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

Letter

Enterprises Had a Mixed Record in Achieving Housing Mission Objectives, and Risk Management Deficiencies Compromised Their Safety and Soundness

It is generally accepted that the enterprises were successful in achieving key housing mission objectives to support the secondary mortgage market and facilitate the flow of mortgage credit: (1) We reported that the enterprises established a viable mortgage market for secondary loans that enabled capital to flow to areas with the greatest demand for mortgage credit. (2) The enterprises’ activities have been credited with lowering interest rates on qualifying mortgages below what they otherwise would have been, although estimates regarding the extent of this benefit vary. (3) Furthermore, the enterprises established underwriting practices and forms for conventional mortgages that became standard in the industry, increased the efficiency of underwriting, and helped develop the MBS market.

However, it is not clear to what extent the enterprises have been able to support a stable and liquid secondary mortgage market during periods of economic stress, which is another key objective. As noted in our 1996 report, we did not find clear evidence that Fannie Mae’s mortgage purchase activities during the 1980s supported mortgage markets in certain states that had experienced substantial economic setbacks. During the current financial crisis, the enterprises have provided critical support to mortgage finance as private-sector MBS issuance largely collapsed. Yet the enterprises have been able to provide this support to mortgage finance only with the substantial financial assistance from Treasury and the Federal Reserve discussed earlier.

While the enterprises also were to facilitate mortgage credit opportunities for targeted groups, it is not clear that the numeric mortgage purchase program materially benefited such groups. HUD administered the program from 1992 until the authority was transferred to FHFA in 2008. Recent research indicates that, although the enterprises have enhanced their product offerings to meet the housing goals, the effects of the housing goals on affordability and opportunities for targeted groups have been limited. For example, one study found that as the enterprises’ activities increased in certain areas pursuant to the mortgage purchase program, they may have been offset by a decline in FHA’s existing activities in those areas. Earlier research sponsored by HUD in 2001 found that the enterprises generally did not play a leading role in affordable multifamily mortgage finance because their underwriting standards were considered conservative and fairly inflexible, compared with those of other multifamily mortgage providers. In contrast, I should note that representatives from mortgage finance, housing construction, and consumer groups we contacted said that the benefits from enterprise purchases of multifamily mortgages were significant. The representatives said that the enterprises’ involvement in or guarantees of the financing of affordable multifamily projects were crucial to their successful completion. In addition, they said that during the current financial crisis the enterprises were the only source of funding for multifamily projects because many other traditional providers, such as banks and insurance companies, largely have withdrawn from the market.

While housing finance may have benefited from the enterprises’ activities over the years, GAO, federal regulators, researchers, and others long have argued that the enterprises’ structures (for-profit corporations with government sponsorship) undermined market discipline and provided incentives to engage in potentially profitable but risky business practices that did not necessarily support their public missions. As examples, We and others raised consistent concerns about rapid growth in the enterprises’ retained mortgage portfolios, which reached a combined $1.6 trillion by 2005. Although increasing the size of the portfolios may have been more profitable than issuing MBS, it exposed the enterprises to significant interest rate risk. We reported that the rapid increase and the associated interest rate risk did not result in a corresponding benefit to the achievement of their housing missions.

In 2003 and 2004, the enterprises were found to have manipulated accounting rules so that their public financial statements showed steadily increasing profits over many years and thereby increased their attractiveness to potential investors. The misapplication of accounting rules generally involved standards for reporting on derivatives, which the enterprises used to help manage interest rate risks associated with their large retained portfolios. The enterprises had to restate their financial statements and adjust their earnings reports by billions of dollars.

Finally, beginning in 2004 and 2005, the enterprises purchased a large volume of questionable mortgage assets, such as private-label MBS and Alt-A mortgages, which typically did not have documentation of borrowers’ incomes and had high loan-to-value or debt-to-income ratios. According to FHFA, these questionable mortgage assets accounted for less than 20 percent of the enterprises’ total assets but represented a disproportionate share of credit-related losses in 2007 and 2008. FHFA stated that the losses on these assets helped precipitate the enterprises’ financial deterioration and resulted in the decision to place them in conservatorship in September 2008.

Options for Restructuring the Enterprises Aim to Achieve Housing Mission Objectives while Mitigating Safety and Soundness Risks

The enterprises’ mixed records in achieving their housing mission objectives and the losses and weaknesses that resulted in the conservatorships reinforce the need for Congress and the executive branch to fundamentally reevaluate the enterprises’ roles, structures, and business activities in mortgage finance. Researchers and others believe a range of options could better achieve housing mission objectives (in some cases through other federal entities such as FHA), help ensure safe and sound operations, and minimize risks to financial stability. These options generally fall along a continuum, with some overlap among key features, and advocate (1) establishing a government corporation or agency, (2) reconstituting the enterprises as for-profit GSEs in some form, or (3) privatizing or terminating them (see table 1).

