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Fannie's Perilous Pursuit of Subprime Loans

Fannie Mae chief Daniel H. Mudd says few predicted a downturn.
Fannie Mae chief Daniel H. Mudd says few predicted a downturn. (By Carol T. Powers -- Bloomberg News)
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Despite such reservations, Fannie Mae moved ahead.

In 2006 and 2007, Fannie Mae "carefully broadened our entry into the subprime market," Faith said in a statement. At the time, it wasn't clear how severe the problems in the housing market would become, he said.

In a written statement provided for this story, Mudd said, "In 2006 and early 2007, the industry, many analysts and market observers were generally not predicting a downturn in the housing and credit markets to the magnitude of what has since emerged, and outlooks for particular market segments at that time varied significantly."

Compared with the broader market for Alt-A loans, Fannie Mae "was more conservative in its approach and the loans have continued to perform better," Mudd added.

Chartered by the government to keep mortgage money flowing, Fannie Mae buys loans from lenders, enabling them to make more loans. It also packages loans into securities for sale to other investors, guaranteeing it will make the payments if borrowers default. Its mortgage-related investments and guarantees total $3 trillion.

During the peak years of the housing bubble, the company was distracted by an accounting scandal and its fallout. For much of 2006, the company was focused on a continuing effort to correct years of false financial reports, a massive project that cost more than $1 billion and ultimately revealed that Fannie Mae had overstated past profits by $6.3 billion.

Mudd promised his employees a celebration when the restatement was done, and he delivered. In December 2006, the company threw a holiday bash at a Washington hotel with entertainment by Earth, Wind & Fire, the '70s group known for such hits as "Boogie Wonderland" and "Fantasy."

"I hope you had a fantastic time at the holiday party. I sure did. And my feet still hurt. Thank you for making the party a blowout," Mudd wrote in a year-end message to employees.

In his year-end memo to the board, Mudd said he hoped the completion of the accounting corrections would prove to be a turning point -- "a time when we began to put a difficult past behind us and also to build for the future."

Mudd said he worried that while the company focused on its accounting problems, "the business itself would get away from us." He said the company avoided that pitfall but now faced another: intense competition from "usurpers and innovators."

Buying Alt-A and subprime mortgages was part of Fannie Mae's effort to meet the challenge. Fannie Mae sought to reap the rewards and protect itself from the downside of the investments through a feat of financial engineering it called its "Risk Transformation Facility," which was meant to transfer the riskiest elements to other investors.

"We engaged in the subprime market, for the first time closing deals to guarantee and securitize subprime loans, with help from the new facility that allows us to sell off the riskiest layers," Mudd wrote. By October, the company had signed $3 billion of such deals.


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