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Legislative Updates

February 15, 2006

I. GSE Reform Overview

Last week saw an intense level of activity regarding the consideration of government-sponsored enterprise (GSE) regulatory restructuring.

The Administration:

• On Monday, the administration released its budget (item II) which covered in extensive detail its thinking on the need for GSE regulatory reform while keeping specifics about future policy initiatives vague.
• At this time, the administration posture on GSE reform is not to discuss specific initiatives with outside parties, even those from Congress. Social Security reform and tax reform remain at the top of the administration’s short-term agenda.

The Congress:

• Three hearings last week focused in whole or in part on GSEs (item IV).
• Senate Banking Committee Chairman Richard Shelby (R-AL) expressed a determination to enact GSE reform this Congress. He also indicated that FHLBanks would receive greater attention than last year.
• Ranking Senate Banking Committee Democrat Paul Sarbanes
  (D-MD) questioned the value that FHLBanks bring to support mortgage markets and affordable housing during a Senate Banking Committee hearing.
• Senators Chuck Hagel (R-NE), John Sununu (R-NH) and Elizabeth Dole (R-NC) introduced the first GSE reform bill this year (item III). This bill was developed from the Senate Banking Committee bill of last year but added several tough new restrictions on Fannie Mae and Freddie Mac in the area of new business activities.
• Representative Richard Baker (R-LA), chairman of the House Capitals and GSE Subcommittee, indicated he would introduce legislation in early March.

Outlook:

• Congressional sources have indicated that the committees of jurisdiction in both houses will begin to mark up GSE reform legislation in April and May.
• The issues of receivership authority and capital-setting powers of the new regulator for Fannie Mae and Freddie Mac that killed last year’s bill are no longer in play. These provisions are expected to be in any bill that passes this year. However, recent statements from the major rating agencies that the toughest receivership language last year would not trigger a downgrade in the GSEs rating is leading some to consider revisiting the receivership language.
• This year’s policy debates appear to be focusing on new program approval and mission focus for Fannie Mae and Freddie Mac.
• Greater scrutiny of FHLBanks is also likely although the main focus of the debate continues to be Fannie Mae and Freddie Mac.

II. The Administration’s '06 Budget Advocates GSE Regulatory
    Reform

On February 7, the administration released the FY 2006 budget which covered GSE issues in great detail, underscoring a serious commitment on the part of the administration to work for the reform of the GSE regulatory structure. The message focuses in large measure on Fannie Mae and Freddie Mac but spends a significant amount of attention on the FHLBanks.

The budget lays out the administration’s views or simply raises central GSE policy questions on a number of issues central to the debate, including:

• Support for providing enhanced receivership authority over Fannie Mae and Freddie Mac as a means of instilling market discipline on entities perceived by the markets as having implicit government backing;
• A reiteration of the Treasury’s authority to control the issuance of GSE debt;
• The concern that the GSEs pose a systemic risk to the nation’s financial system;
• A discussion of the relative risks of large portfolios at Fannie Mae and Freddie Mac as opposed to their securitization of mortgages;
• How much of the GSE borrowing advantage is passed on to homebuyers; and
• How the statutory affordable housing focus of Fannie Mae and Freddie Mac differs from that of the FHLBanks.

Following are excerpts of particular interest.

The President’s FY 2006 Budget Message – GSE Highlights

Regulatory Reform: “The administration intends that any proposed new regulatory framework for the GSEs follows the principles for regulation of financial institutions established by the international Basel Committee, principles accepted throughout the world as requirements for first-class regulation.”

• Receivership: “Currently, the means by which the failure of a GSE could be resolved differs between Fannie Mae and Freddie Mac, on the one hand, and the FHLBs on the other. In the case of a failed FHLB, the FHFB [Federal Housing Finance Board] has power to liquidate such institution, subject to certain limitations relating to the whole number of Banks in the system. OFHEO [Office of Federal Housing Enterprise Oversight], on the other hand, lacks the power to place an entity into bankruptcy or receivership.”
  
