Why Fannie and Freddie Continue to Cost Taxpayers Billions

Of all the companies bailed out by the federal government, mortgage finance giants Fannie Mae and Freddie Mac are shaping up as the deepest money pits. A close look at their past and recent financial filings shows why their losses continue to mount.

Fannie and Freddie effectively became wards of the government in 2008. The Obama administration had promised to reveal its plans for the agencies last month, but Washington’s focus on reforming the banking system pushed them to the bottom of the to-do list. Fannie and Freddie aren't mentioned in either the Senate or House financial regulatory reform bills.

Treasury Secretary Timothy Geithner may reveal some of the administration’s ideas on Tuesday when he testifies before Congress about Fannie and Freddie. But in general, the companies’ troubles have drawn less attention than the rest of the financial industry. For example, unlike bonus announcements made on Wall Street, Fannie and Freddie’s recent disclosures of about $40 million in executive compensation and bonuses for 2009 caused little stir on Main Street.

Together the two firms have already tapped $125 billion from government lifelines and the Congressional Budget Office predicts they ultimately will drain $380 billion. That would far exceed the final tabs for rescuing the big banks, the automakers or even insurance behemoth American International Group (AIG).

“These calls on taxpayer funds are troubling to all of us,” Edward J. DeMarco, acting director of the Federal Housing Finance Agency, said in a letter to congressional leaders last month.

DeMarco’s predecessor at the housing finance agency, Fannie and Freddie’s regulator, has acknowledged that taxpayers are unlikely to ever see a full return on their investment.

Why are the two companies in such dire shape, when many large banks have been able to turn a profit even as they take huge losses from their real estate investments?

Fannie and Freddie's losses largely stem from internal decisions made in 2006 and 2007 that sent the companies on a shopping spree for dubious mortgages, according to regulatory filings, congressional testimony and interviews with economists and former Fannie Mae employees. Fannie and Freddie uncharacteristically collected more than $1 trillion in subprime and other risky mortgages---many of which were branded “alternative,” or alt-a, because they did not meet the rules set by Fannie and Freddie.

“It’s ironic because the original definition of alt-a mortgages was that it didn’t meet Fannie and Freddie’s underwriting standards,” said Thomas Lawler, a former senior vice president of Fannie Mae who left in 2006 to start a consulting business. “A disturbingly high share of losses were incurred from loans acquired during those dog years.”

Chasing Market Share

Fannie’s and Freddie’s ill-fated decision to hop on the risky mortgage bandwagon was inevitable given their inherently contradictory missions, housing specialists said in interviews.

For 40 years, they functioned as publicly traded companies controlled by shareholders who demand profits. But they also operate under a congressional charter, as government-sponsored enterprises (GSEs), to keep credit flowing in minority and low-income communities. The charter also carried an implicit guarantee that if the companies got into trouble, the taxpayer would bail them out.

To follow their mandates, the companies developed two key lines of business. One is to buy mortgages from lenders, which can then use the money to offer new loans to consumers. Fannie and Freddie bundle the loans, guarantee them against default and sell them as securities to investors such as pension funds. The second line of business is management of their own investment portfolios.