In my view, limitations on GSE mortgage holdings are a necessary, but probably not a sufficient, reform, because this step addresses one, but not both, of the fundamental flaws of the housing GSEs, which primarily relate to the safety net the firms enjoy. The first current problem is that policymakers have virtually no direct control over the amount of safety net subsidy the GSEs receive. The second flaw is that the primary tool the GSEs use to achieve their main mission of increasing homeownership does little in practice to encourage or permit renters to become owners.

As you know, the Federal Reserve has argued for a substantial time that the portfolios are larger than is needed to serve the fundamental housing mission of the GSEs.  And my advice would be not to set a hard cap or a number -- you know, restrict the portfolio in that way -- but to give strong guidance to the regulator about how to relate the portfolio to the mission of the GSEs...By grounding the size of the portfolio in the mission of the agency, you would bring down, over time, the portfolio, to a safer level and not hurt the underlying mission of the GSE.

The question is, why are we allowing the portfolios to exist when they have as much inherent risk as they do. The question is, how much of the portfolio is necessary to fulfill the mission.  That is something that may require some judgment and analysis, but it seems clear that at the much smaller number than currently being held by the large GSEs.

In light of the recent events at the GSEs, the need for meaningful reform has become even more clear. As we originally outlined in detail in 2003, the regulator for the GSEs should have powers comparable in scope and force to those of other world-class financial supervisors and fully sufficient to carry out the agency's mandate. The regulator must have clear general regulatory, supervisory, and enforcement powers with respect to the GSEs. These powers must include the authority to set both minimum capital standards and risk-based capital standards; the power to assess the entities for independent funding outside of the appropriations process; and the ability to place a failed GSE in receivership.

In order to protect against the systemic risk posed by the housing GSEs' mortgage investment business, the Administration also recommends that limitations be placed on the size of the housing GSEs' retained mortgage investment portfolios.

The costs and the quantity of options (or swaps or other derivatives) needed to sufficiently passively hedge a mortgage portfolio, however, can become substantial, especially when the portfolio is leveraged, is growing rapidly, is large relative to the supply of options and whose outcome, in any event, is not a perfect hedge.  Moreover, thse strategies, which are complex, can be costly when they fail.  Thus, even if Fannie and Freddie were to fully rely on passive hedges (a very expensive approach to managing prepayment risks), the system would again rely on Fannie and Freddie avoiding large errors.

It is certainly true that when dealing with policies that affect so important an institution as homeownership in this country, caution is always commendable.  However, caution based on concerns without merit can be counterproductive.  Indeed, in the case of GSEs, excessive caution in reducing their portfolios could prove to be destabilizing to our financial system as a whole and in the end could seriously diminish the availability of home mortgage funds.

I think that the idea of portfolio caps is a good one.

Financial instability coupled with the higher interest rates it creates is the most formidable barrier to the growth, if not the level, of homeownership. Huge, highly leveraged GSEs [government-sponsored enterprise] subject to significant interest rate risk are not conducive to the long-term financial stability that a nation of homeowners requires.

As I testified before the Congress both this year and in 2004, the GSEs need a regulator with authority on par with that of banking regulators, with a free hand to set appropriate capital standards, and with a clear and credible process sanctioned by the Congress for placing a GSE in receivership, where the conditions under which debt holders take losses are made clear.

The strong belief of investors in the implicit government backing of the GSEs does not by itself create safety and soundness problems for the GSEs, but it does create systemic risks for the U.S. financial system as the GSEs become very large. Systemic risks are difficult to address through the normal course of financial institution regulation alone and...can be effectively handled in the case of the GSEs by limiting their investment portfolios funded by implicitly subsidized debt.

The GSEs need a regulator with authority on a par with banking regulators, with a free hand to set appropriate capital standards, and with a clear and credible process sanctioned by the Congress for placing a GSE in receivership, where the conditions under which debt holders take losses are made clear. However, if legislation takes only these actions and does not limit GSE portfolios, we run the risk of solidifying investors' perceptions that the GSEs are instruments of the government and that their debt is equivalent to government debt...Without restrictions on the size of GSE balance sheets, we put at risk our ability to preserve safe and sound financial markets in the United States, a key ingredient of support for homeownership.

Beyond strengthening GSE regulation, the Congress will need to clarify the circumstances under which a GSE can become insolvent and, in particular, the resultant position--both during and after insolvency--of the investors that hold GSE debt, as well as other creditors and shareholders.

If we fail to strengthen GSE regulation, we increase the possibility of insolvency and crisis. We at the Federal Reserve believe this dilemma would be resolved by placing limits on the GSEs' portfolios of assets, perhaps as a share of single-family home mortgages outstanding or some other variation of such a ratio. Almost all the concerns associated with systemic risks flow from the size of the balance sheets of the GSEs, not from their purchase of loans from home-mortgage originators and the subsequent securitization of these mortgages.

We at the Federal Reserve remain concerned about the growth and magnitude of the mortgage portfolios of the GSEs, which concentrate interest rate risk and prepayment risk at these two institutions and makes our financial system dependent on their ability to manage these risks. Although Fannie and Freddie have chosen not to expand their portfolios significantly this past year (presumably at least partly in light of their recent difficulties), the potential for rapid growth in the future is not constrained by the existing legislative and regulatory regime.