"Getting Money to Where It Hasn't Gone"

A talk with Fannie Mae CEO Frank Raines on the agency's goals and housing's future

Franklin D. Raines took over Fannie Mae (FNM ) four years ago in the middle of a housing boom. His goal: to make sure the boom didn't elude lower-income folks who often find it hard to buy a house.

He has been successful -- homeownership has risen sharply in all income brackets and especially in the lower rungs. While the government-backed company doesn't lend money directly to homebuyers, it buys mortgages from banks and other lenders, enabling them to lend more. But critics dog Washington (D.C.)-based Fannie Mae, charging that its government sponsorship allows it to borrow money more cheaply than rivals, that its debt is too high, and that its reliance on derivatives could land it in trouble.


After years in Washington, the Seattle-born Raines, 54, is well-suited to this political and financial hot seat. At 20, he was a White House intern for Daniel Patrick Moynihan, then President Richard M. Nixon's urban affairs adviser. Once he was called on to brief Nixon and the Cabinet on the Vietnam War protests. He attended Harvard University; Oxford, as a Rhodes scholar; and Harvard Law School. He returned to the capital to work at the White House's Office of Management Budget before leaving for an 11-year stint at Lazard Frères, where he was a partner. Then he served as head of the OMB under President Bill Clinton until he was tapped as Fannie Mae's chairman and chief executive in 1999.

BusinessWeek Editor-in-Chief Stephen B. Shepard spoke with Raines on May 1, as part of the magazine's Captains of Industry series at Manhattan's 92nd Street Y. Here are excerpts from that discussion:

We've had an extraordinary housing market in the past few years. Are you concerned there will be a runup in interest rates that will dampen the demand for housing?

We've been saying interest rates will rise by the end of the year, but only by a quarter of a percentage point. That will have a dampening effect, but I don't think that it will cut off the interest of people in having homes.

But if economic growth accelerates, rates will go up by more than a quarter of a point.

They will, but incomes will rise as well. So as long as incomes are increasing, that will help to maintain the affordability. Buying a home is now the most affordable it has been in 30 years. We can't expect that to go on forever, but we can hope that it will remain within the affordable range.

Is there a housing bubble?

I don't think so. With a bubble, prices rise without any relation to value. You can see that with a stock with a high price-earnings ratio. Everyone is hoping that the company's profits will grow and the ratio will come down. People from all around the world can be buying that stock, and you might be smart to have owned it early on.

Houses aren't bought that way. If you buy a house, you usually have to live in it. So you don't get an international market bidding up the prices of housing. These are local markets.

Critics say Fannie Mae is big enough to do its job without government help. What's the case for keeping a subsidy?

The biggest case is that we pass the subsidy on to the homeowner. Loans for less than $300,000 have lower interest rates than loans for more. The reason is that Fannie Mae can buy the smaller loans. The difference between a so-called jumbo loan and a Fannie Mae-eligible loan can be 25 basis points to 50 basis points [hundredths of a percentage point]. That's $15,000 to $30,000 over the life of the loan. So when people say that Fannie Mae shouldn't have any subsidies, we say: "Well, then you're saying that the homeowner should pay more."

Why can't you buy mortgages that are bigger than $300,000?

The government limits us on that. If the government wants us to buy larger mortgages, we will. It turns out the larger mortgages have higher credit risk, so we're not losing anything by not buying them.

Why is Federal Reserve Chairman Alan Greenspan worried about your use of derivatives?

He's not worried about Fannie Mae. He's worried about our counterparties. Derivatives have gotten a bad name. What we use are pretty simple things that are called interest-rate swaps, where we turn a short-term instrument into a longer-term instrument, or options or "swaptions" [where we reserve the right to pay off our bonds before they mature].

But there is a credit risk involved. You do have to have the other guy perform. We make our counterparties put up collateral to guarantee they're going to perform.

Another criticism is that your reserve requirement is lower than a bank's, and if there's a financial shock, you don't have adequate capital reserves. How do you respond to that?

Banks invest in a wide range of assets, so they require a lot of capital. We're mandated to invest in only low-risk assets. So our capital ought to approximate the risk that we actually have. But we are also asked the question: "What if something bad happened? What would you do then?" The answer is that we have created and gone over with the authorities a plan that if we lost market access, Fannie Mae could continue to operate for 90 days without needing to borrow.

How do you persuade lenders to go into poor neighborhoods?

The financial-services industry has never been good at marketing, so it tends to go to the easiest places to market. That's why everyone wants to go with high-net-worth individuals. So we have to help them understand these lower-income markets [and] that they need to offer people products like our timely-payment-reward mortgage, where if you make all of your payments on time for 24 months, the rate automatically goes down. Also low-downpayment products.

What's next on your agenda?

We want to keep pushing this process of getting money to where [it] hasn't gone [before]. Penetrating these communities where traditional banks and mortgage banks aren't functioning is hard. What the communities have instead is subprime lenders [whose clients have no or poor credit] that know how to market. Their loans went from about $10 billion to $150 billion over 10 years. But it's very expensive money -- as much as $200,000 more [than a standard mortgage] over the life of a loan. That's a huge tax on the people who live there. We need to get conventional lenders in there with the lowest-cost capital. People shouldn't have to pay any more than what they qualify for. It's hard enough to save up money to buy a home or to make your payment.

Do you buy subprime loans?

We buy what we call credit-impaired loans, A- loans that were made to people whose credit is impaired. We used to not buy them at all, but then those people could get only high-cost loans. We don't buy C and D loans, people who have just come out of bankruptcy. We would want them to wait and build up their credit. But we've begun to bring our products into these markets and dramatically cut costs for people.

The President is proposing tax cuts that could increase the deficit. Are you worried about the direction of fiscal policy?

The key now is that the economy needs stimulus. So I would look at having even deeper tax cuts. I might look at the payroll tax, since it's such a regressive tax, and have a payroll tax holiday. Put money in people's pockets today but not make it permanent. What we found when I was OMB director was that the best welfare-reform plan was jobs. The best housing plan was jobs. The best educational plan was jobs. The most important thing is to have a strong economy where the average guy can support his family by working.

We've had a terrible scandal on Wall Street. What is your view?

Investment banking is a business that's so denominated in dollars that the temptations are great, so you have to have very strong rules. My experience is where there is a one-to-one relation between if I do X, money will hit my pocket, you tend to see people doing X a lot. You've got to be very careful about that. Don't just say: "If you hit this revenue number, your bonus is going to be this." It sets up an incentive that's overwhelming. You wave enough money in front of people, and good people will do bad things.

Merrill Lynch & Co. Chairman and CEO Stan O'Neal says that with all the new regulations, we are becoming too risk-averse -- and capitalism, of course, depends on risk-taking. Do you think the pendulum is swinging too far?

I think there are probably some areas where [the process has] gone too far and adjustments will have to be made. That's why I favor empowering the Securities & Exchange Commission to make the rules, rather than having legislation. It can modify them if it's gone too far.

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