Funny business at Fannie Mae: how'd those Clintonites get so rich?

National Review, June 19, 2006 by Byron York

ON May 23, as a jury in Houston deliberated the case against top Enron executives Kenneth Lay and Jeffrey Skilling, a little-known regulatory agency in Washington, the Office of Federal Housing Enterprise Oversight (OFHEO), released a study with the dryly bureaucratic title "Report of the Special Examination of Fannie Mae." The document received far less attention than the news from Enron, but its conclusions were stunning. In meticulous detail, it outlined a culture of corruption at the Federal National Mortgage Association--better known as Fannie Mae--that rivals the most serious corporate scandals in recent years. In this case, however, the main players are Washington insiders--some of them prominent veterans of the Clinton administration--and the scandal's effects could ripple through Congress for years.

Fannie Mae is the biggest single source of money for mortgages in the United States. From 1998 to 2004, the years covered by the OFHEO investigation, it was headed by former Clinton budget director Franklin Raines, whose top management team included former Clinton Justice Department official Jamie Gorelick, sometimes mentioned as a future attorney general in a Democratic administration. During that period, the report says, Raines and his team grossly overstated Fannie Mae's earnings--to the tune of $10.6 billion--for the purpose of paying themselves big bonuses. "By deliberately and intentionally manipulating accounting to hit earnings targets," the report says, "senior management maximized the bonuses and other executive compensation they received, at the expense of shareholders."

In doing so, the report says, Raines and his team steered Fannie Mae far afield from its original mission, transforming it from a stable business into a risky one. Fannie Mae has its roots in the New Deal, when it was established to increase the amount of money available for mortgages. Over the years, its main business has been to issue debt and then use the proceeds to buy mortgages from lenders, allowing those lenders to give out new mortgages. Originally a government agency, Fannie Mae went private in 1968, with the goal of "increasing the availability and affordability of homeownership for low-,moderate-, and middle-income Americans," according to its mission statement.

But Fannie Mae is not just any private institution. It is congressionally chartered, meaning its existence is established in law, it does not have to pay state and local income taxes, and it is not subject to bankruptcy laws. It can borrow money at a lower rate than anyone else except the federal government itself. Given all that, there is a public perception that Fannie Mae is a rock-solid government institution. "There is an implied guarantee," says Sen. John Sununu, a member of the Senate Banking, Housing, and Urban Affairs Committee who has sponsored legislation to reform Fannie Mae. "Investors think they are the next best thing to Treasuries."

There's no doubt that Fannie Mae succeeded in its original mission of increasing the amount of money available for mortgages. In the 1980s, it went a step further, essentially creating a new product when it bought up mortgages and bundled them for sale to investors as mortgage-backed securities. It was an extraordinarily profitable move for Fannie Mae, and good for the housing market, too.

But in the 1990s, the company moved in a much riskier direction. Fannie Mae used its borrowing power to buy up mortgages and hold them, making a profit from the difference between the low price it paid to borrow the money and the higher interest rate it received on the mortgage. It was potentially profitable, but it had nothing to do with helping low- and middle-income people buy houses. "It doesn't do anything to support their core mission," says Senator Sununu, "and it increases their exposure to interest-rate risks."

But the OFHEO report suggests that none of that mattered to Raines, who had been a top official at Fannie Mae in the early 1990s before leaving to join the Clinton administration and then returning to Fannie Mae as chief executive in 1998. According to the report, Raines became obsessed with propping up Fannie Mae's earnings per share, or EPS, even if he had to use creative accounting to make it happen. Raines set a series of increasingly higher EPS goals that, if met, would trigger bonuses for the executive team that far surpassed what they received in salary.

In 1999, Raines announced a new goal to double Fannie Mae's EPS in five years, from $3.23 per share to $6.46. It was an audacious goal, and reaching it, according to OFHEO, became Fannie Mae's reason for existence: "$6.46, the EPS goal, became the corporate mantra--everything else was secondary to hitting that target." To convey an idea of just how obsessed Raines had become, and how he passed on that obsession to his top managers, the OFHEO report quotes at some length from a speech given in 2000 by Sampath Rajappa, head of the Office of Auditing, to his accounting team: