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GSE Crisis and its implication –

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									                    Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010   369



GSE Crisis and its implication – with focus on corporate
governance∗


Masahiro Kobayashi
Senior Economist, Research and Survey Department, Japan Housing Finance Agency


Yuji Orui
Deputy General Manager, Industry Research Division, Mizuho Corporate Bank




Abstract

     Fannie Mae and Freddie Mac, known as housing “GSEs”, have a unique – federally chartered,
shareholder owned – status. Although both are listed in the NYSE, investors believed that the federal
government would bail them out in case of emergency because of various privileges. This widely
accepted perception of “implicit guarantee” by the government allowed them to raise relatively low cost
funds, contributing to the expansion of business volume to nearly half of 10 trillion US mortgage market.
     Their mission is stipulated in their respective charter to provide liquidity to housing market to expand
homeownership among middle class American. They have two lines of businesses, namely portfolio
investment and MBS credit guarantee. US MBS market expanded in order to alleviate disintermediation
by S&Ls after 1970. Since the late 1990’s, systemic risk had been discussed on their portfolio investment,
and their regulator (OHFEO) imposed portfolio cap and other sanctions in 2004 after accounting scandal
emerged on hedge accounting treatment as well as lack of internal control was apparent. But these
sanctions were lifted gradually beginning 2007 to utilize GSEs to address housing correction triggered by
subprime crisis.
    Further aggravating housing market, however, placed GSEs in the center of crisis in July 2008 when
their stock price plummeted because the uncertainty of their business model escalated. Congress in
coordination with Bush Administration enacted Housing and Economic Recovery Act (H.R. 3221) to
expand the Treasury line of credit and endow authority for Treasury to purchase stock of GSEs. Based on
this Act, GSEs are placed under conservatorship, but they are fulfilling their mission to sustain housing
market until the market conditions warrants. Simultaneously, reduction of portfolio size was proposed
after 2010 to limit systemic risk. But President Obama allowed GSEs to expand their portfolio by 50
billion each in his Homeowner Affordability and Stability Plan announced on February 18, 2009.

∗
    This article is based on a study first reported in the Kobayashi and Orui (2009), ‘GSE Kiki to sono Implication’,
    Financial Review,Vol.95, pp.64-92 (in Japanese).
370                                   M. Kobayashi, Y. Orui / Public Policy Review



  There are similarities and dissimilarities between the GSE crisis and this financial crisis as a whole.
This financial crisis highlighted the problems with regards to 1) risk management capability of individual
institutions 2) executive compensation mechanism and 3) regulatory framework and regulatory arbitrage.
1) includes A) mismanagement of ALM in funding long-term assets with short-maturity instruments by
SIVs and other vehicles resulting in the liquidity evaporation B) sudden increase of volatility in the price
of illiquid products such as subprime-mortgage backed securities resulting in the market liquidity crisis
and C) traditional credit risk which is the cause of all other problems. 2) relates to 1) in that compensation
mechanism did not take accounts of the risks mentioned in 1) and allowed executives to pursue
maximization of short term profit which was not commensurate with the longer term risk. 3) refers to the
case of non-depository institutions including Lehman Brothers and AIG which was not supervised by
FRB.
  In case of GSEs, 1-A) has been long discussed in the context of systemic risk. However, the GSE crisis
was not caused by the mismanagement of ALM risk. Although GSE did not have stable retail deposit and
depended on market for liquidity, their access to the capital market was not terminated, though adversely
affected to some extent. This differs from Bear Sterns or Lehman Brother. As for 1-B), they incurred some
loss from holding subprime PLS, but this loss was less crucial compared to the problems of 1-C) and 2.
The main cause of the GSE crisis is the increase of credit risk triggered by the declining home price which
spread to prime borrowers. Their executive compensation was linked to their profit as was the case of
many large financial institutions as well. Their compensation mechanism caused accounting scandal
around 2003. To some extent, they exposed themselves to riskier borrowers because they were required to
support low and moderate income bracket in accordance with their affordable housing goal. With regard
to 3), their regulator, OFHEO, was not capable of conducting as strict supervision as FRB and other
banking regulators. But the key issue is why politics allowed them to grow “too big to fail” in the form of
GSEs.
  This paper focused on the corporate governance of GSEs which contains fundamental ambivalent
value of public policy implementation and maximization of return to private shareholders. We also
analyzed the implication to the Japanese mortgage market which underwent significant structural reform
incorporating US model.


Keywords: GSE, Securitization, Corporate Governance
JEL Classification:G21, G28, G38
                      Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010                       371



I. What is GSE?

I.1. Definition of GSEs

   It is needless to say that the epicenter of the current financial crisis is the US housing market. The two
  (Government Sponsored Enterprise) namely Fannie Mae and Freddie Mac play a important role in
GSE                                s,
this market and remain so even after they are put under conservatorship of the federal regulator in
September 2008. But there are lot to study the process and cause of their current situation especially from
the viewpoint of corporate governance.


 Figure 1 What is GSE?


   Issuer of Agency MBS
   ※MBS issued or guaranteed by these entities are called “Agency MBS”, but Fannie                                      【GSE】
   and Freddie are not “Agency” but “Instrumentality”, in a strict sense.


                                                                                                                Farmer Mac
                                                                                                                Farm Credit System
      Ginnie Mae                     Fannie Mae               Freddie Mac                  FHLB                 Financing Corporation
                                                                                                                Resolution Funding Corporation

                                                                                                              ※Sallie Mae is not GSE any more
                                               Housing GSEs




 Government Agency,                                                                       Housing GSE, but
      Not GSE                                                                             ・Mutually owned
                                                                                          ・No Securitization


                                                                       (Source)Congressional Research Services, Library of Congress




   The concept of GSE is not popular in Japan and often translated as “Public Corporation”. However,
GSEs are different from public corporations in Japan which belongs to public sector. According to
Omnibus Reconciliation Act of 1990, GSEs are defined, among others, as follows; 1) a corporate entity
created by a law of the United States that has a Federal charter authorized by law; 2) is privately owned,
as evidenced by capital stock owned by private entities or individuals; 3) is under the direction of a board
of directors, a majority of which is elected by private owners; 4) is a financial institution with power to
make loans or loan guarantees for limited purposes such as to provide credit for specific borrowers or one
sector; 5) raise funds by borrowing (which does not carry the full faith and credit of the Federal
Government) or to guarantee the debt of others in unlimited amounts; and 6) does not exercise powers
that are reserved to the Government as sovereign (such as the power to tax or to regulate interstate
commerce).
   More generally speaking, GSEs are summarized as “Federally Chartered, Shareholder Owned”
corporations, meaning that private sector owns the equity but they have special connection with federal
372                                      M. Kobayashi, Y. Orui / Public Policy Review



government. There are 7 GSEs1) and 3 of them are housing –related. FHLB2) (Federal Home Loan Banks),
in addition to Fannie and Freddie, is the one. Another agency secuitization vehicle, Ginnie Mae, is 100%
owned by the federal government and is not classified as GSEs.
      MBS(Mortgage Backed Securities)issued or guaranteed by Fannie Mae, Freddie Mac and Ginnie
Mae are called “Agency MBS”. In a strict sense, Agency refers to a government body and is applied only
to Ginnie Mae. But traditionally, MBS backed by Fannie Mae and Freddie Mac are also called Agency
MBS. Ginnie Mae was separated from Fannie Mae in 1968 and remains a part of Department of Housing
and Urban Development (HUD). Ginnie Mae MBS carries “Full Faith and Credit of the Government of
the United States” while Fannie Mae and Freddie Mac MBS do not, which is clearly stated in their
Offering Circular and Prospectus. Market participants, however, believed in the “implicit guarantee by the
government”, which enabled GSEs to raise low cost fund.


I.2. Establishment of GSEs

I.2.1. Fannie Mae


      Fannie Mae’s history goes back to the Era of Great Depression. Great Depression triggered by the
plunge of the NY stock exchange in 19293) imposed devastating damage on to the US housing and
housing finance market. In order to address housing problem, FHA4) (Federal Housing Administration)
was established in 1934 and primary market credit enhancement was implemented. But more was needed
to extend loan to the borrower with more lenient terms – long term fixed rate mortgages. A possibility of
establishment of a new entity which provide liquidity to the mortgage market with such terms was
discussed on top of credit enhancement.
      Fannie Mae’s Charter is based in the same act with FHA (National Housing Act of 1934). Although
private sector equity provider was explored, none proposed such an offer. Hence, RFC (Reconstruction
Finance Corporation), a New Deal organization, subscribed the stock of Washington National Mortgage
Association in 1938. This association was renamed as Federal National Mortgage Association in the same
year. This is Fannie Mae that we see today. It is often said that President Roosevelt established Fannie
Mae. As of January 6, 1997, this corporation adopted “Fannie Mae” as the official name of the company.




1)
   There used to be one more, Sallie Mae, which converted into fully privatized enterprise on its own initiative to get
   more discretion on business judgment.
2)
   FHFB was created by the Congress in 1932 and consists of 12 regional banks as does FRB. It is cooperatively
   owned by member banks and its share is not listed in stock exchange. It is not engaged in securitization business
   either.
3)
   US economy was already in recession from August 1929.
4)
   FHA is another government agency whose main business is mortgage insurance. Majority of FHA insured loans are
   securitized by lenders to be guaranteed by Ginnie Mae. In such a transaction, credit risk of the borrower is born by
   FHA while Ginnie Mae guarantees timely payment to investors in case servicers fails to deliver cash.
                      Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010   373



I.2.2. Freddie Mac


       Freddie Mac was established in 1970 based on Emergency Housing Finance Act of 1970. Freddie
Mac was funded by the non-voting preferred stock by FHLB. Different as their sponsors and Charter,
Fannie Mae and Freddie Mac has similar authorities stipulated in their Charter and often called sibling
corporations. The full name of the Freddie Mac is Federal Home Loan Mortgage Corporation, but as with
Fannie Mae, Freddie Mac is more commonly referred.
       The purpose of establishing Freddie Mac was to provide liquidity to S&L (Savings and Loan
Association) and from historical perspective, Freddie Mac was more closely connected with thrifts than
commercial banks or non-depository mortgage banks. This is because the owner of Freddie is FHLB,
which is cooperatively owned by S&Ls. Freddie was established on top of Fannie not only to promote
competition among them but also Fannie had already established close relationship with commercial
banks an mortgage banks. S&Ls were dominant player in the field of mortgage origination at that time,
but they faced disintermediation in 1960’s and 70’s. There was a need to address liquidity problem of
S&Ls by refinancing their mortgage portfolio.
      The existence of FHLB as backstop for S&Ls, however, may have dictated the function of Freddie
Mac as issuer and guarantor of MBS. Freddie Mac started issuing MBS (PC5)) in 1971, the next year of
inauguration, which is 10 years earlier than Fannie Mae that was established much earlier.


