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How Washington Failed to Rein In Fannie, Freddie
...Congress chose to create a weak regulator, the Office of Federal Housing Enterprise Oversight. The agency was required to get its budget approved by Congress, while agencies that regulated banks set their own budgets. That gave congressional allies an easy way to exert pressure.

"Fannie Mae's lobbyists worked to insure that [the] agency was poorly funded and its budget remained subject to approval in the annual appropriations process," OFHEO said more than a decade later in a report on Fannie Mae. "The goal of senior management was straightforward: to force OFHEO to rely on the [Fannie] for information and expertise to the degree that Fannie Mae would essentially regulate itself."

Congress also wanted to free up money for Fannie Mae and Freddie Mac to buy mortgage loans and specified that the pair would be required to keep a much smaller share of their funds on hand than other financial institutions. Where banks that held $100 could spend $90 buying mortgage loans, Fannie Mae and Freddie Mac could spend $97.50 buying loans.

Finally, Congress ordered that the companies be required to keep more capital as a cushion against losses if they invested in riskier securities. But the rule was never set during the Clinton administration, which came to office that winter, and was only put in place nine years later.

The Clinton administration wanted to expand the share of Americans who owned homes, which had stagnated below 65 percent throughout the 1980s. Encouraging the growth of the two companies was a key part of that plan.

"We began to stress homeownership as an explicit goal for this period of American history," said Henry Cisneros, then Secretary of Housing and Urban Development. "Fannie and Freddie became part of that equation."

The result was a period of unrestrained growth for the companies. They had pioneered the business of selling bundled mortgage loans to investors and now, as demand from investors soared, so did their profits. ...

...Fannie Mae and Freddie Mac enjoyed the nearest thing to a license to print money. The companies borrowed money at below-market interest rates based on the perception that the government guaranteed repayment, and then they used the money to buy mortgages that paid market interest rates. Federal Reserve Chairman Alan Greenspan called the difference between the interest rates a "big, fat gap." The budget office study found that it was worth $3.9 billion in 1995. By 2004, the office would estimate it was worth $20 billion.

As a result, the great risk to the profitability of Fannie Mae and Freddie Mac was not the movement of interest rates or defaults by borrowers, the concerns of a normal financial institution. Fannie Mae's risk was political, the concern that the government would end its special status.

So the companies increasingly used their windfall for a massive campaign to protect that status.

"We manage our political risk with the same intensity that we manage our credit and interest rate risks," Fannie Mae chief executive Franklin Raines said in a 1999 meeting with investors.

Fannie Mae, and to a lesser extent Freddie Mac, became enmeshed in the fabric of political Washington. They were places former government officials went to get wealthy -- and to wait for new federal appointments. At Fannie Mae, chief executives had clauses written into their contracts spelling out the severance benefits they would receive if they left for a government post. ...

...In June 2003, Freddie Mac dropped a bombshell: It had understated its profits over the previous three years by as much as $6.9 billion in an effort to smooth out earnings.

OFHEO seemed blind. Months earlier, the regulator had pronounced Freddie's accounting controls "accurate and reliable."

Humiliated by the scandal, then-OFHEO director Armando Falcon Jr. persuaded the White House to pay for an outside accountant to review the books of Fannie Mae. The agency reported in September 2004 that Fannie Mae also had manipulated its accounting, in this case to inflate its profits.

The companies were humbled. The flaws of their business practices were laid bare.

The companies soon faced new bills in both the House and the Senate seeking increased regulation. The Bush administration took the hardest line, insisting on a strong new regulator and seeking the power to put the companies into receivership if they foundered. That suggested the government might not stand behind the companies' debt.

Fannie Mae and Freddie Mac succeeded in escaping once more, by pounding every available button.

The companies orchestrated a letter-writing campaign by traditional allies including real estate agents, home builders and mortgage lenders. Fannie Mae ran radio and television ads ahead of a key Senate committee meeting, depicting a Latino couple who fretted that if the bill passed, mortgage rates would go up.

The wife lamented: "But that could mean we won't be able to afford the new house."

Most of all, the company leaned on its Congressional supporters.

In the Senate, Robert F. Bennett (R-Utah) added an amendment giving Congress the ability to block receivership, weakening that bill to the point where the White House would no longer support it. Bennett's second-largest contributor that year was Fannie Mae; his son was then the deputy director of Fannie's regional office in Utah. ...

...An employee at one of the companies said it was already a constant discussion around the office in 2004: When would the regulators notice?

"It didn't take a lot of sophistication to notice what was happening to the quality of the loans. Anybody could have seen it," the staffer said. "But nobody on the outside was even questioning us about it."...