Part two. Franklin Raines moves Fannie into Subprime The Clinton Administration’s 1995 CRA changes authorized GSE’s to buy subprime mortgages, which it began to do in 1997. “Subprime” means that the person receiving the loan has a poor credit record and/or very low income compared to the loan size. Almost immediately, Fannie began to loosen its standards, requiring people to show lower wealth amounts in order to qualify for mortgages. By 1997, Fannie Mae was offering to buy 97% loan-to-value (LTV) mortgages. If a mortgage is $300,000 on a house worth $500,000, the LTV is 60% (3/5). The higher the mortgage relative to the house value, the higher the LTV. In other words, in 1997, Fannie started offering to buy mortgages that required recipients to put barely any money down. Fannie’s subprime backing caused the percentage of all new US mortgages that were of subprime quality to rise to 13% by 1999, versus 5% in 1994 when the Clinton Administration changed the CRA. According to a 2002 Housing Department report, “From 1993 to 1998, the number of subprime refinance increased tenfold.” As Fannie’s CEO, Franklin Raines explained in 1999, “Fannie Mae has expanded home ownership for millions of families in the 1990′s by reducing down payment requirements. Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.” A September 1999 New York Times article describing the situation stated, “Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.” That stockholder pressure was primarily through the board of directors, much of which was Clinton appointed, and specifically due to the earnings-based compensation program the directors structured. The chart below shows the dramatic rise in home ownership rates during Mr. Raines’ tenure, from 1995 to December 2004, after roughly 25 years at roughly constant levels. This chart is what the Democrat party fell in love with, and represented what Congressional Democrats so fiercely defended in committee hearings about regulating Fannie. The vast majority of the rise happened before George W. Bush became President. Clinton GSE Framework Leads to the Rise of ACORN in Chicago “You’ve got only a couple thousand bucks in the bank. Your job pays you dog-food wages. Your credit history has been bent, stapled, and mutilated. You declared bankruptcy in 1989. Don’t despair: You can still buy a house.” – so said an April 1995 Chicago Sun Times article that directed people with very poor credit to contact to a group of “community organizers” called ACORN. Recall, the Clinton CRA changes focused on numbers of mortgages made inside poor neighborhoods, not the credit quality or safety and soundness. If people came to ACORN seeking a mortgage, ACORN referred them on to a bank, and if that bank denied the application, ACORN would make sure it was fully accounted for in the government CRA rating. As shown in the table below, the impact of Chicago community organizers was quick and dramatic. While reckless subprime lending increased a bit in most major cities, the Chicago explosion was relatively off the charts. These numbers came a July 2002 Housing and Urban Development (HUD) report titled, from “Subprime Foreclosures: The Smoking Gun of Predatory Lending?” They track the number of home mortgage borrowers who did not pay back their loans. HUD is the government department that oversees GSE activities. The first person President Clinton appointed to Fannie Mae’s board of directors was William Daley in 1993 — son of Chicago’s legendary Richard M. Daley and brother of Chicago Mayor, Richard Daley who holds the position to this day since 1989. During the 2008 Democrat Presidential primaries, William Daley was a strong Barack Obama supporter. At the height of the housing bubble, in 2004-2005, William Daley was “Midwest Chairman” of key mortgage market player JP Morgan Chase, and was primarily tasked with overseeing Chase’s takeover of another key player in the Chicago-region mortgage market, Bank One. 2002 – 2005: The Bush Administration and Republicans Push to Regulate GSEs 2002 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. 2003 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.” At risk for Democrats included the following: 1. Democrats had changed the law governing Fannie Mae’s mission (the CRA) to pressure management to take more risks, but did nothing to adapt the regulatory structure to the new mission. Allowing the discovery of aggressive accounting at both Freddie and Fannie, without a fight, would place Democrat party at political risk ahead of a Presidential election cycle. 2. Democrats had appointed Fannie’s senior executives and much of the board of directors, who would had to have been involved with the illegalities – and may easily be publicly viewed as such if no fight had been put up to reframe the issue. 3. Publicly, Democrats fiercely defended the increased home ownership rates in poor neighborhoods, which were based upon investors having trust in purchasing Fannie’s repackaged mortgages. This easy access to funding would dry up if investors viewed investments in the securities Fannie issued as increasingly risky. 