I.3. Background of privatization

I.3.1. Fannie Mae


       The purpose of establishment of Fannie Mae was to make housing more affordable to low and
moderate income families by expanding maturity of mortgage and loan to value ratio. Fannie Mae
initially purchased FHA-insured mortgages with borrowing from The U.S. Treasury. In 1948, Fannie Mae
was authorized to purchase VA (Department of Veterans Affairs) -guaranteed mortgages and thus,
expanded its business gradually. In 1954, President Eisenhower decided to partially privatize Fannie Mae
by requesting private financial institutions which make deals with Fannie Mae to underwrite a certain
percentage point of shares of Fannie Mae.
       In 1960’s, there was a shortage of funding for mortgages and the U.S mortgage market saw the dawn
of securitization via legislative measures including the Housing and Urban Development Act of 1968.
Traditional policy-oriented undertakings of Fannie Mae were transferred to Ginnie Mae and the new
Fannie Mae as we know today was entirely privatized in 1970.
       Behind the partial privatization in 1954 was a criticism for expanding business coverage. Privatization
in 1968 was a bit different. In seeking to reduce the budget deficits associated with the Vietnam War and

5)
     Freddie Mac calls its pass-through security “Participation Certificate (PC)” instead of MBS.
374                                        M. Kobayashi, Y. Orui / Public Policy Review



Great Society programs, the (Johnson) administration hit upon the idea of “privatizing” Fannie Mae by
allowing the company to sell shares to the public. This, according to the budget theories of the time,
would take Fannie’s expenditures off-budget. .But turning Fannie into a wholly private company was not
acceptable either (AEI). There remained a special relationship with Federal Government, including 2.25
billion dollars line of credit from the US Treasury.
       US Treasury holding of preferred stock to Fannie Mae was retrieved by September 30, 1968 and
converted into common stock, which was listed at New York Stock Exchange as of August 1, 1970.


I.3.2. Freddie Mac


       FHLB paid in all capital of Freddie Mac at the incorporation of 1970. Since 1984, however, FHLB
commenced to transfer its holding of Freddie Mac’s share to its member Savings and Loan Associations6).
S&L financial position deteriorated through 1980’s and the S&L Crisis culminated to the collapse of their
deposit insurer, FSLIC in 1989. Elimination of restriction on transfer of Freddie Mac’s stock was intended
to alleviate the fiscal burden of cleansing S&L Crisis because by selling those shares in open market may
provide some capital gain to S&Ls.
       The shares of Freddie Mac were listed in NYSE as of December 2, 1988.


I.4. Regulatory Framework for GSEs before the crisis

 Figure 2 Regulatory Framework for Fannie Mae and Freddie Mac

                                                  Charter Act

                   ・National Housing Act of 1934 as amended in 1968 for Fannie Mae
                   ・Emergency Housing Finance Act of 1970 for Freddie Mac
                   ・Both are quite similar in the configuration of articles, albeit Fannie has a bit complicated one.
                   ・Charter Act defines mission, privileges, authority of the Board, business operation, conforming loan
                   limit, philosophy for executive compensation etc.
        Modify




                   Federal Housing Enterprise Financial Safety and Soundness Act of 1992

                   ・Common for Fannie and Freddie
                   ・Established OFHEO as a regulator for Fannie and Freddie.
                   ・Stipulated OFHEO shall monitor financial soundness of Fannie and Freddie while other regulatory
                   authority including those on Affordable Housing Goals were retained with HUD
                   ・OHFEO was required to establish capital standard for Fannie and Freddie.


                              The Housing and Economic Recovery Act of 2008

                   ・Abolished OFHEO to be replaced by Federal Housing Finance Agency (FHFA)
                   ・Regulatory authority of HUD on mission is also transferred to FHFA
                   ・Abolished Presidential appointment sheet of the board members (Number of board member is
                   decreased to 13 from 18.
                   ・Expanded the Treasury authority to buy GSE debt and endowed its authority to buy stocks of GSEs.



6)
     Membership of FHLB was limited to S&Ls in those days, but is now open to commercial banks.
                     Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010   375



       Regulatory Framework for GSEs underwent significant change after GSE Crisis emerged summer
2008. In this section, our analysis is focused on the previous regulatory framework which existed from
1992 to 2008, which was established by enactment of the Federal Housing Enterprise Financial Safety
and Soundness Act of 1992 (hereinafter refereed to as “1992 Act”). Authorities delegated to GSEs were
stipulated by respective Charters as is previously described. 1992 Act established OFHEO(Office of
Federal Housing Enterprise Oversight) to monitor the financial safety and soundness of the GSEs while
leaving general regulatory authorities on GSEs with HUD including Affordable Housing Goal. In other
words, OFHEO became the financial regulator of GSEs while HUD became the mission regulator of
them.
       OFHEO was mandated to establish capital standards to GSEs and introduced three categories in 1997,
namely, Minimum Capital Standard, Risk Based Capital Standard and Critical Capital Standard.
Minimum Capital Standard is calculated by aggregating the amount equivalent of 2.5%7) of mortgage
related assets held in portfolio plus 0.45% of outstanding MBS held by the third parties. Critical Capital
Standard is five-ninth of Minimum Capital Standard and GSE would have been placed under
conservatorship if it broke this threshold. Risk Based Capital Standard is calculated by conducting stress
test wherein housing price decline 10% at national average or interest rate spontaneously rises75% or
declines 50% from the current level. Under a certain circumstance, Risk Based Capital Standard can
exceed Minimum Capital Standard, but as of 2008 the latter was larger than the former.
       Although OFHEO is a part of HUD, its operational expense was not appropriated from the budget of
the federal government, but from the assessment on GSEs.
       HUD, on the other hand, had an authority to establish Affordable Housing Goal to promote
homeownership among medium and low income bracket. If GSE fails to meet these goals, HUD had
general regulatory authority to remedy such shortcomings or impose civil money penalty. Achievement of
these goals was one of the elements of consideration for computing executive compensation of GSEs as
well. This is unique to GSEs because ordinary shareholders do not require such social goals. Board
members are elected by shareholders to maximize return to them with such fiduciary duties. GSEs,
however, had 5 directors to be appointed by the President of the United States, whose fiduciary duties
may have had been to implement public missions. There seems to be a fundamental conflict of interest
even among the Board itself. In retrospect, rationale for GSE status was based on the confidence in
market discipline wherein achievement of affordable housing goal and maximization of profit via
portfolio investment business deeply interconnected with capital markets was believed to be compatible.
However, they became too big to fail because of funding advantage endowed by implicit guarantee by the
federal government.
       Freddie Mac was placed under supervision of HUD by FIRREA (Financial Institutions Reform,
Recovery, and Enforcement Act, leaving from the umbrella of FHLBB (Federal Home Loan Bank Board).
With this realignment, oversight of GSEs was unified under HUD considering that OFHEO is part of

7)
     Leverage ratio of Fannie Mae in 1960’s was limited to around 40 times.
376                                                  M. Kobayashi, Y. Orui / Public Policy Review



HUD. The authority and capacity of OFHEO was not as strong as other regulators such as Federal
Reserve. Initially, OFHEO had only 70 staff to monitor both GSEs, which contributed discretionary
management of GSEs by their senior executives.
      In order to address regulatory arbitrage which exacerbated irresponsible lending in subprime
mortgage, especially by brokers and independent mortgage companies licensed and regulated only by
state authorities, regulatory overall is proposed by Treasury8) to bring all mortgage origination under
single supervisory regime. Not being depository institutions, GSEs were not subject to federal regulators
such as Federal Reserve either, which comprised part of regulatory patchwork.


II. Business Model of GSEs

 Figure 3 Business lines of GSEs


         Fannie and Freddie are mandated to provide liquidity to mortgage market nationwide. They have two lines of
         business, namely “Portfolio Investment Business” and “MBS Credit Guarantee Business”. The former are subject
         to all risks associated with holding mortgages as are the case with investment banks while the latter are free from
         ALM risk because it is transferred to investors of pass-though certificate (MBS or PC).

                                                          GSEs combined                                              Investors
       Private label MBS backed by                                                     【Portfolio Investment Business】→capital requirement: 2.5%
       subprime mortgages are                            Mortgage Portfolio
       included to some extent.                                1.50
                                                                                      All risk associated
                                                     Whole Loan                       with mortgages
                                                       0.85                           remains with GSEs
                                                                        Bond                                            Bond
                                                       MBS              1.50                                            1.50
                                                       0.65
         Lenders                        5.28

                                                         Off-balance trust               Buy back to                Guarantee timely payment
                                                     4.43【mainly prime loans】            stabilize OAS              ※Credit risk remains with GSEs
                                                                                         or as a pure
                                                                                         investment
                                                     Mortgages          MBS                                             MBS
                                                       4.43             4.43                                            3.78

       ※Unit in Trillion dollars. As of Sep.2008
       ※Balance of bond is a bit larger than this.                                                                ALM risk transferred to investors
                                                                                      【MBS Credit Guarantee Business】→capital requirement: 0.45%




      In order to achieve their mission to provide liquidity to mortgage market and hence improve mortgage
affordability to low and medium income Americans, both GSEs deploy two line of business, namely
Portfolio Investment Business9) and MBS Credit Guarantee Business.


8)
    US Department of Treasury “Blueprint for a Modernized Financial Regulatory Structure” March 2008
   and ”Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and Regulation” June
   2009
9)
   This categorization is in accordance with that of Fannie Mae. Freddie Mac does not necessarily name the same, but
   since the substance of business is same, this categorization shall be used in this paper hereinafter.
                       Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010   377



II.1. Portfolio Investment Business

       Under Portfolio Investment Business, GSEs purchase mortgage products originated by private
financial institutions and replenish their positions. This is a sort of refinancing assistance for mortgage
lenders. GSEs issue debt securities to fund these mortgage related products including MBS. As assets held
in balance sheet generate turbulence in their cash flow by fluctuation of prepayment speed, this line of
business is subject to ALM (Asset and Liability Management) risks.


