All the Devils Are Here

by Bethany McLean; Joe Nocera

  Fannie responded to Freddie’s problems with astonishing—yet unsurprising—self-righteousness. Raines publicly accused Freddie of causing “collateral damage.” The frequently asked questions section on Fannie’s Web site included the following statement: “Fannie Mae’s reported financial results follow Generally Accepted Accounting Principles to the letter…. There should be no question about our accounting.”

  The Freddie restatement was yet another humiliation for Falcon. Not long before Freddie revealed that it would have to restate its earnings, Falcon had publicly pronounced the company’s internal controls “accurate and reliable.” Furious at having been so wrong about Freddie Mac, Falcon decided to launch an investigation to see if Fannie had the same problems. OFHEO hired Deloitte & Touche, the big accounting firm, to dig into Fannie’s books.

  The White House piled on, yanking Bush’s presidential appointees from the GSEs’ boards. Then, in the fall of 2003, it put its weight behind a bill to toughen regulation of the GSEs—a bill that Fannie’s lobbyists managed to water down, causing the White House to pull its support. (The bill failed.) Around the same time, John Snow, the new Treasury secretary, even called for a receivership provision should Fannie or Freddie become insolvent. Amazingly, there was no real procedure in place for reorganizing the GSEs in the event of a bankruptcy. The larger implications were clear: the government was signaling that it would not stand behind Fannie and Freddie’s debt.

  Some White House aides began to jokingly call the campaign against the GSEs “Operation Noriega,” after the strategy the United States used to roust former Panamanian strongman Manuel Noriega. (It bombarded him with loud rock music.) The administration helped spur anti-Fannie and anti-Freddie op-ed columns and editorials. It also got HUD in the act, which announced that it would begin steadily increasing the GSEs’ affordable housing goals from 50 percent of their purchases to 56 percent. “It was consciously punitive,” says a former Fannie executive. The real significance wasn’t so much the percentage increase as it was the fact that the GSEs, for the first time, had specific single-family goals in metropolitan areas. It could no longer use apartment buildings or refinancings to get around the rules. Dow Jones got a copy of an e-mail a Fannie staffer had written: “You just cannot appreciate how truly bad this is—from a purely Republican standpoint,” it read, in reference to the new, tougher goals.

  Even Greenspan got involved. He and Raines were social friends, but he simply didn’t buy Fannie’s rationale for its enormous mortgage portfolio. “The explanation they gave was utter nonsense,” Greenspan later said.

  The White House assault seemed to embolden the Fed chairman, who began speaking out regularly against Fannie and Freddie. His most pointed comments came in 2004, when he told Congress, “To fend off possible future systemic difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are required sooner rather than later.” (Fannie, of course, responded in kind; even Greenspan wasn’t immune.)

  In the fall of 2004, OFHEO announced the preliminary results of its investigation. Fannie, the agency said, had willfully broken the complex accounting rules surrounding derivatives to facilitate smooth earnings growth. Whereas Freddie had understated its earnings, OFHEO charged Fannie with overstating them and willfully breaking accounting rules.

  The clear implication was that Fannie Mae was cooking its books so that the executives could line their pockets. During the previous five years, the company had, indeed, doubled its earnings just as Raines had promised when he first became CEO, generating tens of millions of dollars in management bonuses. OFHEO was now saying that much of that profit was basically the result of accounting fraud. OFHEO also said that Fannie, under Raines, had fostered an environment of “weak or nonexistent internal controls.” Raines responded in a highly unusual way. Throwing down the gauntlet, he demanded that the SEC reinvestigate the company’s accounting.

  Fannie had one more trick up its sleeve. An aide to Kit Bond, a Republican senator from Missouri, played poker with Bill Maloni, Fannie’s top lobbyist. Bond sat on the appropriations committee that oversaw OFHEO. Before the results of the OFHEO investigation were made public, Bond sent a letter to HUD’s inspector general, requesting that it investigate not Fannie or Freddie, but OFHEO. (A draft of Bond’s letter, which was nearly identical to the letter that was actually sent, was later found on Fannie Mae’s computer system.) Separately, the committee also called for $10 million of OFHEO’s budget to be withheld until Falcon was removed.

