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GAO-11-33R:
United States Government Accountability Office:
Washington, DC 20548:
November 15, 2010:
Subject: The Cooperative Model as a Potential Component of Structural
Reform Options for Fannie Mae and Freddie Mac:
On September 6, 2008, the Federal Housing Finance Agency (FHFA) placed
the Federal National Mortgage Association (Fannie Mae) and the Federal
Home Loan Mortgage Corporation (Freddie Mac) into conservatorships.
FHFA took this step after concern developed that the deteriorating
financial condition of the two government-sponsored enterprises (GSE),
which had about $5.4 trillion in combined financial obligations,
threatened the stability of financial markets. Since then, the
Department of the Treasury (Treasury) has provided financial support
to Fannie Mae and Freddie Mac (the enterprises) to help stabilize
their financial condition and help ensure their ability to continue to
support housing finance. As of September 2010, Treasury had provided
about $150 billion in capital contributions to support the
enterprises, and the Congressional Budget Office has estimated that
the total cost to taxpayers could be nearly $400 billion over a 10-
year period. In recent months, Congress and the administration have
been considering a variety of proposals to reform the enterprises in
order to help ensure their safety and soundness and the effectiveness
of the U.S. housing finance system.
One structural reform option for the enterprises that has generated
some interest in Congress and among housing finance participants and
observers is known as the cooperative model. Congress chartered Fannie
Mae and Freddie Mac to be for-profit corporations owned by
shareholders. Their primary mission over the years has been to
establish a liquid, secondary market for what are known as
conventional conforming mortgages by purchasing such mortgages from
lenders, which can use the proceeds to originate additional
mortgages.[Footnote 1] The enterprises' critics argue that their
structures and federal sponsorship, which allowed for the issuance of
debt at advantageous rates, have undermined market discipline and
encouraged them to engage in profitable but potentially risky
activities with inadequate capital levels. Under the cooperative
model, the enterprises would be converted from shareholder-owned
corporations to cooperatives owned by the lenders that sell mortgages
to them. Proponents of the cooperative model believe it would promote
safer and sounder mortgage underwriting practices because lenders
could potentially lose some or all of their capital investments in a
cooperative if it suffered significant losses.
We issued a report under the Comptroller General's authority on
structural reform options for the enterprises in September 2009 and,
on the basis of subsequent congressional interest, we conducted this
work as a follow-up effort, also under the Comptroller General's
authority.[Footnote 2] This letter summarizes briefings that we
provided to the staffs of the Senate Committee on Banking, Housing,
and Urban Affairs and the House Financial Services Committee (see
enclosure I for the briefing slides). Our objectives were to (1)
identify the key characteristics of the cooperative model, (2) discuss
the cooperative model's potential role as part of any long-term
structural reform option for the enterprises, (3) discuss some likely
advantages and disadvantages of the cooperative model as a potential
reform option for the enterprises, and (4) identify some of the key
decisions that Congress and the administration would have to make to
initiate overall structural reform for the enterprises and design an
effective transition process.
To address our objectives, we reviewed and analyzed reports, studies,
and other information on the cooperative model and the characteristics
of its structure. We also interviewed officials from FHFA; the Federal
Home Loan Bank System (FHLBank System), another government-sponsored
housing enterprise that is a cooperative; and the Farm Credit
Administration (FCA), which regulates another government-sponsored
enterprise that also has a cooperative structure, the Farm Credit
System (FCS).[Footnote 3] We also reviewed and analyzed prior GAO and
other reports and studies on varying structural reform options for the
enterprises to determine how, if at all, the cooperative model could
apply. Finally, we interviewed select industry groups, market
participants, and experts to get their views on the potential
advantages and disadvantages of structuring Fannie Mae and Freddie Mac
as cooperatives and on transition issues.
We conducted our work from January 2010 through September 2010 in
accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain
sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe
that the evidence obtained provides a reasonable basis for our
findings and conclusions based on our audit objectives.
Background:
Congress established Fannie Mae and Freddie Mac in 1968 and 1989,
respectively, as for-profit, shareholder-owned corporations.[Footnote
4] Their primary mission has been to help provide a secondary mortgage
market for conventional conforming loans and thereby to enhance
liquidity in housing finance. To do so, they issue debt in financial
markets and use the proceeds to purchase mortgages that meet their
underwriting standards from primary mortgage lenders that can use the
proceeds to originate additional mortgages. The enterprises either
hold the mortgages in their portfolios or package them into mortgage-
backed securities (MBS) that are sold to investors. In exchange for a
fee (the guarantee fee), the enterprises guarantee the timely payment
of interest and principal on MBS that they have issued.
While the enterprises operated profitably for many years, their
structures have long been in question. For example, some commentators
have stated that the federal government's sponsorship conveyed certain
financial and other advantages to the enterprises that encouraged them
to engage in riskier activities than otherwise would have been the
case. In particular, even though the enterprises' statutory charters
explicitly state that the federal government does not guarantee their
debt and MBS and the enterprises are not included in the federal
budget, there was an assumption in financial markets of an "implied"
federal guarantee, which enabled the enterprises to borrow at lower
rates than other for-profit corporations. Critics argued that this
implicit government guarantee and access to less costly credit created
a moral hazard. That is, it encouraged the enterprises to assume
greater risks and hold less capital than would have been the case in
the absence of such a guarantee. At the same time, we and others have
previously said that the fragmented financial regulatory system that
was in place for many years was not designed to adequately oversee
such large and complex financial institutions.[Footnote 5]
Over the years, the enterprises engaged in potentially profitable but
risky activities that were complex to manage and, in some cases,
resulted in significant financial losses. Beginning in the 1990s, both
Fannie Mae and Freddie Mac rapidly increased the size of their
retained mortgage portfolios. While potentially more profitable than
their MBS guarantee business, large retained mortgage portfolios
exposed the enterprises to potential losses if interest rates
fluctuated. When the enterprises issued MBS, however, investors
assumed the risks associated with fluctuations in interest rates.
