—With additional reporting by Andre Shashaty

As Fannie Mae begins to emerge from its accounting scandal and Freddie Mac reorganizes and refocuses its multifamily division, there’s a high-stakes poker game going on in the halls of Congress.

In the House of Representatives, Rep. Barney Frank (D-Mass.), chair of the House Financial Services Committee, has been in negotiations with the U.S. Department of the Treasury for weeks, mulling legislation that would reform the government-sponsored enterprises (GSEs) and force them to do more for affordable housing.

An affordable housing advocate, Frank helped pass a bipartisan GSE reform bill through the House of Representatives in 2005, which subsequently stalled in the Senate. Frank is confident that the new bill will be introduced to the House floor, and pass, in April, though its fate on the Senate floor remains in doubt. Significantly, the new bill would create an affordable housing fund that Frank expects will generate $500 million to $600 million in its first year alone, as well as a new regulatory structure for GSE oversight.

“If people think that [the GSEs] were doing affordable housing as we define affordable housing, then they aren’t looking closely enough,” Frank said. “Simply buying loans without an added element of subsidy is a very limited way to help affordable housing. We are, therefore, creating a new way to help affordable housing.”

When the accounting scandals were revealed, the GSEs worked feverishly to beat back proposals for increased oversight and fight back at their critics in Congress. But like punished schoolchildren, they now are ready to sit quietly in their seats and take instruction. When the dust settles on these reform efforts, the nation’s two largest mortgage financers will get back to business with a new blank slate, regulated with more stringent oversight than they have ever faced, and growing at a rate that has as much to do with their regulator as with Wall Street.

As such, the clouds of turmoil are finally starting to part for the GSEs, giving way to the dawning of a new era.

After a long period of uncertainty, fundamental questions—Who will lead the organizations? How will the accounting scandals be punished? What regulatory structure will be in place?—are beginning to get answered. And as those questions get answered, many industry observers see the re-made GSEs aggressively re-engaging the market, emerging from their suspended animation with a market-driven appetite, hungry to get back in the game.

Renewed focus

After the setbacks of the last several years, and in the face of greater competition from banks and bond buyers, many lenders say 2006 is when the GSEs started to become more market-driven and aggressive. That momentum is building in 2007.

“They were saddled with what they could and couldn’t do over the last couple of years,” said Vincent Toye, managing director for Wachovia’s Real Estate Capital Markets group. “As they get their houses in order, I think they’ll have more latitude to get creative and innovative on their products.” Several lenders believe that the GSEs are again making those moves as they strive to win back market share. “I think they’ll continue to become more aggressive in order to compete more effectively with the commercial banks,” said Paul Weissman, a senior vice president and director at Credit Suisse/Column Capital. “For tax credit-type deals, we’ve already seen them begin to lower debt service coverage, with occasional waivers to 1.15x.”

Additionally, Weissman has seen the GSEs offer occasional extensions of amortization past the 30-year benchmark, “which was for a very long time kind of a sacred thing to them,” he said. “We have a couple of 1.15x/35-type deals that are under application right now.”

Due to the timeline of each GSE’s accounting scandal, Fannie Mae is at a disadvantage when compared to Freddie Mac. “Freddie got a two-year head start,” which has allowed Freddie to become more aggressive and evolve more quickly over the last two years, said Donald King, a director of production at Credit Suisse/Column.

In King’s view, Freddie Mac does a very good job of looking at deals on a case-by-case basis and assessing the business risk. “They’re not always worried about if it fits into a specific box, but [are] looking at any deal on its individual merits,” King said. “Over the course of 2006, they became more flexible in going down to a 1.20x and even a 1.15x debt service coverage. Freddie Mac has been ahead of Fannie in that regard,” he said.

Phil Melton, a director responsible for affordable housing efforts at Collateral Real Estate Capital, sees Freddie Mac’s multifamily affordable housing efforts as being more focused of late. For 2007, “I think you’re going to see Freddie take a harder look at trying to figure out ways to serve the rural market, the affordable, smaller 9 percent tax credit deals that have been historically fairly inefficient for the agency,” he said.

As Fannie struggled to get its financial statements current under the hawkish gaze of auditors over the last few years, there wasn’t much money, time, or effort left over to concentrate on product innovation and market strategy.

“The staff is basically 100 percent distracted; there’s very little appetite for new program development,” said Chris Tawa, a senior vice president at MMA Financial, Inc., a subsidiary of MuniMae. “I think whatever it takes, [Fannie Mae] is pretty much dead in the water until this is behind them.”

Eventually, though, lenders expect Fannie Mae to get back to its market leadership position. The agency “used to lead the market and they’ve been responding to and following the market recently,” said Donald King. “You’re almost starting to see some of the load being lifted and some focus on trying to be the innovator instead of the follower.”

And some lenders say that move to the front of the pack has already begun. Fannie Mae has gotten much more flexible on terms and pricing, they say.

