Fannie Mae and Freddie Mac: Analysis of Options for Revising the Housing Enterprises' Long-term Structures
Published: 2009-09-10T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Congress established Fannie Mae and Freddie Mac (the enterprises) with two key housing missions: (1) provide stability in the secondary market for residential mortgages (also in periods of economic stress) and (2) serve the mortgage credit needs of targeted groups such as low-income borrowers. To accomplish these goals, the enterprises issued debt and stock, purchased mortgages from lenders with the proceeds, and retained them in portfolio or pooled them into mortgage-backed securities (MBS) sold to investors. On September 6, 2008, the Federal Housing Finance Agency (FHFA) placed the enterprises into conservatorship out of concern that their deteriorating financial condition ($5.4 trillion in outstanding obligations) would destabilize the financial system. With estimates that the conservatorship will cost taxpayers nearly $400 billion, GAO initiated this report under the Comptroller General's authority to help inform the forthcoming congressional debate on the enterprises' future structures. It discusses the enterprises' performance in meeting mission requirements, identifies and analyzes options to revise their structures, and discusses key transition issues. GAO reviewed studies and data, and interviewed housing finance experts and officials from the enterprises, FHFA, Departments of the Treasury (Treasury) and Housing and Urban Development (HUD), the Federal Reserve, lenders, and community groups.
section_title: What GAO Found
paragraphs: The enterprises have a mixed record in meeting their housing mission objectives, and both capital and risk management deficiencies have compromised their safety and soundness as follows: (1) The enterprises' secondary market activities are credited with helping create a liquid national mortgage market, lowering mortgage rates somewhat, and standardizing mortgage underwriting processes. However, their capacity to support housing finance during periods of economic stress has not been established, and they only have been able to do so during the current recession with substantial financial assistance from Treasury and the Federal Reserve. (2)There is limited evidence that a program established in 1992 that required the enterprises to meet annual goals for purchasing mortgages serving targeted groups materially benefited such groups. (3) The enterprises' structures (for-profit corporations with government sponsorship) undermined market discipline and provided them with incentives to engage in potentially profitable business practices that were risky and not necessarily supportive of their public missions. For example, the enterprises' retained mortgage portfolios are complex to manage and expose them to losses resulting from changes in interest rates. Further, the enterprises' substantial investments in assets collateralized by subprime and other questionable mortgages in recent years generated losses that likely precipitated the conservatorship. It will be necessary for Congress to reevaluate the roles, structures, and performance of the enterprises, and to consider options to facilitate mortgage finance while mitigating safety and soundness and systemic risk concerns. These options generally fall along a continuum with some overlap in key areas: (1)Reconstitute the enterprises as for-profit corporations with government sponsorship but place additional restrictions on them. While restoring the enterprises to their previous status, this option would add controls to minimize risk. As examples, it would eliminate or reduce mortgage portfolios, establish executive compensation limits, or convert the enterprises from shareholder-owned corporations to associations owned by lenders. (2) Establish the enterprises as government corporations or agencies. Under this option, the enterprises would focus on purchasing qualifying mortgages and issuing MBS but eliminate their mortgage portfolios. The Federal Housing Administration (FHA), which insures mortgages for low-income and first-time borrowers, could assume additional responsibilities for promoting homeownership for targeted groups. (3) Privatize or terminate them. This option would abolish the enterprises in their current form 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. During the conservatorship, the federal government has tasked the enterprises to implement a variety of programs designed to help respond to the current housing crisis, such as helping borrowers forestall foreclosures. While these efforts may be necessary to help mitigate the effects of the housing crisis, they also might significantly affect the costs of the conservatorship and transition to a new structure. For example, investors might be unwilling to invest capital in reconstituted enterprises unless Treasury assumed responsibility for losses incurred during their conservatorship. Finally, any transition to a new structure would need to consider the enterprises' still-dominant position in housing finance and be implemented carefully (perhaps in phases) to ensure its success.

section_title: Letter
paragraphs: On September 6, 2008, the Federal Housing Finance Agency (FHFA)  placed Fannie Mae and Freddie Mac into conservatorship out of concern  that the deteriorating financial condition of the two government- sponsored enterprises (GSE or enterprise) threatened the stability of  financial markets. According to FHFA’s former Director, James B.  Lockhart III, at the time the conservatorships were established, Fannie  Mae and Freddie Mac had worldwide debt and other financial obligations  totaling $5.4 trillion, and their default on those obligations would have  significantly disrupted the U.S. financial system. The Department of the  Treasury (Treasury) has agreed to provide substantial financial support to  the enterprises so that they can continue to support mortgage finance  during the current financial crisis. As of June 30, 2009, Treasury had  provided about $85 billion in funds to support the enterprises. The  Congressional Budget Office (CBO) has estimated that the total cost of the  conservatorships to taxpayers will be $389 billion. The Board of  Governors of the Federal Reserve System (Federal Reserve) also has  committed to a variety of activities, including purchasing substantial  amounts of the enterprises’ debt and securities, to support housing  finance, housing markets, and the financial markets more generally. While  the conservatorships can remain in place indefinitely as efforts are  undertaken to stabilize the enterprises and restore confidence in financial  markets, FHFA has 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. To accomplish this goal, the  enterprises issued debt and stock and used the proceeds to purchase  conventional mortgages that met their underwriting standards, known as  conforming mortgages, from primary mortgage 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 that they  purchased in their portfolios. However, most of the mortgages were  packaged into mortgage-backed securities (MBS), which were sold to  investors in the secondary mortgage market. In exchange for a fee (the  guarantee fee) the enterprises guaranteed the timely payment of interest  and principal on MBS that they issued. The charter requirements for  providing assistance to the secondary mortgage markets specify that those  markets are to include mortgages on residences for low- and moderate- income families. In 1992, Congress instituted authority for requiring the  enterprises to meet numeric goals set by the Department of Housing and  Urban Development (HUD) on a yearly basis for the purchase of single-  and multifamily conventional 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 the  federal government’s sponsorship conveyed certain financial and other  advantages to the enterprises that encouraged them to engage in riskier  activities than otherwise would be the case. In particular, despite the  federal government explicitly not guaranteeing the enterprises’ debt and  MBS or including them in the federal budget, there was an assumption in  financial markets of an “implied” federal guarantee, which enabled the  enterprises to borrow at lower rates than other for-profit corporations.  Critics argued that this implicit government guarantee and access to less  costly credit created a moral hazard. That is, it encouraged the enterprises  to assume greater risks and hold less capital than would have been the  case in the absence of such a guarantee.
According to former Treasury Secretary Henry M. Paulson, Jr., the FHFA  conservatorships provide an opportunity for Congress to reconsider the  nature and structure of the enterprises and make revisions to better  ensure their safety and soundness as they participate in efforts to stabilize  the mortgage markets. Researchers and research institutes, financial  commenters and market participants, and others have made a variety of  proposals about the future structure of Fannie Mae and Freddie Mac, both  before and after the establishment of the FHFA conservatorships. Some  proposals call for converting the enterprises into government entities  while others advocate privatization or termination. While there is no  consensus on what the next steps should be, whatever actions Congress  takes will have profound impacts on the structure of the U.S. housing  finance system.
We initiated this review under the Comptroller General’s authority to  provide Congress with information on the roles, benefits, and risks  associated with the enterprises’ activities in housing finance over the years  and to help inform the forthcoming deliberation on their future structure.  Specifically, this report (1) discusses how the enterprises’ roles,  structures, and activities have changed over time and their performance in  achieving key housing mission objectives; (2) identifies various options for  revising the enterprises’ eventual structure; (3) analyzes these options in  terms of their potential capacity to achieve key housing mission and safety  and soundness objectives; and (4) discusses 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 also met with researchers who  wrote relevant reports or were knowledgeable on 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. Through such research and  interviews, we sought to identify (1) key housing mission, safety and  soundness, and other objectives that have been associated with the  enterprises over the years; (2) options to reform the enterprises’ structures  and how they would affect these objectives; and (3) principles associated  with effective regulatory oversight structures. While it is not possible to  conclusively determine the potential implications of the various proposals,  we grounded our analysis of likely outcomes on previous research and  evaluations. We also sought to include, where appropriate, assessments of  how recent developments in financial markets, particularly actions by  federal agencies to provide financial support to troubled banks and other  institutions, could affect the operations of the various options. We  recognize that a variety of factors could change over time, such as the  condition of credit markets and the financial performance of the  enterprises while in conservatorship, which could affect our analysis of  the options. A more detailed analysis of our objectives, scope, and  methodology is included in appendix I.
We conducted this performance audit from October 2008 to September  2009, in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: The enterprises constitute one component of a range of federal initiatives  that, since the 1930s, have facilitated the availability of mortgage credit  and housing opportunities (see table 1). While these initiatives may involve  differing missions, structures, and activities, they generally rely on federal  support and subsidies to achieve their objectives. In some cases, these  initiatives—such as the Federal Home Loan Bank System (FHLBank  System), the enterprises’ general mortgage support activities, federal tax  deductions for mortgage interest, and exemptions for capital gains—apply  broadly and are designed generally to facilitate mortgage lending and  homeownership. In other cases, the initiatives have been designed to  facilitate home ownership and housing opportunities for targeted  populations and groups. For example, programs administered by the  Federal Housing Administration (FHA), Department of Veterans Affairs  (VA), Department of Agriculture’s Rural Development Housing and  Community Facilities Programs (USDA/RD), and HUD’s Office of Public  and Indian Housing (PIH) are designed to facilitate homeownership and  housing opportunities for moderate- and low-income persons, as well as  first-time buyers, veterans, residents of rural areas, and Native Americans,  respectively. In some cases, these federal housing initiatives also target  similar populations and borrowers. For example, through their general  business activities and affordable housing goal requirements, the  enterprises, like FHA, provide mortgage credit to low-income borrowers  and other targeted groups.
subsections: section_title: Establishment and Management of the FHFA Conservatorships
paragraphs: During 2007 and the first half of 2008, Fannie Mae’s and Freddie Mac’s  financial conditions deteriorated significantly, which FHFA officials said  prompted the agency to establish the conservatorships. As later described  in this report, the enterprises incurred substantial credit losses on their  retained portfolios and their guarantees on MBS. These credit losses  resulted from pervasive declines in housing prices, as well as specific  enterprise actions such as their guarantees on MBS collateralized by  questionable mortgages (mortgages with limited or no documentation of  borrowers’ incomes), and investments in private-label MBS collateralized  by subprime mortgages. In July 2008, Fannie Mae’s and Freddie Mac’s  financial condition deteriorated, which prompted congressional and  Executive Branch efforts to stabilize the enterprises and minimize  associated risks to the financial system. In particular, Congress passed and  the President signed the Housing and Economic Recovery Act of 2008  (HERA) which, among other things, established FHFA. HERA sets forth  FHFA’s regulatory responsibilities and supervisory powers, which include  expanded authority to place the enterprises in conservatorship or  receivership, and provides Treasury with certain authorities to provide  financial support to the enterprises, which are discussed below. While  Treasury and other federal regulatory officials stated in July 2008 that the  conservatorship or other major measures likely would not be necessary,  the enterprises’ financial conditions continued to deteriorate. According to  FHFA and Treasury officials, their ongoing financial analysis of Fannie  Mae and Freddie Mac in August and early September 2008, as well as  continued investor concerns about the financial condition of each  enterprise, resulted in FHFA’s imposition of the conservatorships on  September 6, 2008, to help ensure the enterprises’ viability, fulfill their  housing missions, and stabilize financial markets.
