Congress should overhaul the operations of mortgage repurchasers Fannie Mae and Freddie Mac by focusing their portfolios on affordable housing and making it clear that the government will not bail them out if the companies overextend themselves outside of that arena.
Those were the first public remarks by Federal Reserve Chairman Ben Bernanke on GSE reform as Congress continues to debate legislation in the wake of the accounting and management scandals at Fannie and Freddie.
Speaking at the Independent Community Bankers of America’s annual convention in Honolulu, Hawaii, Bernanke echoed warnings by his predecessor that Fannie and Freddie could pose a systemic risk to the financial markets if they are allowed to grow unchecked.
Although the government-sponsored entities, or GSEs, were converted to for-profit, publicly traded companies in the late 1960s, they are still able to borrow money at lower interest rates than competitors because of a belief that the government will bail them out if they become overextended, Bernanke said.
“The perception of government backing allows Fannie and Freddie to borrow in open capital markets at an interest rate only slightly above that paid by the U.S. Treasury and below that paid by other private participants in mortgage markets,” Bernanke said.
Unlike other private firms, “the GSEs face little or no market discipline from their senior debt holders because of the belief among market participants that the U.S. government will back these institutions under almost any circumstances.”
To encourage creditors to either reduce their exposure to Freddie and Fannie’s debts or charge more when they feel the GSEs are taking more risk, Bernanke said GSE reform legislation should establish a mandatory process for placing the companies into receivership if they run into financial difficulties.
The process must ensure “that both the shareholders and creditors of a failed GSE will bear financial losses,” Bernanke said. “Only if GSE debt holders are persuaded that the failure of a GSE will subject them to losses will they have an incentive to exert market discipline.”
Although the GSEs are supposed to provide liquidity to mortgage lending market that reduces the cost of home loans for average Americans, Bernanke said there’s little evidence that they have.
The Office of Federal Housing Enterprise Oversight estimates that less than 30 percent of the GSEs’ current portfolio holdings support affordable housing.
Bernanke said pools of mortgage-backed securities have “become extremely deep and liquid,” and that the GSE’s purchases of highly rated mortgages and their own mortgage-backed securities are “unlikely to do much to enhance liquidity in the secondary markets for these assets or to promote affordable housing.”
By mandating that Freddie and Fannie’s senior debt — the portion investors see as government-backed — be used to finance affordable housing and other assets with “a clear and measurable public benefit,” Congress could limit the size of the GSEs’ portfolios while preserving their ability to generate a profit.
Bernanke said he is not advocating that the GSEs reduce their exposure to subprime loans, and that an approach emphasizing affordable housing can be implemented without increasing risk.