II.2. MBS Credit Guarantee Business

       Under the MBS Credit Guarantee Business, GSEs securities mortgages originated by private lenders
by utilizing trust wherein GSEs themselves are trustee, and return identical MBS to lenders. For lenders,
mortgages are swapped into MBS with credit enhancement by GSEs, and hence this program is called
MBS Swap Program (Fannie Mae) or Guarantor Program (Freddie Mac)10). Lenders may retain these
MBS in their balance sheets or may sell outright to other investors. If it is difficult to find investors by
themselves, lenders may turn to Fannie Mae or Freddie Mac as an investor, in which case GSEs may
retain those MBS in their balance sheets under Portfolio Investment Business. The benefits for lenders to
swap mortgages into MBS are higher liquidity and less capital requirement under Basel Accord. GSEs
bear credit risk of the mortgage pools because they guarantee timely payment on MBS, but are immune to
ALM risk because it is transferred to investors.
       In this regard, MBS Credit Guarantee Business was deemed to entail less risk than Portfolio
Investment Business and required regulatory capital was less than one-fifth of the latter. Anecdotally
speaking, Portfolio Investment Business was similar to the business of investment banks in trading
account with high leverage, while MBS Credit Guarantee Business was similar to monocline insurance.


II.3. Risk Management under both line of business

       As a method of immunize ALM risk associated with Portfolio Investment Business, GSEs issue
callable bond to counter prepayment from the borrowers when interest rate declines, which accounts for
30 to 40 percent of debt instruments, while GSEs hedge cash flow by utilizing derivatives such as
pay-fixed swap when interest rate surges. Notional principal amount of those derivatives varies depending
on market conditions, but basically, GSEs create liability position so as to immunize the optionality
embedded in the mortgage assets and thus maintain constant margin.




10)
      There are some portfolio securitizations, but it is not the major issuing style.
378                                         M. Kobayashi, Y. Orui / Public Policy Review



 Graph 1 Outstanding balance of long term debt of Fannie Mae by maturity


 (billions)
  600
                              Before exercising call option
  500

  400                              After exercising call option

  300

  200

  100

      0
           2008      2009   2010         2011       2012          2013

 *As of March 2009

 (Source) Fannie Mae Form 1o-K


      Fannie Mae implemented Portfolio Investment Business as its core operation since its establishment
in 1938 before it commenced MBS Swap Program in 1981. Although Fannie Mae was authorized to
implement MBS Credit Guarantee Business by legislation when it separated Ginnie Mae in 1968, Fannie
Mae did not implement securitization immediately contrary to Ginnie Mae or Freddie Mac, which
commenced securitization operation in 1970 and 1971 respectively. One reason for this is that Fannie
Mae was more comfortable with Portfolio Investment Business which seemed to generate more revenue
compared to MBS Credit Guarantee Business. However, the skyrocketing interest rate in the late 1970’s
to early 1980’s exacerbated the financial position of Fannie Mae and it incurred 200 million dollar loss in
1981. This forced Fannie Mae to engage in securitization business in 1981 with reluctance.
      As MBS market expanded, however, more diversified hedge tools became available and development
of financial technology enabled to contain ALM risk, which made Fannie Mae to more incline itself to
Portfolio Investment Business again. Many experts with other technological background including
aerospace entered into financial world. Advancement of computer technology also contributed to the
sophistication of risk management, all together made Fannie Mae more confident in their ALM.
      “Implicit guarantee” escalated their involvement in Portfolio Investment Business as well. Fannie
Mae started to launch “Benchmark Note Program” while Freddie Mac did the same under the name of
“Reference Note Program”, wherein they issued large amount of bullet bond as a substitute for US
Treasury bond whose issuance declined significantly amid of shrinking fiscal deficit in the late 1990’s,
thus supplementing the shape of long range yield curve. With these low cost funding, both GSEs could
expand their balance sheet. Associated ALM risk was mitigated by derivatives, and their net income
increased steadily. In the meantime, many financial experts in Wall Street were hired by GSEs. But such
pursuit of profit maximization per se did not violate the organizational rationale of GSEs. The problem
was found, however, in the accounting treatment of derivatives instruments which were executed to hedge
                            Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010   379



their mortgage portfolio against fluctuation of market conditions, especially interest rate and prepayment
activities by the borrowers. Flaws were identified in internal control as well, and their regulator,
OFHEO, imposed portfolio cap on Fannie Mae and Freddie Mac under consent order in 2004 and 2006
respectively.
   It is to be noted that most of the criticisms to GSE’s operation were focused on Portfolio Investment
Business. MBS Credit Guarantee Business which exposes GSEs only to the credit risk of the borrowers
did not gather as much attention as Portfolio Investment Business.


II.4. Operational results of both business lines

 Graph 2 Net Income of GSEs until 2007


 (billions)
  12
              Fannie Mae
  10          Freddie Mac

   8

   6

   4

   2

   0

  -2

  -4
       1971      1976       1981     1986     1991     1996     2001     2006


 (Source) OFHEO Report to Congress


   Fannie Mae and Freddie Mac made prosperous operational results throughout the 1990’s and in the
early 2000’s. Fannie Mae reported net income of 8 billion in 2003 while Freddie Mac reported 10 billion
in 2002. Both of them were recognized as excellent companies which outperformed other firms in steady
growth. However, both of them started to record quarterly loss since the third quarter of 2007 and their
stock price began to decline since then. Historically, Portfolio Investment Business which entails ALM
risk generated more profitability in exchange for higher risk profile, while MBS Credit Guarantee
Business was recognized fairly low-risk, low return business. However, recent operational losses are,
partly attributable to ALM risk, mainly caused by skyrocketing credit related expenses due to the
declining home price. This phenomenon deviates significantly from historical experience. Detailed
analysis will be covered in Chapter 5.
380                                                        M. Kobayashi, Y. Orui / Public Policy Review



 Graph 3 Nominal margin of both lines of business for Fannie Mae
      2.50%
                     MBS Credit Guarantee

      2.00%          Portfolio Investment


      1.50%

      1.00%


      0.50%

      0.00%


  -0.50%

  -1.00%
              1981           1986           1991    1996        2001        2006


 (Source) OFHEO Report to Congress


II.5. Accounting Scandal

 Graph 4 Duration gap of Fannie Mae

        10

                                                                       Assets have longer maturity
          5



          0



        -5
                                                                       Liabilities have longer maturity

      -10
                                                            Prepayment surged under huge refinance wave
                                                            →Rebalanced by calling callable debt etc.

      -15
         2001                       2002           2003           2004             2005          2006     2007   2008

 (Source)Fannie Mae “Monthly Summary”


      Starting 2003, concern was raised on the accounting treatment of both companies, and their regulator,
OFHEO, imposed limit on the size of portfolio they could retain (Portfolio Cap). OFHEO also imposed
30% surcharge on the capital requirement on top of statutory level. The accounting scandal related mainly
to Portfolio Investment Business. Both of them uses huge amount of derivatives instruments to hedge
their position against market fluctuations. These derivatives instruments are subject to fair value
                      Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010   381



accounting in accordance with SFAS 133, and mark to market loss must be recognized in the income
statement, not at an accrual base. But if fair value accounting is applied, their net income may fluctuate
significantly because of the size of the notional principal amount of such derivatives, and both of them
violated SFAS 133 to smooth their income. They did the same on the accounting treatment on premiums
and discounts of mortgages they purchased other than par price, which constituted the violation of SFAS
91. These mistreatments were intended to show their investors that they are companies with stable growth.
Fannie Mae paid 400 million and Freddie Mac paid 125 million civil money penalty for these violations.
These fair value accounting matters only to Portfolio Investment Business, not to MBS Credit Guarantee
Business.
   Background for misconducts in accounting treatment was related to executive compensation
framework which was linked to the financial performance of the corporation, which allured the executives
to show stable growth to shareholders. However, refinance boom in 2003 aggravated the situation. With
the significant decline of long term interest rate, prepayment on outstanding mortgage skyrocketed which
made adverse impact on the fair value of GSE’s retained portfolio. In case of Fannie Mae, duration gap
between assets and liabilities widened to negative of 14 months in the autumn of 2003. In order to
rebalance the duration mismatch, Fannie Mae exercised the call option embedded in callable bonds with
success. However, in such a circumstance, fair value of derivatives instruments plummeted that were
purchased for the purpose of cash flow hedge. The price of pay-fixed swap and swaption had to be
marked down, which might have had a significant negative impact on net income. And hence, Fannie
Mae did not recognize such losses in income statement against accounting rule. Hedge accounting was
allowed only when hedging instruments and hedged assets are matched, which was not the case here.


II.6. Leverage level of GSEs

 Graph 5 Leverage level of GSEs
  200
                                                              Fannie Mae
                                                              Freddie Mac
  150


  100


   50


    0
        1971   1976      1981      1986     1991      1996     2001      2006

 (Source) OFHEO “Report to Congress”
382                                          M. Kobayashi, Y. Orui / Public Policy Review



      The leverage ratio of GSEs, assets per capital, was in no doubt higher than other financial institutions
because statutory capital requirement on GSEs was more lenient than banks. However, their high leverage
ratio did not increase significantly during recent years. From historical perspectives, their leverage ratio in
recent years is much lower than those in 1980’s and 1990’s. Fannie Mae placed more emphasis on
Portfolio Investment Business than MBS Credit Guarantee Business. For retained portfolio, required
capital used to be 2.5% of the outstanding mortgage assets since 1970 when Fannie Mae was privatized.
Throughout the 1970’s, leverage ratio for Fannie Mae did not exceed 40.
      Contrary to Fannie Mae, Freddie Mac commenced securitization before they expanded portfolio
investment because Freddie Mac was founded by FHLB. This resulted in higher leverage ratio compared
to Fannie Mae, which exceeded 100 in the beginning of 1980’s. Maximum leverage ratio theoretically
applicable is 222 if later-introduced OFHEO minimum capital requirement for MBS Guarantee Business
is applied. 222 is the reverse of 0.45%.
      Compared with other large financial institutions, their leverage ratio as of 2007 was higher than
commercial banks, but was at a similar level of investment banks. If off-balance MBS they guarantee is
added on the basis for calculation, their leverage ratio exceed investment banks, but it is the investors of
those MBS, not the GSEs, that bears the market risk of MBS.