As conservator of the enterprises, FHFA has replaced their Chief  Executive Officers, appointed new members of the boards of directors,  assumed responsibility for overseeing key business decisions, and ceased  the enterprises’ lobbying activities. While FHFA oversees key enterprise  business decisions, agency officials said that they expect enterprise  managers to continue to run day-to-day business activities. FHFA officials  also said that the agency’s staff continues to oversee the enterprises’  safety and soundness and housing mission achievement. For example,  FHFA officials said that agency examiners are located on-site at each  enterprise to assess their ongoing financial performance and risk  management.
Since FHFA became conservator, the enterprises have been tasked by the  federal government to help respond to the current housing and financial  crisis. For example, in November 2008, the enterprises suspended the  initiation of foreclosure proceedings on mortgages that they held in their  portfolios or on which they had guaranteed principal and interest  payments for MBS investors, and this initiative subsequently was extended  through March 31, 2009. Furthermore, under the administration’s  Homeowner Affordability and Stability Plan, which was announced on  February 18, 2009, the enterprises are tasked to (1) provide access to low- cost refinancing for loans they own or guarantee to help homeowners  avoid foreclosures and reduce monthly payments and (2) initiate a loan  modification plan for at-risk homeowners that will lower their housing  costs through a combination of interest rate reductions, maturity  extensions, and principal forbearance or forgiveness.
section_title: Treasury Has Been Providing Financial Support to the Enterprises during Their Conservatorships
paragraphs: As authorized by HERA, the Secretary of the Treasury entered into  agreements with Fannie Mae and Freddie Mac on September 7, 2008, to  provide substantial financial support to the enterprises and thereby  minimize potential systemic financial risks associated with their  deteriorating financial condition. Specifically, Treasury has entered into  agreements and announced the following initiatives:    Enhance the enterprises’ financial solvency by purchasing their senior  preferred stock and making funding available on a quarterly basis, to be  recovered by redemption of the stock or by other means. While the initial  funding commitment for each enterprise was capped at $100 billion,  Treasury increased the cap to $200 billion per enterprise in February 2009  to maintain confidence in the enterprises. As of June 30, 2009, Treasury  had purchased approximately $50.7 billion in Freddie Mac preferred stock  and $34.2 billion in Fannie Mae preferred stock under the agreements. As  part of the preferred stock purchase agreement, Treasury has received  warrants to buy up to 79.9 percent of each enterprise’s common stock for  $0.00001 per share. The warrants are exercisable at any time and should  the enterprises’ financial conditions improve sufficiently, the warrants  would help the government recover some of its investments in the  enterprises. However, according to CBO, it is unlikely that the federal  government will recover much of its massive financial investments in the  enterprises. Treasury also is to receive dividends on the enterprises’  senior preferred stock at 10 percent per year and, beginning March 31,  2010, quarterly commitment fees from the enterprises.
Purchase MBS until December 31, 2009, when the purchase authority  expires. From September 2008 through July 2009, Treasury purchased  $171.8 billion in the enterprises’ MBS. While Treasury’s authority under  HERA to make such MBS purchases expires at the end of 2009, it may  continue to hold previously purchased MBS in its portfolio beyond that  date.
Establish a temporary secured credit lending facility that allows the  enterprises, as well as the FHLBank System, to borrow funds in the event  they face difficulties issuing debt in financial markets. Under this Treasury  program, the enterprises are to collateralize any borrowings with their  MBS and the FHLBanks are to collateralize such borrowings with  mortgage assets. To date, neither the enterprises nor any FHLBanks have  used this borrowing authority, and Treasury’s authority for this program  expires at the end of 2009.
section_title: The Federal Reserve’s Steps to Improve Conditions in the Mortgage Markets
paragraphs: The Federal Reserve also has agreed to acquire substantial amounts of  debt and MBS of the enterprises and other entities in order to reduce the  cost and increase the availability of credit for the purchase of homes, and  to foster improved conditions in financial markets. In November 2008, the  Federal Reserve announced it would purchase up to $100 billion of debt  issued by Fannie Mae, Freddie Mac, and the FHLBank System, and up to  $500 billion in MBS guaranteed by Fannie Mae, Freddie Mac, and Ginnie  Mae. On March 18, 2009, the Federal Reserve announced that during the  current year it would purchase an additional $100 billion of the  enterprises’ debt up to a total of $200 billion and an additional $750 billion  of enterprise MBS up to a total of $1.25 trillion. As of August 19, 2009, the  Federal Reserve had purchased $111.8 billion in federal agency housing  debt securities and $609.5 billion in guaranteed MBS.
section_title: The Enterprises Had a Mixed Record on Achieving Housing Mission Objectives, and Risk-Management Deficiencies Compromised Their Safety and Soundness
paragraphs: To help inform the forthcoming congressional consideration of the  enterprises’ future purposes and structures, this section discusses key  aspects of their histories and performance in achieving key housing  mission and safety and soundness objectives. Specifically, in this section,  we discuss (1) the enterprises’ changing roles, structures, and activities  over the years; (2) their performance in supporting mortgage finance  consistent with charter obligations; (3) the extent to which the numeric  housing goals may have materially benefited homeownership  opportunities for targeted groups; and (4) the effect of the enterprises’  risk-management practices on their safety and soundness.
subsections: section_title: Enterprises’ Roles, Structures, Activities, and Regulatory Oversight Underwent Important Changes since the 1930s
paragraphs: As discussed below, the enterprises underwent important structural  changes over the decades and accrued diverse missions and activities  relating to the public and for-profit aspects of their structures and  functions. Table 2 provides a time line that summarizes the key events in  the federal housing finance system related to the enterprises over the past  77 years.
Prior to the 1930s, the federal government did not play a direct role in  supporting housing finance. Typically lenders—mainly savings and loans  (thrifts), but also banks—originated short-term mortgages (from 3 to 10  years). Since thrifts and banks primarily served local markets, regional  differences in the demand for and supply of mortgage credit resulted in  regional disparities in mortgage interest rates and credit availability.  During the Great Depression, thousands of thrifts and banks failed due to  their credit losses, and housing finance generally became unavailable.
In response, the federal government established institutions and initiatives  to revive the housing finance market. In 1932, Congress established the  FHLBank System—the first housing GSE—to provide short-term loans  (called advances) to member savings and loans institutions that would use  them to fund home mortgages. Additionally, Congress established FHA in  1934 in part to promote and insure long-term housing mortgages (up to 20  years) that called for borrowers to pay off the principal and interest of  loans over a specified number of years. Fannie Mae was established by  FHA under authority provided in 1938 as a government-held association to  buy and hold mortgages insured by FHA, thereby providing additional  liquidity to the mortgage market. During the 1940s, Congress authorized  Fannie Mae to purchase VA-guaranteed mortgages to facilitate the efforts  of veterans to purchase homes.
The Housing Act of 1954 instituted Fannie Mae as a mixed-ownership  corporation and specified in its federal charter the entity’s role and  requirements that subsequently served as some of the enterprises’ key  housing mission objectives. Among its provisions, the act required  Fannie Mae to (1) provide liquidity for mortgage investments to improve  the availability of capital for home mortgage financing and (2) support t mortgage market when there was a threat to the stability of the economy.  The 1954 act also provided Fannie Mae with certain financial benefits  thought necessary to carry out its objectives, such as exemptions from all  local taxes except property taxes. Lenders that sold mortgages to Fannie  Mae were required to purchase stock in it, but the federal government  remained the enterprise’s majority owner.
Throughout the late 1950s and 1960s, Fannie Mae’s purchases of FHA- insured and VA-guaranteed mortgages increased substantially. During this  period, limits on interest rates that banks and thrifts could offer for  deposits and restrictions on their ability to branch across state lines  contributed to liquidity constraints and continuing regional disparities in  mortgage interest rates. By operating across the nation, Fannie Mae could  help alleviate such scarcities and disparities.
subsections: section_title: Congress Established Fannie Mae and Freddie Mac as For- profit Corporations in 1968 and 1970, Respectively, to Carry Out Housing Missions
paragraphs: In 1968, the Housing and Urban Development Act (the 1968 act)  reorganized Fannie Mae as a for-profit, shareholder-owned company with  government sponsorship and established Ginnie Mae as an independent  government corporation in HUD. Ginnie Mae’s primary function was to  guarantee the timely payment of principal and interest from pools of FHA-,  USDA/RD-, and PIH-insured and VA-guaranteed mortgages. Ginnie Mae  has the full faith and credit backing of the federal government. Although  now a for-profit, shareholder-owned company, Fannie Mae continued its  activities, which were mainly purchasing FHA and VA mortgages.  According to some financial analysts, Congress largely reorganized Fannie  Mae as a private company for budgetary purposes (that is, to remove its  financial obligations from the federal budget). The 1968 act also gave the  HUD Secretary general regulatory authority over Fannie Mae, as well as  authority to require that a reasonable portion of its mortgage purchases  serve low- and moderate-income families. The Secretary subsequently  established numeric housing goals for Fannie Mae that essentially required  that at least 30 percent of its purchases serve low- and moderate-income  families, and at least 30 percent serve families living in central cities.
However, HUD was not given authority to collect data that would be  necessary to determine compliance with the goals.
In the Emergency Home Finance Act of 1970, Congress chartered Freddie  Mac as a housing GSE to help mitigate business challenges facing the thrift  industry. Increasing interest rates had undermined thrifts’ capacity to  finance long-term mortgages held in their portfolios. Freddie Mac was to  purchase long-term mortgages from thrifts and thereby help stabilize the  industry and enhance its capacity to fund additional mortgages. As a  result, Freddie Mac was the first enterprise to develop products to  facilitate securitization of mortgage loans. Freddie Mac was first owned by  the Federal Home Loan Bank Board, which regulated the thrift industry.  Freddie Mac did not become a shareholder-owned company like Fannie  Mae until it was reorganized in 1989. While subject to HUD’s general  regulatory oversight under the 1989 legislation, Freddie Mac initially was  not subject to the same mortgage purchase goals as Fannie Mae.
Although both Freddie Mac and Fannie Mae were to provide a secondary  market for conventional mortgages, they pursued markedly different  business strategies in the 1970s and 1980s. Freddie Mac focused its  business activities on purchasing conforming, conventional mortgages  from thrifts and issuing MBS rather than holding mortgages in its portfolio.  According to a Freddie Mac official, this business strategy was intended to  help the thrift industry manage interest-rate risk by passing such risk to  the MBS investors. In contrast, Fannie Mae followed its traditional  business strategy by purchasing mortgages and holding them in its  portfolio. During the early 1980s, Fannie Mae experienced substantial  losses, as did the thrift industry, due to sharply rising interest rates while  Freddie Mac’s financial performance generally was unaffected. During this  period, the federal government provided certain financial benefits to  Fannie Mae, such as regulatory forbearance and tax benefits, to help it  recover. After Freddie Mac was turned into a for-profit, shareholder- owned corporation in 1989, it began to hold more mortgages in its retained  portfolio, similar to Fannie Mae.
section_title: Congress Revised Enterprise Regulation in 1992 to Better Ensure Safety and Soundness and Help Manage the Potential Conflict between Their Profit Motives and Housing Missions
paragraphs: By 1992, Congress concluded that the enterprises posed potential safety  and soundness risks, and regulations that had been in place since 1968  were inadequate to manage such risks. Over the years, the enterprises had  become large and complex organizations, and Fannie Mae’s financial  difficulties in the early 1980s indicated that they posed risks to taxpayers  and financial stability. Furthermore, HUD had not fulfilled its statutory  responsibility to monitor the enterprises’ financial operations and risks.  For example, HUD did not routinely examine the enterprises’ financial  activities or promulgate regulations necessary to help ensure their safe  and sound operations. There was also a concern that the enterprises were  not adequately serving the mortgage credit needs of low- and moderate- income borrowers and other targeted groups due to their potentially  higher default risks. In a 1996 report, we noted that, in 1992, there was a  perception that the enterprises’ distribution of conventional, conforming  loan funding to low- and moderate-income borrowers was lagging behind  the primary mortgage market, and a Federal Reserve study was consistent  with this perception. Moreover, HUD did not enforce the housing goals— which at that time applied only to Fannie Mae—or collect the data  necessary to do so.
