H.R. 1461: A GSE "Reform" That Is Worse than Current Law

HR 1461--a bill that was supposed to create a “world class regulator”--is in fact a world class failure. Not only does it fail to improve significantly upon the regulatory authority of the Office of Federal Housing Enterprise Oversight (OFHEO), but it actually increases the opportunities for Fannie and Freddie to exploit their subsidies in order to expand into other areas of residential finance. While the bill makes some modest improvements to the weak regulatory structure of OFHEO today, these improvements do not bring the authority of the new regulator of Fannie Mae and Freddie Mac to the level currently exercised by federal bank regulators. Moreover, the deficiencies of the bill so far outweigh its modest regulatory improvements that the taxpayers and the economy generally would be better off with current law. Under these circumstances, unless there is a reasonable chance that the bill can be strengthened on the House floor, in the Senate, or in conference, it does not deserve to proceed further in the legislative process.

This memorandum presents an overview of the bill--both its weaknesses and its limited benefits--and then a more detailed look at specific provisions. Because of limitations of time and space, only the most important provisions will be covered, and only those relating to Fannie Mae and Freddie Mac (Fannie and Freddie, the GSEs or the “enterprises”), although the bill also covers the Federal Home Loan Banks.

Major Elements of HR 1461

The bill would create a new regulator with new powers. The new regulator would assume the responsibilities of OFHEO for prudential regulation of Fannie and Freddie, and the responsibilities of the Department of Housing and Urban Development (HUD) for controlling the mission and the affordable housing role of the enterprises.

H.R. 1461 is a massive bill, amounting to 327 pages in the Discussion Draft released by the House committee on financial services on May 26, 2005, after a committee mark-up the previous day. It makes numerous changes to the regulatory framework applicable to the enterprises. These changes must be read in great detail since the specific language adopted by the House committee can and does affect not only the section in which it is included but also the usefulness or weakness of other provisions.

After the committee acted, Freddie Mac characterized the bill as "a tough bill, one that creates a regulatory regime that goes well beyond the requirements applied to other financial institutions. And it imposes significant new administrative requirements on Freddie Mac and Fannie Mae." Fannie Mae called the House bill "a significant step forward in the process."

The bill is a significant step forward for Fannie and Freddie, but it is far from a tough bill. Indeed, HR 1641 is so fundamentally flawed as a “reform” measure that it would leave the two GSEs much better off than they are under current law.

Some of the problems are the result of what one hopes is only poor drafting. To take the most egregious example, the bill limits OFHEO’s activities immediately after enactment to winding up its operations, but does not authorize the new regulator to begin operations for a year. In the meantime, the GSEs (including the Federal Home Loan Banks) are free from safety-and-soundness oversight, and their expansion into new lines of business would not be controlled. Then, when the new regulator begins operations, it is prohibited from reviewing the activities in which Fannie and Freddie are already engaged. The result is a hiatus in which Fannie and Freddie have a free pass to enter any field that might arguably be related to their mission, with little authority in the new regulator to question its legitimacy under the law. This provision alone should be of concern to the many housing-related industries that might find themselves competing with Fannie and Freddie one year after the enactment of a law that contains the elements of this bill.

H.R. 1461 actually promotes further expansion of the enterprises beyond their current mission. It creates, as a “principal duty” of the regulator, an obligation to ensure that that the operations and activities of each GSE will foster “…national housing finance markets that minimize the cost of housing finance…” The effect of this provision, which will be read in its broadest sense by the GSEs in the future, is to make the regulator--which was supposed to restrain the power of the enterprises--into their government cheerleader and supporter. This language will inevitably affect the way the regulator interprets the rest of the bill, giving the GSEs an argument for expanding their activities into new sectors of the housing finance market where, arguably, they might be able to reduce the costs faced by homebuyers. When combined with the vague language of the GSEs’ charters, this regulatory direction may compel the new regulator to approve activities--such as title insurance, appraisal and perhaps even real estate brokerage--that compete with other services in the housing industry.1 If the use of the GSEs’ subsidy will “minimize the cost of housing finance” the regulator may be obligated to approve these new services.

Another part of the bill would allow the GSEs to serve high cost areas and finance mortgages up to $ 540,000 in size. This would greatly expand the GSEs’ market share to parts of the market that clearly do not deserve government subsidies beyond the generous tax preferences already available. If there is any justification for the existence of the GSEs, it might be the use of their subsidies to assist low cost or affordable housing. The bill makes a flawed attempt to do this, too (see below), but its increase in the ceiling on mortgage size detracts from this mission and marks it as another effort at welfare for the upper middle class rather than a genuine attempt to increase funds for low income housing. To qualify for a $ 540,000 mortgage, a homeowner probably needs to earn at least $150,000-200,000 annually.

