Freddie Mae: If only we had listened five years ago

Robert Bidinotto has posted a link to a damning video showing Congressmen including Barney Frank chastising Armando Falcon, director of the Office of Federal Housing Oversight, who blew the whistle on Fannie Mae in 2004. If you’re interested here are links to the web site and to the most recent (2006) report. The report runs 348 pages but reading the 13 page executive summary gives the lowlights of this appalling story. I have provided some quotes below.

What is even more sickening is the fact that the same web page lists reports going back to 2003. All of them share the same theme: Fannie Mae violated standard accounting rules and engaged in dubious (to put it mildly) practices to accomplish the goals of senior management.

When Franklin Raines became Chairman and Chief Executive Officer (CEO) of Fannie Mae in 1999, he sought to lead the Enterprise into a new era of growth in business volumes and profits by challenging senior management and employees to double EPS in five years. Mr. Raines also made changes in Fannie Mae’s compensation programs that enhanced incentives to achieve that goal.

A combination of factors led Fannie Mae senior management, through their actions and inactions, to commit or tolerate a wide variety of unsafe and unsound practices and conditions. Those factors included the Enterprise’s enormous financial resources and political influence, the expectation that senior management could write the rules that applied to Fannie Mae, financial rewards tied to a measure of profits that management could easily manipulate, and the relative disinterest of senior executives in adhering to standards of prudent business operations.

Fannie Mae’s Board of Directors contributed to those problems by failing to be sufficiently informed and to act independently of its chairman, Franklin Raines, and senior management, and by failing to exercise the requisite oversight over the Enterprise’s operations.

That misconduct ultimately led to the Securities and Exchange Commission (SEC) directing Fannie Mae to restate its financial results for 2002 through mid-2004, the departure of Mr. Raines and the Enterprise’s Chief Financial Officer (CFO), Timothy Howard, losses of tens of billions of dollars in market capitalization for Fannie Mae shareholders, and expenses for the restatement process, regulatory examinations, investigations, and litigation that the Enterprise has recently estimated will exceed $1.3 billion in 2005 and 2006 alone.

Improper earnings management at Fannie Mae increased the annual bonuses and other compensation linked to EPS that senior management received. Compensation for senior executives that was driven by or linked to EPS dwarfed basic salary and benefits. For CEO Franklin Raines, for example, two compensation components directly tied to meeting EPS goals accounted for more than $20 million for the six years from 1998 through 2003. Three-year EPS goals also played a crucial role in determining the size of the approximately $32 million awarded to Mr. Raines during that six-year period under a long-term executive compensation program. In total, over $52 million of Mr. Raines’ compensation of $90 million during the period was directly tied to achieving EPS targets.

The image of Fannie Mae communicated by Mr. Raines and his inner circle and promoted by the Enterprise’s corporate culture was false. In the words of one current member of Fannie Mae’s Board of Directors, the picture of the Enterprise as a “best-in-class” financial institution was a “façade.” To maintain that façade, senior executives worked strenuously to hide Fannie Mae’s operational deficiencies and significant risk exposures from outside observers—the Board of Directors, its external auditor, OFHEO, the Congress, and the public. The illusory nature of the Enterprise’s public image and senior management’s efforts at concealment were the two essential features of the Enterprise’s corporate culture. Those features, which were both supported by repeated improper manipulation of earnings, are a major theme of the report.

The Bailout: Hey Buddy Can You Spare $700B?

Before I start here are two links to helpful explanations of the economic "crisis." Both come from the Ludwig von Mises Institute. The first, titled The Bailout Reader, lists various articles on their web site. The second, titled The Housing Bubble in 4 Easy Steps, explains how the Fed's manipulations of the interest rate contributed to the housing market bubble. See more below but first I'd like to make a comment on what passes for explanations in the media and among many politicians.

When a systemic problem surfaces like this we need to look at something that leads people to act in a certain way. The popular "explanation" is to lay the blame at the greed of Wall Street and bankers. Question: why didn't bankers greedily loan money to poor folks before the passing of the Community Reinvestment Act during the Carter era and the strengthened enforcement imposed by the Clinton administration? If bankers didn't act this way previously we need to look at a deeper, more plausible reason than greed. Answer: because the change in laws and its enforcement dictated these poor loan choices. Before these laws went into effect the bank's underwriters knew that the rate of default on the loans would make this practice unprofitable. In fact, the people who pushed for these laws did so because the argued banks were "redlining" [not loaning to certain groups of people] and therefore needed to be encouraged [i.e., forced] to do so.

