Origins of a Conflicted Government Entity

Like many Federal agencies, Fannie Mae was founded during the Great Depression. Throughout the country rising joblessness caused home foreclosures to soar. Thousands of banks then failed. Unsurprisingly, mortgage money dried up.

At the heart of this disaster lay a classic banking dilemma—bank assets typically are long-term loans while their funding deposits customers can retrieve “on demand.” Depositor confidence is critical. When depositors become scared, “runs” on deposits result; banks often cannot liquidate their longer term assets quickly enough to raise needed cash, and the bank, not able to meet depositor demands, then “fails.”

America’s banks were mired in this trap in 1938. Desperate to preserve liquidity, they would not risk making new mortgage loans. Congress sought to break this deadlock by establishing Fannie Mae to purchase mortgage loans from banks. The core of Fannie Mae’s mission was thus to create and preserve a liquid secondary mortgage market.

Initially this involved Fannie buying mortgages insured by the Federal Housing Administration (FHA) and the Veterans Administration (VA). For its first several decades, Fannie Mae enjoyed a virtual monopoly over the secondary mortgage market. During this time, it was backed by the full faith and credit of the U.S. Government and was included in the federal budget.

Fannie’s profile began to blur in 1954 when the government had the agency sell common stock to the public. More change arrived in 1968. Fannie was split into two entities, the Government National Mortgage Association (Ginnie Mae) and a successor to Fannie Mae. The former kept the FHA/VA business and the full U.S. Government guarantee. The new Fannie Mae became solely owned by public stockholders. Fannie’s assets, liabilities and appropriations were removed from the federal budget.

However, if the new Fannie Mae was no longer a government agency, what was it? Although no longer officially on budget, Fannie was dispatched into the private sector with an enviable set of advantages. These included exemption from state and local taxes, freedom from filing SEC financial statements, and a credit line from the U.S. Treasury that would eventually rise to $2.5 billion.² There was also the murky question of what the U.S. Government would do if Fannie Mae ever faced insolvency. Looking at Fannie’s preferred status and importance to the mortgage market, private investors widely assumed it would not be allowed to fail. Thus was born the perception that Fannie Mae enjoyed an “implied government guarantee.” So pervasive was this view that Fannie regularly issued bonds at interest rates barely higher than the U.S. Treasury.

Stripped of its FHA/VA activity, Fannie needed to develop a new business. This began in 1970 when Fannie was permitted to purchase non-guaranteed mortgages. This new activity led Fannie to develop rigorous underwriting standards to qualify the loans purchased. Fannie determined that it would not buy jumbo loans, i.e., mortgages bigger than a certain size. Another guideline stipulated that the mortgage could not be for more than 80% of the home’s assessed value. This rule required typical borrowers to make a 20% down payment.³ It also assured that homeowners had skin in the game. This encouraged owners to maintain their homes and to fight hard to meet their mortgage payments if adversity hit.

These and other Fannie guidelines defined what came to be called “conforming mortgages.” In the decades that followed, banks and Savings and Loan (S&L) companies knew that if they originated a mortgage following these guidelines, it was instantly liquid. The originator could sell it to Fannie at its option. This knowledge helped develop the U.S. mortgage market into the largest and deepest such market in the world. By 2008 outstanding U.S. mortgages totaled $12 trillion. The “conforming” 30 year, fixed rate, amortizing mortgage was also the envy of countries everywhere.

Initially, Fannie Mae held the mortgages it purchased. Starting in 1981 it added a new activity—the packaging of multiple, single-family mortgages into “mortgage-backed securities” (MBS). The first MBSs were straight “pass-through” bonds; investors received payments when interest and principle were received by Fannie. However, Fannie guaranteed the MBS investors that if scheduled repayments failed to be made, Fannie would still pay the bond holder; for this assurance Fannie collected a fee. Thus, as the 1970s gave way to the 1980s, Fannie Mae’s business model comprised these two lines —a growing MBS guarantee business and its original franchise of purchasing and holding conforming mortgages. Using the “implied guarantee” to borrow at rates just above the Treasury, Fannie generated attractive margins and consistent, if not rapidly growing profits.

