Fannie Mae Investigation

Business

Fannie Mae's prime regulator told a House subcommittee that the "giant mortgage company deliberately flouted accounting rules" to project an image of relatively low-risk-earnings growth.

In a February paper with Fed economist W. Scott Frame, Lawrence J. White, professor of economics at New York University's Stern School of Business, argued that "greater competition in the primary and secondary mortgage markets will be beneficial for borrowers and will likely reduce the relative size and importance of Fannie Mae and Freddie Mac." However, he also stated that this could result in Fannie Mae and Freddie Mac engaging in riskier behavior unless restrained by regulation.

White was online Thursday, Oct. 7, at 2 p.m. ET to take your questions and comments about the Fannie Mae investigation.

A transcript follows.

White is an Arthur E. Imperatore Professor of Economics at New York University's Stern School of Business, general editor of the Review of Industrial Organization and a former chief economist at the Justice Department's antitrust division under President Reagan. He has written several articles and papers on the government-sponsored mortgage-financing giants Fannie Mae and Freddie Mac, both of which have faced intense scrutiny of their accounting practices and widespread criticism of their potential influence over the nation's financial system.

Editor's Note: Washingtonpost.com moderators retain editorial control over Live Online discussions and choose the most relevant questions for guests and hosts; guests and hosts can decline to answer questions.

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Lawrence J. White: I'm Lawrence J. White, Professor of Economics at NYU's Stern School of Business. I am pleased to be available to answer questions about Fannie Mae, Freddie Mac, housing finance, and the recent revelations.

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Washington, D.C.: I believe that the alleged accounting issues at Fannie Mae are prevalent throughout the corporate world. If this is true, how can we trust ANY financial statements? How can we rely on the advice of accounting firms, audit departments, the SEC, the FASB, ratings agencies?!;?!;?!;?!;?

Lawrence J. White: Issues of "flexible" interpretations of accounting rules, so as to meet earnings targets and smooth earnings, are a widespread problem and will continue to be so, so long as CEOs feel the pressures to meet quarterly earnings targets and accounting firms are ready to accede to the pressures of CEOs (who have hired them). One long-run solution has been suggested by my colleague here at Stern, Prof. Joshua Ronen. It would involve a change in structure as to who hires the accounting/auditing firms -- who they report to, who they see as their client. For the shorter run, I have become much more sympathetic to the idea of mandatory rotation of accounting/auditing firms on a periodic basis -- say, every five years. Though there are costs in terms of loss of expertise, there are gains in terms of a new team coming in who are not invested in the old information and old way of doing things.

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Boston: If the SEC finds in favor of OFHEO's / D&T's interpretation of FAS 133 (thereby triggering an accounting restatement by Fannie), do the users of derivatives claiming hedge accounting like BankAmerica, Wells Fargo & others who aren't currently audited by D&T then have to go back and restate earnings to reflect the new, higher standard of what qualifies for hedge treatment?

Lawrence J. White: Exactly what would happen next would be up to the SEC and how many questions they want to start raising for how many other companies.

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Washington, D.C.: In April, the Senate Banking Committee voted out legislation that would establish a new regulator for the GSEs. The new regulator, like most financial regulators, would have receivership powers. This appeared to be the real dividing point on the bill. What kind of impact do you think such a provision would have on the housing/mortgage market?

Lawrence J. White: The issue of receivership power is the most important of all of the regulatory issues. Right now, the regulator of Fannie Mae and Freddie Mac -- OFHEO -- does not have receivership power; it only has conservatorship power. So, if either company were to become insolvent and could not honor its obligations, only the Congress could provide a permanent solution. This reliance on the Congress heightens the perception that Fannie and Freddie are special and that the Federal Government would bail them (and their creditors) out in the event of financial difficulties; and that perception in turn allows the two companies to borrow more cheaply and to pass some of that lower borrowing cost on to home buyers. To the extent that receivership powers would weaken the "specialness" perception, the two companies' borrowing costs would go up a little bit, and home mortgage interest rates would go up a little bit.

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Richmond, Va.: When will the investor community know whether the accusations against the Fannie Mae management (cooking its books to receive bonus) are real or just dreamed up by the OFHEO's investigators? Both the Fannie Mae management and their outside auditor KPMG disagree with the OFHEO's findings and conclusion. What is your opinion?

Lawrence J. White: These kinds of investigations take a while. The SEC and the Justice Department usually move slowly and carefully, so there will be no quick resolution. Further, even if their initial conclusions are adverse to Fannie Mae, the company may dispute those findings... Also, the OFHEO report is just one of "...Findings to Date" and its examination "is continuing". So, OFHEO may also have more to report.

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Fairfax, Va.: Based on statements from several people I know who have worked at Fannie Mae, if an employee takes a stand that is contrary to the corruption within the company, they very quickly are pressured to resign. If they don't resign, then their performance suddenly is rated as unacceptable and they are fired with a severance package, along with an agreement to keep quiet. No doubt intimidation is the primary method of controlling the employees at FM. Fannie Mae has a continuing pattern of violating federal laws related to retaliation and they get away with it.

Is there any method of bringing this issue into the open?

