Another good read
take from it what you will
COVER STORY
Siblings Fat And Sassy
Friday, May 12, 2000
by Julie Kosterlitz
On a ravishing April afternoon, Fannie Mae Chairman
Franklin Raines sits in his office at the company's bucolic campus on a hill above Washington and attempts to explain why his corporation -- an odd hybrid created by Congress during the Depression to make mortgages more available to American families -- is such a financial success and a darling on Wall Street, but is suddenly so beleaguered in its own hometown.
"I think as Fannie Mae has become more successful at what it does, it quite naturally occasions a lot of scrutiny, so I don't think that that is very unusual," he says in a deceptively mild first response. Then he takes off the velvet gloves and suggests that all of the company's critics (and perhaps even his interviewer) are inspired by a coterie of banks and mortgage insurers out to get Fannie Mae. "We have a very well-organized group of financial companies who have banded together with the express purpose of doing harm to Fannie Mae. If you spend enough money in Washington on lobbyists and PR people, you have an impact," Raines said.
That day's newspaper headlines illustrate clearly Fannie Mae's best-of-times, worst-of-times conundrum. A number of articles mention Raines, who was
President Clinton's budget director, as a possible running mate for presumptive Democratic presidential nominee
Al Gore. That's a high-water mark even for a company already legendary for its stable of politically well-connected executives and board members.
The other news of the day was more of a slap than an ego boost, and it came from Raines' former colleagues in the Clinton Administration, who believe that Fannie, and its similarly government-created sibling, Freddie Mac, might be exceeding their mission. In essence, Fannie Mae (short for Federal National Mortgage Association) and Freddie Mac (Federal Home Mortgage Corp.) are designed to create a larger pool of money for home purchasers. They do this by buying up loans that banks and other lenders make to home purchasers, and converting them into relatively safe mortgage-backed securities that are popular with many investors. But Housing and Urban Development Secretary
Andrew Cuomo announced that day his intent to bar the siblings from buying so-called "predatory loans" that unscrupulous lenders increasingly make on onerous terms to low-income, higher-risk homebuyers. Cuomo's announcement pointedly pre-empted the companies' own planned announcements that they had intended to voluntarily screen out the controversial loans.
This good news-bad news seesaw on the Washington-Wall Street axis has been giving Fannie Mae and Freddie Mac motion sickness since at least the beginning of the year. Even as the two mortgage makers continued to post impressive financial results in the first quarter of 2000, they also racked up an unusually broad and serious set of political challenges from a variety of sources. And those challenges, although they involve many arcane financial issues, all revolve around the theme of whether Fannie and Freddie are just too big, and too powerful, for their own good, or for the good of the country.
The two have come to dominate the mortgage markets. According to the Treasury Department, Fannie and Freddie owned or guaranteed at the end of 1999 roughly 63 percent of all outstanding midsized, middle-class mortgages -- the kind of mortgages that most Americans have, and that technically are known as conforming, conventional mortgages. If Raines hews to his ambitious growth plans, and Freddie keeps a similar pace, the two will hold or guarantee more than 90 percent of these conventional, conforming mortgages and nearly half of all home mortgages by year's end in 2003, according to a report this year by the business-oriented think tank American Enterprise Institute. Meanwhile, the two are also fast becoming nearly as large a presence as the Treasury itself in the bond markets -- which serve the economy as key lubricants. As the federal government uses budget surpluses to pay down the federal debt, the siblings could soon be a bigger player in the financial markets, and a larger borrower, than
Uncle Sam.
Some lawmakers want to rein in Fannie and Freddie, which now rank 26th and 62nd, respectively, on the Fortune 500 list of top American companies. Two leading members of the House Banking Committee -- Rep.
Richard H. Baker, R-La., and Chairman
Jim Leach, R-Iowa -- are pushing legislation to step up oversight of the two companies and to scale back government links to them. Budget Committee member
Pete Hoekstra, R-Mich., is pressing for oversight hearings in his committee, and Senate Banking Committee Chairman
Phil Gramm, R-Texas, has also mentioned the possibility of hearings on the two companies this year. American Enterprise Institute is holding a series of symposia on the two companies and published a harsh report on them, while a new coalition of libertarian and budget hawk groups has promised to make the two a central focus of its agenda. Even left-leaning consumer advocate
Ralph Nader -- the Green Party's presidential candidate -- is speaking out against Fannie Mae.