The early 1980s brought severe shocks to the mortgage market. Persistent inflation led the Federal Reserve to increase short-term interest rates dramatically. For a time, the “overnight” Fed funds rate exceeded 20% p.a. For the S&Ls, the experience was lethal. Trapped owning long-term mortgages at rates far below their deposit funding costs, S&Ls went deep into the red. Many were driven out of business. Fannie Mae was not spared. Results on its portfolio of purchased mortgages resembled those of the private lenders. Since Fannie Mae operated with less equity capital than banks, it was feared that the government might have to make good on its implied guarantee.

Fannie survived, but the experience caused the firm to follow a more conservative course. Under CEO David Maxwell, Fannie steadily expanded its guarantee fee business, but the retained mortgage portfolio was scaled back. By the end of the decade, Fannie’s mortgage holdings totaled only about $150 billion.⁴ Maxwell’s steady hand produced results. Fannie’s profits surpassed $1 billion annually by the end of the decade. Investors were impressed and duly bid up Fannie Mae’s stock price (see Attachment 1).

Fannie’s near-death experience had another effect—that of mobilizing the Privatizers. Throughout the Reagan years they aimed persistent fire at Fannie and Freddie. They suspected that if the housing market ever turned ugly, the government would end up having to make good on Fannie’s implied guarantee, just as it had to spend $500 billion cleaning up the S&L wreckage. The Privatizers repeatedly called for Fannie and Freddie to give up all government preferences. In this the Privatizers were quietly supported by Wall Street. Leading investment banks disliked Fannie’s stranglehold over the “conforming” mortgage market, which they attributed to the implied guarantee. Putting Fannie and Freddie on an equal footing with Goldman and Morgan Stanley would enable the banks to scoop up a bigger share of the huge mortgage market.

Wall Street even had invented the instrument they could use to compete. Called a Collateralized Mortgage Obligation (CMO), this security was not a straight “passthrough” of interest and principal. Rather, it gathered mortgages into pools, and then redirected interest/principal payments into flows resembling bond payments. This approach produced a “mortgage-backed” bond equivalent security which could be sold to investors. The innovation greatly expanded capital market appetite for mortgage-based assets and offered originators the opportunity to decide whether to hold or sell off the mortgages they created.

Investors, however, were not prepared to bet big money on securities not backed by Fannie and Freddie’s guarantees. CMO issuance built around non-conforming mortgages thus remained small. This fact plus David Maxwell’s steady hand delivered Fannie Mae into the 1990s with its business model intact. The ambiguities surrounding this model were now, however, more out in the open. What indeed was Fannie Mae’s purpose for existing? Was it an instrument of government policy, giving primacy of mission to maintaining mortgage market liquidity through good times and bad—or was it an investor-owned company dedicated to maximizing profits for its shareholders?

The several ambiguities in Fannie’s identity were about to be multiplied. Ironically, the vehicle that accomplished this feat was a law intended to bolster Fannie and Freddie’s financial strength.

New Law, Politics and the ‘Housers’ Complicate Fannie Mae’s Mission

The year 1992 saw big changes affecting Fannie Mae. Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act. The ‘Houser’ lobby succeeded in seeding this law with new goals that promoted riskier lending. And, Fannie Mae saw Jim Johnson succeed Maxwell as CEO.

