Of all the companies bailed out by the federal government, mortgage
finance giants Fannie Mae and Freddie Mac are shaping up as the deepest
money pits. A close look at their past and recent financial filings
shows why their losses continue to mount.
Fannie and Freddie effectively became wards of the government in
2008. The Obama administration had promised to reveal its plans for the
agencies last month, but Washington's focus on reforming the banking
system pushed them to the bottom of the to-do list. Fannie and Freddie aren't mentioned in either the Senate or House financial regulatory reform bills.
Treasury Secretary Timothy Geithner may reveal some of the
administration's ideas on Tuesday when he testifies before Congress
about Fannie and Freddie. But in general, the companies' troubles have
drawn less attention than the rest of the financial industry. For
example, unlike bonus announcements made on Wall Street, Fannie and
Freddie's recent disclosures of about $40 million in executive
compensation and bonuses for 2009 caused little stir on Main Street.
Together the two firms have already tapped $125 billion from
government lifelines and the Congressional Budget Office predicts they
ultimately will drain $380 billion. That would far exceed the final
tabs for rescuing the big banks, the automakers or even insurance
behemoth American International Group (AIG).
"These calls on taxpayer funds are troubling to all of us," Edward
J. DeMarco, acting director of the Federal Housing Finance Agency, said
in a letter to congressional leaders last month.
DeMarco's predecessor at the housing finance agency, Fannie and
Freddie's regulator, has acknowledged that taxpayers are unlikely to
ever see a full return on their investment.
Why are the two companies in such dire shape, when many large banks
have been able to turn a profit even as they take huge losses from
their real estate investments?
Fannie and Freddie's losses largely stem from internal decisions
made in 2006 and 2007 that sent the companies on a shopping spree for
dubious mortgages, according to regulatory filings, congressional
testimony and interviews with economists and former Fannie Mae
employees. Fannie and Freddie uncharacteristically collected more than
$1 trillion in subprime and other risky mortgages---many of which were
branded "alternative," or alt-a, because they did not meet the rules
set by Fannie and Freddie.
"It's ironic because the original definition of alt-a mortgages was
that it didn't meet Fannie and Freddie's underwriting standards," said
Thomas Lawler, a former senior vice president of Fannie Mae who left in
2006 to start a consulting business. "A disturbingly high share of
losses were incurred from loans acquired during those dog years."
Chasing Market Share
Fannie's and Freddie's ill-fated decision to hop on the risky
mortgage bandwagon was inevitable given their inherently contradictory
missions, housing specialists said in interviews.
For 40 years, they functioned as publicly traded companies
controlled by shareholders who demand profits. But they also operate
under a congressional charter, as government-sponsored enterprises
(GSEs), to keep credit flowing in minority and low-income communities.
The charter also carried an implicit guarantee that if the companies
got into trouble, the taxpayer would bail them out.
To follow their mandates, the companies developed two key lines of
business. One is to buy mortgages from lenders, which can then use the
money to offer new loans to consumers. Fannie and Freddie bundle the
loans, guarantee them against default and sell them as securities to
investors such as pension funds. The second line of business is
management of their own investment portfolios.
Although both sides of the business helped bring the companies down,
last year's losses stemmed largely from the loans they bought and
guaranteed in 2006 and 2007. Before 2006, the companies dominated the
residential mortgage market, owning or guaranteeing more than half of
new mortgages. But after initially resisting the subprime boom, they
began losing their control to Wall Street banks. Fannie and Freddie's
market share plummeted to 37 percent in 2006.
They decided to rev up their buying and guaranteeing of risky
mortgages. This decision restored their market share but also helped
destroy the companies.
The riskiness of the 2006 and 2007 loans handled by Fannie and
Freddie can be read in the details of their financial filings. Compared
to earlier years, the borrowers had lower credit scores yet higher
outstanding balances on their mortgages. Both companies became
especially fond of the alt-a mortgage. Fannie acquired $135 billion in
alt-a mortgages that were originated in 2006 and 2007 alone, more than
twice the total in all years before 2005. Ultimately, alt-a loans
caused about 40 percent of Fannie's credit losses last year.
Ironically, the alt-a name is short for "alternative to agency,"
meaning that they were the type of loans that Fannie and Freddie
historically refused to buy or guarantee. People who secure alt-a
mortgages typically have good credit scores but do not identify their
incomes or net worth. Such mortgages are prone to default though
technically are not subprime, which allowed Fannie and Freddie to
rationalize their purchases.
It's still unclear exactly what drove Fannie and Freddie to
prioritize market share over safety. To be sure, the shift came partly
in response to a series of federal rules crafted
during the Clinton and Bush administrations. The rules, adopted by the
Department of Housing and Urban Development, required the companies to
promote affordable housing in low-income and minority communities.
But the companies often failed to meet their housing goals between
2005 and 2008, "and without any significant repercussions from their
regulators," Dwight Jaffee, a professor at the University of California
Berkley's Haas School of Business, said in testimony last month before
the Financial Crisis Inquiry Commission.
Fannie and Freddie's drop in standards, Jaffee said, more likely
came from a desire to please shareholders. After Fannie got more
aggressive in 2007, their stockholders' equity increased six percent to
"The bottom line is that GSE managers long understood that they and
their shareholders would benefit from risk-taking as long as the higher
risks created higher expected returns," Jaffe said.
