If a GSE's troubles coincide with a broader financial crisis, Government officials will face additional pressures to rescue the GSE. For if during the crisis those officials seriously upset established expectations, they may create contagious uncertainty about the Government's willingness to meet other expectations. A crisis is thus a particularly inopportune time for attempting to reeducate market participants about the scope of the Government's undertakings. So if the Government tacitly accepts "too big to fail" expectations during good times, it may find itself constrained during a crisis to rescue a GSE against its better judgment. But the circularity of systemic risk also has a positive side: If the Government acts in a timely way, it can correct "too big to fail” expectations. Congress did just that in the FDIC Improvement Act of 1991 (FDICIA) by curtailing the practice of treating FDIC-insured banks as "too big to fail." 19 FDIČIA's "least-cost resolution" rule allows the FDIC to protect a failed bank's uninsured depositors and nondeposit creditors only if doing so is the "least costly to the deposit insurance fund of all possible methods" for meeting the FDIC's obligation to insured depositors. 12 U.S.C. § 1823(c)(4). The rule has a narrow systemic-risk exception, which has never been used.20 Before FDICIA, the FDIC was spending extra money from the deposit insurance fund to protect uninsured depositors at banks as small as $500 million in total assets. But less than 1 year later, when an $8.8 billion bank group in a swing State failed just a few days before the 1992 Presidential election, the FDIC did not protect uninsured depositors and financial markets took that action in stride. By giving clear and timely notice of the new policy, Congress had succeeded in changing market participants' expectations. Proper and timely Government action can thus reduce the potential for systemic risk.21 Effective safety and soundness regulation of the GSE's can further reduce that risk. Yet we should beware of relying excessively on regulation. Regulation did not prevent the U.S. banking system from collapsing in 1933. Regulation did not prevent the 1980's thrift debacle, with its $125 billion cost to the taxpayers. Regulation did not prevent the bank failures of the 1980's and early 1990's, which depleted the FDIC's Bank Insurance Fund. Nor, more recently, did OFHEO detect Fannie and Freddie's accounting problems, even though it had examiners scrutinizing each GSE year-round. The failings of regulation underscore the need to maintain market discipline on the GSE's and other large financial institutions. Miscellaneous ENDING THE GOVERNMENT'S ROLE IN APPOINTING GSE DIRECTORS Under current law, Federal officials appoint some members of each housing GSE's board of directors. For both Fannie and Freddie, the President appoints 5 of each GSE's 18 directors. 12 U.S.C. §§ 1452(a)(2)(A), 1723(b). The Federal Housing Finance Board appoints 6 of each Federal Home Loan Bank's 14 directors. § 1427(a). The Administration rightly proposes to end governmental appointment of GSE directors (and, as an initial step in that direction, has indicated that it will no longer appoint directors of Freddie). Government-appointed directors face a conflict of interest. They presumably have some duty to serve the public. Yet under corporate law they presumably also have fiduciary duties to their corporation's shareholders. These duties conflict whenever the shareholders' interests run counter to some broader public interest: For example, when the shareholders' interest in maximizing profits conflicts with the public interest in protecting the taxpayers or promoting affordable housing. In 1988, Freddie's directors concluded that their fiduciary duties 19 In context of a failed FDIC-insured bank, "too big to fail" treatment involves spending extra money from the deposit insurance fund to protect deposits above the $100,000 limit on deposit insurance coverage. It may also involve extra spending to protect nondeposit creditors. 20 The systemic-risk exception becomes an option only if recommended to the Secretary of the Treasury by two-thirds majorities of both the Federal Reserve Board and the FDIC's Board of Directors. The Secretary can make the exception only if the Secretary determines, "in consultation with the President," that least-cost resolution of a given institution "would have serious adverse effects on economic conditions or financial stability." The Secretary must document the determination. The General Accounting Office must review and report on the exception, including the potential for it to diminish market discipline and encourage unsound risk-taking. To recoup the additional cost of deviating from least-cost resolution, the FDIC must levy a special assessment on insured depository institutions. § 1823(c)(4)(G). Congress designed these rules to promote accountability and make the process sufficiently unpleasant that systemic-risk exceptions would be made rarely (if at all) and never lightly. 