Some of this may appear old hat: For decades, academics, libertarians, and taxpayer watchdog groups in and out of government have questioned whether the special perks government gives Fannie and Freddie advance public, or merely private, interest, and whether the government's special ties to the two are putting taxpayers unknowingly at risk. But what's strikingly different is that today, after a decade of phenomenal growth by the two companies, even some of their traditional allies are getting squeamish.
Although many liberals see Fannie and Freddie as champions of working families and minorities, the Clinton Administration is becoming an increasingly harsh critic. HUD has criticized the two companies' track record on buying mortgages that lenders make to minorities, and it has set stiff new targets for the two to meet in backing loans made to disadvantaged homebuyers. In a move that has made waves on Wall Street, the Treasury Department recently questioned whether government ties to the two companies might actually be fostering risks to the nation's entire financial system. Treasury also endorsed portions of the Baker bill -- and even suggested additional limitations.
Fannie and Freddie's growth spurts have also engendered fear and loathing among some former allies in the private sector. Fearing the two juggernauts' encroachment into its markets, a coalition of banks, mortgage insurers, consumer lenders, and others in the home finance sector has, under the name FM Watch, begun a campaign to question Fannie and Freddie's size and mission. This is the group that Raines asserted was intent on causing "harm" to Fannie. For the first time, the two companies -- famous for spending freely for political insurance -- face antagonists with deep pockets of their own.
On Wall Street, where Fannie and Freddie are seen as endless profit machines, the hubbub in Washington amounts to just so much background noise. Financial analysts are betting that the two siblings will prevail politically, as they have time and again in years past. "I can't imagine the upside to a politician telling constituents, 'Look what I've done, I've raised [mortgage] interest rates,' " said
Kenneth Posner, a specialty finance analyst for Morgan Stanley Dean Witter in New York City, who recently rated Fannie Mae stock shares a "strong buy."
But it's precisely the fear that the federal government has lost control of its own overgrown offspring that may yet inspire reforms. Certainly Fannie and Freddie are taking the threat seriously. The two are beefing up their already formidable lobbying legions and stepping up their political contributions. Fannie has also adopted a combative public stance in attacking its critics. Freddie Mac officials, on the other hand, tend to take a lower political profile and refused to be interviewed for this article.
[FONT=Trebuchet MS, Arial, Verdana, Helvetica]Public-Private Hybrids[/FONT]
Congress created Fannie Mae as a government agency in 1938 and converted it in 1968 to a private company with some government connections -- technically called a government-sponsored enterprise. Freddie Mac was founded and chartered in 1970 as another such enterprise, originally serving different lenders and using different financial tools. In doing so, Congress hoped to combine the best of public- and private-sector attributes to form an efficient, profit-oriented enterprise to advance the public goal of homeownership.
The idea was to increase the supply of money available to lend to homebuyers by helping banks and other lenders get the same kind of access to capital held by private investors nationwide -- and, today, worldwide -- that governments and large corporations have long had. Before the two companies were created, funding for mortgages depended largely on the deposits available to local banks and savings and loans -- which were themselves restricted in how and where they could attract deposits.
Fannie and Freddie helped launch what is known as a "secondary market" for mortgages that links lenders with investors in two different ways: by selling bonds to investors and using the proceeds to buy mortgages from lenders, or by buying mortgages from lenders and repackaging them into securities that are then sold to investors. These "mortgage-backed securities" are essentially rights to a share of the interest and principal payments from many different homebuyers. In exchange for a fee, Fannie and Freddie guarantee that investors get their payments on time; the two, meanwhile, assume the risk that an individual borrower might default.
Although neither company lends directly to consumers, both have a huge influence on what kinds of loans get made. Because the two companies are the largest purchasers of mortgages from lenders (who would usually rather have more cash to lend than keep a mortgage on their books), the lenders usually adopt quickly the standards the two set for the loans they're willing to purchase. No one denies that Fannie and Freddie have been effective in realizing their original mandates. But there are sharp disagreements about the costs and benefits of continuing the arrangement.
