New Questions About the Financial Crisis Inquiry Commission

By Peter J. wallison.



The report of the Financial Crisis Inquiry Commission (FCIC) is frequently cited as the authoritative source for the causes of the 2008 crisis, but its key findings are contradicted by documents in its own files that were never disclosed in its final report.


• By 2008, most mortgages in the US were subprime or otherwise weak. Of these risky loans, 76 percent were on the books of government agencies, principally Fannie Mae and Freddie Mac.
• The FCIC claimed that Fannie and Freddie bought these loans primarily because they were profitable, and not because of the government’s housing policies—particularly the affordable housing goals.
• However, the FCIC documents discussed in this paper show that Fannie and Freddie knew these loans would be unprofitable and in some cases loss-producing.
• As a government study commission, the FCIC failed in its obligation to report fairly on all the evidence it collected, not just the evidence for the story it wanted to tell.


The Financial Crisis Inquiry Commission (FCIC) is often cited as the definitive source for information about the causes of the 2008 financial crisis. I was a member of the FCIC and dissented1 from its majority report,2 which was issued in January 2011.3 However, in my subsequent research for a book on the financial crisis,4 I found that the principal findings and conclusions in the commission’s report were contradicted by materials in the commission’s own files—materials that were never made available to me or, I believe, to the FCIC’s other members. Whether this was error or deception is not clear, but clearly, a major report by a publicly funded commission appointed by Congress did not adequately inform the American people or their representatives.


The Fundamental Question


Everyone agrees that the precipitating event of the financial crisis was a “mortgage meltdown”—that is, defaults among a large number of subprime and other risky mortgages5 that were in the US financial system in 2007 and 2008. The meltdown caused a sharp decline in mortgage and housing values, weakening the financial condition of many banks and other financial firms that held these assets and leading eventually— after Lehman Brothers’ bankruptcy—to the 2008 financial crisis.

The fundamental question for the commission, therefore, was why there were so many subprime and other risky mortgages in the US financial system in 2007 and 2008. In my dissent, which was based on the research of my AEI colleague Edward Pinto,6 I argued that government housing policies—principally the affordable housing goals7—were responsible for this phenomenon. I had not seen much of the data in this paper until I had begun work on my book.

In 1992, Congress adopted the affordable housing goals, which required the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac to meet certain quotas when they acquired mortgages

 The Increase in the Affordable Housing Goals and the GSEs’ Efforts to Comply


from banks and other originators. Before and after 1992, the GSEs were the dominant players in the US housing finance system. As noted by a US Department of Housing and Urban Development (HUD) commission as early as 1991, their underwriting standards set the standards for the market as a whole.8 The GSEs did not make mortgages; they bought mortgages from banks and other originators, thus creating a liquid secondary market that fostered vigorous mortgage lending by banks and other originators. By 2008, Fannie and Freddie together held about $1.5 trillion in whole mortgages and mortgage-backed securities (MBS), and had guaranteed mortgage-backed securities totaling approximately $3.5 trillion. They were thus, by far, the largest holders of mortgages and mortgage credit risk in the United States.

The government’s affordable housing goals required that a certain number of the mortgages acquired by the GSEs each year be made to borrowers who were at or below the median income in their communities. At first, the quota was 30 percent—that is, in any year, 30 percent of all mortgages bought by the GSEs had to be made to these borrowers. There were also other special goals for low-income borrowers and minorities. HUD was given authority to increase these goals, and it did so, aggressively, between 1996 and 2008. Chart 1 shows the increases in the goals. The top set of lines are the low- and moderate-income (LMI) goals; the two lower sets of lines are special goals for underserved (i.e., minority) borrowers and very-low-income borrowers (80 percent or 60 percent of median income).

The increases in the goals had a major effect on the GSEs’ underwriting standards. Before the goals were enacted, the GSEs generally bought only prime mortgages (a prime mortgage had a 10–20 percent down payment, a borrower credit score above 660, and borrower debt-to-income ratio of no more than 38 percent). After the goals came into force and especially as they were increased between 1996 and 2008, the GSEs found that they could not find a sufficient number of prime mortgages to meet the goals; there were simply not enough prime borrowers below median income. Accordingly, Fannie and Freddie gradually reduced their underwriting standards through the 1990s and into the 2000s in order to acquire nonprime loans and thus meet the affordable housing quotas.

