5 Second Amended Complaint 03/02/2012
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W a a UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF NEW YORK In re FANNIE MAE 2008 SECURITIES LITIGATION COMPREHENSIVE INVESTMENT SERVICES, INC. Plaintiff, No. 08-CV-07831-PAC MDL No. 09-2013 No. 09-CV-06102-PAC -vs- FANNIE MAE, DANIEL H. MUDD, ROBERT J. LEVIN, STEPHEN M. SWAD ENRICO DALLAVECCHIA, CITIGROUP GLOBAL MARKETS, INC., and WACHOVIA CAPITAL MARKETS, LLC., Defendants. SECOND AMENDED COMPLAINT
Transcript of 5 Second Amended Complaint 03/02/2012
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UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF NEW YORK
In re FANNIE MAE 2008 SECURITIES LITIGATION
COMPREHENSIVE INVESTMENT SERVICES, INC.
Plaintiff,
No. 08-CV-07831-PAC MDL No. 09-2013
No. 09-CV-06102-PAC
-vs-
FANNIE MAE, DANIEL H. MUDD, ROBERT J. LEVIN, STEPHEN M. SWAD ENRICO DALLAVECCHIA, CITIGROUP GLOBAL MARKETS, INC., and WACHOVIA CAPITAL MARKETS, LLC.,
Defendants.
SECOND AMENDED COMPLAINT
Case 1 :08cw07831 PAC Document 348 Filed 03/02/12 Page 2 of 121
TABLE OF CONTENTS
I. PARTIES
A. Comprehensive Investment Services, Inc........
B. Federal National Mortgage Association...........
C. Underwriter Defendants ...................................
D. Officer Defendants ...........................................
II. JURISDICTION AND VENUE.................................
III. OVERVIEW..
IV. FACTS .....................................................................................................................
A. Fannie Mae In Brief The"Worst Run Financial Institution ........................
B. The Growing Subprime Market ......................................................................
1. The Mortgage Market: Creative Financing ....................................................
2. Classifications of Mortgage Loans: Prime Loans vs. Risky Loans ................
a. Prime Mortgage Loans ............................................................................
b. Risky Subprime Mortgage Loans............................................................
C. Risky Alt-A Mortgage Loans ..................................................................
C. Fannie Mae's Exposure to Risky Subprime and Alt-A Mortgages................
1. Fannie Mae Ramps Up its Involvement in Subprime and Alt-A Mortgages..
2. Fannie Mae Conceals Risk Exposure ..............................................................
D. Fannie Mae's Capital Base..............................................................................
1. Deferred Tax Assets ........................................................................................
2. Failure to Write Down Other-Than-Temporary Impairments.........................
3. Insufficient Loss Reserves ..............................................................................
4. Weak Risk-Based Capital................................................................................
5. The Reality of Fannie Mae's Financial Position .............................................
E. Fannie Mae's Risk Management Failures .......................................................
F. Defendants Misrepresents Risks .....................................................................
G. Defendants Materially Misrepresented Fannie Mae's Mortgage Portfolio ....
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H. The Materially False and Misleading Offering Circular ................................................74
V. UNDERWRITER DEFENDANTS .........................................................................................79
VI. OFFICER DEFENDANTS' SCIENTER ...............................................................................90
A. Mudd ..............................................................................................................................93
B. Levin...............................................................................................................................96
C. Swad ...............................................................................................................................99
D. Dallavecchia .................................................................................................................100
VII. LOSS CAUSATION ...........................................................................................................101
VIII. CAUSES OF ACTION ......................................................................................................104
A. Statutory Fraud....................................................................................................................104
1. Primary Violations of Statutory Fraud .....................................................................105
2. Statutory Fraud Aiding & Abetting ..........................................................................105
B. Texas Securities Act.....................................................................................................107
1. Primary Violations of the Texas Security Act .............................................................107
2. Texas Securities Act Control Persons ..........................................................................108
3. Texas Securities Act Aiding & Abetting .....................................................................109
C. Common Law Fraud.....................................................................................................111
D. Negligent Misrepresentation ........................................................................................112
E. Violation of Section 10(b) of the Exchange Act ..........................................................113
F. Violation of Sction 20(a) of the Exchange Act ............................................................116
X. PRAYER ................................................................................................................................ 116
CERTIFICATE OF SERVICE .............................................................................119
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SECOND AMENDED COMPLAINT
Plaintiff Comprehensive Investment Services, Inc. ("CIS" or "Plaintiff') files this Second
Amended Complaint against Daniel H. Mudd, Robert J. Levin, Stephen M. Swad, Enrico
Dallavecchia, Federal National Mortgage Association, Wachovia Capital Markets, LLC, and
Citigroup Global Markets, Inc.
I. PARTIES
A. Comprehensive Investment Services, Inc.
1. Plaintiff CIS is a Nevada corporation with its principal place of business in
League City, Texas. CIS is a wholly owned subsidiary of American National Insurance
Company.
B. Federal National Mortgage Association
2. Defendant Federal National Mortgage Association ("Fannie Mae") is a
government-sponsored enterprise ("USE") chartered by Congress, with its principal place of
business located at 3900 Wisconsin Avenue NW, Washington, D.C. 20016-2892. Fannie Mae
may be served with process upon its attorney, Mike Walsh, O'Melveny & Myers LLP 1625 Eye
Street, N.W. Washington, D.C. 20006-4001. Fannie is owned by the shareholders, and its
equity securities were listed and traded on the NYSE during the relevant period. Fannie Mae
operates in the U.S. secondary mortgage market by providing funds to mortgage lenders through
the purchase of mortgages and mortgage-related securities. Fannie also issues and guarantees
mortgage-related securities. On May 13, 2008 Fannie Mae issued, and Plaintiff purchased,
8.25% non-cumulative preferred stock, Series T, which forms the basis of this lawsuit (the
"Preferred Stock").
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C. Underwriter Defendants
3. Defendant Citigroup Global Markets, Inc. ("Citigroup"), incorporated in New
York, is a subsidiary of Citigroup Inc., a financial services institution that provides commercial
and investment banking services to corporate entities. Citigroup underwrote the Preferred Stock.
4. Defendant Wachovia Capital Markets, LLC, incorporated in Delaware, is a
financial services institution that provides commercial and investment banking services to
corporate entities. Wachovia Capital Markets, LLC underwrote the Preferred Stock and its
affiliate broker/dealer acted as a common business enterprise, and is referred to herein as
"Wachovia Securities." Wachovia Securities is a Wells Fargo Stock Company and today goes by
the name Wells Fargo Securities LLC.
5. Defendants Citigroup and Wachovia Securities are herein collectively referred to
as the "Underwriter Defendants".
D. Officer Defendants
6. Defendant Daniel H. Mudd ("Mudd") was Fannie Mae's President and Chief
Executive Officer from June 2005 to September 2008. Mudd was also Fannie Mae's Vice
Chairman of the Board from February 2000 to June 2005, Interim Chief Executive Officer from
December 2004 to June 2005 and Chief Operating Officer from February 2000 to December
2004.
7. Defendant Robert J. Levin ("Levin") was Fannie Mae's Executive Vice President
and Chief Business Officer from November 2005 to September 2008. Levin was Fannie Mae's
Interim Chief Financial Officer from December 2004 to January 2006, Executive Vice President
of Housing and Community Development from June 1998 to December 2004 and Executive
Vice President-Marketing from June 1990 to June 1998.
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8. Defendant Stephen M. Swad ("Swad") was Fannie Mae's Executive Vice
President from May 2007 to September 2008. Swad was also Fannie Mae's Chief Financial
Officer from August 2007 to September 2008.
9. Defendant Enrico Dallavecchia ("Dallavecchia") was Fannie Mae's Executive
Vice President and Chief Risk Officer from July 2006 until January 2009. Dallavecchia also
chaired the Allowance for Loan Losses Oversight Committee during his term as Chief Risk
Officer.
10. Mudd, Levin, Swad, and Dallavecchia are herein collectively referred to as
"Officer Defendants".
II. JURISDICTION AND VENUE
11. This Court has jurisdiction under the Exchange Act of 1934 (the "Exchange
Act"), 15 U.S.C. §§ 78j(b) and 78t, and Rule lOb-5, 17 C.F.R. § 240.10b-5. This Court has
jurisdiction over the subject matter of this action pursuant to 28 U.S.C. §§ 1331 and 1332,
section 27 of the Exchange Act, 15 U.S.C. § 78aa. This action arises under the laws of the United
States and involves federal questions.
12. Venue is proper in the Southern District of Texas pursuant to the federal securities
laws asserted by Plaintiff and pursuant to 28 U.S.C. § 1391 because a substantial part of the
events or omissions giving rise to the claim occurred in Galveston County, Texas. The action
was transferred to this Court pursuant to the Rules of Procedure of the Judicial Panel on
Multidistrict Legislation adopted under 28 U.S.C. § 1407 is pending in the Southern District of
New York for pre-trial purposes only. CIS has not been joined or consolidated with any other
action and has been proceeding on its own procedural track. The Court has supplemental
jurisdiction over Plaintiff's state law claims pursuant to 28 U.S.C. § 1367.
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13. The Court has personal jurisdiction over all Defendants in connection with the
acts alleged in this complaint. Defendants, directly or indirectly, used the means and
instrumentalities of interstate commerce, including, but not limited to, the mails, interstate
telephone communications, and the facilities of the national securities markets. All Defendants
are residents of the United States and have availed themselves of the federal securities laws and
the laws of the State of Texas. The Court has jurisdiction over the parties and subject matter of
this cause, and has jurisdiction to grant all relief requested by Plaintiff.
III. OVERVIEW
14. In May 2008, Plaintiff purchased 600,000 shares of the Preferred Stock for $15
million. The prospectus for the Preferred Stock (the "Offering Circular") was dated May 13,
2008 and specified an issue date of May 19, 2008.
15. Plaintiff purchased the Preferred Stock from Wachovia Securities.
16. Not long after Plaintiff purchased the Preferred Stock, its value took a nosedive.
The shares are now worthless on the open market.
17. Unknown to Plaintiff at the time it purchased the Preferred Stock, Defendants
had, for a substantial period of time, secretly directed Fannie Mae to engage in high-risk
transactions. In 2006, the Officer Defendants made numerous public statements assuring the
public that all accounting issues from previous accounting scandals had been resolved and that
Fannie Mae's financial statements honestly represented Fannie Mae's true financial condition.
18. Each Officer Defendant deceived the investing public in numerous ways. The
Officer Defendants continuously made deceptive and misleading public statements in press
releases and during conference calls with investors. Each Officer Defendant knew or should
have known, but failed to reveal, the absence of adequate risk controls. The Officer Defendants
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caused Fannie Mae's financial statements to be materially false and misleading. Included in the
false financial statements are Fannie Mae's 2007 10-K and 2008 First Quarter 10-Q which were
referenced in the Offering Circular. The Officer Defendants approved and/or assisted in
preparing both the financial statements and the Offering Circular for filing with the SEC. As a
result of each Officer Defendant's wrongful and illegal conduct, each is liable to Plaintiff under
state and/or federal law. Fannie Mae also made numerous actionable misrepresentations and
omissions of material fact.
19. The Underwriter Defendants were responsible for performing due diligence and
placing the Offering Circular for dissemination to the investing public. The Underwriter
Defendants were aware, at the time of the offering, of Fannie Mae's prior accounting problems
and ignored the numerous red flags that minimal due diligence would have revealed.
20. According to the Offering Circular, the Underwriting Defendants collectively
received between $53.128 million and $63 million in fees for performing underwriting functions.
In other words, the Underwriter Defendants benefited substantially from failing to perform due
diligence and placing the Preferred Stock. Further, the Underwriter Defendants actively solicited
Plaintiff and sold the Preferred Stock to Plaintiff all the while misrepresenting Fannie Mae's true
financial condition. The Offering Circular approved by the Underwriter Defendants contained
actionable misrepresentations and actionable omissions of material fact.
21. This suit arises out of Defendants' wrongful acts and omissions in connection
with the sale of the Preferred Stock to Plaintiff.
Iv. FACTS
A. Fannie Mae in Brief—The "Worst Run Financial Institution"
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22. Fannie Mae, although shareholder owned, is a USE. According to the Offering
Circular used to solicit Plaintiff's purchase of Preferred Stock, Fannie Mae is a "federally
chartered and stockholder-owned corporation organized and existing under the Federal National
Mortgage Association Charter Act, 12 U.S.C. § 1716 et seq."
23. Fannie Mae was established in 1938 to provide stability and liquidity to the
mortgage market and became a stockholder-owned and privately managed corporation in 1968.
Fannie Mae operates in the secondary market securitizing mortgage loans into mortgage-backed
securities and other mortgage-related securities. Fannie Mae also purchases mortgage loans for
its mortgage portfolio. One of Fannie Mae's primary responsibilities is to manage and liquidate
federally owned mortgage portfolios in an orderly manner, with minimum adverse effects on the
residential mortgage market and minimal loss to the federal government
24. In 2004 Fannie Mae was investigated for irregular accounting practices.
25. Between 2005 and 2008, Fannie Mae purchased or guaranteed hundreds of
billions of dollars in loans to borrowers who were viewed by the lending industry as risky.
"Fannie Mae went from being the watchdog of credit standards and thoughtful innovators to the
leader in default prone loans and poorly designed products."' While Fannie Mae increased its
exposure to risk, its capital base became more and more nebulous. Fannie Mae was a financial
house of cards.
26. On March 7, 2008, apparently in an effort to continue its scheme to purchase yet
more risky debts, Mudd proposed a deal to the Undersecretary for Domestic Finance at the
Treasury Department wherein Fannie Mae would agree to raise new capital, if the Office of
1 Pinto, Edward J., "Statement of Edward J Pinto Before the Committee on Oversight and Government Reform United States House of Representatives," December 9, 2008.
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Federal Housing Enterprise Oversight ("OFHEO") 2 would lower Fannie Mae's portfolio cap. A
similar deal was proposed for Federal Home Loan Mortgage Corporations ("Freddie Mac"). In
an earlier letter to shareholders in Fannie Mae's 2007 Annual Report, Mudd said that through
decreased capital requirements, Fannie Mae could pay less for loans and allow an increase in
shareholder returns.
27. The OFHEO agreed to lower the capital requirements and Fannie Mae and
Freddie Mac said they would begin the process of raising more capital .3 However, in what
would be a telling turn of events, while Fannie Mae did go to the market to raise more capital,
Freddie Mac did not. 4 Specifically, Fannie Mae's method of raising new capital was to issue the
Preferred Stock, which Plaintiff purchased. Freddie Mac did not issue any similar stock
offerings. James Lockhart, the director of OFHEO, would later speculate that Freddie Mac did
not raise additional capital because of the threat of lawsuits. 5 Lockhart said that "[Syron, CEO of
Freddie Mac] was getting advice from attorneys about the high risks of raising capital before
releasing [quarterly earnings] ... and our lawyers could not disagree because we know about
their accounting issues." 6 Fannie Mae apparently had no such reservations, the Offering Circular
was distributed to would-be investors, and the Plaintiffs bought the Preferred Stocks.
28. In July of 2008, less than 90 days after the issuance of the Offering Circular and
Plaintiff's purchase of the Preferred Stock, Fannie Mae ran out of capital. Fannie Mae's
2 OFHEO is an agency within the Department of Housing and Urban Development charged with ensuring the capital adequacy and financial safety and soundness of Fannie Mae. See Neil Adler, Lfting Portfolio Cap Could Hurt Fannie, Freddie, Washington Business Journal (October 5, 2007).
"OFHELO, Fannie Mae and Freddie Mac Announce Initiative to Increase Mortgage Market Liquidity," OFHEO news release, March 19, 2008.
Financial Crisis Inquiry Report - Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, Submitted by the Financial Crisis Inquiry Commission, Pursuant to Public Law 111-21, January, 2011, (the "FCIC Report") pg. 315. CIS incorporates the FCIC Report into the Second Amended Complaint. 5 id 6 id
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common stock plummeted to less than $7 a share. On July 30, 2008, the newly passed Housing
and Economic Recovery Act dissolved OFHEO and gave new powers to the Federal Reserve
(the "FED") and the Office of the Comptroller of the Currency ("0CC") to regulate Fannie Mae.
The FED and the 0CC undertook a review of Fannie Mae in conjunction with the Financial
Crisis Inquiry Commission, created pursuant to Public Law 111-21, and it was discovered that
Fannie Mae's financial condition was "worse than their suspicions had led them to believe." 7
The examiner for the FED testified that Fannie Mae's operations were "unsafe and unsound."
The 0CC rejected Fannie Mae's forecasting methodologies. 8 Using its own metrics, the 0CC
found insufficient reserves for future losses and identified significant problems in credit and risk
management. 9 The 0CC issued a report in August of 2008 and stated that "given the role of
USEs and their market dominance, they should be industry leaders with respect to effective and
proactive risk management, productive analysis, and comprehensive reporting. Instead they
appear to significantly lag the industry in all respects." 10 On September 7, 2008, Congress, after
reviewing Fannie Mae's financial condition, determined that Fannie Mae was no longer in a
position to accomplish the task for which it was created. In a letter sent to Mudd around the
same time, the Federal Housing Finance Agency said that Fannie Mae was being placed into
conservatorship because of numerous concerns, including "imprudent decisions" made by Fannie
Mae's management and board and the "critical unsafe and unsound practices and conditions that
gave rise to the Enterprises' existing condition, the deterioration in overall asset quality and
significant earnings losses experienced through June 2008 as well as forecasted future losses." 11
Fannie Mae was deemed to be "the worst run financial institution" that the government examiner
7 FCIC Report pg. 317. 8 FCIC Report, pg. 317 9 FCIC Report, pg. 317 ° FCIC Report, pgs. 317-318
FCIC Report, pg. 318
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had seen in 30 years as a bank regular. 12 Congress placed the company in conservatorship - to
be run by the Federal Housing Finance Agency. 13 Fannie Mae's top executives were ousted and
replaced. 14 The Plaintiffs were left with the practically worthless Preferred Stocks.
29. On December 18, 2011 the Securities and Exchange Commission, after an
extensive investigation, determined that Fannie Mae, Mudd and Dallavecchia made false and
misleading statements that they knew materially false public misrepresentations. Defendants
knew that Fannie Mae improperly and deceptively misrepresented the size of the block of
business called Serious Delinquency Rates ("SDQ Rate") which the public would commonly call
"subprime mortgages."
B. The Growing Subprime Market
1. The Mortgage Market: Creative Financing
30. In the 1990's and early 2000's, the United States real estate market boomed due
to rising home values and low interest rates on mortgages. As a result, more Americans sought
financing for homeownership. Lenders competed for potential borrowers by lowering credit
standards and offering alternative mortgage products to people who would not have otherwise
qualified for a traditional loan.
31. Alternative mortgage products included:
(a) No-documentation and low-documentation loans: Known in the industry
as "liar loans," these loans involve practice of requiring little or no
documentation from the borrower.
12 FCIC Report, pg. 321 13 Mark Jickling, Fannie Mae and Freddie Mac in Conservatorship, Congressional Research Service, The Library of Congress, September 15, 2008. 14 1d.
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(b) Piggy-back loans: These combine a mortgage with a home-equity loan or
line of credit, allowing borrowers to finance more than 80 percent of the
home's value without paying for private mortgage insurance.
(c) Interest-only mortgages: These allow borrowers to pay only interest in the
loan's early years, which keep payments low for a time, but require that
the deferred payment of principal be made in the future through increased
monthly or balloon payments.
(d) Option adjustable-mortgages: These loans, called hybrid ARMs, 15 were
marketed with promotional or "teaser" rates during an introductory period
that later ballooned to much higher rates once the introductory period has
ended.
32. In addition to the increase in the number of mortgages, including alternative
mortgages, originated, many financial firms securitized mortgages by buying them from the
original lender, pooling them with other mortgages and then selling interests in the underlying
cash flow (the monthly mortgage payments from the borrowers to investors). This mortgage
securitization practice freed up capital for the original lender so that it could approve more and
more loans, which would be securitized as the cycle repeated again and again. As lenders
competed for business, and as the types of mortgages pooled during the securitization process
became more and more "creative," the mortgages themselves as well as the bundles of security
interests in their cash flow became increasingly risky.
33. As all Defendants knew, in the mid to late 2000's, the real estate and mortgage
markets experienced a tremendous downturn initiated and fueled by falling home values, rising
interest rates and the proliferation of high-risk mortgage loans. As a result, the market
' "ARM' refers to an "Adjustable Rate Mortgage."
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experienced a surge in mortgage defaults, causing increased exposure to losses for financial
institutions like Fannie Mae that were heavily invested in mortgage-backed securities.
2. Classifications of Mortgage Loans: Prime Loans vs. Risky Loans
34. There are various types of mortgage loan products with a correspondingly varying
degree of risk exposure. Mortgage loans differ based on factors such as loan rate, payment
options, maturity date and amortization of principal. When applying for a mortgage loan,
borrowers are generally placed into three major categories based upon the perceived risk that
they will default on their loan: Prime, Subprime and Alt-A.
35. Fannie Mae also offered two primary programs for borrowers with weaker credit
histories: the Expanded Approval /Timely Payment Rewards ("EA") program and the
'MyCommunityMortgage ("MCM") program.
36. In May 2001. Mudd wrote to the then-CEO noting that EA loans "are the highest
default risk loans we have ever done."
37. Various internal documents Fannie Mae documents carried EA loans as
"subprime loans."
a. Prime Mortgage Loans
38. Prime mortgage loans are of high quality and given to borrowers who are not
perceived as likely to default on their loans. Lenders use the Fair Isaac & Company ("FICO")
credit scoring system (in which a borrower is assigned a score ranging from 300 to 850) to
determine which borrowers qualify for prime loans. Generally, a borrower with a FICO score of
greater than 620 is considered eligible for a prime loan. Prime Mortgage borrowers have a good
past payment history, are unlikely to have filed bankruptcy or have had a past foreclosure, and
have a favorable loan-to-value ratio.
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b. Risky Subprime Mortgage Loans
39. Subprime mortgage loans are issued to borrowers with low or deficient credit
scores who do not qualify for a loan under conventional credit criteria and are therefore
perceived as more likely to default on their loan. Because of this higher likelihood of default,
Subprime loans are riskier than prime loans and subprime borrowers pay higher interest rates set
proportionate to the higher credit risk.
40. Subprime loans began to proliferate due to a confluence of factors including rising
home prices, declining incomes, historically low interest rates, intense lender competition,
innovations in the structure and marketing of mortgages, and an abundance of capital from
lenders and mortgage securities investors as a result of mortgage securitization 6
41. In 2006, subprime lending amounted to approximately 20 percent of the nation's
mortgage lending and approximately 17 percent of homes were purchased subject to subprime
mortgages. 17
C. Risky Alt-A Mortgage Loans
42. Alt-A borrowers generally have a clean credit history but may have some qualities
that increase the probability of default and risk to the lender, such as higher loan-to-value and
debt-to-income ratios or inadequate documentation of income. In theory, an Alt-A borrower was
self-employed, had good cash flow, a higher FICO score and a good credit history but for
whatever reason could not validate his income. In practice this would not always be the case.
43. Alt-A products were actively marketed to subprime borrowers so that any
practical difference between Alt-A and subprime loans was virtually eliminated. Alt-A loans are
16 Sandra L. Thompson, Dir., Div. of Supervision and Consumer Prot., Testimony Before the Committee on Banking, Housing and Urban Affairs, U.S. Senate: Federal Deposit Insurance Corporation on Mortgage Market Turmoil: Causes and Consequences, Mar. 22, 2007. ' 7 1d.
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often referred to as "liar loans" because no documentation of income was required. Thus a
borrower with a relatively good credit score, but who was otherwise lacking in any ability to
provide evidence of assets or income sufficient to pay a mortgage, could hide the fact that they
were highly likely to default on their mortgage by getting a "liar loans."
C. Fannie Mae's Exposure to Risky Subprime and Alt-A Mortgages
44. As other lenders began investing in these risky mortgages, Fannie Mae decided to
abandon sound practices and follow its competitors so that it could maintain its status as a market
leader. Fannie Mae was faced with the decision to "(1) Stay the course; or (2) Meet the market
where the market is." 18 Fannie Mae, knowing of the risks involved with investing in subprime
and Alt-A loans, joined its competitors and became heavily invested in the riskiest part of the
real estate market.
