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FANNIE MAE AND FRIENDS

James A. Johnson, chief executive officer, Fannie Mae, 1991-1998, director, Goldman Sachs; former director, KB Home; former chairman of The Brookings Institution and The Kennedy Center for the Performing Arts Franklin Delano Raines, former director, Office of Management

and Budget; chief executive officer, Fannie Mae, 1999-2005 David O. Maxwell, chief executive officer, Fannie Mae, 1981-1991 William Jefferson Clinton, forty-second president of the United States

Barney Frank, Democratic congressman from Massachusetts Robert Zoellick, executive vice president, Fannie Mae, 1993-1997 Thomas Donilon, head of government affairs, Fannie Mae, 1999-2005

LaRRy SummERS, deputy secretary, United States Treasury, 1995-

1999. Secretary of the Treasury, 1999-2001 Robert Rubin, Secretary of the United States Treasury, 1995-1999 Richard Holbrooke, cofounder with James Johnson of Public

Strategies, consulting firm Leland Brendsel, former chief executive, Freddie Mac, 1987-2003

Timothy Howard, chief financial officer, Fannie Mae, 1990-2005 Thomas Nides, executive vice president, human resources, Fannie Mae, 1998-2001

Herb Moses, community affairs official, Fannie Mae, 1991-1998,

and former partner of Barney Frank R. Glenn Hubbard, Columbia Graduate School of Business Peter Orszag, senior economist, Council of Economic Advisors, 1995-1996

Bruce Vento, Democratic representative from Minnesota, 1977-2000

Robert Bennett, Republican senator from Utah, 1993-2010 Kit Bond, Republican senator from Missouri, 1987-2003 Stephen Friedman, former director, Fannie Mae, and former chief

executive, Goldman Sachs Maxine Waters, Democratic representative from California

DOUBTERS AND THOSE WHO PUSHED BACK

Dean Baker, codirector, Center for Economic & Policy Research Anne Canfield, lobbyist for community banks and author of The GSE Report

Marvin Phaup, former director, Financial Studies/Budget Process

group, Congressional Budget Office June O'Neill, director, Congressional Budget Office, 1995-1999 Walker Todd, former chief counsel at Federal Reserve Bank of Cleveland

Richard S. Carnell, assistant secretary for financial institutions, United States Treasury

EDwArd) DeMarco, director, office of Financial Institutions Policy,

Treasury Department, 1993-2003 William Lightfoot, former D.C. Council member Armando Falcon, director, Office of Federal Housing Enterprise

Oversight, 1995-2005 Roy E. Barnes, governor of Georgia, 1999-2003, and predatory

lending adversary William J. Brennan Jr., former director, Home Defense Program,

Atlanta Legal Aid Janet Ahmad, president, Homeowners for Better Building, San Antonio

Marc Cohodes, former money manager, Marin County, California

SUBPRIME LENDERS AND THEIR ENABLERS

Angelo Mozilo, cofounder and former chief executive, Countrywide Financial Wright H. Andrews Jr., subprime lending lobbyist Walter Falk, founder, Metropolitan Mortgage of Miami David Silipigno, founder, National Finance Company J. Terrell Brown, former chief executive, United Companies Financial

Scott Hartman, former chairman, NovaStar W. Lance Anderson, former chief executive, NovaStar Bruce Karatz, former chief executive, KB Home Henry Cisneros, secretary, Housing & Urban Development, 1993-1997

Murray Zoota, former chief executive, Fremont Investment & Loan David McIntyre, former chief executive, Fremont Corporation Louis Rampino, former chief executive, Fremont General

FECKLESS REGULATORS

Timothy F. Geithner, president, Federal Reserve Bank of New York, 2003-2008

RogER FERGUSON, vice-chairman of the FEDERAL ReServE, 1999-2006

Andrew Cuomo, secretary, Housing & Urban Development, 1997-2001

Robert Peach and John McCarthy, researchers at the Federal

Reserve Bank of New York Alan Greenspan, chairman, Federal Reserve Board, 1987-2006 Frederic Mishkin, governor, Federal Reserve Board, 2006-2008

This is not the first book to be written about the epic financial crisis of 2008 and neither will it be the last. But Josh and I believe that Reckless Endangerment is different from the others in two important ways. It identifies powerful people whose involvement in the debacle has not yet been chronicled and it connects key incidents that have seemed heretofore unrelated.

As a veteran business reporter and columnist for the New York Times, I've covered my share of big and juicy financial scandals over the years. For more than a decade as an established financial and policy analyst, Josh has seen just about every trick there is.

But none of the scandals and financial improprieties we experienced before felt nearly as momentous or mystifying as the events that culminated in this most recent economic storm. That's why we felt that this calamity, and the conduct that brought it on, needed to be thoroughly investigated, detailed, and explained.

The disaster was so great—its impact so far-reaching—that we knew we were not the only ones who wanted to understand how such a thing could happen in America in the new millennium.

Even now, more than four years after the cracks in the financial foundation could no longer be ignored, people remain bewildered about the causes of the steepest economic downturn since the Great Depression. And they wonder why we are still mired in it.

Then there is the maddening aftermath—watching hundreds of billions of taxpayer dollars get funneled to rescue some of the very institutions that drove the country into the ditch.

The American people realize they've been robbed. They're just not sure by whom.

Reckless Endangerment is an economic whodunit, on an international scale. But instead of a dead body as evidence, we have trillions of dollars in investments lost around the world, millions of Americans jettisoned from their homes and fourteen million U.S. workers without jobs. Such is the nature of this particular crime.

Recognizing that a disaster this large could not have occurred overnight, Josh and I set out to detail who did it, how, and why. We found that this was a crisis that crept up, building almost imperceptibly over the past two decades. More disturbing, it was the result of actions taken by people at the height of power in both the public and the private sectors, people who continue, even now, to hold sway in the corridors of Washington and Wall Street.

Reckless Endangerment is a story of what happens when unfettered risk taking, with an eye to huge personal paydays, gains the upper hand in corporate executive suites and on Wall Street trading floors. It is a story of the consequences of regulators who are captured by the institutions they are charged with regulating. And it is a story of what happens when Washington decides, in its infinite wisdom, that every living, breathing citizen should own a home.

Josh and I felt compelled to write this book because we are angry that the American economy was almost wrecked by a crowd of self-interested, politically influential, and arrogant people who have not been held accountable for their actions. We also believe that it is important to credit the courageous and civically minded people who tried to warn of the impending crisis but who were run over or ignored by their celebrated adversaries.

Familiar as we are with the ways of Wall Street, neither Josh nor I was surprised that the large investment firms played such a prominent role in the debacle. But we are disturbed that so many who contributed to the mess are still in positions of power or have risen to even higher ranks. And while some architects of the crisis may no longer command center stage, they remain respected members of the business or regulatory community. The failure to hold central figures accountable for their actions sets a dangerous precedent. A system where perpetrators of such a crime are allowed to slip quietly from the scene is just plain wrong.

In the end, analyzing the financial crisis, its origins and its framers, requires identifying powerful participants who would rather not be named. It requires identifying events that seemed meaningless when they occurred but had unintended consequences that have turned out to be integral to the outcome. It requires an unrelenting search for the facts, an ability to speak truth to power.

Investigating the origins of the financial crisis means shedding light on exceedingly dark corners in Washington and on Wall Street. Hidden in these shadows are people, places, and incidents that can help us understand the nature of this disaster so that we can keep anything like it from happening again.

The president of the United States was preaching to the choir when he made that proclamation in 1994, just two years into his first term. Facing an enthusiastic crowd at the National Association of Realtors' annual meeting in Washington, D.C., Clinton launched the National Partners in Homeownership, a private-public cooperative with one goal: raising the numbers of homeowners across America.

Determined to reverse what some in Washington saw as a troubling decline of homeownership during the previous decade, Clinton urged private enterprise to join with public agencies to ensure that by the year 2000, some 70 percent of the populace would own their own homes.

An owner in every home. It was the prosperous, 1990s version of the Depression-era "A Chicken in Every Pot."

With homeownership standing at around 64 percent, Clinton's program was ambitious. But it was hardly groundbreaking. The

U.S. government had often used housing to achieve its public policy goals. Abraham Lincoln's Homestead Act of 1862 gave away public land in the nation's western precincts to individuals committed to developing it. And even earlier, during the Revolutionary War, government land grants were a popular way for an impoverished America to pay soldiers who fought the British.

Throughout the American experience, a respect, indeed a reverence, for homeownership has been central. The Constitution, as first written, limited the right to vote to white males who owned property, for example. Many colonists came to America because their prospects of becoming landowners were far better in the New World than they were in seventeenth- and eighteenth-century Europe.

Still, Clinton's homeownership plan differed from its predecessors. The strategy was not a reaction to an economic calamity, as was the case during the Great Depression. Back then, the government created the Home Owners' Loan Corporation, which acquired and refinanced one million delinquent mortgages between 1933 and 1936.

On the contrary, the homeownership strategy of 1994 came about as the economy was rebounding from the recession of 1990 and '91 and about to enter a long period of enviable growth. It also followed an extended era of prosperity for consumer-oriented banks during most of the 1980s when these institutions began extending credit to consumers in a more "democratic" manner for the first time.

Rather than pursue its homeownership program alone, as it had done in earlier efforts, the government enlisted help in 1995 from a wide swath of American industry. Banks, home builders, securities firms, Realtors—all were asked to pull together in a partnership made up of 65 top national organizations and 131 smaller groups.

The partnership would achieve its goals by "making homeownership more affordable, expanding creative financing, simplifying the home buying process, reducing transaction costs, changing conventional methods of design and building less expensive houses, among other means."

Amid the hoopla surrounding the partnership announcement, little attention was paid to its unique and most troubling aspect: It was unheard of for regulators to team up this closely with those they were charged with policing.

And nothing was mentioned about the strategy's ultimate consequence—the distortion of the definition of homeownership—gutting its role as the mechanism for most families to fund their retirement years or pass on wealth to their children or grandchildren.

Instead, in just a few short years, all of the venerable rules governing the relationship between borrower and lender went out the window, starting with the elimination of the requirements that a borrower put down a substantial amount of cash in a property, verify his income, and demonstrate an ability to service his debts.

With baby boomers entering their peak earning years and the number of two-income families on the rise, banks selling Americans on champagne hopes and caviar dreams were about to become the most significant engine of economic growth in the nation. After Congress changed the tax code in 1986, eliminating the deductibility of interest payments on all consumer debt except those charged on home mortgages, the stage was set for housing to become Americans' most favored asset.

Of course, banks and other private-sector participants in the partnership stood to gain significantly from an increase in home-ownership. But nothing as crass as profits came up at the Partners in Homeownership launch. Instead, the focus was on the "deeply-rooted and almost universally held belief that homeownership provides crucial benefits that merit continued public support." These included job creation, financial security (when an individual buys a home that rises in value), and more stable neighborhoods (people don't trash places they own).

In other words, homeownership for all was a win/win/win.

A 1995 briefing from the Department of Housing and Urban Development did concede that the validity of the homeownership claims "is so widely accepted that economists and social scientists have seldom tested them." But that note of caution was lost amid bold assertions of homeownership's benefits.

"When we boost the number of homeowners in our country," Clinton said in a 1995 speech, "we strengthen our economy, create jobs, build up the middle class, and build better citizens."

Clinton's prediction about the middle class was perhaps the biggest myth of all. Rather than building it up, the Partners in Home-ownership wound up decimating the middle class. It left Americans in this large economic group groaning under a mountain of debt and withdrawing cash from their homes as a way to offset stagnant incomes.

It took a little more than a decade after the partnership's launch for its devastating impact to be felt. By 2008, the American economy was in tatters, jobs were disappearing, and the nation's middle class was imperiled by free-falling home prices and hard-hit retirement accounts. Perhaps most shocking, homeownership was no longer the route to a secure spot in middle-class America. For millions of families, especially those in the lower economic segments of the population, borrowing to buy a home had put them squarely on the road to personal and financial ruin.

Fueled by dubious industry practices supported by many in Congress and unchecked by most of the regulators charged with oversight of the lending process, the homeownership drive helped to plunge the nation into the worst economic crisis since the Great Depression.

Truly this was an unprecedented partnership.

But what few have recognized is how the partners in the Clinton program embraced a corrupt corporate model that was also created to promote homeownership. This was the model devised by Fannie Mae, the huge and powerful government-sponsored mortgage finance company set up in 1938 to make it easier for borrowers to buy homes in Depression-ravaged America. Indeed, by the early 1990s, well before the government's partnership drive began, Fannie Mae had perfected the art of manipulating lawmakers, eviscerating its regulators, and enriching its executives. All in the name of expanding homeownership.

Under the direction of James A. Johnson, Fannie Mae's calculating and politically connected chief executive, the company capitalized on its government ties, building itself into the largest and most powerful financial institution in the world. In 2008, however, the colossus would fail, requiring hundreds of billions in taxpayer backing to keep it afloat. Fannie Mae became the quintessential example of a company whose risk taking allowed its executives to amass great wealth. But when those gambles went awry, the taxpayers had to foot the bill.

This failure was many years in the making. Beginning in the early 1990s, Johnson's position atop Fannie Mae gave him an extraordinary place astride Washington and Wall Street. His job as chief executive of the company presented him with an extremely powerful policy tool to direct the nation's housing strategy. In his hands, however, that tool became a cudgel. With it, he threatened his enemies and regulators while rewarding his supporters. And, of course, there was the fortune he accrued.

Perhaps even more important, Johnson's tactics were watched closely and subsequently imitated by others in the private sector, interested in creating their own power and profit machines. Fannie Mae led the way in relaxing loan underwriting standards, for example, a shift that was quickly followed by private lenders. Johnson's company also automated the lending process so that loan decisions could be made in minutes and were based heavily on a borrower's credit history, rather than on a more comprehensive financial profile as had been the case in the past.

Eliminating the traditional due diligence conducted by lenders soon became the playbook for financial executives across the country. Wall Street, always ready to play the role of enabler, provided the money for these dubious loans, profiting mightily. Without the Wall Street firms giving billions of dollars to reckless lenders, hundreds of billions of bad loans would never have been made.

Finally, Fannie Mae's aggressive lobbying and its methods for neutering regulators and opponents were also copied by much of the financial industry. Regulators across the country were either beaten back or lulled into complacency by the banks they were supposed to police.

How Clinton's calamitous Homeownership Strategy was born, nurtured, and finally came to blow up the American economy is the story of greed and good intentions, corporate corruption and government support. It is also a story of pretty lies told by politicians, company executives, bankers, regulators, and borrowers.

And yet, there were those who questioned the merits of the homeownership drive and tried to alert regulators and policymakers to its unintended consequences.

A handful of analysts and investors, for example, tried to warn of the rising tide of mortgage swindlers; they were met with a deafening silence. Consumer lawyers, seeing the poisonous nature of many home loans, tried to outlaw them. But they were beaten back by an army of lenders and their lobbyists. Some brave souls in aca-demia argued that renting a home was, for many, better than owning. They were refuted by government studies using manipulated figures or flawed analysis to conclude that homeownership was a desired goal for all.

