Fannie Mae, Freddie `House of Cards' Prompts Takeover (Update1)

Sept. 9 (Bloomberg) -- Fannie Mae and Freddie Mac used accounting rules that created a ``house of cards'' as the housing market descended into its worst slump since the Great Depression.

While the two largest mortgage-finance companies met regulatory requirements for their capital, reviews by the Treasury, the Federal Housing Finance Agency and the Federal Reserve found they probably wouldn't weather the highest delinquency rates on record, lawmakers and regulators said.

``Once they got someone looking closely at Fannie and Freddie's books, they realized there just wasn't adequate capital there,'' U.S. Senator Richard Shelby of Alabama, the ranking Republican on the Senate Banking Committee, said after a briefing by Treasury officials. ``They found out they had a house of cards.''

Treasury Secretary Henry Paulson and FHFA Director James Lockhart seized control of Fannie and Freddie less than a month after Lockhart, whose job is to oversee the companies, declared them ``adequately capitalized'' under law. The discrepancy highlights the flaws in legislation and in the regulatory oversight of Fannie and Freddie that didn't demand they keep more assets as a cushion against losses, according to Joshua Rosner, an analyst with Graham Fisher & Co. in New York.

``Fannie and Freddie's accounting during the housing crisis appears to have been more fantasy than reality,'' said Rosner, who first highlighted problems in 2003, before the two companies were forced to restate about $11.3 billion in earnings.

`Not Adequate'

Washington-based Fannie had $47 billion of regulatory capital as of June 30, about $9.5 billion above what FHFA required, according to company filings. McLean, Virginia-based Freddie's capital stood at $37.1 billion, a cushion of about $2.6 billion over FHFA's standard, filings show.

``They met the legal definition,'' Lockhart said in an interview with Bloomberg Television yesterday. ``As I have been telling lawmakers for a long time, that legal definition was not adequate.''

As their stock prices declined and yields on their debt rose to the highest in at least 10 years above benchmark rates, the FHFA saw ``big questions out there,'' Lockhart said.

``The issue is that the exposures are continuing and continuing to grow and it looked like in the future there were going to be significant issues and they were going to have capital problems,'' Lockhart said.

Lockhart said he brought in financial examiners for the Federal Reserve and the Office of the Comptroller of the Currency to help with a review of the companies' finances. Treasury also sought help from Morgan Stanley officials, who prepared a report after trawling through the accounts.

`Too Low'

After looking through the finances, Fed examiners deemed their capital reserves too low, Dallas Fed President Richard Fisher said yesterday.

``We concluded that the capital of these institutions was too low relative to their exposure,'' Fisher said in response to an audience question after a speech in Austin, Texas. Further, ``that capital in and of itself was of low quality.''

Fannie counted $20.6 billion in so-called deferred tax credits toward its $47 billion of regulatory capital as of June 30, according to company disclosures. Freddie applied $18.4 billion in deferred-tax assets toward its $37.1 billion in regulatory capital in the second quarter.

Fannie and Freddie have posted four straight quarterly net losses totaling a combined $14.9 billion and have said they anticipate more. The tax credits don't have any value unless the companies are generating profit.

`Not Even Real'

``That's not even real money,'' Shelby said.

Senator Christopher Dodd, a Connecticut Democrat and chairman of the Senate Banking Committee responsible for oversight of the companies, said yesterday he plans to hold hearings on why the Bush administration didn't act sooner.

``Why weren't we doing more, why did we wait almost a year before there were any significant steps taken to try to deal with this problem?'' Dodd said in a Bloomberg Television interview. ``I have a lot of questions about where was the administration over the last eight years.''

Market Value

After more than eight years of debate, Congress passed a law in July expanding Lockhart's authority to raise capital requirements, curb growth and to take over the companies' operations in a conservatorship or liquidate their assets under receivership. The legislation also gave Paulson temporary power to inject unlimited sums of taxpayer money into the companies.

The companies just four years ago admitted to $11.3 billion in earnings misstatements that led to $525 million in federal fines, tighter regulatory controls and the ouster of the CEOs.

Paulson said he stepped in to prevent a collapse of the companies, protecting investors owning more than $5 trillion of Fannie and Freddie corporate debt and mortgage-backed securities while potentially sacrificing holders of the common and preferred stocks.

The companies yesterday lost the majority of their market value, with Fannie falling 90 percent to 73 cents in New York Stock Exchange composite trading, its lowest level since 1982. Freddie dropped 83 percent to 88 cents, the lowest since the regular common stock began trading 20 years ago.

