Shaky Ground: What Investors Can Learn From The Strange Saga Of Fannie Mae And Freddie Mac

Bethany McLean, Contributing Editor – Vanity Fair, Chicago

Many observers believe that the policies of Fannie Mae and Freddie Mac led to the financial crisis of 2008–2009, and many would like to remove them from the US mortgage market. Although Fannie Mae and Freddie Mac were not blameless, their policies were less destructive than those of private lenders. Unless the US housing market is thoroughly reformed, Fannie and Freddie will remain essential to its existence.

The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are immensely important companies. They own or guarantee more than $5 trillion in US mortgage debt; together they are the largest financial institution in the world. At one time, they were also great investments, as many investors can attest. By the end of the 1990s, Fannie Mae (established in 1938) was the United States’ third-largest company ranked by assets, and Freddie Mac (established in 1970) was close behind. They were ranked first and second on Fortune’s list of the most profitable companies per employee.

Fannie Mae and Freddie Mac are part of the hidden machinery that makes the United States work and that everyone tends to take for granted until it malfunctions. They should matter to everyone in the United States, not only because they help determine the price and availability of mortgage credit—and even help dictate the price of homes—but also because housing makes up some 15%–20% of US GDP. Marriner Eccles, chairman of the Federal Reserve Board from 1934 to 1948, said that President Franklin Roosevelt, in his New Deal programs, understood that housing “would act as the wheel within the wheel to move the whole economic engine.”1 It still does.

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I will discuss the nature and history of these two institutions, the resentment and animosity (both deserved and not) with which they are perceived, the role they did and did not play in the 2008–09 financial crisis, the need for reform in US housing policy, the factors working against such reform, and the reasons that Fannie Mae and Freddie Mac (no matter how disliked) remain a necessary element in the US housing market.

Recent History

Jim Johnson, a Washington, DC, power broker who served as Fannie Mae’s CEO from 1991 to 1998, was once described by politician Harold Ickes as the “chairman of the universe,” so powerful did the institution appear to outsiders. Johnson himself used to paraphrase the famous General Motors quote in this way: “What’s good for American housing is good for Fannie Mae.”

When Johnson stepped down in 1998, Franklin Delano Raines became Fannie’s CEO. Raines grew up in Seattle, where his father was a custodian for the city parks department and his mother was a cleaning woman for Boeing, a company on whose board Raines would later serve. Raines was a star student who earned a scholarship to Harvard University, was named a Rhodes Scholar, interned at the White House during the Nixon administration, and served in the Carter administration before leaving for Lazard Frères. He later returned to Washington, DC, to run the Office of Management and Budget under President Bill Clinton and received enormous credit for balancing the budget. There was even talk that he might one day be the first black president of the United States.

Both Raines and Johnson were architects of what former Congressman Jim Leach once described as the greatest, most sophisticated lobbying operation in the history of modern finance. A congressional source once said, “Fannie has this grandmotherly image, but they will castrate you, decapitate you, tie you up and throw you in the Potomac. They are absolutely ruthless.”

Facing Increased Scrutiny. Both Fannie Mae and Freddie Mac started receiving additional attention in 2004, partly as a result of an apparent accounting scandal.5 Fannie and Freddie have always been controversial because they are a weird mix of public and private. They are called “government-sponsored enterprises” (GSEs). Many people have questioned the purpose of a GSE in a free market economy; why should the government have its thumb on the scales of mortgage credit?

Fannie Mae and Freddie Mac are like unimaginably gigantic mythical beasts but with shareholders and a board of directors, just like normal companies. They have a responsibility to help the flow of housing credit in the form of affordable housing goals, and they are required to buy a certain amount of loans made to middle- and lower-income people. The two companies are very much insurance companies. They purchase loans from other lenders, put a stamp on them that homeowners will pay, package the loans into securities, and sell them off. Back in 2005, Fannie Mae’s executives argued that their enemies wanted to turn Fannie’s operations over to the big banks, along with its profits.

The Financial Crisis. As mot people know, the US government took over Fannie Mae and Freddie Mac during the 2008 financial crisis and put them into a state of conservatorship. In this state, they were (and continue to be) supported by a line of credit from the US Treasury and effectively run by a government agency. Henry Paulson, the secretary of the Treasury at the time, referred to the conservatorship as a “time-out.” It was supposed to be temporary while the government assessed how to resolve the inherent problems in these two companies.

Some in government were even discussing a reassessment of the role that government has long played in promoting and supporting the US “cult” of homeownership. Had that occurred, it might have been the silver lining of the financial crisis. But now, more than seven years after the takeover of Fannie Mae and Freddie Mac, little has changed.

The big banks have at least superficially paid back the money the government gave them during the crisis. General Motors and Chrysler are out of bankruptcy. But Fannie Mae and Freddie Mac are still in conservatorship, and there is no plan for getting them out. Furthermore, about 80% of mortgages made today are guaranteed by a government agency, which is a far greater percentage than before the financial crisis.

Mervyn King, the former governor of the Bank of England, once noted that most countries have socialized health care and a free market for mortgages but that the United States does not. In the United States, these roles are exactly reversed. Although homes are the most domestic asset possible, Fannie Mae and Freddie Mac are, in effect, global entities. Through the securities they issue—more than $5 trillion of mortgage-backed securities (MBS)—foreign investors, including China’s central bank, finance the purchases of US homes.