Even the credit-rating agencies, supposedly neutral assayers of risks in mortgage securities, quelled attempts to rein in predatory lending.

All the critics were either willfully ignored or silenced by well-funded, self-interested, and sometimes vicious opposition. Their voices were drowned out by the homeownership trust, a vertically integrated, public-private housing machine whose members were driven either by ideology or the vast profits that rising homeownership would provide.

The consortium was too big and too powerful for anyone to take on. Its reach extended from the mortgage broker on Main Street to the Wall Street traders and finally to the hallowed halls of Congress. It was unstoppable.

Because housing finance was heavily regulated, government participation was vital to the homeownership push. And Washington played not one but three starring roles in creating the financial crisis of 2008. First, it unleashed the mortgage mania by helping to relax basic rules of lending that had been in place for decades. Then its policymakers looked the other way as the mortgage binge enriched a few and imperiled many. Even after the disaster hit and the trillion-dollar bailouts began, Congress and administration officials did little to repair the damaged system and ensure that such a travesty could not happen again.

This was a reckless endangerment of the entire nation by people at the highest levels of Washington and corporate America.

Barney Frank, the powerful Massachusetts Democrat and ardent supporter of Fannie Mae, summed it up perfectly back in March 2005. He had just delivered a luncheon speech on housing at the Four Seasons Hotel in Georgetown.

Walking up from the lower-level conference room where he had addressed the Institute of International Bankers, Frank was asked whether he had considered the possible downsides to the homeownership drive. Was he afraid, for instance, that easy lending programs could wind up luring many of his constituents into homes they could not ultimately afford? Was he concerned that, after the groundbreaking and ribbon-cutting ceremonies were forgotten, the same people he had put into homes would be knocking on his door, complaining of being trapped in properties and facing financial ruin?

Frank brushed off the questioner. "We'll deal with that problem if it happens," he barked.

It was a cool and partly cloudy day in May 2002, when Augsburg College seniors gathered in their downtown Minneapolis campus to collect the undergraduate degrees they had worked so hard to earn. Before them stood James Arthur Johnson, a major donor to the college and a Minnesota boy, made good. A man who had climbed to the top of two cutthroat worlds—corporate America and the Washington power scene—Johnson had been invited to provide guidance and advice to the class of 2002. He was returning to his roots that day in Minneapolis—Johnson's mother, Adeline, a schoolteacher, had been an "Auggie" graduate seventy-one years earlier.

Invoking Adeline, his father, Alfred, and his Norwegian emigrant grandparents, Johnson urged the graduates to pursue their careers with integrity and honesty. Just months after a rogue energy company called Enron had hurtled into bankruptcy, faith in corporate America and the nation's markets had been shaken.

Avuncular, professorial, and attractive, Johnson delivered a reassuring message: "Good ethics are good business."

It was the kind of advice to be expected from a man who just three years earlier had presided over Fannie Mae, one of the world's largest and most prestigious financial institutions. Johnson had then gone on to serve on the boards of five large and well-known public companies, including the mighty investment bank, Goldman Sachs. "What we want from friends—honesty and integrity, energy and optimism, commitment to family and community, hard work and high ethical standards—are the same qualities we need from American business," he told the graduates.

But as he wound up his speech, the fifty-nine-year-old Johnson struck a wistful tone. Just before George Bernard Shaw died, Johnson said, the playwright had been asked to name a famous deceased man—artist, statesman, philosopher, or writer—whom he missed the most.

Johnson recounted Shaw's reply: "The man I miss most is the man I could have been."

It was a surprising, almost regretful comment from a man who had it all—wealth, power, prestige, and access to men and women at the highest levels of government. Johnson was not only the former chief executive of Fannie Mae, the quasi-government mortgage finance giant; he had also run the Kennedy Center for the Performing Arts in Washington and the Brookings Institution, an influential D.C.-based liberal think tank. Even as he addressed the graduates, he was vice-chairman of a blue-chip private equity firm, Perseus Capital.

A regular in Washington's halls of power, Johnson had also been a top adviser to Walter Mondale, when he was vice president of the United States. John Kerry, the 2000 Democratic presidential nominee, had also relied on Johnson for guidance.

Just one of Johnson's achievements, by almost anybody's reckoning, would have placed him in the top echelons of success.

And yet, for all of his accomplishments, Johnson's ultimate aspirations in Washington remained unmet that May. "The man I could have been" was a likely nod to his longtime desire to become

Treasury secretary of the United States, people who know him say.

But that appointment never came. Nor is it likely to. In the wake of the mortgage crisis of 2008, Johnson's legacy has become decidedly darker. Sure, he retired as vice-chairman of Fannie Mae in 1999, almost a decade before the financial debacle took hold. But Johnson's command-and-control management of the mortgage finance giant and his hardball tactics to ensure Fannie Mae's dominance amid increasing calls for oversight are crucial to understanding the origins of the worst financial debacle since the Great Depression.

Little known outside the Beltway, Johnson was the financial industry's leader in buying off Congress, manipulating regulators, and neutralizing critics, former colleagues say. His strategy of promoting Fannie Mae and protecting its lucrative government association, largely through intense lobbying, immense campaign contributions, and other assistance given to members of Congress, would be mimicked years later by companies such as Countrywide Financial, an aggressive subprime mortgage lender, Goldman Sachs, Citigroup, and others.

Perhaps more crucial, Johnson's manipulation of his company's regulators provided a blueprint for the financial industry, showing them how to control their controllers and produce the outcome they desired: lax regulation and freedom from any restraints that might hamper their risk taking and curb their personal wealth creation.

Under Johnson, Fannie Mae led the way in encouraging loose lending practices among the banks whose loans the company bought. A Pied Piper of the financial sector, Johnson led both the private and public sectors down a path that led directly to the credit crisis of 2008. It took more than a decade to assemble the machinery needed to create the housing mania. But it took only a year or two for the juggernaut to collapse in a heap, destroying millions of jobs and retirement accounts, and devastating borrowers.

After years of crisis coverage in the media, multiple government investigations, and numerous books on the topic, Johnson's role in the mortgage maelstrom has escaped scrutiny. Remarkably, his reputation as a mover and shaker in both business and government remains largely intact, even after the September 2008 taxpayer takeover of an insolvent Fannie Mae, at a cost of hundreds of billions of dollars.

And while others on Wall Street and in the mortgage lending industry have been damaged by the crisis, Johnson is still viewed as a D.C. power broker, respected corporate director, and philanthropist. He enjoys a luxurious life, splitting time between homes in such glamorous locales as Ketchum, Idaho; Palm Desert, California; and a penthouse apartment atop the Ritz-Carlton in Washington, D.C.'s Georgetown neighborhood.

Johnson continues to hobnob with highly placed friends in government and industry—indeed, before Barack Obama was elected president of the United States, Johnson hosted a party to honor the candidate at his $5.6 million Washington apartment.

Some of Johnson's past associations did come back to haunt him in the summer of 2008, however. Obama had asked Johnson to help sift through possible vice presidential candidates but just weeks after he began the search, details emerged of sweetheart mortgage deals Johnson had received from Countrywide Financial, the nation's largest purveyor of toxic subprime loans during the lending boom. Johnson was forced to resign quickly from the Obama team.

But Johnson's involvement in the mortgage crisis goes far beyond receiving low-cost loans from Countrywide and its chief executive, Angelo Mozilo. Former colleagues say that Johnson, during his years running Fannie Mae, was the original, if anonymous, architect of what became the disastrous homeownership strategy promulgated by William Jefferson Clinton in 1994. Johnson, after becoming chief executive of Fannie Mae in 1991 and under the auspices of promoting homeownership, partnered with home builders, lenders, consumer groups, and friends in Congress to transform Fannie Mae into the largest and most influential financial institution in the world.

"Clinton was clearly coordinating with him—they had the same goals at the same time," said Edward Pinto, former chief credit officer at Fannie Mae, who is a consultant. With other high-level Democrats on his side, Johnson beat back all attempts to rein in Fannie Mae's operations or growth plans.

Although Johnson left Fannie Mae's executive suite in 1999, his stewardship of the company not only opened the door to the mortgage meltdown, it virtually guaranteed it, former colleagues said.

Johnson's many peers in the financial and homebuilding industries watched closely as he remade the government-created and -sponsored Fannie Mae from a political lapdog of housing policy into an aggressive, highly politicized attack dog. In the meantime, he created enormous wealth for himself and his executives even as the company took on outsized risks.

Fannie also funneled huge campaign contributions to supporters in Congress. Between 1989 and 2009, according to the Center for Responsive Politics, Fannie Mae spent roughly $100 million on lobbying and political contributions.

Johnson's most crucial win was making sure that Congress was the company's boss, not the Office of Federal Housing Enterprise Oversight (OFHEO), a regulator created in 1992 to watch over the company. With Congress as his de facto overseer and with millions of dollars to hand out to lawmakers, Johnson could be confident his company would always receive the support it sought on Capitol Hill.

"Fannie has this grandmotherly image," a congressional aide told a writer for The International Economy magazine in 1999. But when it came to opponents, "they'll castrate you, decapitate you, tie you up, and throw you in the Potomac. They're absolutely ruthless."

As Daniel Mudd, a former Fannie Mae executive, wrote in an e-mail after Johnson's departure from the company: "The old political reality was that we always won, we took no prisoners, and we faced little organized political opposition."

Fannie Mae, which was originally known as the Federal National Mortgage Association, was not always ruthless and all-powerful.

Like many financial institutions, it had a near-death experience in the 1980s when interest rates rocketed into the high teens. Technically insolvent in the early part of the decade because its mortgage portfolio carried interest rates well below prevailing levels, the mortgage finance company was delivered from the brink by an executive named David O. Maxwell.

The U.S. government had created Fannie Mae in 1938 to buy mortgages from banks that loaned money to homebuyers. Fannie Mae did not lend directly to borrowers, but by buying mortgages from banks the company reduced consumer reliance on mortgages that were short-term in nature, hard to refinance, and issued by fly-by-night lenders. It was a Depression-era creation designed to ease financing costs for borrowers still recovering from the economic devastation of the 1930s.

In 1968, President Lyndon B. Johnson changed the company from an agency of the government into a partially private entity that issued common stock to public investors. With the costs of the Vietnam War escalating, the president's idea was to get the company's liabilities off the government's balance sheet. It still had close ties to the government and perquisites that other finance companies could only dream of, but by the 1980s, Fannie Mae was a financial colossus that had to please both shareholders and the government. Its shares were first offered to the public in 1989.

Before becoming the head of Fannie Mae in 1981, Maxwell had a career that spanned private industry and public service. He had been president of a mortgage insurance company and then in 1970 became general counsel at the Department of Housing and Urban Development, the federal agency that oversaw the Federal Housing Administration loan programs and also served as part-time regulator to Fannie Mae and its sibling, Freddie Mac.

Maxwell was a brilliant manager and a natural leader, according to those who worked under him. "He was a Brahmin," one former employee said. Unlike Johnson, the man he chose to be his successor, Maxwell was a businessman, not a politician.

While Fannie Mae was faltering, James A. Johnson was overseeing the 1984 presidential campaign of Walter Mondale, a fellow Minnesotan who had been vice president under Jimmy Carter.

Johnson was born on Christmas Eve in 1942 to Alfred and Adeline Rasmussen Johnson, residents of Benson, Minnesota, a town of four thousand. Democratic politics was the mainstay in the house—Alfred Johnson was Speaker of the House in Minnesota during the 1950s. Adeline was a schoolteacher.

Johnson's upbringing was typical of a 1950s Scandinavian family. Words were few and displays of affection even fewer. In an interview with the Washington Post, he described life at home with his parents and older sister, Marilyn.

"There was no touching, no kissing, no 'I-love-yous,'" he said. "On the other hand, there could not have been a warmer, more protective, more supportive unspoken environment. If you go to the maximum of what you get through the unspoken, that's where we were. If you go to the furthest you can get in not touching and not speaking, I think we were there."

Johnson was interested in politics early on, working on campaigns locally even before he could vote. As a sophomore at the University of Minnesota, he won election for student body president; after graduation, he moved to Princeton, where he received a master's degree in public policy at the Woodrow Wilson School in 1968. He joined the antiwar movement and avoided serving in Vietnam on the strength of a student deferment. He worked on Senator Eugene McCarthy's campaign in 1968, and in 1972 he volunteered for George McGovern.

In 1969, Johnson attended a strategy session convened by antiwar activists in Martha's Vineyard. He roomed with William Jefferson Clinton, then an unknown twenty-two-year-old Georgetown University graduate.

When he wasn't campaigning, he worked at the Minneapolis department store, Dayton Hudson, and taught at Princeton.

Johnson, a tall and trim man who favors horn-rimmed glasses, met Mondale through his father, who knew him from Minnesota politics. Mondale recalled the meeting in a 2008 interview with

MinnPost.com. "As I remember it," Mondale said, "he came by to visit. He was bright and interested and so I hired him."

He became his aide-de-camp both when Mondale was a senator and later when he became vice president under Jimmy Carter in 1977.

After sitting out the 1980 election, Mondale decided to run for the presidency in 1984, hoping to unseat the popular Ronald Reagan by making him appear to be disengaged. Mondale chose Johnson, only forty years old at the time, to be his campaign chairman. Johnson's campaign machinery was highly centralized, with decisions made by a small circle of trusted officials. Prominent Democrats described the campaign as insular, arrogant, and "uncomfortable with outsiders." The New York Times quoted an influential party official this way: "There has been a real effort to keep out individuals who threaten that structure."

Such a setup was vintage Johnson. During the presidential race, advice from party leaders was not requested by the Mondale campaign, and ignored if it came. A highly polished operation that worked more like a hushed corporate boardroom than a frenetic presidential contest, the campaign was a closed shop, in the words of a midlevel aide. "Only a very few people know what's going on and why, and there's a sense of exclusivity, almost secrecy, that's potentially very damaging," the official said.

Those trying to plumb Johnson's inner reaches found it to be "a lot like the Minnesota pastime of ice fishing." The man was all politics all the time. During the Mondale campaign, the candidate's family and friends put together a book of recipes for supporters. All the staffers provided their favorites, according to Mondale's recollections recounted in MinnPost.com.

"In his recipe, Jim said you put a hot dog in steaming water, put the hot dog in a bun, open a can of Coke and turn on the 6 o'clock news," Mondale recalled.

There was no doubt about Johnson's ambitions. A political junkie, he had been "preparing himself for 15 years to be White House chief of staff," according to one staffer.

It was not meant to be, alas. Mondale never caught on with voters. The bland and buttoned-down Midwesterner lost the election in a landslide, winning only one state—his home territory of Minnesota.

