September 2006

Breakfast with Jim Lockhart and Senator Chuck Hagel

In just a few months, Jim Lockhart, the new director of the Office of Federal Housing Enterprise Oversight (OFHEO), has shown himself to be a nonpartisan administrator, a quick study, and a practical man. Since taking office, he has repeatedly asked Congress, with increasing urgency, for the additional authority OFHEO requires for effective regulation of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. Nonetheless, a Senate committee bill that would provide the necessary powers remains stalled because of partisan disagreements. At an AEI breakfast conference, Mr. Lockhart gave a presentation on the urgency of GSE reform and made the case for Senate action. His address was followed by remarks from Senator Chuck Hagel (R-Neb.), a key proponent of GSE regulatory reform.

Peter J. Wallison
AEI

The time for strengthening GSE oversight is long overdue. The only question is why Congress accords them such respect. Fannie and Freddie are the poster children for corporate welfare, profiting immensely thanks to the privileges associated with their government charters, but--as shown by recent academic work--doing almost nothing to lower interest rates or stabilize the mortgage market during turbulent times. In addition, despite the GSEs’ inability to issue financial statements, the spread of their debt over Treasury bonds actually declined, showing that there is no market discipline: investors clearly believe that the GSEs will be bailed out by Uncle Sam if they get into financial difficulty. Accordingly, strong regulation is critical as a substitute for the absence of market discipline. That is why Congress should heed Jim Lockhart’s urgent call for GSE regulatory reform.

The Honorable Jim Lockhart
OFHEO

During the past year, OFHEO has issued four key reports on the state of the GSEs and the capacities of the regulator itself. In May, OFHEO released the Fannie Mae Special Examination Report, which revealed many of that enterprise’s problems--such as the accounting scandals, earnings manipulation, and management failures--as well as areas in which OFHEO needs to be strengthened. In June, OFHEO submitted its 2006 Annual Report to Congress, which noted that Fannie and Freddie have made progress over the past year, but that they will likely need another several years to fully achieve safe and sound practices. It also recommended legislative enhancements to the agency’s authority, consistent with those proposed by Congress. The quarterly House Price Index (HPI), released in early September, shows that the housing market is softening, which, if it results in credit losses, could have a major negative impact on the GSEs. Consequently, stronger oversight is essential. Finally, OFHEO has issued a draft of its strategic plan, which has three main goals: (1) enhance supervision to ensure the enterprises operate in a safe and sound manner, are adequately capitalized, and comply with legal requirements; (2) provide support for statutory reforms to strengthen OFHEO’s regulatory powers; and (3) continue to support the national policy of an efficient secondary mortgage market which promotes home ownership and affordable housing.

With respect to strategic goal (2), the ideal scenario would be for Congress to phase out OFHEO within the next year, replacing it with a stronger, more independent regulator with powers akin to those of bank regulators. However, if Congress fails to act, several negative consequences will likely result. In addition to the uncertainty that the GSEs and their investors will continue to face, OFHEO will still lack the bank regulator-like powers and independence it needs to carry out effective oversight of Fannie and Freddie. In order to prevent future problems, OFHEO needs explicit legal authorities, such as independent litigation authority, receivership, and better enforcement powers. Greater independence would mean freeing OFHEO from the appropriations process, which is currently cumbersome, inefficient, and can prevent the office from securing funds quickly for a timely investigation. Furthermore, without new legislation, regulatory authority over the GSEs will remain divided between OFHEO, which oversees safety and soundness issues, and the Department of Housing and Urban Development, which has authority over the GSEs’ charters, mission, and new products. New legislation is also needed to strengthen capital requirements, which are currently set at half of what large banks must maintain in order to be classified as well-capitalized.

Finally, a major consequence of Congress failing to act will be that the growth of GSEs will stay unrestrained. Between 1990 and 2005, the GSEs’ residential mortgage debt grew by 247 percent, their mortgage-backed securities by 326 percent, and their retained portfolios grew by 960 percent, while GDP, in comparison, grew by 118 percent. This sort of unrestrained growth can cause market, credit, and operational risks, as well as systemic risk, which can be the most dangerous risk of all. Because market discipline--or lack thereof--has failed to constrain the growth of Fannie and Freddie, the new regulator must have statutory authority to limit the growth of the GSEs’ retained portfolio. The Senate bill accomplishes this, but it needs to be more flexible. However, even under the current language, the Senate bill--like its counterpart in the House--does not prevent Fannie and Freddie from continuing their major business of buying mortgages and packaging them with guarantees for securitization. Ideally, Congress will act on GSE reform legislation this year by creating a stronger regulator, which will better serve the interests of continued growth in homeownership and affordable housing, and  will help to maintain a strong U.S. housing finance system.

The Honorable Chuck Hagel (R-Neb.)
U. S. Senate

The aim of pending legislation on GSE regulatory reform is simply to bring the enterprises back to fulfilling the mission for which they were originally chartered. Because the massive retained portfolios do not seem necessary for Fannie and Freddie to carry out their mission, and because those portfolios do pose a systemic risk to the economy, it is reasonable to constrain their growth. The GSEs have special privileges because of their government-chartered status and as a result are obliged to fulfill a specific mission. In recent years, however, that status has enabled Fannie and Freddie’s managements to take risks and behave irresponsibly, while simultaneously reaping major profits. The enterprises cannot have it both ways: either they retain their charters and stick strictly to their missions, or they lose their privileges and operate as normal public corporations. The other major sticking-point in the current debate is the oversight that ought to be afforded to the regulator with respect to the affordable housing fund. Unless OFHEO is given appropriate authority over the fund, I will not support the legislation. When time is short, a compromise can sometimes be reached more easily. But if no compromise is reached, I am committed to reintroducing the issue next session.

AEI research assistant Daniel Geary prepared this summary.