Journal of Financial Crime

Fannie Mae and Freddie Mac: a case study in the politics of financial reform
Muhammad Islam Neil Seitz James Millar James Fisher James Gilsinan
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Muhammad Islam Neil Seitz James Millar James Fisher James Gilsinan, (2013),"Fannie Mae and Freddie
Mac: a case study in the politics of financial reform", Journal of Financial Crime, Vol. 20 Iss 2 pp. 148 - 162
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JFC
20,2 Fannie Mae and Freddie Mac:
a case study in the politics of
financial reform
148
Muhammad Islam
Department of Economics, John Cook School of Business,
Saint Louis University, St Louis, Missouri, USA
Neil Seitz
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Department of Finance, John Cook School of Business,

Journal of Financial Crime
Vol. 20 No. 2, 2013
pp. 148-162
q Emerald Group Publishing Limited
1359-0790
DOI 10.1108/13590791311322346
Saint Louis University, St Louis, Missouri, USA
James Millar
Department of Finance, University of Arkansas, Fayetteville, Arkansas, USA
James Fisher
Department of Marketing, John Cook School of Business,
Saint Louis University, St Louis, Missouri, USA, and
James Gilsinan
Department of Public Policy Studies, Saint Louis University,
St Louis, Missouri, USA
Abstract
Purpose – The desirability of financial reform to avoid another financial melt-down is widely
accepted, but the likelihood of reform is uncertain. The purpose of this paper is to present a case study
of evolution and reform attempts at US mortgage giants Fannie Mae and Freddie Mac and provides an
instructive model of the likely long-term success of attempts to reform the financial system.
Design/methodology/approach – A model of the legislative and regulatory change process is first
developed, considering the range of influences that arise. The history of reform attempts for US
government sponsored mortgage giants Fannie Mae and Freddie Mac are examined in the context of
this model.
Findings – The model predicts that reform will often be thwarted. US government sponsored mortgage
giants Fannie Mae and Freddie Mac helped fuel the housing bubble and required a government bail-out.
Sentiment for reform was high, but what happened next was – nothing. Fannie Mae and Freddie Mac
have a long history of successful lobbying, and they succeeded again. They did not need to stop
legislation. They needed only to see it delayed long enough for attention to turn elsewhere. Five years
after the bubble broke, their market dominance and the implied guarantees continue. Reform is not on the
legislative agenda. This outcome does not bode well for financial market reform or stability.
Originality/value – An understanding of the process, influences, and likelihood of reform is
important for governments, businesses, and individuals. While the picture this paper paints is not
optimistic, it is important.
Keywords Finance, Fannie Mae, Freddie Mac, Financial reform, Financial crisis, Mortgage companies
Paper type Conceptual paper
No organizations were closer to ground zero of the real estate bubble and sub-prime
mortgage melt-down than the Federal National Mortgage Association (Fannie Mae) and
 the Federal Home Loan Mortgage Corporation (Freddie Mac). These US Government Fannie Mae and
sponsored enterprises (GSEs) were created to provide a secondary market for Freddie Mac
mortgages, thereby increasing the availability of mortgage loans. They took advantage
of favorable tax treatment and implied government guarantees to become the lead
players in the US mortgage market before and after the bubble broke, requiring
taxpayers to bail them out at a cost likely to reach hundreds of billions of dollars.
We examine the growth, influence, failure, and possible future of Fannie Mae and 149
Freddie Mac. We particularly focus on the legislative process that has determined the
historical and current structure of these GSEs. The rest of the paper is organized as
follows: in Section 1 below, we present a general model of the legislative process. In Section
2, we briefly present the history of Fannie Mae and Freddie Mac along with a discussion of
the proposals for reform and the objections to some of the proposals. Through this, we
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identify some of the key stakeholders in the legislative process including the management
of the GSE’s, advocates of privatization and fundamental reform of GSE’s, and advocates
of greater flexibility and access to low-cost mortgage loans for moderate to low income
home buyers. In Section 3, we look at the various legislative attempts to reform
Fannie May and Freddie Mac and the failure of such attempts over the last two decades.
As the general model of the legislative process suggests, legislation ultimately is a
compromise between the stakeholders having interest in a particular piece of legislation,
and in the case of Freddie May and Fannie May, stakeholders often had strong incentives
to derail laegislation, and acted to undermine lagislative efforts not to their liking.

