How Fannie and Freddie went wrong

Some of the nation’s largest government-sponsored mortgage institutions were nearly toppled internally by poor management, excessive market dominance, and by their improper interference with government regulators.

Now, according to The Economist, two of these government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, are trying to get back on track  and may be poised to play a rescue role in the nation’s subprime mortgage crisis.

But how did the GSEs go wrong in the first place?  An article  in the current (September/October 2007) issue of Public Administration Review provides some useful lessons on the importance of oversight of private entities that have such a large impact on our financial markets, and helps explain how Fannie Mae and Freddie Mac, in particular,  nearly caused an implosion in those markets. 

Fannie Mae and Freddie Mac each fund $1.5 trillion to $2.5 trillion in home mortgages.  Sallie Mae, a smaller GSE, which funds student loans, has also been in the news lately in connection with the student loan scandal, although it has given up its government sponsorship and become a completely private company.

In “The Life Cycle of the Government-Sponsored Enterprise: Lessons for Design and Accountability,” Thomas H. Stanton, explains that due to their government backing, GSEs often grow rapidly into huge institutions that dominate their markets.  They also tend to receive only minimal feedback from the markets; and because of their political power, they often receive only minimal feedback from the political process. 

Stanton notes that the huge size of the GSE mortgage portfolios coupled with the likelihood that the federal government would have to step in and bail them out if they were to fail—similar to the savings and loan debacle—puts the government at substantial risk.  He warns that “the GSEs should be red flags for policy makers,” and notes:

If GSEs are to thrive in the future, they need to be supervised by regulators with the mandate and capacity to provide effective feedback before problems get out of control.

Case of Fannie Mae and Freddie Mac 

Stanton maintains that the combination of government backing and private ownership and control leads to a “concentration of political power that can allow a GSE to obtain a favorable accountability framework and then prevail over its regulator.” 

For instance, in April 2006, Freddie Mac paid a record $3.8 million fine to the Federal Elections Commission to settle charges that it had violated federal law by using company resources to hold $1.7 million in fundraisers, many involving the then chairman of the House Financial Services Committee, Michael G. Oxley, R-Ohio.

Stanton notes that after Freddie Mac announced in 2003 that it had misstated its earnings going back as far as 2000, the Office of Federal Housing Enterprise Oversight (OFHEO) issued a report on the GSE, which found numerous accounting and financial irregulaties.  Among the findings were that the company had constrained resources for accounting and internal controls.  In April 2006, Freddie Mac settled lawsuits with shareholders for $410 million, stemming from internal control failures and accounting misstatements.  Since 2004, the company has replaced virtually all of its senior managers. 

Fannie Mae has had a similar history.  In September 2004, an OFHEO interim report led to a review by former U.S. Sen. Warren Rudman.   According to Stanton,  Rudman and his law firm reported that Fannie Mae had a “culture of arrogance”  and that “management (had) created an environment that was not conducive to open discussion and exchange of views.”  There were similar findings about accounting violations and compensation tied to earnings. 

But Fannie Mae may have gone even further than Freddie Mac.  Stanton notes that Fannie Mae had continually tried to thwart OFHEO and lobbied for congressional requests for federal investigations of OFHEO.  Fannie Mae also convinced the Senate Appropriations subcommittee to try to withhold $10 million from OFHEO until a new director could be appointed.  Like Freddie Mac, Fannie Mae had imposed constraints on internal auditing, accounting and other staff, despite net income in 2003 of $7.9 billion.

The Economist has reported, however, in “Fannie and Freddie Ride Again,” that both organizations have spent billions of dollars on new systems and controls and that they are trying to regain their credibility as buyers of last resort in the subprime market.  They have pledged to buy tens of billions of dollars of new subprime mortgages, and are working on products to alleviate the plight of the worst-hit borrowers.

But The Economist also notes that Fannie Mae and Freddie Mac hold large amounts of bonds linked to subprime mortgages.  It’s not inconceivable, the magazine suggests, that a continuing rise in subprime delinquencies could result in losses of billions of dollars for the two GSEs.   

That ties in with Stanton’s recommendation of the insertion of a sunset provision into the initial design of a GSE.  He notes that “the fundamental lesson” of the life cycle of the GSEs he reviewed:

is that the GSE does not offer a free lunch.  In creating a GSE, or in permitting it to expand its scale and scope, policy makers make a trade-off.  They receive access to an off-budget vehicle that can help funnel government subsidies to preferred purposes.  In return, the government takes on risk—in some cases, substantial risk.