The corporate governance and accounting problems experienced by the housing related government sponsored enterprises (GSEs) over the past several years have been well documented. This article discusses the evolution of, recent problems facing, and systemic risks associated with these GSEs and the latest efforts by Congress to reform the GSEs in order to protect the long-term stability of the financial markets and realign their activities with their public interest mission.
History of GSEs
Congress chartered the housing related GSEs for the purpose of enhancing the availability of mortgage credit and maintaining a well established secondary market for residential mortgages in order to promote homeownership. The housing related GSEs include the Federal Home Loan Bank System (FHLB), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac).
The FHLB consists of 12 regional banks and is supervised by the Federal Housing Finance Board (FHFB). Each regional bank is a private co-operative enterprise that is owned by member depository institutions within its respective region, and the stock of the regional banks is held only by its members and is not publicly traded.
The FHLB was established in 1932 to make advances to thrifts in order to revive the housing market after the Great Depression. The operation and function of the FHLB changed little in the decades following its creation until the 1980s. The economic recession and thrift crisis of the 1980s caused a contraction in FHLB business and resulted in an overhaul of the FHLB membership, regulation, and mission requirements. Membership was opened to commercial banks and credit unions in 1989. Consequently, membership jumped from 2,855 to over 8,000 financial institutions as of 2004. Likewise, total assets of the FHLB soared from $165 billion to $934 billion.
As a result of legislative changes in recent years, the scope of the FHLB has expanded to include providing liquidity for small business, community and rural development, and agricultural purposes. Starting in 1997, the FHLB initiated programs to purchase mortgages directly from member financial institutions. This activity has increased the risk profile of the FHLB, since sophisticated risk management techniques, including financial derivatives, must be employed to manage the associated interest rate risk.
Many of the FHLB regional banks had to restate earnings over the past few years due to the misapplication of accounting standard SFAS 133, “Accounting for Derivative Instruments and Hedging Activities.” Increased interest rate risk and decreased profitability caused credit downgrades for several banks. In addition, the FHFB entered into written agreements with two of the regional FHLB banks in 2004 to address weaknesses in governance, risk management, capital management, financial performance, internal audit, accounting, and financial record keeping.
Fannie Mae was originally chartered in 1938 to create a secondary market for mortgages by purchasing government insured or guaranteed mortgages. The 1968 Charter Act transformed Fannie Mae into a privately owned, publicly traded GSE that could buy most insured and conventional mortgages. The Emergency Home Finance Act of 1970 created Freddie Mac to provide a secondary market for conventional mortgage loans written by savings and loan providers, other lenders, and brokers. At its inception, Freddie Mac was capitalized and owned by the FHLB. However, starting in 1989, stock of Freddie Mac began to be publicly traded.
The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 charged the Office of Federal Housing Enterprise Oversight (OFHEO), which is part of the Department of Housing and Urban Development, with supervisory authority over both Fannie Mae and Freddie Mac.
Fannie Mae and Freddie Mac provide liquidity to the mortgage market in two ways: by purchasing mortgages from lenders and holding them or by securitizing these mortgages into marketable securities, which it sells in the capital markets to obtain funding. These GSEs are highly leveraged, with total equity that is less than 4 percent of total assets. Although securities issued by Fannie Mae and Freddie Mac are not guaranteed by the federal government, investors believe that the government would provide backing in times of financial distress and, therefore, are willing to allow these two GSEs to borrow at a discount. Empirical studies suggest that they benefit from a 35-40 basis point funding advantage. This ability to borrow at below market rates, combined with the relatively low capital requirement, has fueled the rapid asset growth of these two GSEs and has enabled them to earn returns on equity that far exceed those of similar financial institutions.
In the last ten years, the combined total assets of Fannie Mae and Freddie Mac surged 450 percent to approximately $1.8 trillion. They have become the largest providers of funds for home mortgages by owning or guarantying about 50 percent of mortgages in the United States. Based on asset size, Fannie Mae is the second largest financial corporation in the United States, surpassed only by Citigroup.
The rapid asset growth can be attributed to the dramatic increase in their retained investment portfolios. Over the past ten years, the combined retained investment portfolios of Fannie Mae and Freddie Mac increased tenfold to approximately $1.5 trillion, due to purchasing their own or each others’ mortgage-backed securities. Unlike the purchase and securitization of mortgages, the retained investment portfolios do not enhance the availability of mortgage funding for households. A study conducted by Federal Reserve staff found no correlation between the size of the GSEs' retained investment portfolios and mortgage rates.1 Therefore, the dramatic buildup of the investment portfolios for the purpose of earning higher returns illustrates how these two GSEs have shifted away from their primary mission to one more focused on generating on returns and increasing shareholder value.