21 By engineering a bailout of Long Term Capital Management in 1998, the Federal Reserve Bank of New York squandered some of FDICIA's hard-won gains. Yet the dramatic change in how the FDIC dealt with failed banks during the early 1990's shows that progress can be made in curtailing too big to fail treatment. compelled them to side with the shareholders against the taxpayers.22 In any event, government appointments to GSES' boards of directors have served more as political plums than as vehicles for upholding the public interest. Ending such appointments-so that GSE shareholders would elect all GSE directors-would remove the conflict of interest. By strengthening shareholders' control over each GSE, ending such appointments could also help shareholders hold management more accountable and thus promote better corporate governance. COMPLYING WITH SECURITIES LAWS The GSES' statutory exemption from the registration and reporting requirements of the Federal securities laws is an anachronism and deserves to be repealed. The exemption sends the wrong signal: That GSE's are so "special," so close to the Government, that investors in their securities have no need for the protections afforded by those requirements. OPPORTUNITIES FOR IMMEDIATE ADMINISTRATIVE ACTION Regulators can and should act now to improve the regulation of Fannie and Freddie. First, to help avoid unhealthy concentrations of credit risk among FDIC-insured banks, the Federal banking agencies should prescribe guidelines for banks' credit exposure to individual GSE's and to GSE's generally.23 Second, the Securities and Exchange Commission should prohibit mutual funds whose portfolios consist largely of GSE securities from mislabeling themselves as "Government" or "U.S. Government" funds.24 Third, the Federal Reserve Board should proceed with its proposal to curtail socalled "daylight overdrafts" by GSE's. Fourth, HUD should tighten its scrutiny of the GSEs' mission, using its authority to review activity-expansion, prescribe affordable-housing goals, and interpret rel evant statutes. Conclusion The GSE's argue as though the present is always the wrong time to enact any reform that they do not want, such as reform that benefits taxpayers or homebuyers rather than the GSEs' managers and shareholders. In the GSEs' view, either (1) there is no acute problem warranting reform, or (2) reform now would crimp housing markets and risk destabilizing the financial system. But now is the right time to act to correct the deficiencies in GSE regulation before a crisis hits or another scandal breaks. Introduction PREPARED STATEMENT OF JAMES R. RAYBURN The 215,000 members of the National Association of Home Builders (NAHB) appreciate the opportunity to present their views to the Senate Committee on Banking, Housing, and Urban Affairs on the regulatory framework for Fannie Mae, Freddie Mac, and the Federal Home Loan Bank (FHLBank) System, including safe 22 The three members of the old Federal Home Loan Bank Board-appointed by the President and confirmed by the Senate-served ex officio as Freddie's board of directors. Freddie's preferred share price had more than doubled in response to a proposal to allow anyone to own Freddie shares. (By severing Freddie's historic link to the thrift industry, the proposal would free Freddie to increase its profits by amassing a large portfolio of mortgage-backed securities.) Senate Banking Committee Chairman William Proxmire developed a plan to grant the relief desired upon payment of a fee to reduce the taxpayers' bill for the thrift clean-up. But Freddie's management convinced Freddie's directors that their fiduciary duties compelled them to oppose the Proxmire plan. con [is] 23 Regulators could, for example, prescribe rules or guidelines under Section 305(b)(1)(A)(ii) of FDICIA, which requires risk-based capital standards to "take adequate account of. centration of credit risk." Regulators could also issue more specific examination standards. 24 The SEC prohibits a mutual fund from having "name suggesting that the Fund. guaranteed by the United States Government." 17 CFR §270.35d-1. But many mutual funds that invest predominantly in GSE securities nonetheless call themselves "U.S. Government Securities Funds." To take what is probably an extreme example, the Pacific Capital U.S. Government Securities Cash Assets Trust had 98.8 percent of its assets in GSE securities as of September 30, 2003; it evidently held no U.S. Government securities at all. See http:// www.aquilafunds.com/ourcompany/moneyfunds.htm (semi-annual report), at 9. ty and soundness oversight, new program approval, and the establishment and enforcement of affordable housing goals. These housing-related Government sponsored Enterprises (GSE's) are critical components of the Nation's housing finance system and are largely responsible for the efficiency and resiliency of that system, as reflected in the tremendous advances recorded in the availability and affordability of mortgage products for homebuyers and providers of rental housing. The success and value of our housing finance system has been clearly evident in recent years, as the housing sector sustained economic performance while other areas of the economy faltered. Considering the complexity of the housing finance marketplace and the risks at stake, the task of restructuring the regulatory framework of the housing-related GSE's is a daunting one. However, NAHB believes that two governing principles should guide the debate. First, the regulatory framework for the GSE's must be credible and effective to ensure these organizations fulfill their mission in a safe and sound manner. Second, the public/private partnership of the housing finance system is sacrosanct; any other changes to the current system should not disrupt the efficient operation of the mortgage markets and the impediments to the development of effective programs to address the Nation's housing needs. With these concepts as a foundation, NAHB offers the following recommendations. NAHB maintains its previously asserted position that the Department of Housing and Urban Development (HUD) is the appropriate agency to regulate the mission of Fannie Mae and Freddie Mac, including approving new programs and establishing and enforcing affordable housing goals. However, if Congress chooses to explore the option of creating an independent regulator with oversight for all the housing-related GSE's, we implore Congress to ensure that the regulator has a thorough understanding of and extensive involvement in housing-related issues. We do not believe that the Department of the Treasury, which is well-suited as a safety and soundness regulator, has sufficient expertise