FOR THE PAST FEW YEARS NOW, FANNIE MAE AND Freddie Mac have been mired in bad news. First, accounting irregularities resulted in a surprise ouster of long-standing top executives at Freddie Mac. Now, investigations by the Office of Federal Housing Enterprise Oversight (OFHEO) and the Securities and Exchange Commission (SEC) have prompted a reshuffling at the top for Fannie Mae as well.
What's next for Fannie and Freddie? At conventional companies, throwing the responsible executives out might well be the end of the story. But Fannie Mae and Freddie Mac have between them $1.5 trillion of U.S. mortgages on their balance sheet, according to the companies' latest figures. What's more, their special status as government-sponsored enterprises (GSEs) means, arguably, that the taxpayer is essentially a co-signer on much of that paper, even if there is no direct guarantee from the government on GSE securities.
As a result, Congress and the administration are very eager to make sure things run more smoothly at Fannie and Freddie from now on--yet perhaps almost as anxious to avoid the political risks involved in re-engineering the two largest players in the secondary residential mortgage market.
Last year legislation was introduced and passed in the Senate Banking Committee, but never enacted. Both Fannie and Freddie field powerful lobbies, and they were able to help muster support to sideline the bills due to conflict over various provisions.
Even the White House was said to have pulled back its support from legislation due to concern that the measures weren't tough enough. But with the start of a new Congress, the field is wide open for the legislative process to begin anew.
As of press time, the White House had not made known its position on what it wants in GSE reform legislation. "Last year, the White House effectively vetoed the bill Chairman [Richard] Shelby moved by signaling no support. This year, the administration's views will again have a strong influence," says Kurt Pfotenhauer, senior vice president of government affairs for the Mortgage Bankers Association (MBA).
Already, a bill similar to the one that failed last year has been reintroduced in the Senate. Filed on Jan. 26 by Sens. Chuck Hagel (R-Nebraska), John Sununu (R-New Hampshire) and Elizabeth Dole (R-North Carolina), the bill would:
* Create an independent, world-class regulator to oversee safety and soundness of Fannie Mae and Freddie Mac;
* Give the regulator the authority to shut down a failing GSE and protect against a taxpayer-funded bailout;
* Give the regulator greater decision-making in raising capital standards;
* Direct the regulator to draw a "bright line" separating the primary and secondary mortgage markets;
* Give the new regulator flexible approval power over new programs and activities;
* Require annual audits of affordable-housing programs to ensure compliance with the mission; and
* End presidential appointments to the boards of the GSEs.
In reintroducing the legislation, Hagel said, "Since we first introduced this legislation in 2003, the gross mismanagement of GSEs Fannie Mae and Freddie Mac has become glaringly apparent and dangerous. The need for a world-class regulator to increase the safety and soundness of the GSEs has never been clearer."
Sununu said, "Given the current climate, we must seize the opportunity to pass legislation this year to produce a credible and capable regulator so that the GSEs operate in a safe and sound manner."
Finally, Dole added, "We know the problems within these organizations are not isolated, but systemic and require a world-class regulator with the authority to oversee their operations."
Over on the House side
House members have also been considering what to do with the GSEs. A Feb. 9 hearing before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises heard testimony from Donald Nicolaisen, chief accountant, SEC. The hearing followed a decision by the SEC's chief accountant in December 2004 that "certain accounting practices of the Federal National Mortgage Association [Fannie Mae] did not comply in material respects with specific provisions within generally accepted accounting principles (GAAP)."
In his testimony, Nicolaisen cited a Dec. 15 SEC press release that noted "the SEC accounting staff indicated that, based upon our review of the information provided by Fannie Mae and OFHEO, during the period from 2001 to mid-2004 Fannie Mae's accounting practices did not comply in material respects with the [Financial Accounting Standards Board's] accounting requirements in Statement Nos. 91 and 133."
Although the SEC's latest findings and the resignation of top executives at Fannie Mae seems likely to lead even diehard GSE loyalists to support tightening GSE oversight, the opening statements at the February hearing by three Democratic members of the House Financial Services Committee suggests that positions may not have shifted all that much from last year.
