“If you were looking for the absolutely best way to mine money out of the government, it was brilliantly designed to do just that. I’m not sure they figured it out, or if they just took advantage of opportunities.”
—Larry Summers, Director of the National Economic Council, 2009–2010
In late 1998, Jim Johnson stepped down. His handpicked successor was Franklin Delano Raines, who had grown up in Seattle, where his father was a custodian for the city parks department, and his mother was a cleaning woman for Boeing—a company on whose board Raines would later serve. Raines was a star. He earned a scholarship to Harvard, was named a Rhodes Scholar, interned in the Nixon White House, and then served in the Carter Administration before leaving to become a partner at Lazard Frères, where he spent the next eleven years. After his first stint at Fannie Mae, from 1991 to 1996, he became the head of the Office of Management and Budget at the beginning of Bill Clinton’s second term. Raines reaped enormous credit for balancing the budget. When he returned to Fannie Mae in 1998—with a promise from Johnson that he could soon take it over—his political stock could not have been higher. There was talk that he would be the first black president of the United States.
Raines, while at Harvard, was a member of both the Young Democrats and the Young Republicans. He’d later joke that Vice President Al Gore suspected he was a Republican because of his focus on the budget. But like Johnson, he was indeed a Democrat, as were many top Fannie executives, and the fact that Democratic operatives made fortunes at Fannie fed into a subterranean resentment of both companies—a resentment that would soon burst to the surface.
Many economists, including liberal economists, have never been entirely comfortable with the concept of a government-backed private company. Larry Summers, the economist who served as Treasury Secretary in the Clinton Administration and became the head of the National Economic Council in the Obama Administration, said: “If you were looking for a way to extract rents from the government, what would you do? Well, first, you would have it be as non-transparent as possible. So you’d have an implicit guarantee. You would do your best to staple the rents to a broad middle class subsidy so you couldn’t attack the rents without also attacking the middle class subsidy. The third thing is, you would make yourself a source of positive opportunity for opportunistic politicians.”
Even in the Johnson years, there were little rebellions against the GSEs’ growing power, which were mostly squelched. In 1996, Ed DeMarco, then an economist at the Treasury, was the chief author of a report that was more critical of Fannie and Freddie than most people dared to be. (DeMarco, who had previously been at the Government Accountability Office, had also written a report recommending much stronger regulation for the GSEs.) The last chapter recommended various ways in which Fannie and Freddie could be severed from the government. But the final version of the report lacked that chapter, as well as other critical parts. In Tim Howard’s book, he writes that it was Summers who edited the tough report. But a former Treasury official says the report was changed because the analysis didn’t pass the review process, not because of the conclusions. Certainly, Summers would prove to be no friend of Fannie and Freddie.
Several things brought the resentment to a fever pitch. By the late 1990s, the substantial profits that Fannie and Freddie were reporting were not just from their traditional business of stamping mortgages with a guarantee and collecting a fee in exchange. Increasingly, both Fannie and Freddie had begun to buy up their own mortgage-backed securities and hold them on their balance sheet. Because of their special position, they could make money on the difference between higher yield of the mortgage portfolio and what their cost of funds was. The “big fat gap” is what Alan Greenspan, the very powerful chairman of the Federal Reserve for almost two decades, until 2006, took to calling it. The GSEs’ combined portfolios would peak in 2008 at a stunning $1.6 trillion. To put that in context, at the end of 2007, the entire public federal debt stood at around $9 trillion.
As the portfolios grew, they provided critics with a convenient target. After all, what did they do besides mint money for the GSEs’ shareholders and executives? And due to all the interest-rate risk that Fannie and Freddie were holding on their balance sheet—and all the derivatives they were using to manage that interest-rate risk—weren’t they a disaster waiting to happen, a disaster that would land on taxpayers? Among critics of Fannie and Freddie, an oft-repeated line was that they privatized gains—those went to shareholders and executives—while socializing losses.
Surprisingly, given the prominent Democrats at Fannie, it was the Clinton Treasury that first took on Fannie and Freddie in an organized way, when Gary Gensler, an assistant Treasury Secretary who would later become the chairman of the Commodities Futures Trading Commission, said, among other things, that the U.S. Treasury should cut the GSEs’ $2.5 billion line of credit. Yields on Fannie and Freddie debt soared, meaning that investors now saw the debt as much riskier. Tim Howard called Gensler’s comments “inappropriate” and “unprofessional.” Fannie took to describing itself as a “bulwark of our financial system.”
Gene Sperling, who was the director of the National Economic Council, says that he, Summers, and Gensler had agreed to stand strong together. “I thought it was a moment of pride in doing the right thing, not the politically convenient thing,” he says today. They began making other comments that suggested a lack of true government support for Fannie and Freddie. Sperling, who considers himself a progressive, marvels today: “The GSEs brought out a conservative side of me. The thing that turned me, that made me unwilling to do anything personally for them, is when you see that dynamic where a company is completely dependent on the U.S. government for their profit and they spend so much money and time focused on lobbying the U.S. government. It really gets kind of sick.” He used to joke: “If you think a bad thought about Fannie and Freddie, you can hear the fax machine going.”