The stocks rebounded in European trading today. Fannie rose 12 cents, or 16 percent, to 85 cents by 9:44 a.m. in Frankfurt, and Freddie gained 8 cents, or 9 percent, to 96 cents.

McCain May Privatize Fannie, Freddie; Obama Sees Federal Role

Sept. 9 (Bloomberg) -- John McCain and Barack Obama agree the Treasury needed to step in to rescue Fannie Mae and Freddie Mac. They disagree over how much the U.S. government should be involved in the housing market once the immediate crisis is past.

Republican Senator McCain of Arizona wants the government to take over the two agencies, split them up, and then exit the mortgage-finance business by selling them off. Democratic Senator Obama of Illinois is suggesting a more lasting federal involvement.

``The role of the U.S. government in the housing industry is in play,'' said Jim Leach, a former 15-term Republican congressman from Iowa who is now an Obama supporter. ``There are pragmatic and philosophical issues at stake.''

The differences between the two presidential candidates over the lenders mirror a broader philosophical divide over the part the government should play in the economy. McCain supports steep cuts in taxes and spending to promote growth. Obama, while backing some tax reductions, favors increased public investment to boost the economy and job growth.

Conservatorship

Treasury Secretary Henry Paulson and Federal Housing Finance Agency Director James Lockhart placed Fannie and Freddie in a government-operated conservatorship over the weekend, ousting their chief executives and eliminating their dividends.

McCain, 72, and Obama, 47, have both endorsed the Treasury rescue of the two firms as necessary given the fragile state of the housing market and economy. They were also sharply critical of the managements of the government-sponsored companies, which together own or guarantee almost half of U.S. home loans.

The candidates found less common ground on the mortgage giants' long-term fate, which Paulson, 62, said remained undetermined until at least after the November election.

``The new Congress and the next administration must decide what role government in general, and these entities in particular, should play in the housing market,'' he told reporters over the weekend.

Robert Litan, vice president for the Kansas City, Missouri- based Kauffman Foundation, said the next president faces three choices for dealing with Fannie and Freddie: retain the current public/private partnership in some form, nationalize the companies, or privatize them.

McCain Plan

McCain is clear on what he wants to do. He backs a solution put forward by former Federal Reserve Chairman and fellow Republican Alan Greenspan that would break the companies up and sell the pieces off.

McCain would ``get them completely off the taxpayers' back,'' Douglas Holtz-Eakin, McCain's chief economic adviser, said in an interview on Bloomberg Television yesterday.

He added though that the Republican nominee saw some role for government in ``making credit available to those who otherwise can't get a mortgage'' through the Federal Housing Administration and other agencies.

Obama has been more circumspect on what should be done once the crisis is over, while making clear that a return to the status quo that existed before the rescue is unacceptable.

``We must ensure that any plan clarifies the true public and private status of our housing policies,'' the Democrat said over the weekend. ``We have to make clear that in our market system investors can't be allowed to believe that, unlike working families, they can simply invest in a `heads they win, tails they don't lose' situation.''

`Hasty' and `Ideological'

Jason Furman, Obama's top economic adviser, attacked McCain's privatization plan as ``hasty'' and ``ideological.''

``These institutions do serve a lot of vital public functions for affordable housing that just aren't served right now by any other government institutions,'' he told Bloomberg Television in a separate interview yesterday.

Furman said the outcome would depend on ``disentangling'' the important roles that Fannie and Freddie perform that can't be replicated by the private sector from those functions that can be handled by the market.

``Both candidates agree that the current model doesn't work,'' said Daniel Clifton, head of policy research in Washington for Strategas Research Partners. ``They have different solutions based on their ideological bent.''

Democratic Congress

In any case, whoever wins the presidential race will have to get a plan through a Democratic-controlled Congress that has strongly supported Fannie Mae and Freddie Mac.

``You can't eliminate them,'' Connecticut lawmaker Chris Dodd, the chairman of the Senate Banking Committee, told Bloomberg Television yesterday. ``They have been a tremendous source of stability and strength'' for the housing market.

His counterpart in the House, Massachusetts Representative Barney Frank, who heads the Financial Services Committee, lauded Fannie and Freddie's ``vital role'' in a statement issued Sept. 6.

Charles Calomiris, chairman of Reston, Virginia-based Greater Financial Corp. and a long-time critic of the two firms, told Bloomberg Radio that Congress had persistently opposed overhauling the companies.

