Modernizing the U.S. Financial Regulatory System and Federal Role in Housing Finance
The United States continues to recover in the aftermath of the worst financial crisis in more than 75 years. To stabilize the financial system, unprecedented federal support was provided to many firms, including Fannie Mae and Freddie Mac, two large, housing-related government-sponsored enterprises (the enterprises). Many households suffered as a result of falling asset prices, tightening credit, and increasing unemployment. These events clearly demonstrated that the U.S. financial regulatory system was in need of significant reform. As a result, we designated reform of the financial regulatory system as a high-risk area in 2009. Also, in the years since the crisis began, the federal government has directly or indirectly supported over three-quarters of the value of new mortgage originations in the single-family housing market. Mortgages with federal support include those backed by the enterprises, which were placed under government conservatorship in 2008, and whose future role has yet to be determined. The federal government also supports mortgages through the insurance programs of the Federal Housing Administration (FHA), which has experienced substantial growth in its insurance portfolio and significant financial difficulties. Until decisions are made as to what role the federal government will play in housing finance, housing and mortgage markets may continue to pose increased risks to taxpayers and the U.S. financial system. In light of developments concerning the enterprises and FHA, we added this issue to the scope of this high-risk area in 2013.
See GAO, Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System, GAO‑09‑271 (Washington, D.C.: Jan. 22, 2009), and Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System, GAO‑09‑216 (Washington, D.C.: Jan. 8, 2009).
Congress and financial regulators have made progress in meeting the criteria for removal from our High Risk List regarding reforming the U.S. financial regulatory system. However, definitive steps have yet to be taken to address the federal government’s role in housing finance. Demonstrating leadership commitment and capacity, Congress enacted sweeping reforms in 2010 through the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) and regulators have worked to implement the act’s numerous reforms. Continued leadership commitment will be needed to fully implement the reforms. Moreover, additional work is needed to complete action plans, monitor progress, and demonstrate the effectiveness of new rulemakings and regulatory bodies. Policymakers have made proposals to overhaul the federal government’s role in the housing finance system, but additional leadership commitment will be needed to reach consensus and enact changes to the system. The ongoing federal conservatorship of the enterprises and FHA’s financial challenges underscore the need for reconsideration of the federal role. Federal agencies have taken some steps to develop plans, build capacity, and provide monitoring mechanisms that could help build a more robust housing finance system. However, progress toward resolution of the federal government’s role within that system will be difficult to achieve without an overall blueprint for change.
In the decades leading up to the recent crisis, 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—that had come to play critical roles in the financial markets were not subject to sufficiently comprehensive regulation and oversight. Third, the regulatory system was not effectively 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 to adapt to new products and participants as they arise could reduce the likelihood that the financial markets will experience another financial crisis similar to the one in 2007- 2009. Losses from risky mortgage products also resulted in the enterprises being placed into government conservatorship in 2008, creating an explicit fiscal exposure for the federal government. The enterprises received more than $187 billion in financial assistance from Treasury through purchases of senior preferred stock, but have paid more than $200 billion in dividends to Treasury under the stock purchase agreements. Distressed housing and mortgage markets also expanded FHA’s role in the mortgage market, while leading to deterioration in the agency’s financial condition.
Actions Taken to Implement and Ensure the Effective Functioning of Regulations and New Financial Regulatory Bodies
Leadership commitment: Policymakers and regulators have partially met the leadership criterion for removal from the high-risk list. Since the crisis, policymakers and regulators have shown leadership commitment by enacting and implementing the Dodd-Frank Act, which included a range of reforms intended to better position the financial regulatory system to address many of the risks that we identified. For example, a new Financial Stability Oversight Council (FSOC) that includes various financial regulators was created to, among other things, monitor the stability of the U.S. financial system and take actions to mitigate risks that might destabilize the system. In addition, the act consolidated responsibility for consumer financial protection laws into a new bureau known as the Consumer Financial Protection Bureau (CFPB). However, reforms in various areas, including rules addressing some mortgage disclosures or over-the-counter derivatives reforms, have yet to be fully implemented.