1. A model of the legislative process

The US legislative process can be likened to an iceberg. While one can observe the
visible mass of the iceberg, much of the process is hidden below the surface, and only
individuals and institutions that have a strong stake in the legislation are aware of
what lies underneath. These stakeholders protect their interest through the intense
lobbying of legislators. Much of this lobbying is also absent from the public eye.
Though lobbying is often frowned upon and viewed as extraneous to the legislative
process, it is an essential part of democratic law making, and provides a mechanism for
interested citizens to participate in the legislative process. What appears as final
legislation, however, is an outcome from a process involving many compromises
among stakeholders, compromises that are not necessarily visible to an outside
observer. Sometimes, lobbying is successfully able to derail legislation.
Legislation of any kind begins as an idea in what Birkland (2005) terms the agenda
Universe. The agenda universe consists of all possible ideas that could be advanced in
any society. The content of this universe changes over time. To illustrate the steps in
this process, consider the examples of Equal Rights Amendment for women and of gay
marriage. At one point in time, the former had a strong presence in the agenda
universe, and the latter was not even mentioned. Now the situation is reversed.
The issue of gay marriage gained strength in the agenda universe to the point where it
actually moved to what Birkland (2005) terms the systemic agenda, the place where
items that could actually be considered by participants in the policy process reside. From
there, it moved to the institutional agenda, the agenda of items actually being considered
by governmental bodies. The final step in the process, according to Birkland (2005), is
making it to the decision agenda. This is the more public part of the process, where
legislators debate and decide whether or not to pass a piece of legislation. The fate
 JFC of both gay marriage and the Equal Rights Amendment floundered at this stage.
20,2 Some state legislatures have endorsed gay marriage, others have rejected it. And the
Equal Rights Amendment did not garner enough support in the state legislatures to be
ratified as a constitutional amendment. The lesson here is that making it to the decision
agenda is no guarantee of success. Moreover, less visible lobbying takes place at all
points in the process, with proponents trying to move causes to the next agenda level and
150 opponents trying to stop such movement.
As illustrated in Sections 2, reform of the two GSE’s, Fannie May and Freddie Mac,
has been under discussion, and therefore, part of the both the agenda universe and the
systemic agenda, for almost 30 years. Throughout, academics, journalists and
legislators have debated the pros and cons of the role of the GSE’s in the mortgage
market, and also the direction of reform, if any.
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GSE reform has also made it on to the institutional agenda and has been part of
legislative discussion in both houses of the US Congress. As discussed in Section 3, as far
back as the early 1990s, both the House and Senate held hearings and proposed
legislation to reform the GSE’s. Movement to the actual decision agenda is helped by the
presence of focusing events. For the GSE’s two such events have played an important
role in moving through the institutional agenda into the decision agenda. The first event
was the GSE accounting scandal of the late 1990s that resulted in legislative calls for
greater oversight. The second was the housing market collapse, and along with that the
collapse of GSE finances requiring massive government intervention. The latter event
has forced legislators to consider GSE reform, including privatization that would shield
taxpayers from any future liability. It is certainly, now, part of the decision agenda.
However, as we have seen, presence in the decision agenda does not necessarily imply
that legislators will be able to resolve conflicts, and actually succeed in passing
legislation.
As discussed briefly above, but detailed in Section 3 below, at each stage in
the agenda-setting process, stakeholders will try to take advantage of the
opportunities presented by focusing events, political turnover, and expert input to
push forward or stall legislation. Lobbying by stakeholders can help move an issue
through the next leve of the decision-making process. Conversely, intensive lobbying
can also occur to stop movement through the decision process. With regards to GSE’s,
congressional committees held hearings, brought reform proposals to vote in various
legislative committees, but could not move legislation out of committees for a vote of the
entire congress. Sometimes, lobbying occurs not to oppose legislation, but to restrict
legislation in such a way that the final outcome is not palatable for the other
stakeholders, and efforts to legislate simply die.

