crossposted from Source of Title  

Ohio Congressman Michael Oxley (R-Mansfield) has an axe to grind with critics who blame Congress for failing to pass reforms that may have averted the need for this week's government takeover of mortgage giants Fannie Mae and Freddie Mac.  As Oxley sees it, he did his part by crafting a reform bill in 2005 and getting it passed by the House of Representatives. 

From the Financial Times :

[Oxley] fumes about the criticism of his House colleagues. “All the handwringing and bedwetting is going on without remembering how the House stepped up on this,” he says. “What did we get from the White House? We got a one-finger salute.”

The House bill, the 2005 Federal Housing Finance Reform Act, would have created a stronger regulator with new powers to increase capital at Fannie and Freddie, to limit their portfolios and to deal with the possibility of receivership.

...

“We missed a golden opportunity that would have avoided a lot of the problems we’re facing now, if we hadn’t had such a firm ideological position at the White House and the Treasury and the Fed,” Mr Oxley says.

But a look back at the efforts to pass that bill calls into question Oxley's version of events.

First, a little bit of background... Fannie Mae and Freddie Mac's core business involves buying mortgages from originators, repackaging the mortgages into bond-like instruments called Mortgage-Backed Securities (MBS), and either selling the MBSs to other institutions or keeping them in their own investment portfolios.  To finance the purchase of mortgages, Fannie and Freddie issue debt in the form of bonds.

Fannie and Freddie had unique advantages afforded to them by their government charters as Government Sanctioned Entities (GSEs) that no other private firms who might wish to compete with them had.  In particular, they were able to borrow money at much lower interest rates than other institutions with similar credit ratings, because of a perception that the government would step in and make Fannie and Freddie's creditors whole if they ever failed-- an "implied guarantee" which had never been disavowed by the government and had been actively fostered at times.  This perception caused investors to consider Fannie and Freddie's bonds to be nearly as risk-free as Treasury bonds, which carry the "full faith and credit" of the United States.  Investors were willing to accept a much lower interest rate for Frannie and Freddie bonds in return for that kind of safety.

In and of itself, this was probably all looked upon as a net positive by most people in Washington.  After all, it was Fannie and Freddie's chartered mission to promote homeownership through the wide availability of mortgages to the lower and middle classes, and the borrowing advantages that they had helped keep interest rates on mortgages low.  The attractive rates on mortgages were helping push homeownership rates to all-time highs.

But by 2005, many folks were becoming concerned by the sheer amount of debt Fannie and Freddie were issuing, and the purposes for which the debt was being used.  The companies' combined debt was over $2 trillion, and total assets were a bare 5% or so above liabilities as the companies operated at near the minimum amount of capital required by statute.  And their asset portfolios not only included mortgage and mortgage-backed securities, but also complex derivatives used to hedge against the risk of interest rate changes and other business risks.  In fact, Fannie and Freddie were getting most of their profits from their own huge investment portfolios, not through securitizing mortgages and selling the securities.  Experts were questioning the purpose of these huge portfolios and worried about the implications to the taxpayer if the value of these portfolios should suddenly collapse and cause the GSEs to become insolvent, requiring the government to step in and make good on its implied guarantees on their debts.

Reform was needed-- badly.  Existing regulatory bodies did not have a sufficient statutory mandate to monitor Fannie and Freddie and rein in any excesses.  For starters, Fannie and Freddie's charter allowed them immunity from the rules of the Security and Exchange Commission (SEC).  In other words, Fannie and Freddie didn't have to regularly report their finances to the public the way that other publicly-traded companies had to.  Instead, Fannie and Freddie were accountable only to a special oversight bureau within HUD, the Office of Federal Housing Enterprise Oversight, (OFHEO).  The effectiveness of this setup came under scrutiny after OFHEO issued a report in 2004 which revealed that Fannie Mae executives had been cooking its books all the way back to 1998 in order to fraudulently give the appearance of meeting profitability targets, so that the executives could max out on their performance bonuses.  The fraud netted Fannie Mae CEO Franklin Raines up to $52.8 million in bonuses . 

Fannie Mae tried to steamroll its underpowered regulator all along the way.  At one point, Fannie Mae instigated a retailatory HUD investigation against the OFHEO regulators who were looking into their accounting fraud in order to undermine the credibility of the regulator.  They had one of their lobbyists draft a letter for Sen. Christopher "Kit" Bond (R-Mo) to send to HUD and request the investigation.  Bond sent the letter on to HUD under his own name, made public statements directed at getting the lead regulator sacked, and was rewarded for his efforts with tidy campaign contributions from Mr. Raines and other Fannie Mae execs. 

