Several things have occurred over the last week or so in the ongoing saga of Freddie Mac, Fannie Mae and their financial improprieties which date back almost to the turn of the century.

First, Freddie Mac recently announced that it had voluntarily adopted a temporary policy of limited growth for its portfolio of retained loans. The use of the term "voluntarily" may be a bit of an overstatement as the restriction was in response to a request from the Office of Federal Housing Oversight (OFHEO) which is the designated regulator for Freddie and for Fannie Mae the two Government Sponsored Enterprises (GSEs) which effectively run the secondary mortgage market.

Freddie has agreed to keep its mortgage portfolio at a level no more than two percent above the level that existed on June 30, 2006 and will adhere to that level until the company has resumed timely reporting of its quarterly financial results. The company said its objective was to return to quarterly reporting following release of full-year 2006 results. The corporation admitted that "this is a challenging objective, and we need to achieve a number of interim objectives relating to controls and reporting systems to be successful." No date was given for achieving that goal.

Fannie Mae, in the meantime, announced that it would once again fail to file its required quarterly report with the Securities and Exchange Commission for the quarter ended on June 30, 2006. Fannie has failed to file quarterly or yearly reports since the scandal surrounding its financial statements erupted two years ago. Generally a publicly held corporation that is more than a year delinquent in its financial reporting is de-listed from the New York Stock Exchange. Fannie Mae, however, was granted a waiver from this sanction.

A spokesman for Fannie Mae said that the corporation is committed to issuing a restated financial statement for 2004 by the end of this year and, presumably, will then begin catching up on more recent reports.

The two GSEs are obviously not moving fast enough to please their chief regulator. OFHEO Director James B. Lockhart, III, speaking before a committee of the American Bar Association on August 9 called for more reform of the two corporations and stronger powers for his own agency.

Mr. Lockhart recapped the problems arising from accounting irregularities stating that earnings were misstated for an estimated $16 billion dollars (for the two corporations combined), "fines exceeded one-half billion dollars, lawsuits will total well over a billion dollars, and remedial costs will exceed $2 billion."

Freddie and Fannie are making progress in fixing their problems, he said, but it is slower than they or we would like or expect. It will take several more years and legislation is needed to make sure that the companies do not falter again.

"From the beginning," Lockhart said, "OFHEO has been no match for the responsibility assigned to it of being the safety and soundness regulator of Fannie Mae and Freddie Mac. Together they represent more than a 40 percent share of the residential mortgage market, a share that has doubled since 1990. This unconstrained growth led to significant operational problems, mismanagement, and earnings manipulation"

Lockhart blamed the credit markets for not providing normal market discipline to restrain growth. During the last 15 years the nations GDP doubled but the mortgage market tripled. The GSEs' guarantees quadrupled and their portfolios grew 900 percent. Lockhart said that much of this growth was based on the corporations' GSE status rather than their balance sheets.

He stressed that such wild growth can cause market, credit, and operational risk but most importantly systemic risk. Financial difficulties of such an institution could disrupt the financial sector enough to transmit problems to other financial institutions or markets with which it is interdependent. For example, he said, 60 percent of U.S. banks have more than half of their capital invested in agency securities.

Two bills in Congress, one passed in the House and the other approved by the Senate Banking Committee, contain many features which will help prevent problems in the future, primarily by strengthening OFHEO's regulatory powers Lockhart said. The bills grant the agency powers similar to a bank regulator - independent litigation authority, receivership, and better enforcement powers, and also permit OFHEO to seek damages from institution-affiliated parties and a longer statute of limitations to pursue former employees.

The legislation also seeks to free OFHEO from the appropriations process. Even though the agency is essentially funded by Freddie and Fannie (much like the Federal Deposit Insurance Corporation is funded by member banks) it is still subject to Congressional approval of its budgets and does not always have the funds available to respond to crises. The bill would also combine the agency with the Federal Housing Finance Board and free it somewhat from its organizational chart placement in HUD.

He called for higher minimum capital requirements, currently about half that required of large banks and asked for explicit authority to set portfolio growth limits. Fannie Mae's portfolio, he said, has grown 13 percent annually and Freddie Mac's 26 percent since 1990 to $727 billion and $710 billion respectively. In contrast the residential mortgage market grew at an average rate of 8.5 percent. "Absent the agreed upon portfolio limits, Fannie Mae and Freddie Mac could each increase their portfolios by well over $100 billion without exceeding the present minimum capital rules including the 30 percent operational risk requirement that OFHEO imposed."

He denied that limits on portfolios would hurt the GSEs' ability to support the secondary market and fulfill their missions of liquidity, stability, and affordability. He said that neither the House nor the Senate bill will limit the corporations' ability to buy and securitize mortgages which is the key liquidity mechanism for the secondary market. These mortgage-backed securities (MBS) not owned by the GSEs represent 26 percent of the total U.S. mortgage market. OFHEO estimates that less than 30 percent of the retained portfolios actually contribute to the GSEs' stated mission of affordable housing.

Lockhart concluded by claiming that, were Freddie and Fannie not GSEs, the market would have made them quickly shrink their portfolio businesses. "The markets are not performing that discipline and OFHEO does not have the powers or tools to be a strong regulator, let alone be a substitute for market discipline."