Reduced standards could not be limited to low-income borrowers. Even homebuyers who could have afforded prime mortgages were happy to take mortgages with much lower (or zero) down payments. By 2007

37 percent of loans with down payments of 3 percent went to borrowers with incomes above the median.9 Thus the lower underwriting standards—meant to assist low- or middle-income borrowers—spread to the wider market.

This produced the largest housing price bubble in modern history between 1997 and 2007, when it finally began to deflate, as shown in Figure 2.

It’s easy to see how lower underwriting standards can result in a housing bubble. If a potential buyer has saved $10,000 to buy a home and the underwriting standard requires a 10 percent down payment, he can buy a $100,000 home. But if the underwriting standard is reduced to 5 percent, he can buy a $200,000 home. Instead of borrowing $90,000, he borrows $190,000. This not only puts upward pressure on home prices, but also makes the borrower a weaker credit risk.

Thus, my explanation for why there were so many subprime and other risky mortgages in the financial system pointed to the government’s policies—principally the affordable housing goals—that required Fannie and Freddie to reduce their underwriting standards and to acquire large numbers of these mortgages. As they reduced their underwriting standards, the wider market followed. When the bubble finally deflated, the defaulting mortgages weakened many financial 3

institutions. Fannie and Freddie themselves became insolvent in September 2008 and were taken over in a government conservatorship.

The commission’s majority report never cited any particular numbers for subprime and risky mortgages in the financial system before the crisis, but Pinto’s analysis concluded that 31 million such mortgages were outstanding in 2008.10 This was more than a majority of the 55 million US mortgages outstanding at the time. Of these 31 million, as shown in Figure 3, 76 percent were on the books of government agencies, principally Fannie and Freddie. This shows, without question, that the government had created the demand for these mortgages.

The FCIC’s View


The FCIC’s explanation for the GSEs’ acquisition of these risky mortgages was entirely different. According to its majority report, the banks and other mortgage originators had acted on their own to reduce their underwriting standards—because they were greedy, insufficiently regulated, and took too many risks. Here is a typical statement from the FCIC’s report:

There was a view that instincts for self-preservation inside major financial firms would shield them from fatal risk-taking without the need for a steady


Entities Exposed to the Credit Risk of Subprime and Other High-Risk Mortgages as of June 30, 2008


regulatory hand, which, the firms argued, would stifle innovation. Too many of these institutions acted recklessly, taking on too much risk, with too little capital, and with too much dependence on short-term funding. In many respects, this reflected a fundamental change in these institutions, particularly the large investment banks and bank holding companies, which focused their activities increasingly on risky trading activities that produced hefty profits.

This was at least a plausible explanation for why private firms might have been willing to take substantial risks on mortgages, but as I’ve shown in Figure 3, most of these mortgages were acquired by government agencies, primarily Fannie and Freddie. Yes, they were initially made by banks and other private lenders, but they were bought by the GSEs. Indeed, if the GSEs had not been eager to buy these loans—to meet the affordable housing quotas—these loans would never have been made. The banks and other originators that made them certainly did not want to hold most of these subprime and risky mortgages on their books; they wanted to sell them to the government, primarily Fannie and Freddie. So in my view it is not a difficult question why Fannie and Freddie would abandon their traditional prime mortgage standards and buy so many of these

risky mortgages. The affordable housing goals were the answer, and that’s the answer I pressed upon the FCIC.

