This is an adaptation from "Reckless Endangerment", an exploration of the origins of the recent financial crisis, by Gretchen Morgenson and Joshua Rosner. The book was published Tuesday by Times Books. This excerpt examines how Fannie Mae, the government-sponsored mortgage giant, took on greater risks in the years leading up to a taxpayer bailout -- under the guidance of its CEO, James Johnson, and with the support of Congressional defenders, like Barney Frank. This is the last of three excerpts.
In the summer of 2008, as the financial crisis gathered steam, Barack Obama, the putative Democratic presidential nominee, began the crucial search for a vice presidential candidate. The man he chose to lead his effort was James A. Johnson, the former chief executive of Fannie Mae and one of the most powerful men in Democratic circles in Washington.
But on June 11, before Johnson had gotten far in the vetting process, he resigned from the committee. News that he had received $7 million in cut-rate mortgage loans from Countrywide Financial prompted the resignation.
It was a rare trip-up for Johnson, a consummate Washington insider who had advised John Kerry in his run for the presidency, run Walter Mondale's failed presidential bid and enjoyed, as he still does, a prestigious post as a director at Goldman Sachs.
But for many who knew Johnson and had watched him work his power base over decades in the nation's capital, it was paradoxical that a raft of sweetheart mortgages from Countrywide had driven him from the Obama A-list. Indeed, Johnson's ties to the burgeoning financial crisis were far greater than a few Countrywide loans. They arose from his eight years at the head of Fannie Mae, the mortgage finance giant that became taxpayer-owned in September 2008. Presiding over the company from 1991 to 1999 placed him front and center in the nation's homeownership push, an effort that would bring about the worst financial debacle since the Great Depression.
And yet Johnson has largely escaped scrutiny in the aftermath of the crisis. This is surprising because under his direction, Fannie Mae capitalized on its government ties, building itself into the largest and most powerful financial institution in the world. In 2008, when the colossus fell, it required more than $100 billion in taxpayer backing to keep it afloat. Fannie Mae became the quintessential example of a company whose risk-taking allowed its executives to amass great wealth -- but when those gambles went awry, the taxpayers had to foot the bill.
Beginning in the early 1990s, Johnson's position atop Fannie Mae placed him astride Washington and Wall Street, providing him with an extremely powerful policy tool to direct the nation's housing strategy. In his hands, however, that tool was a cudgel. With it, he threatened his enemies and regulators while rewarding his supporters. And, of course, there was the fortune he accrued.
Perhaps even more important, Johnson's tactics were watched closely and subsequently imitated by others in the financial industry interested in creating their own power and profit machines. Fannie Mae led the way in relaxing loan underwriting standards, for example, a shift that was quickly followed by private lenders. Johnson's company also automated the lending process so that loan decisions could be made in minutes and were based heavily on a borrower's credit history, rather than on a more comprehensive financial profile as had been the case previously.
Eliminating the traditional due diligence conducted by lenders soon became the playbook for financial executives across the country. Wall Street, always ready to play the role of enabler, provided the money for these dubious loans, profiting mightily. Finally, Fannie Mae's aggressive lobbying and its methods for neutralizing regulators and opponents were also copied by much of the financial industry. Regulators across the country were either beaten back or lulled into complacency by the banks they were supposed to police.
When Johnson became chief executive of Fannie Mae in 1991 the tone at the top of the company began to change from that of a sleepy utility to a political machine, according to people who worked there at the time. Under Johnson, Fannie's primary goal changed from buttressing the mortgage market when necessary to protecting -- at all costs -- the company's government ties and the riches that sprang from them.
Because the company was perceived to be at least implicitly backed by the government and would be rescued by it if necessary, Fannie Mae found it easier and cheaper to raise money than its competitors. And it routinely claimed that it passed along every penny of its cost savings to homebuyers in the form of lower mortgage rates. This allowed the company to argue that any change in its status would result in higher housing costs for everyday Americans.
It wore the claim like a coat of armor, protecting itself from critics' slings and arrows. Only later would it emerge that the company kept billions of dollars -- at least one-third of the government subsidy -- for itself each year. Fannie dispensed this money to its executives, shareholders, and friends in Congress.
