Why Were Mortgage Warnings Ignored?

Aug. 6, 2008 — -- Why didn't early warnings stop the rush to invest in risky mortgages? It's a question some are asking this week in light of news that the chief executive of mortgage giant Freddie Mac may have dismissed concerns raised in 2004 about an impending housing crisis.

The New York Times reported on Tuesday that Freddie CEO Richard Syron failed to follow advice by David A. Andrukonis, the company's former chief risk officer, who warned that the loans bought by the company "would likely pose an enormous financial and reputational risk to the company and the country."

Freddie Mac, which on Wednesday morning posted a second-quarter loss of $821 million, released a statement calling the Times story "superficial" and defending its record, saying that its "mortgage default and credit loss rates are a fraction of the industry averages."

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Other early – and, apparently, overlooked – warnings have also made headlines. The Times reported in December that Federal Reserve governor Edward Gramlich, who died last fall, had warned about the risks of subprime mortgages – home loans made to high-risk borrowers -- as early as 2001. Reuters reported in October that a Merrill Lynch analyst concluded in 2006 that companies could suffer as a result of their subprime investments.

Why weren't these and other warnings enough to ward off the mortgage mess? Experts told ABCNews.com that several factors kept the key players in the mess – financial firms – from pulling back.

Money: Syron received $18.3 million in compensation last year. Daniel Mudd – the CEO of the country's other mortgage giant, Fannie Mae – received $11.6 million. Stanley O'Neal, former chairman and CEO of Merrill Lynch, Charles Prince, the former chairman and CEO of Citigroup and Angelo Mozilo, the former chairman and chief executive officer of Countrywide Financial Corp., all also earned tens of millions at their posts.

CEOs weren't the only ones raking it in: Lower-ranked finance types involved in structuring mortgage investments also saw big paydays. Those short-term gains, said Robert E. Wright, a finance historian at New York University's Stern School of Business, made the long-term risks worth it.

"Many of them are not career types … they went into investment banking to make a killing and get out," Wright said. "So you're 35 years old, 40 years old, whatever, you see the possibility of seven-figure bonuses for the next two years or five years."

"Even if you have significant qualms about the long-term viability about the product you're selling, you put that aside because you're making so much now," he said.

In other words, greed played a role, said Hung Tran, the senior director of capital markets and emerging market policy at the Institute of International Finance.

"Financial markets tend to gyrate between greed when things are going well and fear when things are not going well," Tran said. "We are always alternating between the two."

Competition: Warnings notwithstanding, the profitability of mortgage-backed securities made firms eager to snatch up that market for themselves, analysts say.

They were reluctant to see their competitors gain market share, said Robert Aliber, a professor of international economics and finance at the University of Chicago Graduate School of Business.

They were "very quantity-oriented," he said.

Tran said that investment bankers who pared back on their subprime investments would have seen, in the short-term, smaller returns than those of their competitors and risked losing their clients.

"If the markets are still performing well, then the incentive to stay with the winning strategy is very strong and people who prematurely took the opposite view were penalized by market performance," Tran said.

Too Little and Too Much Information: Tran said there wasn't hard data available in time to back up the early warnings about the mortgage market.

It would have helped investors, government regulators and others to ascertain early on how much exposure the banks had to risky mortgage investments, he said.

Wright, meanwhile, said the general glut of information makes it difficult for bank leaders to pinpoint valuable advice and analysis.

"A responsible executive at these investment banks -- who should they listen to when there are a hundred bloggers out there and 50 analysts and they're not all saying the same thing? There's a lot of noise," Wright said.

Wright said that at the top levels of the investment banks, there might have also been a lack of understanding of how some complex mortgage investments worked.

"I can see scenarios where some hotshots came in with some fancy math and the older executives didn't understand the math but they didn't push it," he said. "What boss wants to say to an employee, 'I don't understand what you're talking about here?'"

The Government Safety Net: The term "too big to fail" has become a common catchphrase on Wall Street these days – it refers to the idea that the government, worried that the failure of a large financial institution would have wide-reaching, disastrous effects, will step in to save the day when necessary.

The government-backed purchase of the failed investment bank Bear Stearns by the financial firm JPMorgan is considered by some to be such a bailout, although others point out that Bear Stearns shareholders still took massive hits to their portfolios as part of the deal.

Wright said that Freddie Mac and Fannie Mae, which were established by the federal government but are owned by shareholders, have "the most solid and clearing backing" by the government and, therefore, "have tremendous incentive to take risk."

Recently, the government ironed out its support for Fannie and Freddie in a new housing bill. The bill, which was signed by President Bush last month, allows the Treasury Department to lend money to Fannie and Freddie and to buy stakes in the companies if they need to raise more capital.

In its statement Tuesday, Freddie Mac denied that the prospect of government intervention played a role in its investment decisions, adding "we have an obligation to balance safety and soundness, mission and our fiduciary duty to shareholders."