This article was my final paper for my Banking Law Seminar class in the Spring of 2008. I thought about piecing it out in a series but decided it was better to post it in its entirety. The way you view it today is exactly how I submitted it without modification aside from the title page. The date was April 16th of 2008. I earned the very highest grade possible with it. I hope you enjoy it.
By: Thomas L. Antoine
INTRODUCTION
The housing industry has been the center of the recent financial crisis troubling the nation and dominates current financial news. Government Sponsored Enterprises (GSEs) have been swept up in the turbulence and possibly a major contributor to these problems. This paper will discuss the history of Fannie Mae and Freddie Mac as an example of the GSE. An explanation of how GSEs are regulated will be outlined and the current business and economic climate will be discussed. GSEs are integral in the packaging of Mortgage Backed Securities (MBS). A discussion of how MBSs are valued is an important part of understanding the regulation of Fannie Mae and Freddie Mac and their roll in the economy. Currently, there are pressing calls for new or different federal regulation on the front burner in Washington. The impact of how proposed revisions may or may not impact GSEs will be reviewed.
BREIF HISTORY of GSEs
The most commonly known GSEs are Fannie Mae, Freddie Mac, and Ginnie Mae. The Federal National Mortgage Association (FNMA) is commonly called Fannie Mae. The FNMA originated in 1938 as part of Franklin D. Roosevelt’s New Deal and a part of an effort to stimulate home ownership that started with the Home Owner’s Loan Act of 1933.[1] The national housing market had collapsed in the wake of the Great Depression and private lenders were apprehensive to invest in home loans. Fannie Mae was established to provide local banks with federal money to finance home mortgages.[2] This was an attempt to make housing more affordable in a time when home ownership was on the decline. 1968, due to fiscal pressures created by the Vietnam War, Lyndon B. Johnson privatized Fannie Mae in order to remove it from the national budget. Currently it is traded under the symbol FNM. The origin of Freddie Mac occurred in 1970 shortly after Fannie Mae was privatized. The business name is the Federal Home Loan Mortgage Corporation (FHLMC). It was created to expand the secondary market for mortgages at the same time the Bank Holding Company Act (BHCA) Amendments were enacted.[3] Freddie Mac was intended to address concerns that Fannie Mae would monopolize the market. Freddie Mac is traded under the symbol FRE.
Other GSEs include the Government National Mortgage Association (GNMA) and SLM Corporation, formerly USA Education. SLM Corporation is commonly known as Sallie Mae, a publicly traded corporation. They are the United States’ largest student loan company. The company primarily provides federally guaranteed student loans originated under the Federal Family Education Loan Program (FFELP). Sallie Mae also provides resources to assist students, parents, and professionals guidance with the financial aid process. GNMA, known as Ginnie Mae, is a U.S. government-owned corporation within the Department of Housing and Urban Development (HUD).[4] Ginnie Mae provides guarantees on mortgage-backed securities (MBS) guaranteed by federally insured loans. These loans are issued by the Federal Housing Administration, Department of Veterans Affairs, Rural Housing Service, and Office of Public and Indian Housing. Ginnie Mae securities are the only MBSs that are guaranteed by the United States government. This creates confusion as to whether Fannie Mae and Freddie Mac carry the same protection.
GENERAL OPERATION of FANNIE MAE and FREDDIE MAC
Both Fannie Mae and Freddie Mac have common business purposes. Each is a government-sponsored enterprise (GSE) of the United States.[6] Both companies are stockholder-owned corporations authorized to make loans and loan guarantees. Neither GSE is backed or funded by the U.S. government, nor do the securities they issue benefit from any explicit government guarantee or protection. Along with other entities, Fannie Mae and Freddie Mac buy mortgages on the secondary market, pool them, and sell them as mortgage-backed securities to investors on the open market.[7] This secondary mortgage market helps to replenish the supply of lendable money for mortgages and ensures money continues to be available for new home purchases. Their common names, Fannie Mae and Freddie Mac, are used for ease of identification.
