Freddie and Fannie Under Fire

This has been a long, hot summer for executives at Freddie Mac. What at first appeared to be a disagreement over arcane accounting rules turned into much more when Freddie Mac, the nation’s second largest housing finance company, announced the forced departures of its three top executives. The details behind the shake-up are still emerging, but regulatory changes for both Freddie Mac and its larger cousin Fannie Mae are likely. The turmoil is making mortgage lenders and Wall Street nervous.

Should the low-income housing sector be jittery as well? You bet. But probably not for the same reasons you have been reading about in the newspapers. Before examining the controversy and its potential impact on the affordable housing goals of both companies, it will be helpful to review the unique role that Fannie Mae and Freddie Mac play in the mortgage market.

What are Fannie Mae and Freddie Mac and what do they do? Congress chartered the Federal National Mortgage Association (Fannie Mae) in 1968 and the Federal Home Loan Mortgage Corporation (Freddie Mac) in 1970 as government sponsored enterprises (GSEs) to create a secondary market for residential mortgages and to smooth the flow of housing credit throughout the nation. As the nation’s two largest home finance companies, both GSEs essentially serve the same function and compete with one another for market share of the entire mortgage origination industry.

Both companies own or guarantee more than $3 trillion in mortgages – almost one-half of all outstanding mortgage debt – and fund nearly 80 percent of the estimated total of all non-government insured mortgages. Because of their market dominance, the underwriting standards of the GSEs have much sway over who is eligible for mortgage credit and on what terms.

The GSEs are for-profit, privately capitalized and managed companies, but their public charters also require them to serve a public purpose. For example, the GSEs are statutorily mandated to meet an annual percentage of business goals that serve the needs of low- and moderate-income families and underserved geographic areas. These housing goals play an important role in encouraging mortgage originators to undertake more affordable single-family and rental housing.

As financial intermediaries, the GSEs do not make mortgages directly to individual borrowers. Instead, as wholesale institutions they buy mortgages from loan originators such as banks, savings institutions and mortgage companies. They either keep these loans in their own portfolios or more typically package the loans and sell them to investors as mortgage-backed securities. This process provides lenders with the funds needed to issue new mortgages, thereby bringing additional capital into the housing loan market so that more mortgages can be made.

The GSEs are not funded by government appropriations. Instead, Fannie Mae and Freddie Mac raise money to buy mortgages by borrowing the funds they need by selling bonds in the capital market. Basically, the GSEs make their money on the spread between the interest they receive on the mortgages and the interest they pay on their debt. Their GSE status enables them to obtain funds more cheaply than if they were fully private financial institutions. Because of their public charters, the financial markets sense the GSEs have an implicit government guarantee that is the real source of their funding advantage. The Congressional Budget Office estimated that in 2000 the benefits of federal sponsorship were worth about $11 billion annually to the GSEs, of which about two-thirds were passed along to borrowers, with the remaining one-third retained by the GSEs.

What’s the situation at Freddie Mac all about? The first hint of a problem occurred in January 2003 when outside auditors questioned the methods Freddie Mac used to account for its large derivatives portfolio.

Derivatives are complex financial instruments commonly used by the GSEs and other large financial institutions to try to offset or “hedge” against sudden fluctuations in interest rates. The GSEs seek to match the maturity of their assets and liabilities to avoid situations where they have to finance long-term, low-interest mortgages with higher cost debt. Because of their vast long-term mortgage holdings, a sudden rise in interest rates can create large losses. Thus, both GSEs have become major players in the volatile derivatives market, to hedge this risk.

The accounting dispute over how to value the derivatives Freddie Mac holds attracted only limited attention at the time. Freddie Mac was still generating large profits. However, the other shoe dropped in June when Freddie Mac’s board of directors fired the company’s president, David Glenn. The board cited Glenn’s failure to cooperate with an internal investigation, and said that Glenn had acknowledged altering or destroying pages from a business diary that investigators wanted to read. Glenn’s firing, along with the simultaneous departures at the board’s request of Freddie Mac’s long-time chairman Leland Brendsel and another senior executive, left the financial community wondering whether larger problems were afoot. In late August federal regulators also told the board that it must replace its chief executive.

