June 13, 2006
JS-4316
Remarks of Randal K. Quarles
Under Secretary for Domestic Finance
U.S. Department of the Treasury
Before the Women in Housing and Finance
Washington, DC- It is a great pleasure to have this opportunity to speak before Women in Housing and Finance. For over a quarter of a century, this has been one of the principal forums in Washington for the discussion of the central issues of the day in financial regulation, and it is an especially appropriate venue to discuss two topics that are the focus of much attention right now: the housing market generally, and our housing finance system in particular. This morning, I would like to provide my impressions of current developments in the housing market and their implications for economic activity more broadly, and then turn to the Administration's government sponsored enterprise (GSE) reform effort. As we all know, housing plays an important role in our economy, both as a generator of economic activity and as a store of wealth for the nation's homeowners. An efficient housing finance system is essential for the market in housing to operate properly, and Fannie Mae and Freddie Mac have a part to play in our housing finance system. The Administration's GSE reform effort has been carefully crafted to ensure that they continue to perform that function successfully.
The Housing Market and Mortgage Payment Shocks
So let me begin this morning with a topic with which most of us are not only professionally but also – certainly here in Washington – personally much involved. Open the local real estate section of many newspapers these days and one finds a mixture of giddiness and angst--giddiness over the escalation of home prices over recent years and angst that the boom in home prices may soon come to an end. Some analysts have suggested that house prices in some markets could be substantially "overvalued." There is not, however, universal agreement either on what factors determine "overvaluation" or on whether our measures of those factors are reliable. In particular, analysts have debated whether biases in some standard house price series might account for a significant portion of the notable rise in price-to-rent ratios over recent quarters.
Regardless of where one falls out in this debate, there is concern that a broad-based decline in house prices would almost certainly exert a noticeable drag on economic activity. Based on standard estimates relating wealth to spending, every 1 percent drop in house prices might translate to something on the order of a 0.1 percent drop in household spending over time. Of course, these spending effects might be more pronounced if a fall in house prices were especially marked and occurred over a short time period. Such a sharp decline in house prices would be very unusual and could well shake business and household confidence about economic prospects. The decline in confidence, in turn, could depress spending by more than suggested by simple wealth effect calculations.
But I have to say that I do not think this is a likely scenario. Of course, it would not be at all surprising to see a moderation in the escalation of home prices. Indeed, the Office of Federal Housing Enterprise Oversight (OFHEO) house price index released recently this month did suggest that house price appreciation had slowed over the first quarter of this year. I would not, however, expect to see a substantial drop in broad house price indexes as long as income is rising and interest rates remain moderate.
Another worry in housing markets centers on the rapid expansion of variable payment mortgages, which include standard ARMs and so-called non-traditional mortgages that may incorporate "interest-only" periods and other special features. Regulatory agencies have expressed concerns that banks have been aggressively marketing such mortgages to a broad audience without taking full account of the risks involved. To address these issues, the regulatory agencies issued draft guidance on non-traditional mortgages last December. The guidance focused on three broad areas--underwriting standards, risk management practices, and consumer protection.
While I will not venture into all the details here, the draft guidance suggested that banks need to ensure that their underwriting standards take account of the borrower's ability to repay over the life of the loan, that their capital and loan loss provisions recognize that the performance of these loans has not been tested in a stressed environment, and that information provided to borrowers regarding the terms of non-traditional mortgages is understandable, timely, and accurately conveys the full range of risks associated with any particular mortgage product.
At the macro level, some reports have suggested that increases in mortgage payments under non-traditional mortgages may represent a substantial hit to household disposable income. However, many households that have taken out interest-only mortgages, for example, appear to have opted for five- to ten-year interest-only payment periods. As a result, only a relatively small portion of outstanding interest-only mortgages is expected to reprice over the next few years. Market estimates suggest that the potential increase in mortgage payments in 2006 and 2007 from such repricing effects might total as much as $20 billion. While that is certainly a large number, it represents only a small hit to aggregate personal income, which totaled as of last quarter totaled over $9 trillion a year.
Given all the attention that has been given to the housing market and its relation to the broader economy, however, and given the substantial discussion surrounding developments in house prices and the increased use of non-traditional mortgages, I have been struck that the role of Fannie Mae and Freddie Mac does not seem to enter into the calculations of most observers about the expected path of the housing sector in the near term. The reason appears clear: even with the slowdown or reduction in the housing GSEs' mortgage investment activity in recent years, the housing finance market has remained robust and liquid. For example, since October 2004, Fannie Mae's mortgage investment portfolio has decreased from $913 billion to $730 billion. Over that same time period, Freddie Mac's mortgage investment portfolio grew much more slowly than in the past, increasing from $660 billion to $723 billion. And yet there is no indication that this has affected the availability of mortgage credit, or activity in the housing sector more generally.
