The most sensational possible motive in last week's scathing regulator's report on mortgage giant Fannie Mae was that for years, managers manipulated earnings reports to reach financial targets so as to receive significant bonuses. Yet this is far from the most important aspect of the report by the Office of Housing Finance Enterprise Oversight (Ohfeo). Rather, the "smoothing" of earnings should be viewed as the latest powerful reason why federally chartered but privately owned Fannie Mae, with a trillion dollars in assets, is not the riskless public service entity it represents itself to be. Furthermore, it will do whatever is necessary to ensure the survival of a politically based business model which benefits its shareholders and management more than the public in whose name it was first chartered.
* * *
In any discussion of Fannie Mae, one must keep foremost in mind that its management and investors have got a very good thing going. The market's perception is that Fannie is simply too big for the Treasury Department to allow it to default on the debt it has accrued in buying mortgages; this makes it possible for Fannie to borrow at significantly below-market rates of interest. Its low cost of capital, combined with other privileges accruing from its status as a "government-sponsored enterprise" (GSE) -- including a line of credit from the Treasury and exemption from state and local taxes -- have allowed Fannie (and Freddie) to dominate the broad middle of the housing market (set by rule at mortgages below $333,000) -- operating in effect as a mortgage finance duopoly.
The two together are involved in some $4 trillion worth of home mortgages, comprising three-fourths of the U.S. total. The Fed has estimated that more than half the market value of the firms is the result of what Alan Greenspan calls their "implicit subsidy." That might not be a problem -- except that a December Fed study found that Fannie and Freddie bring down mortgage interest rates by a negligible (seven basis points) amount. As Mr. Greenspan, much concerned about the risk they might pose to the entire financial system, has put it: "A substantial portion of the GSE's implicit subsidy accrues to shareholders in the form of increased dividends and stock market value."
Given all that, it is not surprising that Fannie would be substantially in the business of managing its political risk -- working hard to keep its good thing going. The smoothing of earnings, whether through targeted deployment of cash reserves or the use of non-standard accounting techniques, would fall squarely in this category. As with any firm, stable earnings over time reassure the market. In Fannie's case, if the price-to-earnings ratio holds steady even as interest rates change and potentially roil the mortgage market, investors are especially reassured.
Even more important, steady earnings and a calm market reassure Capitol Hill -- and deter any changes in the rules which allow Fannie to grow ever larger by making private competition essentially impossible, further enriching management and investors. The overriding goal of what Ohfeo refers to as an identifiable Fannie Mae culture is, in the words of a former GSE staff economist, "to protect the franchise value by protecting the special status."
One must put all this in context. Earnings smoothing, if indeed proved, would hardly be the only step Fannie takes to manage political risk. It is legendary in DC for its bipartisan legions of lobbyists. It advertises heavily to the public -- on air and in print, on NBA games and in policy magazines -- despite the fact that it is not a retail organization. (All the mortgages it holds are purchased from banks or mortgage companies.)
Its Fannie Mae Foundation engages in an extensive grant-making program, much of it directed to non-profit developers of subsidized housing. It has made grants to 12,000 organizations totaling $347 million -- and no state has gone without. This is corporate responsibility in the eyes of some but, arguably, just another way of protecting the franchise. The particularly pernicious part of such grants is Fannie's promotion of the view that community organizing and "affordable" (read subsidized) housing development are the preferred ways to help low-income neighborhoods, an arguable proposition at best.
Such grants must also be seen as a part of its ongoing PR and political management effort to show that it's doing enough to help low- and moderate-income homeowners -- as if it were a public program rather than a private corporation -- and to hold off political demands that it meet higher and higher "affordable housing goals" mandated by the Department of Housing and Urban Development. The Clinton administration ramped up such goals, which complicate the GSE's business and thus raise its costs. But even the Bush administration, as part of its "ownership society" focus, has proposed to raise them from 50% of all GSE loans to 57%, with 40% targeted to so-called "under-served areas."
The risk here, of course, is that the credit spigot will have to be opened to the marginally creditworthy, a threat both to the GSE's finances and to low-income neighborhoods, should they be hit by delinquencies and foreclosures. Or, as the National Association of Realtors has put it, the proposed rules "may cause the GSE's to take actions that will distort mortgage markets, with negative results." Such are the things that can happen when what should be a low-profile and competitive market process -- the purchase of mortgages and their packaging as securities -- becomes part of the political process instead.
When what was the Federal National Mortgage Association was chartered in 1938, it may well have made sense for the federal government -- in a much poorer country without a tradition of long-term mortgages -- to inject capital into the housing finance market. But that day is long past. After all, it was Wall Street (Salomon Brothers) that invented the mortgage-backed security which has become central to Fannie Mae's business -- and has drawn billions into housing markets. It was the private sector (Fair Isaac Corporation) which came up with credit-scoring, also crucial for Fannie, and which has allowed more precise evaluations of mortgage risk, opening the door to the sub-prime lending which has helped extend home-ownership to those with checkered credit histories.
In other words, were Fannie and Freddie either to be scaled back or fully privatized, there is every reason to believe that the cause of homeownership would still be well-served. As Mr. Greenspan has said, "our financial system would be more robust if we relied on a market-based system that spreads interest rate risks, rather than on the current system, which concentrates such risk with the GSEs."
Still, the good news is that the critique of Fannie's accounting, hard on the heels of a similar scandal at Freddie, may at last lead to change. Congressional calls for stronger regulation -- including higher capital reserve requirements meant to stave off financial meltdown -- are likely to gain traction. Fannie may not be able to fend off the higher affordable housing goals, which may well have the unintended effect of limiting the slice of the market on which Fannie and Freddie can focus; and this could even motivate them to give up their special status and simply go private of their own volition.
There is a precedent. Sallie Mae, the student loan financing firm which was a GSE chartered as the Student Loan Marketing Association, has successfully gone through privatization -- started in 1997 at its own request and soon to be complete, including a financial mechanism through which the firm has compensated the public for the value of the taxpayer subsidy it inherited.
Today's housing market bears little resemblance to that of the Depression, when Fannie Mae was first chartered -- or even 1968, when it nominally ceased to be a government agency and became shareholder-owned. The fact that it must apparently go to questionable lengths to manage both markets and politicians shows that the time for deeper change has arrived.