JEFFREY BROWN: Fannie Mae is one of the largest financial institutions in the country, and it impacts millions of Americans who take out home mortgages. But it is also perhaps one of the least understood of our major institutions.
Fannie Mae is a publicly traded company, but it also has a government charter: To help spread the risk of making loans and to help make those loans available to more Americans, including low and middle-income earners. Its business, buying mortgages from banks and then reselling them, has grown tremendously, and today Fannie and the smaller Freddie Mac own or guarantee roughly half of the $7.9 trillion of U.S. mortgages outstanding.
In recent years, though, a lively debate has grown as to whether Fannie Mae is too big. And last week, a federal regulator found that Fannie Mae had painted a false picture of some of its finances. Yesterday, the company agreed to significant changes in some accounting and management practices.
And here to walk us through this story is Stephen Schurr, U.S. market editor of the Financial Times newspaper. Steve, welcome. I want to start by explaining a bit more about Fannie Mae. I see it described as quasi- company and quasi-government agency. How does that work?
STEPHEN SCHURR: Yeah, it's a strange, nebulous terrain. Essentially, Fannie Mae is what's known as a government- sponsored entity. It is a publicly traded company that also has a federally chartered mission.
That mission is to help spread the dream of home ownership here in America. And to do that, they get certain benefits that other publicly traded companies don't get from the government, such is the ability to borrow at a lower interest rate. And, of course, because it's not under the sum of a big bureaucratic government, it's a publicly traded company, it's theoretically more nimble and has the ability to act more as a creative company would.
Of course, its critics would say that this intersection of government and Wall Street isn't the best of outcomes because you... their contention would be that Fannie Mae and its smaller sibling, Freddie Mac, get certain benefits in federal largess which allows them to outrun their competition, but it also enriches a few of the executives rather than spreading its mission.
JEFFREY BROWN: Well, give us a sense of... how does it make its money?
STEPHEN SCHURR: In one sense, it's very simple. They essentially sell bonds and then use the proceeds to buy up mortgages, which, in effect, provides liquidity for the housing market that enables more individuals to buy homes.
But that's where the simplicity ends. They have a trillion dollar mortgage portfolio, and it's not the easiest accounting ledger to make heads of tails of.
JEFFREY BROWN: I guess it makes a little bit on each mortgage loan?
STEPHEN SCHURR: That's exactly right. It makes a small amount of money on the spread between interest rates on the loans that it... on the bonds that it sells versus the mortgages that it buys. But when you add up those very small amounts into a trillion dollar portfolio, you're talking about serious money, usually on the order of several billion dollars in earnings in a year.
JEFFREY BROWN: Tell us what this government regulator found in its report last week.
STEPHEN SCHURR: It's a regulator that few people know of, at least until this past week. It is the Office of Federal Housing Enterprise Oversight. Its primary mandate is to ensure the safety and soundness of Fannie Mae and Freddie Mac and other GSE's, government sponsored entities.
The findings come after an eight-month investigation into Fannie Mae's accounting, and the investigation is still under way. And among the various findings in the report are that Fannie Mae used an improper "cookie jar"-- that's their word-- of reserves to...
JEFFREY BROWN: "Cookie jar" is a technical term?
STEPHEN SCHURR: (Laughs) Exactly. I think we can all understand what a cookie jar is. In any event, they used this cookie jar to keep certain money in key to make sure that their earnings growth was as smooth as possible, which Wall Street likes.
But, of course, FHEO found that this was an artificial smoothing of earnings that flies in the face of generally accepted accounting principles.
JEFFREY BROWN: Explain what you mean, though, by "smooth." That means that, instead of a lot of bumps in the road, it keeps a steady...
STEPHEN SCHURR: Yeah, that's exactly right. The course of corporate earnings never runs smooth except on the balance sheet of certain companies such as Fannie Mae, where you see a very steady, uninterrupted pattern of growth quarter over quarter, year over year.
And when you're talking about a company that manages literally trillions of dollars in mortgages that are very vulnerable to movements in the interest rate environment, you would expect that there would be a fair amount of zigging and zagging in terms of the earnings that they bring in. But the numbers that they've reported, what are called the core numbers, exclude some of this volatility, have been remarkably smooth.
JEFFREY BROWN: Okay, and what are the other... some of the other things that the report found?
STEPHEN SCHURR: Well, some of the other issues and one of the most contentious right now is that the company has deferred reporting certain expenses in a timely fashion in order to meet certain bonus compensation targets that ended up causing the top officials to reap multimillion dollar windfalls because they effectively hit the numbers that they were hoping to make.
And, of course, if that's the case, that poses real challenges for the executives in charge.
JEFFREY BROWN: Now, what's at stake here? I mean, once these findings are put out there, why is this important? What do we take from it?
STEPHEN SCHURR: Well, I think Americans need to understand the important role that Fannie Mae plays in the economy, not just in the housing market. We all indirectly benefit from the liquidity that they are engaged to provide, but, of course, if there are accounting issues and if there are unfair windfalls to some of the top executives, one has to really seriously question if the current structure passes on its as much to individual homeowners as it should.
The other important thing to recognize is that Fannie Mae has become so large that some folks, including Alan Greenspan, have questioned whether or not they pose a risk to the U.S. financial system if there were to be some excessive risk in their... in their portfolio, which remains largely a black box to most... even the most sophisticated folks on Wall Street.
JEFFREY BROWN: So yesterday, Fannie Mae, after some negotiations with the regulator, agreed to some changes. Tell us what it agreed to.
STEPHEN SCHURR: Well, first and foremost-- and this is the most important component of it-- they agreed to raise their capital surplus by 30 percent. And what that really means is... FHEO, the regulator, said, "these numbers aren't quite clear us to. We're a little concerned that you're not adequately capitalized to deal with changes in the economy." So Fannie Mae...
JEFFREY BROWN: This is like having money for a rainy day if something bad happened.
STEPHEN SCHURR: That's exactly right, yeah. So, essentially, the company agreed to raise its capital by 30 percent, which is going to pose some operational challenges for the company. They've also agreed to make some recalculations to how they account for some of their relatively complicated portfolio.
And they've also agreed that they're going to... this is, by the way, Fannie's board of directors. They've agreed also to take a closer look at the operational structure of the company to make sure everything is on the up and up.
JEFFREY BROWN: And there's some potential consequences for the leadership?
STEPHEN SCHURR: That's exactly right. One of the things that's interesting about Fannie Mae is, it's long been a political power house in Washington in addition to being a long-time favorite on Wall Street. It's run by Franklin Raines, who was on the short list for Al Gore's vice presidential candidate in 2000.
And if the initial findings that FHEO has come out with mushroom into more substantial findings as the investigation continues, one really has to question whether he's going to remain in this post.
JEFFREY BROWN: So, what does happen next? I know the FCC is conducting an investigation. Congress has talked about looking into this. What do we look for the next?
STEPHEN SCHURR: What we're looking for is continued findings from FHEO. Next week, the House Financial Services Committee is holding hearings into what's going on at Fannie Mae and try to bring some of the issues to light. We're going to be looking to see what happens to the top management.
We're going to look and see if all of the accounting scandal issues are going to mean that next legislative session Congress decides: "You know what, we're going to push forward with the plan to install a stricter regulator over Fannie Mae and Freddie Mac."
JEFFREY BROWN: Okay, Stephen Schurr of the Financial Times, thanks very much.
STEPHEN SCHURR: Thank you.