There is concern that the enormity of Fannie Mae and Freddie Mac, their explosive growth, and their dominance in the mortgage market adds substantial risk to the financial system. As the size of these portfolios grows, so does the level of interest rate risk. In his testimony before the Committee on Banking, Housing, and Urban Affairs on April 6, 2005, former Federal Reserve Chairman Alan Greenspan warned of the “growth and magnitude of the portfolios of the GSEs, which concentrate interest rate risk and prepayment risk at these two institutions and make our financial system dependent on their ability to manage these risks.” The fact that six out of ten institutions in the banking industry hold GSE debt in excess of 50 percent of their capital compounds this risk. Holdings of GSE debt by commercial banks in the Third District mirror the national trend.
In response to heightened concern that any financial shock to Fannie Mae and Freddie Mac could cause substantial damage to the economy and reveal significant accounting irregularities, the OFHEO conducted special investigations of Freddie Mac and Fannie Mae in 2003 and 2004, respectively. The OFHEO determined that management of both organizations had disregarded accounting rules, internal controls, and disclosure standards to smooth the volatility of their earnings in order to meet market expectations and earnings targets.
The OFHEO’s investigation found that compensation packages that tied bonuses to earnings performance provided motivation for management to strive to report consistent earnings. Freddie Mac understated earnings by approximately $5 billion from 2000 through 2003. Meanwhile, Fannie Mae is required to restate earnings back to 2001, which will force it to recognize almost $11 billion in losses. Fannie Mae has yet to file the required earnings reports to the SEC, and additional accounting errors have been disclosed as recently as March 13, 2006.
The former director of the OFHEO contends that the ability of the OFHEO to effectively supervise Fannie Mae and Freddie Mac was hindered by inadequate resources, a constraining funding mechanism, and powers that do not equal those of other regulators.
To address the systemic risks posed by the three GSEs, the ineffective regulatory oversight, the lack of corporate governance, and the digression from their public interest mission, the House of Representatives passed H.R. 1461 “The Federal Housing Reform Act of 2005” on October 28, 2005. On October 31, 2005, this bill was referred to the Senate’s Committee on Banking, Housing, and Urban Affairs. Likewise, the Senate Banking Committee passed S. 190 “Federal Housing Enterprise Regulatory Reform Act of 2005” on July 28, 2005. However, this bill stalled before the full Senate due to the failure to reach a compromise on a key issue: how to limit the retained investment portfolios of Fannie Mae and Freddie Mac.
The two bills are similar in that they:
While there is agreement that the vast investment portfolios held by Fannie Mae and Freddie Mac pose substantial systemic risk to the financial markets, the bills differ on how to limit the size of these portfolios.
H.R. 1461 permits the director to require a GSE to dispose of an asset or obligation based on safety and soundness considerations. In comparison, the Senate’s bill allows the GSEs to keep only certain types of assets, which, as a result, would restrict the size of the portfolios and reduce their balance sheets. The new regulator would oversee a gradual sell-off of prohibited assets. The Bush Administration and the Federal Reserve favor the provision in the Senate’s bill because it better ensures that the GSEs’ portfolios are more in line with their primary purpose, and it reduces the risk associated with these portfolios.
In addition, H.R. 1461 also contains a controversial provision that is not included in the Senate’s bill. H.R. 1461 requires Fannie Mae and Freddie Mac to fund separate affordable housing funds from a percentage of their profits. Each entity would control and manage its own fund and allocate funding according to regulations that the regulator would promulgate. Affordable housing advocates praised this initiative, but critics fear that, given the profit driven cultures engrained at these two entities, these funds could be mismanaged.
While addressing GSE reform is a priority for Congress in 2006, a timetable for debates and votes has not yet been scheduled. The Senate is waiting to hear Federal Reserve Chairman Bernanke’s views and to analyze two reports on Fannie Mae’s accounting problems before bringing legislation to the Senate floor. One of these reports, “The Rudman Report,” which presents the findings of an independent investigation led by Senator Warren Rudman (R-NH), was issued on Thursday, February 23, 2006, and can be accessed at http://download.fanniemae.com/execsum.pdf. Congress met on March 14, 2006, to review this report. Supporters of the reform effort believe passage in some form is likely in 2006, given the support of the White House, Treasury Department, and Federal Reserve; the momentum created by H.R. 1461 and S. 190; and the growing intolerance of organizations, public or private, that violate the public trust.
To review the full text of these bills or to monitor their status in Congress, please go to: http://thomas.loc.gov/.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.