After the defeat, Johnson returned to the Washington-based political consulting firm he had started with Richard Holbrooke, an investment banker who was a former assistant secretary of state for Asia. In 1985 the firm—Public Strategies—was bought by Shearson Lehman Brothers, a Wall Street investment bank. Both Johnson and Holbrooke became managing directors at the firm and remained in Washington.

Around this time, Johnson met David Maxwell, the Fannie Mae head, at a dinner party in Washington. It was a fateful introduction that would not only bring immense wealth and power to Johnson but would also pave the way for the housing bubble years later.

Although their meeting was strictly social, Maxwell saw Johnson as someone who might help him protect Fannie Mae. The political winds were shifting, thanks to the conservative, small-government approach of the Reagan administration, and Fannie Mae, a company with lucrative federal ties, was at risk.

Fannie Mae was now a private company with shareholders but it was also a quasi-government enterprise with a raft of lush perquisites associated with its federal ties. The biggest benefit of its government association was the impression held by investors that Fannie was backed by the full faith and credit of the United States, a view that translated to far cheaper borrowing costs, fully one half of one percentage point for the company.

Now there was talk of making Fannie Mae a fully private company, removing its government benefits. In addition to the lower borrowing costs, these benefits included a $2.5 billion line of credit at the U.S. Treasury, an exemption from paying state and local taxes, and freedom from filing financial statements with the Securities and Exchange Commission.

Eliminating these perks would make Fannie Mae far less profitable and turn its business model upside down, Maxwell knew. Perhaps Johnson, an investment banker with Washington sensibilities, could provide guidance on how to fend off the privatization crew.

"We needed some analytical work done at Fannie Mae to help chart our future course," Maxwell said of his meeting with John-Hon in an interview with the Post. "There was a lot of pressure from the Reagan administration to give up our federal ties and privatize the company. People like [Reagan budget director] David Stockman were very determined. We just wanted to take a look at exactly what this might mean and whether it was possible to do it."

Shearson Lehman was hired to conduct the privatization analysis and Johnson oversaw the task. The report they produced in 1989 concluded that privatization was not feasible. "To put it another way," Maxwell said, "at this point in time it was a pretty ridiculous proposition."

Ridiculous or no, the threat continued to hang over the company. A slew of losses at savings and loans across the country that had also threatened Fannie's solvency earlier in the decade, and the ensuing $500 billion in taxpayer funds to clean up the mess, focused Congress on the possibility that bad loans might also be lurking on the books at Fannie Mae and Freddie Mac. In 1989, lawmakers ordered a study of both government-sponsored enterprises.

While this analysis was going on, Maxwell began preparing for his retirement. In 1990, he recruited Johnson to be vice-chairman of Fannie Mae and a member of its board. It was a clear sign that Johnson would succeed Maxwell at the helm of Fannie Mae.

"David Maxwell had built a very good company and ran it well," recalled one of his lieutenants. "Maxwell recognized that there were risks. But in Johnson, he picked the wrong heir apparent."

During the transition from Maxwell to Johnson, a young man who was looking to start his career recalled lunching with Fannie Mae's new chief executive at the Metropolitan Club in Washington. Johnson's laserlike focus on how he planned to monetize the company's government ties was remarkable, he said. There was little talk of Fannie Mae's social purpose; it was all about how much money he would make if he came to work at the company.

As soon as Johnson took over Fannie Mae he began to demonstrate his mastery of political patronage and populist spin. Hoping

to tamp down a controversy that erupted after the disclosure of Maxwell's $27 million retirement package, real money in 1991, Fannie Mae announced that Maxwell had agreed to contribute his final bonus payment of $5.5 million to the Fannie Mae Foundation. It, in turn, would dispense the $5.5 million to low-income housing projects.

When Johnson took over, the tone at the top of Fannie Mae began to change. This was partly because the political spotlight was trained on the company, insiders say, and partly because the new chief executive was such a political animal. Maxwell had run the company as a sleepy utility that facilitated mortgage lending, as its charter required. But under Johnson, Fannie's primary goal changed to protecting—at all costs—the company's government ties and the riches that sprang from them.

Protecting the company's federal sponsorship was all the more crucial, insiders say, because Johnson intended to expand Fannie's portfolio and balance sheet significantly. Along the way, he and his lieutenants would be able to enrich themselves on the government's dime.

Fannie Mae was on sound financial footing when Maxwell retired in January 1991, in spite of the massive losses the company had suffered in the savings and loan crisis. Maxwell told a Post reporter "it would take an event of such cataclysmic proportions as to result in a change of our form of government to put this company under."

The cataclysm was, in fact, just fifteen years away.

When James Johnson took over Fannie Mae, no one in the government had taken the time to quantify precisely how much the federal charter was worth to the company. But those inside Fannie's Colonial Williamsburg-like headquarters in Washington knew its value was significant. Because the company was perceived to be at least implicitly backed by the government, Fannie Mae could raise money from investors who were willing to buy its debt at lower yields than they would accept from fully private and riskier companies. That the government would step in to save Fannie if it

over got into trouble was the prevailing assumption, and investors wore happy to accept lower interest rates on the company's debt because of it.

Fannie Mae routinely claimed that it passed along every penny of its cost savings to homebuyers in the form of lower mortgage rates. This allowed the company to argue that any change in its status would result in higher housing costs for everyday Americans.

It wore the claim like a coat of armor, protecting itself from critics' slings and arrows. Only later would it emerge that the company kept billions of dollars—at least one third of the government subsidy—for itself each year. This money it dispensed to its executives, shareholders, and friends in Congress.

That the company was siphoning off billions of dollars every year was unknown outside its Wisconsin Avenue headquarters in 1991. But inside Fannie Mae, in his capacious office with its working fireplace, Johnson knew he had to work hard to protect the subsidy if he was to enjoy the power and wealth that the top job at the company promised. After all, when Maxwell had retired from Fannie, he walked away with a retirement package worth more than $20 million. A princely sum in the early 1990s, it was not bad for quasi-government work.

Johnson also recognized that if he wanted to make the company larger and more profitable, and reap the personal benefits its growth would provide, Fannie Mae's special privileges had to be maintained. To reach its full profit potential, the company needed to grow its portfolio of mortgage securities, but Johnson knew that some in government, the meddlesome privatization crowd, would be wary of a bulked-up Fannie Mae. Unlike fully private companies that increased their operations on the strength of consumer demand and private financing, Johnson was aware that if he were to grow Fannie Mae's revenues and earnings, he had to have the government on his side.

Fannie Mae was already something of a political species, of course. Always concerned with the company's image, Johnson drove his employees to ensure that the company regularly ranked high

on the dubious "best of lists published by various consumer magazines. These included Fortune's "Best Companies to Work For in America" and "Best Companies for Minorities," Working Mother's Best Companies list, and the American Benefactor's "America's Most Generous Companies."

But generating this soft spin was not nearly enough to protect the company, and Johnson himself, from the kind of political ill winds that could rise up out of nowhere in Washington. The rumblings about privatization posed a more significant threat than Fannie Mae had experienced before.

One of those who outlined this threat was Thomas H. Stanton, a professor at Johns Hopkins University, who wrote an article arguing for privatization in the magazine The Financier in May 1995. In "Government-Sponsored Enterprises and Changing Markets: The Need for an Exit Strategy," Stanton contended that the government should remove these companies' perquisites sooner rather than later.

"Pressures for the status quo, often backed by powerful political constituencies, can deter the government from acting until it is very late," he wrote, presciently.

To protect against this threat, Johnson turned to the political action committee (PAC) the company had set up years before. Unique among federally created organizations, Fannie Mae's PAC made generous contributions to lawmakers.

Under Johnson, it became bigger and brassier than ever.

"Johnson knew he had to keep the golden goose laying the golden eggs," another former executive said. "Once he walked in the door, Fannie Mae became a political machine."

As Fannie Mae was ramping up its political efforts, the regulator charged with its oversight was fighting for its life. The Department of Housing and Urban Development, created as a cabinet-level agency in 1965, was supposed to promote homeownership and eliminate housing discrimination.

HUD was a second-tier agency visited regularly by scandals. Its officials spent a good deal of time justifying their existence to Republicans eager to shut the inefficient agency down. These assaults had only grown during the Reagan presidency.

HUD was not much of a watchdog. Its oversight of Fannie and Freddie was a part-time arrangement—only a handful of people at the agency dealt with matters involving the companies, and they juggled other duties as well.

But in the aftermath of the savings and loan crisis, the days of part-time regulators for Fannie appeared to be numbered. After paying out millions to clean up failed savings and loans, Congress was considering legislation to protect taxpayers from potential losses at Fannie and its smaller cohort, Freddie Mac.

Founded in 1970, Freddie Mac was created by an act of Congress to provide competition for Fannie Mae in housing finance. Like Fannie, Freddie was a hybrid institution—a public company with shareholders but one that also enjoyed government perquisites.

There were several ways to protect taxpayers from possible harm where Fannie and Freddie were concerned. First was to create a new overseer for the companies. In addition, Congress wanted the institutions to increase the money they held in reserve to cover possible losses. Increased capital requirements, as they are called, act as a safety measure, a cushion to soften the effect of loans purchased by the company that went bad. But such a cushion also means lower earnings for financial institutions because the money they set aside cannot be used to buy mortgages or other interest-bearing assets.

Confronting the reality that his company might soon be dealing with a much more energetic regulator and significantly higher capital requirements, Johnson went to war on two fronts.

One attack was to be conducted very much in public. The program to advance homeownership was a quintessential "white-hat" issue, in Washington parlance. Johnson's launch of a high-level public relations campaign to turn renters into homeowners would put a friendly face on Fannie Mae, an enigmatic entity that was neither bank nor mortgage lender and not quite a government agency either.

Johnson's other battlefront, designed to protect the company's government benefits, would occur behind the scenes, in the halls of Congress. The sunny public relations campaign about how Fannie Mae helped homeowners would provide cover for the company's backroom dealings, through which it subdued critics and showered money and favors on supporters.

Among Johnson's first public initiatives was a $10 billion commitment by the company in 1991 to provide financing for lower-income borrowers. Called the "Open Doors to Affordable Housing," it was one of many Fannie Mae programs designed to blunt criticism of Johnson's aggressive growth plans. The idea, according to former company employees, was to finance so much low-income housing that Fannie Mae's government perquisites could never be taken away.

As Congress mulled over the company's future, Fannie Mae began making significant grants, hundreds of thousands of dollars each, to consumer and community groups favoring increases in low-income housing. The groups, such as the Association of Community Organizations for Reform Now, or ACORN, had been agitating for tighter regulations on Fannie Mae. But after receiving the grants, ACORN and most of the other groups changed their tunes.

"The timing of the grants is self-evident," Congressman James Leach, a Republican from Iowa, told the New York Times. "This is the most important legislation since the inception of Fannie and Freddie and they pulled out all the stops to make sure potential critics were silenced."

Even as Fannie Mae trumpeted its "Open Doors" program and spread money around low-income communities, Johnson was working to ensure that the new regulations being created by Congress would be weak and malleable.

First was the problem of a new regulator. An assertive overseer could throw a monkey wrench into Johnson's plans to increase Fannie's profits by growing its portfolio of mortgage investments

and entering other businesses. He needed to ensure that his regulator would be unable to thwart those plans, that it would be captive to the institution it was supposed to police.

Capital requirements were another potential disaster. Setting aside greater reserves meant lower earnings for his company, anathema to any chief executive hoping to please demanding investors.

But beyond his need to keep shareholders happy, Johnson had an even more compelling reason to keep Fannie's earnings on the rise: his own paycheck.

For years, Fannie Mae's compensation structure had been a conservative one, with executive pay linked to a wide range of performance measures. These metrics included how well the company managed its costs each year and what its return on assets was, a calculation of how much the company made on the loans it held on its books.

But after Johnson took over the company, Fannie Mae's executive pay structure changed. Compensation became tied almost solely to earnings growth.

Beginning in 1992, for example, earnings-per-share growth and "strategic" goals were the only measures used to determine incentive pay for Fannie executives. Salaries were never that large at Fannie, its former executives said, but stock grants and bonuses could make its executives wealthy indeed.

The shifts in Fannie Mae's pay structure had a clear, measurable effect. During Johnson's years at the company—between 1993 and 2000—the percent of total after-tax profits devoted to annual incentive pay for Fannie's executives rocketed from 0.46 percent to 0.79 percent. In actual numbers, the incentive pay handed to Fannie executives more than quadrupled, rising from $8.5 million to $35.2 million.

But in the early 1990s, it was clear that Fannie's new executive pay structure would be severely threatened by new and more onerous capital requirements on the horizon. Earnings per share would likely fall, hurting the potential for pay bonanzas. Johnson had to get involved in the writing of the 1992 law.

Brazen it was. And unusual. Manipulating the legislative process was an entirely new strategy for a corporate executive, according to a former government official who worked with Johnson. "He was the designer of the culture of obstinance," this official said. "Take on your regulator. Go to the Hill. Use your muscle."

It had taken three years for Congress to enact the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, and it had many moving parts. Its chief aim was to protect taxpayers from potential losses if Fannie or Freddie got into trouble with mortgages they financed or held. Nobody wanted a repeat of the shocking savings and loan crisis where corrupt lenders enriched themselves at the taxpayers' expense.

The largest change in the law was the creation of two separate overseers for the companies. A new and supposedly independent regulator within the Department of Housing and Urban Development, called the Office of Federal Housing Enterprise Oversight, was tasked with overseeing the operations of Fannie and Freddie with an eye for safety and soundness.

Meanwhile, HUD had the often conflicting task of ensuring that the companies fulfilled their mission of promoting homeownership. It was proposed that OFHEO, like other financial regulators, be funded by fees charged to the regulated institutions, in this case Fannie and Freddie. This proposal was never implemented.

Among OFHEO's tasks, under the new law, was calculating and enforcing minimum capital requirements for Fannie and Freddie, as well as conducting examinations of the companies' operations. The law also required that OFHEO come up with a so-called stress test that would create worst-case scenarios for the companies, and then calculate how much capital and cash flows the companies would need to survive them.

The stress test was supposed to include situations where interest rates gyrated as they had during the 1980s when Fannie Mae teetered on the edge of solvency. Both the new capital requirements

and OFHEO's stress test were to be finalized by December 1, 1994.

But the law had another key element that would, more than any other single act, lead to the disastrous home lending practices of the 2000s. The Federal Housing Enterprises Financial Safety and Soundness Act actually encouraged unsafe and unsound activities at both Fannie and Freddie by assigning them a new affordable housing mission.

Under the law, the companies had to use their mortgage purchases to help provide housing to those across the nation who had previously been unable to afford a home. While historically Fannie and Freddie supported housing by buying safe mortgages when other sources of capital for borrowers dried up, now the companies' focus on soundness was diluted by the requirement that they serve the housing needs of "low-income and underserved families."