“[Last year] saw Fannie Mae step back into a much more aggressive posture after having been relatively conservative compared to the market in 2004 and 2005, both in terms of pricing and underwriting,” said Michael Berman, president of CWCapital, LLC. “There was a time when it was very difficult to do a Fannie Mae loan under 1.25x debt service coverage, and that was a big disadvantage.”

In 2006, “Fannie Mae became much more competitive on pricing and terms and proceeds, consciously doing so, recognizing they need to right the ship because their market share was going down,” said Todd Rodenberg, senior vice president and agency lending director for KeyBank Real Estate Capital. Fannie Mae’s increased flexibility means that its delegated underwriting and servicing (DUS) guide, which sets standards for the loans Fannie Mae-affiliated lenders can make without the agency’s pre-review, has gradually become more fluid.

“Each deal is so independent now that the guide is really just that, a guide; each one of our deals is now almost individually structured,” said Collateral’s Melton. “You’re going to see a real focus on stretching for the right deals.”

Fannie Mae is also openly soliciting requests from its affordable housing-focused lenders, “to basically provide them with a blanket list of pre-approved waivers that we want as a lender,” Melton said. “Those things will help in giving more delegation and autonomy to the lenders.”

New products and process

According to Phil Weber, senior vice president of Fannie Mae’s multifamily division, the company’s pipeline is rich for 2007. Following on the heels of last year’s single asset substitution product, the company expects to roll out a new acquisition-rehab mezzanine product aimed at the affordable arena in the first half of 2007.

“We think it’s a very exciting new product that will serve a need especially in the preservation space, where there’s a lot of product that is 30-plus years old that needs modest rehab,” said Weber. “We’re trying to be innovative and bring flexible features to our DUS lenders.” The company is also aiming to improve its early rate-lock program with an eye on quicker cycle times.

Fannie Mae has reorganized the administration of its DUS network, creating internal “deal teams” featuring a customer service manager, credit officer, and pricing officer, dedicated to a specific lender. With the new structure, the agency hopes to decrease deal cycle time.

Freddie Mac’s reorganization of its multifamily division is focused on streamlining divisions of labor for maximum efficiency. The agency also is working on bolstering the roster of its targeted affordable housing seller/servicers, delegated lenders focused on affordable housing, a subset of its Multifamily Program Plus Seller/Servicers.

In February, the agency announced that PNC and Wachovia Multifamily Capital joined its delegated underwriting network for tax credit properties.

The beefed-up network will help the agency expand its affordable housing business and reach out to rural areas and smaller projects, boosting the agency’s production of small loans. The agency has worked on the network’s infrastructure for a couple of years, during which the competitive landscape for affordable housing has changed.

“The banks have become much more significant players because of CRA (Community Re-investment Act) incentives, and bond conduits have become a bigger player as well,” said W. Kimball Griffith, who leads affordable sales and investments at Freddie Mac. “The challenge for us is to make sure we build a network that is flexible enough to deal with the changing marketplace.”

The GSE is also making enhancements to its early rate-lock program, and will roll out a new acquisition-rehabilitation product in the first half of 2007. “We’re going to do acquisition-rehab business in a bigger way,” said Mike May, senior vice president of Freddie Mac’s multifamily sourcing division. “With the right sponsors in the right market with the right story, we’re going to be aggressive and win that business.”

Affordable housing fund

The accounting scandals at Freddie Mac and Fannie Mae hastened reform, opening the door to GSE critics to pass legislation that would impose stricter federal oversight. And in some ways, the accounting scandals also illustrated the identity crisis inherent in a GSE—one foot firmly planted in industry, and the other entrenched in government.

The Office of Federal Housing Enterprise Over-sight (OFHEO), which ensures that the GSEs are adequately capitalized and operating their businesses in a financially sound manner, exemplifies this public/private tension. “I think they have a higher standard,” said James Lockhart, OFHEO director. “Corporate America has a very high standard, or should have a very high standard, but being a GSE, it’s my belief they should have an even higher standard.”

An independent office at HUD, OFHEO once played the role of David to the GSEs’ Goliath. To say that the regulator lacked teeth is an understatement: As Fannie Mae engaged in its accounting manipulation in the late ’90s and early 2000s, OFHEO continued to give the company the highest safety and soundness ratings.

But OFHEO has been transformed into a more powerful entity under the leadership of James Lockhart, a man with a deep understanding of the financial markets. Lockhart previously served as deputy commissioner of Social Security, as well as executive director of the Pension Benefit Guaranty Corp. He also happens to be close friends with President Bush; they attended the same prep school and were fraternity brothers at Yale.

In its special report on Fannie Mae, OFHEO alleged that the corporate culture was so focused on hitting earnings targets, which triggered sizable bonuses for senior management, that it lost sight of its mission—to help provide housing affordable to all Americans.

“My view is that they were doing some affordable housing, but their primary goal was rapid growth, and therefore a lot of their portfolio ended up not being in affordable housing,” said Lockhart. “We believe that their portfolio should be refocused on their mission.”