One of the worst features of H.R. 1461 requires the GSEs to create affordable housing funds with 5% of their profits in each year. This will amount over time to billions of dollars for each GSE. While low income housing groups welcome this support, there is a darker side. The bill allows the GSEs to control these funds, enabling them to further increase their political power by allocating billions of dollars to their supporters in the mortgage market and away from those with whom they have policy or other disagreements. Undoubtedly, much of the largess will flow to the congressional districts represented on the financial services committee.

Slightly offsetting these major deficiencies are a few provisions of H.R. 1461 that improve upon the current regulatory structure of GSE oversight. The most important of these improvements is that the bill removes the safety-and-soundness regulator from the appropriations process. The GSEs have applied pressure through the congressional appropriations process to hamper OFHEO in its efforts to prevent, detect, and address violations of law and other missteps by the GSEs. The Senate appropriations committee recently attempted to deny OFHEO the funds needed to complete the Special Examination Report of Fannie Mae. That report revealed internal control failures so substantial that they caused the ouster of Fannie Mae’s CEO, CFO, and other senior officers. Thus, it would be a welcome improvement to remove OFHEO from pressure Congress can exert on the regulator through the appropriations process. In addition, H.R. 1461 does make some improvements in the weak regulatory framework available to OFHEO today, but these improvements in regulatory authority over the GSEs do not bring the regulation of the GSEs up to the standard of federal bank regulation.

The details of the bill are essential reading to understand these points. In the discussion below, we review in greater detail the provisions of the bill that (i) are seriously flawed compared to current law, (ii) are weaker than the regulatory authority available to the federal bank regulators, and (iii) represent a lost opportunity for regulatory reform that will reduce the risk to taxpayers and the economy. We also cover those few areas where the bill improves on OFHEO’s existing authority. In appropriate places, we note where the bill creates opportunities for Fannie and Freddie to expand their political power, and extend their activities into the businesses of other members of the housing finance industry.

Finally, although in many cases we compare the regulation of Fannie and Freddie to the regulation of banks, it is important to understand that there are material differences between the enterprises and banks. For one thing, only the deposits in banks are covered by the FDIC; in addition, since the adoption of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991, the capital of the banking industry--and not the taxpayers--is the primary source for protecting insured deposits, while in the case of the enterprises all their outstanding obligations are implicitly backed by the federal government. Arguably, then, the regulation of Fannie and Freddie should be tougher than the regulation of banks. Finally, and most important, Fannie and Freddie have far more political clout than individual banks, or even the entire banking industry, and that must be taken into account when considering whether the new regulator will be able to exercise its new powers effectively or resist pressure from the GSEs to expand their range of activities.

I. Serious Flaws

The reported version of H.R. 1461 contains significant flaws, even when compared to current law.

One-Year Gap

Current Law
: For all of the shortcomings in their statutory mandates, OFHEO, HUD, and the FHFB today are going concerns, organized and staffed to carry out significant responsibilities vis-à-vis the GSEs.

H.R. 1461
: the bill has an effective date that brings the new regulator into existence one year after the legislation is enacted (see Section 184). On the other hand, the bill provides that, during that one-year period, OFHEO, the GSE-related functions of HUD, and the FHFB may be operated solely to be wound up and their employees may be paid solely for this purpose. (Sections 301, 341 and 321, respectively)

The Comparable Federal Bank Regulatory Structure
: The federal bank regulators have not had to try to cope with a one-year gap. For example, when FIRREA created the Office of Thrift Supervision (OTS) as a successor organization to the Federal Home Loan Bank Board (FHLBB), the legislation transferred authority without any gap.

Opportunities for the GSEs
: The one-year gap means that, for a full year, the GSEs will operate without examination, regulation of safety and soundness, regulation of their new activities, or regulation of their affordable housing activities. For the GSEs, this is a great benefit. They will be able to expand into new activities which, thanks to another part of the bill, would be grandfathered and immune from review when the new regulator finally comes into being. For example, it is conceivable that they could enter many new areas of activity during this period without any regulator having authority to stop them.

Duty to Encourage GSE Activities That Minimize the Cost of Housing Finance

Current Law
: Currently, OFHEO and HUD operate under statutory mandates that are clear, even if they provide limited authority. OFHEO is clearly responsible for safety and soundness oversight of Fannie and Freddie, and HUD is responsible for mission oversight. Neither agency is responsible for promoting the business of the enterprises.