The ranking minority member of the subcommittee holding the hearing, Rep. Paul Kanjorski (D-Pennsylvania), chided the Bush administration for derailing a bill that last year won bipartisan support in the House Financial Services Committee. At the hearing, Kanjorski said, "Like many of my colleagues, I was greatly disappointed in the last Congress when the Bush administration rejected our bipartisan efforts to create an independent regulator. Politics, in my view, should play no role in financial regulation."
Rep. Ruben Hinojosa (D-Texas) was more noncommital about whether reform was needed. He said, "It will be interesting to see if legislation will be introduced in the House to reform the government-sponsored enterprises and, if so, what it will contain, how the committee will proceed with consideration and what ultimately will be the outcome of any and all actions taken by Congress."
But Hinojosa did find something to like in the Hagel bill: "I have also noticed that the legislation would greatly expand the regulator's ability to limit benefits and bonuses within severance packages paid to GSE executives who leave entities. That component of Sen. Hagel's bill is very important to me and to many of my colleagues in Congress," he said.
Focusing in on what had been a contentious issue for law-makers--receivership powers--Rep. William Lacy Clay (D-Missouri) said, "I am still not sold on the idea of granting receivership powers to a regulator. I do not see the need for that action at this time." Clay noted that the SEC and Federal Bureau of Investigation (FBI) investigations of Fannie Mae's accounting practices are still incomplete. He added, "We will be better able to determine the exact needs of reform when the investigations are complete and have been evaluated. Those decisions on oversight will be made after later hearings and negotiations."
What's next from Congress
The depth of congressional commitment to remaking the ground rules for Fannie and Freddie is difficult to assess. In December, one House staffer said she believed how much is done on GSEs depends on how much energy is focused on Social Security and tax reform; another staffer on the Senate Banking Committee was more optimistic.
Andrew Gray, press secretary of the Senate Committee on Banking, said in December that the chairman, Sen. Richard Shelby (R-Alabama), is committed to a bill that would strengthen GSE regulation in the current session, and optimistic that he'll be able to get it through. "I think he feels optimistic about the chances of being able to move strong legislation," he said.
In the House, Rep. Michael Oxley (R-Ohio), chairman of the House Financial Services Committee, has indicated that his committee considers GSE legislation a high priority. However, Rep. Barney Frank (D-Massachusetts), the ranking minority member on the committee, said he was not sure what will happen in the new Congress.
"I don't know," Frank said in December. "I assume the administration will start out at least trying to do what it did last year--which was not simply improve the quality of the regulation, but weaken [the GSEs'] ability to do housing--and I hope we will reject that part of it."
One analyst who followed the latest March hearings on the issue says that he isn't convinced about the depth of congressional commitment to a big GSE reform bill. "We keep watching the body language and everything else in these hearings, and we don't see it," says Christopher Whalen, managing director of Institutional Risk Analytics, a credit analysis firm based in Croton-on-Hudson, New York. "... We just don't see the political equation coalescing yet." His prediction: Regulators will continue "grinding away," but don't expect a big reform package.
In January MBA published an issue paper outlining what it would support in a new regulatory scheme for the GSEs. MBA supports combining oversight for safety and soundness and mission under one independent and well-funded regulator.
MBA supports giving the regulator flexible capital authority, and the powers to intervene "in the unlikely event of a financially distressed GSE," but only under certain conditions. MBA suggested that "Congress should draw a clear line between the primary and secondary mortgage markets.... GSEs should not be permitted to encroach upon the mortgage origination process, and should not be permitted to use their government-sponsored benefits to distort the competitive landscape of the primary mortgage market."
The bill introduced in the Senate in January adopts MBA's approach to distinguishing the primary market from the secondary market.
While the results of ongoing investigations and the support of MBA and some other industry trade groups is likely to encourage Congress to take on a reform bill, others argue that it's a mistake to underestimate the power of Fannie and Freddie to stall or ambush this legislation, even now.
"Don't forget that every member of Congress has constituents in his or her district that have loans purchased by Fannie Mae," warns Jonathan Koppell, an assistant professor of politics, policy and organization at the Yale School of Management, New Haven, Connecticut, "... If Fannie Mae comes to you and shows you a map of your district and all the people that own homes because they have Fannie Mae-purchased loans, and they tell you, 'You know what, if you pass this law half these people wouldn't have their house,' you're going to be nervous. For good reason," says Koppell.
