Continuing from last week, I am reviewing Morgenson and Rosner’s eye-opening new book about near meltdown of the American economy in 2008 – Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon. You may want to reread last week’s blog before this one.
What role did the rating agencies, regulators, and the revolving door between Washington and Wall Street have in protecting Fannie and Freddie instead of protecting investors and taxpayers?
Were the rating agencies culpable? Not wantonly. However the best and the brightest don’t go to work for a low-paying rating agency; they go to work with the high-paying big brokerage firms creating these exotic CDO and credit default swap “investments.” So the ratings agencies are chronically behind the power curve from the get-go as new products emerge from the brains on Wall Street, and since the Street can innovate so fast, Fitch, Moody's, and S&P analysts can’t keep up. If anything, the rating analysts want to accommodate their clients in hopes that they can jump ship to where the big bucks are. Moreover, CDO risk was hard to comprehend in the early days because of their limited history, and their rapid diffusion into the investor community spread the cancer before it could be detected.
How about the regulators? Were they asleep at the switch? In a sense agency regulators were outmaneuvered and policy regulators were lulled into complacency. Fannie CEO James Johnson and the Fannie/Freddie tag team were always able to quash any regulatory agency’s aggressiveness by complaining to Congress that closer scrutiny would impede their mission to get more low income people into home ownership. And with conniving campaign contributions, Johnson was also able to persuade Congress that their committees and subcommittees could provide better oversight than a regulatory agency. Those relative few in Congress who paid attention to Fannie’s shenanigans and objected to its manipulations were silenced or ignored.
Policy regulation also eased. Some of the easing was the relaxing of historic requirements that prevented unqualified people from being home buyers. Some easing was legislative. For example, in 1999, led by Republican Sen. Phil Gramm, Congress repealed Glass-Steagall – a law dating back to the New Deal when in 1933 it had been enacted to prevent certain types of financial institutions from merging or otherwise getting into conflicting businesses. Sanford (Sandy) Weill, CEO of Travelers Group, found his way blocked by Glass-Steagall when he thought it would be sorta’ nice if his company and John Reed’s Citibank could merge to form Citigroup. It didn’t hurt that Weill the Dealmaker had friends in high places, like Robert Rubin, Secretary of the Treasury, who would pull the congressional strings needed to clear the way for Weill to work his will. Rubin would subsequently leave Treasury and return to corporate American where the real bucks were. In fact his first job after leaving Treasury was Vice Chairman of Citigroup. Payback time! Over the next decade, Rubin would move up to Chairman and make more than $100 million, even as Citigroup sank deeper in the financial tar pit – requiring it to be rescued twice by taxpayers and forcing him to leave and join the unemployed. Poor baby.
There was a good reason for keeping commercial and investment banks separate – it protected depositors from losing their money if a commercial bank incurred losses trading for its own account. But with Glass-Steagall gone the door was open for banks to take greater risk. This should have been cause for the Federal Reserve to keep activities under tight scrutiny. Instead, the Fed was convinced that bankers would do the right thing. Why would bankers blow up their own company, the Fed reasoned? In fact, Alan Greenspan promoted this casual view. But in 2009, with the financial world flapping like a torn flag in a stiff breeze, Greenspan acknowledged his naiveté. His Ozship was no Wizard after all.
A tight web of personal relationships connected Fannie, Goldman Sachs, Citigroup, the New York Fed, the Federal Reserve, and the Treasury. In 1996, Fannie added Stephen Friedman, the former chairman of Goldman Sachs, to its board. In 1999, Fannie’s CEO Johnson joined Goldman’s board. Rubin’s protégé, Timothy F. Geithner, became President of the New York Federal Reserve Bank in 2003 and reduced its oversight of Wall Street. At that point, the banks knew they held all the cards, authors Morgenson and Rosner contend in their book.
Henry “Hank” M. Paulson Jr. became the head of Goldman in 1999 after CEO John Corzine, having made $500 million during his tenure, left to become first the Senator and then the Governor of New Jersey. Paulson’s tenure created many of Goldman’s most disastrous securities – while Geithner’s New York Fed looked the other way. While Big Hank headed Goldman, his net worth grew to $700 million. As the Treasury Secretary under George W. Bush, Paulson would oversee the taxpayer bailout of Fannie Mae, Freddie Mac, Goldman, Citigroup, other banks, and the giant insurer American International Group (AIG), on which Goldman had relied. As head of the New York Fed, and then as the Obama’s Treasury Secretary, Geithner would also oversee the bailout. Geithner was another of Sandy Weill’s protégés, and Weill even invited him to come over and run Citigroup before Geithner accepted Obama’s invitation to be Treasury Secretary.