  “Giving such uniform powers to a Federal regulator of GSEs could likewise help prevent dislocation in financial markets in the event of the insolvency of such an institution. Further, such powers would address any misperception that the GSEs are backed by the government. By providing clarity to the markets that the GSEs
  (and their creditors) are subject to the same business risks as are other corporate entities, an even greater level of market discipline might be brought to bear on the GSEs’ operations.”

Treasury GSE Debt Authority: The budget document reiterates the administration’s repeated assertions that it has the authority to limit GSE debt issuance. The document notes, “The Treasury Department has discretionary authority to approve or disapprove the issuance of the GSEs’ debt... As it does with respect to Fannie Mae and Freddie Mac,
the Treasury Department has discretionary authority over the issuance of FHLB debt.”

GSE Borrowing Advantage: “In 2004 the Congressional Budget Office estimated the implicit Federal subsidy to the three housing GSEs was $23 billion during the previous year. A Federal Reserve study suggests that over one-half of the implicit subsidy to Fannie Mae and Freddie Mac accrues to the GSEs’ shareholders.”

Systemic Risk Presented by GSEs: “The risks undertaken by the GSEs, if not properly managed, may pose a threat to their solvency. Under some circumstances, they also may threaten the stability or solvency of other financial institutions and the economy.”

Securitization by Fannie Mae and Freddie Mac: The budget documents pointed out the reduced risk of securitization as opposed to portfolio holdings. “Viewed in isolation, Fannie Mae and Freddie Mac’s assumption of credit risk arising from guarantees of MBS held by other investors benefits the market and homebuyers while incurring a risk that is
easily managed and well-understood.”

Fannie Mae and Freddie Mac Portfolio Growth: “Fannie Mae, and more recently Freddie Mac, have built large portfolios of mortgages and repurchased MBS. However, by choosing to borrow substantially in order to build large retained portfolios of mortgages and mortgage-backed securities, they assume a different, more challenging set of risks and increase the complexity of their operations. Their ability to repurchase large volumes of their own MBS is driven by their ability to finance these mortgages with lower-cost debt than other investors, thanks to market misperceptions of a unique status for the enterprises that allow them to borrow at lower rates. Federal Reserve economists have found no evidence that these repurchases provide any additional benefit to borrowers. They clearly provide an opportunity for the GSEs to increase their earnings, however.”

GSE Operations Risk: “The techniques necessary to manage interest rate risk and its potential effect on earnings are complex, and their management becomes increasingly difficult with increases in the size and complexity of the portfolio to be managed. While other large financial institutions may face similar challenges, the management of interest
rate risk and operations risk is a particular challenge for the GSEs, given their size, regulatory structure and the lack of full market discipline.”

Different Affordable Housing Approaches for the GSEs

• Fannie Mae and Freddie Mac “have trailed the marketplace in lending to first-time minority homebuyers in the 2001-2003 time frame. It is likely that, as a result of these new, higher goals, they will need to improve their efforts to reach out to low-income and minority first-time homebuyers.”
• FHLBanks “address their affordable housing obligations in a different fashion. For instance, by statute, each FHLB is assessed ten percent of its net income for support of affordable housing. This assessment enables each FHLB member to provide subsidized and other low-cost funding to create affordable rental and homeownership opportunities, and support for commercial and economic development activities that benefit low- and moderate-income neighborhoods.”

III. Senators Hagel, Sununu and Dole Introduce GSE Reform
     Legislation

S. 190, the Federal Housing Enterprise Regulatory Reform Act of 2005, introduced by Sen. Hagel on January 26, 2005, with Sens. Sununu and Dole, is closely modeled on the GSE reform bill passed last year by the Senate Banking Committee on a 12–9 vote. That legislation died largely over a dispute concerning the new regulator’s receivership powers over Fannie Mae and Freddie Mac.