Whether OFHEO or a successor office ultimately does the job, some observers predict that if legislation passed, regulators would be given powers more akin to the powers granted to bank regulators. Bank regulators, for instance, are able to remove directors or employees from a bank if they "committed misconduct" such as breaking the law, but OFHEO directors can only remove someone if the conduct jeopardizes the firm's capital, according to testimony by Richard Carnell, an associate professor of law at Fordham School of Law, New York, in testimony given to the Senate Banking Committee last spring.
Proponents argue that a strong receivership rule is an important way to maintain safety and soundness at Freddie and Fannie, whatever mistakes management makes in the future. Carnell argues that receivership would enable the government to step in quickly if a major problem arose, limiting the need for a more expensive bailout later on.
"A lot of people, when they see receivership, think that must mean a meltdown with no survivors," Carnell explained in a later interview. "The fact is that the FDIC [Federal Deposit Insurance Corporation] has developed extraordinary expertise at selling failed institutions, either in whole or in parts, and then getting money into the hands of depositors and other creditors."
What probably won't happen is full privatization. Koppell believes that the kind of complete privatization advocated by some Fannie Mae critics not only won't happen, but can't. He argues that even if all the aspects of the government's special relationship were to change, the agencies really have become "too big to fail," and Congress would be highly unlikely to just stand by and watch them sink if they get into trouble.
"If people were worried about the consequences of Chrysler failing, this would make Chrysler look like a five-and-dime. The shock waves of a Fannie Mae failure would be felt around the world, not just in the United States. It's a little simplistic to say just cut the strings between Fannie and the government and walk away, because that's not possible at this point," says Koppell, a former OFHEO staffer and the author of a new book, The Politics of Quasi-Government, which examines the power dynamics of public/private enterprises such as the GSEs.
Inside Fannie Mae and Freddie Mac, there is likely to be more activity--some of it rapid, some slow. But beyond some quick personnel changes at Fannie, the deeper structural changes are likely to take more time.
John McIlwain, former president and chief executive officer of the Fannie Mae Foundation and now a senior fellow for housing at the Urban Land Institute, Washington, D.C., a real estate think tank, said in December that he believes there is only one thing that might reverse Fannie's and Freddie's political fortunes: a sharp rise in interest rates.
In 1998, during the Long Term Capital Management (LTCM) crisis, Fannie Mae and Freddie Mac kept the mortgage market liquid, even as other fixed-income markets froze, McIlwain recalled. And he believes it could happen again: "If interest rates get much over 7 [percent], you start to get into a territory that I think is going to slow down housing demand," he said. "You get 10-year Treasuries up to 5.5 [percent] or above--and there are some projecting that that's where we'll be at the end of 2005--you're in a territory where the difference that [Fannie Mae and Freddie Mac] can provide is important to keep the market running."
The new rules of the game
Assuming Fannie Mae and Freddie Mac aren't saved by the chance to make such a rescue, it seems likely that the next decade will be much more difficult for these two firms than the last one.
For a long time, Freddie's and Fannie's special congressional charters gave them the best of both the public and private spheres--exemption from many of the nagging filings and taxes that conventional companies faced, but with all the upside of a publicly traded company. Now, however, some say the situation is reversed.
Thanks to recent events, managers are now likely to have all the worries of the private sector, plus some of the hassles faced by government agencies--such as the need to meet affordable-housing goals. "They have the worst of all worlds," says Whalen. "They have all the responsibilities of a public company, and yet they have Congress and OFHEO judging whether they're doing their job."
Freddie Mac Chief Executive Officer and Chairman Richard F. Syron argues that GSE critics can't demand an end to the GSEs' special privileges without easing their responsibilities as well. "[O]ur critics can't have it both ways," Syron told the National Association of Home Builders (NAHB), Washington, D.C., in December. "They can't demand that we meet ambitious goals, and at the same time strip away what makes us unique and treat us as if we were just another couple of private-sector financial institutions. Because those kinds of changes would make it all but impossible for us to serve our mission."
Impossible or not, it looks like that's kind of what's being demanded: stricter requirements and more ambitious goals. Here's what's changing for Fannie and Freddie so far.
