With the re-election of President Bush and increased Republican majorities in the Congress, legislation addressing stronger regulation of the housing GSEs is now highly probable.

The stock market appears to share this forecast. When exit polls suggested a Kerry win on Election Day, Fannie Mae stock markedly rose. When it became clear on November 3 that President Bush had been re-elected, Fannie stock opened down and fell sharply for the day--while financial stocks in general gained.

From an economic policy point of view, it is essential that future GSE regulatory reforms be pro-competitive. This indeed is the now re-elected Bush Administration’s position.

U.S. Treasury under secretary Brian Roseboro recently said (as reported by Reuters) that “the Administration welcomes the idea of greater competition from Federal Home Loan Banks with Fannie Mae and Freddie Mac in buying mortgages and holding them or selling them in capital markets.”

On a closely related subject, the under secretary reconfirmed the administration’s position that “the importance and the evolution of our housing finance markets require that all of the housing enterprises be included in a single program of world-class supervision. We see the need for this for the Federal Home Loan Banks just as we see it for Fannie Mae and Freddie Mac.” 

Treasury deputy assistant secretary Greg Zerzan reiterated the message, explaining that “Having a single regulator should create the institutional expertise necessary to monitor and evaluate those risks both with regard to the enterprises individually as well as with an eye towards the health of the housing finance system as a whole.”

Over the last decade I have argued (both as practitioner and theorist) that the Federal Home Loan Banks, twelve good-sized GSEs with aggregate assets of about $900 billion, offer the opportunity to develop a much more competitive secondary mortgage sector. Such a more economically efficient sector would in time significantly reduce the duopoly profits now enjoyed by Fannie and Freddie. The economic benefits of GSE status will thus be pushed by competitive pressure through the GSEs into the hands of the customers, even before or without privatization.

Essential to this competitive outcome is the creation of a single housing GSE regulator and a regulatory regime which fosters level playing field competitive conditions for all fourteen GSE competitors.

The current accounting scandal at Fannie, coming hard on the heels of the scandal at Freddie, increase the pressure for legislation early in 2005. Senator Shelby’s bill, passed by the Senate Banking Committee last spring, will surely be revived, probably in stronger form.

If the new, stronger regulator is to avoid the perverse effect of strengthening the perceived government ties and implied guaranty, and thus extending the duopoly status and duopoly profits of Fannie and Freddie, it must focus on insuring a competitive GSE sector.

A few specifics:
  
The New Regulator: To replace today’s GSE regulatory structure, the common GSE regulator should be a new agency, as provided in Senator Shelby’s bill and proposed by the Administration. It should not be a continuation of either OFHEO or the Federal Housing Finance Board. OFHEO was designed as a very constrained regulator by the politics of its charter act of 1992, and the FHFB is the lineal descendant of the unlamented Federal Home Loan Bank Board.  Both were designed to oversee too narrow a domain. The new organization, with the ability to view the housing GSE sector as a whole, would have broad perspective and more balanced bases of comparison. 

The Role of FAS 133: All practitioners and observers of financial markets are aware of the vagaries introduced into financial reporting, especially for holders of mortgages, by Financial Accounting Standard (FAS) 133. These have been central to the accounting scandals and disputes at both Fannie and Freddie. One effect of applying the complex rules of FAS 133 is that large amounts of “accumulated other comprehensive income” (AOCI) are apt to result, residing in the net worth section of the balance sheet, but excluded from the calculation of regulatory capital.

The current debates about Fannie Mae’s accounting make it apparent that Fannie’s reported AOCI, in addition to unrealized marks to fair value, contains realized losses on terminated interest rate swaps to the tune of over $8 billion. These losses represent cash which is without question gone and can never return. 

Whatever one may think of FAS 133, a strong recommendation to the new GSE regulator is that realized losses (or gains) on derivatives must be included in the calculation of regulatory capital, while the rest of AOCI should continue to be left out. This would reduce Fannie’s regulatory capital by more than $8 billion.

Government-Appointed Directors: President Bush has already declined to make appointments to the boards of Fannie and Freddie. Congress in its GSE reform bill to come, should simply eliminate all government-appointed directors from all housing GSEs.

In Sum: The creation of a common GSE regulator and a competitive GSE secondary market sector would greatly improve the American mortgage finance system. 

Alex J. Pollock is a resident fellow at the American Enterprise Institute.