Excerpts from Reckless Endangerment

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Under the direction of James A. Johnson, Fannie Mae’s calculating and politically connected chief executive, the company capitalized on its government ties, building itself into the largest and most powerful financial institution in the world. In 2008, however, the colossus would fail, requiring hundreds of billions 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.

This failure was many years in the making. Beginning in the early 1990s, Johnson’s position atop Fannie Mae gave him an extraordinary place astride Washington and Wall Street. His job as chief executive of the company presented him with an extremely powerful policy tool to direct the nation’s housing strategy. In his hands, however, that tool became 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 private sector, 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 in the past.

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. Without the Wall Street firms giving billions of dollars to reckless lenders, hundreds of billions of bad loans would never have been made.

Finally, Fannie Mae’s aggressive lobbying and its methods for neutering 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.


In 1999, the growth trajectory that Johnson had dreamed of for Fannie was fast becoming a reality.
As Glass-Steagall was falling and the Fed and other regulators were easing up on financial institutions, Johnson began preparing for his exit from Fannie Mae. To outsiders, both the company and its chief executive appeared to be doing fabulously. During 1998, Fannie’s mortgage financing hit the $1 trillion mark and Johnson basked in the glow of being named Washingtonian of the Year by Washingtonian magazine.

But internally, top executives knew the year had been a difficult one for the company. Dislocations in the financial markets stemming from the Russian debt default had taken a toll. Indeed, to make its earnings-per-share targets and trigger the all-important executive pay bonanzas, Fannie had had to resort to accounting fraud.

Because bonuses at Fannie Mae were largely based on per-share earnings growth, it was paramount to keep profits escalating to guarantee bonus payouts. And in 1998, top Fannie officials had begun manipulating the company’s results by dipping into various profit cookie jars to produce the level of income necessary to generate bonus payouts to top management.

Federal investigators later found that you could predict what Fannie’s earnings-per-share would be at year-end, almost to the penny, if you knew the maximum earnings-per-share bonus payout target set by management at the beginning of each year. Between 1998 and 2002, actual earnings and the bonus payout target differed only by a fraction of a cent, the investigators found.

Investigators uncovered documents from 1998 detailing the tactics used by Leanne Spencer, a finance official at Fannie, to make the company’s $2.48 per-share bonus target. That year, Fannie Mae earned $2.4764 per share.

In a mid-November memo to her superiors, Spencer forecast that the company was on track to earn $2.4744 per share, just shy of what was needed to generate maximum bonus payments to executives. She described various ways she could juice the company’s profits if need be.

“What do I have up my sleeve to solve an earnings shortfall?” she asked rhetorically. Then she proceeded to answer, detailing three options that would generate $6 million in earnings. One proposal was to return to Fannie’s income statement $1.8 million previously set aside to cover an environmental tax that it no longer had to pay. Another $1 million came back to the company in the form of miscellaneous income related to loss recoveries among its lenders when loans went bad.

Spencer boasted: “This is how I would solve a small problem.”

Instrumental in helping Fannie achieve these earnings and bonus targets was the company’s minimal capital requirement. At the end of 1998, Fannie Mae held capital of only 3.64 percent of its assets. By comparison, the ratio for banks insured by the FDIC stood at 8.22 percent at that time.
But 1998 had been tough enough for Fannie that by the time November rolled around, it looked as though the bonus figures would fall short.

That month, Thomas Nides, Fannie’s executive vice president for human resources, warned a swath of top managers that earnings growth was coming in weak as the year-end approached.

“You know that as a management group member, you help drive the performance of the company,” Nides wrote in a memo. “That’s why your total compensation is tied to how well Fannie Mae does each year. Current estimates indicate that we are exceeding the aggressive EPS target set by our Board of Directors. However, currently we do not expect to exceed the target to as great an extent as we did last year. As a result, the AIP bonus pool is somewhat smaller than it was last year, which means your bonus may be smaller than last year.” The emphasis was Nides’s.