Freddie Mac eventually agreed to increase the profits reported for each of the past three years and pledged to use more standard accounting methods. Company officials say the problems arose because of efforts to “smooth out” quarterly earnings, presumably to make Freddie Mac appear less susceptible to interest rate moves, thereby lowering its cost of borrowing. A number of investigations and lawsuits are underway to determine if the company deliberately manipulated profits and if any criminal laws were broken.

Are Freddie Mac’s accounting problems a sign of more fundamental problems? For all the teeth gnashing, there still is no solid indication that either Freddie Mac or Fannie Mae is in any serious financial difficulty. Yet there are those who believe that both companies have traded on their special privileges to grow too large and pile up too much risk. Nonetheless, both GSEs are getting closer to tapping out their portion of the mortgage market, except for segments of the affordable housing market. There is concern in some quarters that the desire to keep expanding is leading the GSEs to take on additional risk that they would not have before. Increased investment risk can result in greater financial risk, and serious financial trouble for the GSEs is likely to mean a costly bailout for taxpayers, so the argument goes. Consequently, investors are quite sensitive to any whiff of trouble.

Freddie Mac has presented itself as the more cautious GSE, which has some believing that Fannie Mae may be more vulnerable to sudden interest rate moves and have greater risk exposure. Some institutional investors and analysts are saying that Fannie Mae has already experienced large losses for the past two years which have been obscured by the complexity of its accounting. Fannie Mae executives insist they have placed strict controls over their derivatives portfolio and have exercised care in accounting for these investments. In August a former Fannie Mae employee provided the New York Times with the computer models used by the company to estimate the value of its assets and debts. According to the Times, the models show that Fannie Mae faces much bigger losses from interest rate swings than it has publicly disclosed. Fannie Mae officials told the Times that the models are outdated, providing information that is both incomplete and misleading.

Nevertheless, until the full picture emerges, Wall Street will continue to be nervous and institutional investors will pay extra close attention to the financial reporting of Freddie Mac and Fannie Mae. The uncertainty is likely to intensify pressures to bring both companies under the Securities and Exchange Commission’s securities disclosure requirements, from which they are currently exempted.

How will Freddie Mac’s difficulties affect the overall housing market? How the debt markets perceive the GSEs’ financial condition is critical to their ability to operate. For a decade or more, Fannie Mae and Freddie Mac were able to borrow the funds they needed for only slightly more than the Federal government pays. However, in the weeks since the Freddie Mac story first broke, the cost of funds to both companies has risen. Because they need to pay more now, they have less with which to fund mortgages. Fannie Mae said recently that, before rates jumped this past summer, it could probably refinance 90 percent of mortgages but that now the proportion is less than half that.

No one is saying for sure whether, and for how long, these conditions will continue. But a reduced supply of mortgage funds translates into increased interest rates for borrowers, which can be particularly harmful to those at the margins of qualifying for mortgages. As a result, homeownership opportunities for low- and moderate-income homebuyers could especially suffer if rates continue to rise.

Will the GSEs be regulated differently in the future? Freddie Mac’s current troubles certainly have attracted the attention of lawmakers. Hearings are being held, and legislation has been introduced to stiffen controls over the GSEs. Congressional action could entail changing the regulatory structure, restricting GSE activities or severing GSE ties to the government – or all of the above.

The most support exists for either expanding the powers of the Office of Federal Housing Enterprise Oversight (OFHEO) or transferring oversight to another agency. There is also some Congressional support for additional restrictions on GSE financial activities. Legislation is pending to bring both companies under SEC registration and disclosure requirements. However, there appears to be little support at the moment for taking steps to fully privatize the GSEs – which some of the severest GSE critics hope will eventually happen.

OFHEO was established in 1992 as an independent entity within the Department of Housing and Urban Development (HUD). As their “mission” regulator, HUD has general regulatory responsibility for ensuring that Fannie Mae and Freddie Mac operate within their public charters and otherwise fulfill their statutory mandates, such as meeting their annual affordable housing goals and abiding by fair lending requirements.

Unfortunately, OFHEO was never vested with the powers it needs to regulate the GSEs effectively. Unlike banking regulators, OFHEO cannot assess the GSEs for the cost of oversight. Its budget is subject to the appropriations process, which greatly limits the agency’s funding. OFHEO’s current budget is $27 million, compared to the $70 million a banking regulatory agency would be able to assess to examine financial institutions the size of the GSEs. Further, OFHEO is not equipped with “cease and desist” enforcement authority, a tool that most financial regulators typically have.