The revolving door between Washington’s regulators and Wall Street was openly incestuous.
Without Wall Street’s willingness to supply billions of dollars to reckless lenders, the millions of Johnson’s bad loans couldn’t have been made. But enticed by the fees that Wall Street made to underwrite Fannie and Freddie’s securities, further enticed by the money to be made supplying credit lines to lenders like Countrywide to expand into risky mortgages, and even further enticed by the commissions made selling the MBSs and CDOs to investors around the world, the greed machine kicked into high gear.
As it did, Fannie’s privatization detractors began to take notice of its warm and fuzzy claim of helping the underprivileged homebuyer, particularly the claim that its federal perks allowed Fannie to pass through its lower borrowing cost to its customers. The distinctly unfuzzy CBO was one of those detractors. In 1995 CBO deputy director, Marvin Phaup, calculated that Fannie and Freddie realized about $7 billion in benefits from their government links and they kept $2.1 billion for themselves and their shareholders. Phaup had discovered how Fannie was able to pay exorbitant executive bonuses and fund its self-preservation schemes.
Phaup’s report noted that the top five executives at Fannie held $44 million of its stock at the end of 1995. Since the management team at Fannie controlled taxpayer subsidies to a considerable extent, compensation levels like this could be in conflict with the interests of taxpayers and the government, Phaup therefore reported. “Congress may want to revisit the special relationship that exists between the government and Fannie Mae and Freddie Mac.” Oops!
CBO head June O'Neill was asked to quash the publication of the report but she refused. Then she received a visit from Franklin “the Enforcer” Raines, chief goon of Fannie’s CEO Johnson, who would later succeed Johnson as CEO. In her own words, O’Neill said, “Frank Raines and Bob Zoellick came and met with me and the people from CBO. All of us had the same feeling – that we were being visited by the Mafia.” O’Neill later testified before Congress corroborating the report’s findings but Congress wasn’t interested.
Although David Maxwell, James Johnson’s predecessor, had walked away with $20 million at his retirement, executive compensation at Fannie and Freddie had been relatively conservative. But when Johnson took over, compensation became tied to earnings growth and earnings growth became a strategic goal. During Johnson’s tenure, which ended in 1999, the annual executive incentive pay ballooned from 0.46% of after-tax profits to 0.79% – an increase from $8.5 to $35.2 million annually. Over his nine years while running Fannie, Johnson would personally take home roughly $100 million. His successor, Frank Raines, would do as well. The executives at Fannie and Freddie paid themselves private sector salaries without taking private sector risks.
The following year a long-delayed report required by law from Treasury was scheduled for release. It detailed the risks that Fannie and Freddie represented to the taxpayers and argued for their privatization. The CEOs of both Fannie and Freddie got copies. As usual, Johnson employed his brass knuckle approach in dealing with this threat. A meeting was demanded with Treasury Secretary Robert Rubin. Since Rubin was a personal friend of Johnson, he delegated the matter to Larry Summers, the Deputy Secretary who would later succeed Rubin as Secretary. The meeting dragged on over two days during which Fannie’s EVP, Robert Zoellick, and its CFO, Tim Howard, argued strenuously against the report’s conclusions. The conclusions were unacceptable, one observer recalled them saying. After the meeting ended, Summers demanded that staffers rewrite the report. One of the staffers said, “Nobody has bullied me in my adult life the way that Larry did on this one.” Summers and Zoellick met again after the meeting to discuss the position Treasury would take on privatization, after which Zoellick was seen “floating with euphoria” in the halls of Treasury, say the authors.
Incidents like these gave Fannie’s executives free rein to underwrite far more loans, further enriching themselves and their shareholders, but at increasing risk to taxpayers as lending standards declined.
A Johns Hopkins researcher studied those declines in underwriting standards and he too concluded it was time to cut the umbilical cord to Fannie and Freddie. In his 1995 report entitled “Government-Sponsored Enterprises and Changing Markets: The Need for an Exit Strategy,” Thomas Stanton wrote, “Pressure for the status quo, often backed by powerful political constituencies, can deter the government from acting until it is very late.” Johnson turned on Fannie’s PAC machine and began making generous contributions to the political campaigns of lawmakers. Stanton’s warning went nowhere in Congress.