4. The CRA changes had significantly boosted community organizers, such as ACORN, which were rapidly becoming a Democrat party power base. 5. Local Democrat-linked political power brokers, such as Valerie Jarrett and friends, were making fortunes in the Chicago subprime housing market, where ACORN was a major player. Clinton appointee Franklin Raines, and Congressional Democrats moved swiftly with the “best defense is a good offense” strategy. They painted anyone who presented evidence against Fannie Mae as being motivated by politics or greed. The same day auditors released the full Freddie Mac report, Franklin Raines held a press conference in which he accused Freddie of impeding Fannie’s lofty mission by causing “collateral damage.” Fannie’s management changed the Frequently Asked Questions section of the company’s website to include the following statement: “Fannie Mae’s reported financial results follow Generally Accepted Accounting Principles to the letter…. There should be no question about our accounting.” They were wrong. In October 2003 — less than four months after Freddie’s admission — Mr. Raines wrote a letter to Treasury Secretary John Snow that began, “Dear John, From the beginning of our discussions, you and I have agreed to avoid disrupting the capital markets by indicating a wish to change Fannie Mae’s charter, status, or mission.“ After complaining about a comment that Raines said a high Treasury official had made about Fannie’s government-extended line of credit, he wrote, “The result of his comment was that trading in our debt came to a halt for an extended period of time. I am disappointed and hope we can change course. Very truly yours, Frank.” According to renown financial market and (at the time) Fortune Magazine reporter, Bethany McLean, “In political terms, the letter was an astonishment — what other CEO would dare dress down the Treasury Secretary, much less address him as “Dear John?” Clinton Changed the GSE’s Mission but Not the Framework that Oversaw It The Clinton Administration changed GSEs’ mission to become far more active, but did nothing to adapt the regulatory structure to the new mission. GSEs were “regulated” by the Office of Federal Housing Enterprise Oversight (OFHEO), which was a part of HUD – Housing and Urban Development. Congress essentially controlled OFHEO, because Congress had life or death control over OFHEO’s funding. The regulator was customarily in a middling position, careful not to make statements too strong in any direction, especially as political battle lines became more distinct, for risk of having its funding cut, delayed, or in any way becoming an issue. Fannie Mae controlled one of the most powerful Washington lobbies in existence – for OFHEO to take on Fannie Mae would have been like an entry level employee openly accusing a senior executive…Fannie’s violations were so significant, that is exactly what OFHEO wound up doing. 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 House Financial Services Committee began debate on September 11, 2003 and held multiple hearings over the next several weeks. In supporting the bills, Republicans focused on GSE’s potential impact on the broader financial system. Democrats focused solely on the mortgage lending targets, stating there was no risk to the broader financial system because the federal government would bail out the GSEs if necessary. Here are a few representative quotes on how those hearings went: Sen. Charles Schumer (D, NY): “And my worry is that we’re using the recent safety and soundness concerns, particularly with Freddie, and with a poor regulator, as a straw man to curtail Fannie and Freddie’s mission.” Rep. Maxine Waters (D-CA): “nearly a dozen hearings where, frankly, we were trying to fix something that wasn’t broke… In fact, the GSEs (Fannie, Freddie) have exceeded their housing goals. What we need to do today is to focus on the regulator, and this must be done in a manner so as not to impede their affordable housing mission – a mission that has seen innovation flourish, from desktop underwriting (no formal analysis) to 100% loans (no collateral).” Rep. Maxine Waters (D, CA), speaking to Housing and Urban Development Secretary Mel Martinez: “Secretary Martinez, if it ain’t broke, why do you want to fix it? Have the GSEs ever missed their housing goals?” Rep. Barney Frank (D-MA): “I don’t want the same kind of focus on safety and soundness that we have in OCC (Office of the Comptroller of the Currency) and OTS (Office of Thrift Supervision). I want to load the dice a little bit more in this situation towards subsidized housing.” Rep. Barney Frank (D-MA): “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.” Rep. Gregory Meeks (D-NY): To OFHEO head, Armando Falcon, “The question that represents is the confidence that your agency has with regard to regulating these GSEs… Why should I have confidence; why should anyone have confidence in you as a regulator