It was the Dem's on the Housing & Banking Committee
The Enron Scandal Uncovered it All
Fannie Mae’s success reaching amazing housing goals began to come under scrutiny in 2002, in the wake of accounting scandals at Enron and Fannie’s GSE cousin, Freddie Mac. Enron had filed for bankruptcy late in 2001, after regulators proved management used illegal accounting to spice reported earnings. Freddie Mac and Enron had the same auditor. When it was found that Enron’s auditor was complicit, there was significant concern about Freddie who had a close relationship with that auditor since 1970. Freddie had to change auditors in February 2002. The new one, PriceWaterhouseCoopers, took as its first task a major scrubbing of Freddie’s books.
PriceWaterhouse quickly found that Freddie used improper hedge accounting with regard to Treasuries. The rules governing this process are rather straight forward, so Freddie’s violations stuck out like a sore thumb.
Freddie’s management reported unaudited record earnings for the 2002 fiscal year, putting PriceWaterhouse in a make or break position of either certifying that report, or invalidating it and issuing its own. In 2002, it was highly suspect for any major mortgage house to post record earnings. Interest rates had moved sharply lower. By all rights and reason, the move should have negatively affected GSE’s earnings, since the companies that buy mortgages lose money when they are forced to reinvest the proceeds of mortgage interest payments at lower rates. When Freddie and Fannie kept posting higher earnings that just met management compensation incentive targets, Wall Street investors became skeptical. Short positions — which involve “selling” stock and then “buying” it back later, hopefully at a lower price — in Fannie Mae began to rise sharply. When Republican Senator Chuck Hagel (R-NE) asked for details on how many losses Fannie accounted for in the negative interest rate environment, the company said the information was “confidential and proprietary.”
By then, auditors were deep into another Freddie accounting scandal. Management had improperly failed to recognize declines in value on a meaningful portion of the $260 billion in mortgages it owned. Through its accounting methods, management was squeezing optimal earnings out of the machine, but illegally glossing over Freddie’s true financial position…health…in other words, it was juicing the income statement by bastardizing the balance sheet.
The Freddie Mac Scandal Caused Democrats to Circle the Wagons
By June 2003, the Freddie accounting investigation had forced management to admit to having misstated $5 billion of earnings. Of course, many analysts and investors began to look very closely at Fannie’s accounting.
Republicans moved swiftly to enact a stronger GSE regulatory framework… Democrats dug trenches and defended. Please recall – if investors become more skeptical about Fannie’s health, they would not purchase as many of Fannie’s repackaged mortgage securities, at least not at market-low interest rates. That situation would reduce Fannie’s ability to buy mortgages, particularly in the risky subprime market. This was something Democrats wanted to avoid, at severe cost if necessary. One way to counter the increased risk perception was to directly state that, while the government does not guarantee Fannie’s individual securitized mortgage issues, the federal government would, in fact, step in to bail Fannie out if it got into serious financial trouble. During a Congressional hearing, Barney Frank (D-MA) stated, “I think we see entities that are fundamentally sound financially and withstand some of the disastrous scenarios. And even if there were a problem, the federal government doesn’t bail them out.”
Republicans Move Swiftly and Strongly
In the wake of the Enron scandal, President Bush put his Chief of Staff, Andrew Card, in charge of a team to investigate potential GSE mortgage market problems. Mr. Card led a joint White House – Treasury Department team that recommended the President not reappoint any directors to either GSE board; that Fannie’s accounting methods needed to be thoroughly scrutinized, and that GSEs needed much stronger regulatory oversight. HUD Secretary, Mel Martinez, got Fannie Mae to raise the downpayment requirement on newly constructed houses from only 3% to 10% — if a house was appraised at $500,000, the builder would have to commit $50,000 to the project instead of just $15,000.
On September 11, 2003, President Bush sent Congress a sweeping GSE regulation proposal; the first of what U.S. News & World Report counted was 17 times President Bush would call on Congress to regulate GSEs. The proposed regulations would have averted the worst national crisis since, well, 9-11…had they been inacted. Let’s let the New York Times tell the story, as it reported the day of the White House proposal:
“The Bush administration today recommended the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis a decade ago. Under the plan, disclosed at a Congressional hearing today, a new agency would be created within the Treasury Department to assume supervision of Fannie Mae and Freddie Mac, the government-sponsored companies that are the two largest players in the mortgage lending industry. The new agency would have the authority, which now rests with Congress, to set one of the two capital-reserve requirements for the companies. It would exercise authority over any new lines of business. And it would determine whether the two are adequately managing the risks of their ballooning portfolios. The plan is an acknowledgment by the administration that oversight of Fannie Mae and Freddie Mac — which together have issued more than $1.5 trillion in outstanding debt — is broken.”