The memo achieved the desired result. Fannie Mae executives wound up exceeding their target in 1998 by accounting improperly for low-income housing tax credits the company received. The result: 547 people shared in $27.1 million in bonuses. This was a record—the bonuses represented 0.79 percent of Fannie Mae’s after-tax profits, more than ever before in the company’s history.*

The eighteen directors charged with overseeing Fannie Mae for both the government and its shareholders received regular updates on the company’s progress toward making its earnings forecasts. Thirteen of these directors were elected by owners of Fannie shares while five were appointed by the president of the United States. Among the appointees one always hailed from the homebuilding industry, another from a mortgage lending business, and a third from the real estate arena.

In 1998, Fannie’s board was burnished by the addition of Stephen Friedman, former chief executive of Goldman Sachs, the prestigious Wall Street firm. Brokerage firms like Goldman Sachs flourished from the fees generated by underwriting securities issued by Fannie and Freddie, with fees totaling $100 million a year. With a former Goldmanite on Fannie’s board, Goldman was likely to gain even more of the favors the company had to dish out.

In 1999, Johnson joined Goldman’s board, stepping into a highly lucrative position that offered rich investment opportunities overseen by the firm and opened doors for Johnson around the world. In 2000, the Goldman board position paid Johnson $50,000, not counting stock awards.

Johnson was still on the Goldman board in 2010, when the Securities and Exchange Commission sued the investment bank for securities fraud relating to its sale of a dubious mortgage security. By that time, Johnson was earning almost $500,000 for his work on the Goldman board.

With Goldman’s former head on Fannie’s board and Fannie’s former chief on Goldman’s, a close and mutually profitable association between the two companies was assured. And it was one that would last well into the financial crisis years.

The firm even helped Fannie manipulate its accounting, according to investigators who uncovered a 2001 deal designed by Goldman Sachs to boost the company’s earnings. The complex transaction involved a mortgage-backed security that allowed Fannie to “better manage the recognition of income” for accounting purposes. It let Fannie push $107 million in income to future years—providing another cookie jar to delve into when the company needed it.

Goldman received $625,000 in fees for one of the two dubious transactions unearthed by OFHEO investigators, who concluded that the deals “had no significant purpose other than to achieve desired accounting results.”

Although the federal investigation into Fannie’s accounting tricks determined that they had begun under Johnson’s watch, he was never charged with civil fraud, as his successor Franklin Raines was. In any case, by the time the investigation had been launched, Johnson was long gone.

The accounting fraud at Fannie went undiscovered until 2005 when an investigation by OFHEO unearthed it. In a voluminous, intensely detailed 2006 report, OFHEO noted that if Fannie Mae had used appropriate accounting methods in 1998, the company’s performance would have generated no executive bonuses at all.

A lawsuit filed by the Securities and Exchange Commission in 2006 said the company’s 1998 results were “intentionally manipulated to trigger management bonuses.”

Although a highly kept secret at the time, Johnson’s bonus for 1998 was $1.9 million, investigators determined. It later emerged that the company had made inaccurate disclosures when it said Johnson earned a total of almost $7 million in 1998. In actuality, his total compensation that year was more like $21 million, OFHEO said, referring to an internal Fannie Mae analysis it had turned up.

None of this was mentioned when Fannie Mae announced record earnings for 1998. The company bragged about the $100 billion growth in its portfolio from the year earlier and its record purchases of $188 billion in mortgages, up from $71 billion the year before.

And yet, after a decade running Fannie Mae, Johnson was ready to move on. To help with the transition to a new chief executive, Johnson agreed to remain at the company for a year, as chairman of its powerful executive committee.

Why would he leave Fannie Mae just as all of his hard work was beginning to pay off? Former colleagues speculate that he may have been making himself available for an appointment to run the Treasury Department when the current secretary, Bob Rubin, left government service to return to the private sector.

