In order to meet these government quotas, Fannie and Freddie resorted to buying mortgage-backed securities based on subprime loans. This involved taking additional risks, since subprime loans were low quality because the borrowers generally had blemished credit records, but these loans were the most likely to meet the affordable housing goals. Wall Street and other firms made up pools of loans specifically to meet the GSEs requirements, and eventually Fannie and Freddie became the largest purchasers of the mortgage-backed securities issued against these pools of low-quality loans.
Moreover, in order to certify to HUD that they had met the quotas in any year, Fannie and Freddie had to know the percentage of loans in each pool that contributed to meeting the affordable housing goals and subgoals. It is likely, then, that in defending themselves in this suit, the banks will point out how much information the GSEs had about the loans they were buying, and hence that they assumed the risk.
Indeed, the GSEs were well aware of the additional risks they were assuming in buying subprime loans in order to comply with government requirements. For example, here is a statement in Fannie Maes 2006 10-K:
Fannie Mae 10K - "We have made, and continue to make, significant adjustments to our mortgage loan sourcing and purchase strategies in an effort to meet HUDs 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 that are more likely to serve the borrowers targeted by HUDs goals and subgoals, which could increase our credit losses."
In effect, then, the government is suing 17 banks for helping Fannie and Freddie meet the governments own affordable housing quotas.