at this point?” Rep. Gregory Meeks (D-NY): “I’m just pissed of at OFHEO (the regulator), because if it wasn’t for you I don’t think that we’d be here in the first place…you’ve given them an excuse to try to have this forum so that we can talk about it and maybe change the direction and the mission of what the GSEs had, which they’ve done a tremendous job. Barney Frank (D-MA): “I worry about increasing the capital requirements…I’d like to get Fannie and Freddie more deeply into helping low income housing and possibly moving into something that’s more explicitly a subsidy (taxpayer money used as principle in subprime mortgages). My concern is that this would not what would be a regulator’s or Treasury’s idea of what would be the best way of promoting safety and soundness… “ Barney Frank (D-MA) even went so far as to suggest the issue of Fannie Mae regulation should rest in the hands of Fannie’s CEO: Barney Frank: Let me ask [George] Gould and [Franklin] Raines on behalf of Freddie Mac and Fannie Mae, do you feel that over the past years you have been substantially under-regulated? Mr. Raines? Franklin Raines: No, sir. Barney Frank: Mr. Gould? George Gould: No, sir. . . . Barney Frank: OK. Then I am not entirely sure why we are here. . . . When Republican Christopher Shays challenged Franklin Raines on Fannie Mae’s 3% capital ratio — how much money Fannie had on hand versus the amount of mortgage liabilities it owned – which was dangerously low by private market standards, Mr. Raines responded “our assets are so riskless, we could have a capital ratio of under 2%.” His claim was that Fannie’s subprime mortgage portfolio involved less risk than the typical private bank’s loan portfolio. Democrat Delay Tactics: There was a particularly illustrative example of Democrat Party administrative tactics during the September 25, 2003 House Financial Services Committee hearing, in which Paul Kanjorski (D-PA) argued it should take a very long time for Congress to debate any serious GSE regulation. Steve Bartlett, President of the Financial Services Rountable — an organization that represents practically every major US bank — responded, “Mr. Kanjorski, our organization and our companies have been quite concerned about this from a safety and soundness as well as mission, for the last several years. We have communicated that concern, but recently that concern seems to have been highlighted by a number of factors. So yes sir, I believe there is an urgency to the tune of some $3.3 trillion that is either owned or guaranteed by these two agencies…We think they are not being properly regulated, and we believe that with $3.3 trillion, you don’t want to wait too long, and so now is the time to act.” Mr. Kanjorski then continued as if Mr. Bartlett had never spoken, and brought up something Franklin Raines had suggested Congress debate, saying, “I could anticipate it taking weeks and weeks and weeks“ just to do that. A few minutes after this exchange, Mr. Bartlett tried to persuade David Scott (D-GA) that Democrat statements of concern about regulation potentially impacting Fannie’s mortgage lending “mission” was becoming empty, stating, “It’s gotten to a $3.3 trillion overhang over the nation’s economy, and unless strong, independent regulation is provided, the housing goals for Fannie and Freddie will go in the tank, because the system will ultimately not…will be in jeopardy.” 2004 The Campaign Against Regulation Grows More Daring Fannie Mae’s “Astounding” National Television Ad On March 31, 2004, the day before the Senate Banking Committee was scheduled to begin debating GSE regulations, Franklin Raines had Fannie Mae run the following advertisement on national television. Featuring a worried looking Hispanic couple, a man said, “Uh-oh.” Woman: “What?” Man: “It looks like Congress is talking about new regulations for Fannie Mae.” Woman: “Will that keep us from getting that lower mortgage rate?” Man: “Some economists say rates may go up.” Woman: “But that could mean we won’t be able to afford the new house. Man: “I know.” Senator Chuck Hagel (R-NE) responded at the hearings. “Here is an organization that was created by the Congress … spending money questioning the Congress’s right to take a serious look at oversight … I find it astounding. Astounding!” President Bush Tries to Act Despite a Stonewalling Congress ACORN v. Bush With such fervent Democrat resistance, the Bush Administration continued to do what it could within the Executive Branch. In February 2004, the Office of the Comptroller of the Currency (OCC) tried to strengthen its GSE oversight. The Democrat party and its allies, such as ACORN, moved swiftly and strongly. In a March press conference, Barney Frank (D-MA) stated, “We cannot accept and leave alone this sweeping decision by a federal regulator to substantially diminish the role state-elected and appointed officials have in protecting their economies and their consumers.” On April 7, Senator John Edwards (D-NC) introduced legislation to quietly nullify the OCC