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July 31, 2008

The True Nature of Fan and Fred
by Thomas Tan

Last Wednesday, WSJ had a great article called "The Fannie Mae Gang" by Paul A. Gigot, as linked below.
http://online.wsj.com/public/article/SB121677050160675397.html

It had good discussion of another aspects of the current mortgage crisis and roles and responsibilities of many players dated back many years ago. It showed the public the inner circle of the secret "Skull and Bones" society around Fannie Mae (FNM) and Freddie Mac (FRE). It detailed among, for example, former Fannie Mae Chairman Franklin Raines, former Countrywide Financial CEO Angelo Mozilo and House Financial Services Committee Chairman Barney Frank that have helped create the monsters called Fan and Fred.

It wrote, "I recount all this now because it illustrates the perverse nature of Fannie and Freddie that has made them such a relentless and untouchable political force..... The abiding lesson here is what happens when you combine private property with government power. You create political monsters that are protected both by journalists on the left and pseudo capitalists on Wall Street, by liberal Democrats and country club Republicans. Even now, after all the dishonesty and failure, Fannie and Freddie could emerge from this taxpayer rescue more powerful than ever."

There are probably few things more disturbing and scary than this.

Back in 2002, WSJ had an article called "Fannie Mae Enron?", questioning their shaky derivatives accounting. And the person who was angry about this article, obviously besides the then-CEO of Fannie, Mr. Raines, was surprisingly the then-CEO of Countrywide, Mr. Mozilo. Mr. Mozilo loudly insulted Paul by stating he knew nothing about accounting or mortgage markets, among other things. Apparently Mr. Mozilo and Mr. Raines were partners, with Countrywide feeding mortgages to Fannie to make Mr. Mozilo very rich. Of course, he got to protect his most valuable customer.

Thanks to its quasi-public and quasi-private dual status, with implicit but correct assumption of government guarantees, Fan and Fred can borrow from financial markets at super low interest rate, enjoyed the spread between such low borrowing rates and much higher mortgage rates in their portfolio from Mr. Mozilo and other originators. If that is not enough, Fannie was creating shaking derivatives from these mortgages to generate more profits, which brought the above WSJ article that compared Fannie to Enron. No wonder Mr. Mozilo was angry, so was Mr. Raines, since regulator James Lockhart later on discovered that Fannie had rigged its earnings in a way that allowed it to pay huge bonuses to their executives, especially Mr. Raines who was forced to resign.

Then the famous FOM (friends of Mozilo) in Congress quickly came over to rescue. First, Republican Rep Cliff Stearns of Florida was stripped of his subcommittee of jurisdiction over Fan and Fred's accounting by House Speaker Dennis Hastert. Then Barney Frank was taking over the whole show to protect Fan and Fred from stronger regulatory oversight. When Wisconsin Rep. Paul Ryan advocated more supervision for Fan and Fred, Fannie played hardball by calling every mortgage holder in his district, claiming that Mr. Ryan wanted to raise the cost of their mortgage, resulting Mr. Ryan receiving 6,000 telegrams. He left Financial Services for a seat on Ways and Means which of course doesn't oversee Fannie anymore.

In addition, the "Fannie Mae Gang" article wrote, "Fan and Fred also couldn't prosper for as long as they have without the support of the political left, both in Congress and the intellectual class. This includes Mr. Frank and Sen. Chuck Schumer (D., N.Y.) on Capitol Hill, as well as Mr. Krugman and the Washington Post's Steven Pearlstein in the press.......Yet as studies have shown, about half of the implicit taxpayer subsidy for Fan and Fred is pocketed by shareholders and management. According to the Federal Reserve, the half that goes to homeowners adds up to a mere seven basis points on mortgages. In return for this, Fannie was able to pay no fewer than 21 of its executives more than $1 million in 2002, and in 2003 Mr. Raines pocketed more than $20 million. Fannie's left-wing defenders are underwriters of crony capitalism, not affordable housing."

This is similar to some charity organizations that use half of the donations for their "expenses" and only pay out half to the claimed causes.

Fast forward to today, taxpayers not only have paid so much and so dearly to support this crony capitalism and so many friends of Mozilo, but also have to inject more capital in the companies, in addition to guaranteeing their trillions of bonds issued in the past, many of which should not have been issued and are now held by foreign governments of our trade partners in their currency reserves. Talking about global crony capitalism among many governments which U.S. taxpayers have to cover all their losses. This is really the beauty of quasi-private and quasi-public dual structures. Profits go to the few Skull & Bones members, while the losses are dumped to the whole society, and all is done in the name of "helping poor people to own houses".

The best part of this WSJ article is that one analyst at Sanford C. Bernstein, wrote in 2002 about the "Fannie Mae Enron?" article, "Taxpayer Are on The Hook: This is incorrect. The agencies' debt is not guaranteed by the U.S. Treasury or any agency of the Federal government." We should all hope his great insight from 6 years ago was correct, so that U.S. taxpayers don't need to pay for all these huge losses, since we are quickly going down a slippery path from "too big to fail" to now "too big to be guaranteed".

Back in Savings & Loan crisis, we had the Keating Five. Today in home mortgages, we have the Fannie Mae Gang. Some things never change.

Thomas Tan, CFA, MBA
www.investorwalk.com

Disclaimer: The contents of this article represent the opinion and analysis of Thomas Tan, who cannot accept responsibility for any trading losses you may incur as a result of your reliance on this opinion and analysis and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Do your own due diligence regarding personal investment decisions.

Copyright © 2006-2009 Thomas Z. Tan

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