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A: Eventually, just about everything. Due to their origins, the culture of each organization was to be responsive to political pressure. Moreover, they were often headed by political hangers-on, not actual financiers—although they certainly proved adept at enriching themselves personally, even while running their institutions into conservatorship, with the U.S. taxpayers being the fall-guy.
Q: What were the first signs of trouble?
A: The problems were gradual in the making. Let’s go back for a minute to 1977 when Congress passed, and Jimmy Carter signed, a measure called the Community Reinvestment Act.
This law forced the nation’s banks to make loans to poor and minority neighborhoods, on penalty of being denied the ability to merge, expand, or open new branches. Understandably, the banking industry fought this provision, as did Fannie Mae and Freddie Mac. But when Fannie and Freddie lost that fight and the law took effect, Fannie and Freddie decided to profit from it by buying up billions upon billions of dollars of securitized packages of CRA loans (from companies such as the now-defunct Bear Stearns.) In 1999, Congress, at President Clinton’s request, beefed up the enforcement of the CRA, and applied it to Fannie Mae and Freddie Mac as well.
Q: What happened next?
A: In 1991, James A. Johnson, a top aide to former Vice President Walter Mondale, left Lehman Brothers (now also defunct) to run Fannie Mae. He promptly announced a policy called “Opening Doors” in which Fannie would purchase $10 billion worth of mortgages for low and moderate income Americans. Three years later, under overt pressure from Congress and the Clinton administration, Fannie Mae announced it was increasing this figure to $1 trillion in targeted housing finance to minorities and the poor. The seeds of the “subprime mortgage” crisis had been planted. “Fannie Mae was buying up not just the mortgages of responsible working folks, but also those of a lot of deadbeats and house-flippers out to make an easy profit,” says economist Arthur Brooks, president of the American Enterprise Institute. “Bad business practices were not just allowed, they were demanded by the government.”
Q: Did anyone see this coming?
A: Some did.
- More than three years ago, The Economist, a prestigious British-based magazine wrote that the world was in the biggest real estate bubble in history. “Never before have real house prices risen so fast, for so long, in so many countries. Rising property prices helped to prop up the world economy after the stock market bubble burst in 2000. What if the housing boom now turns to bust?”
- Five years ago, in 2003, former Goldman Sachs vice president John R. Talbott wrote a book called, The Coming Crash in the Housing Market. Talbott began writing that book after a friend who was a San Diego schoolteacher making $45,000 a year refinanced his condo by taking out a $255,000 mortgage. A salary that small doesn’t justify a mortgage that large, and Talbott realized that the nation’s mortgage lending system was operating on the same logic as a Ponzi scheme—and had all the makings of a classic bubble.
- One of the earliest alarms was sounded by A.E.I. scholar Peter J. Wallison, who served as general counsel at the U.S. Treasury Department during the Reagan administration. In the years 2000-2004 he warned in a series of books, articles, and public lectures that Freddie Mac and Fannie Mae had come to dominate the residential mortgage market. Wallison warned that by 2003 they would be responsible for half the residential mortgage risk in the United States and that, because of their unique charters, it was really the American taxpayers who were holding the bag to a portfolio—held by just two companies—of some six trillion dollars. “The level of risk was just insane,” Arthur Brooks told Reader’s Digest. Congress simply wouldn’t listen to any of Wallison’s warnings, however. It’s too bad. If they had, this entire financial crisis might have been avoided.
Q: So why weren’t these voices heeded?
A: Psychologists call it “denial,” and it’s a powerful phenomenon. The American public, members of Congress, government regulators, and even most of those in the housing and banking industries simply couldn’t bring themselves to believe that a housing bust was coming. Home prices had always gone up and up and up, and after awhile, it became embedded in people’s minds that they could only go in one direction. No one in authority seems to have been immune from the group-think. Alan Greenspan, a smart man and the longtime chairman of America’s central bank, the Federal Reserve Board (known as the Fed), said in May 2005 that although he’d noticed “a lot of local bubbles” in the nation’s housing sector, he didn’t perceive a national problem on the horizon. This proved to be wishful thinking.
Q: What about greed; you’re not discounting that as a factor, are you?
A: No. It’s clear that many of those profiteering from the bubble simply didn’t want to get off the gravy train—even after it became clear something had gone terribly wrong.
Q: Can you name names?
A: Sadly, any number of names can be rattled off, beginning with James Johnson, who earned $6 million to $7 million per year as the head of Fannie Mae, along with a going- away present of $21 million when he left in 1998. Even as Fannie Mae’s exposure grew, the habit of executives paying themselves enormous salaries continued unabated. Johnson was replaced by former Clinton White House official Franklin D. Raines, whose total compensation in 2002 alone was $17.7 million. That year, 19 other top Fannie Mae executives were paid more than $1 million, a dozen more made better than $2 million and nine made more than $3 million. Here’s a 2004 news account raising questions about the propriety of those salaries for a government-backed entity.
Q: Maybe it’s gross, but is there anything fraudulent about it?
A: Quite possibly. In 2006, an oversight investigation of Fannie Mae’s conduct from 1998 to 2004 revealed that the reason Fannie Mae engaged in “extensive financial fraud” by doctoring its earnings was so that its executives could reap hundreds of millions in bonuses. According to the report by the Securities and Exchange Commission and the Office of Federal Housing Oversight, Fannie Mae was able to report “extremely smooth profit growth and hit announced targets” only because it was using “inappropriate accounting” methods designed to overstate earnings so top executives could make their bonuses. And make them they did: While Fannie Mae was over-reporting its earnings and capital by some $10.6 billion, Raines was paying himself $90 million during a six-year span—some $52 million because of the improper bookkeeping. Jamie S. Gorelick, another former Clinton administration hand hired at Fannie Mae despite having no background in finance, was paid $26.4 million during that period. Here’s the complete report, but a warning—it’s a very large pdf file:
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