Companies can get into dire straits when they ignore early signals of problems

The Sarbanes-Oxley legislation passed in the wake of massive accounting scandals has not solved the problems entirely and has introduced new challenges. The solutions lie with the hedge fund industry policing its own house. How would that happen? It means asking the questions people in polite conversation don’t want to ask.

The combined public and private missions of the Federal National Mortgage Association and the Federal Home Loan Mortgage Corp. may have contributed to special leadership problems at those companies. A quasi-public private organization, such as Fannie Mae or Freddie Mac, has difficulties in terms of playing a dual role of enhancing the ability of private individuals to gain mortgage financing to purchase their own homes and maximizing shareholder value in a highly competitive environment.
Meanwhile, pressure within the mortgage industry intensified disconnect between the dual roles within both Fannie and Freddie. Mortgage securitization seems to have been allowed to spiral out of control with insufficient regulatory oversight. Pressure to increase profits at Fannie Mae and Freddie Mac led to excessive financial risk-taking rather than prudent banking. In retrospect, regulatory efforts to encourage competition between Fannie Mae and Freddie Mac were misguided because they intensified the pressure on entities that were not completely free-market vehicles. Leaders either did not understand or were unable to balance the goals of a “public-private hybrid”. It might be more sensible to have a clear division between ‘public’ and ‘private’ organizations in order for them to focus on a clear mission.
Fannie Mae and Freddie Mac spent more than $150 million on lobbyists over the past decade, illustrating another leadership problem stemming from the organizations’ structures. That’s wholly inappropriate for a government agency and yet, given the way the business model was set up, lobbying had to be an attractive option for the leaders though perhaps not to that extent.

An independent equity research firm in New York, says the leadership failures at Fannie and Freddie were aggravated by the recent housing price bubble that has led to problems across the financial services sector. While asset bubbles are common, from tulips to Internet stocks, the housing bubble was even more difficult to prick because the price inflation benefited so many Americans across the income spectrum. You would have to create a system where some human being would blow the whistle as everyone else is benefiting.

A Credit Suisse analyst who follows the mortgage industry came under the same pressures that led private mortgage firms and companies in other industries to restate income related to derivatives. Fannie and Freddie continued to write loans after the credit markets seized up in 2007 in order to fulfill their public mission, leaving them with a greater share of the market and more problem loans. If you take market share without tightening criteria, you effectively loosen.

In recent years, regulators did raise questions about management at the government sponsored housing lenders. In 2006, the Office of Federal Housing Enterprise Oversight (OFHEO), which monitors the financial health of Fannie Mae and Freddie Mac, released a report describing an arrogant and unethical culture at Fannie Mae where employees manipulated earnings to generate higher bonuses for executives between 1998 and 2004. Our examination found an environment where the ends justified the means. Senior management manipulated accounting; reaped maximum, undeserved bonuses; and prevented the rest of the world from knowing. They co-opted their internal auditors.

Companies can get into dire straits when they ignore early signals of problems like those at Fannie Mae and Freddie Mac. These warnings kept popping up. At some point in time there had to be somebody somewhere in these organizations that said, ‘This just doesn’t feel right.’ It’s a common mistake.”