The Safety and Soundness Act aimed to insulate taxpayers from a Fannie meltdown. It established a new regulator, the Office of Federal Housing Enterprise Oversight (OFHEO). OFHEO was tasked to enforce minimum Fannie/Freddie capital requirements. However, community activists convinced key legislators to embed a contradictory requirement in the law. Congress had passed the Community Reinvestment Act in 1977, a law requiring banks to report on their lending activities for “underserved” areas and groups. With the Safety and Soundness Act as a canvas to paint on, the community activists convinced Henry B. Gonzalez, chairman of the House Banking Committee, to specify lending goals for these “underserved” areas and groups.⁵ The law specified that Fannie would have to direct a minimum of 30% of its total housing loans to low and moderate income households. Another 30% must be directed to inner-city locations. The two goals could overlap, meaning that an inner-city mortgage for a low income household counted towards both. Finally, the Safety and Soundness Act encouraged Fannie and Freddie to meet these goals by being willing to purchase mortgages where the owner down payment was as little as 5%—a significant departure from the 20% required for a “conforming” mortgage.⁶

Fannie Mae had time to see the Safety and Soundness Act coming. The law took three years to enact. During this incubation period, Jim Johnson spotted acute contradictions embedded in the law, and pondered how to shape them into something that would allow Fannie Mae to continue its profitable growth.

Johnson, a political operator who had run Fritz Mondale’s presidential campaign, reached two conclusions. The first was that Fannie Mae’s past success had simply emboldened its critics to demand that it do more to serve their particular agendas. How else could you explain attaching provisions requiring Fannie to purchase low down-payment loans from nonqualified borrowers to a “Safety and Soundness” Act?

A second conclusion followed from the first. Fannie Mae would need a more powerful political operation to defend itself. This operation would have to play all the cards that constitute political currency inside the Capital Beltway—legislative lobbying, White House connections, a local presence in key congressional districts and an ability to mobilize favorable research.

Johnson waded with a will into the Safety and Soundness Act’s legislative process. Coupling an army of lobbyists with headline grabbing initiatives, Johnson influenced the final Act in three ways. First, Fannie was able to take a major soundness issue off the table by having the Act bless low Fannie Mae capital levels. Most banks kept 8–10% equity capital. The 1992 Act endorsed Fannie capital levels as low as 2.5%. Second, Johnson got his new regulator, OFHEO, both lodged within HUD and made subject to the annual congressional appropriations process. This move preempted having the OFHEO operate out of a more independent base, such as the Treasury or the Federal Reserve. It also meant Fannie could quietly lobby Congress to starve OFHEO of funding. Third, but most important, Johnson got the Affordable Housing goals to carry a technical definition which Fannie Mae could readily meet. By including moderate income households in the definition of the 30% quota, mortgages to median income households would count towards that goal.⁷ Fannie was already making such loans under its “conforming mortgage” rules. Simply put, the new law had no teeth. What Fannie Mae was already doing would suffice.

Still, Johnson took the episode as a warning. Fannie Mae had stakeholders on all sides; they all wanted different and conflicting outcomes. As CEO he was going to have to be proactive if these tensions were to be managed. Johnson resolved to build a political operation that Fannie Mae’s stakeholders would respect and fear.

Finally, Johnson decided that he and the rest of Fannie Mae’s top executives deserved to be properly incentivized. Compared with the private sector, government agencies greatly underpay top management. Fannie Mae wasn’t exactly a government agency anymore, so its compensation was better. David Maxwell had received a $27.5 million lump sum upon his departure. Still, Johnson thought that annual salary and incentive compensation was woefully low by Wall Street standards. He addressed this issue by changing the metrics used to measure top management performance. Under Maxwell, Fannie Mae’s performance measures were broad, covering operating costs and return on assets as well as profits. Johnson narrowed the focus. Henceforth Fannie Mae executive compensation would be principally determined by its Earnings per Share performance.⁸

Reconciling Wall Street Performance and ‘Affordable Housing’

Johnson’s biggest bet involved greatly expanding Fannie Mae’s portfolio of retained mortgages.

Mortgage portfolios are subject to three main risks: 1) default by the borrower; 2) prepayment of the mortgage; and 3) interest rate risk when the source of funding has a different tenor than that of the mortgage.

Johnson had concluded that default risk was not much of a worry for Fannie Mae. So long as it stuck with its tested underwriting guidelines and purchased largely conforming mortgages, default losses would likely be low. However, prepayment and interest rate risks together could be threatening. Fannie knew from personal experience that there really was no safe approach to building a large mortgage portfolio. David Maxwell had kept the portfolio small for exactly this reason.

