(FORTUNE Magazine) – On a sunny Monday in June 2002, President George W. Bush stood in the St. Paul AME Church in a formerly dilapidated neighborhood on the south side of Atlanta. Sitting in prime seats were Franklin Raines, the CEO of Fannie Mae, and Leland Brendsel, the CEO of Freddie Mac. The President was there to unveil an initiative aimed at helping 5.5 million minority families buy homes before the end of the decade--"Part of being a secure America," he said, "is to encourage home-ownership."

Raines and Brendsel were there because, well, encouraging home-ownership was what their congressionally chartered companies existed to do. By purchasing hundreds of billions of dollars' worth of mortgages held by banks, Fannie and its cousin Freddie made it possible for financial institutions to turn around and make more loans to prospective homeowners. Or at least that's the theory.

Franklin Delano Raines is a prominent Democrat, but that hadn't kept him from currying favor with the new Republican President. For more than 30 years Fannie Mae has straddled two worlds--business and politics--and the company placed enormous emphasis on maintaining good relations with key government officials. In 2001, Raines had written an op-ed in the Wall Street Journal lauding Bush's faith-based initiative. He had also reached out to Bush allies in the faith-based community, including Kirbyjon Caldwell, the Houston pastor who gave the benediction at Bush's first inaugural. In October 2002, at the White House Conference on Minority Home Ownership, Raines and Caldwell were both on hand to be praised warmly by Bush for their work.

It hasn't even been three years since that sunny day in Atlanta, but oh, how the world has changed. Both Brendsel and Raines have been deposed in the wake of multibillion-dollar accounting scandals. Brendsel fell in 2003, after government regulators accused Freddie Mac of understating billions in profits in an effort to smooth earnings. More recently the Securities and Exchange Commission ruled that Fannie Mae--the larger and more important of the two companies--had violated accounting rules, overstating profits by an estimated $9 billion since 2001, which represents almost 40% of its total earnings during that period. Raines, who was paid more than $90 million during his six years as CEO--much of it linked to meeting profit targets--made a last-ditch effort to save his job, but to no avail. CFO Tim Howard was also forced out. Fannie's accounting firm of 36 years, KPMG, was fired. Once one of the most politically powerful companies in America--with staunch allies in Congress who did its bidding, a notoriously weak regulator, and a willingness to steamroller its critics--Fannie today is more vulnerable, in both a business and political sense, than it has ever been before. However it emerges from this scandal, it will almost surely never again be the unstoppable force it once was.

The Fannie story is not like other accounting scandals, though. Yes, the company broke the rules to produce a smooth stream of earnings, just as Enron, Tyco, WorldCom, and all the others did. But that's only one of a half-dozen different story lines. The Fannie Mae saga is also about a company that lost sight of its original mission. It's about power politics run amok, and the combustible blend of politics and business. It's about a company whose huge debt terrified top government officials, and whose very existence drew ideological opposition. It's about an orchestrated, behind-the-scenes campaign to rein in a financial powerhouse. It's about a regulator who learned to fight back against a much more formidable foe.

It's about all these things and one more. Fannie Mae thought itself so different, so special, and so powerful that it should never have to answer to anybody. And in this, it turned out to be very wrong.

■THE 'BIG FAT GAP'

The Federal National Mortgage Association (Fannie) and the Federal Home Loan Mortgage Corp. (Freddie) have always been unique institutions. They are publicly held, for-profit corporations that were legislated into existence by Congress and operate with a congressional charter to help lower- and middle-income Americans buy homes. (They are often referred to as government-sponsored enterprises, or GSEs.) Fannie was founded in 1938 as a federal agency and became a for-profit company in 1968. Freddie, started in 1970, offered shares to the public in 1989.

The central idea behind the GSEs was that they would encourage home-ownership by buying mortgages from banks. This was in an era when federal law forbade interstate banking--which meant that most banks were necessarily small. When Fannie or Freddie bought a mortgage, it freed up the bank's limited capital, allowing it to make more loans. The purchase also relieved the bank of both the credit risk and the interest rate risk--that is, of having to worry that people might default, or that interest rates might rise during the life of the loan. Fannie and Freddie are one reason America is one of only two countries where lenders offer 30-year fixed rate mortgages. (Denmark is the other, by the way.)

Their congressional charters give Fannie and Freddie advantages unmatched to this day even by such giants as Citigroup and Wells Fargo. For example, the Treasury is permitted to buy $2.25 billion of each company's debt (commonly referred to as Fannie and Freddie's line of credit). Fannie and Freddie are exempt from state and local taxes and have much less stringent capital requirements than banks. Best of all, their cost of capital is only a smidgen higher than long-term Treasuries--and lower than that of even the most creditworthy companies. This last advantage, however, is not due to any regulation. Rather, it is the result of the market's belief that Fannie and Freddie's debt is safer than even AAA-rated corporate debt. Why? Because thanks to Fannie and Freddie's congressional charters, the markets believe that the U.S. government will never let them default.