Greenspan, for a while, was quieter. But inside Fannie, it wasn’t any secret that the powerful Fed chairman was opposed to them too. “I knew the Fed thought of Fannie as a tar baby,” says Raines. “When I came back to Fannie, it was clear that we were at war.” Greenspan still came to Raines’s annual Christmas parties, and Raines says he made a point of going to see Greenspan, bringing with him presentations that explained how Fannie managed its risk. (Greenspan would later call the explanations “nonsense.”) But, says Raines, “Greenspan is a great maneuverer and he was maneuvering to get the Fed positioned to take on Fannie.”
The stew of distaste and envy was compounded by questions about what value Fannie and Freddie actually provided. The Congressional Budget Office produced study after study showing that the subsidy wasn’t going to homebuyers; instead, it was going to shareholders and executives. After one study estimated that about 40 percent of Fannie and Freddie’s profits were due to their implied government support, a Fannie spokesman denounced the report, calling it the work of “economic pencil brains who wouldn’t recognize something that works for ordinary homebuyers if it bit them in their erasers.” Raines would often argue that the private-market cost for a mortgage was 25 to 50 basis points more than the Fannie Mae price, or a quarter to half a percent. What the GSEs never advertised was an “average” figure was somewhat misleading. Because for years, everyone who qualified for a Fannie or Freddie mortgage paid a similar rate; what the GSEs really were was a giant subsidization machine, where wealthier borrowers in desirable areas paid more than they otherwise would have, while less well-off borrowers in less desirable locations paid less than they otherwise would have.
Oddly enough, the steps the GSEs took to fulfill their affordable-housing mandates were a cause of controversy too—although for exactly the opposite reason that they became controversial after the crisis. In 1994, Jim Johnson announced, with great fanfare, that by the end of the decade Fannie would make $1 trillion available to finance housing for “minorities, low and moderate income families, new immigrants, families who live in central cities and distressed areas, and people with special housing needs.” By the mid-1990s Fannie and Freddie were guaranteeing loans with down payments as low as 3 percent, which is shocking to anyone who grew up in the era where you needed a 20 percent down payment. But these were not the sort of crazy loans that would become so prevalent by the mid-2000s. They were long-term fixed-rate mortgages made to people who fully documented their income, and Fannie often insisted that borrowers undergo financial counseling. The default rate on these loans was, as you’d expect, higher than on prime loans, but the overall default rate remained very low.
At the time, the controversy was that despite all these programs, Fannie and Freddie didn’t do enough for the cause of affordable housing. One critic was John Taylor, the president of the access-to-credit advocacy association National Community Reinvestment Coalition. Another was the conservative economist Peter Wallison, who now blames Fannie and Freddie’s pursuit of the affordable-housing goals for the financial crisis. In an introduction to a 2004 book that recommended privatizing Fannie and Freddie, Wallison wrote that their “extensive advertising has created the false impression that they are essential to the provision of affordable housing to disadvantaged groups. As many studies have shown, however, they lag ordinary banks in this respect.” He continued: “Study after study has shown that Fannie Mae and Freddie Mac, despite full-throated claims about trillion-dollar commitments and the like, have failed to lead the private market in assisting the development and financing of affordable housing.” (Wallison now says that he, like others, just wasn’t aware that Fannie and Freddie actually were leading the market.)
Fannie played hardball even here. Taylor recalls getting a commitment from Fannie for a small grant. After he testified at a congressional hearing that the company didn’t do enough for affordable housing, he got a call from a Fannie executive who told him that they had run out of money. Taylor says he picked up the phone and called Jim Johnson. “I said, ‘You have to tell me that Fannie is not that small minded,’” he says. The grant was reestablished. Wallison, who served on the board of a mortgage insurer until 1999, later alleged that pressure from Fannie led to his resignation from the board.
In 1999, Raines announced that Fannie would begin buying some subprime mortgages—generally more expensive mortgages made to people with less than pristine credit. Fannie executives still argue that they were helping borrowers who were very close to qualifying for a Fannie Mae loan, but would otherwise have been shoved into a more expensive subprime product. “This was a follow-the-market innovation,” says another executive, who notes that at the time, Fannie released a strict set of standards that barred it from purchasing many of the subprime loans the private sector was making. “I would get yelled at because I was saying, ‘We’ll take the top end,’” Raines says today. “Because people didn’t belong there. But we were told to stay out.”
Indeed, others in the mortgage industry worried that Fannie and Freddie were controlling more and more of the market. Around the same time, a group of private mortgage companies launched an organization called FM Watch, which dedicated itself to reining in Fannie and Freddie. Its initial sponsors were three large bank-owned mortgage lenders (Chase Mortgage, Wells Fargo, and PNC Mortgage), one subprime lender (Household Financial), and GE and AIG, the parent companies of two mortgage insurers. FM Watch also argued that Fannie didn’t “want to risk its profit margins by doing as much as it should to serve affordable housing.” Fannie, in turn, labeled FM Watch “The Coalition for Higher Mortgage Costs.”