The way Fannie's many admirers on Wall Street and some consumer advocates see it, this blend of public- and private-sector enterprise is a runaway success. At virtually no direct cost to the government, Raines and others argue, the two companies have not only helped launch a vibrant secondary market for mortgages -- thereby helping to pump up homeownership rates -- they have also saved borrowers money by making funds available to lenders at lower rates than would otherwise be available. "What we have shown is that this is the technique that gives the maximum benefit at the minimum cost," says Raines. "Remember, we don't get a nickel from the government."
Raines calculates that a consumer who gets the largest loan Fannie Mae and Freddie Mac are allowed by law to buy (currently $252,700) will pay $19,000 less over the life of the loan than he or she would pay for a so-called "jumbo loan" of $252,701 made without Fannie Mae's backing. Such savings are possible, Raines says, because the company is efficient and innovative, and because it passes along to consumers all the benefits and savings conferred by its federal charter.
[FONT=Trebuchet MS, Arial, Verdana, Helvetica]The Counterargument[/FONT]
But critics have long argued the reverse: that the government-sponsored enterprise represents the worst blending of government and capitalism by conferring private profit at public expense. Although the siblings get no direct cash handouts from the federal government, they do reap hefty benefits from their government lineage. They don't have to register with the Securities and Exchange Commission the debt or securities they issue (savings: $280 million in registration fees last year, according to the Treasury). They're exempt from state and local corporate income taxes (savings: roughly $690 million in 1999.) But by far the biggest benefit to the two is a broad hint by the U.S. government that it stands ready to make good on Fannie and Freddie's debt in the event of default.
This perk doesn't show up anywhere in federal law. Indeed, for the record, Uncle Sam disavows responsibility for Fannie and Freddie's debt, and the disclaimer is printed right on the companies' bonds.
Investors, however, watch what Uncle Sam does, not what he says. The government offers the two a $2.25 billion line of credit from the Treasury, and the Federal Reserve treats their bonds very much like government bonds. Fannie and Freddie securities can be used as collateral for public deposits and for loans from Federal Reserve banks, for example. Their securities are considered lawful investments for federal fiduciary and public funds -- so governments and public pension funds can invest in them, too.
Moreover, the federal government, which for reasons of safety and soundness normally limits how much capital banks can invest in any one company's debt securities, exempts Fannie and Freddie's debt securities from such limits. If all this isn't enough, the President of the United States appoints several members of Fannie Mae's board of directors.
History also reinforces investor beliefs: When interest rates rose to about 20 percent between 1979 and 1984 and left Fannie technically insolvent, the federal government granted the company tax relief and kept regulators from storming the place, until falling interest rates eventually rescued the company. Wall Street analysts need no additional convincing. "There's no explicit guarantee of their debt, but that implied guarantee is pretty powerful,"
Gary Gordon, a consumer finance analyst at PaineWebber, told CNN in mid-April while touting Fannie and Freddie's stock.
This implied guarantee is as lucrative as it is ethereal. Because of it, the markets let the two companies borrow money at substantially lower interest rates than other financial companies -- and below what their own credit ratings would seem to justify. In recent months, Treasury estimates, the two were able to borrow at roughly 0.4 percentage point below the rates available to banks and financial firms rated AA -- the same rating Standard & Poor's gave the two companies when it last rated them in 1996. The seemingly small differential represents a huge financial advantage. All told, the Congressional Budget Office estimated in 1996 that this "federal credit enhancement" -- which it considers a subsidy -- was worth about $6.5 billion total to Fannie and Freddie in 1995.
Moreover, the implicit federal guarantee of the siblings' debts grows automatically along with the size and risk that the two take on. "Fannie Mae and Freddie Mac, rather than public officials, substantially control the amount of the subsidy provided," the CBO noted in its 1996 study. They "can increase the size of their benefit and the cost to the government by adjusting the composition of their business," the report said. And although Fannie Mae claims it passes its borrowing advantage along to consumers, the CBO said that Fannie and Freddie's sticky fingers extracted roughly one-third of the subsidy (some $2.1 billion in 1995) for the benefit of shareholders -- including their corporate officers, who are showered with stock options as part of their compensation.