Further, in 2004, the enterprises began to rapidly increase their
purchases of mortgages and mortgage assets with questionable
underwriting standards. For example, the enterprises increasingly
purchased Alt-A mortgages that typically did not have documentation of
key items such as borrowers' incomes, and packaged these mortgages
into MBS for sale to investors. In addition, the enterprises increased
their purchases of private-label MBS (i.e., MBS collateralized by
subprime mortgages) and retained an increasing number of these
securities in their mortgage portfolios.[Footnote 6] By the end of
2007, the enterprises collectively held more than $313 billion in
private-label MBS, of which $94.8 billion was held by Fannie Mae and
$218.9 billion by Freddie Mac. When the housing market began to
decline sharply in 2007 and 2008, the enterprises lost billions of
dollars on their guarantees to investors in MBS collateralized by Alt-
A loans. In addition, significant losses were also incurred on their
investments in private-label MBS.
In July 2008, Congress passed and the President signed the Housing and
Economic Recovery Act of 2008 (HERA), which, among other things,
established the FHFA, and charged it with the supervisory and
regulatory oversight of Fannie Mae and Freddie Mac.[Footnote 7] In
response to growing concerns that the enterprises' deteriorating
financial condition would destabilize the financial markets, in
September 2008, FHFA placed the enterprises in conservatorships. As
provided in HERA, Treasury also entered into agreements with Fannie
Mae and Freddie Mac to maintain the enterprises' net worth by
purchasing their preferred shares on a quarterly basis. As of
September 2010, Treasury had purchased about $150 billion of their
preferred shares. In November 2008, the Federal Reserve implemented a
program to purchase up to $1.25 trillion in the MBS and debt of the
enterprises to help stabilize the housing finance system.
While the conservatorships can remain in place indefinitely as efforts
are undertaken to stabilize the enterprises and restore confidence in
financial markets, FHFA has said that the conservatorships were not
intended to be permanent. Over the long term, Congress and the
administration will face difficult decisions on how to restructure the
enterprises and promote housing opportunities while limiting risks to
taxpayers and the stability of financial markets. In September 2009,
we issued a report that identified several proposed long-term
structural reform options for the enterprises.[Footnote 8] These
options generally fall along a continuum, with some overlap in key
areas:
* Establish the enterprises as government corporations or agencies.
Under this option, the government corporation or agency would focus on
purchasing qualifying mortgages and issuing MBS but would not have
mortgage portfolios.
* Reconstitute the enterprises as for-profit corporations with
government sponsorship and additional restrictions. While restoring
the enterprises to their previous status, this option would add
controls to minimize risk. For example, it would eliminate or reduce
mortgage portfolios and establish executive compensation limits.
* Privatize or terminate them. This option would abolish the
enterprises in their current form and disperse mortgage lending and
risk management throughout the private sector. Some proposals involve
the establishment of a federal mortgage insurer to help protect
mortgage lenders against catastrophic mortgage losses.
In our September 2009 report, we also analyzed these three options in
terms of their potential capacity to achieve key housing mission and
safety and soundness objectives, and identified trade-offs among the
various options. For example, a government corporation or agency may
mitigate the safety and soundness and systemic risk concerns of the
traditional GSE structure. That is, it would eliminate the concern
that profit-maximizing corporations would be able to operate with
relatively low levels of capital and take excessive risks because of
an implied federal guarantee that undermined market discipline. And if
a government corporation or agency were to focus on MBS issuances and
not retain a mortgage portfolio, then it would be less complex and
potentially less risky than the GSEs were. Nevertheless, a government
corporation or agency may find successfully managing a large
conventional mortgage purchase and MBS issuance business to be
challenging. As described in our previous work on the Federal Housing
Administration, which insures mortgages meeting its underwriting
criteria, government entities may lack the financial resources to
attract highly skilled employees and obtain information technology to
manage complex business activities.[Footnote 9] The failure to
adequately manage the associated risks also could result in
significant losses for taxpayers.
Subsequently, Congress and the administration have initiated debate
and analysis of the various reform options for the enterprises and the
housing finance system. For example, congressional committees have
held a number of hearings on the topic of government-sponsored
enterprises and housing finance system reform. In April 2010, Treasury
and the Department of Housing and Urban Development issued a set of
questions for public comment on the future of the housing finance
system that received more than 300 responses from a broad cross
section of consumer groups, industry groups, market participants, the
general public, think tanks, and others. It is likely that Congress
and the administration will further consider proposals to reform the
enterprises' long-term structures during 2011.[Footnote 10]
Summary:
A cooperative is generally defined as an entity that is jointly owned
and controlled by the members that use its services. The members—such
as businesses—finance and operate the cooperative for their mutual
benefit and, by working together, can potentially reach an objective
that would be unattainable if acting alone. Cooperatives often involve
participants in a single industry that have common economic interests
and goals and that undertake joint activities such as marketing,
purchasing supplies and equipment, and providing certain services.
Typically, cooperatives are governed by a board of directors that is
elected by the members. Cooperatives may acquire capital through
membership fees or members' stock purchases, withholdings from
members' net earnings, assessments on the members' sales or purchases,
or a combination of these. Therefore, procedures have to be
established to determine the role of members in cooperatives'
corporate governance and their required capital contributions in the
cooperatives. Two government-sponsored enterprises have a cooperative
structure—the FHLBank System and FCS.
