Private Prot vs.

Public Purpose
The Collapse of Fannie Mae
by NICK FRONTINO

At Fannie Mae, we are in the American Dream business. Our mission is to tear down bar-
riers, lower costs, and increase the opportunities for homeownership and aordable rental
housing for all Americans. Because having a safe place to call home strengthens families,
communities, and our nation as a whole.

Fannie Mae mission statement beginning in

1999, under CEO Franklin D. Raines

Under CEO Franklin Raines, mortgage nancier Fannie Mae is as close as youll get to own-
ing an invincible earnings machine.

Money, December 2001

22 PANORAMA 2009
Introduction
The current economic maelstrom in the U.S. housing sector has left
few major players standing. Fannie Mae, the quasi-public corporation
that, along with its younger sibling Freddie Mac, has long dominated
the secondary market for residential mortgages in the United States,
is no exception. By investing in high-risk mortgage products, the com-
pany betrayed its public purpose and damaged public trust in its good
judgment and reliability. The company prioritized shareholder return
above the public interest, resulting in its placement into a government
conservatorship in September of 2008essentially nationalizing
the company and its losses at the expense of American taxpayers. The
impacts of this decision have distinct implications for the vitality of
American real estate and aordable housing. This paper looks beyond
recent statements that place the blame for Fannies demise solely at the
feet of the companys quasi-governmental status. Evidence demon-
strates that major failures in leadership, not just a defect in organiza-
tional structure, are to blame.
Unlike private companies active in the secondary mortgage market,
Fannie Mae is beholden to a public purpose. Created by an act of Con-
gress in 1938, the companys government-written charter charges it
with fostering stability in the mortgage market, providing liquidity to
mortgage lenders, and increasing the availability of credit to low- and
moderate-income borrowers. These responsibilities led Fannie to invest
heavily in mortgages for aordable housing and thus, by extension,
Fannie became deeply involved in the real estate markets of Americas
cities. Community and neighborhood development eorts have long
relied on Fannie Mae to facilitate access to straightforward mortgages
for low- and moderate-income residents. And so Fannie Maes fate is
bound to have great eect on the future of urban America.
The Financial Collapse and
Government Takeover
The current American housing crisis, spanning at least from mid-2007
through 2009, swiftly crippled numerous mortgage institutions. Finan-
cial distress seemed to appear out of nowhere, as the housing market
went from boom to bust in barely a year. In reality, however, impru-
dent activity in the mortgage market had been forming the foundation
for collapse for some time. Fannie Mae was doubtlessly complicit in
this activity. As the American secondary mortgage market exploded
in the 1990s, Fannie began to purchase even more mortgage-backed
securities (MBS), keeping some on its books while guaranteeing and
selling others to banks or other investors. The company grew steadily,
and returns to its shareholders were robust.
The U.S. Department of Housing and Urban Development (HUD)
launched a campaign dubbed the National Homeownership Strategy
in 1995 to increase the national rate of homeownership. According to
one report, this program put Fannie under increasing pressure from
the Clinton Administration to expand mortgage loans among low and
moderate income people while it still felt pressure from its private
investors to continue its growth in prots (Holmes, 1999).
After the recession of the early 2000s, demand for MBS grew to new
levels. To meet this demand, many private mortgage lenders increased
their oering of non-traditional nancing products that targeted
subprime and Alt-A borrowers whose credit was imperfect. These loans
serviced higher-risk borrowers and often included attractive marketing
strategies such as teaser interest rates, which remained low at rst and
then suddenly increased after a few years. Mortgage lenders were not
overly concerned with any additional risks, as the secondary mortgage
market remained robust, with willing MBS buyers such as Bear Stearns
and Merrill Lynch. Mortgage companies could thus quickly remove the
risk from their balance sheets.
As investor appetite for non-traditional mortgages grew, Fannie Mae
felt pressure to join the fray. Though the company continued to grow
and pay handsome executive salaries, it struggled to maintain market
share in the face of increased competition. Fannie eventually gave in
to market pressure by relaxing its underwriting standards and increas-
ing its appetite for risk. It expanded its lending into the Alt-A and
subprime markets, both holding and guaranteeing loans that had been
made to borrowers with little or no credit or income. Some argue that
Fannies entrance into the non-traditional markets was seen as a signal
of the governments approval of subprime and Alt-A products, eec-
tively legitimizing and turbocharging investment in them (Wall Street
Journal, 2008).
By 2006, interest rates on loans sold with teaser interest rates began to
adjust, often causing monthly premiums to suddenly increase for many
borrowers. Default rates on non-traditional mortgages increased, and
with it the housing bubble burst. Home prices nationwide began to
fall, and companies with extensive subprime and Alt-A holdings were
exposed holding vast quantities of depreciating assets. Fannie Mae
was no exception, and by September 2008 it was essentially bankrupt.
The U.S. Treasury decided against injecting equity into Fannie directly,
and instead announced it would take the company into government
conservatorship. This eectively saddled taxpayers with Fannies bad
debt and nationalized the rm.
Although the current crisis directly precipitated Fannies failure, the
companys trajectory over the past 20 years ultimately illustrates the
failure of its leadership to establish a balance between its duty to the
public interest and to its private shareholders. Fannie Maes leaders
prioritized short-term prots above public purpose, crippling an insti-
tution originally created to serve the public interest when the United
States was struggling to emerge from the Great Depression.
Fannie Maes Public Purpose
the Federal National Mortgage Association and the Federal Home
Loan Mortgage Corporation have an armative obligation to facilitate
the nancing of aordable housing for low- and moderate-income families
