Bill Black: Did OFHEO Fix Fannie and Freddie’s Compensation Systems after discovering their Frauds?

Bill Black, the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. Cross posted from New Economic Perspectives.

I have been chastised by a friend and former colleague for writing:

“Here is the crazy thing – the SEC, OFHEO, and Department of Justice all failed to demand that Fannie and Freddie end their perverse executive compensation system that made the executives wealthy through fraud and put the entities and the government at risk.”

My friend notes that Fannie, under pressure from OFHEO and with its prior approval, changed its compensation system after the initial accounting fraud.

My sentence would be clearer if it was revised to read as follows:

“Here is the crazy thing – the SEC, OFHEO, and the Department of Justice all failed to prevent Fannie and Freddie from using perverse executive compensation systems that made the executives wealthy through fraud and put the entities and the government at risk.”

The new compensation systems at Fannie and Freddie remained exceptionally perverse after the changes.  Their CEOs continued to cause them to engage in systematic accounting fraud by not providing remotely adequate loss reserves and allowances for loan losses despite purchasing massive amounts of fraudulent liar’s loans and fraudulent subprime liar’s loans.  The same scam that made the officers rich was certain to destroy Fannie and Freddie.

I have also examined a number of statements by both of OFHEO’s leaders during the relevant period, concerning compensation and the initial Fannie accounting fraud.  James Lockhart issued a hard hitting release on May 23, 2006 accompanying OFHEO’s report on its investigation of Fannie entitled:  “FANNIE MAE FAÇADE: Fannie Mae Criticized for Earnings Manipulation.”  The release begins with this passage that directly ties the accounting fraud to the controlling officers’ desire to trigger bonuses.

Note that the release emphasizes that the OFHEO report “prescribes corrective actions.”  The purpose of the release, of course, is to emphasize the most important aspects of the lengthy OFHEO report.  The release makes it clear that executive compensation drove the fraud.

“By deliberately and intentionally manipulating accounting to hit earnings targets, senior management maximized the bonuses and other executive compensation they received, at the expense of shareholders. Earnings management made a significant contribution to the compensation of Fannie Mae Chairman and CEO Franklin Raines, which totaled over $90 million from 1998 through 2003. Of that total, over $52 million was directly tied to achieving earnings per share targets.”

When it comes to the steps that Lockhart considered critical, however, executive compensation was not specifically mentioned.

Similarly, on June 6, 2006, Lockhart testified before the House on Fannie’s fraud.  He explained how Fannie’s executive compensation system created the perverse incentives that drove the massive accounting fraud.  He ended by listing how OFHEO responded to the frauds by ordering changes at Fannie.  None of these changes discussed executive compensation.  The failure of this excerpt to discuss executive compensation is particularly striking.

“Fannie Mae must take additional steps to improve its internal controls, accounting systems, operational and other risk management practices and systems, data quality, and journal entries. Emphasis must be placed on implementation with dates certain.”

Executive compensation, the most critical problem at Fannie and Freddie, the problem that drove their accounting control frauds, received minimal 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 and Freddie.  OFHEO took no effective action to remove these perverse incentives.

Armando Falcon, Lockhart’s predecessor as head of OFHEO, achieved the remarkable – his revulsion for Fannie’s controlling officers exceeded Lockhart’s.  “While all of this political power satisfied the egos of Fannie and Freddie executives, it ultimately served one primary purpose: the speedy accumulation of personal wealth by any means.”  Testimony of Armando Falcon, submitted to the Financial Crisis Inquiry Commission (April 9, 2010).  His testimony details how Fannie’s controlling officers used accounting fraud to attain massive bonuses.

The Terrible Cost of Failing to Understand Accounting Control Fraud

The sad irony is that immediately after Falcon explained the perverse incentives arising from Fannie’s compensation system he went on to be only half right in his analysis of Fannie and Freddie’s eventual failure.  The half he got wrong stemmed from his failure to understand the interplay of accounting control fraud and perverse executive compensation.

In addition, OFHEO made it very clear to both enterprises that safety and soundness was always a higher priority than the affordable housing goals. They should not take on excessive risk in order to meet any one of the goals.”

Falcon almost gets this right, but his failure to understand the most destructive financial fraud mechanism leads him to miss what happened at Fannie and Freddie even with the benefit of hindsight.  His analytical failures exemplify OFHEO’s central analytical failure.  He is correct that only the exceptionally naïve could believe that Fannie and Freddie’s controlling officers based their business decisions on meeting the affordable housing goals.  He is grotesquely incorrect in assuming that their controlling officers only engaged in an activity if “there was a profit to be made.”  His error is bizarre given the fact that he had explained that Fannie’s controlling officers engaged in activity that caused large losses and then used accounting fraud to transmute real losses into fictional gains in order to maximize their bonuses.

