Freddie & Fannie Were Most Certainly On a Mission

Yesterday I watched Freddie Mac CEO Dick Syron interviewed by Maria Bartiromo on CNBC and I have to say both did a good job asking and answering many tough questions.  The foundation of many of Mr. Syrons answers centered around Freddie Mac fulfilling its "mission".  That mission, according to Mr. Syron, was the mission to provide affordable home finance to many Americans in order to fulfill the dream of homeownership for as many as possible.  This was a cornerstone in the Bush Administration's "Ownership Society."  One could definitely argue that this goal has been a primary goal of American domestic policy since the 1950's.  This was the reason for the very existence of Freddie Mac and Fannie Mae.  I am going to argue however, that since the mid-1990's, the real mission of Freddie and Fannie was to make the shareholders happy and enrich  the executives that benefited from happy shareholders.

Dick Syron came to Freddie Mac at a time where the very integrity of the company was in tatters.  In 2003, it was discovered that the company had engaged in multiple counts of fraudulent accounting practices.  The books and records of the company needed to be restated back to the year 2000.  It was also discovered that Freddie's accounting infrastructure was woefully incapable of supporting the financial accounting of one of the most complex financial companies on earth.  Mr. Syron was tasked with fixing the problem and to his credit, he did.  Many might have legitimate gripes about how he managed the process but from the macro perspective, Mr. Syron achieved his objective. 

Mr. Syron repeatedly said yesterday that the deterioration in Freddie's credit book was owed to the company being pressured to fulfill its affordable housing goals.  In this I think Mr. Syron is not painting a completely accurate picture.  It is certainly true that HUD was pressuring Freddie to step up its affordable housing efforts back in 2004.  I remember having sympathy for Mr. Syron at the time because Freddie and Fannie were being screamed at to reduce the massive interest rate risk of their retained portfolios, while simultaneously being yelled at to increase credit risk from another area of government and its constituents! 

However, if you look back at how Freddie Mac (Fannie too, but we'll deal with them tomorrow!) was run, certainly since the mid-1990's, it was all about placating the shareholders and getting paid.  Freddie Mac has two distinct businesses;

1. Mortgage insurance through the securitization of conventional, conforming mortgage loans.
2. Managing a highly leveraged portfolio of mortgage assets.

In the mid-1990's Freddie really started taking advantage of their cheap funding by exponentially increasing its retained portfolio and leveraging up the favorable net interest margin.  At the same time, credit losses began to drop precipitously.  The mortgage insurance business really started raking it in.  In fact, you know it was a great business at the time because one of the largest investors was Warren Buffett.  As many of you know, Mr. Buffett loves insurance models that collect lots of premiums and never have to pay off, who the hell wouldn't!  In the late 1990's however, Buffett began to see three things that bothered him;

1. The GSE's were competing with each other more aggressively each year, thus reducing insurance premiums.  Additionally, mortgage originators like Countrywide, were growing in strength and pushing back on the GSEs with regard to insurance premiums.
2. Defaults and losses on conventional, conforming mortgage loans were dropping very close to zero.  Therefore, at some point they had nowhere to go but up.
3. Freddie had levered up its retained portfolio about as far as Mr. Buffett was comfortable with. 

So in the late 1990's, one of Freddie's biggest shareholders called it quits, and Freddie probably agreed with his reasoning.  However, to offset the declining revenue in the insurance business as competition with Fannie Mae intensified and originators morphed from price takers to price makers, Freddie kept increasing the retained portfolio AND the leverage.  The bang for the buck was also being enhanced by declining funding costs as Freddie successfully marketed its exploding debt.  The money poured in and the stock price continued to rise, especially during the 1998 refinancing wave.  To keep shareholders happy, Freddie portrayed the image of "Steady Freddie", a incredibly consistent money making machine.  To insure this, Freddie spent billions on interest rate derivatives to properly hedge the retained portfolio.

Therefore, when accounting rules changed in late 2000, where bye Freddie would have to mark to market its derivative hedges while not marking a vast majority of its balance sheet to market, there was a big problem.  In volatile times the derivative hedges would do what you want them to do, swing around in price as they were the offset to the balance sheet risk.  However, huge swings in the derivative book would destroy the image of "Steady Freddie".  The equity investors had never been properly educated in how Freddie managed this complex risk.  They had "Steady Freddie" embedded in their brains.  It didn't matter that "Freddie" was actually showing it was "Steady" by the swings in its derivative book, as the market value of portfolio equity (MVPE) remained remarkably steady. The earnings volatility, due to the accounting rules, would freak investors out.  So what did Freddie Mac do?  They kept with "the mission" of course.  The engaged in multiple acts of accounting fraud to "smooth" earnings so as to keep the share price up and get the executives paid.

When the accounting fraud exploded in 2003, the old management was whisked out and Mr. Syron came in with a new team.  As I said before, they built the accounting infrastructure and began to mend fences with the government and rebuild their integrity.  However, the rise of the Wall Street securitization game was creating another shareholder problem for Mr. Syron and his circle.  The Street was grabbing huge, overall mortgage market share through its securitization of both Jumbo and non-prime mortgage loans.  GSE market share of the overall market began to drop precipitously.  The pressure was on to not only defend their turf but retake market share.  I am going to argue that the pressure from shareholders easily trumped pressure from HUD.  Freddie Mac began first by buying huge quantities of AAA rated subprime bonds.  They were the bid that drove hundreds of billions of subprime deals.  Then, despite the objections of many inside  of Freddie Mac, management began to compete with Wall Street to guarantee riskier and riskier mortgage loans.  If you look at some of the objectives of senior Freddie Mac management (you can find these on the company's website), their job was to "touch" as many loans as possible.

In 2006, when Freddie vastly increased its credit risk, Mr. Syron's "affordable housing mission" argument loses credibility. Nobody needed to be pressured to increase affordable housing finance.  Anyone whose breath could fog a mirror could get a $150,000 loan at the drop of a hat.  Mr. Syron's "mission" was to regain market share, make shareholders happy, and get himself and his inner-circle paid.  And they were paid!  Now however, that risk is crushing Freddie Mac.  Could this have been avoided?  I believe it could have been.  When it comes to housing, there's probably no collection of people who know more about it than Freddie Mac.  Their gut was telling them there was something wrong.  Mr. Syron could have gone to shareholders and told them he didn't want to fight a market share battle when mortgage insurance pricing had become delusional.  There was still plenty of regular prime mortgage business to be done.  He also could have raised more capital to take advantage of any future dislocation.  However, instead of decreasing leverage, he increased it.  Now he, Freddie Mac and all of us have to pay the price for Mr. Syron's "Mission Accomplished".

Comments

[AntiLemming]

Excellent summary. I think the incestuous relationship with the boys and girls on Capitol Hill ended up biting them in the ass, too.