Fannie Mae, the federally chartered company that buys home mortgages and sells them as securites, is receiving a highly public fanny-kicking. After accounting issues arose last summer at Fannie's smaller and younger sibling, Freddie Mac, the Office of Federal Housing Enterprise Oversight began to examine Fannie Mae's accounting practices. The result of the probe, detailed in a 211-page report issued last week, paints Fannie Mae as an Enron-in-the-making. At the company that prides itself on being a cuddly enabler of the American dream, OFHEO unearthed a "pervasive" misapplication of accounting standards, poor internal controls, and—the most headline-worthy charge—a pay structure that rewarded executives for meeting earnings goals, which encouraged executives to manipulate earnings to hit the number.
In contentious hearings yesterday before the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, Fannie Mae CEO Franklin Raines and other executives, who denied wrongdoing, were raked over the coals. (Click here to read an "Assessment" of Raines.)
The current disputes are couched in the language of financial arcana—accounting standards and the tricky task of valuing derivatives. But at root, Fannie's troubles concern psychology more than bookkeeping.
Fannie Mae, created by a congressional charter granted in 1938, has been able to grow into the nation's fourth-largest company (by assets) thanks to a grand bargain in which everybody—executives, investors, politicians, regulators—ignores published rules and instead agrees to follow a set of unstated, unsupported, unjustified beliefs. Indeed, the most significant sector of the U.S. economy—the housing market—can only operate because of a vast sequence of winks and nods surrounding Fannie Mae's status. It's a case study of what the Romantic poet Samuel Taylor Coleridge dubbed "the willing suspension of disbelief."
Fannie Mae's business is at once simple and remarkably complex. It buys mortgages, then either holds onto them or packages them into sale as bonds to investors. It also buys and sells the mortgage-backed securities it produces—and derivatives based on them—as part of an effort to hedge its risks. As the market for securitized mortgages developed, it has grown into the largest financing source for home mortgages.
But the whole arrangement—which benefits executives, mortgage bankers, politicians, and homeowners—relies on sophisticated people convincing themselves and others that things are not necessarily what they seem.
Mortgage lending is inherently risky and volatile. People who make (or buy) mortgages assume the risk that people won't pay them back. They also assume the risk that borrowers will pay them back too soon. If you amass a gigantic portfolio of any interest-bearing products—government bonds, mortgages, credit card receivables—its value will shift every day as interest rates shift and consumer behavior changes.
But Fannie Mae has convinced itself that massive exposure to interest-rate volatility can be a low-risk business. It has propounded the notion that a giant financial company, through efficient hedging, can produce earnings that are as smooth and predictable as those reported by General Electric in Jack Welch's heyday. The people who owned Fannie's stock—worth $74 billion just two weeks ago—explicitly bought into this belief.
The desire to have earnings conform to some pre-existing plan is a recipe for trouble at a large corporation. One of the most damning segments of the OFHEO report (see Pages 7-12) discusses how, in order to be perceived as low risk, Fannie felt it had to present regular earnings growth. The meeting of earnings goals was so crucial that bonuses for top executives were pegged to them. In 1998, bonuses were based on hitting targets: earnings of $3.13 a share for the minimum bonus, $3.18 for the target bonus, and $3.23 or above for the maximum bonus. "Remarkably the 1998 EPS number turned out to be $3.2309," OFHEO deadpans. In order to meet the target, OFHEO suggests, Fannie Mae may have improperly deferred some $200 million in expenses.
The larger suspension of disbelief is expressed by the people who buy, own, and trade the $1.37 trillion in securities issued by Fannie Mae. At every possible turn, the government and Fannie Mae executives take pains to note that the government does not in any way, shape, or form, guarantee the debt Fannie Mae issues to the public.
To which bond investors and traders, a bunch of guys not known for blind faith, say: Riiiight.
Investors permit interest rates from Fannie Mae to be lower than those they demand from, say, Citigroup, and only a bit higher than those they demand from Uncle Sam. In general, the academic consensus holds that Fannie Mae enjoys a 40-basis-point advantage on borrowing over private-sector borrowers. (If Mortgage Lender X borrows at 6 percent, Fannie Mae borrows at 5.6 percent.)
In other words, investors plainly think there is some implicit government guarantee of Fannie's debt. Not a total guarantee, but a pretty substantial one. If things went seriously amiss at Fannie Mae, they believe, the government would somehow step in. Meanwhile, there's plenty of evidence to suggest that Fannie Mae enjoys most-favored-company status. The president appoints five of the company's 18 directors. Fannie Mae doesn't have to register its mortgage-backed securities with the Securities and Exchange Commission. It has its own regulator, OFHEO. It doesn't pay state and local taxes and is subject to lower capital requirements than banks. Everybody knows that Fannie Mae is too big and too important to fail, and that the government and Congress have a huge stake in Fannie Mae's success.
Fannie Mae is taking a beating on the Hill and in the marketplace of public opinion. The stock is down, and the stock of CEO Raines is down even more. (One of the undiscussed subtexts here is that Fannie Mae, an equal opportunity political donor, has become something of a holding pen for key Democrats.) But while there may be calls to privatize the company or revoke some of its privileges, the smart money is betting no significant changes are in the offing.
If mortgage-backed securities traders and investors really feared that Fannie's special status was threatened, prices would shift, and the rates on its debt would be rising. But after some unease last week, the spreads between government debt and Fannie Mae's debt have returned to their levels of two weeks ago. Investors are still suspending their disbelief.