In fact, there is no such federal guarantee, something Fannie and Freddie are forced to point out in their federal filings. But the two GSEs play what former assistant Treasury secretary Rick Carnell calls "a double game"--disavowing federal backing in their public boilerplate, while quietly encouraging the notion. In 1998, for instance, Fannie argued in a letter to the Office of the Comptroller of the Currency that its securities were safer than all AAA-rated debt because of the "implied government backing of Fannie Mae."

Fannie and Freddie dominate the mortgage market, but they don't originate home loans. Instead, they make their money in two major ways. One is conservative: They get a fee for guaranteeing the payments on mortgages they buy, which they then resell to investors, usually in the form of mortgage-backed securities. The more aggressive way is to hold on to the mortgages, assume all the inherent risk, and make money on the spread between their low cost of capital and the higher yield of the mortgage portfolio. (Alan Greenspan would later call this "the big, fat gap.") The more mortgages the GSEs buy, the faster their profits can grow. Since 1995, Fannie and Freddie's holdings of residential debt have grown an average of 20% a year, and together they now carry $1.5 trillion in home loans and mortgage securities on their books--more than the top ten commercial banks combined. Thanks in large part to this growth, Fannie has had double-digit profit gains for the last 17 years--and an average return on equity of 25%. But the GSEs' size has people increasingly worried about what might happen if anything went wrong--and not just to Fannie and Freddie but to the entire financial system.

There is one additional concern: derivatives, which institutions rely on to hedge interest rate risk. Over time, Fannie and Freddie became two of Wall Street's top users of derivatives. Of course, derivatives have their own risks--as America discovered in 1998 when hedge fund Long Term Capital Management blew up--and very nearly brought down the U.S. financial system with it. The idea that its activities might pose a danger infuriates Fannie Mae, which describes itself as "a bulwark of our financial system." For some of its critics, though, Fannie's refusal to acknowledge that its portfolio posed any risk would become the scariest thing of all.

■THE BEAR IN THE CANOE

Fannie Mae has always been run by power brokers. Its CEO in the 1980s was a savvy and extremely charming man named David Maxwell. He left two legacies. First, he rebuilt the company after its one brush with death in the early 1980s, when interest rates spiked and the payments on its mortgage portfolio didn't cover the cost of its debt. Fannie survived in part because banks kept lending it money--based on the perception that the government stood behind it.

Maxwell also put in place elements of the political and business machine Fannie would become. But it was his successor, Jim Johnson, who perfected the machine. The smooth, Princeton-educated son of a Minnesota politician ran Fannie for most of the 1990s. He had worked as an advisor to Walter Mondale and was a longtime member of the Washington establishment. Indeed, last year he headed Senator John Kerry's search for a vice-presidential candidate and was rumored to be a top choice for Treasury Secretary in a Kerry administration--along with Franklin Raines.

Like both his predecessor and his successor, Johnson could speak passionately about Fannie Mae's mandate--to help create affordable housing. "The mission," he liked to say, "flows in our veins." But that idealism could be accompanied by a win-at-all-costs attitude, traits that were, and are, reflected in Fannie. A former government official remembers trying to cut a deal with Johnson by pointing out that Fannie might lose if the issue went to Congress. Johnson's reply, as the official recalls it: "There is no probability that we lose."

Despite such bravado, Johnson's essential belief was that Fannie would always be vulnerable to the whims of politicians because so few people really understood what Fannie did. "There's nothing in the home-owner's life called Fannie Mae or Freddie Mac," he would say. He came up with two key strategies he believed would insure that Congress never took away Fannie's special status. He called them "indispensability" and "tangibility." To put it simply, he wanted Congress to see that America couldn't live without Fannie Mae. And he wanted Fannie Mae to be practically synonymous with the idea of home-ownership.

The cornerstones of the Johnson political machine were the Fannie Mae Foundation and the company's Partnership Offices ("POs," in Fannie parlance). The foundation had existed in a small form since 1979, but in 1996, Fannie Mae seeded it with $350 million of its own stock and gave it responsibility for Fannie's advertising. Over the past five years the foundation has given away some $500 million to thousands of organizations ranging from the Congressional Black Caucus to the Cold Climate Housing Research Center in Fairbanks.

Fannie began opening its Partnership Offices in 1994. These are regional offices that Fannie says act as catalysts for housing projects in their communities; but inside Fannie, the POs are also referred to as the "grassroots" of the political operation. They are frequently staffed by ex-politicos. (Bob Simpson, who heads the South Dakota office, was an aide to Democratic Senate leader Tom Daschle, for instance.) The opening of a Partnership Office is always a grand ceremony featuring prominent politicians. And it's often accompanied by an announcement that Fannie's American Communities Fund will make an investment in a high-impact local project. Politicians may not understand the secondary-mortgage market, but they do understand a photo opportunity and the dispensation of pork.

Over time, Fannie built close alliances with homebuilders, Realtors, and trade groups--whom it could call on to pressure lawmakers whenever the need arose. It employs more high-powered lobbyists than just about any organization in Washington. It hires people for their political juice, including Duane Duncan, former chief of staff of Republican Congressman Richard Baker of Louisiana (a Fannie critic, as it happens), Michele Davis (a former Paul O'Neill aide), and Robert Zoellick, who is set to become deputy secretary of state.