Johnson decided to take the risks. On his watch, Fannie’s retained portfolio had grown by 167%, from about $150 billion to over $400 billion.⁹ Johnson justified the bet on the grounds that Fannie Mae had such large margins to work with that it could absorb any losses that developed. Spreads of 1.5–2% were not uncommon—this was what Alan Greenspan would later refer to as a “big, fat gap.”¹⁰ According to the Congressional Budget Office, the profitability of Fannie’s retained portfolio was 4–5 times that of its guarantee fee business. With these spreads and the very low capital/debt ratio allowed Fannie under the 1992 Safety and Soundness Act, Fannie’s growing mortgage portfolio generated a profit wave.

Johnson’s strategy delivered the performance the stock market was craving. Attachment 2 details Fannie Mae’s financial performance during Johnson’s tenure, along with the company’s stock price performance. Attachment 3 details the Total Shareholder Return harvested by a typical investor who bought Fannie’s stock when Johnson took office and held it into 1998. In terms of market capitalization, Fannie Mae was valued at roughly $10 billion when Maxwell ceded his office to Johnson. By mid-1998, Fannie Mae was being valued at $70 billion.¹¹

Under its Earnings per Share metrics for incentive compensation, Fannie Mae’s performance generated a management compensation gusher. Johnson had done the numbers for his Fannie Mae compensation; if he resigned at the end of 1998, the combination of his compensation while in office and his retirement benefits would exceed $100 million.¹²

As for the Affordable Housing pressures, Johnson had found clever ways to neutralize them. Taking advantage of the 1992 Act’s easy to satisfy target, Fannie then made great political headlines by announcing large, “affordable housing” programs. In March 1994, Johnson announced a Fannie commitment to provide $1 trillion in affordable housing loans by the end of the decade. Closer examination revealed the plan to be anything but transformational. For starters, it involved only $140 billion in new financing. The rest of the $1 trillion would either refinance borrowers who had already proven their creditworthiness or replace paid-up mortgages.

Next, Johnson implemented a “Fannie Neighbors” program. This initiative would “increase home ownership and promote revitalization in minority and low and moderate-income urban areas … [emphasis added].” Johnson would later point out that during 1994–97 Fannie Mae had spent $7 billion on these “underwriting experiments.”¹³ While that number looks big, it amounted to less than 2% of Fannie’s retained mortgage portfolio.

A former Fannie Mae executive was later quoted as saying:

“About 98 percent of our mortgages were done at market rates. We were giving away a little at the edge of the big machine … Johnson’s attitude was, ‘I am not going to let the government define what affordable housing is to this company.”¹⁴

Johnson himself commented: “But we didn’t say yes to crap, to fraud. We were probing the boundaries, but it was carefully circumscribed.”¹⁵

Beating Back the Privatizers

While Johnson was dealing successfully with the Housers, pressures to privatize Fannie Mae intensified.

During 1995 Johnson got wind that the Treasury was preparing a report contemplating privatization of the Government Sponsored Entities (GSEs). An early draft stated that if the GSEs were privatized:

“Fannie and Freddie would be exposed to the full discipline of private capital market investors, rather than the weakened and distorted discipline resulting from GSE status.” The draft went on to indicate that privatizing Fannie and Freddie “should also improve the safety and soundness of the housing finance market.”¹⁶

The Privatizers got additional ammunition from a study carried out by the Congressional Budget Office that attempted to quantify the value of the subsidy Fannie Mae derived from its implied guarantee. The report estimated this subsidy to total $7 billion annually. Moreover, the report asserted that only $4.9 billion of this sum got passed through to households. Fannie retained $2.1 billion annually, which it could devote to dividends, lobbying and executive compensation.¹⁷ The same CBO report indicated that in 1995 its top 5 executives held $44 million in Fannie Mae stock.

