Federal Reserve Chairman Alan Greenspan today told a Congressional committee that Congress needs to take action to improve the regulatory oversight of Fannie Mae and Freddie Mac. The two giant government-sponsored entities securitize and resell or own a substantial portion of the outstanding home mortgage debt in the United States.

“The expansion of home ownership is a widely supported goal in this country…But there are many ways to enhance the attractiveness of home ownership at significantly less potential cost to taxpayers than through the opaque and circuitous GSE paradigm currently in place,” Greenspan said.

Greenspan told the Senate Committee on Banking, Housing, and Urban Affairs that Congress must not only create a stronger regulator, but also place new limits on the issuance of GSE debt and the purchase of both mortgage and nonmortgage assets.

Investors persist in their belief, despite warnings and protestations to the contrary, that the federal government backs the GSEs because they have special privileges not granted to other corporations. As a result, Greenspan concluded, strengthening the GSE regulator without implementing new financial restrictions could send the wrong message to investors.

“Congress needs to create a GSE regulator with authority on a par with that of banking regulators, with a free hand to set appropriate capital standards, and with a clear process sanctioned by the Congress for placing a GSE in receivership. However, if the Congress takes only these actions, it runs the risk of solidifying investors’ perceptions that the GSEs are instruments of the government and that their debt is equivalent to government debt. The GSEs will have increased incentives to continue to grow faster than the overall home mortgage market.

“Because they already purchase most conforming mortgages, they, like all effective profit-maximizing organizations, will be seeking new avenues to expand the scope of their operations, assisted by a subsidy that their existing or potential competitors do not enjoy.

“Thus, GSEs need to be limited in the issuance of GSE debt and in the purchase of assets, both mortgages and nonmortgages, that they hold. Fannie and Freddie should be encouraged to continue to expand mortgage securitization, keeping mortgage markets deep and liquid while limiting the size of their portfolios. This action will allow the mortgage markets to support home ownership and home-building in a manner consistent with preserving the safe and sound financial markets of the United States,” Greenspan said.

The belief among investors that the federal government would prevent the GSEs from defaulting on their debt because of their government perks and their huge size is “widespread in the marketplace despite the privatization of Fannie and Freddie and their control by private shareholders, because these institutions continue to have government missions, a line of credit with the Treasury, and other government benefits,” he noted.

The Federal Reserve is concerned about the GSEs huge mortgage portfolios, which “concentrate interest rate and prepayment risks at these two institutions,” Greenspan said. He noted that Fannie and Freddie manage this risk with higher leverage, rather than the higher capital reserves a commercial bank would use. Higher leverage increases the GSEs’ profitability, but would not be possible without either “the expectation of government support in a crisis” or “a significantly higher cost of debt,” he said.

Greenspan said Fannie Mae and Freddie Mac have managed these risks well so far, but “preventive actions” are needed to avoid “possible future systemic difficulties.” The GSE regulator should have “a free hand” in determining the minimum and risk-based capital standards for these institutions, he concluded.

The Fed chairman suggested that Congress could constrain the GSEs’ huge balance sheets by limiting the dollar amount of their debt relative to the dollar amount of the mortgages they’ve securitized and held.

“Although it is difficult to know how best to set such a rule, this approach would continue to expand the depth and liquidity of mortgage markets through mortgage securitization but would remove most of the potential systemic risks associated with these GSEs,” he told the Senate committee.

***

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