(Archived document, may contain errors)

168

November26,1991

HK 29M DOES IT RMUCE THE RISK OF FANNIE AIAE AND I:DDIE MAC FAILURE?

INTRODUCTION The Senate is now considering legislation passed overwhelmingly this Septem- ber by the House of Representatives that will have profound consequences for America's residential mortgage lending industry. The Government-Sponsored Housing Enterprise Financial Safety and Soundness Act of 1991 (I-LR. 2900) is sponsored by Representatives Henry Gonzalez, the Texas Democrat, together with Chalmers Wylie of Ohio, and Marge Roukerna of New Jersey, both Republicans. The bill gives the U.S. Department of Housing and Urban Development (HLID) extensive responsibility to oversee America's two major providers of residential mortgage capital: the Federal National Mortgage Association, or "Fannie Mae," and the Federal Home Loan Mortgage Corporation, or "Freddie Mac." The bill also would give the Federal Home Loan Bank System THLBS), which is another source of mortgage capital, greater opportunities to promote housing investment. The Bush Administration supports some, though not all, provisions of the bill. Lawmakers' Fear. This legislation was introduced in Congress principally be- cause of concerns about how Fannie Mae and Freddie Mac, with a combined $800 billion in assets, function in the economy and how much potential risk they pose to the taxpayer. Many policy makers, for instance, are troubled that while the organizations operate with the profit incentives of private firms, they enjoy special taxpayer subsidies and federal protection from failure. The haunting fear is that if the corporations falter, the taxpayer could end up being forced to bail them out.

Policy makers also are unsure how best to regulate such quasi-private organiza- dons. Policy makers disagree about what public obligations should be required of such corporations as a condition of their special status. It was such worry among policy makers that current regulatory safeguards may not be sufficient to prevent

Fannie Mae and Freddie Mac from potentially experiencing heavy losses that has prompted H.R. 2900. Its sponsors do not want a repeat of the multi-billion dollar federal bailouts required for the thrift industry. Privileged Status. Although technically privately owned, these corporations ac- tually are in a twilight zone between the private and the public sectors. This is be- cause they enjoy a privileged status that combines their right to profit from private sector mortgage lending with an obligation that they act in a way that ser- ves the public good. They also receive special financial benefits from the United States Treasury. Fannie Mae and Freddie Mac were established by the federal government, in 1938 and 1970 respectively, to serve the purpose of supplying banks and other in- stitutional lenders with ready access to residential mortgage capital, on the as- sumption that only publicly sponsored institutions could do this effectively and safely. The corporations receive federal favors that are denied to other mortgage institutions. For this reason, they are among the group of commercial organiza- tions known as "Government-Sponsored Enterprises," or GSEs. A growing unease about the risks posed to taxpayers by GSEs, reinforced by the costly savings and loan crisis, led Congress in recent years to mandate several studies to assess the danger of losses to GSEs. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), for example, requires the Treasury Department and the General Accounting Office to conduct two annual studies to assess the financial safety and soundness of government-sponsored enterprises. The Omnibus Budget Reconciliation Act of 1990 (OBRA), meanwhile, requires the Treasury Department and the Congressional Budget Of- fice (CBO) to assess GSE financial soundness and regulatory adequacy. OBRA also requires the Treasury Department to draft legislation to ensure the soundness of GSEs in general, and requires both the House Committee on Banking, Finance and Urban Affairs, and the Senate Committee on Banking, Housing and Urban Affairs to report such legislation by September 15, 199 1. The legislation passed the House in September and is now before the Senate. Triple-A Ratings. Despite the understandable sense of alarm, Fannie Mae and Freddie Mac am in no apparent danger of failing. Extensive review by five federal agencies-the Treasury Department, the Department of Housing and Urban Development, the Congressional Budget Office, the Office of Management and Budget, and the General Accounting Office-each concludes that Fannie Mae and Freddie Mac are well-run and pose no immediate threat to the taxpayer. Fannie Mae and Freddie Mac also enjoy Triple-A ratings (the highest rating pos- sible) from nationally recognized securities-rating agencies such as Standard and Poor's and Moody's.