2. GSE’s (Freddie Mac and Fannie Mae): a brief history and arguments for
reform
Fannie Mae and Freddie Mac (or just Fannie and Freddie) were created by the federal
government of the USA for the purpose of increasing home ownership by increasing
the supply of mortgage loans. More specifically, Fannie Mae and Freddie Mac were
created to provide a second market for mortgage loans so that original lenders could
free up their money for new loans.
Fannie Mae was created by the Roosevelt administration in 1938. Fannie Mae was a
government agency, owned and overseen by the federal government. Fannie Mae’s role
 was to buy government guaranteed mortgages from loan originators. The mortgages Fannie Mae and
were guaranteed by the Federal Housing Administration, the Veterans Administration, Freddie Mac
and the Farmers Home Administration. The government was at risk because it
guaranteed loans, but the guarantees made loans risk-free for Fannie Mae.
The goal of the government in creating Fannie Mae was to make more funds
available for lower income and less credit worthy families. Fannie Mae appears to have
been successful for a number of years in this regard. 151
The government’s goals with regard to its involvement in the mortgage market
shifted over time. 30 years after its founding, Fannie Mae was converted to private
ownership as a publicly traded corporation. Although it was now privately owned,
Fannie Mae was still a GSE with favorable tax status and an implied guarantee.
Consequently, there was little competition from private companies.
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The government moved to enhance competition in 1970 by creating the Federal Home
Loan Mortgage Corporation to provide essentially the same services as Fannie Mae,
thereby providing competition in the marketplace for the purchase of home mortgages.
Freddie Mac was created as a government-owned entity.
1970 also saw government approval to purchase mortgages that were not guaranteed
by the government. A year later, Freddie Mac issued its first mortgage-backed security.
A decade later, Fannie Mae followed suit. The mortgages were not guaranteed by the
federal government, but mortgage-backed securities were guaranteed by Freddie Mac
and Fannie Mae. The era of risk-return decision making was thus ushered in for
Freddie Mac and Fannie Mae.
In 1989, Freddie Mac joined Fannie Mae as a private company with publicly traded
stock. This put both Fannie Mae and Freddie Mac in the position of private, for-profit
companies, but with status as GSEs with implied government guarantees (which turned
out to be real guarantees when the mortgage crisis hit). Fannie Mae and Freddie Mac had
drifted a long way from the structure created in 1938. They had become the principal
players in the home credit market. Credit standards for mortgages were primarily those
necessary to sell the loans to Fannie Mae or Freddie Mac.
The appeal of the structure to which Freddie Mac and Fannie Mae had morphed was
that the implied guarantee allowed these institutions to supply credit to the housing
market at very low costs. The costs were low because the value of the implied guarantee
did not show up on anyone’s books. Without an implied government guarantee or greatly
increased equity in their capital structures, the Fannie Mae and Freddie Mac guarantees of
mortgage-backed securities would have been worthless and the required returns would
have had to be high enough to compensate for risk. Through implied guarantees and the
unique structures of Freddie Mac and Fannie Mae, the government could execute its
housing policies at no cost, or at least there was no cost until the real estate bubble broke.
The government took advantage of the costless opportunity to increase housing
credit with increased enthusiasm. In 1992, the Housing and Community Development
Act gave Fannie Mae and Freddie Mac the goal of purchasing 30 percent of low and
moderate income housing loans. In 1999, Freddie Mac and Fannie Mae again lowered
credit standards under government pressure.
In 2004, Fannie Mae was caught up in an accounting scandal and accused of
shifting losses on interest rate hedges so management could earn bonuses. Fannie Mae
was eventually required to restate earnings for the prior three years. Fannie Mae was
 JFC also placed in the position of being eager to rehabilitate its image with the congress and
20,2 others, thus setting the stage for the next round of problems.
With their cost advantages and implied guarantees, it is not surprising that Fannie
Mae and Freddie Mac grew to the point of $1.5 trillion in combined assets. Even more
importantly, these institutions had $5.3 trillion in combined assets and
mortgage-backed security guarantees. These two agencies plus the Federal Housing
152 Authority guaranteed 90 percent of all mortgages.
In 2007, the government raised Freddie Mac’s and Fannie Mae’s goals to 55 percent
of low and moderate income housing loans. The quality of loans purchased by Freddie
Mac and Fannie Mae deteriorated.
Loan losses grew exponentially over the next year, and these agencies hurtled toward
bankruptcy. On September 8, 2008, Fannie Mae and Freddie Mac were placed under
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conservatorship to avoid complete collapse, with 79.9 percent government ownership.

Government ownership was held just below 80 percent to avoid consolidated accounting
of Fannie Mae and Freddie Mac as part of the federal government.
With collapse and government takeover in 2008, the implicit government guarantee
became real. The government has lost $150 billion, and the eventual loss is still unknown.
Following the collapse, two narratives competed for public opinion, as is often the
case in the legislative process. The narratives can be characterized with two recent titles:
(1) Calomiris and Wallison (2008); and
(2) Center for Responsible Lending (2011).
The essence of the competing narratives was:
.
Fannie Mae and Freddie Mac purchased low quality loans because “Wall Street”
created them.
.
Sub-prime loans were created by diverse mortgage lenders across the country
because Fannie Mae and Freddie Mac were ready to buy them.

While the debate between the scenarios can never be resolved, it is interesting to note
that the UK experienced a 90 percent increase in housing prices from 1998 to 2007
without Fannie Mae, Freddie Mac, or Wall Street to blame[1]. Regardless of the blame,
many of those on both sides of the debate support the same solution: privatization.

