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Mortgage Giants' Mess Falls to Their Regulator

By David S. Hilzenrath and Zachary A. Goldfarb
Washington Post Staff Writers
Thursday, September 11, 2008

With the government's seizure of Fannie Mae and Freddie Mac on Sunday, the federal regulator who oversaw the mortgage giants during their long descent is now in charge of restoring them to financial health.

In the months before the takeover, James B. Lockhart III repeatedly assured investors that the mortgage giants were financially sound. In March, he even called fears about a government bailout "nonsense" as he reduced the financial cushion they were required to maintain.

He eventually came to a different conclusion, deciding the companies were in perilous shape and would pose a major risk to financial markets if the government did not intervene.

In an interview, Lockhart said he was "obviously wrong" about his assessment in March. As the director of the newly created Federal Housing Finance Agency (FHFA), he now finds himself in full control of the companies and facing many of the same challenges that brought Fannie Mae and Freddie Mac down -- along with a few new ones.

Fannie Mae and Freddie Mac were chartered by the government to keep money flowing to the mortgage market, but they also had a duty to shareholders to maximize profits. Lockhart said it is now Fannie Mae and Freddie Mac's first priority to support the battered mortgage market, which he said might include loosening standards for mortgages the companies fund. The companies had pulled back on more risky lending when the housing market collapsed.

"They may look at targeted changes that might allow more people to get more mortgages," Lockhart said. If the companies' losses mount, "we know the U.S. government will be there" to cover them, he said.

Lockhart also must find new incentives for employees who have watched the value of their Fannie Mae and Freddie Mac stock fall more than 98 percent over the past year and may be tempted to look elsewhere.

Lockhart said he would seek to retain employees, potentially offering special bonuses. "I want to make sure there is an incentive for these people to stay," he said.

Lockhart said he would work with the new chief executives he appointed to run the companies.

Richard S. Carnell, a law professor at Fordham University and a former senior Treasury official, said there was a "tension" between Lockhart's goals of providing a boost to the mortgage markets and maintaining the companies' health.

"They got into problems by guaranteeing mortgages where the credit quality of the loans was too weak," he said. "The more careful they are [in expanding lending], the more it constrains the macroeconomic and housing market goals."

Lockhart faces other sensitive questions. He must decide whether to write off tens of billions of dollars of troubled assets on the companies' books, potentially increasing the near-term cost of the government bailout, or whether to defer the reckoning.

Then there are the golden parachutes. The ousted chief executives, Daniel H. Mudd of Fannie Mae and Richard F. Syron of Freddie Mac, have the potential to leave with multimillion-dollar severance packages. Prominent lawmakers are calling on Lockhart to severely scale back the size of those packages.

"Under no circumstances should the executives of these institutions earn a windfall at a time when the U.S. Treasury has taken unprecedented steps to rescue these companies with taxpayer resources," Illinois Sen. Barack Obama, the Democratic presidential nominee, wrote in a letter to Lockhart and Treasury Secretary Henry M. Paulson Jr. this week.

The campaign of Sen. John McCain (Ariz.), the Republican nominee, did not respond to a request to provide the candidate's view on the compensation question.

The regulator said the issue of compensation was under review.

Lockhart, 62, is a former Navy submariner and veteran of the financial-services industry. He has been friends with President Bush since they attended Andover prep school, Yale University and Harvard Business School. He worked for the Social Security Administration and the Pension Benefit Guarantee Corp. before signing on as Fannie and Freddie's chief regulator in 2006.

His arrival at what was then known as the Office of Federal Housing Enterprise Oversight came as the companies were still recovering from separate accounting scandals. Lockhart spent much of his time warning that he lacked the tools of other regulators and urging Congress to create a new, more powerful overseer for the companies.

Lockhart began his tenure at OFHEO aggressively. He issued a scathing report on past accounting problems at Fannie Mae. Later, he accused former Fannie Mae executives such as Franklin D. Raines of manipulating earnings to maximize bonuses. He also imposed limits on the volume of mortgages the companies could hold.

But this year, Lockhart turned from confrontation to accommodation. The housing market meltdown was making the government more dependent on Fannie Mae and Freddie Mac, and the firms were making progress toward fixing long-standing internal weaknesses.

He settled the claim against Raines on terms that required Raines to pay nothing out of pocket. He issued a report raising questions about accounting that enabled Freddie Mac to boost its bottom line by $1 billion, but he didn't force the company to change that accounting.

In addition, Lockhart authorized the companies to expand their portfolios of mortgage investments and then reduced the amount of financial cushion -- known as capital -- they were required to have to protect them against insolvency. In return, the companies promised to raise more capital, but Freddie Mac never did.

The agency "had to strike an appropriate balance between the objective of enabling Fannie Mae and Freddie Mac to perform their mission during a period of weakness in housing and mortgage markets, and the objective of limiting the risk the enterprises pose to taxpayers and the financial system," Lockhart said in a May speech.

Doing so, he added, was "quite a challenge."

In July, as panicked investors dumped stock in the two companies, Lockhart declared that their capital levels were "well in excess" of federal requirements. "At a very difficult time in the market, the enterprises have the flexibility and sound operations needed to support their mission."

In late July, Congress created a more powerful agency to replace OFHEO, and Lockhart was named to head it.

In recent weeks, FHFA examiners, working with the Federal Reserve and other agencies, concluded that the underlying economics of Fannie Mae and Freddie Mac were precarious.

"The issues were pervasive" with the companies' ability to stay solvent and manage risk, Lockhart said in the interview. Without taking them over, he said, "they could have caused a significant systemic event" in the world markets.

In separate meetings Friday at his agency's headquarters near the White House, he and Paulson told the heads of Fannie Mae and Freddie Mac they should consent to being taken over by the government -- and signaled that if they did not, the government would do it, according to people familiar with the matter who spoke anonymously because the talks were private.

In the interview, Lockhart said he was surprised by how fast the companies ran into severe trouble.

"No one projected how bad this market was going to get," he said. "We thought with the ability to raise capital in a significant amount they could weather this storm. But what happened, of course, is the storm got worse and worse."

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