Big changes are in store for Fannie Mae and Freddie Mac. The Obama administration intends to develop a comprehensive reform proposal for these government sponsored enterprises (GSEs), Treasury Secretary Timothy Geithner said in testimony prepared for the House Financial Services Committee on Tuesday.

"After reform, the GSEs will not exist in the same form as they did in the past," Geithner said at a hearing on overhauling the U.S. housing finance system. "Private gains will no longer be subsidized by public losses, capital and underwriting standards will be appropriate, consumer protection will be strengthened, and excessive risk-taking will be restrained," he pledged.

Broad reforms of the entire housing finance system must be undertaken in order for the country to have a more stable housing market, he said. Government has a key role to play in shaping that system and in setting housing policy goals, Geithner said.

Asking for Public Input

The administration will develop comprehensive reform proposals that it will send to Congress, and Treasury and the Department of Housing and Urban Development will submit a list of questions for public comment by April 15. They'll ask for input on priorities for government housing policies, characteristics of mortgage products available to consumers and best practices to ensure consumer protection, Geithner said.

Fannie Mae's (FNM) and Freddie Mac's (FRE) purchases of mortgages from private lenders (as well as Treasury's and the Federal Reserve's purchases of mortgage-backed securities) "have been crucial to restoring stability in the housing market and to maintaining the availability of mortgage credit," the Treasury secretary said.

"Private capital has not yet returned to provide the amount of funding that would be needed to allow families to get a mortgage to buy a new home or to sensibly refinance the house they already live in," he said. Without the continued activity of the GSEs and the Federal Housing Administration, mortgage rates would be higher, and homeowners would have a much hard time getting loans, he said.

Insufficient Regulation and Enforcement


The failure of Fannie Mae and Freddie Mac, which were taken over by the federal government in 2008, "was part of a broader crisis that revealed structural flaws in the entire housing finance system," Geithner said. He blamed problems in the housing market on insufficient regulation and enforcement, which did not provide a check on "lax underwriting, irresponsible lending and excessive risk-taking."

The two entities guaranteed more than $5 trillion of residential mortgage-backed securities, nearly half of the overall residential mortgage market. The GSEs and the federal government are playing a larger role in housing finance today than they have since the Great Depression, Geithner said. "Conditions must be created so that private capital will return in a substantial manner to the housing market."

While the government needs to ensure that the GSEs "have sufficient capital to perform under any guarantees issued now or in the future," Geithner also said that the federal role in housing finance and the level of direct involvement will change. "The substantial direct support for the housing markets that has been put in place will be allowed to fade as the market recovers and fully stabilizes," he said.

Unfair Advantages

The performance of the GSEs was "symptomatic" of regulatory and oversight failure, Geithner said. They were allowed to earn private gains for many years, but ultimately the taxpayer subsidized their losses. They were allowed to expand and manage their investment portfolios without regard to the risk they posed to the system," Geithner said.

GSEs should have been required to hold more capital to protect against losses as they took on more risk to shore up their market share during the housing boom, Geithner said. Federally regulated banks are required to hold 4% capital against their mortgages, while Fannie Mae and Freddie Mac were required to hold only 2.5% against their on-balance-sheet mortgage portfolio, and only 0.45% against mortgages they guaranteed, he said. That, coupled with the perception of government guarantees, "pushed out competition," he said.

The residential housing market is one of the U.S. economy's largest sectors, and the U.S.mortgage market is the second-largest securities market in the world after U.S. Treasuries.

The Obama administration intends to develop reform proposals for GSE's role in the housing finance system through public consultation with a wide variety of constituents, market participants, academic experts and consumer and community organizations, Geithner said.

The Goal: Long-Term Viability

In addition, the crisis exposed flaws in the Federal Home Loan Bank (FHLB) system and the Government National Mortgage Association (Ginnie Mae), Geithner said. "Some of the same incentive alignment issues became clear in the decisions by several of the FHLBs to make large investments in nonagency [not made through Fannie or Freddie], subprime mortgage securities at the peak of the housing boom. These decisions have greatly affected the health of several of the FHLBs," he said.

Geithner called for aligning incentives for mortgage issuers, loan originators, brokers, ratings agencies and insurers so that mortgages are originated and securitized with the goal of long-term viability rather than short-term gains. If government guarantees are provided, appropriate returns should be earned for taxpayers with the assurance that "private sector gains and profits do not come at the expense of public losses."

Mortgage products need to be standardized and transparency improved as well, he said, and government support needs to continue for multifamily housing to ensure affordable rental options.

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