Fannie Mae and Freddie Mac
Analysis of Options for Revising the Housing Enterprises' Long-term Structures Gao ID: GAO-10-144T October 8, 2009This testimony discusses the results of our recently issued report on options for restructuring two government-sponsored enterprises (GSE): Fannie Mae and Freddie Mac (enterprises). On September 6, 2008, the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac in conservatorship out of concern that their deteriorating financial condition and potential default on $5.4 trillion in financial obligations threatened the stability of financial markets. Since then, the Department of the Treasury (Treasury) has provided nearly $100 billion to the enterprises, and the Congressional Budget Office (CBO) estimated that the total cost of Treasury financial assistance will be nearly $400 billion. Moreover, the Board of Governors of the Federal Reserve System (Federal Reserve) has committed to purchasing up to $1.45 trillion in the debt and securities of the enterprises (and other entities) to support housing finance, housing markets, and financial markets. While the conservatorships can remain in place as efforts are undertaken to stabilize the enterprises and restore confidence in financial markets, FHFA said that the conservatorships were not intended to be permanent. Over the longer term, Congress and the executive branch will face difficult decisions on how to restructure the enterprises and promote housing opportunities while limiting risks to taxpayers and the stability of financial markets. This testimony will will (1)summarize the enterprises' performance in achieving key housing mission objectives; (2) identify various options for revising the enterprises' long-term structures; (3) analyze these options in terms of their potential capacity to achieve key housing mission and safety and soundness objectives; and (4) discuss how the federal government's management of the conservatorships and response to the housing crisis could affect any transition.
It is generally accepted that the enterprises were successful in achieving key housing mission objectives to support the secondary mortgage market and facilitate the flow of mortgage credit: (1) We reported that the enterprises established a viable mortgage market for secondary loans that enabled capital to flow to areas with the greatest demand for mortgage credit. (2) The enterprises' activities have been credited with lowering interest rates on qualifying mortgages below what they otherwise would have been, although estimates regarding the extent of this benefit vary.6 (3) Furthermore, the enterprises established underwriting practices and forms for conventional mortgages that became standard in the industry, increased the efficiency of underwriting, and helped develop the MBS market. However, it is not clear to what extent the enterprises have been able to support a stable and liquid secondary mortgage market during periods of economic stress, which is another key objective. The enterprises' mixed records in achieving their housing mission objectives and the losses and weaknesses that resulted in the conservatorships reinforce the need for Congress and the executive branch to fundamentally reevaluate the enterprises' roles, structures, and business activities in mortgage finance. Researchers and others believe a range of options could better achieve housing mission objectives (in some cases through other federal entities such as FHA), help ensure safe and sound operations, and minimize risks to financial stability. These options generally fall along a continuum, with some overlap among key features, and advocate (1) establishing a government corporation or agency, (2) reconstituting the enterprises as for-profit GSEs in some form, or (3) privatizing or terminating them. We sought to assess each restructuring option in terms of its capacity to meet key housing objectives (providing liquidity and support to mortgage markets and facilitating housing opportunities for targeted groups) while also mitigating safety and soundness and financial stability risks. Our analysis indicates that each option involves important trade-offs. Although it is not possible to predict what effects federal initiatives to respond to the housing crisis and the Treasury agreements with the enterprises could have on any transition, they could be substantial. For example, under the proposal to reconstitute the enterprises, potential investors might not be willing to invest in reconstituted GSEs that had a substantial volume of nonperforming mortgage assets or financial obligations to Treasury. To minimize this risk, the federal government could retain nonperforming assets in a "bad bank," spin off the performing assets to a "good bank," and devolve key functions, such as issuing MBS, to investors in a reconstituted GSE. Or, the federal government could use this process to terminate or privatize the enterprises. However, to the extent that the enterprises previously engaged in activities or incurred financial obligations inconsistent with maintaining long-term financial viability, the level of nonperforming assets and long-term costs to taxpayers may be higher than otherwise would be the case.
GAO-10-144T, Fannie Mae and Freddie Mac: Analysis of Options for Revising the Housing Enterprises' Long-term Structures
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Testimony:
Before the Committee on Banking, Housing, and Urban Affairs, U.S.
