. They consistently showed that they couldn't handle even basic accounting for their own balance sheets. If not for the imprimatur of the government and the protection of their pet politicians, they would have been de-listed from major exchanges. They probably should have been shut down altogether.

Neither Fannie nor Freddie had the resources to review loan level data on the mortgage securities they purchased—which is why they should never have been in that business to begin with. Neither even attempted to do this work. Instead, they required the banks that sold them securities to vouch that they met Fannie and Freddie's charter requirements. It was the duty of the bank issuing the securities to check the quality.

This might be a stupid way to do business, but it was the deal that the banks used to make billions. Fannie and Freddie bought the right to rely on the banks.

It is nonsensical to try to say that Fannie and Freddie were not entitled to rely on the banks when it came to the quality of the mortgages. This is like arguing that the Apple Store can sell you a brick instead of an iPhone because you should have opened the box before you paid for it. If your iPhone turns out to be a piece of masonry, you have the legal right to return it to Apple. And this is what the FHFA is doing: Claiming it was sold bricks in boxes labeled high-quality mortgage securities.

Using this example of the brick in an iPhone box, we can also see why it doesn't make sense to argue that it was the mortgage originators who should be sued by the FHFA instead of the banks that issued mortgage securities. Even if there was massive fraud or negligence at the originator level, the originators aren't the ones who were doing deals with Fannie and Freddie. They weren't vouching for the quality of the mortgages to Fannie and Freddie—the issuers were. Saying the FHFA should sue the originators is like saying the person who buys a brick should have to sue the Chinese manufacturing plant rather than demand a refund from Apple.

It all comes down to the fact that Fannie and Freddie relied on the banks and were legally entitled to rely on the banks. Fannie and Freddie paid enormous fees to the banks for this right to rely on them. If the mortgage securities they purchased did not meet the standards that the banks vouched for, it's the banks who should take the losses.

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