1. Fannie Mae Ramps Up its Involvement in Subprime and Alt-A Mortgages
45. Shortly after Mudd became Chief Executive Officer in 2004, Fannie Mae's
proportionate market share of the mortgage industry dropped dramatically. 19 Lenders were
selling the mortgages to Fannie Mae's competitors. Fannie Mae did not just "meet the market
where the market is" - it launched a campaign to all but corner the market in risky sub-prime and
Alt-A loans. During the course of 2005 to 2008 Fannie Mae became a leader in the mortgage
backed securities market that would later sustain catastrophic losses. The following chart from
the New York Times 20 demonstrates the dramatic way that Fannie Mae ramped up its
involvement in risky lending to maintain market share:
18 Confidential Fannie Mae Presentation, Single Family Guaranty Business Facing Strategic Crossroads, June 27, 2005. 19 Charles Duhigg, Pressure to Take More Risk, Fannie Reached Tipping Point, New York Times (Oct. 4, 2008). 20 Charles Duhigg, Pressure to Take More Risk, Fannie Reached Tipping Point, New York Times (Oct. 4, 2008).
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Leaning on Risks
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46. In January 2007, Mudd sent a confidential memo to Fannie Mae's Board touting
the company's expansion into the subprime market. 21
47. Just one month later, Fannie Mae, while recognizing the poor performance of
subprime loans, predicted that performance would improve in 2007. In an effort to increase its
market share, Fannie Mae outlined plans to increase its involvement in the subprime mortgage
market. 22
48. Fannie Mae made plans to specifically target both Alt-A and subprime mortgage
loans, with a stated objective to "increase our penetration into subprime." 23
21 David S. Hilzenrath, Fannie's Perilous Pursuit of Subp rime Loans, Washington Post (August 19, 2008), at Dl. 22 David S. Hilzenrath, Fannie's Perilous Pursuit of Subp rime Loans, Washington Post (August 19, 2008), at Dl. 23 Id.
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49. As the subprime and Alt-A market experienced a downturn, Fannie Mae ignored
the signs of a failing real estate market and continued to increase its investment in these risky
loans.
50. On April 17, 2007, Fannie Mae announced to the House Financial Services
Committee that it would increase its involvement in the subprime mortgage market by offering
expanded programs aimed at borrowers with poor credit histories. 24 Under the program, Fannie
Mae would ease its credit requirements and buy 40-year loans as well as 30-year loans in the
secondary market. 25
51. On September 12, 2007, Fannie Mae requested a further relaxation of restrictions
on its ability to expand its mortgage-related portfolio. 26
52. One week later, in response to Fannie Mae's request to increase its stakes in the
subprime mortgage sector by buying billions of dollars in subprime mortgages and refinanced
loans for borrowers with lower credit scores, the OFHEO slightly increased the cap on Fannie
Mae's portfolio to a 2 percent annual growth rate with no more than a 0.5 percent growth rate per
quarter. 27
53. Despite numerous warning signs of surges in mortgage defaults, and with no
regard to their potential risk exposure, Fannie Mae, in October of 2007, again requested to have
the cap on its mortgage-related portfolio loosened to permit it to increase the size of its
mortgage-related portfolio. At the time, OFHEO Director James Lockhart expressed concern
24 See Fannie Mae, Freddie Mac Looks at New Loans, MSNBC.com (April 17, 2007). 25 Id. 26 See Pete Kasperowicz, Fannie Mae Renews Pitch to Add Liquidity to Market by Lifting Caps, Forbes.com (September 12, 2007). 27 See Neil Adler, Lfting Portfolio Cap Could Hurt Fannie, Freddie, Washington Business Journal (October 5, 2007).
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about Fannie Mae's attempt to enlarge its portfolio, stating that should the company take on too
much risk, it "certainly could affect their financial results." 28
54. In response, Fannie Mae stated that "it would be inappropriate to speculate on
how increasing their portfolios would affect the company's financial results." 29
55. Rather than focus on its exposure to losses, Fannie Mae issued a 2007 Q1-Q3 10-
Q Investor Summary which stated it would seek to have the restrictions on its mortgage-related
portfolio lifted, claiming that it was in a good financial position and thus should be relieved from
its capital surplus requirement and portfolio cap.
56. Fannie Mae continued to increase its exposure to risk when on May 16, 2008 it
announced that it was lowering, on a nationwide basis, the amount of required down payments
on mortgages it purchased - meaning that it would purchase loans with higher loan-to-value
ratios. 30
57. By July 2008, Fannie Mae had an extremely high proportion of Alt-A and
subprime mortgages, both on its books and in the mortgage backed securities portfolios it
guaranteed. Of Fannie Mae's $2.2 trillion in loans and guarantees, $396 billion, or a whopping
18%, were Alt-A or subprime. 31
58. Fannie Mae and Freddie Mac together ended up with about half of the $3 trillion
world-wide exposure to subprime and Alt-A losses. 32 Furthermore, Fannie Mae stayed in the
market long after the mid-2006 downturn when other lenders were exiting. Originators of
subprime and Alt-A mortgages knew that Fannie Mae would buy their poorly underwritten
28 Id. 29 Id. 30 News Release from Fannie Mae: Fannie Mae Announces Single National Down Payment Policy; Replaces Policy Regarding Markets Where Home Prices are Declining, (May 16, 2008). 31 Joe Specht, Fannie Mae - orMay Not, Seeking Alpha.com (July 11, 2008). 32 Statement of Charles W. Calomiris, United States House of Representatives Committee on Oversight and Government reform, December 9, 2008.
16
instruments. Indeed, Fannie Mae legitimized these originators (like IndyMac Federal Bank
("IndyMac") and Countrywide Financial Corp. ("Countrywide") and their unsound underwriting
practices and gave assurance that there was a source of demand for these products. 33
59. Edward Pinto ("Pinto"), Fannie Mae's Chief Credit Officer from 1987-1989, in
testimony before the United States House of Representatives Committee on Oversight and
Government Reform on December 9, 2008, stated that Fannie Mae and Freddie Mac's subprime
and Alt-A34 holdings comprised over a third of their respective risk portfolios and those loans
were experiencing a default rate eight times higher than the USEs' traditional quality loans.
Together, the companies held 34 percent of all outstanding subprime loans and 60 percent of all
outstanding Alt-A loans. 35 Fannie Mae alone held approximately 20 percent of all outstanding
subprime loans and 30 percent of all outstanding Alt-A loans. 36
2. Fannie Mae Conceals Risk Exposure
60. Notwithstanding the enormous proportions of Fannie Mae's risky mortgage
holdings, Fannie Mae downplayed their numbers and, indeed, continued to use databases and
tracking tools that literally concealed or mischaracterized its risky mortgage assets. This was
material since, because Fannie Mae bore the risk for any loans it purchased and held, a surge in
mortgage defaults, which are inherently more likely in these risky loans, would result in a huge
exposure to Fannie Mae.
61. Fannie Mae reported in its 2007 10-K that it had total assets of $882 billion and
Alt-A and subprime exposure of $405 billion. Fannie Mae's subprime and Alt-A loans were
33 Id. ' Although Alt-A loans are generally not classified as subprime because the FICO score of the borrower is
generally above 660, these loans defaulted at rates approaching those of subprime loans. Pinto, Edward J., "Statement of Edward J Pinto Before the Committee on Oversight and Government Reform
United States House of Representatives," December 9, 2008. 36 id
17
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equivalent to 45% of its total assets. Simply put, Fannie Mae put most of its eggs in one very
risky basket. However, this is not what Fannie Mae told the investing public.
62. On a December 11, 2006 conference call, Peter Niculescu, Fannie Mae's
Executive Vice President for Capital Markets mentioned that securities in Fannie Mae's Portfolio
included "some Alt-A."
63. On a February 27, 2007 conference call, Mudd was asked about Alt-A loans to
which Mudd responded, "we don't have so much that this is a major, significant exposure on our
books."
64. On a November 9, 2007 conference call, Dallavechia said Fannie Mae had a "very
small amount of subprime loans."
65. In truth, this "very small number" of subprime loans amounted to, as stated above,
45% of Fannie Mae's entire asset base.
66. To make matters worse, many loans purchased or securitized by Fannie Mae were
included in the company's prime loan databases, even though 34 percent of these loans should
have been classified as subprime, Alt-A or other non-prime loans. 37
67. Pinto stated in his testimony to Congress:
For historical reasons, these loans are also carried in databases as prime loans when they were purchased by Fannie and Freddie, which conveniently allowed them to deny that they were active in the subprime market. This created tremendous disclosure problems for the industry, since a massive portion of subprime, Alt-A mortgages and other non-prime lending has long been hidden behind Fannie and Freddie's "prime" façade. Accordingly, there are many more subprime and Alt-A mortgages outstanding today than many people suppose, because half of all these loans are held or securitized by Fannie and Freddie and yet are carried in many databases as prime loans. 38
37 1d. 38 1d.
18
68. Fannie Mae, Officer Defendants nor the Underwriter Defendants ever notified the
Plaintiff of the "Prime facade" before it purchased Fannie Mae securities.
69. According to Pinto's testimony, Fannie Mae reported 0.24 million subprime
loans, but maintained an additional 3.05 million loans it listed as prime despite the fact that the
borrowers had FICO scores of less than 660 - which would indicate a subprime designation. 39
70. Charles Calomiris, the Henry Kaufman Professor of Financial Institutions at
Columbia Business School, in testimony before the United States House of Representatives
Committee on Oversight and Government Reform on December 9, 2008, stated that Fannie Mae
did not disclose the extent of its subprime and Alt-A exposure and noted that most market
observers had no idea of the extent of Fannie Mae's exposures until recently. 40
71. Moreover, on July 9, 2008, Bloomberg reported that, "Credit-default swaps tied to
$1.45 trillion of debt sold by the two biggest U.S. mortgage-finance companies are trading at
levels that imply the bonds should be rated A2 by Moody's Investors Service." 41 Derivative
traders began to overlook the government's implied guarantee of Fannie Mae's debt as credit
losses grew and concern rose that Fannie Mae would not have enough capital to weather the
housing slump. 42
D. Fannie Mae's Capital Base
72. As Fannie Mae dove head first into the risky mortgage market, it boasted that its
strong capital base exceed minimum capital requirements. Purchasers of Fannie Mae securities
believed and relied on Fannie Mae when it said its capital base was strong and invested $15
39 1d. 40 Calamoris, Charles W., "Statement Before the Committee on Oversight and Govermnment Reform, United States House of Representatives," December 9, 2008. 41 See Shannon D. Harrington and Dawn Kopecki, Fannie, Freddie Downgraded by Derivatives Traders, Bloomberg.com (July 9, 2008). 42 Id.
19
million in the Preferred Stock. The reality, however, was that Fannie Mae's capital consisted of
nebulous assets such as deferred tax assets, "other than" temporary impairments, and low loan
reserves. Fannie Mae's capital did not consist of "actual cash that could be used in a crisis." 43
1. Deferred Tax Assets
73. Fannie Mae's capital base consisted in large part of deferred tax assets, which are
assets whose value can only be recognized if the company posted profits in future quarters.
74. Under Financial Accounting Standard No. 109 ("FAS 109"), a deferred tax asset
is recognized for temporary differences that will result in deductible amounts in future years and
for carry-forwards. For example, a temporary difference is created between the reported amount
and the tax basis of a liability for estimated expenses if, for tax purposes, those estimated
expenses are not deductible until a future year. Settlement of that liability will result in tax
deductions in future years, and a deferred tax asset is recognized in the current year for the
reduction in taxes payable in future years.
75. A valuation allowance is recognized if, based on the weight of available evidence,
it is more likely than not that some portion or all of the deferred tax asset will not be realized .44
76. In determining whether to report deferred tax assets, a company has to consider
both positive and negative evidence regarding whether it will post profits in the future and
generate sufficient future taxable income for applying the credits. 45 In making its determination,
a company should consider the existence of cumulative losses in recent fiscal years, its operating
results history, adverse unsettled circumstances and forecasted future taxable income.
See Dawn Kopeck: and Jody Shenn, Fannie Mae to Reduce Value of Deferred Tax Assets, Bloomberg.com (October 29, 2008). 44 See FAS 109. 45 1d. at T23.
20
77. Deferred tax assets do not have value unless a company generates a profit. The
public and its investors were deceived into believing Fannie Mae's capital base was nearly two
times greater than the actual capital base.
78. Fannie Mae reported a series of quarterly losses, had a huge investment in the
failing real estate market and predicted a 50% drop in housing prices over a three to five year
period. The company, however, continued to report increased deferred assets with every quarter
that led Plaintiff and other investors to believe that Fannie Mae remained financially healthy.
79. In the third quarter 10-Q of 2007, Fannie Mae recorded net losses of $1.52 billion
dollars. Losses increased to $3.6 billion in the fourth quarter.
80. Fannie Mae continued to recognize substantial losses in 2008. The company
recorded $2.2 billion in losses in the first quarter 10-Q, $2.3 billion in the second quarter 10-Q,
and a shocking $29 billion loss in the third quarter 10-Q of 2008.
81. Even though Fannie Mae had not recognized a profit in several quarters and
losses continued, Fannie Mae increased its risky strategy by reporting deferred tax assets
throughout 2007 and 2008. These inflated assets deceived Plaintiff and other investors.
82. In the third quarter of 2007, Fannie Mae reported $9.89 billion dollars of deferred
tax assets. In the fourth quarter 10-Q, Fannie Mae reported approximately $12.97 billion in
deferred tax assets. Fannie Mae continued to increase its recognition of deferred tax assets
throughout 2008, reporting $17.8 billion in the first quarter 10-Q and $20.6 billion in the second
quarter 10-Q:
Q ILl ItCIIV ItC1)OIt I ()SS (S I)CIiIIC(I lax Assets
(in I)iIIilJIIS) (in billions) 1O-Q 3rd Quarter 2007 $1.52 $9.89
10-K 4th Quarter 2007 $3.6 $12.97
10-Q 1st Quarter 2008 $2.2 $17.8
21
10-Q 2nd Quarter 2008 $2.3 $20.6
10-Q 3rd Quarter 2008 $29.0 $4.6
83. Fannie Mae inflated its capital base by using deferred tax assets and presented the
appearance that the company was financially strong when, in fact, the company did not have
sufficient capital to support its losses. Without recognizing the deferred tax assets, Fannie Mae
could not meet its minimum capital requirements:
RCj)OltCd in billions
Date Statutory 11, II1" 4 /01`IIF() (ott Capital Capital Without Minimum \Iiiiiiiiuiii I)efcirctl lax. sscts
09i30i07 $30303 $39393 $41713 $31823
12/31/07 $31927 $41505 $45373 $32403
03/31/08 $31335 $37602 $42676 $24876
06/30/08 $32.631 $37525 $46964 $26364
84. Without recognizing offsets from deferred tax assets, Fannie Mae did not meet the
statutory minimum capital requirements in the first and second quarter of 2008 and would not
have met the mandated surplus requirement established by the OFHEO in the third and fourth
quarters of 2007. For Fannie Mae, not reporting deferred tax assets would have resulted in
falling well below its minimum requirements.
85. Even when Fannie Mae did recognize large profits, the deferred tax assets did not
have value because the company already had large numbers of affordable housing tax credits,
which offset profits. 47
86. Fannie Mae continuously touted its capital holdings affirming that it held capital
above the minimum requirements, but much of its capital base involved assets which would not
be realized in the future with the deteriorating real estate market.
46 Federal Housing Finance Agency ("FHFA"), as of July 30, 2008, regulates Fannie Mae, Freddie Mac and other lending institutions.
Gretchen Morgenson and Charles Duhigg, Mortgage Giant Overstated the Size of its Capital Base, NYTimes.com, (September 6, 2008).
22
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87. George Victor, a partner at Holtz Rubenstein Reminick, LLP, an accounting firm,
stated, "when a company has had a continued loss and doesn't anticipate future profits to offset
the deferred-tax assets, it - shouldn't be on the books .,,48
88. An article issued on September 14, 2008, in Financial Week stated:
Other companies, especially commercial banks, could also boost their capital with deferred-tax assets and get away with it to a certain extent. But only the banks, or at least big ones, might be able to count on auditors and regulators being as lax on them as they were on Fannie and Freddie, because of the risk to the financial system their failure might pose. 49
89. On October 29, 2008, The New York Times stated that "deferred tax assets became
controversial for Fannie Mae after the company posted a string of surprising quarterly losses,
which hamstrung its ability to raise capital to offset losses from rising foreclosures. "50
90. As Fannie Mae reassured the public that its capital base was strong enough to
withstand the market, Plaintiff invested $15 million in the Preferred Stock. Only after this
purchase did the news become public that Fannie Mae would not expect to realize its deferred
tax assets and that the capital held by the company was in such dire condition that the
government felt compelled to place Fannie Mae under conservatorship.
91. A Bloomberg report dated October 29, 2008, revealed that the use of deferred-tax
assets and other accounting methods by Fannie Mae to inflate their capital was cited by
regulators as one of the reasons why the government took control .51
92. Treasury Secretary Henry Paulson, in a statement regarding Fannie Mae and
Freddie Mac issued on September 7, 2008, stated:
48 Marine Cole, Financial Week, "IRS break boosts Fannie, Freddie", September 14, 2008, available at http://www.financialweek.com/apps/pbsc.dll/article?AID=/20080914/REG/8091 29952.
Marine Cole, Financial Week, "IRS break boosts Fannie, Freddie", September 14, 2008, available at http://www.financialweek.com/apps/pbsc.dll/article?AID/20080914/REG/8091 29952. ° Fannie Mae to Write Down Deferred Tax Assets, NYTimes.com, October 29, 2008, available at
http://www.nytimes.com/2OO8/l0/3Olbusinessl3Ofannie.html. ' Bloomberg, Fannie Mae to Reduce Value ofDeferred Tax Assets, October 29, 2008.
23
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Based on what we have learned about these institutions over the last four weeks -
including what we learned about their capital requirements - and given the condition of financial markets today, I concluded that it would not have been in the best interest of the taxpayers for Treasury to simply make an equity investment in these enterprises in their current form.
93. Fannie Mae's government-appointed Chief Executive Officer, Herb Allison,
stated that all of Fannie's assets would be revalued . 52 Soon after, Fannie Mae wrote down over
$20 billion in deferred assets. In the third quarter of 2008, Fannie Mae's core capital dropped
from $47 billion to $16.6 billion, less than half of the $33 billion in statutory minimum capital it
was required to maintain.
2. Failure to Write Down Other-Than-Temporary Impairments
94. The Financial Accounting Standards Board ("FASB") requires that all material
information be disclosed that is necessary to ensure that the company validly represents
underlying events and conditions. FASB is an organization that develops generally accepted
accounting principles ("GAAP") and issues bulletins called FAS statements. FAS Statement No.
115 requires an institution to determine whether a decline in fair value below amortized cost for
an individual available-for-sale security is other-than-temporary. if the security is considered to
be other-than-temporary, the security must be written down to the fair value and the amount of
the write-down must be included as a realized loss. Available-for-sale securities made up 33%
of Fannie Mae's total assets at the end of 2007.
95. GAAP is the standard framework of guidelines for financial accounting used in
the United States and includes the standards, conventions, and rules for accountants to follow in
recording and summarizing transactions and in the preparation of financial statements. SEC
Regulation S-X, 17 C.F.R. § 210.4-01(a)(1), states that financial statements filed with the SEC
that are not prepared in compliance with GAAP are presumed to be misleading and inaccurate,
52 id
24
despite footnotes or other disclosures. GAAP requires reporting by means of fair value
accounting. Fair value accounting is financial reporting which requires a company to measure
certain assets and liabilities "at estimates of the prices they would receive if they were to sell the
assets or would pay if they were to be relieved of the liabilities." GAAP defines fair value of an
asset as the amount at which the asset could be bought or sold in a current transaction other than
in a forced or liquidation sale.
96. FAS Statement No. 115 specifies that if an institution "is unable to collect all
amounts due according to the contractual terms of a debt security not impaired at acquisition,
another-than-temporary impairment shall be considered to have occurred."
97. For the second quarter of 2008, Fannie Mae reported $6.6 billion in unrealized
loss to its available-for-sale securities but recognized only $507 million in other-than-temporary
impairment. Beginning in the third quarter of 2007, Fannie Mae reported only $84 million in
other-than-temporary impairment and $727 million, $55 million, $507 million, $1.8 billion in the
following quarters. However, in the fourth quarter 10Q of 2008, when Fannie Mae's failing
financial position was exposed, Fannie Mae reported $4.5 billion in other-than-temporary
impairment.
98. Fannie Mae did not recognize other-than-temporary impairments to its available-
for-sale securities with the appropriate write-downs. As a result, these unrealized losses were not
included within Fannie's core capital calculations and the investing public had an erroneously
inflated perception of Fannie Mae's core capital.
3. Insufficient Loss Reserves
99. When Fannie Mae determines a loan is uncollectible, Fannie Mae is supposed to
record the charge-off against its loss reserves. However, notwithstanding increasing
25
uncollectible loans, Fannie Mae's loss reserves did not account for the significant credit risk it
was undertaking which inflated its core capital and misled its investors.
100. Fannie Mae's 2006 10-K stated that Fannie Mae expected the "overall serious
delinquency rates to increase in 2007." Moreover, a January 2007 internal report forecasted a
50% decline in home prices over a three to five year period . 53 Therefore, Fannie Mae's credit
losses were likely to increase over the next several years. However, Fannie Mae failed to
increase its loss reserves in correlation with the expected market change. Fannie Mae did not
account for these economic changes until the fourth quarter of 2007, when it reported a $2 billion
increase in loss reserves for a total of $3.4 billion in loss reserves, well after the market had
begun its decline.
101. Indeed, even without considering the minimum statutory requirement, Fannie
Mae was expected to hold sufficient capital reserves to withstand a decline of housing prices
comparable to a severe recession.
102. In the wake of Freddie Mac and Fannie Mae's respective accounting scandals
between 2001 and 2004, OFHEO imposed on both of the USEs a 30 percent required capital
surcharge above the statutory requirement. 54 The minimum capital requirement was therefore
3.25 percent. 55
103. All named Defendants knew about Fannie Mae's lack of capital base and
wrongfully ignored the red flags raised by Fannie Mae's lack of adequate reserves.
Fannie Mae Strategic Plan 2007-2011 - Produced by the House Committee on Oversight and Government Reform: FM-COGR
—00011806 - FM-COGR 0001 1900, available at http://www.feic.gov/hearings/Pdfs/2010-
0409-faimie-mae-strategic-plan.pdf Fannie Mae is required by statute to hold a minimum capital of 2.5 percent of on-balance sheet assets. This
leverage capital requirement is lower than those for Federal Home Loan Banks ("FHLB") or for private financial institutions.
James B. Lockhart III, Director, Office of Federal Housing Enterprise Oversight, "Reforming the Regulation of Government Sponsored Enterprises", Statement Before the Senate Banking, Housing and Urban Affairs Committee (February 7, 2008), available athttp://www.fhfa.gov/webfiles/1453/2708Lockhart.pdf
26
4. Weak Risk-Based Capital
104. In testimony to the Congressional Oversight Committee, Arnold Kling, a senior
economist at Freddie Mac from 1986-1994, blamed Fannie Mae for taking on more risk than it
should have, with less capital than was prudent.
105. On November 9, 2007, Fannie Mae issued a press release entitled "Fannie Mae
Files 2007 Quarterly Reports with the SEC - Company Returns to Current Financial Reporting"
wherein Mudd represented that Fannie Mae was in "solid shape to support the market."
106. The report went on to brag that "Fannie Mae's core capital in the third quarter
was $41.7 billion, $2.3 billion above the level mandated by the OFHEO-directed 30 percent
capital surplus requirement."
107. What Mudd failed to say was that because of improper or fraudulent risk
management without the inclusion of unattainable and unrecognizable deferred tax assets, Fannie
Mae would not have met its minimum capital requirements.
