In early August, the Wall Street Journal printed an op-ed piece by Franklin Raines titled, “Truce Time in the Fan-Fred Wars.” Raines is the former Clinton administration budget director, who left government to become CEO of the Federal National Mortgage Association (“Fannie Mae”). Raines resigned from Fannie Mae in 2004 to “take responsibility for” an accounting scandal on his watch. Fannie’s erstwhile regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), accused Fannie of overstating its earnings by billions of dollars so Raines and other senior management could reap huge financial rewards through their executive compensation package.
In the Journal article, Raines argued in favor of letting recent legislation passed by Congress work its magic with Fannie Mae and the Federal Home Loan Mortgage Corporation (“Freddie Mac”). Fannie was established as a New Deal government agency in 1938. The Johnson Administration privatized Fannie during the Vietnam War to get it off the federal budget. Freddie Mac was created by Congress in 1970 as a counterbalance to Fannie, which had held a virtual monopoly over the secondary mortgage market since its inception.
The primary function, theoretically, for both “government- sponsored enterprises” (GSEs) is to operate a secondary mortgage market. Before Fannie came along, home loans were held by the lender for the duration of the mortgage. Suppose you borrow $100,000 from your local bank to buy your home and give the bank a 30-year mortgage as security. The bank funds your loan with money it receives from depositors. If interest rates on deposits rise above your mortgage rate, the bank will lose money.
Today, the bank sells the mortgage to Fannie or Freddie, which packages it with those of numerous other homeowners into mortgage-backed securities, which are then sold to investors such as pension funds, mutual funds and individuals. The bank now has more money to lend to the next home buyer and avoids taking a long-term interest rate risk. The investors have highly diversified mortgage securities written to what are called “conforming” standards.
To make the system work, Fannie and Freddie guarantee they’ll make good on the mortgage payments should a homeowner default. Fannie and Freddie currently guarantee about $6 trillion in mortgages. And because they’re “government-sponsored,” investors assume these guarantees are backed by the U.S. Treasury.
The implicit backing of the U.S. Treasury lies at the heart of the fiasco that is Fannie and Freddie today. The implicit backing lets the GSEs borrow money at interest rates significantly lower than private competitors. That in itself might be a good thing, if all Fannie and Freddie did was borrow enough to provide working capital. But for years, both GSEs have used their position to leverage themselves almost beyond belief. As I write this column, they’ve issued about $1.6 trillion in combined outstanding debt.
Against its $893 billion in debt, Fannie, which is slightly larger than Freddie, holds less than $8 billion in cash and “near cash.” Most of the rest of its “assets” are mortgage-related debt securities.
Fannie and Freddie are making money on the spread between the mortgage rates on the securities they hold and the rates they must pay on their implicitly backed debt. If all goes well in the mortgage market, Fannie and Freddie shareholders—and especially their senior management—reap the benefit. If things go sour, the Treasury (taxpayers) stand to pick up the tab for the losses.
In testimony in 2004, Alan Greenspan told Congress of the Fed’s concern about the growth and scale of Fannie and Freddie’s mortgage portfolio because they weren’t constrained by the need to support their borrowings through increased capital. Instead, they’ve greatly increased their leverage in a way that wouldn’t be possible without the expectation that the Treasury would support them.
As housing prices fall, the chickens are coming home to roost. Foreclosure rates are now climbing, even with “conforming” loans issued with the tougher lending standards applied by Fannie and Freddie. This, in turn, places a greater risk that the GSEs must make good on their guarantees when they have no capital. And given their extreme leverage, even a very small write-down in the value of the debt securities they hold means insolvency for the GSEs.
Greenspan’s 2004 testimony is but one of many warnings the Fed gave Congress over the years. But Congress hasn’t listened, for the simple reason that Fannie and Freddie operate massive and sophisticated lobbying efforts. According to a July 17 USA Today article, the two GSEs rank in the top 20 in money spent on lobbying. Over the past decade, they’ve spent a combined $170 million on lobbying, and their executives have donated more than $16 million to Congressional campaigns.
OFHEO brought a civil action against Raines in 2006 seeking disgorgement of $50 million in additional pay he received based on overstated earnings. The suit was settled in April this year in what the Wall Street Journal called a “paltry settlement.” Fannie’s insurance policies covered the penalties of $3 million levied against Raines and two other top executives. Raines did agree to give up certain bonuses and options but, according to the Journal, kept the bulk of the riches he’d amassed, along with a pension of $114,000 a month and lifetime health benefits.
Should we heed Raines’ plea to let recent legislation work its wonders? Raines’ endorsement tells me Congress has once again failed to address the underlying problem of the GSEs. The risk of failure of these critical entities, which together underwrite half the mortgages in this country, continues unabated, posing a continuing and unnecessary risk to our economy.