As indicated in our September 2009 report, the cooperative model is
generally viewed as a component of the three larger reform options
(government corporation or agency, reconstituted GSE, or privatization
or termination) rather than an option by itself. While the cooperative
model could conceivably fall under any of the options, it is generally
seen as most closely associated with the reconstituted GSE option.
Under this option, the enterprises could be established as privately
owned entities that would generally focus on purchasing qualifying
mortgages from lenders and issuing MBS, which would benefit from
explicit federal financial guarantees. These private entities could be
structured as cooperatives owned by mortgage lenders, shareholder-
owned corporations as is the case today, or possibly as nonprofits. In
contrast, the cooperative model is generally not viewed as integral to
establishing a government corporation or agency to replace the
enterprises. As a public entity, a government corporation or agency
would not likely be capitalized by lenders, nor would they likely have
a role in its governance or operations. And while lenders may choose
to form cooperatives if the enterprises are privatized or terminated,
this decision would likely depend on whether they decide that doing so
is in their economic interests.
One potential benefit of the cooperative model, as cited by
proponents, is that it would encourage safer and sounder mortgage
underwriting practices. For example, as the owners of the
cooperatives, lenders might have financial incentives to help ensure
that the mortgages sold to the cooperatives were properly underwritten
in order to minimize potential losses that would adversely affect
their capital investments. However, a cooperative model does not
necessarily guarantee safe and sound operations. In recent years,
several FHLBanks have experienced significant losses on their
investments in nontraditional mortgage assets such as private-label
MBS, and FCS suffered significant losses during the 1980s because of
poor lending practices, and the federal government ultimately
authorized financial support for the system. Another potential
advantage of the cooperative model is that a limited number of such
entities could promote mortgage underwriting standardization and
consistency if members use common forms, rules, and procedures. But
some observers have noted that a potential disadvantage of the
cooperative model is that the time that could be needed for members to
reach consensus on key business decisions could result in delays in
their implementation. Consequently, these observers question whether
the cooperative model would be well suited to meeting the requirements
of complex and dynamic secondary mortgage market functions. Moreover,
consistent with the discussion in our September 2009 report regarding
proposals to establish multiple GSEs to replace the enterprises,
multiple cooperatives could lead to fragmentation in mortgage and
housing finance.
Reforming the enterprises' long-term structure requires Congress and
the administration to make key decisions on the appropriate reform
option, the mission of the entity or entities, and the oversight
framework. If the new structure includes the cooperative model, a
number of decisions would also have to be made on the number of
cooperatives that would be formed and their membership requirements,
governance and capital structures, and permitted business activities.
Key transition issues would also include:
* ensuring that the entity or entities replacing the enterprises have
sufficient resources, staffing, and technology to carry out their
responsibilities and;
* if applicable, determining the best means and time frames for
lenders to establish cooperatives.
Moreover, regulators would need the authority, expertise, and
resources to manage a potentially lengthy transition process while
minimizing the risk to housing markets.
Agency Comments and Our Evaluation:
We provided a draft of this correspondence to FHFA for its review and
comment. FHFA provided technical comments that we incorporated as
appropriate. Further, we requested comments on selected excerpts of
this draft correspondence from FCA and an industry observer whom we
interviewed and whose remarks we cited. Generally, both FCA and the
industry observer indicated their agreement with the excerpts of the
draft correspondence and FCA provided other technical comments that we
incorporated as appropriate.
We are sending copies of this correspondence to interested Members of
Congress and the Acting Director of FHFA. In addition, this report
will be available at no charge on the GAO Web site at [hyperlink,
http://www.gao.gov].
If you or your staff have any questions about this report, please
contact me at (202) 512-8678 or shearw@gao.gov. Contact points for our
Offices of Congressional Relations and Public Affairs may be found on
the last page of this report. Major contributors to this report were
Wesley Phillips, Assistant Director, Michelle Bowsky; Emily Chalmers;
Shamiah Kerney; and Paul Thompson.
Signed by:
William B. Shear:
Director, Financial Markets and Community Investment:
Enclosure:
List of Committees:
The Honorable Christopher J. Dodd:
Chairman:
The Honorable Richard C. Shelby:
Ranking Member:
Committee on Banking, Housing, and Urban Affairs:
United States Senate:
The Honorable Joseph I. Lieberman:
Chairman:
The Honorable Susan M. Collins:
Ranking Member:
Committee on Homeland Security and Governmental Affairs:
United States Senate:
The Honorable Tim Johnson:
Chairman:
The Honorable Mike Crapo:
Ranking Member:
Subcommittee on Financial Institutions:
Committee on Banking, Housing, and Urban Affairs:
United States Senate:
The Honorable Robert Menendez:
Chairman:
The Honorable David Vitter:
Ranking Member:
Subcommittee on Housing, Transportation and Community Development:
Committee on Banking, Housing, and Urban Affairs:
United States Senate:
The Honorable Barney Frank:
Chairman:
The Honorable Spencer Bachus:
Ranking Member:
Committee on Financial Services:
House of Representatives:
The Honorable Edolphus Towns:
Chairman:
The Honorable Darrell Issa:
Ranking Member:
Committee on Oversight and Government Reform:
House of Representatives:
The Honorable Paul E. Kanjorski:
Chairman:
The Honorable Scott Garrett:
Ranking Member:
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises:
Committee on Financial Services:
House of Representatives:
The Honorable Luis V. Gutierrez:
Chairman:
The Honorable Jeb Hensarling:
Ranking Member:
Subcommittee on Financial Institutions and Consumer Credit:
Committee on Financial Services:
House of Representatives:
The Honorable Maxine Waters:
Chairwoman:
The Honorable Shelley Moore Capito:
Ranking Member:
Subcommittee on Housing and Community Opportunity:
Committee on Financial Services:
House of Representatives:
[End of section]
Enclosure I: The Cooperative Model as a Potential Component of
Structural Reform Options for Fannie Mae and Freddie Mac:
Briefing to Congressional Committees:
Introduction:
The Federal National Mortgage Association (Fannie Mae) and the Federal
Home Loan Mortgage Corporation (Freddie Mac the enterprises) are two
housing government-sponsored enterprises (GSE). That is, as described
in this briefing, the enterprises are private corporations owned by
shareholders that derive certain benefits from their federal
sponsorship such as advantageous borrowing costs.
