By James Hamilton, J.D., LL.M.
Acting on a broad consensus that government sponsored enterprises need a strong well-funded federal regulator, Title III of the massive housing bill would overhaul the regulatory oversight of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. The American Housing Rescue and Foreclosure Prevention Act (HR 3221) would create a new, independent regulator of the GSEs with broad powers analogous to current banking regulators. The Federal Housing Finance Agency would be headed by a Director, appointed by the President and confirmed by the Senate for a 5-year term. The bill also imposes many of the corporate governance provisions of the Sarbanes-Oxley Act on the GSEs, including certification of financial statements, codes of ethics, loan prohibitions, and independent audit committees.
HR 3221 has passed the House and Senate, but was returned to the House for additional consideration. It also faces a veto threat from the Bush Administration.
The housing GSEs are uncommon institutions with a unique set of duties and stakeholders. They are chartered by Congress, limited in scope, and are subject to congressional mandates, yet they are publicly traded companies with all the earnings pressure the markets can apply. They are also among the largest US financial institutions, and are among the largest issuers of debt in the world.
Title III is based on two previous bills that passed the House in the past few years, HR 1427 and HR 1461, which was championed by Rep. Michael Oxley.
The measure has two major components. First, it significantly increases the strength of the regulator of the two major federal housing government-sponsored enterprises, Fannie Mae and Freddie Mac. Second, it deals with the Federal Home Loan System, which was seen as less in need of drastic change.
With regard to Fannie Mae and Freddie Mac, the bill establishes an independent regulator and makes the GSEs function more like private corporations. The new regulator will review and set portfolio limits, establish minimum capital requirements, and review new programs and products. More broadly, the bill authorizes the new regulator to supervise the GSE portfolios for safety and soundness. Any new financial products developed by the GSEs must be approved by the Director, after a finding that the product is in the public interest and consistent with the safety and soundness of the GSE.
FHFA would issue and enforce prudential management and operations standards for the regulated entities, including credit, interest rate, and market risks, internal controls, liquidity, and investments. The agency may also require a regulated entity to withhold compensation from an executive officer during a review of the reasonableness and comparability of compensation, and may take into consideration any wrongdoing by the officer.
The bill also empowers FHFA to adjust minimum and risk based capital levels. The agency may increase the minimum capital level through regulation or, if there is a serious safety and soundness concern, temporarily through an order. The agency may also establish capital or reserve requirements with respect to particular programs or activities as the agency considers appropriate. The measure also authorizes the regulator to adjust the portfolio holdings of the GSEs. This could be done for either the purpose of increasing safety and soundness of the enterprise or fulfilling the housing mission.
The bill requires the GSEs to register at least one class of capital stock with the SEC under Exchange Act reporting requirements. Also, the GSEs will be subject to SEC proxy and insider reporting provisions. Thus, their directors and policymaking officers will have to comply with the reporting requirements of Section 16(a).
Section 115 of the Act requires the SEC, in consultation with the Fed, to study the impact of fair value accounting standards on financial institutions and report its findings and recommendations to Congress within 90 days of the bill’s enactment. Specifically, the SEC must examine the impact of fair value accounting with respect to residential mortgages that are at risk of foreclosure and mortgage-backed securities involving such mortgages, as well as the effects of fair value accounting on a financial institution's balance sheet and capacity to provide refinancing to residential mortgagors that are at risk of foreclosure. Further, the SEC must examine the feasibility of modifying fair value accounting standards during periods of market fluctuation in order to maintain the ability of the financial institution to continue to carry mortgages on residential property at risk of foreclosure and assure the availability of credit to refinance at-risk residential mortgages.
Importantly, the legislation requires the enterprises to comply with a number of significant provisions of the Sarbanes-Oxley Act. Fannie Mae and Freddie Mac must have independent audit committees as required by Section 301 of Sarbanes-Oxley. The audit committee will be responsible for hiring, firing and compensating the outside auditor. Audit committee members must be given funds to engage independent counsel and other advisers as they determine necessary to carry out their duties. In addition, audit committees must set up a system to receive and address complaints regarding accounting, internal control and auditing issues. The bill also requires the rotation of audit partners involved in the audit of the enterprise after five years, which is similar to the mandate in Section 203 of Sarbanes-Oxley.
The bill also requires Fannie Mae and Freddie Mac to establish a code of ethics with the standards enunciated in Section 406 of Sarbanes-Oxley. Thus, the code of ethics must contain standards designed to promote honest and ethical conduct, including the ethical handling of conflicts of interest between personal and professional relationships. The code must also promote full and accurate disclosure in the periodic financial reports filed by the enterprises.
Significantly, in a provision modeled on Section 302 of Sarbanes-Oxley, the reform measure would require the chief executive and financial officers of the enterprise to review the quarterly and annual reports and certify that these financial statements fairly present the operations and financial condition of the enterprise. Similarly, in a provision based on Section 402 of Sarbanes-Oxley, the bill prohibits Fannie Mae and Freddie Mac from making loans to any of their directors or executive officers.
The Act would also amend Section 105(b) of the Sarbanes-Oxley Act by adding the Federal Housing Finance Agency to the list of those federal agencies with which the PCAOB may share information without loss of confidentiality.
As originally passed, Section 105(b) allows the PCAOB to share confidential and privileged information gathered during inspections and investigations with the SEC, and state and federal attorneys general. The GSE reform measure would add the Federal Housing Finance Agency to the list of governmental agencies with which the Board can share such information.
Going beyond Sarbanes-Oxley, the GSE reform bill would mandate that the Fannie Mae and Freddie Mac boards must meet at least eight times a year, and at least once a quarter. In addition, the independent directors must meet at regularly scheduled sessions without management participation. A majority of the board members must be independent under NYSE standards.
Finally, the reform measure requires each enterprise to establish a risk management program designed to manage the risks of its operations. The program would be headed by a risk management officer reporting directly to the CEO. Moreover, the risk management officer must report regularly to the directors on compliance with, and the adequacy of, current risk management policies and procedures of the enterprise, and recommend any necessary adjustments to the procedures.