Freddie Mac Told Investors It Had “Basically No Subprime Exposure”. But Was That True?

The Facts

Freddie Mac, formally the Federal Home Loan Mortgage Corporation, is a federally chartered company created to support liquidity in the U.S. secondary mortgage market. During the period at issue, Freddie Mac purchased home loans, bundled many of them into mortgage-backed securities, and guaranteed payment of principal and interest to the investors who bought those securities.

The Ohio Public Employees Retirement System, a pension fund serving more than 1.3 million Ohio public employees and over 3,700 public employers, bought Freddie Mac common stock during what the lawsuit calls the “Class Period”: August 1, 2006 through November 20, 2007. OPERS filed suit on January 18, 2008, on behalf of itself and everyone else who bought Freddie Mac stock during that window, alleging the company’s public statements about its exposure to risky mortgages misled the market.

Freddie Mac tracked loan risk through a proprietary system called Loan Prospector, which sorted loans into two broad tiers: “Accept Loans,” a safer tier that could be approved automatically, and “Caution Loans,” a riskier tier requiring manual underwriting. How Freddie Mac talked about those Caution Loans to the investing public, compared with how it tracked them internally, sits at the center of this case.

What OPERS Alleges Freddie Mac Concealed

OPERS’s complaint centers on what it calls the “primary fraud” in the case: Freddie Mac’s public description of its own exposure to subprime mortgages. According to the complaint, Freddie Mac’s executives repeatedly minimized that exposure to investors while the company’s internal risk-tracking systems told a different story.

Subprime Exposure

OPERS points to public statements by Freddie Mac’s top executives. It also points to Freddie Mac’s own internal Loan Prospector data, which in 2007 classified 10.8% of the company’s portfolio as “Caution” loans, and to a separate internal model called “Segmentor,” which OPERS says estimated the company’s subprime exposure at between 9.53% and 11.50% in July 2007. Freddie Mac publicly quantified its subprime exposure at “approximately $2 billion, or 0.1 percent” of the portfolio as of June 30, 2007.

OPERS also alleges that individual defendants, including Syron, Piszel, and McQuade, attended a February 2007 internal offsite meeting and a March 2007 Board presentation at which they were told Freddie Mac “already purchase[d] subprime-like loans.” Freddie Mac disputes that these internal references meant what OPERS says they meant. The company argues no generally accepted definition of “subprime” existed at the time, that its “Caution” designation was an internal risk-management tool rather than a public disclosure category, and that employees using terms like “subprime-like” internally were speaking “pejoratively,” not describing loans that met any recognized definition of subprime. Freddie Mac also argues that investors could have calculated its exposure to low-credit-score borrowers themselves from other public filings.

The district court originally credited Freddie Mac’s explanation and granted summary judgment. The Sixth Circuit reversed that conclusion, holding that a reasonable jury, not a judge, should decide whether Freddie Mac’s blanket statements disclaiming subprime exposure misled investors who were not told about the company’s exposure to loans that internal documents and models described as subprime or subprime-like.

Alt-A Exposure

Freddie Mac’s August 30, 2007 Information Statement told investors the company had classified “approximately $120 billion, or eight percent” of its portfolio as Alt-A, using a stated definition: a loan qualified as Alt-A if the lender delivering it classified it as Alt-A, “or” if it had reduced documentation requirements indicating it should be so classified.

OPERS alleges that Freddie Mac did not actually apply that definition as written. It points to an internal Sourcing group finding that 29% of loans being purchased were flagged “low/no doc” by the lender, and 18% were classified Alt-A under the company’s own external definition, both well above the 8% publicly disclosed. It also points to an internally used risk model, the Mortgage Credit Risk Analytics (“MCRA”) framework, which tracked 93 lender-assigned loan codes and produced a 17% Alt-A exposure estimate, compared with the public definition, which excluded 65 of those 93 codes.

Freddie Mac argues its narrower public figure was defensible because many of the excluded loans, while flagged “low/no doc” by lenders, came from higher-credit-quality borrowers that the company did not believe should be labeled Alt-A. The district court agreed. The Sixth Circuit did not: it found that Freddie Mac’s own stated definition, using the word “or,” appeared to require including any loan a lender classified as Alt-A, regardless of Freddie Mac’s own view of the borrower’s credit quality, and that a jury should decide whether the company’s practice matched its stated definition.

