I welcome recent efforts to improve the regulatory oversight of the government-sponsored enterprises, Fannie Mae and Freddie Mac. If these firms are strong, well-regulated, well-capitalized, and focused on their mission, they will be better able to serve their function of increasing access to mortgage credit, without posing undue risks to the financial system or the taxpayer. Policymakers are also discussing the modernization of the Federal Housing Administration and the expansion of the products and programs it might offer to make mortgage credit available and to help prevent avoidable foreclosures.

That speech [March 2003] caused a little stir. I don’t think anything constructive by way of reform has happened since. I don’t take credit for disclosing the accounting irregularities, but when I look back, is there something I wish I had said or not said? The answer is no. One of the reasons I went down that track is that I have a vivid memory when I was at the Council of Economic Advisers in Washington. We had many discussions and were all very well aware of the problems being covered up in the savings and loan industry. That experience led me to rather deep regret that I had not raised that issue publicly. I might not have been in a position to do it because it was a very politically difficult issue, and many people were trying to cover it up, sweep it under the rug and ignore it. But I wish I would have somehow found a way to raise that issue and improve public consciousness. If I had been able to do that in 1982 or 1983, and if there had been some earlier action, it might have saved taxpayers quite a bit of money. It probably wouldn’t have made any difference, but I would have felt better.

Separately, the GSEs--Fannie Mae and Freddie Mac--could be asked to do more. Recently, the Congress has greatly expanded Fannie Mae's and Freddie Mac's role in the mortgage market by temporarily increasing the conforming loan limits for these GSEs. In addition, their federal regulator, the Office of Federal Housing Enterprise Oversight, has lifted some of the constraints that were imposed on these entities because they have resolved some of their recent accounting and operational problems. Thus, now is an especially appropriate time to ask the GSEs to move quickly to raise more capital, which they will need to take advantage of these new securitization and investment opportunities, to provide assistance to the housing markets in times of stress, and to do so in a safe and sound manner. As the GSEs expand their roles in our mortgage market, there is a strong need for the Congress to move forward on GSE reform legislation, including the creation of a world-class GSE regulator.

With modernization and expansion, the FHA could play an important role in relieving stress in the mortgage and housing markets as well as in restarting securitization markets. Securitization markets are needed to help relieve capital stresses on banks and to provide more affordable mortgages to borrowers. To this end, more consideration needs to be given to how the FHA can scale up quickly and improve its processes and underwriting systems so that they are comparable in quality with those currently being used by Fannie Mae and Freddie Mac. In addition, providing the FHA with broad authority to offer innovative products that meet market needs and to outsource loan underwriting and other program elements to private-sector providers could allow the FHA to insure more mortgage borrowers and to do so more quickly. The FHA needs to be better able to compete in today's marketplace and it needs access to the best risk-management tools available when managing the risks to the government.

The government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, likewise could do a great deal to address the current problems in housing and the mortgage market. New capital-raising by the GSEs, together with congressional action to strengthen the supervision of these companies, would allow Fannie and Freddie to expand significantly the number of new mortgages that they securitize. With few alternative mortgage channels available today, such action would be highly beneficial to the economy. I urge the Congress and the GSEs to take the steps necessary to allow more potential homebuyers access to mortgage credit at reasonable terms.

U.S. banks entered the period of turmoil last year pretty well capitalized and have been able to withstand large losses.

I am more skeptical of the financial strength of the GSEs, and believe that we could see substantial problems in that sector.

As I have emphasized before, the Federal Reserve can deal with liquidity pressures but cannot deal with solvency issues. I do not have any information on the GSEs that the market does not also have. Nevertheless, in assessing the risk of further credit disruptions this year, I would put the GSEs at the top of my list of sources of potentially serious problems. If those problems were realized, they would be a direct result of moral hazard inherent in the current structure of the GSEs.

So, one possibility would be, if the federal government were willing to act as guarantor. For example, suppose that the GSEs were to pay their usual mortgage insurance credit fee to the federal government, which enacted is guarantor -- so, to take away the credit risk from the GSEs, then they could process these jumbo loans and sell them into the secondary market and that would be, I think, of some assistance to the mortgage market.

From the federal government's point of view, they would be taking on some credit risk, which you may or may not be willing to do. I think that if you did that, it would be a good idea to make the GSEs ultimately responsible for some -- any excess losses or some part of excess losses, relative to the premiums that are paid, and leave it to the regulator to determine when the safety and soundness was adequate that the GSEs could make that repayment.

So, I think there might be some mechanisms that would involve federal interaction. But I think it's extremely important, as we look at these options, that we don't take actions that will endanger the safety and soundness of the underlying institutions.

From the Q&A session

The government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac are, to a limited extent, assisting in subprime refinancings and should be encouraged to provide products for subprime borrowers to the extent permitted by their charters.  However, the GSE charters are likely to limit the ability of the GSEs to serve any but the most creditworthy subprime borrowers.  Indeed, if GSE programs remove the strongest borrowers from the pool, the risks faced by other programs--such as a modernized FHA program--could be increased.

