David Frum on the demise of Fannie Mae and Freddie Mac

Posted: July 11, 2008, 4:00 PM by Marni Soupcoff
David Frum

"The shapers of the American mortgage finance system hoped to achieve the security of government ownership, the integrity of local banking and the ingenuity of Wall Street. Instead they got the ingenuity of government, the security of local banking and the integrity of Wall Street.

Yesterday, shares of the two U.S. mortgage companies Fannie Mae and Freddie Mac collapsed. Freddie's shares have lost 70% of their value in a week; Fannie's 55% over the same period.

Fannie and Freddie are technically known as government-sponsored enterprises. What that means in practice is that everybody assumes they carry a government guarantee even though in reality they do not.

This assumed guarantee has allowed them to engage in decades of dubious market activity, which has now come to a disastrous head.

For its first 30 years of life, Fannie Mae actually was owned by the government. In those quiet early years, Fannie (formally known as the Federal National Mortgage Association) borrowed at very low rates, typically an eighth of a point above the U.S. Treasury itself, then loaned the money to banks for middle-class mortgages.

In 1968, the Johnson administration decided to privatize Fannie — not for any free-market reason, but because the federal government's debt was rising fast, and the administration realized it could make the government's accounts look better by moving Fannie Mae's obligations off the books.

The administration then created a second company to provide competition to Fannie. Thus was born Freddie Mac, the Federal Home Loan and Mortgage Loan Corporation. (It owes its nickname to its ticker initials FRE.)

Today the two companies together are responsible for some US$5-trillion of mortgage debt. To put that in perspective, that's more than half the entire U.S. federal debt.

Fannie's and Freddie's ability to pay their debts depends in turn on their ability to collect from retail mortgage lenders. And with those lenders dropping dead like roses in a heat wave, collection suddenly looks very much in doubt.

The two institutions have long been run not by bankers but by retired political figures, predominantly Democrats. From 1991 to 1998, Fannie Mae was headed by James Johnson, a longtime aide to former Democratic vice president Walter Mondale. Johnson's successor, Franklin Raines, had served as budget director to Bill Clinton. Jamie Gorelick, vice chair of Fannie Mae from 1998 to 2003, served as deputy attorney general in the Clinton administration.

These figures have paid themselves impressive private-sector salaries. Johnson earned US$21-million in just his last year at Fannie Mae. Raines earned US$90-million for five years' work at Fannie Mae. Gorelick got US$26-million.

Yet the companies never had to meet the discipline of the private marketplace. They paid no taxes, and they had access to a line of credit at the Treasury department. More ominously for today's crisis: They were not required to provide anything like the level of information about their internal operations expected of a privately owned company.

This non-transparency allowed Fannie Mae to engage in serious accounting fraud, overstating its earnings by more than US$6-billion over the Raines years — overstatements that incidentally justified the company's lavish compensation packages. (Both Johnson and Raines incidentally also received below-market mortgages from the large mortgage company — and major Fannie Mae beneficiary — Countrywide Mortgage.)

The loss of confidence that struck the markets this week has been gathering for years. It is the natural byproduct of the bad practice of merging private business with government power.

As so often happens with large scandals, the cost will fall on everyone except the responsible parties. In 2006, federal regulators sued Franklin Raines and two other Fannie Mae executives to recover  US$115-million of compensation. The case was settled for US$3-million, plus the surrender of some (now probably valueless) stock options and other contingent benefits. The US$3-million was paid from Fannie Mae's own insurance.

And at the polls this November, the voters will likely exact a political price for the debacle from John McCain and the Republicans — even though the party most tainted by the failure ought to have been the Democrats. Indeed, James Johnson until recently chaired Barack Obama's vice presidential selection committee.

That's not close enough to justice, not even close enough for government work. "