“Fannie and Freddie – Will They or Won’t They?”

Sydney M. Williams

Thought of the Day

“Fannie and Freddie – Will They or Won’t They?”

July 25, 2012

Go into liquidation that is. The Federal Housing Finance Agency (FHFA), the regulator that overseas the two Government Sponsored Enterprises (GSEs) has hired a consulting firm (at our expense) to create contingency plans for taking the mortgage finance firms – Fannie Mae and Freddie Mac – into receivership, according to Bloomberg News yesterday. Receivership implies that a bankruptcy court will appoint a receiver to manage the businesses, as the assets are sold off.

However, in the years since the credit collapse of September 2008, the private mortgage market has essentially disappeared, so that 90% of all new mortgages are guaranteed by Fannie, Freddie and the FHA, far above historic levels. Liquidation of Fannie and Freddie may have become riskier, both to the housing market and to the economy. The two entities continue to hold about $1.5 trillion in mortgages, many of which are under water, the questions are ones of timing and how – how long will it take and to whom and at what price would the assets (the mortgages) be sold.

In September 2008, both companies went into conservatorship, which essentially meant that they would be operated by a court appointed custodian. The stocks of both companies continued to be traded on the NYSE, but for a fraction of the price they had been trading at. In June 2010, by a directive of their regulator the FHFA, the common and preferred shares of both were delisted. On the news, both stocks dropped another 30%. Both Democrats and Republicans have indicated the ultimate goal of winding down both institutions. The Obama Administration did so in a report to Congress, written by HUD and Treasury in February 2011, and Mitt Romney did so in November, 2011 when he said, in regard to the GSEs, “Let markets work.” While the goal marks an unusual agreement between the two parties, the timing is questionable and the Obama Administration has been acting in a manner contrary to their stated intentions. The Administration has been escalating efforts to ease conditions for homeowners, including those who owe more than their home is worth, which is tantamount to weakening the two GSEs.

In the last half of the 1990s and earlier in the last decade, Fannie Mae and Freddie Mac came to symbolize the unhealthy, symbiotic relationship between government and the private sector – with Congress approving the paying of their executives very richly and with taxpayers footing the bill. In return, politicians accepted political donations of commensurate size from the two firms.

The misuse of taxpayers’ funds was appalling. Franklin Raines, former CEO of Fannie Mae, was accused in December 2006 with manipulating earnings – off of which his bonus was paid – over a six year period. The restatement for the years 1998-2004 amounted to $6.3 billion. During those six years in office (1998-2004) Mr. Raines received total compensation of $91.1 million, including $52.5 million in bonuses. He ended up settling in 2008 for $24.7 million, of which $15.6 million was in options that were worthless. Thus his cash settlement was about $9.1 million. Daniel Mudd, who succeeded Raines as CEO, was paid $14.45 million in 2006 and $12.2 million in 2007, despite reporting a loss for the year 2007 of $2.1 billion. In 2009, the year after the two firms were put into conservatorship but when they were still costing taxpayers billions of dollars, Fannie Mae and Freddie Mac reported that their CEOs were eligible for compensation of $6 million each. “Compensation must be sufficiently high to ‘attract and retain’ top talent, their regulator, the FHFA, said in a statement,” as reported by Bloomberg on December 24, 2009. Would losses have been any greater with less talented management? In the three and a half years since the government rescued the firms, taxpayers have advanced $50 million in legal payments to defend former executives of Fannie and Freddie – an unconscionable indictment of the whole system!

During the years 1989-2008 political contributions from Fannie Mae and Freddie Mac totaled $4,844,572. Senator Chris Dodd of Connecticut and Chairman of the Senate Banking Committee was the number one recipient with $165,400. Number two was a new comer to the Senate. Despite only having been in the Senate two years, Barack Obama received $126,349 from the two GSEs.

Problems for these GSEs have been building for sometime, but were ignored by Congress for years. Greed and taxpayer abuse are the root cause. The Community Reinvestment Act (CRA) was originally passed in 1977. It mandated banks to reduce discriminatory credit practices against low-income neighborhoods, a practice known as redlining. Banks were encouraged to meet the credit needs of the communities in which they were chartered. In 1995, the Act was amended to conform to President Clinton’s desire to deal with the problems of the inner city and distressed rural communities. Credit, according to then Secretary of the Treasury, Lloyd Bentsen should not depend on where you live, but “whether or not you can pay it back.” Unfortunately the latter requirement was ignored. The consequences were to encourage people to borrow more than they could afford on the expectation that housing prices would move ever higher.

The expansion of home ownership was a policy that was promoted by President Bush as well. Though, in Bush’s favor, he attempted to reform the GSE’s, but was unable to get anything through Congress. In 2001, the Administration’s budget declared that the size of Fannie Mae and Freddie Mac represent a “potential problem because financial trouble of a large GSE could cause strong repercussions in financial markets.” In May 2002, President Bush called for the disclosure and corporate governance principles contained in his 10-point plan for corporate responsibility be applied to Fannie Mae and Freddie Mac. Nothing was done and a year and a half later Freddie Mac had to restate its financial results for the previous six years. In June 2004, Deputy Secretary of the Treasury Samuel Bodman, testifying before Congress, said “We do not have a world-class system of supervision of the housing government sponsored enterprises.” He called for a new regulatory supervisor. Attempts at reform were rejected by Congress.

The point is that these entities, whose original intent and purpose was to provide easier financing to middle class working people aspiring to homeownership, became political feedstock for furthering political agendas and feathering campaign chests, while enriching management. They remind me of a line from one of John Kenneth Galbraith’s very few novels, A Tenured Professor published in 1990. One of his characters describes Texas banks of the early 1980s, which, in those day had the bulk of their liabilities insured by the FDIC: “Free enterprise, but with the ultimate and benign support of socialism.” Similarly, the GSEs became perfect examples of cronyism, with profits accruing to management, and through them to politicians, while losses became socialized with taxpayers picking up the pieces.

There is no doubt in my mind that the current entities should vanish (taxpayers have anted up $190 billion since the fall of 2008), but timing is critical and, while Mr. Obama says he wants them to go, instead of weaning homeowners from dependency on them, he has been pressuring them to ease conditions for those with underwater mortgages. It is a problem, getting worse, and without a visible solution. Price fixing, whether it’s gold, oil or interest rate, never works in the long run.

The lead editorial in yesterday’s Wall Street Journal dealt with the growing problem of student loan bankruptcies. The last sentence could apply as well to the mortgage companies: “But wouldn’t it be easier merely to encourage job creation rather than try to anticipate and make taxpayers pay for every consequence of joblessness?”