Some have suggested that the GSEs could help restore functioning in the secondary markets for non-conforming mortgages (specifically jumbo mortgages, those with principal value greater than $417,000) if the conforming-loan limits were raised.   However, in my view, the reason that GSE securitizations are well-accepted in the secondary market is because they come with GSE-provided guarantees of financial performance, which market participants appear to treat as backed by the full faith and credit of the U.S. government, even though this federal guarantee does not exist.  Evidently, market participants believe that, in the event of the failure of a GSE, the government would have no alternative but to come to the rescue.  The perception, however inaccurate, that the GSEs are fully government-backed implies that investors have few incentives in their role as counterparties or creditors to act to constrain GSE risk-taking.  Raising the conforming-loan limit would expand this implied guarantee to another portion of the mortgage market, reducing market discipline further. 

A straightforward means of anchoring the GSE portfolios to a clear public mission would be to require Fannie and Freddie to focus their portfolios almost exclusively on holdings of mortgages or mortgage-backed securities that support affordable housing.  The evolution of mortgage markets since the GSEs were created strongly suggests that a concentration on affordable-housing products would provide the greatest public benefit.  

I think the ideal situation would be one in which the portfolios did exactly what you said, they were to be the way station for securitized mortgages and they would contain mostly liquid assets for the purpose of purchasing mortgages and then selling them back to the market. I would like to see a bill. I think we need to have a strong regulator in this arena. And we need to find some way that we can limit the growth of the portfolios.

As a practical matter, I think that restricting portfolios to mortgages related to affordable housing might be an appropriate compromise, appropriate approach that would provide some limitation.

But the Federal Reserve has always been concerned about the size of the portfolios. It never has found a substantial benefit to homeowners from large portfolios.

I’ll confine most of my comments to Fannie Mae and Freddie Mac, where the largest issues arise. My purpose is to make the case once again that failure to reform these firms leaves in place a potential source of financial crisis. Although there is pending legislation in Congress, a major restructuring of these firms and genuine reform appear to be as distant as ever.

...

These two firms ...  cannot meet their growth targets in the long run if they confine their operations to conforming home mortgages. Their interest in increasing the conforming mortgage limit is clear. Moreover, in my opinion it is inevitable that they will look for ways to extend their operations into new areas. They have that clear incentive because of the implicit federal guarantee they enjoy. For them to extend their operations into market segments already well served by existing private firms will not enhance the efficiency of mortgage markets or reduce costs to mortgage borrowers.

{The Administration} wanted to, arbitrarily in my judgment or at least summarily, say and we're going to reduce their size. 

Once you get an agreement that we are not going to have an arbitrary limit or a preset limit on the size of their portfolio, then you can go to regulation.
 
By the way, you know, arguments for the portfolio, one of the things that many of us are going to be arguing for is some forbearance by lenders so you don't get excessive foreclosures.
 
If you sell all of this mortgage stuff into the secondary market, forget about forbearance.  The secondary market can't do forbearance.  Forbearance -- allowing people who are in trouble a little extra time, et cetera -- can only come from an entity that holds those mortgages.
 
I can ask Fannie Mae and Freddie Mac to show forbearance.  I can go ask the secondary market to do it, and they won't pay any more attention to me than Dick Cheney does. 
 
     (LAUGHTER)
 
So the answer is we will increase the regulation of Fannie Mae and Freddie Mac.
 
And we will do one other thing.  And this is sort of -- well, let me give you two microcosmic examples of the bargain I want to make.  I want to keep Fannie Mae and Freddie Mac in business.  People have said, you know what, they get too many advantages, because they can borrow money more cheaply because of various perceptions of their involvement with the government, and the stockholders make too much money -- too much profit accrues to them.  Let's cut back on their
profit.
 
     My answer is no.  Let's leave them the profit, but let's take a chunk of it and put it into affordable housing.

As I’ve emphasized before, the Federal Reserve does not have the legal authority to bail out a troubled GSE. The Fed can provide liquidity support through its discount window, but only indirectly through collateralized loans to banks that would then bear the credit risk of making loans to a troubled firm.  Under emergency conditions, the Fed does have the authority to make loans directly to a GSE, but the loans must be fully collateralized. The Fed is obviously disinclined to use its emergency powers to lend to firms other than banks; despite numerous financial upsets over the years, the Fed has not used this authority since the 1930s.

I believe that supervisory oversight is in pretty good shape, with one glaring exception. Government-sponsored enterprises are not adequately capitalized and the supervisory powers of the Office of Federal Housing Enterprise Oversight (OHFEO) are inadequate. I’ll concentrate on the housing GSEs—Fannie Mae and Freddie Mac. This is a topic I’ve addressed several times in the past (Poole, 2003 and 2004) and I’ll not repeat those arguments in any detail here. Although the GSEs are not formally insured by the federal government, the market clearly believes that they are effectively backstopped.