By William K. Black
I have been chastised by a friend and former colleague forwriting:
“Here is the crazy thing – theSEC, OFHEO, and Department of Justice all failed to demand that Fannie andFreddie end their perverse executive compensation system that made theexecutives wealthy through fraud and put the entities and the government atrisk.”
My friend notes that Fannie, under pressure from OFHEO andwith its prior approval, changed its compensation system after the initialaccounting fraud.
My sentence would beclearer if it was revised to read as follows:
My sentence would beclearer if it was revised to read as follows:
“Here is the crazy thing – theSEC, OFHEO, and the Department of Justice all failed to prevent Fannie andFreddie from using perverse executive compensation systems that made theexecutives wealthy through fraud and put the entities and the government atrisk.”
The new compensation systems at Fannie and Freddie remainedexceptionally perverse after the changes. Their CEOs continued to cause them to engage in systematic accountingfraud by not providing remotely adequate loss reserves and allowances for loanlosses despite purchasing massive amounts of fraudulent liar’s loans andfraudulent subprime liar’s loans. The samescam that made the officers rich was certain to destroy Fannie and Freddie.
I have alsoexamined a number of statements by both of OFHEO’s leaders during the relevantperiod, concerning compensation and the initial Fannie accounting fraud. James Lockhart issued a hard hitting releaseon May 23, 2006 accompanying OFHEO’s report on its investigation of Fannie entitled: “FANNIE MAE FAÇADE: Fannie MaeCriticized for Earnings Manipulation.” The release begins with this passage that directly ties the accountingfraud to the controlling officers’ desire to trigger bonuses.
“The report details an arrogant andunethical corporate culture where Fannie Mae employees manipulated accountingand earnings to trigger bonuses for senior executives from 1998 to 2004. Thereport also prescribes corrective actions to ensure the safety and soundness ofthe company.”
Note that the release emphasizes that the OFHEO report “prescribescorrective actions.” The purpose of therelease, of course, is to emphasize the most important aspects of the lengthyOFHEO report. The release makes it clearthat executive compensation drove the fraud.
“The combination of earnings manipulation,mismanagement and unconstrained growth resulted in an estimated $10.6 billionof losses, well over a billion dollars in expenses to fix the problems, andill-gotten bonuses in the hundreds of millions of dollars.”
“By deliberately andintentionally manipulating accounting to hit earnings targets, seniormanagement maximized the bonuses and other executive compensation theyreceived, at the expense of shareholders. Earnings management made asignificant contribution to the compensation of Fannie Mae Chairman and CEOFranklin Raines, which totaled over $90 million from 1998 through 2003. Of thattotal, over $52 million was directly tied to achieving earnings per sharetargets.”
When it comes to the steps that Lockhart consideredcritical, however, executive compensation was not specifically mentioned.
The report ends with recommendations fromOFHEO’s staff to [Lockhart], which he has accepted. Some of the keyrecommendations include:
Fannie Mae must meet all of its commitments forremediation and do so with an emphasis on implementation – with dates certain –of plans already presented to OFHEO.
Fannie Mae must review OFHEO’s report todetermine additional steps to take to improve its controls, accounting systems,risk management practices and systems, external relations program, dataquality, and corporate culture. Emphasis must be placed on implementation ofthose plans.
Fannie Mae must strengthen its Board ofDirectors procedures to enhance Board oversight of Fannie Mae’s management.
Fannie Mae must undertake a review ofindividuals currently with the Enterprise that are mentioned in OFHEO’s report.
Due to Fannie Mae’s current operational andinternal control deficiencies and other risks, the Enterprise’s growth shouldbe limited.
OFHEO should continue to support legislation toprovide the powers essential to meeting its mission of assuring safe and soundoperations at the Enterprises.
Similarly, on June 6, 2006, Lockhart testified before theHouse on Fannie’s fraud. He explainedhow Fannie’s executive compensation system created the perverse incentives thatdrove the massive accounting fraud. Heended by listing how OFHEO responded to the frauds by ordering changes atFannie. None of these changes discussedexecutive compensation. The failure ofthis excerpt to discuss executive compensation is particularly striking.
“Fannie Mae must takeadditional steps to improve its internal controls, accounting systems,operational and other risk management practices and systems, data quality, andjournal entries. Emphasis must be placed on implementation with dates certain.”