Capacity: Regulators have partially met the capacity criterion for removal from the High Risk List. Regulators have made considerable progress in finalizing the rulemakings necessary to implement the regulatory reforms. As of November 2014, regulators had issued final rules for 146 (62 percent) of the 236 provisions of the act that we identified as requiring regulators to issue rulemakings. In the last 2 years, financial regulators have made progress in completing rulemakings in various areas. For example, the Commodity Futures Trading Commission has finalized 90 percent of the rules relating to the trading of swaps and other derivatives that were required by the act. CFPB also issued a key rule—which became effective in January 2014—requiring mortgage lenders to consider consumers’ ability to repay home loans before extending them credit. Additionally, in October 2014, several agencies completed a joint rulemaking that identifies the types of mortgages for which the entities that pool mortgage loans and issue securities based on the loans’ cash flows will be required to retain a portion of the loans’ credit risk. We have also reported that delays in completing rules sometimes arose because the large volume of required rules strained regulators’ capacities or because of the need to coordinate complicated rulemakings across multiple regulators or with international counterparts.
Action plans and monitoring: Regulators have made some progress in developing action plans for completing reforms and for monitoring implementation progress—both criteria for removal from the high-risk list. Regulators have described developing priorities for more important rules and for completing rules necessary to be in place to accommodate later rulemakings. In 2010, FSOC published an integrated implementation road map that included a list of the rules regulators were required to promulgate and a time line for the agencies involved in rulemakings. It also developed a consultation framework that established time frames for coordination activities among agencies where interagency consultation was required by the Dodd-Frank Act. However, we reported previously that these documents have limited usefulness to facilitate coordination among agencies. In the absence of a strategic plan, FSOC’s annual reports serve as the council’s key accountability document, as each report discusses the progress regulators have made in implementing reforms, identifies threats that are newly emerging and includes recommended actions to address them. However, we have identified the need for FSOC to improve its processes for identifying and prioritizing potential emerging threats to financial stability in its reports. In addition, the financial regulators are required (under various statutes) to conduct retrospective analyses of the impact of their rules, but have yet to include the rules completed under the Dodd-Frank Act in these planned analyses. Finally, regulators have shown diligence in reviewing resolution plans, otherwise known as “living wills,” and in conveying continued shortcomings and concerns with the initial plans submitted. Accordingly, large banking institutions are instructed to further develop and refine contingency plans for their orderly resolution by July 2015 to better protect the U.S. financial system stability against serious adverse effects from a potential failure.
Demonstrated Progress: Regulators have partially met the demonstrated progress criterion for removal from the high-risk list. For example, since the financial crisis, the newly-created regulatory bodies have been taking actions to carry out their missions. FSOC has held numerous meetings and has issued various congressionally-mandated studies and multiple annual reports addressing market and regulatory developments across the financial system. FSOC has also developed some mechanisms for monitoring threats to the U.S. financial system. As of September 2014, it had also designated various financial market utilities (which perform key functions in the financial system) and four nonbank financial companies for enhanced prudential standards and supervision by the Board of Governors of the Federal Reserve (Federal Reserve). To date, OFR has provided analyses to FSOC, has issued reports, and has assisted with an effort to develop a global legal entity identifier standard—which will provide unique identifying numbers to parties to financial transactions and should assist in resolving troubled firms and provide other benefits. Since commencing operations in 2011, CFPB has issued a number of rules, including those relating to mortgages and international money transfers. This agency has also been conducting examinations of the entities it oversees, including large banks and credit reporting agencies. In addition, it has taken enforcement actions against numerous institutions, obtaining a total of over $2.2 billion of redress for consumers and penalties from various financial institutions since 2012.
Progress has also been made to reduce the potential systemic implications of certain concentrations of credit risks that were not addressed by the Dodd-Frank Act. Regulators have been working to reduce the potential for serious problems arising from the failure of one of the two clearing banks that provide credit to facilitate transactions in the tri-party repurchase (repo) market that provides short-term funding to many financial institutions. FSOC’s 2014 annual report noted that an influx of customer deposits has reduced banks’ dependence on such short-term funding, but some securities broker-dealers continue to primarily fund themselves in these markets. The Federal Reserve has worked with the two clearing banks to reduce their problematic credit exposures.
Actions Taken to Resolve the Federal Role in Housing Finance
Leadership Commitment: Policymakers have shown some leadership commitment in resolving the federal role in housing finance. For example, in 2013 and 2014, several legislative proposals were introduced to change the housing finance system. These proposals ranged from a major overhaul of both the primary and secondary mortgage markets to more specific measures aimed at improving FHA’s financial condition. In addition, these proposals varied in their views on the appropriate role for the federal government in a new housing finance system. As of December 2014, none of the proposals had passed either the House of Representatives or the Senate.