The enterprises support housing finance by establishing secondary
mortgage markets for what are known as conventional conforming loans.
They do so by issuing debt and purchasing mortgages and related
instruments that meet their underwriting criteria from lenders that
can use the proceeds to make additional loans. The enterprises either
package the mortgages to create mortgage- backed securities (MBS) that
are sod to investors or hold these mortgages, or the MBS, in their
retained portfolios.
Because of the enterprises' mounting losses on subprime mortgage
assets, in September 2008, the Federal Housing Finance Agency (FHFA)-
131-aced them into conservatorships out of concern, among other
things; that their deteriorating financial condition could potentially
destabilize financial markets.
The Department of the Treasury (Treasury) has pledged to provide the
enterprises with substantial assistance to stabilize their financial
condition and, as of September 2010, had purchased about $150 billion
of their preferred shares. The Congressional Budget Office estimates
that the conservatorships could cost taxpayers nearly $400 billion
over 10 years.
While the conservatorships are in place to help stabilize Fannie Mae
and Freddie Mac and restore confidence in financial markets, they are
not intended to be permanent.
Industry participants and others agree that Congress and the
administration need to reevaluate the enterprises' roles, structures,
and performance and consider options to facilitate mortgage finance
while mitigating concerns about safety and soundness and systemic risk.
A September 2009 GAO report analyzed the long-term structural reform
options for the enterprises.[Footnote 11] These options included (1)
establishing a government agency or corporation; (2) reestablishing
the enterprises as GSEs, but with additional restrictions on their
activities; and (3) privatizing or terminating them.
Subsequently, Congress and the administration have initiated debate
and analysis of various reform options for the enterprises as well as
for the housing finance system generally.
One proposal that has generated some interest among industry
participants, Congress, and others is referred to as the cooperative
model. Under this model, the enterprises would be converted from their
current structure as shareholder-owned corporations with government
sponsorship into cooperative entities owned by mortgage lenders.
Objectives:
This review is a follow-up to our September 2009 report on enterprise
reform options. We conducted this performance audit under the
Comptroller General's authority. Our objectives for this review are to:
* identify the key characteristics of the cooperative model,
* discuss the cooperative model's potential role as part of any long-
term structural reform option for the enterprises,
* discuss some likely advantages and disadvantages of the cooperative
model as a potential reform option for the enterprises, and,
* identify some of the key decisions that Congress and the
administration would have to make to initiate overall structural
reform for the enterprises and design an effective transition process.
Summary:
A cooperative is an entity that is owned, capitalized, and operated by
its members, usually participants in a particular industry, such as
banks, for their mutual benefit. Examples of other cooperatives that
are also GSEs include the Federal Home Loan Bank (FHLBank) System and
the Farm Credit System (FCS).
As indicated in our September 2009 report, the cooperative model is
generally viewed as a component of the three overall structural reform
options for the enterprises (government corporation or agency,
reconstituted GSEs, and privatization or termination), rather than an
option by itself. While the cooperative model could conceivably fall
under any of the three overall options, it is generally seen as most
closely associated with the option of reconstituting them as GSEs.
Under this option, the entity or entities that replace the enterprises
would be privately owned and conduct secondary mortgage market
operations with explicit financial support from the federal
government. Such private entities could be owned by lenders under the
cooperative model, through shareholders, as is the case with the
enterprises today, or on a nonprofit basis.
One potential benefit of the cooperative model, as cited by
proponents, is that it would encourage safer and sounder mortgage
underwriting practices as lenders could potentially lose some or all
of their capital investments in a cooperative to which they sell
mortgages. However, a cooperative model does not necessarily guarantee
safe and sound operations. In recent years, several FHLBanks have
experienced significant losses on nontraditional mortgage assets, and
FCS suffered significant losses during the 1980s because of poor
lending practices. A potential disadvantage of the cooperative model,
as cited by some observers, is that, because of the time that may be
needed to reach consensus among its members, it may not be well suited
to meeting the requirements of the dynamic secondary mortgage market.
Congress and the administration would need to make key decisions on
the appropriate overall structural reform option, the mission of the
entity or entities, and the oversight framework. If the new structure
includes the cooperative model, a number of decisions would also have
to be made on the number of cooperatives that would be formed and
their membership requirements, governance and capital structures, and
permitted business activities. Moreover, regulators would need the
authority, expertise, and resources to manage a potentially lengthy
transition process while minimizing the risk to housing markets.
Background:
Fannie Mae was originally established in 1938 as a government entity,
and later chartered as a for-profit, shareholder-owned corporation in
1968. Similarly, Freddie Mac was established in 1970 as an entity
within the FHLBank System and reestablished as a shareholder-owned
corporation in 1989.
