Fannie Mae: the implied story, Part 7: What now?
[For the introduction, see Part 1.]
[For previous installments, see Parts 2, 3, 4, 5, and 6.]
[Quotes in green are from the OFHEO report (full document, .pdf), on which Fannie Mae declined to comment. Sentences are occasionally reformatted (bullets, boldface emphasis, inconsequential brief elisions) for clarity.]
Fannie Mae, the refresher course
AHI’s refresher course consists of the following posts:
1. Fannie Mae, the OFHEO report
2. Fannie Mae, the story so far
3. Primary and secondary markets
5. Balance sheet turbocharging
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To recapitulate, OFHEO claims at least five interlinked stratagems for executive self-enrichment at the taxpayers’ risk:
OFHEO’s Main Charges Against Fannie Mae
1. Maximizing executive bonuses. Fannie Mae’s senior management sought to maximize their personal bonuses through a deliberate strategy that permeated all aspects of the company’s operations.
2. Gaming the bonus formula. Management selected a bonus metric, Earnings Per Share, that could be gamed (manipulated for favorable effect) and was gamed.
3. Turbocharging the balance sheet. Earnings were boosted by a strategy of expanding the balance sheet through three means: (a) penetrating business areas already being well served for affordable housing, (b) trimming affordability benefits (subsidy passthrough) to customers, and (c) turbocharging the balance sheet by lending long and borrowing short, taking advantage of a favorable yield curve.
Turbocharging the balance sheet is the linchpin of OFHEO’s beef, for this is what placed taxpayers at enormous, multi-billion-dollar risk. All of OFHEO’s charges before and after this key charge amount to reasons why and coverup strategies for the central charge. More on this below.
4. Buffing the image by smoothing earnings in covert ways. To downplay balance sheet turbocharging, management smoothed out earnings using a variety of winkles, gimmicks, and tricks, all with the goal of giving the image of a flawlessly performing engine comfortably under control.
5. Squelching criticism. Management maintained a multiple-front campaign to conceal, cow, coerce, contain, or undercut analysts, critics, and regulators that might otherwise spotlight the earnings smoothing and balance sheet turbocharging.
Five strategies, all interlaced
As OFHEO puts it in one of many similar passages:
Under the Fannie Mae executive compensation program, senior management reaped financial rewards when the
The structure of the executive compensation program created the incentive and opportunity for senior executives to benefit at the expense of safety and soundness. In addition, Fannie Mae disclosure of executive compensation obscured public understanding of how much compensation senior executives actually received. Page 55.
For so many years and decades, Fannie Mae has been a huge force for good in affordable housing, That makes these revelations beyond disappointing.
Reading the OFHEO report initially, I was shocked and disgusted. Over the ensuing month, that ire faded and I began wondering, had I over-reacted? Now, as I recompile and reorganize OFHEO’s complaints, I again feel like Henry V at Agincourt, discovering that the evil French have shamefully ridden behind English lines to slaughter the camp boys:
I was not angry since I came to
Until this instant.
In designing the appropriate remedy, we have to separate emotion from logic, and ascribe proper weight to each.
Over the years, I’ve known many fine people who worked at or joined Fannie Mae. To a person, those I encountered have been upright, hard-working, smart, dedicated to affordable housing — among the best and most committed our nation has. They have done fine research work, published useful periodicals and journals, and innovated new financial products and services — all helping substantially to increase American homeownership to the highest it has ever been. They and the work they have done has been a great force for good in
Many of these outstanding people still work at Fannie Mae. As these scandals come out, one after another, seemingly without end, what must they be thinking, even if loyalty and prudence silence their voices?
If little faults, proceeding on distemper,
Shall not be wink’d at, how shall we stretch our eye
When capital crimes, chew’d, swallow’d and digested,
Appear before us?
I will weep for thee;
For this revolt of thine, methinks, is like
Another fall of man. Their faults are open:
Arrest them to the answer of the law;
And God acquit them of their practises!
Had I worked at Fannie Mae in this interval, I would now be furious. All the good Fannie Mae has done, and it is considerable, is now stained by the shenanigans done in the executive suite. Were I a Fannie Mae employee, I would feel personally betrayed by my former leadership.
Take a trumpet, herald;
Ride thou unto the horsemen on yon hill:
If they will fight with us, bid them come down,
Or void the field; they do offend our sight:
If they’ll do neither, we will come to them,
And make them skirr away, as swift as stones
Enforced from the old Assyrian slings:
Besides, we’ll cut the throats of those we have,
And not a man of them that we shall take
Shall taste our mercy. Go and tell them so.
If this were a private company, it might be Enron.
Anger dissipates. Outrage burns off. What should Fannie Mae do to redeem itself? What should Congress do to assure its redemption and prevent its recidivism?
“Arrest them to the answer of the law/ and God acquit them of their practices.”
For a purely private company, market mechanisms work. If such a company collapses, whether or not through executive malfeasance — which Enron did, but Fannie Mae has not and almost certainly will not — then ultimately the matter would be one for the courts to settle redress for violations of shareholder rights. For the GSEs, that is insufficient, because all American taxpayers are de facto partners, so when they take risks, it’s we who are their insurance company.