Under Johnson, Fannie Mae also developed a reputation for invincibility tactics. "You did not question Fannie Mae," says former Housing and Urban Development Secretary Andrew Cuomo, who is proud of winning one skirmish with Fannie. "Fannie did as Fannie wanted." Partly that was because Fannie people had an almost religious conviction about the virtues of housing--a sense that they were both right and righteous.

Another reason for Fannie's uncompromising attitude was Fannie executives' continuing fear that what politics giveth, politics could take away--and their belief that Fannie's congressional charter, which gave it so many advantages in the marketplace, had to be fought for at every turn. There was some truth to this. The Reagan administration, for instance, ideologically opposed to government-subsidized corporations, worked hard to privatize the company. (Fannie beat back the effort.) Fannie execs felt they couldn't afford to lose even one fight, because that would open the floodgates. "You're thinking survival--winning, not compromise," says a former employee. A former Fannie lobbyist adds that the attitude was "Just win, baby."

At the same time Johnson was turning Fannie into a political juggernaut, he was transforming it into one of the greatest growth vehicles ever. In the years Johnson ran Fannie, its market cap grew from $10.5 billion to more than $70 billion. It posted steady earnings gains, and its executives made fortunes. (The wealth-sharing had begun before Johnson; when Maxwell left, he walked away with a $19.5 million retirement package.)

In the mid-1990s, Raines told the Washington Post that "we are the equivalent of a Federal Reserve system for housing." The same article noted that Fannie's financial moves generated more than $100 million a year in fees for Wall Street firms. By the time Johnson retired in late 1998, Fannie guaranteed a stunning $1 trillion of mortgages and held $376 billion of mortgages and mortgage-backed securities on its own books.

Inevitably, Fannie's growth began to prompt serious questions from a variety of critics. There were ideological foes who believed that GSEs shouldn't have special advantages bestowed by the government. The big national banks wanted more of the mortgage securities market--and wanted to see Fannie shackled. Many housing activists believed the company had become so focused on Wall Street that it had lost sight of its mission. What, they asked, did Fannie's ever-growing portfolio do to lower mortgage rates? Other critics looked at that portfolio and saw huge potential risks--risks that would likely be borne by taxpayers if anything went wrong. Financial consultant and prominent GSE critic Bert Ely is among those who argue that Fannie has created a moral hazard; namely, that if everyone thinks the government will rescue the GSEs, the companies aren't subject to market discipline.

Fannie's knee-jerk response to criticism was to push back hard. It accused anyone who questioned it of being anti-home-ownership. In 1996, when the Congressional Budget Office issued a critical study, a Fannie spokesperson sneered that the report was "the work of economic pencil brains who wouldn't recognize something that works for ordinary homebuyers if it hit them in their erasers." And it was quick to remind politicians where their interests lay. Fannie put together a book, personalized for each member of the House Banking Committee, detailing all the good things it did in each district to bolster home-ownership. Even that critical CBO study acknowledged that it would probably be impossible to get rid of the GSEs even if it made economic sense--because Fannie and Freddie had become so inextricably linked to the idea of home-ownership. "Once one agrees to share a canoe with a bear, it is hard to get him out without obtaining his agreement or getting wet," said the report.

■THE EARNINGS TRAP

"The future is so bright that I am willing to set as a goal that our EPS will double over the next five years."

So said Franklin Raines at an investor conference he hosted in May 1999, five months after becoming CEO. During his tenure, that promise was at the heart of everything the company did. The board even tied much of management's compensation to earnings goals. And though Fannie met the target--announcing profits of $7.3 billion in 2003--the intense focus on consistent earnings growth did a lot to bring Raines down.

In assuming the top job at Fannie, Frank Raines--everyone calls him Frank--became the first African-American CEO of a FORTUNE 500 company. He was born in Seattle to blue-collar parents; his mother cleaned offices at Boeing, where Raines was appointed to the board in 1995. (He is now on the boards of PepsiCo and Pfizer.) Raines graduated from Harvard and Harvard Law, became a Rhodes Scholar, interned in the Nixon White House, and served in the Carter administration before leaving government to become a partner at Lazard Frères. In 1991, Johnson lured him to Fannie Mae, where he became vice chairman. Five years later Raines was named Bill Clinton's budget director; he returned to Fannie when Johnson retired.

Raines, who would not comment for this article, has what Andrew Lowenthal, a lobbyist whose clients include Freddie Mac, calls "extraordinary presence.... You see him, you meet him, you want to believe him." (Some Fannie lobbyists referred to him as "The Great One.") And like Johnson before him, Raines could talk the talk with great sincerity; former Goldman Sachs analyst Bob Hottensen remembers him often telling a story about how his father had to get a high-priced loan rather than a lower-cost mortgage. "You cannot hurt Fannie Mae without hurting the housing market," Raines liked to say. One of his great assets, people said, was his strong will--but that eventually became a liability. "If a lot of people disagree with you, you have to ask, are they all wrong?" says someone who knows Raines well.