The enterprises' primary mission has been to create secondary markets
for conventional conforming mortgages (i.e., mortgages not insured or
guaranteed by other federal agencies such as the Federal Housing
Administration or the Department of Veterans Affairs). They do so by
issuing debt and purchasing mortgages that meet their underwriting
criteria from primary lenders, such as banks, which can use the
proceeds to make additional loans. The enterprises either package the
mortgages to create mortgage-backed securities (MBS) that are sold to
investors or hold the mortgages or MBS in their retained portfolios.
Pursuant to their charters and legislation, the enterprises are
required to serve the mortgage needs of targeted groups, such as low-
income borrowers, and expected to support mortgage finance during both
good and bad economic periods.
Fannie Mae and Freddie Mac operated profitably for many years, but
observers have noted that federal sponsorship came with financial and
other advantages that undermined market discipline and encouraged
risky activities.
In particular, despite the explicit statement in their statutory
charters that the enterprises did not have a federal guarantee on
their debt and MBS, financial markets have long viewed them as
benefiting from an implied federal guarantee. The implied guarantee
allowed the enterprises to borrow funds at relatively low interest
rates and to operate with lower capital levels than commercial banks.
Further, they had incentives to engage in potentially profitable but
risky activities that were not necessarily consistent with their
housing missions.
For example, the enterprises' large mortgage portfolios exposed them
to interest rate risk and were complex to manage.
GAO and others have also stated that the fragmented regulatory
structure overseeing the enterprises for many years was inadequate,
given their size and complexity.
Background:
In the 2000s, the enterprises began losing market share as subprime
and Alt-A (i.e., nontraditional mortgages) lending increased, along
with the market for private-label MBS that were generally backed by
pools of nontraditional mortgages.
In response, the enterprises increased their purchases of Alt-A
mortgages, which they packaged into MBS with guaranteed principal and
interest payments, as well as private-label MBS for their own
portfolios.
When the housing market began to decline sharply in 2007 and 2008, the
enterprises began losing billions of dollars on these investments. And
as home prices declined, their exposure on their guarantees of prime
mortgage assets increased.
In response to growing concerns about the financial condition of the
enterprises, in July 2008, Congress passed and the President signed
the Housing and Economic Recovery Act of 2008 (HERA), which, among
other things, established FHFA, and charged it with the supervisory
and regulatory oversight of Fannie Mae and Freddie Mac. In September
2008, FHFA appointed itself as their conservator.[Footnote 12]
Under authority provided in HERA, Treasury entered into agreements
with the enterprises to maintain the enterprises' net worth through
purchases of their preferred shares on a quarterly basis.
Treasury initially set a $100 billion cap on the amount of preferred
shares it would purchase from each enterprise. Treasury later raised
the cap to $200 billon per enterprise in February 2009 and
substantially raised the cap in December 2009. Under the agreement,
Treasury can continue to purchase preferred shares indefinitely.
In November, 2008, the Federal Reserve announced a program to purchase
up to $500 billion in the MBS guaranteed by the enterprises, and
increased this amount in March 2009 up to a total of $1.25 trillion.
It may also purchase up to $100 billion in direct obligations.
Scope and Methodology:
To help address our objectives, we took the following actions:
* We reviewed and analyzed reports, studies, and other information on
the cooperative model and characteristics of its structure, including
the organization, governance and capitalization. We interviewed Farm
Credit Administration and FHFA officials on characteristics of certain
cooperatives, such as FCS and the FHLBank System, and the potential
relevance of these characteristics to the enterprises.
* We reviewed and analyzed reports, studies, and other information on
the structural reform options for the enterprises to determine how, if
at all, the cooperative model could fit into these options.
* We reviewed previous work we reported in September 2009 and
interviewed select industry groups, market participants, and experts
on their views regarding the potential advantages and disadvantages of
structuring Fannie Mae and Freddie Mac as cooperatives.
* We assessed the cooperative model against objectives identified in
the September 2009 report, particularly safety and soundness
objectives.
We built upon previous work and collected other information on the
decisions that policymakers will have to make regarding overall
structural reform for the enterprises and designing a transition
process to a new enterprise structure.
We conducted our work from January 2010 through September 2010 in
accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain
sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe
that the evidence obtained provides a reasonable basis for our
findings and conclusions based on our audit objectives.
Objective 1: Cooperatives Are Intended to Operate for Members Mutual
Benefit:
In general, a cooperative is an enterprise that is jointly owned and
controlled by the members who use its services. The members capitalize
and operate the cooperative for their mutual benefit, and work
together to reach an objective, such as access to financing, which may
be difficult if acting alone.
Cooperatives often involve participants in a single industry that have
common economic interests and goals. Members of cooperatives may
undertake joint activities such as marketing, purchasing supplies and
equipment, and providing certain services.[Footnote 13]
Cooperatives in the United States date back to the mid-1700s starting
in the insurance industry. From about 1890 to 1920, cooperatives
flourished in the farming industry, and have more recently expanded to
the financial services and housing industries.[Footnote 14]
Characteristics of Cooperatives:
Cooperatives are characterized by their organization, governance, and
methods of capitalization.
1. Cooperatives are owned and managed by the entities they serve,
which benefit from their participation.
2. Like many corporations, cooperatives are governed by a board of
directors. Members generally elect the board and may vote on major
organizational issues.
3. Cooperatives may acquire capital through membership fees or
members' stock purchases, withholdings from members' net earnings,
assessments on the members' sales or purchases, or a combination of
these.
4. Cooperative members' ownership shares in the cooperative are
nontransferable.
The FHLBank system and FCS are cooperatives that are also GSEs (see
slides 16 and 17). One difference between the FHLBank System and FCS
and other cooperatives is that they were created and organized through
federal legislation and subsequent regulations. Other cooperatives may
have been formed independently by members of a particular industry.
