All the Devils Are Here

by Bethany McLean; Joe Nocera

  Long Beach Mortgage was just four years old when Maxwell retired; the subprime business was still a speck in the ocean. Countrywide was growing by leaps and bounds—not by making subprime loans, but by selling conforming mortgages to Fannie Mae. The vast majority of the nearly 60 million American homeowners were members in good standing of the middle class, with the financial wherewithal to make a down payment and monthly mortgage payments.

  But Fannie Mae was never as invulnerable as it seemed to Maxwell in 1991. The company had enemies on all sides. From one direction, Wall Street was just starting to realize that subprime mortgages might allow them to effectively sidestep the GSEs, thus creating a competitive threat that seemed insignificant at the time but would ultimately prove life-threatening. From another direction, Fannie and Freddie’s half-government/half-corporate structure meant that they were always going to face opposition in Washington—sometimes subterranean, sometimes overt, much of it ideological. Critics on the left felt that Fannie and Freddie weren’t doing enough to help poor people buy homes. Critics on the right believed that the government-sponsored entities had no place in the private housing market, and that they should be forced to live or die competing on an equal basis with Wall Street’s securitizers. Although this criticism ebbed and flowed over the years, it never entirely went away.

  As Fannie Mae became ever more profitable and powerful, it also became more arrogant and high-handed. Yet at the same time, as the criticisms continued, it became increasingly paranoid. And as the sheer amount of money at stake grew exponentially over the ensuing decades, Fannie Mae became more determined than ever to protect both its own special privileges and its bottom line. It made for a lethal stew.

  In 1992, the year after Maxwell retired, Congress passed a bill imposing on Fannie and Freddie two things they had never had to deal with before. The first was a regulator, called the Office of Federal Housing Enterprise Oversight, or OFHEO. The second was a clear definition of what had previously been the GSEs’ vague mission to help lower-income Americans buy homes, including specific steps the GSEs were supposed to take to perform that mission. You might think that these two new facts of life would have had the effect of clipping Fannie and Freddie’s wings—maybe even costing them some profits. They did nothing of the sort.

  The main reason was Fannie Mae’s new CEO, a smooth-as-silk longtime Democratic operative named Jim Johnson. A tall, forty-seven-year-old Minnesotan and a graduate of Princeton, Johnson was, as they say, a player. He had spent his twenties working on the campaigns of Eugene McCarthy and George McGovern, and then served as Vice President Walter Mondale’s executive assistant during the Carter administration. In 1984, he had managed Mondale’s failed presidential bid; a year later, he co-founded Public Strategies, a policy-oriented public relations firm, with Richard Holbrooke, the well-known diplomat. He counted among his friends senators, members of Congress, top administration officials, and even the president, Bill Clinton, whom he had first met at a reunion of former McCarthy campaign staffers. When he wasn’t running Fannie Mae, he was serving as chairman of the Brookings Institution, Washington’s leading liberal think tank, and heading up the capital’s premier arts venue, the Kennedy Center for the Performing Arts. The Washington Post once called him “the chairman of the universe.”

  As Fannie Mae’s CEO, though, Johnson also played a brand of take-no-prisoners political hardball that even Maxwell—no slouch himself in that department—would likely have shied away from. Maxwell had handpicked Johnson for the job, and it was easy to see why. Like Maxwell, Johnson oozed charm. He was exceedingly smart; Maxwell recalls being dazzled by his brilliance the first time they met, at a dinner party in the 1980s. Also like Maxwell, he was a tough cookie who wasn’t afraid to play rough to get his way.

  The major difference between the two men was that Johnson’s bare knuckles were much more visible than Maxwell’s. Maxwell ran a smaller, less threatening company, and he had always had a sense of where the limits were, of what lines were best not crossed. Johnson didn’t calibrate things that way. When it came to political fights, he believed in all-out warfare, no matter how important—or unimportant—the issue. “In daily life, he’d say things like, ‘We’re going to cut them off at the knees,’” recalls a former Fannie executive. Once, a government official in the middle of a negotiation with Johnson asked him jokingly what the possibility was that Fannie Mae might lose. There was no humor in Johnson’s reply: “There is no probability that we lose.”