How these GSE’s operate is unique to other corporations. Fannie Mae and Freddie Mac generate profits for stock holders while enjoying the benefits of exemption from taxation and oversight as well as implied government backing.[8] Depending on the source, it is reported that Fannie Mae and Freddie Mac have controlled between 40 and 60 percent of the nation’s secondary mortgage market. Fannie Mae and Freddie Mac are the only two Fortune 500 companies that are not required to inform the public about any financial difficulties that they may be having.[9] Both companies are exempt from registration filing requirements with the Securities and Exchange Commission (SEC) under their respective Charters.[10] Therefore, the corporations’ quarterly and annual financial reports are not available on the SEC’s Electronic Data Gathering, Analysis, and Retrieval system (EDGAR). However, both corporations are required to make analogous disclosures available. These financial disclosures include Information Statements similar to the 10K yearly and 10Q quarterly Information Statements and Supplements. The Fannie Mae and Freddie Mac statements are available from the corporations’ Investor Relations Departments. In addition to these unique reporting requirements, Fannie Mae and Freddie Mac are subject to special regulation under the Housing and Urban Development (HUD) department.
OVERVIEW of REGULATORY SYSTEMS
Government-sponsored enterprises are unique in how they are regulated. The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (the GSE Act) established the current regulatory structure for the GSEs. The GSE Act is codified under Title 12 Chapter 46 for Government Sponsored Enterprises.[11] The Act focuses on Protection of taxpayers from liability of the GSE operation. The legislation divided the Federal Government’s regulatory responsibilities of Fannie Mae and Freddie Mac between the Secretary of Department of Housing and Urban Development (HUD) and the Director of the Office of Federal Housing Enterprise Oversight (OFHEO). [12] Under the GSE Act, the Secretary of HUD is charged with general regulatory authority over Fannie Mae and Freddie Mac in all areas other than the GSEs’ financial safety and soundness, which is the responsibility of the Director of OFHEO. The Director is authorized, without the review or approval of the Secretary, to make determinations and take regulatory actions necessary to ensure the safety and soundness of GSEs.[13] Those actions may include the establishment of capital standards and examinations of the enterprises.[14] The examinations may be used to determine the capital levels of the enterprises, assist in decisions to appoint conservators for the enterprises, and include administrative enforcement actions.
In addition to GSE health, financial actions are also closely monitored. The enterprises must submit reports of their financial status to the Director for review.[15] A GSE must seek approval of payments of capital distributions to its shareholders from the Director.[16] Excessive compensation by the enterprises to any executive officer of the enterprises is prohibited under section 4518 of the title. The management of the office, including the establishment and implementation of annual budgets, the hiring of, and compensation levels for, personnel of the office, and annual assessments for the costs of the office must be included in the Director’s review.
The director of the OFHEO, James B. Lockhart III, reports to the Secretary of HUD. The current Secretary of HUD is Alphonso Jackson. The actions of HUD are dictated by the Real Estate Settlement Procedures Act (RESPA) along with the Truth In Lending Act (TIL). These statutes are designed to deter abuse by requiring disclosure of closing terms, financial terms, and the operation of HUD to protect consumers.[17] RESPA applies to all federally related mortgage loans except loans for business purpose, temporary financing, loan conversions, and secondary market transactions. [18] This means that the secondary securities bundled and sold by the GSEs are not covered by RESPA oversight. Similarly, mortgage broker transactions that are table-funded are not secondary market transactions and do fall under RESPA either. Neither the creation of a dealer loan or dealer consumer credit contract, nor the first assignment of such loan or contract to a lender, is a secondary market transaction and do come under RESPA purview which HUD is responsible for enforcing.
HUD’s authority includes setting the level of, and enforcing, three affordable housing goals. The first, goal includes compliance with fair lending requirements, issuance of TIL statements, and the like. Second, the Secretary must collect loan-level data from the GSEs regarding their mortgage purchase activities. Then create and make available to the public a database of non-proprietary GSE loan purchase data. Finally, HUD must review new proposed GSE programs. HUD has express authority to disapprove any program that the Secretary determines is not authorized under a GSE’s Charter or the Act for purposes that are not in the public interest. The actions of Fannie Mae and Freddie Mac and reports made by the Secretary of HUD are closely monitored because Banks use the mortgage backed securities that they hold to calculate their Risk Weighted Assets which is used in determining whether the bank meets Regulatory Capital Requirements.[19] The standard is imposed by the International Lending and Supervision Act 12 U.S.C. §3907.