 Graph 6 Comparison of leverage level as of 2007
  90
  80                                Leverage ratio skyrockets for
  70                                GSEs when off-balance
                                    guranteed MBS is included
  60
  50
  40
  30
  20
  10
      0
          Fannie   Freddie   Citi       Bank of    Goldman     Morgan
           Mae      Mac                 America     Sachs      Stanley

 (Source)OFHEO, SEC
                   Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010               383



Box 1 Special feature of Fannie Mae’s income statement


    Fannie Mae’s “book of business” is around 3 trillion dollars, of which 700 billion plus is the
mortgage related assets held in their balance sheet. Fannie Mae bears the credit risk of the borrower’s
defaults on their mortgage obligations, which amounts 3 trillion. However, when it comes to ALM risk
associated with interest rate fluctuation, their exposure is limited to 700 billion. Traditionally,
arguments related to their systemic risk were focused on their portfolio investment. Current crisis,
however, is rooted in the credit risk management rather than ALM risk. MBS Credit Guarantee
Business that was thought to be safer proved to be the cause of the trouble due to unexpected decline of
housing price since the Great Depression.


Table 1 Business Volume of GSEs

                                                                                                                          (billion)
                                                                           Fannie Mae             Freddie Mac              Combined
Retained Mortgage Portfolio                        ①=②+③                        792.196                    804.762         1,596.958
       Own MBS                                     ②                            228.950                    424.524           653.474
       Whole Loans and others                      ③                            563.246                    380.238           943.484
Outstanding Balance of MBS                         ④=②+⑤                     2,518.409                  1,827.238          4,373.456
       Held by others                              ⑤                         2,289.459                  1,402.714          3,719.982
Book of Business                                   ⑥=①+⑤                     3,109.464                  2,207.476          5,316.940

(Source) FHFA “Report to Congress”


Graph 7 Fair Value of Derivative Instruments


(billion)
  60                                                                   12

  40                                                                   8

  20                                                                   4

   0                                                                   0

 -20                                                                   -4
            Pay-fixed
 -40        Receive-fixed                                              -8

 -60        Others                                                     -12
            Total (RH)
 -80                                                                   -16
            2006                  2007                  2008

(Source) Fannie Mae
384                                           M. Kobayashi, Y. Orui / Public Policy Review



       But recent financial statements shows more fluctuation in segment earnings on Portfolio Investment
 Business because fair value accounting on derivatives. Notional principal amount of derivatives is 1.25
 trillion as against 700 billion portfolios, the larger reason for which is two-way positioning. Among
 two-way position, cash flow hedge instruments such as pay-fixed swap exceed fair value hedge
 instruments such as receive-fixed swap because major instruments of fair value hedge is the exercise of
 call option embedded in callable bonds. If interest rate declines, the fair value of pay-fixed swap etc.
 declines while the callable bond is just called. There is no recognition of fair value of callable bond at a
 premium to offset the decline of pay-fixed swap because it is bond, not derivatives. There is
 asymmetric feature of derivatives position due to the existence of callable bond. In a declining interest
 environment, their loss on portfolio investment tends to expand, which has been the case for these
 several quarters.
       The use of callable bond is to dynamically reposition the liability structure in order to immunize fair
 value change in the asset side caused by prepayment of the borrowers. It is ironic that the existence of
 callable bond is the cause of large swing of Portfolio Investment Business whose purpose was to
 stabilize income regardless of market condition. Compared to Fannie Mae, Freddie Mac has more
 securities than whole loans in their portfolio, which also affect the financial result.


 Figure 3 Image of ALM

                                         【Assets】                 【Liabilities】
                                                                                              Funding cost rise when interest rate rises

                                   Aggregate Amount
                                                                Short term debt                           Cash flow hedge
                                       912.404                                                           by pay-fixed swap
                                                                   330.991
                                                                                                        in case interest rate
                                  Majority of these are                                                         rises
                                  Fixed rate mortgages
                                        And MBS                 Long term debt                                       Apply
                                                                   539.402
       Interest rate
     declines trigger
                                     Exercise call
    fair value losses                                         Of which, callable        N/A
                                       option of
  on assets because                                                                                       Mark to Market
                                    callable debt if              192.480
   of prepayment by                  interest rate
      the borrowers                    declines




 *Figures are in billions for Fannie Mae at the end of 2008



III. GSE Crisis and Bailout

III.1. Early stage of subprime crisis

      Subprime crisis became so notorious to ordinary citizens when BNP Paribas refused to redeem the
funds in August 2007. At that time, both GSEs were still making profit on a quarterly base. In August
                        Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010   385



2007, Mr. Daniel Mudd, the CEO of Fannie Mae at that time, proposed to expand its portfolio to address
liquidity squeeze in the US mortgage market, which was supported by Congressman Barney Frank and
Senator Christopher Dodd. Congressional debate on GSE reform bill was stagnant at that time, and it is
easy to imagine that GSE had an incentive to help the ailing market in exchange for getting political
support to direct the course of the debate more favorable to them.
       If they were authorized to implement rescue package immediately, they could have prevented further
deterioration of mortgage market at that time since they were still not in red. It was too late when they
were authorized to do so in 1st quarter of 2008. They already started to record losses. The reluctance of the
authorities to give go signal immediately was the reflection of their concern on the capacity of GSEs
because both Fannie Mae and Freddie Mac had not completed restatement of their financials. Bush
Administration was inclined to depend on the initiatives taken by FHA or HOPE NOW Alliance in vain.
In August 2007, Chairman Bernanke of FRB made negative comments on the expansion of GSE’s
portfolio and Director Lockhart officially declined the request from Daniel Mudd11).


III.2. Before the GSE Crisis

  Graph 8 OAS and share of MBS retained in portfolio
      250                                                                   50%



      200                                                                   40%
                               OAS(LH: bp)


      150                                                                   30%



      100                                                                   20%



       50                % of MBS retained in                               10%
                            portfolio(RH)

        0                                                               0%
        1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009


  * OAS(Option Adjusted Spread) is for FNCL6.0

  (Source) OFHEO, Bloomberg


       Amid of mounting concern on monoline insurance companies and retreat of DeCoupling advocacy in
the early 2008, Economic Stimulus Act (H.R. 5140) was enacted on February 13, 2008. This Act
authorized the lifting of conforming loan limit from $417,000 to $729,750. Since then, the capacity of
GSE’s was dramatically expanded.
       First, portfolio cap on Fannie Mae which was set at around 730 billion was removed as of March 1,
2008 because they completed to catch up financial statement reporting12). Next, OFHEO directed

11)
      However, 2% increase was permitted as of September 19, 2007.
12)
      Freddie Mac agreed with OFHEO to limit its portfolio size based upon consent order, but it was not mandatory as
      was the case with Fannie Mae.
386                                   M. Kobayashi, Y. Orui / Public Policy Review



minimum capital requirement which was set 30% higher than statutory level was alleviated to 20% excess
as of March 19, 2008. This measure was expected to bring 200 billion liquidity to US mortgage market.
      Expansion of portfolio limit means for GSEs to have more capacity for MBS market operation, which
may be analogous to the market operation function of central banks. The portfolio cap imposed after
accounting scandal discouraged them to absorb excess supply of MBS even when the spread was
widening, which made the mortgage note rate remain high. Lifting the portfolio cap was thought to bring
the mortgage rate down, but it was too late. What was effective in 2007 was not the case in 2008.


III.3. GSE Crisis in July 2008

      When Bear Sterns, the fifth largest investment bank in the US, faced liquidity crisis in March 2008,
Federal Reserve Bank of New York extended credit to it via JP Morgan Chase based on its authority
under Article 13(3) of Federal Reserve Act. Disorderly failure was avoided and this extraordinary
treatment gave some comfort to financial industries. Perception that too big to fail theory was maintained
spread and market stabilized for a while.
      In the meantime, however, housing price continued to decline and delinquency ratio continued to rise.
In such a circumstance, stock of Fannie Mae and Freddie Mac plummeted in July 2008 and GSE Crisis
exploded.


III.3.1. Housing and Economic Recovery Act of 2008 (HERA)


      The first event that triggered GSE Crisis was the release of report by Lehman Brothers which
indicated that Fannie Mae and Freddie Mac need to raise 75 billion equity if amendment of accounting
rule applied. This report mentioned that amendment of FAS 140 may require GSEs to consolidate MBS
that are guaranteed by them but are not booked on their balance sheet. This report was just on simple
mathematics, and did not focus on risk analysis or any other intrinsic issues. James Lockhart, OFHEO
Director, repealed this allegation that the regulator had no intent to require GSEs more capital even if
accounting rule were amended. However, this was enough to trigger loss of confidence in GSE’s financial
conditions. What made situation worse was a remark by William Poole, Former Governor of Federal
Reserve Bank of St.Louis, who had been known as a critics on GSEs. He said in an interview with
Bloomberg that they were insolvent under fair value accounting. This intensified fear.
      And these triggered panic sale of GSE stocks. Although Fannie Mae raised new capital through equity
sales, it got further difficult for Freddie Mac to raise additional capital. If new capital raising were
unsuccessful, they could not fulfill their mission to provide liquidity to mortgage market because of
capital constraints. After the Paribas Shock in August 2007, private label securities issuance virtually
stopped, and if the liquidity provision by GSE were to stop, there would be no entity that can support
already ailing housing market. If home purchase becomes less affordable because of financial constraints,
it would cause decline of housing price due to weaker demand, which in turn increase the bad assets for
                        Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010   387



financial institutions because loss severity increases. Thus, US economy could have fallen into adverse
feedback loop.


 Graph 9 Stock price of GSEs
     100
                                                                 Fannie Mae
     90                                                          Freddie Mac
     80

     70

     60

     50

     40

     30

     20

     10

      0
      2000     2001   2002   2003   2004   2005    2006   2007     2008       2009



 (Source) Bloomberg


      On the other hand, outstanding amount of GSE debt and their MBS exceeded 5 trillion US dollars,
and it was unacceptable to allow them to fail in a disorderly manner. No doubt they were too big to fail.
Foreign investors including central banks held nearly 1.6 trillion Agency MBS and GSE debt because
they enjoyed high reputation only second to US Treasury Securities. If default occurred with these
instruments, it would have shaken confidence in the United States of America itself. Bush Administration
and US Congress suddenly added new articles to a bill under deliberation in the Congress and it was
enacted on July 30, 2008 as Housing and Economic Recovery Act of 2008 (HERA), H.R. 1427.
      HERA includes articles relating to modernization of FHA, but what are important in this context are
as follows;
1.         HERA authorized the US Treasury to inject capital into GSEs.
2.         HERA authorized the US Treasury to expend credit to GSE without ceiling (this was limited to 2.25
           billion under Charter Act).
3.         HERA abolished OFHEO and established Federal Housing Finance Agency (FHFA).
4.         FHFA shall establish new capital requirement for GSEs and work close to FRB.
5.         FHFA shall have the authority to place GSEs under receivership (there was no stipulation on
           receivership under previous regime. Only conservatorship was possible).