``McCain would be inclined toward a more radical solution, though Obama might have a better chance at a less radical solution,'' said Gerald O'Driscoll, a former vice president of the Federal Reserve Bank of Dallas and now a scholar at the Cato Institute in Washington. ``But both of them face a Democratic Congress that is very wedded to these two firms as they exist.''

Generals Behaving Badly

When Abraham Lincoln famously sent word to Gen. George McClellan that he'd like to "borrow" the army if the general wasn't planning on using it, the commander of Union forces likely did not take it kindly. McClellan, after all, was a man whose letters home referred to Lincoln as an "idiot," "a well-meaning baboon" and other colorful language.

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Gen. George Casey.

In the first few pages of "The War Within," Bob Woodward opens with another presidential remark that offended another wartime general. This time the recipient was the commander of U.S. forces in Iraq, Gen. George Casey. During a videoconference with Baghdad, the president said, "George, we're not playing for a tie. I want to make sure we all understand this." Gen. Casey, Mr. Woodward writes, took this as "an affront to his dignity that he would long remember."

Whether or not Gen. Casey long remembered, "The War Within" makes clear his disdain for his commander in chief. If the views and remarks attributed to Gen. Casey are not accurate, Mr. Woodward has done him a grave injustice. If they are accurate, they come as further evidence of the obstacles President George W. Bush had to overcome to get his commanders to start winning in Iraq.

Opening with Gen. Casey also says something about Mr. Woodward. There's a case, I suppose, for using the general who opposed the surge to open what is hailed as the definitive account of that surge (not to mention using Robert McNamara, the Defense secretary who helped lose Vietnam to end the book). Surely, however, that would be the same case for wrapping the definitive account of the strategy that brought Robert E. Lee to Appomattox around Gen. McClellan.

Gen. Casey, after all, was the commander who all along maintained that the solution in Iraq was for America to draw down its forces -- even after the bombing of the Golden Mosque in Samarra. He was the commander who later that year was given his own chance to secure Baghdad with Operations Together Forward I and II, and failed. Most of all, he is the commander who was wrong when the president was right to insist that Baghdad could be secured and al Qaeda dealt a harsh blow with more troops.

Gen. Casey's continued adherence to a failed strategy does not make him a dishonorable man. It does make him an odd choice to serve as the foundation for the charge that the president was out of touch with the war. As evidence, both the general and the journalist point to questions about how many of the enemy we were killing as a sign that "the president did not get it."

Then again, maybe it's Gen. Casey and Mr. Woodward who did not get it. The questions the president asked were driven by something everyone in the West Wing worried about. Every night for years, Americans tuning into the evening news were greeted by the same image from Iraq: a burning car or Humvee, accompanied by a fresh report about soldiers or Marines who'd been blown up by an improvised explosive device or suicide bomb.

Nor did these images exist in a vacuum. A media obsessed with body counts featured grim roll calls of the dead, marking each macabre "milestone" -- 1,500 war dead, 2,000 war dead -- along the way. In this context, was it really unreasonable for a president to ask his commander on the ground if we were fighting back, when it sure didn't look that way to the American people?

The same might be said of the one truly original take offered by Mr. Woodward. This is his curious assertion that it's not the surge that has produced the great reduction in violence in Iraq. The reduced violence, he says, is the result of the increased lethality of covert operations against terrorist leaders and operatives.

Which brings up two interesting points. First, we are led to find fault with a president allegedly obsessed with a "kill the bastards" approach to Iraq. But then we are asked to accept that the reason we're now seeing success in Iraq because we're . . . killing the bastards.

Second, the surge was a shift in mission, not simply an addition of five brigades. Until the surge, we had pursued a political solution, hoping that the answer to Iraq was the rise of a democratic government that would persuade Iraqis to come together for their future. The surge, by contrast, finally recognized the obvious: Until Iraqis started feeling safe in their own homes and neighborhoods, there would be no compromise or rebuilding.

Sophisticates have never liked Mr. Bush for his preference for words like "win" and "victory" to describe what America is trying to do in Iraq. And if Mr. Woodward's latest contribution is any clue, they'll never forgive him for doing something even worse: proving it can be done.

ObamaTax 3.0

The good news is that Barack Obama said on ABC Sunday that he might not go through with his plans to increase taxes.

The bad news is that the economy has to be mired in recession to avoid the largest tax increase in the nation's history.

