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The implicit federal guarantee for Fannie Mae and Freddie Mac, long assumed by investors but often denied by government officials, became explicit last week, as the Treasury Department and the Federal Reserve announced separate but coordinated plans to provide financial backing for the two giant government services enterprises (GSEs).

The Federal Reserve’s Board of Governors voted to open the Fed’s discount window to the companies, authorizing the New York Fed to loan them money “if needed” to ensure that they have sufficient capital “to continue to serve their mission” of providing liquidity to the secondary mortgage market.

At the same time, Treasury Secretary Henry Paulson announced that the Bush Administration will seek Congressional approval of legislation temporarily increasing the line of credit Fannie and Freddie have with the Treasury and authorizing the federal government to purchase stock in either or both companies “if needed.” Additionally, the Administration is asking Congress to amend the pending GSE reform package — part of the comprehensive housing rescue legislation — to give the Fed “a consultative role in the new GSE regulatory process for setting capital requirements and other prudential standards.”

These dramatic emergency moves came at the end of a week in which Paulson, Fed Chairman Ben Bernanke and other government officials had struggled unsuccessfully to reverse the steady erosion of investor confidence in Fannie and Freddie that had driven the shares of both companies to record lows, threatened to further weaken the already battered housing and credit markets in the United States and potentially roil financial markets worldwide.

Critics of the GSEs have warned for some time that they did not have sufficient capital to back the billions of dollars in mortgages they guarantee. But what had been an undercurrent of rumbling erupted into a full-throated roar when a Lehman analyst pointed out in a note to investors that a proposed change in accounting rules could force the two Government services enterprises (GSEs) to acknowledge and restate on their balance sheets $75 billion in mortgages the companies have securitized, pushing their capital levels well into the “red” zone, below their regulatory requirements.

The analyst, Bruce Harting, also noted that the two mortgage companies, lynchpins of the secondary market (and the ‘go-to’ entities in various efforts to stabilize the teetering housing market) would likely be exempt from the accounting requirements if they are adopted. “It is in no one’s interest for the GSEs to be saddled with overwhelming capital requirements at a time when the market needs them,” Harting noted. But that assurance didn’t calm investors, already nervous about the financial pressures on Fannie and Freddie, who headed for the proverbial hills, driving shares of the two companies to their lowest levels in 17 years and pushing their borrowing costs up. Despite the triple-a rating on their bonds, the spread over Treasuries widened last week to 76 basis points, nearly triple the margin two years ago.

Critics of the GSEs, who have long warned that they have grown too large, strayed too far from their mission (ensuring liquidity in the secondary market) and pose a growing threat to the financial system and to taxpayers, unleashed a resounding chorus of “I told you so,” led by William Poole, former president of the St. Louis Federal Reserved. It was Poole who rattled the financial markets a few years ago by suggesting publicly that the Treasury Department should eliminate the implicit government guarantee of the GSEs by severing their line of credit. Pulling no punches last week, Poole told Bloomberg News in an interview that Fannie and Freddie are both insolvent – the financial equivalent, he suggested, of dead men walking. “Congress ought to recognize that these firms are insolvent and that [lawmakers are] allowing [them] to continue to exist as bastions of privilege, financed by the taxpayer,” Poole insisted.

His criticism, echoed by other analysts, resounded in the stock market throughout the week. Media reports that Bush Administration officials were weighing their strategic options should Fannie and Freddie fail intensified the concerns of investors, who continued to pummel Fanny and Freddie’s shares, despite public assurances from the companies, their top regulator and other Bush Administration officials that the GSEs were well-capitalized now, were successfully raising additional capital, and in no need of a federal bail-out.

Paulson and Bernanke both downplayed speculation about the need for a federal bail-out in testimony before the House Financial Services Committee, with Bernanke describing both companies as “well-capitalized, in a regulatory sense,” and Paulson assuring lawmakers that the companies were successfully “working through this challenging period. They play an important role in our housing markets today and need to continue to play an important role in the future,” he added.

