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The United States continues to recover from the aftermath of the worst financial crisis in more than 75 years, which led to federal assistance being provided to many firms, including the two large housing-related government-sponsored enterprises (the enterprises). These events clearly demonstrated that the U.S. financial regulatory system was in need of significant reform. GAO designated reform of the financial regulatory system as a high-risk area in 2009. Since then, the Federal Housing Administration’s (FHA) mortgage insurance portfolio has continued to grow, and its insurance fund has experienced major financial difficulties. Accordingly, the title and scope of this high-risk area has evolved to include the federal role in housing finance from Modernizing the Outdated U.S. Financial System to Modernizing the U.S. Financial Regulatory System and Federal Role in Housing Finance.

During the past few decades, the U.S. financial regulatory system failed to adapt to significant changes. First, although the U.S. financial system had increasingly become dominated by large interconnected financial conglomerates, no single regulator was tasked with monitoring and assessing the risks that these firms’ activities posed across the entire financial system. Second, various entities, such as nonbank mortgage lenders, hedge funds, and credit rating agencies, were not subject to sufficiently comprehensive regulation and oversight, despite their critical roles in financial markets. Third, the regulatory system was not effective at providing key information and protections for new and more complex financial products for consumers and investors. Taking steps to better position regulators to oversee firms and products that pose risks to the financial system and consumers and adapt to new products and participants as they arise could reduce the likelihood that the financial markets will experience another financial crisis similar to one in 2007-2009. Losses from risky mortgage products also resulted in two large housing-related enterprises—Fannie Mae and Freddie Mac—being placed into government conservatorship, and the distressed housing and mortgage markets have led to a growing role by the Department of Housing and Urban Development’s FHA in mortgage finance.

Since the crisis, policymakers have taken significant actions intended to reform the U.S. financial regulatory system to address the risks associated with evolving financial firms, markets, and products. After considerable debate within the administration and Congress, in July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) was enacted. The Dodd-Frank Act’s reforms aim to better position the financial regulatory system in many of the areas addressing the changes and risks that GAO identified.

• A new Financial Stability Oversight Council made up of the various financial regulators was created to identify risks to U.S. financial stability, including risks posed by large, interconnected financial conglomerates. This council has begun operating, including holding numerous meetings and issuing various congressionally-mandated studies and two annual reports addressing market and regulatory developments across the financial system. The new office that is intended to collect and analyze data to assist this council—the Office of Financial Research—has also begun hiring staff and conducting activities, such as assisting with a global effort to develop a worldwide standard for uniquely identifying parties to financial transactions.
• Financial regulators are also making progress in issuing proposed rules to implement the Dodd-Frank Act’s requirements that U.S. bank holding companies with total consolidated assets of $50 billion or more and U.S. nonbank financial companies supervised by the Federal Reserve be subject to enhanced prudential standards and oversight, including enhanced requirements for these firms regarding their capital, leverage, liquidity, and stress testing efforts.
• The act also creates a new resolution authority to address failing financial firms whose disorderly resolution would have serious adverse effects on U.S. financial stability by granting the Federal Deposit Insurance Corporation the authority to liquidate large financial firms, including nonbanks, outside of the bankruptcy process. After banking regulators finalized related rules, the large financial institutions first required to prepare the resolution plans—”living wills”—called for under this authority submitted their plans to regulators as expected in July 2012.
• Securities and futures regulators are also attempting to finalize many of the rules that will create a new regulatory structure and requirements for the over-the-counter derivatives known as swaps. This new regulatory framework for swaps is intended to reduce risk, increase transparency, and promote market integrity by, among other things, moving trading to exchanges and requiring trades to be centrally cleared.
• Regulators have also made progress in implementing additional requirements and oversight on advisers to hedge and private funds and credit rating agencies that were previously subject to less regulation. For example, final rules were issued specifying the information that hedge fund advisers that trade either securities or futures should provide to these regulators periodically. The Securities and Exchange Commission has also created a new internal office to oversee credit rating agency activities and additional requirements for these entities are forthcoming.
• To address concerns over consumer regulation, the new Bureau of Consumer Financial Protection—a new agency created by the Dodd-Frank Act—has begun operations. This entity now has responsibility for consumer protection laws previously overseen by different regulators. It has been issuing rules and begun taking enforcement actions, including obtaining refunds for consumers and imposing penalties on certain credit card issuers for practices that violated the law.
  
