The Future Of Fannie Mae
by Peter G. Miller
It used to be that a good Wall Street hubbub involved companies that reported profits they didn't have. Think of Enron and the like. But now we have a new phenomena, companies not reporting profits they do have. In November 2003 we had the spectacle of Freddie Mac, a huge company that buys local mortgages with investor money, admitting that it had unreported profits which amounted to a "net cumulative increase" of $5 billion as well as a previously unreported quarterly loss. Now we have the spectacle of Fannie Mae, an even bigger company that buys local mortgages with investor money, facing allegations that it too hid profits. That Fannie Mae now faces profit-hiding allegations in an effort to "smooth" financial reports is a surprise. Consider this Q&A with Fannie Mae CEO Franklin D. Raines: Question: "Can you assure us that Fannie Mae does not have the accounting issues raised in the 'Report to the Board of Directors of Freddie Mac'?" Answer: "Yes. The report reinforces that the issues do not relate to Freddie Mac's status as a GSE and therefore do not inherently apply to Fannie Mae, and indeed we do not have similar issues." At the heart of this matter is a tangled accounting rule, SFAS 133, which explains how companies are supposed to measure the value of derivatives, financial instruments used to hedge investment bets. This is complex stuff and different interpretations by reasonable people are entirely possible. The Office of Federal Housing Enterprise Oversight (OFHEO), the federal agency which regulates both Fannie Mae and Freddie Mac, says Fannie Mae has agreed to "address the improper accounting and inadequate controls" OFHEO found in a recent review of Fannie Mae accounting practices. In the eight-page agreement Fannie Mae says it will take certain steps required by OFHEO. One of the most important changes is that starting next year Fannie Mae "will cease hedge accounting for any derivatives, including terminated hedges, that do not or did not qualify under SFAS 133 for such treatment." Under the deal, Fannie Mae must also increase its capital base within nine months. How long will Fannie Mae be required to set aside the extra funds? Until the OFHEO director "determines the requirement should be modified or expire." Fannie Mae, for its part, deserves credit for quickly striking a deal with OFHEO to assure the public of its financial soundness. However, those who oppose the special benefits Freddie Mac and Fannie Mae receive as GSEs -- government sponsored enterprises -- now have more reason to press for GSE reform if not total privatization. "Even with this agreement," says J.C. Watts, a former republican congressman from Oklahoma and now chairman of FM Policy Focus, a group which essentially seeks more competition in the mortgage buying field, "problems in the current GSE oversight structure remain unresolved, leaving taxpayers at continued risk. OFHEO's report demonstrates that Fannie Mae placed the interests of its stockholders and its executives first." Fannie Mae and Freddie Mac were once federal agencies but are now owned by private shareholders. These two GSEs, as explained at the time of the Freddie Mac revelations, each has a line of credit with the Treasury, special exemptions from certain Securities and Exchange Commission filing requirements, and is exempt from the payment of state taxes. In the eyes of many investors, those special federal ties mean that Freddie Mac and Fannie Mae represent less risk than competing private companies that also buy local mortgages. The result is that Fannie Mae and Freddie Mac are able to borrow funds at low rates, a huge competitive advantage. The real issue with Freddie Mac and Fannie Mae is not that any question has been raised about their viability or safety, it is instead the embarrassment of riches which produces multi-billion profits for private shareholders, limits competition and creates perceived or actual taxpayer liabilities. The time has come for Fannie Mae and Freddie Mac to end their quasi-government status and join the rest of the risk-taking and tax-paying mortgage buyers who populate the private sector. However, the march to privatization should not be instant or foolish. We can use a phased approach to re-assure both the public and investors that life will go on even if Fannie Mae and Freddie Mac must compete on equal terms in the mortgage marketplace. For instance, we might create a three-year transition schedule. In year one the GSEs would lose one-third of their ability to avoid state taxes. In year two they would lose two-thirds. In year three all state taxes would be due and payable. The same principle, of course, can apply to other special benefits now reserved for GSEs. | 