The FCIC refused to accept this view, but it was still necessary to explain why the GSEs had acquired so many subprime and other risky mortgages. Accordingly, the commission’s majority report adopted the idea that Fannie and Freddie wanted these mortgages for profit and market share, in order to please investors on Wall Street:


Our examination revealed stunning instances of governance breakdowns and irresponsibility. You will read, among other things, about . . . Fannie Mae’s quest for bigger market share, profits, and bonuses, which led it to ramp up its exposure to risky loans and securities as the housing market was peaking.11

We find that the risky practices of Fannie Mae . . . particularly from 2005 on, led to its fall: practices undertaken to meet Wall Street’s expectations for growth, to regain market share, and to ensure generous compensation for its employees. Affordable housing goals imposed by the Department of Housing and Urban Development (HUD) did contribute marginally to these practices.12


Not coincidentally, FCIC Chairman Phil Angelides favored this explanation. Angelides was a Democrat, a friend of then-House Speaker Nancy Pelosi, and a strong believer that the crisis was caused by insufficient regulation of an irresponsible private financial sector. He saw the commission as another opportunity, like the Pecora hearings in the 1930s, to blame the private sector for a financial disaster. The Pecora hearings, conducted by Ferdinand Pecora, the chief counsel of the Senate Banking Committee, blamed the Depression on the country’s largest financial institutions, and Angelides mentioned several times in commission meetings that he saw the FCIC as a new Pecora inquiry. A strong report supporting the idea that the private sector was responsible for the mortgage collapse would provide a foundation—as the Pecora Commission did— for tough new regulatory legislation. This goal was realized in 2010 with the enactment of the Dodd- Frank Act.


Did the GSEs Acquire Subprime and Alt-A Mortgages for Profit?


Fannie and Freddie were by far the largest buyers of both whole subprime mortgages and private mortgage-backed securities that were backed by subprime or other risky mortgages. Had they bought these mortgages because they were profitable assets, that would have been a plausible explanation for the GSEs’ substantial exposures. A profit motive for buying these mortgages would also have supported the notion that the affordable housing goals were irrelevant (or “marginal” as the FCIC report described them) as a reason for the GSEs’ purchases. To sustain this idea, the majority report minimized the GSEs’ difficulties in meeting the goals, with statements such as:

In 2003 and 2004, Fannie Mae’s single- and multifamily purchases alone met each of the goals; in other words, the enterprise would have met its obligations without buying subprime or Alt-A13 mortgage-backed securities. In fact, none of Fannie Mae’s 2004 purchases of subprime or Alt-A securities were ever submitted to HUD to be counted toward the goals.14

This statement, for which no support was provided, is directly contradicted by a 2005 memorandum to Fannie’s CEO, Dan Mudd, from Adolfo Marzol, then Fannie’s chief credit officer. In his report, Marzol states that “large 2004 private label [private MBS] volumes were necessary to achieve challenging minority lending goals and housing goals.”15 This is only one example of the commission’s failure to report what was in its own

records, where those documents were inconsistent with the case the commission was trying to make.

Indeed, I found a great deal of material in the commission’s files that contradicted the conclusions in the majority report. This evidence shows that the mortgages acquired by the GSEs between 2003 and 2008 (the period covered by the FCIC’s majority report) not only were unprofitable but in some cases were producing losses for both Fannie and Freddie.

It is impossible to know whether Angelides, who hired the staff and controlled what the commission studied and who it interviewed, was aware that the commission had received documentary information that was inconsistent with its assertion that the GSEs were buying subprime and other risky mortgages for profit.

One peculiarity of the FCIC’s investigation is that it developed much of its evidence from interviews. These were not generally taken under oath, and the commission members were not told when these interviews were occurring or given an opportunity to attend. In the transcripts I’ve seen, the witnesses were not confronted with documentary evidence that would at least refresh their memories, and there was no cross-examination. The commission’s report, accordingly, is dominated by statements from witnesses whose motives or recollections were never challenged. This enabled the commission to cherry-pick statements in the interviews that supported its position.

Documentary evidence that the GSEs were suffering losses on the mortgages they bought to meet the goals is widespread throughout the commission’s files, and it is difficult to believe that Angelides and the top staff were not aware of it. I am reasonably sure, however, that the members of the commission, even those who voted for the final report, were not aware that these documents existed. With very few exceptions, the commission members were never given an opportunity to review the information the commission had collected.

