Bernanke Wants to Expand Fed's Market Oversight

Federal Reserve Chairman Ben Bernanke called on Congress Tuesday to write new laws that would expand the Fed's role in preventing financial crises, such as the collapse of Bear Stearns last March.

"The financial turmoil is ongoing, and our efforts today are concentrated on helping the financial system return to more normal functioning," Bernanke told a mortgage-lending forum in Arlington, Va. "It is not too soon, however, to begin to think about the steps we might take to reduce the incidence and severity of future crises."

Bernanke also announced that the Fed may keep its so-called discount lending window open to big investment banks and brokerage houses through at least the end of the year. The window essentially extends credit to big financial institutions, as a way of keeping them operating during crises and restoring confidence in the nation's financial system.

The Fed decided to begin extending credit to such institutions, even though they're not regulated by the agency, during the Bear Stearns crisis. The window was supposed to stay open through September, but with the continuing turmoil in the credit markets, fed officials have decided they may keep it open longer.

Bernanke said the Fed has also been working with the U.S. Securities and Exchange Commission to strengthen capital positions, liquidity reserves and risk-management practices at the banks it regulates. But many big financial institutions, such as investment banks, fall outside its jurisdiction.

Congress needs to expand the Fed's role and "task the Fed with promoting the overall stability of the financial markets," Bernanke said. For instance, the Fed should be given the authority to examine the books at financial institutions on the verge of financial collapse, to better understand the extent of their liabilities. It should also be given more tools to stabilize the markets when necessary, such as establishing bridge financing for insolvent banks.

These changes represent a huge potential transformation in the Fed's role.

"I think he was outlining both some immediate changes that would be very dramatic and, down the road, an even more profound restructuring of the U.S. financial system," said Karen Shaw Petrou, managing director of the research firm Federal Financial Analytics.

The financial markets are so anxious right now that almost anything can shake investor confidence, Petrou said. A single analyst report suggesting that Fannie Mae and Freddie Mac may face capital problems sent shares of the two companies plummeting on Monday. They rebounded somewhat on Tuesday after government regulators said the fears were overblown, but Petrou says there's a lesson in what happened.

"The financial markets remain extremely troubled, and none of the immediate regulatory fixes is sufficient to reduce the systemic risk posed right now," she said.

The speech by Bernanke came at a time when the Bush administration is wrestling with the question of how to respond to the nation's many economic troubles. Vince Reinhardt, a former Fed economist now with the American Enterprise Institute, worries that regulators may overplay their hand, imposing new laws that stifle the banking sector.

"We need more governance of the financial system," Reinhardt said. "That's a lesson of the last year and a half. Nobody would disagree with that. The question is, 'Are we going to do it right, or are we going to be heavy-handed in it?'"

Bernanke also announced that the Fed would release new rules next week aimed at protecting homebuyers from unscrupulous lending practices.

Q&A: Behind Fannie's And Freddie's Stock Slides

Questions swirling about whether housing financing giants Fannie Mae and Freddie Mac would need a federal bailout sent shares of the two companies tumbling on Thursday. Fannie Mae closed at $13.20, a decline of 13.8 percent for the day. Freddie Mac closed at $8, down 22 percent. Both stocks are at historic lows, with steep declines overall from a year ago — Fannie is down 78.5 percent and Freddie is down 86.1 percent.

The Wall Street Journal reported Thursday that the Bush administration was developing contingency plans for the collapse of the companies. Treasury Secretary Henry Paulson testified on Capitol Hill in an effort to calm investor anxiety about Fannie and Freddie. "They play an important and vital role in our economy and housing markets today, and they need to continue to play an important role in the future," Paulson told legislators. "Their regulator has made clear that they are adequately capitalized."

Mark Zandi, chief economist for Moody's Economy.com and an adviser to Republican Sen. John McCain's presidential campaign, told NPR that the companies may need to issue more shares of stock to raise money. That would dilute the value of existing shares, he said. "Unless you're a shareholder I wouldn't be worried because there is no chance that the federal government would allow these institutions to fail — to stop doing business. It would just be catastrophic for the system, for our economy. It's just not going to happen," Zandi said.

Here's a look at the role the two firms play in the housing market.

What are Fannie Mae and Freddie Mac?

Fannie Mae and Freddie Mac were chartered by Congress as government-sponsored enterprises, or GSEs, which gives them a quasi-governmental status. Both are in the same business: They buy home loans from lenders, then hold them in their portfolios or repackage them into bonds — known as mortgage-backed securities — that are traded on Wall Street. Fannie Mae was created in 1938; its smaller rival, Freddie Mac, was established in 1970.

What role do they play in the housing market?

Fannie and Freddie are the largest buyers of home loans in the nation. As such, they provide liquidity to housing markets. This enables banks, mortgage companies and savings and loans to keep making home loans. Consumers benefit, too: Greater liquidity means there is more money with which financial institutions can make home loans, and they can offer those loans at lower rates.

Fannie and Freddie's role is particularly important nowadays: With the credit market drying up, the firms are often the "buyer of last resort" for a mortgage at a time "when a broad-based buyers' strike threatened to paralyze the markets," says Bruce W. Harting, an analyst at Lehman Brothers, in a research note. Any threat that they might fail, he says, "could trigger a meltdown in credit markets that would make the movements in credit markets that we've seen over the last year look like a modest hiccup."

Why did shares of Fannie and Freddie plunge so far on Monday?

Shares of the two firms have been dropping for months as the housing downturn has worsened. But Monday's slide was prompted in part by a report from Harting in which he indicated that the Financial Accounting Standards Board was contemplating an accounting rule change that would have boosted the amount of capital the two companies have to keep on hand. Fannie would have to add $46 billion to its reserves; Freddie would need to add $29 billion.

The large sums spooked investors, who worried about the firms' abilities to raise that kind of cash in the current tight credit market. And the sell-off began.

Harting's report noted that the changes were "unnecessary." "It's in no one's interest for the GSEs to be saddled with overwhelming capital requirements at a time when the market needs the GSEs to buy mortgages, and when the capital markets and the economy are in very fragile states," he wrote.

Are these companies in financial trouble?

In June, the Office of Federal Housing Enterprise Oversight (OFHEO), the primary federal regulator for Fannie and Freddie, said the two companies were "adequately capitalized" — in other words, they had enough cash on hand to keep doing business.

OFHEO Director James Lockhart told reporters that Freddie and Fannie did not deserve the beating they got in the market Monday. "If you look at the financials of these two companies, how they are prudently growing their books of business ... it was hard to imagine what happened yesterday," he said.

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