Funny business at Fannie Mae: how'd those Clintonites get so rich?

ON May 23, as a jury in Houston deliberated the case against top Enron executives Kenneth Lay and Jeffrey Skilling, a little-known regulatory agency in Washington, the Office of Federal Housing Enterprise Oversight (OFHEO), released a study with the dryly bureaucratic title "Report of the Special Examination of Fannie Mae." The document received far less attention than the news from Enron, but its conclusions were stunning. In meticulous detail, it outlined a culture of corruption at the Federal National Mortgage Association--better known as Fannie Mae--that rivals the most serious corporate scandals in recent years. In this case, however, the main players are Washington insiders--some of them prominent veterans of the Clinton administration--and the scandal's effects could ripple through Congress for years.

Fannie Mae is the biggest single source of money for mortgages in the United States. From 1998 to 2004, the years covered by the OFHEO investigation, it was headed by former Clinton budget director Franklin Raines, whose top management team included former Clinton Justice Department official Jamie Gorelick, sometimes mentioned as a future attorney general in a Democratic administration. During that period, the report says, Raines and his team grossly overstated Fannie Mae's earnings--to the tune of $10.6 billion--for the purpose of paying themselves big bonuses. "By deliberately and intentionally manipulating accounting to hit earnings targets," the report says, "senior management maximized the bonuses and other executive compensation they received, at the expense of shareholders."

In doing so, the report says, Raines and his team steered Fannie Mae far afield from its original mission, transforming it from a stable business into a risky one. Fannie Mae has its roots in the New Deal, when it was established to increase the amount of money available for mortgages. Over the years, its main business has been to issue debt and then use the proceeds to buy mortgages from lenders, allowing those lenders to give out new mortgages. Originally a government agency, Fannie Mae went private in 1968, with the goal of "increasing the availability and affordability of homeownership for low-,moderate-, and middle-income Americans," according to its mission statement.

But Fannie Mae is not just any private institution. It is congressionally chartered, meaning its existence is established in law, it does not have to pay state and local income taxes, and it is not subject to bankruptcy laws. It can borrow money at a lower rate than anyone else except the federal government itself. Given all that, there is a public perception that Fannie Mae is a rock-solid government institution. "There is an implied guarantee," says Sen. John Sununu, a member of the Senate Banking, Housing, and Urban Affairs Committee who has sponsored legislation to reform Fannie Mae. "Investors think they are the next best thing to Treasuries."

There's no doubt that Fannie Mae succeeded in its original mission of increasing the amount of money available for mortgages. In the 1980s, it went a step further, essentially creating a new product when it bought up mortgages and bundled them for sale to investors as mortgage-backed securities. It was an extraordinarily profitable move for Fannie Mae, and good for the housing market, too.

But in the 1990s, the company moved in a much riskier direction. Fannie Mae used its borrowing power to buy up mortgages and hold them, making a profit from the difference between the low price it paid to borrow the money and the higher interest rate it received on the mortgage. It was potentially profitable, but it had nothing to do with helping low- and middle-income people buy houses. "It doesn't do anything to support their core mission," says Senator Sununu, "and it increases their exposure to interest-rate risks."

But the OFHEO report suggests that none of that mattered to Raines, who had been a top official at Fannie Mae in the early 1990s before leaving to join the Clinton administration and then returning to Fannie Mae as chief executive in 1998. According to the report, Raines became obsessed with propping up Fannie Mae's earnings per share, or EPS, even if he had to use creative accounting to make it happen. Raines set a series of increasingly higher EPS goals that, if met, would trigger bonuses for the executive team that far surpassed what they received in salary.

In 1999, Raines announced a new goal to double Fannie Mae's EPS in five years, from $3.23 per share to $6.46. It was an audacious goal, and reaching it, according to OFHEO, became Fannie Mae's reason for existence: "$6.46, the EPS goal, became the corporate mantra--everything else was secondary to hitting that target." To convey an idea of just how obsessed Raines had become, and how he passed on that obsession to his top managers, the OFHEO report quotes at some length from a speech given in 2000 by Sampath Rajappa, head of the Office of Auditing, to his accounting team:

   By now every one of you must have 6.46
   branded in your brains. You must be able
   to say it in your sleep, you must be able to
   recite it forwards and backwards, you
   must have a raging fire in your belly that
   burns away all doubts, you must live,
   breathe and dream 6.46, you must be
   obsessed on 6.46.... After all, thanks to
   Frank, we all have a lot of money riding
   on it.... We must do this with a fiery
   determination, not on some days, not on
   most days but day in and day out, give it
   your best, not 50%, not 75%, not 100%,
   but 150%. Remember, Frank has given
   us an opportunity to earn not just our
   salaries, benefits, raises ... but substantially
   over and above if we make 6.46.

   So it is our moral obligation to give well
   above our 100% and if we do this, we
   would have made tangible contributions
   to Frank's goals.

It worked. Fannie Mae met its EPS goals, and Raines rewarded his top executives--and most of all himself--with unheard-of amounts of money.

Even though his salary never topped $1 million, Raines' total compensation shot from $6.48 million in 1998 to $8.52 million in 1999, to $13.89 million in 2000, to $18.86 million in 2001, to $18.20 million in 2002, to $24.15 million in 2003, all on the strength of EPS bonuses. Investigators found that of the $90.12 million Raines was paid in that six-year period, more than $52 million came from EPS bonuses.

Gorelick's situation was similar. OFHEO found that she took home $26.46 million in the period from 1998 to 2002 (she left in that year, so she wasn't there for the entire period under investigation). Of that figure, nearly $15 million came from EPS bonuses.

Of course, it wasn't legit. "Fannie Mae reported extremely smooth profit growth and hit announced targets for earnings per share precisely each quarter," the OFHEO report says. "Those achievements were illusions deliberately and systematically by the Justice Department, and will likely be in trouble with the Securities and Exchange Commission, too. And there probably won't be much more talk about Gorelick as attorney general should a Democrat win the White House in 2008.

But there still is the matter of cleaning up Fannie Mae. Senator Sununu and his colleagues on the Senate banking committee have been trying for two years to win approval of a bill that would create a new regulatory body for Fannie Mae and give that body the authority to crack down on the company's riskier practices.

But the bill has faced a lot of opposition, mostly from Democrats. When Raines was still at Fannie Mae (he was forced out in 2004), he tried, in Sununu's words, "to slow-walk the process. Frank Raines decided they were stronger and better and smarter than everyone else, so they would push back." Democrats allied themselves with Raines and said they created by [Fannie Mae's] senior management with the aid of inappropriate accounting and improper earnings management."

In other words, they cooked the books. And to make matters worse, according to OFHEO, when regulators began to catch on to what was happening, Raines and his team then "sought to interfere" with the OFHEO investigation by trying to get Congress to start up a separate probe of OFHEO. Fannie Mae also lobbied Congress to cut OFHEO's funds unless it got rid of the top official in charge of investigating Fannie Mae.

That didn't work, and, as a result of the investigation, Fannie Mae has agreed to pay $400 million in penalties. The company is now under criminal investigation worried that reform might harm Fannie Mae's ability to provide mortgages to low- and middle-income homebuyers. Sununu's bill was approved in the banking committee last year, but only on a straight party-line vote.

Now, however, there is the OFHEO report, which will probably make it impossible for anyone to oppose reforming Fannie Mae. "It's not a very smart move politically to stand up and defend people who manipulate earnings to get $50 million bonuses," says Sununu.

So look for reform to happen, with the support of Republicans and Democrats. It took a long time, and $10.6 billion in overstated earnings, and a scathing report from regulators, but things are finally moving along.