If There is Going to Be a Housing Bubble, It Could Largely Occur Because of Fan’s and Fred’s Trouble

An important warning was issued today by former director of the Office of Federal Housing Enterprise Oversight (Ofheo) Armando Falcon Jr. in the Wall Street Journal (requires subscription). He is concerned about possibly precarious financial conditions at Freddie Mac and Fannie Mae, the two housing corporations that buy billions of dollars of mortgages from financial institutions and securitize them (i.e., package and issue them as bonds) with the implicit backing of Uncle Sam:

Adult Supervision
By ARMANDO FALCON JR.

Over the past several years, corporate America has been rocked by major scandals involving billions of dollars of financial restatements, significant losses for investors, reputation problems for big business, and, in some cases, jail time for senior executives. Whether it was Enron, Adelphia or WorldCom, Congress wasted no time examining and strengthening the oversight functions and regulatory authority of various federal agencies, including passage of the wide-ranging Sarbanes-Oxley Act.

To date, there remains one glaring exception. In the past two years, accounting failures at Fannie Mae and Freddie Mac, known as Government Sponsored Enterprises (GSEs), have led to the largest financial restatements in history — totaling more than $20 billion — dwarfing the combined restatements of both Enron and WorldCom. In recent days, news reports indicate the financial misconduct could be wider and deeper than has emerged thus far.

Left undetected and unchecked, the web of misconduct at Fannie Mae and Freddie Mac might have unraveled in a way that caused serious disruptions to our financial system. The likely collateral damage was presciently spelled out in a report on systemic risk that their regulator, the Office of Federal Housing Enterprise Oversight (Ofheo) issued in 2003.

….. two and a half years after Freddie Mac’s scandal unfolded, legislation to strengthen regulation remains mired in gridlock.

One of the key areas of disagreement is the appropriateness and size of the mortgage portfolios these enterprises retain. Unfortunately, much of the discourse around the portfolios is characterized by misinformation and scare tactics. It is critical to have a candid discussion about the portfolios. The fact is that they have grown 12-fold in 14 years for one reason: to generate additional profits for the GSEs. That is nonjudgmental, just a fact. Other stated purposes for the portfolios, such as enhancing the liquidity of the mortgage-backed security market and promoting affordable housing, would be no less well-served if the Fannie and Freddie continued to buy mortgage products as they do today but retained much smaller portfolios.

Currently, there are no real limits on the size of the portfolios. Ofheo’s statutory mandate is to ensure that the enterprises manage the risks of their portfolios in a safe and sound manner, not to limit their amount. However, Fed Chairman Greenspan and other economic leaders have repeatedly warned policy makers that they should be concerned not just about the safety and soundness of Fannie and Freddie, but more broadly concerned about the risks to our financial system.

Smaller, mission-focused portfolios would better serve everyone, even shareholders. If well managed, they are capable of a fair return to investors and a strong return to the public interest. But as it is now all too clear, the enterprises never were the steady earnings juggernauts they held themselves out to be.

Legislation should give the regulator discretion to manage the size of the portfolios, but be clear as to the regulator’s mandate. The mandates in the Senate and House bills are very different and would produce different results. The Senate bill would direct regulators to design and implement an orderly reduction in the enterprises portfolios without harm to affordable housing efforts. But the House bill would preserve the status quo, which permits the enterprises to maintain portfolios of any size as long as safety and soundness considerations are met. The House bill should be amended to put the proper mandate in place.

Time is not necessarily a luxury in passing legislation to strengthen regulation. Fannie Mae and Freddie Mac have constructed their portfolio risk-management strategies around hedging techniques that remain untested by adverse market conditions. Even assuming the companies employ the very best risk-management practices, prudence demands that we have the strongest regulatory structure in place to deal with the fallout if they just get it wrong.

Two government-sponsored enterprises whose financial reports lack the needed transparency are in many ways dominating the market. If Fan and Fred run into trouble and stop buying loans, banks used to getting them off their books as soon as the deals are done will likely slow their lending down and make their qualification standards much stricter. While tightening standards is a good idea, applying the brakes too quickly could reduce demand for housing and drive home prices down–perhaps way down.