The Secretary of HUD is not responsible for reporting on the safety and soundness of HUD that is the Director of OFHEO’s responsibility. The Director of OFHEO is required to compile data on GRE safety and soundness and report it to the US Senate Committee on Banking, Finance and Urban Affairs and the United States House Committee on Financial Services. Currently, the Senate Committee members include Senator Chris Dodd Chairman (D-CT) and Richard C. Shelby Ranking Member (R-AL) among others. The House Committee members include Barney Frank, Chairman (D-MA) and Spencer Bachus, Ranking Member (D-AL). The Director must submit two yearly reports to these Committees. Not later than June 15 of each year, a written report on actions taken, and being undertaken for the financial safety and soundness of each GSE must be submitted.[20] The report includes recommendations for legislation to enhance the financial safety and soundness of each GSE. In addition to this report another is required on March 15 of each year. The March report requires the Director to include written documentation of the year’s requests of enforcement actions by the Director to the Attorney General. Specific data on the total number of requests made by the Director, number of requests that resulted in the commencement of litigation by the Department of Justice, and other related data is required. These measures primarily target consumer protection and attempt to safeguard taxpayers from potential GSE corporate misbehavior.
TREND of FUTURE REGULATION
The housing industry is at the epicenter of the nation’s current financial problems and has prompted discussion regarding reformation of the GSEs responsible for creating mortgage backed securities. The Department Of The Treasury’s “Blueprint For A Modernized Financial Regulatory Structure” with Henry M. Paulson, Jr. as Secretary includes discussion on where legislation may or may not be going. Those components of the plan that affect Fannie Mae and Freddie Mac are part of the short, intermediate, and possibly long term recommendations. The short term recommendations include expanding government to regulate loan origination. Two intermediate recommendations will likely have an impact one includes transitioning Thrifts to Bank Charters. The other intermediate change would merge the Securities and Exchange Commission with the Federal Trade Commission.[21] These recommendations are supported by developments in asset securitization. The asset securitization process includes pooling single mortgage loans with other mortgage loans in a portfolio of assets and selling securities backed by the pool of mortgage loans (MBSs) to obtain funding from the public with which to originate new mortgage loans.
The Blue Print acknowledges that mortgage backed securities is where GSEs hold a key role. “The advent of the residential mortgage securitization market and the large growth of both government-sponsored enterprises (“GSEs”), such as ‘Fannie Mae’ and ‘Freddie Mac’, and other asset-backed securities markets have shrunk traditional depository institutions’ share of the overall residential mortgage market.”[22] In 2005 Fannie Mae’s and Freddie Mac’s combined book of MBSs represented 40 percent of the total residential mortgage debt outstanding, slightly down from the 43 percent share at the end of 2004. In total, GSEs and non-GSE corporations that securitize mortgages control between 60 to 65 percent of the total residential mortgage market. The Blue Print continues to say that “despite recent stress in the securities market, there is still a robust level of GSE securitization.”[23] The report calls for prudential regulation of Government-Sponsored Enterprises but does not offer suggestions that are different than today’s regulation. The report acknowledges that the GSEs’ unique structure does not fit well within any regulatory structure. Even though no explicit guarantee backs the GSEs’ obligations, Government sponsorship provides each GSE with a set of benefits not available to other financial institutions. The sponsorship creates the appearance of a guarantee and perceived stableness of GSEs.
Paulson’s plan includes what is named the Prudential Financial Regulatory Agency (PFRA). Given the existing market misperception that the federal government stands behind the GSEs’ obligations, the Blue Print states that the “optimal structure implies that PFRA should not regulate the GSEs.” [24] PFRA’s regulation of the GSEs would likely serve to strengthen that misperception even further. However, the plan does recommend employment of a separate regulator to address the issues in the near-term. Paulson believes a separate regulator would be an important signal that the GSEs do not have government guarantees. The report contends that in order to ensure that the GSEs operate in a safe and sound manner the regulatory structure needs to maintain a flexible framework for regulating the “wholesale financing activities” of Fannie Mae and Freddie Mac. In the long term Paulson states that there should be a continued evaluation of the need for separate GSE charters, a hint that these charters may not continue. This leaves whether GSEs will be completely privatized or taken into a government agency unresolved.