108. On a November 9, 2007, conference call, Nandu Narayanan, an analyst from
Trident Investment Management posed the following question to Mudd:
Given your equity capital of $40 billion and given that more people are saying that this might be one of the worst housing markets since the Great Depression. Because we've never had a national home price decline since the Great Depression, and given that with $40 billion of capital, you've got something in the order of $3 trillion of risk. You know, what do you see as the prognosis?
109. Mudd responded, in part, by saying:
Do we plan for all kinds of scenarios? Yes. Do we plan for scenarios that might be significantly worse than what we are projecting? Yes. Is that what we hold capital against? Yes. Is our total capital more than our risk-based capital? Yes. Is this a time to be conservative from a capital standpoint? Yes, it is. Is this a time to take these issues and these scenarios extremely seriously? Yes. Is this a time to make sure that we are beefing up all of our back-end resources to manage loss mitigation and foreclosures? Yes. Are we doing that? Yes. Do we know what's going to happen? No. That's when I finally have to give you a no answer. But are we prepared for scenarios that are somewhat historical? Yes.
27
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110. Mudd represented to investors that Fannie Mae was prepared for a severe crisis.
However, the truth as proper risk management reporting would have made clear was that Fannie
Mae was severely undercapitalized and could not weather a substantial downturn in the market.
These conditions forced the government to take control of Fannie Mae and to correct its financial
position.
111. During the November 9, 2007 conference call, Howard Shapiro, an analyst from
Fox-Pitt Kelton asked:
Okay, so if you we[re] to have a very large charge of some magnitude, you could conceivably be undercapitalized, or your capital ratios would go below the 30% OFHEO surcharge; that is conceivable?
112. Swad avoided a direct response to Shapiro's question by saying:
I think the way to think about it is, our capital is affected by GAAP earnings. SOP 03-3 is a component of GAAP earnings, as is our 22 basis point U fee revenue and growing. And to look at any one line item I don't think is the appropriate way to look at it. Just to remind you, we have over $2 billion of excess above the minimum.
113. Fannie Mae and the Officer Defendants continuously attempted to reassure the
market that it had adequate capital and downplayed its losses.
114. During a November 16, 2007 conference call with analysts, Citigroup Analyst
Brad Ball asked about Fannie Mae's capital adequacy. Swad boasted:
We disclosed over $41 billion of capital as of September [30, 2007] and over $2 billion of excess. And I also want to highlight that we are currently in an environment where there are very profitable incremental investments in both of our major businesses, on the Single-Family side and on the Capital Market side, where we believe we can make investments and earn returns well above our cost of capital.
115. Fannie Mae announced the issue of new preferred shares in December 2007 to
provide additional funds for managing higher risk in the housing and credit markets.
116. On February 27, 2008, Fannie Mae reported fourth quarter and full year 2007
financial results, reporting a net loss of $2.1 billion, or ($2.63) per diluted share, versus net
28
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income of $4.1 billion during 2006. The company also reported substantial losses from subprime
and Alt-A mortgages. However, Fannie Mae continued to stress that its capital base was strong.
117. During a February 27, 2008 conference call regarding Fannie Mae's 2007 results,
Mudd reassured investors:
The number one priority is capital. We want to stay long capital. 2007 was a tough year. 2008 will be tough as well. And 2009 we do not anticipate will be particularly rosy, so through this period, capital remains king and we want to remain long capital...
The third priority, responding to the crisis. We're fully cognizant of the fact that responding in crisis is something that we were chartered to do, that we have to marshal capital to play that role, which is providing liquidity and stability and affordability in the markets, including now the jumbo market as well.
118. Mudd concluded his remarks commenting:
So we're not making - we're not under any illusions here. I think we're being realistic. This is a tough environment. We are taking all the necessary steps to manage our way across it to move across that bridge I have talked about.
119. However, while recognizing the difficulty in the real estate market, Fannie Mae
continued to hide the truth from investors and create the illusion of financial health and stability
by reporting deferred tax assets as a significant portion of its capital base.
120. During the February 27, 2008 conference call with investors, Fannie Mae
continued to assure the public that it was taking a conservative approach to managing capital.
"As the market recovers, we will be a prime beneficiary," Mudd said, "when the housing market
finally stabilizes, the company will 'feast' on the mortgages it is currently buying."
121. Mudd also claimed in the same call, "You can see we ended 2007 with $47.4
billion in core capital, that's $13.4 billion above the statutory minimum and $3.9 million above
the OFHEO-mandated 30% level." He continued by emphasizing that Fannie Mae was
managing its capital account "very conservatively."
29
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122. Additionally, on the February 27, 2008 conference call with investors, Levin,
reassured investors saying "[o]ur operating philosophy for capital is to manage it to protect
ourselves against market scenarios more adverse than we expect. It's a conservative approach
to managing the capital." (Emphasis added.)
123. Swad also made statements in the same February 2008 conference call regarding
Fannie Mae's capital base. He stated:
[W]e ended 2007 with $45.4 billion in [core] capital, that's $13.4 billion above the statutory minimum and $3.9 [billion] above the OFHEO-mandated 30% level. In addition, we have got approximately $50 billion of very short-term maturing assets, mainly bank deposits within our liquid investment portfolio against which we hold $1.6 billion in capital. We can reduce our capital requirement and thereby increase our capital surplus just by permitting these highly liquid ass[ets] to mature without replacement. So the $3.9 billion of stated [assets], plus 1.6 in capital applied to short-term assets is $5.5 billion, which I view as potential capital.
124. On the February 27, 2008, conference call, Mudd commented:
I think there are two things, and I talked about them in my remarks. One is to be conservative in terms of protecting the capital that we have, but the other is to be aware that we are trying to build for the future.
125. However, Moshe Orenbuch, an analyst with Credit Suisse in New York noted that
while many companies took partial reserves against their deferred tax assets, Fannie Mae
"recognized the entire tax asset, which was certainly on the aggressive side." 56
126. On a February 27, 2008 conference call, with respect to capital raised in the
market, Mudd repeatedly stressed that Fannie Mae approached its capital base conservatively:
The additional capital we're raising will bolster our "protect and grow" strategy - it will allow us to maintain a strong, conservative balance sheet through the housing correction, pursue growth opportunities to enhance long-term shareholder value, and provide liquidity and stability to the secondary market.
(Emphasis added)
56 Bloomberg, Fannie Mae to Reduce Value ofDeferred Tax Assets, October 29, 2008.
30
127. On May 6, 2008, Fannie Mae announced it would raise $6 billion in new funds.
To entice investors, Fannie Mae, the Officer Defendants and the Underwriter Defendants
wrongfully downplayed its exposure to losses and exaggerated the strength of its capitalization.
In short, all defendants dispelled concerns about Fannie Mae's financial strength.
128. Also on May 6, 2008, days before Plaintiff purchased its Preferred Series T
shares, Fannie Mae held its first quarter earnings conference call. During that call, Mudd spoke
about the new capital being raised:
So, taking together, all of those factors mean that we will have more capital to protect the balance sheet, to grow the business, and to serve the market. So, all told, including this prospective capital raise that we're undertaking starting today, we will go into the belly of this cycle with about $48 billion in core capital which is about $17 billion above our statutory capital level.
We've said before that this is the time to be long capital and this plan firmly gets us there. We plan to harness the capital we're raising for three goals - one, to attain a position of unquestioned capital strength; two, to pursue the best business opportunities we have seen without constricting capital; and three to step out and play a major role in helping the market recover better and sooner and to the benefit of all investors in housing whether they be consumers or originators or realtors or homebuilders or investors of Fannie Mae.
(Emphasis added)
129. Mudd concluded:
Let me now close out on the brief discussion of the capital plan. Our strategy for working through this period is to protect and grow. That means protecting the company by building and conserving capital and setting aside the right amount of loss reserves as we continue to work to reduce foreclosures and credit losses. This strategy also means growing our business as we help stabilize the market and perform our mission.
130. On June 25, 2008, - not long after Plaintiff's purchase of Preferred Stock -
Fannie Mae reported a two-fold increase in mortgage delinquency rates over the prior year
period, but claimed "We're managing our portfolio in a safe and sound manner." 57 Despite
57David S. Hizenrth, Delinquencies Rise at Fannie Mae, Freddie Mac, Washington Post (June 26, 2008), at Dl.
31
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Fannie Mae's representations regarding its management of its portfolio and capital reserves, in
truth the company was without adequate risk controls and was severely undercapitalized.
131. In a July 11, 2008 statement concerning Fannie Mae's capital adequacy, Chuck
Greener, Fannie Mae Senior Vice President, said:
Fannie Mae raised $7.4 billion of additional capital in May, for a total of more than $14 billion in new capital in November of 2007. Our capital level is substantially above both our statutory minimum capital and the OFHEO-required 15 percent surplus over minimum capital. In fact, we have more core capital, and a higher surplus over our regulatory requirement, that at any time in the company's history.
As we work through this tough housing market, we are maintaining a strong capital base, building reserves for our credit losses, and generating solid revenues as our business continues to serve the market. We also have access to ample sources of liquidity, including access to the debt markets. The company issues more than $24 billion in debt alone, including a $3 billion Benchmark Notes sale that was oversubscribed. In short, Fannie Mae remains well-equipped to fulfill our critical role in the housing financing system, today and in the future.
(Emphasis added)
132. In truth, without its deferred tax assets, Fannie Mae would not have met its capital
requirements - much less held sufficient capital to withstand a severe crisis.
133. The statements regarding Fannie Mae's capital base were materially false and
misleading because the reported capital was inflated due to the overuse of deferred tax assets.
Fannie Mae continuously included the full value of deferred tax assets without any write-down
reflecting the likelihood that they would never be useable as an offset to earnings.
134. Fannie Mae continued to mislead the public when it said its regulatory capital
stood at $47 billion as of June 30, 2008; $14.3 billion above its statutory minimum capital
requirement and $9.4 billion above its 15 percent surplus requirement. Over $20 billion of that
regulatory capital, approximately 43%, consisted of deferred-tax assets, up from $13 billion at
the end of 2007.
32
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135. Despite Fannie Mae's deteriorating financial position, the company continued to
release positive statements with regard to its capital base stating that it not only had sufficient
capital, but a strong capital base.
136. As the housing market declined, Fannie Mae continued to reassure investors that
it had sufficient capital to withstand the downturn even with its substantial exposure to the
market. Fannie Mae continued to conceal that it did not have adequate capital to overcome the
market conditions.
137. On October 9, 2008, the FHFA published a news release stating that:
Director Lockhart is classifying Fannie Mae and Freddie Mac as of June 30, 2008, prior to the conservatorship, as undercapitalized using FHFA's discretionary authority provided in the statute. Both Fannie Mae and Freddie Mac have publicly released financial results for the second quarter of 2008. Although both Enterprises' capital calculations for June 30, 2008, reflect that they met the FHFA and statutory requirements for capital, the continued market downturn during late July and August raised significant questions about the sufficiency of capital. The following factors, which led to the need for conservatorship, support the Director's decision to downgrade the classification to undercapitalized:
• Accelerating safety and soundness weaknesses, especially with regard to credit risk, earnings outlook, and capitalization;
• Continued and substantial deterioration in equity, debt, and MBS market conditions;
• The current and projected financial performance and condition of each company as reflected in its second quarter financial reports and our ongoing examinations;
• The inability of the companies to raise capital or to issue debt according to normal practices and prices;
• The critical importance of each company in supporting the country's residential mortgage market; and
• Concerns that a growing proportion of their respective statutory core capital consisted of intangible assets.
(Emphasis added)
138. This press release revealed and confirmed that Fannie Mae was not managing its
capital conservatively.
33
taR.1affztiaiathIt*junr*sIaI1t*yIWaPagti.tsYzItflI
5. The Reality of Fannie Mae's Financial Position
139. On March 8, 2008, White House economist Jason Thomas sent Treasury Official
Robert Steel an alarming confidential analysis that revealed "in reporting its 2007 financial
results, Fannie was masking its insolvency through fraudulent accounting practices and further
stated:
• . . Any realistic assessment of Fannie Mae's capital position would show the company is currently insolvent. Accounting fraud has resulted in several asset categories (non-agency securities, deferred tax assets, low income partnership investment) being overstated, while the guarantee obligation liability is understated. These accounting shenanigans add up to tens of billions of exaggerated net worth... 1158
140. The Confidential White House Memo was cited as authority in the FCIC Report
and it further stated that:
Even as its financial sector peers are announcing sizeable writedowns, Fannie management asserts its subprime and Alt-A securities were still worth in the 90s. These marks are not realistic, and do not represent market prices that Fannie could actual[ly] receive were it to sell its securities. This is a violation of GAAP... Fannie is overvaluing its portfolio relative to the market. "59
141. Further criticism in the Confidential White House Memo was made for Fannie
Mae's use of other-than-temporary impairments: "Contrary to Fannie's assertions, these are
permanent writedowns, not temporary. The determination of permanent writedowns, or other-
than-temporary impairments, is a critical accounting policy for Fannie. . . it appears factors such
as severity and duration of impairment, mortgage market duress, and ratings downgrades are set
aside in favor of management judgment that all contractual cash flows will be collected. This is
approach is not GAAP compliant." With respect to Fannie Mae's questionable use of deferred
tax assets the Confidential White House Memo states: "even during the highly felicitous credit
environment from 2003 to 2006, in no year was Fannie profitable enough to realize and reduce
See FCIC Report pg. 314. See FCIC Report pg. 314
34
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its DTA. Therefore, it is highly dubious that Fannie would ever be able to utilize its DTA, even
were the current stressful credit environment to quickly dissipate."
142. After the Federal Reserve Board consented to furnish emergency loans to Fannie
Mae in mid-July 2008, Fed staff and representatives of the Office of the Comptroller of the
Currency ("0CC"), along with Morgan Stanley, initiated a review of Fannie Mae. 6° The 0CC
and Morgan Stanley review confirmed the fraud discussed in the Confidential White House
Memo: "According to [Timothy] Clark, the Fed found that the USEs were significantly
'underreserved,' with huge potential losses and their operations were 'unsafe and unsound. ,61
Morgan Stanley's review of Fannie Mae found with respect to Fannie Mae's accounting
practices stated:
"Fannie had overvalued its deferred tax assets - because without future profits, deferred tax assets had no value. Loss projections calculated by Morgan Stanley substantiated the Fed's and the 0CC 's findings. Morgan Stanley concluded that Fannie's loss projection methodology was flawed, and resulted in the company substantially understating losses. Nearly all of the loss projections calculated by Morgan Stanley showed that Fannie would fall below its regulatory capital requirement. Fannie's projections did not." 62
143. To make matters worse, the models Fannie Mae used to forecast losses had not
been independently validated or updated for several years. The FHFA judged that in an up-to-
date model, estimated losses would likely show a 'material increase.' In addition, Fannie had
overvalued its deferred tax assets. 63
144. In a July 9, 2008 Bloomberg report, Friedman, Billings, Ramsey & Co. analyst
Paul Miller observed, "Fannie and Freddie are going to have to raise more capital and nobody
60 See FCIC Report pg. 317
61 See FCIC Report pg. 317
62 See FCIC Report pg. 317 61 See FCIC Report pg. 319
35
thinks they're going to be able to raise capital when they need to. It's going to be very
expensive."
145. On July 10, 2008, former St. Louis Federal Reserve Board President William
Poole stated in an interview that Fannie Mae was technically insolvent. 64
146. On July 11, 2008, The New York Times published an article titled "U.S. Weighs
Takeover of Two Mortgage Giants," indicating that the federal government was considering a
plan to take over Fannie Mae and place it into a conservatorship. 65
147. On July 30, 2008, President Bush signed a housing rescue bill which included a
Fannie Mae bailout. 66 Specifically, Fannie Mae was given an unlimited line of credit with the
United States Treasury (increased from $2.25 billion). The bill also authorized the Treasury to
purchase shares in Fannie Mae, if necessary. 67 However, even this measure proved to be
insufficient.
148. On September 2, 2008, Fitch Ratings lowered its rating on Fannie Mae preferred
stock to just one level above junk status, citing: (a) Fannie Mae's lack of capitalization due to its
lack of reliable access to equity markets; and (b) Fannie Mae's $307 billion in Alt-A
mortgages. 68
149. On September 7, 2008, the government placed Fannie Mae into conservatorship.
150. That same day, Market Watch published the report "Washington takes over
Fannie Mae, Freddie Mac" which stated, "Henry Paulson told reporters that a careful review of
the two mortgage giant's books made it 'necessary to take action."
64 David S. Hizenrth, Delinquencies Rise at Fannie Mae, Freddie Mac, Washington Post (June 26, 2008), at Dl. 65 Stephen Labaton and Steven R. Weisman, U.S. Weighs Takeover of Two Mortgage Giants, NYTimes.com (July 11,2008). 66 See Jeanne Sahadi, Bush Signs HousingRescue Law, CNNltvloney.com (July 30, 2008) 67 1d 68 Jeff Clabaugh, Fannie Mae, Freddie Mac Preferred Stock Cut at Fitch, Washington Business Journal (September 2, 2008).
36
151. The report continued:
There were reports that auditors called in by the Treasury and FHFA had found accounting irregularities at the two firms and that their capital base was smaller than expected.
* * *
At first, Paulson had talked in terms of an equity investment in the two firms. But after review, a full-scale takeover of the two firms was seen as the only option.
152. A Bloomberg article published on September 9, 2008, entitled, "Fannie Mae,
Freddie 'House of Cards' Prompts Takeover" reported:
Once they got someone looking closely at Fannie and Freddie's books, they realized there just wasn't adequate capital there," U.S. Senator Richard Shelby of Alabama, the ranking Republican on the Senate Banking Committee, said after a briefing by Treasury officials. "They found out they had a house of cards."
* * *
Fannie and Freddie's accounting during the housing crisis appears to have been more fantasy than reality," said Rosner, who first highlighted problems in 2003, before the two companies were forced to restate about $11.3 billion in earnings.
* * *
After looking through the finances, Fed examiners deemed their capital reserves too low, Dallas Fed[eral Reserve] President Richard Fisher said yesterday.
We concluded that the capital of these institutions was too low relative to their exposure," Fisher said in response to an audience question after a speech in Austin, Texas. Further, "that capital in and of itself was of low quality."
(Emphasis added)
153. James Lockhart, director of OFHEO revealed that much of Fannie Mae's assets
were based on intangible assets that did not amount to actual cash that could be used .69
154. According to Dallas Federal Reserve President, Richard Fisher, examiners from
the Federal Reserve found that in addition to thin and low quality capital the company may have
been understating their losses. 70
69 Fannie Mae to Reduce Value of Deferred Assets (update 2), Bloomberg, October 29, 2008.
37
155. On September 9, 2008, Standard & Poor's announced that, following the close of
trading on September 10, 2008, it would remove Fannie Mae from the S&P 500, citing the fact
that the company's capitalization had fallen well below the $5 billion required to list among the
S&P 500.71
156. After Plaintiff invested $15 million in Fannie Mae, the truth about the company's
capital base was revealed. Although Fannie Mae, the Officer Defendants, and the Underwriter
Defendants represented that Fannie Mae's capital was being managed conservatively and that the
company had sufficient capital to weather a market more adverse than expected, the reality was
Fannie Mae reported deferred tax assets that could not be realized in future quarters, retained
insufficient capital and was more heavily invested in the failing portions of the market than other
financial institutions.
E. Fannie Mae's Risk Management Failures
157. As the real estate market became increasingly risky, Fannie Mae became a lead
investor in risky loans. Fannie Mae, each Officer Defendant and the Underwriter Defendants all
aided in the fabrication of misinformation as a means of reassuring investors that its risk was
being controlled.
158. On December 9, 2008, House of Representatives Committee on Oversight and
Government Reform held a hearing regarding the takeover of Fannie Mae and Freddie Mac
revealing Fannie Mae's entry and involvement in risky loans.
159. Among documents produced to the Oversight Committee from Fannie Mae was a
confidential presentation from June 27, 2005, which stated: "We face two stark choices: (1)
Stay the course; or (2) Meet the market where the market is." "Stay the course" meant focusing
70 Id. 71 Press Release, Standard & Poor's, Standard &Poor'sAnnounces Changes to US. Indices, September 9, 2008.
38
predominantly on more secure, prime and fixed-rate mortgages. The presentation explained that
this option would "maintain our strong credit discipline" and "protect the quality of our book."
160. But according to the presentation, the "meet the market where the market is" was
in buying subprime and other alternative mortgages. To pursue this course, Fannie Mae would
have to "accept higher risk and higher volatility of earnings." This presentation admitted that
homes were "being utilized ... like an ATM." It acknowledged that investing in subprime and
alternative mortgages would mean "higher credit losses" and "increased exposure to unknown
risks." Even though established as a conservative stable USE, Fannie Mae did not want to be left
behind as its competitors sought higher potential earnings and instead strived to "meet the market
where the market is."
161. The documents produced to the Oversight Committee make clear that Fannie Mae
knew the risk involved in the subprime meltdown, because their own risk managers repeatedly
warned about the dangers of investing heavily in the subprime and alternative mortgage market.
162. On November 10, 2005, a top Fannie Mae official warned with respect to private-
label securities that layering of risk had not adequately been reflected in their pricing. 72
163. On September 20, 2007, Mudd stated in a Congressional hearing that Fannie Mae
could provide more help to the home finance market without taking risks.
164. On October 28, 2006, Fannie's Chief Risk Officer, Enrico Dallavecchia, sent an
email to Mudd warning about control processes. He informed Mudd:
Dan, I have a seriFousi problem with the control process around subprime limits.
The business actions in terms of ramping up business much faster than what would be consistent with the $5 [billion] limit for [the] year end we agreed upon
72 Staff of Committee on Oversight and Government Reform, 111th Congress, Report on The Role of Government Affordable Housing Policy in Creating the Global Financial Crisis of 2008, July 7, 2009, available at http://blog.heritage.org/wp-content/uploads/2009/07/7-7-09-housing-crisis-report.pdf
39
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less than two months ago is de facto preventing me to exercise my reserved authority to determine limits without damaging relationships with customers.
This is on top of the recent lack of process on the Chase deal (also a limit excess on concentration and debt to income ratios), and after we approved twice (in March and in June) to buy loans without having completed the new business initiative.
There is a pattern emerging of inadequate regard for the control process.
165. On July 16, 2007 Dallavecchia sent an email to Fannie Mae's COO, Michael
Williams, stating:
Doing the budget for n[e]xt year off my forecast with a 16pct further reduction in budget is best being ill informed or maybe... [is] due to malice. I find it offensive to my intelligence and that of my staff.
The company has one of the weakest control processes I [have] ever witness[ed] in my career. . . This company really doesn't get it, we are not even current and we are already back to the old days of scraping controls and people...
166. On July 16, 2007, he forwarded this email to Mudd and added to it complaining
that the Board of Directors had been told falsely that "we have the will and the money to change
our culture and support taking more credit risk." Dallavecchia wrote:
I do not even think that with what I was given for 2008 is adequate for the current risk, considering how far we already are from adequate market practices.
I have been saying that we are not even close to having proper control processes for credit market and operational risk. I got a 60 percent budget cut. Do I look stupid?
167. At a December 9, 2008, Congressional hearing, Mudd admitted that he was
warned in October 2006 that Fannie Mae "[was] rushing into billions of dollars worth of
subprime loan purchases without really knowing what [it was] doing."
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168. Moreover, Marc Gott, a former director in Fannie Mae's loan servicing
department stated, "We didn't really know what we were buying. . . This system was designed for
plain vanilla loans and we were trying to push chocolate sundaes through the gears." 73
169. Mortgage experts, Peter Wallison and Charles Calomiris stated:
The Fannie Mae propaganda machine purposefully misled people into believing that it was keeping risk low and operating under an adequate prudential regulatory regime.
170. Moreover, Confidential Witnesses cited in the Class Action Complaint for In re:
Fannie Mae 2008 Securities Litigation, and described in Judge Crotty's Opinion and Order
issued on September 30, 2010, stated Fannie Mae did not evaluate the risk of the subprime
mortgage pools it bought; it did not have a model to evaluate them. Upon information and
belief, since Fannie Mae did not have the ability to analyze pools in-house, it relied on ratings
issued by ratings agencies to guide its mortgage pool purchases.
171. Even though Fannie Mae's risk officers recognized that Fannie Mae was not
adequately managing its risk and warned the Officer Defendants of potential problems, Fannie
Mae reported in the Risk Management section of its SEC filings each year that it was properly
managing risks.
