Fannie Mae and Freddie Mac: Analysis of Options for Revising the Housing Enterprises' Long-term Structures
Published: 2009-10-08T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: This 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.
section_title: What GAO Found
paragraphs: 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.

section_title: Letter
paragraphs: 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). 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.
Congress originally established Fannie Mae and Freddie Mac as  government entities in 1968 and 1989, respectively, chartering them as for- profit, shareholder-owned corporations. 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. 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. 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  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.
subsections: section_title: Enterprises Had a Mixed Record in Achieving Housing Mission Objectives, and Risk Management Deficiencies Compromised Their Safety and Soundness
paragraphs: 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.   (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.  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. 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. 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.
section_title: Options for Restructuring the Enterprises Aim to Achieve Housing Mission Objectives while Mitigating Safety and Soundness Risks
paragraphs: 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).
The following paragraphs summarize key principles and aspects of each  option:  Government corporation or agency. 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. 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. 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.
section_title: A Framework for Analyzing Trade-offs Associated with the Options and Potential Oversight and Regulatory Structures to Help Ensure Their Effective Implementation
paragraphs: 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.
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. 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.
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.
section_title: Federal Efforts to Support Housing Markets during the Conservatorships Could Affect Transition to New Structures
paragraphs: 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. 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.
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