Senate:
United States Government Accountability Office:
GAO:
For Release on Delivery:
Expected at 9:30 a.m. EDT:
Thursday, October 8, 2009:
Fannie Mae And Freddie Mac:
Analysis of Options for Revising the Housing Enterprises‘ Long-term
Structures:
Statement of William B. Shear, Director:
Financial Markets and Community Investment:
GAO-10-144T:
Chairman Dodd, Ranking Member Shelby, and Members of the Committee:
I am pleased to be here today to discuss the results of our recently
issued report on options for restructuring two government-sponsored
enterprises (GSE): Fannie Mae and Freddie Mac (enterprises).[Footnote
1] On September 6, 2008, the Federal Housing Finance Agency (FHFA)
placed Fannie Mae and Freddie Mac in conservatorship out of concern
that their deteriorating financial condition and potential default on
$5.4 trillion in financial obligations threatened the stability of
financial markets. Since then, the Department of the Treasury
(Treasury) has provided nearly $100 billion to the enterprises, and the
Congressional Budget Office (CBO) estimated that the total cost of
Treasury financial assistance will be nearly $400 billion.[Footnote 2]
Moreover, the Board of Governors of the Federal Reserve System (Federal
Reserve) has committed to purchasing up to $1.45 trillion in the debt
and securities of the enterprises (and other entities) to support
housing finance, housing markets, and financial markets. While the
conservatorships can remain in place as efforts are undertaken to
stabilize the enterprises and restore confidence in financial markets,
FHFA said that the conservatorships were not intended to be permanent.
Over the longer term, Congress and the executive branch will face
difficult decisions on how to restructure the enterprises and promote
housing opportunities while limiting risks to taxpayers and the
stability of financial markets.
Congress originally established Fannie Mae and Freddie Mac as
government entities in 1968 and 1989, respectively, chartering them as
for-profit, shareholder-owned corporations.[Footnote 3] They share a
primary mission that has been to stabilize and assist the U.S.
secondary mortgage market and facilitate the flow of mortgage credit,
including in periods of economic stress. To accomplish this goal, the
enterprises issued debt and stock and used the proceeds to purchase
conventional mortgages (conforming mortgages) that met their
underwriting standards from lenders such as banks or thrifts.[Footnote
4] In turn, banks and thrifts used the proceeds to originate additional
mortgages. The enterprises held some of the mortgages they purchased in
portfolio, but packaged most into mortgage-backed securities (MBS) sold
to investors in the secondary mortgage market.[Footnote 5] For a fee,
the enterprises guaranteed the timely payment of interest and principal
on MBS that they issued. Charter requirements for providing assistance
to the secondary mortgage markets also specify that those markets are
to include mortgages on residences for low- and moderate-income
families (targeted groups). In 1992, Congress instituted authority for
requiring the enterprises to meet numeric goals set by the Department
of Housing and Urban Development (HUD) annually for the purchase of
single- and multifamily mortgages that serve targeted groups.
While the enterprises operated profitably for many years, their
structures long have been in question. For example, critics questioned
the extent to which private for-profit corporations could be expected
to serve a federally mandated housing mission. Furthermore, critics
stated that federal sponsorship conveyed certain financial and other
advantages that encouraged them to engage in riskier activities than
otherwise would be the case. In particular, despite the lack of an
explicit government guarantee on enterprise debt and MBS, the
assumption in financial markets of an ’implied“ federal guarantee
enabled the enterprises to borrow at lower rates than other for-profit
corporations. Critics argued that this implicit guarantee and access to
less costly credit created a moral hazard, or encouraged the
enterprises to assume greater risks and hold less capital than would
have been the case in the absence of a guarantee.
We initiated our recently issued report”on which my statement is based”
as part of a broader effort to assist Congress in its efforts to
address the current financial crisis and weaknesses in the U.S.
financial regulatory system. The report provides Congress with
information on the roles, benefits, and risks associated with the
enterprises‘ activities and is intended to help inform the forthcoming
deliberation on their future structures. In my testimony, I will:
* summarize the enterprises‘ performance in achieving key housing
mission objectives;
* identify various options for revising the enterprises‘ long-term
structures;
* analyze these options in terms of their potential capacity to achieve
key housing mission and safety and soundness objectives; and;
* discuss how the federal government‘s management of the
conservatorships and response to the housing crisis could affect any
transition.
To meet our objectives, we reviewed reports, studies, and data on the
enterprises and their regulation, including our reports, as well as
proposals to revise their structures. We met with researchers who wrote
relevant reports on or were knowledgeable about enterprise-related
issues and with representatives from FHFA, Treasury, the Federal
Reserve, HUD, the Government National Mortgage Association (Ginnie
Mae), CBO, the enterprises, banking and mortgage organizations, the
National Association of Home Builders, and community groups. In
addition, FHFA provided written comments on a draft of the report. FHFA
stated that the report is timely and does a good job summarizing the
dominant proposals for restructuring the enterprises and some of their
strengths and weaknesses. FHFA also offered key questions and
principles for guiding initial decisions that will have to be made
about the future of the mortgage market.