H.R. 1461
: The bill provides that a principal duty of the new regulator will be “to ensure that …the operations and activities of each regulated entity foster liquid, efficient, competitive, and resilient national housing finance markets that minimize the cost of housing finance…” (Section 102, emphasis added). Because Fannie and Freddie can argue that their activities usually lower the cost of any housing finance activity in which they engage, and enjoy vaguely worded charters, the regulator may be hard put to resist a demand by Fannie or Freddie to enter an area of the housing finance markets where their competition will arguably “minimize the cost of housing finance.” The term “housing finance markets” may not materially limit the force of this argument, since many businesses--such title insurance, appraisal and perhaps even real estate brokerage--function in markets of their own that are intimately related to housing finance.

The Comparable Federal Bank Regulatory Structure: The federal bank regulators do not operate under a statutory responsibility to promote the institutions that they regulate. The former Federal Home Loan Bank Board (FHLBB), which failed effectively to regulate the savings and loan industry in the 1980s, was bound by a statutory mandate that required the FHLBB to promote the institutions that it regulated. The Congress learned its lesson from the S&L debacle--that it is difficult for a regulator to protect taxpayers and the American public when it is saddled with a mandate to encourage expansion of the institutions that it regulates. When Congress established a new regulator the S&L industry, it eliminated the obligation to promote the industry. Apparently, the lesson taught by the S&L industry debacle only 20 years ago has now been forgotten.

Opportunities for the GSEs
: The GSEs will be able to press their new regulator for the authority to expand into numerous new areas of the housing economy. They will argue that the statute requires the regulator--as “a principal duty”--to as expand the GSE activities of Fannie and Freddie to any area where they can increase competition and “minimize the cost of housing finance.” In this connection, it is important to recall, as noted in footnote 1, that the federal courts generally give deference to the decisions of regulators that have authority to define the scope of activities of a regulated industry.

Increase in Conforming Loan Limits

Current Law
: Fannie Mae and Freddie Mac currently are limited by their charter acts to purchasing mortgages that do not exceed a size determined annually through a survey of house prices. The current conforming loan limit for single-family homes is $ 359,650. Because the applicable index is based on the price of new homes, it increases much faster than the price of all homes, including resale homes. Also, the statute is designed with a ratchet effect, so that the conforming mortgage limit can increase when prices go up, but will not decrease when prices drop.

H.R. 1461: the bill (Section 123) would allow the regulator to select an appropriate house price index other than the current index, subject to review by the GAO. The bill also would allow the conforming loan limit to drop as well as increase, depending on the annual change in house prices. More significantly, the bill allows the conforming loan limit to increase for so-called “high cost” areas, where the median house price exceeds the median house price used in the index. The conforming limit for such areas would become the lesser of (i) the median house price, or (ii) 150 percent of the conforming loan limit that otherwise would apply. This year, for example, 150 percent of the conforming loan limit is almost $ 540,000.

Opportunities for the GSEs: Especially when read together with the principal duty of the regulator to encourage expansion of the GSEs, discussed above, the regulator will be under pressure to adopt a narrow definition of the ambiguous term “area” in this section of the bill. This will push the regulator to define a high-cost “area” as a census tract or even as a numbered block of houses. That reading of the bill could mean that virtually every upper middle class neighborhood in the United States might be deemed “high-cost” and a proper area for the GSEs to fund mortgages up to the new high-cost limit ($ 540,000 or the median house price).

Standards for Approval of New GSE Activities

Current law: The very general language in the charters of Fannie and Freddie have made it difficult for either OFHEO or HUD to rein in their expansion into new activities outside the secondary mortgage market. This is understandable because of the GSEs’ political power. To take them on by restricting their activities would require a regulator to have clear authority to do so from Congress, and that does not exist in their current charters.

HR 1461
: The bill (Section 122) directs the regulator to approve only those new activities and products that are consistent with Fannie and Freddie’s charters, taking into account the definitions of the terms “mortgage loan origination” and “secondary mortgage market”--terms that the regulator is directed to define. The Director also is supposed to disapprove a new business activity if it “is not in the public interest.” Although this language gives the regulator the patina of new authority, in reality it does nothing. The problem--as under current law--is that the charters of Fannie and Freddie are extremely general, and say nothing that would give the regulator any guidance on how to define these terms. Moreover, the principal duty of the Director to encourage expansion of the GSEs (Section 102, discussed above), is likely to affect the Director’s weighing of what is in the public interest.

The Comparable Federal Bank Regulatory Structure
: As it happens, there is an exact parallel in current law of the problem of inadequate statutory guidance. When Congress passed the Gramm-Leach-Bliley Act in 1999, it gave the Fed and Treasury the authority to define the activities--designated financial activities--in which companies affiliated with banks would be permitted to engage. Unfortunately, there is no way to determine what is or is not a financial activity, and Congress provided no standards for such a determination. As a result, the question of whether real estate brokerage is a financial activity is still in dispute, and the Realtors have successfully gone to Congress to prevent the Treasury and Fed from permitting banks to engage in this business. If Congress had decided this question in 1999, or provided definitive guidance, that dispute would never have arisen.