and involvement in housing issues to serve as a housing-related GSE program regulator. Background HOUSING AND THE ECONOMY The housing market has been an engine of growth in recent years, sustaining the economy during a difficult stretch. That performance continued in 2003, with new home sales reaching a record performance of more than a million closings. Singlefamily home construction has been robust and totaled 1.5 million units in 2003. Multifamily activity has been more subdued, but still posted a respectable showing, pushing total housing starts above the lofty 1.8 million units threshold. While low interest rates and favorable demographics have spurred demand, these results would not have been possible without the support of the finance system for housing. The bedrock of that system is a liquid and vibrant secondary market that is the product of the activities of Fannie Mae, Freddie Mac, and the FHLBank System. These enterprises have not only contributed to the affordability of housing credit, but also have taken the lead in expanding the menu of affordable housing programs and products. GSE'S AND HOUSING FINANCE The housing-related GSE's are American success stories. As mentioned above, they have brought enormous benefits to homebuyers, renters, and the housing finance system. These include: Reduction of mortgage interest rates-The impact of the housing-related GSE's on mortgage borrowing costs is well documented. Homebuyers with conforming loans-mortgages eligible for purchase by Fannie Mae and Freddie Mac, those up to $333,700 for one-unit properties-pay mortgage rates that are approximately 25 to 50 basis points lower than rates paid by other conventional mortgage borrowers. The FHLBanks have done their share by passing through their advantageous borrowing rates for use in member loan programs. Further rate reductions are provided through the subsidies of the FHLBank System's Affordable Housing Program (AHP) and the Community Investment Program (CIP). Reliable and stable flow of mortgage credit-The linkage that the GSE's provide to the national and international capital markets sustains the flow of capital to housing, even under changing economic conditions. While the economy has undergone major shocks over the past decade, homebuyers have experienced no interruption in the availability of mortgage credit. Elimination of regional disparities in interest rates-The GSE's provide a nationwide market for mortgage funds, a key factor in the elimination of regional disparities in the availability and cost of mortgage credit, which oc curred regularly before the housing-related GSE's came on the scene. Today, interest rates in mortgage markets around the country vary by no more than 10 basis points. Cushion against local economic downturns-When regional economies begin to slow, some participants in the mortgage industry have restricted credit or abandoned markets in search of opportunities elsewhere. This is not the practice of the GSE's. They maintain a presence in all markets under all economic conditions, cushioning the impact of local or regional declines in economic activity. Market standardization and innovation-The GSE's have brought innovation to the mortgage markets to address a broad range of borrower and investor preferences. For example, Fannie Mae and Freddie Mac have established reduced downpayment programs to help cash-strapped first-time homebuyers. Recently developed mortgage products to assist borrowers with tarnished credit histories further exemplify the extent to which Fannie Mae and Freddie Mac employ novel approaches to respond to consumer credit needs. The FHLBanks also stand out in this area by virtue of the programs that are stimulated and supported by the AHP and the CIP. Expansion of homeownership and rental housing opportunities-The housing GSE's have made very significant strides in expanding homeownership opportunities and increasing the supply of affordable rental housing in underserved areas. The housing goals enacted by the 1992 GSE Act have successfully encouraged both Fannie Mae and Freddie Mac to significantly increase their service to the market sectors targeted by the housing goals. The supply of affordable housing is further augmented by the 12 FHLBanks; each contributes at least 10 percent of its annual net earnings to its statutorily prescribed Affordable Housing Program to subsidize the cost of housing for very low-income and low- or moderate-income households. CONTEXT FOR GSE OVERSIGHT EVALUATION NAHB believes that debate and discussion on the future of GSE regulation should begin by reflecting on how and why these entities came to exist. The genesis of all three housing-related GSE's can be traced to Congress' recognition of the strong public policy benefits of housing and homeownership opportunities. Fannie Mae, Freddie Mac, and the FHLBank System were chartered to provide liquidity and stability for the Nation's housing finance system. The decision by Congress to confer the sponsorship of the U.S. Government on these entities was not a superficial one. Undoubtedly, Congress realized that no private corporation would assume the risks or expend the resources to undertake an objective of this magnitude. Moreover, it would be unlikely that any particular entity would have the credibility to attract the appropriate blend of borrowers and investors. Rather, Congress was keenly aware that in order for an enterprise to overcome such obstacles it would need the imprimatur of the U.S. Government. It is this well-forged public/private alliance that makes this Nation's housing finance system the model, if not the envy, of the world. As mentioned above, housing is a significant financial element in today's economy, not just in a macroeconomic sense, but also in terms of every homeowner's portfolio. The remarkable growth of Fannie Mae, Freddie Mac, and the