Federal Reserve Chairman Alan Greenspan today said Fannie Mae and Freddie Mac have used their government-granted benefits to profit their shareholders and not for the benefit of the housing-finance system.
Greenspan called on Congress to sharply reduce the two companies' massive mortgage portfolios "while we can."
His comments before the Senate Banking Committee, in preparation for widely expected legislation to strengthen government oversight of the mortgage finance companies, were Greenspan's most pointed on his view that Fannie and Freddie pose systemic risks to the financial markets unless their size and structure are drastically changed.
At a separate hearing in the House, Armando J. Falcon, who heads the agency that regulates Fannie and Freddie, said that Fannie's accounting and internal control problems have mushroomed well beyond what he expected when uncovered last year. He said accounting managers at Fannie made "pervasive application" of entry changes in Fannie's databases that made its accounting systems unreliable.
Falcon said his agency, the Office of Federal Housing Enterprise Oversight, found that some changes were made to Fannie's journal entries using falsified signatures, and that those changes were related to the shifting of expenses to later periods.
"We expect additional accounting issues to surface," Falcon said of its ongoing examination of Fannie's internal controls. So far, OFHEO has identified accounting errors that could result in as much as $12 billion reduction in Fannie's previously reported earnings.
While there is a general consensus in Congress that Fannie and Freddie need a new, stronger regulator, Greenspan's testimony focused largely on the most controversial aspect of the debate: The size of Fannie and Freddie's own portfolio of mortgage assets. Together, the mortgages and mortgage-backed securities that Fannie and Freddie own total $1.5 trillion, a more than a 10-fold increase in the past 15 years.
Fannie, Freddie and housing industry advocates say the two companies size has strengthened their financial health and improved their flexibility in providing a stable and affordable flow of cash to the home mortgage market -- their congressionally chartered mission.
But Greenspan said the only reason he could find for the vast increase in the two companies' balance sheets is so that Fannie and Freddie could make more money for their shareholders. Both Fannie and Freddie, because of their implicit government backing -- which he repeatedly called a subsidy -- are able to borrow money at below-market rates and invest the money in market-rate investments. This so-called spread between its borrowing costs and what it makes on mortgage investments creates a "profit motive" that is at odds with the company's public mission to provide affordable mortgages and, further, concentrates mortgage-investment market risks in two very large companies, he said.
Greenspan said that the large portfolios require both companies to use complicated derivatives and other hedging strategies to protect earnings from interest-rate swings that have proved to have hidden and unforeseen risks.
"I have found no sensible or coherent view which would suggest that curtailing their portfolio creates more serious problems for the public goals of these institutions," he said.
Greenspan argued that Fannie and Freddie should largely be conduits, selling most of the mortgages they buy from lenders into the secondary market as mortgage-backed securities. He suggested that Congress restrict the size of the two firm's mortgage investments to a certain percentage of all residential mortgages or some other ratio that would keep their investment portfolios in check.
One proposed bill, offered by Rep. Richard Baker (R-La.), calls for giving a new regulator authority to restrict the size of either Fannie or Freddie if the size of the portfolio poses a safety and soundness risk, but it does not call for specific limits or decreases in their balance sheet.
For its part, Freddie said it does not think the legislation should set limits on the size of its retained mortgage portfolio.
"I would say we have a great deal of respect for Chairman Greenspan," said spokesman David Palombi. "We agree on the need for legislation. However, we disagree with the chairman on the issue of portfolio growth limits. Freddie Mac's retained portfolio is vital to our mission. . . . We look forward to sharing our views on this issue with Congress at the appropriate time."