Reform plans: privatization

President Obama promised a reform that would assure the country that a crisis like
this would never happen again. Senior members of both political parties, regardless of
which blame narrative they accepted, saw privatization of Fannie Mae and Freddie
Mac as the way to avoid another crisis. The Wall Street Journal described the Obama
proposal as a plan to “gradually dissolve ailing housing giants Fannie Mae and
Freddie Mac and to shrink the government’s role in the mortgage market (Alan Fram,
2011a)”. Republican representative Jeb Hensarling was more direct, introducing
legislation to wind down the two entities within five years (Alan Fram, 2011b).
The debate around privatization often focuses on debate about the impact of Freddie
Mac and Fannie Mae as GSEs (hereafter referred to as GSEs) on home ownership and the
availability of mortgage credit, particularly for those of low and moderate income.
Calls for privatization are not new. In arguing for the privatization of GSE’s, many
commentators have argued that the implied government guarantee to the GSE’s had
 the effect of GSE being able to borrow at rates more favorable than that of AAA rated Fannie Mae and
corporations when without the implicit guarantee the GSE’s would have the higher Freddie Mac
borrowing cost of AA-rated corporations. This implicit guarantee had lowered GSE
borrowing cost between 30 and 45 basis points (White, 2005). Further, GSE mortgage
loans are made without pre-payment penalties. As a result, the borrower is able to shift
all interest risk associated with pre-payment to the lender though it is possible that the
lack of pre-payment penalty may be reflected in higher mortgage rates relative to rates 153
that would prevail with explicit pre-payment penalties.
The favorable borrowing terms offered by the GSEs implies higher homeownership
and associated positive externalities of home ownership. As the current chairman of the
Federal Reserve Banks has noted, it is possible that GSE enhance liquidity and reduced
mortgage costs in at least some markets: specifically, the market for mortgages for lower
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and middle income first time home buyers, and for mortgages in low income
neighborhoods (Bernanke, 2007). However, the size of the GSE’s may pose significant
systemic risk: that financial distress at the GSE’s may quickly impact the rest of the
financial sector. While there are no guarantees that financial distress will not strike,
Federal Reserve Board Chairman Bernanke states that systemic financial risk has two
primary sources:
(1) that the particular financial institution is very large; and
(2) lack the discipline that market forces impose on privately owned and operated
institutions.

The two GSE’s fulfilled both conditions: they were indeed very large, and together held
more than $5 trillion in debt in 2007, and lacked market imposed discipline because
creditors believed in the implicit government guarantee of GSE debt. To the extent that
the GSE’s were taking excessive risk, markets did not respond by asking the GSE’s for
better terms or better collateral.
Calls to privatize the GSE’s are predicated on the assumption that the systemic risk
inherent in the GSE’s under the current regulatory environment would be ameliorated
because privatized GSE’s would have to curb excessive risk taking due to market
demands placed on the privatized institutions, or would have to hold collateral assets
in sync with the risk undertaken. Large banks Tier I capital requirements are
significantly higher, 8 percent (and due for further increase under Basel III), while
GSE’s held less than 4 percent. As has been pointed out, under current regulatory
regime, GSE’s have every incentive to grow faster than the mortgage market growth
(William, 2007). A combination of low capital requirement together with the ability to
borrow at below market rates and invest in mortgages results in high profit margins,
providing GSE’s the incentive for growth. Privatized.
GSE’s would have to hold a higher level of reserve capital to protect private
investors in case of financial distress. They would no longer be able to shift the risk of
financial distress is ultimately shifted to the tax payer.
There is, of course, concern that privatization will have significant adverse impact on
the mortgage market and the ability to purchase homes. One concern is that without the
implicit government guarantee, the structure of the mortgage market will change. The
30 year fixed mortgage market came to being following the Great Depression when
homeowners holding five year mortgages were unable to re-finance those mortgages
because home values had fallen below what was owed on the mortgages (Charles and
 JFC Kenneth, 2010). The Homeowners’ Loan Corporation took many of these shorter
20,2 maturity loans and converted them into longer term fixed rate amortizing mortgages.
Some have expressed concern that privatization of the GSE’s would reduce in the
availability of 30 year fixed rate mortgages. Some estimates suggest that the availability
of fixed rate mortgages without the implicit government guarantee could fall anywhere
between 10 and 20 percent (Zandi and deRitis, 2011). The mortgage market may become
154 a shorter duration market similar to that prevalent in European countries, and home
ownership could also fall. Further, private markets would have to charge higher rates,
by as much as 140 basis points (Zandi and deRitis, 2011) due to interest rate risk and
pre-payment risk associated with longer duration fixed rate mortgages, and these
problems would heighten during periods of financial distress.
Proponents of privatization argue that a decline in availability of longer term
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mortgages and higher rates are not forgone conclusions. They point to the fact that
financial institutions still hold about 20 percent of the mortgages that they initiate in
their own portfolios, and are able to withstand interest rate and pre-payment risk by
hedging against such risk. The existence of the appropriate hedging instruments would
allow private markets to initiate longer term mortgages at the current risk. Proponents
also point out that removal of the implicit guarantee of GSE debt may not raise
borrowing cost. They point out that along with GSE conforming loans, private financial
institutions have been issuing non-conforming Jumbo loans. Researchers have looked at
the interest rate differential between conforming and non-conforming loans from 1998 to
2009. Over this time period, the interest rates charged for conforming and
non-conforming loans were very similar, with rates on non-conforming loans about
25 basis points higher than that of conforming loans (Scharfstein and Sunderam, 2011).
Thus, they argue that even if loan rates rise, the increase would be limited to that range,
and would not result in significant increases in long-term mortgage rates. It has to be
recognized that the small interest rate differential that exists between conforming and
non-conforming loans may be because financial institutions are better able to assume the
risk of non-conforming loans. The bulk of their mortgages, which are conforming, have
the implicit government guarantee through the GSEs, allowing financial institutions to
hold down lending rates for the riskier non-conforming loans. Further, non-conforming
loans, particularly of the jumbo kind, go to home owners with high income, reducing risk
associated with jumbo loans. Whether that experience can be translated for conforming
loans going to middle and low income borrowers is an open question. Recent evidence is
a cause for concern because private capital available for the non-conforming loans has
dried up, and almost all mortgage finance has been GSE backed.
Proponents of privatization also have pointed to countries like Canada, Germany, and
Denmark to argue that a fully functioning and well capitalized private mortgage market
can exist and thrive in the absence of implicit government guarantees (Wallison, 2011).
However, others have pointed out that the argument that the above mentioned countries
do not have implicit guarantees is not credible. They point to the guarantees through
insurance or re-insurance mechanisms. For example, in Canada, government provides
guarantees for private mortgage insurers along with direct participation in housing finance
through the Canadian Mortgage and Housing Corporation. Thus, over two-thirds of
mortgage origination in Canada has some form of government guarantee (Swagel, 2011).
Critics of complete privatization also point out that during the financial crisis of 2008, both
 Germany and Denmark made it clear that they would stand behind lenders, the financial Fannie Mae and
institutions that provide capital to the mortgage markets (Swagel, 2011; Min, 2010). Freddie Mac
Another objection to privatization has to do with the publicly policy goal of
increasing home ownership for middle income and low income earners. If the impact of
privatizing GSEs is asymmetric, adversely affecting the availability of loans and
mortgage interest for middle and low income borrowers, positive externalities
associated with home ownership would be lost. Proponents of privatization have 155
argued that while this observation has merit, there are other government entities that
the government can utilize to meet this important public policy goal. Specifically, they
point to the FHA, and state that the role of FHA can be expanded to meet the goal of
increasing home ownership for low and middle income earners.
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3. Agenda universe, legislative initiatives, and outcome