Enterprises Had a Mixed Record in Achieving Housing Mission Objectives,
and Risk Management Deficiencies Compromised Their Safety and
Soundness:
It is generally accepted that the enterprises were successful in
achieving key housing mission objectives to support the secondary
mortgage market and facilitate the flow of mortgage credit: (1) We
reported that the enterprises established a viable mortgage market for
secondary loans that enabled capital to flow to areas with the greatest
demand for mortgage credit. (2) The enterprises‘ activities have been
credited with lowering interest rates on qualifying mortgages below
what they otherwise would have been, although estimates regarding the
extent of this benefit vary.[Footnote 6] (3) Furthermore, the
enterprises established underwriting practices and forms for
conventional mortgages that became standard in the industry, increased
the efficiency of underwriting, and helped develop the MBS market.
However, it is not clear to what extent the enterprises have been able
to support a stable and liquid secondary mortgage market during periods
of economic stress, which is another key objective. As noted in our
1996 report, we did not find clear evidence that Fannie Mae‘s mortgage
purchase activities during the 1980s supported mortgage markets in
certain states that had experienced substantial economic setbacks.
[Footnote 7] During the current financial crisis, the enterprises have
provided critical support to mortgage finance as private-sector MBS
issuance largely collapsed. Yet the enterprises have been able to
provide this support to mortgage finance only with the substantial
financial assistance from Treasury and the Federal Reserve discussed
earlier.
While the enterprises also were to facilitate mortgage credit
opportunities for targeted groups, it is not clear that the numeric
mortgage purchase program materially benefited such groups. HUD
administered the program from 1992 until the authority was transferred
to FHFA in 2008. Recent research indicates that, although the
enterprises have enhanced their product offerings to meet the housing
goals, the effects of the housing goals on affordability and
opportunities for targeted groups have been limited. For example, one
study found that as the enterprises‘ activities increased in certain
areas pursuant to the mortgage purchase program, they may have been
offset by a decline in FHA‘s existing activities in those areas.
[Footnote 8] Earlier research sponsored by HUD in 2001 found that the
enterprises generally did not play a leading role in affordable
multifamily mortgage finance because their underwriting standards were
considered conservative and fairly inflexible, compared with those of
other multifamily mortgage providers.[Footnote 9] In contrast, I should
note that representatives from mortgage finance, housing construction,
and consumer groups we contacted said that the benefits from enterprise
purchases of multifamily mortgages were significant. The
representatives said that the enterprises‘ involvement in or guarantees
of the financing of affordable multifamily projects were crucial to
their successful completion. In addition, they said that during the
current financial crisis the enterprises were the only source of
funding for multifamily projects because many other traditional
providers, such as banks and insurance companies, largely have
withdrawn from the market.
While housing finance may have benefited from the enterprises‘
activities over the years, GAO, federal regulators, researchers, and
others long have argued that the enterprises‘ structures (for-profit
corporations with government sponsorship) undermined market discipline
and provided incentives to engage in potentially profitable but risky
business practices that did not necessarily support their public
missions. As examples,
* We and others raised consistent concerns about rapid growth in the
enterprises‘ retained mortgage portfolios, which reached a combined
$1.6 trillion by 2005. Although increasing the size of the portfolios
may have been more profitable than issuing MBS, it exposed the
enterprises to significant interest rate risk. We reported that the
rapid increase and the associated interest rate risk did not result in
a corresponding benefit to the achievement of their housing missions.
* In 2003 and 2004, the enterprises were found to have manipulated
accounting rules so that their public financial statements showed
steadily increasing profits over many years and thereby increased their
attractiveness to potential investors. The misapplication of accounting
rules generally involved standards for reporting on derivatives, which
the enterprises used to help manage interest rate risks associated with
their large retained portfolios. The enterprises had to restate their
financial statements and adjust their earnings reports by billions of
dollars.
* Finally, beginning in 2004 and 2005, the enterprises purchased a
large volume of questionable mortgage assets, such as private-label MBS
and Alt-A mortgages, which typically did not have documentation of
borrowers‘ incomes and had high loan-to-value or debt-to-income ratios.
According to FHFA, these questionable mortgage assets accounted for
less than 20 percent of the enterprises‘ total assets but represented a
disproportionate share of credit-related losses in 2007 and 2008. FHFA
stated that the losses on these assets helped precipitate the
enterprises‘ financial deterioration and resulted in the decision to
place them in conservatorship in September 2008.
Options for Restructuring the Enterprises Aim to Achieve Housing
Mission Objectives while Mitigating Safety and Soundness Risks:
The enterprises‘ mixed records in achieving their housing mission
objectives and the losses and weaknesses that resulted in the
conservatorships reinforce the need for Congress and the executive
branch to fundamentally reevaluate the enterprises‘ roles, structures,
and business activities in mortgage finance. Researchers and others
believe a range of options could better achieve housing mission
objectives (in some cases through other federal entities such as FHA),
help ensure safe and sound operations, and minimize risks to financial
stability. These options generally fall along a continuum, with some
overlap among key features, and advocate (1) establishing a government
corporation or agency, (2) reconstituting the enterprises as for-profit
GSEs in some form, or (3) privatizing or terminating them (see table
1).