FHLBank System has been raised by others as a point of discussion and concern. NAHB suggests that the performance of these entities should be evaluated within the context of the growth of the housing finance sector and its impact on consumers, investors, and the economy at large. From this perspective their growth can be viewed in a positive light. NAHB believes it would be a tremendous mistake to turn discussion on GSE regulation into a referendum of our highly successful housing finance system. Attempts to alter the Government's sponsorship of Fannie Mae, Freddie Mac, or the FHLBanks arguably contradicts Congress' intent, and most definitely would destroy the foundation upon which the system rests. The key to the GSEs' success is their steadfast focus on their mission. They are in one business, housing finance-a relatively low-risk endeavor. This narrow focus should be recognized in the discussion of any future regulatory framework. The GSE's are not banks operating in far-flung and highly risky product lines and markets and should not be regulated as such. Even the staunchest advocates of GSE regulatory reform would agree that there is no imminent crisis in the GSE system. Therefore, NAHB urges a careful and thoughtful approach on GSE regulation. NAHB is certain that such a course will produce tremendous rewards to those with most at stake in the process-America's homeowners and renters. Guiding Principles for GSE Oversight Since the GSE regulatory reform debate began in earnest last year, there has been no shortage of recommendations on a wide range of elements that many policymakers believe would enhance the stature of the regulatory system for Fannie Mae, Freddie Mac, and the FHLBank System. NAHB notes that most of the recommendations focus primarily on enhancing the power of the regulator to impose restrictions on the GSE's. Such proposals often make no reference to the responsibility of the regulator to ensure that the GSE's fulfill their Congressionally mandated purpose. Furthermore, others have recommended simply transferring the oversight from one agency to another without establishing a logical nexus between the expertise of the regulator and the mission of the entities to be regulated. NAHB urges this Committee to take a more rational approach by first establishing a foundation of core principles on which to build a solid regulatory framework. As direct participants in the production of housing and related activities, NAHB offers the committee the following set of core principles: 1. The GSE status of these institutions must be maintained. Efforts to privatize, withdraw any of the Federal privileges and legal exemptions, or otherwise diminish the ability of the GSE's to provide housing financing at the lowest possible cost should be opposed. 2. The GSE's should fulfill their public mission by conducting activities authorized by their charters in a safe and sound manner and by promoting access to mortgage credit to address the needs of affordable housing throughout the Nation. 3. The regulatory framework of the GSE's should be strong and credible, possess adequate authority and resources and reflect the differences inherent in the charters and operating structures of the GSE's. Further, the regulatory framework should foster competition among the GSE's to develop and implement innovative, low-cost funding and other programs to meet the nation's housing credit needs. 4. The mission oversight of Fannie Mae and Freddie Mac (including approval of new programs and enforcement of affordable housing goals) should be conducted by the Department of Housing and Urban Development or another entity with a thorough understanding of and extensive involvement in housing-related issues. 5. The safety and soundness oversight of Fannie Mae and Freddie Mac should be conducted by an independent regulatory agency through rigorous examinations, enforcement of regulations (including capital standards) and transparency, without unnecessarily impairing the ability of these GSE's to accomplish their mission. 6. The recently implemented risk-based capital standards for Fannie Mae and Freddie Mac should be allowed to remain in place for a period of time sufficient to evaluate the effectiveness of the new standards. 7. The regulation of the mission and safety and soundness of the Federal Home Loan Bank System should reflect the uniqueness of the System's mission, cooperative operating structure, charter type, and other characteristics. This is best accomplished by having a regulator dedicated solely to FHLBank System oversight or by having a separate FHLBank System oversight division if a single agency regulates all of the housing GSE's. Current GSE Regulatory Framework FANNIE MAE AND FREDDIE MAC The 1992 GSE Act established a dual regulatory oversight structure for Fannie Mae and Freddie Mac. HUD is the programmatic (or mission) regulator and the Office of Federal Housing Enterprise Oversight (OFHEO) is the safety and soundness regulator. The 1992 GSE Act requires Fannie Mae and Freddie Mac to obtain prior approval by HUD of any new mortgage programs. The Act defines new programs as any programs that are significantly different from programs previously approved or engaged in prior to 1992. HUD is required to review new programs to ensure that they are consistent with the GSEs' charters and are in the public interest. In addition, Fannie Mae and Freddie Mac are required by law to meet annual housing goals established by HUD. Finally, the 1992 GSE Act established OFHEO as an independent office within HUD to oversee the safety and soundness of Fannie Mae and Freddie Mac. OFHEO's primary responsibilities are to establish and enforce capital standards for Fannie Mae and Freddie Mac and to conduct annual on-site examinations of the firms to ensure that they are operating in a safe and sound manner. Fannie Mae |