Which is a good transition to the next issue that I would like to discuss – the Administration's GSE reform efforts.
GSE Reform
The most significant domestic finance policy issue that Treasury will address in the near term is GSE reform. While issues of improving the regulation of the housing GSEs have been debated for a number of years, the accounting and corporate governance scandals at first Freddie Mac then Fannie Mae have brought this issue to the forefront. 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 statutorily-based instruction to the new GSE regulator to reduce the size of the GSE's retained investment portfolios.
I think most people in this room are familiar with the reasons we believe it is important to limit the size of these 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.
As a consequence, 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. While legislation has thus far has been stalled, it appears that change is in the air.
Troubling news continues to emerge about the GSE's operations. We have now learned that these institutions – far from being the world leaders in financial innovation and the management of risk that they had always portrayed themselves as – were seriously deficient in some of the most basic responsibilities of financial institutions: corporate governance, financial reporting, internal controls, and risk management. These critical areas were starved of necessary funding and senior-executive attention. Perhaps most alarming is that a number of these issues remain unresolved in the post-Sarbanes-Oxley era where these matters are subjected to heightened attention and scrutiny.
In February of this year, the "Rudman Report" outlined weaknesses in Fannie Mae's accounting standards, internal controls, and corporate governance. Funds that could have been used to bolster these critical areas were used to fund undeserved executive compensation packages. This report documented clearly that Fannie Mae's corporate culture was driven to meet earnings targets at all costs and with disregard for its mission.
In early May, Fannie Mae disclosed more errors in its past accounting practices that will force a restatement of results costing it $800 million this year.
Later that same month, OFHEO released a report that was particularly damning. OFHEO's report amplifies previous findings that the Fannie Mae's carefully crafted image of being low-risk and well-managed was an illusion. Fannie Mae was not able to manage properly its investment portfolio. Its mismanagement cost it billions of dollars in economic losses. Moreover, Fannie Mae intentionally misapplied accounting guidance to obscure the true economic picture of its investment portfolio business.
On the same day that OFHEO issued its report, Fannie Mae also into a settlement agreement with OFHEO and the Securities and Exchange Commission (SEC) agreeing to pay one of the largest fines ever imposed on a financial institution and certainly the largest on an enterprise created for a public purpose. Equally important, as a central condition of the agreement with OFHEO, Fannie Mae agreed to cap its investment portfolio at essentially current levels. This groundbreaking settlement clearly shows that Fannie Mae not only did not but does not have adequate control over the growth and risks of its investment portfolio business.
I have heard it argued that the portfolio cap in OFHEO's settlement agreement with Fannie Mae shows that statutory guidance limiting the GSEs' investment portfolios is not necessary in the GSE reform legislation. In fact, it shows exactly the opposite. A settlement agreement is exactly that: an agreement, and without Fannie Mae's agreement – obtainable only temporarily and under unusual circumstances – this cap would not have been put in place. Given these facts, OFHEO's action does not address the fundamental long-term concerns the Administration has raised regarding the systemic risk presented by the GSEs' investment portfolio.
Moreover, this agreed cap does not apply to Freddie Mac. While the recent regulatory attention has been focused on Fannie Mae, the issues surrounding Freddie Mac remain equally important. For example, Freddie Mac recently announced the "goal" of returning to quarterly reporting and filing timely GAAP-compliant capital reports with OFHEO when it releases full-year 2006 results. It then plans to begin the process of registering with the SEC. The Administration first recommended that the GSEs voluntarily register with the SEC in 2002, so Freddie Mac's compliance with this recommendation might take place over five years later. It is hard to imagine any non-GSE company being able to maintain preferential access to the capital markets under similar circumstances.
In addition, Freddie Mac recently announced that in order to devote the resources needed to complete its internal controls review effectively and return to timely reporting, it has decided to limit the number of internal controls initiatives it plans to undertake in 2006 as well as defer lower priority internal controls systems efforts. This is particularly troubling in light of recent comments made by OFHEO's leadership that Freddie is still at least two years away from having acceptable internal controls systems. OFHEO has made a similar assessment regarding the timing of Fannie Mae having acceptable internal controls systems.
Over the course of the past three years, it has been revealed that Fannie Mae and Freddie Mac managed their earnings to hit specific targets while misleading the public as to their financial health. They have documented failings in accounting, corporate governance, risk management, and internal controls. Members of Congress have referred to Fannie Mae as the "Enron of the financial services industry." To put it mildly, this is not a pretty picture, especially at a time where these enterprises' non-GSE counterparts and competitors are experiencing increased regulatory oversight of their risk taking and internal controls environments.