1 The most important of these studies are U.S. Department of the Treasury, Report of the Secretary of the Treasury on Government-Sponsored Enterprises, May 1990; U.S. General Accounting Office, Government-Sponsored Enterprises: The Government's Exposure to Risks, GAO/GGD-90-97, August 1990; Congressional Budget Office, Controlling the Risks of Government-Sponsored Enterprises, April 199 1. Nevertheless, widespread fear does exist among Bush Administration officials and lawmakers that the large obligations of the mortgage corporations, especially in the current recession, require more careful scrutiny of their activities. Treasury Under Secretary for Finance Robert R. Glauber told Congress this summer: The lack of an immediate GSE problem has caused some to suggest 'If it ain't broken, don't fix it.' We, however, believe that complacency would be inappropriate. The financially devastating failure of many federally insured thrift institutions in the 1980s was preceded by many years of profitability of these institutions.. ..The luxury of waiting until a financial crisis is painfully evident has now clearly been seen as costly and difficult for the American taxpayer.2 H.R. 2900 thus is being touted as preventative medicine to preserve the finan- cial integrity of Fannie Mae, Freddie Mac, and the Federal Home Loan Bank Sys- tem, but without undermining their historic mandate of widening opportunities for homeownership among all income groups. As it now reads, H.R. 2900 would: * * Place many of the operations of Fannie Mae and Freddie Mac under the supervision of a new regulatory office within the Department of Housing and Urban Development, to be known as the Office of Secondary Market Ex- amination and Oversight (OSMEO). HUD has had some regulatory powers over Fannie Mae since 1968, and over Freddie Mac since 1989, but H.R. 2900 would greatly expand HUD's authority to monitor the GSEs. * * Set standards for capital reserves for Fannie Mae and Freddie Mac. After an eighteen-month transition, these corporations would be required to main- tain 2.5 percent of their total assets as equity capital. No such standards currently exist for GSEs, although each GSE is capitalized at about 1 percent. By com- parison, federal regulators require fully private institutions to maintain 4 percent of their total assets as equity capital. * * Require purchases of low-income mortgages. Fannie Mae during 1992 and 1993 would have to buy $2 billion in mortgages on homes purchased by low- income homebuyers from mortgage lenders. Half of these purchases would be for family residences (defined as fewer than five dwellings per structure) and the other half for multifamily residences. Freddie Mac would have to buy $1.5 billion in such mortgages under the same guidelines. Some 45 percent of these mortgages must be for buyers with incomes of no more than 80 percent of the median income in the area. Fannie Mae and Freddie Mac additionally would be barred from doing business with lenders demonstrating "substantial non-com- pliance" with the Community Reinvestment Act. This 1977 law, strengthened in