MORE CONSERVATIVE ACCOUNTING
Now that financial heads have rolled at both Fannie and Freddie, stricter accounting may be the one certainty in their future. At Freddie Mac, executives are still working to set up stricter internal accounting controls mandated by OFHEO in its 2003 consent decree. In January, Syron reported that the company would release its 2004 results at the end of March.
The most immediate accounting issue for Fannie Mae is likely to be setting up stronger accounting systems. Last fall, OFHEO Director Armando Falcon Jr. told a congressional subcommittee that the current systems were inadequate. "The limited documentation and audit trails for amortization processes and systems allow Fannie Mae to manage its earnings and volatility in such a way that proper regulatory oversight can be impeded," he said. "Such behavior is a major safety-and-soundness concern."
Fannie Mae will also need to recognize income sooner. Falcon told Congress last fall that the company had set up a kind of "cookie jar" reserve to delay recognition of revenue "whenever it best served the interests of senior management." This practice is one of the more serious issues that is at the heart of the company's troubles.
How Fannie Mae accounts for derivatives, the particular issue that brought down longtime Chief Financial Officer Timothy Howard, is a concern as well. As noted earlier, in a short statement released Dec. 15, Nicolaisen, the SEC's chief accountant, wrote that Fannie Mae had not complied "in material respects with the accounting requirements in Statement Nos. 91 and 133"--two SEC rules governing the accounting of derivatives.
In particular, Nicolaisen noted, "Fannie Mae's methodology of assessing, measuring and documenting hedge ineffectiveness was inadequate and was not supported by the statement."
MORE CONSERVATIVE INVESTING
GSEs make money two ways. First, they charge a guaranty fee for securitizing mortgages. The second, and more lucrative business, has been by holding mortgages and earning a profit on the difference between the cost of their short-term funds and the interest they are paid by mortgage holders long-term. As long as the relationships hold steady, that difference can add substantially to profits: Every year that managers guess right on interest rates, profits magnify. But one wrong guess can move those bets in the other direction.
How much of the GSEs' portfolio is mismatched? St. Louis Federal Reserve Bank President William Poole told an audience of bankers last May that Fannie Mae and Freddie Mac "financed a large fraction of their portfolios of long-term mortgages with short-term debt--on the order of 38 percent of the net mortgage portfolio, or 34 percent of total assets."
The problem is that while the agencies hedge their interest-rate risk through interest-rate swaps, it's not a perfect hedge, according to Poole, who estimated that if the spread between short-term commercial paper and Treasuries were to widen from 10 to 60 basis points, the level it stood at between 1998 and 2001, Fannie Mae could lose 21 percent of its profit.
Speaking about Fannie Mae to Congress in October, Falcon said that Fannie had assumed many of its hedges were "perfect," and thus had no risk and couldn't show how risky its hedges actually were. "By improperly assuming perfect effectiveness for many of its hedges, Fannie Mae has failed to perform the proper assessment of effectiveness and measurement of ineffectiveness," Falcon said. "Furthermore, the enterprise has many deficiencies in its hedge-designation documentation."
DEEPER FOCUS ON AFFORDABLE HOUSING
Unless something changes, Fannie and Freddie will both be required to buy more loans for low- and moderate-income housing in the next few years. The requirement is set to rise from its current level of 52 percent to a new level of 56 percent. The higher affordable-housing goals were mandated in regulations issued by the Department of Housing and Urban Development (HUD) last year.
Fannie Mae warned HUD in a July comment letter, "If the mandated business mix goes beyond the market business mix, the new goals could, by definition, force market-distorting behavior." It warned that the requirements would push overinvestment in multifamily rental housing, manufactured housing and subprime mortgages, and away from families earning more than the goals, "including 'the broad middle class' Congress intended Fannie Mae to serve."
Freddie Mac, however, is trying to put a good face on the new requirements. Douglas Robinson, a Freddie Mac spokesman, says that just because loans are to low-income borrowers "doesn't mean that they're necessarily less profitable." And Eugene McQuade, the company's new president and chief operating officer, told attendees at a November Merrill Lynch Banking & Financial Services Investor Conference that he expects "growth in business will come from serving previously underserved communities."
MORE UPS AND DOWNS
Paradoxically, less uncertainty for regulators is likely to mean more surprises for Wall Street. As a result of the greater volatility of unsmoothed earnings, the one real certainty going forward is that the earnings at Fannie Mae and the companion firm that investors used to call "Steady Freddie" are likely to continue to wobble from here on out.