The Administration's reform proposals are intended to ensure greater regulatory oversight, appropriate capital requirements, and alleviate systemic risk, and we continue to urge Congress to take action soon to address these issues. We strongly support GSE reform legislation that addresses each of these points, and in particular provides direction to limit the size of the GSEs' investment portfolios. We remain hopeful that by the end of the year we will have a stronger regulator for the housing GSEs with the authority and direction to limit the size of their investment portfolios.
Even as we work toward an expected legislative outcome this Congressional session, however, we at Treasury also have to consider how what we now know about the operation of the GSEs – the weakness of their risk management practices, their governance and accounting failures, the changing financial environment in which they operate, the implications of their continued unchecked growth – should affect our own ongoing responsibilities.
As you know, these enterprises are unlike other publicly traded companies in that they were chartered by Congress for a specific public purpose. The charters that Fannie Mae and Freddie Mac operate under are nearly identical, and included in these charters is the requirement that these entities may only issue debt with the approval of the Secretary of the Treasury. The requirement for this approval is long-standing, and the GSEs seek and obtain the approval of the Treasury for all of their debt issuances, as they must under their charters.
The nature of the current business plans of Fannie Mae and Freddie Mac requires that they issue debt on a regular basis to fund their mortgage investment business. Historically, it has been much more difficult to grow earnings in the GSEs' other main business line – the credit guarantee business. It has been much easier for Fannie Mae and Freddie Mac to grow earnings in the mortgage investment business because the GSEs have the ability to issue debt at rates lower than their peers that do not have GSE status and use those funds to invest in mortgages or mortgage-backed securities. This is essentially the arbitrage strategy that has allowed the GSEs virtually unconstrained balance sheet growth without any significant additional contribution to the housing market. As I noted earlier, the best example of how unrelated the GSEs' mortgage investment business is to the broader availability of mortgage credit are the events of the last few years. As they have retrenched to address their serious reporting and control problems, Fannie Mae's mortgage investment business has shrunk dramatically in recent years, and the growth in Freddie Mac's mortgage business has slowed considerably. The consequences for the availability of mortgage credit have been negligible. The mortgage-backed securities (MBS) market is broad and deep, with investors other than Fannie Mae and Freddie Mac holding about $5 trillion in MBS: $2.6 trillion of Fannie Mae and Freddie Mac MBS, $2.1 trillion of private-label MBS, and $400 billion of Ginnie Mae MBS. It appears to us that as long as Fannie Mae and Freddie Mac can perform their credit guarantee function, there would be little impact in the housing market from further shrinkage in their roles as mortgage investors.
Of course, as I noted above, in order for Fannie and Freddie to enter the public debt market to fund either of their lines of business, they seek and obtain the approval of the Treasury. The process by which Treasury has evaluated and responded to these requests has obviously evolved from time to time depending on the factors we have deemed important in light of then current conditions in the economy and the financial markets. Given the accumulation of information on developments in the operation of the GSEs, culminating in the release of the Rudman and OFHEO reports, the time is right for Treasury to review its debt approval process to ensure that we continue to act as appropriate custodians of the power that Congress gave us when the charters of Fannie Mae and Freddie Mac were created. We need to ensure that our process corresponds adequately to the importance of our responsibility, especially in a changing environment. As a consequence, I have asked the Treasury staff to undertake such a review to ensure that the process by which we exercise this responsibility is appropriate in light of all the circumstances.
Let me be clear about a few points. First, this process review does not of itself presuppose any conclusion about outcomes. Rather, we are aiming first to ensure that all the appropriate considerations are taken into account in exercising a regular and long-standing responsibility. As the review proceeds, we will provide more detail about our current thinking on Treasury's review of its debt approval process.
Second, obviously, one of the important factors that any process must consider in evaluating requests for Treasury debt issuance approval is the expected effect on markets – not merely the housing market, but financial markets generally, in many of which the GSEs are active and important participants. It goes without saying, but Treasury will carefully consider the market impact of any future action.
I should make one last point. The fact that we at the Treasury are reviewing our debt approval process should not be misconstrued. It should not in any way be interpreted as changing our longstanding position that a legislative solution is the best approach to addressing the systemic risks created by Fannie Mae's and Freddie Mac's outsized portfolio. The legislative approach supported by the Administration gets to the heart of our central concern in a direct and clear manner. While the Treasury does have tools that can indirectly slow the growth of the GSEs' portfolios, we cannot directly control their risk taking activities or refocus them back to their core mission. In that way, the legislation addresses our concerns with precision.
Thank you very much and I would be happy to take your questions.