The act required Fannie and Freddie to meet three separate housing goals through their mortgage purchases. First were those related to low- and moderate-income housing; then came so-called special affordable housing goals, and, finally, those associated with inner cities, rural areas, and other underserved areas.

Initially, the law specified that 30 percent of the housing units financed by the companies must go to low- and moderate-income families; another 30 percent would go to housing located in inner cities.

Congress did not come up with these requirements on its own. It asked for help from community activist groups like ACORN, which had helped lawmakers draw up the affordable housing goals for Fannie and Freddie. Henry B. Gonzalez, the Texas Democrat who headed the House Banking Committee and its subcommittee on housing and community development, had invited ACORN, Fannie's new ally, to help legislators define the goals when they were devising the new legislation covering Fannie and Freddie.

Meeting these targets required that the companies take an easier approach to what they considered acceptable underwriting standards from banks whose loans they would buy. Safety and soundness, the supposed goals of the legislation, took a backseat to politically driven housing goals.

Down-payment requirements were the first to go. Traditionally, banks had required that borrowers put 20 percent of the property price down to secure a mortgage loan, but the 1992 act encouraged Fannie and Freddie to buy mortgages where borrowers put down a nominal amount—5 percent or less—of the total loan amount. Never mind that the risks associated with these loans were far greater; history showed that the more money, or equity, borrowers had in their homes, the less likely they would be to default on their mortgages.

With lower down payments blessed by the 1992 legislation, Fannie and Freddie were suddenly far more likely to buy riskier loans from banks. And if those loans helped the companies meet their affordable housing targets, well, all the better.

While Johnson and his crew knew the risks among such loans were far higher, they also recognized that meeting affordable housing goals would give Fannie Mae enormous political cover for its growth plans. If it wanted to move into new and more lucrative businesses, such as mortgage insurance, for example, the company could always argue that without new business lines, it could not meet its housing goals.

"Affordable housing was the price they would have to pay to keep their benefits," recalled one industry official who was on hand during the legislative process.

While input on the legislation was provided by both Fannie Mae and Freddie Mac, Fannie approached the project much more aggressively. Leland Brendsel, the chief executive of Freddie Mac, was not a politician, former colleagues say and, unlike Johnson, he did not have friends on the Hill. "Leland didn't run with this crowd," said a former Fannie Mae executive. "He may have had some lobbyists working in different places but Leland listened to his lobbyists for direction. Johnson gave his lobbyists direction."

When the administration began prescribing broad outlines of the government-sponsored enterprises regulation, Fannie Mae was right there, guiding the officials tasked with the project. And

when the legislation moved to Capitol Hill, Fannie exploited relationships it had forged over the years there to make sure that the Safety and Soundness Act would not be hazardous to the company's expansion plans.

Laws governing the appointment of Fannie and Freddie's board allowed the president to choose five directors for each firm, and Johnson recognized the power this gave him. Fannie hired an army of lobbyists, and increased the use of its politically chosen directors to help it blanket the Capitol. The company even paid lobbyists to agree not to lobby against it.

Coupling power politics with populist support through shrewd moves like a $5.5 million donation to create the National Center for Lead-Free Housing, Johnson was able to work closely with those writing the legislation that would create a new regulator for the company, a former high-level Fannie executive said.

In September 1992, for example, Texas congressman Gonzalez withdrew the new regulatory bill from the House floor as it was about to be debated. Gonzalez did so "to allow more time for Fannie Mae to pursue changes in the bill," a staffer told the New York Times. Those changes involved capital requirements; Johnson believed the bill, as written, gave too much discretion to regulators on the matter of such requirements and he had voiced his alarm over it.

Johnson got his way.

The executive's interference meant Fannie got two bites of the apple and was able to manipulate the terms of the debate from beginning to end, said Jonathan G. S. Koppell, a former OFHEO employee who is a professor at Yale University's School of Management. "In each part of the Act, the government sponsored enterprises were able to dilute or obfuscate the objectives," Koppell wrote in a 2003 book, The Politics of Quasi-Government. "Fannie Mae was able to design its regulation. The government sponsored enterprises control their own controllers."

With Fannie Mae as a key architect of the legislation, it is no surprise that the company extracted huge benefits from it. Fannie's biggest win involved capital requirements, which were set at levels far below those of other lenders—2.5 percent versus the 10 percent demanded of banks. This sliver of a capital cushion was appropriate, Johnson argued, because losses on Fannie Mae's mortgages had been a fraction of those experienced by other lenders and other banks held higher-risk assets.

But the company's past experience with losses was almost certainly not going to be repeated going forward, given the new low-income housing requirements mandated by Congress. Fannie was embracing a new world of riskier loans that would benefit Johnson, his protectors in Congress, and his paycheck. Those who stood to lose, because of the microscopic capital requirements that left Fannie unequipped to deal with its losses—taxpayers.

A financial executive who tried to get Congress to raise Fannie's capital requirements said: "If the company is run rationally and carefully it represented a governor on the rest of the industry. If they were rational, then everyone else was forced to be rational. If they had to have more capital, that would have been good for everybody. We were quite active in lobbying for that legislation but we never had a chance."

Meanwhile, Fannie also got what it wanted in a regulator—a ninety-eight-pound weakling. While the Government Accountability Office had recommended in a 1991 report that Fannie be placed under a tougher and more established regulator, the company persuaded legislators to keep HUD as its overseer. The company preferred the regulator it knew could be controlled. Never an aggressive or especially effective overseer, HUD was far preferable to an unknown and possibly more assertive agency, in Johnson's eyes.

HUD was weak, but Fannie Mae also needed to make sure that the agency would never grow more muscular. So Johnson and his army of persuaders argued that OFHEO, the cop on the beat inside HUD, should be forced to ask Congress for approval over any new regulations, even those related to capital requirements, that the overseer wanted to implement. In addition, Fannie suggested that, unlike bank regulators, OFHEO be forced to

submit to annual appropriations reviews before lawmakers. The overseer would have to beg for money to operate.

Not only were these crucial hurdles for the regulator to leap over, they also allowed Fannie to shift the power of oversight to congressional subcommittees, run by members who could be easily swayed by the company's lobbying efforts and campaign contributions. Once his company's oversight was in the hands of Congress, Johnson knew that he could work behind the scenes to derail any restrictions on the company's activities that OFHEO might suggest.

The long arm of Fannie Mae was often felt by other financial executives who traveled to Washington to meet with lawmakers. As one recalled, "I used to go to Washington and lobby on issues we thought were wrong. I would go to Jim Leach, Chuck Schumer, and half an hour or an hour later they would have a visit from Fannie Mae. How the hell did they know I was there?"

If lobbying money and campaign contributions didn't do the trick, Johnson had another high card to play. Simply tell lawmakers that proposed rules disliked by Fannie would prevent the company from meeting its affordable housing goals. Any congressman or -woman who objected would instantly be labeled anti-housing, elitist, or an enemy of the American dream.

Fannie Mae's influence over the legislation may have been unusual, but not many in Congress found it objectionable. Two who did were James Jarrell Pickle, a Democratic congressman from Texas who had served on the powerful Ways and Means Committee, and Willis David Gradison Jr., a Republican congressman from Ohio.

"The time has come to protect the public purse, not Fannie Mae's profits," they wrote in a prescient letter to their colleagues in 1992. "Fannie Mae should not possess a veto over the form of its own supervision. The primary concern of Congress in drafting this legislation should be to protect the taxpayer by requiring all G.S.E.'s to be capitalized adequately. Public policy on such a serious issue should not be stalled, perhaps permanently, by lobbying efforts that put the private interest of a single enterprise above the broader public interest."

Articulate though they were, these objections were overridden by Fannie's many friends on the Hill. The safety and soundness legislation that the company had been so instrumental in devising passed both the House and the Senate resoundingly. By the end of 1992, it had become law.

It soon became clear that Fannie Mae had scored a major win with the passage of the legislation. Even those on Wall Street took note of Johnson's feat. Jonathan Gray, an analyst at Sanford C. Bernstein and Company, a respected research firm in New York, characterized Johnson's role in formulating the legislation as the executive's finest moment. It "really created Fannie Mae as a growth stock," he said.

That feat would translate to immense paydays for Johnson and his high-level cronies. Indeed, over his nine years at the company, he took out roughly $100 million in pay.

Those who criticized Fannie Mae got nowhere with their arguments. As Johnson had told the New York Times a few months earlier: "One of the points I generally make to people in the administration and people on Capitol Hill is that in the context of there being so few clear public-policy successes, you should rejoice in Fannie Mae and Freddie Mac rather than fight them. This is a very unique idea that Congress and the Presidency put in place that works beautifully."

While Congress wrestled with new regulations for Fannie Mae and Freddie Mac, researchers at the Federal Reserve Bank of Boston, one of the more powerful regional banks in the United States' Federal Reserve System, were hard at work analyzing thousands of mortgages. Their goal: to determine whether lenders were discriminating against minority borrowers.

Discrimination in lending practices had been a target of lawmakers since the civil rights era swept across America in the 1960s. But in 1977 the focus on the problem intensified when Congress passed the Community Reinvestment Act, a law requiring banks to lend broadly across their areas. The legislation was designed to eliminate so-called redlining practices, where banks refused to make loans in poor neighborhoods.

Two years earlier, the Home Mortgage Disclosure Act of 1975 had required lenders to supply the government with details of their loans and the people who applied for them. Armed with this data, the government rated banks' compliance with the Community Reinvestment Act, handing out scores based upon the institutions' adherence to the law.

Still, years after the law had been enacted, accusations of discrimination by banks against minority borrowers—especially blacks and Hispanics—continued. Banks contended that they were willing lenders and color-blind in their operations; why would they pass up the profits that such loans would generate? And yet, activist consumer groups such as ACORN, the Association of Community Organizations for Reform Now, maintained that discrimination was rampant.

Too often, though, the bias claims were based upon anecdotal evidence, a handful of cases in a few low-income neighborhoods. This all changed in 1991, when the Home Mortgage Disclosure Act began requiring information about the race of a prospective borrower to be included on every application.

That year, ACORN used the new data to study loans made by twenty banks in ten cities across the nation. It found that in every city, minority applicants were between 1.6 and 3.4 times more likely to be rejected for loans than whites.

"In cities across the country, ACORN members have seen their communities devastated by banks' systematic refusal to make loans in low-income neighborhoods and to people of color," the organization said.

At about the same time, Boston Fed researchers, led by Alicia H. Munnell, the institution's research director, were digging into the HMDA figures. They hoped to determine once and for all whether home-mortgage discrimination was indeed a major problem.

In October 1992, "Mortgage Lending in Boston: Interpreting HMDA Data" was published by the Boston Fed. Its authors were Munnell, Lynn E. Browne, James McEneaney, and Geoffrey M. B. Tootell. Although the title was dull and the writing dry, its conclusions were explosive. The study was immediately hailed as a landmark in research on lending discrimination.

Racial bias by mortgage lenders, Munnell and her colleagues

wrote, not only existed, it was pervasive. The HMDA data showed that black and Hispanic loan applicants were far more likely to be rejected by banks than were whites. The rejection ratio for minorities was 2.8 to 1 compared with white applicants.

The findings lit up the media, confirming many people's suspicions about banks' lending practices. The fact that the study emerged from an institution as credible and supposedly apolitical as the Boston Fed made its conclusions all the more damning.

Federal regulators heaped praise on the study. Calling its analysis "definitive," an official at the Office of the Comptroller of the Currency, the overseer for large national banks, said that it "changes the landscape."

The president of the Boston Fed, Richard F. Syron,1 said the study "comports completely with common sense." Then he added, "I don't think you need a lot more studies like this." Munnell herself even weighed in, telling a reporter for the Wall Street Journal that her work "eliminates all the other possible factors that could be influencing decisions" made by banks relating to mortgages.

To those inside Fannie Mae, the Boston Fed analysis was another threat to its political power. If banks were discriminating against minority borrowers, then Fannie Mae and Freddie Mac, the buyers of those mortgages, were by extension aiding and abetting the questionable practices.

"It was one of our biggest problems," a former executive said. "A lot of our congressional protectors had political relationships with the black community and needed a 90 percent vote, so that was a big blow. After that report, the activist groups just kept piling on us."

James Johnson saw the opportunity for Fannie Mae in this potential problem: Lending to minorities could help his company's expansion efforts as well as its image. He was soon fanning the flames lit by the Fed's report. "We see evidence that there are a significant number of prospective home buyers in this country whose only barrier to achieving their dream of home ownership is not their economic status, but their racial status," he wrote in the Wall Street Journal in late November 1992.

One "outreach effort" was the creation in October 1992 of the Housing Impact Advisory Council, a thirty-five-member group that would advise Fannie on how the company could meet the affordable housing goals set out by Congress in the new legislation.

Knowing how important it was to keep potential adversaries, especially low-income housing groups, close to Fannie Mae, Johnson invited top-level executives at nonprofits like ACORN, the National Council of La Raza (an entity devoted to the Hispanic community), and the National Low Income Housing Coalition in Washington to join his council. Of course, bankers and mortgage lenders were also asked to join the council, as were executives from the National Association of Real Estate Brokers. But almost half of the advisory council's initial members came from housing advocacy groups.

Not only did they get a seat at Fannie's council table, these housing advocacy groups also received grants from the company.

In addition to setting up the advisory council, Fannie Mae offered to begin buying new types of mortgages to expand its affordable housing reach. This allowed the company to grow its operations, and its earnings, while positioning itself as a do-gooder.

With this action, Johnson created the centerpiece of what would, by the fall of 1994, become William Jefferson Clinton's National Partners in Homeownership. The partnership's strategy served Johnson's goal by "making homeownership more affordable, expanding creative financing, simplifying the home buying process, reducing transaction costs, changing conventional methods of design and building less expensive houses, among other means."

A brand-new initiative from the company was "FannieNeigh-bors," a program "to increase homeownership and promote revi

talization in minority and low- and moderate-income urban areas across America. Single-family homes that fall within specially designated low- and moderate-income and/or minority census tracts, or areas designated by housing finance agencies as targeted areas for neighborhood revitalization, are eligible for community lending underwriting flexibilities."

As Johnson would later proudly point out, Fannie Mae spent $7 billion between 1994 and 1997 on "underwriting experiments."

Underwriting flexibilities. New products. Expanding outreach efforts. All were code words for loosening underwriting standards and lending to people whose incomes, assets, or abilities to pay fell far below the traditional homeowner spectrum. No longer would Fannie Mae stick to its practice of ensuring that borrowers could meet their obligations and, therefore, that the loans it purchased carried relatively low risk. These standards had for decades acted as a kind of governor on lax lending among banks interested in selling loans to Fannie. But amid cries of racial discrimination, risk-averse practices were jettisoned.

There was only one problem. The methods used by the Boston Fed researchers to prepare their report were flawed, according to a throng of critics in and out of academia who questioned the paper's findings the following year. Its claims of bias were by no means proved, these people contended.

