The failure of Fannie Mae and Freddie Mac will be a case study in business schools for decades. How do you operate a business with the most generous government subsidies possible, which confer very powerful market advantages, and run the business into the ground?
– Armando Falcon Jr., Former Director of the Office of Federal Housing Enterprise Oversight (OFHEO) from Oct. 1999- May 2005
We’ve created the worst form of socialized capitalism: private gains combined with public losses.
– Robert Reich, UC-Berkeley Public Policy Professor and Former U.S. Labor Secretary
I owe investment bankers an apology. Not because I called them psychopaths – they are. But I left the impression that they were the lowest form of financial life – they aren’t. After watching last week’s hearings held by the Financial Crisis Inquiry Commission (FCIC), which is a non-partisan body established in May 2009 to investigate the causes of the 2008-09 financial meltdown, I realize that my venom needs to be directed elsewhere. The real bottom dwellers are the executives at the government-sponsored enterprises (GSEs) Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE).
100-to-Leverage Was Insane But Legal
Whereas investment bankers took outrageous risks that blew up only their company’s shareholders, former CEOs Daniel Mudd at Fannie Mae and Richard Syron at Freddie Mac took outrageous risks that blew up the American people. Although I was shocked to learn that in 2004 investment banks had successfully lobbied the SEC to increase their balance sheet leverage to 40-to-1 (from 12-to-1), I was flabbergasted to discover that this leverage was child’s play next to the 100-to-1 leverage the GSEs were legally permitted!
Background of a Tragedy
First a little background. In 1938, Congress created the granddaddy of GSEs, the Federal National Mortgage Association (Fannie Mae), in reaction to a shortage of mortgage financing. The country’s private banks, who were the traditional home lenders, had lost a lot of money during the Great Depression and consequently severely restricted the amount and number of home loans they would originate. Fannie Mae filled the void by offering to purchase mortgages originated by banks, thus encouraging banks to make such loans.
Fannie Mae remained a government entity until 1968, when the costs of the Vietnam War convinced the government to raise money and reduce its balance sheet debt by privatizing part of the organization under the Fannie Mae moniker and keep the other half a government entity catering to the home mortgage needs of government employees and veterans (Ginnie Mae).
The new Fannie Mae, although privately owned, maintained its government charter that restricted its business activities to financing home mortgages in exchange for benefits not enjoyed by other private companies, such as a U.S. Treasury line of credit and exemptions from state and local taxes, SEC filing requirements, and leverage limits. The government did not guarantee Fannie Mae’ debts (that is, until the 2008 takeover), but Fannie was able to borrow money at lower rates anyway because lenders perceived (rightly, it turned out) that the government would not let Fannie fail.
In 1970, Congress created the Federal Home Loan Mortgage Corporation (Freddie Mac) as a second privately-owned mortgage purchaser that would compete with Fannie Mae.
Billions in Losses For as Far as the Eye Can See
Flash forward to the present. In 2008-09, the Federal Finance Housing Agency (the successor organization to OFHEO) placed both Fannie Mae and Freddie Mac under government conservatorship and took an 80% common equity stake in each company in exchange for each company receiving a credit line of $200 billion (subject to increase as needed). Both Fannie’s Mudd and Freddie’s Syron were fired. So far, the government has injected more than $125 billion into both companies with no end in sight. According to the Congressional Budget Office, losses from the investment portfolios of both GSEs are expected to total $370 billion by 2020.
Fannie and Freddie Shares Keep Trading Even Though They are Worthless
What a mess! Both companies have negative common shareholder equity. Their common stock is clearly worthless, yet they both continue to trade, Fannie for $1.25 per share and Freddie for $1.55 per share. In a previous article, I asserted that the common stock of American International Group (NYSE: AIG) was worthless. My conviction was shaken when I read that Bruce Berkowitz of the Fairholme Fund, Morningstar’s Domestic Fund Manager of the Decade, had purchased 15 million shares of AIG common stock. But Berkowitz hasn’t purchased any Fannie or Freddie, so I’m really sure these stocks should be trading at zero.