In enacting the Federal Housing Enterprises Safety and Soundness Act of  1992 (the 1992 Act), Congress fundamentally revised regulation of the  enterprises and took steps to clarify Fannie Mae’s and Freddie Mac’s roles  within the housing finance system and better define their public housing  mission responsibilities. For example, the 1992 Act reiterated the  enterprises’ long-standing obligations to support mortgage finance through  secondary market activities, including during stressful economic periods,  and clarified and expanded the enterprises’ charter obligations to facilitate  the flow of mortgage credit serving targeted groups. Moreover, the 1992  Act set forth oversight authority and mechanisms to better manage  potential conflicts between the enterprises’ profit motivations and housing  missions.
First, it established OFHEO as an independent agency in HUD responsible  for the enterprises’ safety and soundness. Among other things, OFHEO  was given supervisory authority to establish and monitor compliance with  minimum and risk-based capital standards and conduct routine safety and  soundness examinations. In so doing, Congress established a safety and  soundness regulatory framework that resembled the supervisory  framework for insured depository institutions such as banks and thrifts,  although OFHEO’s authority was less extensive.
Second, the 1992 Act expanded the enterprises’ previous housing mission  responsibilities by requiring them to meet specific annual goals for the  purchase of mortgages serving targeted groups. Specifically, it directed the  HUD Secretary to promulgate regulations setting annual housing goals for  both Fannie Mae and Freddie Mac for the purchase of mortgages serving  low- and moderate-income families; special affordable housing for families  (i.e., low-income families in low-income areas, and very low-income  families); and housing located in central city, rural, and other underserved  areas. The 1992 Act also provided HUD with the authority to collect data  necessary to monitor the enterprises’ compliance with the goals and to  enforce such compliance. It should be noted that the enterprises’  affordable housing goals required them to compete with other federal  initiatives to support housing, particularly FHA’s mortgage insurance  programs that also primarily serve low- and moderate-income borrowers  and first-time homeowners. This issue is discussed in more detail later in  this report.
Third, the 1992 Act set forth HUD’s regulatory authority over the  enterprises and specified procedures that HUD must follow when  reviewing and approving new mortgage program proposals by the  enterprises. That is, it directed the HUD Secretary to approve any new  program that an enterprise proposed, unless the Secretary determined that  the program violated the enterprise’s charter or would not be in the public  interest. Additionally, the 1992 Act required the HUD Secretary, for a  specified transition period, to reject a new program proposal if the  Director of OFHEO determined that the proposal would risk a significant  financial deterioration of the enterprise.
section_title: Despite Improvements, Limitations in Oversight Continued to Affect The Enterprises’ Safety and Soundness and Mission Compliance
paragraphs: While the 1992 Act enhanced the enterprises’ regulatory structure in  several important respects, it still had important limitations in its capacity  to ensure the enterprises’ safety and soundness and housing mission  compliance. First, federal oversight of the enterprises and the FHLBank  System was divided among OFHEO, HUD, and FHFB—which was the  safety and soundness and housing mission regulator for the FHLBank  System. However, OFHEO and FHFB were small agencies that lacked the  resources necessary to monitor large and complex financial organizations  from the standpoint of safety and soundness, as well as mission goals.  Furthermore, as compared with federal bank regulators, both OFHEO and  FHFB lacked key authorities—such as authority to take enforcement  actions based on declining capital levels and unsound financial practices— that were available to federal bank regulators.
Enterprise regulation also had limited capacity to address potential  conflicts between the enterprises’ profit motivations and their federally  mandated housing missions. In particular, we noted that, due to the  financial benefits derived from their federal charters and their dominant  position within the mortgage finance system, the enterprises had financial  incentives to engage in potentially profitable activities that were not fully  consistent with their charter obligations and restrictions. For example,  Freddie Mac, during the mid-1990s, had invested in nonmortgage assets,  such as long-term corporate bonds, that potentially allowed the enterprise  to earn higher returns based on the enterprises’ funding advantage.  Freddie Mac argued that its investments in nonmortgage assets were  permissible and necessary to help manage the liquidity of its investment  portfolio. Although HUD had general regulatory and new mortgage  program authorities, it was not clear if HUD was well-positioned to assess  such arguments or the extent to which the enterprises may have been  straying from their charter obligations and restrictions. At that time, HUD  officials said that they lacked staff with the expertise necessary to oversee  large and complex financial institutions and determine if the enterprises’  activities were consistent with their charters and housing finance  missions.
By retaining the enterprises’ off-budget status as GSEs, the 1992 Act  permitted a continuation of the lack of transparency about the enterprises’  risks and potential costs to taxpayers. Under the Federal Credit Reform  Act of 1990, the potential costs associated with many direct federal loan  and loan guarantee programs have to be disclosed in the federal budget.  Congress and the Executive Branch can use such disclosures to assess the  potential costs and future risks of such programs and take steps on a  timely basis to potentially mitigate such costs and risks (for example,  tightening eligibility criteria). Despite the implied federal guarantee of  their obligations, the government’s exposure in connection with the  enterprises is not disclosed in the federal budget because GSE activities  were excluded from the federal budget totals. The 1992 Act did not  change the status of the enterprises as off-budget entities. However, it  should be noted that such financial disclosures could have involved an  offsetting risk. Such treatment might have increased the perception that,  despite the enterprises’ statements to the contrary, the federal government  would provide financial support to them in an emergency, which may have  further reduced market discipline and enterprise actions to mitigate risks.
Congress substantially revised the enterprises’ regulatory structure with  the passage of HERA in 2008. In HERA, Congress abolished OFHEO and  FHFB and established FHFA as the regulator of the enterprises and the  FHLBank System. HERA charges FHFA with responsibility for housing  GSE safety and soundness. In this regard, HERA augments the safety and  soundness responsibilities and authorities administered by the  predecessor agencies. Additionally, HERA transferred responsibility for  the enterprises’ mission oversight, including their satisfaction of numeric  goals for purchases of mortgages to low- and moderate-income borrowers  and the review and approval of enterprise new mortgage programs, from  HUD to FHFA. FHFA’s supervisory authority over safety and soundness  matters includes specific authority to place the housing GSEs into  conservatorship or receivership based on grounds set forth in HERA.  Since placing Fannie Mae and Freddie Mac into conservatorship in  September 2008, FHFA has appointed new Chief Executive Officers and  boards of directors at each enterprise and stands in lieu of shareholders in  matters of corporate governance. In contrast, FHFA’s role with respect to  the FHLBank System has remained solely that of an independent  regulator.
section_title: The Enterprises’ Performance in Achieving Key Housing Finance Support Objectives Has Been Mixed
paragraphs: It is generally accepted that the enterprises have been successful in  enhancing liquidity in the mortgage finance system as directed in their  charters. We have reported that the enterprises established a viable  secondary mortgage market for conventional loans that enabled capital to  flow to areas with the greatest demand for mortgage credit. This free  flow of capital tended to equalize interest rates across regions for  mortgages with similar risk characteristics. However, the removal of  restrictions on the ability of banks and thrifts to pay market rates for  deposits and to operate across state lines also have contributed to  mortgage liquidity and the establishment of an integrated national  mortgage finance system.
The enterprises’ activities also have been credited with achieving other  benefits consistent with their charter obligations to support mortgage  finance, which include the following:    Lowering mortgage interest rates on qualifying mortgages below what they  otherwise would be. GAO and others have stated that the advantageous  borrowing rates that the enterprises derived from the implied federal  guarantee on their financial obligations were passed on to borrowers to  some degree, although estimates vary. However, we also have noted that  these benefits were not entirely passed along to homebuyers. Rather, the  enterprises’ shareholders and senior management also benefited for many  years from the relatively higher profits that the companies achieved due to  cost savings associated with the implied guarantee.
Establishing standard underwriting practices and forms for conventional  mortgages. Due to the enterprises’ large purchases of conventional  mortgages each year, their underwriting guidelines and forms became the  industry standard. GAO and others have found that standardization  facilitated the efficiency of the mortgage underwriting process and  resulted in cost savings for lenders and borrowers. The enterprises’ efforts  to standardize mortgage underwriting likely also helped develop the MBS  market, as consistent standards are viewed as critical for helping investors  evaluate risks.
However, the extent to which the enterprises have been able to support a  stable and liquid secondary mortgage market during periods of economic  stress, which are key charter and statutory obligations, is not clear. In  1996, we attempted to determine the extent to which the enterprises’  activities would support mortgage finance during stressful economic  periods by analyzing Fannie Mae’s mortgage activities in some states,  including oil producing states such as Texas and Louisiana, beginning in  the 1980s. Specifically, we analyzed state-level data on Fannie Mae’s  market shares and housing price indexes for the years 1980–1994. We did  not find sufficient evidence that Fannie Mae provided an economic  cushion to mortgage markets in those states during the period analyzed.
During the current financial crisis, the enterprises have provided critical  support to mortgage finance, but only with the benefit of substantial  financial assistance provided by Treasury and the Federal Reserve during  the conservatorships. As shown in figure 1, the enterprises and Ginnie Mae  accounted for nearly 60 percent of MBS issuances in 2006, while private- label issuances, such as MBS collateralized by pools of subprime and  jumbo mortgages, accounted for nearly 40 percent. By the end of 2008, the  enterprises and Ginnie Mae accounted for about 97 percent of MBS  issuances, while private-label issuances stood at about 3 percent due to  the collapse of many subprime lenders and the associated reduction in  nonconforming mortgage origination and precipitous downturn in  securitization markets. According to FHFA’s former Director, one of the  reasons that the agency established the conservatorships in September  2008 is that the financial challenges the enterprises were facing as  independent entities compromised their capacity to support mortgage  finance. For example, the enterprises’ mortgage purchases slowed in 2008,  and they planned to raise certain fees to help offset their losses. While the  enterprises are now a critical component of the federal government’s  response to the housing crisis, such support would not be possible without  Treasury’s financial support and the Federal Reserve’s plans to purchase  almost $1.45 trillion of their MBS and debt obligations as well as those of  other entities.
section_title: Evidence to Support Effectiveness of Enterprises’ Program to Increase Purchases of Mortgages Serving Targeted Groups Is Limited
paragraphs: While the enterprises’ numeric housing goal mortgage purchase program  has been in place for more than 10 years, its effectiveness in supporting  homeownership opportunities for targeted groups and areas is not clear.  Pursuant to the 1992 Act, HUD established interim goals for 1993 and 1994,  which were extended through 1995, and final goals for the period from  1996 through 1999. In 1998, we found these were conservative goals, which  placed a high priority on maintaining the enterprises’ financial  soundness. For example, according to research conducted by HUD and  OFHEO, the additional mortgage purchases required under the goals were  modest and would not materially affect the enterprises’ financial  condition. HUD also established housing goals in 2000 (covering 2001– 2004) and in 2004 (covering 2005–2008). According to a speech by the FHA  Commissioner in 2005, the 2004 goals established significantly higher  requirements than the 2000 goals.
According to HUD data, the enterprises generally have met the numeric  housing goals since the beginning of the program. For example, table 3  shows that Fannie Mae and Freddie Mac met the low- and moderate- income housing goals in place from 2002 through 2007. However, the  enterprises failed to meet this goal in 2008, and, according to HUD, did not  meet certain subgoals in 2007.
