One highly touted feature of the housing legislation signed into law in July is the creation of a tougher regulator to oversee Fannie Mae and Freddie Mac — the coddled, gargantuan twins of the housing markets, whose poor financial judgment has forced them onto their parent's (read: Congress') doorstep for help.

Fannie and Freddie do desperately need a firm disciplinary hand. And, on paper, the new regulator looks the part. The old regulator, the Office of Federal Housing Enterprise Oversight, was replaced with a more powerful Federal Housing Finance Agency. This new agency can control executive compensation, set tougher capital requirements and, critically, it will be funded by fees from Fannie and Freddie, not by a Congressionally approved budget.

Sounds promising, but how will all this work in practice? Gus Faucher, director of macroeconomics at Moody's, says, "The regulator will have more teeth, but how willing will the regulator be to use that authority? It's tough to tell at this point. That takes time to work through." Indeed, it's worth remembering that the Federal Reserve and the Securities and Exchange Commission, both of which have plenty of authority, failed to take any real steps to avert the current crisis by, say, taking a tougher look at nonbank lenders even with numerous reports of predatory practices in states with virtually no licensing or supervision.

There is much the Federal Housing Finance Agency could do to shore up Fannie and Freddie. It could incentivize execs to take less risks, not more — and given the now explicit taxpayer guarantee of Fannie and Freddie's debt this seems logical. Altering capital requirements is also critical, says Gibran Nicholas of the CMPS Institute, an organization that certifies mortgage bankers and brokers. Requirements need to be raised and managed differently, adjusted to account for liquidity risk and changes in the risks of the assets, which can change when underlying loans are modified. Ongoing risk assessment could help avoid downward price spirals when assets must be suddenly marked to market.

The former head of the OFHEO, James B. Lockhart III, will head the new agency. He does bring some legitimacy to the table. When he took over two years ago, Fannie and Freddie were coping with serious accounting scandals and he responded by capping the mortgage investment limits. Lockhart has also been inclined to increase the lenders' capital requirements by, for instance, insisting that the agencies keep reserves 30 percent above the minimum legal limit to guard against losses.

So, given this track record, it's possible Lockhart will use his position's new power to bring meaningful reform to Fannie and Freddie. Alas, so far, his comments have not been inspiring, except for those hoping the status quo will prevail. Take the issue of executive compensation, for which there is widespread disgust for its lavishness. Last year, Freddie Mac CEO Richard Syron pocketed $19.8 million in compensation even though the company's stock lost half its value. This year, he is guaranteed $8.8 million in stock grants regardless of performance. So what is the tough new regulator's response? Wording that should put executives very much at ease; he will be careful with his compensation authority, he says, since he doesn't want to drive away talent.

In the past, Lockhart has noted that the GSEs weren't required to hold as much capital as banks. To be specific, the law puts the minimum capital at 2.5 percent of assets held on their balance sheets, plus 0.45 percent of the mortgage securities held by other investors but guaranteed by Fannie and Freddie. By comparison, the minimum tier one capital at banks is four percent, but regulators like to see it higher than seven percent.

Clearly, one reason Fannie and Freddie are in such dire straits today — Freddie Mac has been technically insolvent for months — is their very low capital requirements. Yet, when asked about this after the mortgage legislation was signed, Lockhart declined to predict whether he would boost these rates. "I want to go into this with a fresh mind," he said.

One dilemma the new regulator cannot resolve, however, is the ambiguity of Fannie and Freddie's hybrid public/private status. As long as that status continues, the mortgage market will be skewed, and GSE investors will assume the government backs their investments. The remedy for that dilemma is legislation for another day.

(c) 2008 U.S. Banker and SourceMedia, Inc. All Rights Reserved. 

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