  There is no question that OFHEO actions were well beyond the bounds of normal regulatory behavior. Like the White House, it had gone to war with Fannie Mae, leaking damaging information to the press and actively seeking to embarrass the GSEs. To put it bluntly, it was out to get Fannie. Which is precisely what the HUD inspector general wrote in his report.

  The inspector general’s report was supposed to be confidential. But Fannie had a long history of strategic leaks itself. Sure enough, just before a key hearing, it managed to get the HUD report into the hands of members of Congress. Not surprisingly, when the hearing began, the committee members went after OFHEO and Falcon instead of Raines.

  “This hearing is about the political lynching of Franklin Raines,” said Congressman William Lacy Clay, an African-American Democrat from Missouri.

  “Is it possible that by casting all of these aspersions … you potentially are weakening this institution in the market, that you are potentially weakening the housing market in this country?” chimed in Congressman Artur Davis, Democrat of Alabama.

  In responding to the OFHEO charges, Raines was unapologetic. “These accounting standards are highly complex and require determinations on which experts often disagree.” A congressional aide would later say, “I have never seen anyone treated as disrespectfully as Armando Falcon was by the Democrats and Franklin Raines.”

  Raines, however, had overplayed his hand. In demanding that the SEC look at Fannie’s account, he assumed it would side with the company rather than its regulator. But he had calculated wrong. On December 15, 2004, at a meeting that included Raines, Falcon, and Justice Department officials, the SEC’s chief accountant, Donald Nicolaisen, announced that Fannie Mae’s accounting did not comply “in material respects” to the accounting rules.

  Raines was flabbergasted. “What did we get wrong?” he asked, his voice wavering. Nicolaisen held up a sheet of paper. If the four corners represented what was possible under GAAP accounting rules and the center was perfect compliance, he told Raines, “you weren’t even on the page.” Fannie’s representatives tried to argue that if they couldn’t get it right, no one could. Nicolaisen wasn’t having it. “Many companies out there get it right,” he said.

  The restatement was astounding. OFHEO alleged that Fannie Mae had overstated its earnings by $9 billion since 2001, representing a staggering 40 percent of its profits. (Ultimately, Fannie restated its earnings by a “mere” $6.3 billion.) OFHEO also reported that Raines had been paid $90 million between 1998 and 2003—$52 million of which was directly tied to Fannie’s meeting its earnings targets. Raines and his number two, CFO Tim Howard, were forced to step down. Fannie agreed to pay a $350 million civil penalty to the SEC and $50 million to the Treasury. As part of a consent decree with OFHEO, Fannie agreed to hold 30 percent additional capital and stop growing the portfolio. Freddie agreed to the same measures.

  There are many former Fannie executives, including Raines and Howard, who will go to their graves believing that the entire scandal was drummed up by OFHEO and the White House solely to bring Fannie down. In August 2006, the Justice Department took the rare step of publicly announcing that it was dropping its investigation into Fannie Mae’s accounting; no criminal charges were ever filed. For that matter, the SEC never filed civil charges against any individual, either. And an investigation by the law firm Paul, Weiss exonerated Raines of any wrongdoing. While OFHEO settled with Raines and Howard, it did so on terms that can only be described as i
ncredibly generous. The bulk of Raines’s settlement—some $25 million—came from stock options he had received that were so out of the money they’d likely never be worth anything anyway. Raines today describes the accounting scandal as “a dispute among accountants,” because Fannie’s outside accountants had agreed with its original interpretation of GAAP. Derivatives accounting is incredibly complex, and the line between sloppiness, aggressiveness, and fraud is often difficult to discern. The fact that the SEC—which had no dog in the fight—agreed with OFHEO suggests that the scandal was real. The fact that the Justice Department declined to prosecute suggests that maybe it wasn’t.

  Whichever the case, Raines had no one to blame but himself. CEOs of regulated companies may grouse privately about their regulator, but few are so foolish as to let the relationship become so openly hostile. Whether because of sloppy accounting or something less excusable, Fannie gave its regulator enough rope to hang it with. Having abused its regulator for years, how could Fannie expect OFHEO not to use that rope?