Table 1: Summary of Options to Revise the Enterprises‘ Structures:
Potential structure: Government corporation or agency;
Proposed function: Focus on purchasing qualifying mortgages and issuing
MBS but eliminate mortgage portfolios, which are complex to manage and
can result in losses due to fluctuations in interest rates.
Responsibilities for promoting homeownership for targeted groups could
be transferred to FHA, which insures mortgages for low-income and first-
time borrowers.
Potential structure: Reestablish for-profit enterprises with government
sponsorship;
Proposed function: Restore the enterprises to their previous status but
add controls to minimize risk. These controls might include eliminating
or reducing mortgage portfolios or imposing public utility-type
regulation, which involves business activity restrictions and
profitability limits, and establishing executive compensation limits.
Or, convert the enterprises from publicly traded, shareholder-owned
corporations to cooperative associations owned by mortgage lenders.
Potential structure: Privatization or termination;
Proposed function: Abolish the enterprises and disperse mortgage
lending and risk management throughout the private sector. Some
proposals involve the establishment of a federal mortgage insurer to
help protect mortgage lenders against catastrophic mortgage losses.
Source: GAO.
[End of table]
The following paragraphs summarize key principles and aspects of each
option:
Government corporation or agency.[Footnote 10] Supporters of these
proposals maintain that the implied federal guarantee and the
enterprises‘ need to respond to shareholder demands to maximize
profitability encouraged excessive risk taking and ultimately resulted
in their failures. They believe that a government entity, which would
not be concerned about maximizing shareholder value, would best ensure
the availability of mortgage credit for primary lenders while
minimizing risks associated with a for-profit structure with government
sponsorship. Establishing a government corporation or agency also would
help ensure transparency through appropriate disclosures of risks and
costs in the federal budget. Elements of the proposals include
eliminating retained mortgage portfolios over time; establishing sound
underwriting standards and risk-sharing arrangements with the private
sector; establishing financial and accountability requirements for
lenders; instituting consumer protection standards for borrowers; and
eliminating responsibility for the numeric mortgage purchase program
(instead, FHA‘s mortgage insurance programs would be expanded to
address this objective).
Reconstituted GSEs. Market participants and commenters, trade groups
representing the banking and home construction industries, and
community and housing advocates we contacted believe that
reconstituting the enterprises would help ensure that they would remain
responsive to market developments, continue to produce innovations in
mortgage finance, and be less bureaucratic than a government agency or
corporation. But they also advocate a variety of additional regulations
and ownership structures to help offset the financial risks inherent in
the for-profit GSE structure, such as substantially downsizing or
eliminating the enterprises‘ mortgage portfolios; breaking up the
enterprises into multiple GSEs to mitigate safety and soundness and
financial stability risks; establishing public utility-type regulation
for the enterprises (for example, limiting their rates of return); and
converting the enterprises into lender-owned associations (creating
incentives for mortgage lenders to engage in more prudent underwriting
practices).
Privatization or termination. Some analysts and financial commenters
contend that privatizing or terminating the enterprises (including
dispersing key functions among private-sector entities) represents the
best public policy option.[Footnote 11] Advocates believe that
privatized entities would align mortgage decisions more closely with
market factors and that the resultant dispersal of credit and interest
rate risk would reduce safety and soundness risks. Federal Reserve
Chairman Ben S. Bernanke has suggested that privatized entities may be
more innovative and efficient than government entities, and operate
with less interference from political interests.[Footnote 12] Elements
of the proposals include introducing a transition period to mitigate
any potential market disruptions and facilitate the development of a
new mortgage finance system; and establishing a federal entity to
provide catastrophic mortgage insurance for lenders and help ensure
that mortgage markets would continue functioning during stressful
economic periods.[Footnote 13]
A Framework for Analyzing Trade-offs Associated with the Options and
Potential Oversight and Regulatory Structures to Help Ensure Their
Effective Implementation:
We sought to assess each restructuring option in terms of its capacity
to meet key housing objectives (providing liquidity and support to
mortgage markets and facilitating housing opportunities for targeted
groups) while also mitigating safety and soundness and financial
stability risks. Our analysis indicates that each option involves
important trade-offs, which are summarized in table 2. The table also
identifies regulatory and oversight structures that might help ensure
that any option implemented would achieve housing mission and safety
and soundness objectives.
Table 2: Trade-offs Associated with Enterprise Reform Options as They
Relate to Long-Established Enterprise Objectives and Potential
Oversight Structures:
Proposed reform option: Government corporation or agency;
Provide liquidity and support to mortgage markets, including in bad
economic times: A government entity, with access to Treasury-issued
debt to fund its operations, may be in a better position to provide
liquidity to the mortgage market during normal economic periods and
when capital markets are impaired. However, because in some cases
investor demand for its MBS may be limited in times of financial
stress, a government entity that does not have a retained portfolio may
face challenges supporting mortgage markets during such periods.