Rubin’s departure was imminent, an open secret in Washington circles. In 1997, Johnson had pushed hard to name Rubin head of the prestigious Carnegie Corporation of New York, a grant-making foundation created by Andrew Carnegie in 1911.

Johnson was chairman of the search committee charged with identifying candidates to head the foundation. As he lobbied for Rubin, others on the committee felt that Vartan Gregorian, a self-made man and brilliant educator who was president of Brown University, was a better candidate.
“They were flabbergasted at the way Johnson ran them around because he wanted Bob Rubin rather than Vartan,” said one person briefed on the discussions. “It ultimately worked out, but it was a good example of how Johnson likes being in the club of the elite. That was going to be a great job for someone coming out of the government.”

In a rare loss for Johnson, Gregorian got the nod.

Had Rubin been tapped to head the Carnegie Corporation, the former Treasury secretary with close ties to the Clinton administration would have had Johnson to thank for the job. And that, as Johnson knew better than anyone, would have been an immensely valuable chit to have out to Rubin.

Still, Johnson could afford to be patient as he awaited the prize of a cabinet position. During his years at Fannie Mae, making a cool $100 million, he made sure to arrange for an inflation-adjusted consulting contract with the company that began at $390,000 a year. His pension—around $900,000 a year—was secure and so were company-paid perquisites such as a car and driver for him and his wife, office space at the prestigious Watergate complex, and the services of two employees.

And it wasn’t as if Johnson would be spending his days bored on the golf course. He was chairman of the prestigious Brookings Institution, and head of the John F. Kennedy Center for the Performing Arts in Washington. Johnson also sat on the boards of KB Home, Target Corp., and United Healthcare and was about to become a director at Goldman Sachs.

Looking back on his years at Fannie Mae in a November 1998 speech at the National Press Club, Johnson once again extolled the virtues of homeownership and his company’s role in promoting it. He spoke of the public-private partnership he had been so instrumental in crafting. “American government policies that support homeownership are among the most efficient and effective ever devised,” he said. “The American housing finance system, as it has developed and matured over the past 60 years, is at its core a durable and effective partnership between government and the private sector. Fannie Mae is at the heart of this enormously successful public-private partnership.”
Just a month later, however, as Johnson prepared to leave the chairmanship of Fannie Mae to his trusted enforcer, Franklin Raines, another threat to the company arose. Clinton administration officials had begun discussing the merits of requiring the company to pay to register its securities. Fannie’s exemption from paying these fees was one of the valuable benefits reaped from its government association.

According to the Washington Post, Fannie officials called John Podesta, the White House chief of staff, to argue against the idea. He was unreachable, so Fannie asked one hundred mayors and other local officials to call Podesta’s private telephone line that day to complain. The idea of forcing Fannie to pay registration fees on its securities died soon thereafter.

It was as though Johnson, even with one foot out the door, was reminding the government that messing with his company was unwise.

After the accounting scandal erupted and the subprime mortgage crisis rocked the economy, some who knew Johnson wondered if he had left Fannie Mae because he saw that the company’s growth days were over and that its risk profile was rising.

“I’m not sure he totally saw the handwriting on the wall,” said one former executive who worked closely with him. “I think Johnson always moved on. He had all the perks of a big deal. Maybe he felt there were some other fish to fry including getting involved in a presidential election. Remember, in good times you start to believe in your own infallibility.”

* Executive pay at Fannie Mae was a well-kept secret and the company successfully blocked some in Congress, such as Representative Richard Baker of Louisiana, from receiving information about salaries and bonuses paid by the company. It was only after Fannie was caught cooking its books that details of its lavish executive pay came out.

Excerpted from Reckless Endangerment by Gretchen Morgenson and Joshua Rosner; pp. 6-7 & 117-123; Copyright 2011 by Gretchen Morgenson and Joshua Rosner. Published in 2011 by Times Books, an imprint of Henry Holt and Company. All rights reserved. This work is protected under copyright laws and reproduction is strictly prohibited. Permission to reproduce the material in any manner or medium must be secured from the Publisher.

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