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SEPTEMBER : THE TAKEOVER OF FANNIE MAE AND FREDDIE MAC 

“You are not likely to take it out,” Paulson told legislators. “I just say that by having
something that is unspecified, it will increase confidence. And by increasing confi-

dence it will greatly reduce the likelihood it will ever be used.” Fannie’s Mudd and
Freddie’s Syron praised the plan. 
At the end of July, Congress passed the Housing and Economic Recovery Act
(HERA) of , giving Paulson his bazooka—the ability to extend secured lines of
credit to the GSEs, to purchase their mortgage securities, and to inject capital. The
-page bill also strengthened regulation of the GSEs by creating FHFA, an inde-
pendent federal agency, as their primary regulator, with expanded authority over
Fannie’s and Freddie’s portfolios, capital levels, and compensation. In addition, the
bill raised the federal debt ceiling by  billion to . trillion, providing funds to
operate the GSEs if they were placed into conservatorship.
After the Federal Reserve Board consented in mid-July to furnish emergency
loans, Fed staff and representatives of the Office of the Comptroller of the Currency
(OCC), along with Morgan Stanley, which acted as an adviser to Treasury, initiated a
review of the GSEs. Timothy Clark, who oversaw the weeklong review for the Fed,
told the FCIC that it was the first time they ever had access to information from the
GSEs. He said that previously, “The GSEs [saw] the Fed as public enemy number
one. . . . There was a battle between us and them.” Clark added, “We would deal with
OFHEO, which was also very guarded. So we did not have access to info until they

wanted funding from us.” Although Fed and OCC personnel were at the GSEs and
conferring with executives, Mudd told the FCIC that he did not know of the agencies’
involvement until their enterprises were both in conservatorship. 
The Fed and the OCC discovered that the problems were worse than their suspi-
cions and reports from FHFA had led them to believe. According to Clark, the Fed
found that the GSEs were significantly “underreserved,” with huge potential losses,
and their operations were “unsafe and unsound.” The OCC rejected the forecasting

methodologies on which Fannie and Freddie relied. Using its own metrics, it found
insufficient reserves for future losses and identified significant problems in credit and
risk management. Kevin Bailey, the OCC deputy comptroller for regulatory policy,
told the FCIC that Fannie’s loan loss forecasting was problematic, and that its loan
losses therefore were understated. He added that Fannie had overvalued its deferred
tax assets—because without future profits, deferred tax assets had no value. 
Loss projections calculated by Morgan Stanley substantiated the Fed’s and OCC’s
findings. Morgan Stanley concluded that Fannie’s loss projection methodology was
flawed, and resulted in the company substantially understating losses. Nearly all of
the loss projections calculated by Morgan Stanley showed that Fannie would fall be-
low its regulatory capital requirement. Fannie’s projections did not.
All told, the litany of understatements and shortfalls led the OCC’s Bailey to a
firm conclusion. If the GSEs were not insolvent at the time, they were “almost there,”

he told the FCIC. Regulators also learned that Fannie was not charging off loans un-
til they were delinquent for two years, a head-in-the-sand approach. Banks are re-
quired to charge off loans once they are  days delinquent. For these and numerous
other errors and flawed methodologies, Fannie and Freddie earned rebukes. “Given