Table: Example of Cooperative Model The Federal Home Loan Bank System:
Mission:
The mission of the FHLBank System is to support residential mortgage
lending and related community investment and extend credit through
member financial institution.
Organization:
The 12 FHLBanks that compose the FHLBank System issue debt on a
consolidated basis via their Office of Finance. Each FHLBank is
jointly and severally liable for the FHLBanks’consolidated financial
obligations in the event of a default. Each FHLBank is owned by member
financial institutions in its district. The members are typically
insured depositories such as banks and thrifts. Benefits of FHLBank
membership include access to low-cost loans (known as advances) and
payment of dividends.
Governance:
The 12 FHLBanks are each separate legal entities governed by boards of
directors that are elected by the membership. The board includes
independent directors that are not associated with the FHLBank. Laws
and regulations pertaining to FHLBank directors are designed to help
ensure that large members do not dominate the board (e.g., board
representation is not based on volume of business with the FHLBank).
Capitalization:
The 12 FHLBanks are privately capitalized. Eligible financial
institutions invest stock in their FHLBank to become members. The
stock is not publicly traded, and is valued at par. Two classes of
stock are allowed, each subject to various restrictions on capital
redemption. The stocks generally cannot be redeemed for a period of 6
months or 5 years for Class A and Class B stock, respectively.
Source: GAO.
[End of table]
Table: Example of Cooperative Model The Farm Credit System:
Mission:
The mission of the Farm Credit System is to provide credit and
financially related services to farmers, ranchers, producers, or
harvesters of aquatic products, farmer-owned cooperatives, and rural
homeowners, businesses and communities.
Organization:
As of January 2010, FCS included 93 banks and associations—5 Farm
Credit banks, 85 Agricultural Credit associations, and 3 stand-alone
Federal Land Credit associations. In addition, the Federal Farm Credit
Banks Funding Corporation issues and markets debt securities to raise
loan funds for the banks and associations. FCS associations are
cooperatives owned by their borrowers, and Farm Credit banks are
cooperatives primarily owned by their affiliated associations.
Governance:
Although jointly and severally liable, the banks and associations each
have their own boards of directors composed of directors elected by
the voting shareholders and at least one outside director. Each bank
and association manages and controls its own business activities,
operations, and financial performance. The Farm Credit Act and FCA
regulations and guidance establish criteria for the management of FCS
banks and institutions.
Capitalization:
FCS banks and associations are subject to varying capital
requirements. For example, they are required to maintain a permanent
capital level of at least 7 percent of their risk-adjusted assets.
Source: GAO.
[End of table]
Objective 2: Cooperative Model Is a Component of Structural Reform
Options for the Enterprises:
Generally, Congress and the administration are considering various
reform options for the enterprises, including the three options that
GAO discussed in its September 2009 report: creating a new government
corporation or agency, reestablishing for-profit enterprises with
government sponsorship but with additional restrictions on their
activities, or privatizing or terminating them (see slide 19).
Each of the options would function differently, and each would involve
trade-offs (see slide 20).
As indicated in our report, the cooperative model is generally viewed
as a component of these larger options rather than an option by itself.
While the cooperative model could conceivably fall under any of the
three overall options, it is generally seen as most closely associated
with the option of reconstituting the GSEs.
Table: Summary of Options to Revise the Enterprises' Structures:
Potential structure: Government corporation or agency;
Proposed function: Focus on purchasing qualifying mortgages and
issuing MBS but eliminate mortgage portfolios, which are complex to
manage and can result in losses because of fluctuations in interest
rates. Responsibilities for promoting home ownership for targeted
groups could be transferred to the Federal Housing Administration
(FHA).
Potential structure: Reestablish for-profit enterprises with
government sponsorship;
Proposed function: Restore the enterprises to their preconservatorship
status but add controls to minimize risk. These controls might include
eliminating or reducing the enterprises’mortgage portfolios or
subjecting the enterprises to public utility-type regulation, which
involves business activity restrictions, profitability limits, and
executive compensation limits. Potentially convert enterprises from
shareholder-owned corporations to cooperative associations owned by
mortgage lenders.
Potential structure: Privatization or termination;
Proposed function: Abolish the enterprises and disperse mortgage
lending and risk management throughout the private sector. Potentially
establish a federal mortgage insurer to help protect mortgage lenders
against catastrophic mortgage losses.
Source: GAO-09-782.
[End of table]
Table: Structural Reform Options Involve Trade-offs:
Potential structure: Government corporation or agency;
Potential trade-offs: This option could mitigate some of the safety
and soundness risks and may have some advantages over private entities
in terms of supporting housing finance during periods of economic
stress. However, it is not clear whether government corporations would
be able to obtain the resources and staffing necessary to manage a
potentially complex secondary mortgage market function.A government
corporation may need sufficient flexibility in its operations to be
able to meet these challenges.
Potential structure: Reestablish for-profit enterprises with
government sponsorship;
Potential trade-offs: While this option may represent the least
potential change in the current housing finance structure and thus
help ensure continuity, it has potential risks from a safety and
soundness standpoint. For example, if the federal government
explicitly guaranteed certain financial obligations of reconstituted
GSEs, it could further undermine market discipline. Proponents believe
that eliminating or reducing their mortgage portfolios may minimize
potential safety and soundness risks.
Potential structure: Privatization or termination;
Potential trade-offs: This option could mitigate potential safety and
soundness risks by helping ensure mortgage underwriting decisions are
based on market factors. However, the federal government may need to
support a largely privatized mortgage lending industry in a financial
crisis, as lenders may withdraw from the market in such a situation.
