Housing GSE reform legislation needs to be enacted. The House Financial Services Committee and Senate Banking Committee bills are generally consistent, although a few points of controversy must be addressed.

The Main Point: Creating the New GSE Regulator

Everyone agrees with the bills’ provisions to abolish the Federal Housing Finance Board and OFHEO and replace them with a new regulatory agency with a broader mandate. The new regulator’s proposed greater powers in capital standards and receivership, which were hotly debated only a year and a half ago, are no longer disputed. A common housing GSE regulator, with combined oversight of Fannie Mae, Freddie Mac and the twelve FHLB's, would have a logical regulatory domain. Its fourteen regulated entities are among the largest debt issuers in the world and all have the same financial essence: linking residential mortgage loans to the global bond markets. A coherent regulatory understanding and approach to the entire sector would be a big step forward.

The Implicit Guaranty and Competition

One ironic problem results from such improved regulation, however: it will be perceived as tying the GSEs even more closely to the government and making the implicit guaranty of GSE obligations even stronger than before.

A general lesson of the history of banking legislation is that the pursuit of safety and soundness without equivalent emphasis on competition leads to cartels and monopolies, often presided over by the regulators. Fortunately, the GSE reform bills can readily address this problem.

The FHLB's have demonstrated through their mortgage programs, which now have over one thousand participating mortgage lenders, that they can be effective alternatives to Fannie and Freddie. Since the proposed regulator’s domain will include the FHLB's, a pro-competitive regulatory framework could be applied to the GSE sector.

The key step is obvious: to bring the FHLB's into the business of securitization performed for their member institutions, in direct competition with Fannie and Freddie. This would especially benefit smaller FHLB members and address the distortions of a powerful duopoly in the mortgage securitization business.

It would be best to have this power made explicit. Such a provision should be added to the final GSE reform legislation.

The 5% Solution

The second most controversial issue is the provision in the House bill which would direct 5% of Fannie and Freddie’s profits to an affordable housing fund.

While avidly supported by affordable housing advocates, this provision is opposed by those who fear it would create a formidable political slush fund for Fannie and Freddie. Given the history of the GSE's, such fears are not unreasonable.

Supporters of the provision point to the affordable housing program of the FHLB's, which is universally considered a major success. However, the FHLB program and what is proposed for Fannie and Freddie are in key respects opposites. The FHLB program is by nature bottom-up, locally based and decentralized. The Fannie and Freddie program would be top-down, national and centralized. The decentralized structure of the FHLB program ensures that it cannot be warped into a political agenda.

Therefore, I propose an exceptionally simple solution to this debate: take the Fannie and Freddie 5% contribution and give it to the FHLB affordable housing program to disburse and administer.

Portfolio Limits

By far the most controversial issue and the most radical proposal is Section 109 of the Senate bill, which would take Fannie and Freddie out of the mortgage portfolio business. Needless to say, removing one of their two lines of business would dramatically reduce their profits and balance sheets.

Proponents of this move, including the Bush Administration and Federal Reserve Board chairman Alan Greenspan, point out that it would also remove most of their interest rate risk and their presence as huge derivatives counterparties. It would correspondingly reduce the government’s risk exposure.

What the effects on mortgage markets would be remains speculative. The most important question is: where would the risk go if it moves out of Fannie and Freddie? Could much of it be shifted to unlevered portfolios?

It appears to me that higher capital requirements, which the new regulator would probably set, would themselves function as a kind of portfolio limit, by reducing the return to capital from holding the portfolio.

Privatization as an Option

An important longer-term possibility is that portfolio limits and other regulatory burdens could lead to privatization, if GSEs decide for themselves that the costs of government-sponsored status have come to outweigh the benefits, and that they would be better off as private competitors.

The creation of a common GSE regulator and more competitive GSEs is consistent with the ultimate goal of privatization of all housing GSEs at the same time, but it is also consistent with simply having a better GSE sector.

Alex J. Pollock is a resident fellow at AEI.