The control of private sector systems is also addressed in the Blue Print. The Blue Print proposes introducing a Corporate Finance Regulator (CRE) to monitor the activity of these private firms.[25] It is recommended that the CRE should be responsibility for general issues related to corporate oversight in public securities markets. Those responsibilities would include the SEC’s current oversight of corporate disclosures, governance, accounting oversight, and other similar issues. The Depository Trust & Clearing Corporation (DTCC) which is currently regulated by the Securities and Exchange Commission (SEC) is one of the companies that the CRE would regulate. A subsidiary of DTCC is the Fixed Income Clearing Corporation (FICC). FICC is designed to ensure orderly settlement in the government and mortgage-backed securities marketplaces. The FICC is composed of two divisions, the Government Securities Division (GSD) and the Mortgage-Backed Securities Division (MBSD).[26] The MBSD provides automated post-trade comparison, position netting, risk management, and pool notification services to the mortgage-backed securities market. That market is largely comprised of Government National Mortgage Association, Federal Home Loan Mortgage Corporation, Fannie Mae and Freddie Mac.
When comparing the current regulatory systems for GSEs to the proposed revisions in the Blue Print it is difficult to discern any real differences between the two. Real change is needed. Currently, if there was a financial collapse within any of these companies, U.S. taxpayers would likely bail out hundreds of billions of dollars in outstanding debt. A recent investigation by the Justice Department and the SEC looked into the accounting practices at Freddie Mac. They revealed accounting errors in the amount of 4.5 to 4.7 billion dollars which resulted in the termination of three of the company’s top executives.[27] In addition, the current Director Alphonso Jackson announced his resignation at a brief press conference on March 3 2008, citing personal and family matters. He will step down April 19 of this year.[28] Jackson is currently under a grand jury investigation by the Justice Department, the FBI, and the HUD inspector general for impropriety in awarding federal HUD contracts.[29] It is likely that those investigations have precipitated the discussion to re-evaluate the regulation of Fannie Mae and Freddie Mac within the Blue Print. The ongoing investigations by the Congress House Finance Services subcommittee will likely determine how the Department of Treasury writes their proposal on regulating GSEs and the future role of the proposed Corporate Finance Regulator. Fannie Mae, Freddie Mac and the secondary mortgage market that they dominate will have to adjust. Nowhere in the blue print does it discuss expanding regulation to the financial modeling of mortgage backed securities that the GSEs develop. Rather, it focuses on regulating mortgage approvals and leaves the bundling and securitization of those mortgages to the GSEs’ discretion. This leaves the debate of whether marked-to-model valuation of mortgage backed securities is appropriate for another time.
SUMMARY of MARKED TO MODEL
In October 1997, Congress enacted the Multifamily Assisted Housing Reform and Affordability Act (MAHRA), commonly referred to as the ‘‘mark-to-market’’ legislation.[30] Congress decided to disengage from the regulatory constraints and contractual obligations that resulted from the Section 8 production programs.[31] In accounting and finance, mark to market is the act of assigning a value to a position held in a financial instrument based on the current market price for that instrument or similar instruments. The intent was to rescue HUD from bankruptcy due to a glut of section 8 housing that had been approved in the prior six years. The influx of this inventory would have sent HUD into default because rising supply made those contracts unattractive to private developers and investors. HUD is a vast banker and asset manager, in 1998 it had over $42 billion in loan risk outstanding through FHA insurance or HUD-held loans. At the time HUD had an annual contractual outflow of about $20 billion through all forms of Section 8.[32]
The market for this type of investment is limited. Developers and investors are drawn primarily because HUD underwrites the construction loans and there are long term federal tax credits available to float the investment. In general, the credit is allowed by the invested to be used over a 10-year credit period (the “Credit Period”) with respect to each qualified low-income building. The Credit Period begins with the taxable year in which the building is placed in service or, at the election of the taxpayer, with the next succeeding taxable year.[33] The Tax Code requires the building to retain qualified low-income status for at least 15 years after the compliance period (the “Extended Use Period”). For an existing building, the Credit Period for the acquisition and rehabilitation expenditures will not begin until those rehabilitation costs are completed.[34] There are also restrictions on eviction and other requirements that impact the financial performa of these types of properties. Congress realized that making a major mistake on evaluating property for marked-to-market treatment, or just being unlucky in the new market operations, could put the property back into default and developed an elaborate evaluation procedure.[35]
Despite these concerns the program had favorable results and rescued HUD from certain failure. The concept was so successful it was applied to the residential mortgage market a few years later, generally. The problem is that when the market price cannot be objectively determined because there is no real day-to-day market available, assets are being ‘marked to model’ using estimated valuations. This happens with unique property such as real estate where values are derived from financial modeling and sometimes marked to fantasies rather than realities. Mortgage backed securities are marked in a similar manner as the HUD section 8 programs. The financial industry depended on the reliability of the HUD regulated actions of the GSEs namely Freddie Mac and Fannie Mae. This has proven to be catastrophic and one of the largest reasons for the world’s current financial crisis including the recent struggles of Bears, Stearns, & Co. Inc., Deutsche Bank AG, Citigroup Inc., and others.