Freddie Mac and Fannie Mae were moved off the government books so the GSE’s debt did
not show up as public debt. Whether Freddie Mac or Fannie Mae would maintain status as
GSE’s or become entities that relied solely on private capital markets was very much part
of the early discussion, as it is now. The 1982 President’s Commission on Housing report
called for greater deregulation of mortgage banking and an enhanced role for private
sector in the secondary market for mortgages. It was the Commission’s view that greater
deregulation would accomplish the goal of privatised GSE. They noted:
Eventually, the Commission believes, both FNMA [Fannie Mae] and FHLMC [Freddie Mac]
should become entirely private corporations, without special access to the deep pockets of
the treasury (Mckenna and Hills, 1982)[2].
Obviously, the Commission relied on the assumption that in deregulated private
markets, capital would flow to its best use, and Fannie Mae and Freddie Mac would
have to take on the characteristics of efficient private firms to compete effectively.
However, just the opposite happened. Fannie Mae and Freddie Mac being GSEs,
retained the implicit government guarantee, which provided the safe haven to simply
drive capital into the GSE’s. The GSEs’ share of mortgage market grew fourfold from
7 percent within the next decade, and to 44 percent by 2002.
This expansion, according to Wallison and Burns (2011), was brought about by the
changing role of the GSE’s in the housing market. In 1992 Congress passed in 1992 H.R.
5334. While signing into law H.R. 5334, President George Bush said:
[. . .] bill establishes a sound regulatory structure for GSE). This legislation addresses the
problems created by the rapid expansion of certain GSEs in the last decade. It establishes a
means to protect taxpayers from the possible risks posed by GSEs in housing finance. The
bill creates a regulator within the Department of Housing and Urban Development (HUD) to
ensure that the housing GSEs are adequately capitalized and operated safely (Bush, 1992).
Wallison and Burns argued that this very law may have pushed the GSE’s toward
taking increased risk because one of the goals of HR 5334 was to increase home
ownership among moderate and low income people. The latter was supported by both
the Bush and the Clinton administrations, and led the GSE’s toward subprime and
higher risk lending.
The inherent risk in GSE expansion was also understood outside of the immediate
policy circle. For example, in 1999, the New York Times reported that the GSE’s were
 JFC lowering credit standards to increase home ownership. This was not denied. Instead,
20,2 Franklin Raines, the then Chief Executive Officer (CEO) of Fannie Mae, stated in the article:
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 (Holmes, 1999).
156
The risks in the implicit guarantee that the GSE’s enjoyed and their increased presence
in the mortgage market were well understood. A number of policy makers and policy
watchers, both from the Democratic and Republican side, have commented on the
inherent risk. For example, in October, 1999, then Treasury Secretary Lawrence
Summers, stated: “Debates about systemic risk should also now include GSEs, which
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are large and growing rapidly (Summers, 1999)”. On March 22, 2000, in testimony in
support of HR 3703, “Housing Finance Regulatory Improvement Act”, a bill designed
to constrain the GSE’s, Treasury Under Secretary, Gensler (2000) said, “As the GSEs
continue to grow and to play an increasingly central role in the capital markets, issues
of potential systemic risk and market competition become more relevant”.
Warnings of the systemic risk inherent in the GSE’s and the need to reform
continued unabated. In September 2003, the Treasury Secretary John Snow said:
There is a general recognition that the supervisory system for housing-related government
sponsored enterprises (GSEs) neither has the tools, nor the stature, to deal effectively with the
current size, complexity, and importance of these enterprises[3].
In November, Mankiw (2003), Chairman of the Council of Economic Advisers warned:
The enormous size of the mortgage-backed securities market means that any problems at the
GSEs matter for the financial system as a whole. This risk is a systemic issue also because the
debt obligations of the housing GSEs are widely held by other financial institutions.
The importance of GSE debt in the portfolios of other financial entities means that even a
small mistake in GSE risk management could have ripple effects throughout the financial
system, [. . .] legislation to reform GSE regulation should empower the new regulator with
sufficient strength and credibility to reduce systemic risk.
Greenspan (2004), Chairman of the Federal Reserve Board of Governors, offered a
similar warning:
The Federal Reserve is concerned about the growth and the scale of the GSE’s mortgage
portfolio, which concentrate interest and prepayment risks at these two institutions. Unlike
many well-capitalized savings and loans and commercial banks, Fannie and Freddie
have chosen not to manage that risk by holding greater capital. Without the expectation of
government support in a crisis, such leverage would not be possible without a significantly
higher cost of debt.
Throughout this crucial time period, there were legislative efforts to limit GSE activities.
These efforts included both increased capital requirements and the appointment of an
independent regulator who would ensure transparency in GSE accounting and capital
reserves in line with riskiness of assets. The call for such reforms became frequent after the
GSE’s were caught polishing earnings to the benefit of management. That accounting
scandal led to re-statement of earnings and departure of most of the top management.
Despite the misgivings of the policy makers, and repeated discussion of the systemic risk
posed by the GSE’s and the need to reform, legislative efforts failed.
 Failure of legislative efforts can be blamed, to a large extent, to the powerful Fannie Mae and
incentives the GSE’s had to argue and lobby against such initiatives. The Congressional Freddie Mac
Budget Office (CBO) estimates that the implicit government guarantee that lowered
GSE borrowing cost amounted to a subsidy of over $150 billion over time. However, this
subsidy was not passed onto homeowners through lower mortgage costs. Instead, much
of this subsidy resulted in private gains to the managers and the shareholders of the
GSE’s. Many observers have noted the success the GSE’s had stalling reform efforts. 157
Ralph Nader commented:
Fannie Mae and Freddie Mac are fast learners. Born of the federal bureaucracy, these
enterprises have swiftly and skillfully managed to pick up the roughshod tactics of the
private corporate world and at the same time cling tightly to one of the federal government’s
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deepest and most lucrative welfare troughs [. . .] The combination has produced two GSEs
that are not only too big to be allowed to fail but perhaps too influential and too politically
connected to be regulated or shaped effectively in the public interest. Any suggestion that
their power be limited or that subsidies be reduced triggers an immediate no-holds-barred
counterattack from Fannie Mae and Freddie Mac. As John Buckley, Fannie Mae’s vice
president for communications, bluntly told the Wall Street Journal, “We’re casual about
managing our political risk”.
Fannie and Freddie are extremely skilled at playing the heart strings to the fullest about
America’s love affair with homeownership. Rarely does a Fannie Mae newspaper
advertisement appear or a television spot air without emphasis on the corporations’ role in
“helping families achieve the American Dream”.
But Fannie and Freddie do not depend solely on the goodwill generated by a housing finance
role to shield their corporations from scrutiny. Far from it. These GSEs, particularly Fannie Mae,
have built an almost impenetrable moat that essentially seals off their operations from serious
ongoing examination by Congress, the media, or even many advocacy groups engaged in
promoting affordable housing [. . .] Washington’s approach to the GSEs is the product of an
influence machine that is oiled by revolving doors, the care and feeding of key politicians across
the nation, a quick-strike take-no-prisoners public relations operation, and targeted contributions
to advocacy organizations – activities financed by slush funds created by generous forms of
corporate welfare (Nader, 2001).
Nott and Jickling (2005) of the Congressional Research Service (CRS), in a report
prepared for the 108th Congress also noted the GSE’s lobbying effort and the strong hold
that the GSE’s had over members of Congress. Following the Savings and Loan crisis,
Congress created the Office of Federal Housing Enterprise Oversight to oversee GSE
operations. Yet repeated efforts, as many as four bills in the 108th Congress, aimed to
regulate the GSE’s failed to garner sufficient legislative support (Nott and Jickling, 2005).
But, as Combs (2010) observes:
Despite efforts to regulate them, the GSEs successfully protected their charter powers by
increasing influence in Congress. Indeed, especially after the S&L crisis, the GSEs faced a
“political risk” that Congress would alter their charters.
But as Franklin Raines, ex-chairman of Fannie Mae once told his investors, “we manage
our political risk with the same intensity that we manage our credit and interest rate risks
(Combs, 2010)”.
When necessary, the GSE’s fought back with intensity to protect their interest. The GSE
Report provides a glimpse of this ability to fight back: in 2000, Treasury Under Secretary