Much of the focus of the legislation is on Fannie Mae and Freddie Mac. The following provisions are of direct interest to FHLBanks.

Regulatory Structure: The legislation establishes a new independent agency, the “Federal Housing Enterprise Regulatory Agency,” with regulatory authority over Fannie Mae, Freddie Mac and the Federal Home Loan Banks (the “regulated entities”) and the new FHLBank Finance Corporation.

• Federal Housing Enterprise Board: The legislation establishes a new four-member advisory board — "The Federal Housing Enterprise Board” — that is generally precluded from exercising any executive authority — consisting of the director, as chair; the secretary of the Treasury; the secretary of HUD; and the chairman of the SEC.
• Deputy Directors: The legislation would establish three deputy director positions for the Division of Enterprise (Fannie Mae and Freddie Mac) Regulation; the Division of Federal Home Loan Bank Regulation; and for Housing Mission and Goals. In the case of the Division of Federal Home Loan Bank Regulation, the deputy director must have a “demonstrated understanding of financial management or oversight” and a “demonstrated understanding of the Federal Home Loan Bank System and housing finance.” The deputy director for Housing Mission and Goals deals with the housing mission and goals of Fannie and Freddie, and not the FHLBanks.

Regulatory Authority:

• Risk-based Capital Levels: The bill would require the regulator to issue regulations establishing risk-based capital requirements for Fannie/Freddie and the FHLBanks.
• Prompt Corrective Action: The bill applies prompt corrective action to the GSEs. The receivership provisions apply to Fannie and Freddie, and not the FHLBanks.
• Limitations on Golden Parachutes and Indemnification Payments: The bill provides authority to regulate or preclude golden parachutes and indemnification payments for Fannie/Freddie and the FHLBanks.

SEC Registration: The bill would require each of the GSEs to register with the SEC. FHLBanks will register (and maintain registration of) at least one class of capital stock with the SEC under the Securities Exchange Act of 1934. The bill:

• Includes exemptions from compliance with several sections of the '34 Act and SEC regulations for the FHLBanks and their members.
• Confirms the government securities and exempted status of FHLBank securities.
• Directs the SEC, when issuing regulations implementing the act, to consider the distinctive characteristics of the FHLBanks when evaluating the accounting treatment of REFCORP payments, the combined financial statements of the twelve FHLBanks, and the accounting treatment of redeemable stock and joint and
  several liability.

The FHLBanks’ requests for mandatory SEC consultation with the new regulator, expeditious SEC action, language clarifying audit committee independence and accommodations for officer certifications under Sarbanes-Oxley as a result of joint and several liability were not included.

Federal Home Loan Bank Governance: The bill, as did last year’s bill, does away with the process of appointing directors for Fannie Mae, Freddie Mac and the FHLBanks. Following the Senate Banking Committee's action on GSE reform legislation last year, a task force of FHLBanks offered a number of suggested revisions to the provisions
regarding nonmember director selection. The bill addresses each of the governance matters endorsed by all the FHLBanks, including:

• FHLBank boards are to be composed of member directors and nonmember directors (with at least two community interest directors as a subset of nonmember directors).
• A majority of the boards are to be member directors — with at least 1/3 nonmember directors.
• Nonmember directors are to be nominated by the boards and elected by the membership. Procedures for the nomination and election of nonmember directors are to be prescribed by FHLBank bylaws, consistent with rules and regulations issued by the new regulator.
• Member and nonmember director vacancies are to be filled by a vote of the remaining directors.
• All directors are to have four-year, rather than three-year, terms. The bill includes a transition rule providing that directors serving before the date of enactment may continue to serve for the remainder of their terms, until their successors assume office.
• The bill deletes the statutory director compensation cap.
  