III.3.2. Conservatorship


      Among the articles of HERA, US Treasury authority to purchase stock of GSEs had special
importance since this relates to the very status of GSE itself. If Treasury invests in GSEs, interest of
shareholders might be infringed upon, or shareholders might be wiped out. It was not clear immediately
after the enactment of HERA if the existing shareholders may or may not be protected and the stock price
388                                                            M. Kobayashi, Y. Orui / Public Policy Review



of GSEs fluctuated when there arose rumors regarding how the Administration reacts. In this uncertainty,
foreign investors sold Agency MBS and GSE debt and concerns were raised on the roll over of GSE’s
debt scheduled in September.


 Graph 10 Issuance of MBS by issuer type

 (billion)
  300
                Agency MBS

  250           Private Label Securities


  200



  150



  100



      50



       0
       2006/1          7        2007/1     7          2008/1         7       2009/1


 (Source) SIFMA


 Graph 11 Net foreign purchase of Agency securities

 (billion)
      50
      40
      30
      20
      10
       0
  -10
  -20
  -30
  -40
  -50
     2005                    2006              2007                2008

 (Source) US Department of the Treasury


       It was the time to take action for the Treasury and FHFA. In order to achieve three objectives -
providing stability to financial markets, supporting the availability of mortgage finance, and protecting
taxpayers -both by minimizing the near term costs to the taxpayer and by setting policymakers on a
course to resolve the systemic risk created by the inherent conflict in the GSE structure, FHFA placed
Fannie Mae and Freddie Mac under conservatorship as of September 6, 2008. Director James Lockhart
appointed FHFA as the conservator and management of Fannie Mae and Freddie Mac was revamped.
Authority of board of directors and shareholders was suspended and was replaced by FHFA. Maximum
amount of preferred stock purchase agreed was 100 billion dollars each and in exchange for initial 1
                        Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010                 389



billion investments13), Treasury received warrants to take 79.9% stakes. All political activities, including
all lobbying, were halted immediately.
       On October 9, 2008, FHFA announced to suspend capital classifications of Fannie Mae and Freddie
Mac during the conservatorship, in light of the United States Treasury’s Senior Preferred Stock Purchase
Agreement. On November 25, Federal Reserve announced to purchase 500 billion Agency MBS and 100
billion GSE debts. To provide greater support to mortgage lending and housing markets, the FOMC
decided on March 18, 2009,to increase the size of the Federal Reserve’s balance sheet further by
purchasing up to an additional $750 billion of Agency MBS, bringing its total purchases of these
securities to up to $1.25 trillion, and to increase its purchases of GSE debt by $100 billion to a total of up
to $200 billion (In November 2009, GSE debt purchase cap was reduced to 175 billion).
       Under the conservatorship, it was not required of GSEs to unwind business volume. Rather, they are
expected to continue providing liquidity to the mortgage market to improve market conditions. After 2010,
size of portfolio holdings will be turned to decrease, eventually to one third of current position, thus
alleviating systemic risk to financial market as a whole. More precisely, GSEs can not increase debts
beyond 110% of June 30, 2008 level without consent of the Treasury, and new ceilings on their mortgage
portfolio shall be 850 billion until the end of 2009, which shall be wound down by annual rate of 10%
until it reaches 250 billion. The future role of GSE is a matter that Congress shall decide.


III.3.3. Under Obama Administration


  Figure 4 Federal assistance to GSEs


                                                                                                      Treasury line of credit
                                                                                                      2.25 bil. (1968~)→Unlimited(2008/7/30)
                                                                                                      ※Not exercised
                                             【Assets】                        【Liabilities】
      Conforming loan limit                                                                           Purchase of Debt by FRB
                                           Portfolio Cap                                              139.841 bil.(Max 200 bil.:2009/3/18)
        $417,000(2007)
              ↓                        727.7 bil (2006/5/23)
      $729,750(2008/2/13)                 ※Fannie Mae
                                                                              【Capital】               Capital Standard(OFHEO→FHFA to set)
              ↓                                  ↓
      $625,500(2008/7/30)              Abolished(2008/3/1)
                                                                        Treasury’s Investment         2.5% of Assets+0.45% of MBS(1997~)
              ↓                                  ↓                                                    →+30%(2006/5/23)
      $729,750(2009/2/18)               850 bil.(2008/9/7)
                                                                      100 bil. each (2008/9/7)        →+20%(2008/3/19)
                                                 ↓                   →200 bil each (2009/2/18)        →+15%(2008/5/19:Only for Fannie)
                                        900 bil.(2009/2/18)
                                                                                                      →Abolish(2008/10/9)
              LTV
                                                                       Freddie received 51.7bil.
                                                                       Fannie received 60.9bil.
             80%
              ↓
        105%(2009/2/18)                                                                               Purchase by Treasury
              ↓                                                                                       192 bil. (No specific ceiling)
        125%(2009/9/1)
                                               Off-balance MBS guaranteed by GSEs                     Purchase by FRB
                                                                                                      776.868 bil. (Max 1,250 bil.:2009/3/18)
                                                                                                      ※Actual figure is as of 2009/11/6




13)
      This represents liquidation preference and does not mean that Treasury paid 1 billion cash each.
390                                     M. Kobayashi, Y. Orui / Public Policy Review



      One week after GSE’s being placed under conservatorship, Lehman Brothers, the forth largest
investment bank, collapsed without any federal assistance. Financial market was put under extreme stress
and real economy also contracted abruptly. Dozens of measures were taken to stabilize financial market to
avoid meltdown of the system, including TARP (Troubled Assets Relief Program) under EESA
(Emergency Economic Stabilization Act of 2009). During the autumn to winter of 2008, most policy
measures were focused on rescue operation to financial market, not to the mortgage borrowers. But the
root cause of the crisis stemmed from the housing market. One month after the inauguration of President
Obama, new initiative to address housing problem was launched. Homeowner Affordability and Stability
Plan (HASP) was announced on February 18, 2009. HASP comprise of two major program; Home
Affordable Modification Program (HAMP) and Home Affordable Refinance Program (HARP).
      Under the HARP, GSEs are encouraged to allow homeowners with negative equity to refinance by
expanding LTV from 80% to 105% (125% after September 2009). Borrowers with underwater mortgages
who cannot refinance otherwise can benefit from refinancing into lower rate mortgages, which could
contribute to avoid unnecessary foreclosure. It was estimated that 4 to 5 million borrowers would benefit.
Simultaneously, Treasury amended the Preferred Stock Purchase Agreements, contractual agreements
between the Treasury and the conserved GSEs designed to ensure that each company maintains a positive
net worth, to $200 billion each from their original level of $100 billion each. This expansion of Treasury’s
authority is based on HERA, not on EESA that created TARP. Portfolio cap of GSEs was also expanded
to 900 billion from 850 billion each.


IV. Perspectives of Governance

      With regard to the corporate governance, problems can be categorized into two; regulatory framework
and very status of GSE.


IV.1. Problems on regulatory framework

Outstanding balance of the debts and MBS issued or guaranteed by GSE exceed 5 trillion combined, but
they were not subject to supervision by FRB or other bank regulators. Their capital requirement was
unique, which is different from Basel Accord. On this point, convergence of regulatory framework is
discussed on a broader horizon of financial industry, not to mention that patchwork of the regulation
allowed state licensed mortgage banks or brokers to engage in predatory lending in subprime mortgage.
However, considering that many commercial banks under supervision of FRB and other federal banking
regulators were not immune to mismanagement of risks, convergence of regulatory framework per se is
not enough to stabilize financial system, although it is necessary. New regulatory framework for
systemically important financial institution is proposed under the Treasury’s comprehensive regulatory
revamp announced in June 2009, but there are oppositions to make FRB the primary regulator from both
sides.
                     Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010   391



IV.2. Problems stemmed from GSE Status

       Problems stemmed from GSE status can be categorized into two; Since GSE had to pursue two
conflicting interests – public mission and shareholder return – they
1.      accommodated borrowers with higher risk profiles
2.      put more emphasis on short term profit in stead of long term risk management.


IV.2.1. Increase of riskier borrowers


       GSEs are required by HUD to achieve Affordable Housing Goal14), which set criteria that certain
portion of mortgages they purchase or guarantee must be allocated for medium and low income bracket,
etc. If they do not achieve the goal, HUD Secretary may issue cease and desist order, and in a
extraordinary case, may charge civil money penalty based on 1992 Act. Achievement of Affordable
Housing Goal was also one element of deciding executive compensation. In this regard, in order to
achieve public mission, they might have increased their exposure to riskier borrowers.
       In principle, borrowers for conforming loans are categorized as prime, but Alt-A and subprime
combined comprised nearly 10% of book of business for Fannie Mae and Freddie Mac. These 10% of
borrowers accounted for nearly half of credit related loss for both GSEs.
       Why did they expose themselves to such riskier borrowers? One reason was for yield. The other was
to achieve public mission to some extent. But they did so not just to achieve Affordable Housing Goal. By
pretending to be the supporter of homeownership for low-income borrowers, they could get political
support to protect GSE status. Their share in the mortgage market declined between 2004 and 2006
because of subprime origination skyrocketed by private sectors. The erosion of market share decreased
the raison d'tre of GSEs. Against these background, GSE had to increase purchase of riskier borrowers.


Table 2 Fannie Mae’s exposure to Alt-A and Subprime as of December 2008

                                                                                   (billion)
                          Whole Loan                     PLS                      Total
  Alt-A                             295.62                     27.86                  323.48
  Subprime                            19.09                    24.55                    43.64

(Source)Fannie Mae




14)
      For example, Fannie Mae was required to invest 55% of its fund into medium and low income families in 2007.
392                                     M. Kobayashi, Y. Orui / Public Policy Review



IV.2.2. Pursue of short term return


      Although they had to achieve public mission, they had to maximize return to shareholders, which is
unavoidable need as a privately owned corporation. It was natural that they focused on Portfolio
Investment Business which historically yielded higher return in normal condition.
      One thing to be noted, however, is that the asset and liability management of GSEs was quite different
from SIVs (Structured Investment Vehicles) or investment banks which arbitrated the mismatch of
duration on both side of balance sheet. Although GSEs do not clearly set a target range for duration
mismatch15), actual duration gap is contained in a couple of month range after 2004. In this regard, it is not
too much to say that their failure was not due to mismanagement of ALM even though they faced
liquidity constraint to some extent. Their failure was mismanagement of credit risk16).
      After the refinance boom of 2003, in order to show to the shareholders that they are steadily growing
companies, they might though that it might be necessary to increase mortgage which carried higher yields.
If home price continued to appreciate, their bets may have proved to be a success, which was not the case.