2 Statement of Robert R. Glauber. Under Secretary of the Treasury for Finance, U.S. Congmss, House of Representatives, Committee on Banking, Finance and Urban Affairs, Subcommittee on Housing and Urban Development, July 1991. reprinted in Treasury News, July 18, 199.1, pp. 1-2. 1989, mandates that lenders take affirmative steps to lend in low-income neigh- borhoods. * * Lift the current 30 percent ceiling allowed on Federal Home Loan Bank System advances to banks making housing loans. The Federal Home Loan Bank System makes available funds, known as "advances," to thrifts and banks to use as capital for mortgages. But only 30 percent of these advances cur- rently can be made to banks, limiting their ability to serve the mortgage market. The intent of this provision is for the Federal Home Loan Bank System to en- courage more commercial banks to make mortgage loans, thereby increasing com- petition and giving homebuyers a wider choice of lender. Although this legislation stems from laudable motives, it is by no means clear that it will make the mortgage market operate more efficiently, or actually protect the taxpayer from a bailout. Among the dangers implicit in the legislation: * * The legislation retains the quasi-independent nature of Fannie Mae and Freddie Mac. Thus managers of the corporations will still have the perverse incentive of shareholder pressure to pursue profit combined with taxpayer protec- tion against failure. Further, the legislation continues the favored status of the cor- porations, courtesy of the Treasury; competing, fully private firms, of course, are not so privileged. # * The new regulatory office proposed by Congress would be more answerable to Congress than to the Executive Branch. Recent history, how- ever, suggests that congressional "oversight" often leads to favoritism and corrup- tion rather than to prudent regulation. * # Raising capital standards actually may reduce the soundness of the corporations by encouraging managers to pursue riskier business to main- tain acceptable returns to shareholders. * * Requiring Fannie Mae and Freddie Mac to increase their purchases of low-income mortgages will reduce further their profitability and financial soundness. Rather than trying to micromanage these quasi-independent government-spon- sored enterprises, taxpayers would be better protected, and homebuyers better served, if Congress were to completely privatize Fannie Mae and Freddie Mac, en- ding the benefits that they receive from the Treasury. This would end the risk posed by corporations in which the profits are private yet the risks ultimately are public. If Congress, however, insists on retaining Fannie Mae and Freddie Mac in their privileged position, lawmakers need to make sure that the corporations are regu- lated in a manner that will protect the taxpayer while distorting the mortgage market as little as possible. To do this, Congress should assure that the regulators are answerable primarily to the Executive Branch, and then to Congress, rather than being micromanaged by Congress. In addition, Congress should establish reasonable minimum capital requirements for these institutions. While it is justified in establishing risk-based requirements, Congress should avoid the mistake of making them too high-

thereby actually weakening the soundness of the corporations. In addition, the bill should avoid mandating that Fannie Mae and Freddie Mac allocate a certain por- tion of their mortgage purchase to mortgages deemed "affordable" to low-income homebuyers. Instead, Congress would be wiser to take action through separate legislation to reduce the red tape that unnecessarily raises cost of housing. The need for financial solvency at Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System is not at issue. Everyone in the Administration and Con- gress knows that taxpayers should not be exposed to widespread default on their assets. In seeking safeguards for solvency, however, the federal government should not hamper the ability of these firms to be run in the public interest.

HOW GOVERNMENT-SPONSORED ENTERPRISES FUNCTION

Fannie Mae and Freddie Mac are Government-Sponsored Enterprises designed to increase and manage investment in housing. Their function is to purchase mortgages from banks and other mortgage lenders, using funds from shareholders and other investors.

Other private firms, of course, also can buy mortgages. These private firms, however, mainly buy mortgages above $191,250, since Fannie Mae and Freddie Mac legally are restricted to mortgages below this. Similar GSE corporations operate in other areas of the economy. In agriculture, the equivalent agency is the Farm Credit System. For higher education, it is the Student Loan Marketing As- sociation ("Sallie Mae'). Fannie Mae was created by Congress as a government agency in 1938, and rechartered, as a shareholder-owned private firm in 1968. Freddie Mac was created in 1970 as a part of the Federal Home Loan Bank System to specialize in conventional home mortgages; in 1989 it was made into a fu-m similar to Fannie Mae.