Returning back to the Ludwig von Mises Institute to which I refer at the beginning. I was lucky enough to go to Grove City College for my degree in chemical engineering. Why? At the time I was not aware of Grove City's strong free market economics department, headed by Hans Sennholz, an advocate of the Austrian school of economics. This school, which includes Friedrich Hayek (author of The Road to Serfdom) and Ludwig von Mises, proposed a theory of money, banking and business cycles at odds with the Keynesian model. I happened to become friends with several older students (including Robert Bidinotto) who were taking economics. Out of curiosity I started to monitor Sennholz's classes. What he said made sense so I sat in as many of his classes (with Sennholz's permission) as I could. Sennholz even offered to award me a minor in economics if I paid the school for the credits (which unfortunately I couldn't afford).

I'm probably doing it an injustice in trying to summarise the Austrian approach but in essence they argue that government attempts to foster economic growth by controlling and manipulating the money supply and interest rates ultimately create boom-and-bust cycles that are much more extreme than would occur in an economy where interest rates responded to market signals. Having centrally controlled interest rates leads to mis-investment as businesses plan their future and expansion plans on false information. The analogy which I've drawn in an earlier post is similar to government setting price controls. The inevitable result of government price controls leads to shortages or overstock because no bureaucrat, no matter how brilliant, can predict better than the pricing system of a free market.

The Austrian economists also argue against other attempts by the government to "steer" the economy via legislation. Their arguments are based on economics while others argue that it is immoral for politicians to redistribute wealth by using the full enforcement power of government to ensure we abide by its edicts.

The current financial situation perfectly illustrates both follies of artificially depressing interest rates while forcing banks to make loans to people who normally wouldn't qualify. These policies have resulted in the exact opposite outcomes as the stated intentions of its advocates. Instead of boosting low-income neighbors it will cause them to deteriorate (while leading to frantic calls for even more government "solutions" to fix the problems caused by previous government policies). In a way their egalitarian goals are accomplished but by an opposite mechanism. Instead of helping improve the economic welfare of their intended beneficiaries, the actions of egalitarian motivated politicians makes life more difficult for the middle class, thus pushing them down.

Anyway, I hope you check out the two links at the beginning of this post. Their explanations of what happened makes much more sense than the conventional explanations.

10 Minute Explanation of the Financial Mess

If you have 10 minutes to spare check out this clip that explains how the subprime mess happened. (Thanks to Robert Bidinotto who first posted this clip on his blog.)

The McCain Puzzle

I'm puzzled why McCain doesn't harp on Obama's role in this financial mess: how Obama opposed attempts to impose oversight and controls on Fannie Mar and Freddie Mac, how Obama received so much in campaign contributions from these organizations and how he hired a former top dog to help search for a VP running mate. The MSM certainly isn't going to run these stories (although you can bet if McCain had these ties that's all you'd hear about).

I don't know if McCain feels this is beneath him, if he thinks this would come back to bite him, he is holding this as a trump card to be played at an appropriate time or if his campaign strategists are overlooking this. Wish I knew!

Meanwhile Obama is running ads tying McCain to lobbyists.

The Freddie Mac/Fannie Mae Mess: A good brief explanation

Here is a link to a Fox News bit that does a nice job of explaining what happened with Freddie Mac and Fannie Mae.

The Unquestioned Premises Behind the Financial Crisis

While it is disturbing to watch the financial debacle unfold, it is even more disturbing that the true culprits escape notice: faulty premises.

Faulty premise #1: egalitarianism. There are different versions of egalitarianism. For instance, our political system rests on the idea that all people should be treated equal in terms of rights, due process, etc. However, economic egalitarianism strives to ensure equality in terms of equal pay, living conditions, etc. The extreme version of this is captured in this quote by Karl Marx: “From each according to his abilities, to each according to his needs.” Naturally in America this belief fundamentally contradicts the idea of meritocracy, rags-to-riches, and the America dream.

Economic egalitarianism lies behind the Left’s continual efforts to “correct” the “evils” of capitalism and under girds redistributing money from taxpayers to the “underprivileged” via welfarism. [Note how the use of this term implies that the folks who have done well don’t really deserve it, that they are privileged. A privilege being a special favor dispensed by someone.]

Eventually the Left dreamed up a new tact: instead of cash handouts, why not provide easy credit?

The Office of Thrift Supervision (a government agency I never heard of before researching this post) describes the purpose of the Community Reinvestment Act, a key law in this scenario.

History of the Community Reinvestment Act

The CRA was enacted in 1977 to encourage financial institutions to help meet the credit needs of their communities, including low- and moderate-income neighborhoods, consistent with safe and sound lending practices. It extends and clarifies the longstanding expectation that financial institutions will serve the convenience and needs of their local communities. The CRA and its implementing regulations require federal financial institution regulators to assess the record of each bank and savings association in helping to fulfill their obligations to the community and to consider that record in evaluating applications for charters or for approval of mergers, acquisitions and branch openings. The federal financial institution regulators are the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation and the Office of Thrift Supervision.

