The top executive at Freddie Mac and the head of the federal agency charged with overseeing the company’s financial soundness are butting heads over a proposal to limit the portfolios of government-sponsored mortgage repurchasers.
James Lockhart, director of the Office of Federal Housing Enterprise Oversight, on Friday renewed his calls that Congress give OFHEO greater authority over Freddie Mac and Fannie Mae to reduce what he calls the “systemic risk” the companies pose to the U.S. banking system and financial markets.
Lockhart, speaking at the Hudson Institute in Washington, D.C., cited two recent studies that concluded tighter controls on Fannie and Freddie’s portfolios won’t necessarily drive up the cost of home loans for consumers or hurt affordable housing goals.
In the last 15 years, while the nation’s gross domestic product has doubled and the mortgage market has tripled in size, Fannie and Freddie’s portfolios have grown by a factor of 10, Lockhart said, to $1.4 trillion. Combined with the $2.6 billion in mortgage-backed securities guaranteed by the enterprises, Fannie and Freddie own or guarantee $4 trillion in loans — more than 40 percent of U.S. mortgages.
That’s nearly as much as the $4.7 trillion in debt held by the U.S. public and the projected 75-year Social Security shortfall of $4.6 trillion, Lockhart said in a speech at the Hudson Institute in New York.
The case for reform “is very strong given Fannie Mae’s and Freddie Mac’s mismanagement history and the risks caused by their massive size,” Lockhart said, referring to management and accounting scandals that led both companies to fire top executives and restate earnings.
Freddie Mac Chief Executive Officer Richard Syron, hired two and a half years ago to help the company put its books in order, took issue with claims that the government-sponsored entities, or GSEs, pose a systemic risk.
Speaking Wednesday in San Francisco to members of the Commonwealth Club of California, Syron noted that in the most recent quarter, Freddie Mac’s duration gap “did not budge from zero months” during a quarter when interest rates moved considerably — evidence that the company’s assets balance its liabilities and that “we manage interest rate risk very conservatively.”
The duration gap is a measurement of risk from changing interest rates, which can upset the balance of cash flowing into a company from assets and outflows from liabilities.
Freddie and Fannie transfer risk from homeowners to the capital markets, “which are much better equipped to handle it,” Syron said. “If we don’t handle this task, it will simply have to go to someone else.”
Syron said there’s little evidence that a “handful of big banks” whose mortgage portfolios are growing much faster than Freddie and Fannie “can handle the risk any more safely than we do. In fact, there is strong evidence to the contrary, including the GSEs’ much greater use of callable debt. Simply put, the system is safer with the GSEs playing our current role, than if we are arbitrarily cut back in what we can do for our housing mission.”
In his speech Friday, Lockhart addressed the comments by Freddie Mac’s CEO directly.
Syron, he said, “ignores the inability of the GSEs to diversify to reduce risk, unlike banks. He also ignores the fact that systemic risk is much broader than market risk and can be caused by operational problems, including deficient models or unauthorized trading. A stronger regulator and smaller portfolios should help to reduce the potential for systemic risk.”
Lockhart said that the callable debt and derivatives used by Freddie and Fannie to manage risk “just pass the mortgage prepayment risk elsewhere.”
Freddie and Fannie also have lower capital requirements than banks, Lockhart noted. In 1992, Congress passed a requirement that the enterprises maintain stockholder’s equity equal to 2.5 percent of assets in portfolio — about half of what large banks must maintain to be considered well capitalized, Lockhart said.
Some critics say tighter restrictions on Freddie and Fannie’s portfolios will drive up the cost of home loans at a time when housing markets in many regions of the country are in a downturn.
Lockhart cited a recent study by the Federal Reserve Board’s Division of Research and Statistics that concluded curbs on the growth of the enterprises’ portfolios would not necessarily increase mortgage rates, but would reduce risks to the financial system.
The study, “GSEs, Mortgage Rates, and Secondary Market Activities,” concluded that Freddie and Fannie’s portfolio purchases “have economically and statistically negligible effects on both primary and secondary market rate spreads.”
Lockhart cited another recent study by the Federal Reserve Bank of Boston, which concluded that access to credit has improved since 1969, allowing more Americans to buy homes based on their long-term income prospects. But the report, “Do Households Benefit from Financial Deregulation and Innovation?” found no evidence that Freddie and Fannie have contributed to the phenomenon.
“This is true whether we look at all home buyers, or at subsamples of the population whom we might expect to benefit particularly from GSE activity, such as low-income households and first-time home buyers,” the report said. Lockhart noted that less than 30 percent of Freddie and Fannie’s mortgage portfolios is used to support affordable housing.
Lockhart said Freddie and Fannie’s portfolios could be reduced gradually with a “minimal” impact on the mortgage market. Over the last two years, he said, the enterprises’ mortgage-backed security portfolios shrank by more than $280 billion “without market disruption as these sales were easily absorbed by investors.”
Lockhart wants Congress to pass legislation that would merge OFHEO with the Federal Housing Finance Board, which regulates 12 federal home loan banks, and grant it greater oversight powers over Freddie and Fannie. The Department of Housing and Urban Development currently governs the enterprises’ mission and new products.
OFHEO needs “bank regulator-like powers” over the enterprises, including receivership authority and enhanced enforcement powers such as the ability to address misconduct by employees and directors, Lockhart said.
Officials at Freddie and Fannie have supported legislation that would give OFHEO greater regulatory powers. But Lockhart wants the new regulatory agency that would be created by the merger of OFHEO and FHFB to have the power to set and enforce risk-based annual portfolio limits.
Freddie and Fannie are opposed to curbs on portfolio growth, and the issue has stalled a Senate version of a bill that would create many of the other reforms sought by Lockhart and the Bush administration. Syron said Freddie still wants “very much to see an appropriate bill signed into law” and that the company is “playing a constructive role in that process.”
“I don’t want to let my fundamental disagreement on systemic risk obscure an important point,” Syron said. “Since the day I arrived at Freddie Mac more than two and a half years ago, we have supported legislation to strengthen regulatory oversight of the GSEs.”
