The regulatory spotlight returned to the world’s largest mortgage buyer, Fannie Mae (FNM), this past week. What they see is not pretty. And neither is what the worst case scenario would mean for your mutual fund investments, to say nothing of your home and your future tax bill.

Fannie Mae (A.K.A. Federal National Mortgage Association) is a government-sponsored enterprise that exists to lower home buying costs. They do so by providing capital to the mortgage market by purchasing mortgage loans and by guarantying mortgages (for a fee) to make them more palatable to investors who buy baskets of mortgages. In doing so Fannie lowers the cost of buying homes, and makes cash available to make mortgage loans – a noble pursuit and the reason the government created the entity in the first place.

The biggest accusations of financial mischief at Fannie include earnings smoothing and expense deferment.

Earnings smoothing is the practice of holding back earnings and then reporting them for future quarters, making a company appear to be a stable grower instead of one with volatile earnings. Wall Street loves stability, especially with a confusing, debt-soaked company like Fannie.

Expense deferment refers to booking expenses in the future that should be booked now. The result is overstated earnings in the short term—a mighty profitable situation if your compensation is tied to short run profits. WorldCom is a now an infamous example of deferring current expenses to juice short term profits.

The most startling aspect about these crimes is that executives (who work for what is essentially a government agency) stand to make tens of millions of dollars for themselves by committing them.

So what does this have to do with you? There’s a possibility that your stock fund may include a portion of Fannie Mae stock. It’s even more likely that your bond fund owns a large stake in debt issued by the company. This raises concern because Fannie Mae is a misunderstood company that has more financial power over the economy than the Federal Reserve.

Fannie is the world’s largest debtor. Accounting at the company is foggy, but they are likely carrying well over a trillion dollars in debt. That’s right, 1/10th of U.S. GDP, more than the debt of every financial scandal that went bust combined: Enron, WorldCom, Global Crossing, Adelphia, and so on.

To be fair, Fannie has assets to back up this debt. But so did Enron. To understand the issue and the massive power of this outfit you need to understand their business.

When a prospective home buyer goes to a bank to take out a mortgage to buy a $350,000 one room apartment in New York City with $15,000 down, the bank may give them a $335,000 mortgage. If they do, the bank usually sells off the mortgage, often to Fannie Mae. The new home owner winds up making 6% interest payments for 30 years to Fannie Mae, sometimes without realizing it.

Why would the bank sell the mortgage? Because if they didn’t they wouldn’t be able to come up with more cash to loan the next guy money for an apartment; they need capital to make money, and Fannie Mae supplies it. The bank is happy with collecting fees related to originating the loan and maybe servicing it over the long term (which translates into cash flow from collecting interest payments on the mortgage).

So where does Fannie Mae get the money to buy the mortgage from the bank? Simple—they borrow it.

Fannie Mae issues billions of dollars in bonds to investors (like your bond fund) each week. They are buying an asset (a mortgage) with their own borrowings (issued bonds). So how does Fannie Mae make billions of dollars each year in what sounds like a wash transaction? If they are earning 6% a year on the mortgage payments and paying out 6% a year to the bond holders, what kind of business is that?

It would be a crummy business, unless you can borrow at a lower rate than you invest. Imagine borrowing money at 6% interest per year to buy a corporate bond fund that pays about 6% a year. What a colossal waste of time. Now imagine putting the money in a junk bond fund that pays 8% a year. You just made a “free” 2%!

Or did you? This 2% return is earned by borrowing money at a low rate and investing it at a high rate. This is possible because you are taking on risk—the issuing companies may not make the 8% payments. If some companies default, you could be left owing the bank 6% while taking in only 2% on your bond fund.

Fannie Mae earns money the same way; they issue bonds that pay 5% and buy mortgage loans paying 6%. Investors buy Fannie bonds and are paid indirectly by the money Fannie takes in through buying mortgages. Fannie is a conduit between the payments from the 1 room apartment owner and the Fannie bond holders. Basically, they spread the risk.

Something is missing. In the above example, you probably got a 6% loan from the bank to buy the junk bond fund because you backed up the loan with your home—a home worth more than the loan principal.

What is backing up the Fannie debt? You would think Fannie bond investors would want the same yield Fannie is earning on the mortgages it owns, because Fannie bond buyers are indirectly taking on that risk.

