An obscure regulatory agency, the OFHEO, has succeeded in bringing down one of the politically savviest and most well-connected figures in the Washington, Fannie Mae CEO Franklin Raines. An OFEHO investigation revealed that Fannie Mae had been violating rules concerning derivatives accounting, and that the resulting mis-statements in their finances enabled Fannie to meet numerical targets that were required for Raines and other top executives to earn multi-million dollar bonuses.
While most of Washingtonis “shocked, shocked” that Fannie Mae has been caught cooking their books, two Austrian analysts who follow the company have been drawing attention to discrepancies in the company’s accounting for over a year. David Tice, a fund manager and director of a firm that does research for short sellers writes The Fate of Fannie. Peter Eavis, writing for The Street, has published a series of analytical pieces on Fannie and CEO Raines. See, for example Fannie Fight About to Get Nastier, which is available on the free portion of the site, and excerpts from Franks’ Fallujah, starting on page 21 of a recent issue of The GSE Report. The GSE Report is highly recommended for ongoing coverage of this issue. They present in digest form major articles from media sources. The current issue contains detailed coverage of the unfolding debacle.
Fannie is primarily a political creature, not a private sector business firm. The company purchases mortgages from banks and then either resells them as mortgage-backed securities with a form of credit insurance, or holds them on its own books. Their role as an intermediary is to assume credit risk for those institutions that wish to assume interest rate risk only.
Fannie along with its slightly less evil twin Freddie Mac, were created during the depression as government to purchase mortgages that were in default extend additional credit to home owners. Over time, their intermediary role has become less important relative to their activity as a mortgage investment portfolio. They currently hold more than $1 trillion in mortgages on their own balance sheet. They were eventually “privatized”, but not really. The default risk that Fannie assumes is probably underwritten by the Fed. Although Fannie denies this, they also rely on the perception of the market that their bonds have a similar default risk to US Treasuries, which will always be paid off in the same nominal amount of dollars so long as the Fed can print money.
The Greenspan Fed’s policy of “too big to fail”, and its reckless expansion of credit whenever a large player started to wobble further reinforced the perception that Fannie was an extension of the US Treasury. This gave Fannie an advantage in competing against private firms who have a higher cost of capital. As a result, they have come to dominate that segment of the mortgage market in which they are allowed to participate. The GSEs, then, are the worst type of hybrid public institution: one in which profits were privatized but risk was socialized. Peter Wallison has written:
So if Fannie and Freddie are not lowering interest rates by purchasing these securities, why are they doing it? The question answers itself. The taxpayers, through the generosity of Congress, have offered Fannie and Freddie a great deal: heads you win; tails we lose. You can take interest rate risk by repurchasing your own mortgage-backed securities; if you earn substantial profits from your government support, you can keep them; if the market moves against you and you suffer losses, we will cover them.
Combined with Raines formidable skill as a lobbyist and political operator, and his facile use of economic fallacies to justify what his organization’s function, Fannie became in essence an out-of-control government agency. Bert Ely has written in Nationalizing Mortgage Risk, that the residential mortgage market has been in effect socialized without any public or congressional debate, and without most Americans even being aware. Their mission was aided and abetted by enormous expenditures on lobbying. Fannie contributed liberally to the Demopublican party and funds marketing events in almost every congressional district to publicize the amount of subsidized mortgage credit that they have showered there. An ad campaign with the goal of creating a brand identity for Fannie as the institution that enables many Americans to buy a home has been launched.
One of the most destructive side effects of the GSE explosion has been their role in the housing bubble. As the buyer of first and last resort of residential mortgages, they enabled banks to recycle their capital into new mortgages. The risk that piles up on Fannie’s balance sheet difficult to quantify, but could become a huge liability when the credit expansion reaches its inherent limits. Their mortgage-backed securities have been a favorite asset class of foreign institutions and central banks in their accumulation of US$-denominated debt. By funneling domestic and foreign credit into residential real estate, they have created a variant of the mal-investment that Mises first identified in his business cycle theory. Mises noted that the extension of bank credit to producers would result in a form of mal-investment from the creationg of more higher order capital goods than could be afforded given the amout of available savings. The GSEs enable credit expansion to fund the construction of residential real estate, while the socialization of risk defeats the markets’ mechanism for containing credit which would occur naturally if private parties were required to bear the risk. The result is an over-consumption of housing, a mal-investment in home building and mortage-brokering, and the creation of the liability associated with the interest-rate and default risk of the mortgage credit.
Is OFHEO really a regulatory agency? Regulatory agencies create and enforce rules that the private sector must follow. The Fannie flap, then, is really a brawl between multiple government agencies: Fannie, OFHEO, and the SEC. Can the government really regulate itself? Raines has been chosen to fall on his sword, taking semi-retirement with a multi-tens-of million dollar pension as his show of contrition and acceptance of responsibility. In the end, will anything change as a result of the accounting scandal? Undoubtedly, a new CEO with impeccable bean-counting credentials will be put in place to clean up the political mess. Likely, they will not have Raines personal charisma, his Washington connections, or his ability to lobby congress.
I am confident that Greenspan understands the importance of extending the housing bubble to avert the liquidation of the mal-investments that remain from the stock market bubble that he created. Putting Fannie Mae on a tighter leash would inhibit its ability to further inflate US residential real estate. But competition between government agencies is not entirely planned. Perhaps Fannie now is under enough scrutiny and the political capital generated by going after another fat-cat CEO will have unintended consequences of its own. There has been increased talk of “privatization” of these entities, but like the “privatization” schemes proposed for Social Security, the biggest hurdle would be unwinding the current liabilities. What private entities would take on Fannie’s balance sheet without the Fed guarantee? Risk has been significantly under-priced throughout the financial sector, but no where more so than in the GSEs. An accurate pricing of risk would surely show these firms to have a negative net worth. Who will pick up the difference?
