By Annys Shin
Washington Post Staff Writer
Friday, May 20, 2005

The Bush administration has backed legislation that could substantially reduce Fannie Mae and Freddie Mac's investment holdings, part of an accelerating push to shrink the size and influence of the mortgage companies.

Hours after Federal Reserve Chairman Alan Greenspan called for strict limits on the two companies, the administration yesterday delivered its proposal for tighter regulation of Fannie and Freddie to House Financial Services Committee Chairman Michael G. Oxley (R-Ohio).

Oxley's committee is slated on Wednesday to consider legislation that would create a more powerful regulator for Fannie and Freddie. The Senate is expected to consider a similar bill in late June, part of a legislative backlash to accounting scandals at the two companies.

A senior administration official familiar with the administration's proposal said it would let the new regulator limit the amount of mortgage investments Fannie and Freddie can hold on their books, as opposed to reselling them to investors.

The size of Fannie and Freddie's investment holdings has become the central focus of debate among lawmakers working to create a new independent agency to replace Fannie and Freddie's current regulator, the Office of Federal Housing Enterprise Oversight. OFHEO last year uncovered accounting violations at Fannie Mae that led to the ouster of top executives and the possible restatement of as much as $12 billion in previously reported earnings.

Critics of Fannie and Freddie, including Greenspan, have long argued that by holding more mortgages and mortgage-backed securities for investment purposes, the two companies are exposing themselves -- and the U.S. financial system -- to greater levels of risk.

Greenspan, speaking yesterday via satellite to a housing finance conference in Atlanta, said the risk of a problem or financial collapse at two "huge, highly leveraged" companies like Fannie and Freddie is "not conducive to the long-term financial stability that a nation of homeowners requires."

The administration's proposal would give a new regulator the power to limit Fannie and Freddie's ability to make investments that are only intended to increase their profits.

Much of Fannie and Freddie's business involves buying mortgages from retail lenders and repackaging them for investors around the world. That role as middleman for the mortgage industry is lucrative in itself and is also crucial to keeping money available for home buying: When Fannie or Freddie buys a mortgage from a bank, it frees the bank to make more loans.

Since the early 1990s, however, the two companies found it was more profitable to hold onto mortgages rather than remarket them, a practice that boosted earnings for stockholders and helped trigger millions of dollars in bonuses for top executives. But it also exposed Fannie and Freddie to more risk if borrowers defaulted or interest rates began rising -- risks that lawmakers, Greenspan, and others contend would ultimately be borne by taxpayers because the two companies are government chartered.

The changing investment strategy also led Fannie to manipulate its accounting to inflate its earnings, according to OFHEO.

Under the administration's proposal, Fannie and Freddie would be allowed to hold "only those assets that are necessary to provide a liquid and efficient secondary mortgage market," the administration official said. That, for example, would include the small portion of mortgages granted to home buyers that meet the guidelines of the two companies but would not be attractive to other investors.

It is unclear by how much such a rule would reduce the nearly $1.5 trillion mortgage portfolio that the two companies hold, and the idea is still subject to modification as the legislation proceeds through Congress.

But one analyst, reflecting the opinion that Fannie and Freddie have grown too big, said the change could be dramatic. Under Treasury's proposal, the companies "would be reduced to look like what Dr. Atkins promises if one goes on his diet -- a shadow of one's former self," said Karen Shaw Petrou, a financial industry consultant who co-publishes a newsletter on Fannie and Freddie.

While Fannie and Freddie, stung by revelations about their accounting practices, are generally accepting of stricter regulation, they are also worried it could be carried too far.

A Freddie Mac spokeswoman said the company's investment portfolio is integral to its mission to keep cash for home buying plentiful. "Our portfolio supports our affordable housing activities by allowing us to increasingly subsidize" more marginal home buyers, said Sharon McHale. "The portfolio is very conservatively managed and tightly regulated. Very few institutions in the world manage such a tight book, provide the monthly disclosures to prove it, or could pass the risk-based stress test that we do."

The portfolio also allows Freddie to attract foreign capital, which it makes available to lenders, and ultimately, to home buyers.

The mortgage portfolio "enables us to in-source a significant share of the financing of American homeownership," she said.

Yesterday, the Fed chairman sought to counter such arguments, citing the fact that housing markets "have functioned well" over the past two years, even as Fannie and Freddie were in the midst of uncertainty because of their accounting problems.

Freddie has largely rebounded from its problems two years ago. Fannie is still researching the extent of its accounting foul-up, though OFHEO yesterday reported that the company now has adequate reserve capital on hand to guard against losses -- an important fiscal milestone.

The administration also delivered a copy of its proposal yesterday to Senate Banking Committee Chairman Richard C. Shelby (R-Ala.), whose committee is expected to draft legislation next month.

"I'm hoping in the weeks ahead we can bring about a strong piece of proposed legislation and that we can get some bipartisan support for it, because I think it is absolutely necessary to have a strong regulator" for the two companies, Shelby said. "It's necessary that their mission be understood and that the regulator know everything about the risk that they pose and the regulator have the power to rein that risk in if they deem it a real problem."