Mortgage risk and the two kinds of bell curves

The NYT reports in "Pressured to Take More Risk, Fannie Reached Tipping Point:"

But by the time Mr. Mudd [son of newscaster Roger Mudd] became Fannie’s chief executive in 2004, his company was under siege. Competitors were snatching lucrative parts of its business. Congress was demanding that Mr. Mudd help steer more loans to low-income borrowers. Lenders were threatening to sell directly to Wall Street unless Fannie bought a bigger chunk of their riskiest loans.

So Mr. Mudd made a fateful choice. Disregarding warnings from his managers that lenders were making too many loans that would never be repaid, he steered Fannie into more treacherous corners of the mortgage market, according to executives.

For a time, that decision proved profitable. In the end, it nearly destroyed the company and threatened to drag down the housing market and the economy.

Dozens of interviews, most from people who requested anonymity to avoid legal repercussions, offer an inside account of the critical juncture when Fannie Mae’s new chief executive, under pressure from Wall Street firms, Congress and company shareholders, took additional risks that pushed his company, and, in turn, a large part of the nation’s financial health, to the brink.

Between 2005 and 2008, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers — more than three times as much as in all its earlier years combined, according to company filings and industry data.

“We didn’t really know what we were buying,” said Marc Gott, a former director in Fannie’s loan servicing department. “This system was designed for plain vanilla loans, and we were trying to push chocolate sundaes through the gears.”

No comment.

Last month, the White House was forced to orchestrate a $200 billion rescue of Fannie and its corporate cousin, Freddie Mac. On Sept. 26, the companies disclosed that federal prosecutors and the Securities and Exchange Commission were investigating potential accounting and governance problems.

Mr. Mudd said in an interview that he responded as best he could given the company’s challenges, and worked to balance risks prudently.

“Fannie Mae faced the danger that the market would pass us by,” he said. “We were afraid that lenders would be selling products we weren’t buying and Congress would feel like we weren’t fulfilling our mission. The market was changing, and it’s our job to buy loans, so we had to change as well.” ...

Fannie never actually made loans. It was essentially a mortgage insurance company, buying mortgages, keeping some but reselling most to investors and, for a fee, promising to pay off a loan if the borrower defaulted. The only real danger was that the company might guarantee questionable mortgages and lose out when large numbers of borrowers walked away from their obligations.

So Fannie constructed a vast network of computer programs and mathematical formulas that analyzed its millions of daily transactions and ranked borrowers according to their risk.

Those computer programs seemingly turned Fannie into a divining rod, capable of separating pools of similar-seeming borrowers into safe and risky bets. The riskier the loan, the more Fannie charged to handle it. In theory, those high fees would offset any losses.

With that self-assurance, the company announced in 2000 that it would buy $2 trillion in loans from low-income, minority and risky borrowers by 2010.

A trillion here, a trillion there, pretty soon you are talking about real money.

Look, the problem with Fannie Mae's computer models can be summed up like this: They were looking at the wrong bell curve. They assumed that the risk of mortgage defaults were normally distributed along a bell curve, so you could use all the usual tools of statistical reasoning to diversify away this purely random risk.

Instead, they should have been looking at The Bell Curve. The homeownership rate had been stuck around 64% for a quarter of a century. Then the Clinton and Bush Jr. Administrations pushed it up, by hook and by crook, to 68 or 69% (published figures differ on what was the precise peak). Bush announced in 2002 that he wanted to add 5.5 million more minority homeowners, which would have pushed the rate above 70%.

In other words, the national policy was to keep pushing homeownership farther down toward the left tail of The Bell Curve (in less technical terms, further scraping the bottom of the barrel) by debauching traditional credit standards for everybody. This movie doesn't end well.

But, can you imagine what longtime Fannie Mae CEO Franklin Raines' response would have been if one of his modelers had tried to inject insights from The Bell Curve into their bell curves of mortgage default risk? Heck, nobody -- public, private or hybrid -- would be allowed to do it because it would show up in discovery of discrimination lawsuits. ACORN and La Raza would have a field day.