For their part, FHA and FHFA have also demonstrated commitment to strengthen the financial condition of FHA and the housing enterprises. Further, FHFA has undertaken efforts to harmonize enterprise securitization and to put in place a common securitization platform that might be used under a reformed housing finance system. Finally, financial regulators have finalized rules defining qualified mortgages and qualified residential mortgages, which will be important in clarifying mortgage safeguards.
Capacity: While it is too early to know what capacity the federal government will require in a future housing finance system, FHA has made some progress in strengthening its financial capacity. As we have previously reported, FHA’s Mutual Mortgage Insurance (MMI) Fund has been out of compliance with its statutory 2-percent capital requirement since fiscal year 2009. Additionally, a weakening in the projected performance of FHA-insured mortgages led to FHA receiving $1.68 billion from the Treasury at the end of fiscal year 2013, to ensure that the MMI Fund had sufficient funds to pay for all expected future losses on existing insurance obligations.
FHA has taken a number of steps to restore its financial health. For example, FHA has adjusted its insurance premiums multiple times since 2009, and in 2013 it began requiring new borrowers to continue paying annual insurance premiums regardless of their loan balance. In 2010, FHA also increased down-payment requirements for borrowers with lower credit scores. Further, FHA has taken steps to mitigate losses by revising guidelines on home retention options for struggling borrowers and by implementing cost-effective alternatives for disposing of nonperforming loans and foreclosed properties.
While FHA’s capital ratio is still below the required level, in November 2014, FHA reported that its capital ratio was positive (0.41 percent) for the first time since 2011. Further, we have made recommendations to FHA, including actions designed to increase returns on foreclosed properties, which could help strengthen FHA’s financial position. FHA has begun to address a number of these recommendations.
Action Plans: Although fundamental changes to the housing finance system have yet to be enacted, federal agencies have taken some planning steps to help resolve the federal role in housing finance. Some of these actions have addressed the role of the two housing enterprises, which have continued to support more than half the total value of new single-family mortgage loans while operating under federal conservatorship. Specifically,
- in February 2011, 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 2012 and 2014, the Federal Housing Finance Agency (FHFA), which oversees the enterprises’ operations, issued plans that identified strategic goals for the next phase of conservatorship for Fannie Mae and Freddie Mac. The goals in the 2014 plan are maintaining credit availability and foreclosure prevention activities in the housing finance market in a safe and sound manner, reducing taxpayer risk through increasing the role of private capital in the mortgage market, and building a new infrastructure for the secondary mortgage market.
- to help build a new infrastructure for the secondary mortgage market, FHFA directed the enterprises in 2012 to develop a new mortgage securitization platform that would replace the enterprises’ proprietary systems and that could be used by multiple securities issuers to process payments and perform other functions. The enterprises have made progress on several aspects of the securitization platform, including the development of software, but development and implementation challenges remain.
- in June 2014, Treasury invited public comment on the role of the private-label market for mortgage-backed securities in the current and future housing finance system as a way to help resolve issues impeding the revival of that market.
Monitoring: Federal agencies have also taken initial steps to provide the types of monitoring that will be needed to assess the impact of changes to the housing finance system when they occur. For example, CFPB and FHFA have strategic plans that call for monitoring different aspects of the mortgage market, such as emerging risks and consumer access. In addition, FHFA has jointly funded an initiative with CFPB to build a national mortgage database that would contain data fields that could be useful for examining the effect of mortgage market reforms.
Demonstrated Progress: Overall progress on resolving the federal role in housing finance will be difficult to achieve until Congress provides further direction by enacting changes to the housing finance system. Federal agencies have begun taking some planning, capacity building, and monitoring steps. Among these are actions mentioned above to strengthen the financial condition of FHA and the housing enterprises. FHFA and FHA have also taken steps to monitor their progress in these efforts by reporting on their financial condition and activities. Further, Treasury and HUD have combined to report routinely on the condition of the housing market through their housing market scorecard. Nonetheless, because an overall blueprint for the future of the federal role in housing finance and the specific roles to be played by these institutions has not been determined, assessing progress against any specific goal is not yet possible.
While progress has been made on different aspects of modernizing the financial regulatory system and the federal role in housing finance, additional work is needed.
Actions Needed to Complete and Ensure the Effective Functioning of Reforms to the U.S. Financial Regulatory System
Continued leadership commitment is needed to ensure that the financial regulators complete the implementation of the Dodd-Frank rulemaking. Although regulators have finalized 62 percent of the 236 rules the Dodd-Frank Act required, some rules have effective dates such that the affected financial institutions may not have to begin complying with these provisions until sometime in 2015 or later. Furthermore, 66 rules—28 percent of the total required—have only been issued in proposed form and have yet to be finalized. Finally, regulators have not yet issued any rulemakings for the remaining 24 actions (10 percent) required under the act.
