Fannie, Freddie Deflected Risk Warnings

For Years, Critics Sounded Alarms About Firms' Thin Capital Reserves

Though the implosion of investor confidence in Fannie Mae and Freddie Mac last week was sudden, the worries driving it have been the subject of countless warnings over many years.

From a Washington think tank to the halls of Congress, from the Treasury to the Federal Reserve, from the Clinton to the Bush administrations, critics of the government-sponsored mortgage giants have long argued that they were allowed to operate with financial cushions that were too thin to support their far-reaching financial risks.

The critics argued that regulators should be empowered to require deeper capital cushions at Fannie Mae and Freddie Mac, but their persistent efforts were thwarted in the face of the companies' formidable lobbying. Many members of Congress defended the companies, contending that efforts to rein them in were tantamount to an assault on housing.

The critics' warnings finally hit home for investors last week in a frenzy of panicked selling. The companies' stocks sank to dizzying lows as fear spread that the twin titans of the mortgage market had overextended themselves, potentially requiring a government rescue.

Whether Fannie Mae, of the District, and Freddie Mac, of McLean, could ride out the housing crisis on their own remained to be seen. They said their finances were sound, and their chief regulator was trying to allay the fears. But any sense that their shares were the safest of investments had clearly been shattered.

The government created the firms to keep money flowing to mortgage lenders. They do that by buying mortgages and pooling them into securities for sale to other investors, guaranteeing to pay the investors if the borrowers default.

Their unusual status was the key to their business. The fact that they are federally sponsored led the financial markets to believe the government would cover their debts if they were unable to do so themselves. The assumption that they were virtually as reliable as the U.S. Treasury enabled them to borrow at low rates and fund their investments with cheap money. It also helped them charge a premium for their mortgage guarantees.

As Alan Greenspan described in 2004, the result was rapid growth, high concentrations of risk and insulation from the discipline the market applied to ordinary companies.

"Unlike many well-capitalized savings and loans and commercial banks, Fannie and Freddie have chosen not to manage that risk by holding greater capital," Greenspan, then chairman of the Federal Reserve, told lawmakers in 2004. To keep them from undermining the financial system, "preventive actions are required sooner rather than later," he added.

As of March, when the government provided its most recent snapshot, the companies had $81 billion of capital to absorb potential losses -- a big number, but only a fraction of their $5.1 trillion of investments and loan guarantees.

Fannie Mae argued that housing was such a safe investment that it didn't need as much capital as banks, which make a wide variety of loans. But having all their eggs in one basket left Fannie Mae and Freddie Mac all the more vulnerable to a downturn in the housing sector. As home prices have plunged and defaults and foreclosures have soared, the companies have lost billions of dollars and face the prospect of losing billions more.

The political battle lines were drawn by 2000, when a senior Clinton administration official called on Congress to take steps that might have diminished the companies' special status. Treasury Undersecretary Gary Gensler also urged that regulators be given more power to set capital requirements for Fannie Mae and Freddie Mac.