The simplest course would appear to be to upgrade OFHEO’s powers but this ignores the politics of GSE regulation. OFHEO does not have a favorable image with some key lawmakers and the agency was not helped by the appearance that it was caught off-guard by the Freddie Mac dismissals. OFHEO officials had issued a report only days before, pronouncing itself “satisfied” with Freddie Mac’s handling of the accounting issues. OFHEO has since created a special task force to investigate the matter, but it may be too little too late.

Rep. Richard Baker (R-LA) chairs the House Capital Markets Subcommittee and is a long-time critic of OFHEO, Fannie Mae and Freddie Mac. He introduced legislation to abolish OFHEO as an independent agency within HUD and transfer its authority to a revamped Office of Thrift Supervision, a unit within the Treasury Department that regulates savings institutions. Baker’s bill retains HUD as the supervisor of the affordable housing mandates, provides the department with new enforcement powers for this function and allows HUD to assess the GSEs for the cost of this oversight (which is currently paid with funds from the HUD general operating budget). The bill also expands HUD’s authority to review new GSE programs, requiring prior department approval for all new activities. Baker quickly gathered 20 cosponsors – all Republicans – for his bill. Committee Democrats have not signed on, at least for now.

Senate Banking Committee members Chuck Hagel (R-NE), John Sununu (R-NH) and Elizabeth Dole (R-NC) have introduced legislation similar to Baker’s. Additionally, Sen. Jon Corzine (D-NJ) is planning to introduce legislation to transfer authority and provide for further controls over the GSEs’ portfolio management. Others on the committee have endorsed changing authority to Treasury as well.

The Bush Administration has also joined in by outlining an ambitious plan to concentrate regulatory oversight for Fannie Mae, Freddie Mac and even the Federal Home Loan Bank system in a single new bureau at Treasury. Freddie Mac’s difficulties have tied its hands, but Fannie Mae has come out in favor of the transfer and is negotiating the details with the administration and lawmakers.

There is little doubt that some changes to GSE oversight will occur, if for no other reason than to shore up housing markets and assure Wall Street. But it does not necessarily follow that the switch to Treasury will improve things, at least not for the short run. Those who favor the transfer believe the GSE regulator could benefit from Treasury’s financial expertise and stature as a cabinet agency. Yet the move is likely to cause at least some short-term disruptions in oversight. There are also disturbing indications that the new bureau would operate with less independence than bank and thrift regulators. Diminishing HUD’s oversight role could also undermine the GSEs’ strong housing mission focus, and hamper efforts to push Fannie Mae and Freddie Mac to serve more low- and moderate-income housing needs.

The Treasury Department, by style and orientation, is not necessarily best suited to make important determinations about GSE program activities. HUD’s track record as mission regulator is far from perfect but as the principal federal agency responsible for housing it is still better suited for mission and program oversight. Treasury’s primary focus is likely to be on safety and soundness considerations, and a strong mission regulator will be needed to balance these sometimes competing demands. The experience with Community Reinvestment Act enforcement for banks confirms this.

Meanwhile, emphasis on the GSEs’ low-income housing mandates already appears to be slipping. HUD failed to establish new affordable housing goals for 2004 and beyond, and current levels will rollover for at least another year.

HUD last raised affordable housing goals in 2000, significantly increasing the annual volume of low- and moderate-income housing mortgage activity both Fannie Mae and Freddie Mac must undertake. Note that one unit may qualify for more than one goal:

Low- and moderate-housing goal – at least 50 percent of the dwelling units financed by each GSE’s mortgage purchases must be for families with incomes no greater than area median income.
Special affordable goal – at least 20 percent of dwelling units financed by each GSE’s mortgage purchases must be for very low-income families or for low-income families living in low-income areas.
Geographically-targeted (underserved areas) goal – at least 31 percent of the dwelling units financed by each GSE’s mortgage purchases must be for units in central cities, rural areas and other underserved areas, based on income and minority concentration as defined by HUD.