Although the enterprises generally satisfied the numeric purchase goals  through 2007, HUD and independent researchers have had difficulty  identifying tangible benefits for targeted groups associated with the  enterprises’ purchase program. In setting higher housing goals beginning  in 2005, HUD stated that the intent was to encourage the enterprises to  facilitate greater financing and homeownership opportunities for the  groups targeted by the goals. HUD concluded that, although the  enterprises had complied with previous goals, they continued to serve less  of the affordable housing market than was served by conventional  conforming primary market lenders during those years. Furthermore,  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 target groups have  been limited. For example, a 2003 study that modeled the impacts of the  housing goals found that the enterprises likely increased credit in  specified areas in only 1 of the 5 years included in the model. A 2006  study concluded that the enterprises’ purchases of mortgages in certain  targeted low- and moderate-income areas (census tracts in California  during the 1990s with depressed housing markets) generally did not  increase homeownership rates as compared with other low- and moderate- income areas that were not specifically targeted by the numeric housing  goals. The research found only one low-income target area (in San  Francisco) that showed improvements in homeownership rates as a result  of the enterprises’ activities.
Another study suggested that enterprise-FHA interactions in the same  areas may help explain why the program’s benefits were limited. While  the enterprises’ numeric mortgage purchase program and FHA’s mortgage  insurance were intended to benefit similar targeted groups, such as low- income and minority borrowers, the study suggested that the programs  may have offset each other. That is, as the enterprises increased their  mortgage purchases in areas with concentrations of targeted groups, FHA  activity declined in those areas. According to the study, while the  relatively lower costs of conventional loans compared with FHA-insured  loans provided benefits for those households able to switch to a  conventional loan, this cost differential also permitted the enterprises to  attract an increasing share of the most creditworthy targeted borrowers in  these areas, which FHA had served before. In response to losing its more  creditworthy borrowers, FHA could have retained market share by  reaching for borrowers that represented greater credit risks and either   (1) accepted the riskier portfolio wholesale or (2) increased premiums to  insure itself against expected losses. However, the study concluded that  FHA applied stricter underwriting standards and reduced its loan volume.  Therefore, the overall impact of the two programs on promoting  homeownership opportunities in these areas was limited. After 2002, both  the enterprises’ and FHA’s market share declined in areas with  concentrations of low-income and minority groups as subprime lending  grew in size, which may have limited the impact of both the enterprises’  housing goal program and FHA’s mortgage insurance activities.
Earlier research sponsored by HUD in 2001 largely discounted the alleged  benefits for affordable multifamily finance resulting from the enterprises’  numeric mortgage goals. According to the research, 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 other multifamily  mortgage providers. In contrast, representatives from mortgage finance,  housing construction, and consumer groups we contacted said that the  benefits from the enterprises’ purchases of affordable multifamily  mortgages pursuant to their goals have been significant. The  representatives said that the enterprises’ involvement and, in some cases,  guarantees on the financing of affordable multifamily projects, which may  be complex and involve a variety of government and private-sector  entities, were crucial to their successful completion. In addition, the  representatives said that 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  during the current financial crisis.
section_title: The Enterprises’ Risk- management and Operational Practices Have Been Deficient
paragraphs: While housing finance may have derived some benefits from the  enterprises’ activities over the years, GAO, federal regulators, researchers,  and others long have argued that the enterprises had financial incentives  to engage in risky business practices to strengthen their profitability partly  because of the financial benefits derived from the implied federal  guarantee on their financial obligations. For example, during the late 1990s  and early 2000s, we raised concerns about the rapid growth of the  enterprises’ retained mortgage portfolios, which reached about $1.6  trillion by 2005 (see fig. 2). Although increasing the size of their mortgage  portfolios may have been more profitable than issuing MBS, it also  exposed the enterprises to significant interest-rate risk. We reported that  the rapid increase in the enterprises’ mortgage portfolios and the  associated interest-rate risk did not result in a corresponding benefit to the  achievement of their housing missions. For example, the rapid growth in  the enterprises’ retained mortgage portfolios in the late 1990s, and in 2003  through 2004, occurred during periods of strong economic growth when  mortgage markets did not necessarily require the enterprises to be robust  portfolio lenders.
In 2003 and 2004, OFHEO found that Freddie Mac and Fannie Mae  manipulated accounting rules so that their public financial statements  would show steadily increasing profits over many years and thereby  increase their attractiveness to potential investors. The misapplication of  accounting rules generally involved standards for reporting on derivatives,  which the enterprises used to help manage the interest-rate risks  associated with their large retained mortgage portfolios. According to  investigative reports, the enterprises also may have manipulated their  financial reports to show consistently increasing profits to help ensure  senior executives would receive bonuses. OFHEO also found that the  enterprises lacked key operational capacities, such as information systems  and personnel, necessary to manage large mortgage portfolios and  account for them correctly. The enterprises were required to restate their  financial statements and adjust their earnings reports by billions of dollars.
While the enterprises were subject to increased OFHEO scrutiny because  of these accounting and operational deficiencies in 2004 and 2005, they  still embarked on aggressive strategies to purchase mortgages and  mortgage assets with questionable underwriting standards. For example,  they purchased a large volume of what are known as Alt-A mortgages,  which typically did not have documentation of borrowers’ incomes and  had higher loan-to-value ratio or debt-to-income ratios. Furthermore, as  shown in figure 3, enterprise purchases of private-label MBS increased  rapidly as a percentage of retained mortgage portfolios from 2003 through  2006. By the end of 2007, the enterprises collectively held more than $313  billion in private-label MBS, of which $94.8 billion was held by Fannie Mae  and $218.9 billion held by Freddie Mac. According to some commenters,  the 2004 increase in housing goals provided the enterprises with incentives  to purchase mortgage assets, such as Alt-A mortgages and private-label  MBS collateralized by subprime and Alt-A mortgages,that in large degree  served targeted groups. However, former FHFA Director Lockhart stated  that the enterprises’ primary motivation in purchasing such assets was to  restore their share of the mortgage market, which declined substantially  from 2004 through 2007 as the “nontraditional” (for example, subprime)  mortgage market rapidly increased in size. FHFA further stated that the  enterprises viewed such mortgage assets as offering attractive risk- adjusted returns.
According to FHFA, while these questionable mortgage assets accounted  for less than 20 percent of the enterprises’ total assets, they represented a  disproportionate share of credit-related losses in 2007 and 2008. For  example, by the end of 2008, Fannie Mae held approximately $295 billion  in Alt-A loans, which accounted for about 10 percent of the total single- family mortgage book of business (mortgage assets held in portfolio and  mortgages that served as collateral for MBS held by investors). Similarly,  Alt-A mortgages accounted for nearly half of Fannie Mae’s $27.1 billion in  credit losses of its single-family guarantee book of business in 2008. At a  June 2009 congressional hearing, Lockhart said that 60 percent of the  AAA-rated, private-label MBS purchased by the enterprises have since  been downgraded to below investment grade. He also stated that investor  concerns about the extent of the enterprises’ holdings of such assets and  the potential associated losses compromised their capacity to raise needed  capital and issue debt at acceptable rates.
section_title: Options to Revise the Enterprises’ Structures Aim to Help Ensure Housing Mission Achievement, 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  that there is a range of options available to 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 4). This section discusses  some of the key principles associated with each option and provides  details on how each could be designed to support housing objectives.
subsections: section_title: Government Corporation or Agency
paragraphs: Some proposals advocate that, after the FHFA conservatorships are  terminated, consideration should be given to establishing a government  corporation or agency to assume responsibility for key enterprise business  activities. Supporters of these proposals maintain that the combination of  the implied federal guarantee on the enterprises’ financial obligations, and  their need to respond to shareholder demands to maximize profitability,  encouraged excessive risk-taking and ultimately resulted in their failures.  Accordingly, they also believe that a government corporation or agency,  which would not be concerned about maximizing shareholder value,  would be the best way to ensure the availability of mortgage credit for  primary lenders, while minimizing the risks associated with a for-profit  structure with government sponsorship. Establishing a government  corporation or agency also would help ensure transparency in the federal  government’s efforts through appropriate disclosures of risks and costs in  the federal budget.
Under one proposal, a government corporation would assume  responsibility for purchasing conventional mortgages from primary  lenders and issuing MBS. However, under this proposal, the enterprises’  retained mortgage portfolios would be eliminated over time because of  their interest-rate risk and associated safety and soundness concerns.  Taxpayer protections would come from sound underwriting standards and  risk-sharing arrangements with the private sector. The government  corporation also would be required to establish financial and  accountability requirements for lenders and institute consumer protection  standards for borrowers as appropriate.
While this proposal advocates the establishment of a government  corporation to replace Fannie Mae and Freddie Mac, it states that there  are risks associated with doing so. For example, a government corporation  might face challenges retaining capable staff or become overly  bureaucratic and unreceptive to market developments. Accordingly, the  proposal includes a provision that the government corporation should be  carefully reevaluated to ensure that it does not “ossify” over time. The  proposal also concludes that the new government corporation either  “sunset” (terminate) after 5 years if the market has stabilized or be allowed  to continue under a renewable charter that would require periodic  reviews.
Under a second proposal, a government corporation or agency also would  focus on issuing MBS rather than maintaining a retained mortgage  portfolio. Borrowers would be charged actuarially based premiums to  help offset the risks associated with the government corporation’s or  agency’s activities. For example, mortgages with a 10 percent or lower  down payment would be subject to a higher premium than mortgages with  a 20 percent down payment. The government corporation or agency also  would focus its activities on middle-income borrowers, and the mortgage  credit needs of targeted groups would be served by an expansion of FHA’s  mortgage insurance programs. The proposal suggests that specific  appropriations to FHA represent a more efficient means to assist low- income borrowers than seeking to assist such borrowers through the  enterprises’ activities. A third proposal advocates that the government  provide funding directly to targeted borrowers though down-payment  assistance rather than relying on the enterprises’ mortgage purchase  program.
For purposes of comparison, we note that Ginnie Mae is an existing  government corporation that performs important functions in the  secondary markets for government guaranteed and insured mortgage  loans. Specifically, Ginnie Mae guarantees the timely payment of principal  and interest on MBS that are collateralized by pools of mortgages that are  insured or guaranteed by FHA, VA, PIH, and USDA/RD. However, Ginnie  Mae does not perform functions that are envisioned for a government  corporation or agency that might replace Fannie Mae and Freddie Mac. In  particular, Ginnie Mae does not issue MBS, as do Fannie Mae and Freddie  Mac. Moreover, Ginnie Mae is not responsible for monitoring the  underwriting or the credit risk associated with the mortgages that  collateralize the MBS pools but instead relies on FHA, VA, PIH, and  USDA/RD to do so.
section_title: Reconstituted GSEs
paragraphs: While many of the enterprises’ critics view the for-profit GSE structure as  precipitating the enterprises’ financial crises that led to conservatorship,  market participants and commenters, trade groups representing the  banking and home construction industries, as well as community and  housing advocates we contacted, believe that the for-profit GSE structure  generally remains superior to the alternatives. They assert that continuing  the enterprises as for-profit GSEs 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 generally advocate  additional regulations and ownership structures to help offset the financial  risks inherent in the for-profit GSE structure.
While this option generally envisions that the enterprises would focus on  issuing MBS, as is the case with proposals to establish government  corporations or agencies, several proponents believe they should be  permitted to maintain a mortgage portfolio to meet certain key  responsibilities. For example, home construction, small bank, and  community and housing advocates noted that the enterprises may need to  maintain portfolios to support multifamily and rural housing finance.