Our check of the Dow Jones Factiva database suggests that other than viewers of ABC's "This Week," only three or four newspapers carried an account of Senator Obama's amended tax plan. While it's possible that the story of a deferred tax increase could shock the media into paralysis, we take it as an encouraging sign. The education of Barack Obama continues apace.

For the record, here is what he told ABC's George Stephanopoulos.

Mr. Stephanopoulos: "So even if we're in a recession next January, you come into office, you'll still go through with your tax increases?"

Senator Obama: "No, no, no, no, no. What I've said, George, is that even if we're still in a recession, I'm going to go through with my tax cuts. That's my priority."

Mr. Stephanopoulos: "But not the increases?"

Senator Obama: "I think we've got to take a look and see where the economy is. The economy is weak right now. The news with Freddie Mac and Fannie Mae, I think, along with the unemployment numbers indicates that we're fragile. I want to accelerate those tax cuts through a second stimulus package, get more money into the pockets of ordinary Americans, see if we can stabilize the housing market, and then we're going to have to reevaluate at the beginning of the year to see what kind of hole we're in."

* * *

Even individuals staring down the barrel of Mr. Obama's tax increases should not wish for an economic recession to give them a reprieve. The relevant point is that it was early last year, when the "Bush economy" was still humming, that Senator Obama first proposed pushing taxes sharply upward on "the wealthy," while giving what he calls "tax cuts" (actually they are credits, not rate reductions) to "the middle class."

At the time, Mr. Obama was the long shot in the Democratic Presidential sweepstakes, and it made some political sense to reassure the party's intensely liberal primary voters with class-war boilerplate on taxes.

Under ObamaTax 1.0, he would have repealed all the Bush tax cuts, lifted the cap on wages subject to the payroll tax, put the top marginal rate up to 39.8% and raised the rate on capital gains and dividends to at least 25% from 15% now. The official campaign line was that tax rates really don't matter to economic growth.

Summer arrived, the Clinton challenge was history and with the general election ahead came ObamaTax 2.0. It posited that the top rate on capital gains now would be 20%, described on this page August 14 by economic advisers Jason Furman and Austan Goolsbee as "almost a third lower than the rate President Reagan set in 1986." This was progress.

Now with the big vote less than 60 days off and John McCain pounding him as a tax-raiser and pulling ahead in some polls, the Democratic nominee has decided to release ObamaTax 3.0, the most interesting upgrade so far. If the economy is still weak in January, a President Obama might defer all of the planned increases.

Several interpretations of this shift are possible, none of which reflect badly on Senator Obama's political learning curve.

At the bloodless level of simply wishing to win, the Obama camp may have concluded that in the sprint to November it is a losing strategy to be the election's only doctrinaire tax raiser. A tight race tends to focus political minds, and none forget Walter Mondale's catastrophic promise in his 1984 acceptance speech: "Mr. Reagan will raise taxes, and so will I. He won't tell you. I just did."

Beyond this lies the economic reality of jacking up income, investment and payroll taxes on "the wealthy" amid a flat or falling economy. In the standard narrative, these taxpayers exist as fat cats atop hedge funds, banks and megacorporations. Let's toss into the vat the top-tier managers of Fannie Mae and Freddie Mac, the Beltway's own fat-cat sinecure.

The reality is that the creators of new jobs in the economy are more likely to be rising entrepreneurs or filers under Subchapter S, who typically pay taxes at individual rates. Hanging three or four tax millstones around their productive necks in January if the economy is weak will likely produce unimpressive growth and job numbers in the first year of the new Obama Presidency, and likely beyond. That in turn could drag down the Democrats in Congress who will get credit for voting these higher taxes into law.

Thus Mr. Obama's unambiguous answer Sunday to whether he'd insist on his tax increases if the economy is in an official recession: "No, no, no, no, no." It seems Mr. McCain is right that taxes do matter.

Mr. Obama's most ardent primary supporters may not like it, but we'll take the five "Nos" as evidence that Senator Obama may be learning the difference between liberal doctrine and sensible governance.

The GOP Should Kiss
Gay-Bashing Goodbye

By JAMES KIRCHICK

Political conventions are memorable not only for what the party grandees say, but for what they leave out. What was noticeably absent from last week's Republican gabfest? Gay-bashing.

This is not an insignificant development for Republicans. In 2004, gays featured prominently at the Republicans' convention and in their rhetoric. In February of that year, President George W. Bush announced his support for the Federal Marriage Amendment (FMA), which would have written discrimination into our country's founding document by stipulating that marriage can only occur between a man and a woman.