172. According to an October 2008 New York Times article, Mudd stated, "Fannie
Mae faced the danger that the market would pass us by. . . We were afraid that lenders would be
selling products we weren't buying .... ..
76 The same article reported that in or around late
2004/early2005:
Charles Duhigg, Pressure to Take More Risk, Fannie Reached Tipping Point, New York Times (Oct. 4, 2008). Wallison and Calom iris, The Last Trillion Dollar Commitment— The Destruction ofFannie Mae and Freddie
Mac, September 2008. See Docket Entry No. 288, 1:08-CV-07831-PAC.
76 Duhig, Charles, Pressured to Take More Risks, Fannie Reaching Tipping Point, October 4, 2008.
41
Fannie had a longstanding and lucrative relationship with Countrywide, which sold more loans to Fannie than anyone else. But. . . [Countrywide] . . .threatened to upend their partnership unless Fannie started buying Countrywide's riskier loans. 77
173. Fannie Mae began investing heavily in the risky loans offered by Countrywide
even though Fannie Mae knew that it was unequipped to handle the risks. In the early 1990's,
"Fannie and Freddie publicly announced they were no longer buying [Alt-A] loans because they
were too risky. ,78
174. Moreover, an internal presentation from June 27, 2005 stated Fannie Mae had a
lack of 1) capabilities and infrastructure and 2) knowledge of the credit risks. The presentation
also noted that market participants were not appropriately pricing for risk. Additionally, a
Fannie Mae document from March 2005 noted that: "Although we invest almost exclusively in
AAA-rated securities, there is a concern that rating agencies may not be properly assessing the
risk in these securities." 79
F. Fannie Mae Misrepresents Risks
175. Fannie Mae boasted about its superior risk management as stating in an OFHEO
"Report of the Special Examination of Fannie Mae" dated May 2006, "Fannie Mae senior
management promoted an image of the Enterprise as one of the lowest-risk financial institutions
in the world and as 'best in class' in terms of risk management, financial reporting, internal
control, and corporate governance."
176. On November 8, 2006 Fannie filed 10-Q for the period ending September 30,
2006, and in it stated:
77 id 78 Written Statement of Edward J. Pinto before the Committee on Oversight and Government Reform, U.S. House of Representatives, December 9, 2008, at 9.
Single Family Guaranty Business, Facing Strategic Crossroads: June 27, 2005 - Produced by the House Committee on Oversight and Government Reform: FM-COGR 00088741-00094025.
42
We have increased our participation in types of products where we have concluded that it would be economically advantageous or that it would contribute to our mission objectives. Our participation in these products reflects our assessment of anticipated guaranty fee income in light of our expectation for potentially higher credit losses. We continue to closely monitor credit risk and pricing dynamics across the full spectrum of mortgage product types... We believe that our assessment and approach to the management of credit risk continued to contribute in the third quarter of 2006 to the maintenance of a credit book of business with strong credit characteristics.
177. On December 6, 2006, Fannie Mae filed its 10-K for 2004 0 signed by, among
others, Defendants Ashley and Mudd. With regard to risk management, the annual filing stated:
Effective management of risks is an integral part of our business and critical to our safety and soundness. In the following sections, we provide an overview of our corporate risk governance structure and risk management processes, which are intended to identify, measure, monitor and control the principal risks we assume in conducting our business activities in accordance with defined policies and procedures. Following the overview, we provide additional information on how we manage each of our four major categories of risk. In "Item 1A—Risk Factors," we identify other risk factors that may adversely affect our business.
Risk Governance Structure
We made significant organizational changes in 2005 and 2006 to enhance our risk governance structure and strengthen our internal controls due to identified material weaknesses. During 2005, we adopted an enhanced corporate risk framework to address weaknesses in our risk governance structure. This new framework is intended to ensure that people and processes are organized in a way that promotes a cross-functional approach to risk management and controls are in place to better manage our risks. Basic tenets of our corporate risk framework include establishing corporate-wide policies for risk management, delegating to business units primary responsibility for the management of the day-to-day risks inherent in the activities of the business unit, and monitoring aggregate risks and compliance with risk policies at a corporate level.
Risk Policy and Capital Conunittee of the Board of Directors
The Board of Directors is responsible for approving our risk governance framework and providing capital and risk management oversight. The Board exercises its oversight of credit risk, market risk, operational risk and liquidity risk primarily through the Board's Risk Policy and Capital Committee. The responsibilities of the Risk Policy and Capital Committee include:
° Fannie Mae did not file timely financial results beginning in July 2004, through November 9, 2007.
43
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• recommending for Board approval enterprise risk governance policy and limits consistent with our mission, safety and soundness;
• overseeing the development of policies and procedures designed to: (i) define, measure, identify and report on credit, market, liquidity and operational risk; and (ii) establish and communicate risk management controls throughout the company;
• overseeing compliance with all enterprise-wide risk management policies;
• overseeing the Chief Risk Office; and
• reviewing the sufficiency of personnel, systems and other risk management capabilities.
In 2006, the Board of Directors adopted corporate risk principles that are being implemented to govern our risk activities. These principles include taking risks in an informed and disciplined manner and ensuring that we are adequately compensated for the risks we take, consistent with our mission goals.
178. The statements regarding risk controls in the 2006 10-Qs and 2006 10-K
constitute a misrepresentation as can be seen from the emails described above from Dallavecchia
to Mudd from 2006 through 2007 concerning Fannie Mae's risk controls.
179. On February 27, 2007, Fannie Mae filed its Form NT 10-K. In that filing, Fannie
Mae stated: "We continue to closely monitor credit risk and pricing dynamics across the full
spectrum of mortgage product types."
180. In the February 27, 2007 conference call with investors, Dallavecchia stated:
I think from a control and risk underwriting standpoint, we want to continue maintaining prudent underwriting standards. One thing that we always look very carefully to is the layering of the risk, not that all subprime loans are bad, but there's some conditions where all risks are layered one on top of the other which makes risk higher. And we want to make sure that we understand the risk and we are remunerated for it.
44
181. In that same call, Mudd stated: "we have a book of business with very strong
credit risk characteristics." He also added:
With the creation of the CR0 position and the CR0 office also came an appropriate set of processes and controls that went around that.. .that involved a process of setting standards and settle limits.
182. The statements by Dallavecchia and Mudd on February 27, 2007 were false and
misleading as can be seen from the emails described above from Dallavecchia to Mudd from
2006 through 2007 concerning Fannie Mae's risk controls.
183. On May 2, 2007, Fannie Mae filed its 10-K for 2005 signed by, among others,
Ashley and Mudd. Fannie Mae's filing included statements substantially similar to the
statements in its 2004 10-K set forth above. In addition, Fannie Mae's 2005 10-K stated:
At the end of 2006, we restructured our risk management committees to enhance our risk governance framework. We dissolved the Corporate Risk Management Committee, which had previously focused on both credit and market risk oversight, and formed two separate committees, the Credit Risk Committee and the Market Risk Committee. We now have three management-level risk committees that focus on our major categories of risk: (i) the Credit Risk Committee, which focuses on credit risk; (ii) the Market Risk Committee, which focuses on market, liquidity and model risk; and (iii) the Operational Risk Committee, which focuses on operational risk. Each committee is responsible for, among other things:
• monitoring aggregated risk exposure;
• discussing emerging risk issues;
• reviewing key corporate risk limits and exposures;
• reviewing the risk aspects of significant new business initiatives; and
• reviewing and recommending risk policies with corporate- wide or significant business unit implications.
We also established two additional management-level risk committees that focus on other significant business risks: (i) the Capital Structure Committee, which focuses on capital management activities; and (H) the Compliance Coordination Committee, which focuses on compliance with legal and regulatory requirements. Our
45
Compliance Coordination Committee also is responsible for coordinating the legal and regulatory compliance risk governance functions with other control functions, such as Legal, Internal Audit and the Chief Risk Office.
The Management Executive Committee, which is chaired by the Chief Executive Officer and composed of principal executive officers of the company, has responsibility for reviewing and approving our enterprise-wide risk tolerance policy and our enterprise-wide risk framework, addressing issues referred to it by our risk committees, addressing matters that involve multiple types of risks and addressing other significant business and reputational risks. Where appropriate, the Management Executive Committee brings transactions of an extraordinary nature and significant potential new business activities to the Risk Policy and Capital Committee of the Board of Directors, as well as other relevant committees, if necessary, for review and approval.
184. Fannie Mae also stated on its 2005 10-K:
We have worked to enhance our credit analytics and data to better understand, assess and price for the risks associated with these products to allow us to closely monitor credit risk and pricing dynamics across the full spectrum of mortgage product types.
185. On August 16, 2007, Fannie Mae filed its 10-K for 2006. The 2006 10-K was
signed by, among others, Ashley and Mudd. With respect to risk management, the 10-K filing
stated:
Effective management of risks is an integral part of our business and critical to our safety and soundness.
* * *
Our corporate risk framework is intended to ensure that people and processes are organized in a way that promotes a cross-functional approach to risk management and that controls are in place to better manage our risks. Basic tenets of our corporate risk framework include:
• Establishing corporate-wide policies for risk management, • Delegating to business units primary responsibility for the management of
day-to-day risks inherent in the activities of the business unit, • Enacting policies and procedures designed to ensure that we have an
independent risk oversight function with appropriate checks and balances throughout our company; and
• Monitoring aggregate risks and compliance with risk policies at a corporate level.
46
186. Also on the 2006 10-K, Fannie Mae stated:
We believe that our approach to management of credit risk during the past several years has contributed to our maintenance of a credit book with strong credit characteristics overall, as measured by loan-to-value ratios, credit scores and other loan characteristics that reflect the effectiveness of our credit risk management strategy.
187. With respect to Single-Family Business, Fannie Mae's 2006 10-K boasted:
Our conventionally single-family mortgage credit book of business remained relatively strong from 2004-2006. We believe that our assessment and approach to the management of credit risk during these years allowed us to maintain a conventional single-family mortgage credit book of business with strong credit risk characteristics as evidenced by our credit losses, which remained low during the three-year period from 2004-2006.
* * *
We continue to closely monitor credit risk and pricing dynamics across the full spectrum of mortgage product types. Our assessment of these dynamics will continue to determine the timing and level of our acquisitions of these types of mortgage products...
188. Fannie Mae's 2006 10-K filing went on to state:
Capital Markets Group
The Capital Markets group continues to seek ways to maximize long-term total returns while fulfilling our chartered liquidity function.
* * *
In an effort to gain better returns, we have acquired new products for which we have been attractively compensated for the risk assumed. We will continue to seek out these beneficial opportunities in the future.
189. Fannie Mae's 2006 10-K also remarked on its credit risk management:
Credit Risk Management
We are generally subject to two types of credit risk: mortgage credit risk and institutional counterparty credit risk. The degree of credit risk to which we are exposed will vary based on many factors, including the risk profile of the borrower or counterparty, the contractual terms of the agreement, the amount of the transaction, repayment sources, the availability and quality of collateral and
47
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other factors relevant to current market conditions, events and expectations. We evaluate these factors and actively manage, on an aggregate basis, the extent and nature of credit risk we bear, with the objective of ensuring that we are adequately compensated for the credit risk we take, consistent with our mission goals.
190. The 2006 annual filing also stated:
Acquisition Policy and Standards
We use proprietary models and analytical tools to price and measure credit risk at acquisition. Our loan underwriting and eligibility guidelines are intended to provide a comprehensive analysis of borrowers and mortgage loans based upon known risk characteristics. The underwriting of single-family mortgage loans primarily focuses on an evaluation of the borrower's creditworthiness and ability to repay the loan based on the value of the property and LTV ratio, the loan purpose and the loan product features. . . Our guidelines for both types of loans require a comprehensive analysis of the property value, the LTV ratio, the local market, and the borrower and their investment in the property.
191. The 2006 10-K signed by Mudd and Ashley, also stated with respect to risk
management:
Chief Risk Office
The Chief Risk Office is an independent risk oversight organization with responsibility for oversight of credit risk, market risk, operational risk and liquidity risk. The Chief Risk Officer is responsible for establishing our overall risk governance structure and providing independent evaluation and oversight of our risk management activities. In 2006 and 2007, we centralized oversight of our business continuity efforts, information security programs, corporate insurance program and SOX Finance Team under our Operational Risk oversight function within the Chief Risk Office to further strengthen our existing operational risk programs...
192. The above statements filed in the 2006 10-K were untrue because Fannie Mae
significantly reduced the Chief Risk Officer's budget and staff as can be seen from the c-mails
described above between Dallavecchia and Mudd.
193. The Officer Defendants making the false statements never corrected the
statements before Plaintiff's purchase of the Fannie Mae securities.
48
194. All Officer Defendants knew or should have known that Fannie Mae was
concealing the truth about its risk controls. Yet, none of the Officer Defendants revealed the
truth prior to the time Plaintiff purchased the Fannie Mae securities.
195. On September 20, 2007, Mudd stated in a Congressional hearing before the House
Committee on Oversight and Government Reform that Fannie Mae could provide more help to
the home finance market without taking risks Fannie Mae was not capable of managing and that
Fannie Mae had "vastly reduced material control weaknesses."
196. Fannie Mae filed its 2007 10-K on February 27, 2008 which was signed by,
among others, Ashley, Mudd, and Swad. With respect to risk management, Fannie Mae's filing
stated:
Our risk governance framework, which is approved by our Board of Directors, is designed to balance strong corporate oversight with well-defined independent risk management functions within each business unit. The objective of our corporate risk framework is to ensure that people and processes are organized in a way that promotes a cross-functional approach to risk management and that controls are in place to better manage our risks and comply with legal and regulatory requirements.
Senior managers of each business unit are responsible and accountable for identifying, measuring and managing key risks within their business consistent with corporate policies. Management-level credit, market, liquidity and operational risk committees provide oversight of the business units and are responsible for establishing risk tolerance policies, monitoring performance against our risk management strategies and risk limits, and identifying and assessing potential issues. We also have a Chief Risk Office that is responsible for establishing our overall risk governance structure and providing independent evaluation and oversight of our risk management activities. Our Board of Directors, through the Risk Policy and Capital Committee, provides additional risk management oversight.
Our Internal Audit group provides an objective assessment of the design and execution of our internal control system, including our management systems, our risk governance, and our policies and procedures. Our Office of Compliance and Ethics is responsible for overseeing our compliance activities and coordinating our OFHEO and HUD regulatory reporting and examinations; and managing our data privacy and anti-fraud efforts.
49
197. On a conference call on February 27, 2008, Mudd stated, "First, we are taking
steps to protect our business from the risks that are apparent in this extraordinary market." He
also stated with respect to Fannie Mae's risk, "On credit, we're taking additional steps to protect
the book by controlling our risk and our losses."
198. Although Fannie Mae continued to reassure investors that the risk was being
monitored, in fact Fannie Mae ignored warnings of risks during a failing market and invested in
subprime and Alt-A mortgages. Even when other institutions were leaving the subprime and
Alt-A market, Fannie Mae continued to invest in risky loans.
199. These representations in the 2007 10-K and in the conference call on February 27,
2008 were materially false and misleading because Fannie Mae did not maintain adequate
internal risk controls particularly with respect to the vast amount of risk it took on in the failing
market.
200. Fannie Mae gave investors false security. Contrary to what Fannie Mae
represented to the public, Fannie Mae dove into risky investments without the proper risk
controls.
201. Mudd went on to say on the February 27, 2008 conference call:
So as you can see by doing the math there, there's about $13 billion above the statutory requirement. The 30% OFHEO requirement was put in place against those uncertainties from the restatement in '01 to '04. As I noted, I think we worked diligently and in very good cooperation with OFHEO to address all of those 81 remediation items, embodied, certainly in the 10-K, in the clean socks opinion. And as you know, OFHEO made a statement today and we really welcome and appreciate director Lockhart's comments, which I think lay a path for us to move through the consent order, but through that, to continue to manage the capital very conservatively, given the uncertainties in a troubled market So we'll conserve capital. We will - we will continue those discussions to access the capital that is there above the - above the statutory minimum, and I think us being able to apply that capital to both sides of the equation I talked about, fulfilling our role as a guarantor and insurer and in an environment that's taking losses but at the same time, to be able to provide liquidity to
50
a market that really needs it, you know, is in really everybody's interest right now. I'm pleased that we are moving that direction.
(Emphasis added)
202. On November 9, 2007, Fannie Mae issued a press release entitled "Fannie Mae
Files 2007 Quarterly Reports with the SEC - Company Returns to Current Financial Reporting"
wherein Mudd stated:
During the last year, we vastly reduced our material weaknesses in internal controls, expanded our risk-management functions, reduced our headcount, and cut our operating expenses. The Company is in solid shape to support the market, and is in better shape to benefit when the market correction ends.
(Emphasis added)
203. Fannie Mae issued a press release in December 2007 regarding the issue of new
preferred shares stating:
This financing will provide the company with additional capital to conservatively manage increased risk in the housing and credit markets, help meet its mission of providing affordability, liquidity and stability, and free up capital to pursue emerging growth opportunities.
204. The statements by Mudd on the February 27, 2007 conference call, the press
release on November 9, 2007 and the December 2007 press release were all false and misleading
as can be seen from the emails described above from Dallavecchia to Mudd from 2006 through
2007 concerning Fannie Mae's risk controls.
G. Defendants Materially Misrepresented Fannie Mae's Mortgage Portfolio
205. As already noted, Fannie Mae did not disclose to investors that in calculating its
reported exposure to subprime loans, Fannie Mae did not include loan products specifically
targeted by Fannie Mae towards borrowers with weaker credit histories, including most
significantly, "Expanded Approval" ("EA") loans. As of December 31, 2006, the amount of EA
loans owned or securitized in the Fannie Mae's single-family credit business was approximately
51
$43.3 billion, yet none of these loans were included in Fannie Mae's disclosed subprime
exposure.
206. Fannie Mae's exclusion of loans such as EA from its subprime disclosures was
particularly misleading because EA loans were exactly the type of loans that investors would
reasonably believe Fannie Mae included when calculating its exposure to subprime loans. In fact,
Fannie Mae identified EA as its "most significant initiative to serve credit impaired borrowers"
in response to regulatory requests for information on its subprime loans. In addition, all of the
Defendants knew that EA loans had higher average delinquency rates, higher credit losses, and
lower average credit scores than the loans Fannie Mae included when calculating its disclosed
subprime loan exposure.
207. In a November 2007 public filing, Fannie Mae described subprime loans as a loan
to a borrower with a "weaker credit profile than that of a prime borrower," and classified
mortgage loans as "subprime" if the mortgage loans were originated by a "specialty" subprime
lender or a "subprime division of a large lender." Fannie Mae represented that only 0.2%, or
approximately $4.8 billion, of its Single Family credit book of business consisted of subprime
mortgage loans or structured Fannie Mae MBS backed by subprime mortgage loans as of both
March 31, 2007, and June 30, 2007.
208. Fannie Mae did not tell investors that in calculating its exposure to subprime
loans reported in this filing, Fannie Mae again did not include at least $43 billion of EA loans,
included loans from only fifteen loan originators of the approximately 210 lenders listed on the
HUD Subprime Lender list, and did not even have the capacity to track whether loans were
originated by a subprime division of a large lender.
52
209. Fannie Mae made similarly misleading disclosures concerning its exposure to
subprime loans in public filings throughout the Relevant Period. The result of these disclosures
was to mislead investors into seriously underestimating Fannie Mae's exposure to subprime
loans.
210. Similarly, Fannie Mae misled investors concerning its exposure to Alt-A loans
with reduced or alternative documentation requirements. Fannie Mae did not disclose to the
public the total percentage of its Single Family mortgage guarantee business consisting of
reduced documentation loans as reflected in its own internal reporting, which Defendants
routinely received.
211. Instead, in its public disclosures, Fannie Mae described Alt-A loans as loans with
lower or alternative documentation requirements, and then further stated that it classified loans as
"Alt-A if the lenders that deliver the mortgage loans to us have classified the loans as Alt-A
based on documentation or other product features."
212. Based on this reporting construct, for example, in the May 2, 2007 10-K filing,
Fannie Mae publicly reported that approximately 11% of its total Single Family mortgage credit
book of business as of March 31, 2007, consisted of Alt-A mortgage loans or Fannie Mae
mortgage securities backed by Alt-A mortgage loans. This filing materially underreported the
extent of Fannie Mae's total exposure to low documentation loans, which was approximately
17.9% as of March 31, 2007, based on Fannie Mae's own internal records.
213. Fannie Mae also did not disclose to investors that certain reduced documentation
loans it received from lenders were not included in the calculation of Fannie Mae's publicly
disclosed Alt-A loan exposure if the reduced documentation requirements were internally
designated as Lender-Selected. Despite this exclusion, Lender-Selected Reduced Documentation
53
taR.1affztgajpthIt.Nunr*sIaIrTt*yaapa1t1.[awzItnI
Loans had a serious delinquency rate that was substantially higher than Fannie Mae's full
documentation loans with similar credit risk profiles. Further, Fannie Mae did not tell investors
that Fannie Mae itself provided lenders - in advance - with the coding designations for Alt-A
versus Lender-Selected.
214. The result of these disclosures was to mislead investors into materially
underestimating Fannie Mae's exposure to reduced documentation loans. Fannie Mae made
similarly misleading disclosures concerning its exposure to reduced documentation loans in
public filings throughout the Relevant Period.
215. The Securities and Exchange Commission ("SEC") performed an investigation
and then filed an action against Mudd, Dallavecchia and a third Fannie Mae officer, Thomas
Lund, on December 16, 2011. The SEC concluded that Mudd and Dallavecchia each knew,
based on reports and internal data they received on a regular basis, that Fannie Mae's reported
exposure to subprime and Alt-A loans was inaccurate. The misleading statements describing
subprime and Alt-A loans occurred in periodic and other filings with the SEC, and public
settings, including investor and analyst calls and media interviews. Mudd and Dallavecchia
reviewed and approved each of the false public filings. Mudd and Dallavecchia each made public
statements falsely claiming that Fannie Mae's exposure to subprime loans was minimal.
216. The SEC action against Mudd and Dallavecchia was brought under federal
securities laws and sought injunctive relief, disgorgement of profits, prejudgment interest, civil
penalties and other appropriate and necessary equitable relief from both defendants. One result
of the SEC litigation was an agreed list of facts attached to a non-prosecution agreement (the
"NPA" incorporated by reference). Mudd (the "CEO") and Dallavecchia (the "CR0") agreed
that the following facts contained in an Exhibit A to the NPA were true and correct. While the
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*IaRs1affztgajpthIt.Nunr*I jjjgliii~IaIrt*wwapa1t1.[sj.ntnI111
NPA provides that Mudd and Dallavecchia can contest the facts if the SEC is not a party to the
action, the facts are either true as stated in the NPA or such recitation of the facts is a sham.
Mudd and Dallavecchia cannot have it both ways as a matter of logic, and reality and fact.
STATEMENT OF FACTS FROM NPA
(1) Federal National Mortgage Association ("Fannie Mae") is a government-
sponsored enterprise that was chartered by congress in 1938 to support liquidity,
stability and affordability in the secondary mortgage market, where existing
mortgage-related assets are purchased and sold. Fannie Mae provides market
liquidity by securitizing mortgage loans originated by lenders in the primary
mortgage market into Fannie Mae mortgage-backed securities ("MBS"), known
as Fannie Mae MBS, and purchasing mortgage loans and mortgage-related
securities in the secondary market for its mortgage portfolio. In or about February
2008, Fannie Mae began reporting billion-dollar credit losses resulting from its
portfolio of mortgage-related assets and guaranty contracts. For the period
January 1, 2007 through March 31, 2011, Fannie Mae reported cumulative net
losses of $153.2 billion.
(2) From 1992 until July 30, 2008, Fannie Mae's primary regulator was the
Office of Federal Housing Enterprise Oversight ("OFHEO").
(3) On July 30, 2008, when the President signed into law the Housing and
Economic Recovery Act of 2008, the Federal Housing Finance Agency ("FHFA")
became Fannie Mae's primary regulator. On September 6, 2008, FHFA placed
Fannie Mae into conservatorship, and as conservator succeeded to all rights, titles,
55
powers and privileges of Fannie Mae, its shareholders, and the officers or
directors of Fannie Mae with respect to the company and its assets.
