The Big Fat Gap – Part II

The following is an excellent excerpt from the book “ALL THE DEVILS ARE HERE: The Hidden History of the Financial Crisis” by Bethany McLean and Joe Nocera from Chapter 3 “The Big, Fat Gap” on page 45 and I quote: “And those who persisted in criticizing Fannie Mae? They learned to regret it. When some of Fannie’s large competitors, worried about its growing dominance, launched an organization called FM Watch to keep tabs on the GSEs, Fannie openly threatened them. GE Capital CEO Denis Nayden told the Wall Street Journal that GE was on the “receiving end of multiple communications from Fannie Mae indicating that GE would suffer financial consequences if GE remained a member of FM Watch.” Said Hank Greenberg, the chief executive of AIG: “They use their muscle to threaten competitors, and that’s an outrage.” Soon, FM Watch stopped disclosing the names of its members.
When the Congressional Budget Office published a report in May 1996 estimating that about 40 percent of Fannie and Freddie’s profits were due to their implied government support, Fannie Mae denounced the report, calling it the work of “economic pencil brains who wouldn’t recognize something that works for ordinary home buyers if it bit them in their erasers.”
When the General Accounting Office wrote in a letter to house majority leader Richard Armey that the GSEs received a government subsidy amounting to $2.2 billion in 1995, the letter’s author, James Bothwell, says that he received a call from Franklin Raines, who was then the vice chairman of Fannie Mae. According to Bothwell, Raines demanded that he take out the line about the subsidy–and if he didn’t, Raines would make a call that might cost Bothwell his job. Bothwell refused. In the end, he didn’t lose his job. (Raines denies the incident.)
And when, in 1996, the Treasury Department was preparing to issue a tough report on the GSEs, Fannie somehow managed to get it watered down–and turned into a largely positive report–before it ever saw the light of day. The early draft, for instance, said that if the GSEs were privatized, “Fannie Mae and Freddie Mac would be exposed to the full discipline of private capital market investors, rather than the weakened and distorted discipline resulting from GSE status.” That sentence was gone from the final report. The draft also contained a paragraph that cited several reasons why ending government sponsorship “should also improve the safety and soundness of the housing finance market.” That was gone from the final report, too. The fifth chapter of the draft disappeared entirely. It has been entitled “Policy Options for Altering the Relationship Between the Federal Government and the GSEs.”
No one who’s talking can prove what happened, but those who know about the rewrite have long speculated that Johnson put in a call to his friend, Bill Clinton or to Treasury Secretary Robert Rubin, another friend. Johnson has denied calling either man. The mystery was never solved.
The ferocity of Fannie Mae’s response to criticism was strange, in a way. After all, Fannie Mae and Freddie Mac did play an important role in homeownership. Their guarantees allowed more people to buy homes. Over time, they made it possible for mortgage originators like Countrywide to overtake the dying S&L industry as the country’s primary mortgage lender–thus keeping the mortgage spigot open even as the thrifts were shutting down.
And Fannie and Freddie had far more friends than critics, including some powerful Republicans. Republican senator Phil Gramm, an ardent champion of free markets, was in as good a position as any to cause Fannie and Freddie trouble; he became chairman of the Senate banking committee in 1994. But Gramm always gave Fannie and Freddie a pass. Why? Because, like Johnson, Gramm saw the political fruit that homeownership could beat. According to a former banking committee staffer, the Republicans studied what it was that made people vote Republican. “The number one predictor of voting Republican was a job in the private sector,” he said. “Number two, and it’s a close second, is that you own your own home.” He adds, “Gramm preached that gospel to all who would listen.”
Then again, maybe Fannie’s tendency, as Maloni later put it, “to throw one brick too many rather than one brick too few” wasn’t so surprising after all. When you got right down to it, there was something about the GSEs’ business model that made no sense. Nobody in his or her right mind would establish a company whose competitive advantage was built on a guarantee that was nowhere written down and that no one could say for sure even existed. Yet that was the premise upon which Fannie Mae and Freddie Mac had built their dominance. Their advantages were based in large part on the belief by investors that the government would never let the GSEs default.
When Fannie dealt with investors, it encouraged that perception. (It once claimed that its securities were even safer than triple-A-rated bonds because of the “implied government backing of Fannie Mae.”) Yet whenever anyone in government brought it up, Fannie Mae went mildly berserk. To admit that it had government backing would mean admitting that taxpayer support was the key source of Fannie’s huge profits–and that taxpayers would be on the hook if anything went wrong. And that was something Fannie could never concede. That’s why even the most muted criticism was treated as life or death–because Fannie Mae always felt that it was life or death. Some former lobbyists used to compare Fannie to the old Oakland Raiders, whose motto in the seventies was “Just win, baby.”