Opportunities for the GSEs
: It is certain that if the regulator attempts to put a definition in place that in any way restricts Fannie and Freddie, they will go either to the courts or Congress and challenge the regulator’s action. What clearly happened here is that the committee ducked its responsibility to give the regulator any help in dealing with these powerful companies, and left the task of restricting their expansion outside the secondary mortgage market wholly unfinished. As a result, because of the political power of the enterprises, no industry associated with housing can be assured that it will not have to compete one day with Fannie or Freddie, or both.

Procedures for Approval of New GSE Activities

Current Law: Currently, Fannie Mae and Freddie Mac may not undertake a new program without obtaining the prior approval of HUD. The statutory framework has a number of shortcomings: (i) the regulator must disapprove the new program within 30 days (plus a possible 15 day extension), or the program is deemed to have been approved, (ii) HUD’s prior approval authority is limited to new mortgage programs, not new activities, (iii) the GSEs often contend that what might be new programs are simply new activities, and (iv) the GSEs are not required to submit complete information before the 30-day clock begins to run. HUD has not been energetic in exercising its prior approval authority.

H.R. 1461: Although the bill provides no standards with which the regulator will be able to do more than OFHEO or HUD in restricting the activities of the enterprises, HR 1461 (Section 122) makes a show of putting in place somewhat tougher procedures.. For new programs, it requires that the GSEs submit completed applications and that the Director publish a notice and invite public comment regarding the proposed new program. If the Director has not approved the new program within 30 days after the close of the 30-day comment period, the program will be deemed to be approved. The bill grandfathers the GSEs’ automated underwriting systems (AUS) in existence on the enactment date of the legislation and counseling and education activities of the GSEs, whether or not these were properly reviewed and approved by HUD. The bill also authorizes the regulator to disapprove new GSE “activities,” a broadly defined term, in a process roughly comparable to the current process for approving new programs today (i.e., no requirement that the notice given by the GSEs contain complete information; deemed to be approved if the regulator has not disapproved within 30 days of receiving notice).

The bill grandfathers all GSE activities through 2006, which are not subject to review by the regulator. Because of its wording, the bill creates an inference that GSE “products” and “business operations” are not new programs subject to review and approval. Finally, the bill expressly prohibits aggrieved parties from bringing private rights of action to enforce the prior approval provisions of the bill and, in Section 164, discussed below, precludes the regulator from enforcing orders to seek GSE compliance with these provisions.

The weakness of Section 122 compared to current law is seen in the recent action of the HUD Secretary to disapprove the international programs of Fannie Mae. If H.R. 1461 had been in place, the regulator would have been precluded from acting, both because the Fannie Mae activities would have been grandfathered, and because they were not “new” business activities subject to the regulator’s scrutiny.

The Comparable Federal Bank Regulatory Structure: The process of regulatory approval of bank activities is different both from current law and from the processes in H.R. 1461. In particular, permissible bank activities are well defined by statute, and provide regulators with a set of standards with which to judge new activities. In addition, industry groups who believe that banks are illegally entering their turf have standing to bring private actions against the regulatory agency that is authorized to approve the activity. This absence of this right in the case of the GSEs and adds weight to the concern that during the one-year hiatus period before the new regulator is in place, or when the regulator allows the GSEs to enter new housing related industries, there will be no avenue for challenging such a ruling.

Opportunities for the GSEs: Again, when read in connection with the principal duty of the regulator to minimize the costs of housing finance, the regulator is likely to interpret this section as authorizing the expansion of GSE programs and activities into new areas. The GSEs, for example, will be able to add to their automated underwriting systems new components as they become available, such as automated valuation models to substitute for many appraisals and their own self-insurance to substitute for title insurance.

Affordable Housing Funds

Current Law
: Under current law, the Federal Home Loan Banks, which are cooperatives owned and controlled by their members, set aside 10 percent of their income for an affordable housing program that provides funding so that their members may subsidize affordable housing according to requirements established by law. Fannie Mae and Freddie Mac are not required to establish funds for affordable housing and have not done so.