The following paragraphs summarize key principles and aspects of each option: Government corporation or agency. Supporters of these proposals maintain that the implied federal guarantee and the enterprises’ need to respond to shareholder demands to maximize profitability encouraged excessive risk taking and ultimately resulted in their failures. They believe that a government entity, which would not be concerned about maximizing shareholder value, would best ensure the availability of mortgage credit for primary lenders while minimizing risks associated with a for-profit structure with government sponsorship. Establishing a government corporation or agency also would help ensure transparency through appropriate disclosures of risks and costs in the federal budget. Elements of the proposals include eliminating retained mortgage portfolios over time; establishing sound underwriting standards and risk- sharing arrangements with the private sector; establishing financial and accountability requirements for lenders; instituting consumer protection standards for borrowers; and eliminating responsibility for the numeric mortgage purchase program (instead, FHA’s mortgage insurance programs would be expanded to address this objective).

Reconstituted GSEs. Market participants and commenters, trade groups representing the banking and home construction industries, and community and housing advocates we contacted believe that reconstituting the enterprises would help ensure that they would remain responsive to market developments, continue to produce innovations in mortgage finance, and be less bureaucratic than a government agency or corporation. But they also advocate a variety of additional regulations and ownership structures to help offset the financial risks inherent in the for- profit GSE structure, such as substantially downsizing or eliminating the enterprises’ mortgage portfolios; breaking up the enterprises into multiple GSEs to mitigate safety and soundness and financial stability risks; establishing public utility-type regulation for the enterprises (for example, limiting their rates of return); and converting the enterprises into lender- owned associations (creating incentives for mortgage lenders to engage in more prudent underwriting practices).

Privatization or termination. Some analysts and financial commenters contend that privatizing or terminating the enterprises (including dispersing key functions among private-sector entities) represents the best public policy option. Advocates believe that privatized entities would align mortgage decisions more closely with market factors and that the resultant dispersal of credit and interest rate risk would reduce safety and soundness risks. Federal Reserve Chairman Ben S. Bernanke has suggested that privatized entities may be more innovative and efficient than government entities, and operate with less interference from political interests. Elements of the proposals include introducing a transition period to mitigate any potential market disruptions and facilitate the development of a new mortgage finance system; and establishing a federal entity to provide catastrophic mortgage insurance for lenders and help ensure that mortgage markets would continue functioning during stressful economic periods.

A Framework for Analyzing Trade-offs Associated with the Options and Potential Oversight and Regulatory Structures to Help Ensure Their Effective Implementation

We sought to assess each restructuring option in terms of its capacity to meet key housing objectives (providing liquidity and support to mortgage markets and facilitating housing opportunities for targeted groups) while also mitigating safety and soundness and financial stability risks. Our analysis indicates that each option involves important trade-offs, which are summarized in table 2. The table also identifies regulatory and oversight structures that might help ensure that any option implemented would achieve housing mission and safety and soundness objectives.

While the table provides a comprehensive overview of our analysis, let me highlight some implications and trade-offs as they relate to the critical issues of safety and soundness and systemic risk. In some regards, a government entity may mitigate the safety and soundness and systemic risk concerns of the traditional GSE structure. That is, it would eliminate the concern that publicly held profit-maximizing corporations would be able to operate with relatively low levels of capital and take excessive risks because of an implied federal guarantee that undermined market discipline. And, if a government entity were to focus on MBS issuances and not retain a mortgage portfolio, then it would be less complex and potentially less risky than the GSEs were. Nevertheless, a government entity may find successfully managing a large conventional mortgage purchase and MBS issuance business to be challenging. As described in our previous work on FHA, government entities may lack the financial resources to attract highly skilled employees and obtain information technology to manage complex business activities. The failure to adequately manage the associated risks also could result in significant losses for taxpayers. For example, the enterprises’ losses in recent years have been credit-related (because of mortgage defaults), including substantial losses in their MBS guarantee business. This risk may be heightened if a government entity was expected to continue purchasing mortgages and issuing MBS during stressful economic periods.

Reconstituting the GSEs could present significant safety and soundness concerns as well as systemic risks to the financial system. In particular, the potential that the enterprises would enjoy explicit federal guarantees of their financial obligations, rather than the implied guarantees of the past, might serve as incentives for them to engage in risky business practices to meet profitability objectives. One option to mitigate these safety and soundness concerns would be to make the enterprises into lender-owned associations. By selling mortgages to the enterprises, lenders would have financial incentives to adopt sound underwriting practices (as any losses the reconstituted GSEs incurred on such mortgages would affect the lenders’ investments in them). While the public utility model of regulation also has been proposed to help mitigate the risks associated with reconstituting the GSEs, it is not clear that this model is appropriate. Unlike natural monopolies such as electric utilities, the enterprises faced significant competition from other providers of mortgage credit over the years.

