Follow the Loan Money
By Jonathan GS Koppell
New Haven -- When the company that is involved in financing about a quarter of all home mortgages in the United States becomes mired in a $9 billion accounting scandal, Congress can be expected to take notice -- especially if that company, Fannie Mae, is widely seen to be backed by the government.
Under pressure from regulators and facing heightened scrutiny in Congress, Fannie Mae's board replaced its chief executive and chief financial officer last week. The question is whether the sacrifices of two executives will be enough to mollify members of Congress who are ready to put the screws to Fannie Mae and its sibling, Freddie Mac.
Reform will be at the top of the agenda when Congress returns from its recess. But regulatory reshuffling will not fundamentally alter Fannie Mae or Freddie Mac's behavior, because the root of the problem lies in the companies' very DNA. As government-sponsored enterprises, Fannie and Freddie serve two masters with competing priorities: the American public, whose credit implicitly backs their liabilities, and its shareholders, who expect them to maximize profits.
Fannie Mae and Freddie Mac work on an intuitively appealing premise: a profit-seeking company can accomplish the same tasks as a government agency with greater efficiency. Moreover, they can provide a public service without spending a dime of government money by leveraging Uncle Sam's top-notch credit rating.
But Congress should know that it never gets something for nothing. First, as government-sponsored entities, the companies pose a real risk to the taxpayers. Though their financial obligations are only implicitly backed by the federal government, their mistakes or misdeeds could cost billions.
Second, in order for the American people to get something in return for effectively co-signing Fannie and Freddie's paper, the government has to establish clear performance targets and make sure the companies fulfill a public purpose. But defining these goals turns out to be rather tricky: what percentage of their loan portfolio should come from low-income areas, for example?
Of course, fiscal prudence and program performance are radically different imperatives. The cautious executive will resist anything with a whiff of undue risk. The policy-driven executive will focus on making more loans in distressed areas -- regardless of risk. The recently deposed executives seemed to have something else on their minds as well: maximizing financial results.
And that, obviously, is the third goal. As enterprises, the companies are trying to make money. Investors expect a competitive return. There is nothing inherently wrong with this; Congress wants them to make money. It is enshrined in their charters. More fundamentally, it is part of the idea. Fannie and Freddie are supposedly more efficient precisely because they are trying to make money.
Trouble is, making money can conflict with providing financial security and carrying out a public mission. Keeping larger capital reserves will drag down the return on equity. Taking on riskier, lower-yield loans may do the same.
Fannie Mae has been particularly adept at using the tension among this triangle of goals for political advantage. If critics or members of Congress push it to encourage more affordable housing loans, then Fannie warns that such meddling invites financial insolvency. If they suggest that Fannie Mae keep a little more capital for a rainy day, then they are accused of preventing deserving families from owning a home. To bolster either position, Fannie calls on financially dependent ''friends'' in the financial industry or at housing advocacy groups to back it up. Such tactics have enabled Fannie and Freddie to resist stricter regulation for years.
All the while, however, management has been able to deliver on bold promises of growth to shareholders. And Fannie Mae executives take home multimillion-dollar salaries.
The accounting scandals at Fannie and Freddie may do more than just force the companies to restate their earnings. They may succeed in sapping the companies' legendary political strength and force them to agree to a regulatory overhaul.
It appears that this is exactly what is happening. Fannie recently announced it supports a review of its regulatory arrangement, just as the company did 12 years ago when the incumbent regulator, the Office of Federal Housing Enterprise Oversight, was on the drawing board. The office, known as Ofheo, was outgunned from pretty much the day it was created.
Its support may reflect Fannie's political savvy more than its sincerity. By supporting that 1992 legislation, Fannie was able to insert a few choice phrases that made Ofheo's task much more difficult. Most notably, the legislation required an annual appropriations review -- at the hands of Fannie's staunch Congressional allies -- even though Ofheo is financed not by appropriations but by assessments on the two companies it regulates. As a result, Ofheo's requests for additional money and personnel were often rejected and agency shortcomings were met with a Trump-like upbraiding in committee hearings.
The Bush administration's proposal -- shifting Ofheo's responsibilities to the Treasury Department -- may give the regulator more institutional heft and, arguably, the power to go toe-to-toe with Fannie and Freddie. But it would introduce a new raft of problems. One has to be wary that Treasury will give short shrift to the housing mission. More troubling is the possibility that regulation will be overly politicized, with decisions made to suit the fiscal and monetary policies of the administration in power.
Besides, if the past few months are any indication, Ofheo appears to be quite able to take on Fannie Mae and Freddie Mac. With more support in Congress, Ofheo could be more effective. Providing Ofheo with the powers outlined for a new regulator would most likely accomplish the same objectives as the Treasury proposal without the costly reorganization.
More important, either of these ''solutions'' ignores the bigger picture. Fannie and Freddie are the largest, but not the only, quasi-governmental entities creating trillions of dollars in federal liability. This moment of opportunity should be seized to create a single financial regulatory body with oversight responsibility not only for Fannie Mae and Freddie Mac, but also for other quasi-governmental entities.
Such a regulator could establish consistent capital standards, accounting rules and examination procedures well suited to these unique enterprises. The new agency's board could include Treasury Department representatives as well as the leaders of the government departments, like Housing and Urban Development and Agriculture, with an interest in the policy goals of these companies. Thus mission objectives will be balanced with financial management.
When Congress determined that America's national security was threatened by an uncoordinated array of domestic defense agencies, it placed them under one organizational roof. Recent events have shown that our fiscal security is jeopardized by innovative companies run amok. A financial super-regulator is the only institution that can guarantee both financial security and public benefit.
Jonathan GS Koppell, an assistant professor of politics, policy and organization at the Yale School of Management, is the author of ''The Politics of Quasi-Government.''