H.R. 1461: The bill (Section 128) would require Fannie Mae and Freddie Mac to set aside 5 percent of their after-tax income for an affordable housing fund. Each of the two GSEs would control and manage its own fund and allocate funding according to regulations that the regulator would promulgate. The bill does state (Section 129) that nothing in this subpart should be construed to authorize the GSEs to engage in activities beyond the authority in their charter acts, although as noted above it is difficult to define the precise limits of GSE activities under their charters. Most importantly, the bill does not prohibit the GSEs from discriminating against potential recipients when they distribute their affordable housing funding. Given the track record of the GSEs in retaliating on political grounds against those who oppose them, this is an important omission.

The Comparable Federal Bank Regulatory Structure: Instead of contributing to an affordable housing fund that they would control, banks are subject to requirements of the Community Reinvestment Act (CRA) to make mortgage and other loans and provide funding for low income people and communities. It would be far preferable to subject the GSEs to CRA-type requirements in the secondary market than to permit the GSEs to allocate potentially huge amounts of money to their friends and supporters.

Opportunities for the GSEs: The affordable housing language is broad. The GSEs can use this broad language--for example their authority to guarantee tax-exempt and taxable bonds of housing finance agencies (section 125)--to justify their expansion into other comparable areas, such as guaranteeing bonds that states and localities issue for other purposes, such as community development. Again, especially but not solely because of the duty under the bill to encourage expansion of the GSEs, the regulator is likely to approve these new activities and thereby allow the GSEs to become major participants in the financial guaranty business.

These six elements of H.R. 1461 represent serious flaws that would undermine the regulator (the one-year gap), require the regulator to promote the business of the institutions that it regulates (one of the principal duties of the regulator), greatly expand the market share of Fannie Mae and Freddie Mac (increase in the conforming loan limit), weaken the current prior approval authority of the regulator (by grandfathering GSE programs and activities, whether or not properly approved), and create an opportunity for the GSEs to wield potentially billions of dollars of influence by allocating funds to their political friends and away from those whom they disfavor (the affordable housing funds). Taken together, these flaws in H.R. 1461 far outweigh the few significant positive features noted in section IV below.

II. Weak Regulatory Authority

While H.R. 1461 does make some improvements in the regulator’s enforcement authority, the authority of the regulator remains inferior to that of the federal bank regulators. Given the demonstrated failure of internal controls at Fannie and Freddie, the huge potential risks they create for the taxpayers and the economy generally, and their enormous and carefully cultivated political power, the supervisory structure for the GSEs should be stronger--not weaker--than that in place for banks. That, however, is not the pattern in HR 1461.

Minimum Capital Requirements

Current Law: Under current law, minimum capital requirements for Fannie Mae and Freddie Mac are set at fixed percentage amounts, and three levels of deficient capitalization--undercapitalized, significantly undercapitalized and critically undercapitalized--are established as prerequisites for various actions by OFHEO. Reclassification to any one of these levels can only occur if the enterprise is engaging in conduct that “could result in the rapid depletion of core capital.” Although these statutory levels impose some limitations on the discretion of OFHEO’s director, OFHEO used its cease-and-desist authority to require Freddie Mac to increase its minimum capital to 30 percent above the amount prescribed in the law, and negotiated a similar agreement with Fannie Mae.

H.R. 1461: The bill (section 141 (a)) continues the statutory capital classification categories in current law, but does not add significantly to the regulator’s authority to reclassify an enterprise to a lower capital category. This may be done (subsection 141(c)) only under one of three conditions: (i) if the enterprise is engaging in conduct that could “result in a rapid depletion of core or total capital”, (ii) if, after notice and opportunity for a hearing, the regulator determines that the enterprise is in an unsafe or unsound condition, or (iii) if the enterprise is engaging in an unsafe or unsound practice, but this last condition is only available if an unsatisfactory rating in an examination is not corrected.

None of these conditions allows the regulator to act quickly in the event of the most likely cause of an enterprise’s financial deterioration--a sudden rise or fall in market interest rates. Only condition (ii) permits such an event to be taken into account, and that requires a hearing before the regulator can act. Accordingly, the bill does not substantially improve on the authorities now available to OFHEO if an enterprise suffers sudden and severe losses, and does not take account of the fact that a failing enterprise may have significant systemic effects that require emergency action.

Even if the predicate exists for the appointment of a receiver under these circumstances, the regulator is not required to do so--providing an opportunity for Fannie or Freddie to put political pressure on the regulator that will result in costly forbearance.

The bill also provides (section 112) that the regulator, with notice and comment, may issue regulations to establish a minimum capital standard for Fannie and Freddie that is higher than the amounts fixed by statute. And the regulator may by order increase capital requirements to assure the safety and soundness of an enterprise’s program or activity. The regulator also may, by order, increase the minimum capital level for a GSE for a temporary period, provided that the regulator meets one of several preconditions that are specified in the bill. Again, this does not substantially improve on OFHEO’s powers under current law.