Executive compensation, the most critical problem at Fannieand Freddie, the problem that drove their accounting control frauds, receivedminimal attention from OFHEO’s head. Fannie and Freddie’s CEOs proceeded to become wealthy through bonuses“earned” through business strategies that were sure to destroy Fannie andFreddie. OFHEO took no effective actionto remove these perverse incentives.
Armando Falcon, Lockhart’s predecessor as head of OFHEO,achieved the remarkable – his revulsion for Fannie’s controlling officersexceeded Lockhart’s. “While all of thispolitical power satisfied the egos of Fannie and Freddie executives, itultimately served one primary purpose: the speedy accumulation of personalwealth by any means.” Testimony ofArmando Falcon, submitted to the Financial Crisis Inquiry Commission (April 9,2010). His testimony details howFannie’s controlling officers used accounting fraud to attain massive bonuses.
TheTerrible Cost of Failing to Understand Accounting Control Fraud
The sad irony is that immediately after Falcon explained theperverse incentives arising from Fannie’s compensation system he went on to beonly half right in his analysis of Fannie and Freddie’s eventual failure. The half he got wrong stemmed from hisfailure to understand the interplay of accounting control fraud and perverseexecutive compensation.
“Your letter also asked me about the impact of the affordablehousing goals on the enterprises’ financial problems. In my opinion, the goalswere not the cause of the enterprises demise. The firms would not engage in anyactivity, goal fulfilling or otherwise, unless there was a profit to be made.Fannie and Freddie invested in subprime and Alt A mortgages in order toincrease profits and regain market share. Any impact on meeting affordablehousing goals was a byproduct of the activity.”
In addition, OFHEOmade it very clear to both enterprises that safety and soundness was always ahigher priority than the affordable housing goals. They should not take onexcessive risk in order to meet any one of the goals.”
Falcon almost gets this right, but his failureto understand the most destructive financial fraud mechanism leads him to misswhat happened at Fannie and Freddie even with the benefit of hindsight. His analytical failures exemplify OFHEO’scentral analytical failure. He iscorrect that only the exceptionally naïve could believe that Fannie andFreddie’s controlling officers based their business decisions on meeting theaffordable housing goals. He isgrotesquely incorrect in assuming that their controlling officers only engagedin an activity if “there was a profit to be made.” His error is bizarre given the fact that hehad explained that Fannie’s controlling officers engaged in activity thatcaused large losses and then used accounting fraud to transmute real lossesinto fictional gains in order to maximize their bonuses.
Falcon is correct that Fannie’s controllingofficers had “one primary purpose” at all times – “thespeedy accumulation of personal wealth by any means.” What he fails to understand is thataccounting control fraud is a “sure thing” and that the formula for maximizingfictional income (and real bonuses) maximizes real losses. Fannie and Freddie’s controlling officers“one primary purpose” was making themselves wealthy. Accounting fraud was their “weapon of choice”to produce great wealth very quickly. Purchasing large amounts of “liar’s” loans guaranteed that Fannie andFreddie would suffer massive losses. Purchasing large amounts of subprime liar’s loans guaranteed that theywould suffer catastrophic losses. Liar’s(home) loans create such intense “adverse selection” that they have a sharplynegative “expected value.” In plainEnglish, the purchaser will lose money. It’s equivalent to betting against the House, except that the odds areso bad that the expected value is more negative than playing the lottery. Liar’s loans can only fail to produce obvioussevere losses temporarily while the bubble is expanding. Refinancing hides the losses during the rapidexpansion phase of the bubble. Thesaying in the trade is that “a rolling loan gathers no loss.” Bubbles, however, are only temporary andliar’s loans will begin blowing as soon as the bubble starts inflating, whichcan be over a year prior to the bubble bursting.
Fannie and Freddie’s CEOs chased higher nominal yields, notreal “profit” for the firms. Theirstrategy exemplified the logic of George Akerlof and Paul Romer’s famous 1993article, captured in their title (“Looting: the Economic Underworld ofBankruptcy for Profit”). The firm fails,but the controlling officers walk away rich because the frauds they leadproduce fictional income and real bonuses. (Akerlof and Romer’s use of the word “profit” is ironic. It refers to gains to the controllingofficers from fraudulent business strategies that cause fatal losses to thefirm.) Akerlof and Romer aptly termedthe accounting control fraud strategy a “sure thing.”