Gensler before the House Banking Committee that that the GSE’s line of credit with the
 JFC US Treasury be removed and that their total debt be limited to what commercial banks
20,2 were willing to hold, the GSE’s. GSE response to this seeming threat is detailed as follows.
Fannie called Gensler’s comments “unprofessional and irresponsible,” adding that
the bond market’s reaction raised costs to consumers (editorial note: Fannie Mae’s
standard response to anyone who expresses concerns about the GSEs).
In a statement to reassure the market, Gensler stated that his testimony was
158 “consistent with longstanding administration principles in this area [. . .] It does not
represent a change in the government’s relationship with the GSEs”.
Fannie apologized for its comments about Treasury and then six days later lashed
out again at Treasury saying Gensler’s testimony caused a destabilization in the
agency debt market and raised costs to consumers, claiming that 206,000 families will
be disqualified for homes.
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The next day Fannie apologized again for its comments about Treasury.
Cong. Baker accuses Fannie of using intimidation tactics and “verbal attacks” to
keep lawmakers and administration officials from supporting his GSE bill. Fannie’s
contention that:
[. . .] the mere mention of GSE reform means turbulence for national mortgage rates, and to a
lesser extent by presuming it can intimidate the very government that sponsors its activities,
Fannie Mae is itself providing the strongest justification for concern over its size (The GSE
Report, 2000).
Interestingly, the GSE’s were not timid about their lobbying efforts. Where it served
their purpose, they would take their lobbying efforts directly to the voting public.
Fearing that a 2004 Congressional bill would constrain Fannie Mae and Freddie Mac
operations, Fannie Mae ran a television advertisement right before the Senate Banking
Committee was preparing to draft a bill. The advertisement shows a couple.
He says “Uh-oh”, and the wife responds, “What?” “It looks like Congress is talking
about new regulations for Fannie Mae”, the man states. “Will that keep us from getting
that lower mortgage rate?” the women replies. “Some economist’s say rates may go up”
he says. “But that could mean we won’t be able to afford the new house”, says the
woman. “I know”, the husband concludes (The GSE Report, 2000; Acharya et al., 2011).
The political risk was often managed by appointing well connected individuals to
the GSE’s Board and management. As one observer noted:
It is also a classic example of bipartisan back-scratching. Political appointees to the
companies’ boards pocket millions in stock options to keep the pork flowing on Capitol
Hill. Clinton-appointed board members at Fannie Mae include Marc Rich’s lawyer Jack Quinn
and Janet Reno’s lieutenant at the Justice Department, Jamie Gorelick. At the helm of Fannie
Mae is Franklin Raines, who served as director of the Office of Management and Budget
under former President Clinton. Raines just happens to be a buddy of Bush Treasury
Secretary O’Neill. “I consider Frank Raines to be a close personal friend of mine”, O’Neill said
glowingly in the Bloomberg interview (Washington Times, 2001).
The huge $1.6 million that the former Republican Speaker of the House of Representatives
collected since leaving office is now well known. The relationship that the GSE’s enjoyed
with former Congressman Newt Gingrich is detailed in the New York Times:
Two of the sponsors for part of the Ireland trip were frequent partners of Mr. Gingrich:
Freddie Mac and Fannie Mae – the government-backed housing industry giants [. . .]
Mr. Gingrich has faced many questions recently about the more than $1.6 million in
 consulting fees he got from Freddie Mac since leaving Congress in 1999. But part of the Fannie Mae and
relationship started years earlier, as records and interviews show that Mr. Gingrich, as House
leader in the 1990s, aligned himself with Freddie and Fannie on a number of key issues – Freddie Mac
defending them in Congress against political attacks, joining with them on housing projects
and seeing top aides go work for them [. . .] Of particular significance, several officials said,
was Fannie’s hiring of Arne L. Christenson, Mr. Gingrich’s chief of staff, as a top executive
and lobbyist in 1999 (Lichtbau, 2012).
159
Regarding the rather robust lobbying efforts of the GSE’s former Representative
Jim Leach (R-IOWA), member House Banking Committee made the following comment:
It is no accident that no commercial companies in the past generation have had as muscular a
lobbying operation on Capitol Hill. When, for instance, I once introduced a battery of
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constraining amendments, including a doubling of capital requirements, to legislation

