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By Melissa Hoffmann Lajara
Posted on 9/11/08
The government takeover of monster mortgage lenders Fannie Mae and Freddie Mac raises a number of questions, but three dominate: Who-or what-is to blame for their failure? Did the government act appropriately? And is there a lasting solution?
Some point fingers at the companies' auditors, others at managers, and some blame the system itself. But all agree on one thing: It's a brave new world for Wall Street.
The plan puts the two institutions in a conservatorship run by the Federal Housing Finance Administration (FHFA) and allows the United States Treasury to buy $1 billion in senior preferred stock, as well as warrants that will, according to Forbes, allow it to buy up to 79.9 percent of the common stock of each company. Common shareholders have been stripped of their ownership rights and influence until the conservatorship ends. Lobbying by the companies-one of their primary functions-has ceased.
The takeover came a mere two months after Treasury Secretary Henry M. Paulson asked Congress to allow the Fed to open its discount window to the companies and bestow upon the government the power to intervene to save Fannie and Freddie if necessary-while at the same time insisting the possibility of such a bailout was low.
What was once considered a doomsday scenario has now come to pass. But according to some, the seeds of Fannie's and Freddie's current struggle were sown years ago.
"They had unbelievable problems," said Howard M. Gluckman, immediate past chair of the NYSSCPA's Banking Committee. "They couldn't even produce audited financial statements, which is mind-boggling, considering their size."
But Gluckman said pinning responsibility on the auditors-Deloitte for Fannie Mae, PricewaterhouseCoopers for Freddie Mac-is a mistake.
"These are serious firms," he said. "They know this is big-time being watched by Congress and the whole country. I would be surprised if there were any shenanigans."
Charles M. Carlson, a member of the Society's Stock Brokerage Committee, agreed with that assessment. He said "the blame belongs with management" and believes any firm chosen to audit the companies would have taken the same approach.
"Anything can be blamed on anyone, but to blame the auditors … as being the primary reason for [their] downfall would be a huge leap," said Amit Govil, a member of the Society's Banking Committee. "The fact that the auditors were not aggressive enough in challenging the accounting decisions over the years is certainly a factor in this crisis, but not the main reason.
"Auditors almost always get blamed for not being proactive enough in [sending up] the red flag," he continued. "There is certainly some merit in wondering how the auditors were able to sign off on the questionable accounting practices. While those questions will eventually be asked, for now the market conditions and the housing [crisis] have been tagged as the primary reasons for their demise. It is clear these factors have contributed to a greater extent … than the auditors' lack of vigilance."
But Bruce S. Glaser, also a member of the Stock Brokerage Committee, said auditors always have to take some degree of blame when "something of this magnitude occurs, especially in light of earnings volatility and restatements."
However, he said, "There are more serious issues at play than pointing fingers. The blame game will come out at some point, but right now the focus is on righting two sinking ships."
Saying his firm does not comment on client issues, PricewaterhouseCoopers spokesman Steven Silber declined to speak about Freddie Mac's downfall and said no company statement is pending. Deloitte & Touche did not return a call seeking comment.
Stock Brokerage Committee member Paul S. Ehrenstein, who said he's spent the last four decades on Wall Street, said it was worth noting that the focus on risk assessment in audits is a relatively new concept.
"As the world changes, you have to change your model. Risk assessment is a new world for us," he said. "I do think there will be auditor liability there, but it's not them alone. It's a shared responsibility."
A Fundamental Conflict?
Both Fannie and Freddie occupy a unique position in the lending world-as government-sponsored enterprises (GSEs), they seek to serve both a public mission and turn a profit for shareholders. They guarantee mortgages with backing from the federal government.
Both also share experience with questionable accounting practices.
In 2003, Freddie Mac disclosed that it had misstated earnings by some $5 billion for 2000-2002 in order to meet Wall Street expectations. Three years later, Fannie Mae found itself in the middle of an $11 billion accounting scandal, after the Securities and Exchange Commission (SEC) and the Office of Federal Housing Enterprise Oversight (OFHEO) reported that the company had misstated financial statements "from at least 1998 through 2004."