Treasury or the Federal Reserve may have to purchase mortgage assets
under such circumstances (as has been the case during the current
disruption in mortgage credit markets).
Support housing opportunities for targeted groups: A government entity
most likely would be expected to pursue housing opportunity programs
for targeted groups because of its public status. However, if the
government entity does not have a retained mortgage portfolio, it may
face certain challenges in managing a housing goal program, since some
types of affordable loans, like multifamily loans may be difficult to
securitize, and therefore, often have been held in portfolio. As
alternatives, fees could be assessed on the government entity‘s
activities to support housing opportunities for targeted groups or
FHA‘s mortgage insurance programs could be expanded.
Ensure safe and sound operations: This structure may represent less
risk than has been the case with the GSE structure because MBS issuance
is less complicated and risky than managing a retained mortgage
portfolio. However, this activity still would be more complicated than
Ginnie Mae‘s (a government corporation that does not buy or sell loans
or issue MBS) and could result in substantial taxpayer losses if
mismanaged. A government corporation could face greater challenges than
private-sector entities in obtaining the human and technological
resources needed to manage complex processes or it might lack the
operational flexibility to do so.
Possible elements of regulatory and oversight structure: Key elements
for consideration include (1) certain operational flexibilities to
obtain appropriate staff and information technology to carry out
responsibilities, (2) risk-sharing agreements with private lenders or
mortgage insurers, (3) appropriate disclosures in the federal budget of
risks and liabilities to ensure financial transparency, and (4) robust
congressional oversight of operations.
Proposed reform option: Reconstituted GSEs;
Provide liquidity and support to mortgage markets, including in bad
economic times: As reconstituted GSEs, the enterprises may provide
liquidity and other benefits to mortgage finance during normal economic
times, as they did for many years. However, their ability to provide
such support during stressful economic periods is questionable given
current experience. Furthermore, with significantly reduced or
eliminated retained mortgage portfolios, the capacity of reconstituted
GSEs to provide support to mortgage markets during periods of economic
distress also may be limited.
Support housing opportunities for targeted groups: Reconstituted GSEs,
with their responsibility to maximize profits for their shareholders,
might find it difficult to support some public policy housing
initiatives. Moreover, without a retained mortgage portfolio, the
reconstituted GSEs may face challenges in implementing a numeric
housing goal purchase program. This challenge could be addressed by
permitting a reconstituted GSE to maintain a relatively small portfolio
or by supporting housing opportunities for targeted groups through
assessments on its activities.
Ensure safe and sound operations: The current financial crisis
highlights problems with the traditional GSE structure, including
incentives to increase leverage and maximize portfolios. Reconstituting
the GSEs would reestablish and might strengthen the incentive problems,
which could lead to even greater moral hazard and safety and soundness
concerns and increase systemic risks. Proposals to regulate GSEs like
public utilities in principle could constrain excessive risk-taking,
but the applicability of this model to the enterprises has not been
established. Moreover, FHFA has not been tested as an independent
safety and soundness and housing mission regulator, as the agency has
largely acted as a conservator since its establishment in July 2008.
Possible elements of regulatory and oversight structure: Key elements
for consideration include (1) reducing or perhaps eliminating retained
mortgage portfolios as deemed appropriate depending on prioritization
of numeric housing and safety and soundness objectives, (2)
establishing capital standards commensurate with relevant risks, (3)
developing additional regulations such as executive compensation limits
or perhaps including public utility-type regulation, (4) requiring
appropriate financial disclosures in the federal budget to enhance
transparency, and (5) ensuring strong congressional oversight of the
enterprises‘ and FHFA‘s performance.
Proposed reform option: Privatization or termination;
Provide liquidity and support to mortgage markets, including in bad
economic times: Privatizing or terminating the enterprises would
eliminate many problems with the current GSE model, including the
conflict between public policy and private shareholders. If key
enterprise activities such as mortgage purchases and MBS issuances are
provided by other financial institutions, liquid mortgage markets could
be reestablished in normal economic times. There is significant reason
to question the capacity of private banks to support mortgage markets
in times of financial distress without government support, given the
failure or near failure of key financial institutions and the absence
of private-label securitization during the current financial crisis. A
federal mortgage insurer could help such lenders provide liquidity and
other benefits in times of financial stress.
Support housing opportunities for targeted groups: Privatization or
termination would remove the traditional legislative basis, government
sponsorship, for the enterprises to implement programs to serve the
mortgage credit needs of targeted groups. However, the basis for such
programs may remain if a government insurer for mortgage debt is
established and the federal government guarantees its financial
obligations. Furthermore, Congress might justify the programs on the
grounds that large lenders that assume responsibility for key
enterprise activities or purchase their assets are viewed as ’too big
to fail“ and benefit from implied federal guarantees of their financial
obligations.
