Fannie, Freddie Share Spotlight in Mortgage Mess

By JAMES R. HAGERTY

Fannie Mae and Freddie Mac have become prime suspects in the political debate over who caused the mortgage meltdown.

Last week, Sen. John McCain, the Republican presidential nominee, said the government-backed mortgage investors are "the match that started this forest fire" in the U.S. economy. Others contend that a push by Congress that forced Fannie and Freddie to sharply ramp up lending to lower-income borrowers is what did in the mortgage giants. A television ad campaign by the American Issues Project, a conservative political organization, accuses Democrats in Congress of coddling Fannie and Freddie, allowing them to escape tougher regulation.
[Photo] Associated Press

Fannie Mae President and CEO Herbert Allison Jr., left, and Freddie Mac CEO David Moffett talk during a break in congressional testimony last month.

"That's nonsense," said Rep. Barney Frank, the Massachusetts Democrat who heads the House Financial Services Committee. He said in an interview that when Republicans had a majority in Congress they failed to pass legislation improving regulation of the companies.

Even accounting scandals that led to billions of dollars in fines and remediation costs in recent years failed to bring major change. In October 2005, a majority of Republicans in the House of Representatives joined Democrats in rejecting a Bush administration plan that could have drastically shrunk Fannie and Freddie.

Fannie and Freddie do share some of the blame for the mortgage and housing bust. They recorded a combined $14 billion of losses in the 12 months ended June 30, largely because they lowered their credit standards and purchased or guaranteed dubious home loans.

But "they weren't the leaders in lowering credit standards," said Andrew Davidson, a mortgage industry consultant in New York who has done work for Fannie and Freddie and also criticized them for taking excessive risks. He noted that the worst-performing mortgages are those that were originated by subprime lenders and packaged into securities sold by Wall Street, rather than by Fannie and Freddie. And while loans for low-income people -- programs championed by Democrats as well as many Republicans -- have contributed to Fannie and Freddie's losses, they aren't the biggest part of the problem.
[loans for the lower half]

Fannie has said that 50% of its credit losses in the second quarter came from Alt-A loans, which generally go to borrowers with good credit records who don't fully document their income. Fannie officials have said Alt-A loans make up the company's biggest problem area. Fannie has said that about 17% of its Alt-A loans were to real-estate investors and 32% financed homes in California and Florida, where home prices have plunged.

Still, the recent problems that led to the downfall of Fannie and Freddie -- the government seized their operations last month -- weren't the first sign of trouble. For decades the two companies were allowed to grow without close scrutiny as policy makers missed repeated opportunities to rein them in.

Fannie Mae got its start in 1938 under President Franklin Roosevelt's administration, which created it as a federal agency charged with buying mortgages from banks to ensure a steady flow of funds to make new home loans. In 1968, Fannie was put on the path toward private ownership when the Johnson administration wanted to avoid having to put Fannie's growing debt on the government books.

The result was "a strange creature," noted a 1986 report by the Department of Housing and Urban Development. Private shareholders acquired ownership of Fannie, but it still had a charter from Congress, giving it a public mission of supporting the housing market. Because of this close link with the government, Fannie could borrow money at rates almost as low as those on Treasury bonds.

Despite protests from the Federal Reserve about the risks of increased borrowing and mortgage investments by government-backed entities, Congress in 1970 created Freddie as a second source of funds for home loans and gave Fannie authority to buy a wider variety of mortgages.

In the 1970s, Fannie fought off attempts by the Carter administration to impose tighter clamps on the company and require it to do more to help finance homes for the poor. Those battles helped breed a culture of aggressive lobbying of Congress to prevent stricter regulation.

Like thousands of savings-and-loans institutions, Fannie got into trouble when interest rates soared in the late 1970s and early 1980s as the Fed battled inflation. In 1981, Fannie owned about $61 billion of mortgages with average yields of about 9.9%. That portfolio was financed with debt at costs averaging 11%. Fannie's liabilities in 1981 exceeded the estimated current-market value of its assets by $11 billion, according to a report by HUD, then Fannie's main regulator.

"Basically, Fannie Mae was the nation's largest insolvent thrift," says Susan Woodward, who was HUD's chief economist in the late 1980s. "What the government did about them mostly was to cross their fingers and pray for lower interest rates."

Freddie remained profitable throughout the 1980s because, unlike Fannie, it didn't hold large amounts of mortgages and focused on providing guarantees for mortgages held by others.

Fannie installed new management in 1981, led by David O. Maxwell, who had served as a Nixon administration official and headed a mortgage-insurance company. To offset the drag of low-yielding mortgages on its books, Fannie bought large amounts of higher-yielding home loans. Fannie's mortgage holdings grew to $98 billion in 1986 from $57 billion in 1980.

Meanwhile, Fannie got a little help from the Reagan administration. As losses ate into Fannie's capital, HUD in 1982 allowed the company to raise its borrowings to 30 times capital from 25 times. HUD called the move "prudent" and said it would help Fannie support the housing market. Also in 1982, Congress passed legislation allowing Fannie to "carry back" losses to offset taxes paid as much as 10 years before, compared with three years under previous rules.

As interest rates came down in the mid-1980s, Fannie returned to the black and became one of the nation's biggest and most profitable financial institutions. With those profits came more political clout.

The Reagan administration occasionally called for "privatizing" Fannie and Freddie by ending the close relationship with the government that allows them to borrow money at relatively low interest rates. But those calls never led to legislation in Congress, where lobbyists for home builders and Realtors were powerful backers of the companies.

"They beat us politically," says Lawrence Kudlow, who was an associate budget director in the Reagan White House. One reason, he says, is that the administration was distracted by other matters, including the collapse of hundreds of savings-and-loans.