Under Raines, Fannie began to come under increasing criticism--and it responded ever more aggressively. In June 1999, for instance, Fannie's banking competitors banded together to form a group called FM Watch. The company reaction can only be described as over-the-top: It called FM Watch "fat-cat bankers," compared it to the ruthless ex-dictator Slobodan Milosevic, and went around hiring powerful lobbying firms just to keep them from working for FM Watch.

FM Watch, however, wasn't the biggest of Fannie's worries. The real problem was that as Fannie's mortgage portfolio continued to balloon, top government officials became concerned about the potential consequences. In late 1999, then Treasury Secretary Lawrence Summers made a speech that included this sentence: "Debates about systemic risk should also now include government sponsored enterprises, which are large and growing rapidly." It was an incendiary remark. Then in March, Gary Gensler, Treasury's undersecretary for domestic finance, suggested in a speech that the Treasury should reconsider Fannie and Freddie's $4.5 billion line of credit.

All hell broke loose. Yields on GSE debt rose dramatically, meaning that investors wanted to be compensated for taking more risk. This, of course, reduced the spread Fannie was able to earn on its portfolio--and threatened Fannie's earnings. Fannie called Gensler "irresponsible," "unprofessional," and (of course) anti-housing. Raines wrote that repealing the line of credit would "disrupt the capital markets and inexorably lead to higher mortgage rates for consumers."

The market reaction was so ugly that Fannie and Freddie realized they had to respond. And so, in an October 2000 press conference, Brendsel and Raines announced "six voluntary initiatives" to disclose more information about, for instance, interest rate risk. Both stocks shot up by almost 10% that day. What few knew was that Raines furiously resisted the "voluntary initiatives" and signed on only when it became clear that Freddie was going to proceed. Speaking to investors later that year, Raines portrayed the initiatives as a triumph, not a retreat. "We didn't stray, we didn't cry uncle, we didn't concede anything that would affect us in the long run."

One of the six voluntary initiatives was that the "duration gap," a measure of sensitivity to interest rates, would be disclosed monthly instead of quarterly. In 2002 accounting sleuths and short-sellers became suspicious of Fannie's smoothly growing earnings. Fannie's duration gap made it clear that the company had been on the wrong side of interest rate bets during a period of rapidly declining rates in the fall of that year. Yet that didn't seem to have had any effect on Fannie's earnings. John Barnett, then an analyst at the Center for Financial Research and Analysis, which produces detailed accounting reports for institutional investors, suggested that Fannie Mae was distorting economic reality by putting billions of dollars in derivative losses on its balance sheet instead of on its income statement. Fannie's responses were rarely illuminating. When Republican Senator Chuck Hagel of Nebraska asked for details on Fannie's derivative losses, the company said the information was "confidential and proprietary." Eventually, it provided some additional data.

In fact the situation was worse than even the harshest critics believed. "We thought their accounting was lousy but legal," said Mark Haefele, who helps run Sonic Capital, a hedge fund that is short Fannie's stock. "It turns out it was just lousy."

■UNDERFED WATCHDOG

The chain of events that eventually brought Frank Raines down starts with Enron. When the Enron scandal exploded, Freddie Mac, which had employed Enron's accounting firm, Arthur Andersen, quickly fired the firm and hired new accountants. In the fear-ridden environment of 2002, the new accountants, PricewaterhouseCoopers, scrubbed Freddie's books. The result of that scrutiny was Freddie's admission, about a year later, that it had understated its profits for years, in an effort to smooth out earnings. The company agreed to a $5 billion restatement and ousted many of its top executives, including Brendsel.

Fannie responded to Freddie's problems with astonishing self-righteousness. Raines held a press conference in which he accused Freddie of causing "collateral damage." The Frequently Asked Questions section of Fannie's website included the following statement: "Fannie Mae's reported financial results follow Generally Accepted Accounting Principles to the letter.... There should be no question about our accounting."

Just days before the Freddie crisis had erupted into public view, the Office of Federal Housing Enterprise Oversight (OFHEO)--the agency that regulates the GSEs--had pronounced Freddie's internal controls "accurate and reliable." This was a colossal misjudgment. Embarrassed by the error, OFHEO's director, a Texas Democrat named Armando Falcon Jr., who had been appointed to his job in 1999, resolved to make sure it didn't happen again. In early 2004, OFHEO hired Deloitte & Touche and began an investigation of Fannie Mae. The lead partner was Bob Maxant, who had previously handled the Enron board's in-house investigation.

OFHEO is not like most regulatory agencies; it is much weaker. Established in 1992, OFHEO is actually an illustration of Fannie's political power. When the legislation creating the agency was being debated, Fannie's allies in Congress made sure OFHEO was placed in the Department of Housing and Urban Development, which had no experience regulating financial markets. In the years prior to Falcon's appointment it was notoriously understaffed. Although its budget comes from fees paid by the GSEs, a Fannie-inspired amendment called for OFHEO to go through the appropriations process every year. Since Fannie and Freddie had numerous allies in Congress, this meant that the GSEs would effectively control their regulator. OFHEO, says one person who was there, had two choices: "Appease Fannie and Freddie or risk getting reamed in the budget." Former Treasury official Carnell once described OFHEO as a watchdog that was "hobbled, muzzled, and underfed."

