Freddie Mac: Tone Deaf at the Top

By William K. Black

Freddie Mac made a terse announcement Wednesday in a securities filing about the resignation of its chief operating officer, Bruce Witherell. Freddie said that Witherell resigned "for personal reasons." His departure was effective immediately and he received no termination benefits. He had been receiving several millions of dollars in annual compensation from Freddie. The Wall Street Journal reporter commented:

Efforts to attract and retain top managers at Freddie and its larger sibling, Fannie Mae, have been stymied by salary restrictions that are modest relative to comparable to private sector pay and by the fact that the firm’s federal overseers have effective veto rights over major decisions.

It is true that pay at Fannie and Freddie used to be even more criminogenic. According to the Los Angeles Times:

In 2007, then-Freddie Mac CEO Richard F. Syron had a base salary of $1.2 million and total compensation of $18.3 million, according to SEC filings. In the same year, Daniel Mudd, the chief executive of Fannie Mae, had a base salary of $987,000 and total compensation of $11.7 million.

Those were the days, when you could in a single year be made wealthy for destroying a company and causing scores of billions of dollars of losses to the taxpayers. The title of Akerlof & Romer’s famous 1993 article has never looked more prescient — "Looting: the Economic Underworld of Bankruptcy for Profit."

I do not know why Witherell resigned. I hope he is not facing a family emergency. I write to ask why he was hired. Witherell’s principal experience was with Lehman. In particular, he was chief executive officer of Aurora Loan Services from 2003 to 2006. Lehman owned Aurora. Aurora specialized in purchasing and reselling "liar’s" loans.

I testified before the House Financial Services Committee on April 21, 2010 about Lehman and Aurora’s pervasive accounting fraud. A copy of that testimony can be found here.

The key point is that Aurora was a massive fraud — purchasing and selling often fraudulent mortgages. It is virtually certain that Freddie purchased material amounts of Aurora’s fraudulent mortgages (directly, or by purchasing collateralized debt obligations (CDOs) that were supposed to be backed by Aurora’s liar’s loans). As my colleague Randy Wray has emphasized, we need a new term for the toxic MBS (mortgage-backed securities) because they often weren’t backed by mortgages due to lender fraud.

The proverbial bottom line is that a global search for talent, after Fannie and Freddie’s second descent into accounting control fraud bankrupted both firms, Fannie and Freddie (with its regulators’ blessing, chose Witherell. (Heidrick & Struggles, which describes itself as the leading executive search firm, issued a press release praising itself for finding Witherell.) When Obama knew he had to clean up the Stygian Stables that were Fannie and Freddie — knew that their senior managers and their regulators had failed catastrophically — he left in charge the failed regulatory leadership team. The regulator team allowed Freddie to select as its COO one of the leaders in the creation of the liar’s loans that were the greatest single contributor to Freddie’s failure and the financial crisis. This was bizarre politics — the senior regulator Obama left in power until his voluntary resignation was a Republican chosen because he was George Bush’s close friend since their days together in prep school. It was even more insane regulatory policy.

Freddie (and Fannie) should be suing Aurora/Lehman for their frauds. Freddie and Fannie should be making thousands of criminal referrals against Aurora’s fraudulent loans. Witherell would be a key witness in the cases. Freddie placed him in impossible positions due to his conflicts of interest.

Aurora was notorious — why would anyone, much less Freddie, hire a top official from one of the firms most responsible for the frauds that destroyed Freddie and cost the taxpayers billions of dollars in losses? Is there anything that a business leader can do that disqualifies him from receiving millions of dollars annually — paid for by the taxpayers? It’s bad enough that our elites now loot with impunity. Do we really have to make them even richer?

Fannie and Freddie have no need to pay these high salaries to senior managers. It was the perverse executive compensation that drove the accounting control frauds at Fannie and Freddie — as the SEC explicitly charged. Executive compensation created the perverse managerial incentives that destroyed Fannie and Freddie. This was an unanticipated consequence of their privatization. Because Fannie and Freddie were privatized, their officers designed their compensation system in the same perverse manner as most firms (Bebchuk & Fried 2004). The mangers stood to gain enormous compensation if they inflated short-term accounting income, and as Akerlof & Romer famously observed, accounting fraud is a "sure thing." Mr. Raines explained in response to a media question what was causing the repeated scandals at elite financial institutions:

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.

If we are going to continue Fannie and Freddie’s existence then the business model they should follow is simple and requires modest executive pay. Fannie and Freddie should purchase only prime loans and it should promptly package those loans to form MBS and sell the MBS. This will minimize credit and interest rate risk. Fannie and Freddie can hedge the modest interest rate risk created by the "pipeline" of inventory without the need for any esoteric derivatives. The safe business turns out to be a simple business.

William Black


William K. Black, J.D., Ph.D. is Associate Professor of Law and Economics at the University of Missouri-Kansas City. Bill Black has testified before the Senate Agricultural Committee on the regulation of financial derivatives and House Governance Committee on the regulation of executive compensation.