Falcon is correct that Fannie’s controlling officers had “one primary purpose” at all times – “the speedy accumulation of personal wealth by any means.”  What he fails to understand is that accounting control fraud is a “sure thing” and that the formula for maximizing fictional 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 and Freddie would suffer massive losses.  Purchasing large amounts of subprime liar’s loans guaranteed that they would suffer catastrophic losses.  Liar’s (home) loans create such intense “adverse selection” that they have a sharply negative “expected value.”  In plain English, the purchaser will lose money.  It’s equivalent to betting against the House, except that the odds are so bad that the expected value is more negative than playing the lottery.  Liar’s loans can only fail to produce obvious severe losses temporarily while the bubble is expanding.  Refinancing hides the losses during the rapid expansion phase of the bubble.  The saying in the trade is that “a rolling loan gathers no loss.”  Bubbles, however, are only temporary and liar’s loans will begin blowing as soon as the bubble starts inflating, which can be over a year prior to the bubble bursting.

Fannie and Freddie’s CEOs chased higher nominal yields, not real “profit” for the firms.  Their strategy exemplified the logic of George Akerlof and Paul Romer’s famous 1993 article, captured in their title (“Looting: the Economic Underworld of Bankruptcy for Profit”).  The firm fails, but the controlling officers walk away rich because the frauds they lead produce fictional income and real bonuses.  (Akerlof and Romer’s use of the word “profit” is ironic.  It refers to gains to the controlling officers from fraudulent business strategies that cause fatal losses to the firm.)  Akerlof and Romer aptly termed the accounting control fraud strategy a “sure thing.”

Fannie and Freddie’s risk officers alerted their CEOs to the fact that nonprime loans were likely to produce far greater losses, that the rapid rise in home prices was temporarily suppressing default rates, and that the rapid rise in home prices could not continue indefinitely.  It is inconceivable that Fannie and Freddie did 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 an economic “crisis” if it were not contained.  Fannie and Freddie’s purchase of liar’s loans that cause severe losses overwhelmingly occurred after the FBI’s warning.  “The government” never required any entity to make or purchase liar’s loans.  Most of the liar’s loans that caused Fannie and Freddie’s severe losses were purchased after 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 TO the MORTGAGE BANKERS ASSOCIATION.”  (It is inconceivable that Fannie and Freddie’s controlling officers, or OFHEO, were unaware 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 reduced documentation loans speed up the approval process, but they are open invitations to fraudsters. It appears that many members of the industry have little historical appreciation for the havoc created by low-doc/no-doc products that were the rage in the early 1990s. Those loans produced hundreds of millions of dollars in losses for their users.”

MARI’s third warning quantified the incidence of fraud in such loans.  It paired these data with its fourth warning dealing with the revealing label the industry used internally for such loans.

“One of MARI’s customers recently reviewed a sample of 100 stated income loans upon which they had IRS Forms 4506. When the stated incomes were compared to the IRS figures, the resulting differences were dramatic. Ninety percent of the stated incomes were exaggerated by 5% or more. More disturbingly, almost 60% of the stated amounts were exaggerated by more than 50%. These results suggest that the stated income loan deserves the nickname used by many in the industry, the “liar’s loan.””

MARI’s fifth warning reported the views of federal banking regulators.

Federal regulators of insured financial institutions have expressed safety and soundness concerns over these loans with lower documentation requirements and other “nontraditional” loans.

To summarize, MARI warned every member of the Mortgage Bankers Association (MBA) in writing in early 2006 that so-called “stated income” loans:

It was in this context that (1) lenders moved massively to increase their origination of fraudulent liar’s loans and to sell such loans through fraudulent “reps and warranties” (2) Fannie and Freddie (and their investment banker counterparts) moved massively to purchase these endemically fraudulent loans, and (3) OFHEO did nothing meaningful to prevent Fannie and Freddie from purchasing fatal amounts of fraudulent liar’s loans.

Fannie and Freddie (and the FHFA) still get it wrong

 

Indeed, even after the second wave of accounting control fraud caused the failure of Fannie and Freddie, OFHEO failed to end their perverse executive compensation practices.  Steve Linick, the FHFA’s Inspector General (FHFA is the successor agency to OFHEO) reported:

“Linick said the FHFA rejected his recommendation that it test and independently verify the annual pay packages, which are set by the boards of Fannie and Freddie and approved by the agency in consultation with the Treasury Department.

Further, the agency “lacks independent testing and verification of the Enterprises’ submissions in support of executive compensation packages,” the report said.”

The federal “pay czar” heavily criticized all but one of the executive compensation plans submitted by the bailed-out firms still subject to special regulation.  Executive compensation is so typically perverse that it is one of leading causes of criminogenic environments for accounting control fraud.  The intellectual father of modern executive compensation, Michael Jensen, has decried the results, which he concedes includes rampant earnings manipulation.  Fannie and Freddie are simply the most expensive failures to date caused by accounting control fraud.