The Wages of Hubris (I) – Fannie Mae and Freddie Mac

Scandals and crises are periodic occurrence in financial markets.  Sometimes the arrogance of those involved is breathtaking.  For example, who can fail to remember Enron or the accounting scandals of Fannie Mae and Freddie Mac?

With respect to the latter, Fannie and Freddie had successfully fought off Treasury’s attempts to rein them in over the years.  The Treasury has had an institutional bias against Government Sponsored Enterprises (“GSEs”), of which Fannie and Freddie are the largest.  The reason for this was once succinctly summarized to me by a senior career Treasury official – “They pay themselves private sector salaries but do not take private sector risks.”

At Treasury, we knew that no matter how loudly we proclaimed that the Treasury did not guarantee Fannie and Freddie securities, which was technically accurate, no one would believe us.  Consequently, GSE securities, with somewhat higher yields than Treasuries, competed with Treasury securities.  Treasury’s debt managers did not appreciate this.

When the firms were approaching failure and were put into conservatorship, market participants’ assessment of the value of the “implicit” guarantee proved accurate.  The government had little choice.  Even if it had been willing to make private investors in Fannie and Freddie debt suffer financial losses, it could not afford to do this to foreign central banks which had invested in Fannie and Freddie debt.    

The creation of a new safety and soundness regulator in 1992 at Treasury’s urging, the Office of Federal Housing Enterprise (“OFHEO,” which was merged into the Federal Housing Finance Agency in 2008), did not faze these firms.  In fact, the two mortgage giants took on more interest rate risk while under OFHEO’s supervision.  For both GSEs at the time of OFHEO’s creation, the income from guarantee fees on their mortgage backed securities (“MBS”) was greater than the income from the interest rate spread on their portfolio holdings.  During the years of OFHEO supervision, this relationship between the two types of income reversed, meaning that Fannie and Freddie were taking on interest rate risk as well as credit risk in order to increase their profits.  (Ultimately, of course, the interest rate risk did not matter.  Their recent fate was due to growing defaults.)

But in the late 90s and subsequent years, Fannie and Freddie apparently did not realize that the political landscape was changing.  They had most of Wall Street intimidated by their size, but the relaxation of Glass-Steagall rules and then its repeal in 1999 allowed the big banks to get even larger.  In 1999, some of these banks created an organization called “FM Watch.”  They were concerned that Fannie and Freddie, in their attempt to maintain their historical returns on equity, which at times was around 30%, would continue to broaden their activities in direct competition with the banks.  The market for conforming mortgages might not grow fast enough to suit the GSEs, and the banks wanted at a minimum to limit what Fannie and Freddie could do.

Both firms decided to adopt aggressive accounting policies which crossed the line of what was permissible. In Fannie’s case, the arrogance was remarkable; right up to the end in 2004, Frank Raines was testifying before a Congressional committee that he thought the accounting rules were complex but did not believe that Fannie had done anything wrong.  (I was following this at Treasury, and, though I have forgotten the details, I remember thinking at the time that it was hardly a close question of whether Fannie had crossed over the line in its accounting.)

Mr. Raines insisted that the SEC review the conclusions of the more aggressive OFHEO he was then facing. One has to wonder what he was thinking.  The SEC also thought Fannie had broken the rules, and by the end of 2004, Frank Raines had left Fannie Mae.

Currently, the knives seem to be out for yet another firm Goldman Sachs, though not, at least not yet, from the regulators.  Goldman is the subject of the next post.