“In the context of a government-sponsored enterprise, in which management controls taxpayer subsidies to a significant extent, those compensation agreements can be inconsistent with the interests of taxpayers and the government. Congress may want to revisit the special relationship that exists between the government and Fannie Mae and Freddie Mac.”¹⁸

Before a privatizing consensus could coalesce, Fannie launched a congressional lobbying effort. To this it added two master gambits in political patronage.

In 1994 Johnson began opening Fannie Mae “Partnership Offices.” These strategically located storefronts provided occasions for ribbon cutting ceremonies and other publicity events. The first opened in San Antonio in the congressional district of Henry Gonzalez, the chairman of the House Banking Committee. By the end of 1994, twelve Partnership Offices existed in cities such as Boston, Miami, Baltimore, Cleveland and Los Angeles.¹⁹ Offices in Atlanta and Kansas City, homes of prominent Republican leaders, followed shortly thereafter. Eventually Fannie Mae would build a network of fifty-five such offices. Each Office oversaw local affordable housing initiatives and reached out to community organizers. Observers would later liken them to a “local Tammany Hall operation—a jobs program for ex-pols.”²⁰ When Fannie Mae needed local support to rebuff congressional initiatives not to its liking, the Partnership Offices proved adept at getting its networks to mobilize, write to Congress and lobby in person.

Then in 1996, Johnson donated $350 million in Fannie Mae stock to the company’s small foundation. The foundation proceeded to make donations to beneficiaries like the non-profit arms of the Congressional Black Caucus and the Hispanic Caucus.²¹

These measures, combined with Johnson’s White House contacts and Fannie Mae’s cultivation of favorable academic research, enabled it to neutralize the Privatizer’s efforts. The Treasury Department’s report essentially came to nothing. The prevailing congressional attitude was that the GSEs had done a lot of good. They were going to do more good in affordable housing (and in our districts!)—”it isn’t broke so don’t fix it.”

Wall Street Mounts an End Run, and Fannie Lowers its Standards

For all of Johnson’s efforts, the mortgage markets, and with them the case for privatization, refused to stand still.

Change began in June 1993 when United Companies Financial (UCF), a Louisiana mortgage lender, sold the first “private label” mortgage-backed bond. With Wall Street’s help, UCF pooled $165 million of mortgages and stacked them into tranches. UCF was able to secure a AAA rating for the higher tranches from all three rating agencies; for the first time mortgage-backed securities not bearing a GSE guarantee had been sold to investors.²²

This development was good news for subprime mortgage originators. Up to then no GSE would touch the mortgages they created. The subprime lenders thus followed strict, even severe lending standards. It was not uncommon for subprime lenders to require down payments as high as 50%. That now began to change. Part of the impetus for change came from new criteria which the GSEs embraced. Part of it came from technology. A final piece came directly from the Wall Street banks.

In response to the 1992 Safety and Soundness Act, Fannie had launched the first of its pilot underwriting programs testing the market for “Alternative Qualifying” (AQ) mortgages. Within this program Fannie dropped its longstanding guidelines that a borrower’s monthly housing payment could not exceed 28% of income and that a borrower’s debts could not exceed 36% of net worth. Other traditional lending standards soon were waived. For example, in 1995 HUD dropped the requirement that property appraisals needed to be secured from independent appraisers. Henceforth, mortgage lenders could hire their own appraisers.

Around the same time, “desktop” scoring models began to replace the laborious procedures used to verify the credit history of prospective borrowers. The most famous of these was developed by Fair Isaac Corporation (FICO). Using FICO scores or similar models, mortgage lenders ramped up activity, approving and closing as many as fifty loans a day.²³

Acute minds on Wall Street saw the pieces of a new business model coming together. At one end were mortgage originators now capable of producing a high volume of subprime mortgages. At the other was Wall Street’s mortgage security packaging with its demonstrated ability to obtain high credit ratings from Moody’s, S&P, and Fitch. All that was needed was a way to provide the subprime lenders with working capital. With “private label” CMOs generating big profits, Wall Street banks saw big incentives to step up and provide working capital themselves.