The analysis did not consider whether an applicant met a lender's credit guidelines, one researcher noted, while others pointed out that the type of model used by the Boston Fed oversimplified the complex mortgage lending process.

Given these weaknesses, it was impossible to conclude that banks routinely rejected minority borrowers or that their decisions were driven by anything other than sound lending decisions.

Forbes magazine was among the few media outlets to question the study's findings. For an article published on January 3, 1993, staffers Peter Brimelow and Leslie Spencer interviewed Munnell,

who revealed yet another problem with the analysis. Munnell told Forbes that in preparing the study, Fed researchers looked at default rates across census tracts and found that minorities do not tend to fail more often on their loans than whites.

"What we found was, there was no relationship between the racial composition of the tract and the default rate," Munnell told Forbes. "So it wasn't true that tracts with large minority populations had higher default rates."

Such a finding should have been a signal to the researchers that their discrimination findings were off base, Forbes contended. After all, if bias were at work in minority neighborhoods, default rates in those areas would have been lower than among white areas, indicating that bankers were refusing loans to legitimate minority borrowers.

Munnell agreed that discrimination against blacks should show up in lower, not equal, default rates. "You need that as a confirming piece of evidence," Munnell told the Forbes reporters. "And we don't have it."

But the magazine's criticisms did nothing to cool the frenzy surrounding the report's "evidence" of bias in banking. Only years later did Munnell's peers in academia begin publishing papers attacking the Boston Fed's findings. In 1996, for example, an economist at the Cleveland Federal Reserve Bank, Stanley D. Longhofer, wrote that if the question is whether widespread discrimination exists in the home-mortgage market, "Ultimately, the answer must be 'we don't know.'"

The regulatory response to the Boston Fed study was immediate. Bankers received a new message from their overseers: Discrimination against minorities hoping to become homeowners must be eliminated.

Just six months after its questionable report was published, the Boston Fed put out a twenty-eight page guide for banks called "Closing the Gap, a Guide to Equal Opportunity Lending." It was

a blueprint for banks showing them how to relax their lending practices to eliminate discrimination. "Special care should be taken to ensure that standards are appropriate to the economic culture of urban, lower-income, and nontraditional consumers," the guide said.

What did this mean in practice? Dispensing with tried-and-true lending rules. As Franklin D. Raines, Johnson's successor as chairman of Fannie Mae, said later, "We have to keep bending financial markets to serve the families buying the homes you build."

First to go was a reliance on credit history, an age-old method for measuring borrower risk. "Lack of credit history should not be seen as a negative factor," the recommendations said. "In reviewing past credit problems, lenders should be willing to consider extenuating circumstances." Neither should relatively high expenses among low-income borrowers disqualify them from receiving loans. "Special consideration could be given to applicants with relatively high obligation ratios who have demonstrated an ability to cover high housing expenses in the past," the guide said.

Changes should also be made in down-payment requirements, the guide pointed out. Because poor borrowers are less able to save for their housing needs, banks should be open to the use of monetary gifts from others as a way for these people to satisfy down-payment requirements. Among those who might donate to such causes, the Boston Fed said, were relatives, municipal agencies, or nonprofit groups. Mortgages using down-payment programs from municipal agencies and nonprofits would later demonstrate among the highest default rates.

"Cash-on-hand could also be an acceptable means of payment if borrowers can document its source and demonstrate that they normally pay their bills in cash," the publication pronounced.

The Boston Fed went on to advise lenders that to facilitate minority lending, they should track the more unusual aspects of such loans and make exceptions to their normal standards. "Loan production staff may find that their experience with minority applicants indicates that the institution's stated loan policy should be modified to incorporate some of the allowable compensating factors," the guide urged.

Banks that did not abide by these suggestions should take heed: "Management should also review HMDA data regularly, monitoring the volume, location, and composition of loan applications received, and the disposition of those applications," the guidelines noted. "If the number of applications received from minorities seems disproportionately low, the cause should be determined. If denial rates are relatively high for minority applicants, management should be able to explain the disparity."

For loan officers who might be worried about the risks of default in such mortgages, the Fed's guidelines provided a wonderful out. "Institutions that sell loans to the secondary market should be fully aware of the efforts of Fannie Mae and Freddie Mac to modify their guidelines to address the needs of borrowers who are lower-income, live in urban areas, or do not have extensive credit histories."

In other words, a banker confronted with these new relaxed requirements could off-load any risky loans to the government-sponsored enterprises responsible for financing home mortgages for millions of Americans. For institutions concerned about having to hold onto questionable loans and possibly generate losses in them, the fact that they could sell them to Fannie or Freddie meant one beautiful thing: Any downside could be handed off to the government.

Under Johnson's leadership, Fannie was especially supportive of this downward slide in lending standards. "This was the beginning of the company deciding to put itself in the crosshairs of lowering underwriting standards," said a former Fannie executive. "They started doing that with new products in 1993 and this began to characterize everything they were."

Because Fannie was the leader in housing finance, its actions set the tone for private-sector lenders across the nation. "They wore omnivores," the former executive said. "The further they moved out on the risk curve, the more they pushed the market to follow. Johnson viewed this as his strategy of protecting the franchise at all costs."

While some of those who dealt with Fannie thought that the company was forced to lower its standards by the prevailing political winds, some who worked inside the company contend that Johnson worked closely with the community groups to argue for relaxed lending. After all, lower underwriting standards meant Fannie could grow its portfolio and, of course, its earnings.

Increasing the portfolio, and the fees and revenues associated with that, was a major Johnson goal, one that his company expressed openly to lenders in an early 1992 letter. "We will pursue every avenue," Fannie said. "Mortgage lenders, community groups, builders and developers, housing finance agencies, mortgage insurers, and federal, state, and local governments—to find partners that will help us fulfill our corporate objective of providing viable financial products and services that will increase the availability and affordability of housing for low-, moderate-, and middle-income Americans."

In late 2010, the degradation of mortgage lending and its disastrous effects, especially on minorities whom predatory lenders had targeted, had become obvious to all. In an interview, Munnell said that she never intended her 1992 study to result in relaxed lending practices for minorities. She said that she left the Boston Fed two months after her study was published and had nothing to do with its guidelines.

Now a professor at Boston College, Munnell said that her 1992 findings had not meant that bankers were biased against minorities, but rather that they were biased toward people like themselves. "Bankers worked with people with whom they felt comfortable and they didn't do that for people who seemed different from them," Munnell said. "It was not that they were doing bad things to black people, they were doing nice things for white people so when you look at it statistically, race becomes a factor.

At the same time that the Boston Fed was making a fool of itself on the subject of home-mortgage discrimination, a lawyer and researcher at the Cleveland Fed was making a nuisance of himself with his superiors in Washington.

That lawyer was Walker F. Todd, an assistant general counsel and research officer at the Federal Reserve Bank of Cleveland. Todd had been examining the intricacies of a 1991 law known as Federal Deposit Insurance Corporation Improvement Act, or FDICIA (pronounced "fidisha").

Yet another response to the savings and loan crisis of the late 1980s, FDICIA was designed to limit the taxpayer's exposure to failing financial institutions. It required the Federal Deposit Insurance Corporation, the entity that insured deposits at commercial banks and paid depositors if their institutions failed, to take prompt corrective action when a bank got into trouble. The law also required that the FDIC resolve failing institutions at the least possible cost to the government.

Both of these elements represented significant improvements to previous rules and protected taxpayers from future losses produced by troubled banks.

But in scrutinizing FDICIA, Todd had uncovered an obscure amendment to the law that dramatically expanded the federal safety net, increasing the likelihood of taxpayer bailouts in the future. While previously only commercial banks who were members of the Federal Reserve System could request emergency financial support from the central bank in times of crisis, the amendment to FDICIA increased the availability of Fed assistance to include investment banks and insurance companies.

The amendment had not attracted much attention before or after the bill was passed. Todd discovered that the change had been quietly inserted late in the legislative process by Christo-

We were never arguing that you should give loans to people who don't qualify."

Still, that was the result.

pher Dodd, the Connecticut senator whose constituents include most of the nation's large insurance companies.2 During a debate about the bill on the Senate floor, Dodd said that his provision would give "the Federal Reserve greater flexibility to respond in instances in which the overall financial system threatens to collapse. My provision allows the Fed more power to provide liquidity, by enabling it to make fully secured loans to securities firms in instances similar to the 1987 stock market crash."

Lawmakers asked if the Fed had a point of view on the amendment. The Fed took no exception to it, they were told.

Todd, an expert on bank failures and dubious lending practices, was among the few who recognized the significance of the amendment at the time. "This amendment was introduced suddenly in the Senate markup, with no hearings, no prior notice," he recalled in an interview almost twenty years later. "It was antithetical to the spirit of FDICIA, which was to retrench emergency lending."

In a 1993 article about the change published by the Federal Reserve Bank of Cleveland Economic Review and entitled "FDI-CIA's Emergency Liquidity Provisions," Todd identified the change and its potential impact. "Although nonbanks still have strong incentives to run their firms prudently, their managers now have potential access to another funding source during financial crises," he wrote. "Whether this potential access alters nonbanks' business decisions—so as to make their calling upon that funding source more likely—remains to be seen."

"Moral hazard" is the term used by economists to describe what Todd was talking about. If access to emergency capital made bank managers less likely to exercise caution, as they would if they could not expect help when experiencing losses, then that would be a moral hazard—it would encourage risk taking among

banks because their executives knew they could be bailed out if they got into trouble.

Todd's uncertainty about whether nonbanks would take on more risk would be erased some fifteen years later when the Fed rescued the world's largest insurance company, the American International Group, providing $180 billion in taxpayer assistance. Despite claims by government officials that taxpayers profited from rescues of GM, AIG, and Citigroup, the expansion of the federal safety net that began with a little-noticed amendment to FDICIA would wind up costing taxpayers hundreds of billions of dollars.

But Todd received no praise from his colleagues at the Federal Reserve Board in Washington for his groundbreaking research. In fact, they worked feverishly to prevent its publication. When those efforts were unsuccessful, Fed officials in Washington rewarded Todd with a reprimand in his personnel file.

Twenty years later, working as a senior research fellow at the American Institute for Economic Research, Todd was still perplexed by the episode. He could only conclude, he said, that Washington wanted no discussion of the expanding safety net and its costly implications for taxpayers.

Even as Congress was writing legislation to allow investment banks and insurance companies to tap the Federal Reserve in times of crisis, the Federal Reserve Bank of New York, the most powerful of the twelve regional banks that make up the nation's central bank system, was reducing its oversight of the Wall Street firms it did business with. Known as primary dealers, these firms were used by the government to help manage its auctions of U.S. Treasury securities. The dealer firms also acted as the Fed's eyes and ears on Wall Street, supplying information about goings-on in the financial world.

In January 1992, the Fed ended a program called dealer surveillance that it had long used to audit and inspect these Wall

Street firms. The Fed had decided to close one of the windows it had onto the workings of the Street.

A press release issued by the New York Fed said that its longstanding surveillance arrangement needed to be changed "to address certain shortcomings." The program had helped to create a widespread misperception that the Fed regulated the primary dealer firms. So it decided to shutter the unit altogether. "This change reiterated the point that the bank does not have—nor did it ever have—regulatory authority over the primary dealers," the Fed said in its release.

From this moment on, the Fed would no longer be able to conduct its own due diligence on dealer firms. Now it would have to rely on audits and reports filed by the firms but that were verified by other regulators, such as the Securities and Exchange Commission or the Office of the Comptroller of the Currency, a division of the Treasury that oversaw large national banks. It was, to some Fed officials, a dangerous delegation of an important duty that had given the central bank access to crucial information about the soundness of the Wall Street firms it was dealing with.

Like the amendment to FDICIA uncovered by Walker Todd, the Fed's decision to close down dealer surveillance went largely unnoticed. But to some inside the organization, it was a clear indication that the days of a tough regulatory approach at the Fed were over.

Supervision and regulation, as the bank overseers' unit is called, had for years been a tight ship run by William Taylor, an independent thinker with a bulldog personality. A top adviser to Alan Greenspan, the chairman of the Federal Reserve Board, Taylor was an aggressive supervisor who "had no political sponsors, nor did he seek any," according to Paul Volcker, the chairman of the Federal Reserve Board in the 1980s and, for a decade, Taylor's boss.

Taylor was a tough-guy regulator. He had, for example, forced Citibank to stop paying its stock dividend in October 1991 when the bank was staggering under a mountain of bad loans. Taylor knew that eliminating its dividend was necessary for Citibank to shore up its capital; the bank's management resisted the idea because it would cause shareholders to flee and Citi's stock to plummet.

As head of "supe and reg," Taylor's primary goal was to ensure the safety and soundness of the nation's banking system. To him that meant Citibank had to improve its capital position by the most expedient method possible. If that meant axing its dividend, so be it.

But in the midst of Citi's crisis, Taylor left the Federal Reserve to become chairman of the FDIC. It was the autumn of 1991; by the following August, Taylor was dead at the age of fifty-three.

"The regulatory ethos at the Fed died with Bill Taylor," a former colleague said. "After Taylor left, and especially after he died, Alan Greenspan, the Fed chairman, was never really engaged in bank regulation. In 1992 or '93, the Senate asked Greenspan: 'With Taylor gone who is in charge of regulatory policy at the Board?' The answer surprised the Senate staff when it came back in writing because Chairman Greenspan said he had delegated the task to E. Gerald Corrigan, the president of the New York Fed."

This was news. For the first time the Board was not managing its own supervisory policy, the former Fed official said. Instead, it was delegating that important duty to the New York Fed, an organization that operated hand in glove with the banks it was supposed to regulate.

The New York Fed is a private corporation with a board comprised primarily of top executives of the banks it oversees in its region, and its president is chosen by those board members. As such, they are unlikely to choose a president they think will be especially tough on them.

Suddenly, supervision of the nation's banks was being overseen by an organization viewed by many as a captive to the entities it regulated. It was a power shift that would, years later, prove to be disastrous for the American people.

Bill Taylor's death also coincided with another shift at the Fed in Washington. In the early 1990s, the regulatory view was that capital requirements at the nation's banks should be strict. The savings and loan crisis and Citibank's woes had struck fear in many regulators' hearts. But over the next decade, the Fed would side with the major banks on capital requirements, pushing harder for looser rules and regulations.

The drive by Jim Johnson, the Fed, and others to expand home-ownership to lower-income Americans was more radical than many of them wanted to admit. Indeed, a completely new approach to lending would be necessary if policymakers wanted the ranks of homeowners to grow beyond current levels.

All the old rules about what made a prospective borrower a good risk—based upon past repayment practices—would have to go by the boards. Looking to what a borrower could become—his credit future—had so much more potential. "The power of 'Yes!'" was what Washington Mutual, a big subprime lender, would later call its lax lending during the great mortgage bubble of the late 2000s.

