The Fannie/Freddie Culture of Influence and Corruption

Politico has a startling report today that should put into context exactly how Fannie and Freddie fell apart.

If you want to know how Fannie Mae and Freddie Mac have survived scandal and crisis, consider this: Over the past decade, they have spent nearly $200 million on lobbying and campaign contributions.

But the political tentacles of the mortgage giants extend far beyond their checkbooks.

The two government-chartered companies run a highly sophisticated lobbying operation, with deep-pocketed lobbyists in Washington and scores of local Fannie- and Freddie-sponsored homeowner groups ready to pressure lawmakers back home.

They’ve stacked their payrolls with top Washington power brokers of all political stripes, including Republican John McCain’s presidential campaign manager, Rick Davis; Democrat Barack Obama’s original vice presidential vetter, Jim Johnson; and scores of others now working for the two rivals for the White House.

Now, let's look again at an excellent analysis of the risky behavior that got both these giants into this mess.

A new team of people took over the finance side of Fannie Mae and implemented a series a relatively sophisticated and ultimately incredibly profitable Asset and Liability Management (ALM) strategies. One of the key innovations was issuing debt instruments, specifically callable debt instruments, that enabled Fannie Mae to much more closely match both the duration and pre-payment characteristics of its Assets (primary residential mortgage securities) with its debt (primarily Fannie Mae corporate debt). Normally, callable debt is quite expensive (much more expensive than residential mortgage debt), because bond holders want to be compensated for selling the call option to the issuer, but thanks to Fannie Mae’s quasi-government status it was able to issue this callable debt at yields that were only marginally above straight treasury yields. This debt combined with a more sophisticated overall ALM approach, not only reduced Fannie Mae’s borrowing costs significantly, but enabled it to very quickly adjust its portfolio in the event of rapid changes in pre-payments.

With this strategy in hand, not only could Fannie Mae buy mortgage securities for less than the cost of its debt (and thus earn a nice spread), but it could almost entirely contain pre-payment risk effectively making the purchase of mortgage securities “risk free” except for credit risk, which itself was very low thanks to Fannie Mae’s strong underwriting guidelines. Fannie Mae had discovered the equivalent of a financial golden goose.

Let’s Get This Party StartedWith its golden goose in hand, Fannie Mae almost immediately began buying a lot more mortgage securities. Who did it buy these securities from? Why none other than Fannie Mae itself. You see Fannie Mae’s original role was to buy mortgages from individual banks, package them up into securities, guarantee those securities against loss, and then sell them to other financial institutions. However once Fannie Mae realized that the “golden goose” allowed them to buy those same securities for its own portfolio and lock-in “risk free” profits, Fannie became a major buyer of its own securities. Fannie Mae was thus in the rather bizarre position of guaranteeing an ever increasing portion of its own assets against default.

By the time I showed up in the mid-1990’s, Fannie Mae had become one of the largest buyers of its own securities. Its stock was up over 40X from it’s 1980s nadir and it seemed as though the single biggest problem it had was deciding on how much money it wanted to make. This was a bigger problem than you might imagine because as a quasi-government agency, and a constant political football, Fannie Mae realized it couldn’t be seen to be abusing its market position. So rather than go crazy and buy every mortgage security in sight, Fannie Mae just settled on charting a nicepredictable upward growth in earnings fueled largely by buying an ever increasing share of its own securities.

Now a normal private company could not pursue this strategy because as it issued more and more debt to fund the golden goose, the yields on the incremental debt would start to increase to the point where the strategy no longer made sense. But Fannie Mae was different. Because of the implicit government guarantee of its debt, Fannie could issue incremental debt with little or no regard to its existing debt load because everyone assumed the federal government would backstop the debt.

Fannie Mae’s only significant problem thus became that the supply of mortgage securities would prove insufficient to fund its projected earnings growth (which was well above the projected growth in mortgage debt). As a result Fannie began a series of largely successful political campaigns to increase the volume of mortgage securities available to fund their habit.

Theoretically, the easiest way to increase the supply of mortgage securities was to get the federal government to increase the size limit of mortgages that Fannie could buy and guarantee, but this was a very difficult political fight for Fannie to win because commercial and investment banks dominated the so-called “jumbo” mortgage market and, already smarting from Fannie’s dominance of the so-called “conforming” market, they had drawn a line in the sand in the jumbo market and committed most their lobbying resources to keeping Fannie’s size limit as low as possible.

So, what we had was extremely risky behavior by these two, many times with government money, while at the same time lobbying the government to likely look the other way or tacitly approve this risky behavior.

The nexus of this problem is Fannie/Freddie's status as so called Government Sponsored Entities. That makes both quasi public quasi private. As such, they take advantage of both. Talk about a corrupting force. The government gives both things they don't give any other normal company. They have access to all sorts of credit that other companies shouldn't have. As such, the government should be providing significant scrutiny of their practices. Instead, what has happened is that most of the high level officers at both are former politicians or those with influence in politics. The Politico article points out just how tied both are to each campaign.

Given all the special perks that each receives from the government as part of their GSE status, is anyone really surprised that each has so many former pols on their payroll? For Fannie/Freddie, much more than the regular government, it is vital that they continue to have as much influence as possible.

That's why, in my solution, the first step was to cut the chord between Fannie/Freddie and the government. Both of these entities need to be fully privatized and stop enjoying status with the government other companies don't enjoy. The sort of corrupting influence that the Politico reported on will continue as long as that relationship continues.