Moreover, even after being finalized, some Dodd-Frank rules, or parts of certain rules, are yet to go into effect. For example, the Dodd-Frank Act prohibits insured depository institutions and any company affiliated with an insured depository institution from engaging in proprietary trading and from acquiring or retaining ownership interests in, sponsoring, or having certain relationships with a hedge fund or private equity fund. The regulators issued a final rule adopting this prohibition in January 2014. However, in December 2014, the Federal Reserve announced that banking entities would have until July 21, 2016, to conform investments in and relationships with covered funds and foreign funds that were in place prior to December 31, 2013 (“legacy covered funds”). Similarly, although the regulators adopted higher capital requirements for banks in October 2013, some provisions are not fully effective until January 2019. Leadership commitment to completing and implementing Dodd-Frank Act rules will be required, given competing demands on the regulators, pressure from some market participants to delay or forgo certain reforms, and the inertia of maintaining the status quo as we move farther from the period of the financial crisis. FSOC may need to become involved if individual regulators experience problems or unnecessary delays in finalizing the remaining rules.
Regulators must also demonstrate additional leadership and capacity to make progress in ensuring the effectiveness of the financial reforms being implemented. Importantly, the recent financial crisis highlighted the lack of an agency or mechanism responsible for monitoring and addressing risks across the financial system, as well as a shortage of timely information to facilitate that oversight. FSOC was charged with (among other things) systemic risk monitoring. However, it continues to lack a comprehensive approach for identifying and addressing threats to financial stability. As we reported in 2012 and 2014, the current mechanisms may facilitate analysis of risks through interagency discussions and responses, but may not help to identify new risks or threats that FSOC member agencies have not already identified on their own. We have also recommended that FSOC and OFR clarify responsibility for monitoring threats to financial stability between their two agencies, including addressing the role of FSOC member agencies, to better ensure that the monitoring and analysis of the financial system are comprehensive and not unnecessarily duplicative. OFR continues to work to develop indicator-driven tools to assess risks to the financial system, but until such tools are finalized and used, FSOC cannot be assured that it is fully informed about critical vulnerabilities in the financial system.
Demonstrated progress is also needed to ensure the effectiveness of reforms addressing the resolution of troubled firms. Although the unprecedented support provided to financial institutions to stabilize financial markets during the financial crisis helped to avert a more severe crisis, these actions raised questions about the appropriate scope of government safety nets for financial institutions. We had recommended that the Federal Reserve take steps to ensure timely completion of the development of procedures related to its emergency lending. In January 2014, the Federal Reserve published proposed rules on these procedures, but as of November 2014, it had yet to issue them in final form. Furthermore, although regulators have issued the rules that require financial institutions to develop resolution plans or “living wills” for a rapid and orderly resolution in the event the institution’s solvency is threatened, in the summer of 2014, banking regulators instructed firms to improve their resolution plans so that they more realistically reflect the likely financial circumstances that could be faced when a firm fails. Because the global legal entity identifiers will provide important information in resolving a large financial firm failure, OFR should encourage U.S. financial regulators to embed the use of these identifiers into rules and reporting requirements.
Additional progress is required to address other risks. Although the Federal Reserve has worked with the two clearing banks for the repo market to reduce their problematic credit exposures, FSOC has acknowledged that policymakers must continue to examine ways to minimize risks from this activity. Similarly, regulators must finalize rules that will implement heightened governance requirements for derivatives clearinghouses.
The regulators must also take actions to monitor the effectiveness of their reform efforts. Regulators are required to conduct retrospective reviews of their rules, which provide opportunities to assess the impact of their rulemaking. However, we found in 2011 that some regulators have not yet developed plans to review their Dodd-Frank rules. We noted that the regulators would be better prepared to undertake reviews if they had identified the needed data before beginning a review and, even better, before promulgating the rule. If regulators fail to plan for how they will measure the performance of their rules and how they will obtain the data they need to do so, they may be limited in their ability to accurately measure the progress or true effect of the rules. More recently, FSOC told us that it planned to assess the impact of its rules in a recurring requirement under the Dodd-Frank Act to study the economic impacts of regulatory limitations, which is next due no later than January 2016. FSOC said this study could be the appropriate mechanism to study the impact of its designations of nonbank financial companies for enhanced prudential supervision by the Federal Reserve. Given that the designations will likely have important benefits and costs for the designated firms—which will become subject to a number of other rules from multiple regulators—and potentially the nation’s economy, we recommended in 2012 that FSOC study the impact of its designation process. FSOC has not started planning for this study. In 2014, we examined the process FSOC is using to determine which nonbank entities are sufficiently systemically important to subject them to enhanced supervision by the Board of Governors of the Federal Reserve System. We recommended that FSOC take several steps to enhance the accountability and transparency of its determination process, such as tracking key evaluation information, including additional details in public documentation about the rationale for determination decisions, and establishing procedures to evaluate companies under the different statutory determination standards.