Ensure safe and sound operations: Termination and reliance on private-
sector firms would leave market discipline and regulators of financial
institutions with responsibility for promoting safety and soundness.
However, moral hazard concerns would remain if some mortgage lenders
were deemed ’too big to fail.“ These concerns may be heightened because
the current financial regulatory system already faces challenges in
overseeing such organizations. Additionally, safety and soundness
concerns may remain if a federal entity were established to insure
mortgage debt and did not charge appropriate premiums to offset the
risks it incurred. FHA and the FHLBank System may become more prominent
if the enterprises were privatized or terminated.
Possible elements of regulatory and oversight structure: The need for a
new financial regulatory system, due to concerns about the current
fragmented system, may be heightened to the extent that terminating or
privatizing the enterprises results in larger and more complex
financial institutions. In considering a new system, Congress should
consider the need to mitigate taxpayer risks and consider establishing
clear regulatory goals and a systemwide risk focus. If a new federal
mortgage insurer is established, there should be an appropriate
oversight structure for such an entity. This structure might include
appropriate regulations and capital standards, the disclosure of risks
and liabilities in the federal budget, and congressional oversight.
Source: GAO.
[End of table]
While the table provides a comprehensive overview of our analysis, let
me highlight some implications and trade-offs as they relate to the
critical issues of safety and soundness and systemic risk. In some
regards, a government entity may mitigate the safety and soundness and
systemic risk concerns of the traditional GSE structure. That is, it
would eliminate the concern that publicly held profit-maximizing
corporations would be able to operate with relatively low levels of
capital and take excessive risks because of an implied federal
guarantee that undermined market discipline. And, if a government
entity were to focus on MBS issuances and not retain a mortgage
portfolio, then it would be less complex and potentially less risky
than the GSEs were. Nevertheless, a government entity may find
successfully managing a large conventional mortgage purchase and MBS
issuance business to be challenging. As described in our previous work
on FHA, government entities may lack the financial resources to attract
highly skilled employees and obtain information technology to manage
complex business activities.[Footnote 14] The failure to adequately
manage the associated risks also could result in significant losses for
taxpayers. For example, the enterprises‘ losses in recent years have
been credit-related (because of mortgage defaults), including
substantial losses in their MBS guarantee business. This risk may be
heightened if a government entity was expected to continue purchasing
mortgages and issuing MBS during stressful economic periods.
Reconstituting the GSEs could present significant safety and soundness
concerns as well as systemic risks to the financial system. In
particular, the potential that the enterprises would enjoy explicit
federal guarantees of their financial obligations, rather than the
implied guarantees of the past, might serve as incentives for them to
engage in risky business practices to meet profitability objectives.
One option to mitigate these safety and soundness concerns would be to
make the enterprises into lender-owned associations. By selling
mortgages to the enterprises, lenders would have financial incentives
to adopt sound underwriting practices (as any losses the reconstituted
GSEs incurred on such mortgages would affect the lenders‘ investments
in them). While the public utility model of regulation also has been
proposed to help mitigate the risks associated with reconstituting the
GSEs, it is not clear that this model is appropriate. Unlike natural
monopolies such as electric utilities, the enterprises faced
significant competition from other providers of mortgage credit over
the years.
It is difficult to determine the extent to which privatizing or
terminating the enterprises mitigates current safety and soundness and
financial stability risks. Under one scenario, such risks would be
mitigated because large and complex enterprises that might engage in
risky business practices due to an implied federal guarantee would not
exist. Instead, private lenders would be subject to market discipline
and be more likely to make credit decisions on the basis of credit risk
and other market factors. However, if a federal entity were established
to insure mortgage debt and did not set appropriate premiums to reflect
its risks, then lenders might have incentives to engage in riskier
business practices than otherwise would be the case. Moreover, if large
private-sector financial institutions assumed responsibility for key
enterprise activities or purchased a significant portion of their
assets, the perception could arise that the failure of such an
institution would involve unacceptable systemic financial risks.
Therefore, perceptions that the federal government would provide
financial assistance to such financial institutions could undermine
market discipline. As we previously reported, the fragmented and
outdated U.S. financial regulatory structure already lacks the capacity
to effectively oversee large financial conglomerates and reform is
urgently needed.[Footnote 15]
Oversight and regulatory structures could help ensure that each option
mitigated safety and soundness and systemic risk concerns while helping
to achieving housing mission objectives. These oversight and regulatory
structures could include the following:
* for the government entity, granting operational flexibility to obtain
staff and informational technology to carry out responsibilities,
requiring appropriate disclosures in the federal budget of risks and
liabilities to ensure transparency, and instituting robust
congressional oversight;
* for the reconstituted GSE option, reducing or perhaps eliminating
mortgage portfolios, establishing capital standards commensurate with
risk, and establishing executive compensation limits; and
* for the privatization or termination option, reforming the current
regulatory structure, setting capital standards commensurate with risks
(if a federal insurer is established), disclosing risks and liabilities
in the federal budget in the interests of transparency, and instituting
robust congressional oversight.
