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Audit Freddie and Fannie

Posted by Larry Doyle on December 30, 2009 12:16 PM |

Who will reveal the truth and consequences embedded in the operations of Washington’s newly designed slush funds housed within Freddie Mac and Fannie Mae? The Washington Way all too often pays off those who promote the administration’s interests (both Republican and Democrat alike) while sticking future generations with an ever larger bill.

Is slush fund too harsh a characterization for a Washington-issued blank check? In my opinion, a blank check in Washington has never been anything other than that.

Ron Paul (R-TX) has created quite a stir in 2009 given his continual calls to audit the Fed. Who in Congress will call for the same treatment for Freddie and Fannie?

Let the record show that on December 30th, Sense on Cents is issuing what will be the first of many calls to audit Freddie Mac and Fannie Mae. Why am I calling for an audit of these entities?

Freddie and Fannie are de facto wards of the state, but their operations are housed off Uncle Sam’s balance sheet. As such, who will keep them accountable? Who will properly monitor their operations? Who will question their business practices?

I have no doubt that the blank check provided to Freddie and Fannie on Christmas Eve is nothing short of the continuation of Uncle Sam’s quantitative easing program currently managed by the Federal Reserve. Recall that the Fed’s quantitative easing program to purchase mortgage-backed securities is scheduled to end on March 31, 2010. At that point, if not prior, I fully expect the internal investment portfolios housed within Freddie and Fannie to reenter the marketplace and become the biggest buyer of mortgages.

Readers may wonder why I am so concerned about this activity. Look for economists, market analysts, and political pundits to promote this activity as both necessary and beneficial for the American housing market. This misinformed crowd believes Freddie and Fannie can issue debt at favorable rates, use the proceeds to purchase mortgages at prevailing rates, and make big, fat, juicy returns. Look for this overly simplistic analysis to be fed to the American public a lot over the next quarter and throughout 2010.

If it were that easy, and that is the Freddie/Fannie business model, why and how did these entities lose so much money? Don’t listen to those who would say it is sub-prime or Alt-a exposures that brought these companies to their knees. The fact is, Freddie and Fannie have not only mispriced risk across their core mortgage operations for a long time but continue to do so. The blank check is a clear indication to me that the mispricing of this risk is about to be increased dramatically. In my opinion, this activity is extremely unhealthy for American housing over the long haul. Why? Let’s navigate.

Freddie and Fannie are now clearly in the too big to fail camp. The beneficial financing rates Freddie and Fannie can access in the capital markets provide a cheap source of funds to run their operations. Those funds are used to run the day-to-day operations. For a long time, a major component of the operations was the purchase of mortgages. The risks in purchasing mortgages are threefold:

1. Simple interest rate risk of rising interest rates and thus falling values on the mortgage-backed securities.

2. A greater risk is the prepayment risk embedded in each mortgage. Any homeowner in our country can choose to refinance his mortgage, or not, whenever he so chooses. That risk makes it challenging for an investor to determine and manage the effective duration of his portfolio. Fannie Mae was exceptionally horrendous at managing its effective duration risk.

3. The greatest risk is the credit risk of the underlying mortgages. This risk of default is guaranteed by Freddie and Fannie.

All of these risks are exacerbated by the blank check provided to Freddie and Fannie. That check will keep mortgage rates artificially low. What is wrong with that? It promotes borrowing from those who truly can not afford a mortgage. It promotes the purchasing of homes otherwise outside a borrower’s price range. It detracts from appropriately risk-based and risk-priced private pools of capital entering the market. It forces losses onto the taxpayer which would and should otherwise be borne private entities.

Ultimately, the transferral of risk to the American taxpayer is nothing more than a massive redistribution program.

If Washington truly wanted to support the economy, how about they issue a blank check in the form of small business loans to companies that create real jobs? Issue a blank check in the form of funds to entities which will provide credit cards at a mere 10% rate instead of the usury charged by our large Wall Street banks.

This blank check for Freddie and Fannie must be tracked.

America deserves an independent audit of Freddie and Fannie now and on a going forward basis.

I’d love to hear from those who disagree with my assessment. Please regale us with why Freddie and Fannie should not be subject to an aggressive and independent audit.


  • Where’s Franklin Raines

    Worst Justification of the Decade

    Can’t you just picture Franklin Raines sipping a cocktail and yachting with his tens of millions in illicit compensation from cooking Fannie’s books…!!

  • Mike


    I think if we audited Fannie, Freddie and the Fed we would find that they have sustained much greater losses than actually disclosed to the public. It would be completely out in the open to our nations creditors that we have no chance at paying back our actual debt.

    What would happen if Fannie and Freddie didn’t get any support and had to file for bankruptcy? Would it be worse than this?

    • Larry Doyle


      I am not calling for these entities to be allowed to fail but I am also not willing to provide a blank check which is a clear indication that Uncle Sam is going to utilize them as a piggy bank or dare I say a repository for all sorts of garbage and unmitigated losses.

      Freddie and Fannie should provide a service in which they bundle mortgages into securities. The mortgage rates should be set in the private market. If rates go up so be it. We will survive and heal much sooner.

      • Mike

        Out of curiosity, what would happen if they failed?

        Would all the homeowners that owe them money be given a free ticket?

        • Larry Doyle

          No, homeowners typically do not even know if their mortgage has been sold to Freddie and Fannie and then bundled into a mortgage-backed security. Homeowners make their mortgage payments to a servicer who passes the payment along.

          If Freddie and Fannie failed, all shareholders would be wiped out. Creditors would be paid some percentage of their holdings out of bankruptcy proceedings. The losses would be systemic meaning that Freddie’s and Fannie’s failure would precipitate significant losses and potential failings for other entities.