The law provides a framework for financial institutions and community organizations to work together to promote the availability of credit and other banking services to underserved communities. Under its impetus, banks and savings associations have opened new branches, provided expanded services, adopted more flexible credit underwriting standards and made substantial commitments to state and local governments or community development organizations to increase lending to underserved segments of local economies and populations.

I added emphasis in the second paragraph. The banks adopted “more flexible underwriting standards” no doubt because this is the only way they could comply with the law’s criteria.

Howard Husock of the Manhattan Institute elaborates.

The Trillion-Dollar Bank Shakedown That Bodes Ill for Cities

Howard Husock

The Clinton administration has turned the Community Reinvestment Act, a once-obscure and lightly enforced banking regulation law, into one of the most powerful mandates shaping American cities—and, as Senate Banking Committee chairman Phil Gramm memorably put it, a vast extortion scheme against the nation's banks. Under its provisions, U.S. banks have committed nearly $1 trillion for inner-city and low-income mortgages and real estate development projects, most of it funneled through a nationwide network of left-wing community groups, intent, in some cases, on teaching their low-income clients that the financial system is their enemy and, implicitly, that government, rather than their own striving, is the key to their well-being.

During the seventies and eighties, CRA enforcement was perfunctory. Regulators asked banks to demonstrate that they were trying to reach their entire "assessment area" by advertising in minority-oriented newspapers or by sending their executives to serve on the boards of local community groups. The Clinton administration changed this state of affairs dramatically. Ignoring the sweeping transformation of the banking industry since the CRA was passed, the Clinton Treasury Department's 1995 regulations made getting a satisfactory CRA rating much harder. The new regulations de-emphasized subjective assessment measures in favor of strictly numerical ones. Bank examiners would use federal home-loan data, broken down by neighborhood, income group, and race, to rate banks on performance. There would be no more A's for effort. Only results—specific loans, specific levels of service—would count. Where and to whom have home loans been made? Have banks invested in all neighborhoods within their assessment area? Do they operate branches in those neighborhoods?

The reason why I say egalitarianism is a faulty premise is that it violates the basic facts of reality. People are unequal in talents, ambition and, yes, in credit risk. The Left capitalizes on our sympathy for people who are less well off. However, the fact that enough people defaulted on their loans to trigger the tsunami of financial failures should be proof enough of the futility of rewriting reality to meet the desires of egalitarians.

Faulty premise #2: the belief that it is the proper role of government to “level the playing field” by manipulating interest rates and encouraging “flexible credit underwriting standards” in order to achieve egalitarian goals. By trying to suspend the basic laws of economics the CRA and other measures distort the signals normally transmitted by the market.

Recall what happened in the 1970s when former President Nixon imposed price controls to stem inflation? As is usual with price controls Nixon’s created shortages of goods as the prices set by government were below the point set by demand. Forcing banks to provide credit to people who normally wouldn’t qualify leads to increased demand for loans. However, there is one key difference. In dealing with material commodities price controls lead to shortages if the government sets the price below the market clearing level. However since money and credit can be easily created at the government’s whim the supply increases to meet the escalating demand.

Meanwhile the management of Freddie Mac and Fannie Mae highly leveraged their organizations with almost no oversight and built a precarious house of cards that was susceptible to the cold wind of falling home prices.

Financial Fiasco: Some Inconvenient Facts

Stephen Hicks has a flow chart (posted September 19) that does a nice job of showing how the current financial fiasco unfolded.

Investor's Business Daily has an editorial titled, Congress Lies Low To Avoid Bailout Blame. Here are some key points from this editorial.

President Bush in 2003 tried desperately to stop Fannie Mae and Freddie Mac from metastasizing into the problem they have since become.

[Referring to Bush's actions on September 11, 2003] Bush tried to act. Who stopped him? Congress, especially Democrats with their deep financial and patronage ties to the two government-sponsored enterprises, Fannie and Freddie.

As for presidential contender John McCain, just two years after Bush's plan, McCain also called for badly needed reforms to prevent a crisis like the one we're now in.

Since 1989, Fannie and Freddie have spent an estimated $140 million on lobbying Washington. They contributed millions to politicians, mostly Democrats, including Senator Chris Dodd (No. 1 recipient) and Barack Obama (No. 3 recipient, despite only three years in office). [NOTE from me: Be sure to check the table of top recipients of campaign contributions from Fannie Mae and Freddie Mac at the end of the article.]

The Clinton White House used Fannie and Freddie as a patronage job bank. Former executives and board members read like a who's who of the Clinton-era Democratic Party, including Franklin Raines, Jamie Gorelick, Jim Johnson and current Rep. Rahm Emanuel.