The new lines of business aspect had a backstory. From the beginning of the Clinton CRA changes through 1998, Fannie’s assistant director for product initiatives was Herb Moses, who was — in their words — “spouse” with Barney Frank (D-MA), the Democrats’ ranking member on the House Financial Services Committee, which oversaw GSEs.
The War Over Housing Market Regulation Goes Full Tilt
The Bush proposal generated bills in the House and Senate. According to the Congressional Research Service, each bill would have replaced the weak GSE regulator with one that was independent of Congressional political pressures and independently responsible for GSE “safety, soundness, and mission regulation.” If the new regulator determined that Fannie or Freddie was in financial distress, it could put them into receivership, limiting their activities until safety and soundness could be regained.
Receivership was a key provision, because it would be a strong step towards separating GSE liabilities from the US federal government — and telling the financial markets that the federal government not bail Fannie Mae out if it took met financial difficulties due to taking on inordinate risk. If Fannie essentially went bankrupt, it was strongly implied – even stated outright by Democrats during 2003 Congressional hearings – that the US federal government would back Fannie. The receivership would eliminate politicians’ ability to “dance the Potomac two-step” on the issue…publicly stating the government does not guarantee Fannie’s individual securitized mortgages, while also stating the government stands behind Fannie in the event that Fannie runs into serious financial trouble. In absence of government backing, Fannie would have to act more like an independent company in charge of its own risk profile. Any investor doing business with Fannie Mae would therefore have to do the same. Receivership would be akin to bankruptcy reorganization, in which investors were often not paid what they put in.
In August 2003, Barney Frank (D-MA) — ranking Democrat on the House Financial Services Committee and the person who generaled the Democrat strategy with regard to GSE regulation — argued strongly to make it easier for people/speculators to get new house construction loans while putting less money up as collateral. In a mid-August letter to Fannie Mae, Mr. Frank urged Fannie to withdraw the underwriting guidelines that the Bush Administration had successfully gotten Fannie to strengthen (raising the principal/collateral commitment from 3% to 10%). He wrote, the Bush-inspired “changes could make manufactured housing too expensive for many Americans.” Mr. Frank was successful; Fannie announced in February 2004, it would lower the capital requirement from 10% to 5%… the move became effective December 1, 2004, two weeks before the SEC released a scathing report on Fannie’s improper accounting. Easy money on new house constructions turned out to be one of the prime causes of the housing overexpansion that helped define the bubble.
The Enron Scandal Uncovered it All
Fannie Mae’s success reaching amazing housing goals began to come under scrutiny in 2002, in the wake of accounting scandals at Enron and Fannie’s GSE cousin, Freddie Mac. Enron had filed for bankruptcy late in 2001, after regulators proved management used illegal accounting to spice reported earnings. Freddie Mac and Enron had the same auditor. When it was found that Enron’s auditor was complicit, there was significant concern about Freddie who had a close relationship with that auditor since 1970. Freddie had to change auditors in February 2002. The new one, PriceWaterhouseCoopers, took as its first task a major scrubbing of Freddie’s books.
PriceWaterhouse quickly found that Freddie used improper hedge accounting with regard to Treasuries. The rules governing this process are rather straight forward, so Freddie’s violations stuck out like a sore thumb.
Freddie’s management reported unaudited record earnings for the 2002 fiscal year, putting PriceWaterhouse in a make or break position of either certifying that report, or invalidating it and issuing its own. In 2002, it was highly suspect for any major mortgage house to post record earnings. Interest rates had moved sharply lower. By all rights and reason, the move should have negatively affected GSE’s earnings, since the companies that buy mortgages lose money when they are forced to reinvest the proceeds of mortgage interest payments at lower rates. When Freddie and Fannie kept posting higher earnings that just met management compensation incentive targets, Wall Street investors became skeptical. Short positions — which involve “selling” stock and then “buying” it back later, hopefully at a lower price — in Fannie Mae began to rise sharply. When Republican Senator Chuck Hagel (R-NE) asked for details on how many losses Fannie accounted for in the negative interest rate environment, the company said the information was “confidential and proprietary.”
By then, auditors were deep into another Freddie accounting scandal. Management had improperly failed to recognize declines in value on a meaningful portion of the $260 billion in mortgages it owned. Through its accounting methods, management was squeezing optimal earnings out of the machine, but illegally glossing over Freddie’s true financial position…health…in other words, it was juicing the income statement by bastardizing the balance sheet.
The Freddie Mac Scandal Caused Democrats to Circle the Wagons
By June 2003, the Freddie accounting investigation had forced management to admit to having misstated $5 billion of earnings. Of course, many analysts and investors began to look very closely at Fannie’s accounting.