There was another reason why Fannie Mae was so quick to push back against it critics. Over time, the bulk of its profits were being generated from an activity that critics said–correctly–had nothing whatsoever to do with helping people buy affordable homes.
The business of stamping mortgages with its guarantee and turning them into mortgage-backed securities was a good, steady business. It gave Fannie Mae and Freddie Mac immense power in the marketplace. But while profitable, it wasn’t off-the-charts profitable; it didn’t generate the kind of profits that put companies in the upper echelon of American business. For that, Fannie and Freddie turned to another activity; they began to build up their own portfolio of mortgages and mortgage-backed securities, which they held on their own books, instead of selling them to investors.
Although owning a portfolio of mortgages had almost bankrupted Fannie in the early 1980s, the company never got rid of its portfolio entirely. “We always viewed it as a core part of the business,” says Maxwell. Fannie’s mantra was “Good times and bad,” meaning it would be in the market when investors were eager to buy mortgages, as well as when they were uninterested–and the only alternative was for Fannie to hold the mortgages in a portfolio. Maxwell, typically, had kept the portfolio fairly small so it wouldn’t attract too much attention.
Johnson, also typically, expanded it exponentially. The core idea behind the portfolio reflected, once again, the advantages of being a GSE. Fannie and Freddie would issue some of that low-cost debt their implied government backing made possible, use that money to buy higher-yielding mortgages, and pocket the difference. “The big, fat gap,” Federal Reserve chairman Alan Greenspan used to call it disparagingly, a phrase that perfectly captures the almost moronic simplicity of the strategy. By the end of 1998, Fannie had a $415 billion portfolio of mortgages, up from just $156 billion in 1992. In its 1996 report to Congress, the Congressional Budget Office estimated that the profit margin on this business was four or five times higher than the guarantee business. By the end of the decade, it accounted for most of Fannie’s profits.
This business also helped make Fannie even more of a force on Wall Street. Over the years, it paid Street firms hundreds of millions of dollars worth of fees to issue all the debt. “People dealt with them [Fannie and Freddie] as if they were sovereign credits,” says one former Wall Streeter. “You just knew better than to get on the wrong side of them.”
By the end of the decade, Fannie Mae had become America’s third largest corporation, ranked by assets. Freddie was close behind. The companies were ranked one and two respectively on Fortune’s list of the most profitable companies per employee. Fannie’s stock price had soared. Its market value under Johnson went from the $10.5 billion he’d inherited from Maxwell to over $70 billion. “There is no other financial institution in America with such a significant share of such a huge market,” Johnson said in one speech, and he was exactly right.
Here’s the great irony of the mortgage market in the 1990s: to the extent that lower- and moderate-income Americans were being swept along in the rising tide of homeownership in the 1990s, it was happening not because of Fannie and Freddie but despite them. The replacement of the S&L industry by the new mortgage origination companies; the toughening , in the 1990s, of the Community Reinvestment Act, which forced banks to make loans to people in poorer neighborhoods; even the rise of the subprime industry (though it was more focused on refinancings than new home loans)–these were all factors in helping poorer people own homes. Fannie and Freddie may have been given a federal mandate to help lower- and moderate-income Americans buy homes, but the GSEs were cautious about the credit risk they took. They preferred to game their housing goals rather than meet them, using methods that Fannie referred to internally as “stupid pet tricks.” They wanted nothing to do with subprime. Subprime loans didn’t conform. And anyway, there was so much money to be made elsewhere.
Many affordable housing activists found this infuriating. For all its sanctimony about its mission, they complained, the GSEs did very little for those who truly needed help. Both John Taylor, the CEO of the National Community Reinvestment Coalition, and Judy Kennedy, the former Freddie lobbyist in charge of the National Association of Affordable Housing Lenders, complained bitterly about Fannie and Freddie. Repeated studies by HUD showed that the GSEs’ purchases of loans made to lower-income borrowers lagged the market.
That’s not to say Fannie and Freddie did nothing. When Countrywide ginned up its program to provide low-income mortgages, it sold them to Fannie through a special program Fannie had set up to handle such loans. But back then, programs like Countrywide’s were small and highly controlled–experiments, really, and valid ones at that, because they sought an answer to an important question. As Dan Mudd would later ask, “Do you want to live in a country where someone who has a blemish on their credit, or someone who happens to be a minority, can’t get a home? Where do you draw the line?”
Mostly, though, Fannie Mae made no apologies for its stance. “I used to say that the goal at Fannie was to have a seamless yes to anyone who wants to do anything for housing,” Johnson later said. “But we didn’t say yes to crap, to fraud. We were probing the boundaries, but it was carefully circumscribed.”