House of cards built on faulty foundation

As the financial markets roil with the latest developments Democrats like Nancy Pelosi, Barney Frank and even Barack Obama are distancing themselves from the legacy of policies they have endorsed or proposed. They try to blame this mess on Bush’s last 8 years where in fact the roots of this dilemma go back to Clinton and earlier. As this article in Investor’s Business Daily says the main motive of the policies leading up to this was to provide people without good credit ratings to buy homes. So lenders were strong armed into lending to risks they normally wouldn’t have to avoid the wrath of the regulators.

The regulation grew to monstrous proportions during the Clinton administration, obsessed as it was with multiculturalism. Amendments to the CRA [Community Reinvestment Act] in the mid-1990s dramatically raised the amount of home loans to otherwise unqualified low-income borrowers.

The revisions also allowed for the first time the securitization of CRA-regulated loans containing subprime mortgages. The changes came as radical "housing rights" groups led by ACORN lobbied for such loans. ACORN at the time was represented by a young public-interest lawyer in Chicago by the name of Barack Obama.

HUD, in turn, pressured Fannie Mae and Freddie Mac to purchase more subprime mortgages, and Fannie and Freddie, in turn, donated to the campaigns of leading Democrats like Barney Frank and Pelosi who throttled investigations into fraud at the agencies.

The problem is that all of us will pay for the sins of these policies while the true perpetrators pontificate about the greed of Wall Street and the “failure” of the market. Most people don’t understand economics (like many politicians) so it’s appallingly easy to throw “bad guys” (i.e., Wall Street) as chum into the water. Meanwhile the true lesson will be lost in this feeding frenzy: when the government tries to force the market to behave in a certain way to achieve egalitarian goals this goal to make everyone equal indeed does becomes reality but not in the way that was intended. We’re all made equal – in terms of financial losses and the pain that goes with it. Instead of a rising tide of prosperity lifting all of our boats we’re drowning in the rising tide of tears and pain, the inevitable consequences of bad premises.

Financial Woes and Free Market Foes

In the aftermath of the most recent financial implosion McCain lays the blame for the recent financial woes on greed thus displaying a dismaying lack of understanding of economics. Meanwhile Obama pontificates about the "ownership society" advocated by Bush really means you're on your own. Well, he's right but not in the way Obama meant. We indeed are on our own .. or should be. As the article titled The Real Culprits In This Meltdown in the Investor's Business Daily notes the roots of this collapse traces back well before George Bush. It traces back even before Clinton but this article has some interesting things to say about the Clinton administration's role. Check it out.

Also recommended, http://www.gregransom.com/prestopundit/ for interesting commentary from a Hayekian viewpoint and for many posts on the Palin impaling by the media.

McCain and Obama: Do they both preach sacrifice?

Before I proceed I encourage visitors to check out Robert Bidinotto's posts on Sarah Palin at http://bidinotto.journalspace.com/. I posted something there that I'd like to put here as well.

I know we cringe when we hear Republicans like Giuliani and McCain make negative comments about self-interest. But I think we make the mistake of assuming that they have the same concept in mind as we do. We need to ask whether McCain and the others have ever read Rand and, if they have, do they really understand what she is saying? (The same question can be asked about some of her admirers.) I am just starting to read McCain’s Worth Fighting For to get a better feel. In the opening pages he makes a brief reference to individualism versus egotism without explaining the distinction he is making. Furthermore, if McCain and his colleagues were completely dead set again self-interest why do they appeal to ours? By that I mean their proposed programs and policies are aimed at our needs.

We ultimately will have a choice between McCain who believes we should serve our country in order to protect and improve it versus Obama who wants us to sacrifice ourselves to everyone else, both foreign and domestic. On the surface it appears there is no fundamental difference between the two. McCain asks us to serve our country while Obama wants us to serve others in general. I think buried in this is a key distinction. McCain is not denying that we have a right to be happy or to pursue happiness. (At least I haven’t found any quotes to that affect.) I think he believes we need to put the interests of the U.S. first because protecting this framework will ensure our freedom and our ability to pursue our values. I’ll admit that maybe this is wishful thinking and might be too generous but I think his voting record supports what I’m saying.

On the other hand I’m confident that deep down Obama does indeed want to change us … into another more consistent welfare-state with a heavily government regulated market that is more in line with the “enlightened” European-model where we can’t drive our SUVs, have to turn down our thermostats and can’t eat as much. (This is paraphrasing a quote from him.) Kind of intrusive, isn’t it? I think he is ultimately uncomfortable with and ashamed of the self-interest that drives us. It doesn’t take much digging to find the collectivist intellectual influences in Obama’s life that would explain his antipathy to self-interest.