How the once-mighty have fallen! Last Wednesday, TheWall Street Journal reported that the chief regulator for Fannie Mae
First, a quick review of the facts as they pertain to Fannie Mae; Freddie's case is quite similar (for a primer on their business, see this article by Bill Mann). At the end of 2004, the SEC ruled that the company had violated accounting rules in order to smooth its reported earnings, requiring Fannie to restate historical earnings. Since then, the CEO and CFO have resigned, and the company has agreed to meet higher capital requirements and overhaul its internal controls. In May of this year, Fannie reached a settlement with regulators which includes a $400 million fine. Company estimates for its aggregate earnings restatement amount to $11 billion.
These events illustrate the way in which even a seemingly impregnable competitive position can deteriorate. Fannie and Freddie enjoyed a government-sanctioned quasi-duopoly -- they were able to borrow at lower cost, thanks to the market's perception that its mortgage securities had the implicit backing of the federal government. That's not as good as actually owning a license to print money, but it's the next best thing: Everyone believes you own the license. However, when a private-sector organization is thought to be "too big to fail," it creates a moral hazard by skewing the relationship between business risk and reward. As regulators examined the accounting violations, they found evidence of greed, mismanagement, and excessive risk-taking. They concluded that the size and leverage of the GSEs mortgage portfolios must be reduced in order to mitigate any systemic risk (a fancy way of saying that in the hypothetical event of Fannie Mae's failure, widespread disruption in the financial markets or the economy could ensue).
If I analyze Fannie Mae as a business rather than a government program (and how else should investors evaluate it?), I can't find any competitive advantage, aside from favorable borrowing costs based on the perception of implicit government backing. There is no evidence that it has developed specific expertise that doesn't exist elsewhere. Does anyone believe that Lehman Brothers
Of course, the market hasn't been blind to these developments -- Fannie Mae's share price is more than 40% below its five-year high. While Warren Buffett's decision to sell the bulk of BerkshireHathaway's
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