  Here’s the stunning thing, though: despite scandals at both Fannie and Freddie, despite a Republican White House, despite some powerful enemies in Congress—like Richard Baker and Senator Richard Shelby, the chairman of the Senate banking committee, even despite the importunings of Alan Greenspan—Congress and the administration took no steps to impose new regulation on the GSEs. That wouldn’t happen until much later.

  “Can you imagine if they all had said, ‘Enough is enough. We’re sending legislation to the Hill to privatize Fannie and Freddie and end their beneficial status with the federal government?” asks a former Fannie lobbyist. “At the time, the Republicans never believed they could get that done. And on the other side of the political spectrum, Democrats like Barney Frank and Senator Chris Dodd would never have supported such an effort, because the companies would no longer be bound to support affordable housing. You were never going to get to the middle.”

  In truth, the Treasury Department could have done something about the GSEs even without new legislation. During the early stages of Operation Noriega, Treasury had researched an obscure provision in a 1954 law that appeared to give the Treasury the right to limit the GSEs’ issuance of debt. Treasury and the Justice Department concluded that Treasury did, indeed, have that right. By exercising it, they could have shut down the GSEs entirely. But they never tried. Even the Bush administration was afraid to see what would happen to the mortgage market without Fannie and Freddie.

  Fannie’s new CEO was Daniel Mudd, a self-deprecating ex-Marine who had run General Electric’s Japanese operation before joining Fannie Mae in 2000. The son of the well-known television journalist Roger Mudd, the new chief executive could not have been more different from his three predecessors. He wasn’t a Democrat, a Washington power player, or a houser. He and Raines had never been close, and Mudd had thought about leaving the company because he didn’t like its “arrogant, defiant, my-way Fannie Mae,” as he later put it. When he became CEO, he embarked on a strategy of conciliation. “I thought for a very long time that it was our fault, because we were heavy-handed, because we had a propaganda machine,” he said. Though he tried to patch things up with the administration, no one in the White House would take his calls.

  On the other hand, the White House was the least of Mudd’s problems. While Washington had been transfixed by the war between Fannie and the White House, something every bit as dramatic was taking place in the marketplace: Fannie’s stranglehold on the secondary mortgage market was weakening. And not just by a little. In 2003, Fannie Mae’s estimated market share for bonds backed by single-family housing was 45 percent. Just one year later, it dropped to 23.5 percent. As a 2005 internal presentation at Fannie Mae noted, with some alarm, “[P]rivate label volume surpassed Fannie Mae volume for the first time.”

  There was no question about why this was happening: the subprime mortgage originators were starting to dominate the market. They didn’t need Fannie and Freddie to guarantee their loans—and for the most part didn’t want the GSEs mucking around in their business. The subprime originators sold their loans straight to Wall Street, which, unlike the GSEs, didn’t really care whether they could be paid back. “The subprime market needed the companies who created all the rules to go away,” says subprime entrepreneur Bill Dallas. “Fannie and Freddie were in the penalty box. They were gone.”

  As Fannie’s market share dropped, the company’s investors grew restless—so restless that Fannie hired Citigroup to look at what Citi called “strategic alternatives to maximize long-term Phineas [the code name the Citi team gave Fannie] shareholder value.” In a July 2005 presentation, Citi concluded that Fannie shouldn’t privatize, because its charter was its “core asset,” accounting for up to 50 percent of its current market capitalization. Among Citi’s key recommendations for increasing that market capitalization: Fannie should begin guaranteeing “non-conforming residential mortgages”—i.e., subprime.

  Fannie’s relationship with its biggest customer, Countrywide, was also increasingly difficult. In some years, Countrywide generated a quarter of the loans purchased by Fannie; and the company had long supported certain key Mozilo causes, like low down payments. “The single defining quality of that relationship was the mutual dependence,” says one lobbyist. But now the balance was shifting, because Countrywide had other options. Unlike the pure subprime companies, Countrywide wanted Fannie in the subprime market. Countrywide originated so many loans that Mozilo wanted as many buyers as he could get, even Fannie. Besides, Countrywide liked the idea of having Fannie impose some order on the Wild West of subprime, with its insistence on sound underwriting standards. That would probably help Countrywide, with its long history of working hand in hand with the GSEs, and hurt the pure subprime companies like Ameriquest and New Century.