It's fair to say that Fannie underestimated Falcon. The OFHEO chief, who is 44, seems shy and hesitates when he speaks. He's the middle of six children, raised outside San Antonio; his father was an aircraft mechanic. After attending St. Mary's, a Catholic college in San Antonio, he went to the University of Texas Law School and the Kennedy School of Government. He came to Washington in 1989 to work on the House Banking Committee under its populist chairman, Henry Gonzales, for eight years. After a failed political run in Texas, Falcon returned to D.C. and was appointed by Clinton to his current job. He didn't initially distrust Fannie or Freddie. But after wrangling with the GSEs, he became convinced that the last thing Fannie wanted was a capable regulator.

At first, it didn't look as if Falcon would last. (He is, after all, a Texas Democrat.) In February 2003 the White House announced that it planned to nominate a former J.P. Morgan executive named Mark Brickell to replace him. But Brickell's nomination was killed by foes who believed he was too close to the derivatives industry, and in the meantime the White House was warming up to Falcon. Later in 2003 the administration signaled its support for the agency by pointedly adding it to the President's corporate fraud task force. And it was the White House that got OFHEO the funds to hire Deloitte & Touche to investigate Fannie.

It would be wrong to say that OFHEO and the White House became allies. It was more like a wary marriage of convenience. What happened was that the White House's attitude toward the GSEs had changed--and it saw that OFHEO could help its cause.

■OPERATION NORIEGA

There are people in Washington who will tell you that the White House turned on Fannie Mae because it's seen as a Democratic Party stronghold. There are others who will say it happened because of the Bush administration's pro-market ideology. There's probably some truth to both of those explanations. But the most important reason was self-preservation. The White House didn't want to be dragged into another business scandal--not after Enron. And when it looked to see where it might be vulnerable, well, considering what was going on with Freddie, it could hardly miss the GSEs.

First, there was the issue of Freddie's and Fannie's boards. Under their charters, five of the 18 directors on each board are appointed by the President. If something went wrong, wouldn't the President inevitably be blamed? In 2003 chief of staff Andrew Card was put in charge of a group to study the matter. The White House decided that it would not reappoint any presidential directors to either GSE board. (The posts are now vacant.) It also decided that their books needed to be cleaned up and they needed stronger oversight.

At the same time Alan Greenspan's public remarks about the GSEs were becoming increasingly pointed. His sharpest comments came in early 2004, when he told Congress that "to fend off future systemic difficulties, which we assess as likely if GSE expansion continues unabated, preventative actions are required sooner rather than later." In Greenspan-speak, those were strong words indeed.

The White House became part of a loose alliance that took on the Fannie Mae machine in a way no one had before. A short list of examples:

• In late 2003, Federal Reserve economist Wayne Passmore released a paper that put the value of the government's implied guarantee of the GSEs at as much as $164 billion. This subsidy "accounts for much of the GSEs market value," wrote Passmore, who added that "the GSEs' implicit subsidy does not appear to have substantially increased home-ownership or homebuilding." He also argued that the GSEs did very little to lower mortgage costs.

• HUD toughened its low-income housing goals for Fannie and Freddie--and then insisted the GSEs meet the new requirements. HUD had long felt that Fannie and Freddie were not doing enough to promote affordable housing. "HUD had permitted Fannie and Freddie to consistently dispute our findings and challenge us publicly," says Alphonso Jackson, the current head of HUD. "Not on my watch and not under this President." ("You just cannot appreciate how truly bad this is," a Fannie employee complained in an e-mail to a Republican staffer, referring to the prospect of HUD having more clout.)

• In the summer of 2004 the Justice Department rendered an opinion--which Fannie and Freddie had viewed as bad news--that Treasury could actually limit future debt issuance by the GSEs.

• Administration operatives began making anti-Fannie arguments to key opinion makers, such as the editorial boards of major newspapers. They seem to have had an impact. Over the past year anti-GSE editorials have appeared in key papers--not just the Wall Street Journal, but also the Washington Post,the Los Angeles Times, and the Christian Science Monitor.

Aides battling the GSEs came up with a half-joking code name for their assault: "Noriega"--as in Manuel Noriega, the former Panamanian dictator who was blasted with nonstop rock music from loudspeakers while holed up in the Vatican's diplomatic mission in Panama City, trying to avoid surrendering to the U.S. Attack mode, of course, has always been Fannie's way, but now the situation was reversed. As one former lobbyist for the GSEs put it: "Payback is hell."

On Sept. 10, 2003, Treasury Secretary John Snow and then-HUD head Mel Martinez outlined the administration's thinking on reforming Fannie and Freddie. Testifying before the House Financial Services Committee, Snow called for a new regulatory regime, one key element of which would be a receivership provision. Amazingly, there is no real procedure in place for reorganizing Fannie or Freddie in the event of a bankruptcy. By setting up a receivership mechanism, the government would be sending an unmistakable message: It would not stand behind Fannie and Freddie's debt.