Democrat Rep. Barney Frank considerably enjoyed Fannie’s largesse, which included not only campaign contributions (called bribes in most countries) but also the employment of Herb Moses, his “lover,” as Frank usually introduced him, in a cushy job at Fannie in 1991. In 2010 Frank was asked if Fannie’s hiring of Moses put him in a conflicted position for working on legislation favorable to the organization and Frank said, “I don’t think it influenced me at all.”
Other Congressional recipients of Fannie’s appreciation were Democrat Rep. Maxine Waters, Democrat Rep. Henry Gonzalez, Republican Sen. Chris Bond, Republican Rep. Robert Ney (later convicted of felony in the Abramoff bribery scandal that also snared Tom Delay), and Republican Sen. Bob Bennett.
Fannie’s payment of protection money would prove to be well spent. After a 2005 speech, Barney Frank was asked if the Fannie/Freddie subsidies would lure people into housing they couldn’t afford, he brushed it off with a curt, “We’ll deal with that problem if it happens.” When asked if it was becoming clear that Fannie and Freddie’s business practices were incautiously risky, Frank came back with “I think we see entities that are fundamentally sound financially.” During congressional hearings about Fannie and Freddie in 2003, Frank concluded that “there has been more alarm raised about potential unsafety (sic) and unsoundness than, in fact, exists.” Frank became Fannie’s most tireless defender and he was their baby.
Rep. Maxine Waters, water-carrier for Fannie, (sorry: couldn’t resist that one,) refused to support Republican Rep. Richard Baker’s 2003 plan to transfer oversight of Fannie and Freddie to a regulator in Treasury. Fannie liked being overseen by the feckless Office of Federal Enterprise Oversight (OFHEO) because it was weak and malleable. Republican Rep. Robert Ney, who received $10,250 from Fannie’s campaign gift machine and Republican Rep. Ed Royce, who received $5,850, sided with Waters. “I’ve sat through nearly a dozen hearings where, frankly, we were trying to fix something that wasn’t broke,” Waters said. “Housing is the economic engine of our economy and in no community does this engine need to work more than in mine.” Earlier that year Waters had introduced an initiative to eliminate down payments for low income homebuyers.
Fannie and Freddie had other powerful Republican defenders in the fight against increased oversight including Newt Gingrich and Robert Zoellick. Zoellick used his sharp elbows in Congress to assure that Fannie didn’t face tougher oversight, while Gingrich once stated that “Fannie Mae is an excellent example of a ‘former’ [my quotes] government institution fulfilling its mandate while functioning in the market economy.”
Fannie even bought off academia, commissioning well-compensated reports from leading lights. Of note, the frequently obtuse economists Joseph Stiglitz (whose text I used in graduate school) and Peter Orszag (later Obama’s OMB Director) authored a study that chided critics who argued that “both Fannie and Freddie posed significant risks for the taxpayer.” According to these wise ones, the possibility of a blowup was “substantially less than one in 500,000 – and may be smaller than one in three million.” In 2003, the vastly overrated Republican Bush advisor, R. Glenn Hubbard, wrote a paper defending Fannie Mae’s risk management.
As George Bush began his campaign for a second term, an accounting audit found some significant book cooking at Fannie. By then Johnson had left as CEO and Frank Raines had taken over in 1999. The Office of Federal Housing Enterprise Oversight (OFHEO) found that, during Johnson's tenure as CEO, Fannie Mae had improperly deferred $200 million in expenses, enabling Johnson and his successor, Raines, to receive substantial bonuses in 1998, the last year of Johnson’s reign. A 2006 OFHEO report would later find that Fannie Mae had also thoughtfully underreported Johnson's compensation. No, it wasn’t the reported $7 million, it was more like $21 million.
The SEC isn’t amused when it learns that accounting has been irregular, and its laxatives are harsh. A meeting was called in December to convene SEC officials, the executives of Fannie and their lawyers, OFHEO and their counsel, and the SEC senior accounting staff. With everyone sitting around the meeting table, the SEC Chief Accountant, Donald Nicolaisen began. Holding up a sheet of paper, Nicolaisen said the vagaries of accounting might allow one acceptable accounting interpretation to be on one corner of this sheet and another equally appropriate interpretation could be on the opposite corner. Fannie’s accounting? Not even on the sheet of paper. Not even in the same area code. Maybe not even on same the planet. That’s how far out Fannie’s accounting was.