Both companies ousted their top executives, and the SEC fined Fannie Mae $400 million, which was offered as restitution to defrauded shareholders. Freddie Mac settled for a $50 million fine in 2007.
In announcing the punishment of Fannie Mae in May 2006, SEC Chairman Christopher Cox criticized a lack of internal oversight.
"Fannie Mae's size and status make it a financial giant. Yet despite its prominent position in the financial marketplace, the company's internal controls were wholly inadequate in light of the size, complexity, and sophistication of Fannie Mae's business," Cox said in his statement. "Its failure in key areas highlights the critical need for senior management to constantly assess internal controls as their business grows. Such an investment is necessary for the good of the business, for the protection of shareholders, and for the health of our capital markets. Fannie Mae is a clear example that neglecting internal controls can be devastating for a company and its investors."
Some would say that the companies learned little from the mistakes of the past. But Gluckman noted that both Fannie and Freddie have more recently received unqualified opinions on their audits by Big Four firms.
"For the most part, it's my understanding that those problems were taken care of," he said.
But Fannie and Freddie also have consistently dealt with conflicting goals resulting from their GSE status.
"The mix of a public mission and a private company earning a profit for their shareholders-that's definitely an inherent conflict," Gluckman said. "Part of the reason they grew so big was because of unfair competition. With the implicit backing of the government, costs were lower than for others that may have wanted to go into that business."
Glaser said that because securities issued by Fannie and Freddie were "touted as being guaranteed by the U.S. government" to one degree or another, they came with a false sense of safety.
"If the credit crisis hadn't materialized in August 2007," he said, "there is no doubt that the amount of mortgages participated in by these two institutions would be closer to $6 trillion today."
Glaser said he believes that being a for-profit entity with a mandate to provide for the public good "puts management in a conflicting situation where personal gratification and reward comes before all else."
But, according to Carson, the GSE model provides "necessary stability" for the housing market. He said Fannie's and Freddie's failure should, instead, be attributed to the ongoing credit crisis.
"In their quest for profits, the real estate and lending institutions relaxed the rules, which allowed unqualified buyers to purchase properties well above their means," he said. "They built a house of cards, and stricter credit controls are necessary [to ensure] that it doesn't happen again."
Governmental Intervention
With the two companies guaranteeing about half of the nation's home loans, was the government takeover a necessary act?
Carson says yes. "The government could not take the chance that they might fail," he said.
Glaser concurred. "Something decisive had to be done quickly to reclaim the confidence [of] investors and the market overall," he said. "The concept that Fannie and Freddie were 'too big to fail' was severely tested, and I think the government had no choice in the short run. One thought here is whether, given the nature of their mandate, Fannie and Freddie should have been privatized in the first place."
Prior to the rescue action, the two companies had been given deadlines to raise money. Freddie Mac was unable to raise enough capital to offset billions of dollars in losses stemming from the mortgage crisis, according to the New York Times. Fannie Mae, on the other hand, raised its requisite $7 billion, but Paulson noted that in the eyes of the market, the two are not just brother and sister, but Siamese twins, joined at the hip.
And so they were taken over as a pair.
"There is a school of thought that suggests that the government could have provided the financial support necessary to rebuild the companies to strength," Govil noted. "While that is possible, it is more probable that the government [saw] more financial and operation issues within the companies" that needed remediation.
Whether or not auditors saw problems with the companies' financial statements before the government's dramatic rescue, Paulson was, according to the Times, unaware of the trouble until recent weeks. Fannie and Freddie had been hailed as possible saviors of the struggling housing market. Suddenly, they were its most immediate risks.
"By taking them over," Govil said, "the financial markets are spared the continued media coverage of [the companies'] financial woes and operational improprieties, and [it] enables the government to implement a new plan."