  A variety of challenges affected regulators’ progress in fully implementing the act’s reforms. Regulators noted that completing rules has taken time because of the number and complexity of the issues and because many rules are interconnected. Further, regulators said that implementing the act’s reforms require a great deal of coordination, at the domestic and international levels, which increased the amount of time needed to finalize rulemakings. Finally, regulators noted that they have prioritized developing responsive, appropriate rules over meeting tight statutory deadlines. As a result, some of the important rules are taking considerable time to develop.
  
  Some actions were also taken to address the role of the two housing enterprises. Both continue to operate under the conservatorship placed on them in September 2008, but continue to support the majority of single-family mortgage loans. As of the end of fiscal year 2012, under agreements with Treasury, these enterprises had received over $187 billion, although recently both entities began earning profits that are being returned to the U.S. Treasury. In February 2011, the Department of the Treasury and the Department of Housing and Urban Development issued a plan that outlines a vision for the government’s role in housing finance, including reducing the activities of the two enterprises over time until they are eventually wound down completely. In addition, in 2012, the Federal Housing Finance Agency (FHFA), which oversees the enterprises’ operations, put out a strategic plan that identified three strategic goals for the next phase of Fannie Mae and Freddie Mac conservatorships, including building a new infrastructure for the secondary mortgage market, gradually contracting the enterprises’ dominant presence in the marketplace while simplifying and shrinking their operations, and maintaining foreclosure prevention activities and credit availability for both new and refinanced mortgages. In August 2012, this agency took two actions affecting the enterprises. First, to encourage greater participation in housing markets by private firms, FHFA directed Fannie Mae and Freddie Mac to raise the fees they charge lenders for securitizing mortgage loans to reduce the cost difference between securitizations done by the enterprises compared to those done by private firms. Second, FHFA, in conjunction with Treasury, revised the senior preferred stock purchase agreements to have the enterprises pay dividends to the U.S. Treasury based on their net worth when positive rather than as a fixed percentage of the outstanding senior preferred stock, which, among other things, should eliminate the need for the enterprises to borrow from Treasury to pay such dividends. In October 2012, FHFA also sought public comment on a proposal for developing a new mortgage securitization platform to process payments and perform other functions that could be used by multiple issuers that would replace the enterprises’ proprietary systems.
  
  Decisions about the future role of the enterprises will need to consider impacts on other parts of the housing finance system, including the single-family mortgage insurance programs of FHA. During the recent financial crisis, FHA’s insurance activity rose dramatically and provided key support to distressed housing and mortgage markets. However, FHA’s financial condition deteriorated rapidly over the same period. As GAO has reported, since 2009, FHA’s Mutual Mortgage Insurance (MMI) Fund has not met its statutory 2-percent capital requirement. Further, a weakening in the performance of FHA-insured mortgages has heightened the possibility that FHA will require funding from the U.S. Treasury to help cover its costs on insurance issued to date. FHA has taken a number of steps to improve its financial health and help reduce its market share, including fee increases and underwriting changes, but additional actions may be necessary. GAO previously recommended that Congress or FHA specify the economic conditions that the MMI Fund would be expected to withstand without drawing on the Treasury. Recent events suggest that the 2-percent capital requirement may not be adequate to avoid the need for Treasury support under severe stress scenarios. Implementing this recommendation would be an important step not only in addressing FHA’s long-term financial viability, but also in clarifying FHA’s role. Efforts to reduce the market presence of the enterprises could shift some borrowers currently served by that market segment to FHA, and the resulting impacts on FHA’s risk exposure should be considered. In addition, changes in the role of the enterprises will need to consider interactions with mortgage market reforms contained in the Dodd-Frank Act. For example, regulations required by the Dodd-Frank Act will have major implications for the size and borrower composition of the private-label market for mortgage-backed securities, which, in turn, could affect the risk exposure of FHA and the enterprises.
  