Raines sat stupefied, knocked him out cold by the SEC Chief Accountant. The wicked witch was dead. On December 21, 2004 Raines “accepted” what he called "early retirement" as Fannie’s CEO. Fannie would have to restate billions in earnings.
In 2006, the OFHEO sued Raines to recover $90 million in payments he received based on the overstated earnings, initially reported to be $9 billion but restated as $6.3 billion. Civil charges were filed against him and two other former executives by the OFHEO seeking $110 million in penalties and $115 million in returned bonuses from the three accused. On April 18, 2008, the government announced a “settlement” with Raines together with Tim Howard, Fannie's former CFO, and Leanne G. Spencer, Fannie's former controller. The three executives agreed “to pay” fines totaling about $3 million, which were actually paid by Fannie's insurance policies. Raines also agreed to donate the proceeds from the sale of $1.8 million of his Fannie stock and to give up stock options. The stock options were worthless. Raines also gave up an estimated $5.3 million of "other benefits" related to his pension and forgone bonuses. Compared to Raines, Willie Sutton was a chump.
Between 2000 and 2004 housing prices skyrocketed 31%. At mid-decade, 40% of the mortgages were for second homes – a clear warning sign of speculation. Refinancings reached $2.8 trillion in 2003. Thinking that housing prices had permanently enriched them, millions refinanced the equity out of their houses – historically the best forced-saving plan they had ever had – and used it to improve their lifestyles, albeit only temporarily. The nation was getting older and the traditional nest eggs or ways to transfer wealth to the younger generation was, in the words of Margret Mitchell, gone with the wind.
Many of the mortgages taken out by subprime borrowers were hybrid adjustable rate mortgages (ARMs). ARMs kept payments low for a set number of years, but when they reset, payments could easily double – exceeding what the homeowner could afford. When homeowners began to stop making mortgage payments, MBSs started performing poorly, and their derivatives, CDOs, lost about half of their value between 2006 and 2008. The riskiest tranches in the CDOs became worthless as subprimes defaulted.
About mid-decade, the Fed raised interest rates. The housing bubble burst in 2007 when the housing price index maxed out and began to decline. Supply and prices had outstripped housing demand and the tipping point had been reached. Many of those who had refinanced and cashed out their equity now found themselves owing more than their houses were worth.
What began happening was much like a network blackout – a fuse blows, overloading other circuits, and when their breakers blow, more overloads begin racing throughout the network until the network collapses. This happened to the American economy in 2008.
ARM defaults forced too many homes on the market just at the time the housing market was collapsing and couldn’t absorb them. No sales meant an acceleration of foreclosures, which began increasing in 2006. New home construction had already outpaced demand, and when large numbers of sales and foreclosures became available at deeply discounted prices, builders found that they couldn't sell the inventory of homes they'd built. Their construction loans were then foreclosed.
Clinton's calamitous National Partners in Homeownership program lay in tatters, a victim of incompetence, greed, Pollyanna intentions, corruption, government perfidy, unethical politicians and bankers and business executives, emasculated regulators, and the hubris of the Fed.
Taxpayers shelled out $153 billion to bail out just Fannie and Freddie, now wards of the state. For what? Both companies today still back more than half of all new mortgages – $5 trillion. Their executives are still pocketing fortunes while taxpayers underwrite the risks they take. Wall Street’s biggest banks are 20% larger than they were when they got into trouble, and the pay packages of their bright boys are as generous as ever. Government’s elected leaders and senior officials appear to have learned remarkably little from the country’s near death experience with economic collapse.
Could the 2008 credit crisis happen again? Yes, because Congress has done nothing to fix Fannie and Freddie, among other things. The laughably incompetent Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 – ironically authored by two of the cronies who most benefitted from the Fannie/Freddie excesses – was Congress’ response to the crisis. It should be repealed immediately and Glass-Steagall reinstated as law. Dodd-Frank spanned 2,300 pages. Glass-Steagall, the law that protected consumers for 76 years, consisted of only 34 pages.
In the end, we Americans will have paid dearly for this crisis with a decade of lethargic depreciated assets. We will have paid dearly with a decade of legitimate opportunities that would have arisen in a normal growing economy but are now forever lost. Yet we are and will remain more recklessly endangered than ever.
