Collapse of Fannie Mae, Freddie Mac was Self-Inflicted

(MoneyWatch)  One thing that stands out in this GAO report on what went wrong at Fannie Mae and Freddie Mac is how the Government Sponsored Enterprises were hardwired -- in part by perverse executive compensation incentives and shoddy accounting -- to blow themselves to smithereens.

The report recounts how government auditors in 2003 and 2004 busted Fannie and Freddie for manipulating accounting rules so they'd look more profitable, and thus prettier to investors. Mostly, the GSEs cooked how they booked derivatives, which they used to manage interest-rate risks related to their large retained mortgage holdings. Says the GAO:

According to investigative reports, the enterprises also may have manipulated their financial reports to show consistently increasing profits to help ensure senior executives would receive bonuses.

The auditors also discovered that the GSEs "lacked key operational capacities, such as information systems and personnel, necessary to manage large mortgage portfolios and account for them correctly," GAO concludes.

Details.

Properly chastened, Fannie and Freddie subsequently went on a shopping spree for dubiously underwritten debt. Stuff like Alt-A mortgages and, especially, "private-label" mortgage-backed securities, which aren't backed by the GSEs. Between 2003 and 2006, the enterprises went on a tear for these things (click on chart to expand). By 2008, they held a combined $313 billion in private-label MBSs.

Such assets made up only about 20 percent of the GSEs' total assets, but when the market fell apart they composed the lion's share of their losses. For example, in 2008 Alt-A mortgages accounted for nearly half of Fannie Mae's $27.1 billion in credit losses on single-family mortgages. Some 60 percent of the private-label MBSs purchased by the GSEs -- securities then rated AAA -- have since been downgraded to below investment grade.

The Treasury Department has pumped roughly $85 billion in the GSEs, now on government life support, to prop them up. The Congressional Budget Office estimates the total cost to taxpayers at $389 billion. The guy once charged with overseeing Fannie and Freddie said this week that we're not getting all of our money back. If it makes you feel any better, he's sailing off into the sunset (take the pain!).

The GAO proposes a range of possible fixes for Fannie and Freddie. Each has their pros and cons. But the status quo, it says, amounts to a short fuse on another powder-keg:

Continuing the enterprises as GSEs could present significant safety and soundness concerns as well as systemic risks to the financial system. In particular, the potential that the enterprises would enjoy explicit federal guarantees of their financial obligations, rather than the implied guarantees of the past, might serve as incentives for them to engage in risky business practices to meet profitability objectives.