It wasn't long before Fannie and the administration were effectively at war. Two bills to reform the GSEs were introduced--a Fannie-friendly bill in the House and a White House--friendly bill in the Senate sponsored by Republican Senator Richard Shelby of Alabama. The administration squashed the House bill; Wayne Abernathy, a Treasury official, said, "We must not settle for a crippled regulator." The Senate bill was moving along--until Republican Senator Bob Bennett of Utah (who had the backing of other Senators) added an amendment giving Congress a 45-day window to veto the receivership. That, of course, completely undercut the notion that the government would no longer back the GSEs. Bennett's son is the deputy director of Fannie's Partnership Office in Utah.

At every turn, Fannie declared publicly its desire for a strong new regulator. And at every turn, it stonewalled behind the scenes. "No, no, hell no," is how one person who watched the process describes Fannie's attitude. Some administration officials began to refer to Fannie's efforts to undermine the receivership provision as "deceivership."

On Oct. 22, 2003, for instance, Raines sent Snow a letter. "Dear John," it began. "From the beginning of our discussions, you and I have agreed to avoid disrupting the capital markets by indicating a wish to change Fannie Mae's charter, status, or mission." After complaining about a comment that Raines said a high Treasury official had made about Fannie's line of credit, he wrote, "The result of his comment was that trading in our debt came to a halt for an extended period of time. I am disappointed and hope we can change course. Very truly yours, Frank."

In political terms the letter was an astonishment--what other CEO would dare dress down the Treasury Secretary, much less address him as "Dear John"?

(In the spring of 2004, Snow announced that his financial advisor had mistakenly bought GSE debt for his personal account instead of Treasury bills. Months later, Democratic Senator Max Baucus, who is featured in a Fannie press release for its Montana Partnership Office, referred the matter to the Justice Department "for review.")

Then, in 2004, Raines wrote another stern letter, this one to White House chief of staff Card, accusing Card of misrepresenting Fannie's position on a regulation issue to the National Association of Home Builders. Card first learned of the letter from the NAHB because it got a copy before he did. After that, Card stopped returning Raines's phone calls. "It's hard to depersonalize these things," says NAHB CEO Jerry Howard. "It's hard to step back."

And then there was the TV ad Fannie ran on March 31, 2004--the day before the Senate Banking Committee was scheduled to work on its bill. The ad featured a worried looking Hispanic couple.

Man: "Uh-oh."

Woman: "What?"

Man: "It looks like Congress is talking about new regulations for Fannie Mae."

Woman: "Will that keep us from getting that lower mortgage rate?"

Man: "Some economists say rates may go up."

Woman: "But that could mean we won't be able to afford the new house.

Man: "I know."

Even longtime Fannie watchers were stunned. "Here is an organization that was created by the Congress ... spending money questioning the Congress's right to take a serious look at oversight ..." sputtered Senator Hagel during the hearing that day. "I find it astounding. Astounding!"

By late spring 2004 it was clear that Fannie had fought the White House to a draw--there would be no bill, and hence no new regulator. But it's all too clear now that Fannie Mae had won a Pyrrhic victory. Raines would have been far better served by compromising when he had the chance. Thanks to the accounting scandal, the GSEs now face regulations that are likely to be far tougher than those in the bill Fannie helped kill. One former Fannie lobbyist describes it as "the greatest political malpractice ever committed." Says another person close to the events: "What is amazing to me is Raines's will and misjudgment to continue fighting in the face of the first truly organized resistance the company had ever faced. To this day I don't know if he fought because he thought he was right, or because he knew the company's actions were so wrong."

■FIGHTING FALCON

On Sept. 22, 2004, OFHEO released results of its continuing investigation. The "Special Examination of Fannie Mae" was a dense 211 pages packed with technical accounting details. But the message was clear: OFHEO accused Fannie Mae of both willfully breaking accounting rules and fostering an environment of "weak or nonexistent" internal controls. OFHEO focused on exactly the issue that the skeptics had earlier noticed, which was Fannie's use of accounting rules to defer derivative losses onto its balance sheet. Except OFHEO said that Fannie hadn't just bent the rules, it had broken them.

What got the most attention, though, was OFHEO's charge that in 1998, when an internal model said Fannie would need to recognize a roughly $400 million expense, Fannie only recognized $200 million. That, OFHEO charged, allowed the company to report earnings of $3.23 per share, which meant that Fannie paid out a total of about $27 million in bonuses. Both the SEC and Justice quickly announced their own investigations.

Two weeks later Falcon and Raines faced off against each other in a hearing before the House subcommittee on capital markets, which was chaired by Baker. Consider the circumstances. Falcon was Fannie's regulator and had leveled serious charges, amounting to fraud, against Fannie Mae. Most CEOs would have seen the wisdom of humility at this point, but Raines showed little. "These accounting standards are highly complex and require determinations on which experts often disagree," he said, adding that "there were no facts" that supported OFHEO's charge that Fannie executives had deferred an expense in 1998 to earn bonuses.