What role did the rating agencies, regulators, and the revolving door between Washington and Wall Street have in protecting Fannie and Freddie instead of protecting investors and taxpayers?
Were the rating agencies culpable? Not wantonly. However the best and the brightest don’t go to work for a low-paying rating agency; they go to work with the high-paying big brokerage firms creating these exotic CDO and credit default swap “investments.” So the ratings agencies are chronically behind the power curve from the get-go as new products emerge from the brains on Wall Street, and since the Street can innovate so fast, Fitch, Moody's, and S&P analysts can’t keep up. If anything, the rating analysts want to accommodate their clients in hopes that they can jump ship to where the big bucks are. Moreover, CDO risk was hard to comprehend in the early days because of their limited history, and their rapid diffusion into the investor community spread the cancer before it could be detected.
How about the regulators? Were they asleep at the switch? In a sense agency regulators were outmaneuvered and policy regulators were lulled into complacency. Fannie CEO James Johnson and the Fannie/Freddie tag team were always able to quash any regulatory agency’s aggressiveness by complaining to Congress that closer scrutiny would impede their mission to get more low income people into home ownership. And with conniving campaign contributions, Johnson was also able to persuade Congress that their committees and subcommittees could provide better oversight than a regulatory agency. Those relative few in Congress who paid attention to Fannie’s shenanigans and objected to its manipulations were silenced or ignored.
Policy regulation also eased. Some of the easing was the relaxing of historic requirements that prevented unqualified people from being home buyers. Some easing was legislative. For example, in 1999, led by Republican Sen. Phil Gramm, Congress repealed Glass-Steagall – a law dating back to the New Deal when in 1933 it had been enacted to prevent certain types of financial institutions from merging or otherwise getting into conflicting businesses. Sanford (Sandy) Weill, CEO of Travelers Group, found his way blocked by Glass-Steagall when he thought it would be sorta’ nice if his company and John Reed’s Citibank could merge to form Citigroup. It didn’t hurt that Weill the Dealmaker had friends in high places, like Robert Rubin, Secretary of the Treasury, who would pull the congressional strings needed to clear the way for Weill to work his will. Rubin would subsequently leave Treasury and return to corporate American where the real bucks were. In fact his first job after leaving Treasury was Vice Chairman of Citigroup. Payback time! Over the next decade, Rubin would move up to Chairman and make more than $100 million, even as Citigroup sank deeper in the financial tar pit – requiring it to be rescued twice by taxpayers and forcing him to leave and join the unemployed. Poor baby.
There was a good reason for keeping commercial and investment banks separate – it protected depositors from losing their money if a commercial bank incurred losses trading for its own account. But with Glass-Steagall gone the door was open for banks to take greater risk. This should have been cause for the Federal Reserve to keep activities under tight scrutiny. Instead, the Fed was convinced that bankers would do the right thing. Why would bankers blow up their own company, the Fed reasoned? In fact, Alan Greenspan promoted this casual view. But in 2009, with the financial world flapping like a torn flag in a stiff breeze, Greenspan acknowledged his naiveté. His Ozship was no Wizard after all.
A tight web of personal relationships connected Fannie, Goldman Sachs, Citigroup, the New York Fed, the Federal Reserve, and the Treasury. In 1996, Fannie added Stephen Friedman, the former chairman of Goldman Sachs, to its board. In 1999, Fannie’s CEO Johnson joined Goldman’s board. Rubin’s protégé, Timothy F. Geithner, became President of the New York Federal Reserve Bank in 2003 and reduced its oversight of Wall Street. At that point, the banks knew they held all the cards, authors Morgenson and Rosner contend in their book.
Henry “Hank” M. Paulson Jr. became the head of Goldman in 1999 after CEO John Corzine, having made $500 million during his tenure, left to become first the Senator and then the Governor of New Jersey. Paulson’s tenure created many of Goldman’s most disastrous securities – while Geithner’s New York Fed looked the other way. While Big Hank headed Goldman, his net worth grew to $700 million. As the Treasury Secretary under George W. Bush, Paulson would oversee the taxpayer bailout of Fannie Mae, Freddie Mac, Goldman, Citigroup, other banks, and the giant insurer American International Group (AIG), on which Goldman had relied. As head of the New York Fed, and then as the Obama’s Treasury Secretary, Geithner would also oversee the bailout. Geithner was another of Sandy Weill’s protégés, and Weill even invited him to come over and run Citigroup before Geithner accepted Obama’s invitation to be Treasury Secretary.
