Fannie and Freddie Don't Need Banklike Regulation

One of the least heralded accomplishments of Congress in the post-Depression era has been the creation of stockholder-owned government-sponsored enterprises - known as GSEs - to serve as secondary-market and liquidity resources for lenders engaged in housing finance and student loans.

Today, the three privately managed enterprises engaged in these activities - the Federal National Mortgage Association, the Federal Home Loan Mortgage Corp., and the Student Loan Marketing Association - successfully and profitably fulfill their public missions with very little government oversight or intervention.

They currently hold or guarantee almost $1 trillion in obligations. And during the 1980s, it is estimated, Fannie Mae and Freddie Mac together brought into the housing markets approximately $450 billion of liquidity that would not otherwise have been available.

In view of the thrift industry's collapse, Congress became concerned that operations of government-sponsored enterprises might pose an undue risk to taxpayers.

But seven government studies plus one by a rating agency have found that Fannie Mae, Freddie Mac, and Sallie Mae pose no imminent danger.

An Inherent Inconsistency

Still, the studies' recommendations include the costly bank regulatory model, with one or more bodies empowered to conduct examinations, issue regulations, and correct deficiencies.

Also recommended are the full panoply of supervisory tools presently available to bank supervisors, including cease-and-desist orders, severe fines, and consevatorships.

At the low end of the range is a model relying on independent rating agencies, with federal corrective action triggered only by a substantial decline in capital or some other threat to financial viability.

Many of the recommendations, including the Treasury-sponsored bills (S. 1282 and what appears to be the current vehicle, H.R. 2900), advocate the bank regulatory model.

There is an inherent inconsistency in claiming that increased federal oversight of the government-sponsored enterprises is justified by the collapse of the savings and loan industry. These studies recommend the very regulatory model that failed to stem the collapse.

Role for Market Discipline

The central weakness of the bank regulatory approach is its willingness to substitute the judgment of federal employees for capital market discipline and modern analytic methods.

Bank regulation traces its origin to a time when banks made no public disclosure of their condition - and well before electricity, phones, and other technology made remote communication possible. Consequently, the bank regulatory model depends primarily on the judgment of onsite examiners.

But today, publicly held companies in the United States and the rest of the developed economies are "regulated" most effectively by market discipline. When a company seeks to borrow money or sell equity, it must convince lenders or investors that their investment will be safe and produce a market rate of return.

Financial analysts probe the disclosure of publicly held companies, visit management to assess present operations and future prospects, and combine their views with those of economists to produce a marketplace assessment that is reflected in the pricing of debt obligations or equity securities.

Less Risk

In our country, the legitimacy of corporate disclosure is reinforced by accounting standards and the fraud provisions of federal and state securities laws. Market discipline is a particularly effective means of insuring the integrity of Fannie Mae, Freddie Mac, and Sallie Mae, since these enterprises must constantly fund their activities in the debt markets and their stock is actively traded, widely held, and carefully followed by a multitude of analysts.

These enterprises do not present the same types of safety and soundness risks that depository institutions present. The enterprises lack the authority to engage in the riskier types of lending - such as commercial credit, consumer credit, or international lending - that triggered significant losses at commercial banks and thrifts. Furthermore, since the enterprises purchase and guarantee loans from every region of the country, they are less susceptible to regional economic downturns.

In fact, by continuing to provide liquidity in regions experiencing an economic downturn, the enterprises serve to stabilize and support regional economic sectors when lending would not otherwise be available. In the mid-1980s, as others pulled out of Texas, Fannie Mae and Freddie Mac stood fast, funding a significant portion of home mortgages. This is being repeated today in New England and the Middle Atlantic states.

Banklike regulation of these enterprises could impair their ability to provide liquidity to primary lenders, thereby adversely impacting credit to homebuyers and students.

Regulatory Costs

Modern bank regulation is fashioned to supervise literally thousands of institutions and tens of thousands of institution-affiliated parties engaged in a wide spectrum of activity. The breadth of the bank regulatory mission requires generic fail-safe authority, because individualized regulation is impossible.

For the government-sponsored enterprises, a tailored, institution-specific approach would be more effective and less costly.

Regulation entails direct and indirect costs. Borrowing costs at the government-sponsored enterprises are significantly below that of similarly rated private corporations because of implicit government support.

Reduced borrowing costs translate into reduced loan prices for consumers. One study found that mortgage rates are 25 to 50 basis points lower because Fannie Mae and Freddie Mac are active market participants.

|Stress Tests'

A less intrusive regulatory approach for the enterprises is warranted. Congress should establish minimum enterprise capital requirements based on specific economic "stress tests." Congress should not delegate this responsibility, since setting capital standards for these enterprises involves significant policy judgments and possible mission tradeoffs.

Stress tests are computer simulations designed to predict how an enterprise's financial holdings and obligations will perform under adverse economic conditions.

For entities that take interest rate and credit risk, such tests also subsume virtually all of what is sometimes called "operation and management risk."

National credit rating agencies, such as Standard & Poor's Corp. and Moody's Investors Service, currently use stress tests to evaluate the capacity of private mortgage insurance companies and private mortgage-backed securities issuers to withstand defaults.

However, sole reliance on private rating agencies is not advocated. Instead, a federal regulatory agency, preferably one with existing expertise in the relevant subject area, should monitor the enterprises' compliance with the minimum capital requirements based on stress tests.

Banklike examination and enforcement powers should become operative only if an enterprise fails the applicable stress test. The enterprises thus would remain largely unregulated - free to explore the types of innovative products and services that have greatly benefited the public. They would be constrained only to the extent that they pose a risk to taxpayers.

Do we really want federal employees micromanaging the complex secondary market operations of enterprises, in place of private managers? A minimalist approach to federal oversight, coupled with existing market discipline, provides better assurance that government-sponsored enterprises will successfully fulfill their legislatively mandated missions in the safest and least costly manner.

Mr. Lehr is a partner in the law firm of Hogan & Hartson, based in Washington.

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