But in the early and mid-1990s, "The Power of No" held sway in the traditional banking world. To entrepreneurs like J. Terrell Brown, head of United Companies Financial, traditional bankers were the abominable No-men, stick-in-the-muds who refused to

moo that times had changed. The 1950s-era Leave It to Beaver household where Dad worked and Mom stayed home to mind the kids was giving way to a world of two-income families and latchkey children. Lenders that failed to respond to these changes by being open to more atypical borrowers would be left behind.

Happily for the housers, as the homeownership brigade was known, Wall Street's creative minds were on the case. Teaming up with Brown and a handful of other upstart financial companies, Wall Street bankers helped devise newfangled mortgage products and services to expand the pool of potential borrowers. The innovation not only made borrowing easier, it brought increased profits to the companies that embraced it.

Underwriting loans, a bank's bread and butter, had long been a burdensome task. Loan officers collected information from credit bureaus, amassed data on applicants' job histories and financial holdings, and, perhaps most important, looked a potential borrower in the eye to decide if the loan was a risk worth taking for the next thirty years.

It was hard for renters, living from paycheck to paycheck, to build credit histories that were extensive and clean enough to be taken seriously by a mortgage lender. Among people who didn't have a history of paying credit-card bills, being approved for a mortgage was unlikely in the late 1980s and early 1990s.

Although there was no industry standard for what separated a good borrower from a bad one, banks used benchmarks to judge a consumer's financial position and ability to pay off a loan. One measure compared the amount of debt the borrower carried versus his or her income. Anything over 36 percent was deemed too onerous.

Another metric compared the size of the loan to the worth of the property that would secure it—known as the loan-to-value ratio. Normally a bank would only lend 80 percent of a property's appraised value.

Finally, there was the credit history of the borrower to consider.

Using these benchmarks, banks graded potential borrowers.

Like a Hide of beef, the best prospects were considered "prime" or "A." Those with blemishes on their credit histories or numerous job changes over a short period were "B&C" customers. Lenders later renamed this category "subprime" because "B&C" sounded vaguely insulting to borrowers in these ranks.

Many of those in the B&C category had never had relationships with traditional banks. They relied instead upon unregulated and costly check-cashing services or payday lenders, entities that provided loans to tide borrowers over until they received their paychecks. Such services charged astronomical interest rates and were only a step above loan sharks.

Still, low-income consumers preferred their loan sharks to the intimidation that the local branch banker represented. Walking into a bank to ask for a loan meant submitting to a lengthy and invasive process involving endless questions about finances. Getting approved on a home mortgage seemed so difficult for those who were unfamiliar with the financial world that it was simply not worth attempting. With weak or no credit histories and little to no savings to put toward a down payment, borrowers figured they were shut out of homeownership.

Although banks were careful to make only those loans to people they felt certain would be "money good," in Wall Street parlance, or able to repay their loans, these institutions did not always hold on to the mortgages they made. If the bank made a loan that it thought Fannie Mae, Freddie Mac, or the government's Federal Housing Authority programs would buy, then the bank could sell it to one of those entities and free up that money to make another loan. Fannie and Freddie would then turn around and bundle thousands of these loans into mortgage-backed securities that income-seeking investors would buy.

But if the bank could not convince Fannie or Freddie to buy a loan, it had to hold on to it and hope the borrower would pay it off. Banks did not create pools of loans and sell them to investors like Fannie and Freddie did. They either sold them to the government or kept them.

All this changed, however, in June 1993 when United Companies Financial, a publicly traded mortgage lender based in Baton Rouge, Louisiana, cobbled together its first mortgage pool. The company, founded in 1946, had been originating loans, bundling them into pools of mortgages, and selling them to affiliates and government agencies for almost a decade. But the $165 million worth of mortgages that it bundled into a security in the summer of '93 was the first ever to be sold to investors under the United Companies name.

The pool, part of a series or "shelf' of securities under which United could raise up to $1 billion from investors, received an investment grade rating of AAA, the highest possible, from all three ratings agencies. With this imprimatur from Moody's, Standard & Poor's, and Fitch Ratings, investors felt comfortable buying the deal.

This AAA rating was crucial. Analyzing one mortgage to try to predict its performance was hard enough. Assessing the risks in a security that contained thousands of loans was beyond complex. If the ratings agencies were convinced that the securities were good enough to assign them a triple-A rating, then most investors were happy to go along.

Little fanfare accompanied the United Companies residential mortgage-backed securities offering that June. Nobody on Wall Street rang a bell to memorialize the moment. But the issuance of its first mortgage pool represented the dawning of a new age, one in which mortgage-backed securities issued by private lenders would compete with those sold by Fannie and Freddie. By 2003, ten years after the United Companies issue, mortgage securities worth $467 billion were sold to investors.

No one recognized it at the time, but the financial world's equivalent of an arms race had begun. Rather than producing nuclear weapons, though, this race would generate millions of worthless loans, leaving investors with hundreds of billions in losses. As often occurs in the financial world, a good idea was soon transformed into a monstrosity by Wall Street.

Officials at Fannie Mae and Freddie Mac certainly took notice of the United Companies deal. Neither agency had ever had competition from the private sector when they went into the market to sell their mortgage pools. But the success of the United Companies Financial deal meant investors interested in the risks and returns of the mortgage market had a new option.

Two months after it sold its first private-label securitization to investors, United Companies returned to the market with another $130 million in mortgage-backed securities. In a little over sixty days, this obscure company had shifted almost $300 million of mortgage risks from its own books to those of investors. The following year, United Companies increased the size of its securities "shelf' to $3 billion.

The United Companies deals might have been a one-hit wonder had it not received a big assist from Duff & Phelps, a financial services firm that assessed risks in securities and rated them accordingly. In an August 1993 study entitled "Special Report on the Securitization of B&C Quality Loans," Duff & Phelps made a novel and counterintuitive argument about the risks inherent in such loans. While many investors viewed lower-quality loans made to sketchy borrowers as high-risk, one important aspect of these obligations made them somewhat less risky in actual practice, the Duff & Phelps analysts argued. Indeed, risk-averse investors might actually gain from buying securities made up of these loans.

Like any investment, fixed-income securities posed multiple risks to investors who bought them. The most obvious was credit risk—the potential that the loan would not be repaid. Another was interest-rate risk—if prevailing rates rose, then the market value of a loan paying a lower rate would decline.

A third risk, and one that was harder to predict, involved the early repayment of the loan. Because an investor wanted to keep receiving the stream of income on the loan he or she had purchased for as long as possible, getting repaid before the loan matured was a big risk associated with mortgage investing. This was known as prepayment risk.

Such was the risk that Duff & Phelps argued was reduced among loans made to sketchy borrowers. Because the loan approval process required of these borrowers was so much more onerous, the firm maintained, they would be far less likely to be able to refinance their loans if interest rates dropped. Getting a new loan might be a cinch for stellar customers, Duff & Phelps noted, but H&C borrowers had a harder time refinancing. Therefore, the risk that these mortgages would be repaid early was vastly reduced.

Investors would benefit twice, therefore. First, the income streams were larger because riskier borrowers were forced to pay higher interest rates on their obligations. Second, because these borrowers were locked in, prepayment risk was diminished.

This argument was made more compelling by the fact that at this particular moment prepayment risk was a serious threat. With interest rates declining in the early 1990s and competition for better-quality mortgage loans rising, locking borrowers into higher rates was an attractive investment concept. It meant that the higher income stream prized by investors would keep on paying far longer than was typical among better loans.

It came as no surprise, therefore, that investors began to embrace this less competitive, more fractured market. They loved its richer margins and appreciated B&C loans' reduced sensitivity to interest-rate moves. In 1994, some $40 billion in subprime loans was made. Just five years later, annual issuance of subprime mortgages would rise to $160 billion.

At the time of its 1993 report, Duff & Phelps seemed simply to be making a persuasive investment thesis. But by allaying investor fears about the risks inherent in lower-quality loans, Duff & Phelps helped open the floodgates of subprime lending. Millions of investors were on the prowl for interest income—insurance companies and pension funds, for example, had billions to invest in fixed-income securities. Pointing out the appeal of such loans to these and other investors helped unleash a boom that would be the downfall not only of the mortgage market but also of the entire mortgage securitization process.

In 1993, though, investors were just beginning to whet their appetites for riskier mortgage loans. Nevertheless, their rising interest in these loans encouraged Wall Street banks and other investors to provide mortgage lenders with capital to make them.

Just as manufacturers of tires, dishwashers, and other goods need warehouses and funding to build up inventory until they can sell it, so do lenders. And with increasing support for loans from rating agencies like Duff & Phelps and the investors who heeded them, lenders suddenly found it far easier to establish warehouse lines of credit. Money soon flowed in from investment banks and other investors eager to make money on the warehouse lines and ensure a steady stream of mortgages to package and sell to investors. The larger the volume of loans originated by a lender, and the more quickly they could sell those loans to investors, the larger the "warehouse line" the lender was likely to receive.

Quantity, not quality, was rewarded by the firms providing the warehouse lines. And because those institutions buying the loans had to take the losses if they went bad, the bankers making the loans had less incentive to ensure the borrowers were "money good."

Fannie Mae, always on the alert for competitors out to eat its lunch, closely watched the activities of United Companies and other newcomers to the mortgage securitization business. And in the early fall of 1993, Fannie and Freddie Mac joined with PNC Bank of Pittsburgh, Sears Mortgage, and Mortgage Guaranty Insurance Corporation to launch a pilot-underwriting program that would redefine lending practices in the "conforming market," the term used for loans that could be purchased by Fannie and Freddie.

The new program had a prosaic name—it was known as "Alternative Qualifying"—but it challenged many conventional lending rules. For example, "AQ" did away with long-standing traditions requiring that a borrower's monthly housing payment not exceed 28 percent of his or her income and that his or her debt did not exceed 36 percent of income. Instead, the program said that if an applicant had previously demonstrated

some ability to manage very high payments as a percent of their income, perhaps in the form of rent, then that should be considered favorably.

It was all reminiscent of the guidelines put out by the Boston Fed earlier in the year, after publication of its problematic mortgage discrimination study. "Closing the Gap," the Boston Fed's rules for nondiscriminatory lending, directed banks to "consider extenuating circumstances" of atypical borrowers.

But while the Fed's suggestions were just that, the new Fannie and Freddie program institutionalized the endorsement of untested underwriting criteria. By allowing greater flexibility in the loans they would consider for purchase, these historically conservative firms offered B&C lenders like United Companies Financial the chance to expand their own lending and receive what seemed to be the U.S. government's "Good Housekeeping Seal of Approval" on loans they made and sold to Fannie or Freddie.

Although risky borrowers were supposed to make larger down payments when they bought a home or have more equity in their property before they could refinance, the "AQ" program was the first in a series of steps to ease lending practices and expand loan volumes. The years of profits and peril that would be known as "Subprime 1.0" were about to begin.

Within months, advertisements detailing new opportunities for borrowers began appearing in newspapers and on radio. It wasn't quite the anything-goes lending spree that would characterize the mid-2000s where all you needed was a pulse to get a loan, but it was on the way there.

Watching the growth in securitization of B&C loans by United Financial and other upstarts, Fannie Mae grew worried about rising competition. Fannie Mae was not allowed to own a mortgage underwriter, so it had to rely on the kindness of third parties to produce the loans that the company would buy. Johnson needed to ensure that such lenders would continue to send the lion's share of their loans to Fannie Mae.

An obvious solution to this problem involved cultivating a company that Fannie Mae already had a relationship with: Countrywide Financial.

A mortgage lender launched in 1969 by two entrepreneurs named David Loeb and Angelo R. Mozilo, Countrywide Financial was, by the mid-1990s, a formidable mortgage machine generating billions of dollars in loans a year. Johnson's goal was to ensure that Countrywide sold as many of these loans as possible to Fannie Mae rather than its rival, Freddie Mac.

Countrywide's ties to Fannie went back to the days when David Maxwell ran the company. During his time as head of a mortgage insurance company in Los Angeles, Maxwell had written a letter of recommendation for Countrywide when it was just getting on its feet.

To strengthen its ties with the growing Countrywide, Johnson went about courting Mozilo. Johnson "became a student of Angelo," according to Mortgage Strategy, an industry publication, and set about learning the executive's likes, dislikes, and routine.

A crude and hotheaded butcher's son from the Bronx, Mozilo was the polar opposite of the cool and calculating Johnson. A perennially tanned man who drove flashy cars, Mozilo wore his ambitions on his French-cuffed and monogrammed sleeve.

The two men did share a love of golf, however. Whenever Johnson headed out West for business, he'd make a point of setting up a golf game with Mozilo. Johnson showcased Mozilo at corporate retreats for Fannie Mae's executives and sales force and took time out to be interviewed for "The Countrywide Story," a television program that aired in 1997 as part of a series on Californian entrepreneurs.

Mozilo returned some of these favors. He allowed Johnson frequent flights on Countrywide's corporate jet and provided Johnson with cut-rate loans on the many properties the Fannie Mae chief owned.3 These included Johnson's multimillion-dollar homes in Ketchum, Idaho; Washington, D.C.; and Palm Desert, California.

His "friendship" with Johnson, Mozilo well knew, was driven by money. He had once characterized Johnson to reporters at Mortgage Strategy as so slick that "he could cut off your balls and you'd still be wearing your pants."

Recognizing that Johnson needed him more than he needed Johnson, Mozilo forced Fannie to discount the fees it charged to guarantee the company's loans it sold to investors. Fannie's guarantee fees were typically 0.23 percent of a loan's amount. They were also a nonnegotiable item.

But under the terms of Countrywide's special deal, reported in the Wall Street Journal, Fannie charged the company only 0.13 percent of the loan amount. To keep its side of the bargain, Countrywide agreed to provide enormous volume to Fannie Mae and refused altogether to deal with Freddie Mac.

It was a deeply symbiotic relationship and central to the public-private partnership at the heart of the homeownership push. Fannie got the volume it needed to balloon its portfolio and profits, and Countrywide fattened its earnings by paying reduced fees to Fannie Mae. Soon Countrywide was Fannie Mae's single largest provider of home loans.

In the mid-1990s, Countrywide was still making the types of standardized loans Fannie Mae favored. Elsewhere in the market, more liberalized lending programs were springing up. For example, Arbor National Mortgage, a lender based in Uniondale, New York, was offering to refinance customers' homes through its "50/50 Homeflex" program. Borrowers could be approved even if their debt payments ate up half their monthly incomes.

And by early 1994, Option One Mortgage, a company that would become a major player in the mortgage mania of the mid-2000s, was approving loans for borrowers whose debt-to-income levels went as high as 60 percent.

Soon, mortgage lenders that had stuck to the upper tiers of borrowers were setting up subsidiaries devoted to B&C loans. The industry had come to understand borrowers better, its

representatives explained. Those whose loans would have been rejected in the past were being given a second chance.