The revolving door between Washington’s regulators and Wall Street was openly incestuous.
Without Wall Street’s willingness to supply billions of dollars to reckless lenders, the millions of Johnson’s bad loans couldn’t have been made. But enticed by the fees that Wall Street made to underwrite Fannie and Freddie’s securities, further enticed by the money to be made supplying credit lines to lenders like Countrywide to expand into risky mortgages, and even further enticed by the commissions made selling the MBSs and CDOs to investors around the world, the greed machine kicked into high gear.
As it did, Fannie’s privatization detractors began to take notice of its warm and fuzzy claim of helping the underprivileged homebuyer, particularly the claim that its federal perks allowed Fannie to pass through its lower borrowing cost to its customers. The distinctly unfuzzy CBO was one of those detractors. In 1995 CBO deputy director, Marvin Phaup, calculated that Fannie and Freddie realized about $7 billion in benefits from their government links and they kept $2.1 billion for themselves and their shareholders. Phaup had discovered how Fannie was able to pay exorbitant executive bonuses and fund its self-preservation schemes.
Phaup’s report noted that the top five executives at Fannie held $44 million of its stock at the end of 1995. Since the management team at Fannie controlled taxpayer subsidies to a considerable extent, compensation levels like this could be in conflict with the interests of taxpayers and the government, Phaup therefore reported. “Congress may want to revisit the special relationship that exists between the government and Fannie Mae and Freddie Mac.” Oops!
CBO head June O'Neill was asked to quash the publication of the report but she refused. Then she received a visit from Franklin “the Enforcer” Raines, chief goon of Fannie’s CEO Johnson, who would later succeed Johnson as CEO. In her own words, O’Neill said, “Frank Raines and Bob Zoellick came and met with me and the people from CBO. All of us had the same feeling – that we were being visited by the Mafia.” O’Neill later testified before Congress corroborating the report’s findings but Congress wasn’t interested.
Although David Maxwell, James Johnson’s predecessor, had walked away with $20 million at his retirement, executive compensation at Fannie and Freddie had been relatively conservative. But when Johnson took over, compensation became tied to earnings growth and earnings growth became a strategic goal. During Johnson’s tenure, which ended in 1999, the annual executive incentive pay ballooned from 0.46% of after-tax profits to 0.79% – an increase from $8.5 to $35.2 million annually. Over his nine years while running Fannie, Johnson would personally take home roughly $100 million. His successor, Frank Raines, would do as well. The executives at Fannie and Freddie paid themselves private sector salaries without taking private sector risks.
The following year a long-delayed report required by law from Treasury was scheduled for release. It detailed the risks that Fannie and Freddie represented to the taxpayers and argued for their privatization. The CEOs of both Fannie and Freddie got copies. As usual, Johnson employed his brass knuckle approach in dealing with this threat. A meeting was demanded with Treasury Secretary Robert Rubin. Since Rubin was a personal friend of Johnson, he delegated the matter to Larry Summers, the Deputy Secretary who would later succeed Rubin as Secretary. The meeting dragged on over two days during which Fannie’s EVP, Robert Zoellick, and its CFO, Tim Howard, argued strenuously against the report’s conclusions. The conclusions were unacceptable, one observer recalled them saying. After the meeting ended, Summers demanded that staffers rewrite the report. One of the staffers said, “Nobody has bullied me in my adult life the way that Larry did on this one.” Summers and Zoellick met again after the meeting to discuss the position Treasury would take on privatization, after which Zoellick was seen “floating with euphoria” in the halls of Treasury, say the authors.
Incidents like these gave Fannie’s executives free rein to underwrite far more loans, further enriching themselves and their shareholders, but at increasing risk to taxpayers as lending standards declined.
A Johns Hopkins researcher studied those declines in underwriting standards and he too concluded it was time to cut the umbilical cord to Fannie and Freddie. In his 1995 report entitled “Government-Sponsored Enterprises and Changing Markets: The Need for an Exit Strategy,” Thomas Stanton wrote, “Pressure for the status quo, often backed by powerful political constituencies, can deter the government from acting until it is very late.” Johnson turned on Fannie’s PAC machine and began making generous contributions to the political campaigns of lawmakers. Stanton’s warning went nowhere in Congress.