Government Accounting and Auditing Committee member Scott M. Adair, on the other side of the coin, sees the government takeover as a worrisome step in a dangerous direction.
"It creates bigger government," he said. "We've taken over an enormous entity and saddled ourselves with additional debts, from the taxpayer standpoint, for the long term."
An Uncertain Future
Never before has the government taken such a dramatic step to steady the market, so no one knows definitively what will happen as a result.
Analysts have made some predictions. Mortgage rates, the Times noted, are expected to initially fall a bit, but a related decline in home prices is unlikely. Some delinquent borrowers may find a lifeline in a modified loan with lower fixed rates. And with the government controlling the two largest mortgage lenders in the country, the rules of lending could change.
"The government was not proactive in stopping subprime lending-even when the regulators knew that it did not make sense," Govil said. "The process will change, and it needs to."
Stock Brokerage Committee Vice Chair David H. Grumer said there should be a thorough investigation before any rules are changed.
"It sounds as if at a minimum there will be a demand for more transparency in disclosing how they operate and a thorough review of how they determine the amount of reserves that they need to accumulate," he said.
Adair said he doesn't think the government should be allowed to apply new rules to loans, but said it wouldn't surprise him if that's exactly what happens.
Searching for a Lasting Solution
After the conservatorship ends, what's to become of Fannie and Freddie? Only days after the takeover, the Times reported that lawmakers and officials were already deliberating that future step.
And already, it's a political football.
Some senior officials at the Treasury, according to the Times, would like to shrink the companies into small, tightly regulated public utilities. Others of a similar mindset would have the two turned into purely governmental agencies, in the fashion that Fannie Mae existed for the 30 years preceding the Vietnam War. Some Democrats have expressed a desire to restore the two companies to health with additional safeguards. And free market theorists, the Times said, would prefer the complete liquidation of the two companies in favor of private-sector institutions.
Glaser's in favor of privatization. He said the two companies, since they share the same mandate, should be merged, and "correct oversight and control" should be put in place.
"If not the SEC, then something akin to the SEC … that has both the experience and expertise to examine them," he said. In addition, he said, periodic reporting by the merged entity should be mandatory.
Ehrenstein said he believes the GSE model could be preserved, or the companies could become completely government-owned. But as it stands, he said, it's obvious "there's not enough regulatory oversight over the whole system."
"The original formula is probably still the best," Carson said. "Unfortunately, more oversight will be required in the future to make sure that management tempers its quest for profits and employs more realistic credit policies."
Adair believes a "public-private partnership" would be a better choice. "To bring it onto the books of the federal government, I think that's a mistake," he said. "Fannie Mae has grown to a size that no one ever expected it to get to, without the infrastructure to support it."
The Times noted that Federal Reserve Chairman Ben S. Bernanke's earlier rescue plan included provisions that tended toward making Fannie and Freddie smaller, and shrinking the companies' portfolios, which now total about $1.4 trillion. That, however, could be reversed, depending on the country's choice of president.
Discussion of the ultimate fate of the two companies-after the conservatorship and crisis have passed-will begin soon, when the Senate holds hearings on the bailout. However, a final decision, according to the Times, is not expected until after the presidential election.
Expected to testify at the Senate hearings are Paulson, Bernanke and James B. Lockhart III, head of the FHFA, the Times said.
The long-term impact on the economy is anyone's guess.
"I was more pessimistic when the whole thing started, when the brokerage firms collapsed," Gluckman said. "This is the [crisis] working its way out. It was inevitable action, and now we can start cleaning up the whole thing and make the changes that need to be made."
"A perfect solution is hard to articulate at this juncture," Govil said. "Certainly the inherent concept behind the creation of these companies was not bad or wrong. They provided the banks with much-needed liquidity to meet [the demands] of the booming housing market. That situation and need may arise again."
Melissa Hoffmann Lajara, Associate Editor, can be reached at mlajara@nysscpa.org.