Many of these lenders made their new business sound almost altruistic. "These (borrowers) are often people who've had credit problems that were beyond their own control," Larry R. Swed-rowe, vice-chairman of Prudential Mortgage, told a reporter for the Los Angeles Times in a July 1994 interview. The company, one of the more conservative lenders in the business, had begun approving borrowers for loans even if they had been late with their mortgage payments in three of the previous twelve months.

Business was business, after all. Because these borrowers were willing to pay a fatter interest rate than higher-quality customers, "they represent a very sound business opportunity," Mr. Swedrowe acknowledged.

When interest rates began rising in 1994, slowing the wave of refinancing among prime borrowers, subprime lending gained even more traction as lenders saw that lower-quality borrowers could pick up some of the slack in the diminished prime loan arena. The fact that subprime loans could be significantly more profitable was icing on the cake.

The final piece of the puzzle fell into place in March 1994. Equifax Inc., one of the emerging leaders in credit scoring, introduced a system specifically tailored to assess the mortgage risk posed by a loan applicant. The system used information about a prospective borrower, applied different weightings to the data, and then predicted whether he or she would be likely to pay off the loan. It was novel and seen by the financial industry as a shiny new toy.

Such systems had already been used to analyze applications made by consumers opening credit-card accounts or borrowing to buy a car. But using a scoring system to try to predict the performance of a far more complex mortgage loan was something new.

Officials at Equifax said they believed that with their model, predicting credit risk in a mortgage application was relatively easy. Because applicants for mortgages typically had a better risk profile

as well as a lengthy history of paying their obligations, they would not be difficult to assess. The changes transforming the old and conservative world of mortgage financing were ignored by Equifax.

Models like those used by Equifax had already begun to find a real foothold with smaller mortgage brokers and lenders. While it once had taken hours to process a loan application, credit check and approval lenders using desktop scoring models developed by firms like Fair Isaac Corporation (FICO) ramped up their production to fifty or so loans a day.

These new approaches embraced by a historically risk-averse industry sounded too good to be true to some. But to the entrepreneurs in the lending market, the models were a natural progression from a staid and buttoned-down business based on personal interactions to a technologically advanced, faster-paced operation that put a premium on speed of execution. The investment banks, who profited by filling the lenders' deal pipelines, and the investors, who reaped higher yields on mortgage securities issued by new lenders, welcomed the changes in lending practices.

Perhaps most surprising was the regulatory response to the relaxed lending rules. Financial regulators either stood by as the old rules designed to promote sound lending were scuttled or, like the Boston Fed, actually encouraged their demise.

An early change came from the Department of Housing and Urban Development, the regulator that Fannie Mae had worked so hard to weaken. In 1995 it relaxed rules involving appraisals, eliminating the requirement that those assessing the value of a property before a borrower took out a mortgage on it were independent from other companies involved in the process. Under a new rule designed to streamline regulations, HUD said that lenders could hire their own appraisers, setting up the potential for inflated valuations.

That is precisely what happened. The inflation game, which would help propel home prices into the stratosphere, began almost immediately.

Unfortunately for United Companies, the pioneer of these game-changing practices, its moment of fame was fleeting. Like many early players in subprime mortgages, the company fell victim to the financial downturn that began as a currency crisis in 1998. The following year, United filed for bankruptcy, closing its two hundred offices and selling off its mortgage servicing and whole loan portfolio to Bear Stearns's EMC Mortgage. Few would remember, years later, that United Companies had been the first mover in private-label mortgage securities.

As United Companies Financial and other upstart lenders readied themselves for a borrowing binge, James Johnson pondered ways to shield Fannie Mae from the critics he knew lurked around every corner. How could he innoculate his company from those who viewed its growth plans with alarm, the naysayers who argued that the bigger Fannie Mae got, the more likely the taxpayer would have to bail it out someday?

The answer to this question was, as usual, money. Truckloads of it.

In March 1994, Johnson announced Fannie Mae's Trillion Dollar Commitment, a program that earmarked $1 trillion to be spent on affordable housing between 1994 and 2000.

The money would finance "more than 10 million homes for low-income families, minorities and new immigrants, families who live in central cities and other underserved communities, and people with special housing needs," the company said. Setting aside these funds meant that "Fannie Mae will transform the nation's housing finance system by working with other industry partners to eliminate the barriers to homeownership, and promote a ready supply of affordable rental housing."

One trillion dollars. Even for a man with plans as big as Johnson's, the figure was audacious.

But it had to be, as those inside the company knew, if Johnson was going to secure the protection Fannie Mae needed. The plan, former Fannie executives say, was to commit so much money to low-income housing—"for families and communities most in need," as the company liked to say—that no one would dare to criticize its other activities.

"This was the beginning of the use of the word 'trillion' in housing," marveled Edward Pinto, a former Fannie executive. "When Johnson announced the $1 trillion commitment, it told Washington that the company could do even more than they already were doing. It was pouring gasoline on the fire."

Fannie Mae boasted that its trillion-dollar commitment contained "11 very significant initiatives that address every dimension of the housing finance system."

The first priority was to bring a new flexibility to the loan underwriting process. Fannie Mae promised to use $5 billion worth of loans by the end of the decade to test new technology-fueled underwriting methods; it would also set up toll-free "flexibility hotlines," and comprehensive training programs, reference materials, and tools. A new automated underwriting system to ease the loan application process was being developed as well.

As always, Fannie's plan was watched closely by banks and other lenders across the country. Indeed, just over ten years later, Countrywide Financial, the subprime lender overseen by Mozilo, Johnson's old friend, launched its own trillion-dollar commitment, known as "We House America."

Mozilo said his plan embodied Countrywide's "long-standing commitment to lead the mortgage industry in closing the home-ownership gap for minority and lower-income families and communities." Never mind that closing this gap meant trapping millions of unsuspecting people, many of them minorities, in high-cost loans they could ill afford.

A trillion dollars was a lot more in 1995 than it was a decade later. Still, Johnson's plan to throw all that money at the housing market to neutralize Fannie Mae's sophisticated critics in Washington did nothing to meet another challenge he confronted. How could he make Fannie Mae, a mortgage finance company whose operations few understood, into a company that was known for helping people realize the American dream of homeownership?

Fannie Mae was a creature of Washington, D.C., and this, Johnson knew, did not help its image. He had to win the hearts of everyday people on Main Street if he were to bullet-proof his company, and his lucrative position atop it.

So, after a cross-country trip in 1993, Johnson came up with the idea that Fannie Mae needed a local presence in communities nationwide. Boots on the ground was what his company required.

Thus were born the Fannie Mae Partnership Offices. Devised by Johnson, the partnership offices put Fannie Mae executives in place across America; soon the company was opening storefronts in cities and towns where it could partner with local officials to promote homeownership and, by association, its role as a good-deed doer. The partnership offices and their large financial commitments were soon garnering upbeat headlines in local newspapers, promoting Fannie's soft side to everyday people.

Even more important, though, the partnership offices cemented the company's relationships with members of Congress. By supporting housing initiatives that lawmakers could take credit for in their home districts, Fannie provided publicity for the very congressmen and -women whom it relied on for help and protection in Washington. With Fannie Mae's new regulator, OFHEO, in the midst of devising new and possibly punishing capital requirements for the company, support in Congress was more crucial than ever.

The partnership offices were vintage Johnson, a decisive response to a challenge. "The test between a strong and a weak organization is not whether you have problems—you always have problems—but how quickly you identify those problems," he had told an interviewer from the New York Times way back during the Mondale for President campaign. "How quickly you solve them and how quickly you change when you're on the wrong course."

The company launched its effort with twelve partnership offices, or POs in company parlance. Initial cities included Boston; Miami; Baltimore; Cleveland; Portland, Oregon; and Los Angeles. By the end of 1994, the company had twelve offices up and running across the nation.

Robert B. Zoellick, then the general counsel at Fannie Mae, described it this way: "For a relatively small investment, Fannie Mae will be recognized as a force for good in each of those cities or states. And by doing so, will have . . . more networks of support."

Boston's was one of the first offices to be opened and in October

1994, Johnson was there, trumpeting Fannie Mae's commitment of $1.5 billion in affordable home financing for twenty thousand local families. At his side during the photo op was Ted Kennedy, the Massachusetts senator who also happened to be engaged in a pitched battle for his Senate seat. His Republican challenger, Mitt Romney, was causing Kennedy so much trouble that he had to take out a second mortgage on his Virginia home to cover campaign costs.

Kennedy wound up prevailing over Romney that November, winning 58 percent of the vote. The Fannie Mae ribbon-cutting ceremony may not have won the election for Kennedy, but it certainly hadn't hurt him.

Democrats like Kennedy were not the only beneficiaries of Fannie Mae's partnership offices. Republicans, who believed in smaller government and fewer agencies, were potential threats requiring special care and feeding by the company. So when Johnson traveled to Atlanta to launch the new office there in February

1995, he made sure to invite some powerful Republicans to join him at the podium.

Once again, the focus for the Atlanta partnership office would be on creating mortgage products for first-time homebuyers and low-and moderate-income consumers, Johnson said. "Our commitment

is to make homeownership in the greater Atlanta area more accessible than ever before. We think that the best way to do that is to work as closely as possible with the people of the city and the surrounding counties in their neighborhoods, and with local community groups, mortgage lenders, nonprofit housing organizations, and the city and county governments."

There to celebrate the Fannie Mae commitment was none other than Newt Gingrich, the Georgia Republican who was Speaker of the House of Representatives and a big proponent of reducing government's size.

"Fannie Mae is an excellent example of a former government institution fulfilling its mandate while functioning in the market economy," Gingrich crowed, not quite accurately, for there was nothing "former" about Fannie Mae's government status. "Fannie Mae has had a regional presence in Atlanta for over 40 years and the announcement of a partnership office demonstrates its continued commitment to affordable housing in the Atlanta metropolitan area."

Another powerful Republican was on hand in another city in 1996, when Fannie Mae opened a partnership office in Kansas City, straddling Missouri and Kansas. As Johnson announced his company's plan to deliver $650 million to promote homeownership and rental financing in the area, Christopher S. Bond, a Republican senator from Missouri, stood beside him at the city hall photo op. "Fannie Mae is committed to making the nation's mortgage finance system work better for the people of Kansas City," Bond said. "I look forward to seeing thousands of families rewarded with new housing opportunities through this partnership."4

But the partnership offices did more than simply provide ribbon-cutting celebrations for members of Congress and local

elected officials. They also supplied jobs for relatives and former staffers of elected officials.

When Fannie Mae opened a partnership office in Utah in 1999, for example, it was headed by Tim Stewart, a former legislative aide to Robert Bennett, the Republican senator. Bennett's son Rob was also hired to work in the office. Up north in South Dakota, Bob Simpson, a former aide to Senator Tom Daschle, ran Fannie Mae's local office.

A former executive working closely with Johnson when the partnership offices came about recalled fears by some inside the company that the strategy would require Fannie Mae to back money-losing projects to satisfy local politicians. "When we started these partnership offices we were all afraid of what it meant—that we were going to politicize all our underwriting decisions," he said.

As it turned out, however, the benefits of what was essentially a Fannie Mae patronage scheme far outweighed the potential for ill-conceived property developments. "The partnership offices gave us an enormous advantage when Congress was debating further regulations," the former executive continued. "We were able to call on our lenders and upon all our partners in the cities where we had these offices and say you have to weigh in. Write to Congress."

Fannie Mae's partnership offices were also mimicked later on by the federal government when it set out to promote homeownership by combining the private sector and public entities.

The projects undertaken by the POs always involved a close collaboration between homebuilders, Realtors, banks, housing agencies, local advocacy groups, and even corporations, such as retail chains, that would seem to have nothing to do with housing. At the launch of the Kansas City office, for example, Larry Small, Fannie's president and chief operating officer, described all those he had invited into the company's big housing tent.

"Over the next few months," Small said, "we will work with city representatives, mortgage lenders, nonprofit housing organizations, real estate professionals, and other housing leaders to craft a comprehensive investment plan designed to help meet the specific housing needs of Kansas City home buyers and renters."

Among those whom Fannie Mae enlisted in its Kansas City effort was Colleen Hernandez, executive director of the Kansas City Neighborhood Alliance, who was asked to join the company's National Advisory Council5

Richard Moore, president of Commerce Mortgage Corp., a local company, was another Kansas City friend of Fannie—he sat on the company's Southwestern Regional Advisory Board. David Stanley, chief executive of Payless Cashways, a regional supermarket chain, was on the board of the Local Initiative Support Coalition, a nationwide nonprofit that regularly partnered with Fannie Mae.

The partnership offices bolstered a company effort begun by Johnson in 1992 that was designed to broaden the reach of Fannie Mae to include a wide array of public and private partners. This was the Housing Impact Advisory Council, a forum sponsored by Fannie Mae that convened more than sixty people interested in increasing the availability of affordable mortgage financing. Council members included civic leaders and those running state housing authorities, financial executives, developers, and real estate professionals. Each served a two-year term.

The council met three times a year with Fannie Mae's senior management "to discuss issues affecting products for low- and moderate-income home buyers and renters."

Under Johnson's direction, Fannie Mae duplicated this public-private partnership effort in every major urban area. Enlisting the aid of bankers, builders, Realtors, and advocacy groups nationwide, all of whom stood to benefit from an increase in homeownership, Fannie Mae soon had an army of foot soldiers at the ready to thwart any opponents.

"I wanted to have everybody and anybody who cared about housing working in partnership with us," Johnson told a reporter from the Washington Post.

The company did not hesitate to marshal these troops when it felt threatened. And that is just what it did in 1995 when one of the company's lucrative perquisites, related to its quasi-government status, came under fire.

Under its charter, Fannie was exempt from paying income taxes to the District of Columbia, where it is headquartered. With the city's budget deficit ballooning, some local officials, such as D.C. council member William P. Lightfoot, suggested that Fannie Mae, an enormously profitable company, start paying local income taxes. One year of taxes, according to an estimate based on Fannie Mae's profits, would bring $300 million to the District, eliminating the entire D.C. budget deficit.

But making such tax payments would also diminish Fannie Mae's earnings and those of its executives. So the company sprang into action, calling in chits from community organizers in the District with whom it had worked in the past.

One was Lloyd Smith, head of the Marshall Heights Community Development Organization, a group devoted to helping residents of a blighted area in Washington, D.C.'s 7th Ward. A neighborhood that was 97 percent black and where one third of its children were living in poverty, the 7th Ward needed all the help it could get.

Well before Fannie Mae's tax fight began, Smith's organization had received affordable housing funds from the company. So when it asked Smith for help in battling the tax issue, he was happy to oblige. He told the Washington Post that he telephoned council members and wrote to them, urging that the idea of levying a local income tax on Fannie be junked.

Fannie Mae had provided affordable housing and scholarships to local high school students, Smith argued. If the company was forced to pay income taxes, it might leave the district and take its programs with it.

Other community leaders joined forces with Smith, at the urging of two Fannie Mae lobbyists, Fred Cooke and David Wilmot. A tidal wave of letters arguing against the tax swamped the offices of

D.C. council members. Cooke, whose wife worked at Fannie Mae, met with each member of the city council, requesting that they give up on the proposal.