Fannie Mae and Freddie Mac are designed to serve sectors of the economy thought to be poorly served by private credit markets. Although they are private corporations, the GSEs do not function as ordinary firms, but rather as public- private partnerships. As partnerships, they have social obligations. Close Scrutiny. The GSEs implicitly are protected by the federal goverriment from insolvency. Considered "too big to fail," the GSEs are given commercial ad- vantages, such as low-cost financing from the Treasury and exemption from state and local taxes. Because of these advantages over their private competitors, the GSEs are scrutinized closely by the federal government to ensure that their privileges are not misused and their legal obligations are discharged. To entice investment in the GSEs by investors who want the same safety as they get from U.S. Treasury bills or bonds, the federal government gives Fannie Mae and Freddie Mac advantages obviously unavailable to competing purely private firms. These special benefits include: * A guarantee against losses, enabling the GSEs to raise funds at interest rates below purely private corporations with similar credit ratings;3 * An exemption from federal deposit insurance fees, which ordinary banks and thrifts must pay; * Lower minimum capital requirements, enabling the firms to attract capital at lower cost; * A line of credit with the U.S. Treasury, currently at $2.5 billion; # An exemption from certain federal securities laws; and # An exemption from state and local taxes. Fannie Mae and Freddie Mac are not "primary" mortgage lenders; in other words, they do not underwrite mortgage loans to individuals or developers. Fan- nie Mae and Freddie Mac have special advantages because Congress chartered them to provide "secondary" mortgage funding. Secondary mortgage institutions buy loans from private lenders, such as thrifts and banks, who make them. Fannie Mae and Freddie Mac then either sell the mortgages to private investors as "mortgage-backed securities" (guaranteeing timely payment of interest and prin- cipal) or to a lesser extent, hold them in a separate fund. These secondary mortgage market operations link mortgage markets and capital markets. They pro- vide greater liquidity for residential mortgages and increase the availability of mortgages in states and regions experiencing a tight mortgage market. Short-Term Liquidity. The Federal Home Loan Bank System, unlike F Mae and Freddie Mac, is not a single firm but an association of mortgage lenders served by twelve regional banks. Analogous to the Federal Reserve System, FBLBS was established in 1932 to provide loans to depository institutions- mainly savings and loan associations-that underwrite residential mortgages. FEILBS raises funds to make loans through issuing bonds in international capital markets. The Home Loan Bank System is subject to much stricter federal capital requirements than either Fannie Mae or Freddie Mac. Its loans, better known as "advances," provide short-term liquidity for lenders to finance housing. The sys- tem is in sound financial condition. No member lending institution has ever defaulted. Because the agency's main beneficiaries-savings and loans-are shrinking in size and influence, the demand for future loans is likely to fall.' The cumulative loans outstanding to GSEs exceed $1 trillion, more than $800 billion of which is accounted for by Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac's combined new purchases of mortgages amounted to about $10.5 billion in 198 1. By last year, new purchases umped to $190 billion, an al- most 2,000 percent increase in less than a decade.y

3 Fannie Mae and Freddie Mac can raise funds at 35 to 75 "basis points" (0.35 to 0.75 of I percentage point of the value of the loan) below private lenders. 4 Congressional Budget Office, Controlling the Risks of Government-Sponsored Enterprises, p. xxxv. 5 Ibid., p. 125. Both corporations are enjoying healthy profits. Last year, Fannie Mae reported a recgrd $1.17 billion profit, a 45 percent jump from 1989's record $807.3 mil- lion. Despite the recession, with many housing lenders forced to curtail new

mortgage underwriting, Fannie Mae and Freddie Mac this year are expected to 7 enjoy combined profits of $2 billion. In comparison with commercial banks, both GSEs are extremely profitable. According to the General Accounting Office, the annual return on average equity for Fannie Mae and Freddie Mac during 1985 to 1989 was 17.9 percept and 27.8 percent, respectively; the average return for banks was 8.9 percent. Because they are the largest Government-Sponsored Enterprises, the fortunes of Fannie Mae and Freddie Mac greatly affect the entire housing industry. During 1980-1990, the proportion of all new mortgage debt secured by these agencies rose from 17 percent to 52 percent.9 Yet, despite the growth and soundness of Fannie Mae and Freddie Mac, Congress and various federal agencies are con- cerned that many of their loans and securities may default, especially given the current deep real estate recession. Distorting the Credit Market. Neither of the firms appears to be in any danger of failing. While they did experience heavy losses during the 1981-1982 recession, their profit margins have steadily increased since the mid- 1980s. 10 TO be sure, the firms do receive benefits from state and local agencies. Ile Treasury Department estimates the value of these benefits at between $2 billion and $4 bil- lion annually. I I Yet even without such help, these GSEs would be sound. Indeed, financial experts agree that Fannie Mae and Freddie Mac would receive adequate credit ratings without actual or potential government assistance. 12 Still, the existence of these GSEs distorts the credit market in a way that reduces overall efficiency. Fannie Mae and Freddie Mac both enjoy federal sup- port enabling them to do profitably what other competitors cannot. HUD Deputy Secretary Alfred DelliBovi has termed Fannie Mae and Freddie Mac a "duppoly," noting, "The two agencies have no competition except each other.,,13 This is the price paid by taxpayers for the special privileges of the two giant GSEs.