favorable to Fannie and Freddie, it took each less than 48 h to orchestrate both parties’
leadership to weigh in against trimming their wings of privilege (Lichtbau, 2012; Combs, 2010).
Nott and Jickling of the CRS note a similar approach in political contributions: they
state that GSE’s were effective because of money that they lavished:
Together, Fannie and Freddie contributed $14.6 million to various congressional campaigns
between 2000 and 2008. The GSEs were “double-givers”, supporting members of both parties,
especially those sitting on committees with jurisdiction over their industry (Lichtbau, 2012;
Combs, 2010; Nott and Jickling, 2005).
The Center for Responsive Politics provides a detailed account of the contributions made by
the GSE’s during the 2000-2008 time period. As can be seen below, the GSE’s spent almost
$180 million in political contributions and lobbying, with political contributions going
roughly in equal proportions to members of the two political parties (Table I).
Not surprisingly, reform efforts failed because of political influence. Even when
both Houses of Congress agreed on reform measures, last minute amendments resulted
in ultimate rejection of such legislation. The CRS report states the following regarding
S. 1508:

Cycle Contributions ($) % to Dems % to Repubs Lobbying ($) Total ($)

Contributions and lobbying: Freddie Mac

2008 483,667 55 45 12,970,000 13,453,667
2006 648,802 46 54 21,424,048 22,072,850
2004 211,988 60 40 33,280,000 33,491,988
2002 4,176,674 43 57 16,960,000 21,136,674
2000 2,466,539 43 57 8,060,000 10,526,539
Total 7,987,670 49 51 92,694,048 100,681,718
Contributions and lobbying: Fannie Mae
2008 916,250 62 38 7,010,000 7,926,250
2006 955,250 53 47 20,240,000 21,195,250
2004 794,024 62 38 17,490,000 18,284,024
2002 2,394,750 51 49 13,647,000 16,041,750
2000 1,591,757 54 46 14,030,000 15,621,757
Total 6,652,031 56 44 72,417,000 79,069,031
Source: Center for Responsive Politics Table I.
 JFC On April 2, 2004, the Secretaries of the Treasury and HUD released a statement of opposition
to S. 1508 as reported by the Senate Banking Committee. The statement referred to an
20,2 amendment adopted in markup which allows Congress to overrule the GSE regulator’s
decision to appoint a receiver, and characterized this amendment as significantly weakening
“a core power needed for a strong regulator”, likely to “reinforce the false impression” that the
GSEs have a government guarantee[2].

160 This simple amendment made Congress the ultimate regulator, instead of independent
regulator, and given the political power of GSE’s noted above, the Treasury Secretary
thought that this would ultimately lead to weak oversight, and withdrew support for
the bill.
The difficulty of financial reform is not limited to the USA. The Bank of England’s
new Financial Policy Committee also found itself frozen by a split vote on mortgage
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market reform bills (Inman, 2012).

4. Plans afoot
Decisions about the future of Freddie Mac and Fannie Mae move ahead on a political
schedule. Both Republicans and President Obama seem to agree in principal on
phasing out of the current roles of Fannie and Freddie as GSEs and privatizing the
secondary market for mortgages. The Obama administration has proposed a separate
guarantee function for the federal government, particularly for lower income buyers,
but there is no need to tie guarantees to the provision of secondary markets. The banks
are eager to take over the secondary market role. Both Republicans and Democrats
were afraid to make changes with possible unanticipated consequences on the eve of an
election.
While privatization of the secondary market for mortgages seemed likely given the
broad support for that idea, neither political party wanted to do anything before the
presidential election. With new priorities such as the federal debt and European debt
crisis, it is unclear if or when reform of Fannie and Freddie will make it back onto the
legislative agenda.
In the meantime Fannie Mae and Freddie Mac continue in their roles as the major
players and guarantors in the secondary mortgage market.

Notes
1. www.thisismoney.co.uk
2. This along with few of the other examples cited in this section is from Viral et al. (2011).
3. Testimony of John Snow before the House Financial Services Committee, reported in the NY
Times by Labaton (2003)

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