Unlimited Greed
The question remains why Fannie and Freddie failed. As stated above, the law allowed the GSEs to leverage their balance sheets 100-to-1. At such leverage, a 1% default rate would wipe out common shareholders. But neither Fannie’s Mudd nor Freddie’s Syron were required to engage in such outrageous risk-taking. They did so out of greed. As former OFHEO head Armando Falcon stated last week in his prepared testimony before the FCIC:
Ultimately, the companies were not unwitting victims of an economic down cycle or flawed products and services of theirs. Their failure was deeply rooted in a culture of arrogance and greed. I should be clear that this was a failure of leadership.
Earlier in the week, in former Federal Reserve Chairman Alan Greenspan’s prepared testimony, Greenspan also was struck by the GSEs thirst for profit at any cost:
Unlike many well-capitalized savings and loans and commercial banks, Fannie and Freddie have chosen not to manage that risk by holding greater capital. Instead, they have chosen heightened leverage, which raises risk but enables them to multiply the profitability of subsidized debt in direct proportion to their degree of leverage.
James Lockhart, another former OFHEO head who served after Falcon, stated in his prepared testimony that both Fannie and Freddie “had serious deficiencies in systems, risk management and internal controls.” Furthermore, “there was no mission related reason why the Enterprises needed portfolios that totaled $1.5 trillion.” He chalked it up to “the Enterprises’ drive for market share and short-term profitability.”
Both Lockhart and Greenspan noted that the U.S. Department of Housing and Urban Development (HUD), as well as the Democratic leadership in Congress, were pressuring the GSEs to expand their commitment to “affordable housing” by lowering standards and purchasing subprime mortgages. But Falcon – the regulator actually responsible for the GSEs – dismissed this alleged pressure:
In my opinion, the goals were not the cause of the enterprises demise. The firms would not engage in any activity, goal fulfilling or otherwise, unless there was a profit to be made. Fannie and Freddie invested in subprime and Alt A mortgages in order to increase profits and regain market share. Any impact on meeting affordable housing goals was a byproduct of the activity.
In addition, OFHEO made it very clear to both enterprises that safety and soundness was always a higher priority than the affordable housing goals. They should not take on excessive risk in order to meet any one of the goals.
Congress as Co-Conspirator
Falcon also recounted how former Fannie Mae CEO Franklin Raines tried to get him fired for looking into the company’s fraudulent accounting practices (in 2004, Raines was forced to resign in disgrace). Much of this arrogance was the result of the GSEs having unquestioned support from the Democrats in the Congress, who resisted any attempt to regulate Fannie and Freddie. In 2005, Republicans introduced Senate Bill 190 entitled “The Federal Housing Enterprise Regulatory Reform Act of 2005” which would have regulated the GSEs and reduced their permitted leverage. The Senate Banking Committee passed it twice in the face of 100% Democratic opposition. The bill never came to a vote on the Senate floor, however, because of a Democratic filibuster.
Just Trying to Make a Profit?
Daniel Mudd, who joined Fannie Mae in 2000 as Chief Operating Officer and took the helm as CEO in 2004 when Raines resigned, said in his testimony before the FCIC that he was “sorry” that the company failed but he would not apologize for “trying to make a profit.” Did a profit require being leveraged 100:1? Did a profit require lowering standards and taking excessive risk? According to the New York Times:
Between 2005 and 2008, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers — more than three times as much as in all its earlier years combined.
Mr. Mudd wasn’t trying to just make a profit — he was trying to take as much risk as possible in order to make a killing. At one meeting in 2006, Mudd reportedly told his employees: “get aggressive on risk-taking, or get out of the company.”
A Shameful Scorecard
Let’s look at the final score of Fannie Mae’s attempt at making a profit:
Franklin Raines executive compensation 1998-2004: $90 million
Daniel Mudd’s executive compensation 2005-2008: $80 million
U.S. Government Bailout Cost: -$125 billion and growing
And I thought investment bankers were the worst. Silly me.
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Elliott Gue of Personal Finance and The Energy Strategist, Roger Conrad of Utility Forecaster and Canadian Edge, Yiannis Mostrous of Silk Road Investor, and Ben Shepherd of Global ETF Profits are all humble, risk-averse and value-conscious investors that take a long-term perspective in their stock and ETF recommendations. Try any of them risk-free today!
Jim Fink is senior online editor for Investing Daily – investingdaily.com
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