The Department of Justice recently announced that it would drop its criminal investigations into the accounting practices of home loan giants Fannie Mae and Freddie Mac.
These are probably the biggest corporate scandals that you’ve never heard of. Despite the incredible sums of money involved, the story never really gained legs outside the D.C. beltway. And that is a real shame because the fate of these two firms will have serious effects on the U.S. economy.
Fannie Mae and Freddie Mac are Frankenstein creations from a bygone era. They aren’t private corporations nor are they government agencies; they are bizarre public-private hybrids known as Government Sponsored Enterprises (GSEs).
Both firms are for-profit entities that have been chartered by Congress to improve homeownership rates in this country. In order to carry out this public mission, the pair have been given a number of special privileges. This arrangement may have made sense when the United States housing market was less mature, but today it creates nothing but problems.
The GSEs’ special relationships to the federal government have led many investors to believe that Congress would back Fannie and Freddie’s debts if either firm became insolvent. This implicit guarantee makes the GSEs very safe homes for investment capital. In exchange for this security, investors allow Fannie and Freddie to borrow at below-market interest rates. This situation has created opportunities for the firms to generate immense profits.
Of course, everyone knows there is no such thing as a free lunch. Fannie and Freddie’s profit margins reflect the amount of risk the firms are willing to accept.
Since the federal government is ultimately responsible for Fannie and Freddie’s debts, the pair has a strong incentive to take on excessive risk. This is exactly what has happened. Over the past decade, the GSEs have taken on increasingly risky ventures and profited handsomely – or so their books claimed.
The GSEs’ accounting woes first came to light in the summer of 2003, when Freddie Mac decided to replace its auditor, Arthur Andersen, following accounting scandals at Enron and WorldCom. The new auditors found a number of irregularities in the company’s financial statements and began an internal investigation.
It was soon discovered that senior executives had misrepresented earnings in order to reduce share-price volatility. In response, the SEC imposed a $125 million fine and mandated that Freddie Mac restate its earnings for the past three years.
The incident at Freddie Mac triggered an investigation into the finances of its sister company, Fannie Mae. The investigation revealed that Fannie Mae suffered from accounting fraud on a much larger scale. Executive compensation at Fannie Mae was conditional on the company meeting certain earnings targets. In order to meet these targets and trigger large cash bonuses, Fannie’s books were heavily doctored.
Earlier this summer, Fannie and Freddie’s regulator, the Office of Federal Housing Enterprise Oversight, issued a scathing indictment of Fannie Mae’s accounting practices. According to the OFHEO report, “the picture of the Enterprise as a ‘best-in-class’ financial institution was a ‘faade.'” To maintain that faade, senior executives worked strenuously to hide Fannie Mae’s operational deficiencies and significant risk exposures from outside observers.” Ultimately, Fannie Mae reached a settlement with the SEC and agreed to pay a fine of $400 million and restate its earnings since 2001.
As of this year, Fannie Mae and Freddie Mac have disclosed a combined $15.8 billion in accounting errors! It’s hard to believe that accounting shenanigans of this size aren’t criminal, but in the past, the DOJ has been loathe to level criminal charges against corporations.
Now it is up to Congress to take corrective action. Together Fannie and Freddie hold nearly $1.45 trillion in their portfolios. The GSEs have become so large that a failure at either firm would lead to massive financial panic. In order to prevent a macroeconomic meltdown, Congress would almost certainly orchestrate a bail out. A very expensive proposition, indeed.
These problems can all be avoided at little to no cost, if Congress simply steps up to the plate. All that is needed is a piece of legislation that puts limits on the GSEs’ risk taking. Unfortunately, this issue has always been a political non-starter because Fannie and Freddie possess enormous clout inside the beltway. The GSEs’ massive lobbying campaigns have made them difficult targets for Congressional oversight in the past.
But with the scandals still fresh in people’s minds, now is the ideal time for Congress to pass bipartisan legislation to curb the pair’s excesses. If this window of opportunity closes, meaningful reform will probably never occur.
Miller can be reach at emiller@campustimes.org.