Fannie Mae and its sibling Freddie Mac were regulated by the Department of Housing and Urban Development. Not much of a watchdog, its oversight of Fannie and Freddie was a part-time arrangement -- only a handful of people at the agency dealt with matters involving the companies, and they juggled other duties as well.
But in the aftermath of the savings and loan crisis, the days of part-time regulators for Fannie appeared to be numbered. After paying out millions to clean up failed savings and loans, Congress was considering legislation to protect taxpayers from potential losses at Fannie and Freddie.
Confronting the reality that his company might soon be dealing with a much more energetic regulator and significantly higher capital requirements, Johnson went to war on two fronts. One attack was to be conducted very much in public. The program to advance homeownership was a quintessential "white hat" issue, in Washington parlance. Johnson's launch of a high-level public relations campaign to turn renters into homeowners would put a friendly face on Fannie Mae, an enigmatic entity that was neither bank nor mortgage lender and not quite a government agency either.
Johnson's other battlefront, designed to protect the company's government benefits, would occur behind the scenes, in the halls of Congress. The sunny public relations campaign about how Fannie Mae helped homeowners would provide cover for the company's backroom dealings, through which it subdued critics and showered money and favors on supporters.
A major recipient of Fannie Mae's largess, albeit indirectly, was Barney Frank, the combative Democrat from Massachusetts. He was a member, and later the chairman, of the House Financial Services Committee, one of the most powerful on the Hill, charged with oversight of "all components of the nation's housing and financial services sectors." The committee also watched over regulators such as HUD, the Federal Reserve, and the Federal Deposit Insurance Corporation.
Fannie Mae was one of the committee's top priorities. As such, its members were targeted by the company for special treatment if they were supporters -- and punishment if they were not.
Frank was a perpetual protector of Fannie, and those in his orbit were rewarded by the company.
In 1991, for example, Fannie Mae hired Herb Moses, Frank's partner and a recent graduate of the Amos Tuck School of Business at Dartmouth. Frank praised Moses' qualifications in a conversation with Gerald R. McMurray, the company's vice president for housing initiatives who had for decades been staff director of the House Banking Committee's subcommittee on housing and community development.
In an interview, Frank said that he was an advocate for his partner because his partner was well-qualified.
"Herb had been an economist with the Department of Agriculture and he went and got an M.B.A. from the Tuck School and was interested in a job," Frank said. "I talked to Jerry McMurray and said: 'Herb's a very good economist and has a business degree.' "
Almost immediately, Moses was being interviewed by a throng of Fannie Mae executives. A former company executive who first met Moses as he went through the interview process at the company recalled: "Barney wanted him to have a job at Fannie Mae so the word was Johnson wanted him hired. He was just getting out of school and we all sort of bid for him. Ultimately, we chose him to be in our targeted community affairs group, the people who were looking for ways to increase our footprint."
Moses' title was assistant director for product initiatives and two of his projects involved relaxing Fannie Mae's restrictions on home improvement loans and small farm mortgages. He stayed at Fannie Mae for seven years.
In late 2010, Frank was asked whether Fannie's hiring of Moses had put him in a conflicted position as a legislator voting on matters relating to the company. "I don't think it influenced me at all," he said. "I was not totally engaged with Fannie Mae and Freddie Mac."
But the record shows Frank exercising a deep and abiding interest in defending the companies as Congress was crafting the 1992 legislation that would protect taxpayers against losses and ensure the company's safety and soundness in the future.
During a congressional hearing that year, Robert D. Reischauer, director of the Congressional Budget Office, voiced his concern that taxpayers might be left holding the bag if Fannie tumbled: "Making sure that Fannie and Freddie are entities that are independent, that have some visibility, that have safety and soundness as their prime objective, I think, is a way to ensure that the taxpayer is protected at those times when the klieg lights go off."
This comment triggered so fierce and unrelenting a cross-examination of Reischauer by Frank that Henry B. Gonzalez, the subcommittee chairman, had to admonish the Massachusetts congressman to let the witness answer.