And most of the Democrats present agreed with him. "This hearing is about the political lynching of Franklin Raines," said Congressman William Lacy Clay of Missouri. Massachusetts Congressman Barney Frank said, "I see nothing in here that suggests that safety and soundness are an issue." Other Democrats complained that the mere fact of releasing the report could increase the cost of home-ownership.

"Is it possible that by casting all of these aspersions ... you potentially are weakening this institution in the market, that you are potentially weakening the housing market in this country?" Congressman Artur Davis of Alabama demanded. When Falcon tried to answer, Davis acted like a prosecutor grilling a hostile witness. He wanted a one-word answer: yes or no. "Is that possible?" he asked again.

"I have never seen anyone treated as disrespectfully as Armando Falcon was by the Democrats and by Franklin Raines," recalls one congressional aide. Adds Andrew Cuomo: "I credit him for not folding and not caving and not running, because he took a tremendous beating."

One of the few bad moments for Fannie came when Baker released information showing that over five years, Fannie had paid its 20 top executives a combined $245 million in bonuses. In 2002 its 21 top executives each earned more than $1 million in total compensation. Even the Democrats winced.

Fannie had one last card to play. Back in April, Republican Senator Kit Bond of Missouri, a member of the Senate Appropriations Committee, had spurred the HUD inspector general to investigate OFHEO. (One of Bond's staffers, John Kamark, is a Fannie supporter who plays poker with Bill Maloni, Fannie's former chief lobbyist and current consultant.) Although the report had only been finished the previous day, and wasn't public, it was clear at the hearing that some members of Congress had already been briefed on it.

The report does not put Falcon or OFHEO in a flattering light. It quotes a "confidential source" inside OFHEO saying that Falcon's top deputy would become "almost gleeful" whenever Fannie's stock declined. This same source said that "OFHEO was trying to embarrass Fannie Mae." In other words, OFHEO wasn't just regulating Fannie Mae, it was out to get Fannie Mae. "This makes it difficult to assess the reliability of recent allegations by OFHEO against Fannie Mae," declared Congressman Frank.

It is true that the SEC would never have done some of the things OFHEO did. But OFHEO supporters say the agency had to play hardball. It was an outgunned regulator trying to investigate one of the nation's most politically powerful companies. And Fannie was being Fannie. For instance, one of the complaints Fannie's allies leveled at OFHEO was that it released the results of an ongoing investigation to the public, something no real regulator would do. But there is an explanation. One source close to the events says OFHEO had told Fannie's board that it wouldn't release the report. But the OFHEO people learned that Fannie lobbyists were telling members of Congress that the report was inconsequential and Falcon wouldn't release it because he didn't want to exonerate Fannie. And so OFHEO released the report.

For his part, Falcon refused to be moved by the barrage of criticism from his fellow Democrats. To him the problems at Fannie were reminiscent of the S&L crisis. He told a friend that the Democrats were "so blinded by their loyalty to Fannie that they can't see what's really happening. If they want to repeat history, I won't be part of it."

Wall Street, of course, was every bit as blind. After the hearing, analyst Bob Napoli at Piper Jaffray wrote: "We thought Frank Raines in particular made excellent points countering OFHEO accusations, in some cases directly contradicting OFHEO assertions." Jonathan Gray of Sanford Bernstein wrote that the "allegations lack cogency," and said, "Plausible charges against FNM are immaterial, while material charges are implausible." (And he noted that "a John Kerry victory would improve the political climate.")

And then Frank Raines overplayed his hand one last time. In a highly unusual move, Fannie insisted that the SEC review OFHEO's accounting allegations. Fannie hired the powerful law firm of Wilmer Cutler to help it make its case; Bill McLucas, the lead partner on the Fannie team, was formerly the SEC's chief enforcement officer. The potential danger of this request was obvious: In a worst-case scenario, if the SEC completely sided with OFHEO, Fannie would have to restate earnings going back to 2001. And the restatement would be massive--an estimated $9 billion in losses. Some Fannie people referred to the restatement possibility as the "ultimate penalty." But, in truth, they really did not seem to think that the SEC would rule against them.

■FRANK'S FINALE

At a little after 6 P.M. on Dec. 15, about 30 people--including Raines, three members of Fannie's board, Wilmer Cutler lawyers, Armando Falcon, representatives from KPMG and Deloitte & Touche, and Justice Department officials--piled into a conference room at the SEC's headquarters in Washington, D.C., and seated themselves around a large rectangular table. SEC officials first made it clear that they had not addressed any issues of individual culpability--those investigations were ongoing. Then, chief accountant Donald Nicolaisen announced that the SEC had decided that Fannie did not comply "in material respects" with accounting rules, and that as a result, Fannie would have to restate its results.

