by Tanta on 11/09/2007 09:01:00 AM

See end of post for update.

The plot thickens on the WaMu/eAppraiseIT front. Yves at naked capitalism runs it down: James Lockhart, head of OFHEO, fires off irritated letter to Cuomo about the latter's public involvement of Fannie and Freddie in the mess without conferring first with OFHEO. The money quote (for which I have not seen anyone include the full context in the letter, alas): Lockhart says Cuomo "may not fully understand the difference between mortgages issued by government sponsored enterprises (GSEs) and those issued by other entities."

Yves runs down a preliminary list of what this might be about. I tend to assume that Lockhart is annoyed mightily because the way in which this was handled by Cuomo did, in fact, lead many people to think that Fannie and Freddie were targets of a criminal probe. That didn't help GSE share prices and it won't help calm the troubled bongwater of the credit markets. I also think it's plausible that Lockhart is responding to Cuomo's at least rhetorical linkage of the GSEs and the investment banks, and by extention prime conforming mortgage paper and subprime goofballery.

But I also suspect that Lockhart knows perfectly well that having a large seller/servicer go up in flames isn't any kind of good news for Fannie and Freddie, whether they're "innocent" or not. Seller/servicer concentration is a huge problem for the GSEs, in my view. One result of "800 pound gorilla" industry consolidations is that you have a handful of large operations not only servicing the majority of Fannie and Freddie's loans, you have that same handful making all those repurchase warranties that limit the GSEs' risk of covering guarantees on fraudulent stuff.

So it's one thing for a state AG to kick around somebody like American Home, whose agency servicing book is fairly small (and can be transferred, at least theoretically, to one of the gorillas if it fails). Kicking around a gorilla could put the GSEs in the position of feeling the effects of the concentration risk they have willingly allowed to build up over the years.

And, as I indicated yesterday, I do think part of what's being dragged out into the light of day is not just inflated appraisals but the whole "post purchase due diligence" model that the GSEs depend on (and that they "risk manage" by, exactly, doing a lot of business with big fat depositories who are, presumably, good for those warranties in the way some relatively small-change REIT isn't). Given this structural way of doing the business, there's nowhere an investigation of appraisal risk-offloading (as opposed to mere individual appraisal fraud) can go except to the parties who write the industry-standard rules on appraisal practices and whose upfront due diligence, or back-end due diligence, is or is not structured in a way that can catch bad appraisals before they, and other loose lending practices, wreak havoc in the housing and credit markets.

So I'm not sure what would be "worse" for the GSEs: that Cuomo does not understand how they operate, or that he does. Yesterday we were meditating on the problems created by relying on shallow-pocket counterparties to cover your liability. Today we are meditating on the risks of relying on deep-pocket counterparties to cover your liability. The latter is the classic "moral hazard" problem and it's worth asking whether Fannie and Freddie aren't hip-deep into it.

UPDATE:

Thanks to bacon dreamz, I have the link to Lockhart's letter to Cuomo (see post below [ed note: it's "above" for those of you who aren't standing on your heads]), which was hiding in plain sight on the internet (um, it's early . . .)

I have always had a lot of respect for Lockhart. This paragraph is making me stare in wonder at my monitor. Is it possible for anyone to be that naive about the mortgage business and still be alive? Here's the whole paragraph in question:

After reviewing these materials, I feel that you and your staff may not fully understand the differences between the mortgage-backed securities (MBS) issued by the GSEs and those issued by other entities. In particular, unlike the issuers of private label MBS, when Fannie Mae or Freddie Mac issues an MBS, they retain the credit risk on the underlying mortgages by guaranteeing repayment to MBS holders. Consequently, they have no economic incentive to knowingly purchase or guarantee mortgages with inflated appraisals. The two firms already have programs in place to prevent this and other types of mortgage fraud as well as contract terms to put back mortgages in such situations to the primary lender. For the past several years, OFHEO has been working with the two firms as they have continued to improve these anti-fraud programs.

Well, yes. Nobody has any incentive to knowingly purchase or guarantee fraudulent mortgages. If you know about it, you are party to it, and that put-back thing doesn't work. Does Lockhart seriously wish us to believe that there are no economic incentives for anybody to work extremely hard on not knowing what is going on, while still allowing it to go on because there's money in them transactions?

You do not have to accuse the GSEs of collusion in appraisal fraud to recognize that they have an economic incentive to allow a big counterparty like WaMu to push the envelope on appraisals, and they have a economic incentive to avoid having to "mark" the LTVs of their current outstanding MBS and retained portfolios to a new market (less the "fraud adjustments" on these bad appraisals).

In Lockhart's logic no one would ever have an economic incentive to request inflated appraisals, because no one is ultimately safe from having to cover the loss. Even nickel and dime mortgage brokers face disgorging loan premia that can bankrupt them, not to mention doing some time in the county jail, which is not "economic" for a small self-employed business person.

I argued a while back that the real problem with stated income lending--which the GSEs are implicated in as well as those private issuers Lockhart doesn't want the GSEs to be lumped in with--is that it allows lenders to make very high-risk loans without having to admit they're doing it, and it sets up a bagholder: the borrower who lied. To the accusation that lenders obviously allowed themselves to be lied to, the retort is that "we have no economic incentive" to be lied to. Sure you do.

Low processing costs. Inexpensive due diligence practices. Lower reserves based on "stated" DTIs and LTVs. Ability to compete with other lenders by offering "faster approval" (no hang-ups over the appraisal!) or lower closing costs (no expensive charge for an experienced independent appraiser when you get some appraisal-mill product for cheap). And on and on. How are these not "economic incentives" for the whole industry to know what is going on while not "knowing" what is going on? It's like no one ever heard of the concept of plausible deniability.

I am not suggesting that the GSEs intentionally colluded with anyone to produce bad appraisals. I actually do think they try harder than most other parties to weed that stuff out, precisely because they are motivated to limit their credit losses. But Lockhart himself names the major mechanism in play: put backs. That means that the GSEs manage their risks to the extent that their counterparties will agree to take the risks instead. And that means that if and when a counterparty gets in trouble over the risks it's taking, the GSEs have to put back nuclear waste at the exact time that doing so could conceivably ruin the counterparty, whose warranties on the other eleventy-jillion loans that don't have bad appraisals are now worthless.

Of course Fannie and Freddie don't want to participate in what could potentially be the ruin of WaMu or any other of their major counterparties. I have to think that Cuomo knows that and intentionally created this situation where they now cannot not participate in the investigation. If so, that's because he recognizes an "economic incentive" that Lockhart apparently wants to not know about.