When The Shoe Fits, Learn From It-Lessons For CUs From Fannie Mae
The business pages, even the front pages, of major newspapers in recent months and weeks have featured a high frequency of stories about Fannie Mae, including regulatory issues, accounting matters, executive compensation, leadership accountability and considerations of new legislation.
During 2003/2004, I served as a credit union representative on Fannie Mae's National Advisory Council (NAC). NAC is a great forum for insight into Fannie Mae's mission, to understand its position in the U.S. financial services market, and for hearing the company's side of the debate around government-sponsored enterprise (GSE) reform and about other of the issues which have been in the press.
That said, I do not possess unique factual information or knowledge about the motives of various parties, but I have closely followed the Fannie Mae and broader GSE stories.
Ultimate resolutions of the various matters will take many months to unfold, but drawing from recent events I think there are significant lessons that can be of value to credit unions and to the credit union movement.
The economic realities of business cycles, interest rate gyrations, housing booms and busts, etc. have not been repealed. Interest rates are cyclical and subject to the shocks of the unforeseen, and in no segment of the economy is that more significant than in the housing market and mortgage financing. Fannie Mae (and Freddie Mac) knew these economic facts, but both seem to have thought that a combination of creative high finance (hedging and use of derivatives) together with selective accounting judgment would normalize their business models to somehow overcome cycles and volatility.
So, in recent years, rather than absorbing and explaining well the consequences of interest rate movements, they have hidden such from the public, and, perhaps, even from themselves.
Fooling The Regulator Is A Dumb Idea
You can fool some of the people all of the time, and all of the people some of the time-but, fooling the regulator is a dumb idea. Regulators have increasingly critical roles to play in modern financial markets and a steady, natural tension between the regulators and regulated is in everyone's best interest. A strong regulator, while annoying at times, serves to keep the players and the games honest.
During the past decade, Fannie Mae and Freddie Mac had both seemed to outgrow their Office of Federal Housing Enterprise Oversight (OFHEO) regulator. Fannie Mae in particular had used political connections and very effective lobbying to prevent and/or avoid any legislation that would have changed and strengthened its regulatory environment. But even a potentially weak or weakened regulator, when embarrassed by the actions of its financial institutions, can and will strike back. OFHEO has flexed its muscle on matters of accounting, decisions about executive and compensation. Now, new legislation is being set in motion to strengthen this or a successor regulator's position over not only Fannie and Freddie, but the 12 Federal Home Loan Banks.
Financial institutions (and any businesses) will direct their energies and their returns to please their sources of capital. GSEs, Fannie Mae, etc. are creations of the federal government with specific advantages and limitations flowing from that unique position. But, Fannie Mae and Freddie Mac may have been more inclined to see themselves more like powerful, for-profit institutions beholden largely to the capital markets and stock-holders.
Consistent with that vision, the concept of maximizing shareholder value and, in turn, executive compensation based on the growth of those profits, became paramount. Further, extreme leverage, possibly due in large part to their favored positions as GSEs, worked to the ends of maximizing shareholder benefits. Largely losing out in this mix was the focus on their original mission to reduce the cost of mortgages to consumers. Narrowing the margin between Fannie Mae's buy-rates and benchmark treasuries was put on the backburner and, minimizing the costs of the mortgage process to financial institutions does not seem to have been reflected in its part of their annual performance goals or success measures.
Two ways to wastefully burn political capital: failing to respect your critics and embarrassing your friends.
Almost no entity has done a better job of building political capital than Fannie Mae. First, by fulfilling well its primary mission of building the secondary market systems that facilitate today's mortgage volumes *; second by targeting key members of Congress and meeting/exceeding their expectations for Fannie Mae services in their districts; and third, by all of the best direct forms of lobbying and public relations that money can buy.
That said, Fannie Mae and Freddie Mac have made a couple of very significant mistakes, having ventured beyond their mission (in the minds of many), and having not listened well or been responsive to their critics. Seeing those who question GSE activities as ideologues or tools of potential competitors is myopic and has resulted in the GSE institutions missing good chances to improve themselves. Fannie Mae and Freddie Mac have also cultivated many more friends on one side of the aisle than another, setting themselves up to become political footballs. Finally, on the issues of accounting and compensation they have embarrassed their friends and, further burned away their political capital.
What Should Drive Compensation
Compensation should be a function of the business model's risks and purposes. At some point among the executives, the boards of directors and the consultants they used, Fannie Mae (and other GSEs) seemed to decide that their reference points for compensation levels were the giant "for-profit" money center banks. The public servants (members of Congress and Civil Service executives) and other restraining reference points to compensation were deemed not relevant. In the Fannie Mae and Freddie Mac cases, it seems that no one saw the essential conflict in benchmarking compensation off the major bank and Wall Street institutions, that "GSEs were creations of the federal government, benefiting from a specific status and they have a very real public service mission."
Another conflict exists in that the extremes of executive compensation in the for-profit giant banks are a function of risks, competition and effective exploitation ** of consumers and businesses. Fannie Mae and other GSE have significant diminished risks, less competition and HOPEFULLY ZERO EXPLOITATION.
It also seems that Fannie Mae and Freddie Mac executive compensation levels were tied (at least any variable portions) to for-profit objectives - growth and share-price. Their missions or purposes, such as reducing costs in the secondary market for financial institutions and consumers, or meeting and exceeding HUD standards or other measures for low and moderate housing financing, etc. may have been stated objectives, but it is not clear if any were incorporated in any manner into compensation structures.
Seeing the recent developments with Fannie Mae, Freddie Mac and GSEs and generally trying to understand some of the flaws and mistakes that have contributed to their problems-and focusing on their current challenges is a great opportunity for credit unions to apply the relevant lessons.
To not learn from the mistakes and pain of other financial entities with special missions would sadly confirm the negative in an observation made by George Bernard Shaw: "If history repeats itself, and the unexpected always happens, how incapable must man be of learning from experience."
* For an excellent summary of the accomplishments and contributions of Fannie Mae, I recommend a report entitled "Home Sweet Loan: How secondary markets changed America" by Todd Buchholz for the Homeownership Alliance.
** A Wall Street Journal commentary (Dec. 6, 2004) entitled Risky Business by Peter R. Fisher talks about how financial institutions/financial intermediaries are capturing almost 30% of total U.S. corporate profits. One reading of that piece might be that those profits are excessive and will not be sustained-but, it can also be assumed that the excesses of such profits have been passed in excess levels of compensation.
John Tippets is president/CEO of AA Credit Union, Dallas/Ft. Worth, Texas.