  Instead, because Fannie wouldn’t buy riskier loans, its share of Countrywide’s business shrank. According to an internal Fannie Mae presentation, in mid-2002 Fannie bought more than 80 percent of Countrywide’s mortgages. By early 2005, that had shrunk to about 20 percent. “This trend is increasingly costing us business with our largest customer,” noted the presentation.

  The new, tougher housing goals of the Bush administration also ratcheted up the pressure. How was Fannie going to achieve those goals without adding subprime mortgages to its books? The products it had carefully tailored for low-income borrowers were no longer appealing in a world where those borrowers could get much bigger mortgages from a subprime originator by making up their income. But Fannie couldn’t just dive headlong into the subprime market. Its systems weren’t able to gauge the risk of subprime mortgages. “[W]e are not even close to having proper control processes for credit, market, and operation risks,” wrote the company’s chief credit officer, Enrico Dallavecchia, in an e-mail. The irony was painful: HUD had increased and toughened Fannie’s housing goals at the precise moment when the market was willing to make loans—often terrible loans that quickly soured, to be sure—to any low-income person who wanted one. “The difference between what the market produced and what we had to produce grew bigger and bigger,” says a former Fannie executive.

  “All these voices on the outside were saying, ‘You are not relevant,’” Mudd later recalled. “And you have an obligation to be relevant.”

  Fannie’s traditional arrogance soon gave way to angst; Mudd would later say that going to work felt like “a choice between poking my eye out and cutting off a finger.” Fannie’s internal struggles were on vivid display at a getaway for executives in the summer of 2005. In a slideshow entitled “Facing Strategic Crossroads,” the first question Fannie asked itself was “Is the housing market overheated?” The next question: “Does Fannie Mae have an obligation to protect consumers?” Executives debated whether the new dominance of subprime products was a permanent change or a temporary phenomenon. The presentation went on to lay out the two “stark choices” Fannie faced. One was to “stay the course,” which meant staying away from subprime
lending and seeing continued market share declines. The other: “Meet the market where the market is.” Which meant subprime. The presentation concluded on a plaintive note. “Is there an opportunity to drive the market back to the thirty-year FRM [fixed-rate mortgage]?”

  Although the company vowed at the meeting to stay the course, in truth it had already begun to stray. First the GSEs bought for their portfolios the safest subprime securities in the marketplace: the triple-A-rated tranches of residential mortgage-backed securities. (Neither GSE ever bought CDOs.) They’d begun buying these securities in the earlier part of the decade because they offered decent yields. But when the housing goals became harder to fulfill, the triple-A tranches provided an easy way to meet their mission numbers. Eventually, the Street began designing a special GSE tranche that was packed with loans that satisfied the affordable housing requirements. And HUD allowed the GSEs to count these purchases toward their goals.

  Over time, Fannie and Freddie became two of the world’s largest purchasers of triple-A tranches. In the peak year of 2004, the GSEs bought about $175 billion in triple-As, or 44 percent of the market. While there were plenty of buyers for triple-A-rated securities, the very size of the GSEs’ purchase undoubtedly helped inflate the housing bubble.

  Putting triple-A subprime securities on its books was, like some of Fannie’s other methods of meeting its housing goals, a stupid pet trick. It didn’t help low-income Americans buy homes. Because the GSEs weren’t determining which loans they would buy, they lost the opportunity to enforce any standards on the lenders. And, as housing advocate Judy Kennedy points out, putting subprime securities on its books was a perversion of its affordable housing mission. From the government’s perspective, GSEs existed to buy up loans to poor and middle-income borrowers—even if that came at the expense of its profits. By buying Wall Street’s securities, the GSEs were able to earn more of a return on their affordable housing investments, rather than less.