(4) On July 8, 2010, Fannie Mae's common stock was delisted from the New
York Stock Exchange and the Chicago Stock Exchange. Fannie Mae's common
stock currently is traded in the over-the-counter market and quoted on the OTC
Bulletin Board under the ticker symbol "FNMA." Fannie Mae's debt securities
are actively traded in the over-the-counter market.
(5) From December 6, 2005 through November 10, 2008 (the "Relevant
Period"), Fannie Mae provided mortgage credit risk disclosures in its periodic
filings and other filings with the Securities and Exchange Commission (the
"Commission") relating to Fannie Mae's single-family mortgage credit book of
business, which consisted of whole single-family mortgage loans and Fannie Mae
MBS backed by single-family mortgage loans (whether held in its portfolio or by
third parties).
(6) During the Relevant Period, Fannie Mae provided disclosures regarding its
exposure to Alt-A and subprime mortgage loans in its single-family mortgage
credit book of business.
(7) On February 27, 2007 Fannie Mae provided its first public quantitative
disclosure of its exposure to subprime mortgage loans in a 12b-25 filing with the
Commission (the "February 2007 12b-25 Filing").
(8) The February 2007 12b-25 Filing stated that "[although there is no
uniform definition for sub-prime and Alt-A loans across the mortgage industry,
Alt-A loans are generally defined as loans with lower or alternative
56
*Iaw1affzsygaipthIt.Nunr*I jjjgliii~IaIt*yaapa1t1.[a1artnI111
documentation requirements, while sub-prime loans typically are made to
borrowers with weaker credit histories." The February 2007 12b-25 Filing further
stated:
• "We estimate that approximately 0/2% of our single-family mortgage credit book of business as of December 31, 2006 consisted of sub-prime mortgage loans or structured Fannie Mae MBS backed by sub-prime mortgage loans."
• "We estimate that approximately 2% of our single-family mortgage credit book of business as of December 31, 2006 consisted of private-label mortgage-related securities backed by sub-prime mortgage loans and, to a lesser extent, resecuritizations of private-label mortgage-related securities backed by sub-prime mortgage loans."
(9) During the Relevant Period, one of Fannie Mae's primary mortgage loan
products targeted towards borrowers with weaker credit histories was called
Expanded Approval/Timely Payment Rewards ("EA"). As of December 31, 2006,
the percentage of EA loans held on Fannie Mae's book of business was 1.8%.
(10) The Unpaid Principal Balance ("UPB") of EA loans owned or securitized
by Fannie Mae in its single-family mortgage credit book of business was $39.7
billion as of December 31, 2005, $43.3 billion as of December 31, 2006, and
$55.6 billion as of December 31, 2007. The UPB of loans Fannie Mae classified
and disclosed as subprime, which it owned or securitized in its single-family
mortgage credit book of business, was $2.3 billion as of December 31, 2005, $4.8
billion as of December 31, 2006, and $8.3 billion as of December 31, 2007. In
addition to EA, Fannie Mae had other mortgage loan programs, such as My
Community Mortgage ("MCM") that served low-to-moderate income borrowers,
including borrowers with weaker credit histories.
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(11) In anticipation of communications with investors in March, 2004, Fannie
Mae's then-Chief Executive Officer ("CEO") received a document listing
questions and answers ("Q&A") relating to Fannie Mae's business. That
document stated in part: .. ....Delinquencies in the subprime market have been
rising. What is Fannie Mae's exposure to subprime loans? Does subprime include
Alt-A loans? ANSWER [1 Our strong risk management tools and practices have
enabled expansion of Fannie Mae's product offerings to include products targeted
to borrowers with minor credit blemishes. The most notable product line for
reaching these borrowers, Expanded Approval with Timely Payment Rewards,
has grown in volume but represents less than two percent of Single Family credit
portfolio." Further, in March of 2005, Fannie Mae's CEO was provided with a
Q&A that stated in part: .. ....Delinquencies in the subprime market have been
rising. What is Fannie Mae's exposure to subprime loans? Does subprime include
Atl-A product loans? ANSWER [1 Fannie Mae's subprime exposure primarily
consists of our own product line for serving credit-impaired borrowers—the
Expanded approval with Timely Payment Rewards product, and mortgage related
securities backed by subprime loans that we hold in our mortgage portfolio ..."
(12) Prior to the February 2007 12b-25 Filing, in April 2005 and April 2006, in
response to requests for information on Fannie Mae single-family subprime loans,
Fannie Mae provided OFHEO with data and information on mortgage loan
purchases and mortgage loan securities under its EA program and described the
EA loans as its "most significant initiative to serve credit-impaired borrowers."
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jjjgl iii~ 111
(13) EA loans were not included in Fannie Mae's calculation or quantification
of its subprime mortgage loans or other subprime exposure set forth in Fannie
Mae's February 2007 12b-25 Filing.
(14) In its February 2007 12b-25 Filing, Fannie Mae publicly disclosed that its
subprime exposure as of December 31, 2006 was approximately 2.2% of its
single-family mortgage credit book of business, of which approximately 0.2%
($4.8 billion) consisted of subprime mortgage loans or structured Fannie Mae
MBS backed by subprime mortgage loans. Fannie Mae's exposure to EA loans in
its single-family mortgage credit book of business was approximately $43.3
billion as of December 31, 2006.
(15) During the Relevant Period, Fannie Mae tracked the serious delinquency
rate ("SDQ Rate") of its mortgage loan products in order to measure the credit
risk of its loan portfolio. Fannie Mae defined SDQ as a loan that is 90 days or
more past due and loans that are in the process of foreclosure. Generally, the
higher the SDQ Rate of loans, the higher the credit risk of those loans. As Fannie
Mae stated in its 2004 Form 10-K: "The SDQ is an indicator of potential future
foreclosures, although most loan that become seriously delinquent do not result in
foreclosure. The rate at which new loans become seriously delinquent and the rate
at which existing seriously delinquent loans are resolved significantly affect the
level of future credit losses."
(16) Internal reports show that Fannie Mae's publicly disclosed subprime loans
had an SDQ rate of 4.72% as of December 31, 2006, and Fannie Mae's EA loans
had an SDQ rate of 5.57% as of December 31, 2006.
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jjjgl iii~ 111
(17) During the Relevant Period, information described in paragraphs 7-16
above was provided and/or available to senior executives, including Fannie Mae's
CEO, Fannie Mae's Executive Vice President for its Single Family business
("Single Family EVP"), and its Chief Risk Officer ("CR0") through internal
reports, presentations, and briefings.
(18) The CEO, the Single Family EVP and the CR0 each reviewed and
approved the February 2007 12b-25 Filing.
(19) On May 2, 2007, Fannie Mae filed its 2005 Form 10-K with the
Commission (the "May 2, 2007 10-K Filing"). This filing stated "Subprime
mortgage' generally refers to a mortgage loan made to a borrower with a weaker
credit profile than that of a prime borrower. As a result of the weaker credit
profile, subprime borrowers have a higher likelihood of default than prime
borrowers. Subprime mortgage loans are often originated by lenders specializing
in this type of business, using processes unique to subprime loans. In reporting
our subprime exposure, we have classified mortgage loans as subprime if the
mortgage loans are originated by one of these specialty lenders or, for the original
or resecuritized private-label, mortgage-related securities that we hold in our
portfolio, if the securities were labeled as subprime when sold."
(20) In the May 2, 2007 10-K Filing, Fannie Mae also stated that "subprime
loans represented approximately 2.2% of our single-family mortgage credit book
of business as of December 31, 2006, of which approximately 0.2% consisted of
subprime mortgage loans or structured Fannie Mae MBS backed by subprime
mortgage loans and approximately 2% consisted of private-label mortgage-related
60
*Iaw1affzsygaipthIt.Nunr*I jjjgliii~IaIrt*wwapa1t1.[antnI111
securities backed by subprime mortgage loans and, to a lesser extent,
resecuritizations of private-label mortgage-related securities backed by subprime
mortgage loans."
(21) The calculation and quantification of Fannie Mae's subprime mortgage
loans or other subprime exposure set forth in the May 2, 2007 10-K Filing did not
include Fannie Mae's exposure to EA loans. As of December 31, 2006, the
percentage of EA loans held on Fannie Mae's single-family mortgage credit book
of business was 1.8%
(22) During the Relevant Period, the Department of Housing and Urban
Development provided a list of lenders specializing in the subprime business (the
"HUD Subprime Lender List"). As of December 31, 2006, the HUD Subprime
Lender List consisted of2lO subprime lenders.
(23) In calculating and quantifying its subprime loans and other subprime
exposure as disclosed in the May 2, 2007 10-K Filing, Fannie Mae did not use the
HUD Subprime Lender List to identify lenders "specializing in this type of
business" and included loans only from fifteen loan originators. Fannie Mae did
not publicly disclose that loans from only fifteen originators were considered
when calculating its subprime exposure or the names of those originators.
(24) During the Relevant period, Fannie Mae purchased and securitized loans
from lenders on the HUD Subprime Lender List but did not include those loans
when calculating or quantifying its subprime loans.
(25) On May 2, 2007, Fannie Mae's CEO certified the May 2, 2007 10-K
Filing. The certification stated, among other things:
61
a. [T]his report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; and
b. [T]he financial statements, and other financial information included in the Report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in the Report.
(26) The Single Family EVP and the CR0 signed sub-certifications for the
May 2, 2007 10-K Filing. Those sub-certifications stated, among other things:
a. [T]he Report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the periods covered by the Report.
b. [T]he financial statements, and other financial information included in the Report, fairly present in all material respects the financial condition, results of operations and cash flows of the business segments for which I am responsible as of, and for, the periods presented in the Report.
(27) On August 16, 2007, Fannie Mae provided a virtually identical subprime
definition and the same subprime quantitative exposure amount in its 2006 Form
10-K filed with the Commission (the "August 2007 10-K Filing") as it did in its
May 2, 2007 10-K Filing.
(28) Fannie Mae's calculation and quantification of its subprime loans or other
subprime exposure set forth in the August 2007 10-K Filing did not include its EA
loans.
(29) On August 16, 2007, simultaneous with filing its 2006 10-K, Fannie Mae
filed an 8-K credit supplement (the "August 2007 Credit Supplement Filing"),
which disclosed that, as of June 30, 2007, 1% of its single family mortgage credit
book of business consisted of loans with both a FICO Score below 620 and
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Original-Loan-To-Value ("OLTV") Greater than 90% (the "Low FICO/High
OLTV Loans").
(30) As of June 30, 2007, only 15.5% of the EA loans had both a FICO score
below 620 and an OLTV greater than 90%.
(31) During the Relevant Period, information described in paragraphs 19-30
was provided and/or available to the CEO, the Single Family EVP and the CR0
through internal reports, presentations, and briefings.
(32) The CEO certified the August 2007 10-K Filing and reviewed and
approved the August 2007 Credit Supplement Filing. The certification was
substantially similar to the representations set forth above in Paragraph 25.
(33) The Single Family EVP and the CR0 sub-certified the August 2007 10-K
Filing. Those sub-certifications were substantially similar to the representations
set forth above in Paragraph 26. The Single Family EVP and the CR0 reviewed
and approved the August 2007 Credit Supplement Filing.
(34) On November 9, 2007, Fannie Mae simultaneously filed its first, second,
and third quarter 2007 Form 10-Q filings with the Commission (the "November
2007 10-Q Filings").
(35) Each of the November 2007 10-Q Filings stated: "A subprime mortgage
loan generally refers to a mortgage loan made to a borrower with a weaker credit
profile than that of a prime borrower. As a result of the weaker credit profile,
subprime borrowers have higher likelihood of default than prime borrowers.
Subprime mortgage loans are typically originated by lenders specializing in this
type of business or by subprime divisions of large lenders, using processes unique
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jjjgl iii~ 111
to subprime loans. In reporting our subprime exposure, we have classified
mortgage loans as subprime if the mortgage loans are originated by one of these
specialty lenders or a subprime division of a large lender."
(36) During the Relevant Period, Fannie Mae did not keep separate statistical
reports or otherwise track loans made by the subprime division of originators. It
therefore could not quantify the number of loans it acquired or securitized that
were originated by the subprime division of a large lender.
(37) Throughout most of the Relevant Period, Fannie Mae's largest customer
was Countrywide Financial Corporation. Countryside's retail subprime lending
division was known as Full Spectrum Lending.
(38) Records indicate that Fannie Mae purchased or securitized $7.7 billion
worth of loans originated by Full Spectrum Lending in 2006, $13.2 billion in
2007, and $7.6 billion in 2008.
(39) During the Relevant Period, Fannie Mae purchased or securitized loans
from other subprime divisions of large lenders.
(40) In the November 2007 10-Q Filings, Fannie Mae stated that approximately
0.2% of its total single-family mortgage credit book of business as of March 31,
2007 and June 30, 2007 consisted of subprime mortgage loans or Fannie Mae
MBS backed by subprime mortgage loans and that this percentage increased to
approximately 0.3% as of September 30, 2007. Fannie Mae also disclosed that
less than 1% of its single-family business volume for the nine months ended
September 30, 2007 consisted of subprime mortgage loans or Fannie Mae MBS
backed by subprime mortgage loans.
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(41) In Fannie Mae's single family mortgage credit book of business, the dollar
amount of the subprime loans and other subprime exposure as disclosed in each of
Fannie Mae's February 2007 12b-25 Filing, May 2, 2007 10-K Filing, August
2007 10-K Filing or November 2007 10-Q Filings did not exceed $8.3 billion.
(42) Fannie Mae's quantitative subprime disclosure in the November 2007 10-
Q Filings did not include its exposure to EA loans. Fannie Mae's quantitative
exposure to EA loans for the periods covered by the Form 10-Qs was at least $43
billion.
(43) On November 9, 2007, Fannie Mae provided disclosure of its exposure to
loans that were both Low FICO/High OLTV in its Form 8-K Credit Supplement
that it filed concurrent with its November 2007 10-Q Filings with the Commission
(the "November 2007 8-K Filings")
(44) Fannie Mae's calculation and quantification of its exposure to loans that
were both Low FICO/High OLTV in the November 2007 8-K Filings did not
include all of its EA loans.
(45) During the Relevant Period, members of Fannie Mae's senior management
were provided with information indicating that Fannie Mae purchased and
securitized loans from subprime divisions of large lenders such as Countrywide's
Full Spectrum Lending. For example, in a February 2007 meeting, the then-CEO
received a presentation on the volume of agency-eligible loans from each of
Countrywide's four lending divisions, including Full Spectrum Lending.
(46) The CEO certified the November 2007 10-Q Filings and reviewed and
approved the November 2007 8-K Filings. The Single Family EVP and the CR0
65
sub-certified the November 2007 10-Q Filings. The Single Family EVP and the
CR0 reviewed and approved the November 2007 8-K Filings.
(47) Post-conservatorship, on November 10, 2008, in its third quarter Form 10-
Q ("November 2008 10-Q Filing"), Fannie Mae disclosed for the first time that
certain loans with features similar to subprime loans were not included in the
calculation or quantification of Fannie Mae's subprime exposure. The November
2008 10-Q Filing stated in part: "We have classified mortgage loans as subprime
if the mortgage loan is originated by a lender specializing in subprime business or
by subprime divisions of large lenders. We apply these classification criteria in
order to determine our ... subprime loan exposures; however, we have other loans
with some features that are similar to ... subprime loans that we have not
classified as ... subprime because they do not meet our classification criteria."
(48) On February 24, 2011, in its Form 10-K for the fiscal year 2010, Fannie
Mae stated for the first time: "We exclude from the subprime classification loans
originated by these lenders if we acquired the loans in accordance with our
standard underwriting criteria, which typically require compliance by the seller
with our Selling Guide (including standard representations and warranties) and/or
evaluation of the loans through our Desktop Underwriter system."
(49) In its February 2007 12b-25 Filing, Fannie Mae stated that Alt-A loans
"are generally defined as loans with lower or alternative documentation
requirements."
66
(50) Prior to May 2, 2007, Fannie Mae did not quantify its exposure to Alt-A
loans in its public filings with the SEC or in other disclosures provided to
investors.
(51) Fannie Mae increased its acquisition of reduced documentation loans in its
conventional single family mortgage guarantee business from at least 17.8%
percent of new acquisitions in 2004 to at least 27.8% of new acquisitions in 2006.
(52) From December 6, 2006 through May 31, 2008, according to internal
Fannie Mae loan acquisition data reports, at least 25% of Fannie Mae's loan
acquisitions in its conventional single family mortgage guarantee business were
reduced documentation loans.
(53) On May 9, 2007, for the first time in a public filing, Fannie Mae
quantified its exposure to Alt-A loans in a 12b-25 filed with the Commission (the
"May 9, 2007 12b-25 Filing").
(54) In the May 9, 2007 12b-25 Filing, Fannie Mae stated that in reporting
"Alt-A exposure, we have classified mortgage loans as Alt-A if the lenders that
deliver the mortgage loans to us have classified the loans as Alt-A based on
documentation or other product features, or, for the original or resecuritized
private-label, mortgage-related securities that we hold in our portfolio, if the
securities were labeled as Alt-A when sold. We estimate that approximately 11%
of our total single-family mortgage credit book of business as of both March 31,
2007 and December 31, 2006 consisted of Alt-A mortgage loans or structured
Fannie Mae MBS backed by Alt-A mortgage loans."
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(55) Fannie Mae had a coding system to identify the loan characteristics for
certain mortgages ("Special Feature Codes"). Loan sellers in the lender channel
were instructed by Fannie Mae to use certain Special Feature Codes in delivering
loans to Fannie Mae. Thus, Fannie Mae's coding system determined those loans
that such sellers classified as Alt-A.
(56) In calculating its Alt-A exposure, Fannie Mae excluded what it classified
as lender-selected loans ("Lender-Selected Reduced Documentation Loans").
(57) During the Relevant Period, Fannie Mae did not publicly disclose that it
excluded Lender-Selected Reduced Documentation Loans from its reported Alt-A
exposure.
(58) At times during the Relevant Period, Lender-Selected Reduced
Documentation Loans had an SDQ Rate that was on average 1.4 times higher than
Fannie Mae's full documentation loans with a similar credit risk profile.
(59) As of March 31, 2007, at least 17.9% of Fannie Mae's total conventional
single-family mortgage guarantee business consisted of reduced documentation
mortgage loans or structured Fannie Mae MBS backed by reduced documentation
mortgage loans.
(60) During the Relevant Period, information described in paragraphs 49-59
was provided and/or available to the CEO, the Single Family EVP and the CR0
through internal reports, presentations, and/or briefings.
(61) Fannie Mae's CEO certified periodic filings during the Relevant Period
that included Fannie Mae's Alt-A disclosures. Those certifications were
substantially similar to the representations set forth above in Paragraph 25.
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(62) The Single Family EVP and Fannie Mae's CR0 sub-certified periodic
filings during the Relevant Period that included Fannie Mae's Alt-A disclosures.
Those sub-certifications were substantially similar to the representations set forth
above in Paragraph 26.
(63) Fannie Mae's CEO, its Single Family EVP and its CR0 reviewed and
approved Alt-A disclosures contained in Fannie Mae's 12b-25 filings during the
Relevant Period.
(64) Post-conservatorship, in its November 2008 10-Q Filing, Fannie Mae
disclosed for the first time that it excluded certain loans with features similar to
Alt-A loans from its calculation and quantification of its Alt-A exposure. The
November 2008 10-Q Filing stated in part: "We have classified mortgage loans as
Alt-A if the lender that delivers the mortgage to us has classified the loans as Alt-
A based on documentation or other features; however, we have other loans with
some features that are similar to ... Alt-A loans that we have not classified as
Alt-A because they do not meet our classification criteria."
217. The agreed statement of facts demonstrates Fannie Mae, Mudd and Dallavecchia
knew that false and misleading statements were purposely disseminated by means of Fannie Mae
SEC filings. The history of Fannie Mae's treatment of EA loans also shows that Mudd and
Dallavecchia knowingly and purposely misled the investing public.
218. Since the late 1990s, Fannie Mae acquired and guaranteed subprime mortgage
loans described in Fannie Mae periodic filings as loans made to "borrowers with weaker credit
histories" or "weaker credit profile[s]" that "have a higher likelihood of default than prime
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loans" as part of Fannie Mae's two primary programs for borrowers with weaker credit histories:
Expanded Approval/Timely Payment Rewards ("EA") and MyCommunityMortgage ("MCM").
219. As detailed in part above, the credit risks posed by these programs were well
understood by the Officer Defendants at Fannie Mae. Mudd was familiar with the EA and MCM
loan programs and the credit risks those loan programs entailed. Officer Defendants received
reports, briefings and presentations containing acquisition volume, Serous Delinquency Rates
("SDQ Rates") and credit loss data with respect to Fannie Mae's Ea and MCM loans. Mudd and
Dallavecchia knew that EA loans were - on average - the highest credit risk loans on Fannie
Mae's book of business, and knew that EA loans contributed disproportionately to Fannie Mae's
credit losses.
220. Indeed, in May 2001, Mudd wrote a memo to the then-CEO noting that EA loans
"are the highest default risk loans we have ever done."
221. Traditionally, Fannie Mae treated EA loans as part of its subprime exposure. For
example, a March 2002 Report prepared for the U.S. Department of Housing and Urban
Development ("HUD") with the participation of Fannie Mae, entitled "Subprime Markets, the
Role of USEs and Risk-Based Pricing," stated under a section entitled "Agency Subprime
Lending Products' that:
The agencies are increasing their presence in the subprime market by rolling-out new subprime mortgage products through updated versions of their automated underwriting systems. Fannie Mae seller/servicers now offer loan products to three groups of credit-impaired borrowers under two new programs. Fannie Mae's Expanded Approval program allows lenders to approve borrowers who would have been formerly classified as 'Refer with Caution' ... by Fannie Mae's Desktop Underwriter (DU). ... The Expanded Approval products are recent innovations, and, according to Fannie Mae representatives, account for a relatively small portion of that USE's book of business ... At most, according to a Fannie Mae stock analyst, these subprime loan purchases will account for no more than five percent of that USE's purchase volumes. (Emphasis added).
70
222. Similarly, in its annual exam process in 2004 and 2005, Fannie Mae's then-
primary regulator, the Office of Federal Housing Enterprise Oversight's ("OFHEO") asked for
information on Fannie Mae's total Single Family subprime loan exposure, specifically
requesting: "[flhe volume of loans purchased in 2004 [and 2005] defined as CE structured
subprime ... or sub-prime as otherwise defined." In March of 2005 and April of 2006,
respectively, Fannie Mae responded by providing OFHEO with information on mortgage loan
purchases and mortgage-backed securities under the EA program, describing the EA program as,
"our most significant initiative to serve credit-impaired borrowers."
223. Moreover, before December 2006, various internal Fannie Mae reports, including
reports to the Board, identified subprime loans as including: (i) investor channel subprime loans
acquired as part of its Subprime NBI; (ii) A-Deal loans that pre-date December 2005; and, (iii)
EA loans.
224. When Fannie Mae first reported its quantitative exposure to subprime loans in a
filing with the SEC on February 27, 2007, Fannie Mae broadly defined subprime as loans to
"borrowers with weaker credit histories." EA and MCM loans fell squarely within this definition,
but were not included in the accompanying quantification of Fannie Mae's subprime exposure.
225. Instead, the quantification consisted primarily of private label securities it held
that were marketed as being backed by subprime loans, certain "A-" loans that Fannie Mae
acquired prior to 2005, and certain loans that had been acquired through a limited new business
initiative beginning in 2006. Fannie Mae's subprime quantification did not include significant
numbers of other loans that fell within its published subprime definition of loans to "borrowers
with weaker credit histories."
71
226. EA loans had, on average, higher SDQ rates than the loans Fannie Mae used in
calculating its disclosed subprime exposure. Senior management at Fannie Mae, including the
Officer Defendants, were aware of this fact, as SDQ rates were tracked and regularly included in
reports and other internal presentations. For example, in a meeting of the Risk Policy and Capital
Committee ("RPCC") of Fannie Mae's Board, the CR0 reported that as of July 2007 Fannie
Mae's SDQ rates for EA were 5.57% (the highest on its book); by contrast, the SDQ rates of its
disclosed subprime loans were 4.95%. Such differences are material.