The reward for the brave OFHEO regulators who exposed the fraud of the mighty Fannie Mae were much more elusive--  Senate appropriators tried to strip OFHEO of its funding.

With legislators like Bond in the hip pocket of the GSEs, it was hard to imagine that Congress would ever be able to pass the needed reforms.  Enter Oxley and the bill he was sponsoring, The Federal Housing Finance Reform Act of 2005 .  On the surface, the bill appeared to contain needed reforms.  It had language to create a new, improved regulatory body to replace OFHEO.  It required the companies to register their stock with the SEC. 

But for the most part, the bill was a flawed and toothless giveaway to the powerful GSEs.  The bill expanded the statutory maximum loan amount to allow the GSEs to take over the jumbo market.  It mandated "affordable housing funds" which could be allocated at the discretion of the GSEs, amounting to a slush fund that could be lavished on the districts of friendly legislators.  There was a loophole which basically gave the GSEs the authority to expand their business beyond the secondary mortgage market and into any business that it deemed would "minimize the cost of housing finance"... some critics claimed that this vague language in the bill would allow the GSEs to enter into the title insurance or appraisal business -- clearly far from their original purpose.  A flaw in the bill would have caused a year-long gap in oversight between the shuttering of OFHEO and the establishment of the new regulator.

Meanwhile, the bill neither increased capital requirements nor set a cap on allowed portfolio size-- two key risk-reducing reforms that the Fed and Treasury department had repeatedly stressed in testimony before Oxley and his peers in Congress.  The regulator was given the authority to impose increased capital requirements and/or limits on portfolio size only if they could show that the GSE's capital position or portfolio was a threat to its soundness.  Critics surmised that this limited authority would not allow quick action by the regulator to avert the failure of a GSE.

Rather than a tough reform bill, the bill was basically a dream come true for Fannie Mae and Freddie Mac.  They'd get to continue to grow their portfolios to juice their earnings; they'd have a new affordable housing slush fund to reward legislators who played ball; their new regulator wouldn't have much sharper teeth than the old one; they wouldn't have to raise capital or sell assets to meet stricter capital requirements; and they'd get a year without much of anyone looking over their shoulders.

Even the not-so-swift-sometimes Bush Administration recognized that this was not the medicine that was needed for the GSEs.  The White House's Office of Management and Budget issued the one fingered salute to Oxley and the other supporters of the bill:

The Administration has long called for legislation to create a stronger, more effective regulatory regime to improve oversight of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks ("housing government-sponsored enterprises" or "housing GSEs") and appreciates the considerable efforts of Chairman Oxley and Chairman Baker in crafting H.R. 1461. However, H.R. 1461 fails to include key elements that are essential to protect the safety and soundness of the housing finance system and the broader financial system at large. As a result, the Administration opposes the bill.

The regulatory regime envisioned by H.R. 1461 is considerably weaker than that which governs other large, complex financial institutions. This regime is of particular concern given that Fannie Mae and Freddie Mac currently hold only about half of the capital of comparable financial institutions. In order for a financial regulator to be respected and credible, it must have the authority and ability to adjust capital requirements of the institutions it oversees as circumstances dictate to ensure prudential operations. An effective oversight regime must also provide for clear review of business activities to ensure the integrity of the housing finance system and consistency with the GSEs' housing mission. The Administration does not believe that the housing GSEs should be exempt from these important standards of world-class regulation.

In hindsight, the list of reforms the White House was requesting seems just about exactly the ones that might have actually worked. 

One more item of note that might shed some light on this flawed legislative effort at "reform"-- Oxley had been a recipient of the largesse of the GSEs in the past:

Robert Mitchell Delk, Freddie Mac’s chief Washington lobbyist, hosted a dinner fundraiser for Rep. Michael Oxley at the upscale DC restaurant Galileo.

Perhaps Oxley was making a good faith effort at reform, perhaps not; when you're accepting these kind of favors from institutions you are charged with reforming, it has to call into question your loyalites.  So if Oxley wants to put himself up on a pedestal and point fingers, perhaps he'd like to answer to some criticism of his own actions while he's at it.