GSEs: how to regulate?
“Catastrophe is normally a precondition for improved regulation.”
– Smith’s Hypothesis of public-policy governance evolution.
With Fannie Mae making nice (contrition is free, which is all the more charming when, to judge by past behavior, it is so palpably insincere) and the Bush Administration proposing its own form of GSE regulation, the real action will take place on Capitol Hill today, where the House is scheduled to mark up (government lingo for amend and then vote on) the Baker proposal (HR 1461, full text here). So what is it that has the GSEs suddenly behaving so well?
Let’s take a look. (You can review the bidding at my Fannie Mae posting archive.)
The Baker legislation rests on two fundamental concepts:
- It doesn’t direct outcomes in legislation, instead it establishes a strong regulator. So if you want to see GSEs’ balance sheets shrink, this function is not capped in the legislation, rather it relies on having the regulator be strong and act as such.
- It places the regulator in a position much like a British colonial governor: passive but with powers plenipotentiary that it can exercise when it (the governor) sees fit.
Reading new legislation is sometimes challenging, because it is written structurally rather than conceptually; the challenge is greater here, when the reform proposes to amend an existing statute (the Housing and Community Development Act of 1992), that carries the current GSE regulatory schema. So here’s the conceptual approach (citations are to the proposed sectional amendments to HCDA 1992):
Start by improving internal governance via the board:
- Raise the stakes for GSE directors. Under 1322A, GSE boards must have a majority of independent directors (1322Aa2), who meet eight (!) times a year (1322Aa3), and hold executive sessions “without management participation” (1322Aa4). All of this makes being a director a very substantial job, both as to risks and as to time commitments and skills required. That’s a whole new ballgame compared to the status quo ante.
Then improve external governance:
- Create a strong regulator. The legislation establishes a Federal Housing Finance Agency (FHFA) with a powerful director (1312a), appointed by the President with the advise and consent of the Senate (1313b), who serves for five years and is backed up by a Housing Finance Oversight Board (1313Bc) consisting of him or herself, the Treasury Secretary, the HUD Secretary, and two other presidential appointments, one expert in mortgage markets, one in housing and economic development.
- Empower the regulator. The GSEs themselves pay the entire cost of creating the FHFA (1316a), which at a minimum testifies annually and directly to Congress (1313Bc) not only on financial safety and soundness but also on fulfillment of affordable housing goals (1324a). The regulator can overturn compensation arrangements for senior management, and can direct the GSEs to withhold compensation due management (1318c).
So the entity will have adequate staff, and will be listened to. But we haven’t got to the real teeth yet: control the business’ growth:
- Limit business conduct by establishing and promulgating mandatory standards (1313Aa) on all sorts of critical things: adequacy of internal controls, internal audit systems, credit and counterparty risk, interest rate risk exposure, management of market risk, adequacy of liquidity reserves, investments, records, subordinated debt, risk management processes.
- Control business growth by approving new business areas. Under 1321a, the regulator must approve any new pilots or other initiatives.
Between the business limit standards and the business growth approval processes, the regulator can effectively prescribe and proscribe the GSEs’ business.
- Constrain use of the implicit Federal subsidy/ risk exposure by limiting financial assets. The director can (1313Ab2B) direct the GSE to cap its assets, increase its core capital, or “require the regulated entity to take any other action that the Director determines will better carry out the purposes ….”
- Compel a sound balance sheet. It can require increases in minimum capital (1362d) and can require the GSEs to dispose of or acquire assets (1369Ebm).
The “or acquire” language is relevant, in that it means that, if there is ever a mismatch between assets and liabilities – term, rate, exposure — the regulator can force compliance in either of two directions. That’s real potency.
And now we come to the piece de resistance: how does the regulator assure compliance?
- Allow the regulator to take over the GSEs’ management. The legislation (1364c) establishes four levels of capitalization: adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. (All this is laid out in lengthy detail in Subtitle C of the Baker legislation, its sections 141-144, a whopping 77 pages, 94-171.) As the scaling rises, if the regulator decides a GSE is severely undercapitalized, it can become an immediate receiver.
In a word, ka-boom.
In effect, FHFA director is like an old-style British colonial governor, who can dismiss the entire government (and lest you think this a theoretical construct, in 1975 the duly elected Australian Labour Government of Gough Whitlam was dismissed from office by Her Majesty’s Governor).
Gough Whitlam, sacked by the queen’s governor.
This is structural legislation that preserves the GSEs’ mission and responds to the averted near-catastrophe that faces us with their balance sheets so swollen and exposed to interest-rate mismatch.
I endorse it.