Barbara Lett Simmons, a local talk show host and former D.C. school board member, also got in on the act. She invited students from 7th Ward schools to appear on her radio and cable television programs to describe assistance they had received from Fannie Mae. "I started having people on my show to help get the word out," she told the Washington Post. "We have got to support our friends." Simmons's husband, Pat, sat on the board of the Fannie Mae Foundation, the company's charitable giving organization.

During the summer of 1995, Representative Pete Stark, a California Democrat, tried to schedule a hearing of the House District Committee on the Washington, D.C., budget problems. He had drafted a legislative proposal that would allow the District to tax Fannie Mae, but when it came time to find witnesses willing to support his plan, everyone he contacted ran for cover.

"The committee staff attempted to get a lot of witnesses to testify about this issue of Fannie Mae," Broderick Johnson, the staffer who worked on the hearing, told a reporter from the Washington Post. "Many of them quite frankly told us that they could not do it because of philanthropic relationships they have with Fannie Mae."

In the face of this pressure, the tax idea died. The $300 million in potential taxes that Fannie Mae might have been forced to pay each year remained safe and sound in its own coffers.

In November 1995, Fannie Mae increased its funding to Smith's Marshall Heights organization, pledging $650,000 in grants and loans to the community. Some of the money was earmarked for new housing construction. "This will enable us to double our production of affordable housing of various types for Ward 7 residents," Smith said upon receiving the check from Fannie Mae in a public ceremony.

Lightfoot, the council member who had tried to get Fannie to pay taxes to the District, recalled the fight years later. "I knew I

was taking on the behemoth, but it seemed only fair that they should pay a tax to the government that allowed them to operate, generating such profits," Mr. Lightfoot said. "Their argument was they donated millions of dollars a year in charitable work to D.C. and that that should be counted in lieu of taxes."

Mr. Lightfoot and two other local representatives traveled to Texas to make their case before shareholders and directors attending Fannie Mae's annual stockholders' meeting. "They allowed us to stand up and make our arguments and there was no response and we left," he recalled. "It was like talking to the wall but the wall did let us talk to it."

It would take another decade before HUD, Fannie's "mission regulator," would investigate the use of Fannie's fifty-five partnership offices and conclude that their activities "were not confined to affordable housing initiatives, rather, a central purpose of the Partnership Offices was to engage in activities that were primarily designed to obtain access to or influence members of Congress."

Taxpayers still don't know how much money was involved in the influence peddling done through these offices because HUD refused to release the full report. But, back in 1995, there were many happy beneficiaries of the Fannie Mae hustle.

It appears that Fannie Mae was highly creative when it came to "encouraging" its higher-level executives to donate to political campaigns.

A major recipient of Fannie Mae's largesse, albeit indirectly, was Barney Frank, the combative Democrat from Massachusetts. He was a member, and later the chairman, of the House Financial Services Committee, one of the most powerful on the Hill, charged with oversight of "all components of the nation's housing and financial services sectors." The committee also watched over regulators such as HUD, the Federal Reserve, and the Federal Deposit Insurance Corporation.

Fannie Mae was one of the committee's top priorities. As such,

its members were targeted by the company for special treatment if they were supporters or punishment if they were not.

Frank was a perpetual protector of Fannie, and those in his orbit were rewarded by the company.

In 1991, for example, Fannie Mae hired Herb Moses, Frank's partner who was a recent graduate of the Amos Tuck School of Business at Dartmouth. Frank praised Moses's qualifications in a conversation with Gerald R. McMurray, the company's vice president for housing initiatives who had for decades been staff director of the House Banking Committee's subcommittee on housing and community development. "Herb had been an economist with the Department of Agriculture and he went and got an M.B.A. from the Tuck School and was interested in a job," Frank said. "I talked to Jerry McMurray and said: 'Herb's a very good economist and has a business degree.'"

Almost immediately, Moses was being interviewed by an array of executives at Fannie Mae. A former company executive who first met Moses as he went through the interview process at the company believed Johnson was behind hiring Moses.

"Barney wanted him to have a job at Fannie Mae so the word was Johnson wanted him hired," the executive recalled. "He was just getting out of school and we all sort of bid for him. Ultimately, we chose him to be in our targeted community affairs group, the people who were looking for ways to increase our footprint."

Moses stayed at Fannie Mae for seven years. His title was assistant director for product initiatives and two of his projects involved relaxing Fannie Mae's restrictions on home improvement loans and small farm mortgages.

In late 2010, Frank was asked whether Fannie's hiring of Moses had put him in a conflicted position as a legislator voting on matters relating to the company. "I don't think it influenced me at all," he said. "I was not totally engaged with Fannie Mae and Freddie Mac."

But the record shows Frank exercising a deep and abiding interest in defending the companies in 1991 as Congress considered crafting legislation that would ensure their safety and soundness in the future. In a May 1991 hearing of the House Banking subcommittee on housing and community development, Robert D. Reischauer, director of the Congressional Budget Office, made a reasoned recommendation: "Making sure that Fannie and Freddie are entities that are independent, that have some visibility, that have safety and soundness as their prime objective, I think, is a way to ensure that the taxpayer is protected at those times when the klieg lights go off."

This triggered so fierce and unrelenting a cross-examination of Reischauer by Frank that Henry B. Gonzalez, the subcommittee chairman, had to admonish the congressman to let the witness answer.

Frank fumed that concerns about safety and soundness of Fannie and Freddie were overdone. "The focus on safety and soundness to the exclusion of any concern about their mission suggests to me that what we're going to get is a result where safety and soundness become, not the primary but the exclusive focus at the sacrifice of our ability to do housing," he said.

In 2010, however, after concerns about the companies' safety and soundness had been proven justified, Frank said: "I really have no recollection of that '92 Act."

Fannie Mae also made sizable contributions on more than one occasion and awarded its "Fannie Mae Maxwell Award of Excellence" at least twice to a Boston nonprofit group cofounded by Elsie Frank, the congressman's mother6 A newsletter issued by the Committee to End Elder Homelessness thanked Frank for "working behind the scenes to open many doors for us to help achieve our goal."

In fact, at a June 2002 Senate hearing, the co-chair of the Commission on Affordable Housing and Health Facility Needs for Seniors in the 21st Century, who was also a cofounder of the Elsie Frank nonprofit, thanked Barney Frank for appointing

her to the Commission post. At the same hearing she praised Fannie Mae.

Whenever concerns were raised about Fannie growing too large and potentially perilous to the taxpayers, Frank would defend the company vociferously. During a House Financial Services hearing in 2003, Frank and the company's other favored members of Congress maintained that the company and Freddie Mac presented no potential harm to taxpayers. "The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see," Frank said. "I think we see entities that are fundamentally sound financially."

One of the most powerful instruments Johnson used in his protection strategy was the Fannie Mae Foundation, a charitable organization founded in 1979. Under Johnson, however, the foundation became a powerhouse in charitable giving that targeted organizations associated with favored politicians or located in their areas.

The foundation took off after 1995, when Johnson put $350 million of Fannie Mae shares into it. As the company's stock rose, so did the amount of money the entity had to dispense. By 1998, the Fannie Mae Foundation was handing out $20 million a year.

A big portion of foundation money went to advertisements about Fannie Mae and its advocacy of homeownership. In 1998, for example, the foundation spent $38.6 million on advertising. This was money that would otherwise come from Fannie Mae's operations. As a result, tapping the nonprofit entity to cover ad expenses helped boost the company's earnings and its executives' pay.

In 1996, Fannie Mae took its strategy to the presidential primaries, inserting itself into the Iowa and New Hampshire contests with full-page ads and mailers damning the proposal for a flat income tax. A key plank of candidate Steve Forbes's platform, a flat tax would have eliminated all individual deductions in exchange for lowering the overall tax rate from the mid-30s to 19 percent.

While most individual deductions hud been eliminated in the Tax Reform Act of 1986, the mortgage interest deduction remained a sacred cow. By proselytizing for the flat tax, and by gaining traction with the plan, Forbes became public enemy number one for Fannie Mae.

In an audacious move to sway voters, the foundation placed numerous ads in the Manchester Union-Leader, the most powerful newspaper in New Hampshire. Using simple drawings, the ads depicted the flat tax as a home wrecker equal to tornadoes, fires, and other natural disasters.

It is unclear, of course, whether the campaign had an effect. But Forbes, who had placed third in the Iowa caucuses, had been riding high in the polls before the New Hampshire primary. On Election Day, however, he won only 12.2 percent of the vote, winning fourth place.

The ads enraged some lawmakers, including Russ Feingold, a Wisconsin Democrat, and John McCain, a Republican from Arizona. "Is it appropriate for a government sponsored enterprise to be involved in activities that may influence the outcome of a federal election?" the senators asked in a joint letter to Fannie and Freddie. Both companies responded by saying the ads had not been designed to manipulate voters.

Fannie Mae's nonprofit foundation also gave the company numerous opportunities to reach out and touch a member of Congress. Big beneficiaries from the foundation each year included political organizations such as Congressional Hispanic Caucus Institute and the Congressional Black Caucus Foundation. In 1998, the Black Caucus Foundation received $82,000 from Fannie Mae.

During congressional testimony, in 2000, former lawmaker Walter Fauntroy, who testified on behalf of the National Black Leadership Council (the national network vehicle of the Congressional Black Caucus), was asked if he had any economic incentive for testifying on behalf of the GSEs. He claimed that his group did not receive any money from Fannie. Financial Services Committee chairman Richard Baker pointed out, however, that the Congressional Black Caucus had recently received $500,000 from Fannie.

Even nonpolitical neighborhood groups funded by the Fannie Mae Foundation helped the company play its power game. When a nonprofit applied for funding from the foundation, it had to supply a list of political contacts within their area or organization. These contacts gave Fannie Mae a roster of influence that grew to four thousand names at its peak.

Trying to wring as much favorable publicity as possible from its donations, Fannie Mae trumpeted them. Johnson himself would travel to Capitol Hill to hand out checks designated for community groups. During one trip to the Senate Caucus Room in 1998, Johnson handed out envelopes containing $2.5 million for Washington, D.C.-based neighborhood groups.

"As the lucky recipients queued up for their money," the Washington Post reported, "Senators Chuck Robb (D-Va.) and Paul Sarbanes (D-Md.) and Representatives Connie Morella (R-Md.) and Jim Moran (D-Va.) sang Johnson's praises."

In 1998, the foundation began sponsoring a charity golf tournament at a local golf club, called the "Help the Homeless Golf Classic." "Help the Homeless Walk-a-thons" were another money-raising tradition at the company, and the company sponsored charity basketball games to benefit the homeless as well.

"The whole homeless thing was an example of Johnson's ability to get the company involved in something at just the right time," said a former executive. "At the height of the interest in the homeless problem, he enlisted Tipper Gore, the vice president's wife, to be his partner in the Walk-a-Thon. It was brilliant."

Johnson never forgot the favors people had done for him and his company. On March 23, 1994, for example, at a National Bankers Association reception in the Rayburn House Office Building, Johnson was on hand to present the first-ever Fannie Mae Housing Hero Award.

The recipient? None other than Henry Gonzalez, the Texas Democrat who had withdrawn the safety and soundness bill from the House floor so that Fannie Mae could water down the rules on capital cushions at the company.

"The Housing Hero Award is Fannie Mae's version of the Oscar,"

Johnson said at the ceremony. "It is presented to a star player in the housing arena who serves in elected office and who uses that office as an activist seeking to create housing opportunities for all low-, moderate-, and middle-income Americans. Henry Gonzalez fits that profile perfectly."

The next day, on the House floor, Barney Frank described the award ceremony for the Congressional record. The inscription on the award plaque read as follows, Frank said:

Fannie Mae Housing Hero

Chairman Henry B. Gonzalez for his lifetime efforts to extend the American dream of homeownership to families across Texas and throughout America.

Presented with gratitude by James A. Johnson, Chairman and Chief Executive Officer.

Gonzalez did not live long enough to see how his efforts on behalf of Fannie Mae turned the American dream of homeownership into a nightmare. He died in November 2000.

Fannie Mae did not limit its outreach to politicians in need of photo ops or community organizers in need of money. The company also enlisted the aid of academics whose research papers on housing issues helped shape the policy debate that was so crucial to the preservation of Fannie's status quo.

The company did this mainly through its financial backing of two academic journals, Housing Policy Debate and the Journal of Housing Research. The publications, both published quarterly, included papers on a broad spectrum of housing issues. More than 325 authors contributed to the academic journals between 1990 and 1997, Fannie Mae documents show.

The publications were immensely powerful in driving housing policy. The Institute for Scientific Information's Journal Citation Reports, now owned by Thomson Reuters, ranked Housing Policy Debate the most influential publication in the field of urban studies.

But the publications rarely brought real scrutiny to Fannie and Freddie, ignoring such issues as whether they were, in fact, lowering borrower costs as they claimed. Instead the articles focused on affordable housing ("To Whom Should Limited Housing Resources Be Directed?" asked one paper, published in 1994) and trends in housing ("Housing Finance in Developed Countries: An International Comparison of Efficiency," published in 1992).

Fannie Mae also published its own series of studies on housing, known as Fannie Mae Papers. In these reports, Fannie would ask prominent academics to discuss topics near and dear to the company's heart. In March 2002 Joseph Stiglitz, a Nobel Prize winner, and Peter Orszag, who would later become the head of the Congressional Budget Office under Obama, along with Jonathan Orszag, published a paper entitled "Implications of the New Fannie Mae and Freddie Mac Risk-Based Capital Standard." The noted academics pushed back against the companies' critics who argued that both Fannie and Freddie posed significant risks to the taxpayer.

For example, their paper concluded that even though Fannie and Freddie held much smaller capital cushions than other financial institutions, these would never have to be used. "The probability of a shock as severe as embodied in the risk-based capital standard is substantially less than one in 500,000—and may be smaller than one in three million," the authors wrote. "If the probability of the stress test conditions occurring is less than one in 500,000, and if the GSEs hold sufficient capital to withstand the stress test, the implication is that the expected cost to the government of providing an explicit government guarantee on $1 trillion in GSE debt is less than $2 million."7

In November 2003, shortly before Fannie Mae's accounting scandal broke, R. Glenn Hubbard, dean of the Graduate School of Business at Columbia University, authored one such paper defending Fannie Mae's risk management.

Fannie Mae's financing of academic research on such a large scale meant that few housing experts were left to argue the other side of any debate involving the company. Any discussion involving Fannie Mae in these papers was designed to defend the status quo.

One bank lobbyist was interested in hiring academics to write papers that might take a different point of view on housing issues. But most of the experts in the area had been co-opted by Fannie Mae. "I tried to find academics that would do research on these issues and Fannie had bought off all the academics in housing," the lobbyist said. "I had people say to me are you going to give me stipends for the next 20 years like Fannie will?"

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