One of the more entrenched principles in business is “pay for performance,” the rewarding of executives with raises, bonuses and other forms of compensation if they meet or exceed expectations. Fannie Mae and Freddie Mac, now wards of the federal government, are negations of that principle. The troubled secondary mortgage lending giants, already having received more than $110 billion in federal subsidies since the fall of 2008, are set for another major feed at the public trough. On December 24, the U.S. Treasury Department, facing a December 31 deadline, approved a no-limit hike in the publicly-traded companies’ combined $400 billion credit line. Were that not enough, regulators approved an annual compensation package of up to $6 million for each chief executive officer. Welcome to pay for performance, Obama-style – not that the Bush version was a bargain.
Fannie Mae and Freddie Mac, originally known as Federal National Mortgage Association and Federal Home Loan Mortgage Corporation, were set up as “Government Sponsored-Enterprises,” or GSEs. That’s a euphemistic way of saying they aren’t real enterprises. Chartered as corporations, respectively, in 1968 and 1970 (Fannie Mae had been established as a government agency back in 1938), they have a congressional mandate to provide mortgage market liquidity. These secondary mortgage market lenders don’t underwrite loans directly. Instead, they buy loans from primary lenders (e.g., commercial banks and savings & loan associations) with the intention of either holding them in portfolio or bundling them into “mortgage-backed securities” for sale to institutional investors. By serving as intermediaries between local lenders and Wall Street, each company, in theory at least, insures an ample stream of cash available for residential mortgages even during economic downturns.
In return for fulfilling its public mandate, Fannie Mae and Freddie Mac enjoy “too big to fail” status. The federal government long has provided several advantages to each entity unavailable to competitors. Fannie and Freddie receive: exemption from state and local taxation; exemption from certain federal securities laws; exemption from Federal Deposit Insurance Corporation fees; and a $2.25 billion line of credit from the Treasury Department (since raised dramatically – more on that later). Historically, this translated into borrower subsidies on average of up to 50 basis points per mortgage. The Congressional Budget Office in a 1996 report estimated that the combined Fannie Mae and Freddie Mac subsidy the previous year amounted to about $5 billion. Investors in mortgage-backed securities reaped a bonanza. The average annual rate of return of Fannie Mae and Freddie Mac investments during 1990-95, the CBO calculated, were a whopping 31.6 percent and 40.3 percent, respectively. The figures for Dow Jones banks, Standard & Poor’s financials, and Dow Jones savings & loans during these heady years were 30 percent, 24 percent and 18.6 percent.
The arrangement had its risks, but on the whole it worked reasonably well – assuming borrowers paid back loans in a timely manner. But over the last two decades, Congress and successive administrations, obsessed with raising the homeownership rate across all income levels and racial/ethnic groups, increasingly laid the groundwork for collapse. In 1992, Congress created a new office within Fannie and Freddie’s regulator, the Department of Housing and Urban Development (HUD), to promote compliance with affordable housing goals and minimum capital standards – a classic example of trying to hit two targets with one arrow. In the mid-Nineties, the Clinton administration pushed through Community Reinvestment Act (CRA) regulations which required lenders to step up volumes of lending to low- and moderate-income families and allowed securitization of CRA loans for risky subprime mortgages. And in this decade, the Bush administration, believing transforming America into an “ownership society” would pay big political dividends, got further raises in Fannie Mae and Freddie Mac affordable housing quotas.
These actions increasingly enabled radical community organizing groups such as the Association of Community Organizations for Reform Now (ACORN) and Neighborhood Assistance Corporation of America (NACA) to block proposed bank mergers, expansions and acquisitions unless it got a piece of the mortgage action. Fannie Mae and Freddie Mac typically acquiesced with these “greenmail” demands, believing it was a small price to pay for making huge sums of money. Few observers recognized the impending off-balance-sheet implosion. So long as the two GSEs could keep competitors at bay through constant political campaign contributions and lobbying, they could reap the rewards of a seemingly permanent housing market boom. Neither the corporations nor their allies in Congress could bring themselves to believe the party could end. In 2003, Rep. Barney Frank, D-Mass., Ranking Democrat on the House Financial Services Committee (and currently chairman), proclaimed, “These two entities – Fannie Mae and Freddie Mac – are not facing any kind of financial crisis.” By late decade, the two firms owned or guaranteed some $5.4 trillion in residential mortgages – more than 40 percent of the outstanding total. Unfortunately, a large and growing portion of the securitized mortgages had were owed by households who couldn’t pay them back, often underwritten through deceptive, if not illegal means. Defaults and foreclosures were rising to dangerous levels. And Fannie Mae and Freddie Mac, despite HUD oversight, couldn’t meet their minimum operating capital requirements.
