Taking On Fannie And Freddie Without stronger regulation, argues Rep. Richard Baker, the mortgage giants present a huge market risk
By Ron Insana; Richard Baker

(MONEY Magazine) – Rep. Richard Baker is a driven man. The mission of this firebrand Louisiana Republican: to ensure that Fannie Mae and Freddie Mac, two of the world's largest financial institutions, aren't on a collision course with disaster. Baker, a minister's son and amateur astronomer, goes so far as to compare the potential havoc that, in his view, inadequate oversight of the two mortgage titans could wreak on financial markets and taxpayers to the fallout from an asteroid hitting the earth.

Baker, chairman of the House subcommittee that oversees the two congressionally chartered "government-sponsored enterprises" (GSEs), has for years been voicing concerns about Freddie, formally known as the Federal Home Loan Mortgage Corporation, and Fannie, the Federal National Mortgage Association. A recent internal investigation of accounting at Freddie Mac proved his concerns about the $34 billion (market capitalization) company to be well founded, with allegations of lax internal controls and questionable accounting maneuvers. Rep. Baker spoke with me about the changes he hopes to bring about this year.


RON INSANA: You've been sounding the alarm about the regulation of these companies for some time now. What have been your main concerns?

REP. RICHARD BAKER: You might remember in the late 1970s that Fannie Mae was insolvent from a technical accounting perspective, and it was only as a result of some creative congressional accounting that they were able to grow their way out of that difficulty--not unlike many in the savings and loan industry in the 1980s. To a great extent, Fannie Mae and Freddie Mac are now super S&Ls, holding billions of dollars of mortgage assets in their portfolios. Over the past decade, they've enjoyed extraordinary growth, but at the same time have enhanced the risk in their portfolios.

For many years, for example, they'd bundle mortgages together, securitize them and sell them off as mortgage-backed securities. That takes the mortgages off their books and spreads the risk across the market. Now, in increasing amounts, they're buying back their securities, bringing that risk back onto their balance sheets to benefit their portfolios because of the higher yields generated by those investments.

I have concerns that if appropriate resources aren't allocated for internal risk management, the consequences will be far more severe than just a real estate slowdown. The losses would fall quickly through the capital these companies have and down to shareholders and taxpayers. These companies have some of the lowest capital margins of any financial institution in the nation, yet, at the same time, they are two of the largest. The concern is that if something doesn't work out the way they predict, the American taxpayer could be called on to pay off the debt in some sort of bailout.


Q. What was your reaction to the report about Freddie?

A. The continuing disclosure of the facts associated with the financial irregularities is more than distressing. There is clear evidence that the management of this highly regarded company went to great extremes to manipulate the public image of the corporation's performance. This occurred for years, at financial levels difficult to imagine, while Freddie Mac's regulator repeatedly stated its approval of their performance.

Q. Freddie Mac will restate earnings by as much as $4.5 billion--though, granted, they were pushing out revenues into future quarters, so the revision was up, not down. Why aren't we hearing about civil or criminal investigations?

A. In my judgment, shareholders and analysts are looking past the reports and looking directly to the U.S. Treasury because there still is, in their mind, very little credit risk with these companies--even if there was business impropriety or outright illegality. Since the firms have a congressional charter and play such a crucial role in the housing markets, the market acts as if their securities are backed by the full faith and credit of the U.S. government. And that's the point at which I am driving. I want the Street to look at the company's business fundamentals and make judgments about credit quality absent taxpayer guarantees.

Q. By the same token, though, the Department of Justice and the Securities and Exchange Commission aren't on fire to do anything about this, right?

A. There's a concern by many that if an inappropriate regulatory action is taken it could hurt one of the strongest legs of the economy, which has been the real estate boom. If it could be alleged that any regulator took an action which in some fashion damaged the secondary mortgage market and slowed down sales of homes, that would be a very bad political thing to do.

Q. It wouldn't be a good economic thing either, given the fragile nature of this recovery, right?

A. Correct. But I'd point out that neither of the bills I've introduced, one years ago and one in recent months, has negatively affected the mortgage market. Stock prices may have been impacted due to some realization about political risks, but interest rates have not ever been adversely impacted by discussing GSE governance.

Q. If either Freddie or Fannie were to implode, what size problem do we have?

A. Let me give you a good explanation by looking at financial institutions insured by the U.S. government. Those institutions--banks, savings and loans, credit unions--are required to maintain a certain level of regulatory capital. That is money put away in the sock drawer for a day when the institution has difficulty. It can use that capital to pay off any unexpected losses.

As of March 31, 38% of commercial banks insured by the Federal Deposit Insurance Corp. had 100% or more of that capital in debt that was directly issued by GSEs. If a GSE had its credit rating downgraded, it would have a dramatic, instantaneous impact on the entire financial marketplace because of the implications to capital held at those institutions.


Q. By the same token, it seems that there's a "too big to fail" doctrine for the GSEs. So how would you regulate, or more accurately, re-regulate, these two?

A. We'd give independent funding to the regulator that's created. The current regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), is the only finance regulator that has to come to the U.S. Congress and get approval for its budget, rather than simply assessing the regulated party. Second, we need to give them the tools that other financial regulators have. If, for example, a bank is engaged in risk-taking activity that a regulator thinks is inappropriate, it can go into that bank and issue cease and desist orders before that activity affects the bank's capital. Under current rules, the GSE regulator can't act until there is a material degradation of capital, which is clearly a different standard.

Q. I understand you've not been very popular with the White House for your stance on Freddie Mac and Fannie Mae.

A. It's not something many homeowners or taxpayers are even aware of, so if you make the change and provide for adequate safeguards, that's not something you can go home and run a 30-second ad about. It's a difficult policy question with only political downside.

Q. Why are you taking it on?

A. Taxpayers don't have any idea what these enterprises do, how large they are or the potential risks. Since we created these enterprises, I feel it is the direct responsibility of Congress to take action to protect taxpayers. I'll be shocked if a new regulator is not legislated for by the end of this session.