  Although mandating a broad range of reforms, the Dodd-Frank Act did not address other risks that many see as significant and worthy of regulatory attention. For example, concerns have been raised about the potential systemic risks posed by money market funds. These funds provide short-term funding to many financial institutions but lack capital buffers and other protections that could reduce the likelihood of destabilizing runs on their holdings. The Securities and Exchange Commission has taken some actions to increase these funds’ resiliency and in November 2012 the Financial Stability Oversight Council approved for public comment various additional reforms for these funds. Concerns also continue about the potential systemic implications of certain concentrations of credit risk. These include the potential for serious problems to arise from the failure of one of the two institutions that provide credit to facilitate transactions in the tri-party repurchase (repo) market that provides short-term funding to many financial institutions. Similarly, concerns exist over the increased concentration of risk arising from the act’s movement of swaps to clearinghouses. Although this change can reduce the market’s risk, a systemic disruption could occur if financial soundness problems affected a clearinghouse. Various proposals for action to address these risks have been put forward, but policymakers and financial regulators have not taken definitive actions to implement them.

These financial regulatory reforms currently underway represent significant steps in this high-risk area. However, many of the rules to implement the new regulatory requirements arising from the act are yet to be completed. As of December 2012, regulators had issued final rules for about 48 percent of the 236 provisions of the act that GAO identified as necessitating regulators to issue rulemakings. However, in some cases the dates by which affected entities had to comply with the rules had yet to be reached. Of the remaining provisions, regulators had proposed rules for about 29 percent, and rulemakings had not occurred for about 23 percent. In some cases, progress has been made but has been slowed to address market participant concerns. For example, the rules implementing new capital requirements for all banks were proposed in June 2012 and were to begin becoming effective by January 2013, but banking regulators announced that this implementation will be postponed to provide more time In light of the volume of comments received and the wide range of views expressed during the comment period.

The reforms that have been implemented also need attention to help ensure their effectiveness. For example, the Financial Stability Oversight Council faces various challenges to ensuring that it achieves its mission, given that identifying risks to financial stability is difficult, vast, and procedurally complex. It also must ensure that it achieves effective collaboration among its many members, almost all of whom come from state and federal agencies with their own specific statutory missions. In a September 2012 report, GAO concluded that whether this council and the Office of Financial Research will fundamentally change the way the federal government monitors threats to financial stability remains to be seen. GAO also made various recommendations to strengthen their accountability and transparency, including having these entities clarify their monitoring responsibilities to better ensure that the monitoring and analysis of the financial system are comprehensive and not unnecessarily duplicative, and systematically sharing key financial risk indicators among member agencies to assist in identifying potential threats for further monitoring or analysis.

The ultimate resolution of the two failed housing enterprises also remains undone. Although various proposals to resolve their role have been issued, no definitive actions have been taken as of yet. Similarly, further actions could be taken to help restore FHA’s financial soundness and define its future role. To improve its condition, FHA has implemented fee increases and underwriting changes, but as GAO previously concluded, Congress or FHA needs to determine the economic conditions that FHA’s primary insurance fund would be expected to withstand without drawing on the Treasury. Finally, definitive actions to address the risk posed by money market funds and the credit exposures arising in the triparty repo market and within clearinghouses also remain outstanding.

Financial Regulatory Reform

Financial Regulatory Reform

Dodd-Frank Act

Financial Stability

Credit Rating Agencies

Bank Capital Requirements

Dodd-Frank Act Regulations

Federal Housing Administration

Mortgage Financing

Fannie Mae and Freddie Mac

Financial Regulation

Financial Regulation

Mortgage Financing

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