Democrat Rep. Barney Frank considerably enjoyed Fannie’s largesse, which included not only campaign contributions (called bribes in most countries) but also the employment of Herb Moses, his “lover,” as Frank usually introduced him, in a cushy job at Fannie in 1991. In 2010 Frank was asked if Fannie’s hiring of Moses put him in a conflicted position for working on legislation favorable to the organization and Frank said, “I don’t think it influenced me at all.”
Other Congressional recipients of Fannie’s appreciation were Democrat Rep. Maxine Waters, Democrat Rep. Henry Gonzalez, Republican Sen. Chris Bond, Republican Rep. Robert Ney (later convicted of felony in the Abramoff bribery scandal that also snared Tom Delay), and Republican Sen. Bob Bennett.
Fannie’s payment of protection money would prove to be well spent. After a 2005 speech, Barney Frank was asked if the Fannie/Freddie subsidies would lure people into housing they couldn’t afford, he brushed it off with a curt, “We’ll deal with that problem if it happens.” When asked if it was becoming clear that Fannie and Freddie’s business practices were incautiously risky, Frank came back with “I think we see entities that are fundamentally sound financially.” During congressional hearings about Fannie and Freddie in 2003, Frank concluded that “there has been more alarm raised about potential unsafety (sic) and unsoundness than, in fact, exists.” Frank became Fannie’s most tireless defender and he was their baby.
Rep. Maxine Waters, water-carrier for Fannie, (sorry: couldn’t resist that one,) refused to support Republican Rep. Richard Baker’s 2003 plan to transfer oversight of Fannie and Freddie to a regulator in Treasury. Fannie liked being overseen by the feckless Office of Federal Enterprise Oversight (OFHEO) because it was weak and malleable. Republican Rep. Robert Ney, who received $10,250 from Fannie’s campaign gift machine and Republican Rep. Ed Royce, who received $5,850, sided with Waters. “I’ve sat through nearly a dozen hearings where, frankly, we were trying to fix something that wasn’t broke,” Waters said. “Housing is the economic engine of our economy and in no community does this engine need to work more than in mine.” Earlier that year Waters had introduced an initiative to eliminate down payments for low income homebuyers.
Fannie and Freddie had other powerful Republican defenders in the fight against increased oversight including Newt Gingrich and Robert Zoellick. Zoellick used his sharp elbows in Congress to assure that Fannie didn’t face tougher oversight, while Gingrich once stated that “Fannie Mae is an excellent example of a ‘former’ [my quotes] government institution fulfilling its mandate while functioning in the market economy.”
Fannie even bought off academia, commissioning well-compensated reports from leading lights. Of note, the frequently obtuse economists Joseph Stiglitz (whose text I used in graduate school) and Peter Orszag (later Obama’s OMB Director) authored a study that chided critics who argued that “both Fannie and Freddie posed significant risks for the taxpayer.” According to these wise ones, the possibility of a blowup was “substantially less than one in 500,000 – and may be smaller than one in three million.” In 2003, the vastly overrated Republican Bush advisor, R. Glenn Hubbard, wrote a paper defending Fannie Mae’s risk management.
As George Bush began his campaign for a second term, an accounting audit found some significant book cooking at Fannie. By then Johnson had left as CEO and Frank Raines had taken over in 1999. The Office of Federal Housing Enterprise Oversight (OFHEO) found that, during Johnson's tenure as CEO, Fannie Mae had improperly deferred $200 million in expenses, enabling Johnson and his successor, Raines, to receive substantial bonuses in 1998, the last year of Johnson’s reign. A 2006 OFHEO report would later find that Fannie Mae had also thoughtfully underreported Johnson's compensation. No, it wasn’t the reported $7 million, it was more like $21 million.
The SEC isn’t amused when it learns that accounting has been irregular, and its laxatives are harsh. A meeting was called in December to convene SEC officials, the executives of Fannie and their lawyers, OFHEO and their counsel, and the SEC senior accounting staff. With everyone sitting around the meeting table, the SEC Chief Accountant, Donald Nicolaisen began. Holding up a sheet of paper, Nicolaisen said the vagaries of accounting might allow one acceptable accounting interpretation to be on one corner of this sheet and another equally appropriate interpretation could be on the opposite corner. Fannie’s accounting? Not even on the sheet of paper. Not even in the same area code. Maybe not even on same the planet. That’s how far out Fannie’s accounting was.