CONCLUSION
Government Sponsored Entities, Fannie Mae and Freddie Mac are at or near ground zero in the new millennia’s housing crisis. It is likely that these entities will be the focus of much media attention in the months to come. Current regulation of these GSEs has contributed directly to the present business and economic climate. Their unique position in both the housing industry and the securities market poses difficult challenges to regulators. Any regulation on how they operate will impact the lending industry in general and effect how financial markets operate. However, the Marked-to-Model practice for valuing mortgage backed securities must be addressed in some form. This practice has proven to be a driving factor in mortgage lending practices. Serious consideration must be given to the wisdom of marking the value of real property based securities to a market or model rate. Historically, real property has been recognized as unique and individual in every other context. Treating real estate and real estate based products as a commodity will prove to be the impetus of much congressional debate and new legislation. The U.S. Treasury’s Blue Print for a Stronger Regulatory Structure has left the discussion of change in current regulation of Freddie Mac and Fannie Mae for the future.
[1] Macey, Miller & Carnell, Banking Law and Regulation 24 (3rd Ed. 2001).
[2] FNMA available at: http://www.fanniemae.com/index.jhtml.
[3] Macey, Miller & Carnell, Banking Law and Regulation 27 (3rd Ed. 2001).
[4] HUD available at: http://www.hud.gov/.
[6] 24 C.F.R. 81.2.
[7] FHLMC available at: http://www.freddiemac.com/.
[8] What Are the Origins of Freddie Mac and Fannie Mae? By Rob Alford, December 18, 2003.
[9] The Wall Street Journal, December 18, 2003.
[10] FHLMC available at: http://www.freddiemac.com/investors/faq.html#quarterly.
[11] 12 U.S.C. § 4502.
[12] 12 U.S.C. § 4503.
[13] 12 U.S.C. § 4513.
[14] 12 U.S.C. § 4517.
[15] 12 U.S.C. §§ 4514, 1723a (k), & 1456 (c).
[16] 12 U.S.C. §§ 1718 (c)(2) & 1452 (b)(2).
[17] Macey, Miller & Carnell, Banking Law and Regulation 173 (3rd Ed. 2001).
[18] 12 U.S.C § 3500.5(a) & (b)(2), (3), & (6).
[19] Macey, Miller & Carnell, Banking Law and Regulation 279 (3rd Ed. 2001).
[20] 12 U.S.C Chapter 46 Subchapter I.
[21] The Department Of The Treasury, Blueprint For A Modernized Financial Regulatory Structure, 95.
[22] Ibid.
[23] Ibid at 168.
[24] Ibid.
[25] Executive Summary available here: http://www.sifma.org/regulatory/pdf/Paulson-BlueprintExec-summary.pdf.
[26] Ibid at 211.
[27] What Are the Origins of Freddie Mac and Fannie Mae? By Rob Alford, December 18, 2003.
[28] The Wall Street Journal, March 31, 2008.
[29] Ibid.
[30] David A. Smith, Mark-to-Market: A Fundamental Shift in Affordable Housing Policy, 143, 1999.
[31] Ibid at 144.
[32] Ibid at 156.
[33] I.R.C. § 42(f).
[34] I.R.C. § 42(f)(5).
[35] David A. Smith, Mark-to-Market: A Fundamental Shift in Affordable Housing Policy, 161, 1999.
Filed under: Real Esate Law Issues | Tagged: Fannie Mae, Freddie Mac
Thanks for sharing that!
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