Fannie and Freddie’s risk officers alerted their CEOs to thefact that nonprime loans were likely to produce far greater losses, that therapid rise in home prices was temporarily suppressing default rates, and thatthe rapid rise in home prices could not continue indefinitely. It is inconceivable that Fannie and Freddiedid not know of the FBI’s September 2004 warning that there was an “epidemic”of mortgage fraud and their prediction that the fraud epidemic would cause aneconomic “crisis” if it were not contained. Fannie and Freddie’s purchase of liar’s loans that cause severe lossesoverwhelmingly occurred after the FBI’s warning. “The government” never required any entity tomake or purchase liar’s loans. Most ofthe liar’s loans that caused Fannie and Freddie’s severe losses were purchasedafter MARI’s five-part warning to the mortgage industry in April 2006. “The Mortgage Asset Research Institute’s(MARI) EIGHTH PERIODIC MORTGAGE FRAUD CASE REPORT TOthe MORTGAGE BANKERS ASSOCIATION.” (Itis inconceivable that Fannie and Freddie’s controlling officers, or OFHEO, wereunaware of these warnings. Louis Freeh,former head of the FBI, joined Fannie’s board of directors in mid-2007.)
MARI paired it first two warnings:
“Stated income and reduceddocumentation loans speed up the approval process, but they are open invitationsto fraudsters. It appears that many members of the industry have littlehistorical appreciation for the havoc created by low-doc/no-doc products thatwere the rage in the early 1990s. Those loans produced hundreds of millions ofdollars in losses for their users.”
MARI’s third warning quantified the incidence of fraud insuch loans. It paired these data withits fourth warning dealing with the revealing label the industry usedinternally for such loans.
“One of MARI’s customersrecently reviewed a sample of 100 stated income loans upon which they had IRSForms 4506. When the stated incomes were compared to the IRS figures, theresulting differences were dramatic. Ninety percent of the stated incomes wereexaggerated by 5% or more. More disturbingly, almost 60% of the stated amountswere exaggerated by more than 50%. These results suggest that the stated incomeloan deserves the nickname used by many in the industry, the “liar’s loan.””
MARI’s fifth warning reported the views of federal bankingregulators.
Federal regulators of insuredfinancial institutions have expressed safety and soundness concerns over theseloans with lower documentation requirements and other “nontraditional” loans.
To summarize, MARI warned every member of the MortgageBankers Association (MBA) in writing in early 2006 that so-called “statedincome” loans:
- Were “open invitations to fraudsters”
- Had produced hundreds of millions of dollars of losses when they became common in the early 1990s
- Had a fraud incidence of 90%
- Deserved the industry term for such loans: “liar’s loans”
- Were opposed by federal banking regulators because of safety and soundness concerns
It was in this context that (1) lenders moved massively toincrease their origination of fraudulent liar’s loans and to sell such loansthrough fraudulent “reps and warranties” (2) Fannie and Freddie (and theirinvestment banker counterparts) moved massively to purchase these endemicallyfraudulent loans, and (3) OFHEO did nothing meaningful to prevent Fannie andFreddie from purchasing fatal amounts of fraudulent liar’s loans.
Fannieand Freddie (and the FHFA) still get it wrong
Indeed, even after the second wave of accounting controlfraud caused the failure of Fannie and Freddie, OFHEO failed to end theirperverse executive compensation practices. Steve Linick, the FHFA’s Inspector General (FHFA is the successor agencyto OFHEO) reported:
“Linick said the FHFA rejected his recommendationthat it test and independently verify the annual pay packages, which are set bythe boards of Fannie and Freddie and approved by the agency in consultationwith the Treasury Department.
The FHFA “lacks key controls necessary to monitorthe enterprises’ ongoing executive compensation decisions under the approvedpackages,” the inspector general wrote. “FHFA has neither developed writtenprocedures to evaluate the enterprises’ recommended compensation levels eachyear, nor required FHFA staff to verify and test independently the means bywhich the Enterprises calculate their recommended compensation levels.”
Further, the agency “lacks independent testingand verification of the Enterprises’ submissions in support of executivecompensation packages,” the report said.”
The federal “pay czar” heavily criticized all but one of theexecutive compensation plans submitted by the bailed-out firms still subject tospecial regulation. Executivecompensation is so typically perverse that it is one of leading causes ofcriminogenic environments for accounting control fraud. The intellectual father of modern executivecompensation, Michael Jensen, has decried the results, which he concedesincludes rampant earnings manipulation. Fannie and Freddie are simply the most expensive failures to date causedby accounting control fraud.