The Wall Street banks called this practice extending a “warehouse line of credit.” These lines assured subprime lenders they could fund new mortgages while awaiting the purchase of mortgages currently on their books. This completed the construction of a lucrative subprime mortgage pipeline. Wall Street firms could now garner fees on the warehouse credit line, on the purchase of the mortgages and on the securities sold to investors. Later they could earn even bigger fees by taking the mortgage companies public via IPOs. Bear Stearns and Lehman Brothers led the charge. Others quickly followed. From 1994–97 annual subprime mortgage originations grew from $35 to $125 billion.²⁴

Impressive as it was, this growth barely dented Fannie Mae’s colossal mortgage machine. Johnson was not worried about Wall Street eroding Fannie’s profits—at least not yet. What did bother him was Wall Street seeming to be doing a better job on affordable housing. While Fannie Mae conducted carefully calibrated pilot programs, Wall Street was orchestrating over $100 billion in annual mortgages to people who couldn’t qualify for a Fannie conforming mortgage. In Johnson’s mind, it wouldn’t take long before the Privatizers seized on this fact as evidence that the private markets could do Fannie and Freddie’s job.

The Year 1998

The current year had provided Johnson with no respite from headaches. Informal word on Secretary Cuomo’s study suggested that it would recommend a significant increase in Fannie Mae’s affordable housing targets.

This was occurring against a backdrop of cracks appearing in the subprime market. The combination of relaxed lending standards and securitization was proving problematic. Unfortunately for them, subprime mortgage originators still had to carry material amounts of product on their balance sheets before sales to Wall Street could be finalized. For some this had proven deadly. Three subprime lenders, Mercury Finance, Jayhawk Acceptance and First Merchants Acceptance Corporation had gone bankrupt in 1997.²⁵

Finally, there was Fannie Mae’s profit outlook. Conventional mortgage activity had slowed during 1998. The summer had brought hints of international financial crisis and associated turmoil in financial markets. Unless conditions improved, it was possible Fannie Mae would miss its Earnings per Share (EPS) target. For the first time in years bonuses would be disappointing. To avoid this outcome, Johnson had asked his CFO whether there were possibilities to manage Fannie’s earnings to reach target levels. His answer, which was generally positive, was provided in a memo (Attachment 4).

Guidance for Franklin Raines

Jim Johnson reached for a legal pad. It was time to make some notes about the policy guidance for Franklin Raines.

Some things were clear. Fannie Mae needed a potent political machine to fend off the conflicting pressures bearing down on it. None of the interest groups were really interested in what had made Fannie work so well. Rather, they had their own narrow agendas. Fannie Mae needed a robust defense. In Washington, a potent offense was often the best defense.

Johnson also saw that the affordable housing movement was the cornerstone of that offense. So long as Fannie Mae was perceived as promoting home ownership among the underserved, it would enjoy strong protection from the Housers and their congressional allies.

Other issues were less clear. What should be Fannie Mae’s role in the future? Fannie could continue its current course—providing liquidity to the prime market, while doing a little at the edge for affordable housing. The problem increasingly would be reconciling this path with sustaining Fannie’s eye-popping financial performance. Just putting its guarantee on conforming mortgages was not going to take Fannie near its EPS targets. To meet Wall Street’s expectations, Fannie would have to keep increasing its ~$500 billion retained mortgage portfolio.

One alternative would be to add subprime mortgage purchases to the retained portfolio. These mortgages had much higher interest rates and profit potential. Going down this road might also produce two other benefits. First, it would add substance to Fannie’s affordable housing efforts. Second, Fannie Mae might come to play the same role in subprime mortgages that it played in conventional loans—that of arbiter of lending standards. Fannie’s willingness to buy this subprime mortgage but not that one might set the bar on permissible lending practices.

Such a course might also preempt Wall Street’s end run. The key question was the credit standard required by bond investors. Here Johnson was worried about Wall Street’s success at the rating agencies. If the banks could continue to get subprime securities rated AAA, investors might well decide that was good enough.