Claims the Court Declined to Revive

Not every statement OPERS challenged survived. The Sixth Circuit agreed with the district court that two categories of Freddie Mac’s statements are not actionable.

Statements from executives describing Freddie Mac as “better positioned for long-term profitability” or having a “relatively strong” credit position were, the court found, non-actionable corporate optimism, sometimes called “puffery” in securities law, too vague for investors to reasonably rely on.

Statements describing Freddie Mac’s “disciplined” and “conservative” approach to underwriting were a closer call. OPERS notes that a conclusion letter from Freddie Mac’s regulator at the time, the Office of Federal Housing Enterprise Oversight (OFHEO), found that 80% of Freddie Mac’s loan volume had received exceptions to underwriting standards, and that an internal report showed “Untested Mortgage Products,” loans whose credit risk Freddie Mac’s own models could not effectively assess, grew from 24% of the portfolio in 2006 to 35% by June 2007. But the court found that Freddie Mac had adequately disclosed, in its 2006 Annual Report, that it was expanding its use of alternative underwriting standards. Because that general disclosure qualified the company’s broader statements about discipline, the court held these particular claims could not proceed.

What the Appeals Court Decided

The Sixth Circuit’s ruling is procedural rather than a verdict on the merits. It reverses the district court’s decision to end the case before trial and sends several disputed issues back for further proceedings. Specifically, the panel:

• Reversed the district court’s conclusion that Freddie Mac’s stock did not trade in an efficient market, finding structural evidence, including an estimated four million shares traded daily and at least 21 analyst firms following the stock, sufficient to support a presumption that investors relied on the integrity of the stock price.
• Endorsed OPERS’s “price-maintenance” theory, under which a misrepresentation can be fraudulent even if it did not cause the stock price to rise, so long as it prevented the price from falling to reflect a concealed risk.
• Vacated the district court’s exclusion of OPERS’s expert witness, Dr. Steven Feinstein, and its denial of class certification, remanding both for reconsideration.
• Reversed summary judgment on OPERS’s core securities-fraud claims tied to the subprime and Alt-A statements, finding a reasonable jury could find them materially misleading.
• Affirmed summary judgment on claims tied to Freddie Mac’s “credit risk” and “underwriting standards” statements.
• Reversed summary judgment on OPERS’s “control person” claims against Syron, Piszel, and McQuade under Section 20(a), which depend on the underlying fraud claims surviving.
• Vacated the district court’s ruling barring OPERS from presenting damages evidence at trial, since that ruling rested on the same rejected legal theory.

On the question of intent, known in securities law as “scienter,” the court found OPERS had produced enough evidence, including the internal warnings described above and the timing of executives’ public statements relative to Freddie Mac’s November 2007 disclosures, for a jury to consider whether defendants acted with reckless disregard for the accuracy of their statements. The court noted, however, that defendants did not sell Freddie Mac stock at a suspicious time; the individual defendants instead bought more shares and lost money when the stock fell, a fact that could support Freddie Mac’s defense at trial but does not resolve the question as a matter of law.

Eighteen Years in Court

Circuit Judge Amul Thapar, who joined the majority opinion in full, wrote a separate concurrence focused on the case’s age. He noted that one of the original individual defendants, Patricia Cook, died while the litigation was pending, and that the surviving individual defendants are now in their seventies and eighties. Drawing a comparison to a similar securities case that settled after 16 years for $100 million plus $33 million in plaintiffs’ fees, Judge Thapar estimated, as his own analysis rather than a finding in this case, that OPERS’s litigation costs to date “may similarly exceed $50 million.”

Judge Thapar also wrote that the district court had, in his view, mistakenly applied a heightened pleading standard for scienter, one Congress reserved for surviving an initial motion to dismiss under the Private Securities Litigation Reform Act, at the later summary-judgment stage, where he argued the ordinary evidentiary standard should apply. He urged district courts and litigants to use case-management tools, including seeking a writ of mandamus, to prevent future cases from taking as long as this one has.

What a Legitimate Fix Looks Like

The following recommendations are not contained in the Sixth Circuit’s opinion or OPERS’s complaint. They are grounded in the specific gaps this case surfaces between how a regulated financial institution models risk internally and how it describes that risk publicly, and in Judge Thapar’s own observations about the cost of prolonged litigation.

What Now?

The case returns to the U.S. District Court for the Northern District of Ohio, where Judge Benita Y. Pearson has presided over the litigation. Several things are worth watching as the case moves forward.