Back in early 2005, when credit was cheap, lenders couldn’t float loans fast enough, but critics say they approved mortgages with little regard for a borrower’s ability to pay back the debt. Investment banks bought billions of dollars of the loans and re-packaged them into mortgage-backed securities, which they then resold to other investors.

Two other key players were Fannie Mae and Freddie Mac, government-sponsored entities (GSE) that own or back about $5.3 trillion, or about half, of the U.S. mortgage market. Fannie and Freddie bought mortgages from banks and other lenders, which freed up the lenders’ money so they could make more loans.

Then, in 2006, the bubble burst. Mortgages became distressed or went into default. Foreclosures increased, and the value of investments secured by those mortgages collapsed. That made mortgages more difficult to obtain. Home values deflated.

Last month, President George W. Bush signed a law designed to clean up some of the mess. The Federal Housing and Economic Recovery Act of 2008 authorizes the Treasury Secretary to invest directly in Fannie and Freddie, and it establishes tougher regulations for the GSEs. Also, the GSE’s must abide by minimum capital requirements and limit the size of their portfolios.

Kilpatrick Stockton litigation partner Mike Crisp of Atlanta heads his firm’s complex business litigation practice group and represents a national bank in litigation against financial institutions related to securitized mortgages. Crisp also heads Kilpatrick Stockton's subprime and credit markets litigation practice group. He discussed the federal bailout of Fannie and Freddie and the outlook for subprime mortgage crisis-related litigation. The conversation was edited for brevity.

How did Fannie Mae and Freddie Mac get into their current predicaments?

On the surface, it was a perfect storm of financial circumstances and bad government. Credit was supplied too readily to unworthy borrowers. It also led to an increase in borrowers with uncertain prospects of making the mortgage payments they agreed to make.

If you dig deeper, the reasons are more systemic and the federal government’s responsibility is great. Prior to 1968, Fannie was a public entity with a public purpose—ensuring liquidity to allow maximum access to home ownership. But in 1968, Congress amended Fannie’s charter to make it a private entity. There was always tension with a private entity serving a public purpose. [Freddie Mac was established as a private GSE in 1970.]

But Fannie remained a government “sponsored” private entity. Nobody has ever been quite certain what “sponsored” meant. Does it mean “guaranteed” or something less? This probably contributed to the current problems because management likely believed that it was immune from the consequences of bad decisions, or that the government would step in and mitigate those consequences. It turns out they were right.

What do you think of the U.S. financial bailout of Fannie and Freddie?

I think it is the largest taxpayer rip-off in history but absolutely necessary. The government cannot let these entities fail.  The liquidity they provide the mortgage markets today is critical to the financial stability of our system. Since the credit crisis began, they have provided most of the funding for mortgages. Because private lenders have largely been unwilling to make loans, few would have been getting mortgage loans without Fannie and Freddie.

What is your opinion of the new regulations for Fannie and Freddie?

Tighter regulation of lending will reduce risk but make home-ownership less obtainable for some borrowers. The government has recently reduced the capital requirements for both Fannie and Freddie to add liquidity. That really does not sound like tighter regulations to me.

Placing greater restrictions on the GSEs to borrow or lend money conflicts with the government’s stated goal of economic growth. The press about putting a tighter rein on the GSEs is largely the illusory bone the government has to throw taxpayers to justify the money it is spending to clean up the mess.  The meaningful reform will come when the crisis passes, if at all.

Will the Federal Housing and Economic Recovery Act of 2008 stem foreclosures and slow the decline in housing prices, as it’s intended to do?

Who knows? That is the theory. You really have to wonder about the consequences to investors and to the financial system when the government starts to fiddle with private contract rights. If the government takes away my right of foreclosure without you first proving in court some valid reason for taking away that right, what happens? I am a lot less likely to lend money the next time. The Act may be good for current distressed homeowners in the short-run, but not so good for the next crop of borrowers.

There is also a risk that the Act will prolong the housing recession by artificially slowing the decline in housing prices. The decline in prices is necessary to bring the supply of homes back into balance with demand. With government intervention, what would have been a relatively short period of contraction in housing prices may turn into a longer period of decline.

What litigation risks do Fannie or Freddie face?

If Fannie or Freddie played a role in marketing or selling now-worthless debt securities that my client bought, I would certainly take a look at them as possible defendants.

In practical terms, Fannie and Freddie stand in the same shoes as all the other financial institutions that securitized mortgages and sold the paper to investors. The open question is whether the federal government will attempt to legislatively insulate Fannie and Freddie from civil liability for their role in the mortgage market crisis and investor losses. That would be disturbing, but I would not bet against it.

Speaking more broadly, there is more litigation to come. Most institutions—underwriters, lenders or investors—are keeping their powder dry. I think many are still assessing the damage and the risks or potential of filing claims. Also, many of the mega-sized law firms that these institutions would usually use to file these cases have legal or business conflicts among their various banking clients. That makes it very problematic or impossible for them to bring these claims. That has likely slowed the rate at which these cases have been filed, but it certainly creates great opportunities for firms like ours to be involved.