  Years later, Fannie’s last real CEO, Daniel Mudd, would say about the Johnson years, “The old political reality was that we always won, we took no prisoners, and we faced little organized political opposition.” One longtime critic, former Republican congressman Jim Leach, says that Johnson built “the greatest, most sophisticated lobbying operation in the modern history of finance.”

  Which was true. At first, the purpose of Fannie’s lobbying machine was to bend the new legislation to its wishes as it wended its way through Congress. The bill had come about because there were people in the first Bush administration who worried that Fannie and Freddie were taking on risk that the taxpayers would likely have to absorb if the housing market ever tanked and they had to make good on their guarantees. At a minimum, these administration critics believed, Fannie and Freddie needed better, tougher regulation. As a general rule, banks had to put aside enough capital to cover around 8 percent of the assets in their portfolios. But Fannie Mae and Freddie Mac put aside only a sliver of capital, allowing them to employ more debt than their competitors could—and produce greater profits. The Treasury Department wanted Fannie and Freddie to be forced to put up more capital.

  In 1990, even before Johnson took over as CEO, Fannie Mae engaged Paul Volcker, the legendary former Federal Reserve chairman, to defend Fannie Mae’s low capital levels. This was a classic Fannie tactic—finding a highly respected expert to defend its position—that Johnson would also employ. In this case, Volcker argued that if Fannie reached the razor-thin capital levels it was arguing were sufficient, then it would be able to maintain its solvency under conditions “significantly worse than any experienced” in the postwar era. Volcker’s endorsement gave Fannie’s supporters “no small measure of comfort that the Treasury’s considerably more Draconian proposals won’t fly,” wrote Barron’s. As the bill neared passage, Fannie Mae rounded up other supporters to argue that increasing the firm’s capital reserves would be bad for homeowners. Why? Because it would “limit credit availability and raise interest rates for home buyers,” testified Stephen Ashley, then the president of the Mortgage Bankers Association. A few years later, Fannie named Ashley to its board. Another classic tactic.

  As the legislation progressed, Johnson got his lobbyists—and several prominent housing activists—to convince Congress that the new regulator should be placed not within the Treasury or the Fed, which were both regarded as “antihousing,” but at HUD, an agency with very little institutional understanding of banking regulation and risk. Sure enough, the new regulator was housed in HUD. And sure enough, the bill allowed the GSEs to hold far less capital than other financial institutions; by the mid-1990s, the GSEs’ capital was about 2.75 percent of total assets.

  There was another little twist that ensured that Fannie Mae would never have much to fear from the new law. Fannie maneuvered to have OFHEO—virtually alone among “safety and soundness” regulators—subject to the appropriations process. This meant that its annual budget was at the mercy of politicians, many of whom often took their cues from Fannie. As a result, one former Freddie Mac lobbyist says, OFHEO had two choices: “Appease Fannie and Freddie or get reamed in the budget.”

  Fannie’s new “mission” requirements underwent a similar process. For instance, under the new law 30 percent of the mortgages the GSEs purchased were supposed to be loans made to low- and moderate-income families living in underserved areas. (The goals were increased slightly beginning in 1996.) But the goals were almost laughably meaningless. As the
General Accounting Office later noted, they were actually below HUD’s estimates of what the market naturally did already. And since “moderate income” meant those who made 100 percent of a certain area’s median income, a mortgage made to your average American family counted toward the purported goals.

  Johnson took great pride in the way Fannie had protected its profits and neutered the law. “It sounds a little muscular, but we wrote the housing goals in 1991 and 1992,” he told friends. “We cooperated with their being written in such a way that they had no teeth.”

  When the bill was signed into law, Johnson declared victory. The legislation, he told the Wall Street Journal, “removes any cloud that remains about our government mandate.” Fannie and Freddie, he seemed to be saying, were now officially untouchable. But like David Maxwell’s earlier prediction, it only seemed that way at the time.