          These losses are embedded in Freddie and Fannie but are being transferred to taxpayers instead of being incurred by shareholders and creditors, including investors.

          Again, I am not saying that F/F should necessarily be allowed to fail but I do think the mortgage finance business should be expedited toward the private market and away from these entities. To the extent that that transition generates losses and pain, we’re going to be faced with it at some point. Sooner rather than later and more by those benefiting than taxpayers strikes me as a healthier long term approach.

          To that end, F/F should be audited now and on a regular basis.

  • Mike

    I always thought that Goldman Sachs holding of AIG credit default swaps was a huge reason as to why AIG received as much bailout money that they did…

    I wonder what important people or entities that Fan and Fred owe money to which has compelled this blank check policy.

    • Larry Doyle

      All the Wall Street banks have tremendous exposure, especially the large interest rate derivative players JPM, Bank of America, and Citi.

  • coe

    Somewhere along the way, the activities (dare I say the publicly condoned mission?) of Freddie and Fannie took a very dangerous and ultimately debilitating turn in the road. Is it coincidental or cause and effect that it just happened to be linked to those institutions becoming more private-like in issuing stock and trying desperately to pump the earnings machine, while remaining public-like in terms of their advantaged agency funding rates? Or parhaps it might have something to do with the misguided notion that individuals are better off in a home that they clearly cannot afford (we all watched and some cheered as the “ownership meter” was climbing from appx 60% toward 70% – did people who made $100K a year truly believe they should be living with a $500K/$1MM mortgage – madness!). And, to add fuel to the fire, the agencies did guaranty non-traditional (i.e. RISKY!) forms of mortgages and they did allow (that’s too passive, they actually aggressively ballooned) their own investment portfolio purchases to bulge at the seams…Why? Because the compensation incentives for the executives/management teams in command of the ships directed them to take on greater risks – that is not shocking – it’s human nature at work. Of course they finessed the “risk management” around the byzantine accounting standards and loopholes. And, if the truth be known, they, as did all other sophisticated capital markets participants, believed in the two most flawed fallacies recently revealed – that housing prices would continue to rise to cover the many credit exposures absorbed, and that there would always be an escape hatch forged by the liquidity in the secondary markets. Who says 50,000,000 ants can’t be wrong in heading to a picnic that never ends?

    So, to your point, LD…should they be audited is less the issue (we already know the answers we will find, don’t we?!) than the belief that they should be reined in and operate within a real markets context, and not this artificially subsidized limbo that the current administration is sponsoring/promoting…haven’t we learned anything from the past two years about volatility and risk? I’ve never subscribed to the theory that a problem delayed is a problem solved and it won’t work for the GSEs or the taxpayers either. It wouldn’t hurt to find/install better management at Treasury and the GSEs either (call that my cheap parting shot)!

    • Larry Doyle


      You have an uncanny ability of providing a comprehensive and clear review and preview of many corners of our economic landscape.

      Do you think there is a chance that the powers that be might want to stuff some of the toxic assets still residing on Wall Street into Freddie and Fannie?

      • coe

        That’s a good question, LD…my instinct tells me that they will absorb some of the remaining “problem assets” – yet I think those will have to be somewhat limited to the underperforming credit paper in securitized form…and there is definitely more to go as every Friday we watch a half dozen banks slip over the edge into the clutches of the resolution death squad of the FDIC (talk about “unintended consequences” – the toll on the communities where these banks reside and on the numbers of people who are directly and indirectly hurt by the resulting unemployment is tragic and, in my opinion, quite avoidable)…I cannot envision a scenario where the GSEs become the holding tank for raw loans/CRE (of course I have been wrong before)…herein lies an enormous other can of worms – why is it that the FDIC and the regulators seem to be stiff-arming the Private Equity and Hedge Fund investors from participating in supporting the banking industry by making it difficult to pert near impossible for them to inject “capital” in regional and community banks BEFORE they fail? Why aren’t we pursuing the “open bank assistance” playbook? What about the “good bank/bad bank” approach used successly in other crises? Lord knows that once the FDIC accepts the Pepsi challenge to accept/repot resolution assets, the pricing is adversely affected. Yet, time and time again, we get the press releases that Bank A will cost the FDIC fund (i.e. the taxpayers!) $200MM here, Bank B $1B there, Bank C $45MM yet somewhere else…it seems to me that your navigation compass will have rich material in 2010 in tracking both the developments at the GSEs as well as this “FDIC resolution” story line…as they say in the commercial, “stay thirsty, my friend”…all the best to you and yours…you are doing a great job

        • Larry Doyle


          There will certainly be no lack of material in 2010. A Bloomberg commentary has a former general counsel of the Treasury, Peter Wallison, estimating the losses at Freddie and Fannie will top $400 billion.

          That’s real money…and it is yours and mine.

  • TeakWoodKikte

    LD, great educational insights on this topic.

    I am increasingly cynical. From a politcal stand point, if F/F was audited it expose a level of corruption and pol’s connected to it, that would make Enron, AIG and Bears combined, look like childs play.
    BO needs to keep his ground game intact and the connection to funding these “troops” is based on the money that flows through housing and community development. Combine that with the risk exposure to the Wall street money that Obama needs as well, to get re-elected, I can not see that anyone would write a carte blanche check and expect it to be audited.

    Main street will suffer greatly next year, which really pisses me off, because I am normally an optimist. Commercial real estate is a dam about to break and the amount of goverment intrusion into the market does not bode well.
    As this decade ends and a new one begins, I offer my deeply felt gratitutude, Larry, for the exellent work you do. I wish you and yours all the best in the coming year.
    Stay Frosty. 🙂

    • Larry Doyle


      Thanks for your ongoing support and interest in my work.

      I echo your sentiments about the ongoing developments in both Washington and on Wall Street.

      Happy New Year to you and yours as well.

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