<http://www.vanityfair.com/politics/features/2009/02/fannie-and-freddie200902-2?currentPage=all>
By mid-2006 there was a new actor in this long-running drama: Hank Paulson, the former Goldman Sachs C.E.O. who had just become Treasury secretary. Unlike the advisers who surrounded Bush, Paulson did not believe that the G.S.E.’s were the bogeymen of the financial system. After all, they had been major clients of his for years, and the ties between Goldman and Fannie ran deep. Nor did Paulson want any part of what he called “the closest thing I’ve witnessed to a Holy War.”
Paulson quickly began to move away from what one observer calls the “extreme rigidity” of the administration’s position. Then, on the Tuesday night before the 2006 Thanksgiving weekend, he “threw down the gauntlet to change course on where the administration was going,” says someone familiar with the events. He “aggressively argued that the White House should soften its position” and cut a deal for new regulation—which Paulson strongly believed was necessary—with Barney Frank, who had just been named the chairman of the House Financial Services Committee. Bush, who had granted Paulson an unprecedented degree of independence in exchange for his taking the job, soon gave him the authority to change existing policy, according to one inside source.
“I was aghast,” says a longtime G.S.E. foe, expressing a common attitude. “Here we were fighting trench warfare with Fannie and Freddie, and Paulson says, ‘Let’s cut a deal and say we won.’ Some of us really did believe they were a house of cards.”
That fall, Barney Frank told The Washington Post that Paulson had told him he wasn’t going to use the Treasury’s authority to limit Fannie’s and Freddie’s ability to raise money by issuing new bonds. The Bush administration had won that right in 2004, and other Treasury officials had been saying the government would use it. With Paulson’s backing down from Treasury’s position, the White House had lost one of its major clubs against the G.S.E.’s.
At the same time, a critical change was occurring in Fannie’s and Freddie’s businesses. By the mid-2000s, the mortgage market was radically different than it had been in Fannie’s and Freddie’s golden years. What we now all know as the subprime business had taken off, and a whole new breed of opportunistic lenders, such as IndyMac and Washington Mutual, were selling their mortgages to Wall Street, which churned out its own mortgage-backed securities. These were often referred to as private-label securities, or P.L.S.’s, because they bypassed Fannie and Freddie and didn’t have the G.S.E. imprimatur. As a result, Fannie and Freddie, which had always been selective as to which mortgages met their criteria for purchase, saw their market share plunge. Shareholders and customers were begging them to dive into this new, highly profitable world.
Although both companies resisted due to their worries about the riskiness of the new products, eventually senior executives disregarded internal warnings, because the lure of big profits was too great. “We’re rushing to get back into the game,” Mudd told analysts in the fall of 2006. “We will be there.” Both companies did two major things. For their portfolios, they bought Wall Street’s P.L.S.’s. They also began to guarantee so-called Alt-A mortgages—loans made to people who had better credit scores than a subprime customer’s, but who might lack a standard job and pay stub. (These mortgages came to be known as “liar loans,” because either the customers or the brokers, or both, were often just making up the information on the applications.) By the spring of 2008, the companies owned a combined $780 billion of the riskiest mortgages, according to the Congressional Budget Office, even though they had bought P.L.S.’s that were rated Triple A by the rating agencies and they thought their Alt-A product was conservative. But they bought in bulk.