If there is an issue that has united popular indignation, Left and Right alike, executive compensation surely ranks near or at the top. But the bipartisan opposition to recent pay increases for the CEOs of mortgage conduits Fannie Mae and Freddie Mac, while highly understandable, misses the larger point. Several months ago, these companies, which account for nearly half the outstanding home mortgage debt in the U.S. and which since 2008 have been wards of the government, announced plans to raise annual CEO pay from $600,000 to $4 million. Their overseer, the Federal Housing Finance Agency, approved the hikes. In response, Congress overwhelmingly has passed (or is on the verge of passing) bills to roll them back. Lawmakers would do better to allow the firms to operate freely and without subsidies.
National Legal and Policy Center has visited the travails of these two companies many times over the last few years. The Washington, D.C.-based Federal National Mortgage Association (“Fannie Mae”) and the McLean, Va.-based Federal Home Loan Mortgage Corporation (“Freddie Mac”), founded, respectively, in 1968 and 1970, own or guarantee a combined roughly $5 trillion, or around half, of outstanding residential mortgage debt in this country (actually, Fannie Mae began as a government agency in 1938, but was re-chartered by Congress as a corporation 30 years later). In recent years, they have bought anywhere from 50 percent to 70 percent of newly-underwritten mortgages. These publicly-traded companies are known as “secondary mortgage lenders.” That is, they do not originate mortgage loans, but instead buy them from institutions that originate them (e.g., banks, savings & loan associations) and eventually package them as bond offerings, known as “mortgage-backed securities,” to outside investors. Fannie Mae and Freddie Mac effectively link Main Street and Wall Street. Their job is expanding mortgage lending liquidity. When functioning properly, this arrangement is of great benefit to the supply and demand side. Banks and thrift institutions, having received cash in exchange for unloading long-term noncash assets, gain flexibility. Investors realize a reliable stream of income. And borrowers see a reduction in interest rates of typically between 20 and 50 basis points.
But things don’t necessarily go according to script. From their earliest years, Fannie Mae and Freddie Mac have operated as “Government-Sponsored Enterprises,” or GSEs. This gave them several advantages over competitors, including a granting of a $2.25 billion line of credit with the U.S. Treasury (caps in recent years dramatically rising and then being removed altogether) and an exemption from state and local taxes. This implicit “too big to fail” federal backing was a key element of a national housing policy that long has promoted homeownership. To some extent, this arrangement has succeeded. Roughly two-thirds of all U.S. households are homeowners. But there has been a downside. And its full effects were not realized until less than a decade ago. Armed with GSE status, Fannie Mae and Freddie Mac became an industry duopoly whose top executives and lobbyists enjoyed an unusually cozy relationship with Congress and a series of administrations. Rather than challenge increasingly stringent mandates, they went along, as the money was too good to resist. Yet the mandates were largely responsible for an eventual credit collapse and a sharp upswing in foreclosures.
Back in 1992, Congress, as part of broad housing and community development legislation, laid the groundwork for an expanded role for Fannie Mae and Freddie Mac. The law created a regulator for these corporations, the Office of Federal Housing Enterprise Oversight (OFHEO), part of the U.S. Department of Housing and Urban Development. The law imposed tighter capital standards on the two companies, and at the same time, laid the groundwork for requirements for Fannie Mae/Freddie Mac to reserve a minimum share of purchases of loans going to low-income (i.e., high-risk) borrowers. This quota-driven approach was driven heavily by black and Hispanic civil rights and community activists, and their allies in Congress, who long had been claiming that the financial services industry had been “redlining” minority communities. The industry preferred to see new opportunities for growth rather than the possibility of severe undercapitalization. Cato Institute Senior Fellow Johan Norberg, in his 2009 book, Financial Fiasco: How America’s Infatuation with Homeownership and Easy Money Created the Economic Crisis (Cato), explained:
President (George W.) Bush’s aim was to create an “ownership society” where citizens would be in control of their own lives and wealth through ownership, which would promote both independence and responsibility. But that did not just mean free markets based on private-property rights – it was the expression of a willingness to use the levers of government to treat ownership more favorably than other contractual relationships in the marketplace. One of Bush’s key objectives was to increase the proportion of homeownership, and two of his best friends in that endeavor were Fannie and Freddie.