Raines was paid nearly $3 million last year in salary, bonus, and other compensation, along with $1.3 million in payouts from long-term incentive plans. He was also awarded stock options valued at $4.3 million at the time they were granted. Freddie Mac's chairman and CEO,
Leland C. Brendsel, received $1.4 million in salary and bonuses last year and owns $5.5 million in special stock from a long-term compensation plan, according to
National Mortgage News.
[FONT=Trebuchet MS, Arial, Verdana, Helvetica]No Longer Needed?[/FONT]
Just what is the public getting in return for subsidizing Fannie and Freddie? Not much, critics say. Today, when Wall Street has created its own vibrant secondary market in mortgages, Fannie and Freddie aren't really needed.
Economists have always been dubious about the siblings' claims that they lower consumers' costs. Passing along a portion of their federal subsidies may lower homebuyers' mortgage rates, but the effect may be to simply drive up housing prices. That's because the subsidy allows borrowers to buy a more expensive house than they otherwise could afford. Nor is it clear to skeptics that the two have actually done much to help anyone who would have otherwise been unable to purchase a home. To date, the two companies have almost exclusively served the solid, credit-worthy middle-class segment of the market that no longer needs much help getting a mortgage.
In 1992, Congress directed the two to use their loan purchasing power to help more low-to-moderate-income and minority homebuyers, and asked HUD to set and enforce goals. Although Fannie and Freddie met the first round of these so-called affordable-housing goals, HUD revealed in March that the two companies' purchases of loans made to African-Americans and Hispanics still fall substantially behind the efforts of banks and other private lenders.
Raines has vehemently protested the implication that Fannie somehow discriminates against blacks. The company, he points out, financed $8.4 billion in mortgages for African-American families in 1999 -- a 31 percent increase over its efforts in 1993 -- the first year HUD goals took effect. Freddie Mac officials have suggested their minority lending has been constrained in part by other contradictory federal regulatory requirements.
Even those who believe the two still offer consumers a worthwhile benefit are alarmed by the gigantic size of the two companies. The siblings have had an astonishing growth spurt, by any of a variety of measures. Fannie's own favorite boast is that it is one of only seven companies in the S&P's 500-stock index that has increased its earnings at double-digit rates in each of the past 13 years. And CEO Raines has promised Wall Street analysts that they can expect more of the same over the next four years.
Using another yardstick, Fannie and Freddie, together with another government-sponsored enterprise, the Federal Home Loan Bank, have more than quadrupled in size in the past decade from around $300 billion to $1.4 trillion in assets. And they are immensely profitable. In Capitol Hill testimony in March, Treasury officials said that between 1995 and 1999, Fannie Mae and Freddie Mac's average return on equity was about 24 percent. That compares with average return on equity, during the same period, of 15 percent for large banks, 12 percent for large thrifts and insurers, and 17 percent for securities firms. In fact, the two companies have begun marketing their own debt as a near substitute for no-risk Treasury bonds, coveted for their security and as a benchmark against which the markets can measure the risk of other bonds. Annointing themselves the new "benchmarks" -- if the markets agree with the characterization -- could make it even easier for the siblings to raise money cheaply in the bond markets, and continue to feed their expansion.
What worries government officials and some economists is that this growth could be adding risks both for taxpayers and the nation's financial system. That fear may seem an idle worry for companies that are as profitable and seemingly healthy as Fannie and Freddie are. But the worry is not about the prosperous present, but how the two might fare during an economic downturn.
First among these worries is that the fortunes of the two companies depend almost exclusively on the fate of the housing market -- which is typically very sensitive to changes in interest rates.
Second, after an unprecedented economic expansion and unparalleled rates of homeownership -- 67.1 percent of Americans now own their own homes -- some fear that the two companies are turning to riskier loans and ventures to maintain their extraordinary growth rates. The two companies have recently launched programs for acquiring home loans with low down payments and have begun wading into the so-called "subprime" market geared toward borrowers with less-than-stellar credit. (Entering that market is partially influenced by the need to meet HUD's "affordable housing" requirements.) And they have begun retaining more loans and mortgage-backed securities in their own portfolio, instead of selling them to other investors -- a move that increases both risks and returns for the two companies.