6 See Albert B. Crenshaw, "Fannie Mae Profit Rises 45 Percent," Washington Post, January 16,1991. 7 Martin blayer, "Another Favor for Fannie Mae and Freddie Mac," Wall Street Journal, October 22, 199 1. 8 U.S. General Accounting Office, Governnwnt-SponsoredEnterprises, p. 64. 9 Letter f1rom Alfred A. DelliBovi, Deputy Secretary, U.S. Department of Housing and Urban Development, to Allan B. Hubbard, Executive Director, President's Council on Competitiveness, August 8. 199 1, p. 1. 10 In 1981, for example, the estimated market value of Fannie Mae's net worth stood at close to minus $11 billion. A wholly private firm, under such circumstances, would have not had access to credit, or would have had to borrow at unusually high rates. Yet with implicit federal guarantees, it was able to continue borrowing large amounts at only a slight increase, in borrowing costs, and to maintain its high credit rating. See U.S. General Accounting Office, Governnwnt-SponsoredEnterprises, p. 9. 11 U.S. Department of the Treasury, Report of the Secretary. 12 See U.S. House of Representatives, Committee on Banldng, Finance and Urban Affairs, "Explanation of Provisions, H.R.2900, Government-Sponsored Housing Enterprises Financial Safety and Soundness Act of 1991," p. 3. THE MAJOR ISSUES BEFORE CONGRESS

The legislation now before Congress would overhaul the regulatory framework for Fannie Mae and Freddie Mac, and would calm fears that the corporations may encounter problems if the real estate market continues to be depressed. The legis- lation raises four questions about GSEs in general, and Fannie Mae and Freddie Mac in particular: 1) Should these institutions continue to enjoy a quasi-public status? 2) Who should be responsible for regulating them If they do con- tinue having a special status? 3) What is the best way to ensure that they remain financially sound? 4) What is the best way to balance their public purpose of serving first-time home seekers with the need to remain financially sound?

Cluestion #1: Ouasi-Public or Private Status? Congress should question the wisdom of allowing GSEs to have it both ways: 1) the right to pursue profit in the private markets, and 2) a taxpayer guarantee against failure. It was the mixture of private profit-making incentives and govern- ment protection against failure, in the form of federal deposit insurance, that led to the staggering financial problems of the savings and loan industry. Observes banking expert Martin Mayer: "There is a case to be made for freeing Fannie and Freddie from all constraint and making them ordinary stockholder-owned com- panies, without tax breaks, presidential appointees on their board or supervision by HUD. There is a case for keeping them as government entities and supervising them closely. But there is no case for extending their freedom while keeping their crypto-government status. ,14 Recommendation: Instead of confining itself to the issue of how to regulate Fannie Mae and Freddie Mac, Congress additionally should consider whether they should retain their privileged status, or be turned into purely private companies. Ideal- ly, Fannie Mae and Freddie Mac should be fully private firms, subject only to a modest degree of federal regulation but losing all their current special finan- cial benefits from the government. This would force managers to balance risk and reward in their business decisions. Failing that, Congress should make sure that the special benefits of these GSEs are employed for their basic pur- pose in the secondary mortgage market, and are not extended to markets which are now being served effectively by other financial institutions.

