Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Sorting Out the Fannie and Freddie Lawsuits

The U.S. Securities and Exchange Commission seal hangs on the facade of its building in Washington, DC.
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I have the feeling that a lot of people are probably scratching their heads over the news that the Securities and Exchange Commission is close to reaching a settlement with Fannie Mae and Freddie Mac over their disclosure of subprime risk.

Didn’t the government just sue 17 banks over this issue? If Fannie and Freddie were misleading their investors about subprime risk, how can the banks be held liable for misleading Fannie and Freddie?

So let’s sort this out. The lawsuits that were announced last week were filed by the Federal Housing Finance Agency, the conservator of Fannie Mae and Freddie Mac. Those suits claim that banks misled Fannie and Freddie about the quality of the mortgages packaged in mortgage backed securities the banks sold to the mortgage companies.

The SEC’s probe, on the other hand, is focused on whether or not executives at Fannie and Freddie misled Congress and investors about how much exposure they had to subprime mortgages. Both companies claimed their subprime exposure was minimal—as low as 2.5 percent in Fannie’s case—but this was only true using a very narrow definition of what counts as subprime.

“About 2.5 percent of our book could be represented as being in subprime, either by virtue of coming from a lender that’s designated as a subprime lender or as terms that would, generally, be considered subprime,” Daniel Mudd told a Congressional panel in April of 2007, when he was chief executive of Fannie.

What Mudd didn’t say—although he surely knew—was that the fact that only 2.5 percent of Fannie’s investments were in subprime didn’t mean that the remaining 97.5 percent of the investments were prime mortgages. Many of them were what industry people called “non-prime”—Alt-A mortgages that were made to people with lower credit scores or with less documentation than required for prime mortgages.

If you add up all the non-prime single-family mortgages purchased by Fannie between 2004 and 2007, you get a much higher figure—around 30 percent.

The SEC has been investigating whether Mudd’s statement—and similar statements made by Freddie executives and both companies in regulatory filings—were materially misleading because they downplayed the exposure to risky mortgages by falsely implying that everything not counted as subprime was prime.

The SEC concluded some time ago that it probably wasn’t going to fine Fannie and Freddie because any fine would just be paid for by the US government, which took over the companies in 2008. What’s would be the point of the US government fining itself?

Now the New York Times is reporting that the SEC may be close to settling the case and dropping potential fraud charges against the companies.

The investigations—and possible civil charges—against the executives involved will likely remain ongoing.


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