The Comparable Federal Bank Regulatory Structure: The federal bank regulators have simple and effective authority over minimum capital: “Each appropriate Federal banking agency shall have the authority to establish such minimum level of capital for a banking institution as the appropriate Federal banking agency, in its discretion, deems to be necessary or appropriate in light of the particular circumstances of the banking institution.” This provision, found at 12 U.S.C. Section 3907(b), and recommended by the Treasury Department, is far superior to the more complex provisions of H.R. 1461. Moreover, if a bank becomes critically undercapitalized, the federal regulator is required to appoint a receiver within a 90 day period. This provision was adopted because of the tendency of regulators to forbear in some cases, especially where significant political questions are involved. Clearly, such questions would be involved with any action to appoint a receiver for a failing GSE, yet the regulator is not required to appoint a receiver.

Opportunities for the GSEs: It appears that the language of H.R. 1461 would require the regulator to reopen the order with Freddie and the agreement with Fannie because those arrangements may not meet the tight preconditions that the bill requires. In general, the regulator will lack the authority and leverage to get a GSE to increase capital temporarily to address a problem such as the recent accounting and internal control failures at Fannie Mae and Freddie Mac, unless it can make the case that these tie directly to safety and soundness. Even if that is the reality, the case can be hard to document and insulate against litigation. The prospect of litigation by the GSEs, again bolstered by the argument that higher capital would violate the Director’s principal duty to encourage expansion of the GSEs, is likely to protect the GSEs from the kinds of supervisory responses that are common for banks that have such operational problems.

Enforcement Authority

Current Law: As was noted above, the statutory framework for OFHEO is far weaker than for the federal bank regulators.

H.R. 1461: The bill does improve in a number of respects on the enforcement powers in current law. However, the bill continues to be weaker than the statutory authority granted by law to the federal bank regulators. For example, H.R. 1461 fails to give the regulator the authority to issue and enforce directives. Directives are needed, for example, to assure that an institution complies promptly with the need to increase its capital. Finally, subtle deletions or changes in wording from the bank regulatory language mean that the regulator’s powers are weaker than they should be. For example, the absence of a definition of the term “violation” such as is found in the laws for bank regulators, means that the regulator will be limited in its ability to deal with potentially serious wrongdoing, such as when an accountant or employee abets a serious violation without directly committing it.

An example of what may be only poor drafting that creates major problem with enforcement powers is found in Section 164 of the bill, which authorizes the regulator to go to court to enforce orders and notices under subtitles B (capital and prompt corrective action) and C (enforcement powers). This expressly omits enforcement of orders under Subtitle A (Supervision and Regulation). Subtitle A includes the regulator’s authority to set prudential standards (Section 102 of the bill) and require reports (Section 104), and requirements that the two GSEs register a class of securities with the SEC (Section 115), and conform to governance requirements (Section 114) and new program approval requirements (Section 122).

The Comparable Federal Bank Regulatory Structure: The federal bank regulators have a more complete toolbox than does the GSE regulator under H.R. 1461. The bill contains a number of drafting issues, such as those in Section 164, that do not complicate the statutory framework of the federal bank regulators. In addition, a federal bank regulator may cancel or withdraw the charter of a failed financial institution and may issue and enforce capital directives. The regulatory relationship between the federal regulators and banks is much more constructive than the relationship between the regulator and the enterprises under this bill, because, at a time of controversy, the bank regulators can call on a full and tested panoply of supervisory authorities that the regulator of Fannie and Freddie simply will not have.

Opportunities for Fannie and Freddie: The problem with loose and missing supervisory language is that it invites a GSE to litigate rather than comply with a regulator’s requests and orders. Litigation at a time of financial crisis is potentially damaging to taxpayers because of the likelihood that a failing GSE would dissipate its assets and, like the S&Ls in the midst of their crisis in the late 1980s, compound its losses. Litigation would mean that the bank regulatory term “prompt corrective action” loses its promptness when applied to the GSEs.

III. The Lost Opportunity for Reducing the Risks Associated with the GSEs

The Congress last undertook a major review of the regulatory structure for the GSEs in 1992. It is unlikely that the Congress will seek to revisit this issue once legislation is enacted to address the recent failings of Fannie Mae and Freddie Mac. As desirable as it might be to update the statutory framework from time to time, the enterprises are simply too powerful to make this anything but a painful exercise for lawmakers. Accordingly, the bill that ultimately emerges from Congress in this or the next session may be the last opportunity, for many years, to rein in and reduce the risks associated with the GSEs.