That was Thursday. By Sunday, unwilling to risk a poor response to a planned Freddie debt auction on Monday morning, Administration officials decided they had to act and announced the rescue plan. The initial reaction in the financial markets was mixed. After surging initially Monday morning, the stock price of both companies fell back. But Freddie, as it turned out, had no trouble finding buyers for the $3 billion in corporate debt it auctioned early in the day.

One unanswered question is what impact the government rescue of Fannie and Freddie will have on the housing rescue legislation pending in Congress, which will be the vehicle for the proposals Paulson outlined. Before the weekend developments, it appeared that some differences between the House and Senate bills could prove difficult to resolve (see related news brief). But Congressional leaders in both parties have vowed to work with the Bush Administration to secure speedy approval of the GSE rescue measures. And Rep. Barney Frank (D-MA), chairman of the House Financial Services Committee, who has indicated that he planned to “tweak” some provisions of the Senate bill, told reporters that he is confident legislators will be able to reach a quick consensus and approve the bill. “This could be on the President’s desk by next week,” he said.

HOUSING ASSISTANCE ADVANCES

Clearing the last series of obstacles thrown in its path, the housing rescue bill won Senate approval last week, but it still faces a presidential veto threat (that may or may not be serious) and the need to resolve differences with the House version of the bill, some of which may prove to be very serious indeed, although probably somewhat less serious now, in light of the government rescue of Fannie Mae and Freddie Mac (see related news brief).

Both the House and Senate bills establish a mechanism for refinancing up to $300 billion in troubled loans through the Federal Housing Administration. Ongoing negotiations between Rep. Barney Frank (D-MA), chairman of the House Financial Services Committee and Sen. Christopher Dodd (D-CT), his Senate counterpart, have resolved many outstanding differences, but not all of them. Among the most troublesome: $4 billion in community development block grant funding to cities and towns, allowing them to purchase and renovate foreclosed properties. Conservative “blue dog” Democrats in the House are insisting on offsetting budget costs to cover the cost; Dodd and supporters of his bill want to treat this program as “emergency” funding that would not require a pay-go offset.

Stripping the block grant program out of this bill and adding it to another measure, as Frank has proposed, would eliminate this problem, but other differences may prove more difficult to resolve. That list includes:

  • Oversight of the government services enterprises (GSEs), including Fannie Mae and Freddie Mac. The Senate bill gives the new GSE regulator more authority to restrict the growth of the GSEs mortgage portfolios; the House bill limits that authority to safety and soundness concerns.
  • Effective date. The Senate bill would make the new regulatory structure for the GSEs effective immediately; Frank wants a six-month phase-in period before the new framework kicks in.
  • Loan ceilings. The Senate bill sets the maximum loan purchases for Fannie and Freddie at $625,000; the House bill sets a higher ceiling at $730,000. Frank has indicated that he won’t try to change the Senate cap but will try to alter the formula used to calculate the maximum loans in “high-cost” housing markets.

Concerns about the financial strength of Fannie and Freddie and continued weakness in the housing market will increase pressure on legislators to hammer out a speedy compromise, and intensify pressure on the White House to back off its previous veto threats. On that score, at least, even before Fannie and Freddie’s problems became headline news last week, the Bush Administration has been softening its previously hard line against allowing anything resembling a federal “bail-out” of borrowers or lenders. Before the favorable vote on the Senate bill, White House spokesman Dana Perino said it appeared that “we are nearer to having something we can work on.” Steve Preston, the newly named secretary of the Department of Housing and Urban Development, expressed similar confidence, telling reporters that he was “very optimistic that something can be worked out.”

LETTING HELOCS FREEZE OVER

Faced with rising delinquencies on home equity loans, lenders are moving aggressively to control their losses by tightening underwriting standards and reducing or suspending existing home equity lines of credit. Homeowners, angered and often surprised by a sudden loss of credit on which they were relying, are complaining loudly, and regulators are responding with directives emphasizing the need for prudent lending policies, but also cautioning lenders to comply with fair lending requirements when adjusting the terms of existing loans.