Imagine you went to a bank and said; “I have nothing to back up the loan, but I will invest it in a junk bond fund paying 8%. If the companies issuing the junk bonds pay me, I’ll pay you.” Such a claim would get you laughed out of a bank, or it might get you a loan at a higher interest rate; the risk level of such a loan is worth 8% (or more), not 6%, since you are not adding any collateral to the equation.

Fannie has a stream of mortgage payments they use to pay bond holders. Bond holders must think the Fannie payments are safer than the NYC apartment owner’s mortgage payments. Otherwise, they would want a higher yield. Who is lowering the risk level to the Fannie bond buyer? This is where things get a little fuzzy.

Fannie has some capital to back up the bond payments. This amount is about $35 billion, which sounds like a lot until you remember they have about $1 trillion in debt outstanding. In other words, if all homeowners stopped making payments on their mortgage simultaneously, Fannie could keep making payments to their bond holders for maybe a year before the $30 billion dollar war chest runs dry.

That doesn’t sound like a lot of collateral now does it? Imagine you wanted to borrow $100,000 from the bank to buy the junk bond fund, and added $3,500 worth of collateral in case the junk bond fund fell apart. Again, you’d be laughed out into the street.

The reason bond buyers don’t laugh Fannie out into the street with their paltry $35 billion in collateral is because a deeper pocketed entity allegedly stands behind the bonds—namely, the full taxing power of the U.S. government.

This is the real reason investors are comfortable owning treasury bond yield like Fannie Mae bonds—Uncle Sam will step in if Joe NYC apartment defaults on his mortgage, along with many others such that Fannie runs out of capital.

Isn’t that nice? Fannie shareholders and executives are getting rich as taxpayers essentially say; “Call me if there is any trouble with this scheme”. You are taking on the risk so they can make a nice spread investing in high yield debt with one hand and borrowing at low rates with the other.

Most reports and articles about the scandals at Fannie focus on the earnings smoothing and the complex issues of Fannie having to hedge interest rate risk. Or the chance that rates will change and Fannie will get a flood of mortgage prepayments and still owe debt at higher rates than they can reinvest in new mortgages. While serious, the overall business model where the U.S. taxpayer is supposedly backing up the world’s largest bond trader is of far more concern to us.

It gets worse. There is another quasi-government agency that is almost as large as Fannie Mae called Freddie Mac, which has also been in regulatory hot water recently. Collectively, these two giants make up the bulk of the secondary market for mortgage debt - they own or guarantee about half of the $7 trillion mortgage market.

How big is this risk and what are the economic ramifications? You don’t need to win a Nobel Prize in economics to know that much of the economic stimulus of the past few years came from people taking out wealth from their homes, or profiting from rising home prices through mortgage refis, sales, home equity loans, and the like. Fannie Mae provides the cash that greases the whole system and gives banks money to loan. If regulators crack down on loosey-goosey accounting at Fannie, it means Joe NYC may not get $335,000 to buy an apartment (because the bank couldn’t sell the last mortgage they wrote and is out of cash). Such a cut in supply would raise mortgage rates and affect home prices because Joe NYC can’t afford a $350,000 apartment if rates are 7%. The seller could have to take $275,000.

The government will crack down on Fannie because they don’t want a repeat of the S&L crisis of over a decade ago—the last time taxpayers were backing up billions in high risk loans. In that multibillion dollar bailout, Savings and Loans paid out low rates on savings and reinvested into higher risk (and rate) loans, then sat back and collected the spread. When the high risk loans failed, the low rate CD buyers didn’t lose money because taxpayers bailed them out as the S&Ls went belly up.

Is this deja-vu all over again? Hopefully not, because Fannie and Freddie have billions more in loans to pay than all the failed S&Ls combined. We could grow our way out of this troubling situation, but right now somebody is earning 4% on a loan that is ultimately being supported by somebody else who just bought an apartment with only 5% down (a property that has doubled in price over the last few years). If enough people lose their jobs, and if home prices fall to the levels of just a few years ago, the entire house of cards will collapse. Such risk warrants more than a 4% payment.

As the optimistic will tell you, home prices have never fallen year after year on a national level (this has only happened in local markets). To us this logic smacks of “stocks will always outperform bonds over a ten year period because they always have”, late 90s groupthink. Just because something hasn’t happened yet does not mean it can’t. Fortunately for Fannie executives and bond fund investors, the taxpayer is taking on the risk that this historical real estate pattern will continue forever, no matter how far prices run up in the short term.