Raines looked stricken. One person who was there says it was the first time he'd ever heard Raines's voice waver. "What did we get wrong?" he asked. Nicolaisen held up a piece of paper. If the four corners of the sheet represented what was possible under GAAP, and the center was perfect compliance, he told Raines, "you weren't even on the page." Fannie representatives tried to argue that if they couldn't get it right, no one could. Nicolaisen wasn't having any of it. "Many companies out there get it right," he said.

It was over for Frank Raines. Falcon told the Fannie board that Raines and CFO Howard had to go, and though Raines fought to keep his job over the next week, holding individuals meetings with board members, he had run out of options. On Dec. 21, Raines announced his resignation. "Although to my knowledge, the company has always made good faith efforts to get its accounting right, the SEC has determined that mistakes were made. By my early retirement, I have held myself accountable," he said. Tim Howard also resigned, and Fannie fired its accountant.

After the Enron scandal broke, nobody defended Ken Lay or Jeff Skilling. But in the wake of the Fannie Mae scandal, Raines still had legions of supporters. There are plenty of people who still believe that what's good for Fannie is good for home-ownership--and that the whole thing was little more than a political dirty trick. "They're just not dishonest in any way," says Martin Eakes, who runs the Self-Help Credit Bureau in North Carolina. "It's a little hard for me to swallow that what appears to me to be a hatchet job by OFHEO has basically been validated by the SEC.... You mark my words, you will not find scandal there or fraud."

As for Wall Street, it has its own reasons for defending Fannie, which is still one of the Street's top fee-payers. "The overwhelming majority of FNM's accounting is correct," wrote a Lehman Brothers analyst. "We view this infraction as a speeding ticket, not a capital offense." Bear Stearns analysts concluded that Raines and Howard had been ousted because of OFHEO's "personal animosity toward the CFO and CEO."

A key tenet of the Street's defense of Fannie is that the $9 billion restatement doesn't really constitute an economic loss. It's just an accounting issue, "technical in nature," as one analyst said.

The other view, of course, is that the $9 billion represents losses that Fannie should have taken--but didn't--since 2001. And that in avoiding those losses, Fannie's top executives collected millions in bonuses they didn't earn.

The restatement will put Fannie well below its regulatory capital requirements, which is why the company quickly sold $5 billion of preferred stock. Nothing says more about the Street's continued belief in Fannie than the ease with which it was able to raise that money. In coming months it will have to raise billions more.

Yet the notion that the worst is over may well turn out to be misguided. "Dig deep into what's there and you find more and more," says a person close to the investigation. One possible example: Critics note that Fannie has $9.1 billion of deferred tax assets included in its regulatory capital measure. Most of these assets were generated because Fannie suffered massive losses on its derivatives; they are an offset to future taxes Fannie might owe. But Lawrence Kam of hedge fund Sonic Capital says the inclusion of these assets in regulatory capital is unhealthy--he notes that bank regulators severely restrict the amount of such assets that can be included in a bank's regulatory capital. (Fannie has previously argued that the number is less than $9 billion, and that its regulatory statutes do not limit the inclusion of deferred tax assets in regulatory capital.)

Another question that has been lost in the political wrangling is whether Fannie's business has changed permanently for the worse. Over the past 18 months the growth in Fannie Mae's portfolio has slowed sharply because of competition from banks and hedge funds, which are financing their mortgage purchases with cheap, short-term debt (a technique known as the carry trade). Back in 2002 the spread between the yield of Fannie's mortgage portfolio and its long-term liabilities was 63 basis points. In the second quarter of 2004 it had fallen to two basis points. To keep profits up, it looks like Fannie, which has disparaged the carry trade as too risky, may now be using the strategy itself, which would make it more vulnerable to rising interest rates. The company disputes this analysis, pointing to its one-month duration gap as a sign that it is not taking interest rate risk. Still, Josh Rosner, an analyst at Medley Global Advisors, who has made a string of accurate calls on GSEs, says a diminished spread is "absolutely permanent."

And then there's the question of whether there will finally be new legislation. Senator Richard Shelby vows to try again. "They [Fannie] didn't listen because they thought they could thwart the whole deal, but time is on our side. We're coming back," he says. But the administration may no longer need legislation to force change at the GSEs. If other bad news emerges, if the spreads continue to shrink--there are a lot of things that could happen in the coming months that will force their own kind of reform.

What Fannie and Freddie may not be able to do any longer is to have it both ways. They can't profess to be devoted to the mission of providing affordable housing while generating turbocharged earnings growth. Freddie's new CEO, Dick Syron, concedes that the company won't grow at anywhere near the rates of the 1990s. He also concedes that the company has not done as much as it should have for affordable housing. "If we're going to have special privileges, then we have to do something special," he says. One of Syron's first moves was to redo management compensation to be weighted toward the achievement of affordable housing goals. "No one chartered us to be Goldman Sachs on the Potomac."

Fannie's new CEO, Dan Mudd, also insists that the mission has to come first. "To the extent that this company strays from its mission of financing affordable housing, we start to lose our compass." He also says that the company will begin to listen to its critics, and admits that "there are areas we have gotten arrogant."

But if Washington has learned anything about Fannie Mae, it's to watch what it does, not what it says.

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