When alt-a and other risky mortgages entered foreclosure in huge
numbers in 2007, Fannie and Freddie were on the hook for many of these
loans, which they had sold to investors with a guarantee against
default. But the companies lacked sufficient funds to cover their
The Bush administration rescued the companies with the promise of
big government lifelines. The Treasury Department also purchased an 80
percent ownership stake in Fannie and Freddie, which promptly entered
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Fannie and Freddie agreed to pay the government a 10 percent
dividend each year on funds they draw from their lifeline. So far the
companies have paid $6.8 billion to the Treasury Department, even as
they continue to take in tens of billions of dollars from Treasury. In
essence they are paying Treasury's dividends with money from Treasury,
the companies disclosed in regulatory filings last year.
Aside from the bailout, the Federal Reserve has purchased about $1.2
trillion of Fannie and Freddie mortgage securities and corporate bonds.
The Treasury Department also has bought about $220 billion of the
companies' mortgage securities.
In total, Fannie and Freddie have received direct and indirect federal support worth more than $1.5 trillion.
Yet the companies' financial health has not been improving. At
first, the companies were each entitled to a $100 billion government
lifeline. The Obama administration later raised the limit to $200
Then on Christmas Eve, the administration quietly lifted the cap
altogether, effectively giving the companies a blank check. It was one
of several controversial Fannie and Freddie-related announcements made
on the holiday. After Dec. 31, the decisions would have required
Some of the announcements were expected. For example, Fannie said it
would need another $15 billion from taxpayers to stay afloat. Freddie
hasn't asked for more money since last May, but indicated that it will
in "future periods."
Amidst these statements was an even more controversial disclosure:
The Treasury Department approved about $42 million in combined cash
compensation and bonuses for Fannie and Freddie's top executives.
The payouts drew the ire of some lawmakers.
"We are paying these people bonuses to lose tens of billions of
dollars," Rep. Jeb Hensarling (R-Texas) said at a House Financial
Services Committee hearing in January. "What people do with their money
is their business. What they do with the taxpayer money is our
Awarding compensation in cash also contradicts the Obama
administration's demands that bank executives pay their employees in
stock. The administration notes that Fannie and Freddie's
conservatorship agreement prohibits stock-based compensation. The
companies' cash payments, the administration said, will be deferred so
they will resemble a stock salary. Fannie and Freddie's total
compensation, on average, dropped 40 percent in 2009, according to a
statement released by the federal housing agency.
Still, Fannie and Freddie's chief executives will each make more
than $6 million for their 2009 performance, including a roughly $2.5
million bonus. Lloyd Blankfein, the chief executive of mega bank
Goldman Sachs, received a $9 million bonus last year, all in stock. His
company turned a record $13.4 billion profit last year.
The latest in a series of Congressional attempts
to tax bonuses awarded at bailed out companies targeted Fannie and
Freddie's executive compensation. Like its predecessors, the bill has
gone nowhere amidst met fierce opposition in the Senate.
Freddie still has not disclosed its final compensation plan so its
exact salaries are unknown. None of Freddie's current executives were
at the company during the bad years.
But Fannie's chief executive, Michael Williams, served as the
company's chief operating officer from 2005 to 2009. The housing agency
says that Williams, who will earn $6.6 million for 2009, did not run or
oversee the purchasing of mortgages. He also has taken a pay cut since
DeMarco, head of the housing agency, defended the payments in recent congressional testimony.
"These new structures are designed to align with taxpayer
interests," he told the House financial committee last month. "In my
judgment, we have achieved the right balance between enough
compensation to acquire and retain quality management, while preventing
compensation from exceeding appropriate bounds."
While a reform plan for Fannie and Freddie takes a back seat to
other government concerns the administration is using the companies to
stabilize the housing market, keep credit flowing during tough times
and direct its seminal foreclosure rescue initiative. By the end of
2009, Fannie and Freddie have approved more than 40,000 permanent
mortgage modifications that lowered interest rates. These actions have
drained the companies of precious income.
Restructuring the companies thus poses a dilemma for Washington that
so far has proven too thorny to tackle: How to protect taxpayers from
Fannie and Freddie's losses while using the companies to protect
homeowners from foreclosure.
Some housing experts want to privatize Fannie and Freddie once the
economy settles, forcing the government out of the housing finance
business altogether. Others suggest turning them into a public utility,
like an electric company. More likely, the government will simply
return the companies to their pre-bailout status as public-private
entities, said Peter Wallison, who follows housing finance for the
American Enterprise Institute, a conservative think-tank.
"There aren't any real good answers," said Wallison, though he added
that he favors the privatization path because it minimizes the
likelihood of future bailouts.
This debate will take center stage Tuesday as the House Financial
Services Committee holds a hearing on the future of the companies.
Geithner has said that his testimony will offer "broad objectives and
principles" for remaking the companies.
In anticipation of the hearing, House Republicans floated a plan last week to phase out the companies over the next few years.
At a hearing in January, Rep. Barney Frank (D-Mass.), chairman of
the House committee and a long-time Fannie and Freddie ally, proposed
eliminating the companies and starting from scratch. "I believe this
committee will be recommending abolishing Fannie Mae and Freddie Mac in
their current form," Frank said, "and coming up with a whole new system
of housing finance."