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Three's Company: How Fannie, Freddie and the Feds Stoked the Housing Bubble

Waterboarding might've been more fun. Members of the Financial Crisis Inquiry Commission on Friday tormented former Fannie Mae CEO Daniel Mudd over why the "government-sponsored enterprise" in 2007 burrowed deeper into subprime lending even as such mortgages were falling apart.

Fannie and its sister GSE, Freddie Mac, got torched when home prices plummeted. The firms may ultimately require more than $160 billion in taxpayer funds to stay alive. Even if they survive, a broader question looms: Can these for-profit entities simultaneously make money, satisfy their government mandate to promote homeownership and manage the risks inherent in the housing business?

That's unclear. Especially given the companies' habit of flexing their muscles to evade regulation. Panelists Brooksley Born, Byron Georgeiou and Bill Thomas intimated that Fannie's failure owed partly to its extensive lobbying over the years to weaken federal oversight of the companies. But they expressed frustration at their inability to get a straight answer from Mudd and another Fannie exec, former Chief Business Officer Robert Levin (see 2:45:15 in video):

Thomas: "Were you ever present at a meeting in which there was a discussion about how a particular member of Congress might be approached in attempting to advance the 'business model' of Fannie Mae?"

Levin: "My recollection stems from the days that I ran the housing and community development organization in Fannie Mae, which was the organization...."

Thomas: "I've got very little time. Really, a yes or no would be sufficient, because you can follow it up with comments to elaborate."

Levin: "I'll be short. We made a big effort to try to do important things in communities...."

Thomas: "I'll try it again. Yes or no?"

Levin: ".... and we made a...." [Thomas interrupts and appeals to commission chairman Phil Angelides]

Angelides: "I was going to say, Mr. Levin, can you answer the question? It's a pretty straightforward question."

Fun stuff. On this point, however, such questions are unnecessary. Fannie's and Freddie's lobbying activities on Capitol Hill are no secret, as the commissioners undoubtedly know.

For years there has been a virtual revolving door between the GSEs and lawmakers and their staffers, many of whom have taken positions with Fannie and Freddie after winding up their congressional careers. The companies have also lavished big bucks to ensure, among other things, that Congress didn't raise their capital requirements even as they dove deeper in recent years into subprime lending.

The GSEs even allegedly sought to limit funding to their government regulator, the Office of Federal Housing Enterprise Oversight. Indeed, as noted during today's session, the financial compensation of Fannie's top four executives commonly exceeded OFHEO's entire annual operating budget.

"Although there were several attempts to limit [the GSEs'] scope and scale and risk profile, entrenched interests and aggressive lobbying thwarted these efforts and critical reforms were not instituted," Treasury Secretary Tim Geithner said in March while testifying before a House panel.

So why apply the third degree by asking questions that have already been answered? Partly, to be sure, because there's value in revealing to the American public how such organizations really operate. But mostly because Fannie and Freddie are also key pieces in the raging battle over favorable government treatment of giant financial companies.

And that's where the storyline gets more complicated. The GSEs are unquestionably "too big to fail," as are companies such as JP Morgan Chase (JPM), Goldman Sachs (GS) and AIG (AIG). More than 90 percent of U.S. mortgages flow through Fannie and Freddie, for example. More to the point, the firms are instruments of federal policy. And under their charters, they get a range of benefits, including exemption from securities laws and from most state and local taxes.

And yet Fannie and Freddie differ from Wall Street and other mortgage originators in one key respect -- the GSEs are supposed to promote affordable housing, especially for poor and minority borrowers. It's partly that mission that has pushed the firms deeper into subprime and Alt-A lending. And most of the duo's losses stem from those loans. By the same token, the firms harvested that market for the same reason as other financial players -- because that's where the revenue growth, and fat financial bonuses, were.

In other words, the GSEs helped inflate the housing bubble by channeling billions of dollars into riskier mortgages. And the government is partly responsible for that by encouraging the firms to buy boatloads of subprime loans.

But while the GSEs made tons of bad loans, because of regulatory limits they made proportionally fewer than the Wall Street players that completely scrapped their underwriting standards. Indeed, Fannie and Freddie lost market share during the peak subprime lending years. After 2003, the GSEs' share of secondary subprime loans fell by half, according to economist Simon Johnson and consultant James Kwak in their new book, "13 Bankers."

In essence, Fannie and Freddie used their special regulatory status, and their immense political clout, to game the housing finance market. They pursued profit with equal, and arguably greater, zeal as they did their mission to help Americans buy homes.

The Obama Administration and lawmakers are now grappling with how to revamp the GSEs. Many critics favor privatizing them. Other proposals focus on regulating the firms as public utilities, or even turning them cooperatives. Phasing out the GSEs is unlikely if only because Fannie and Freddie are so deeply embedded in Washington, as today's hearing underscored.

The questions surrounding the GSEs are, as Angelides said, straightforward; the answers less so.