13 Letter from Alfred A. DelliBovi to Allan B. Hubbard, p. 2. 14 Mayer, op. cit. To be sure, Fannie Mae and Freddie Mac were given a special status be- cause Congress felt that they have a public purpose presumably not achievable in the absence of extensive federal oversight. But it is by no means clear that a secondary mortgage market has to be dominated by Government-Sponsored Enterprises, along with their attendant risk to the taxpayer. Congress ought to question whether the purpose of Fannie Mae and Freddie Mac is indeed "public." If, as HUD Under Secretary DelliBovi maintains, Fannie Mae and Freddie Mac constitute a duopoly, and Congress is interested in encouraging greater competition in the secondary mortgage lending industry, then it should establish a plan for their eventual privatization.

Question #2: Who Is the appropriate regulator? If lawmakers conclude, albeit unwisely, that the existing status should continue, they must then find a way to regulate the GSEs so that they cannot continue to seek maximum profits while relying ultimately on taxpayer help if they get into difficulties. The House bill calls for a new agency, the Office of Secondary Mortgage Examination and Oversight (OSMEO), whose Director would oversee all Fannie Mae and Freddie Mac operations. This new agency would be part of HUD, although the HUD Secretary's role would be limited to approving new con- ventional mortgage program proposals. The Department of the Treasury's role would be to ensure that the debt issuances of the housing corporations are coor- dinated with its own.

A Senate proposal (S. 162 1) sponsored by Herbert Kohl of Wisconsin, John Glenn of Ohio, and Carl Levin of Nfichigan, all Democrats, creates an alternative watchdog agency. This bill reflects the view of the General Accounting Office, which proposes a six-member Federal Enterprise Regulatory Board, consisting of three voting members (a presidentially-appointed chairman, the Secretary of the Treasury, and the Chairman of the Federal Reserve System), and nonvoting I ? 7, members (the Secretaries of Agriculture, Education, and HUD). A bill spon- sored by Senator Pete Domenici, the New Mexico Republican, proposes that the Treasury Department serve as regulator. Yet another proposal, circulated by the staff of the Senate Committee on Banking, Housing and Urban Affairs, would have OSMEO serve as regulator, but with greater independence from the rest of HUD and other federal agencies than that granted to it by H.R. 2900. Recommendation: The central issue is who would be most likely to assure that Fannie Mae and Freddie Mac do not buy excessively risky mortgages, since Fannie Mae and Freddie Mac know that the government ultimately would bail them out. The problem with the new office created by H.R. 2900 is that the regulators would be answerable mainly to congressional committees and powerful lawmakers. The experience of such oversight in the 1980s, particularly with respect to the

15 See statement of Harry S. Havens, Assistant Comptroller General, to U.S. Senate, Committee on Banking, Housing and Urban Affairs, May 10, 199 1. thrift industry and many HUD programs, suggests that the result will be that Fannie Mae and Freddie Mac would be pressured to help favored congres- sional constituents and the pet projects of lawmakers, rather than serve the public interest. A better course would be either to place the regulatory authority in the hands of a board of cabinet members, as recommended by the General Accounting Office, or to give the HUD regulator maximum independence, as the Senate Banking Committee proposal would do.

Question #3: Sound Financial Future? Congress has to strike a fine balance-making sure that the public objectives re- quired as a condition of special benefits for the GSEs do not jeopardize their financial soundness.

A key issue in assuring future soundness is setting a solid standard for capital risk that the GSE takes. H.R. 2900 requires Fannie Mae and Freddie Mac to meet standards that would protect them against default under worst-case conditions. HUD supports the bill's proposal for capital standards. Capital standards set the minimum levels of equity that a financial institution must hold as a cushion against losses. The legislation sets three levels. The highest standard refers to the capital standard that would be sufficient for the corporations to withstand any foreseeable financial "stress" without being hindered from con- ducting normal operations. The middle standard is essentially the amount of capi- tal that they now have on hand-, the lowest standard is about one-half the level of current capital. Under the legislation, Fannie Mae and Freddie Mac must prepare a plan to achieve the highest standard of capital reserves. If either one falls below the mid- dle standard, it is required to improve its capital position. If it falls below the lowest standard, the regulator must appoint a conservator to operate the corpora- tion. Thin Capitalization. The Congressional Budget Office reports that Fannie Mae's total capital (stockholders' equity plus reserves) at the end of 1990, as a percentage of assets and mortgage-backed securities, was 1.06 percent; the figure for Freddie Mac was 0.77 percent. Including only stockholders' equity in the capi- tal figure would reduce these percentages, respectively, to 0.94 percent and 0.60 percent. 16 These are considerably lower than the 4 percent standard required by federal regulators of banks. Federal officials properly see these figures as indicative of the GSEs' thin capitalization. Congress, however, in seeking to raise the current levels, should be wary of potential problems associated with raising capital requirements for Fan- 17 - nie Mae and Freddie Mac. First , shareholders would expect a lower return on