Source: GAO-09-782.
[End of table]
Cooperative Model Is Most Closely Associated with Reconstituting the
Enterprises as GSEs:
Proponents of reestablishing the enterprises as GSEs generally favor
establishing a private entity or entities, which would issue MBS, be
federally guaranteed, and perhaps have mortgage portfolios.
The potential ownership structures for these private entities could be
shareholder-owned (similar to the enterprises' current structure),
cooperatives, or perhaps nonprofit.
It has also been proposed that the enterprises be subject to public
utility regulation. That is, a regulatory agency could issue
regulations governing their activities and rate of return
(profitability). Likewise, the ownership of such entities could also
be the cooperative model or shareholder owned.
Cooperatives Are Not Viewed as Integral to the Government Corporation
or Agency Option:
As a public entity, a government corporation or agency would not
likely be capitalized by lenders, nor would they likely have a role in
its governance or operations, as is the case with cooperatives.
It is conceivable that Congress and the administration could also
choose to organize lenders into cooperatives that would then sell
mortgages to a government corporation or agency.
However, such lender-owned cooperatives are not viewed as integral to
the government corporation or agency option. Ginnie Mae—the Government
National Mortgage Association—is a government corporation that
guarantees the timely payment of principal and interest on MBS
collateralized by pools of mortgages that are guaranteed or insured by
FHA or the Department of Veterans Affairs. Lenders, rather than Ginnie
Mae, issue MBS on which it guarantees the payment of principal and
interest, and these lenders are not members of cooperatives.
Privatization Option Could Involve Cooperatives but Would Depend on
Market Factors:
Proponents of privatizing or terminating the enterprises generally
believe that mortgage lending should be dispersed throughout the
banking system and based on market considerations rather than
government support or subsidies.
While lenders may choose to form cooperatives in the event the
enterprises are privatized or terminated, this decision would likely
depend on whether they decide that doing so is in their economic
interests.
One observer we contacted suggested that Congress and the
administration could facilitate the establishment of lender-owned
cooperatives in conjunction with a decision to privatize or terminate
the enterprises. This observer stated that organizing mortgage lenders
as cooperatives might be one means to help ensure the enterprises'
safety and soundness because lenders' capital would be at risk through
their participation in the cooperative.
Objective 3: Potential Advantages of Cooperative Model:
As discussed, a potential advantage of the cooperative model, as cited
by proponents, is that it would promote safer and sounder mortgage
underwriting practices. Proponents note that lenders would have
financial incentives to engage in sound mortgage underwriting because,
if they do not, then poorly underwritten mortgage loans sold to the
cooperatives could result in significant losses. Ultimately, those
losses could adversely affect the capital investments that lenders
have in such cooperatives.
However, a cooperative model does not necessarily guarantee safe and
sound operations. Several FHLBanks have recently suffered significant
losses because of their investments in nontraditional mortgage assets
(e.g., private-label MBS collateralized by Alt-A and subprime
mortgages) for their investment portfolios, and FCS suffered
significant losses in the 1980s because of poor lending practices. The
federal government provided financial assistance to FCS to help
address these losses.
Under the cooperative model, the potential also exists that
recapitalization could occur more quickly than with other structures.
For example, the cooperative might have rules requiring its members
under certain circumstances, subject to review and approval by their
primary safety and soundness regulator, to invest additional capital
if its capital levels are declining because of deteriorating financial
conditions. Under the shareholder-owned model, the entity may face
difficulties raising capital in financial markets in a financial
emergency, as market participants may not be interested in investing
capital in or providing loans to the entity.
The potential also exists that a limited number of cooperatives could
promote standardization and consistency within the housing finance
system because such cooperatives would likely have common forms,
rules, and procedures.
Potential Disadvantages of Cooperative Model:
Because of cooperatives' structure, some observers believe that
cooperatives can take an extended period to achieve consensus on key
business issues as compared with individual companies because all
members are involved in making the final decisions. As a result, some
question whether the cooperative model and any associated delay in
decision making would be well suited for complex and dynamic secondary
mortgage market functions.
Consistent with the discussion of establishing multiple GSEs in our
September 2009 report, multiple cooperatives could lead to
fragmentation of the housing finance system. Some observers believe
that a key benefit of the enterprises' activities has been that they
have helped create a nationwide housing finance system, which includes
deep and liquid markets for their MBS and debt securities.
Some observers also believe that large lenders could potentially
dominate any cooperative that is established to replace the
enterprises in their current structure. While cooperatives may have
rules in place to limit the influence of large members, such as
elections based on one vote per member rather than the volume of
business each member does with the cooperative, some observers believe
that large members may still circumvent such rules through their sheer
size. Concerns about consolidation within the mortgage industry have
grown in recent years as many lenders have failed and the remaining
lenders have acquired their business. As of year end 2009, the top
five mortgage lenders accounted for about 62 percent of all mortgages
outstanding.
Objective 4: Decisions on Enterprise Structural Reform Require
Consensus on Key Issues:
Congress and the administration will need to discuss and analyze the
merits and trade-offs of the overall reform options and agree on a
preferred approach.
During this process or subsequent to it, other key decisions will need
to be made such as whether the entity or entities would:
* provide a secondary market function for a narrow range of
conservatively underwritten mortgage products or seek to serve more
potential borrowers and promote innovation and risk by expanding the
range of mortgage products offered,
* be responsible for and equipped to support the mortgage market in
both good and bad economic periods, and,
* serve specific mortgage credit needs that provide benefits to
targeted groups, such as low-income borrowers and renters.