in a manner consistent with their overall public purposes, while maintain-
ing a strong nancial condition and a reasonable economic return.
U.S. Code - Title 12, Chapter 46, 4501(7)
The nature of Fannie Maes public service has morphed over the course
of its history. Originally, Fannie was a government agency whose sole
23
responsibility was to the American public. The federal government
charted the Federal National Mortgage Association (FNMA, or Fannie)
to jumpstart the national secondary mortgage market and to expand
the availability of credit to aspiring homeowners. Fannie was charged
with facilitating home mortgages as a way to invigorate the residential
construction industry as well as to provide adequate housing for its
citizens. (International Directory of Company Histories, 2002) At rst,
Fannie was restricted to the purchase and sale of mortgages insured
by the Federal Housing Administration (FHA). Mortgages insured by
the Veterans Administration (VA) were included beginning in 1949.
This remarkable increase in activity, as veterans returned home after
World War II, sparked calls for privatizationwhich would give private
investors direct access to its prots and reduce the governments role in
the housing sector. A compromise was reached in 1954, when Congress
transformed Fannie Mae into a mixed-ownership corporation in which
the U.S. Treasury held preferred stock but mortgage lenders could pur-
chase common stock. Fannies role was adjusted again in 1968 when
President Lyndon Johnson transformed Fannie into a quasi-public
corporation whose responsibilities were split between the public inter-
est and private investors.
Fannies duty to the American public changed again in 1992. President
Bill Clinton passed an act requiring that Fannie dedicate a certain
percentage of its business to mortgages for aordable housing. The
new legislation endowed HUD with the authority to set aordable
housing goals for Fannie Mae. In 1995, HUD launched the National
Homeownership Strategy, which was designed to increase the U.S. hom-
eownership rate. The plan was closely tied to Fannies obligation to the
aordable housing sector. HUD Secretary Henry Cisneros allegiance to
minorities (a former mayor of San Antonio, he is a Mexican-American)
was the driving force behind the new homeownership initiative. In the
late 1990s, minority homeownership rose to historic levels. Fannies
focus on aordable housing marked a new era for the organization and
gave new meaning to its public purpose.
The Lure of Private Prots
I attribute the need for todays action primarily to the inherent conict
and awed business model embedded in the GSE structure
Jim Lockhart, director of the new Federal Housing
Finance Authority, in a Sept. 7, 2008 statement
announcing the government conservatorship
of Fannie Mae and Freddie Mac
When President Johnson signed the Housing and Urban Development
Act of 1968, a 15-member board of directors was created to oversee
Fannie Mae, with ve members appointed by the President and 10
elected by shareholders. Not inconsequentially, the full privatization of
Fannie moved its substantial debt portfolio o of government books,
freeing up capital for the federal governmentwhose nancial burden
had increased considerably due in part to its costly involvement in
the Vietnam War. Under the new arrangement, Fannie was dubbed a
Government-Sponsored Enterprise (GSE). Though privately run, the
company remained accountable to its original Congressional charter
and also received both implicit and explicit benets from the federal
24 PANORAMA 2009
government. These benets included exclusion from taxes and access
to a direct line of credit from the U.S. Treasury. Along with the fact that
Fannie still remained tied to its Congressional charter, these beliefs
fostered the impression among investors that the federal government
would not allow Fannie to fail. Implicit government support allowed
Fannie to borrow funds at rates lower than those available to its private
competitors and helped the company build a reputation of low risk and
reliability.
In retrospect, President Johnsons restructuring of Fannie as a quasi-
public corporation actually created ambiguity within the private
sector and the federal government. While Fannie ostensibly remained
accountable to its original public purpose, the GSE structure allowed
the companys true mission to become unclear. This ambiguity would
eventually contribute to Fannies failure and takeover by the U.S.
government, as the companys leaders proved incapable of striking an
equitable balance between public purpose and private prot during the
housing boom years of the early 2000s. While many government of-
cials would point to the aws of the GSE structure as the cause of the
companys demise, it does not tell the whole story.
Breakdown in Regulation
while regulations did not force nancial institutions to make bad loans,
the absence of consumer protection regulation allowed many bad loans to
be made to the detriment of consumers.
Testimony of former Fannie Mae CEO Franklin D.
Raines before the House Committee on Oversight
and Government Reform, December 9, 2008
President Clintons 1992 act not only set new aordable housing goals,
but also established a new regulatory framework for Fannie. The
legislation formed the independent Oce of Federal Housing Enter-
prise Oversight (OFHEO), whose responsibilities included ensuring the
capital adequacy and nancial soundness of Fannie Mae and Freddie
Mac (see www.ofheo.gov). Fannie would be held to new, more stringent
reporting standards and subject to minimum capital reserve levels and
limitations on its appetite for risk. OFHEO was required to issue an
annual report detailing the nancial status of both Fannie and Fred-
die. The oce was dissolved in 2008 and replaced by a new entity, the
Federal Housing Finance Authority (FHFA).
OFHEO was largely ineective as a regulator for Fannie. During
OFHEOs 15-year life, Fannie consistently paid record dividends to its
shareholders; company executives received million-dollar compensation
packages. The company also burnished its reputation as an excellent in-
vestment. OFHEO did little to curb Fannies extraordinary growth and
to ensure that it was well managed. This was, of course, what Fannies
executives wanted. Former CEO Franklin Raines quotation at the start
of this section, where he seems to blame a lack of consumer protec-
tions for Fannies problems, is disingenuous. Fannies executives,
Raines among them, were actually averse to any regulation or oversight
that would hinder Fannies continued growth of prots and expan-
