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By Root 3552 0

of scaring the GSEs, as it should have—was a source of tremendous optimism. Subprime lenders were shutting down. Wall Street was afraid to securitize mortgages. Banks were reluctant to make new housing loans, since they could no longer sell them to Wall Street. Only mortgages guaranteed by the GSEs were viewed as safe enough to be sold and securitized. At long last, they were back in the driver’s seat. The country needed Fannie and Freddie—truly needed them—in a way it hadn’t in years. “I thought this was an opportunity for the GSEs to demonstrate their value to the world,” Fannie CEO Dan Mudd would later say.

Politicians, housing advocates, Washington think tank types—they were all suddenly rallying around Fannie Mae and Freddie Mac. Democrats like senators Charles Schumer of New York and Chris Dodd of Connecticut, both high-ranking members of the Senate banking committee, were pushing hard to expand the GSEs’ powers. Republicans weren’t far behind. “This is what you’re here for,” Mudd recalls legislators of both parties telling him. Even the Bush White House was backing away from its long-standing hostility toward the GSEs; no matter how much you might be ideologically opposed to Fannie and Freddie, it was hard to go after them when they were the only thing propping up the housing market. “The political environment was ‘We’re inviting you in! Come be part of the solution,’ ” Mudd later recalled.

By the end of August 2007, Fannie’s stock, which had dropped to a low of $48 in the spring of 2005, was almost back to its 2004 peak of $70. “Politics seems increasingly a plus for GSEs,” wrote Morgan Stanley analyst Ken Posner that fall. “Housing market stability is in the process of trumping the anti-GSE ideology that has held sway in recent years.”

That summer, Mudd drafted the company’s strategic plan for the next four years. He had stars in his eyes. He pointed out that over the last ten years, Fannie Mae’s credit losses had amounted to $3.1 billion—compared to profits of $44.2 billion. “We have a great opportunity by taking more credit risk on the balance sheet.” He called on the company to go “deeper into segments where we only have scratched the surface”—meaning, of course, subprime mortgages.

Over the years, whenever Alan Greenspan and others had criticized the GSEs, it was the interest rate risk they worried about. Fannie and Freddie were so huge, they believed, that it would take only one big hedging mistake—and a sudden shift in interest rates—to bring about catastrophe. But they had never focused on credit risk—the risk that the mortgages Fannie and Freddie guaranteed or held would default. Maybe it was because they had been so blind over the years to all the credit risk in the system, from subprime originators to AIG, that they never saw it coming with Fannie and Freddie, either.

Thus it was that in 2007 Fannie and Freddie would add $600 billion in net new mortgage debt to their books, debt that would wind up being highly destructive. They would continue to buy and guarantee mortgages well into 2008. And thus it was that the GSEs would lumber, slowly but inevitably, toward a cliff they didn’t see. The financial crisis came on in fits and starts, and all the while Fannie Mae and Freddie Mac were accumulating the very mortgage risk that would cause the long-dormant volcano to finally erupt.

With all the problems he was facing, Fannie and Freddie were hardly high on Hank Paulson’s list of priorities. As Treasury secretary, he kept in close touch with all the Wall Street CEOs; he knew exactly what was going on. In his memoir, he describes a dinner in June 2007 with a handful of Wall Street chieftains, including Jamie Dimon of J.P. Morgan, Lloyd Blankfein of Goldman Sachs, and Chuck Prince, the CEO of Citigroup. “All were concerned with excessive risk taking in the markets and appalled by the erosion of underwriting standards,” he writes. Prince, he added, “asked whether, given the competitive pressures, there wasn’t a role for regulators to tamp down some of the riskier practices. Basically, he asked: ‘Isn’t