Finance tip mortgage

Byline: John Berlau, INSIGHT

It was reported as another chapter in the saga of great corporate scandals. Highly paid executives allegedly enriching themselves by using questionable accounting tactics involving complex financial instruments called derivatives. Possible criminal probes were announced as the board of Freddie Mac forced out its three top executives, claiming they had obstructed a probe into the company's accounting. But a growing number of critics say this is more than a typical corporate scandal: It is a government-policy scandal for which taxpayers could be left holding the bag. And many are wondering if the controversy over accounting issues at Freddie Mac will spill over to its big sister, Fannie Mae.

Fannie Mae and Freddie Mac are "government-sponsored enterprises" (GSEs) created by Congress with special advantages that include exemptions from certain laws and taxes. Each also has a $2.25 billion line of credit with the Treasury Department. The stated purpose, when Fannie Mae was created as the Federal National Mortgage Association in the 1930s and Freddie Mac as the Federal Home Mortgage Corp., was to create financing to put more Americans in their own homes by having the two entities buy mortgages from banks.

Even though no evidence yet has surfaced of similar alleged malfeasance by executives at Fannie Mae which carries almost twice the debt of Freddie Mac critics worry openly about it. "There's systemic risk and there's no oversight," says former congressman J.C. Watts (R-Okla.), who now is chairman of FM Policy Focus, a coalition of private financial institutions that is critical of some of the GSEs' current lending practices. Watts tells Insight, "It makes no difference whether [Freddie Mac's] announcement is the complete story or the tip of the iceberg, taxpayers and policymakers need to know more than Freddie and Fannie have had to reveal, and the existing regulatory framework for the GSEs is deeply flawed. I think this has to be changed to protect taxpayers, investors and the marketplace from more surprises."

Peter Wallison, Treasury Department general counsel in the Reagan administration who now is a resident fellow at the American Enterprise Institute, tells Insight, "Right now, I don't think the risk is very high" for the companies to fail. But he adds, "We didn't think Enron was going to go down the tubes. It depends on whether their managements are prudent or not. And if they are taking risks, we'll never know until it's too late."

One thing is for sure: Freddie Mac and Fannie Mae carry a lot of debt, and that has been skyrocketing in the last few years during the home-buying and refinancing boom. They have increased their combined debt from $196 billion in 1992 to $1.13 trillion in the first quarter of 2001. That's the equivalent of 46 percent of the U.S. national debt. And some critics, such as Nobel laureate Milton Friedman [see "Budget Is Balanced; Now What to Do," Nov. 17, 1997], argue that their debt actually should be listed as part of the national debt since they likely would have to be bailed out by Uncle Sam in a crisis.

Yet these companies, because of their special status with the government, are the only two Fortune 500 corporations that have been exempt from regulation by agencies such as the Securities and Exchange Commission (SEC). Under Bush administration pressure, they last year agreed to file quarterly and yearly reports with the SEC, as Wallison points out, but they still aren't going to file an SEC registration document as other companies must do, and therefore do not have to disclose as much about their operations as do other public corporations. Fannie Mae and Freddie Mac's sole government regulator is the Office of Federal Housing Enterprise Oversight (OFHEO) at the Department of Housing and Urban Development.

Nonetheless, in a statement sent to Insight, Fannie Mae Senior Vice President Chuck Greener says, "Fannie Mae is a highly regulated company and subject to a rigorous, risk-based capital standard enforced by OFHEO. We have always supported having a strong, well-funded regulator consistent with our role in supporting an efficient, well-functioning housing-finance system."

So why is Fannie Mae still resisting attempts in Congress to subject it to SEC rules? In response to a bill sponsored by Reps. Chris Shays (R-Conn.) and Ed Markey (D-Mass.) to remove the Fannie Mae and Freddie Mac exemptions from SEC regulation, Greener says, "This legislation failed to gain support last year because those in the housing industry and Congress concluded that it would be harmful for consumers and could very well disrupt the housing-finance system, which has been the cornerstone of our economy." He insists that OFHEO oversight is regulation enough.

Watts point out that OFHEO, unlike the big agencies that regulate banks, has no preclearance process. As a result, Watts and other critics say, Fannie Mae and Freddie Mac have gone beyond what they're allowed to do in their special federal charters and now are competing with direct lenders as well as owning the market for secondary mortgages. As an example, he cites Fannie Mae's new program, PaymentPower, in which borrowers may skip as many as 10 payments over the lives of their mortgages, creating new obligations with interest to Fannie Mae as well as new debts. "PaymentPower puts Fannie into consumer lending," Watts warns. "There's a lot of concern there, from predatory lending to taking equity from a homeowner to consumer lending that's outside of their secondary-mortgage charter." FM Policy Focus has charged that PaymentPower could hit consumers with effective interest rates of up to 69 percent. Moreover, consumers have other options such as home-equity loans from banks to meet unexpected financial needs.

In a statement, Greener says, "This is an initiative that was developed at the request of our lender-partners to provide flexibility to homeowners in managing their mortgage payments. It is startling that FM Watch [the original name for FM Policy Focus] companies would choose to attack an initiative that allows more Americans to get into their homes and stay in those homes." Meanwhile, Fannie Mae and Freddie Mac take out full-page ads claiming that they make it possible for low-income and minority buyers to become homeowners. But President George W. Bush's 2003 budget notes that "by the most recent estimate available, the conventional market's loans to low- and moderate-income families and underserved areas exceed the purchases of such mortgages by Fannie Mae and Freddie Mac."

Fannie Mae and Freddie Mac are examples of "profit-side capitalism and loss-side socialism," says Fred Smith, president of the Washington-based Competitive Enterprise Institute. They can afford to take risky ventures to maximize profits for shareholders that true private-sector companies couldn't because there is an implicit guarantee of a government bailout, even though they haven't yet used the lines of credit at the Treasury Department. They are highly leveraged, with a combined debt-to-equity ratio in 2000 of 30-1, in contrast to the average 11-1 ratio for federally insured banks and savings and loans. Like Enron, the companies deal in the risky hedging instruments of derivatives. Wallison says they would not need to take this risk if they truly were public-service corporations simply trying to make housing more affordable. The derivatives are solely for profits to shareholders, he explains, yet it is taxpayers who bear the risks.

The companies also give plum jobs to politically connected Washingtonians who in turn help them in their relationship with Congress. In addition to the five members of its board appointed by the president, Fannie Mae also hired Franklin Raines, Bill Clinton's former director of the Office of Management and Budget, to be its chief executive officer. In his first year, as Insight noted [see "Home $weet Home," May 1, 2000], Raines was paid more than $4 million and had almost $6 million in unexercised stock options. In 2001, he took in $6.9 million in salary and bonuses.

And even if Fannie Mae and Freddie Mac never need a federal bailout, they already are costing the government a lot of money. A Congressional Budget Office study in 2001 found that the companies receive $10.6 billion a year in hidden subsidies, such as federal, state and local taxes they are exempt from paying. The companies' notes also compete directly with Treasury bills because investors see both being guaranteed by the government. It's hard to estimate how much this cost might be, but as former Treasury Department official Francis Cavanaugh wrote in his book The Truth About the National Debt, "even if the competition from GSE debt added only one one-hundredth of 1 percent to Treasury's average cost of borrowing ... the annual interest cost on the government's marketable debt would increase by $360 million."