Having a savior in China financing the purchase of a home in Kansas may appear to be a good thing, an example of globalization that has worked. But such globalization can tie the hands of the government.

Resentment of Fannie Mae and Freddie Mac

Fannie Mae has been around since the Great Depression. But throughout its history, a certain number of people (in and out of government) have wanted Fannie Mae and Freddie Mac dead. Bill Maloney, Fannie Mae’s chief lobbyist, used to call it the “vampire issue” because as powerful as Fannie is and as much as it lobbied, it has never been able to squelch people’s desire to see it shut down.

Part of this antagonism arises from the private mortgage industry, in which many participants have an ideological opposition to GSEs. Another part arises from economists—including liberal economists—who generally view hidden subsidies as a bad thing and have never been entirely comfortable with the idea of GSEs.

Political Entanglements. One visceral reason that people hate these two GSEs is a deep resentment of Fannie Mae and Freddie Mac’s entanglement with politics. Political players have come to these two companies to get rich. The sheer volume of money that their executives have made is mind-boggling. And the list of those who have lobbied or worked for Fannie Mae and Freddie Mac mirrors a “who’s who” of Washington, DC—Tom Donilon, President Barack Obama’s national security administrator; Aaron Christensen, chief of staff to former Speaker of the House of Representatives Newt Gingrich; Newt Gingrich himself; right-wing godfather Grover Norquist; and conservative political activist Ralph Reed. The list goes on and on.

The Big Fat Gap. Another reason to resent Fannie Mae and Freddie Mac arose precisely from the thing that made them such a great investment during the 1990s. By the late 1990s, the substantial profits that Fannie Mae and Freddie Mac were reporting came not only from the traditional business of stamping mortgages with a guarantee, collecting a fee, and packaging them into securities but also increasingly from Fannie Mae and Freddie Mac’s ability to buy their own MBS and hold them on their balance sheets. Because of their special position, they could make money on the difference between the higher yield of the mortgage and their cost of funds; the two companies had an implicit guarantee. Although the US government disavowed that it stood behind the two companies, most people believed that if times got hard enough, the government would bail Fannie Mae and Freddie Mac out.

Alan Greenspan—the very powerful chairman of the Federal Reserve in the 1990s—referred to the spread between the cost of funds and the higher yield of the mortgages the two companies held as “the big fat gap,” and he was enraged by it.6 The GSEs’ combined portfolios of mortgage holdings would peak in 2008 at a stunning $1.6 trillion. To put that in context, the entire national debt at the end of 2007 stood at approximately $9 trillion.

The political power amassed by Fannie Mae and Freddie Mac backfired in many ways. It created an animosity toward the companies that continues to this day. Fannie Mae and Freddie Mac seem to have pushed around so many people in their prime that people now want to get even. The resentment has a very personal edge. Gene Sperling, an economist who served in both the Clinton and Obama administrations, considers himself a progressive, but he has marveled at how Fannie Mae and Freddie Mac have brought out the conservative in him. He was appalled that two companies completely dependent on the US government for their profit would spend so much time and money lobbying that very same government.

Less than Principled Opposition. Although some of the opposition to Fannie Mae and Freddie Mac is principled, much of it is not. The US mortgage market is one of the largest markets in the world. An enormous amount of money is at stake. Much of the opposition to Fannie Mae and Freddie Mac has arisen from private sector players who were enraged that such a substantial portion of the profits should go to these two GSEs.

In 2004, the resentment crystallized in the accounting scandals at Fannie Mae and Freddie Mac. In retrospect, both of the accounting scandals are very odd. In Freddie’s case, the problem was that it was understating, not overstating, earnings. Fannie was supposedly overstating earnings. Fannie’s regulator at the time called it a “government-sponsored Enron,” and the scandal led to the ejection of Raines as CEO and Tim Howard as chief financial officer. But when Fannie Mae’s earnings restatement was completed, shareholders’ equity actually increased.

Both Raines and Howard ended up settling the charges that their regulator brought against them. Neither man admitted guilt, and most of their combined $31 million settlement consisted of worthless stock options that the regulator valued at their grant prices rather than at the actual stock price at the time in order to arrive at a settlement that sounded impressive. In The Mortgage Wars, Howard wrote, “In an ironic way it was a fitting climax. A suit that began with our regulator accusing us of deliberate fraud ended with our regulator putting a deliberately fraudulent value on what we paid to settle it” (p. 267).

As a result of the settlement, both the SEC and the US Justice Department quietly dropped their investigations into wrongdoing at Fannie Mae. And in September 2012, when no one was paying attention any longer, after eight years and 67 million pages of documents and testimony from more than 150 witnesses, a civil suit against Raines, Howard, and another executive ended with a federal judge dismissing all charges. He concluded there was no evidence that Raines and Howard had ever tried to deceive anyone.

Be very careful of investments when politics is involved.

The Financial Crisis

From time to time, bank executives at large banks and others have referred to Fannie Mae and Freddie Mac as “the hidden secret of the financial crisis,” as if the financial crisis had occurred because Fannie Mae and Freddie Mac were pursuing their affordable housing goals and giving mortgages to people who could not afford them. This narrative appeals to many people, perhaps because it simplifies the financial crisis and offers the illusion of clarity. Furthermore, if the entire financial crisis can be blamed on government interference with the markets, then the solution is obvious: Get government out of the markets. And get rid of government regulation because it is also detrimental to the markets.

Fannie Mae

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