The almost inevitable implosion came in September 2008, four months before the end of the Bush administration. Federal officials, led by Federal Housing Finance Agency Director James Lockhart and Treasury Secretary Henry Paulson, placed Fannie Mae and Freddie Mac under emergency federal conservatorship, a step not as dramatic as receivership, but a clear message that these two firms no longer could operate like private-sector corporations. Congress soon raised each company’s Treasury credit line from $2.25 billion to $100 billion. It didn’t take long for these new ceilings to be obsolete. In February 2009, with President Obama now in office, the Treasury Department, led by Secretary Timothy Geithner, again raised the limit to $200 billion – that is, a combined $400 billion. Yet with one in seven outstanding mortgages now either in default or foreclosure, even these new limits would be insufficient to officials jumpy over the prospect of a falling homeownership rate. Fannie Mae and Freddie Mac were becoming a fiscal sinkhole, racking up a combined $71 billion in losses during the first three quarters of 2009.
It wasn’t as if these corporations hadn’t made use of their federal lifeline. In less than a year and a half, Fannie and Freddie had received a combined $111 billion in bailout money. Yet on Thursday, December 24, the Treasury Department lifted the $400 billion combined cap altogether. Here was the true meaning of “too big to fail” on a grand scale. And this Christmas Eve present also was a case of good timing; after December 31 such a move would have required congressional consent.
The Treasury Department went further, requiring the caps on Fannie Mae and Freddie Mac’s mortgage assets held in portfolio to fall to only $810 billion rather than $690 billion by the end of 2010. Officials defended the move as enabling the secondary mortgage giants to buy delinquent loans whose terms are being modified by the Obama administration’s $75 billion Home Affordable Modification Program (HAMP), announced last March and launched the following month. But such a move may backfire. As of early December, less than 5 percent of the more than 700,000 homeowners enrolled in the program had moved from initial to permanent loan modification. And some 30,000 homeowners who entered the program either dropped out or were disqualified. The track record of loan modifications as a whole isn’t promising. According to a recent joint report by the Office of the Comptroller of the Currency and the Office of Thrift Supervision, nearly 40 percent of delinquent homeowners who had their mortgage payments cut by 20 percent or more in 2008 became delinquent again within a year.
Making sure Fannie Mae and Freddie Mac stay busy is the institutional investor of the last resort, the Federal Reserve System. The Fed is in the midst of a $1.25 trillion buying binge of mortgage-backed securities sponsored by Fannie, Freddie and HUD’s in-house secondary mortgage lender, Government National Mortgage Association (“Ginnie Mae”). The Fed apparently is committed to shoring up homebuying opportunities through times thick and thin. Yet its actions over the long run are likely to fuel another credit explosion of a magnitude that led to the current state of affairs.
In the face of all this, Fannie Mae and Freddie Mac have lost a fortune. Its top executives don’t deserve any kind of raise, much less a hefty one. Unfortunately, the Treasury Department doesn’t see things this way. Part of its Christmas Eve announcement contained a provision enabling Fannie Mae CEO Michael Williams and Freddie Mac CEO Ed Haldeman to receive as much as $6 million in annual compensation – all in cash. Granted that’s a good deal less than the lavish pay bestowed upon CEOs before the meltdown, especially Fannie Mae’s James Johnson and (ethically-challenged) Franklin Raines. But it’s worth mentioning that pay levels are exempt from Temporary Asset Relief Program limits that apply to banks taken over by the government. No federal “pay czar” need poke around here.
The overriding issue is the ongoing politicization of the housing market and, more specifically, the holding of the mortgage lending industry hostage to “affordability” goals. We seemingly have learned little from the current mortgage implosion, preferring to labor under the illusion that owning a home is a moral right, backed up by programs, policies and court decisions. Whether Democrat or Republican, most political leaders are possessed of the view that taxpayers must be conscripted to transform as many renters into owners as possible. By forcing Fannie Mae and Freddie Mac to operate as adjuncts to federal agencies and allied community organizing groups, the government sowed the seeds of these corporations’ eventual demise and takeover. The main problem with Fannie Mae and Freddie Mac is that they were set up as “government-sponsored” enterprises, not real ones.