AP

Patrick Sammon, president of the Log Cabin Republicans.

"Because the union of a man and woman deserves an honored place in our society, I support the protection of marriage against activist judges," Mr. Bush declared from the podium at Madison Square Garden.

It would be unfair to ascribe bigoted impulses to everyone who supports such an amendment. After all, gay marriage is an unfamiliar concept and people are naturally resistant to change. But the rhetoric of those supporting the FMA often went above and beyond expressing concern for the state of a weakening social institution and depicted gays as a nefarious force from whose conjugations America had to be protected. Gays became the target of a divisive campaign aimed at stirring up the GOP's socially conservative base.

As disappointing as the GOP's 2004 campaign was in this regard, it didn't hold a candle to the party's 1992 convention. The most famous speech to occur in Houston that year was the prime-time address delivered by Patrick Buchanan on opening night. "Pitchfork Pat" had challenged George H.W. Bush for the Republican nomination and did surprisingly well for a candidate confronting a sitting president. His address that year is best remembered for his observation that "there is a religious war going on in our country for the soul of America . . . a cultural war, as critical to the kind of nation we will one day be as was the Cold War itself."

Mr. Buchanan made it clear that primary soldiers on the other, dark side of this "cultural war" were gay people. Telling the audience that while the "three million Americans who voted for me" disagreed with Mr. Bush on some issues, he declared that "we stand with him against the amoral idea that gay and lesbian couples should have the same standing in law as married men and women."

And while rightly criticizing the Democrats for barring the antiabortion Democratic governor of Pennsylvania Bill Casey from speaking at their convention that year, Mr. Buchanan went on to rail that "a militant leader of the homosexual rights movement could rise at that convention and exult: 'Bill Clinton and Al Gore represent the most pro-lesbian and pro-gay ticket in history.' And so they do."

Other speakers, most prominently Vice President Dan Quayle, joined Mr. Buchanan in denigrating gay people. "Americans try to raise their children to understand right and wrong -- only to be told that every so-called lifestyle alternative is morally equivalent. That is wrong," he told the assembled delegates.

The image that Republicans projected to voters was that of a fearful party looking bitterly toward the past. This was hardly an advertisement for the cheerful, optimistic conservatism of Ronald Reagan, whose convention speech -- his last major address to the nation -- was overshadowed by the divisive rhetoric coming from the likes of Messrs. Buchanan and Quayle.

So it was refreshing to see that gays were not part of the agenda this year. Indeed, the only speaker to make mention of them was the former Arkansas governor and Baptist preacher Mike Huckabee, and he did so only tangentially, stating that Mr. McCain "doesn't want to change the very definition of marriage from what it has always meant throughout recorded human history." (The same, of course, could be said of the supposedly gay-friendly Barack Obama, who also opposes marriage equality for gay couples).

The absence of antigay rhetoric has much to do with Mr. McCain; he is comfortable around gay people, and his old-fashioned sense of honor proscribes against making them pariahs for political gain. He also has a better record on gay issues than most of his Republican colleagues, having courageously stood up against his party by opposing the FMA.

Partly for that stand, he won the endorsement last week of the Log Cabin Republicans, a gay GOP group that declined to endorse Mr. Bush in 2004 over his demagoguing gay marriage. Steve Schmidt, Mr. McCain's senior strategist, spoke to Log Cabin on the last day of the convention, informing them that "my sister and her partner are an important part of my life and our children's life," and that "I admire your group and your organization and I encourage you to keep fighting for what you believe in because the day is going to come."

Republicans might also have noticed the opinions of their own party members and realized that attacking the "gay agenda" would prove unpopular. On the eve of the convention, a New York Times/CBS News poll reported 49% of Republican delegates were in support of either civil unions (43%) or marriage (6%) for gay couples. While 90% of Democratic delegates support either marriage (55%) or civil unions (35%), Republican delegates -- the party's conservative base -- are actually more liberal on this issue than Republican voters, only 39% of whom support either option. With 58% of the American public in favor of some form of legal recognition, Republicans are actually closer to the national mood, and are hopefully beginning to understand that Buchananite "cultural war" rhetoric is fast becoming a thing of the past.

To be sure, the GOP still stands on the wrong side of history. Its platform backs the FMA, and goes so far as to declare that, "homosexuality is incompatible with military service" (not merely open homosexuality -- which is barred by the Clinton-era "Don't Ask, Don't Tell" regulation -- but homosexuality itself). At a time when our country faces such perilous threats from abroad, attacking gay people who wish to serve their country in the armed forces is not just cruel. It weakens our national security. And while the Democrats running Congress have yet to move forward on the promises they've made to gay voters, the party is far more welcoming to gays than the GOP. Mr. Obama did refer to "our gay and lesbian brothers and sisters" in his acceptance speech.