The growth in housing production and mortgage lending, already well underway since the mid-Nineties, accelerated. Underneath the prosperity was a time bomb in danger of detonating. As more loans went to borrowers who could not (or would not) repay them, Fannie Mae and Freddie Mac – and by implication, bondholders and taxpayers – were exposed. By the end of 2007, the sum of their loans and guaranteed mortgage-backed securities were roughly equal to the national debt. High-risk “subprime” loans now constituted about one-fifth of their combined liability. So long as housing prices were rising, this wasn’t a problem because property values were the primary source of collateral. But in the event of a fall, the reverberations throughout capital markets, here and abroad, could be calamitous.
The price bubble, needless to say, burst. Signs of trouble became evident during 2007. And they would hit with hurricane force in 2008. Fannie Mae and Freddie Mac, operating with only $1.20 for every $100 in guaranteed bonds, faced a meltdown if they failed to satisfy bondholder claims. The nation’s financial sector was in peril. Bear Stearns had gone under early in the year, and Merrill Lynch, Lehman Brothers and American International Group (AIG) were headed toward oblivion. Congress responded in July 2008 with the Housing and Economic Recovery Act (HERA), quickly signed by President Bush. The law, among other things, created a GSE regulator, the Federal Housing Finance Agency (FHFA), to replace OFHEO, and gave the new agency the authority to take over Fannie Mae and/or Freddie Mac. Weeks later, in September, then-FHFA Director James Lockhart, with the backing of the Treasury Department and the Federal Reserve Board, used that authority to seize Fannie Mae and Freddie Mac, and place them under emergency conservatorship.
The GSEs remained corporations, but more in name than in fact. These were now de facto government agencies. Keeping them solvent, at least on the government’s terms, required Treasury Department loan bailouts eventually totaling a combined $187.5 billion. The terms of repayment were punitive. Fannie Mae and Freddie Mac had to hand over shares of senior preferred stock and warrants to their benefactors representing 79.9 percent of equity – and with no opportunity to buy back the shares. Moreover, they had to pay the government a 10 percent annual dividend. Yet around 2011, as the companies were paying back their debts, the unexpected happened: The housing market was coming back. Lenders, having greatly tightened credit standards since 2008 in the face of rising defaults and foreclosures on a scale not seen since the Great Depression, now, if ever so cautiously, were loosening them. Fannie Mae and Freddie Mac once again were profitable.
The Treasury Department had taken note. In August 2012, in an effort to hasten debt collection, the department suddenly changed the terms of repayment. It issued a so-called “sweep” rule forcing Fannie Mae/Freddie Mac to surrender future profits. In the department’s own words, the sweep represented “every dollar of profit that each firm earns going forward.” The action, which superseded the “10 percent” rule, was a blatant breach of contract. Various institutional investors representing shareholders of already-depressed company stock, unable to realize a return, sued the government, and to little avail. The most publicized of the actions, Perry Capital, was thrown out by U.S. District Judge Royce Lamberth in September 2014. The plaintiff, a New York-based hedge fund, has appealed.
What made the regulation even more unjustifiable was that the balance sheets of Fannie Mae and Freddie Mac were improving. The companies were coming close to repaying what they had borrowed – and then some. By the close of the Second Quarter 2014, the two corporations had forwarded to the Treasury a combined $213.1 billion, more than $25 billion beyond the amount borrowed. Through Second Quarter 2015, this figure had risen to $239 billion. Yet rather than return the corporations to the market with a “You’re on your own” admonition, the federal government has chosen to lock up profits in perpetuity. Fannie Mae and Freddie Mac now aren’t as much companies as they are government cash cows.