Why Taxpayers Were (And Are!) At Risk
1. GSE default risks are taxpayers’ risks. Because of the GSEs’ unique Federal charters, their securities are widely perceived to have an implicit Federal backing, so if Fannie Mae loses a ton of money and its payments become imperiled, everyone expects the Treasury (meaning us taxpayers) would be on the hook to bail it out. (In effect, the Treasury is Fannie Mae’s credit enhancer or reinsurer.)
2. Turbocharging the balance sheets substantially increases GSE default risks. Mismatching maturities (the term of Fannie Mae’s loan portfolio versus its securities portfolio) and mismatching optionality (who can prepay and when) means that if the yield curve suddenly changes shape, market customers do things that the GSEs cannot mimic, to wit:
· If rates fall, market borrowers prepay (owners refinance their home loans), and Fannie Mae loses the nice spread it is making between their payments and what it owes on the corresponding securities. Interest income drops, interest expense stays level, result losses.
· If rates rise, when Fannie Mae refinances its short-term securities, market lenders demand higher rates to roll over Fannie Mae’s debt. Interest income stays flat, interest expense rises: result losses.
Got it? If you turbocharge the balance sheet, either substantial variation means big losses. The only thing that doesn’t mean big losses is continuation of the status quo.
OFHEO’s whole report seeks to demonstrate that Fannie Mae did this, did it deliberately, concealed it was doing this, and sought to silence those who could blow the whistle.
As I previously quoted Chairman Greenspan:
Under normal circumstances, GSEs are able to easily maintain and grow their large portfolios of mortgage and non-mortgage assets without the significant market checks or balances faced by other publicly traded financial institutions.
A private company trying this trick would be tested for its ability to cover an adverse swing. Since the GSEs are perceived to be protected by Congress, this doesn’t happen, so the market doesn’t charge the GSEs a premium, and hence the market doesn’t check their balance sheet growth.
These large portfolios, while enriching GSE shareholders, do not meaningfully benefit homeowners and do not facilitate secondary market liquidity.
The rate spread compression (cheaper loans) occurs at origination and initial securitization. Buying and selling existing portfolios doesn’t help the consumer. It does make Fannie Mae a ton of money, and it puts taxpayers at risk:
They do add systemic risk to our financial system, which normal market forces are unable to resolve.
“We know what we’re doing.”
We need especially to hear the Chairman’s last clause: “which normal market forces are unable to resolve.” Evidently, the nation dodged a bullet … this time. How can we be sure it will never happen again?
Actually, in one historical sense, this is it happening again. As we saw in Part 4, precisely this sort of balance sheet turbocharging led the GSEs (and the savings and loans associations) astray in the early 1980’s, but Fannie Mae and Freddie Mac were strong enough to survive, even if the savings and loans cost taxpayers billions. Echoing me in this, here is Treasury Assistant Secretary for Financial Institutions Emil Henry:
In fact, has it been so long that we have forgotten Fannie Mae’s significant financial troubles in the late 1970s and early 1980s? During this time period, Fannie Mae’s balance sheet looked a lot like a savings and loan. As interest rates rose, Fannie Mae’s cost of funds rose above the interest rate it was earning on its long-term, fixed-rate mortgages. Like many S&Ls, Fannie Mae became insolvent on a mark-to-market basis. It lost hundreds of millions of dollars. Only a combination of legislative tax relief, regulatory forbearance, and a decline in interest rates allowed Fannie Mae to grow out of its problem.
In the mid-1980s, the Farm Credit System (FCS) fell victim to a sharp drop in land prices, deterioration of agriculture market conditions, and increased interest rate volatility. These economic factors coupled with poor interest rate risk management resulted in $2.7 billion in losses in 1985 followed by a $1.9 billion loss in 1986. In the end, the federal government provided $1.26 billion to the FCS in financial aid.
Somehow the FIRREA lessons were all forgot, at least as they might apply to the GSEs. As the late-1990’s incarnation of Fannie Mae became vastly profitable — real or manipulated — so grew its clout:
Fannie Mae’s financial success gave senior management steadily increasing amounts of money to use in efforts to influence the regulatory and legislative processes. Over the years, the
Surely we can agree to disagree, can’t we?
If OFHEO is right — and recall, Fannie Mae has declined to dispute OFHEO’s findings, presumably reserving its defense for another day and another forum — these practices were ongoing for a decade, amidst an internal conspiracy of silence by all those who ought to have been frantically blowing whistles.
The question thus recurs: are the steps put in place to date sufficient to preclude the possibility of recurrence?
At this moment, the answer is clear: No.
Because of money power, binding an duopoly is just as hard as binding the sovereign. Here’s Assistant Secretary Henry again:
[Consider] the sheer size of the GSEs’ investment portfolio. Since 1990, the mortgage investment business of both of the housing GSEs has grown rapidly. From 1990 through 2003, Fannie Mae’s mortgage investments increased from $114 billion to $902 billion. Freddie Mac’s growth in mortgage investments was even more dramatic. From 1990 through 2003, Freddie Mac’s mortgage investments increased from $22 billion to $660 billion. Today’s combined GSEs’ mortgage investment portfolios still total almost $1.5 trillion. By any standard, these are huge investment portfolios.
OFHEO has done what is in OFHEO’s current power to do, but the OFHEO remedies in place today are neither statutory nor permanent.
What is the right remedy?
That depends on how much you will offset the minuses (the GSEs’ enduring systemic risk) against their pluses (the GSEs’ impact on the US affordable housing ecosystem).
To understand the pluses – and whether they justify the proven minuses — we’ll need a further set of blog posts.