Representatives from the home building industry said that the enterprises  generally have held the majority of their affordable multifamily mortgage  assets in their portfolios. Fannie Mae officials also said that issuing MBS  collateralized by multifamily mortgages can be difficult compared with  issuing MBS collateralized by single-family properties for several reasons.
A variation of this option involves breaking up the enterprises into  multiple GSEs. For example, the Congressional Research Service (CRS)  has stated that the enterprises could be converted into 10 or so GSEs,  which could mitigate safety and soundness risks. That is, rather than  having the failure of two large GSEs threaten financial stability, the failure  of a smaller GSE likely would have a more limited impact on the financial  system. CRS also has stated that creating multiple GSEs could enhance  competition and benefit homebuyers.
A potential regulatory action to limit the risks associated with  reconstituting the enterprises as GSEs would be to establish executive  compensation limits as deemed appropriate. As discussed previously,  OFHEO investigative reports in 2003 and 2004 concluded that the  enterprises manipulated their financial statements in part to help ensure  that senior executives would receive bonuses. In June 2009, FHFA  published proposed rules to implement sections of HERA that give FHFA  authority over executive compensation at the enterprises.
It has also been suggested that the enterprises be converted from publicly  traded companies into cooperatives owned by lenders similar to the  FHLBank structure. For example, one commenter suggested that, by  having lenders assume some of the risks associated with the enterprises’  activities, mortgage underwriting standards could be enhanced. A  mortgage lending group stated in a recent analysis of options to revise the  secondary mortgage markets that, under a cooperative structure for  enterprises, lenders would need to post as collateral a portion of their  loan-sale proceeds to cover some initial level of potential losses. This  collateral would be refundable to the lenders as loans age and that rights  to the collateral could be sold to third parties. The trade group also noted  that while the cooperatives would determine pricing, credit standards, and  eligibility requirements, they still would need to be subject to safety and  soundness oversight by the federal government. However, representatives  from a trade group that represents smaller banks said that it might be  difficult to convince such banks to participate in a cooperative. They said  that many smaller banks suffered substantial losses on the preferred stock  they held in Fannie Mae and Freddie Mac before their conservatorships  and would be very reluctant to make such investments in the future.
It also has been suggested that the reconstituted enterprises be subject to  public utility-type regulation. Traditionally, such regulation has been  cial  used at the federal and state level to oversee and control the finan performance of monopolies or near monopolies, such as electric,  telephone, and gas companies. To help prevent disadvantages to  ratepayers, federal and state governments traditionally have imposed  limits on such public utilities’ rate of return and required that their rate  structures be fair and equitable. It has been suggested that the enterprises’  historically dominant positions in the mortgage markets, and their cost  advantages associated with the implied guarantee, among other  advantages, potentially make them candidates for public utility-type  regulation.
Former Treasury Secretary Paulson advocated keeping the enterprises as  corporations, because of the private sector’s capacity to assess credit risk  compared with government entities, with substantial government support  but with a variety of controls on their activities. First, Paulson suggested  that the corporations purchase mortgages with a credit guarantee backed  by the federal government and not retain mortgage portfolios. Second,  Paulson recommended that the corporations be subject to public utility- type regulation. Specifically, he recommended that a public utility-type  commission be established with the authority to set appropriate targets for  the enterprises’ rate of return and review and approve underwriting  decisions and new mortgage products. Paulson also recommended that  the enterprises pay a fee to help offset the value of their federal support  and thereby also provide incentives for depository institutions to fund  mortgages, either as competitors to a newly established government  structure or as a substitute for government funding.
section_title: Privatization or Termination
paragraphs: Some analysts and financial commenters contend that privatizing,  significantly reducing, or eliminating the enterprises’ presence in the  mortgage markets represents the best public policy option. Advocates of  this proposal believe that it would result in mortgage decisions more  closely aligned with market factors and reduce safety and soundness risks.  That is, sources of mortgage credit and risk would not be concentrated in  two large and complex organizations that might take excessive risks  because of the implied federal guarantee on their financial obligations.  Instead, mortgage credit and risk would be diversified throughout the  financial system. 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.
Proposals to privatize, minimize, or eliminate the enterprises’ presence in  the mortgage markets may involve a transition period to mitigate any  potential market disruptions and facilitate the development of a new  mortgage finance system. For example, one proposal would freeze the  enterprises’ mortgage purchase activities, which would permit banks and  other lenders to assume a greater role in the financial system. Some  researchers and financial commenters also have suggested that private- sector entities, such as consortiums or cooperatives of large banks, would  have a financial incentive to assume responsibility for key enterprise  activities, such as purchasing mortgages and issuing MBS.
Given the substantial financial assistance that Treasury and the Federal  Reserve have provided to the enterprises during their conservatorships, it  may be very difficult to credibly privatize them as largely intact entities.  That is, the financial markets likely would continue to perceive that the  federal government would provide substantial financial support to the  enterprises, if privatized as largely intact entities, in a financial emergency.  Consequently, such privatized entities may continue to derive financial  benefits, such as lowered borrowing costs, resulting from the markets’  perceptions. In exploring various options for restructuring the enterprises,   Bernanke has noted that some privatization proposals involve breaking the  enterprises into smaller units to eliminate the perception of federal  guarantees.
Bernanke also has questioned whether fully privatized enterprises would  be able to issue MBS during highly stressful economic conditions. He  pointed out that, during the current financial crisis, private-sector  mortgage lending largely stopped functioning. Bernanke cited a study by  Federal Reserve economists that advocated the creation of an insurer,  similar to the Federal Deposit Insurance Corporation, to support mortgage  finance under the privatization proposal. The new agency would offer  premium-supported, government-backed insurance for any form of bond  financing used to provide funding to mortgage markets.
Bernanke and Paulson also have discussed using covered bonds as a  potential means to enhance private-sector mortgage finance in the United  States. According to Bernanke, covered bonds are debt obligations issued  by financial institutions and secured by a pool of high-quality mortgages or  other assets. Bernanke stated that covered bonds are the primary source  of mortgage funding for European banks, with about $3 trillion  outstanding. However, Bernanke concluded that there are a number of  challenges to implementing a viable covered bond market in the United  States. For example, as a source of financing, he said covered bonds  generally are not competitive with financing provided by the FHLBanks or  the enterprises, which have lower financing costs due to their association  with the federal government.
section_title: A Framework for Identifying and Analyzing the Trade- offs Associated with Options to Revise the Enterprises’ Structures, and Oversight Structures That Might Help Ensure Their Effective Implementation
paragraphs: Each of the options to revise the enterprises’ structures involves important  trade-offs in terms of their capacity to achieve key housing mission and  safety and soundness objectives (see table 5). This section examines the  three options in terms of their ability to (1) provide ongoing liquidity and  support to mortgage markets, (2) support housing opportunities for  targeted groups, and (3) ensure safe and sound operations. Furthermore, it  identifies potential regulatory and oversight structures that might help  ensure that the implementation of any of the options achieves their  intended housing mission and safety and soundness objectives.
subsections: section_title: Potential Trade-offs Associated with Establishing a Government Corporation or Agency
paragraphs: With many of its activities funded directly through Treasury debt  issuances, a government corporation or agency (a government entity)  could help provide liquidity to mortgage markets during good economic  times through the purchase of large volumes of mortgages that meet  specified underwriting criteria and issue MBS collateralized by such  mortgages. In the process, a government entity also could help ensure  standardization in the mortgage underwriting process. Additionally, a  government entity might have a structural advantage over private  entities—such as reconstituted GSEs, banks, or other private lenders—in  providing liquidity to mortgage markets during periods of economic stress.  That is, a government entity may be able to continue to fund its activities  through government debt issuances. In contrast, for-profit entities face  potential conflicts in supporting mortgage finance during stressful  economic periods because they also must be concerned about maintaining  shareholder value, which may mean substantially reducing their activities  or withdrawing from markets entirely as has occurred during the recent  economic downturn. However, to the extent that a retained mortgage  portfolio may be necessary to help respond to a financial crisis, a  government entity without such a portfolio may face challenges in  supporting mortgage finance, particularly if investor demand for its MBS  were to become limited. Other federal entities, such as Treasury and the  Federal Reserve, may have to step in to purchase and hold mortgage  assets on their balance sheets (as has been the case during the current  financial crisis) if such a situation existed.
The absence of a retained mortgage portfolio for a government entity also  could affect the traditional conventional, conforming mortgage market.  Over the past 10 years, the enterprises, as discussed earlier, have  maintained large mortgage portfolios. If this option is no longer available,  lenders may find it more challenging to find buyers for these mortgages in  the secondary market. It is not clear the extent to which a government  entity could maintain the same general level of mortgage purchases as the  enterprises if it were confined to assembling all such mortgages into MBS.
subsections: section_title: Potential Capacity to Facilitate the Flow of Mortgage Credit to Targeted Groups
paragraphs: A government entity most likely would be expected to support  homeownership opportunities for targeted groups given its status as a  public organization. This option also would resolve any structural conflicts  that the enterprises faced over the years as for-profit, publicly-traded,  shareholder-owned corporations in supporting homeownership  opportunities for targeted groups. A government corporation or agency  would be a public entity without the responsibility to maximize  shareholder value. However, if a government entity were not permitted to  have a retained mortgage portfolio, as some researchers have proposed, it  likely would face challenges in implementing a numeric mortgage  purchase program similar to that of the enterprises. As discussed  previously, the enterprises tended to hold a significant portion of  multifamily mortgages that were purchased pursuant to the numeric  mortgage purchase programs in their retained portfolios. That is because it  may be difficult to convert multifamily mortgage assets into MBS  compared with single-family mortgages. There might be several different  ways to address this challenge. For example, fees or assessments could be  imposed on the activities of the government entity, and such revenues  could be used to directly support the construction of affordable housing or  provide down payment assistance to targeted homebuyers. Under HERA,  the enterprises were to pay assessments to fund a Housing Trust Fund for  the purposes of providing grants to states to increase and preserve the  supply of rental housing and increase homeownership for extremely low-  and very low-income families, but FHFA has suspended this program due  to the enterprises’ financial difficulties. Alternatively, FHA could be  expanded to assume responsibility for the enterprises’ ongoing efforts to  support homeownership opportunities as one researcher has suggested.  However, as is discussed later, FHA’s current operational capacity to  manage a large increase in its business may be limited, which could  increase taxpayer risks.
section_title: Potential Safety and Soundness Concerns
paragraphs: In some respects, a government entity that focused its activities on  purchasing mortgages and issuing MBS might pose lower safety and  soundness risks than has been the case with the enterprises. For example,  a government entity would not be motivated by an implied federal  guarantee to engage in risky business practices to achieve profitability  targets and thereby maintain shareholder value as was the case with the  enterprises. Furthermore, if a government entity were not to retain a  mortgage portfolio, as has been proposed, then it would be less complex  and potentially less risky than the enterprises’ current structure. As  already discussed, the enterprises’ large retained portfolios exposed them  to significant interest-rate risk, and they misapplied accounting rules that  governed the hedging techniques necessary to manage such risks.