The government’s capture of secondary mortgage lending has extended to executive compensation. Part of the bailouts stipulated that Fannie Mae and Freddie Mac CEOs would be paid maximum of $600,000. At the time, the requirement made sense. By the close of 2008, the corporations not only were sustaining enormous losses, but also were still reeling from accounting scandals of a half-decade earlier. Back in 2003, not long after Freddie Mac had received a clean bill of health from OFHEO, the company faced had to deal with revelations that it had hidden almost $7 billion in profits from the previous three years. Suspicious regulators also probed Fannie Mae’s accounts, concluding that the company deliberately had overstated profits by $9 billion, a sum which they later lowered to $6.3 billion. Some of this money had gone for outsized executive compensation to former company chieftains. Fannie Mae CEO Franklin Raines, who assumed the top spot in 1999, was forced out in December 2004; Freddie Mac CEO Richard Syron was terminated by the Federal Housing Finance Agency in September 2008 as part of the conservatorship agreement.
Syron did pretty well for himself, receiving $19 million in 2007 alone in cash, stock and other compensation despite growing possibilities of a financial meltdown. Raines, who had served as director of the Office of Management and Budget under President Clinton during September 1996-May 1998 (and previous to that, Fannie Mae vice chairman), was especially avaricious. Highly paid during his tenure – he had received total compensation in excess of $20 million in 2003 – he received an out-of-this-world retirement package. Raines’ Form 8-K, filed December 27, 2004 with the Securities and Exchange Commission, indicated he was entitled to the following:
- deferred compensation of $8.7 million.
- stock options worth $5.5 million, and potentially millions more.
- “performance share payouts” through 2006, potentially worth millions more.
- a monthly pension of $114,393 for the rest of his life, and for the life of his spouse should she survive him.
- free medical and dental coverage for the rest of his life, as well as for his wife for the rest of her life, and his children until age 21.
- free life insurance in the amount of $5 million until age 60, and $2.5 million thereafter.
- a cash bonus for 2004.
Raines snagged this golden parachute even as SEC investigators were discovering accounting irregularities. As a final touch of chutzpah, Raines stated: “By my early retirement, I have made myself accountable.” This gesture led National Legal and Policy Center President Peter Flaherty to remark in a press release: “Let me get this straight. Raines apparently cooks the books, brings disgrace to the company, and imperils Fannie Mae’s standing with regulators, Congress and the administration. So for his punishment he is made wealthy for the rest of his life?” Flaherty added: “It is like Enron and Tyco never happened. I cannot even fathom the level of arrogance and self-delusion necessary for Raines to claim he’s been made accountable for his mistakes.”
Eventually, in an April 2008 settlement with the SEC and OFHEO, Fannie Mae agreed to pay a $400 million civil fine and revise its accounting practices. As for Franklin Raines, he and two other former Fannie Mae executives, J. Timothy Howard and Leanne Spencer, were hit with civil charges in 2006 by OFHEO. The agency sought $110 million in penalties and $115 million in returned bonuses. Eventually, the trio settled out of court. While admitting to no wrongdoing, they agreed to pay fines totaling $3 million. Raines, for his part, agreed to donate his company stock options to charity. Even this rather modest settlement was less burdensome than it seemed. Fannie Mae insurance policies covered the $3 million in fines. And Raines’ stock options, valued at $15.6 million when issued, now were virtually worthless anyway.
By the time of the September 2008 federal takeover, financial industry golden parachutes had lost their luster. Under heavy pressure from Congress, especially Sen. Charles Schumer, D-N.Y., the Federal Housing Finance Agency nixed severance packages for departing Fannie Mae CEO Daniel Mudd and Freddie Mac CEO Richard Syron worth a combined $24 million. “The agency, serving as conservator, determined that under applicable statute and regulation, the enterprises should not make such payments to these individuals,” noted FHFA in a prepared statement. Both major presidential candidates, Barack Obama and John McCain, also denounced the deals.
The recent announcement by the GSEs to boost the annual pay of its top officials from $600,000 to $4 million attests to the staying power of this resentment. According to SEC filings on July 1, current Fannie Mae CEO Timothy Mayopoulos and Freddie Mac CEO Donald Layton each would receive $4 million a year in compensation. Federal Housing Finance Agency Director Mel Watt, after soliciting proposals for promoting CEO retention, had approved them in May. Watt remarked: “The plan defers significant compensation to ensure retention, is based on performance, does not include a bonus, and is consistent with FHFA’s statutory responsibilities to ensure safety and soundness and a liquid national housing finance market. The plan also positions each CEO’s compensation well below the 25th percentile, one of the requirements set by FHFA in recognition of the fact that the enterprises are in conservatorship.”