... The ripple effect of Fannie’s plunge into riskier lending was profound. Fannie’s stamp of approval made shunned borrowers and complex loans more acceptable to other lenders, particularly small and less sophisticated banks.

Between 2001 and 2004, the overall subprime mortgage market — loans to the riskiest borrowers — grew from $160 billion to $540 billion, according to Inside Mortgage Finance, a trade publication. Communities were inundated with billboards and fliers from subprime companies offering to help almost anyone buy a home.

Within a few years of Mr. Mudd’s arrival, Fannie was the most powerful mortgage company on earth.

Then it began to crumble. ...

Shortly after he became chief executive in 2004, Mr. Mudd traveled to the California offices of Angelo R. Mozilo, the head of Countrywide Financial, then the nation’s largest mortgage lender. Fannie had a longstanding and lucrative relationship with Countrywide, which sold more loans to Fannie than anyone else.

But at that meeting, Mr. Mozilo, a butcher’s son who had almost single-handedly built Countrywide into a financial powerhouse, threatened to upend their partnership unless Fannie started buying Countrywide’s riskier loans.

Mr. Mozilo, who did not return telephone calls seeking comment, told Mr. Mudd that Countrywide had other options. For example, Wall Street had recently jumped into the market for risky mortgages. Firms like Bear Stearns, Lehman Brothers and Goldman Sachs had started bundling home loans and selling them to investors — bypassing Fannie and dealing with Countrywide directly.

“You’re becoming irrelevant,” Mr. Mozilo told Mr. Mudd, according to two people with knowledge of the meeting who requested anonymity because the talks were confidential. In the previous year, Fannie had already lost 56 percent of its loan-reselling business to Wall Street and other competitors.

“You need us more than we need you,” Mr. Mozilo said, “and if you don’t take these loans, you’ll find you can lose much more.”

Then Mr. Mozilo offered everyone a breath mint.

Investors were also pressuring Mr. Mudd to take greater risks.

On one occasion, a hedge fund manager telephoned a senior Fannie executive to complain that the company was not taking enough gambles in chasing profits.

“Are you stupid or blind?” the investor roared, according to someone who heard the call, but requested anonymity. “Your job is to make me money!”

Capitol Hill bore down on Mr. Mudd as well. The same year he took the top position, regulators sharply increased Fannie’s affordable-housing goals. Democratic lawmakers demanded that the company buy more loans that had been made to low-income and minority homebuyers.

“When homes are doubling in price in every six years and incomes are increasing by a mere one percent per year, Fannie’s mission is of paramount importance,” Senator Jack Reed, a Rhode Island Democrat, lectured Mr. Mudd at a Congressional hearing in 2006. “In fact, Fannie and Freddie can do more, a lot more.”

Yes, that is kind of a problem, isn't it? Obviously, the solution to home prices rising faster than incomes is lend more money!

Now, over the last couple of weeks there has been a lot of fingerpainting over who is to blame. And that's a good thing. But the efforts to pin the positive blame on one party or another seem fairly hopeless, since they were all in on it. Sure, the Bush Administration raised qualms about Democrat-infested Fannie Mae in 2003, but Bush was simultaneously pushing zero down payment mortgages to promote minority homeownership, so the Bushies were not interested in dealing with the real problem, just in fighting Democrats over the spoils.

More realistically, there's a lot of negative blame to hand out because nobody in a position of power or influence -- Bush, Clinton, Greenspan, Frank, Dodd, etc. -- was willing to be seen as to stand athwart history, yelling Stop. What if the federal government had imposed a minimum 5% down payment on mortgages right after the 2004 election? That doesn't seem like too much to ask, but it was, because the "promoting minority homeownership" narrative was crucial in dissuading anybody from yelling Stop because that would be, in effect, yelling that minorities were lousier credit risks on average. And that's racism (because it's true, which is what make it so intolerable to mention in public), so that's unthinkable, so nobody thought about it.

So, here we are.

[By the way, Mr. Mudd is now out of a job. I guess his name is now mud, kind of like his ancestor, the Dr. Mudd who set the leg John Wilkes Booth broke while leaping from Abraham Lincoln's box to the stage of the Ford Theatre.]

My published articles are archived at iSteve.com -- Steve Sailer