regulations. On April 30, 32 House Democrats and three Republicans co-sponsored a bill to do the same. In a May 3 letter to Congress, ACORN strongly supported the effort to nullify the regulations, arguing, “the OCC has shut down the laboratories of democracy and its actions place citizens around the nation at risk of becoming victims of predatory lending or other unfair practices.” On September 15, Democrats went after the OCC directly, introducing legislation that would have given Congress stronger power over the bureau. With Republicans holding a majority in Congress, the bill never had a chance of passing, but the move provided a forum for Democrats to reshape the issue from being about Fannie Mae to being about anyone who suggested Fannie be effectively regulated. In April 2004, the Bush Administration fought against a bill introduced to the House by Garry Miller (R-CA) and Barney Frank (D-MA) to eliminate the $290,319 ceiling on mortgage size that the Federal Housing Administration could insure. The bill set far higher cielings, according to each local housing market and influenced by local community organizations. For instance, in San Francisco, the insured limit would soar to $568,000. Fannie Mae’s chief economist testified in favor of the bill, which never made it out of Republican-controlled committee. In the summer 2004, Bush had the Treasury obtain legality opinions from the Justice Department and Congressional Budget Office about limiting Fannie’s ability to issue debt. Congressional Democrats were up in arms, led by Barney Frank (D-MA). At a September 2004 Freddie Mac conference, he stated, “I think they would run into an absolute firestorm if they did that.” According to National Mortgage News, Rep. Frank went on to suggest lowering the income levels borrowers needed to have before receiving mortgages of certain sizes. “Special Examination of Fannie Mae” Put Democrats into Crisis Mode Just days before the Freddie Mac crisis erupted into public view, the Office of Federal Housing Enterprise Oversight (OFHEO) – the agency charged with regulating GSEs – had stated Freddie’s internal controls were “accurate and reliable.” With ample egg on his face, OFHEO’s director, Democrat Armando Falcon, was determined to be certain before giving Fannie Mae a clean bill of health. In February 2004, he obtained White House funding to hire accounting giant Deloitte & Touch to scrub Fannie books. Deloitte assigned to lead the project the same person who had led a similar investigation of Enron a few years earlier. The Bush Administration also proposed increasing OFHEO’s budget from $40 million to $59 million. On September 22, 2004, the OFHEO released “Special Examination of Fannie Mae,” which stated management had purposely broken accounting rules and established “a dysfunctional and ineffective process for developing accounting policies” that involved “weak or nonexistent” internal controls. The report blamed much of the problem on “an executive compensation structure that rewarded management for meeting goals tied to earnings-per-share, a metric subject to manipulation by management.” Between 1994 and 2004, according to the report, Fannie Mae improperly reported $10.6 billion in earnings. From 1998 through 2004, Fannie management reported earnings per share (EPS) figures that triggered the maximum bonus payouts they had set for themselves. As described by OFHEO later, “management of Fannie Mae set earnings-per-share targets. And every quarter, they manipulated — or every year, they manipulated the earnings to hit those numbers because their bonuses were based on them. And every year, they got their maximum bonuses…Fannie Mae’s executives were precisely managing earnings to the one-hundredth of a penny to maximize their bonuses.” Franklin Raines responded to the OFHEO report by questioning the regulator’s abilities and jurisdiction. He also requested that the SEC arbiter between Fannie Mae’s and OFHEO’s positions. Mr. Raines appeared confident this move would support him: he hired the powerful law firm of Wilmer Cutler to help make his case…Bill McLucas, Cutler’s lead partner on the case, had deep SEC connections from his former role as the agency’s chief enforcement officer. Meawhile, Congressional Democrats went after OFHEO directly… The Washington Post referred to the situation as a gutsy David (OFHEO) taking on Goliath. In November 2004, Barney Frank (D-MA), senior Democrat on the House Financial Services Committee, stated continued OFHEO funding was “inappropriate” due to the controversial nature of the OFHEO report. In a November 2004, he bluntly called for a detailed public investigation of OFHEO, stating “It is clear that a leadership change at OFHEO is overdue.” In June, Mr. Frank had supported the Bush request for additional OFHEO funding…in November, after the September “Special Examination” report, he reversed that support and called for a leadership change.
Posted on: Sat, 05 Oct 2013 10:56:04 +0000
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