227. The credit risk associated with Fannie Mae's EA and MCM acquisitions was
reported to and tracked by Officer Defendants, in terms of acquisition volume, delinquencies,
and credit losses - alongside those loans that were included when quantifying its disclosed
"subprime" exposure in its public filings. EA and MCM loans were routinely included in reports
tracking Fannie Mae's high risk loan products (which ranged from three to five or more loan
types during the Relevant Period) that were received by the Officer Defendants.
228. The Officer Defendants were provided with credit loss data that showed that the
greatest amount of credit losses attributable to any one loan type or product on Fannie Mae's
Single Family book were attributable to the EA product. For instance, in an October 26, 2007,
Disclosure Committee report, it is noted that EA loans were responsible for $188.9 million in
losses and MCM loans were responsible for $16 million in losses - compared to $5.5 million in
losses for the loan population Fannie Mae disclosed as its subprime exposure.
229. As a portion of Fannie Mae's book of business, EA loans increased in volume
between 2006 and 2008 from $43.3 billion to $58.3 billion, totaling approximately 2% of Fannie
Mae's book of business during the Relevant Period. MCM loans, which were intended for low-
to-moderate income borrowers, accounted for between 0.3% and 1.5% of Fannie Mae's book of
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business over the same period. None of these loans were included in Fannie Mae's calculation of
its publicly disclosed subprime exposure.
230. Fannie Mae's exposure to EA loans in its Single Family mortgage credit book of
business was approximately $43.3 billion as of December 31, 2006 - approximately 10 times
greater than the 0.2% ($4,8 billion) disclosed as "sub-prime mortgage loans or structured Fannie
Mae MBS back by subprime loans" as of December 31, 2006.
231. The February 27, 2007, 126-25 disclosure falsely stated that Fannie Mae's total
exposure to loans made to borrowers with weaker credit histories (subprime) was 2.2% of its
total mortgage credit book of business, when in fact its exposure was at least 4.64% (as of
December 31, 2006).
232. Nothing in Fannie Mae's public disclosures alerted investors that it held a much
larger volume of loans that matched Fannie Mae's description of subprime loans but were not
included in the reported subprime number.
233. Although Fannie Mae excluded EA from its subprime reporting, Fannie Mae's
EA loans had, on average, SDQ rates higher than those loans Fannie Mae actually included in
calculating its disclosed exposure to subprime loans. As of January 2007, EA loans had an SDQ
rate of 5.69%; disclosed Subprime loans (as-quantified in Fannie Mae's filings) had an SDQ rate
of 4.82%.
234. EA and MCM loans accounted for a higher percentage of Single Family credit
losses (20.4%) at year-end 2006 than loans Fannie reported as its subprime exposure, which at
the time were responsible for no credit losses.
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235. Mudd, Lund and Dallavecchia each reviewed and approved the February 27,
2007, Form 12b-25 statement before it was released by Fannie Mae, knowing its quantified
subprime disclosure excluded EA and MCM loans.
236. In short, Mudd, Dallavecchia and Fannie Mae made or substantially assisted
others in making materially false and misleading statements regarding Fannie Mae's exposure to
subprime and Alt-A loans.
H. The Materially False and Misleading Offering Circular
237. The Offering Circular, dated May 13, 2008, offered the Preferred Stock at a sales
price of $25 per share. The issue date was May 19, 2008, and the New York Stock Exchange
symbol for the issue was "FNMprT." 81 The Offering Circular provided that Fannie Mae would
issue 80,000,000 shares of the Preferred Stock, which would raise a total $2 billion. Of this
amount, $63 million was allocated to the underwriters for fees, although the amount could be as
low as $53 million if the entire issue was sold to institutional investors. In any event, the
Underwriter Defendants benefited substantially in acting as underwriters for the Preferred Stock.
238. The Offering Circular was prepared and reviewed by both Officer Defendants and
Underwriter Defendants. On information and belief, each Officer Defendant and each
Underwriter Defendant had actual knowledge that the Offering Circular misrepresented Fannie
Mae's true financial condition.
239. The names of the Underwriter Defendants appear on the cover-page (the first
page) of the Offering Documents. Citigroup and Wachovia Securities are listed as the Joint
Book-Running Managers.
240. Wachovia Securities purchased a portion of the Preferred Stock and, in turn, sold
a portion of these to Plaintiff.
81 The Preferred Stock was never listed on the New York Stock Exchange as represented in the Offering Documents.
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241. Prior to the offering date, a salesman/dealer from Wachovia Securities made a
solicitation phone call to Plaintiff Wachovia Securities knew that Plaintiff was interested in
purchasing conservative, income-producing preferred stock. On May 13, 2008, Plaintiff
purchased 600,000 shares of the Preferred Stock (CUSIP 313586737) from Wachovia Securities,
pursuant to the Offering Circular, for $15 million.
242. The materially deceptive representations and omissions do not stem merely from
the Offering Circular's generalized statements concerning prospective risks. Rather, the
Offering Circular contained material misrepresentations and omissions concerning past
performance and the then-current financial condition of Fannie Mae. In particular, the Offering
Circular represented that Fannie Mae had an adequate capital base to withstand the coming
financial storm which was materially false. In short, the misrepresentation and omission
concerning Fannie Mae's then-current financial health had the effect of improperly concealing
prospective risks.
243. The Offering Circular summarized, and incorporated by reference, Fannie Mae's
most recent 10K and 10Q filings, including its statement concerning its capitalization. The
Offering Circular misrepresented risks by regurgitating Fannie Mae's previous statements
concerning $17.8 billion in deferred tax assets, which were still being carried at full value. The
Officer and Underwriter Defendants, via the Offering Circular, reassured investors that, under
current conditions, it was appropriate to carry these tax benefits as part of Fannie Mae's capital
base:
We must evaluate our ability to realize the tax benefits associated with our deferred tax assets quarterly. In the future, we may be required to record a material expense to establish a valuation allowance against our deferred tax assets, which like would materially adversely affect our earnings, financial condition and capital position.
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244. The Offering Circular represented that Fannie Mae's core capital, as of March 31,
2008, was $42.7 billion. In the Offering Circular, Defendants alleged that Fannie Mae's core
capital exceeded the statutory minimum capital requirement by $11.3 billion. Defendants further
alleged that the capital base exceeded the statutory minimum capital requirement plus the 20%
OFHEO-directed capital surplus requirement by $5.1 billion. However, the capital help by
Fannie Mae without the deferred tax assets would have only been $24.876 billion, which would
be $12726 billion below the OFHEO-directed capital surplus requirement.
245. According to the Offering Circular, "to ensure compliance with each of our
regulatory capital requirements, we [Fannie Mae] maintain different levels of capital surplus for
each capital requirement." Further, "as a consequence, we generally seek to maintain a larger
surplus over the risk-based capital requirement to ensure continued compliance" and "we target a
surplus above the statutory minimum capital requirement and OFHEO-directed minimum capital
requirement to accommodate a wide range of possible valuation changes that might adversely
impact our core capital base."
246. The Offering Circular's representations concerning Fannie Mae's core capital and
total capital were grossly inflated as the truth came out about Fannie Mae's use of deferred tax
assets. A substantial part of Fannie Mae's assets were the full face value of deferred tax assets
without any write-down.
247. In addition, by the end of 2007, Fannie Mae was holding about $74 billion in Alt-
A and subprime loans in its portfolio, but had written down only $4.6 billion, again showing that
the Offering Circular contained misinformation.
248. As the FCIC Report made clear, Fannie Mae knew, with certainty, that
immediately in conjunction with the sale of the Preferred Stock, it was going to be taking on
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unprecedented amounts of bad debt from the country's mortgage banks: "Many.. believed the
country needed the USEs [government sponsored enterprises] to provide liquidity to the
mortgage market by purchasing and guaranteeing loans and securities at a time when no one else
would. However, there were constraints on how many loans the USEs could fund; they and their
regulators had agreed to portfolio caps - limits on the loans and securities they could hold on
their books - and a 30% capital surplus requirement. "82 On August 1, 2007, Mudd wrote a letter
to the OFHEO asking for an immediate increase in the portfolio cap. Mudd wrote "We have
witnessed growing evidence of turmoil in virtually all sectors of the housing finance market
[and] the immediate crisis in subprime is indicative of a serious liquidity event impacting the
entire credit market, not just subprime." (FCIC Report 310). Mudd was proposing that the caps
on the number of loans it purchased be increased so that Fannie Mae could free up liquidity for
the banks. "As demand for purchasing loans dried up, large lenders like Countrywide kept loans
that were normally securitized, and smaller lenders went under. A number of firms told Fannie
that they would stop making loans if Fannie would not buy them."
249. "If the USEs bought more loans, that would stabilize the market, but it would also
leave the USEs with more risk on their already strained balance sheets." 83 According to Henry
Paulson, even as early as 2006, the Fannie Mae was a "disaster waiting to happen" and "one key
problem was the legal definition of capital, which their regulator lacked discretion to adjust;
indeed, he said that some people referred to it as "bullsh*t capital." "Still, the USEs kept buying
more of the riskier mortgage loans and securities which by the fall of 2007 constituted multiples
of their reported capital .84
82 See FCIC Report, Pg. 310. 83 See FCIC Report, pg. 309. 84 See FCIC Report, pg. 309
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250. The value of risky loans and securities were swamping its reported capital. By
the end of 2007, guaranteed and portfolio mortgages with FICO scores less than 660 exceeded
reported capital at Fannie Mae by more than seven to one; Alt-A loans and securities, by more
than six to one. Loans for which borrowers did not provide full documentation amounted to
more than ten times reported capital.
251. As the mortgage market dried up in 2007, Fannie and Freddie were the "only
game in town." 85 At the end of December 2007, Fannie Mae reported that it had $44 billion of
capital to absorb potential losses on $879 billion of assets and $2.2 trillion of guarantees on
mortgage-backed securities; if losses exceeded 1.45%, it would be insolvent."
252. Notwithstanding the fact that Fannie Mae was teetering on the brink of
insolvency, Mudd urged the OFHEO and the Treasury to lower Fannie Mae's capital surcharge
requirements - if Fannie Mae would raise more capital - so that the company could purchase
more risky loans. So the government lowered the capital surcharge, Fannie Mae purchased the
world's most toxic mortgage assets and issued the Preferred Stock. Given the fact that the sale
of the Preferred Stock was simply a mechanism to allow Fannie Mae to purchase the most toxic
assets on the market, no caveats, disclosures, or "warnings" about possible future losses affecting
the company's reporting can make up for the fact that on the day the Offering Circular was
distributed to the investing public, Fannie Mae knew with certainty that they were going to take
on some of the greatest losses that the mortgage market had ever seen by buying risky loans no
one else wanted.
See FCIC Report, Pg. 311.
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V.
253. As underwriters, Citigroup and Wachovia Securities are liable for any material
misrepresentations or omissions of material facts made in connection with the Offering
Document for the Preferred Stock. Citigroup and Wachovia Securities owed a duty to Plaintiff to
ensure that the Offering Circular described all material information and did not make material
misstatements or omit material facts. Citigroup and Wachovia Securities made and adopted the
statements that are in the Private Placement Memorandum and Offering Circular and thus are
statements of Citigroup and Wachovia Securities.
254. Citigroup's and Wachovia Securities' responsibilities as underwriters included
pricing and selling the Preferred Stock. To price the Preferred Stock appropriately, Citigroup
and Wachovia Securities were required to perform adequate due diligence to understand Fannie
Mae's operations and financial condition and evaluate the assets held by Fannie Mae.
255. Citigroup and Wachovia Securities participated in drafting the Offering Circular
for the Preferred Stock. Citigroup and Wachovia Securities understood that investors expected
Citigroup and Wachovia Securities to test whether the representations made in the Offering
Circular were accurate and not misleading.
256. Citigroup and Wachovia Securities participated in and adopted the statements in
the Offering Circular regarding Fannie Mae's capital, asset value and strength of its risk controls.
Citigroup and Wachovia knew numerous statements in the Offering Circular were false, or
recklessly disregarded the falsity of such misstatements.
257. In connection with the Preferred Stock, Citigroup and Wachovia Securities
represented to potential investors that Fannie Mae was raising additional capital to provide it
with a cushion to ensure compliance -- even in difficult economic conditions -- not only with the
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minimum statutory capital requirement, but also with the minimum capital requirements
mandated by Fannie Mae's government regulator, OFHEO. The Offering Circular stated:
While we are able to reasonably estimate the size of our book of business and therefore our minimum capital requirement, the amount of our reported core capital holdings at each period end is less certain. Changes in the fair value of our derivatives may result in significant fluctuations in our capital holdings from period to period. Accordingly, we target a surplus above the statutory minimum capital requirement and OFHEO-directed minimum capital requirement to accommodate a wide range of possible valuation changes that might adversely impact our core capital base.
Offering Circular, Preferred Series T, at 38.
258. In this regard, Citigroup and Wachovia Securities represented to the Plaintiffs that
as of March 31, 2008, Fannie Mae's core capital exceeded the statutory minimum requirement
by $11.3 billion and exceeded the OFHEO-directed minimum capital requirement by $1 billion.
Offering Circular at 4.
259. The statements in the Offering Circular were false and misleading because they
claimed that Fannie Mae's core capital exceeded the statutory minimum requirement and
exceeded the OFHEO-directed minimum capital requirement when, in fact, it did not. Further,
the Offering Circular led investors to believe that Fannie Mae was maintaining a "surplus" above
the statutory and OFHEO-directed 30% minimum capital requirements. In fact, because the
valuation placed on hundreds of billions of dollars of subprime and Alt-A residential mortgage-
backed securities ("RMBS") and mortgages held by Fannie Mae was significantly overstated,
Fannie Mae had no surplus, but was in a serious capital deficit position at the time of the
Preferred Stock offering. The losses from Fannie Mae's exposure to the Alt-A and subprime
markets were significantly and materially understated in the Offering Circular.
80
260. In addition, the Offering Circular failed to warn investors that, because of new
accounting rules, there was a risk that Fannie Mae would not be able to meet certain minimum
capital requirements imposed on it by its regulator, the OFHEO.
261. In addition, the Offering Circular failed to disclose deficiencies in Fannie Mae's
risk controls concerning the mortgages it purchased. These deficiencies were revealed to the
public in the FCIC Report issued by the Financial Crisis Inquiry Commission.
262. In testifying before the FCIC, John Kerr, the FHFA examiner in charge of the
Fannie Mae's examination made it clear that Fannie Mae was "the worst-run financial
institution" he had seen in his 30 years as a bank regulator. 86
263. Scott Smith, the associate director at FHFA after that agency replaced OFHEO,
concurred with Kerr. Smith and Kerr both noted Fannie Mae's "weak forecasting models, which
included hundreds of market simulations but scarcely any that contemplated declines in house
prices."87
264. According to Austin Kelly, an OFHEO specialist, there was no relying on
Fannie's numbers, because their "processes were a bowl of spaghetti." 88
265. The Report also notes, "Kerr and a colleague said that they were struck that
Fannie Mae, a multi-trillion-dollar company, employed unsophisticated technology; it was less
tech-savvy than the average community bank."
266. What Kerr, Smith and Kelly found at Fannie Mae bears no relationship to
Citigroup's and Wachovia Securities' description of Fannie Mae in the Offering Circular.
267. On March 8, 2008 White House economist Jason Thomas sent to Treasury official
Robert Steel an email with an alarming analysis: it claimed that in reporting its 2007 financial
86 FCIC Report, pg. 321. 87 FCIC Report, pg. 322. 88 FCIC Report, pg. 322
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results, Fannie Mae masked its insolvency through fraudulent accounting practices. This email
and its attachment - a 12-page memo - were released by the Financial Crisis Inquiry
Commission. The summary section of this memo stated:
Any realistic assessment of Fannie Mae's capital position would show the company is currently insolvent Accounting fraud has resulted in several asset categories (non-agency securities, deferred tax assets, low-income partnership investments) being overstated, while the guarantee obligations liability is understated. These accounting shenanigans add up to tens of billions of exaggerated net worth.
Yet, the impact of a tsunami of mortgage defaults has yet to run through Fannie's income statement and further annihilate its capital. Such grim results are a logical consequence of Fannie's dual mandate to serve the housing market while maximizing shareholder returns. In trying to do both, Fannie has done neither well. With shareholder capital depleted, a government seizure of the company is inevitable.
(Emphasis added)
268. The 12-page memo provides an analysis of each of the problems identified. The
first section discusses and demonstrates that Fannie's reported Core Capital overstates its true
core value.
269. The next section is titled "Reported GAAP Equity and Fair Value Overstates
Economic Reality." Subsections discuss non-agency securities, guarantee obligations, deferred
tax assets, and low income housing and explain how Fannie's accounting in these four areas was
improper. "Fannie is obliviously not acknowledging market expectations nearly as much as
Freddie."
270. Next is a section titled "Credit Costs Will Spiral Out of Control" predicting
Fannie Mae's demise because "Fannie Mae's unrealistic optimism about its prospects" has
resulted in inappropriate valuations of it claimed assets.
82
271. After discussing problems associated with Fannie Mae's dual mandate - to serve
the housing market while maximizing shareholder returns - the analysis concludes with a section
titled "Government Bailout is Necessary, Likely, And Potentially Helpful."
272. Unlike CIS, Citigroup and Wachovia Securities had access to Fannie's Mae's
books, records and employees, but failed to provide adequate disclosure of the serious problems
noted in the 12-page analysis.
273. It was not until December 31, 2008 that Fannie Mae acknowledged its asset
devaluation and riskiness, when it recorded significant write downs of the value of its subprime
and Alt-A RMBS assets by $6752 billion, or 12.88 percent, and recorded loss reserves for its
subprime and Alt-A mortgage loans of $24753 billion or 7.87 percent.
274. Citigroup's and Wachovia Securities' misrepresentations in the Offering Circular
were made with knowledge of the falsity of the misrepresentations, or with reckless disregard to
the truth.
275. As lead underwriters, Citigroup and Wachovia Securities had extensive
knowledge, including access to non-public information, about Fannie Mae's capital inadequacy.
Among other things, Citigroup and Wachovia Securities conducted their own assessment of the
residential mortgage loan market, which directly affected the financial health of Fannie Mae.
Both Citigroup and Wachovia Securities possessed independent knowledge of the risks
associated with mortgage backed securities given their sophisticated participation in the
mortgage markets at the time of the Offering Circular.
276. Further, Citigroup and Wachovia Securities, as a result of their extensive business
operations in the residential mortgage market, knew of, among other things (i) industry standards
within the mortgage lending industry, including underwriting and appraisal requirements; (ii)
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standard representations and warranties provided by loan originators to purchasers in the
secondary market; and (iii) the market for mortgage backed securities.
277. Citigroup and Wachovia Securities were aware of Fannie Mae's shifting business
model and its increasing exposure to the high-risk mortgage market. Citigroup and Wachovia
Securities participated in numerous Fannie Mae offerings and thereby had a keen understanding
of Fannie Mae's business practices. Citigroup's and Wachovia Securities' prior experience with
Fannie Mae, and access to view Fannie Mae's internal procedures, gave them superior non-
public knowledge of Fannie Mae's business, accounting practices, risk exposure, and true
financial condition.
278. Citigroup and Wachovia Securities knew, or recklessly disregarded the facts
known to them, that hundreds of billions of dollars of subprime and Alt-A RMBS and mortgage
loans held by Fannie Mae were significantly overvalued at the time of Preferred Stock offering.
Citigroup and Wachovia Securities also knew or recklessly disregarded the fact that extremely
low write-downs of assets and increases in loss reserves recorded by Fannie Mae were materially
inadequate and that Fannie Mae should have disclosed significantly higher write-downs and loss
reserves at the time of the Preferred Stock offering.
279. Citigroup, in addition to serving as underwriter of the Preferred Stock, served as
underwriter and manager for the offer and sale of billions of dollars of RMBS to Fannie Mae.
As underwriter of such securities to Fannie Mae, Citigroup was aware that a material portion of
Fannie Mae's assets contained undisclosed risks due to poor underwriting and poor due diligence
practices in the securitization process, and were overvalued because of misstatements of key
metrics, including occupancy status of borrowers, loan-to-value ratios, inflated property
appraisals, and inaccurate credit ratings for tranches of securities.
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280. Citigroup and Wachovia Securities were further aware that Fannie Mae had
purchased and held hundreds of billions of dollars of Alt-A and subprime RMBS and mortgages.
Citigroup and Wachovia Securities also knew that a relatively small impairment of these
mortgages and mortgage-backed securities could wipe out the OFHEO-directed minimum capital
of Fannie Mae. Moreover, Citigroup and Wachovia Securities knew that investors like Plaintiff
would rely on the representations made with respect to Fannie Mae's capital requirements in
deciding whether to purchase the preferred stock.
281. Particularly, Citigroup and Wachovia Securities knew, or recklessly disregarded,
the fact that the deteriorating subprime and Alt-A market had drastically reduced the value of
Fannie Mae's mortgage-related assets and that Fannie Mae was undercapitalized.
282. According to a Brookings Institute study, "Prime mortgages dropped to 64
percent of the total in 2004, 56 percent in 2005 and 52 percent in 2006." Citigroup, and
Wachovia Securities, which bought and sold such mortgages in large quantities, were aware of
the decreasing quality of mortgages and the challenges this posed to risk management.
283. The FCIC's Report, referenced above, revealed that Citigroup knew numerous
items of material adverse information about Fannie Mae which should have been included in the
Offering Circular.
284. The Report discussed evidence obtained from Richard Bowen, a veteran banker in
Citigroup's consumer lending group. Mr. Bowen received a promotion in early 2006 when he
was named business chief underwriter. His new job was to oversee loan quality for over $90
billion a year of mortgages underwritten and purchased by CitiFinancial.
89 Brookings Institute Study: The Origins of the Financial Crisis - November 2008, available at http://www.brookings.edu/7media/Files/rc/papers/2008/1 loriginscrisisbailylitanll l origins crisis bailylitan. pdf
85
285. The Report quotes Bowen as saying that these mortgages were then sold to Fannie
Mae, Freddie Mac and others.
286. In June 2006, Bowen discovered that as much of 60% of the loans that Citigroup
was buying - and then selling in part to Fannie Mae - were defective. That is, they did not meet
Citigroup's loan guidelines. 90
287. Bowen told the Financial Crisis Inquiry Commission that he tried to alert top
managers at the firm by "email, weekly reports, committee presentations and discussions"; but
though they expressed concern, "it never translated into action." 91
288. Bowen finally took his warnings to the highest level of management - Robert
Rubin, the chairman of the Executive Committee of the Board of Directors and three other bank
officials. The Report describes how Bowen sent Rubin and the three other banking officials a
memo concerning the defective loans with the words, "URGENT - READ IMMEDIATELY."
289. The transcript of Bowen's testimony, from a FCIC Hearing conducted on April 7,
2010, was released in conjunction with the Financial Crisis Inquiry Commission's Report.
Bowen testified that, in addition to sending warnings in the form of e-mail, weekly reports,
committee presentations and discussions, "I even requested a specific investigation from
management that was in charge of internal controls. And that investigation confirmed that we
had very serious problems." 92
290. According to Bowen, "I continued my warnings through 2007. But Citigroup
continued to purchase and sell even more mortgages in 2007." Bowen noted that the portion of
defective mortgages sold to Fannie Mae, Freddie Mac and other investors rose from 60% in 2006
90 FCIC Report, pg. 19. 91 FCIC Report, pg. 19. 92 FCIC Report, pg. 79.
86
to over 80% in 2007. None of this information, known to Citigroup and important to investors,
was reflected in the Offering Circular.
291. Bowen told the Financial Crisis Inquiry Commission that after repeatedly alerting
higher management concerning poor loan quality, he went from supervising 220 people to
supervising only two people, his bonus was reduced and he was downgraded in his performance
review.
292. Citigroup failed to add a warning in the Offering Circular concerning the
defective nature of loans in Fannie Mae's inventory and Fannie Mae's poor risk controls
concerning the mortgages it purchased.