In the discussion below, I cite numerous examples of documents in the commission’s files that show the GSEs’ difficulties in meeting the affordable housing goals and the plain fact that the loans they bought for this purpose were not profitable. This does not necessarily mean that these loans caused losses in all cases, but simply that they were not—as the FCIC alleged— bought for purposes of profit. None of the materials cited below were included in the FCIC’s report, even though they either had been received by the commission in the course of its investigation or were public documents that were published while the commission was preparing its report.



Unreported Documentary Evidence That Contradicts the Commission’s Conclusions


The commission’s report persistently downplayed the pressures that the goals placed on the GSEs. For example, the FCIC majority stated that before 2005 “the goals were intended to be only a modest reach beyond the mortgages that the GSEs would normally purchase.”16 Yet, as early as 2003 a Fannie Mae document outlined the severe disruptions associated with meeting the goals and the fact that the loans acquired for that purpose were not profitable:

In 2002, Fannie Mae exceeded all our goals for the 9th straight year. But it was probably the most challenging environment we’ve ever faced. Meeting the goals required heroic 4th quarter efforts on the part of many across the company. Vacations were cancelled. The midnight oil burned. Moreover, the challenge freaked out the business side of the house. Especially because the tenseness around meeting the goals meant that we considered not doing deals—not fulfilling our liquidity function—and did deals at risks and prices we would not have otherwise done.17

Relying on statements by interested parties rather than documentary materials, the FCIC’s report also noted that “all but two of the dozens of current and former Fannie Mae employees and regulators interviewed on the subject told the FCIC that reaching the goals was not the primary driver of the GSEs’ purchases of riskier mortgages.”18 But in a speech to Fannie’s top staff after almost a year as chairman and CEO of Fannie, Daniel Mudd stated:

We project extreme difficulty meeting our minority goals in 2005, and a progressive squeeze on HUD goals from 2006 on. . . . There is no easy work left here. It is clear to me that after a full year of managing the goals lending efforts—the primary market is simply not going to deliver us the business it should. We meet monthly to review the numbers and the deals. We have studied FHA, new products, new channels, and alternative structures . . . and concluded that there is only one place to change the market and acquire the business in sufficient size—subprime.19

Similarly, the FCIC’s report quoted Robert Levin, the chief business officer of Fannie, for the idea that “there was no trade-off [between making money and hitting goals],”20 but in a slide presentation to HUD on October 31, 2005, entitled “Update on Fannie Mae’s Housing Goals Performance,” Fannie noted several 6

Undesirable Tradeoffs Necessary to Meet Goals.” These included “Deal economics are well below target returns; some deals are producing negative returns” and “G-fees may not cover expected losses.”21

On the simple question of whether the goals-related mortgage purchases were made because they were profitable, the FCIC’s position is contradicted by a Fannie staff slide presentation in June 2005 entitled “Costs and Benefits of Mission Activities.” The authors noted:


Meeting Future HUD Goals Appear Quite Daunting and Potentially Costly. . . . Based on 2003 experience where goal acquisition costs (relative to Fannie Mae model fees) cost between $65 per goals unit in the first quarter to $370 per unit in the fourth quarter, meeting the shortfall could cost the company $6.5–$36.5 million to purchase sufficient units.22


The presentation concluded with slide 20: “Cost of mission activities—explicit and implicit—over the 2000–2004 period likely averaged approximately $200 million per year.23


The FCIC ignored even published reports, easily accessed on the Securities and Exchange Commission (SEC) website, when they were inconsistent with its position that subprime mortgages were bought because they were profitable. In its 2006 10-K report to the SEC, for example, Fannie noted:


[W]e have made, and continue to make, significant adjustments to our mortgage loan sourcing and purchase strategies in an effort to meet HUD’s increased housing goals and new subgoals. These strategies include entering into some purchase and securitization transactions with lower expected economic returns than our typical transactions. We have also relaxed some of our underwriting criteria to obtain goals-qualifying mortgage loans and increased our investments in higher-risk mortgage loan products [i.e., private MBS] that are more likely to serve the borrowers targeted by HUD’s goals and subgoals, which could increase our credit losses.24