  Not surprisingly, for the first roughly ten years of its existence, OFHEO was a notoriously weak regulator. There was a two-year stretch in the late 1990s when the agency didn’t even have a director. Fannie executives didn’t have much respect for OFHEO, and few bothered to hide it. When the regulator requested information, the GSEs would often respond that the information was confidential, explains Stephen Blumenthal, the former deputy director of OFHEO. “No one on Wall Street likes the SEC, but no one is crazy enough to fight with them. You try to develop a civil relationship. When I got to OFHEO, I was shocked. Fannie and Freddie were openly abusive to the agency and its staff.” OFHEO itself would later contend that “the goal of [Fannie’s] senior management was straightforward: to force OFHEO to rely on [Fannie itself] for information and expertise to such a degree that Fannie Mae would essentially be regulated only by itself.” Which is pretty much what happened.

  At the same time Fannie was stiff-arming its new regulator, it was embracing its mission requirements both to justify Fannie’s government-bestowed advantages and to keep critics at bay. In this regard, the fact that its mission was now spelled out in a piece of legislation was a helpful thing.

  The goals themselves, weak to begin with, were easy to game. For Fannie, they were almost beside the point. The real issue for Johnson was that the legislation gave him a huge new rhetorical advantage. His company—by statute—was helping low- and moderate-income Americans achieve the American Dream. The mission made it easy to explain to members of Congress why Fannie mattered. And when critics complained about Fannie, the company could hit back by labeling them “antihomeowner.”

  Fannie Mae had always employed people that insiders called housers, a mildly derisive term that referred to those idealists who believed homeownership was the cure to the world’s ills. It wasn’t long before Johnson became a houser, too. At least, he talked the talk. “The mission runs in our veins,” he liked to say. Another of his favorite lines was a twist on the old saying about General Motors: “What’s good for American housing is good for Fannie Mae.” Fannie began advertising its connection to homeownership on shows like Meet the Press.

  But Johnson went well beyond mere rhetoric. The GSEs’ core problem, he liked to say, was that there was “nothing in the homeowner’s life called Fannie Mae or Freddie Mac.” Everything the GSEs did was behind the scenes. But for Congress, it was the homeowners who mattered, since they were the constituents. So Fannie had to find a way to demonstrate two key traits, which Johnson called “indispensability” and “tangibility.” That, he’d say, would “allow us to survive.”

  Johnson solved this problem by establishing what Fannie Mae called partnership offices. Officially, these were operations dedicated to finding opportunities to purchase mortgages in a given state. Unofficially, they were the grassroots of a highly sophisticated political operation. Fannie’s first partnership office was in San Antonio, which just happened to be home to Representative Henry Gonzalez, then the chairman of the House banking committee. (In 1994, he became the ranking minority member when the Republicans gained majority status in the House.) When Gonzalez retired in 1999, Representative John LaFalsce of Buffalo, New York, became the ranking Democrat. So Fannie opened a partnership office in Buffalo.

  There was a certain formula to these offices. They were staffed by someone close to power—the son of a senator, a governor’s assistant, a former congressional staffer. They held ribbon-cutting ceremonies, always with a politician present, to announce, for instance, that Fannie was going to put millions into a senior citizen center. There were as many as two thousand ceremonies a year in partnership offices all over the country. Members of Congress may not have understood how the secondary mortgage market contributed to homeownership, but they certainly understood the dispensation of pork.

  Fannie Mae also funneled money to politicians. In addition to campaign contributions, Fannie set up a foundation that made contributions to politically useful causes. The foundation had existed in a small way since 1979, but in 1996 Johnson contributed $350 million of Fannie’s stock and handed over responsibility for advertising to Fannie’s foundation. Over the years, the foundation became one of the largest sources of charitable donations in the country. It made heavy donations to, among others, the nonprofit arms of the Congressional Black Caucus and the Congressional Hispanic Caucus.