As Mr. McCain made clear last week, the last eight years of Republican rule in Washington have forced many people to question whether his party actually stands for its self-declared principles of individual liberty and smaller government. In this regard, he criticized his party for succumbing to the "temptations of corruption" and wasteful spending. But he also could have gone after their cynical stigmatization of an entire class of citizens. That Mr. McCain declined to go after his party on this matter is unfortunate, if understandable, given the grief he's caused them on so many other fronts. It may sound like cold comfort, but gay people have something to appreciate in the fact that, this year, Republicans left them alone.

Mr. Kirchick is an assistant editor of The New Republic.

Fannie Mae's Patron Saint

Taxpayers are now on the hook for as much as $200 billion to rescue Fannie Mae and Freddie Mac, and if you want to know why, look no further than the rapid response to this bailout from House baron Barney Frank. Asked about Treasury's modest bailout condition that the companies reduce the size of their high-risk mortgage-backed securities (MBS) portfolios starting in 2010, Mr. Frank was quoted on Monday as saying, "Good luck on that," and that it would never happen.

There you have the Fannie Mae problem in profile. Mr. Frank wants you to pick up the tab for its failures, while he still vows to block a reform that might prevent the same disaster from happening again.

At least the Massachusetts Democrat is consistent. His record is close to perfect as a stalwart opponent of reforming the two companies, going back more than a decade. The first concerted push to rein in Fan and Fred in Congress came as far back as 1992, and Mr. Frank was right there, standing athwart. But things really picked up this decade, and Barney was there at every turn. Let's roll the audiotape:

In 2000, then-Rep. Richard Baker proposed a bill to reform Fannie and Freddie's oversight. Mr. Frank dismissed the idea, saying concerns about the two were "overblown" and that there was "no federal liability there whatsoever."

Two years later, Mr. Frank was at it again. "I do not regard Fannie Mae and Freddie Mac as problems," he said in response to another reform push. And then: "I regard them as great assets." Great or not, we'll give Mr. Frank this: Their assets are now Uncle Sam's assets, even if those come along with $5.4 trillion in debt and other liabilities.

Again in June 2003, the favorite of the Beltway press corps assured the public that "there is no federal guarantee" of Fan and Fred obligations.

FANNIE MAYHEM: A HISTORY

Click here for a compendium of The Wall Street Journal's recent editorial coverage of Fannie and Freddie.

A month later, Freddie Mac's multibillion-dollar accounting scandal broke into the open. But Mr. Frank was sanguine. "I do not think we are facing any kind of a crisis," he said at the time.

Three months later he repeated the claim that Fannie and Freddie posed no "threat to the Treasury." Even suggesting that heresy, he added, could become "a self-fulfilling prophecy."

In April 2004, Fannie announced a multibillion-dollar financial "misstatement" of its own. Mr. Frank was back for the defense. Fannie and Freddie posed no risk to taxpayers, he said, adding that "I think Wall Street will get over it" if the two collapsed. Yes, they're certainly "over it" on the Street now that Uncle Sam is guaranteeing their Fannie paper, and even Fannie's subordinated debt.

By early 2007, Mr. Frank was in charge of the House Financial Services Committee, arguing that he had long favored some kind of reform. "What blocked it [reform] last year," Mr. Frank said then, "was the insistence of some economic conservative fundamentalists in the Bush Administration who, to be honest, don't think there should be a Fannie Mae or a Freddie Mac." What really blocked it was Mr. Frank's insistence that any reform be watered down and not include any reduction in their MBS holdings.

In January of last year, Mr. Frank also noted one reason he liked Fannie and Freddie so much: They were subject to his political direction. Contrasting Fan and Fred with private-sector mortgage financers, he noted, "I can ask Fannie Mae and Freddie Mac to show forbearance" in a housing crisis. That is to say, because Fannie and Freddie are political creatures, Mr. Frank believed they would do his bidding.

And this is exactly what Mr. Frank attempted to prove when the housing market started to go south. He encouraged the companies to guarantee more "affordable" mortgages, thus abetting their disastrous plunge into subprime and Alt-A loans. He also pushed for, and got, an increase in the conforming-loan limits to allow Fan and Fred to securitize and guarantee larger mortgages. And he pressured regulators to ease up on their capital requirements -- which now means taxpayers will have to make up that capital shortfall.