Nevertheless, successfully managing a large conventional mortgage  purchase and MBS issuance business still may be a complex and  challenging activity for a government entity, and the failure to adequately  manage the associated risks could result in significant losses that could be  the direct responsibility of taxpayers. For example, the enterprises’  substantial losses in recent years have been credit-related (due to  mortgage defaults), including substantial losses in their MBS guarantee  business. This risk may be heightened if a government entity were  expected to continue purchasing mortgages and issuing MBS during  stressful economic periods when the potential for losses may be greater  than would otherwise be the case. As discussed previously, Ginnie Mae  provides only a limited model for the establishment of such a government  corporation or agency. Ginnie Mae guarantees the timely payment of  principal and interest on MBS collateralized by mortgages, but federal  agencies insure or guarantee such mortgages and lenders issue the MBS.  Furthermore, Ginnie Mae is not responsible for establishing credit  underwriting standards or monitoring lenders’ adherence to them; rather,  these functions are carried out by FHA, VA, PIH, and USDA/RD. In  contrast, a government entity that issued MBS collateralized by  conforming mortgages as is the case with the enterprises would be  responsible for managing credit risk, including setting appropriate  guarantee fees to offset such risk.
As described in our previous work on FHA, government entities may lack  the financial resources necessary to attract the highly skilled employees  needed to manage complex business activities or the information  technology necessary to help do so. Furthermore, government entities  sometimes are subject to laws and regulations that may limit their capacity  to respond to market developments. In a range of recent reports, HUD’s  Office of Inspector General expressed concerns about whether FHA had  the staffing expertise and information technology needed to manage the  rapid increase in its mortgage insurance business since 2008.
section_title: Oversight Structure That Could Help Ensure the Effective Implementation of a Government Corporation or Agency
paragraphs: To help ensure that a government entity could achieve its housing mission  objectives while operating in a safe and sound manner, an appropriate  oversight framework would need to be established. While such a  framework would need to clearly define the roles and objectives of a  government entity in the mortgage finance system, it would need to afford  the entity sufficient flexibility to acquire adequate resources and manage  its activities to fulfill its mission. The establishment of risk-sharing  arrangements with the private sector, such as requirements that lenders  that sell mortgages to the government entity retain some exposure to  potential credit losses or that private mortgage insurance is obtained on  such mortgages, could help mitigate the risk of potential losses. Such a  government entity could be expected to reflect its risk and liabilities in the  federal budget to help ensure financial transparency of its operations.  Finally, robust congressional oversight of any such entity would be needed  to help ensure that the entity was fulfilling its objectives.
section_title: Potential Trade-offs Associated with Reestablishing the Enterprises as For-profit GSEs
paragraphs: When mortgage credit markets stabilize, the enterprises as reconstituted  GSEs might be expected to perform functions that they have performed  for many years, such as purchasing conventional mortgages, issuing MBS,  and perhaps managing a relatively small retained mortgage portfolio under  some proposals. Through such activities, the enterprises might be  expected to provide liquidity to mortgage markets during good economic  periods, as well as provide standardization to the mortgage underwriting  process and certain technical and procedural innovations. However, as  for-profit corporations, significant concerns remain about how well the  reconstituted enterprises would be able to support financial markets  during stressful economic periods without substantial financial support  from Treasury or the Federal Reserve.
Moreover, the reconstituted GSEs, like government corporations or  agencies, might face challenges in their ability to support mortgage finance  if their mortgage portfolios were substantially downsized or eliminated as  envisioned under some proposals. For example, with substantially  downsized or eliminated mortgage portfolios, the reconstituted GSEs  might further limit their capacity to respond to financial crisis, in which  case, the likelihood that Treasury or the Federal Reserve would need to  respond by buying and holding mortgage assets on their balance sheets  would be increased. In addition, substantially downsizing or eliminating  the reconstituted GSEs mortgage portfolios could limit lenders’ ability to  sell conventional, conforming mortgages on the secondary market.  Permitting the enterprises as reconstituted GSEs to maintain mortgage  portfolios, albeit at lower levels than prior to their conservatorships, could  help address these potential concerns.
subsections: section_title: Potential Capacity to Facilitate the Flow of Mortgage Credit Serving Targeted Groups
paragraphs: Similarly, decisions about the size of the reconstituted GSEs’ mortgage  portfolios would likely affect their capacity to support mortgage purchase  programs to facilitate the flow of mortgage credit to targeted groups. If the  reconstituted GSEs’ mortgage portfolios were substantially decreased or  eliminated, then their ability to purchase and hold multifamily mortgages  that serve targeted groups might be limited. On the other hand, permitting  the reconstituted GSEs to maintain a mortgage portfolio of an appropriate  size could mitigate this potential concern. Another consideration  associated with establishing the enterprises as for-profit GSEs is the  potential conflict with a requirement to facilitate the flow of mortgage  credit serving targeted groups. Alternatives to establishing a numeric  mortgage purchase program to support homeownership opportunities for  targeted groups could include assessing fees on the reconstituted GSEs to  directly fund such programs, expanding FHA’s mortgage insurance  programs, or providing direct down-payment assistance to targeted  borrowers.
section_title: Potential Safety and Soundness Concerns
paragraphs: Continuing the enterprises as 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. Treasury  guarantees on their financial obligations also might provide the enterprises  with significant advantages over potential competitors. Furthermore,  FHFA’s capacity to monitor and control such potentially risky business  practices has not been tested. Since its establishment in July 2008, FHFA  has acted both as the enterprises’ conservator and  safety and soundness  and housing mission regulator. Under the conservatorship, FHFA has  significant control over the enterprises’ operations. For example, the  FHFA Director has appointed the enterprises’ chief executive officers and  boards of directors and can remove them as well. But FHFA officials said  that agency staff also have been monitoring the enterprises’ business risks.  It remains to be seen how effectively FHFA would carry out its oversight  responsibilities solely as an independent regulator if the enterprises were  reconstituted as for-profit GSEs.
While converting the enterprises into multiple GSEs could mitigate safety  and soundness and systemic risk concerns by minimizing concentration  risks, it also likely would involve trade-offs. For example, multiple GSEs,  due to their potentially small size, may not be able to achieve economies of  scale and generate certain efficiencies for mortgage markets as has been  the case with Fannie Mae and Freddie Mac. As discussed earlier, the  enterprises, through their secondary mortgage market activities, have been  credited with facilitating the development of a liquid national mortgage  market and establishing standardized underwriting practices for mortgage  lending.
Alternatively, converting the enterprises from their current structure as  publicly owned corporations into cooperatives owned by the lenders that  sell mortgages to them may offer certain advantages in terms of their  safety and soundness. For example, as the owners of the enterprises,  lenders may have financial incentives to ensure that the mortgages that  they sell to the enterprises are properly underwritten so as to minimize  potential losses that would affect the value of their investments. As  discussed previously, Freddie Mac, as a cooperative, generally managed to  avoid the financial problems that Fannie Mae, which was a publicly owned  corporation, faced during the early 1980s. However, it should also be  noted that the cooperative structure may also have limitations. For  example, some FHLBanks, which are members of the cooperative  FHLBank System, have faced losses recently due to their investments in  private-label mortgage assets.
While the public utility model of regulation has been proposed as a means  to help mitigate the risks associated with reestablishing the enterprises as  GSEs, this proposal involves complexities and trade-offs. For example, it  is not clear that the public utility model is an appropriate regulatory  structure because, unlike natural monopolies such as electric utilities, the  enterprises have faced significant competition from other providers of  mortgage credit over the years. For example, as discussed previously, the  enterprises’ market share declined substantially from 2004 through 2006  due to the rapid growth of the private-label MBS market. Public utility-type  regulation also has been criticized as inefficient and many states have  sought to deregulate their electric and other markets. Furthermore, these  proposals may have offsetting effects on the GSEs’ financial viability. For  example, former Treasury Secretary Paulson’s proposal would subject  their credit decisions and rate of return to preapproval by a public utility- type board, and impose fees on them to offset any benefits derived from  government sponsorship of their activities. It is not clear if an entity  subject to such business activity restrictions, regulations, and fees, even  with Treasury guarantees on its financial obligations, would be able to  raise sufficient capital from investors or purchase mortgages on terms that  mortgage lenders would find cost-effective.
section_title: Potential Oversight Structure That Could Help Ensure the Effective Implementation of Reconstituted GSEs
paragraphs: A range of potential options exist for developing an appropriate regulatory  structure to help ensure that any reconstituted GSEs would operate in a  safe and sound manner while achieving housing mission objectives. For  example, if maintaining safety and soundness is viewed as a priority over a  numeric housing goal program, then eliminating retained mortgage  portfolios may be viewed as appropriate. Alternatively, the retained  mortgage portfolios could be substantially smaller and restricted to certain  types of assets to help ensure safety and soundness while promoting  housing mission achievement. Other steps that may be deemed  appropriate could include establishing capital standards for the  enterprises commensurate with their risk, additional restrictions on their  activities, executive compensation limits, public utility regulation,  appropriate financial disclosures of risks and liabilities in the federal  budget, and strong congressional oversight of the enterprises’ and FHFA’s  performance.
section_title: Potential Trade-offs Associated with Privatizing or Terminating the Enterprises
paragraphs: As with the preceding two sets of options, proposals that involve the  privatization or ultimate termination of the enterprises involve a number  of trade-offs. For example, if a consortium of large banks assumed  responsibility for key activities (such as mortgage purchases and MBS  issuances) of the enterprises, during good economic times it might be able  to provide liquidity to the mortgage finance system, help ensure  consistency through uniform underwriting standards, and potentially  promote innovation in mortgage finance. However, the ability of private  lenders to provide support to mortgage markets during stressful economic  periods is questionable. As discussed previously, many private-sector  lenders have failed or withdrawn from mortgage markets during the  current economic downturn. The establishment of a federal mortgage debt  insurer, as has been proposed, may facilitate private lenders’ capacity to  support mortgage markets during stressful periods.
Privatizing or terminating the enterprises also could affect the structure of  mortgage lending that has evolved over the years. For example, lenders  might be less willing to originate 30-year, fixed-rate mortgages, due to the  associated interest-rate risk of holding them in portfolio, if any ensuing  private-sector secondary market alternatives (such as a consortium of  private-sector lenders) were less willing to purchase such mortgages than  the enterprises had been. Additionally, privatization or termination could  result in a relative increase in mortgage interest rates, because private- sector lenders might not have the funding advantages that the enterprises  derived from their federal sponsorship over the years.
subsections: section_title: Potential Capacity to Facilitate the Flow of Mortgage Credit to Targeted Groups
paragraphs: This option also could eliminate the traditional legislative basis for  requiring that they facilitate the flow of mortgage credit serving targeted  groups, particularly through the numeric mortgage purchase program.  That is, the enterprises currently have a responsibility to help meet the  mortgage credit needs of all potential borrowers due to the financial  benefits associated with federal sponsorship, which would not be the case  for private-sector lenders under the termination and privatization  proposals. However, if new federal organizations were established, such as  a mortgage insurer, to facilitate the transition to a mortgage finance  system in which the enterprises no longer exist, then they could be  required to assume responsibility for facilitating the flow of mortgage  credit to targeted groups. For example, the Community Reinvestment  Act’s requirements that insured depositories, such as banks and thrifts,  serve the credit needs of the communities in which they operate could be  extended to nondepository lenders, such as independent mortgage  lenders, which would obtain mortgage insurance from a new federal  mortgage insurer.
Moreover, if a consortium of large lenders or other financial institutions  assumed responsibility for key enterprise functions (like MBS issuances),  or purchased a substantial share of their assets, then requirements that  such institutions serve the credit needs of targeted groups also might be  justified. For example, such institutions could be perceived as benefiting  from implied federal guarantees on their debt or being too big to fail. We  note that Treasury and the Federal Reserve have provided direct financial  assistance to a range of financial and other institutions during the current  financial crisis, which may create the perception in financial markets that  the federal government is more likely to intervene in a future crisis.
section_title: Potential Safety and Soundness Concerns
paragraphs: The extent to which privatizing or terminating the enterprises mitigates  current safety and soundness and financial stability risks is difficult to  determine. Under one scenario, such risks would be mitigated because  large and complex enterprises, which might engage in risky business  practices due to the implied federal guarantee on their financial  obligations, would not exist. Instead, private lenders would be subject to  market discipline and consequently would be more likely to make credit  decisions largely on the basis of credit risk and other market factors.  However, this scenario would be complicated if a federal entity were  established to insure mortgage debt. If the federal mortgage insurer did  not set appropriate premiums to reflect the risks of its activities, then  lenders might have incentives to engage in riskier business practices than  otherwise would be the case. In similar situations, such as the National  Flood Insurance Program, federal agencies have faced challenges in  establishing appropriate premiums to compensate for the risks that they  underwrite. 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, markets’ perceptions that the federal government would  provide financial assistance to such financial institutions could undermine  market discipline.
