All The Devils Are Here: Unmasking the Men Who Bankrupted the World (35 page)

Fannie was just getting started. February 4, 2003, was the day Falcon had set for releasing the report. He had flown to New York to give a speech outlining its findings. As he waited to give the speech, he got a call from the White House personnel office informing him that the administration was about to announce his replacement. It was none other than Mark Brickell,
the former J.P. Morgan derivatives lobbyist. Although Falcon’s term still had a year and a half to go, he dutifully wrote a resignation letter. Not surprisingly, the news coverage of Brickell totally drowned out any coverage of OFHEO’s report. Falcon was humiliated.

And yet, Falcon wound up keeping his job. In part, Brickell said a few too many impolitic things during his confirmation hearings later that year. But more than that, the political winds were shifting. Whereas it had once been in the administration’s interest to play nice with Fannie and Freddie, it was suddenly in the administration’s political interest to show it could get tough on the GSEs. Although there was no love lost between Falcon and the Bush administration, the White House realized that his doggedness—and, for that matter, his anger—could be useful. When Brickell withdrew his nomination, the White House decided to stick with Falcon. The war between the GSEs and the White House was on.

It was the Enron scandal that caused the political winds to change. The Enron scandal spooked the White House; Bush had been friends with Enron CEO Ken Lay and had even bestowed on Lay one of his famous nicknames—“Kenny Boy.” When the administration looked around in the wake of the Enron debacle to see what other potential business scandal might hurt it, it was hard to miss Fannie and Freddie.

The Enron scandal had another, more practical consequence: it caused Freddie Mac to hire a new accounting firm. Freddie’s longtime firm, Arthur Andersen, had been forced out of business after being indicted for its role in the Enron debacle. In the fear-ridden business environment of 2002, Freddie’s new accountants at PricewaterhouseCoopers scrubbed Freddie’s books and found them seriously wanting. It forced Freddie Mac to restate its earnings going back years. In January 2003, around the same time OFHEO was sending around its report on systemic risk, Freddie Mac announced that it would be restating its earnings “materially” for at least the past two years. The restatement, when it was unveiled six months later, was a stunner: since 2000, Freddie had
understated
its earnings by some $5 billion. (The purpose of the understatement had been to produce smooth earnings growth.) Freddie’s entire senior management team had to step down.

Fannie responded to Freddie’s problems with astonishing—yet unsurprising—self-righteousness. Raines publicly accused Freddie of causing
“collateral damage.” The frequently asked questions section on Fannie’s Web site 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.”

The Freddie restatement was yet another humiliation for Falcon. Not long before Freddie revealed that it would have to restate its earnings, Falcon had publicly pronounced the company’s internal controls “accurate and reliable.” Furious at having been so wrong about Freddie Mac, Falcon decided to launch an investigation to see if Fannie had the same problems. OFHEO hired Deloitte & Touche, the big accounting firm, to dig into Fannie’s books.

The White House piled on, yanking Bush’s presidential appointees from the GSEs’ boards. Then, in the fall of 2003, it put its weight behind a bill to toughen regulation of the GSEs—a bill that Fannie’s lobbyists managed to water down, causing the White House to pull its support. (The bill failed.) Around the same time, John Snow, the new Treasury secretary, even called for a receivership provision should Fannie or Freddie become insolvent. Amazingly, there was no real procedure in place for reorganizing the GSEs in the event of a bankruptcy. The larger implications were clear: the government was signaling that it would not stand behind Fannie and Freddie’s debt.

Some White House aides began to jokingly call the campaign against the GSEs “Operation Noriega,” after the strategy the United States used to roust former Panamanian strongman Manuel Noriega. (It bombarded him with loud rock music.) The administration helped spur anti-Fannie and anti-Freddie op-ed columns and editorials. It also got HUD in the act, which announced that it would begin steadily increasing the GSEs’ affordable housing goals from 50 percent of their purchases to 56 percent. “It was consciously punitive,” says a former Fannie executive. The real significance wasn’t so much the percentage increase as it was the fact that the GSEs, for the first time, had specific single-family goals in metropolitan areas. It could no longer use apartment buildings or refinancings to get around the rules. Dow Jones got a copy of an e-mail a Fannie staffer had written: “You just cannot appreciate how truly bad this is—from a purely Republican standpoint,” it read, in reference to the new, tougher goals.

Even Greenspan got involved. He and Raines were social friends, but he simply didn’t buy Fannie’s rationale for its enormous mortgage portfolio. “The explanation they gave was utter nonsense,” Greenspan later said.

The White House assault seemed to embolden the Fed chairman, who began speaking out regularly against Fannie and Freddie. His most pointed
comments came in 2004, when he told Congress, “To fend off possible future systemic difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are required sooner rather than later.” (Fannie, of course, responded in kind; even Greenspan wasn’t immune.)

In the fall of 2004, OFHEO announced the preliminary results of its investigation. Fannie, the agency said, had willfully broken the complex accounting rules surrounding derivatives to facilitate smooth earnings growth. Whereas Freddie had understated its earnings, OFHEO charged Fannie with overstating them and willfully breaking accounting rules.

The clear implication was that Fannie Mae was cooking its books so that the executives could line their pockets. During the previous five years, the company had, indeed, doubled its earnings just as Raines had promised when he first became CEO, generating tens of millions of dollars in management bonuses. OFHEO was now saying that much of that profit was basically the result of accounting fraud. OFHEO also said that Fannie, under Raines, had fostered an environment of “weak or nonexistent internal controls.” Raines responded in a highly unusual way. Throwing down the gauntlet, he demanded that the SEC reinvestigate the company’s accounting.

