Fannie, Freddie and the Governance Fallout

Being a member of the Eastern Media Elite, I spent my Sunday morning listening to National Public Radio. The lead story was the government's takeover of Fannie Mae and Freddie Mac, and the generally calamitous state of the nation's housing industry and financial system overall. After a first segment sketching out the broad contours of the crisis, the host went into a second segment where she asked a housing finance expert several questions about this mess submitted by listeners via the NPR blog. Almost immediately came the question that made my ears perk up: If regulators find evidence of accounting irregularities at Fannie and Freddie, will their former CEOs be forced to give back the compensation they received during that period?

Oh my, I thought. Here we go.

While a federal takeover of the two mortgage industry giants may indeed have been a wise and necessary move, brace yourself for a grand whirlwind of governance complaint—the same drama we see unfold at scores of flailing companies every proxy season, but writ larger than life. The cost are staggering, the accounting rules complex, and the egos titanic. Worse (for Washington, at least) is that the mortgage crisis isn't some esoteric policy debate the public doesn't quite understand, or doesn't quite perceive as relevant to their lives. This is about buying or selling your house. People get that. And activists—whether they're lawmakers, lobbyists, shareholder activists, do-good crusaders or anyone else—will therefore hammer the Fannie and Freddie governance crises into the public consciousness whenever they can.

Let's start with the scapegoats: Daniel Mudd and Richard Syron, the erstwhile CEOs of Fannie Mae and Freddie Mac, respectively. Mudd reportedly will walk away from his job with a payout worth $9.3 million in deferred compensation, pension benefits and other pay; Syron will receive a package worth $14.1 million. They get the millions, while shareholders lose a fortune and taxpayers are saddled with a bill that could run anywhere from $25 billion to $200 billion.

The irate NPR listener I heard on Sunday is not alone. Without question, Congress will hold hearings about the takeover of Fannie and Freddie, Mudd and Syron will be called to testify, and their golden parachutes will come up for discussion. The House has already passed a say-on-pay bill for CEO compensation; the Senate will almost certainly do the same sometime soon, and both Barack Obama and John McCain have publicly affirmed that they support say-on-pay shareholder votes as well. Mudd and Syron won't be what tips the scale in favor of say-on-pay legislation (that scale tipped long ago), but they will keep the issue fresh in the public eye.

Bloated CEO pay, however, is only the most obvious governance issue at work here. Remember that only the stockholders of Fannie and Freddie have seen their fortunes ruined; debtholders will survive just fine. Who are these debtholders, exactly? They are the central banks of China, Japan, Abu Dhabi, and probably a few other nations in the Middle East keeping a low profile. The prime fact, however, is that they are not people. They are the sovereign wealth funds of governments.

I've always been a bit skeptical of SWFs. Think about it: If a country has tens of billions of dollars at stake in some U.S.-based investment, do you really believe its minister of finance won't pick up the phone and give someone in the Bush Administration an earful? Of course that person would. In fact, the U.S. Treasury Department even went on the offensive last week and had its officials calling the central banks first, easing their fears. The SWFs were placated, flattering statements were issued, the bailout transpired, and everyone (save Fannie and Freddie shareholders and the U.S. taxpayer) is happy.

The subtext in all of this, however, is that sovereign wealth funds—of China in particular, but all of them generally—have enormous leverage over the United States. Do these funds have codes of ethics to keep political interests away from their billions? Mostly, yes. Do these funds actually pay attention to these codes? I suspect that most of the time they do. Will they still pay attention to their codes when hundreds of billions might be at stake? I wonder.

Finally there is the small matter of Fannie and Freddie's supposed accounting irregularities. When Congress revised the oversight laws for Fannie and Freddie in July, Treasury Secretary Hank Paulson described his new power to seize the mortgage giants as such: "If you've got a bazooka, and people know you've got it, you may not have to take it out." Well, my grandfather served in World War II; he had a bazooka too, and the Germans knew it. But he still had to take it out, because the Nazis were making such a god-awful mess of Europe. Years of cynical experience leads me to believe Fannie and Freddie were doing something similar with their financial records ... and when Paulson's team went over the books in detail this summer, they quickly realized the bazooka had to be fired.

Granted, accounting for debt instruments is no simple matter. I have no inside knowledge, but my suspicion is that the financial reporting folks at Fannie and Freddie didn't fully understand what they were doing, or somehow rationalized away whatever fears they had. I don't believe gross fraud occurred akin to what we saw at Enron or WorldCom (but I may be wrong). Regardless, the Financial Accounting Standards Board has had critics complaining about accounting rules related to the mortgage crisis (primarily Financial Accounting Standard No. 157, Fair Value Measurement, and FAS 140, Transfers and Servicing of Financial Assets) for more than a year. That debate isn't going to go away.