Fannie Mae and Freddie Mac will be in a better position to help housing markets weather the current turmoil in subprime lending if Congress doesn’t give regulators free rein to decide how much debt they can safely take on, executives with the companies told lawmakers Thursday.
The government-sponsored entities, which purchase mortgage loans from lenders and guarantee loans that sold to Wall Street investors on the secondary market, have been fighting tighter limits on their lending portfolios, which currently total $1.4 trillion.
In the wake of accounting and managements scandals at the GSEs, Bush administration officials and other Republican lawmakers have warned that Fannie and Freddie’s considerable debt obligations pose a “systemic risk” to the banking system and financial markets.
The GSEs also have critics on the other side of the aisle, with some Democrats and affordable-housing advocates saying they’ve been more focused on profits than the mission Congress created them for — to lower the cost of borrowing for average Americans by guaranteeing conforming loans.
Legislation that would have capped the GSEs’ mortgage portfolios failed to pass the Senate last year. But a new compromise bill introduced in the House last week, HR 1427, would give regulators who oversee the companies’ new powers, including more flexibility in determining Fannie and Freddie’s minimum and risk-based capital requirements.
That flexibility worries Freddie Mac Chief Executive Officer Richard F. Syron.
The GSEs’ minimum capital requirements are currently determined by applying hypothetical stress tests enacted in law. HR 1427 would give regulators more flexibility in setting the requirements.
The GSEs maintain that their capital provisions — assets that can be used to cover potential losses — don’t need to be as conservative as the requirements in place for banks. That’s because banks finance many types of debt, including credit card and automobile loans, which ostensibly carry more varied risks than home loans.
Because the bill doesn’t spell out a requirement for the GSEs to reduce their mortgage portfolios, it’s been “widely interpreted as meaning that the regulator would not impose the drastic reductions in our portfolio called for by our critics,” Syron said in prepared testimony before the House Financial Services Committee
But the bill’s language would give regulators “very broad authority to limit or substantially reduce the size of GSE portfolios, if they choose to do so — making it possible to achieve the policy objectives” of the failed Senate bill, Syron said. “The high degree of discretion has cheered some GSE critics — and that worries us.”
Syron noted that one reason Freddie and Fannie were created “was to mitigate the impacts on the housing finance system of a transition like the one we are experiencing right now,” referring to the rise in delinquencies and foreclosures among risky loans. Because the GSEs provide funds for mortgage lending counter-cyclically, now is not a good time to restrict that capability, he said.
“By acting counter to the business cycle, Freddie Mac and Fannie Mae help reduce the depth of a housing recession and support credit flows during an expansion in an “as needed” basis,” Syron said. “We can only serve this function if we have the capital and operational flexibility to respond quickly to market transitions.”
If regulators require the GSEs to hold capital in excess of their actual risks, Syron said, “We may not have the financial base that allows us to inject liquidity into the marketplace by buying and holding mortgages. We should be careful not to damage the successful GSE business model, especially at a time when GSEs may be needed to sustain the world’s most liquid and successful housing finance system.”
But some critics say Fannie and Freddie contributed to the current crisis by buying up subprime lenders’ risky loans on the secondary market, allowing them to make even more loans. At the same time, the GSEs were turning their back on lenders making loans in less affluent communities under the Community Reinvestment Act, said Judith A. Kennedy, president of the National Association of Affordable Housing Lenders, in her prepared testimony.
“It has recently become clear that the GSEs were the major financiers of private label, mortgage-backed securities backed by subprime loans, while billions of prime, consumer-friendly CRA-eligible mortgages piled up on lenders’ books,” Kennedy said.
About $500 billion in GSE debt is invested in mortgage-backed securities (MBS), half of which are private-label securities backed by subprime loans, she said, citing a report by the Office of Federal Housing Enterprise Oversight (OFHEO).
Meanwhile, the market for CRA loans “is increasingly constipated for lack of capital,” Kennedy said. “Billions of dollars in CRA-eligible loans remain on the books of the originating lenders, unless and until the lenders peddle their loans like Fuller Brush men to pension funds, insurance companies and other investors through expensive, time-consuming, private placements.”
Syron argued that the GSEs’ investments in MBS actually support its mission of helping families purchase affordable housing. He used those investments and others to dispute OFHEO reports claiming that only about 30 percent of Fannie and Freddie’s portfolios support loans for affordable housing.
Freddie’s CEO said closer to two-thirds of Freddie’s portfolio supports affordable housing, if bonds financing low-cost housing are taking into account, along with whole loans, non-agency securities, and loans to first-time home buyers and minority families that are too large to count toward the GSEs’ affordability goals.