First the statistics: The American Bankers Association (ABA) reports that delinquencies on home equity lines of credit increased by 14 basis points to 1.1 percent of accounts outstanding in the first quarter. Weakness in a market segment known for its strong performance reflects the financial pressures on U.S. households as the economy continues to decline. “People are looking for any source of funds to pay their daily expenses,” Carol Kaplan, a spokesman for the ABA, told Bloomberg News. “It’s a sign of the overall condition of the economy that people are having trouble making their payments,” she added.

HELOC delinquencies are now at their highest level in 11 years, and industry analysts aren’t expecting any near-term improvement, given the uncertain economic outlook and continued downward pressure on home values. “Mounting losses on [HELOCs] are likely to deepen the financial woes of many US regional lenders, increasing the risk that one of them might fail and raising the possibility of a wave of emergency mergers in the sector,” a recent article in the Wall Street Journal noted.

The Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) have issued separate home equity lending warnings to the institutions they oversee. Speaking recently to the Financial Services Roundtable’s housing policy council, Comptroller John Dugan cited the need “to ask some hard questions about home equity product structure and underwriting criteria.” He noted in particular problems related to “shortcuts,” such as automated valuation programs and limited documentation loans. Valuation tools, he said must be “closely managed, periodically validated and supported with sound business rules. Cost alone simply cannot be the guiding principle for their use,” Dugan stated.

He was even more critical of limited documentation policies, telling lenders, “We need to think carefully about whether anything short of actual verification of income is acceptable from a safety and soundness perspective for most borrowers. “ Dugan also emphasized the need for lenders to review and increase their loan loss reserves, noting, “With losses accelerating, [existing] reserves are simply not going to be adequate. That’s why our examiners are encouraging more robust portfolio analysis and loss-reserve levels,” he said.

While the OCC is targeting potential HELOC losses, the FDIC is urging lenders to use “best practices” in working with borrowers, when the reduction or elimination of credit lines causes “financial hardship or significant inconvenience.” Among other measures outlined in a recent letter to financial institutions, the FDIC suggested that lenders allow affected borrowers to request a review of their account, particularly when the adverse credit decision results from a decline in home equity and “the institution relied on an automated valuation system in making its decision.”

Regulation Z allows lenders to change the terms of an existing loan under certain circumstances (including a reduction in the value of the collateral securing the loan or a “material” change in the borrower’s financial circumstances), but the FDIC letter reminds lenders that they must provide a written notice of the change in terms explaining the reasons for it. The letter also reminds lenders of the anti-discrimination requirements in the Equal Credit Opportunity Act and the Fair Housing Act, noting that “discrimination may occur in the context of HELOC reductions or suspensions if a lender inconsistently applies its policies or makes the changes in a manner that could constitute redlining. “ The FDIC advises lenders to “calculate revised property values and determine borrower financial circumstances using consistently applied, fact-based methods, without discriminating on prohibited factors, such as race or sex, or crating a redlining situation.”

FINANCIAL INSECURITY

Consumer advocates have opened another front in their war on overdraft fees, this one targeting the harm to older consumers living on fixed incomes. A study by the Center for Responsible Lending (CRL) found that consumers 55 and older pay $4.5 billion annually in overdraft fees, $1 billion of that “stripped” from the accounts of retirees receiving Social Security benefits.

The report, “Shredded Security,” estimates that banks collected approximately $17.5 billion in overdraft fees in a 12-month period on the extension of about $15.8 billion in advances, representing $1.65 for every dollar of credit provided. Those charges hit older Americans harder than other consumers, the report says, even though they use debit cards — the primary trigger for overdrafts – less. Only 41 percent of account holders 55 and older and only 21 percent of those 64 and older say they use their debit cards regularly, compared with 80 percent of account holders under the age of 35.

