The central goal of the Federal Housing Finance Agency (FHFA) in managing its conservatorship of Freddie Mac and Fannie Mae is and  conserving the assets of the corporations by minimizing their credit losses from delinquent mortgages.

This goal and others were outlined in a letter earlier this month from Edward J. DeMarco, Acting Director of FHFA updating leadership of the House Financial Services and Senate Banking, Housing, and Urban Affairs committees on those conservatorships.  

The letter was released as part of a presentation made by DeMarco to the U.S. House of Representatives Committee on Financial Services Thursday.  The presentation was primarily concerned with outlining FHFA's approach to executive compensation at the two government sponsored enterprises while the letter addressed the history of the conservatorship and its plans for the future.

One mechanism by which FHFA plans to minimize credit losses going forward is a commitment of the Enterprises to their core businesses rather than on developing or engaging in new products.  FHFA published an interim final rule last July under the Housing and Economic Recovery Act of 2008 (HERA), implementing a public review process for new products that may be undertaken by the enterprise.  DeMarco said, after considering the statutory requirement and the goals of conservatorship, he has concluded that permitting the Enterprises to engage in new products is inconsistent with the goals of conservatorship and has instructed the Enterprises not to submit any such requests under the rule.

Demarco said he had reached this conclusion as various proposals seek Enterprise involvement that, "even if within charter limitations, could require large expenditures of funds, entry into new business lines with little prior experience, or dedication of personnel already operating in a stressed environment.  New products could also require new risk measuring tools, compliance procedures, and additional oversight from FHFA"  This type of limitation on new business activities, he said, is consistent with the standard regulatory approach for addressing companies that are financially troubled and is even more pertinent for the Enterprises given their uncertain future and reliance on taxpayer funds.

The acting director said that establishment of three funding facilities - the liquidity facility and the mortgage-backed securities facility, both of which expired at the end of 2009 - and the Senior Preferred Stock Purchase Agreements (PSPAs) which provide ongoing financial support to the Enterprises has supported market stability.  "As nearly all other non-governmental participants in housing finance abandoned the market, the Enterprises in conservatorship, operating with the benefit of the PSPAs have ensured that credit continues to flow to housing." 

He pointed out that the Enterprises share of financing or guaranteeing new single family mortgages rose from 54 percent in 2006 to 73 percent in 2008 and 78 percent during the first three quarters of 2009.  Their market share in multifamily housing finance during those same periods grew from 33 percent to 79 percent and was 64 percent through September 2009.

DeMarco stressed that conservatorship, however, cannot be a long-term solution.  In September 2008 when the government took over the Enterprises former Treasury Secretary Henry Paulson described the arrangement as a "time-out" to allow policymakers to reevaluate the role of the government and the Enterprises in future housing finance.  "There are a variety of options available for post-conservatorship outcomes," DeMarco said, "but the only one that FHFA may implement today under existing law is to reconstitute the two companies under their current charters."

In December the basis for calculating the required annual reduction in Freddie Mac and Fannie Mae's retained portfolios was changed to the maximum allowed balances rather than the actual balance at the end of the year.  This, DeMarco said, will give the Enterprises the flexibility to purchase delinquent mortgages out of guaranteed mortgage-backed security pools and DeMarco said he expected any net additions to the retained portfolios would be related to that activity.  He also expects that other private parties will begin to invest in new Enterprise MBSs as the Federal Reserve withdraws its purchase activity.  FHFA is directing each Enterprise to develop a detailed plan for keeping its portfolio within those limitations.

The FHFA will also continue to stress its mandate to maximize assistance to homeowners through the various programs available to minimize foreclosures.  DeMarco pointed to the various programs such as HOPE for Homeowners and the Making Home Affordable Program as critical to minimizing the Enterprises' credit losses.  He said that current and future efforts surrounding foreclosure prevention will focus on mitigating losses but where there is no available, lower-cost alternative to foreclosure he expects the Enterprises to move to foreclose expeditiously.

FHFA expects the Enterprises to continue to fulfill all of their statutory purposes including support for affordable housing and FHFA will soon publish a purposed rule setting housing goals for 2010 and 2011 and a framework for ensuring the Enterprises support for that segment of the housing market.  FHFA does not intend for this to include undertaking "uneconomic or high-risk activities in support of the goals, nor does it intend for the state of conservatorship to be a justification for withdrawing support from these market segments," the letter said.  Under conservatorship, the Enterprises have tightened their underwriting standards to avoid the poor quality mortgages that have contributed so much to past losses.

DeMarco told the Financial Services Committee that much thought has gone into the role of executive compensation in achieving the goals for the Enterprises in conservatorship.  While FHFA no longer sought to employ those executives most responsible for the conditions leading to receivership, they recognized that they needed to retain capable and knowledgeable staff.  The Agency consulted with the FDIC which has considerable experience in conservatorships and hired Hay Group, an executive compensation consultant to help "design a plan to encourage the best employees to say, while not rewarding poor performance.

The pre-conservatorship CEOs left the Enterprises after a brief transition period and received no severance.  Since most of their pay had been in the form of Fannie Mae and Freddie Mac stock, roughly 2/3 of their past compensation was also lost.  Unfortunately, DeMarco said, many of the 11,000 rank and file employees at the Enterprises also had large portions of their life savings in their companies' stock and suffered accordingly.

Under the new compensation structure, the CEOs of each Enterprise will receive $6 million a year; CFOs will receive $3.5 million and Executive Vice Presidents and below will be capped at $3 million.  This is half of the target pay for Enterprise CEOs before the conservatorship and Fannie Mae and Freddie Mac have reduced target pay by an average of 40 percent for all executive officers.  However, these salary amounts will be paid in three parts.  Salaries are generally capped at $500,000 and there will be incentive pay limited to one-third of total compensation and a deferred salary.  Incentive pay will be determined by a formula that does not reward risk.  Deferred salary will be paid with a one year lag only to executives still working for their Enterprise at that time.  This portion will also be based on company performance based on the 2010 scorecard.  In addition there are limitations on perquisites, retirement plans will be equalized across all employee ranks, and deferred salary and incentive pay will be subject to clawbacks in the event of gross negligence or misconduct, conviction of a felony, or erroneous performance metrics.

DeMarco said that, as Congress considers resolution regimes in the future it will be important to consider an orderly resolution and sufficient compensations will be necessary to accomplish this.  "This is especially important in a situation where the future of the firm in question is uncertain.  In the case of the Enterprises, the executive management teams may do a great job in meeting the goals of conservatorship but the future of the companies rests with Congress, not with them.