"The Investor Class - Unsung Victims of Washington"

Sydney M. Williams

Thought of the Day

"The Investor Class - Unsung Victims of Washington"

January 25, 2010

Gretchen Morgenson’s front-page report, in yesterday’s New York Times, was a timely reminder of the fraud perpetuated on shareholders and citizens by the collusion between Fannie Mae and Freddie Mac management and their abettors in Congress. Ms. Morgenson writes that American taxpayers have anted up $160 million to pay for lawyers defending former executives of the two GSEs (Government Sponsored Enterprises) - $29.8 million just for former CEO, Franklin Raines.

During the six years Mr. Raines served as CEO of FNM, he reportedly made $90 million, $52 million of which was due to overstating revenues by $10.6 billion and the resulting fraudulent earnings on which his bonuses were based. In 2006, the Office of Federal Housing Oversight published an in-depth report accusing Fannie’s top management of manipulating profits and generating $115 million in improper bonuses. Those executives were sued for restitution plus $100 million in fines. The three top executives settled, paying out $31.4 million. Fannie Mae (read public shareholders and American taxpayers) ultimately paid out $400 million to settle the charges, according to Ms. Morgenson's report.

What sort of a message does this send? Committing fraud allowed Mr. Raines to pocket an extra $52 million of which he pays back $24.7 million. In the meantime, Mr. Raines incurs about $38 million in legal expenses, all of which is paid for by others, initially by shareholders, and later by taxpayers. Importantly, these two GSEs were among the largest contributors to political campaigns, thereby receiving protection and cover for their nefarious ways. The five largest beneficiaries of their largesse between 1989-2008, in order, were Senator Chris Dodd of Connecticut, Senator John Kerry of Massachusetts, Senator Barack Obama of Illinois, Senator Hillary Clinton of New York and Representative Paul Jankorski of Pennsylvania.

These agencies, whose purpose is supposedly to provide low cost mortgages to lower income people, became a source of significant contributions to favored politicians. As quasi government enterprises, they were able to borrow at favorable rates - borrowings implicitly guaranteed by the federal government. This allowed them to invest in mortgages and earn a reasonable spread. However, the temptation of low borrowing costs, increased allowable leverage and the advent of new derivative products proved irresistible. Congress did nothing to rein in their ambitions. By the end of 2007 the two GSEs had roughly $1.7 trillion in mortgages and other securities (including derivatives) on their balance sheets, supported by about $71 billion in equity - a leverage ratio of 25 times. Of the $1.7 trillion in assets, only about $484 billion in mortgages, the balance being invested in "securities and other assets," a portion of which obviously included mortgage backed securities.

Attempts to reform Fannie and Freddie by the Bush administration in 2003 and later in 2005 met with strong resistance from Congress. As early as 2003, Representative Barney Frank concluded: "these two entities - Fannie Mae and Freddie Mac - are not facing any kind of financial crisis." John McCain sponsored legislation in 2005 to protect what he termed "the enormous risk that Fannie Mae and Freddie Mac pose to the housing industry, the overall financial system and the economy as a whole." This proposed legislation was, in part, a reaction to the accounting scandal unearthed in 2005, which caused the ouster of Franklin Raines as CEO. (It would be difficult to impugn that Mr. Raines, a Harvard college and law school graduate and Rhodes scholar, was an innocent bystander of the scandal that enveloped him.)

Ironically, but not mystifyingly, the Dodd-Frank Bill, in all of its 2300 pages, never found space to include reform of Fannie and Freddie. As late as July 2008, two months before their collapse, Representative Frank declared that the two were "fundamentally sound and not in danger of going under."

While much of the focus of the Press has been on Wall Street's implication in the economic collapse and the loss of approximately 8 million jobs, very little has been written about the impact on the investor class - a group that represents more than half of all Americans. The collapse of Fannie Mae, Freddie Mac, AIG, GM, Citibank and other banks have cost investors at least half a trillion dollars - a significant portion of which was in retirement savings accounts. Additionally, the interests of bondholders, despite laws theoretically protecting them, were subsumed in favor of union employees - the most outrageous example being the GM restructuring.

This is all happening at a time when the country faces an impending crisis of too little capital to support an onslaught of retirees. This habit of ignoring impending doom reminds one of Nero fiddling while Rome burned. We are a consuming nation that badly needs to focus on investment, yet Washington still doesn't get it. Attempts to permit states to file for voluntary bankruptcy being another example. Investors once again risk being sacrificed, so that union leaders and politicians can honor the unrealistic commitments they have made to union and state workers.

Investors knowingly, for the most part, assume risk any time they reach for yield in excess of Treasuries (and they do take risks in buying Treasuries because of the potential ravages of inflation, made more likely should the Federal Reserve assume responsibility for some of the debt obligations of a few states.) No one is asking to bail out risk-takers, but with baby boomers turning 65 at the rate of 10,000 a day for the next eighteen years it is imperative that the government use the tax code to encourage investment and discourage consumption - otherwise default will become common, and the Fed will be further incentivized to print its way out of this mess.

Having taxpayers financially support Mr. Raines, who played a key role in bringing the financial system to its knees and who destroyed over $40 billion in equity value, does not seem to me to be the mark of a government that understands the consequences of their actions. Ms. Morgenson did the country a service in publicizing this scandal.