Federal Efforts to Support Housing Markets during the Conservatorships
Could Affect Transition to New Structures:
Since the beginning of the FHFA conservatorships, the enterprises have
been tasked to initiate a range of programs, such as assisting
homeowners to refinance or modify their mortgages. These initiatives
could benefit housing markets and, in doing so, potentially improve the
enterprises‘ financial condition. However, the initiatives also may
involve additional risks and costs for the enterprises, which could
increase the costs and challenges associated with transitioning to new
structures. For example, borrowers who received mortgage loan
modifications could redefault, incurring additional losses.
Similarly, certain provisions in the Treasury agreements with the
enterprises may affect their long-term financial viability and
complicate any transition. For example, the enterprises must pay
quarterly dividends that accrue at 10 percent annually to the Treasury,
and in a liquidation proceeding the department has a claim against the
assets of any enterprise that cannot pay such dividends. Since Treasury
has already purchased $50 billion in preferred shares of Freddie Mac to
date, the enterprise is responsible for paying a dividend to Treasury
of $5 billion annually. Prior to the conservatorship, Freddie Mac‘s
reported annual net income twice came close to or exceeded $5 billion,
and the dividends it distributed to shareholders in those years likely
were substantially lower.
Although it is not possible to predict what effects federal initiatives
to respond to the housing crisis and the Treasury agreements with the
enterprises could have on any transition, they could be substantial.
For example, under the proposal to reconstitute the enterprises,
potential investors might not be willing to invest in reconstituted
GSEs that had a substantial volume of nonperforming mortgage assets or
financial obligations to Treasury. To minimize this risk, the federal
government could retain nonperforming assets in a ’bad bank,“ spin off
the performing assets to a ’good bank,“ and devolve key functions, such
as issuing MBS, to investors in a reconstituted GSE.[Footnote 16] Or,
the federal government could use this process to terminate or privatize
the enterprises. However, to the extent that the enterprises previously
engaged in activities or incurred financial obligations inconsistent
with maintaining long-term financial viability, the level of
nonperforming assets and long-term costs to taxpayers may be higher
than otherwise would be the case.
Regardless of what changes are implemented, policymakers should pay
careful attention to how a potential transition is managed to mitigate
potential risks to the housing finance system. The enterprises evolved
to become dominant participants in housing finance, and, in some
respects, their roles have expanded during the conservatorships.
Therefore, transitioning to a new structure could have significant
consequences for housing finance and should be managed carefully and
perhaps implemented in phases, with periodic evaluations to determine
if corrective actions were necessary.
Finally, regardless of any enterprise structural reforms that are
adopted, we urge Congress to continue to actively monitor the progress
of such implementation and to be prepared to make legislative
adjustments to ensure that any changes are as effective as possible. In
addition, we believe that it is important that Congress provide for
appropriate GAO oversight of any structural and related reforms to help
ensure accountability and transparency in any new system. GAO stands
ready to assist the Congress in its oversight capacity and evaluate the
progress that is being made in implementing any changes.
Chairman Dodd, Ranking Member Shelby, and Members of the Committee,
this concludes my prepared testimony. I would be pleased to address any
questions that you or the members of the committee may have.
[End of section]
Footnotes:
[1] GAO, Fannie Mae and Freddie Mac: Analysis of Options for Revising
the Housing Enterprises‘ Long-Term Structures, [hyperlink,
http://www.gao.gov/products/GAO-09-782] (Washington, D.C.: Sept. 10,
2009).
[2] On September 7, 2008, Treasury agreed to provide up to $100 billion
in financial support to each enterprise through the purchase of its
preferred stock so that the enterprises could maintain a positive net
worth. In February 2009, Treasury increased this commitment to $200
billion per enterprise. Treasury also agreed to purchase the
enterprises‘ mortgage-backed securities and establish a lending
facility to meet their borrowing requirements if needed.
[3] Congress initially chartered Fannie Mae in 1938 but did not
establish it as a shareholder-owed corporation until 1968. Congress
initially established Freddie Mac in 1970 as an entity within the
Federal Home Loan Bank System and reestablished it as a shareholder-
owned corporation in 1989.
