July 19, 2006
HP-21
Remarks of Randal K. Quarles
Under Secretary for Domestic Finance
U.S. Department of the Treasury
At the Reuters Panel Discussion on Government Sponsored Enterprises
New York City, NY- Thank you for inviting me here today to discuss issues related to government sponsored enterprises and GSE reform.
As many of you know we appear to be at a critical point in the GSE reform debate. We at the Treasury are on record supporting legislative efforts to improve the regulation of the housing GSEs and, importantly, legislation that provides a clear statutory instruction to the new GSE regulator regarding the size of the GSE's retained investment portfolios.
We have spoken many times on why it is important to limit the size of the GSEs' retained portfolios. While the mortgage securitization activity conducted by Fannie Mae and Freddie Mac does in fact provide a public benefit by increasing the amount of capital available to support mortgage credit – thus decreasing its cost and increasing its supply – their retention of large investment portfolios does not further this purpose. These retained portfolios do, however, concentrate rather than distribute the prepayment and interest rate risks associated with mortgages and mortgage-backed instruments held by them, and concentrate them in entities that – as a result of the lower levels of capital they are required to hold – are substantially more leveraged than other financial institutions. Because of the funding advantage enjoyed by the GSEs, they are able to grow these portfolios to a much greater degree than a purely private sector entity could, and as they continue to grow in size it becomes increasingly risky for counterparties to hedge them, particularly given the complicated hedging strategies run by the GSEs.
That has led us to the conclusion, which remains our position today, that it is critical that both of these points – both a strengthened regulator and a mandate to address portfolio size – be included in any final legislation from Congress.
I think what appears to have gotten lost in the debate is actually what is meant by a mandate to address portfolio size or what has often been phrased as "portfolio limits." To address this, let me start with what is not implied by portfolio limits in the legislative context.
First, neither Treasury, nor anyone else for that matter, is suggesting that a hard portfolio cap be put in place. By "hard" cap I mean a fixed dollar amount for the size of the GSEs' retained portfolio that is specified in legislation. There is wide agreement--an agreement shared by Treasury and the Administration--that a "hard" cap would not provide the needed flexibility for the GSEs to accomplish their housing mission.
Second, a portfolio cap does not imply that there would have to be an immediate sell-off of the GSEs' existing retained mortgage portfolios. As Treasury has maintained all along, any portfolio cap would have to have an appropriate transition period to avoid the potential for market disruption.
Finally, a portfolio cap should not limit the ability of the GSEs' to conduct their guarantee business or react to emergency situations. Again, as we have consistently noted, the GSEs' credit guarantee business should not be affected by a portfolio cap, and the new regulator should have the ability to lift these requirements to address material disruptions in the mortgage market.
So what would be accomplished with a portfolio cap?
A properly constructed portfolio cap would address the Administration's fundamental concerns regarding systemic risk. And a key element of such a cap would be clear direction to the new regulator on what should be included in the GSEs' retained mortgage portfolios. There are two reasons this statutory direction is important. First, without that direction, it would be very difficult for the new regulator, given its focus on only the GSEs, to evaluate fully the potential for systemic risk. Similarly, without direction, even a stronger regulator with the full range of necessary authorities can find it difficult to make the tough decisions that are necessary.
A properly constructed portfolio cap would also tie the GSEs' activities more closely to their mission. I remain somewhat puzzled as to why there is not more support for this concept. The GSEs were provided a set of public benefits to accomplish a particular public mission. We should continually evaluate whether or not the GSEs are using their public benefits to accomplish that mission. The portfolio cap supported by the Administration does exactly that: it does not expressly reduce the size of the retained portfolios; it simply directs that the retained investments be tied to the specific missions of the enterprises. It is instructive in itself that all sides agree this focus on mission could result in a substantial reduction of those portfolios.
As you all know, the Administration has strongly supported provisions in the GSE reform bill passed by the Senate Banking Committee S. 190 that address the GSEs' retained portfolios by providing the new regulator clear direction on what assets are permissible for the GSEs to hold. Even though clear direction is provided to the new regulator, it is important to note that whatever specific limitations the new regulator imposes would be done through regulation. Thus, any limits would be reviewed and evaluated in an open and transparent process, and all interested parties would have the ability to comment.
The specific list of permissible assets in S. 190 is directly linked to the GSEs' mission and to reducing systemic risk by focusing the GSEs on their securitization activities. For example, the GSEs would be permitted to hold mortgages and mortgage-backed securities for the purposes of securitization, and mortgages acquired to meet the affordable housing goals if such assets are not readily securitized. Other categories of assets in S.190 relate to the GSEs' basic business operations, including the need to maintain liquidity, which is covered by holding Treasury securities. S.190 recognizes the fact that holding hundreds of billions of mortgages and MBS does not, however, help maintain mortgage market liquidity. If the GSEs needed to act as a liquidity provider in a particular situation, they would not be selling assets from their portfolios to purchase new mortgages or MBS, as these actions would have a destabilizing rather than stabilizing impact. Furthermore, as I noted previously, we fully support providing authority for the regulator to lift the cap to address temporary disruptions in the market.
S. 190 also has another important provision that is often overlooked. The new regulator has the ability, by order, to make temporary adjustments to the regulations regarding the permissible asset holdings for the GSEs. This would seem to give the new regulator clear authority to respond to temporary disruptions in the mortgage market. We would certainly be open to greater clarification of this flexibility if this remains a sticking point.
Let me close by saying that we still believe that a legislative solution is achievable and is the best way to address our concerns. Given the importance of the issue, however, we have to consider all the tools at our disposal. As we have noted recently, Treasury is in the process of evaluating our GSE debt approval process. We are undertaking this evaluation to ensure that our process is more standardized, and so that our process can meet any potential eventuality that might be necessary, including limiting the GSEs' debt issuance.
Secretary Paulson has made it clear to me that he believes there is systemic risk associated with the GSE's retained portfolios. While he shares the view that a legislative outcome is preferable, he has instructed us to ensure that the mechanics of our debt approval process are robust enough to give Treasury the practical option of limiting the GSEs' debt issuance in accordance with our statutory authority should that become necessary. If a legislation solution is not achieved, Treasury will have no choice but to consider additional action.
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