Federal Reserve Chairman Alan Greenspan has been clear that the Fannie and Freddie already create significant systemic risk to the financial system because they concentrate in only two entities trillions of dollars in interest rate, credit, and operational risk. He has also made the point that regulation can never adequately solve this problem, in part because regulation itself encourages the belief in the capital markets that Fannie and Freddie are protected by the government. This view reduces market discipline and is the primary source of moral hazard. For this reason, Chairman Greenspan has proposed that the enterprises’ portfolios of mortgages and mortgage-backed securities--which have a current combined value of approximately $1.5 trillion--be reduced. To accumulate these portfolios, Fannie and Freddie have contracted $1.5 trillion in debt, and the interest rate risk associated with this enormous debt level is far and away the most significant source of the risk they create for the economy and the taxpayers.

In testimony before the committee, both Chairman Greenspan and Treasury Secretary Snow recommended that Congress explicitly authorize the new regulator of Fannie and Freddie to reduce the GSEs’ portfolios, and Secretary Snow proposed specific statutory language that would both authorize the regulator to effect a reduction and establish a standard for the regulator to follow. This proposal was ignored by the committee, which adopted a highly deficient provision that fails entirely to address the problem identified by Chairman Greenspan and the administration.

Portfolio Limits

Current Law
: Current law does not expressly require the GSEs to limit their portfolios. However, there are provisions of current law that were originally designed to limit GSE holdings. Thus, the Fannie Mae charter act states that the GSE should conduct its operations in such a manner “as will reasonably prevent excessive use of the corporation’s facilities…” (See Fannie Mae charter act, Section 304(a) (1), 12 U.S.C. Section 1719 (a) (1)). However, the GSEs have largely or completely ignored these statutory limitations, and because of their political power no regulator has been willing to try to enforce these limitations. The Secretary of the Treasury is also authorized to limit the GSEs’ issuance of debt securities, but probably because of the political power of the GSEs has never attempted to do so.

H.R. 1461: The bill (Section 113) provides that the regulator may review individual assets and liabilities of the GSEs and require an enterprise to dispose of an asset “if the Director determines that such action is consistent with safe and sound operation of the enterprise.” Rather than authorizing the regulator to reduce the enterprises’ portfolios, this provision would seem to have precisely the opposite effect. It would enable the regulator to require a reduction in Fannie and Freddie’s portfolios only when the regulator can demonstrate that the portfolios are a threat to their safety and soundness. When the regulator is finally able to establish this, it will be the result of a significant change in interest rates, or some other event in the financial markets, and far too late to prevent the systemic effects that Chairman Greenspan fears, which will already be underway. In other words, far from taking account of the problem of systemic risk, the bill actually subverts any steps a regulator might wish to take in order to prevent damage to the US economy caused by a failing enterprise.

The Comparable Federal Bank Regulatory Structure
: The FDIC Improvements Act (FDICIA) addresses the systemic risk posed by banks. It provides that, except for tightly limited circumstances, the federal bank regulator is able to intervene, appoint a receiver, and close a failing financial institution as soon as it becomes critically undercapitalized.

Opportunities for the GSEs: The absence of a provision limiting GSE portfolios means that, once they get their accounting and internal controls rebuilt, the GSEs can continue to grow their portfolios by potentially hundreds of billions of dollars annually. This can bring benefits to the GSEs’ bottom line for quite some time until some crisis occurs. Then, as Chairman Greenspan has warned, financial risk can spread from the GSEs to the rest of the financial system at great cost not only to taxpayers, but also to the many people, firms, and governments whose investments depend on a stable U.S. financial system.

IV. Improvements on Current Law

H.R. 1461 improves on current law in three general areas.

Funding the Regulator

Current law
: Currently the Office of Federal Housing Enterprise Oversight (OFHEO), the safety-and-soundness regulator of Fannie Mae and Freddie Mac, and the GSE oversight functions of the Department of Housing and Urban Development (HUD), both are funded through the appropriations process. Fannie Mae and Freddie Mac have repeatedly used their influence over the appropriations process to deny adequate funding for important OFHEO activities, most recently the OFHEO Special Examination of Fannie Mae.

H.R. 1461: H.R. 1461 combines the functions of OFHEO, the GSE-related functions of HUD, and the functions of the Federal Housing Finance Board with respect to the Federal Home Loan Banks, into a single regulator, the Federal Housing Finance Agency. This agency is funded through assessments on the regulated GSEs without regard to the appropriations process. (Section 106).

The Comparable Federal Bank Regulatory Structure: This feature of H.R. 1461 would bring oversight of the GSEs into line with the funding process of the federal bank regulators. They are funded by assessments without regard to the appropriations process.