HR 1427 would establish an affordable-housing fund, to which Fannie and Freddie would contribute amounts equal to 1.2 basis points of outstanding mortgages — about $500 million a year, bill sponsor Barney Frank, D-Mass., has said.
Syron said that no “CEO of any shareholder owned company would enthusiastically support an additional cost imposed on his or her business, and I’m no exception. At the same time, I understand the interest in Congress in creating such a fund.”
If the affordable-housing fund is part of the legislation ultimately passed by Congress, he said, it should be managed by the GSEs, and not regulators.
But the Treasury Department recommends that if Congress insists on establishing an affordable-housing fund, it be controlled by government regulators, temporary and capped, Treasury under Secretary Robert K. Steel said in his prepared testimony to the committee
Originally chartered by Congress, Fannie and Freddie were converted to for-profit, publicly traded companies in the late 1960s. But there is still a perception that the government will come to their rescue if they run into financial problems.
The GSEs “greatly benefit from the market’s perception that the U.S. government guarantees or stands behind GSE obligations, which results in preferential funding rates,” Steel said. “On behalf of Treasury, I want to reiterate that the GSEs’ debt and other financial obligations are not backed by the federal government.”
To make it explicit that the government will not necessarily bail Fannie and Freddie out if they run into trouble, HR 1427 would create a new regulator, the Federal Housing Finance Agency, which would have the power to place the GSEs in receivership.
The FHFA would be authorized to not only take over Fannie and Freddie’s day-to-day operations as a conservator — which regulators are allowed to do under existing law — but close the GSEs down and liquidate their assets, leaving shareholders and creditors responsible for losses.
That could eliminate some or all of the rate discounts the GSEs enjoy, which Syron said save homeowners between $16 billion and $21 billion per year.
It’s hard to argue that the GSEs are dominating the mortgage lending business, Freddie Mac’s CEO said, as Fannie and Freddie have seen their market share of the $11 trillion in outstanding residential mortgage debt fall to less than 7 percent each in 2006 — a 40 percent decline from three years ago.
But Steel stood behind the Treasury Department’s previous statements that the GSEs have taken on too much risk — a conclusion based not only on the size of their portfolios and the false perception that they are backed by the government, but because of their influence on banks and derivatives.
“The combination of these three factors causes the GSEs to present the potential for systemic risk to our financial system and the global economy,” Steel said. “This view has not changed.”
The Treasury Department “would be strongly opposed to changes that weaken (FHFA’s) ability to effectively implement the capital provisions,” Steel said.
Syron said that if Congress tries to push Fannie and Freddie into providing more support for affordable housing while simultaneously limiting its ability to generate profits, lawmakers might hamstring the GSEs. Fannie and Freddie — which receive no direct government funding — must generate a return to investors in order to accomplish the mission Congress intended, Syron said.
Profits, he said “are indispensable to the GSE model,” allowing Fannie and Freddie to use private-sector methods and private capital to respond to changing markets.
“The genius of the GSE model as it has evolved since the Great Depression is the ability to harness private capital as much as possible to promote the public purpose of a liquid secondary market for housing finance,” Syron said. “To that end, Congress has given the GSEs the freedom they needed, within the context and confines of their charters, to successfully compete for private capital and achieve attractive returns on that capital. Imposing too many conflicting demands on the GSEs risks crippling this highly successful model.”
Requiring the GSEs to maintain capital levels greater than required by actual risks would slow growth and the flow of money into the new affordable-housing fund, Syron said.
Constraints on the GSEs’ retained portfolio — loans it buys and holds — would mean conventional mortgage rates would rise. “Extremely aggressive housing goals” targeted at very low-income areas can lead to an “over-extension” of credit to some borrowers, as currently seen in the subprime market, he said.
As housing prices have spiraled upward since the turn of the century, Freddie and Fannie have been able to guarantee fewer loans in high-cost areas, because many mortgages exceed the conforming loan limit, which currently stands at $417,000. Many say that’s been a factor in the growth in market share by subprime lenders in high-cost areas like California and Florida.
HR 1427 would attempt to address the issue by allowing the GSEs to guarantee loans up to 150 percent above the conforming loan limit in high-cost areas, or loans equal to the median home price — whichever is less. Loans above the conforming loan limit would have to be securitized, and FHFA would study whether the securitization requirement raises their cost. FHFA would also be tasked with establishing and enforcing housing goals and an annual home-purchase goal for Fannie and Freddie.