It is difficult to determine the extent to which privatizing or terminating the enterprises mitigates current safety and soundness and financial stability risks. Under one scenario, such risks would be mitigated because large and complex enterprises that might engage in risky business practices due to an implied federal guarantee would not exist. Instead, private lenders would be subject to market discipline and be more likely to make credit decisions on the basis of credit risk and other market factors. However, if a federal entity were established to insure mortgage debt and did not set appropriate premiums to reflect its risks, then lenders might have incentives to engage in riskier business practices than otherwise would be the case. Moreover, if large private-sector financial institutions assumed responsibility for key enterprise activities or purchased a significant portion of their assets, the perception could arise that the failure of such an institution would involve unacceptable systemic financial risks. Therefore, perceptions that the federal government would provide financial assistance to such financial institutions could undermine market discipline. As we previously reported, the fragmented and outdated U.S. financial regulatory structure already lacks the capacity to effectively oversee large financial conglomerates and reform is urgently needed.

Oversight and regulatory structures could help ensure that each option mitigated safety and soundness and systemic risk concerns while helping to achieving housing mission objectives. These oversight and regulatory structures could include the following: for the government entity, granting operational flexibility to obtain staff and informational technology to carry out responsibilities, requiring appropriate disclosures in the federal budget of risks and liabilities to ensure transparency, and instituting robust congressional oversight; for the reconstituted GSE option, reducing or perhaps eliminating mortgage portfolios, establishing capital standards commensurate with risk, and establishing executive compensation limits; and for the privatization or termination option, reforming the current regulatory structure, setting capital standards commensurate with risks (if a federal insurer is established), disclosing risks and liabilities in the federal budget in the interests of transparency, and instituting robust congressional oversight.

Federal Efforts to Support Housing Markets during the Conservatorships Could Affect Transition to New Structures

Since the beginning of the FHFA conservatorships, the enterprises have been tasked to initiate a range of programs, such as assisting homeowners to refinance or modify their mortgages. These initiatives could benefit housing markets and, in doing so, potentially improve the enterprises’ financial condition. However, the initiatives also may involve additional risks and costs for the enterprises, which could increase the costs and challenges associated with transitioning to new structures. For example, borrowers who received mortgage loan modifications could redefault, incurring additional losses.

Similarly, certain provisions in the Treasury agreements with the enterprises may affect their long-term financial viability and complicate any transition. For example, the enterprises must pay quarterly dividends that accrue at 10 percent annually to the Treasury, and in a liquidation proceeding the department has a claim against the assets of any enterprise that cannot pay such dividends. Since Treasury has already purchased $50 billion in preferred shares of Freddie Mac to date, the enterprise is responsible for paying a dividend to Treasury of $5 billion annually. Prior to the conservatorship, Freddie Mac’s reported annual net income twice came close to or exceeded $5 billion, and the dividends it distributed to shareholders in those years likely were substantially lower.

Although it is not possible to predict what effects federal initiatives to respond to the housing crisis and the Treasury agreements with the enterprises could have on any transition, they could be substantial. For example, under the proposal to reconstitute the enterprises, potential investors might not be willing to invest in reconstituted GSEs that had a substantial volume of nonperforming mortgage assets or financial obligations to Treasury. To minimize this risk, the federal government could retain nonperforming assets in a “bad bank,” spin off the performing assets to a “good bank,” and devolve key functions, such as issuing MBS, to investors in a reconstituted GSE. Or, the federal government could use this process to terminate or privatize the enterprises. However, to the extent that the enterprises previously engaged in activities or incurred financial obligations inconsistent with maintaining long-term financial viability, the level of nonperforming assets and long-term costs to taxpayers may be higher than otherwise would be the case.

Regardless of what changes are implemented, policymakers should pay careful attention to how a potential transition is managed to mitigate potential risks to the housing finance system. The enterprises evolved to become dominant participants in housing finance, and, in some respects, their roles have expanded during the conservatorships. Therefore, transitioning to a new structure could have significant consequences for housing finance and should be managed carefully and perhaps implemented in phases, with periodic evaluations to determine if corrective actions were necessary.

Finally, regardless of any enterprise structural reforms that are adopted, we urge Congress to continue to actively monitor the progress of such implementation and to be prepared to make legislative adjustments to ensure that any changes are as effective as possible. In addition, we believe that it is important that Congress provide for appropriate GAO oversight of any structural and related reforms to help ensure accountability and transparency in any new system. GAO stands ready to assist the Congress in its oversight capacity and evaluate the progress that is being made in implementing any changes.

Chairman Dodd, Ranking Member Shelby, and Members of the Committee, this concludes my prepared testimony. I would be pleased to address any questions that you or the members of the committee may have.

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