Fannie and Freddie both used models that stated their mortgage risks in terms of what they called “guarantee fees” or G-fees; the riskier the mortgage, according to their analysis, the higher the guarantee fee they would expect to receive for holding or guaranteeing it. A guarantee fee that is not adjusted for the riskiness of the mortgage it covers would be likely to produce a loss rather than a profit. On June 22, 2007, a Fannie staff meeting considered three plans to meet the 2007 goals. One of the plans was forecast to result in “opportunity costs” of $767.7 million, while the other two plans


Fannie Mae Took Losses on Higher-Risk Mortgages Necessary to Meet the Affordable Housing Goals.




resulted in opportunity costs of about $817 million.25 An opportunity cost was the difference between acquiring a mortgage that was profitable under Fannie’s guarantee fee model and one that was not—that is, where anticipated losses were projected to reduce, eliminate, or exceed anticipated profits. In other words, Fannie was anticipating that to meet the affordable housing goals quota for 2007 it would either have to forgo profits in acquiring those loans or actually suffer losses.

A sense of how difficult it became for the GSEs to meet their goals in the mid-2000s is given by a summary of the problem in a Fannie staff presentation on the 2007 housing plan: “Regular business misses goals by a significant amount. Execution of special initiatives [will be] required to meet the goals; will come down to the wire again.”26 The “special initiatives” were such special deals as My Community Mortgage (MCM), Expanded Approval (EA), and DU Boost (occasionally called DU Bump)—all of which referred to tweaks in Fannie’s automated underwriting system (called Desktop Underwriter or DU) so that it would accept loans and private MBS that would otherwise have been rejected as too risky.

In this connection, Fannie used the term “G-fee gap” to describe the difference between the G-fee that they should receive to hold or guarantee a loan and the G-fee they actually offered to acquire the loan. If the loans were expected to be profitable, the G-fee gap would be zero. The mere fact that Fannie was buying loans with a G-fee gap was irrefutable evidence that the loans did not meet Fannie’s profit expectations—in fact, that they were likely losers. 7

Obviously, it was wrong for the FCIC majority to conclude that the GSEs were acquiring these loans because they were profitable; in fact, in many cases Fannie Mae’s staff expected them to be losers. It is equally obvious that the GSEs acquired them only to meet the affordable housing goals. Table 1, prepared by Fannie staff for a meeting on various plans to meet the goals, shows the costs of these subprime loans in terms of the G-fee gap. Although other riskier options were considered, I will focus only on the 30-year fixed-rate product, shown in bold type in the table.

The table shows that the base product, the 30-year FRM, with a zero down payment should be priced according to Fannie’s model at a G-fee of 106 basis points (bps). However, the Fannie staff memo reports that Fannie was actually buying loans like that at a price consistent with an annual G-fee of 37.50 bps, producing a gap (or loss from the model) of 68.50 bps. The reason the gap is so large is shown in the table: the anticipated default rate on that zero-down mortgage was 34 percent. The table then looks at other possible loan alternatives, with the results made clear in the table.

From this table, it is clear that to meet the affordable housing goals Fannie had to pay up for goals-rich mortgages, taking a huge credit risk along the way. In no sense were these loans profitable in the opinion of the Fannie staff who were making this decision; they were more like deferred losses, and when the losses came, both Fannie and Freddie became insolvent.

Everything that was true of Fannie Mae was also true of Freddie Mac. In a 2009 report to a committee of the  board of directors, Freddie’s management summarized several points that show Freddie’s experience was almost identical to Fannie’s:


• “Our housing goals compliance required little direct subsidy prior to 2003, but since then subsidies have averaged $200 million per year.”
• “Higher credit risk mortgages disproportionately tend to be goal-qualifying. Targeted affordable lending generally requires ‘accepting’ substantially higher credit risk.”
• “We charge more for targeted (and baseline) affordable single-family loans, but not enough to fully offset their higher incremental risk.”
• “Goal-qualifying single-family loans accounted for the disproportionate share of our 2008 realized losses that was predicted by our models.”27
• “In 2007 Freddie Mac failed two subgoals, but compliance was subsequently deemed infeasible by the regulator due to economic conditions. In 2008 Freddie Mac failed six goals and subgoals, five of which were deemed infeasible. No enforcement action was taken regarding the sixth missed goal because of our financial condition.”28
• “Goal-qualifying loans tend to be higher risk. Lower household income correlates with various risk factors such as less wealth, less employment stability, higher loan-to-value ratios, or lower credit scores.”29
• “Targeted affordable loans have much higher expected default probabilities. . . . Over one-half
of targeted affordable loans have higher expected default probabilities than the highest 5% of non-goal-qualifying loans.”30


These examples show that, contrary to the FCIC’s report, Fannie and Freddie had great difficulty meeting the goals, especially as they increased after 2003. Although these loans did not cause losses in the early 2000s, beginning in 2002 or 2003 they certainly did.