CRL’s key complaint in this report is not that banks charge for covering overdrafts but that consumers are enrolled in overdraft protection programs automatically, without being given an opportunity to decide if they want the coverage. Critics say this arrangement is unfair for all consumers, but it is particularly objectionable when applied to Social Security recipients, CRL contends, because banks tap otherwise protected Social Security income to repay overdraft charges account holders have incurred.

During the 12 months covered in the study, CRL estimates that more than $981 million was “drained” from the accounts of consumers who rely on Social Security for half their income; $513 million came from the accounts of consumers who are totally dependent on their Social Security benefits. Three-quarters of those responding to the survey said they would rather have their transaction denied at point-of-sale rather than have an “unauthorized” overdraft fee extracted from their accounts. “The Fed must address these excessive bank fees and end this abuse of long-time and loyal customers many on fixed incomes.”

The AARP has joined the CRL in decrying the impact of overdraft fees on vulnerable older consumers. “AARP is fighting hard to protect the long-standing institution of Social Security, “Bob Jackson, executive director of AARP’s North Carolina office, said in the CRL press statement. “We are concerned that this essential safety net is under a back-door threat from financial institutions that charge unfair fees for unauthorized overdrafts. Banking policies should not allow for Social Security income to be paid unwittingly by beneficiaries,” Jackson asserted.

The CRL study recommends several policy changes, designed, the group says “so they strengthen, rather than threaten, the financial security of older Americans.” Among the proposals:

  • Prohibit financial institutions from automatically tapping Social Security funds to repay overdraft loans and bank fees;
  • Prohibit institutions from “manipulating the order” in which charges clear and the timing for crediting deposits in order to “artificially increase” overdraft fees;
  • Require banks and credit unions to give consumers the choice of “opting in” to overdraft loan programs, rather than automatically including overdraft protection as an account feature.
  • Require banks and credit unions to disclose the cost of overdraft loans as an annual percentage rate;
  • Impose an annual limit on the number of high-cost overdrafts consumers can incur to prevent them from “falling into a cycle of debt.
  • Require depository institutions to warn customers whenever an ATM withdrawal or debit card purchase will overdraw an account and give them the option of canceling the transaction.
  • Allow banks and credit unions to cover ATM and debit card POS overdrafts without warning only if the customer has elected, in writing, to participate in a lower-cost protection program that pays overdrafts from a linked savings account or line of credit.

The study also advises older consumers to protect themselves by doing business only with institutions that allow them to link their checking account to their savings account, or offer less expensive alternatives “so they can avoid unauthorized overdraft fees.”

KNOWING TOO LITTLE

What consumers don’t know – as the subprime debacle illustrates -- can definitely hurt them, which makes a recent survey by the Center for Economic and Entrepreneurial Literacy cause for considerable concern. Nearly 70 percent of the 1,000 adults responding to the telephone survey did not know that “you have to pay both interest on the balance as well as a late fee when making a late credit card payment,” and virtually all (97 percent) could not identify the percentage of a typical service fee on a $20 ATM withdrawal; 90 percent either could not estimate the amount of the fee or seriously under-estimated the cost. And when asked to identify the four most important factors determining eligibility for a loan, only 30 percent selected the credit score.

A separate survey by the Consumer Federation of America, found a sliver of improvement, with 28 percent of respondents noting correctly that 700 is the minimum credit score required to qualify for a prime mortgage compared with only 24 percent who answered that question correctly a year ago. On the other hand, a third survey by the National Foundation for Credit Counseling and MSN Money found that 1 in 10 of Americans holding a mortgage reported being late or missing a payment in the past year, while 25 percent said they do not know enough about owning a home to consider buying one. 

“When so many Americans are unable to answer the most basic questions about personal finance and debt, it is clear that economic literacy is a problem that needs to be correcte din this country,” Kristen Lope Eastlick, senior analyst at the CEEL, said in a press statement. “You don’t have to watch ‘Suzie Orman Show’ to realize just how important it is that we increase personal finance education at a young age so we have better informed employees, borrowers and voters,” she added.