Finally, FSOC’s annual reports could be used to demonstrate progress in implementing reforms and to provide action plans for moving forward. However, we reported in 2012 that these reports do not explicitly prioritize the recommendations the council has made to address emerging threats. As a result, determining which of the already-recognized threats are most likely to have severe outcomes and how decision makers should best act to address them is more difficult. Improving the detail about these threats and expected actions to address them would also better allow Congress to monitor FSOC’s accountability addressing these risks.
Actions Needed to Resolve the Federal Role in Housing Finance
Resolving the role of the federal government in housing finance will require continued leadership commitment by Congress and the administration. Due to the interconnected nature of the housing finance system and the central role homeownership plays in the U.S. economy, changes will need to be carefully designed and implemented. In October 2014, we issued a framework consisting of nine elements that Congress and others can use as they consider changes to the housing finance system. The elements are as follows:
- clearly defined and prioritized housing finance system goals;
- policies and mechanisms that are aligned with goals and other economic policies;
- adherence to an appropriate financial regulatory framework;
- government entities that have capacity to manage risks;
- mortgage borrowers are protected and barriers to mortgage market access are addressed;
- protection for mortgage securities investors;
- consideration of the cyclical nature of housing finance and impact of housing finance on financial stability;
- recognition and control of fiscal exposure and mitigation of moral hazard; and
- emphasis on implications of the transition.
Each element in the framework is critically important in establishing the most effective and efficient housing finance system. Applying the elements of this framework would help policymakers identify the relative strengths and weaknesses of any proposals they are considering. Similarly, the framework can be used to craft proposals or to identify changes to existing proposals to make them more effective and appropriate for addressing any limitations of the current system. However, any viable proposal for change will involve choices that recognize that sometimes tradeoffs will exist among and within the nine elements.
If Congress enacts changes to the housing finance system, relevant federal agencies will need to develop the capacity and action plans necessary to effectively implement the changes and to monitor progress against their plans. Maintaining FHA’s long-term financial health and defining its future role will be a critical part of any overhaul of the housing finance system. We previously recommended that Congress or FHA specify the economic conditions that the MMI Fund would be expected to withstand without drawing on the Treasury. As evidenced by the $1.68 billion FHA received in 2013, the 2-percent capital requirement for FHA’s MMI Fund may not always be adequate to avoid the need for Treasury support under severe stress scenarios. Implementing our recommendation would be an important step not only in addressing FHA’s long-term financial viability, but also in clarifying FHA’s role.
The Federal Reserve also announced its intention to act next year to grant banking entities an additional 1-year extension of the conformance period until July 21, 2017, to conform ownership interests in and relationships with legacy covered funds.
GAO-15-51: Published: Nov 20, 2014. Publicly Released: Nov 20, 2014.
GAO-15-131: Published: Oct 7, 2014. Publicly Released: Oct 7, 2014.
GAO-14-873T: Published: Sep 17, 2014. Publicly Released: Sep 17, 2014.
GAO-14-261: Published: Apr 3, 2014. Publicly Released: Apr 3, 2014.
GAO-14-174T: Published: Jan 8, 2014. Publicly Released: Jan 8, 2014.
GAO-14-67: Published: Dec 11, 2013. Publicly Released: Dec 11, 2013.
GAO-13-722: Published: Sep 9, 2013. Publicly Released: Oct 22, 2013.
GAO-13-542: Published: Jun 20, 2013. Publicly Released: Jul 22, 2013.
GAO-13-400R: Published: Mar 7, 2013. Publicly Released: Mar 7, 2013.
GAO-13-195: Published: Jan 23, 2013. Publicly Released: Jan 23, 2013.
GAO-13-180: Published: Jan 16, 2013. Publicly Released: Feb 14, 2013.
GAO-13-71: Published: Jan 3, 2013. Publicly Released: Jan 3, 2013.