Moments after Freddie Mac announced one of the largest accounting errors in history last week, lawmakers began the process of what is expected to result in major reforms to the two major government sponsored enterprises dominating the secondary mortgage market.
"How is it that a now readjusted restatement figure, up from $3 billion to a now reported $4 billion, over a three year period of operations has not crippled corporate activities and the housing market generally?" asked Rep. Richard Baker, R-La., a frequent critic of Freddie and Fannie Mae, at the start of hearings by the House Financial Services Committee on Capital Markets.
Baker, chairman of the panel, was referring to the disclosures by Freddie Mac just an hour before that the previously announced accounting questions at the company could result in a restatement of after-tax earnings upwards of as much as $4.5 billion for the previous three years (as much as $6 billion before taxes).
While the under-reporting of earnings raises different questions than the overstatement by such corporations as Enron, Worldcom and Global Crossing, it has tremendous ramifications for investors, many of whom may have sold their stock based on the lower earnings figures, Baker pointed out.
"What is even more troubling than the restatement at Freddie Mac is the realization that market observers looked past the corporate misstatements and directly into the taxpayers' pockets," said Baker. "There was no reason to be concerned about corporate misconduct, as long as the taxpayers were standing by ready to pick up any loss. This, in my opinion, is most troubling reality of all."
New Regulatory Agency Suggested
The hearings were held a day after Baker and 17 Republican colleagues introduced a bill to reform the way the two secondary mortgage giants are regulated. It would eliminate their current regulatory agency, the Office of Federal Housing Enterprise Oversight, known as OFHEO, housed in the Department of Housing and Urban Development, and combine it with the Office of Thrift Supervision in a new agency under the Treasury Department, to be known as the Office of Housing Financial Supervision. It would also give that office stiff enforcement powers to fine Freddie and Fannie for noncompliance with its rules and regulations.
This proposal and others would have enormous ramifications for the credit union movement, which is joined at the hip to the two agencies, first because credit unions sell as much as half of their mortgages to one of the two, and second because they have invested tens of billions of dollars in debt and mortgage-backed securities issued by the two. Any additional costs incurred by Freddie and Fannie would certainly be passed on to credit unions and other customers in the way of lower prices for purchased loans and higher prices for debt sold to the institutions.
The growing controversy over the accounting debacle at Freddie Mac is expected to give greater momentum to the Baker proposal and other reforms that critics of the two giant housing agencies have been pushing for years. Among them are a requirement to have the two companies, the largest non-government issuers of debt in the U.S., register their debt with the Securities and Exchange Commission and pay SEC registration fees, which could cost as much as $150 million a year. Another is to enact bank-like capital requirements for them and have them pay the same kind of supervisory fees as banks, which would double their current fees to about $70 million a year.
At the least, lawmakers are almost sure to require that the two companies now file the same quarterly and annual disclosures with the SEC that are required of all other publicly traded companies, in order to give investors a more comprehensive view of their operations. The two now file voluntary "SEC-like" disclosures with the SEC.
Last week's hearings gave an indication as to where Baker's committee may be heading, with several witnesses calling for major reforms to the system regulating the GSEs.
Thomas Schatz, president of Citizens Against Government Waste, a non-partisan group monitoring government, said the federal government should sever its remaining ties with the two government-chartered enterprises in order to bring market discipline to their operations and remove any potential taxpayer liabilities. Schatz endorsed Baker's proposal to move the oversight of Freddie and Fannie into the Treasury Department and apply bank-like standards and fees. He also called for the repeal of the state and local tax exemption for both companies and of the $2.25-billion guaranteed line of credit with the Treasury for each, an implied federal guarantee of debt for both companies that market observers say provides a 50-basis-point advantage in the debt markets.
Ratings Are Distorted
Sean Egan, managing director of his own ratings agency, Egan-Jones Ratings Co., testified to the committee that the ratings for Freddie and Fannie by Moody's, Standard & Poors and other Wall Street rating agencies are distorted by the enormous fees the two companies pay to acquire their ratings. He said that questions his firm has over the prepayment risk of the huge portfolios held by Freddie and Fannie and the non-callable status of some liabilities, as well as low equity, has prompted them to rate the two lower than the other Wall Street agencies. "Although the major market rating firms have issued "AAA" ratings, investors have been burnt by Enron and WorldCom, which had strong investment grade ratings prior to their failure," Egan said.
Democrats on the subcommittee noted the importance of Freddie Mac to the housing market, which has been the chief engine of the economy for the three-year mortgage boom, and urged caution. "Before acting we need to know exactly what happened at Freddie Mac," said Carolyn Maloney, D-N.Y., who estimated the continuing refinancing boom has added an estimated $300 billion to consumers' pockets this year, alone, more than the this year's tax cuts will do. Several other congressional committees have also scheduled proceedings to explore the ramifications of the Freddie Mac controversy.