Federal Home Loan Bank Finance Corporation: The legislation would create a debt issuance facility, the Federal Home Loan Bank Finance Corporation (Corporation), to carry out the present role and function of the Office of Finance. The new corporation would be a jointly owned subsidiary of the FHLBanks. Each FHLBank would own one share of stock in the corporation. The corporation’s board would be made up of the president of each FHLBank. The corporation would be regulated by the new agency.

IV. Congressional Hearings Examine GSE Issues

Last week, three congressional hearings examined issues that directly or tangentially dealt with issues relevant to the GSE debate.

Credit Rating Agencies: The Senate Banking Committee held an oversight hearing on the credit rating agencies, looking at issues such as independence and market domination by the largest three agencies. S&P came under particularly harsh questioning from Sens. Sununu and Hagel for issuing a bulletin prior to last year's GSE Committee vote that they might have to downgrade the secondary market agencies if the Committee put a receivership provision in the bill. Sen. Hagel referred to it as lobbying, but S&P said it was straightforward analysis. S&P indicated that it would not now downgrade the GSEs ratings based on that same language.

Home Loan Banks were not mentioned during the hearing.

Fannie Mae’s Accounting Problems: The House Capital Markets Subcommittee heard testimony from the SEC’s chief accountant Donald T. Nicolaisen on the accounting problems at Fannie Mae. Nicolaisen reiterated the agency’s finding that Fannie Mae was in noncompliance with GAAP and stated that the SEC’s investigation into the matter
could take up to a year to complete.

During the course of the hearing, defenders of Fannie Mae suggested that the GSE was being singled out unfairly and that other financial institutions that use significant amounts of derivatives are not receiving similar scrutiny.

Home Loan Banks were not mentioned during the hearing.

The GSEs' Role in Mortgage Markets: The Senate Banking Committee held a hearing that heard from FHA Commissioner John Weicher and a number of housing academics and experts.

Secretary Weicher’s testimony focused on HUD’s new housing goals for Fannie and Freddie. All of the other panelists testified that the GSEs result in a benefit to borrowers, increase homeownership rates and support the economy. However, it was noted that there are gaps that remain with respect to minority households and projections that the
mortgage growth will come from these households.

Allan Fishbein, executive director of the Consumer Federation of America, raised a number of concerns about the affordable housing efforts of FHLBanks.

• Advances: He cited 2001 CBO research that suggests that more than 52 percent of advances are made to fund jumbo loans to wealthy borrowers. He proposed additional targeting of FHLBank resources to affordable housing.
• MPF/MPP: "Neither the Finance Board nor the Banks have published data disclosing the extent to which these programs (MPF/MPP) expand opportunities for the underserved."
• Regulatory Focus Needed: “Stronger regulatory oversight of affordable housing would help increase FHLBank funding for these activities.”
  

Sen. Sarbanes focused most of his attention on the FHLBanks’ affordable housing program and the FHLBanks' activities addressing predatory lending matters. Secretary Weicher indicated that he could not provide administration policy on changes in the FHLBanks’ affordable housing focus and that would be conveyed when the administration formally testified on GSE legislation. Weicher indicated that predatory
lending violations of FHLBank members are regulated by federal financial regulators who are responsible for seeing that member banks conduct themselves properly in that area. Sarbanes applauded Fannie and Freddie initiatives in the area of predatory lending.

V. Finance Board Chairman Rosenfeld Nominated for Full Term

Ronald Rosenfeld has been nominated by President Bush for a full term on the Federal Housing Finance Board. He has been serving on a temporary recess appointment as a member of the board and as designated chairman since December. The recess appointment will expire at the end of this session of Congress. If confirmed by the Senate, his term will run through Feb. 29, 2009 — assuming the FHFB still exists.

V. NAHB and MBAA urge FHLBank securitization

The National Association of Homebuilders and the Mortgage Bankers Association of America have urged that the Congress authorize the FHLBanks to operate mortgage-backed securities programs. At this point, none of the national member trade associations have taken a position on this matter although it is expected the Financial Services Roundtable will endorse the concept in the near future.