Key decisions would also be required on such issues as:
* explicit federal guarantees on the entity or entities' financial
obligations, such as their MBS;
* granting the entity or entities permission to maintain mortgage
portfolios and, if so, their size;
* the appropriate capital structure and requirements, if applicable
(not necessarily the case for a government corporation or agency
option), for the entity or entities to help mitigate safety and
soundness risks; and;
* the appropriate oversight framework for the entity or entities.
Decisions Necessary if Cooperative Model Is Included in Overall
Structural Reform:
As part of this process, if Congress and the administration decide
that the cooperative model is an appropriate approach, among the
decisions that would need to be reached are:
* the number of cooperatives that would be established;
* the cooperatives' membership requirements;
* the cooperatives' organization, governance, and capitalization
structure;
* the appropriate rules and regulations governing the cooperatives'
involvement in secondary mortgage markets;
* the appropriate oversight structure for the cooperatives to help
ensure that they operate in a safe and sound manner and achieve their
mission objectives.
Transition Considerations for the New Structure:
Once such decisions are finalized, a potentially lengthy transition
process may be needed to move from the current situation, where the
enterprises are in conservatorships, to the new structure, including
cooperatives as applicable.
Some key considerations in designing any transition process would
include the following:
* how to ensure the market viability of the new entity, particularly
if reconstituted GSEs or termination/privatization are the preferred
options, and;
* the process by which the new entity or entities will raise capital,
if applicable (may not be applicable for government corporation or
agency).
Key transition issues would also include the following:
* ensuring the entity or entities have sufficient resources, staffing,
and technology to carry out their responsibilities, and;
* if applicable, determining the best means and time frames for
lenders to establish cooperatives.
Finally, consideration would also need to be given to ensuring that
regulators have sufficient authority, resources, and technology to
carry out their functions.
[End of briefing slides]
Footnotes:
[1] Conventional conforming mortgages are those mortgages that are not
insured or guaranteed by the Federal Housing Administration, the
Department of Veterans Affairs, or the Department of Agriculture and
meet the enterprises' underwriting standards.
[2] GAO, Fannie Mae and Freddie Mac: Analysis of Options for Revising
the Housing Enterprises' Long-term Structures, [hyperlink,
http://www.gao.gov/products/GAO-09-782] (Washington, D.C.: Sept. 10,
2009). In addition to fulfilling congressional mandates and requests,
GAO also conducts work initiated under the Comptroller General's
authority on current or emerging issues that may affect the nation's
future or that are of broad interest to Congress.
[3] The 12 FHLBanks that compose the FHLBank System are owned by
member financial institutions located in each FHLBank's respective
district. The cooperative structure, among other benefits, gives
members access to low-cost loans (advances) and other financial
services. Each FHLBank is privately capitalized and governed by a
board of directors. The FHLBanks are jointly and severally liable for
the consolidated financial obligations of other FHLBanks. FCS, which
is composed of 93 banks and associations, is a cooperative owned by
its borrowers and affiliated associations. The banks and associations
each have their own boards of directors and are also jointly and
severally liable for obligations issued by other FCS banks, including
payments of interest or principal on consolidated systemwide
obligations. In addition, each is required to maintain a permanent
capital level of at least 7 percent of risk-adjusted assets.
[4] Congress initially chartered Fannie Mae in 1938 but did not
establish it as a shareholder-owed corporation until 1968. Congress
initially established Freddie Mac in 1970 as an entity within the
FHLBank System and reestablished it as a shareholder-owned corporation
in 1989.
[5] See GAO, Housing Government Sponsored Enterprises: A New Oversight
Structure Is Needed, [hyperlink,
http://www.gao.gov/products/GAO-05-576T] (Washington, D.C.: Apr. 21,
2005).
[6] Subprime lending generally involves the origination of mortgages
to borrowers who may represent greater default risks than prime
borrowers—for example, borrowers with lower credit scores—on terms
that may increase the potential for default. A common subprime
mortgage product would be an adjustable rate mortgage with an
initially low interest rate that increases substantially after a
certain period. In the years leading up to the financial crisis, many
such subprime mortgages were pooled and sold to investors as private-
label MBS.
[7] Pub. L. No. 110-289, Div. A, Title I, 122 Stat. 2654, 2658 (2008).
[8] See GAO-09-782.
[9] See GAO, Federal Housing Administration: Modernization Proposals
Would Have Program and Budget Implications and Require Continued
Improvement in Risk Management, [hyperlink,
http://www.gao.gov/products/GAO-07-708] (Washington, D.C.: June 29,
2007), and Information Technology: HUD Needs to Strengthen Its
Capacity to Manage and Modernize Its IT Environment, [hyperlink,
http://www.gao.gov/products/GAO-09-675] (Washington, D.C.: July 31,
2009).
[10] Section 104 of the Dodd-Frank Wall Street Reform and Consumer
Protection Act requires Treasury to study and submit a report and
recommendations to Congress on the government's role in the housing
finance system, among other things, by January 31, 2011. Pub. L. No.
111-203, § 1074, 124 Stat. 2067 (2008).
[11] GAO, Fannie Mae and Freddie Mac: Analysis of Options for Revising
the Housing Enterprises' Long-term Structures, [hyperlink,
http://www.gao.gov/products/GAO-09-782] (Washington, D.C.: Sept. 10,
2009).
[12] Among its recent actions, in June 2010, FHFA delisted the
enterprises' stock from all national securities exchanges.
[13] Henehan, Brian M. and Bruce L. Anderson, Considering Cooperation:
A Guide for New Cooperative Development, February 2001.
[14] United States Department of Agriculture, Coops 101: An
Introduction to Cooperatives, June 1997.
[End of section]
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