sion into the MBS markets. Fannies leaders also wanted to ensure
that Congress would not strip the company of its GSE status and the
associated nancial benets. Thus, Fannie annually spent millions of
dollars lobbying Congress including more than $10 million in 2005,
at the height of the companys excesses. This lobbying ran counter to
Fannies identity as a GSE and represented a double standard, as Fannie
was more than willing to continue receiving advantages as a result of its
association with the federal government but did not want to submit to
extensive oversight. This was a failure of Fannie Maes executive leader-
ship, who prioritized private prots over public purpose.
OFHEO was not alone in its authority to regulate Fannie Mae. Prior to
2008, the HUD Secretary was the mission regulator for Fannie and
Freddie, with oversight authority to ensure that both GSEs complied
with the public purposes set forth in their charters (www.hud.gov/
oces/hsg/gse/gse.cfm). However, as Fannie increased its activity in
non-traditional markets and took on more risk, HUD turned a blind
eye. The subprime and Alt-A markets targeted primarily low- and
moderate-income rst-time homeownersthe exact demographic to
whom HUD wished to extend the benets of homeownership. HUD
leadership chose to ignore the risks of Fannies increased appetite for
these mortgages so long as more Americans became homeowners. This
was another grave defect in leadership, as HUD allowed Fannie to skirt
its charter-specied duty to provide long-term stability to the second-
ary market. HUD also considered Fannies extension into non-tradi-
tional markets to be in alignment with the rms duty to expand credit
access for low- and moderate-income borrowers. This decision now
appears extraordinarily shortsighted, as the nancial collapse brought
about by these toxic products has restricted credit availability to nearly
unprecedented levels.
Poor Executive Decisions
Fannie Mae under Franklin D. Raines
I noted that, of the top twenty ocials of [Fannie Mae], none made less
than $1 million a year. And during the course of a ve-year period, there
were bonuses, not salaries ... bonuses paid out of $245 million. This,
going to an entity that was supposed to be focused on helping rst-time,
low-income homebuyers getting access to housing credit.
Former U.S. Congressman Richard Baker, in a July
14, 2008, interview on NPRs All Things Considered
Though regulation of Fannie was often lax in the 1990s and early
2000s, OFHEO and the Securities and Exchange Commission (SEC)
brought charges against the company in 2004 that alleged company
accountants, led by CFO J. Timothy Howard, manipulated company
nancials to trigger maximum payouts to executives between 1998 and
2004. In 2006, a settlement was announced that forced Fannie to pay
$400 million in penalties. When the scandal became public in 2004,
Fannies board of directors forced out Howard and then-CEO Franklin
D. Raines. The scandal exposed how, under Raines, Fannie had become
little more than a money-making machine where obsession with growth
and prot had prevailed over its charter commitments to both the
public and shareholder interests.
As CEO, Raines had shifted Fannies business model to increase prots
while taking on greater risk. While remaining active in creating and
issuing mortgages and mortgage-backed securities, Fannie increasingly
held more mortgages and MBS in its own retained mortgage portfo-
lio. Eventually, the company earned the majority of its income from
these assets. This practice exposed Fannie to both the upside and the
downside of these investments. When mortgages and MBS performed
well, as was the case during most of the 1990s and 2000s, the retained
portfolio had the capacity to generate handsome prots. But when
the assets began to perform poorly in 2006-07, the company suddenly
faced substantial interest rate risk and the potential of extraordinary
nancial duress. Fannie was left over-extended, necessitating the U.S.
takeover in the fall of 2008.
Fannie Mae under Daniel H. Mudd
One of the things we dont feel good about right now as we look into this
marketplace is more homebuyers being put into programs that have more
risk. Those products are for more sophisticated buyers. Does it make sense
for borrowers to take on risk they may not be aware of? Are we setting
them up for failure?
Testimony of former Fannie Mae CEO Daniel
H. Mudd before the House Committee on
Financial Services, April 17, 2007
Raines successor, Daniel Mudd, oversaw a decline in Fannie Maes
retained mortgage portfolio but an increase in the companys invest-
ment in non-traditional mortgages. In a December 2008 Congressional
hearing on the collapse of Fannie and Freddie, Representative Henry
Waxman publicly disclosed a previously condential June 2005 presen-
tation obtained from Mudds les. The presentation used very plain
language to convey that after Raines ouster, executives considered Fan-
nie to be at strategic crossroads. Fannie could, Mudd said, stay the
course, with the company taking pains to maintain [its] strong credit
discipline and protect the quality of [its] book. The second option
was for Fannie to meet the market where the market is and accept
higher risk and higher volatility of earnings. The presentation recom-
mended that Fannie Mae pursue a middle road, staying the course while
dedicating resources and funding to underground eorts (Waxman,
2008). In other words, Fannie would continue to expand into the
subprime and Alt-A markets even though it acknowledged an increased
risk. Mudd justied this foray by claiming that otherwise, the company
risked losing market share to its competitors and compromising its
prots. However, when the market for subprime and Alt-A mortgages
collapsed, Fannies prots nosedived and the American taxpayers were
left holding the bill. Mudds submission to the pressures of the market
suggests that he did not act in line with either of Fannies purposes in
mind. His shortsightedness had negative consequences on both the
public and Fannies private investors.
The Ultimate Accountability of Leadership
Although Fannie Maes two-pronged mission as a GSE rendered it dif-
cult for the companys leaders to fully adhere to its public purpose,
this report demonstrated that many decisions unrelated to its orga-
25
nizational structure and mission contributed to its nancial collapse References
and government takeover. Even Raines is reluctant to pin the blame Fannie Mae. 2002 International Directory of Company Histories, Vol. 45. Farmington Hills:
entirely on the GSE structure, stating, The GSE model is a far from St. James Press.

