Snow falling on Fannie
At a second Senate hearing, held the day after Federal Reserve Chairman Alan Greenspan came out in favor of limiting the GSEs’ ability to grow their balance sheets (and hence increase their exposure to prepayment risk), Treasury Secretary John Snow weighed in with testimony even more plain-spoken than Mr. Greenspan’s:
Since the last time I appeared before you, the following events have transpired:
· OFHEO released a report of initial findings on Fannie Mae in September 2004 citing improper accounting procedures and practices, internal control deficiencies and questionable management oversight.
· The SEC concurred in the findings of inappropriate accounting practices, and directed Fannie Mae to restate its earnings for 2001-2003. Fannie Mae, then, estimated that it would be forced to recognize $9 billion in losses.
· OFHEO concluded in December 2004 that Fannie Mae was “significantly undercapitalized” in the third quarter of 2004, and demanded that the minimum capital requirement be increased by 30 percent to ensure that the
· And just three weeks ago, Fannie Mae disclosed to the SEC that it could be forced to recognize an additional $2.4 billion of losses, stating that it is unable to reasonably estimate the effect of these issues on reported results of operations.
· In 2004 the [Federal Home Loan] Banks of Chicago and Seattle entered into written agreements with their regulator, the Federal Housing Finance Board (Finance Board), to implement changes to enhance their risk management, capital structure, governance and other practices and procedures. In March of 2005, ten FHLBanks implemented new risk-based and leverage requirements. The others are expected to comply soon.
These events demonstrate that the GSEs do not have reliable financial controls to manage their operations risk. Such failure in controls, particularly in such highly leveraged institutions, jeopardizes not only the GSEs’ safety and soundness, but also poses risks to the entire financial system.
He again proposed making Treasury the GSEs’ regulator
“Finally, we believe that there would be less opportunity for regulatory capture [a euphemism for the regulator becoming mesmerized by its subject -- Ed.] were the new regulator housed in Treasury, given the diversity and size of the interests which regularly appear before the Department.”
The Secretary then observed that real or perceived weakness in GSE debt obligations would have powerful ripple effects throughout the
More than six out of ten institutions in the banking industry hold as assets GSE debt in excess of 50 percent of their capital.
He then endorsed Chairman Greenspan’s recommendation to cap the GSEs’ ability to grow their balance sheets by lending long and borrowing short:
As Chairman Greenspan has stated:
“… these institutions, if they continue to grow, continue to have the low capital that they have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest rate risk aversion, … create ever growing potential risks down the road.”
Fannie Mae and Freddie Mac operate two independent main business lines today:
(1) a credit guarantee business associated with securitizing mortgages; and
(2) a portfolio investment business that involves purchasing mortgages and various mortgage-related securities (including their own mortgage-backed securities) and non-mission related assets.
[1] The first of these–the guarantee and securitization of mortgages–is integral to the operation of an effective secondary market for mortgages.
[2] The [second] business of investing and holding an investment portfolio of mortgages and other higher-risk assets for its own proprietary trading account and inventory, however, has a much more tenuous connection to the housing mission of the GSEs.
He invited the inference that the mission for which the GSEs had been created had been fulfilled:
Freddie Mac and Fannie Mae, as we know them, were largely a product of the turbulent financial period of the late 1960s and early 1970s. One of the primary goals of creating Fannie Mae and Freddie Mac was “… to provide supplementary assistance to the secondary market for home mortgages by providing a degree of liquidity for mortgage investments, thereby improving the distribution of investment capital available for home mortgage financing.” Initially, Fannie Mae provided this assistance primarily by buying mortgages while Freddie Mac concentrated on securitizing mortgages, a pattern that continued throughout the 1980s.
Again echoing Chariman Greenspan, he stated that the GSEs had migrated to a new strategy:
Since 1990, however, the mortgage portfolio business of both of the housing GSEs has grown rapidly, much to the financial benefit of the Enterprises’ management and shareholders.
The Treasury secretart observed that the GSEs’ favorable capital ratios allow them to take risks greater than purely private regulated financial institutions:
The potential for systemic risk is associated with Fannie Mae’s and Freddie Mac’s large portfolios of mortgages and mortgage-backed securities and other non-related assets, funded at extremely high rates of leverage. The GSEs hold less than one-half the capital of similarly sized financial institutions. The value of these large portfolios [of held mortgages with long-term fixed-interest rates -- Ed.] can fall dramatically when interest rates change because individuals can prepay their mortgages.
He invited Congress to whether Congress (and by inference if not implication, taxpayers) received sufficient benefits for allowing GSEs to take these risks:
These portfolio holdings thus raise fundamental concerns. Are there benefits that outweigh the potential costs? Neither the Treasury nor the Federal Reserve has found evidence that these portfolio holdings (above some minimum threshold) provide meaningful benefits to borrowers. We believe that Congress could usefully consider whether there are meaningful benefits to such holdings, and whether such benefits outweigh the costs.
Secretary Snow also sought to downplay the GSEs’ access to a $2.25 billion (each) Treasury line of credit:
As members of this Committee are aware, the Treasury Secretary has discretion to issue debt in the amount of $2.25 billion to each of Fannie Mae and Freddie Mac and $4 billion to the FHLBs. Some commentators believe that this credit availability reinforces the perception that the Federal government backs the debt obligations of the Enterprises.
This perception is false. In fact, I would exercise the line of credit (which pales in comparison to the size of the debt obligations of the GSEs today) only in the event that a GSE was in significant financial distress and needed the capital to emerge successfully through the receivership process. Congress may wish to consider reforms in this area as well.
Like Chairman Greenspan, the Secretary pointedly questioned what benefits taxpayers (and buyers of affordable homes) might be deriving from these expanded balance sheets (and risks):
Our recommendation to limit the investment portfolios of Fannie Mae and Freddie Mac does not in any way limit their ability to guarantee mortgage-backed securities. In that regard, it is worth noting that Freddie Mac operated a successful credit guarantee business throughout the 1980s with a retained mortgage portfolio that was only a small fraction of its current size. Therefore, given that these core functions of the GSEs are preserved, we see no reason why limits on the GSEs’ retained mortgage portfolios should impair their ability to provide support for affordable housing, including the ability of Fannie Mae and Freddie Mac to meet their affordable housing goals set by HUD.
Finally, he reminded the Congress that other shoes may drop:
The Administration remains troubled that neither Fannie Mae nor Freddie Mac has financial statements filed with the SEC that can be relied upon. Freddie Mac has yet to file any financial statements in conformity with the securities laws, and Fannie Mae is not expected to be able to issue financial restatements for many months or even years.
