When is a scandal not a scandal? For an answer, let's look at the circumstances surrounding a non-scandal of 2003, a story that yet might prove to be one of the biggest scandals of 2004.

Suppose that:

--The government created an enterprise to help people.

--The enterprise grew too big.

--The government tried to control the entity.

--The enterprise used tens of millions of dollars to oppose that control.

--The government accepted those millions and left the enterprise alone.

--The enterprise grew staggeringly large, controlling assets that exceed $1 trillion.

--The government looked the other way until a huge scandal erupted at the enterprise.

When all of the above happens and is duly reported in the press, and the situation goes from bad to worse, and the public responds with a massive yawn ...that is when a scandal is not a scandal.

The bullet points above don't begin to tell the story behind the "entity" in question, which is not one entity but two: Fannie Mae (search) and Freddie Mac (search), the government-sponsored entities (GSEs) that grease the wheels of the mortgage lending industry. Founded in 1968 and 1970, respectively, Fannie and Freddie sell bonds and buy home mortgages; in turn they package those mortgages into securities that trade on the open market. This activity is supposed to stimulate mortgage lending and make homeownership possible for more families.

Chances are that the mere mention of Fannie and Freddie will make some readers reach for their mouse and click on to the next story. When it comes to scandal, the mortgage-backed securities market doesn't titillate like Michael Jackson's nocturnal habits or a Paris Hilton video (search).

But what if I told you that while Freddie Mac's mortgage portfolio is immense ($600 billion), its derivative contracts (search)--contracts that are supposed to help manage and hedge very large risks--are even larger, exceeding $1 trillion in 2001? Did you know that as a taxpayer, you might be on the hook for a bailout that would make the 1980s savings and loan bailout (search) look like lunch money?

So while this widely reported yet apparently "humdrum" story may not titillate, any taxpayer or investor should want to learn a bit more than they may know today.

Now, many folks say they practice Warren Buffett's (search) investing methods, but lately I've noticed how many people are taking up his writing style. It may have started with Mr. Buffett's letter to shareholders back in March, when he turned the phrase, "derivatives are financial weapons of mass destruction."

The Sage of Omaha did not predict which firm's derivatives may detonate, but his supporters in syntax sure did: They consistently describe Fannie and Freddie with such phrases as --

--"The sheer enormity of the portfolios"

--"Vast amount of leverage"

--"Disaster almost inevitable"

--"These things have killed more people than any other trade" and, my favorite,

--"A creature that hides under the bed."

These quotes come not from an obscure source of doom and gloom, but from the pages of The New York Times, Dow Jones Newswires, and London Financial Times. And yes, the phrases describe problems at Fannie Mae and Freddie Mac.

Because the Congress created and sponsored these enterprises, they enjoy benefits that other private companies can only dream about. For example, Fannie/Freddie don't pay state or local income taxes. They face less stringent securities and financial reporting requirements than other companies do. And according to The Wall Street Journal, they "have a $2.25 billion line of credit with the Treasury."

Yet the greatest benefit is Fannie/Freddie's implicit government guarantee. Not only are they well beyond the "too big to fail" threshold, but as creations of Congress they also enjoy a unique confidence in the capital markets. In other words, they can borrow at lower rates and lend at higher ones.

And while they have been in business more than three decades, Fan and Fred didn't really use their advantages in the marketplace much of that time. Models of quiet consistency, Freddie Mac earned the nickname "Steady Freddie." Yet all this changed in the 1990s. They became aggressively competitive, and began to trade hundreds of billions of dollars of the contracts called derivatives. Freddie Mac even "built a Wall Street-style trading floor, filled with young traders glued to terminals buying billions of dollars a year in mortgage bonds and related securities."

Now, Freddie Mac captured headlines (if not the public's concern) in June, when the scandal broke that saw Freddie's top three executives resign or dismissed over allegations of financial misconduct. An investigation revealed that Freddie had misstated its earnings by $5 billion; the "penalty" amounted to a civil fine of $125 million, which is less than chump change for an enterprise that transacts tens of billions on a given day.

As for Fannie Mae, the New York Times broke an eye-popping story in August, which said the company "faces much bigger losses from interest rate swings than it has publicly disclosed, according to computer models used by the company to estimate the value of its assets and debts." This story also said a former Fannie employee provided the models to the Times, on condition that "he not be identified."

These scandals produced grumbling among legislators about "greater oversight," but the heat never got above room temperature. Congress has many well-to-do offspring, yet none are wealthier than Fan and Fred. What's more, these kids know how to show their gratitude to "Dad." They freely hire individuals from the Treasury and Congressional committee staffs who had been working to oversee their activities. Fan and Fred also know how to throw the sort of parties that really count. According to the Dow Jones Newswires, Freddie's chief lobbyist "has held at least 50 fund-raisers for Congressional Republicans in recent years.... Thirty of the 50 parties were members of House and Senate committees that oversee Freddie."

Does this sound like politics-meets-business inside-the-beltway of the most wretched sort? Yes, because it is wretched. The sordid details would fill a book, but the headlines keep telling the story one chapter at a time. The latest had to do with Fannie Mae's attempt, via the Hispanic Congressional Caucus (search), to squelch a Federal Reserve study which claimed that Fannie and Freddie's "implicit study does not appear to have substantially increased homeownership or homebuilding."

Several years ago a similar study by the Congressional Budget Office reached a similar conclusion, but it was attacked, marginalized and forgotten about, thanks of course to Fan and Fred. This time the fight began before the study was even released. The Hispanic Congressional Caucus decided that the fellow who wrote the study needed to be stopped, so they wrote a letter to his boss -- a fellow named Alan Greenspan. To his credit, Mr. Greenspan gave a green light to the study.

A final question worth asking is, why has the public apparently concluded that this scandal is not a scandal? A number of reasons appear plausible: Fan and Fred obviously know how to get in the way of bad news about what they do; they were large contributors to the Congressional Hispanic Caucus, and you can draw your own conclusion about calling in favors.

Also, Fan and Fred's "mission" allows them to leverage a unique emotional appeal -- the American dream of homeownership, as if George Bailey (search) ran the whole thing in a sequel to "It's a Wonderful Life." But George Bailey managed a savings bank in a small town: He wouldn't know a derivative contract from a cell phone.

You could also think "scandal fatigue" has overtaken the public, but that's an issue of psychology. And the fact is, there's no "fatigue" regarding financial scandals when the economy is sour and the stock market is down. The press and the public couldn't get enough of the corporate scandal stories in 2002, when stocks were in their third year of a bear market.

If the bear returns next year -- and especially if interest rates begin to march higher, which could stress Fan and Fred's derivatives to the breaking point -- the "scandal that's not a scandal" in 2003 will explode into the story of the year in 2004.

Robert Folsom is a financial writer and editor for Elliott Wave International, a financial analysis company. He has covered politics, popular culture, economics and the financial markets for 16 years, and today writes EWI's popular Market Watch column. Robert earned his degree in political science from Columbia University in 1985.

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