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Legislative Updates

February 20, 2007

I. GSE Reform Schedule Shaping Up

House and Senate Banking Committee Chairmen, Rep. Barney Frank (D-MA) and Senator Chris Dodd (D-CT) have indicated they want GSE regulatory reform legislation out of their committees by April. This appears likely in the House but unlikely in the Senate.

The House Financial Services Committee will hold two hearings in mid-March, at the full committee and at the Capital Markets Subcommittee. Committee markup of legislation is expected later in the month with House floor consideration in April. The bill should be similar in many ways to the bill passed by the House in the 109th Congress.

In the Senate, both the timing and framework of the bill are unknown. While Rep. Frank developed the previous House bill with former Chairman Mike Oxley (R-OH), Senate Democrats were not consulted in the development of the bill that passed the Senate Banking Committee and are expected to come up with a different approach.

In a new Congress when old legislation is revisited, new dynamics will be in play. This makes prediction of this legislation’s passage just as challenging as ever.

II. House Financial Services Oversight Plan Targets Committee Focus

On February 13, the House Financial Services Committee met to approve its oversight plan for the 110th Congress. While not a binding blueprint for the coming two years, it signals areas of committee interest. A number of FHLBank issues are in the plan which signals tough oversight of the FHFB.

FHLBank Capital: The Committee signaled its intention to “monitor the various regulatory initiatives undertaken” by the FHFB to alter FHLBank capital requirements. At an oversight hearing last September on the FHFB’s plan to set retained earnings minimums, several legislators suggested that the proposal was counter to statutory capital rules established in the Gramm-Leach-Bliley Act.

FHLBank Board Director Appointments: The FHFB’s appointment of outside directors has also been targeted for committee scrutiny. This matter precipitated aggressive questioning of FHFB Chairman Rosenfeld last year by the committee and correspondence from committee leadership.

FHLB Community and Economic Development: The Committee stated its intent to “focus on the efforts to advance community and economic development within the FHLB system, including the implementation of the enhanced targeted economic development lending for small business, small farms, and small agri-businesses allowed under the Gramm-Leach-Bliley Act and of the performance of the FHLBs in implementing the FHFB’s community investment cash advance regulation.” This is a very key interest of Capital Markets Subcommittee Chairman Kanjorski (D-PA).

REFCORP Payments: The Committee’s oversight plans states its intention to “monitor the efforts of the housing GSEs to pay the obligations of the Resolution Funding Corporation (REFCORP) established to cover the costs of resolving the savings-and-loan crisis and the policy implications for the GSEs upon the satisfaction of the remaining REFCORP debts.”

III. Administration Budget Message Released

On February 5, the Administration released its FY 08 budget message which represents its spending and budget priority “wish list” and an overall policy statement on a broad range of issues – its policy agenda for the year. In recent years, critical statements about all the GSEs have appeared, but this year’s rhetoric was relatively tame.

The budget’s GSE messages focus primarily on Fannie Mae and Freddie Mac. The budget notes that the Treasury is “developing new debt approval procedures to enhance the clarity, transparency, standardization, and documentation of Fannie Mae’s and Freddie Mac’s debt issuances.” It also states the need to bolster capital for all the GSEs and makes a case for GSE regulatory reform.

Once again, the FHLBank Affordable Housing Program is treated as federal spending for budget purposes. This change in budget treatment of these funds first appeared in last year’s FY 07 budget message.

IV. House Members Send Letter in Support of FHLBank Mortgage Programs

On January 5, 2007, Capital Markets Subcommittee Chairman Kanjorski and seven members of the House Financial Services Committee sent a letter to the members of the Finance Board supporting FHLBank development of “alternative methods for acquiring and reselling mortgages from member institutions.” The letter goes on to state, “This is one of the most basic asset management tools that all other regulated financial institutions have at their disposal. This current situation threatens the prudent evolution and viability of these programs. Such authority would create additional capacity for FHLBank members wishing to sell mortgages while allowing FHLBanks to better manage the risks facing their balance sheets.”

Kanjorski was joined on the letter by Reps. Jim Gerlach (R-PA), Don Manzullo (R-IL), Judy Biggert (R-IL), Luis Gutierrez (D-IL), Julia Carson (D-IN), Gwen Moore (D-WI), and Melissa Bean (D-IL).

On January 22, the Finance Board responded that, “As you may be aware, we have spent considerable supervisory resources addressing risk management and capitalization issues arising from the Banks' mortgage programs. We will continue to study ways that our regulation and our oversight of the FHLBanks' mortgage programs might be improved to further the goal of home ownership while enhancing the safe and sound operations of the FHLBanks.”

V. Basel 1A Raises Questions About Risk-weighting Treatment of GSE Paper

In December, the four Federal banking agencies approved a proposed rule known as Basel 1A that would significantly change the minimum risk-based capital rules for all but the biggest banks and thrift institutions. The public comment period is open through March 26, 2007. The largest internationally active institutions will be covered by new so-called Basel II requirements which are also open for comment. The Basel 1A and Basel II changes are expected to take effect in 2008.

Basel II is an effort to assure global capital parity for the largest internationally active banks. There is a concomitant desire within the United States to assure capital parity between the largest domestic banks and the rest of the industry. The proposed rule gives non-Basel II institutions the option of applying Basel 1A or keeping the existing risk-based capital rules.

Treatment of GSEs: Under Basel I (implemented in 1988), the predecessor to Basel II, the capital risk weighting assigned to investments issued or guaranteed by a GSE is 20 percent. The Basel 1A proposal raises the possibility that capital treatments of GSE investments could be disadvantaged under the new rules.

This issue was evidently injected into the agencies’ deliberations on Basel 1A by the OMB. Since two of the banking regulators, the OCC and the OTS, must submit regulations for review to the OMB, the inter-agency rules for all the regulators will come under de facto OMB review. It is the OMB review that has raised concerns that could impact GSEs by changing the capital risk-weighting for GSE debt and (mortgage-backed) securities held by banks and thrifts.

The preamble to the Basel 1A proposal notes that Fannie Mae and Freddie Mac obtain and disclose credit ratings that assess the “independent financial strength” (“IFS”) of these institutions without consideration of any “implied Government backing.” This was done as part of an agreement between Fannie Mae and Freddie Mac and their primary regulator in 2000. The IFS is not a measure of risk to the investor (in this case the depository institution holding the asset) but an attempt to measure the theoretical risk to the Government that is posed by the GSE itself.

The preamble further states that the banking regulators are considering the use of IFS ratings to determine risk weights for all GSE obligations and also poses the question of how to treat GSEs that currently do not have IFS ratings. The question at hand is whether or not the Basel 1A capital treatment for GSE paper should link capital treatment of these IFS ratings and whether this will result in a disincentive for banks to hold this paper. The argument can be made that the risk to the Government is not an appropriate basis for assigning risk weights to bank assets.

A changing IFS score on GSE securities could increase capital requirements, even if the actual investor credit rating remains unchanged. This uncertainty could raise the issue of future capital treatment, and it is not unlikely that the market would charge a premium. This would raise the cost of GSE funds.

The question also raises the possibility of capital inconsistency between Basel 1A and Basel II banks. Under Basel II, a bank holding GSE securities would use the investor credit rating, which reflects the risk to the bank holding the security. Banks following Basel 1A could be under a different set of rules.