293. Citigroup was not the only Underwriter Defendant with knowledge of statements
and omissions in the Offering Circular which made the Offering Circular deceptive and
misleading. Other facts, some unearthed by the Financial Crisis Inquiry Commission,
demonstrate that Wachovia Securities knew of Fannie Mae's improper accounting and improper
risk control.
294. By May 2008, when Citigroup and Wachovia Securities were selling the Preferred
Stock, Citigroup and Wachovia Securities were well aware that RMBS had suffered significant
declines in value. Prior to the Offering Circular, Citigroup and Wachovia Securities, and their
affiliates, announced negative quarterly results and billions of dollars in losses related to
impaired mortgage-backed assets. Nonetheless, even as Citigroup and Wachovia Securities were
themselves writing down the values of mortgage backed securities on their own balance sheets,
they did not insist that Fannie Mae do the same or disclose that the value of its mortgage backed
securities was overstated prior to the Offering Circular.
Id
87
jjjgl iii~ 111
295. Citigroup and Wachovia Securities had the motive and opportunity to conceal
Fannie Mae's true financial condition. Citigroup and Wachovia Securities received substantial
compensation for its role in the Fannie Mae Preferred Stock offering.
296. Citigroup's and Wachovia Securities' intent to mislead the Plaintiff and other
investors is evidenced, among other things, by the following: (1) Citigroup and Wachovia
Securities was systematically shorting the subprime and Alt-A residential mortgage market; (2)
Citigroup and Wachovia Securities was shorting the very subprime loan originators that were
Fannie Mae's lender clients; (3) Citigroup and Wachovia Securities had specific knowledge of
the state of the subprime mortgage industry through its purchase of a controlling stake in a
subprime lenders; (4) Citigroup and Wachovia Securities knew about the poor underwriting
standards and conditions of Countrywide and other subprime lenders during much of the two
years preceding the issuance of the Preferred Stock; (5) Citigroup and Wachovia Securities had
either sold or written down its own inventory of subprime RMBS; and (6) as underwriters,
Citigroup and Wachovia Securities had access to and would have reviewed the books and
records of Fannie Mae.
297. One reason Citigroup and Wachovia Securities may have decided to conceal
Fannie's problems is found in a July 7, 2010 Forbes article titled "How Fannie and Freddie
Unloaded Their Trash." In the article, Professor Seth Lipner questioned why any broker would
be willing to underwrite an offering for a business with risky mortgages; a broker who was told
the business was lacking in controls; a broker who was informed about the business's inability to
manage risk, and a business that showed desperation to raise capital to avoid regulatory sanction.
Wd
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298. So, why were Citigroup and Wachovia Securities willing to promote mortgage-
related underwritings? According to the professor Lipner: "Fees. Big underwriting fees. Over
one-third of a billion dollars in fees between November 2007 and June 2008."
299. At the time of the Offering, Citigroup and Wachovia Securities knew that careful
due diligence was required because of the prevailing financial conditions, and conditions in the
mortgage markets in particular. Citigroup and Wachovia Securities knew that collateralized debt
obligation spreads jumped between July 2005 and May 2008.
300. At the time of the Offering Circular, Citigroup and Wachovia Securities were
suffering losses from their own poor risk controls. Knowing of their own poor risk controls (and
sales of defective mortgages to Fannie Mae), Citigroup and Wachovia Securities had each
learned the need for due diligence to detect risk management problems.
301. Citigroup and Wachovia Securities decided it wanted the fee income from the
Preferred Stock more than it felt the need to tell the truth to the Plaintiff.
302. The misrepresentations made in the Offering Circular were material because
Citigroup and Wachovia Securities were representing that Fannie Mae met the OFHEO-directed
minimum capital requirement even though Citigroup and Wachovia Securities knew that Fannie
Mae had purchased and held hundreds of billions of dollars of subprime and Alt-A RMBS and
mortgages and mortgage-backed securities.
303. Further, Citigroup and Wachovia Securities knew that a relatively small
impairment of these mortgages and mortgage-backed securities could wipe out the OFHEO-
directed minimum capital of Fannie Mae. Moreover, Citigroup and Wachovia Securities knew
that investors like Plaintiff would rely on the representations made with respect to Fannie Mae's
capital requirements in deciding whether to purchase the Preferred Stock.
89
taRs1affztiaiathTIx*junr*i jjjgliii~IaIrt*wWaPai.tasrtflI111
304. Had the Plaintiff been informed that the valuation placed on hundreds of billions
of dollars of subprime and Alt-A and mortgages held by Fannie Mae was significantly
overstated, and that the write-downs and loss reserves reported for the subprime and Alt-A
mortgages were grossly inadequate, it would not have purchased Preferred Stock.
305. The Plaintiff relied upon Citigroup's and Wachovia Securities' misrepresentations
regarding the adequacy of Fannie Mae's capital and write-downs because of the special role
Citigroup and Wachovia Securities served as underwriters, together with their access to
information relating to the financial health of Fannie Mae.
306. Because of its failure or refusal to write down its assets and establish appropriate
loss reserves as of the time of Preferred Stock offering, Fannie Mae's Core Capital was less than
OFHEO required.
307. Plaintiff relied on Citigroup and Wachovia Securities' false and material
representations and omissions in deciding to purchase the Preferred Stock.
308. In reliance on the representations made by Citigroup and Wachovia Securities,
Plaintiff purchased the Preferred Stock offering from Citigroup and Wachovia Securities.
VI. OFFICER DEFENDANTS' SCIENTER
309. Because of their positions in Fannie Mae's hierarchy, the Officer Defendants
received adverse information about Fannie Mae's financial condition and concealed such
information from the public. Each knew, consciously disregarded, was reckless and grossly
negligent in not knowing, and/or otherwise should have known, that it was wrong and illegal to
conceal this information about Fannie Mae from the public. Throughout the relevant period,
each of the Officer Defendants participated in the issuance of false and misleading statements
concerning the operations of Fannie Mae, including misleading press releases, and SEC filings,
90
and participated in the approval of other materially deceptive statements made to the press,
securities analysts, and Fannie Mae shareholders.
310. In short, each Officer Defendant misrepresented facts to the public and omitted
material information when approving SEC filings and during conference calls with analysts and
investors.
311. Internal emails admit that Fannie Mae did not have the proper resources to
monitor and control risk; however, Fannie Mae and the Officer Defendants continuously
represented to the public that they were monitoring and controlling Fannie Mae's risk.
312. Mudd was Fannie Mae's President and Chief Executive Officer from June 2005 to
September 7, 2008; Vice Chairman of the Board from February 2000 to June 2005; Interim Chief
Executive Officer from December 2004 to June 2005; and Chief Operating Officer from
February 2000 to December 2004.
313. Levin was Fannie Mae's Executive Vice President and Chief Business Officer
from November 2005 to September 7, 2008; Interim Chief Financial Officer from December
2004 to January 2006; Executive Vice President of Housing and Community Development from
June 1998 to December 2004; and Executive Vice President-Marketing from June 1990 to June
1998.
314. Swad was Fannie Mae's Executive Vice President from May 2007 to September
7, 2008 and was CFO from August 2007 to September 7, 2008.
315. Dallavecchia was Fannie Mae's Chief Risk Officer from July 2006 through
January 2009. Further, Dallavecchia sent multiple emails to other Fannie Mae executives
acknowledging Fannie Mae's lack of appropriate risk controls.
91
taRs1affzsYiaiathTt*junr*iIaIrt*wWakai.taeICtflI
316. Each Officer Defendant knew the circumstances surrounding Fannie Mae's
business practices and financial position. In various reports, press conferences and other public
statements, Officer Defendants made material misrepresentations and/or failed to disclose
material information regarding the financial stability provided by Fannie Mae's capital base and
Fannie Mae's risk management practices.
317. Fannie Mae's Officer Defendants made deceptive statements to the public and
Fannie Mae's investors that the company had excess capital and superior risk management
practices.
318. Mudd, Levin and Swad signed 10-Qs and/or 10-Ks attesting to their knowledge
and obligation to honestly disclose Fannie Mae's controls and procedures, as defined in
Exchange Act rules 13a-15(e) and 15d-15(E). Each Officer Defendant, however, misrepresented
Fannie Mae's internal controls and misrepresented Fannie Mae's true financial condition.
319. Emails to Mudd and the signatures of all Officer Defendants on the 10-Qs and/or
10-Ks acknowledging a series of losses, evidence each Officer Defendant's knowledge of Fannie
Mae's exposure to the failing market and its lack of sufficient capital. However, the Officer
Defendants continually reassured the public affirmatively and unequivocally stating that Fannie
Mae had sufficient capital and was in a position to, not just overcome, but to in fact profit during
the rough economic circumstances surrounding the real estate and mortgage markets.
320. The real estate and mortgage markets began a tremendous downturn in 2007. The
mortgage market began to experience a surge in mortgage loan defaults because of the
proliferation of high-risk mortgage loans. Throughout this accelerating decline in the mortgage
market, the Officer Defendants continued to state that Fannie Mae was conservatively managing
92
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its capital, was employing risk management controls and had well in excess of the minimum
capital requirements.
321. Despite seeing the warning signs and knowing the unfavorable market conditions,
the Officer Defendants steadfastly refused to disclose the inadequacy of Fannie Mae's capital
base. Instead, they fraudulently hid the truth by the inclusion in the capital base of tax deferred
assets.
A. Mudd
322. Mudd repeatedly misled investors by painting a glowing picture of Fannie Mae's
financial condition in the company's 10-Ks and 10-Qs and in repeated statements in conference
calls on February 27, 2007, November 9, 2007, February 27, 2008, and May 6, 2008. He knew
that the filings and statements contained material misrepresentations regarding Fannie Mae's risk
controls, asset valuation, risk exposure to the non-prime mortgage market and its capital and
liquidity all of which impacted Fannie Mae's reported capital base and earnings.
323. These material misrepresentations were intentionally made. For example, mere
months before Fannie Mae's conservatorship, when Mudd was well aware of Fannie Mae's lack
of capital, Mudd stated that Fannie Mae "is in solid shape to support the market, and is in better
shape to benefit when the market correction ends. "94
324. Mudd assured investors that Fannie Mae was well above both the statutory and
OFHEO minimum requirements for core capital and stated that Fannie Mae continued to manage
its capital account "very conservatively." Yet within a few short months after making these
statements, Fannie Mae finally acknowledged in its second quarter results for 2008 that it might
not be able to "recover our deferred-tax assets." Mudd was aware that Fannie Mae had suffered
' Fannie Mae Files 2007 Quarterly Reports with the SEC - Company Returns to Current Financial Reporting, Press Release from Fannie Mae, November 9, 2007.
93
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a series of quarterly losses and would most likely not realize the deferred tax assets that
comprised a substantial portion of Fannie Mae's reported capital but refused to tell Plaintiffs.
325. It wasn't until after the government placed Fannie Mae in conservatorship, that
Fannie Mae wrote down over $20 billion in deferred assets.
326. On March 15, 2011, the NEW YORK TIMES reported that Mudd had received a
"Wells notice" from the SEC and that another former Fannie Mae executive was expected to
receive one on as well.
327. A Wells notice is an indication that the agency is considering an enforcement
action.
328. On March 15, 2007, Mudd appeared before the House Financial Services
Committee and gave testimony in a hearing on Legislative Proposals on USE Reform. Mudd was
asked: "And you have not engaged in the subprime market. You hadn't gone there to a great
extent is that right?" In response, Mudd testified:
The answer for Fannie Mae on behalf of subprime is that it's important to remember there is subprime and there is predatory. Subprime simply means .
that you have a credit blemish, and we think those people are part of the market. It's less than 2 percent of our book. It's 80 percent insured. It's highly subordinated. We've been in it very carefully, consistent with some very strong anti-predatory lending guidelines we have.
329. At the time that Mudd gave this testimony, he knew that Fannie Mae EA loans
were designed to provide loans to borrowers with weaker credit histories, i.e., "credit
blemish[ed]" borrowers, and that the quantification of Fannie Mae's subprime holding as "less
than 2 percent of our book" did not include EA or MCM loans. The following month, on April
17, 2007, Mudd again appeared before the Committee on Financial Services to provide
testimony in a hearing on solutions to the subprime market turmoil. Mudd again testified:
"Subprime' is, after all, simply the description of a borrower who doesn't have perfect credit."
94
He provided a broad description of Fannie Mae's efforts to reach "borrower[s] who do[n'fl have
perfect credit":
We see it as part of our mission and our charter to make safe mortgages available to people who don't have perfect credit. In the past several years, for example, we have designed mortgage options to give borrowers with blemished credit access to high-quality, low-cost, non-predatory loans. We also set conservative underwriting standards for loans we finance to ensure the homebuyers can afford their loans over the long term . . . we continued our careful entry into the subprime market, by and large supporting lenders, products and practices that met our standards, and which helped us meet our HUD affordable housing requirements.
330. Having broadly defined "subprime" and described Fannie Mae's outreach to the
market for borrowers without perfect credit, Mudd testified as to the amount of subprime held by
Fannie Mae: "today, our exposure remains relatively minimal - less than 2.5 percent of our book
of business can be defined as subprime."
331. Mudd knew EA loans were loans specifically designed for "people who don't
have perfect credit" - his own definition for subprime - and that the 2.5 percent figure he used
did not include billions of dollars of EA and MCM loans. As such, his statement was knowingly
false and misleading when made.
332. Despite grossly overstated capital and an orchestrated and deliberate scheme to
take on monumental future losses from faltering banks in the immediate future, Mudd stated that
Fannie Mae was in "solid shape to support the market," and that its core capital was $2.3 billion
dollars above the level mandated by the OFHEO-directed 30 percent capital surplus
requirement." As discussed above, Fannie Mae was in fact NOT in solid shape to support the
market and was engaged in accounting "fraud" and "shenanigans" to make it appear as though it
was. 95 The FCIC Report and its incorporation of the Confidential White House memo shows
See FCIC Report, Pg. 314.
95
that Fannie Mae were and the Officer Defendants were consciously engaging in accounting fraud
and misbehavior:
While fair value is supposed to represent market-based estimates of a company's assets and liabilities, in practice, management judgment remains the primary arbiter in Fannie Mae's fair value, as well as GAAP, calculations. A careful examination of Fannie Mae's recent financial disclosures reveals several occurrences of overly optimistic figures that do not comport with the market-based results from peer financial institutions. This is accounting fraud.
The Confidential White House Attachment concluded with further indictment of Mudd in
particular:
Under Franklin Raines, the company developed an appetite for growth and imprudent speculation. Such risky behavior led to large losses on interest rate bets gone bad and accounting fraud to cover them up. After this was exposed, Fannie undertook a massive multi-year restatement under current CEO Mudd, a Raines protégé. Just as the company has finally caught up with its financial reporting, details are emerging about the tremendous increase in credit risk that the company undertook in recent years. Fannie Mae fully participated in the mortgage industry's fascination with exotic products, from subprime to alt-A interest only to negative amortization. What is all the more striking is that this dramatic deterioration in credit standards occurred even while the company was under the watchful eye of its regulator as it worked toward remediating its appalling business controls. Once again, the company is faced with large losses. Once again, the Fannie Mae management team, led by Dan Mudd, Michael Williams, Robert Levin, and Peter Niculescu, all veterans of the Raines era, has resorted to accounting fraud to delay loss recognition and dance around capital requirements."
B. Levin
333. Defendant Levin misled investors in his portrayal of Fannie Mae's financial
condition in the company's 10-Ks and 10-Qs and in public statements. He knew that the filings
and statements contained material misrepresentations regarding Fannie Mae's risk controls, asset
valuation, risk exposure to the non-prime mortgage market and its capital and liquidity all of
which impacted Fannie Mae's reported capital base and earnings.
96
334. The misrepresentations made by Levin were intentional. In a February 27, 2008
conference call, Levin, despite knowing of the problems in the non-prime mortgage market and
Fannie Mae's inadequate risk management and insufficient capital base, told investors that the
company was managing its capital conservatively. He further stated in that same conference call
that "[o]ur operating philosophy for capital is to manage it to protect ourselves against market
scenarios more adverse than we expect."
335. However, Levin was aware that Fannie Mae's capital base consisted in large part
of intangible assets that could not be used in a period of crisis.
336. As Executive Vice President and Chief Business Officer. Levin knew of the
misrepresentations made in SEC filings and by various Fannie Mae officers and directors but did
nothing to correct those misrepresentations or filings.
337. As the Chief Business Officer, Levin was involved in the everyday activities of
Fannie Mae. In an email dated March 7, 2008, Mudd tells U.S. Treasury Official Robert Steel,
"Rob Levin, my #2, is fully briefed in case we don't connect before I take off. . . he can also fill
you in on some market perspective...President and CEO Mudd, considered Levin as his
second-in-command, and an authority on Fannie Mae's market strategies.
338. Levin's knowledge of Fannie Mae's falsities in its filings became clear in the
March 7, 2008 email exchange with CEO Mudd. As part of the same string in the email
referenced above, on March 7, 2008, Mudd told Levin, "It's a time game . . . whether they need
us more, sooner to show admin action, or if we hit the capital wall first, Be cool."
339. The "capital wall" referred to in this email was Fannie Mae's lack of adequate
capital reserves, contrary to the information disseminated by Fannie Mae in its public filings.
Instead of responding with shock and outrage at having been kept in the dark about the "capital
97
wall," Levin replied, "You too. Be safe." In telling Levin to "be cool" Mudd implicitly
acknowledged that there is a substantial funding and resources problem. Assuming, arguendo,
Levin did not know about the "capital wall," before March 7, 2008, once he did, as Chief
Business Officer, he had a duty to correct misstatements in the previous and future public
documents and also to correct his inaccurate statements from the February 27, 2008 conference
call.
340. Levin possessed the requisite awareness of the false statements made to CIS.
Levin, as then Chief Financial Officer, proposed a strategic initiative to increase Fannie Mae's
"penetration into subprime" by purchasing riskier loans and securities at Fannie Mae's January
2006 board meeting. (citing Robert J. Levin, Board of Director Presentation, PowerPoint
presentation, January 2006). Levin, as an officer of Fannie Mae, would have had actual
knowledge that the peak in housing prices in the second quarter of 2006 was accompanied by an
increase in delinquencies - meaning higher risk. However, in 2007, under Levin's stewardship
as Chief Business Officer, rather than shore up its current risk exposure, Fannie Mae forged
ahead, purchasing more high-risk loans. In June 2007, Fannie Mae prepared its five-year
strategic plan, titled "Deepen Segments—Develop Breadth." The plan, which mentioned Fannie
Mae's "tough new challenges—a weakening housing market" and "slower-growing mortgage
debt market"—included taking and managing "more mortgage credit risk, moving deeper into
the credit pool to serve a large and growing part of the mortgage market." Levin's strategic
penetration of the sub-prime market proved disastrous when Fannie Mae recorded a loss of $2.1
billion net loss for the year, and failed to report an additional $3.3 billion loss using unrealistic
AOCI methods in violation of GAAP.
98
341. The specific evidence disclosed proves that Levin knew adverse information
about Fannie Mae which should have been included in the SEC filings, Offering Circular, and
conference call statements to investors. Levin was privy to the magnitude of losses, both
reported and hidden, faced by Fannie Mae in 2007, and thereby cognizant that Fannie Mae was
facing a "capital wall." (citing Daniel Mudd, Email to Robert Levin, March 7, 2008).
Furthermore, Levin was aware that Mudd was negotiating with regulators to reduce or eliminate
the 30% capital surcharge in exchange for Fannie Mae agreeing to raise new capital. Levin was
made aware that the negotiations were a "time game" because of the distinct possibility that
Fannie Mae would run up against the "capital wall" before gaining access to the increased
liquidity that a surcharge reduction would provide.
C. Swad
342. Swad misled investors in his portrayal of Fannie Mae's financial condition in the
company's 10-Ks and 10-Qs and in public statements. He knew that the filings and statements
contained material misrepresentations regarding Fannie Mae's risk controls, asset valuation, risk
exposure to the non-prime mortgage market and its capital and liquidity all of which impacted
Fannie Mae's reported capital base and earnings.
343. The misrepresentations made by Swad were intentional. In a November 9, 2007
conference call, Swad, despite knowing of the problems in the non-prime mortgage market and
Fannie Mae's inadequate risk management and insufficient capital base, told investors that
Fannie Mae's capital was in excess of its requirements and that Fannie Mae believed "we can
make investments and earn returns well above our cost of capital." Again, in a February 27,
2008 conference call, Swad reiterated to investors that Fannie Mae had well in excess of its
capital requirements. In truth, Swad knew that Fannie Mae had included billions in deferred
99
assets in its capital base which, if properly reported, would have placed the company well below
its minimum capital requirements.
344. As Executive Vice President and CFO, Swad was primarily responsible for
managing Fannie Mae's financial risks as well as being responsible for financial planning,
financial record-keeping, and financial reporting for Fannie Mae and was aware of the
misrepresentations made in SEC filings and by various Fannie Mae officers and directors but did
nothing to correct those misrepresentations or filings.
D. Dallavecehia
345. Dallavecchia was Executive Vice President and Chief Risk Officer until August
2008. In his role as Chief Risk Officer, Dallavecchia chaired the Allowance for Loan Losses
Oversight Committee, which reviewed and approved the methodology and the amount of Fannie
Mae's allowance for loan losses and reserve for guaranty losses (combined loss reserves) on a
quarterly basis. In addition, as Chief Risk Officer, Dallavecchia had an oversight role regarding
credit, market, operational and liquidity risks. Among other things, Dallavecchia warned Mudd
that Fannie Mae's risk management systems were inadequate. Dallavecchia made a number of
false and misleading statements in conference calls prior to the Offering Circular.
346. On February 27, 2007, Fannie Mae conducted a conference call with investors.
On the call, Dallavecchia represented that, to the extent it invested in subprime and Alt-A loans,
Fannie did so carefully and with the benefit of strong risk controls:
[W]e have increased our participation in subprime product in 2006. Our purchases have been prudent and have been made when we concluded that they would contribute to our mission objectives or they would generate a profitable return. . . [W]e participate in the subprime market in accordance with parameters that were agreed between my team and the business leaders. These parameters were developed to carefully calibrate exposure to layered risk, for example, the exposure to the combination of high loan-to-value duration and stated accommodation. . . [W]e have acquired subprime loans from selected lender partners whose
100
underwriting practices and standards we reviewed. . . . I believe that our activity in the subprime market represents an appropriate and prudent engagement in a segment that has been important to the housing market in this country. . . . I would advise that you consider our exposure in light of the strength of the risk characteristics I have described and the immaterial size of our participation in the subprime market.
* * *
I think from a control and risk underwriting standpoint, we want to continue maintaining prudent underwriting standards. One thing that we always look very carefully to is the layering of the risk, not that all subprime loans are bad, but there's some conditions where all the risks are layered one on top of the other, which makes the risk higher. And we want to make sure that we understand the risk and we are remunerated for it.
347. On November 9, 2007, Fannie Mae conducted a conference call with analysts in
which Dallavecchia made the following misrepresentations as to Fannie's exposure to subprime
mortgages:
Our subprime exposure is composed basically of two large buckets, one bucket which are the PLS securities. We talk about that; we have talked about the fact that they are conforming loans, then they have over a 30% subordination and an average maturity of two years. So I won't spend more time on that. The remaining part bucket, which is really the loans that we own which are subprime loans, and that is about $7 billion of that. On those, I would point out to you that a good 55% are fixed-rate and that most of them have - are a principal residence so they are not loans that we believe are owned by investors. At least that's what our underwriting has told us. For those loans, even in a worse market, the price drops. I think that we're going to have losses but it's very difficult to infer large losses for the whole company just based on how the subprime, the very small amount of subprime loans that we have, how the effect would be on everyone.
348. These statements were misrepresentations as can be seen from the dire warnings
Dallavecchia had previously sounded in his internal October 2006 email to Mudd regarding
Fannie Mae's inability to assess and manage the risks of subprime loans.
VII.
LOSS CAUSATION
101
349. As detailed herein, Defendants engaged in a scheme to artificially inflate the
value of the Preferred Stock by misrepresenting Fannie Mae's business success and future
prospects, including but not limited to, misrepresentations regarding its risk exposure to
subprime mortgage loans, obtained over the objection of senior risk officers, its capital adequacy,
its risk-assessment ability, and its financial reporting.
