Last Tuesday, Rep. Richard Baker (R-La.) introduced legislation creating a new regulator for the GSEs and the Federal Home Loan Banks. The bill - The Federal Housing Finance Reform Act of 2005 - abolishes GSE regulator Office of Federal Housing Enterprise Oversight and FHLB regulator Federal Housing Finance Board and establishes a new independent regulator called the Federal Housing Finance Authority.

A House press release stated that the new regulator would issue and enforce management and operations standards including credit, interest rate and market risks, internal controls, liquidity and investments. Additionally, it would have discretion to adjust minimum and risk based capital levels. The bill would also give the regulator the authority to approve new programs, set the conforming loan limits, and establish housing goals and annual home purchase goals for Fannie Mae and Freddie Mac. The legislation also gives the regulator the ability to put the GSEs in receivership if either one becomes critically undercapitalized.

Rep. Baker's bill does not include caps on the size of the mortgage portfolios as preferred by Federal Reserve Chairman Alan Greenspan and the Bush administration. The Federal Reserve had previously submitted a draft that suggested limiting the Fannie and Freddie mortgage portfolios to $200 billion each year over five years. In response to that, Rep. Baker said that while the GSEs' portfolios needed to be reduced, there should be flexibility to set portfolio limits that incorporate such things as economic and market conditions. Baker intends to begin holding hearings on this bill soon and hopes to have a subcommittee vote in May.

A report from Merrill Lynch said that if the Administration and the Fed do not compromise on the issue of portfolio limits or caps - considering the skepticism expressed on this issue by Senators Paul Sarbanes (D-Md) and Charles Schumer (D-N.Y.) - prospects for the quick passage of GSE legislation this year will be significantly diminished.

In Greenspan's testimony held Wednesday before the Senate Banking Committee, he basically restated previous comments he has made on the GSEs. The Fed Chairman noted that investors have concluded the government will not allow a GSE to default and so will purchase GSE debt at substantially lower interest rates than a comparable institution without ties to the government. This belief "creates systemic risks for the U.S. financial system as the GSEs become very large," he stated. Greenspan added that the investor inference that GSEs have a government guarantee on its debt has enabled the Agencies to profitably expand their portfolios without limit. For example, at the end of 1990, the GSEs' combined portfolios totaled $132 billion, or 5.6% of the single-family home mortgage market. Additionally, at the end of 2003, their combined portfolios totaled $1.38 trillion, or 23% of the home mortgage market. Greenspan also commented on the lack of market discipline regarding GSE leverage and the lack of risk assessment by counterparties to GSE transactions.

Greenspan also believes limits should be placed on the GSEs' portfolio to reduce systemic risk. He noted that the Fed was unable to find any purpose for the huge GSE balance sheets other than creating profit through exploiting its "market-granted subsidy." Additionally, he said a Fed study found no link between portfolio size and mortgage rates. This was further demonstrated, he said, in the past year when the GSEs' portfolios didn't grow while mortgage spreads declined. Also, while GSE stock was impacted by the turmoil over the past year, the mortgage markets have functioned well, Greenspan added.

There was little empirical support that fixed-rate mortgages would be harder to obtain without the GSEs' portfolios, Greenspan stated. As evidence, he pointed to the early 1990s when their portfolios were much smaller saying that in 1992, ARM share averaged about 20% when the portfolios were small, and 34% in 2004 when they were large. "These data suggest that the size of the GSEs' portfolios is unrelated to the availability or popularity of fixed-rate mortgages." Rather, mortgage securitization is the "key ingredient to maintaining and enhancing the benefits of the GSEs to homebuyers and secondary mortgage markets," Greenspan stated.

Meanwhile, Treasury Secretary John Snow last Thursday weighed in with his comments regarding GSE Regulatory Reform before the Senate Banking Committee. His comments were similar to details the administration outlined in 2003, and were in line with comments made the day before by Chairman Greenspan.

He warned that the risks taken by the GSEs could pose a threat to their solvency, the stability of other financial institutions that hold a substantial amount of GSE debt, and the strength of the US economy if reforms weren't put into place. The administration favors establishing a regulator with "clear general regulatory, supervisory, and enforcement powers," he stated. This includes the authority to establish minimum capital and risk-based capital standards, to review existing and new activities to ensure GSEs are within their mission and promoting housing opportunities, and to place a failed GSE into receivership, among other things.

Snow reiterated the need for regulatory reform especially given both Fannie's and Freddie's recent accounting problems. These events "reinforce concerns over the systemic risks posed by the GSEs and further highlight the need for real GSE reform to ensure that our housing finance system remains a strong and vibrant source of funding for expanding homeownership opportunities in America," Snow said.

The administration shares the view of Chairman Greenspan that the GSEs mortgage portfolio has "grown well beyond anything needed in carrying out their housing mission," Snow stated. In order to protect against systemic risk, the administration favors limitations on the size of the GSEs' retained portfolios. He favors a phase-in period for achieving this goal that would not disrupt the mortgage or financial markets, testifying that in no way does the portfolio limit impair GSE ability to guaranty MBS.

The administration favors making the new regulator a part of the Treasury Department, Snow stated, as the costs associated with starting up a new agency would be lower by placing it within Treasury. Additionally, he noted, "the Treasury Department is the Executive Branch agency with the responsibility to adopt a holistic approach to systemic risk and oversee the proper functioning of financial markets".

Copyright 2005 Thomson Media Inc. All Rights Reserved.

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