Moreover, limitations in the structure of the current U.S. financial  regulatory system could heighten concerns about the potential safety and  soundness risks associated with large financial institutions assuming  responsibility for key enterprise financial activities or becoming larger due  to the purchase of their assets. In a recent report, we stated that the  current fragmented regulatory system for banks, securities firms,  insurance companies, and other providers evolved over many years and  often in response to financial crises. We stated that the large and  complex financial conglomerates that have emerged in the past decades  often operate globally across financial sectors and that federal regulators  have faced significant challenges in monitoring and overseeing their  operations. For example, the report noted that a Federal Reserve official  recently acknowledged that, under the current structure, which consists of  multiple supervisory agencies, challenges can arise in assessing risk  profiles of these institutions, particularly because of the growth in the use  of sophisticated financial products that can generate risks across various  legal entities.
Privatizing or terminating the enterprises also could increase the relative  prominence of other federal programs designed to promote  homeownership and housing opportunities, which also may have safety  and soundness implications. Due to the diminished presence of the  enterprises in mortgage finance under these proposals, market  participants, such as banks and thrifts, increasingly might turn to the  FHLBank System as a source of funding for their operations and lending  activities. The FHLBank System could enjoy an advantage over other  potential competitors in filling the void left by the enterprises because, as  a GSE benefiting from an implied guarantee, it may be able to issue debt to  fund its activities at relatively advantageous rates. However, some  FHLBanks have recently reported losses due to investments in private- label MBS. Similarly, FHA’s mortgage insurance programs might increase  if the enterprises’ diminished role limits the availability of mortgage credit  in the conforming market.
section_title: Potential Oversight Structure That Could Help Ensure the Effective Implementation of Terminating or Privatizing the Enterprises
paragraphs: The development of an appropriate regulatory structure to help ensure  housing mission achievement and safety and soundness, as deemed  appropriate, would depend on the outcome of a range of contingencies  associated with options to privatize or terminate the enterprises. For  example, should Congress choose to establish a new public entity to  insure all mortgage debt, with the federal government guaranteeing the  insurance, then a new regulatory and oversight structure would be needed  to oversee the operations of such an insurer. As with other options to  reform the enterprises’ structures, an appropriate structure for such an  entity might involve a regulatory agency with authorities to carry out its  activities and capital standards that reflect the risk of the entity’s  activities, disclosures of risks and liabilities in the federal budget to help  ensure financial transparency, and robust congressional oversight.  Furthermore, revisions may be necessary to help ensure that the U.S.  financial regulatory system can better oversee the risks associated with  large and complex financial institutions, which may assume responsibility  for key enterprise activities or become larger over time through the  acquisition of their assets. Our recent report identified a series of  principles, such as establishing clear regulatory goals, ensuring a focus on  systemwide financial risks, and mitigating taxpayer risks, for Congress to  consider in deciding on the most appropriate regulatory system.
section_title: Federal Efforts to Support Housing Markets during the Conservatorships and Certain Terms of Treasury Agreements Could Increase the Costs and Challenges Associated with the Transition to New Enterprise Structures
paragraphs: Since the beginning of the FHFA conservatorships, the enterprises have  been tasked to initiate a range of programs, such as assisting homeowners  struggling to make their mortgage payments to refinance or modify their  mortgage terms, to respond to the current crisis in housing markets. These  initiatives could benefit housing markets and, in so doing, potentially  benefit 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 over time. Similarly, certain provisions in the Treasury  agreements with the enterprises may affect their long-term financial  viability and complicate a transition to a new structure. Finally, any  transition to a new structure would need to take into consideration the  enterprises’ dominant position within housing finance, even during the  conservatorships, and, therefore, should be carefully implemented— perhaps in phases—to help ensure its success.
The following points summarize several of the initiatives that the  enterprises have undertaken in response to the substantial downturn in  housing markets:    Under the Home Affordable Refinance Program (HARP), which was  initiated in March 2009, borrowers that have current payment histories can  refinance and reduce their monthly mortgage payments at loan-to-value  ratios of up to 105 percent without obtaining mortgage insurance. On July  1, 2009, the program was extended to apply to mortgage loans with loan- to-value ratios of up to 125 percent.
Under the Home Affordable Modification Program (HAMP), certain  borrowers who are delinquent, or in imminent danger of default, on their  mortgage payments may have the terms of their existing mortgages  modified in order to make payments more affordable. Specifically, the  program allows for interest rate reductions (down to 2 percent), term  extension (up to 480 months), principal forbearance, and principal  forgiveness. Under the program, the enterprises will provide up to $25  billion in incentives to borrowers and servicers for program participation  and a successful payment history.
In November 2008, the enterprises suspended the initiation of foreclosure  proceedings on mortgages that they held in their portfolios or on which  they had guaranteed principal and interest payments for MBS investors.  This initiative subsequently was extended through March 31, 2009. In  March 2009, the enterprises also suspended foreclosure sales on  mortgages that may be eligible under HAMP until borrowers’ eligibility for  HAMP has been verified.
While these federal initiatives were designed to benefit homebuyers, in  recent financial filings, both Freddie Mac and Fannie Mae have stated that  the initiative to offer refinancing and loan modifications to at-risk  borrowers could have substantial and adverse financial consequences for  them. For example, Freddie Mac stated that the costs associated with  large numbers of its servicers and borrowers participating in loan- modification programs may be substantial and could conflict with the  objective of minimizing the costs associated with the conservatorships.  Freddie Mac further stated that loss-mitigation programs, such as loan  modifications, can increase expenses due to the costs associated with  contacting eligible borrowers and processing loan modifications.  Additionally, Freddie Mac stated that loan modifications involve  significant concessions to borrowers who are behind in their mortgage  payment, and that modified loans may return to delinquent status due to  the severity of economic conditions affecting such borrowers. Fannie Mae  also has stated that, while the impact of recent initiatives to assist  homeowners is difficult to predict, the participation of large numbers of its  servicers and borrowers could increase the enterprise’s costs  substantially. According to Fannie Mae, the programs could have a  materially adverse effect on its business, financial condition, and net  worth.
However, FHFA officials said that they strongly believe the recent  initiatives to support the housing markets, on balance, represent the best  means available for the enterprises to preserve their assets and fulfill their  housing missions. For example, FHFA officials said that, to the extent that  their initiatives are successful in stabilizing housing markets, the  enterprises will be the major beneficiaries as the number of delinquent  mortgages and foreclosures is reduced. FHFA officials also commented  that recent modification programs, such as HAMP, are more likely to be  successful than modification initiatives dating to 2008, which had high  redefault rates. FHFA officials said that the more recent loan-modification  initiatives were more likely to reduce borrowers’ monthly payments.  According to an FHFA report, the traditional approaches to loan  modifications (allowing borrowers to bring loans current by reamortizing  past due payments over the remaining life of the loan) increased monthly  payments and, therefore, often resulted in high redefault rates.  Furthermore, FHFA officials stated that recent loan-to-value ratio  refinance programs only apply to mortgages that the enterprises already  guarantee, so they already are exposed to the credit risks on these loans.  FHFA officials said that such refinancings also should lower borrowers’  payments and thereby further reduce the enterprises’ existing credit  exposure.
While FHFA’s positions are plausible, it is too early to reach any  conclusion about the effects that the initiatives will have on the  enterprises’ financial condition and preliminary data raise potential  concerns. According to a report by the Office of the Comptroller of the  Currency (OCC) and the Office of Thrift Supervision (OTS), loan  modifications initiated in 2008 that reduced borrowers’ monthly payments  by 20 percent or more had significantly lower redefault rates after 1 year  than modifications that left monthly payments unchanged or higher.  Specifically, the study found that, of the modifications that involved  reductions of 20 percent or more, 38 percent were 60 or more days past  due after 1 year, whereas the rate was nearly 60 percent for modifications  that left monthly payments unchanged or higher. However, the fact that  nearly 40 percent of loan modifications that substantially reduced monthly  payments were already 60 or more days past due after 1 year raises  concerns about whether the additional costs that enterprises incur in  administering such programs will be effective. Furthermore, it is also not  clear whether initiatives to suspend foreclosure proceedings will benefit  the enterprises’ financial condition. Our previous work has found that, for  mortgage providers such as Fannie Mae and Freddie Mac, foreclosure  costs may increase the longer it takes to maintain and sell foreclosed  properties. A potential risk of suspending pending foreclosure sales is  that many borrowers facing foreclosure will not be able to obtain funds  necessary to make their mortgage loan payments current. As a result of  delays in foreclosing on such properties, the potential exists that the  properties will not be maintained or will become vacant, which could  increase the enterprises’ associated costs.
Treasury’s agreements with Fannie Mae and Freddie Mac, which specify  terms under which the department is to provide certain types of financial  support to them, also may have long-term financial consequences. In  connection with the agreements, quarterly dividends declared by the  enterprises are to be paid to holders of the senior preferred stock  (Treasury). These dividends accrue at 10 percent per year and increase to  12 percent if, in any quarter, they are not paid in cash. If either enterprise  cannot pay the required dividends, then Treasury has a claim against the  assets of the enterprise for the unpaid balance in a liquidation proceeding.  Available financial data suggest that the enterprises, while in  conservatorship and over the longer term, will face significant financial  challenges in paying the required dividends to Treasury. For example,  Treasury already purchased $50 billion in preferred stock in Freddie Mac,  which translates into an annual dividend of $5 billion, and CBO estimated  that the department will invest substantially more in the enterprise’s  preferred shares in coming quarters (up to the guarantee limit of $200  billion). Prior to the conservatorship, Freddie Mac’s reported annual net  income twice came close to or exceeded $5 billion, and the dividends that  it distributed to shareholders in those years likely were substantially  lower. In addition, the agreements require that, beginning on March 31,  2010, the enterprises pay a commitment fee to Treasury to compensate the  department for the ongoing financial support that it is providing to them.  While the size of the commitment fee is subject to negotiation, it  represents another potential long-term challenge to the enterprises’  financial viability. For example, like the dividend requirements, any unpaid  commitment fees become a claim by Treasury against the assets of the  enterprises in a liquidation proceeding, unless Treasury waives the fee.
Although it is not possible to predict what effects federal initiatives to  respond the housing crisis and the Treasury agreements with the  enterprises could have on the transition to a new structure, they could be  substantial. For example, under the proposal to reconstitute the  enterprises as for-profit GSEs, potential investors might not be willing to  invest their capital if the reconstituted GSEs had a substantial volume of  nonperforming mortgage assets or substantial financial obligations to  Treasury. To minimize this risk, the federal government could arrange a  transition process in which the government would retain nonperforming  assets in a “bad bank” and spin off the performing assets of the enterprises  to a “good bank” and key functions, such as issuing MBS, to investors in a  reconstituted GSE. Or, the federal government could establish such a  process as a means to terminate or privatize the enterprises. However, to  the extent that the enterprises engage in activities during their  conservatorships or incur financial obligations inconsistent with  maintaining their long-term financial viability, the level of nonperforming  mortgage assets and long-term costs to taxpayers ultimately may be higher  than otherwise would be the case.