Did the GSEs Acquire Subprime and Other High-Risk Loans for Market Share?


The idea that the GSEs were interested in market share—as a business matter—vis-à-vis the private sector was never very plausible. Of course, they were fierce competitors with one another, and market share was important in that context, but because of their perceived government backing they could increase their share of the prime market virtually at will by reducing their guarantee fees. Doing that made them a lower-cost provider of mortgage securitization services for banks and other originators, and would attract more business.

However, Table 2, a table published by their former regulator, the Office of Federal Housing Enterprise Oversight, shows that they did not lower their guarantee fees between 2003 and 2007, the period covered in the FCIC table. During this period, as the table below makes clear, their average guarantee fee increased, which would inevitably reduce their market share.


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Fannie Mae Credit Profile by Key Product Features: Credit Characteristics of Single-Family Conventional Mortgage Credit Book of Business


They likely had to increase their average G-fees during this period to make up for the lower G-fees they had to accept for riskier loans.

So the commission was also wrong to hypothesize that the GSEs were acquiring high-risk loans for market share, just as it was wrong to claim that the GSEs acquired these mortgage for profit. The fact that the commission’s conclusions can be questioned based on public records is particularly troubling because it casts doubt on the thoroughness of its entire report.


The GSEs Own Public Reports


Nothing more effectively confirms the FCIC’s disinterest in the alternative explanations for the financial crisis than its failure to discover or acknowledge what the GSEs were publicly reporting at the very time the commission was placing lack of regulation and Wall Street greed at the center of the financial crisis. In 2009, after both Fannie and Freddie were taken over by a government conservatorship, Fannie finally published a complete credit supplement to its annual 10-K report to the SEC. A table from this supplement—issued on August


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6, 2009, for the quarter ended June 30, 2009—is reproduced as Table 3. I have highlighted the key data.


There are two things to note about the Fannie report. First, across the top of the table are the kinds of loans that the GSE considered to be its riskiest investments. These include mortgages to borrowers with credit scores less than 660 (the accepted definition of a subprime loan), mortgages with down payments less than 10 percent, and Alt-A loans.31

These are the very loans they had to acquire to meet the affordable housing goals. It is true that these loans were not as risky as those securitized by the private sector, but they amounted to $878 billion in unpaid principal balances on Fannie’s books and were risky enough, according to the table, to cause 81.3 percent of Fannie’s losses in 2008, the year it became insolvent and was taken over by the government. They are also precisely the mortgages that Edward Pinto had identified—and the FCIC report had denied—as the source of the GSEs’ insolvency. To acquire these loans, the GSEs had reduced their underwriting standards and thus set off a general reduction of underwriting standards in the wider housing market.

Second, Fannie’s report was issued in June 2009, shortly before the commission began its work, but like

all the other evidence I have cited, it was not included or commented on in the commission’s report. Omitting this data, whether deliberately or otherwise, enabled the commission to claim that the financial crisis was caused by insufficient regulation of the private sector, primarily Wall Street, and that government policy, implemented through Fannie Mae and Freddie, had only a marginal role.




Thus, despite a charge to inform the American people, Congress, and the president about why the US experienced a financial crisis, the FCIC failed in this mission, and its majority report should not be regarded as the definitive account of what caused the 2008 financial crisis.


© 2016 by the American Enterprise Institute. All rights reserved.

The American Enterprise Institute (AEI) is a nonpartisan, nonprofit, 501(c)(3) educational organization and does not take institutional positions on any issues. The views expressed here are those of the author(s).


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