Lawmakers on Capitol Hill, having gotten word of FHFA approval, were outraged. They quickly responded with legislation to rescind the pay increases. On September 15, the full Senate, led by the unlikely duo of David Vitter, R-La., and Elizabeth Warren, D-Mass., unanimously approved a measure, the Equity in Government Compensation Act of 2015 (S.236), restoring Fannie Mae and Freddie Mac CEO annual pay at $600,000. The House Financial Services Committee in late July already had passed an identical bill (H.R. 2243) introduced by Rep. Ed Royce, R-Calif., by a 57-1 vote. Senator Vitter explained: “Giving massive taxpayer-funded pay raises to Fannie Mae and Freddie Mac isn’t just out of touch – it’s downright offensive.” President Obama and the Treasury Department each strongly support the legislation.
On one level, the outrage is justified. Fannie Mae and Freddie Mac, having lowered standards of mortgage risk assessment to reach “underserved” populations and having compensated top brass in lavish fashion, tempted fate. And during conservatorship, they chose to receive potentially costly (to taxpayers) emergency loans. Yet there is a larger issue. What is offensive, more than anything else, is the Treasury Department’s continued insistence that Fannie Mae and Freddie Mac surrender all dividends in perpetuity. These companies are legally imprisoned by an arrangement that is neither needed nor wanted. Yes, they borrowed $187.5 billion. But they have repaid nearly $240 billion. For some reason, this latter figure is not high enough for their release from servitude. Meanwhile, shareholders, already ripped off to the tune of at least $50 billion, stand to be ripped off even further.
Congress has the power to return the companies to the private sector, without government favors or strings, by amending the 2008 HERA legislation. Failing that, the Obama administration can do the job itself. Lawmakers prefer to shut them down and replace them with something ostensibly better. In June 2013, Sens. Bob Corker, R-Tenn., and Mark Warner, D-Va., proposed legislation to liquidate Fannie Mae/Freddie Mac over a five-year period. In March 2014, fleshing out the Corker-Warner plan, Sens. Tim Johnson, D-S.D., and Mike Crapo, R-Idaho, also proposed liquidating these corporations over five years in favor of a new federally-chartered insurance corporation, and creating a new entity, Federal Mortgage Insurance Corporation, whose operations might well leave taxpayers even more exposed than before. A 2013 House bill, sponsored by Rep. Jeb Hensarling, R-Tex., also would have terminated Fannie Mae and Freddie Mac, but at least did not include federal guarantees for investors. None of the bills went anywhere because Republicans and Democrats, though sharing the view that Fannie Mae and Freddie Mac needed to go, could not agree on the specifics of a replacement. As for the Obama administration, it views company dividends merely as a valuable revenue source.
The saga of Fannie Mae and Freddie Mac should serve as a fair warning to those who assume that bailouts of failing business enterprises are necessary if the beneficiary is likely to promptly repay their benefactor. The reality is that even “successful” bailouts contain all kinds of trip wire that the recipient may come to regret later on. The nearly $200 billion in emergency loans that accompanied conservatorship looked good. Yet the money has proven far more trouble than it was worth. The government, though paid in full well over a year ago, arbitrarily has chosen to treat these companies as wild game to be placed in permanent captivity. Even if the federal government does set the companies free, its making available the emergency loans in the first place raises expectations of future bailouts for a wide range of struggling firms.
There is no sound reason why Fannie Mae and Freddie Mac can’t be unshackled from conservatorship – this time without guarantees insulating them from competition and without costly “affordable housing” mandates that amount to gifts to affirmative action advocates. To be sure, limitations on executive pay are a necessary part of any conservatorship. But that is a secondary issue. The real challenge is eliminating the conservatorship itself, not simply operating it more efficiently. Fannie Mae, Freddie Mac and their shareholders have learned an overdue lesson the hard way: Government short-term help can create lots of long-term harm.