16 Congtessional Budget Offixe, Controlling the Risks of Govermnent-Sponsored Enterprises, p. 165. 17 Ibid., pp. 191-92. their equity, and many would react to this by moving their capital elsewhere. Second, the institutions might try to make up for the lack of return on "frozen" assets held for capital requirements by buying riskier mortgages to raise their income.

Thus creating the capital standards too high, as the bill may wen be doing, actually would weaken Fannie Mae and Freddie Mac by making them less attractive to shareholders.

Recommendation: Congress should pause and weigh the risks and benefits of raising the capital requirements of Government-Sponsored Enterprises relative to that of conven- tional lenders. Fannie Mae and Freddie Mae's core capital requirements probably should be higher than their current levels. But they should not be so high that they defeat the purposes for which these GSEs were created. Question #4: Fulfilling a public purpose? H.R. 2900 calls for Fannie Mae and Freddie Mac to promote affordable hous- ing. This objective, however, already is in the charter of both organizations. The bill sets guidelines that would force the corporations to devote many more resour- ces to low-income housing. The bill would require Fannie Mae and Freddie Mac together to purchase $3.5 billion in residential mortgages during 1992 to 1993. Some 45 percent of these mortgages must be on homes that, under federal guidelines, are deemed affordable to households having no more than 80 percent of the median income in the area.

Fannie Mae would have to devote $2 billion of its resources toward these low- income purchases, and Freddie Mac $1.5 billion. Half of the money from each would buy mortgages on structures with fewer than five units, and the other half would buy mortgages on multifamily housing, like apartments. In 1994, the value of at least I percent of the total mortgages purchased in 1993 must be used to pro- vide "affordable" housing, with 40 percent of the housing consisting of structures with one-to-four dwellings, and the remaining 60 percent consisting of multifami- ly dwellings. HUD officials, including Secretary Jack Kemp, have urged the Senate Banking Committee to require both Fannie Mae and Freddie Mac to buy 30 percent of their mortgages in the form of low- and moderate-income housing, and to do 30 percent of their business in central cities. Such requirements have been law since 1978, but are not enforced. Meeting Housing Goals. Fannie Mae and Freddie Mac also would be required by H.R. 2900 to establish Affordable Housing Advisory Councils. These bodies would advise the GSEs on how to meet these housing goals. Congress has made clear that these goals, while for the time being voluntary, could be made man- datory for either GSE, if these agencies do not meet congressional expectations. H.R. 2900 also prohibits Fannie Mae or Freddie Mac from purchasing mortgages from lenders who ignore "anti-redlining" requirements in current law. Redlining is the alleged practice by banks and other lenders of denying mortgage credit to certain neighborhoods, usually those with deteriorating housing and,