IV.3. Why they could maintain GSE Status

      It is no doubt that GSE status contains intrinsic conflict of interests, but the question remains; Why
could they keep GSE status?
      The answer is that every party concerned was happy except for outsiders. Homeowners were happy
because they could purchase a house with low interest rate mortgage which otherwise was not affordable.
Shareholders of GSEs enjoyed high dividends and capital gain in some case. Administrations were happy
with the increase of homeownership which could tender stability to society as a whole17). GSEs
themselves, through implicit guarantee by the government, could fund cheaply and enjoyed relatively
high interest margins, which was the source for high executive compensation18). They never dreamed of
repealing GSE status by themselves. Rather, they resisted any challenge to tighten regulation proposed
mainly by Republicans. They are known to be the prominent lobbying entities in the Capital region.
During the Bush Administration, they are said to have increased their lobbying expenses to Republicans.
There were strong opponent to GSEs such as Congressman Richard Baker (R. LO). When Hurricane
Katrina hit Louisiana, however, it was proposed that Affordable Housing Trust Fund should be created to
assist reconstruction of the area hit by the Hurricane. This Fund was supposed to be funded by the


15)
    Fannie Mae used to limit the duration gap within 6 month range before, but abandoned such a policy.
16)
    After the GSE crisis, however, it became difficult for them to issue longer term debt, hereby increasing their
    dependence on derivative instruments to rebalance the duration gap. The increased position of pay-fixed swap may
    have caused fair value losses amid of accomodative monetary policy.
17)
    Under the advocacy of Ownership Society, GSE loosened underwriting criteria by introducing “Expanded
    Approval”.
18)
    Executive compensation was subject to approval by the Director of OFHEO, but was in line with other large
    financial institutions to retain talented managers.
                         Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010   393



assessment to GSEs. It was a good bargain for GSEs to loosen other regulatory or supervisory clauses.
       One conditionality for conservatorship in September 2008 was the immediate ban of lobbying
activities by GSEs. They could orchestrate such heavy lobbying activities because they were rich. They
were rich because they could generate massive net income from Portfolio Investment Business. What
they strongly opposed was the limit of portfolio holdings. Even if FRB had warned systemic risk, FRB
had no authority to regulate the activities of GSEs.
       However, most of the discussion of systemic risk were focused only on Portfolio Investment Business.
When Fannie Mae requested OFHEO during the aftermath of Paribas Shock in August 2007 to lift
portfolio cap set after the accounting scandal, Mr. Bernanke, the Chairman of FRB, said that GSE could
contribute to provide liquidity to mortgage market by decreasing portfolio holdings and increasing MBS
guarantee because latter required less than one fifth of regulatory capital of the former. Minimum Capital
Standard is computed by multiplying 2.5% of retained mortgage portfolio plus 0.45% of guaranteed MBS.
This statement implies that Mr. Bernanke had imagined that MBS Guarantee Business is safe.
       As is discussed, the major reason for the failure of GSEs is the decline of housing price which
exacerbated the loss severity for defaulted prime borrowers. Fannie Mae reported 58.7 billion losses in
2008 among which credit related loss accounts for 27.1 billion19). MBS Credit Guarantee Business was
not as safe as was assumed. (This became more obvious in 2009)


  Graph 12 Losses of Fannie Mae by business segment

  (billion)
      35
             Credit related losses
      30
             Fair value losses
      25     Investment losses

      20

      15

      10

       5

       0
            2004          2005        2006        2007         2008


  (Source) Fannie Mae


       There was a traditional “Agency” problem for their increased exposure to riskier borrowers while
expanding market share by taking advantage of implicit guarantee by the government. Executive
compensation and dividend to shareholders were linked to the performance of the companies. This gave
incentives for the managements and shareholders to maximize profits. Losses, if incurred beyond a


19)
      According to 2009 3rd quarter earnings report, total deficit was 90.2 billion in fair value balance sheet, of which
      guarantee obligation accounted for 111.9 billion. This illustrates that the problem with Fannie Mae is not related to
      ALM but to credit risk management.
394                                   M. Kobayashi, Y. Orui / Public Policy Review



threshold, may be transferred to taxpayers. It was reasonable for managements and shareholders to take
risks. This is the same for banks to which deposit insurance is applied. Under such circumstances, the
concept of monitoring by shareholders makes no sense for a large institution. There is an argument that
mutual ownership like FHLB is more suited to contain agency problem than shareholder owned
corporation.


V. How GSE Crisis affected the financial crisis?

      There are two elements to be mentioned how GSE crisis affected the financial crisis. One is it became
the detonator to the financial crisis that occurred after September 2008. The other relates to the US
housing market which was the root cause of the entire crisis.


V.1. Detonator to financial crisis

      After Bear Sterns was merged by JP Morgan Chase with assistance from Federal Reserve Bank of
New York in March 2008, complacency spread among financial industry that worst was over and it was
perceived that the principle of “too big to fail” was maintained. But housing price which was the root
cause of the subprime crisis continued to decline in the meantime. The deteriorating market condition in
the US housing market aggravated financial position of Fannie Mae and Freddie Mac inevitably because
they were located at the center of the US housing market. Both Fannie Mae and Freddie Mac were placed
under conservatorship as of September 2008, which fostered concept that too big to fail was applied again.
From the viewpoint of financial regulator, such expectation is nothing but moral hazard. Further
endorsement of too big to fail was not acceptable, and the authorities declined to extend assistance for
Lehman Brothers.
      Had GSEs failed disorderly, the impact should have been by far larger than the collapse of Lehman
Brothers, although it may be nonsense to compare them. Nonetheless, decision making on government
intervention may have been affected to some extent by the failure of GSEs. Refusal to bailout Lehman
Brothers triggered loss of confidence among financial industries to their regulators, and counterparty risk
heated up due to heightened unpredictableness. In this respect, the failure of GSEs was the detonator of
the wide spread financial crisis. It would be recorded as a case of systemic risk realization, although in a
different manner that FRB presumed.
      Financial position of Freddie Mac was worse than Fannie Mae in the summer 2008 because Fannie
Mae raised new capital by issuing preferred stock in May 2008. It became even difficult for Freddie Mac
to raise new capital amid of concerns on its future, and it was not feasible to place only Freddie Mac
under conservatorship and allow Fannie Mae to remain standing on its own. One of the reasons for the
establishment of Freddie Mac in 1970 was to prevent monopoly by Fannie Mae, and existence of rival
was regarded as positive to encourage competition. In duopoly, there may exist a sort of weak link, which
can lead to contagion effect. In structuring a financial system, such contagion effect must be addressed in
                  Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010   395



creating similar institutions.
    The failure of GSE was at the same time the starting point of configuring regulatory revamp of
systemically important financial institutions. Failure of GSEs, Lehman Brothers and AIG accelerated the
discussions on regime for orderly wind down of non-bank institutions, which was proposed by the US
Treasury in March 2009.


V.2. Impact on housing market

    As was noted, half of the credit related losses of GSEs come from Alt-A and subprime exposure, but
remaining half come from prime borrowers which comprise vast majority of their business. Seriously
delinquent ratio for prime borrowers is one tenth of subprime borrowers, but declining housing price
affects the same way. Increased loss given defaults is the major cause of the credit related losses for them.
The failure of GSEs illustrates the contagion of subprime segment to broader housing market.
Unemployment rate in the US has risen close to double digit, and this would increase the default of prime
borrowers in a traditional manner. Their default pattern is different from subprime borrowers who easily
defaulted just because there was no expectation of capital gain and returned the key to walk away from
the property. Without the recovery of job market, the default ratio for GSEs would continue to increase.
    There is another aspect of GSE crisis in relation to financial crisis. Were GSEs the victims of the
housing bubble or the cause of the bubble?


 Graph 13 Share of GSEs per origination
  60%




  50%
                                        declined during
                                         housing boom

  40%




  30%
        2000   2001   2002    2003    2004     2005    2006     2007

 (Source) Inside Mortgage Finance Publications “The 2009 Mortgage Market Statistical Annual”


    There is no dispute that they provided liquidity to the mortgage market, which accelerated the home
price appreciation. The question is if the acceleration was beyond the reasonable threshold to boost bubble
or not. The important fact here is that the share of GSEs declined amid of housing bubble during 2004 to
2006. The background for this erosion of share was the existence of conforming loan limit. In 2007, they
were not authorized to purchase mortgages above $417,000. Conforming loan was not available where
home price skyrocketed such as California. In this regard, conforming loan limit worked counter cyclical
to housing bubble.
396                                     M. Kobayashi, Y. Orui / Public Policy Review



 Box 2 Comparison with Jusen and S&Ls


        Failure of GSEs to invest in Alt-A and subprime mortgages is analogous to the failure of Japanese
 Jusen (Non-depository financial institutions engaged in mortgage origination: most of them were
 subsidiaries of major banks) or savings and loan associations (S&Ls) in the US. Major cause of the
 failure of Jusen and S&Ls is the investment in commercial properties, which is similar to residential
 mortgage to some extent but differs in various respects, especially risk profiles.
        Jusen was a sort of off-balance sheet vehicle of large banks. In this respect, they are similar to SIVs.
 Some people insist that off-balance sheet MBS guaranteed by GSEs are similar to SIVs, but trust for
 Agency MBS is quite different from SIVs in that the former does not take ALM risk.
        On the other hand, in the case of S&L crisis, credit risk of the borrowers was contained on the
 balance sheet of S&Ls and did not spread worldwide. It is widely believed that credit risk of the
 subprime borrowers was spread around the globe through securitization. This risk transfer mechanism,
 however, applies only to Private Label Securities (PLS), not for Agency MBS.


      Issuance of PLS backed by residential mortgages has virtually stalled after the Lehman Shock, and the
price of PLS, even with AAA rating at origination, has plummeted, some well below half of par. That is
not the story for Agency MBS. According to Securities Industry and Financial Markets Association
(SIFMA), average daily trading volume of Agency MBS was 345 billion in 2008, almost 62% of the US
Treasuries. Current coupon of Agency MBS had not declined as low as the US Treasuries, and the spread
upon them had widened. However, nominal price of Agency MBS remained near par. It is regrettable to
hear as if entire securitization market had collapsed. Such an argument is sheer neglect of Agency MBS
market.