Says a former Fannie executive: “About 98 percent of our mortgages were done at market rates. We were giving them away a little at the edge of the big machine.” This person adds: “Johnson’s attitude was, ‘I am not going to let the government define what affordable housing is to this company.”
That would soon begin to change, however. In 1999, Andrew Cuomo, who had been appointed HUD secretary during Bill Clinton’s second term and was a true believer in affordable housing, proposed increasing the affordable housing goals. To an unusual degree, Cuomo was immune to Fannie’s charms and impervious to its threats. He’d already taken on Johnson on another issue, and did not back down when Fannie pushed back. In July 1999, the GSEs agreed that by 2001, 50 percent of the mortgages they guaranteed would be loans made to low- or middle-income Americans. One way the GSEs could meet those goals, of course, was by lowering their underwriting standards, just as the subprime industry had done. Indeed, the housers at Fannie had high hopes that their company could serve as the sheriff in the lawless world of subprime lending. An exhaustive study Fannie had done revealed that many subprime borrowers were so fearful of being rejected that they were willing to pay very high rates just to hear a yes. Some studies showed that plenty of subprime customers could have qualified for a prime loan–meaning they were paying far more for their mortgages than they had to. Fannie said it could use its clout to make sure that borrowers got a fair deal.
Later, many conservative critics of the GSEs would come to see this moment as the capitulation of Fannie and Freddie to the Clinton affordable housing drive. That wasn’t really true. The real reason Fannie was willing to finally move into riskier territory was the same reason Countrywide did: profits. Subprime was taking off–and the GSEs were sitting on the sidelines. “Their motivation to enter this market is to continue a phenomenal record of amazing shareholder enrichment,” Anne Canfield, a longtime critic of the GSEs, wrote at the time. There was another potential issue, too. At a congressional hearing in June of 2000, the Reverend Graylan Scott Hagler of the Plymouth Congregational United Church of Christ, in Washington, D.C., who also claimed that the GSEs were entering the subprime business to “maximize returns,” said, “The real fear here is that when the economy goes south, or just through, if Fannie and Freddie are engaged in these subprime markets, then they will get left holding the bag, and the American taxpayer with them.”
Says a former Fannie executive: “It met our business goals. You have to start there. All the criticisms about Fannie being too shareholder driven and too profit driven–they are true! Shareholders were an important constituency at Fannie. For the smart people we brought in, they were the only constituency.”
Still, Fannie moved cautiously. In 2000, it put out guidelines listing what sort of riskier loans it would buy; Cuomo used those guidelines in Fannie’s affordable housing goals. Under the new rules, certain kinds of high-risk loans, ones that consumer advocates felt took undue advantage of borrowers, wouldn’t count toward Fannie and Freddie’s affordable housing goals. There is no data to prove that the GSEs avoided those loans, although neither company ever guaranteed large quantities of loans that they considered subprime.
In the end, though, it didn’t really matter whether Fannie and Freddie moved into riskier mortgages quickly or slowly, reluctantly or gleefully. What mattered was that they entered this new market at all. In so doing, they gave their imprimatur to what had previously been an entirely separate universe. A line that had once been absolute was now blurring. “The whole definition of subprime was ‘the stuff that Fannie and Freddie wouldn’t touch'” a former executive explains. No longer.
Much later, Maxwell would concede, with great sadness, that Fannie Mae had forgotten a simple question: Why are we here? If Fannie Mae had kept that question paramount, the company would have remembered that it didn’t exist solely to generate ever-increasing profits or to keep pace with the private market, but to supply liquidity when the housing market needed it. If Fannie had remembered that, the company might have found in moral compassion when it needed it most–and maybe left a different legacy.”
LaVern Isely, Progressive, Overtaxed Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran


About tim074

I'm a retired dairy farmer that was a member of the National Farmer's Organization (NFO). Before going farming, I spent 4 years in the United States Air Force where I saved up enough money to get my down payment to go farming. I also enjoy writing and reading biographies and I write about myself as well as articles and excerpts I find interesting. I'm specifically interested in finances, particularly in the banking industry because if it wasn't for help from my local Community Bank, I never could have started farming which I was successful at. So, I'm real interested in the Small Business Administration and I know they are the ones creating jobs. I have been a member of Common Cause and am now a member of Public Citizen as well as AARP. I have, in the past, written over 150 articles on the Obama Blog ( and I'd like to tie these two sites together. I'm also on Twitter, MySpace and Facebook and find these outlets terrifically interesting particularly what many of these people did concerning the uprising in the Arab world. I believe this is a smaller world than we think it is and my goal is to try to bring people together to live in peace because management needs labor like labor needs management. Up to now, that hasn't been so easy to find.
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