But the biggest payoff for Mr. Frank is the "affordable housing" trust fund he managed to push through as one political price for the recent Fannie reform bill. This fund siphons off a portion of Fannie and Freddie profits -- as much as $500 million a year each -- to a fund that politicians can then disburse to their favorite special interests.

This is also why Mr. Frank won't tolerate cutting the companies' MBS portfolios. He knows those portfolios (bought with debt borrowed at taxpayer-subsidized rates) were a main source of Fannie's profits before the housing crash, and he figures that once this crisis passes they can do it again. And this time, his fund will get part of the loot.

* * *

Mr. Frank has had many accomplices from both parties in his protection of Fan and Fred. But he was and is among the most vociferous and powerful. In any other area of American life, this track record would get a man run out of town. In Washington, he's hailed as a sage whose history of willful error will be forgotten faster than taxpayers can write a check for $200 billion.

Monday, September 8, 2008

Paulson Says Fannie, Freddie Crisis `All Consuming' (Update1)

Sept. 8 (Bloomberg) -- Treasury Secretary Henry Paulson said the discussions over how to prop up Fannie Mae and Freddie Mac were ``all consuming'' in recent weeks, when he was forced to make a decision he would rather have avoided.

``This is the first time in my career I had trouble sleeping, and it wasn't because it was a difficult decision,'' Paulson said in interview with Bloomberg television. Paulson, 62, took the Treasury's helm in 2006 after a 32-year career at Goldman Sachs Group Inc.

As financial markets deteriorated, resembling the situation in March when Bear Stearns Cos. collapsed, foreign central banks began expressing concerns about Fannie and Freddie, the mortgage companies whose debt they hold. Paulson said that while he preferred not to oversee a government takeover, in the end there was no choice.

``Government intervention is not something that I came here wanting to espouse, but it sure is better than the alternative,'' the Treasury chief said. He spoke a day after the Treasury and Federal Housing Finance Agency put the companies into conservatorship, providing for up to $100 billion of equity investments by the Treasury in each to keep them solvent.

Foreign central banks had concerns about the two companies, in part because of their size, Paulson said. Fannie and Freddie make up almost half of the $12 trillion U.S. mortgage market. U.S. investors also wanted to know what they were facing, he said.

Stocks, Bonds

Fannie fell 79 percent to $1.46 and Freddie lost 71 percent to $1.50 as of 9:53 a.m. in New York Stock Exchange trading. Credit Suisse analysts cut their price target on the companies to $1. At the same time, the companies' bonds rallied.

The rescue won backing from the world's major central banks, including those in Asia where much of the mortgage companies' debt is held.

``This is positive,'' People's Bank of China Governor Zhou Xiaochuan told reporters today in Basel, Switzerland, at a meeting at the Bank for International Settlements. Bank of Japan Governor Masaaki Shirakawa said he expects the takeover to ``stabilize'' U.S. and global financial markets.

Paulson said the current management and boards of the two companies aren't to blame for the firms' situation. They had a ``flawed'' business model with a federal charter and shareholder ownership, and suffered from the rout in the U.S. mortgage market, he said.

No `Happy Time'

The episode has ``not been a happy time for anyone,'' Paulson said. ``I've never been through any situation which was as difficult, as stressful, as complex.''

The Treasury chief reiterated that yesterday's intervention is a ``time-out'' that leaves it to the next Congress and administration to decide on Fannie's and Freddie's long-term structure.

Yesterday's action leaves open the option favored by former Federal Reserve Chairman Alan Greenspan, to split up and sell off the companies, or a full nationalization that would cement the government's role in mortgage markets. Avoiding a decision on the issue enhances the likelihood of congressional backing for the emergency steps, Democratic Senator Charles Schumer of New York said.

Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat, warned against any attempt to dismantle Fannie and Freddie.

`Real Problem'

``This will be a real problem'' if the takeover was ideologically driven Dodd said. The Fannie-Freddie model has allowed the U.S. to be the ``only country'' where homeowners are able to get 30-year fixed-rate mortgages, he said.

The FHFA, which will run the conservatorship, ejected Fannie CEO Daniel Mudd, 50, and Freddie CEO Richard Syron, 64. They were replaced by Herbert Allison, 65, former CEO of TIAA- Cref, and David Moffett, 56, who was a US Bancorp vice chairman.