"You're going to see variation in their earnings and in their financial statements that you never saw before," says Whalen.
Stock analysts are divided about the long-term outlook for Fannie Mae. In March, according to Thomson Financial/First Call Corporation data, four rated it a "strong buy," 10 rated it "a buy," seven rated it a "hold" and two rated it a "sell." Investors seem to have already priced in the company's travails: Fannie Mae's stock price barely wavered following the SEC's announcement. In fact, it initially climbed a dollar on Dec. 17, the day after the announcement, from $69.30 to $70.31.
However, more negatives for the company--from a decision to cut dividends by 50 percent to statements by OFHEO that examiners have found more accounting violations--have weighed the price down somewhat since then, to $57.30 as of March 11.
At Freddie Mac, by comparison, the outlook may be relatively brighter, as many observers are saying that Freddie Mac has put more of its bad news behind it. Although the two stocks generally behave similarly, they've parted ways since October.
As of March, Freddie Mac stock was up 25 percent for the prior 12 months while Fannie Mae stock was down 5 percent, and as of March 11 it stood at $64.70. New York-based Morgan Stanley equity analyst Kenneth Posner recently advised investors to short Fannie Mae and buy Freddie Mac, but other analysts have not followed suit.
What the new Fannie and Freddie mean to mortgage bankers
GSE watchers have mixed opinions on what working with Fannie Mae and Freddie Mac will be like for mortgage bankers when the dust finally settles. "This isn't going to be a big catastrophic change in the sense that these entities are going to become broken up and everything is going to change," says Whalen. For anyone working downstream from Fannie and Freddie, he predicts, the change will be minimal but positive.
The biggest benefit for mortgage bankers: Whalen predicts that the companies' ability to "extract extortionate sums" through their guaranty fee business is going to end. "They're not going to be allowed to behave that way anymore," he says.
However, Lawrence White, professor of economics at New York University's Stern School of Business, speculates that the companies might actually try to raise their guaranty fee, as they struggle to maintain their current level of profitability. "It isn't written in the U.S. Constitution that guaranty fees have to be 20 basis points," he says. While competition keeps that number where it is now, White says, one company may be tempted to raise the fee hoping that its competitor will follow its lead.
The more profound effect may be for banks that hold a lot of GSE paper, if they conclude that they can no longer be considered as safe as Treasury bonds (in December they were trading about 33 basis points over the bonds). Eventually, the same thought will occur to bank regulators in Washington, D.C., as well, Whalen predicts. "Eventually the people in Washington are going to have to assign a new capital weighting to GSEs," he says.
Under Basel II, Whalen says, the country's biggest banks will be required to create their own risk models, meaning they can no longer hold something just because a regulator said they can, but have to model the risk internally.
Since that's the case, Whalen asked, "If you see that spreads on GSEs are moving around a lot more than they used to and that the volatility of the spreads and the price of the stock has gone up several-fold over the last couple years, which is the case, can you really give it a zero risk rating, even if the regulators say you can? No. You have to internally risk-weight that asset and say, 'Well, gee, this has three times the volatility of Treasuries now--I can't hedge one Treasury versus one GSE now, right? I have to come up with a different hedging ratio.'"
Kinder, gentler GSEs?
What kind of companies will emerge at the end of all these changes? Probably two firms that are a far cry from their former careers as hard-charging giants.
"I can tell you that the people I speak to in the Treasury are not interested in having either Fannie or Freddie in the newspaper ever again," says Whalen. "They want these entities to become boring and relatively predictable, and that means that their behavior operationally is going to change a lot."
"Fannie Mae and Freddie Mac are here to stay," says MBA's Pfotenhauer. "They're going through a rough period, but Congress won't--and shouldn't--cripple them. They'll continue serving the secondary mortgage market," he says.
As 19th-century English economist Walter Bagehot noted sardonically at the end of a critique of the Bank of England (which at that time was also a private corporation working for the public good, as the GSEs sometimes style themselves), "A system of credit which has slowly grown up as years went on, which has suited itself to the course of business, which has forced itself on the habits of men, will not be altered because theorists disapprove of it...."
Bennett Voyles is a freelance business and finance writer based in New York City. He can be reached at email@example.com.…