[4] For example, the enterprises typically purchased mortgages with
loan-to-value ratios of 80 percent or less (mortgages with down
payments of at least 20 percent) and required private mortgage
insurance on mortgages with higher loan-to-value ratios. The
enterprises also had a limit on the size of mortgages they purchased
(the conforming loan limit), with mortgages above this limit called
jumbo mortgages. The conforming conventional market differs from other
markets (such as the subprime market) that generally have differing
underwriting standards, or markets in which the federal government
insures or guarantees mortgages (for example, through Federal Housing
Administration or Department of Veterans Affairs programs).
[5] Each enterprise‘s portfolio also includes MBS that it issued.
[6] In 1996, we participated in research with CBO, HUD, and Treasury
that included analysis of the degree to which the advantageous
borrowing rates the enterprises derived from government sponsorship
were passed to borrowers. We estimated the benefit on interest rates on
30-year, fixed-rate, single-family mortgages below the conforming loan
limits ranged from 15 to 35 basis points (a basis point is equal to one
1/100 of a percent). This amounted to a savings of about $10–$25 on the
monthly payments on a $100,000 mortgage. See GAO, Housing Enterprises:
Potential Impacts of Severing Government Sponsorship, GAO/GGD-96-120
(Washington, D.C.: May 13, 1996). More recent research by Federal
Reserve staff suggests that borrower savings ranged from 0 to 7 basis
points. See Wayne Passmore, Shane M. Sherlund, and Gilliam Burgess,
’The Effect of Housing Government-Sponsored Enterprises on Mortgage
Rates,“ Real Estate Economics, 33, Fall 2005: 427-463, and Wayne
Passmore, Diana Hancock, Andreas Lehnert, and Shane Sherlund, ’Federal
Reserve Research on Government-Sponsored Enterprises,“ Proceedings from
the 42th Annual Conference on Bank Structure and Competition, May 2006.
[7] [hyperlink, http://www.gao.gov/products/GAO/GGD-96-120].
[8] Xudong An and Raphael Bostic, ’GSE Activity, FHA Feedback, and
Implications for the Efficacy of the Affordable Housing Goals,“ Journal
of Real Estate Finance and Economics 36 (2008) 37: 207-231.
[9] Abt Associates, ’Study of the Multifamily Underwriting and the
GSEs‘ Role in the Multifamily Market: Final Report,“ prepared for HUD
(August 2001).
[10] See Dwight M. Jaffee, ’Reforming Fannie and Freddie,“ Regulation,
Winter 2008-2009: 52-57, and Thomas H. Stanton, ’Lessons from Public
Administration: Recommendations for the Future of Fannie Mae and
Freddie Mae,“ presented at the 45th Annual Conference on Bank Structure
and Competition, Federal Reserve Bank of Chicago, May 7, 2009.
[11] We treat ’termination“ and ’privatization“ as equivalent terms.
[12] Federal Reserve Chairman Ben S. Bernanke, ’The Mortgage Meltdown,
the Economy, and Public Policy,“ presented at the University of
California at Berkeley/University of California at Los Angeles
Symposium (Berkeley, California, Oct. 31, 2008).
[13] See Arnold Kling, ’Freddie Mac and Fannie Mae: An Exit Strategy
for the Taxpayer,“ Cato Institute Briefing Papers, no. 106 (Washington,
D.C.: Sept. 8, 2008). For additional information on privatization and
transition issues, see Peter Wallison, Thomas H. Stanton, and Bert Ely,
Privatizing Fannie Mae, Freddie Mac, and the Federal Home Loan Banks:
Why and How, The AEI Press ( Washington, D.C.: 2004); and HUD, Policy
Development and Research, Studies on Privatizing Fannie Mae and Freddie
Mac (Washington, D.C.: 1996). See also Diana Hancock and Wayne
Passmore, ’Three Mortgage Innovations for Enhancing the American
Mortgage Market and Promoting Financial Stability“ The University of
California at Berkeley/University of California at Los Angeles
Symposium. (Berkeley, California, Oct. 31, 2008).
[14] See GAO, Federal Housing Administration: Modernization Proposals
Would Have Program and Budget Implications and Require Continued
Improvement in Risk Management, [hyperlink,
http://www.gao.gov/products/GAO-07-708] (Washington, D.C.: June 29,
2007) and Information Technology: HUD Needs to Strengthen Its Capacity
to Manage and Modernize Its IT Environment, [hyperlink,
http://www.gao.gov/products/GAO-09-675] (Washington, D.C.: July 31,
2009).
[15] GAO, Financial Regulation: A Framework for Crafting and Assessing
Proposals to Modernize the Outdated U.S. Financial Regulatory System,
[hyperlink, http://www.gao.gov/products/GAO-09-216] (Washington, D.C.:
Jan. 8, 2009).
[16] Such proposals generally involve the federal government
maintaining existing guarantees on the assets in the ’bad bank“ as well
as assets in the ’good bank“ as may be required.
[End of section]
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