Fannie Mae and Freddie Mac say they surpassed these goals in 2001 and 2002, although the official HUD tallies have yet to be released. Both companies rely on regulatory bonus points provided for purchasing certain types of mortgages to meet their annual goals, such as small, multifamily, owner-occupied rental units. The bonus points also terminate at the end of this year, which will require the GSEs to significantly increase their loan purchases to make up the difference. It is unknown whether these incentives will be extended, but HUD should seek public comment before going forward.

Fannie Mae, and to a lesser extent Freddie Mac, have worked in recent years to foster relationships with low-income housing and community organizations, and their performance continues to improve. The GSEs routinely meet the three statutory goals. Nevertheless, HUD data through 2000 shows that despite improvements both companies continued to underperform the conventional market in funding affordable home purchase loans for borrowers and neighborhoods targeted by the goals. Also, HUD said last year that Fannie Mae and Freddie Mac continued to account for a very small share of the market for important groups, such as minority first-time homebuyers. Fannie Mae, in particular, insists that data on its more recent performance show that it leads the market in many of these areas.

The 2000 HUD rule that established current goals also recognized that the GSEs “have a public responsibility to help eliminate predatory mortgage practices which are inimical to the home financing and homeownership objectives that the GSEs were established to serve.” The rule disallowed GSEs from receiving credit toward thier affordable housing goals from the purchase of predatory mortgages. HUD should continue to challenge the GSEs to expand upon these prohibited features and act more aggressively to challenge predatory practices in the subprime market. Unfortunately, HUD has not taken these steps.

HUD has also resisted disclosing the results of its major fair lending review of GSEs’ automated underwriting systems (AUS). Most mortgages made by lenders are run through these systems, which rely on credit scoring and other statistical measures to rate creditworthiness. In effect, the systems determine who qualifies for prime mortgages and at what price. Borrowers who do not meet GSE standards often must turn to the more expensive subprime market. Credit scoring models almost always have disparate impacts for people of color, but they have not been subject to a comprehensive regulatory review to determine if they are discriminatory. The purpose of the HUD fair lending review of the AUS was to answer this essential question. Chairman Baker and others have written to HUD asking for the results but the agency seems to be stonewalling.

HUD Secretary Mel Martinez recently offered some constructive proposals to spur additional improvements in the GSEs’ affordable housing performance. These include expanding the department’s authority to set subgoals beyond the three existing statutory goals and to explicitly require the GSEs to increase their support for minority homeownership activity.

At a minimum, it is important that changes to the regulatory structure do no harm to the housing mission and the GSEs’ responsibilities to affordable housing. However, the legislation could go further and work to strengthen or expand upon existing mandates. The 1992 GSE housing goal legislation served an important purpose but it is also unduly broad and does not properly target the neediest segments of the mortgage market.

For example, targeting the low- and moderate-income housing goal to 80 percent or below of Area Median Income (AMI) instead of 100 percent of AMI would mean more GSE activity targeted to truly low- and moderate-income households. It would also make the goals more consistent with the CRA requirements for banks. Providing HUD with authority to establish enforceable housing subgoals could also help target more mortgages to important segments of the affordable housing market, such as rural housing and minority and low-income, first-time homebuyers.

Improved public disclosure of GSE activity at the local level also would help. HUD maintains a GSE public use database ostensibly to provide housing and community groups with information to track GSE activities. Unfortunately, the database does not provide important information, such as breakouts between home purchase loans and refinancings, which would permit a more accurate review of GSE activities within individual communities.

These steps could make an important difference to low-income housing. In fact, it was advocacy by community, consumer and low-income housing organizations that convinced Congress to establish the affordable housing mandates in 1992. Advocates should be looking for opportunities to build on these past gains. They will need to move very quickly to forge a policy agenda to ensure that mortgage funding for low- and moderate-income borrowers does not become a “sacrificial cow” as decisions are made about the GSEs.

 

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Allen Fishbein is director of housing and credit policy for Consumer Federation of America. 202-387-6121 or afishbein@consumerfed.org. He was general counsel of the Center for Community Change. From 1999-2000 he was a senior adviser for Government Sponsored Enterprises Oversight at HUD, where he helped supervise the establishment of new affordable housing goals for Fannie Mae and Freddie Mac.

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