Republicans moved swiftly to enact a stronger GSE regulatory framework… Democrats dug trenches and defended. Please recall – if investors become more skeptical about Fannie’s health, they would not purchase as many of Fannie’s repackaged mortgage securities, at least not at market-low interest rates. That situation would reduce Fannie’s ability to buy mortgages, particularly in the risky subprime market. This was something Democrats wanted to avoid, at severe cost if necessary. One way to counter the increased risk perception was to directly state that, while the government does not guarantee Fannie’s individual securitized mortgage issues, the federal government would, in fact, step in to bail Fannie out if it got into serious financial trouble. During a Congressional hearing, Barney Frank (D-MA) stated, “I think we see entities that are fundamentally sound financially and withstand some of the disastrous scenarios. And even if there were a problem, the federal government doesn’t bail them out.”
Republicans Move Swiftly and Strongly
In the wake of the Enron scandal, President Bush put his Chief of Staff, Andrew Card, in charge of a team to investigate potential GSE mortgage market problems. Mr. Card led a joint White House – Treasury Department team that recommended the President not reappoint any directors to either GSE board; that Fannie’s accounting methods needed to be thoroughly scrutinized, and that GSEs needed much stronger regulatory oversight. HUD Secretary, Mel Martinez, got Fannie Mae to raise the downpayment requirement on newly constructed houses from only 3% to 10% — if a house was appraised at $500,000, the builder would have to commit $50,000 to the project instead of just $15,000.
On September 11, 2003, President Bush sent Congress a sweeping GSE regulation proposal; the first of what U.S. News & World Report counted was 17 times President Bush would call on Congress to regulate GSEs. The proposed regulations would have averted the worst national crisis since, well, 9-11…had they been inacted. Let’s let the New York Times tell the story, as it reported the day of the White House proposal:
“The Bush administration today recommended the most significant regulatory overhaul in the housing finance industry since the savings and loan crisis a decade ago. Under the plan, disclosed at a Congressional hearing today, a new agency would be created within the Treasury Department to assume supervision of Fannie Mae and Freddie Mac, the government-sponsored companies that are the two largest players in the mortgage lending industry. The new agency would have the authority, which now rests with Congress, to set one of the two capital-reserve requirements for the companies. It would exercise authority over any new lines of business. And it would determine whether the two are adequately managing the risks of their ballooning portfolios. The plan is an acknowledgment by the administration that oversight of Fannie Mae and Freddie Mac — which together have issued more than $1.5 trillion in outstanding debt — is broken.”
The new lines of business aspect had a backstory. From the beginning of the Clinton CRA changes through 1998, Fannie’s assistant director for product initiatives was Herb Moses, who was — in their words — “spouse” with Barney Frank (D-MA), the Democrats’ ranking member on the House Financial Services Committee, which oversaw GSEs.
The War Over Housing Market Regulation Goes Full Tilt
The Bush proposal generated bills in the House and Senate. According to the Congressional Research Service, each bill would have replaced the weak GSE regulator with one that was independent of Congressional political pressures and independently responsible for GSE “safety, soundness, and mission regulation.” If the new regulator determined that Fannie or Freddie was in financial distress, it could put them into receivership, limiting their activities until safety and soundness could be regained.
Receivership was a key provision, because it would be a strong step towards separating GSE liabilities from the US federal government — and telling the financial markets that the federal government not bail Fannie Mae out if it took met financial difficulties due to taking on inordinate risk. If Fannie essentially went bankrupt, it was strongly implied – even stated outright by Democrats during 2003 Congressional hearings – that the US federal government would back Fannie. The receivership would eliminate politicians’ ability to “dance the Potomac two-step” on the issue…publicly stating the government does not guarantee Fannie’s individual securitized mortgages, while also stating the government stands behind Fannie in the event that Fannie runs into serious financial trouble. In absence of government backing, Fannie would have to act more like an independent company in charge of its own risk profile. Any investor doing business with Fannie Mae would therefore have to do the same. Receivership would be akin to bankruptcy reorganization, in which investors were often not paid what they put in.
In August 2003, Barney Frank (D-MA) — ranking Democrat on the House Financial Services Committee and the person who generaled the Democrat strategy with regard to GSE regulation — argued strongly to make it easier for people/speculators to get new house construction loans while putting less money up as collateral. In a mid-August letter to Fannie Mae, Mr. Frank urged Fannie to withdraw the underwriting guidelines that the Bush Administration had successfully gotten Fannie to strengthen (raising the principal/collateral commitment from 3% to 10%). He wrote, the Bush-inspired “changes could make manufactured housing too expensive for many Americans.” Mr. Frank was successful; Fannie announced in February 2004, it would lower the capital requirement from 10% to 5%… the move became effective December 1, 2004, two weeks before the SEC released a scathing report on Fannie’s improper accounting. Easy money on new house constructions turned out to be one of the prime causes of the housing overexpansion that helped define the bubble.
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