some maintain, high levels of minority residents. Yet, there are often rational economic reasons why private lenders avoid certain types of borrowers. Thes reasons are not necessarily related to either race or neighborhood condition. What usually disqualifies a borrower from receiving mortgage money is an un- stable credit history. Coercing Fannie Mae or Freddie Mac to take on more low- income mortgages may undermine these GSEs' financial soundness and increase the possibility of the very financial failure that this legislation is intended to avert. Increasing the amount of mortgages to low-income families that these GSEs have to buy, also could damage GSE financial soundness. These institutions in any case are taking steps to fulfill their obligations to make housing more affor- dable for lower-income Americans and first-time buyers. 19 Example: Fannie Mae decided earlier this year to waive the requirement that borrowers provide from personal funds at least 5 percent of a home's purchase price. Fannie Mae has reduced this figure to 3 percent, allowing the remaining 2 percent to be obtained through gifts, grants, or unsecured loans from family mem- bers, non-profit groups or public agencies. Virtually all borrowers using this low down payment mortgage are first-time buyers. Example: Fannie Mae and Freddie Mac are widely purchasing adjustable-rate mortgages. These offer substantially reduced interest rates during the first few years of a mortgage term, a time when the incomes of borrowers frequently are not yet high enough to pay off a mortgage at a normal market rate of interest. Example: Fannie Mae and Freddie Mac have invested heavily in LDw-Income Housing Tax Credits. These are special tax benefits for investing in housing for low-income families. Created in the 1986 Tax Reform Act, these credits have led to the construction and rehabilitation of hundreds of thousands of low-income rental dwellings. Recommendation: Improving the affordability of housing for low-income families is a worthy objective. But strategies that distort credit markets will not accomplish the goal. Such strategies not only are too indirect in their effects but also run the risk of shifting funds to some of the riskiest ldnds of mortgages. What will allow more poor Americans to afford housing is a reduction in the state and local regulatory burdens on housing construction and housing rehabilitation. Congress could make continued federal assistance to states and localities con- tingent upon a demonstrated effort at deregulation. Congress also could, where necessary, help families directly if they need assistance to afford housing. The Advisory Commission on Regulatory Barriers to Affordable Housing, established by HUD Secretary Jack Kemp, reported this year that Americans are paying billions of dollars extra for housing because of federal, state, and

18 See Stephen Chapman, "Overblown Bias Accounts," Washington Times, October 26, 199 1. 19 For a description, see Robert Walters, "Fannie Mae's New Ideology," Washington Times, July 3, 199 1; U.S. House of Representatives, "Explanation of Provisions," pp. 11-16. local regulations that block the construction of new housing, reduce the supply of existing housing, and drive up housing costs. Such regulatory excesses hurt low-income Americans the most, adding as much as 30 percent to the cost of housing in some states. The Commission made many recommendations to eliminate unnecessary red tape at all levels of government. So far Congress has ignored these recommendations. Rather than adding new requirements to Fan- nie Mae and Freddie Mac, Congress should take action on the Commission's recommendations.20

CONCLUSION

In light of the savings and loan bailout disaster, Administration officials and Congress are right to be concerned that taxpayers not become liable for a bailout of secondary mortgage lenders. If secondary lenders are going to continue in their status as private entities with a public purpose, they should continue to be held to certain federal standards that reduce the risk of financial failure. But these stand- ards and obligations should not be so onerous that they in fact increase the risk of failure by discouraging private investors in the firms. At the same time, it is not in the best interest of taxpayers or an efficient hous- ing market to continue the current approach of "privatizing the gains, and socializ- ing the losses." H.R. 2900, in its present form, contains features that would ex- tend this flawed policy further. Moving Toward the Mvate Sector. What the federal government should be doing is examining ways of reducing the dependency of Fannie Mae and Freddie Mac upon the Treasury, while at the same time permitting them freedom to buy and sell loans in a manner that would not expose them to additional risk. The aim of reform thus should be to case Fannie Mae and Freddie Mac into the private sec- tor. The way to make housing more affordable to low-income Americans is through regulatory, tax and other relief to reduce the cost of housing, or through direct help to individual families. Attempting to secure the objective by maintain- ing secondary mortgage firms in a twilight zone between the public and private sectors, and rigidly regulating them, on the other hand, may be a recipe for an eventual taxpayer bailout. Carl F. Horowitz, Ph.D. Policy Analyst

20 See Carl F. Horowitz, "From the Kemp Commission: Sound Advice for Removing Barriers to Affordable Housing," Heritage Backgrounder No. 848, August 26,1991.