perfect way to achieve the goal of using private capital to achieve the Holmes, S.A. Fannie Mae Eases Credit To Aid Mortgage Lending. The New York Times, Sept.
30, 1999.
public purpose of homeownership and aordable rental housing.
However, if the public policy goal remains the same, it will be hard to Paulson, H. Statement by Secretary Henry M. Paulson, Jr. on Treasury and Federal Housing
Finance Agency Action to Protect Financial Markets and Taxpayers. Sept. 7, 2008.
nd a model that has more benets and fewer demerits than the model
Available at: http://www.ustreas.gov/press/releases/hp1129.htm.
that worked reasonably well for almost seven decades at Fannie Mae
Raines, F.D. Testimony before the U.S. House Committee on Oversight Reform, Dec. 9,
(Raines, 2008). Fundamentally, Raines is correctand thus his state- 2008.
ment is somewhat self-incriminating. The failure of Fannie Mae cannot
Waxman, H. Accompanying Documents to Chairman Waxmans Opening Statement.
be reasonably blamed on the GSE model. Even a government conser- Hearing of the U.S. House Committee on Oversight and Government Reform. Dec. 9,
vatorship that place[s] common shareholders last in terms of claims 2009. Available at: http://oversight.house.gov/story.asp?ID=2252.
on the assets of the enterprise will not be a panacea to poor choices Whitewashing Fannie Mae: Congress Begins Its Self-Absolution Campaign. Unsigned
of leaders (Paulson, 2008). Fannies demise was due to a unique series editorial. The Wall Street Journal, Dec. 11, 2008.
of poor decisions on the part of the leaders of Congress, HUD, OFHEO,
and Fannie Mae itself. These leaders failed to uphold the decades-old
mission of Fannie Mae when confronted with the potential for signi-
cant personal nancial gain. Their inability to strike a prudent balance
between serving the public interest and generating prot compromised
the integrity of the U.S. housing market. As a result, American hom-
eowners are now struggling to gain access to mortgage credit, and U.S.
taxpayers are saddled with unprecedented nancial burden that will
undermine the eectiveness of their government for years to come.

26 PANORAMA 2009