350. As a result of the fraudulent conduct alleged herein, the Preferred Stock was
artificially inflated. When Plaintiff purchased the Preferred Stock its true value was substantially
lower than the price actually paid.
351. The false and misleading statements set forth above were widely disseminated to
the securities markets, investment analysts, and to the investing public. Those statements caused
and maintained the artificial inflation of the price of the Preferred Stock, which consequently
traded at prices in excess of their true value. Partial disclosures of Fannie Mae's true condition
concerning its exposure (in terms of both volume and quality) to non-prime and non-traditional
loans, the state of capital availability, and the company's lack of ability and/or willingness to
control and manage risk, caused the price of the Preferred Stock to decline, eliminating a portion
of the inflation in the price. This decline in value caused Plaintiff economic harm.
352. By misrepresenting the success of Fannie Mae's risk exposure, underwriting and
capital adequacy, as well as its ability to control risk, Defendants presented a misleading picture
of Fannie Mae's business and prospects. For example, often-repeated statements by Fannie Mae
executives that its non-prime exposure was limited and that the quality of those loans was similar
to Fannie Mae's conventional book of business caused and maintained the artificial inflation in
the price of the Preferred Stock even as negative news reached the market, until the truth was
finally revealed in 2008.
102
353. Plaintiff relied to its detriment on Defendants' materially false and misleading
statements in purchasing the Preferred Stock at artificially inflated prices. Had Plaintiff known
the truth, it would not have purchased the Preferred Stock.
354. As explained herein, the false statements directly or proximately caused, or were a
substantial contributing cause of, the damages and economic loss suffered by Plaintiff, and
maintained the artificial inflation in the price of the Preferred Stock until the truth was revealed
to the market.
355. Plaintiff relied upon Fannie Mae's misrepresentations. Plaintiff also relied upon
the misstatements and material omissions of all Defendants as this was part of the mix of
information Plaintiff considered in the decision to purchase the Preferred Stock.
356. In July 2008, the first of a series of partial disclosures revealing Fannie Mae's
core capital inadequacy emerged. On Thursday, July 10, 2008, before the market opened,
Bloomberg published an article entitled, "Fannie, Freddie 'Insolvent' After Losses, Poole Says
(Updatel)." The article quoted former St. Louis Federal Reserve President, William Poole:
"Congress ought to recognize that [Fannie Mae and Freddie Mac] are insolvent."
357. News about Fannie Mae's capital inadequacy continued to emerge on July 11,
2008. On that date, The New York Times published an article warning that the federal
government was weighing a takeover of Fannie Mae.
358. On September 7, 2008, the FHFA issued a statement announcing that it had
placed Freddie Mac into conservatorship.
359. The disclosures of Fannie Mae's true condition concerning its true risk exposure
and severe capital inadequacy caused the price of the Preferred Stock to plummet. The decline in
value caused Plaintiff economic harm.
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VIII. CAUSES OF ACTION
360. Plaintiff incorporates by reference all proceeding paragraphs, as relevant, into
each cause of action.
361. Plaintiff also pleads that the principle of tolling laid out by the U.S. Supreme
Court applies, as relevant, to each cause of action. See American Pipeline & Construction Co. v.
Utah, 414 U.S. 538 (1974).
A. Statutory Fraud
362. Fannie Mae, Officer Defendants, and the Underwriter Defendants violated the
Texas Fraud in Real Estate and Stock Transactions statute, section 27.01 of the Texas Business
& Commerce Code.
363. Fannie Mae, Officer Defendants and Underwriter Defendants made false
statements of past and existing fact, and concealed material adverse information about Fannie
Mae's risk-management operations and financial condition, for the purpose of inducing Plaintiff
and other investors to purchase the Preferred Stock in violation of the Texas Fraud in Real Estate
and Stock Transactions.
364. The Offering Circular, devised and approved by Fannie Mae, Officer Defendants
and the Underwriter Defendants contained untrue statements about Fannie Mae's financial
health. The Offering Circular omitted material adverse information about Fannie Mae which, if
disclosed in May 2008, would have been important to, and would have materially affected,
Plaintiff's decision to purchase the Preferred Stock.
365. In short, the Offering Circular for the Preferred Stock was materially false and
misleading because it concealed the absence of adequate risk controls, failed to reveal Fannie
Mae's significant exposure to the subprime market, materially overstated Fannie Mae's capital
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base and inaccurately reported tax-deferred assets. Each Defendant knew of Fannie Mae's false
statements but decided to conceal rather than reveal them.
1. Primary Violations of Statutory Fraud
366. Fannie Mae, Officer Defendants and each Underwriter Defendant made false
representations of past or existing facts that were (1) made to induce Plaintiff into purchasing the
Preferred Stock and (2) were relied upon by Plaintiff.
367. The sole purpose of the Offering Circular was to entice Plaintiff and other
investors to purchase the Preferred Stock by means of statements that falsely stated Fannie Mae's
financial condition and concealed Fannie Mae's inability to management risks associated with
the mortgages Fannie Mae purchased. Wachovia Securities, in particular, solicited Plaintiff by
telephone and transmitted the false information to Plaintiff.
368. Plaintiff relied upon the false representations by Fannie Mae, Officer Defendants
and the Underwriter Defendants in making their purchase of Preferred Stock. Fannie Mae,
Officer Defendants and each Underwriter Defendant are accordingly liable to Plaintiff for actual
damages, reasonable and necessary attorney's fees, expert witness fees, costs for copies of
depositions and costs of court under sections 27.0 1(b) and (e). Additionally, Fannie Mae is liable
for exemplary damages under section 27.01(c).
2. Statutory Fraud Aiding & Abetting
369. In addition or in the alternative, Fannie Mae and each Officer Defendant and each
Underwriter Defendant violated section 27.0 1(d) of the Texas fraud statute.
370. Fannie Mae, and the Officer Defendants, as primary violators, made false
representations of past and existing material fact in its SEC filings and in the Offering Circular.
Fannie Mae and the Officer Defendants authorized and filed the Offering Circular, a document
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prepared for the sole purpose of inducing Plaintiff and other investors to purchase the initial
offering of the Preferred Stock.
371. Fannie Mae and each Officer Defendant and Underwriter Defendants (1) had
actual knowledge of the falsity of representations made by Fannie Mae; (2) failed to disclose the
falsity of the representations; and (3) benefited from the false representations.
372. Fannie Mae and each Officer Defendant and Underwriter Defendant had actual
knowledge that the glowing description of Fannie Mae's financial condition, portrayed by the
Fannie Mae financial statements and various other statements incorporated in the Offering
Circular, were false and misleading.
373. Actual awareness may be inferred where objective manifestations indicate a
person acted with actual awareness. The conduct described in detail supra shows, and creates
the inference of, actual knowledge of material misrepresentations and omissions in the Offering
Circular by Fannie Mae and each Officer Defendant and each Underwriter Defendant.
374. None of the Defendants in this action disclosed the falsity of Fannie Mae's
financial statements or other false statements (including material omissions) to Plaintiff and other
potential investors.
375. Each Officer Defendant benefitted by keeping his job longer that would otherwise
have been the case and by their substantial compensation packages (for example, Mudd's 2007
total compensation from Fannie Mae in 2007 was $12,217,500; Dallavecchia even received
$321,707 in his agreement with Fannie Mae to end his association with Fannie Mae). Each
Underwriter Defendant benefitted by receiving a portion of the $53-63 million dollars in fees
Fannie Mae paid them for underwriting the Preferred Stock. Fannie Mae also benefited by the
proceeds of Plaintiff's investment.
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376. Fannie Mae and each Officer Defendant and each Underwriter Defendant,
therefore, is liable pursuant to section 27.0 1(d) of the Texas Business & Commerce Code.
377. As a result of violating section 27.01(d), Fannie Mae and each Officer Defendant
and each Underwriter Defendant is liable to Plaintiff for actual damages, exemplary damages,
reasonable and necessary attorney's fees, expert witness fees, costs for copies of depositions, and
costs of court as provided in sections 27.01(d) and (e).
B. Texas Securities Act
1. Primary Violations of the Texas Security Act
378. Defendants Wachovia Securities and Fannie Mae each violated Texas Revised
Civil Statute article 581-33A(2).
379. Wachovia Securities and Fannie Mae sold or issued the Preferred Stock to
Plaintiff by means of untrue statements of material fact and/or omissions of material facts
necessary to make the statements made, in the light of the circumstances under which they were
made, not misleading.
380. Fannie Mae was the "issuer" under the Texas Securities Act.
381. Wachovia Securities purchased the shares from Fannie Mae. Next, Wachovia
Securities solicited Plaintiff and sold Plaintiff part of the initial offering of Preferred Stock.
Wachovia Securities was, therefore, a "seller" of the initial offering under the Texas Securities
Act.
382. Wachovia Securities offered and sold to Plaintiff the Preferred Stock by means of
untrue statements of material fact and the omission to state material facts necessary in order to
make the statements made, in the light of the circumstances under which they were made, not
misleading.
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383. The Offering Circular, as discussed at length supra, contained material
misrepresentations, including by means of omission.
384. Plaintiff was unaware of the material untruths.
385. Wachovia Securities and Fannie Mae are liable to Plaintiff for damages, including
attorneys' fees and costs, as specified in article 581-33D.
2. Texas Securities Act Control Persons
386. In addition or in the alternative, each Officer Defendant violated article 581-
33F(1) of the Texas Securities Act.
387. Fannie Mae was the issuer of the Preferred Stock purchased by Plaintiff.
388. Each Officer Defendant was, and acted as, a controlling person of Fannie Mae
within the meaning of article 581 -22F( 1). Each Officer Defendant had direct involvement in the
day-to-day operations of Fannie Mae. Each Officer Defendant was provided with or had access
to Fannie Mae's reports, press releases, public filings, and other statements alleged by Plaintiff to
be misleading prior to and/or shortly after these statements were made and had the ability to
prevent the issuance of the statements or cause the statements to be corrected.
389. Each Officer Defendant was in a position of power and control within the Fannie
Mae hierarchy. With respect to various transactions and financial statements specified supra,
each Officer Defendant had the power to influence and control, and did directly or indirectly
influence and control, Fannie Mae's decision-making processes. Each also made or approved of
public representations or omissions of material fact concerning Fannie Mae's financial health.
390. As a direct and proximate result of the Officer Defendants' wrongful conduct,
Plaintiff suffered damages in connection with its purchases of the Preferred Stock. Each Officer
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Defendant is therefore liable to Plaintiff pursuant to Texas Securities Act article 581-33F(1) for
damages, including costs and attorneys' fees as specified in article 581-33D.
3. Texas Securities Act Aiding & Abetting
391. In addition or in the alternative, Dallavecchia, Mudd and the Underwriter
Defendants violated article 581-33F(2) of the Texas Securities Act.
392. Fannie Mae was the issuer of the Preferred Stock purchased by Plaintiff. Fannie
Mae's 2007 10-K and 2008 First Quarter 10-Q were materially false and deceptive.
393. Dallavecchia and Mudd directly and indirectly, with intent to deceive or defraud
or with reckless disregard for the truth and or the law, materially aided Fannie Mae's
misstatements of material fact, and/or omission of material facts necessary in order to make the
statements made, in light of the circumstances under which they were made, not misleading and
false.
394. Dallavecchia and Mudd knew, or acted with reckless disregard for the truth in not
knowing, that Fannie Mae misrepresented its financial condition in filings with the Securities and
Exchange Commission and in the Offering Circular.
395. Dallavecchia and Mudd, as detailed supra, aided and abetted the fraud by making
false and misleading statements about Fannie Mae's financial condition.
396. Dallavecchia and Mudd knew the truth prior to Plaintiff's purchase of the
Preferred Stock but did not reveal it.
397. Dallavecchia and Mudd both had knowledge regarding, or recklessly disregarded,
Fannie Mae's true financial condition.
398. Dallavecchia and Mudd failed to correct Fannie Mae's misrepresentations prior to
Plaintiff's purchase of the Preferred Stock. Even after Plaintiff's purchase of Preferred Stock,
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neither Dallavecchia nor Defendant Mudd informed Plaintiff of the misrepresentations and
material omissions.
399. As explained in detail supra, Fannie Mae, with material assistance from
Dallavecchia and Mudd, made or omitted to make statements material to Plaintiffs investment
decision with reckless disregard for the truth and employed devices and artifices to defraud in
connection with the purchase and sale of the Preferred Stock. To a reader of the Offering
Circular in May 2008, Fannie Mae appeared to be a well capitalized concern seeking to raise
additional capital to pursue reasonable business opportunities.
400. As discussed, supra, Citigroup and Wachovia Securities aided and abetted Fannie
Mae by misrepresentations of Fannie Mae's financial condition and omission of material facts.
By signing off on the Offering Documents, and with knowledge of the untruths in the Offering
Documents, the Underwriter Defendants made or omitted to make statements material to
Plaintiff's investment decision with intent to deceive or with reckless disregard for the truth and
employed devices and artifices to defraud in connection with the purchase and sale of Preferred
Stock.
401. In reality, and as later recognized by Director James Lockhart of the OFHEO, at
the time of the offering, Fannie Mae was not sufficiently capitalized, even though its balance
sheet reflected a strong capital base.
402. In reality, Fannie Mae had inadequate risk controls, yet was cutting the resources
available to the department responsible for evaluating risk.
403. Information released after Plaintiff's purchase of the Preferred Stock revealed
Fannie Mae's exposure to the subprime debacle which dramatically increased the risk involved
and the need for additional capital. The heart of the problem was wholly inadequate risk
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controls; this information, however, was concealed with the aid of Dallavecchia, Mudd, and the
Underwriter Defendants.
404. Dallavecchia, Mudd, and the Underwriter Defendants knew, or were extremely
reckless in not knowing, that the Offering Circular materially misrepresented the risks associated
with investing in Fannie Mae.
405. Dallavecchia, Mudd, and the Underwriter Defendants are liable because they each
(1) knew, or were legally obligated to know, that Fannie Mae's statements were false and
misleading at the time they were made; and (2) both materially aided Fannie Mae by helping
Fannie Mae conceal its true financial condition.
406. Plaintiff would not have purchased the Preferred Stock if the true financial health
of Fannie Mae had been accurately stated in public statements, in SEC filings and in the Offering
Circular.
407. As a direct and proximate result of conduct by Dallavecchia, Mudd, and the
Underwriter Defendants that aided and abetted Fannie Mae, Plaintiff suffered damages.
C. Common Law Fraud
408. In addition or in the alternative, Fannie Mae, Dallavecchia and Mudd are liable to
Plaintiff for common law fraud.
409. Fannie Mae, Dallavecchia and Mudd made false and misleading statements and/or
material omissions of fact to Plaintiff in connection with its purchase of Fannie Mae securities.
410. Fannie Mae, Dallavecchia and Mudd knew the representations were false at the
time they were made.
411. Such statements of fact were material to Plaintiff in its decision to purchase the
Preferred Stock.
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412. Plaintiff reasonably relied upon Fannie Mae, Dallavecchia and Mudd's materially
false and misleading misrepresentations and/or material omissions of fact.
413. Defendants Fannie Mae, Dallavecchia and Mudd intended that Plaintiff and other
investors would act on the misrepresentations and purchase the Preferred Stock.
414. Plaintiff was damaged as a result of Fannie Mae, Dallavecchia and Mudd's
materially false and misleading statements and/or material omissions of fact. Fannie Mae,
Dallavecchia and Mudd are liable to Plaintiff.
D. Negligent Misrepresentation
415. Fannie Mae, Officer Defendants and each Underwriter Defendant negligently
misrepresented Fannie Mae's financial condition.
416. As detailed supra, Fannie Mae, each Officer Defendant and each Underwriter
Defendant made false and misleading statements and/or material omissions of fact to Plaintiff in
connection with its purchase of the Preferred Stock.
417. Fannie Mae, the Officer Defendants and the Underwriter Defendants owed
Plaintiff the duty to ensure any such statements they made were true and correct and that there
was no omission of material facts required to be stated to make the statements contained therein
fair and accurate.
418. Fannie Mae and the Officer Defendants made such misrepresentations and
omissions in SEC filings and in the Offering Circular, and public pronouncements pursuant to
which Plaintiff purchased the Preferred Stock.
419. The Underwriter Defendants made such misrepresentations and omissions in the
Offering Circular pursuant to which Plaintiff purchased the Preferred Stock.
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420. The material misstatements of fact were made to Plaintiff with the intent that
Plaintiff and other investors would rely on them.
421. Plaintiff reasonably and justifiably relied upon Fannie Mae's, the Officer
Defendants' and the Underwriter Defendants' materially false and misleading misrepresentations
and/or material omissions of fact.
422. Defendant Fannie Mae, the Officer Defendants and the Underwriter Defendants
knew, and in the exercise of reasonable care should have known, that their representations were
false.
423. Plaintiff was in the limited class of persons Fannie Mae, the Officer Defendants
and Underwriter Defendants knew would be potential purchasers of Preferred Stock.
424. Plaintiff was damaged as a result of Defendant Fannie Mae's, each Officer
Defendant's and Underwriter Defendants' materially false and misleading statements and/or
material omissions of fact.
E. Violation of Section 10(b) of the Exchange Act
425. In addition or in the alternative, Fannie Mae, Mudd and Dallavecchia are liable
for violations of section 10(b) of the Exchange Act and its corresponding regulation, Rule lOb-S.
426. Fannie Mae, and Mudd and Dallavecchia are liable for making false and
misleading statements, or failing to disclose material adverse facts and acting directly as a
participant in a scheme and/or course of business which: (i) deceived the investing public,
including Plaintiff, regarding Fannie Mae, its business, products, and prospects; (ii) artificially
inflated the market price of the Preferred Stock; and (iii) caused Plaintiff to purchase the
Preferred Stock at inflated prices. In furtherance of this unlawful scheme, plan and course of
conduct, each Officer Defendant took the actions set forth supra.
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427. Fannie Mae, Mudd and Dallavecchia's direct participation includes the
presentation and/or review of Fannie Mae's false and/or misleading SEC filings, registration
statements, Offering Circular, press releases, and/or conference calls.
428. Fannie Mae, Mudd and Dallavecchia had a duty to disseminate accurate and
truthful information promptly with regard to Fannie Mae's operations, financial condition, and
performance so that the market prices of Fannie Mae's securities would be based on truthful,
complete and accurate information. Additionally, Fannie Mae, Mudd and Dallavecchia each had
a duty to correct any previously issued statements that had become untrue, or were discovered to
be untrue, and to disclose any adverse trends known to them that would materially affect Fannie
Mae's operating results. Mudd and Dallavecchia's duties are specified, in part, by the integrated
disclosure provisions of the SEC as embodied in SEC Regulation S-X 17 and S-K 96 and other
SEC regulations.
429. Fannie Mae, Mudd and Dallavecchia violated Section 10(b) of the Exchange Act
and Rule lOb-5, as pled with specificity in this complaint, because each (a) employed devices,
schemes and artifices to defraud; (b) made untrue statements of material facts, or omitted to state
material facts necessary in order to make the statements made in light of the circumstances under
which they were made not misleading; or (c) engaged in acts, practices and a course of business
which operated as a fraud or deceit upon Plaintiff in connection with its purchases of the
Preferred Stock.
430. Despite knowledge of Fannie Mae's false and misleading statements, Mudd and
Dallavecchia failed to disclose material adverse facts about the financial condition and business
prospects of Fannie Mae, which caused the SEC filings, registration statements, Offering
Circular, press releases and other public statements to be materially false and misleading as
96 17 C.F.R. § 210.01 et seq. and 17 C.F.R. 229-10 et. seq., respectively.
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specified with particularity supra. Mudd and Dallavecchia directly and indirectly, knowingly
engaged and participated in a fraudulent scheme and course of conduct to conceal adverse
material information about the business, finances, financial condition, and future business
prospects of Fannie Mae.
431. Mudd and Dallavecchia's primary liability arises from the fact that: (i) Mudd and
Dallavecchia were high-level executives and/or director of Fannie Mae; (ii) Mudd and
Dallavecchia, by virtue of their responsibilities and activities as a senior executive officer and/or
director of Fannie Mae, was privy to, and participated in, the creation, development and
reporting of Fannie Mae's internal budgets, plans, projections and/or reports; (iii) Mudd and
Dallavecchia had familiarity with each other and were advised of and had access to other
members of Fannie Mae's management teams, internal reports, and other data and information
about Fannie Mae's financial condition and performance at all relevant times; and (iv) Mudd and
Dallavecchia were aware of Fannie Mae's dissemination of information to the investing public
that he knew was materially false and misleading or for which he recklessly disregarded the
truth.
432. Plaintiff, at the time of the misrepresentations and omissions, was ignorant of the
falsity of the statements and believed them to be true. Plaintiff relied upon these
misrepresentations, on the integrity of the market, on the securities offering process and on the
fidelity, integrity and superior knowledge of the Officer Defendants. Plaintiff, in ignorance of
the true condition of Fannie Mae, was induced to purchase and did purchase the Preferred Stock.
Had Plaintiff known the truth, it would not have bought the Preferred Stock at the offering price.
433. Mudd, Dallavecchia and Fannie Mae are liable to Plaintiff for their section 10(b)
violation.
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F. Violation of Section 20(a) of the Exchange Act
434. In addition or in the alternative, Mudd and Dallavecchia violated Section 20(a) of
the Exchange Act and are liable to the Plaintiff. Mudd and Dallavecchia were, and acted as, a
controlling person of Fannie Mae within the meaning of Section 20(a) of the Exchange Act.
435. Mudd and Dallavecchia had direct involvement in the day-to-day operations of
Fannie Mae and with respect to the transactions at issue. Mudd and Dallavecchia had the power
to influence and control and did influence and control, directly or indirectly, the decision-making
of Fannie Mae, including the content and dissemination of the various false and misleading
statements. Mudd and Dallavecchia were provided with and/or had access to copies of Fannie
Mae's reports, press releases, public filings, and other statements prior to and/or shortly after
these statements were issued and had the ability to prevent the issuance of the statements or
cause the statements to be corrected.
436. Mudd and Dallavecchia also had information, internally generated by Fannie
Mae, which warned each Officer Defendant about Fannie Mae's true prospects.
437. By reason of such wrongful conduct, Mudd and Dallavecchia are liable to
Plaintiff pursuant to Section 20(a) of the Exchange Act. As a direct and proximate result of their
wrongful conduct, Plaintiff suffered damages in connection with its purchases of Fannie Mae
securities.
X. PRAYER
WHEREFORE, Plaintiff prays that this Court enter judgment in its favor and against
Defendants as follows:
a. Actual damages, including all direct, consequential, and special damages;
b. All equitable relief to which they may be entitled;
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C. The rescission of Plaintiff's purchase;
d. Pre-judgment interest as provided by law;
e. Punitive damages as provided by statutory and common law;
£ Attorneys' fees and legal expenses (including expert fees);
g. Post-judgment interest; and
h. Costs of Court;
Plaintiff further prays for any other monetary or equitable relief to which it may be
entitled. Plaintiff respectfully demands a trial by jury.
Respectfully submitted,
Andrew J. Frisch The Law Office of Andrew J. Frisch 40 Fulton Street, 23rd Floor New York, New York 10038 (212) 212-285-8000 (646) 304-0352 facsimile [email protected]
GREER, HERZ & ADAMS, L.L.P. Andrew J. Mytelka Attorney-in-Charge S.D. Texas Federal I.D. No. 11084 State Bar No. 14767700 Joe A.C. Futcher S.D. Texas Federal I.D. No. 14126 State Bar No. 07509320 Steve Windsor S.D. Texas Federal I.D. No. 13558 State Bar No. 21760650 Eric J. Kirkpatrick S.D. Texas Federal I.D. No. 500364 State Bar No. 24031215 Laura Englert S.D. Texas Federal I.D. No. 990973
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a WIK troca Vl UI Vu
State Bar No. 24055135 One Moody Plaza, 18th Floor Galveston, Texas 77550 (409) 797-3200 (Telephone) (409) 766-6424 (Facsimile) ATTORNEYS FOR PLAINTIFF, COMPREHENSIVE INVESTMENT SERVICES, INC.
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