Frank fumed that concerns about safety and soundness of Fannie and Freddie were overdone. "The focus on safety and soundness to the exclusion of any concern about their mission suggests to me that what we're going to get is a result where safety and soundness become, not the primary but the exclusive focus at the sacrifice of our ability to do housing," he said.
In 2010, however, after concerns about the companies' safety and soundness had been proven justified, Frank said: "I really have no recollection of that '92 Act."
Fannie Mae also made $75,000 in contributions to a Boston nonprofit group, the Committee to End Elder Homelessness, cofounded by Elsie Frank, the congressman's mother. The company also awarded its "Fannie Mae Maxwell Award of Excellence" at least twice to the group. A newsletter issued by the Committee to End Elder Homelessness thanked Frank for "working behind the scenes to open many doors for us to help achieve our goal."
Whenever concerns were raised about Fannie growing too large and potentially perilous to taxpayers, Frank would defend the company vociferously. During a House Financial Services hearing in 2003, Frank and the company's other favored members of Congress maintained that the company and Freddie Mac presented no potential harm to taxpayers. "The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see," Frank said. "I think we see entities that are fundamentally sound financially."
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As Congress mulled Fannie's future, Johnson worked feverishly to ensure that new regulations would be weak and malleable. He also kept a close eye on Fannie's bottom line and on his own paycheck.
For years, Fannie Mae's compensation structure had been conservative, with executive pay linked to a wide range of performance measures. These metrics included how well the company managed its costs each year and its return on assets, a calculation of how much the company made on the loans it held on its books.
After Johnson took over the company, Fannie Mae's executive pay structure changed. Compensation became tied almost solely to earnings growth. Salaries were never that large at Fannie, its former executives said, but stock grants and bonuses could make its executives wealthy indeed.
The shifts in Fannie Mae's pay structure had a clear, measurable effect. During Johnson's years at the company -- between 1993 and 2000 -- the incentive pay handed to Fannie executives annually more than quadrupled, rising from $8.5 million to $35.2 million.
When Fannie's executive pay scheme was threatened by regulations that would require the company to maintain a heftier financial surplus to protect it from downturns in its business, Johnson sprang into action.
Case in point: The Federal Housing Enterprises Financial Safety and Soundness Act of 1992, which was meant to protect taxpayers from potential losses if Fannie or Freddie got into trouble. In addition to proposals for new capital requirements, the law also created two separate overseers for the companies.
Fannie exploited relationships it had forged over the years on Capitol Hill to make sure that the law wouldn't be hazardous to the company's expansion plans.
In September 1992, for example, Texas Congressman Henry Gonzalez withdrew the new regulatory bill from the House floor as it was about to be debated. Gonzalez did so "to allow more time for Fannie Mae to pursue changes in the bill," a staffer told The New York Times. Those changes involved capital requirements; Johnson believed the bill, as written, gave too much discretion to regulators on such matters.
Fannie also got a weak regulator inside the Department of Housing and Urban Development despite calls from the Government Accountability Office and others to put the company on a tighter regulatory leash.
It soon became clear that Fannie Mae had scored a major financial and regulatory win with the passage of the legislation. Even those on Wall Street took note of Johnson's feat. Jonathan Gray, an analyst at Sanford C. Bernstein and Company, a respected research firm in New York characterized Johnson's role in formulating the legislation as the executive's finest moment. It "really created Fannie Mae as a growth stock," he said.
That feat would translate to immense paydays for Johnson and his high-level cronies. Indeed, over his nine years at the company, he took out roughly $100 million in pay.
His maneuverings came as no surprise to those who knew Johnson. As he had once told a reporter, "I'm not big on losing. Somebody may have mentioned that to you."
Johnson's legacy at Fannie was potent: in laying the groundwork that he and his successors followed at the company, he insured that Fannie had relatively lax oversight and thin financial cushion to fall back on when losses arose -- as they did in 2008, when taxpayers were forced to come to the company's rescue.
By then, of course, Johnson was long gone.