Government Relations « Legislative Updates »

Legislative Updates

February 17, 2006

This update covers developments since the last update (12/27/05).

I. GSE Reform Legislative Outlook

As the second session of the 109th Congress begins, the outlook for passage of government-sponsored enterprise (GSE) reform legislation has not changed. All indications are that the legislation will not be enacted this year although a compromise on the biggest issue, portfolio limits on Fannie Mae and Freddie Mac, would make rapid passage a certainty. At this point, the adversaries on the portfolio matter, Fannie Mae and Freddie Mac on the one side and the Administration and the Federal Reserve on the other, do not feel compelled to compromise. As the conventional wisdom suggests that a bill would be difficult if not impossible to revive in the next Congress (absent additional serious financial problems at Fannie Mae or Freddie Mac), pressure to compromise may build as the year progresses.

Last week, the Administration laid down its GSE policy markers with the release of its budget message (see item IV). These statements have evolved somewhat from last year's budget to reflect the state of play of the GSE debate when Congress adjourned last year. New Federal Reserve Chairman Ben Bernanke also reiterated Fed policy in congressional appearances dealing with monetary policy. The most significant development in this area in the coming weeks will be the release of an internal report prepared at the request of the board of directors of Fannie Mae to examine various problems. This report, known as the Rudman Report for its author, the former Republican senator from New Hampshire, will be the focus of future hearings in the House and Senate.

II. Administration Budget Message Underscores Concerns About
    GSEs

This year's budget message covers GSE policy discussions in great depth. As in the past few years, the message is largely critical.

While the message supports GSE reform, a significant policy shift in this year's message is that the new regulator of GSEs must have authority that goes beyond safety and soundness to be able to address systemic risk. The message goes to some lengths to explain the Administration's concerns about systemic risk. The message states:

"... a new GSE regulator that is limited in its powers cannot properly mitigate systemic risk. When limited to consideration of the safety and soundness risk of a particular enterprise, for example, the regulator may not fully consider potential consequences to others in the mortgage markets and the larger economy. A world-class regulator for the GSEs must be equipped with the power to limit the systemic risk posed by a GSE before any safety and soundness event at a particular GSE occurs."

"A new regulator with appropriate powers would reduce systemic risk by requiring the GSEs over time to dispose of certain assets, leaving only those that provide a specific public benefit, such as a pipeline for mortgage securitization and affordable housing mortgages not suitable for securitization."

The following are key excerpts from the message:

Systemic Risk

"While the interrelationships of the modern financial system permit highly efficient management and dispersion of risk, these interdependencies, if not disciplined by the regulatory and market environment, may allow a failure in one place to immediately disrupt many other sectors."

"Systemic risk also is exacerbated because financial institutions that lend money to the GSEs may treat these investments favorably. Contrary to their other investments, banks are required to hold only a small amount of capital against the risk of decline in value or failure of the GSE investment. As noted by one rating agency in its guidance to investors, the GSEs have a competitive advantage because financial institutions have virtually no investment limits for GSE debt. Research shows that more than 60 percent of institutions in the banking industry hold as assets GSE debt in excess of half of their equity capital."

GSE Status Impedes Market Discipline

The GSE borrowing advantage is roughly 40 basis points.

"[t]hese investors, they act as if there is a legal requirement that the federal government guarantees GSE debt. In fact, there is no such guarantee or federal backing. This perception by investors is reinforced by private ratings agencies in their guidance to investors. For example, recent guidance noted with regard to Fannie Mae and Freddie Mac, ''the firms' strategic importance to the U.S. mortgage finance market and global capital markets implies a strong degree of government support that underpins Moody's Aaa senior unsecured ratings of both housing GSEs.''

"[i]nvestors do not demand the same financial disclosures as for fully private companies. Yet there has been no significant impact on the pricing of GSE debt securities. This lack of market discipline facilitates the growth of the GSE asset portfolios, thereby increasing systemic risk."

GSE Portfolios

"Fannie Mae and Freddie Mac portfolios ... are funded by $1.7 trillion in debt…. In 1990, the GSEs held less than five percent of outstanding mortgages in their asset portfolios. In 2004, they held 18 percent."

"In the last decade, the principal source of income for Fannie Mae and Freddie Mac has been net interest on their portfolios."

"The Federal Home Loan Banks have not to date grown mortgage asset portfolios as large as Fannie Mae or Freddie Mac, but the income generated by the mortgage portfolios of the Federal Home Loan Banks has grown since the mid-1990s."

"[o]ther types of risk in the GSEs' asset portfolios are substantial. Mortgage portfolios carry considerable interest rate risk, partly because of the prepayment risk caused by the refinance option available on most mortgages that allows homeowners to prepay their mortgages at any time to take advantage of lower interest rates. This risk can be mitigated — for example, through purchase of interest rate hedges — but the GSEs protect themselves against only some of the interest rate risk of their portfolios. Moreover, hedges are imperfect. Hedging misjudgments would occur even if the GSEs' policy were to fully hedge the portfolio because predicting interest rate movements and mortgage refinancing activity is difficult. As GSE asset portfolios have grown in size, the GSEs' participation in the market for hedging instruments has become dominant enough to cause interest rate spikes in the event that a GSE needs to make large and sudden adjustments to its hedging position."

Competition with Treasury Debt (a recurring theme in these messages)

"[t]he large amounts of GSE debt may compete to some degree with U.S. Treasury securities, which has the potential to raise the cost of federal borrowing."

SEC Registration

"Most of the GSEs either have failed to register their securities, or have suspended filing financial statements, with the Securities and Exchange Commission."