Strengthening Some Supervisory Powers

Current law
: OFHEO’s authority vis-à-vis Fannie Mae and Freddie Mac is much weaker than the authority available to the federal bank regulators.

H.R. 1461: H.R. 1461 strengthens the new regulator’s authority in a number of places. The risk-based capital test (Section 111) is more flexible than the unworkable statutory scheme that binds OFHEO. The new regulator will have authority to issue prudential management and operations standards (Section 102) and to place a failed GSE into receivership (Section 144). A number of the cumbersome procedural requirements and preconditions that hamper OFHEO’s exercise of enforcement authority have been removed. For example, unlike OFHEO, the new regulator has authority to bring enforcement actions directly, rather than being required to work through the Attorney General. (Sections 164 and 168). Finally, the regulator will have authority to deal with wrongdoing by a broader range of parties and to a greater extent than OFHEO can today. (Section 2, defining an enterprise-related party).

The Comparable Federal Bank Regulatory Structure: As was discussed above, the supervisory authority of the new regulator remains inferior to the authority of the federal bank regulators. Under H.R. 1461, the GSE regulator has limited authority to adjust minimum capital requirements for the GSEs. The regulator may not withdraw or cancel the charter of a failed GSE that is in receivership. The regulator lacks authority to issue and enforce capital directives and to enforce many types of orders in court. The regulator also lacks authority to deal directly with violations that include those who abet violations, such as employees or accountants, without actually committing them.

Affordable Housing

Current law
: HUD recently strengthened the affordable housing goals under current law. However, the statutory definitions are weak. For example, current law defines “low-income” borrowers with incomes up to 80 percent of the area median income and “very-low income” as incomes up to 60 percent of the area median income. In addition, HUD lacks the ability to enforce GSE compliance with the housing goals.

H.R. 1461
: Changes the definition of “very-low income” to 50 percent of the area median income. (Section 125). This helps to target GSE performance on a lower income category of borrower than before. The bill (Section 126) creates a duty of the GSEs to lead the industry in developing loan products and flexible underwriting guidelines to facilitate a secondary market for mortgages on manufactured housing for very-low, low- and moderate-income families and preservation of affordable housing for low- and moderate-income families. The bill (Sections 127 and 130) also strengthens the regulator’s enforcement powers with respect to the affordable housing goals.

The Comparable Federal Bank Regulatory Structure: The Community Reinvestment Act (CRA) holds banks to more stringent affordable housing standards than H.R. 1461 applies to the GSEs. The CRA defines “low income” as income that is less than 50 percent of the area median and “moderate income” as between 50 percent and 80 percent of the area median income. The bank regulators possess extensive authority and leverage to assure that banks meet their CRA goals.

In summary, H.R. 1461 does make several improvements over current law. However, given OFHEO’s success in utilizing its current limited powers, these improvements are insufficient to justify support for a bill that otherwise adds significantly to the GSEs’ political power and ability to expand into other businesses that are related to residential finance.

This is the time to enact statutory improvements in GSE supervision that are needed to address the conspicuous failings of Fannie Mae and Freddie Mac and the risks that they pose to the larger financial system. H.R. 1461 would improve current law in some places. Unfortunately, when taken as a complete package, the bill fails either to improve on current law, or to address the critical issues of financial and systemic risk that have been identified by Chairman Greenspan and the Bush administration.

H.R. 1461 also lacks other important safeguards. Laws are needed to (i) prohibit GSE retaliation against those organizations or individuals that oppose the GSEs through lawful means and (ii) require transparency of the GSEs’ massive political expenditures to influence the Congress and other policymakers. These protective measures can help to limit unfair practices and reveal more clearly in public some of the immense political power that the GSEs wield.

The weakness of H.R. 1461 raises a concern that Congress may be unable to summon the political will necessary for enacting a suitable regulatory framework for these politically powerful entities. The inability of the political process to cope with the power of the GSEs, even after their demonstrable failings in recent years, should be a matter of concern to all Americans. Either Congress controls the GSEs or the GSEs control Congress. There is only one right answer.

Peter J. Wallison is a resident fellow at AEI and co-director of AEI's program on financial market deregulation. Thomas H. Stanton is a fellow of the Center for the Study of American Government at Johns Hopkins University, and author of Government Sponsored Enterprises: Mercantilist Companies in the Modern World (AEI Press, 2002). This analysis of H.R. 1461 represents the current views solely of the authors, who welcome feedback on the paper.


[1] In recent years, federal courts have given great deference to the decisions of regulatory agencies that have authority to define the scope of activities of a regulated industry. See, for example, Clarke, Comptroller of the Currency v. Securities Industry Assn., 479 U.S. 388, 107 S.Ct. 750 (1987).

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