Lawrence J. White: I have no knowledge that would would either confirm or deny the practices to which you refer. If they are going on, then someone who is directly involved would have to get them out into the open by reporting them to the press and/or to the Justice Department.

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Arlington, Va.: Raines said other financial regulators would have handled the matter in private and announced the resolution instead of disclosing unproven allegations. Are you sensing a shift at OFHEO or other regulators?

Lawrence J. White: There is no question that OFHEO has become more aggressive than has previously been its style. Given the high profile of Fannie Mae, given the history of the Freddie Mac revelations of last year, and given OFHEO's claims of Fannie Mae's resistance in providing information, I'm not sure that any other regulator in a similar situation would have handled it differently.

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Arlington, Va.: Franklin Raines and Fred Malek, two members of a group seeking to purchase the Expos baseball team, both serve Fannie Mae as either an officer or director. Is there any evidence that either one profited from the alleged wrongdoing at Fannie Mae? If so, do you think that will be (or should be) a factor in MLB's consideration of their bid for the team?

Lawrence J. White: Since these are still claimed and denied allegations at this point (although the Fannie Mae Board has signed an agreement with OFHEO that agrees to a lot of important changes), I think that it is too early to be drawing drastic conclusions and resting other decisions on those conclusions. I am a strong believer in the proposition that someone should be presumed innocent until proven otherwise.

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Germantown, Md.: Representative Baker stated he'd make public the compensation for the top 20 executives. Has this been done and, if so, where is it available?

Does Fannie Mae have legal ground to sue the congressman?

Lawrence J. White: I don't know if it has yet been done. The compensation of a few senior officers of any publicly traded company is usually a matter of public record. This would just extend that reach a bit. I believe, however, that the issue of the size of executive compensation is usually a small numbers side-show, as compared with the much bigger numbers issues of the consequences of executives' actions on the true profits of their companies and on the market value of their owners' (the shareholders) shares.

Whether Rep. Baker could be sued is far beyond my expertise as a non-lawyer.

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washingtonpost.com: Company Profile (includes executive compensation): Federal National Mortgage Association

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Herndon, Va.: It seems OFHEO caused more damage (14B drop in the stock) due to the flamboyant manner in which this was handled than anything that may or may not have happened inside Fannie Mae. Can OFHEO be investigated to determine why things were presented in such a combative manner and held accountable if actions were found to have been off mission?

Lawrence J. White: Any investigation of OFHEO would occur through Congressional actions: hearings and reports by the GAO and CBO, which are arms of the Congress.

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Washington, D.C.: The idea of privatizing GNMA was seriously discussed inside the government several years ago, to the point of the spin-off being included in HUD's budget submission to OMB, but Raines (at FNMA by then) lobbied against it. Was Raines narrowly protecting Fannie Mae's interests and preventing wider competition?

Lawrence J. White: I just can't remember this set of events, but they don't sound improbable. If they were as you state, then Fannie Mae would have feared the presence of a third entity that would be doing things that are similar to what it does, and I can well understand that they would want to lobby to try to head it off. Similarly, since 1997 the Federal Home Loan Bank System (another GSE) has been engaged in a small (but growing) set of programs that have them more involved in residential mortgage finance. Fannie and Freddie lobbied (unsuccessfully) to try to prevent that originally from occurring.

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Richmond, Va.: What kind of authority does OFHEO have in terms of replacing top management at the Fannie Mae?

Lawrence J. White: If OFHEO believes that the presence of specific top management presents a threat to the safe-and-sound operation of Fannie Mae or Freddie Mac, the agency does have the power to order the removal of that executive. (This is a standard power of bank regulation agencies.) OFHEO exercised that power a year ago in ordering the removal of Freddie Mac's CEO.

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Harrisburg, Pa.: What should be the government role towards public lending agencies? Do you believe it should all be left to the private sector, or that the public agencies need to be restructured or regulated differently, or what?

Lawrence J. White: This is a very broad question. Let me just stay with Fannie Mae and Freddie Mac. I believe that they should be fully privatized (i.e., they should no longer have a special Congressional charter and all of the special privileges that go along with it). They would then likely seek an ordinary Delaware corporate charter and then become just like any other large corporation in the American economy. Residential mortgage interest rates would increase by about a quarter of a percentage point, but grass would not grow in the streets of America and grass would continue to grow in the backyards of America. The two companies have not been especially good at promoting home ownership among low and moderate income households that are trying to become first-time home buyers -- but that's where good social policy should really be focused. So, in addition to privatizing them, I would institute a program of financial assistance (down payment assistance and monthly payment assistance) for low and moderate income households that are first-time home buyers.

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Richmond, Va.: I read in the Post that OFHEO has hired Stanley Sporkin, a former federal judge and senior SEC enforcement official, to help them in the exam of Fannie Mae. Would his work increase the chance that the SEC will eventually side with the OFHEO conclusion?

Lawrence J. White: Judge Sporkin, as a former high-ranking enforcement official at the SEC, is likely held in high regard by the current senior officials at that agency. I am sure that OFHEO was aware of this when they decided to hire him.

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Lawrence J. White: I have enjoyed this chat. I would be happy to pursue these topics at greater length by e-mail. My e-mail address is: lwhite@stern.nyu.edu

Many thanks!

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