Raines sat stupefied, knocked him out cold by the SEC Chief Accountant. The wicked witch was dead. On December 21, 2004 Raines “accepted” what he called "early retirement" as Fannie’s CEO. Fannie would have to restate billions in earnings.
In 2006, the OFHEO sued Raines to recover $90 million in payments he received based on the overstated earnings, initially reported to be $9 billion but restated as $6.3 billion. Civil charges were filed against him and two other former executives by the OFHEO seeking $110 million in penalties and $115 million in returned bonuses from the three accused. On April 18, 2008, the government announced a “settlement” with Raines together with Tim Howard, Fannie's former CFO, and Leanne G. Spencer, Fannie's former controller. The three executives agreed “to pay” fines totaling about $3 million, which were actually paid by Fannie's insurance policies. Raines also agreed to donate the proceeds from the sale of $1.8 million of his Fannie stock and to give up stock options. The stock options were worthless. Raines also gave up an estimated $5.3 million of "other benefits" related to his pension and forgone bonuses. Compared to Raines, Willie Sutton was a chump.
Between 2000 and 2004 housing prices skyrocketed 31%. At mid-decade, 40% of the mortgages were for second homes – a clear warning sign of speculation. Refinancings reached $2.8 trillion in 2003. Thinking that housing prices had permanently enriched them, millions refinanced the equity out of their houses – historically the best forced-saving plan they had ever had – and used it to improve their lifestyles, albeit only temporarily. The nation was getting older and the traditional nest eggs or ways to transfer wealth to the younger generation was, in the words of Margret Mitchell, gone with the wind.
Many of the mortgages taken out by subprime borrowers were hybrid adjustable rate mortgages (ARMs). ARMs kept payments low for a set number of years, but when they reset, payments could easily double – exceeding what the homeowner could afford. When homeowners began to stop making mortgage payments, MBSs started performing poorly, and their derivatives, CDOs, lost about half of their value between 2006 and 2008. The riskiest tranches in the CDOs became worthless as subprimes defaulted.
About mid-decade, the Fed raised interest rates. The housing bubble burst in 2007 when the housing price index maxed out and began to decline. Supply and prices had outstripped housing demand and the tipping point had been reached. Many of those who had refinanced and cashed out their equity now found themselves owing more than their houses were worth.
What began happening was much like a network blackout – a fuse blows, overloading other circuits, and when their breakers blow, more overloads begin racing throughout the network until the network collapses. This happened to the American economy in 2008.
ARM defaults forced too many homes on the market just at the time the housing market was collapsing and couldn’t absorb them. No sales meant an acceleration of foreclosures, which began increasing in 2006. New home construction had already outpaced demand, and when large numbers of sales and foreclosures became available at deeply discounted prices, builders found that they couldn't sell the inventory of homes they'd built. Their construction loans were then foreclosed.
Clinton's calamitous National Partners in Homeownership program lay in tatters, a victim of incompetence, greed, Pollyanna intentions, corruption, government perfidy, unethical politicians and bankers and business executives, emasculated regulators, and the hubris of the Fed.
Taxpayers shelled out $153 billion to bail out just Fannie and Freddie, now wards of the state. For what? Both companies today still back more than half of all new mortgages – $5 trillion. Their executives are still pocketing fortunes while taxpayers underwrite the risks they take. Wall Street’s biggest banks are 20% larger than they were when they got into trouble, and the pay packages of their bright boys are as generous as ever. Government’s elected leaders and senior officials appear to have learned remarkably little from the country’s near death experience with economic collapse.
Could the 2008 credit crisis happen again? Yes, because Congress has done nothing to fix Fannie and Freddie, among other things. The laughably incompetent Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 – ironically authored by two of the cronies who most benefitted from the Fannie/Freddie excesses – was Congress’ response to the crisis. It should be repealed immediately and Glass-Steagall reinstated as law. Dodd-Frank spanned 2,300 pages. Glass-Steagall, the law that protected consumers for 76 years, consisted of only 34 pages.
In the end, we Americans will have paid dearly for this crisis with a decade of lethargic depreciated assets. We will have paid dearly with a decade of legitimate opportunities that would have arisen in a normal growing economy but are now forever lost. Yet we are and will remain more recklessly endangered than ever.