The Treasury also said yesterday it will provide secured short-term funding to Fannie, Freddie and 12 federal home-loan banks, and purchase mortgage-backed debt in the open market. The New York Federal Reserve Bank will act as the Treasury's agent for the lending facility.

``This is not a permanent solution -- they've not saved Fannie and Freddie, what they've done is they've bought 15 months,'' said Bill Ackman, founder of Pershing Square Capital Management in New York, which has sold short the two companies, or bet on declines in their securities. ``It's a band-aid. They haven't permanently recapitalized the companies.''

Bond Rally

Yields on Fannie Mae and Freddie Mac debt relative to Treasuries tumbled by the most on record on rising confidence in their creditworthiness after the government takeover.

The difference between yields on Fannie's five-year debt and five-year Treasuries fell 29.1 basis points to 64.9 basis points as of 8 a.m. in New York, the lowest since May, according to data complied by Bloomberg. The yield fell to 22.1 basis points below interest-rate swaps, another benchmark, the lowest since February and down from 4.8 basis points.

The takeovers bring Fannie, formed after the Great Depression and spun off in 1968, and Freddie, created in 1970, back under the government's fold. It's the biggest step yet in officials' efforts to grapple with a yearlong credit crisis that has caused more than $500 billion of losses and writedowns.

Under the plan, the Treasury will receive $1 billion of senior preferred stock in coming days, with warrants representing ownership stakes of 79.9 percent of Fannie and Freddie. The government will receive annual interest of 10 percent on its stake.

Portfolio Limits

As a condition for the assistance, Fannie and Freddie eventually will have to reduce their holdings of mortgages and securities backed by home loans.

While common stockholders of Fannie and Freddie won't be eliminated, they will be last in line for any claims, Paulson said. Preferred shareholders will be second in absorbing losses, he said. Interest and principal payments will continue to be made on the companies' subordinated debt, Lockhart said.

The government is taking an increasing role in financial markets, after the Fed six months ago provided $29 billion of financing to prevent the collapse of Bear Stearns Cos. Chairman Ben S. Bernanke praised yesterday's action.

Democratic presidential nominee Barack Obama said yesterday that ``some'' intervention was necessary to prevent a ``larger and deeper crisis.'' After the current crisis subsides, ``the plan must move toward clarifying the true public and private status of our housing policies,'' he said.

`Downward Spiral'

``We've got to keep people in their homes,'' Republican presidential candidate John McCain said in an interview with CBS's ``Face the Nation'' program. ``There's got to be restructuring, there's got to be reorganization, and there's got to be some confidence that we've stopped this downward spiral.''

The government takeover comes almost two months after Paulson first sought emergency powers to inject capital into the beleaguered mortgage-finance companies. Congress approved the measure in legislation signed by President George W. Bush on July 30.

Paulson had indicated until early last month that it was unlikely he'd use the authority, and then kept silent even as investors clamored for clarity on how a government intervention would work.

``There are an enormous number of decisions ahead and they will be very controversial and there will be a lot of conflict,'' William Poole, former president of the Federal Reserve Bank of St. Louis, said in a Bloomberg Television interview. ``We don't know what the ultimate cost is. If they lose 5 percent on all their obligations, that doesn't seem like an outrageous amount to lose. That's right away $300 billion.''

MBS Purchases

Included in yesterday's measures is a Treasury program to purchase new mortgage-backed securities from the two companies, starting with a $5 billion purchase this month.

The Treasury will also hire independent asset managers to purchase and run the portfolio of mortgage-backed securities it will buy. ``There is no reason to expect taxpayer losses from this program, and it could produce gains,'' the department said.

Paulson's decision, taken after consulting with Bernanke, followed a review that found Washington-based Fannie and McLean, Virginia-based Freddie used accounting methods that inflated their capital, according to people with knowledge of the decision.

Morgan Stanley Role

Paulson hired Morgan Stanley a month ago to probe the companies' finances. The investment bank concluded that the accounting, while legal, enabled Freddie, and to a lesser extent Fannie, to overstate the value of their reserves, according to the people who declined to be identified because the findings were confidential.

Fannie and Freddie own or guarantee almost half of the $12 trillion in U.S. home loans and the government had been leaning on the companies to help pull the economy out of the housing crisis.

Concern over the companies' capital pushed their borrowing costs to record levels over U.S. Treasuries, sent their common and preferred stocks tumbling and boosted mortgage rates. Fannie is down about 93 percent in New York Stock Exchange trading since the end of June. Freddie has fallen about 92 percent.