Musing about that problem led to the third alternative—accepting a shrinking role. Fannie Mae could confine itself to providing liquidity to the mortgage market and to defining sound lending into the affordable housing segments. Given the inroads made by private capital, this version of Fannie’s role would probably shrink over time. That would mean saying goodbye to ever rising EPS, stock prices and executive compensation. It would, however, be more sustainable and defensible in future public policy battles.

At moments like these Johnson felt tempted to embrace the privatization solution. What Johnson liked about this model was that Fannie would then be free to pursue any business it saw fit. Fannie could diversify outside of the secondary mortgage market. It could also tell the Housers to pursue their quotas elsewhere. Johnson felt sure that much of the implied guarantee would survive. Fannie’s size, history and importance to public policy would give it “too big to fail” status. Fannie’s “big, fat gap” would remain intact.

But did Fannie Mae really want to compete with Wall Street without the Housers behind it? Johnson made a note to mention that quandary to Raines.

One issue remained unaddressed—what to say to Raines about Fannie’s financial targets, incentive compensation and immediate outlook? There was this nasty possibility of disappointing financial results and bonuses in Johnson’s last year. If Johnson let that happen, what would that mean for any broader guidance he would hand to Raines?

Johnson put down his pad, looked out the window, and lapsed into thought.

Author’s Note

Jim Johnson, CEO of Fannie Mae from 1992–98, has emerged as one of the less obvious instigators of the financial crisis. Fannie’s accounting scandal came to light under his successor, Franklin Raines. The firm’s financial implosion occurred under Raines’ successor, Daniel Mudd. For some time, Johnson’s role escaped scrutiny. Recent accounts, however, have reported the dangerous seeds that Johnson planted.

Did it need to work out this way? Was Fannie doomed to a financial meltdown requiring the biggest of all government bailouts? In 1998, Fannie could still dictate mortgage terms to the market. Johnson will remain Fannie’s Chairman for a year. He will have an opportunity to influence the path which Raines will move down. This case gives students a chance to stand in Johnson’s shoes and decide whether continuity or a sharp change of direction is in order.

The case provides considerable information on Johnson’s difficult balancing act. For almost a decade he had to satisfy affordable housing advocates and Wall Street investors, while not providing doubters of the “Government Sponsored Entity” model with ammunition to support privatization. These conflicting currents are outlined in the case. Johnson walked several fine lines, kept all of these pressures at bay, and managed to line his pockets in an impressive fashion.

Now new competitors and political pressures are at hand. In the face of these, Johnson has decided to depart. What should he advise Raines to do in his wake? Should Fannie cement its commitment to one or another business model? Should it align more closely with one of the housing factions? Should it cease trying to present itself as a go-go Wall Street darling? Will such moves enable them to pull back from increasingly dubious accounting practices? Students must sort out these crosscurrents and prepare go-forward advice for incoming CEO Raines.

A particular issue concerns the accounting practices which Johnson is considering to “smooth” Fannie’s earnings. Attachment 4 is a Historical Recreation. No such public document exists. Tim Howard, the putative author, would later become a Fannie CFO. The text reflects standard accounting ways in which firms can “smooth” reported earnings. There is also no public record of Johnson engaging in any formal process to provide “handoff” guidance to Raines. Given Johnson’s stature and his role in promoting Raines, an informal process likely occurred. The case pictures Johnson ruminating on what to say as a setting for depicting the tensions evident during his Fannie Mae tenure.

This case is based on the complementary accounts of Morgenson/Rosner’s Reckless Endangerment, and McLean/Nocera’s All the Devils Are Here. Together the two sources provide a comprehensive look at Fannie Mae’s business and political strategies under Jim Johnson. Reckless Endangerment is especially good in describing Fannie’s relentless lobbying machine. All the Devils Are Here does an excellent job describing how Johnson finessed HUD’s affordable housing rules, and how it largely avoided accumulating subprime exposure during his tenure.