Finally, 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 over  many years 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  any corrective actions would be necessary. For example, any changes  likely would require regulators and institutions to make system changes  and undertake other activities that would take extensive time to complete.  Our previous work also has identified other key issues that likely would be  critical components of any transition process. In particular, an effective  communication strategy would be necessary to help ensure that all  mortgage market participants, including lenders, investors, and borrowers,  have sufficient information to understand what changes are being made  and how and when they will be implemented. Moreover, it will be  important to put effective strategies in place to help ensure that, under  whichever reform strategy is chosen, the new financial institutions and  their regulators will have the staffing, information technology, and other  resources necessary to carry out their missions.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to FHFA, the Federal Reserve, HUD, and  Treasury for their review and comment. While he was still the FHFA  Director, James B. Lockhart III provided us with written comments, which  are summarized below and reproduced in appendix II, as well as technical  comments, which we incorporated as appropriate. Federal Reserve staff,  HUD’s Assistant Secretary for Housing-Federal Housing Commissioner,  and Treasury also provided technical comments, which were incorporated  as appropriate. We also provided excerpts of a draft of this report to seven  researchers whose studies we cited to help ensure the accuracy of our  analysis. Six of the researchers responded and said that the draft report  accurately described their research, while one researcher did not respond.
In his comment letter, Lockhart stated that the report is timely and does a  good job of summarizing the dominant proposals for restructuring the  enterprises and summarizing their strengths and weaknesses. Lockhart  also stated that initial attention should be to the role of mortgage finance  in our society and how the government wants the institutions and markets  that supply it to function and perform. In particular, he said this includes  determining the most appropriate roles for private and public entities,  competition and competitiveness, risks and risk management, and the  appropriate channels and mechanisms for targeting the underserviced and  protecting consumers. Further, he identified key questions and principles  that he believes should be included in the debate on restructuring the  enterprises. These principles include (1) deciding what the secondary  market should look like, before considering specific institutions; (2)  ensuring that the enterprises or any successors have well-defined and  internally consistent missions; (3) ensuring that there is a clear  demarcation of the federal government and the private sector in the  secondary market; (4) establishing a regulatory and governance structure  that ensures prudent risk-taking; and (5) ensuring that housing finance is  subject to systematically prudent supervision that incorporates  countercyclical capital to limit booms and busts.
We concur with the thrust of the view that revising the enterprises’  structures should take place in a measured way and in the context of a  broader assessment of the housing finance system. As discussed in our  report, the enterprises have been key components of the housing finance  system for many years and, therefore, any changes to their structures are  likely to have broad implications for that system and market participants.  In this regard, we stated that it will be important for Congress to  reevaluate the enterprises’ roles, structures, and performance, and  consider structural reform options to facilitate mortgage finance while  mitigating safety and soundness concerns. These options, under certain  scenarios, envision very different approaches to structuring the secondary  market for mortgage loans and facilitating housing opportunities for  targeted groups, and we believe the broad implications of these various  options need to be carefully considered before any final decisions are  made. For this reason, our report addresses implications for various  participants in the mortgage markets, including FHA. Further, we  discussed that a carefully managed and potentially lengthy transition  process needs to be established to help ensure the successful  implementation of whatever structural reform option for the enterprises is  chosen by Congress and the Executive Branch.
Additionally, Lockhart said that FHFA, in its role as the enterprises’  conservator, as well as their mission and safety and soundness regulator,  is working diligently with the Treasury and Federal Reserve to maintain or  restore safe, sound, liquid, and vibrant mortgage markets. He said a  principal focus of FHFA’s efforts has been facilitating the enterprises’  participation in the Home Affordable Modification and Refinance  Programs. While he said the enterprises’ participation in these programs  may result in near-term costs, he believes the programs will result in  stronger and more stable housing markets, which will also benefit the  enterprises.
Finally, he made several suggestions regarding certain aspects of the draft  report. These suggestions and our responses are described below:    The draft report should make clear that the structural reform options  presented in the report are not exhaustive or mutually exclusive and that  hybrids of these options also are possible and may prove to be the most  appealing. We agree and, as the report notes, the options for revising the  enterprises’ long-term structures generally fall along a continuum with  some overlap between key features. For example, as Lockhart noted,  options for privatizing or terminating the enterprises may involve  establishing a government entity to insure mortgages originated by private  lenders. In addition, the government entity and reconstituted GSE options  generally involve focusing enterprise activities on issuing MBS while  downsizing or eliminating their mortgage portfolios.
The draft report should mention the enterprises’ performance in providing  liquidity to mortgage markets. We agree that any discussion of the future  roles of the GSEs should include consideration of their roles in providing  securities that support an active and liquid mortgage market. As the report  notes, providing liquidity to mortgage markets has been a key housing  mission objective of the enterprises and that, while their secondary market  activities have been credited with helping to establish a national and liquid  mortgage market, their performance in providing support to mortgage  markets during stressful economic periods is not clear.
While the draft report’s discussion of the safety and soundness concerns  related to the government entity option is reasonably balanced and fair, it  is short on negative details. In particular, (1) the draft report is organized  in such a way that makes it easy for the reader to conclude that the safety  and soundness benefits of the government entity option outweigh the  added risks; (2) the table in the draft report’s Highlights page states that  the lack of a “profit motive” for a government entity may mitigate risk  should be rephrased to state that the option “addresses the conflict  between private profits and public sector risk bearing;” and (3) the  discussion in the draft report on the potential elimination of the  enterprises’ mortgage portfolios fails to recognize that such an action is a  component of some but not all proposals to reconstitute the enterprises as  GSEs or to establish a government entity, and therefore, mentioning the  benefit of doing so under one option (the government entity option) and  not the other (the reconstituted GSE option) is a significant inconsistency.
Regarding (1), we do not agree that the order of the text in the draft report  implied that the benefits of the government entity option outweigh its  risks. While this option offers potential safety and soundness advantages  such as addressing deficiencies in the traditional enterprise structures and  eliminating their mortgage portfolios, it also has potentially significant  drawbacks, which need to be considered. In particular, we stated that  managing the enterprises’ ongoing MBS business may be complicated and  challenging, and government entities may lack the resources and expertise  necessary to manage such challenges and risks effectively. Regarding   (2), we agree with the thrust of this comment and have modified the text  in the table in the Highlights page to make it consistent with the related  figure and text in the body of the report. Regarding (3), we agree that any  assessment of the options for revising the housing enterprises’ long-term  structure should include discussion of the implications of retaining  mortgage portfolios. As described in the report, the government entity  options we identified advocated the elimination of the enterprises’  portfolios. In contrast, the options we identified for reconstituting the  enterprises as GSEs generally called for reducing the enterprises’  portfolios while one proposal called for their complete elimination. The  report includes analysis of the potential implications of taking such steps  regarding the enterprises’ mortgage portfolios under both options, as well  as the possible elements of regulatory and oversight structures that could  mitigate any potential safety and soundness and systemic stability risks.
We are sending copies of this report to interested congressional  committees and members. In addition, we are sending copies to FHFA,  Treasury, the Federal Reserve, HUD, financial industry participants, and  other interested parties. The report also is available at no charge on the  GAO Web site at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  William B. Shear at (202) 512-8678 or shearw@gao.gov or Richard J.  Hillman at (202) 512-8678 or hillmanr@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on the  last page of this report. GAO staff who made major contributions to this  report are listed in appendix III.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: The objectives of our report were to (1) discuss how the enterprises’ roles,  structures, and activities have changed over time and their performance in  achieving key housing mission objectives; (2) identify various options for  revising the enterprises’ eventual structure; (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.
To address the first objective, we reviewed reports and studies on the  enterprises and their regulation, including GAO reports, as well as reports  from the Department of Housing and Urban Development (HUD), the  Federal Housing Finance Agency (FHFA), the Office of Federal Housing  Enterprise Oversight (OFHEO), the Congressional Budget Office (CBO),  the Congressional Research Service (CRS), and independent researchers.  We also reviewed legislative and charter documents, as well as an internal  history of Fannie Mae, and financial performance data from a variety of  sources. Through this research, we sought to identify key housing mission,  safety and soundness, and other objectives that have been associated with  the enterprises over the years, as well as their performance in meeting  such objectives. In doing so, we identified and summarized recent  literature that addressed the impact of the enterprises on affordability and  opportunities for target groups. While GAO reviewed these studies and  included those that were sufficiently methodologically sound for our  limited purposes, users of this report should note that these studies are  based on data prior to 2001 and contain limitations. Finally, we used data  from the Securities Industry and Financial Markets Association (SIFMA)  and OFHEO. As SIFMA’s data on mortgage-related issuance were  consistent with other data sources and highlight well-established trends in  mortgage-backed securities (MBS) and collateralized mortgage obligation  activity, we found them and the OFHEO data on the balance sheets of the  enterprises sufficiently reliable for our purposes.
To address the second objective, we reviewed a variety of studies and  proposals that have been made prior to and during the conservatorships to  revise the enterprises’ structures. The inclusion of these studies and  proposals is purely for research purposes and does not imply that we  deem them definitive or without limitations. We also met with the authors  of many of these studies and with researchers who have knowledge about  housing finance, the operations of the enterprises, or who have made  proposals to revise the enterprises’ structures. We met with  representatives from FHFA, the Department of the Treasury (Treasury),  the Federal Reserve, HUD, the Government National Mortgage Association  (Ginnie Mae), CBO, the enterprises, bank and mortgage organizations, and  trade and community groups. These interviews provided us with the  different viewpoints about the proposals.
For the third objective, we analyzed the proposed options for restructuring  the enterprises in terms of the potential each proposal offered to achieve  key housing mission and safety and soundness objectives. In our analysis,  we also relied on principles associated with effective regulatory oversight.  While it is not possible to conclusively determine the potential  implications of the various proposals, we grounded our analysis of likely  outcomes on previous research and evaluations. We also sought to  include, where appropriate, assessments of how recent developments in  financial markets (particularly actions by federal agencies to provide  financial support to troubled banks and other institutions) could affect the  various options. We recognize that a variety of factors, such as the  condition of credit markets and the financial performance of the  enterprises while in conservatorship, could change over time and affect  our analysis of the options.
For the final objective, which discusses how the federal government’s  management of the conservatorships and response to the housing crisis  could affect the transition of the enterprises to a new structure, we  reviewed the actions undertaken by FHFA, Treasury, and the Federal  Reserve, as authorized by the Housing Economic and Recovery Act of  2008. We also reviewed financial data from Fannie Mae and Freddie Mac,  including their quarterly 10Q and annual 10K filings. We reviewed and  considered the future impact on the enterprises’ financial condition from  recent initiatives such as the Homeowner Affordability and Stability Act  and foreclosure initiation suspensions. We also discussed relevant issues  with Treasury and enterprise representatives.
We conducted this performance audit from October 2008 to September  2009, from Washington, D.C., and in accordance with generally accepted  government auditing standards. Those standards require that we plan and  perform the audit to obtain sufficient, appropriate evidence to provide a  reasonable basis for our findings and conclusions based on our audit  objectives. We believe that the evidence obtained provides a reasonable  basis for our findings and conclusions based on our audit objectives.
section_title: Appendix II: Comments from the Federal Housing Finance Agency
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the individual named above, Wesley M. Phillips, Assistant  Director; Triana Bash; Martha Chow; Lawrance Evans, Jr.; Marc Molino;  Robert Pollard; Barbara Roesmann; Stacy Spence; Paul Thompson; and  Barbara Williams made key contributions to this report.