 Figure 14 Average daily trading volume of securities

 (billion)
  800
                                               US Treasuries
  700                                          Agency MBS

  600

  500

  400

  300

  200

  100

      0
      January-08       July-08        January-09


 (Source)SIFMA
                    Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010   397



    Both GSEs are placed under conservatorship, not under receivership. At this moment, they are utilized
to restore US housing market as a going concern. There would have had been an option to freeze all
activities of GSEs, which was not a realistic one considering the trade off between the expected benefit
and loss of opportunity cost. Although there was a flaw in the management or governance of GSEs,
market for Agency MBS is functioning as an indispensable infrastructure of US housing market. In this
sense, it is too early to judge that their business per se was a failure. Agency MBS market is supported by
the purchase program by FRB. But this is clearly targeted to lower the mortgage rate artificially. This
market is different from PLS where there is almost no investor at this stage.


 Figure 15 Price of MBS
  120
                                                    Fannie Mae

  100


   80


   60


   40


   20                                         PLS (AAA)


    0
    2006               2007                 2008                 2009


 *Fannie Mae MBS is FNCL6.0, PLS is ABS.HE2006H2

 (Source)Bloomberg, Markit


VI. Implication to Japan

    GSE crisis may impact the future of Japanese mortgage market which evolved leveraging market
function to some extent. These relate to primary market (mortgage origination) and secondary market
(securitization).


VI.1. MBS market

VI.1.1. TBA and SEC exemption


    As is noted in the previous section, Agency MBS has high liquidity even in market turmoil. In this
regard, one privilege of GSE status has a special meaning; exemption from SEC registration. Agency
MBS are traded on TBA (to be announced) market where market participants trade securities without
being notified of underlying collateral until 48 hours before settlement. Such blind trading is possible
because investors are confident of the quality of the collateral which is standardized by underwriting
criteria set by GSEs and by Uniform Practices established by Public Securities Association (PSA : now
398                                    M. Kobayashi, Y. Orui / Public Policy Review



reorganized into SIFMA). Investors are comfortable with the asset quality as well as the guarantee by
GSEs, but such practice is not available in case of PLS. Disclosure of underlying assets is imperative
component of sales of asset backed securities to analyze risk profile of the securities in case of PLS. If
similar disclosure is required of Agency MBS before the sales, it would become impossible to hedge
pipeline risk – fluctuation of interest rate between loan application and closing – and increase the cost for
the borrowers. SEC exemption for Agency MBS is thus integral part of US mortgage market to provide
better service for mortgage borrowers. It is not only good for borrowers, but also good for the entire
market in that this privilege enhances liquidity in the market.
      According to Congressional Budget Office (CBO), this exemption was enacted in 1954 Charter Act.
At that time, Fannie Mae was regarded as an agency of the Federal Government and their obligation was
regarded identical to Treasury securities.
      TBA market is important for the borrowers to lock-in the mortgage note rate at the time of application.
However, it is not easy to establish the similar market in Japan because of the difference of issuing
scheme of MBS.


VI.1.2. Credit enhancement by overcollateralization for JHF MBS


      Fannie Mae MBS and Japan Housing Finance Agency (JHF) MBS is similar in that both issuers retain
credit risk of the borrowers while market risks of the securities including prepayment risk are transferred
to security holders. But they differ in the structuring. In case of Fannie Mae MBS, outstanding balance of
100 is issued against the collateral with face value of 100. In case of defaults of Fannie Mae, cash flow
from these 100 mortgages will be allocated to the investors in accordance with the terms of the mortgages.
In case of JHF MBS, JHF trusts approximately 108 mortgages as collateral for 100 MBS. That is 8%
overcollateralization. Because of this credit enhancement, JHF MBS is rated AAA even the sovereign
rating of the Japanese Government Bond is not AAA in case of S&P or Moody’s. But this rating is
awarded only after rating agency complete analyzing underlying collateral, which is impediment to
establish TBA market for JHF MBS (not to mention PLS in Japan).
      In order to solve the problem, risk sharing arrangement among market participants must be addressed.
For the establishment of TBA market, it is necessary to set a wide increment to coupon of MBS. In case
of the Agency MBS, their coupon is set at 50bp increment whereas that in JHF MBS is 1bp. The
difference is that Agency MBS is issued at any market price while JHF MBS is issued only at par. It is
reported that many investors in Japan prefer purchasing amortizing securities at par. If we set the coupon
rate at a fixed rate, say, 2% at premium or discount, investor appetite would retreat thus pushing up the
cost to mortgage borrowers. In structuring the products, it is imperative to take account of side effect as
well. Continuous dialogue with investors will take time, but it is a necessary step. Mere reproduction of
US system will not work.
      At this moment, FRB and US Department of the Treasury are purchasing Agency MBS to curve
down the mortgage rate which in turn would stimulate economy. There is a room for the government to
                      Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010                 399



intervene in the market in case of emergency. But in a normal time, transaction of marketable securities
had better be vested at the hand of the market.


Table 3 Comparison of various securities


                                                US PLS                          Fannie Mae MBS                           JHF MBS



 Mortgage Pool Location                       Off-balance                          Off-balance                          On-balance



 Loss Mitigation                                Difficult                            Possible                                Possible



 Credit Enhancement                          Subordination                      Fannie Mae wrap                    Overcollateralization



 Credit Risk of the Borrowers           Transferred to investors            Retained by Fannie Mae                   Retained by JHF


                                                                          Assets + stand alone credit of      Assets + stand alone credit of
 Source of credit to securities            Underlying assets
                                                                                   Fannie Mae                                 JHF



VI.2. Primary lending market

       Traditionally, fixed rate mortgage was very popular in the US, but during the housing boom in the
early this decade, exotic type products – Hybrid ARMs including 2/28, Interest Only, and Negative
Amortization – increased, especially among subprime and Alt-A borrowers. In order to address these
issues, Federal Reserve modified Regulation Z to restrict deceptive illustration of product features and
enhance disclosure to protect consumers. Enhancement of financial literacy and consumer protection is
something that Japan should improve.
       It is often said in Japan that US mortgage is non-recourse, i.e. if the borrowers default and there
remains outstanding balance of the loan after the foreclosure, the lender does not claim for the deficiency
on the personal asset of the borrower, if any. This was a practice, however, rather than contractual terms20).
In the past when housing price continued to rise, the lender could recover fairly high percentage of the
loan balance by the disposition of the property. Even if there were deficiencies, it was not financially
feasible to recover the loss because most of the borrowers who default on mortgage did not likely to have
other assets. Expensive legal cost also hindered lender from going to the court. Lenders did not seek
deficiency judgment because it did not pay. It was not because they agreed in the mortgage deed that the
liability of the borrower is limited to the mark to market value of the collateral. But it is not certain if the

20)
      Some states like California prohibits deficiency judgment in case of purchase money mortgage, but such states are
      not necessarily the majority in the US.
400                                                            M. Kobayashi, Y. Orui / Public Policy Review



lender claims on the prime residence of the borrower who defaulted on the investment properties.
           180 degree opposite action taken by the government is the HAMP where reduction of principal
balance was one of the options as a mitigation effort to prevent foreclosure. If similar measures were to be
adapted in Japan to protect responsible borrowers, a thorough discussion should be conducted to evaluate
the social benefit of asking lender to abandon certain portion of the principal and the cost of such policy
measures – why such measure is needed, who bears the cost, to what extent the cost should be shouldered
by the taxpayers and impact on the financial stability.
           Another point on primary market relates to the interest rate on mortgages. Mortgage note rate
comprise of funding cost including ALM risk, credit risk, administration fee including servicing and profit
for the lender. Among these, most important component under current crisis is pricing of credit risk. For
subprime loans, if credit rating agencies conducted fair analysis on the credit risk of the borrowers, they
should have required higher credit enhancement (subordination) and total cost for subprime loan had been
much higher, which could have prevented the growth of subprime market itself. Similarly, if GSE had
charged higher guarantee fee with forward looking perspectives, they might have survived a bit longer.
Their guarantee fee ranges around 20 to 30 bp. If this had been set at 50bp21), equivalent of FHA loan,
they could have generated 10 to 15 billion annual incomes because their combined book of business is 5
trillion. Even this may not be enough to offset the deficit they are running at this moment. But before the
crisis, for example, American Enterprise Institute (AEI) criticized that the guarantee fee of Freddie Mac
was too high. Freddie Mac rebutted this claim, explaining that mortgage business has long life, as long as
30 years, and credit risk analysis should take account of market fluctuation in a longer horizon. The low
credit related expense in the early 2000’s was an extraordinary case, and 6 bp for credit risk component of
guarantee fee was justifiable, they said22). The fact was that such fee rate was not enough. But it was
difficult to set higher fee which can not be reasonably justified using statistical data wherein double digit
decline of housing price was unexpected.


  Graph 16 Observation of YoY change of existing home price
      60
                  until 2005
                  after 2006
      50


      40


      30


      20


      10


       0
           -12%   -8%   -6%    -4%   -2%   0%   2%   4%   6%   8%   10%   12%   14%   16%


  (Source) National Association of Realtors


21)
      FHA charges 150 bp upfront fee in addition to annual 50 bp.
22)
      This URL is not accessible now.
                 Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010   401



    In Japan, credit risk is priced more conservatively because we have already experienced continuous
decline of housing price since 1990’s. Our parameter for loss severity is believed to be set much higher
than the US case. However, if we set too high guarantee fee, it would raise the cost for borrowers which in
turn weaken the demand for housing, resulting in further decline of housing price. To prevent this adverse
feedback loop, utilization of public financial institutions is also considered in Japan. The function of
public and private financial sector should be well structured to take procyclicality into account as well.