  Fannie hired key insiders to plum jobs. Tom Donilon, who had been the chief of staff to Secretary of State Warren Christopher, joined Fannie Mae when he left the government; so did Jamie Gorelick, who had been the deputy attorney general in the Clinton administration. Sometimes, when it suited his purposes, Johnson even hired Republicans, such as Arne Christensen, who had been the chief of staff to Newt Gingrich, the former House majority leader. “It was like the local Tammany Hall operation—a jobs program for ex-pols!” says one close observer.

  Fannie and Freddie spent a staggering amount of money lobbying: $170 million in the decade ending in 2006, just a little less than the American Medical Association. But even the dollar tally understates Fannie’s reach. Money alone couldn’t have gotten a politician’s barber to call him when Fannie Mae wanted something from Congress, as the Washington Post once reported. When one of Fannie Mae’s few congressional critics, Jim Leach of Iowa, who succeeded Gonzalez as House banking committee chairman, proposed taxing Fannie and Freddie’s debt issuances, rumors began circulating that he was going to be stripped of his chairmanship. That was Fannie’s doing as well. “What do you think a Fannie pack is?” asks one critic. “Whenever there was a hearing, anyone involved would get a Fannie pack, which would consist of every single loan originated in their district that Fannie Mae had purchased in the last four or five years.” Says former Louisiana congressman Richard Baker: “They ran a battle plan that would make Patton proud. It was twenty-four/seven and never anything left to chance.”

  And those who persisted in criticizing Fannie Mae? They learned to regret it. When some of Fannie’s large competitors, worried about its growing dominance, launched an organization called FM Watch to keep tabs on the GSEs, Fannie openly threatened them. GE Capital CEO Denis Nayden told the Wall Street Journal that GE was on the “receiving end of multiple communications from Fannie Mae indicating that GE would suffer financial consequences if GE remained a member of FM Watch.” Said Hank Greenberg, the chief executive of AIG: “They use their muscle to threaten competitors, and that’s an outrage.” Soon, FM Watch stopped disclosing the names of its members.

  When the Congressional Budget Office published a report in May 1996 estimating that about 40 percent of Fannie and Freddie’s profits were due to their implied government support, Fannie Mae denounced the report, calling it the work of “economic pencil brains who wouldn’t recognize something that works for ordinary home buyers if it bit them in their erasers.”

  When the General Accounting Office wrote in a letter to house majority leader Richard Armey that the GSEs received a government subsidy amounting to $2.2 billion in 1995, the letter’s author, James Bothwell, says that he received a call from Franklin Raines, who was then the vice chairman of Fannie Mae. According to
Bothwell, Raines demanded that he take out the line about the subsidy—and if he didn’t, Raines would make a call that might cost Bothwell his job. Bothwell refused. In the end, he didn’t lose his job. (Raines denies the incident.)

  And when, in 1996, the Treasury Department was preparing to issue a tough report on the GSEs, Fannie somehow managed to get it watered down—and turned into a largely positive report—before it ever saw the light of day. The early draft, for instance, said that if the GSEs were privatized, “Fannie Mae and Freddie Mac would be exposed to the full discipline of private capital market investors, rather than the weakened and distorted discipline resulting from GSE status.” That sentence was gone from the final report. The draft also contained a paragraph that cited several reasons why ending government sponsorship “should also improve the safety and soundness of the housing finance market.” That was gone from the final report, too. The fifth chapter of the draft disappeared entirely. It had been entitled “Policy Options for Altering the Relationship Between the Federal Government and the GSEs.”

  No one who’s talking can prove what happened, but those who know about the rewrite have long speculated that Johnson put in a call to his friend Bill Clinton or to Treasury Secretary Robert Rubin, another friend. Johnson has denied calling either man. The mystery was never solved.

  The ferocity of Fannie Mae’s response to criticism was strange, in a way. After all, Fannie Mae and Freddie Mac did play an important role in homeownership. Their guarantees allowed more people to buy homes. Over time, they made it possible for mortgage originators like Countrywide to overtake the dying S&L industry as the country’s primary mortgage lender—thus keeping the mortgage spigot open even as the thrifts were shutting down.