Fannie had one more trick up its sleeve. An aide to Kit Bond, a Republican senator from Missouri, played poker with Bill Maloni, Fannie’s top lobbyist. Bond sat on the appropriations committee that oversaw OFHEO. Before the results of the OFHEO investigation were made public, Bond sent a letter to HUD’s inspector general, requesting that it investigate not Fannie or Freddie, but
OFHEO
. (A draft of Bond’s letter, which was nearly identical to the letter that was actually sent, was later found on Fannie Mae’s computer system.) Separately, the committee also called for $10 million of OFHEO’s budget to be withheld until Falcon was removed.

There is no question that OFHEO actions were well beyond the bounds of normal regulatory behavior. Like the White House, it had gone to war with Fannie Mae, leaking damaging information to the press and actively seeking to embarrass the GSEs. To put it bluntly, it was out to get Fannie. Which is precisely what the HUD inspector general wrote in his report.

The inspector general’s report was supposed to be confidential. But Fannie had a long history of strategic leaks itself. Sure enough, just before a key hearing, it managed to get the HUD report into the hands of members of Congress. Not surprisingly, when the hearing began, the committee members went after OFHEO and Falcon instead of Raines.

“This hearing is about the political lynching of Franklin Raines,” said
Congressman William Lacy Clay, an African-American Democrat from Missouri.

“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?” chimed in Congressman Artur Davis, Democrat of Alabama.

In responding to the OFHEO charges, Raines was unapologetic. “These accounting standards are highly complex and require determinations on which experts often disagree.” A congressional aide would later say, “I have never seen anyone treated as disrespectfully as Armando Falcon was by the Democrats and Franklin Raines.”

Raines, however, had overplayed his hand. In demanding that the SEC look at Fannie’s account, he assumed it would side with the company rather than its regulator. But he had calculated wrong. On December 15, 2004, at a meeting that included Raines, Falcon, and Justice Department officials, the SEC’s chief accountant, Donald Nicolaisen, announced that Fannie Mae’s accounting did not comply “in material respects” to the accounting rules.

Raines was flabbergasted. “What did we get wrong?” he asked, his voice wavering. Nicolaisen held up a sheet of paper. If the four corners represented what was possible under GAAP accounting rules and the center was perfect compliance, he told Raines, “you weren’t even on the page.” Fannie’s representatives tried to argue that if they couldn’t get it right, no one could. Nicolaisen wasn’t having it. “Many companies out there get it right,” he said.

The restatement was astounding. OFHEO alleged that Fannie Mae had overstated its earnings by $9 billion since 2001, representing a staggering 40 percent of its profits. (Ultimately, Fannie restated its earnings by a “mere” $6.3 billion.) OFHEO also reported that Raines had been paid $90 million between 1998 and 2003—$52 million of which was directly tied to Fannie’s meeting its earnings targets. Raines and his number two, CFO Tim Howard, were forced to step down. Fannie agreed to pay a $350 million civil penalty to the SEC and $50 million to the Treasury. As part of a consent decree with OFHEO, Fannie agreed to hold 30 percent additional capital and stop growing the portfolio. Freddie agreed to the same measures.

There are many former Fannie executives, including Raines and Howard, who will go to their graves believing that the entire scandal was drummed up by OFHEO and the White House solely to bring Fannie down. In August 2006, the Justice Department took the rare step of publicly announcing that it was dropping its investigation into Fannie Mae’s accounting; no criminal
charges were ever filed. For that matter, the SEC never filed civil charges against any individual, either. And an investigation by the law firm Paul, Weiss exonerated Raines of any wrongdoing. While OFHEO settled with Raines and Howard, it did so on terms that can only be described as incredibly generous. The bulk of Raines’s settlement—some $25 million—came from stock options he had received that were so out of the money they’d likely never be worth anything anyway. Raines today describes the accounting scandal as “a dispute among accountants,” because Fannie’s outside accountants had agreed with its original interpretation of GAAP. Derivatives accounting
is
incredibly complex, and the line between sloppiness, aggressiveness, and fraud is often difficult to discern. The fact that the SEC—which had no dog in the fight—agreed with OFHEO suggests that the scandal was real. The fact that the Justice Department declined to prosecute suggests that maybe it wasn’t.

Whichever the case, Raines had no one to blame but himself. CEOs of regulated companies may grouse privately about their regulator, but few are so foolish as to let the relationship become so openly hostile. Whether because of sloppy accounting or something less excusable, Fannie gave its regulator enough rope to hang it with. Having abused its regulator for years, how could Fannie expect OFHEO not to use that rope?

Here’s the stunning thing, though: despite scandals at both Fannie and Freddie, despite a Republican White House, despite some powerful enemies in Congress—like Richard Baker and Senator Richard Shelby, the chairman of the Senate banking committee, even despite the importunings of Alan Greenspan—Congress and the administration took no steps to impose new regulation on the GSEs. That wouldn’t happen until much later.

“Can you imagine if they all had said, ‘Enough is enough. We’re sending legislation to the Hill to privatize Fannie and Freddie and end their beneficial status with the federal government?” asks a former Fannie lobbyist. “At the time, the Republicans never believed they could get that done. And on the other side of the political spectrum, Democrats like Barney Frank and Senator Chris Dodd would never have supported such an effort, because the companies would no longer be bound to support affordable housing. You were never going to get to the middle.”