VI.3. Organizational Status and Governance

    Many people judge that organizational status as GSE is hard to maintain. Former Treasury Secretary
Paulson and Chairman Bernanke of Federal Reserve insist that GSE status which carries conflict of
interest – public mission and maximize shareholder return – should be repealed. If there is a public policy
target, such business should be conducted under the explicit responsibility of the government and
expanding business using ambiguous implicit guarantee should be banned, they say.
    The fate of Fannie Mae and Freddie Mac is up to the legislative action by the Congress, not by the
executive branch. It is totally unpredictable at this moment. There is an opinion that discussing the fate of
GSEs itself may become a self-fulfilling prophesy in a fragile market and cause mortgage rate to rise with
widened spread. In such a scenario, status quo would continue until housing market fully recovers.
    In the“Financial Regulatory Reform: A New Foundation” proposed by the US Treasury in June 2009,
following options are illustrated.
     returning them to their previous status as GSEs with the paired interests of maximizing returns for
     private shareholders and pursuing public policy home ownership goals;
     gradual wind-down of their operations and liquidation of their assets;
     incorporating the GSEs’ functions into a federal agency;
     a public utility model where the government regulates the GSEs’ profit margin, sets guarantee fees,
     and provides explicit backing for GSE commitments;
     a conversion to providing insurance for covered bonds;
     and the dissolution of Fannie Mae and Freddie Mac into many smaller companies.
But it is not clear to which direction political vector works.
    One argument in Japan is that shareholder owned corporation is better to rein the corporate
governance because management activities are monitored by shareholders. But the fact is that many failed
companies including not only Fannie Mae and Freddie Mac but also Lehman Brothers and AIG are all
shareholder owned companies. Since the loss of shareholder is limited to the investment they made, there
is an agency problem to accelerate moral hazard in shareholder owned companies. Shareholders of AIG
or Lehman Brothers never exercised their authority to restrict risk takings by the management.
    Both Fannie Mae and Freddie Mac received capital injection from the government after
conservatorship. This was the initial case in the current financial crisis for capital injection. In this sense,
rescue package for GSEs provided protocol for other large, systemically important failing financial
402                                     M. Kobayashi, Y. Orui / Public Policy Review



institutions (SIFIs). They are not only too big to fail, but also interconnected in the financial system itself.
Assistance to GSEs ranges all side of the balance sheet; asset, liability and equity. Similar approach is
adopted in other SIFIs.
      Implicit guarantee by the government gave competitive advantage to GSEs, which fueled their
business expansion and made them too big to fail. Existence of too big to fail institutions distorts
allocation of resources, encourage excessive risk taking and restrict competition. There are studies which
analyzed the advantage of GSE status in the mortgage pricing was equivalent of 25 bp. But asking if this
advantage distorted allocation of resources is meaningless because they exist to provide low cost fund to
mortgage market. It is a tautology. The question should be to what extent the government should commit
to improve homeownership. At least, statistics shows that they did not restrict competition; they lost
market share in the housing bubble of 2004 to 2006.
      In this regard, the problem of too big to fail is focused on the excessive risk taking in case of GSEs. At
least, GSEs were not well prepared for home price downturn with this magnitude as well as for the
deterioration of credit quality of the borrowers such as Alt-A. They did not price the risk premium taking
account of the tail event. Although they took excessive risk, however, they did not intend to incur risk as
far as to ruin themselves to be deprived of GSE status, because they tried to maintain GSE status even
exercising heavy lobbying.
      In Japan, Government Housing Loan Corporation (GHLC) suffered significant amount of fair value
loss in the late 1990’s because of unexpected prepayment from the borrowers, but this did not lead to
systemic risk because the government decided to step in to wind down the mortgage origination business
of GHLC. Contrary to this, the government is expanding loan program of government financial
institutions to address recent financial turmoil. Even in such a case, the future policy cost analysis is
conducted and such expansion with appropriation is subject to deliberation by the National Diet. Japanese
system to monitor public financial institution is thus transparent. From the viewpoint of market liquidity
evaporation and consequent credit crunch, the need for institutions like GSE to function as the
infrastructure of financial market to provide credit enhancement and liquidity through promoting
standardized products can not be overstated. In addressing the need for regulatory reform, function is the
first priority to be considered, not the mere appearance of the institutions. Addressing the problems of
“too big to fail” and improving the risk management is an imperative component of the financial
structural reform. In this perspective, we have a lot to learn from the US experience to configure our own
financial structure.


VII. Summary

      GSE crisis posted a question if the existence of half public and half private entity is efficient to
leverage private fund to achieve public mission or public mission should be implemented by solely public
entities. GSE status provides competitive advantage and tends to make it too big to fail, thus leading to
systemic risk. Question here is to what extent is such an expansion justified in light of value of the
                      Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010   403



mission achieved and inherent cost, both explicit and implicit. The lesson learned from US experience is
the relation between the policy target and cost associated with it must be transparent.
       Integration of regulatory framework for large financial institution is advocated as well to prevent
systemic risk. Mortgage has become one of the largest segments in the financial industry in many
jurisdictions as economy matures and this has made the entire financial system and economy as a whole
more vulnerable to the boom and bust of property values. In this regard, how to contain the side effects of
housing bubble is one key component of the macro-prudential approach in the banking supervision.
       It is hard to predict the future of GSEs, but there is a return to simplicity in the wide horizon of
financial market. In this regard, in architecting the financial structure, public mission should be
implemented by an institution with stronger government control, under transparency with cost disclosure
and risk management. Reform of GSE status is to be discussed in the context of broader financial
regulatory reform. Of course, the cost of policy implementation will be the center of debate, but it will not
be limited to the discussion of GSE status or governance of an entity, but rather will go so far as to what
extent the American Dream of homeownership should be encouraged to maintain the country as a going
concern. It is hard to maintain status quo, as President Obama has been repeating since his inaugural
address. We have to closely monitor the change in the housing market through the reform of GSEs23).


Supplementary notes

       Since the publication of original “Financial Review, Vol.95”, there have been tremendous changes of
political environment for GSEs.
       On December 24, 2009, Treasury’s maximum funding commitment to GSEs under the Senior Preferred
Stock Purchase Agreements was unlimitedly increased. The cap on Treasury’s funding commitment shall
increase as necessary to accommodate any net worth deficits for calendar quarters in 2010 through 2012. For
any net worth deficits after December 31, 2012, Treasury’s remaining funding commitment will be
equivalent of unused amount under previous agreement less any positive net worth as of December 31, 2012.
The US Treasury noted that these amendments “should leave no uncertainty about the Treasury’s
commitment to support Fannie Mae and Freddie Mac as they continue to play a vital role in the housing
market during this current crisis.” This action was supposed to provide some relief to investors because
Federal Reserve was planning to wind down its Agency MBS Purchase Program by the end of March 2010.
       However, on the same day, Fannie Mae and Freddie Mac disclosed in its Form 8-K submitted to
Securities and Exchange Commission that compensation of both CEO shall be 6 million and this ignited
criticism again. Congressman Barney Frank, the Chairman of the House Financial Services Committee,
stated in January 2010 that “I believe this committee will be recommending abolishing Fannie Mae and
Freddie Mac in their current form and coming up with a whole new system of housing finance.” He was


23)
      Opinions expressed in this article are personal ones of the authors, and does not represent the opinion of the agency
      or corporation they belong.
404                                   M. Kobayashi, Y. Orui / Public Policy Review



regarded as one of the strongest supporter of GSEs before, but 2010 is the year of mid-term election and
political environment is more volatile than before. He said on March 5 that he does not think the legal
status of GSE debt is not the same as Treasury debt, but this does not prevent the Treasury from treating
the debt of Fannie and Freddie in the manner that it believes best supports the important goal of
stabilizing the financial system.
      Effective January 1, 2010, both GSEs adopted two new accounting standards, SFAS 166 and 167 that
eliminated the concept of Qualified Special Purpose Entities (QSPEs) and amended the accounting for
transfers of financial assets and the consolidation model for variable interest entities (“VIEs”). Based on
their analysis, they are required to consolidate the substantial majority of their MBS trusts. This will result
in other changes to their consolidated financial statements. Although these new accounting standards do
not change the economic risk to their business, these new standards will affect their net worth, 2 to 4
billion for Fannie Mae and 11.7 billion for Freddie Mac. This accounting change made it easier for them
to purchase delinquent loans from trust, which would facilitate loan modification. This gives an
impression that they are required to cooperate the policy objectives of the Administration to reduce
avoidable foreclosure, rather than to improve their financial position.
      On February 1, 2010 Obama administration submitted its 2011 budget proposal and stated in
Analytical Perspectives that it “continues to monitor the situation of the GSEs closely and will continue to
provide updates on considerations for longer-term reform of Fannie Mae and Freddie Mac as
appropriate.” It is hard to predict the prospects for the enactment of GSE reform bill, its timing or content
of legislative proposals regarding the future status of the GSEs.
      In the last week of February 2010, Fannie Mae and Freddie Mac announced their financial result for
 th
4 quarter 2009. Fannie Mae reported net loss of 15.2 billion and Freddie Mac 6.5 billion excluding
dividend to the Treasury. The aggregate liquidation preference on the senior preferred stock shall be 76.2
billion and 51.7 billion respectively by the end of March 2010. which will require an annualized dividend
of approximately 7.6 billion and 5.2 billion each. This amount exceeds their reported annual net income
for most of the past years before the conservatorship by a significant margin. This senior preferred stock
dividend obligation, combined with potentially substantial commitment fees payable to Treasury starting
in 2011 and their effective inability to pay down draws under the senior preferred stock purchase
agreement, will have a significant adverse impact on their future financial position and net worth. It is not
feasible to maintain status quo for the shareholder ownership, but any drastic change of the organizational
status of GSE may negatively impact mortgage market which is still fragile.
      Congressman Barney Frank announced on February 4, 2010, that his “committee will hold a hearing
on March 2 to begin the process of considering the future of housing finance. The hearing will focus on
all the private and public entities that support the mortgage market, which include [Fannie Mae, Freddie
Mac]”. “It is the first step in a legislative process to determine the future of housing finance and the
federal government’s role in responsible homeownership and the supply of affordable rental housing”.
But due to the heavy blizzard, he had to postpone and reschedule the hearing. As of today, we do not have
recovered visibility on the future of GSEs.
                 Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.3, March 2010   405



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SEC, FRB, US Treasury "Enhancing Disclosure in the Mortgage Backed Securities Markets" January
      2003
United State Postal Service "United States Postal Service Transformation Plan Appendix T Overview of
      Selected Government Entities and Government Sponsored Enterprises" April 2002
US Department of Treasury “Blueprint for a Modernized Financial Regulatory Structure” March 2008
US Department of Treasury “Financial Regulatory Reform – A New Foundation: Rebuilding Financial
      Supervision and Regulation” June 2009
Wayne Passmore “The GSE Implicit Subsidy and the Value of Government Ambiguity” Board of
      Governors of the Federal Reserve System 2005-05

								
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