Rep. Frank envisions about $500 million to $600 million a year going into the affordable housing fund, with the first year earmarked for rebuilding the Gulf Coast communities still reeling from Hurricane Katrina.

“Eighteen months after the hurricane, the Bush administration and the Republican Congress have left the Gulf pretty much un-helped,” Frank said. “And we thought our first responsibility was to undo that neglect.”

After the first year, the affordable housing fund also will be a dedicated funding source for a low-income housing trust fund, a provision included in last year’s failed GSE reform bill, Frank said. The low-income housing trust fund would fund the production, rehabilitation, and preservation of affordable housing, especially rental housing for extremely low income households.

The National Low Income Housing Coalition has advocated this idea for years, envisioning a distribution model that would allocate 60 percent of the trust fund to local housing agencies and 40 percent to state housing finance agencies.

The fund would supplement, not replace, the GSEs’ affordable housing goals set by HUD. “The affordable housing goals, after all, don’t carry any direct subsidy,” Frank said. “As currently structured under the law, all [the GSEs] can do is buy loans, but they can’t subsidize. The major way to make them a better contributor to the cause of affordable housing is by a directly funded affordable housing fund.”

At press time, some key provisions of the fund were still being ironed out.

How the fund will be seeded is a source of much contention: Last year’s bill called for 5 percent of the GSEs’ after-tax profits, a provision that is drawing resistance from Republicans this time around. The Bush administration has made it clear that an affordable housing fund has to have three criteria: first, that it is not controlled by Fannie Mae or Freddie Mac, and that the funds are not used for political purposes; second, that the fees the GSEs pay to fund the programs should not be related to profits; and third, that there be a sunset after five years to re-evaluate the program, according to Lockhart.

To protect the bill against a possible presidential veto, Frank has met at least two of these criteria: The GSEs themselves will not control the fund, he said, and it will not be funded directly by their profits.

Some lenders applaud the prospect of more subsidies. According to Credit Suisse/Column Capital’s Weissman, the best way to create more affordable housing is to create additional subsidies. The gap between income growth and construction cost growth has widened since low-income housing tax credits were created in 1986, when maximum tax credit allocations were established.

Over the last 20 years, “You’d probably see income growing at somewhere between 2 and 3 percent, and construction costs growing somewhere between 5 and 7 percent,” Weissman said. “You see that gap widen and it makes it more difficult to make projects feasible under that 4 and 9 percent metric.”

Multifamily goals

The GSEs were created to increase single-family homeownership. Overall multifamily efforts, and the affordable multifamily subgoals, came long after the organizations were established. Freddie Mac launched its current multifamily business in 1993, after a failed effort in the late ’80s forced the company to suspend the division. Fannie Mae began purchasing conventional multifamily loans in 1983, and established an office focused on low- and moderate-income housing in 1987.

Chris Tawa knows a thing or two about the GSEs’ affordable housing activities.

Under Tawa’s watch as national director of multifamily affordable housing at Fannie Mae, the agency tripled its affordable housing production, from $250 million to $750 million, between 1995 and 1997. The affordable housing goals were relatively new at the time.

“Affordable was considered a very quirky nonstandard type of property; it wasn’t broadly accepted in the lending markets,” said Tawa. “Fannie was the leader in this—they showed that you could soundly lend in this area when it wasn’t popular. We now have about a 20-year track record of tax credit properties and how they perform. Back then, you had almost no track record. That was pretty pioneering.”

The affordable housing goals set by HUD have evolved over time. A 1991 HUD study found that Fannie Mae’s and Freddie Mac’s mortgage underwriting guidelines at that time were oriented toward financing “plain vanilla mortgages,” encouraging lending more in suburban, growing, homogenous and higher-income areas.

The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 required HUD to establish two income-based goals and one place-based housing goal. The GSEs’ housing goals are expressed as a percentage of their overall business and include units financed by the GSEs’ purchases of both single-family and multifamily mortgages.

Over the last 10 years, the housing goals for low- and moderate-income families (100 percent of area median income, or AMI, and below) grew from 42 percent to 55 percent of the GSEs’ overall business. The special affordable goals (60 percent AMI or below) grew from 14 percent to 25 percent.

In addition, HUD established a dollar-based multifamily sub-goal. For the 2005 to 2008 period, Fannie Mae’s affordable multifamily subgoals total $5.49 billion per year, while Freddie Mac is on the hook for $3.92 billion annually.

But are the GSEs fulfilling their promise of serving markets that other lenders wouldn’t touch, taking risks on new kinds of lending programs? Any lender would want to serve the middle class, but are the GSEs doing the hard work, like improving inner cities and preserving older affordable housing?

It depends on how you define affordable housing. The GSEs mostly have had success in meeting their affordable housing goals, as set by HUD. However, critics say that the goals are so loosely defined that the GSEs can hit their targets by using methods, such as purchasing batches of commercial mortgage-backed securities, that don’t directly create new affordable housing.

“The numbers they were required to meet were so loose to begin with that it was easy for them to get away with making those numbers,” said Leslie Paige, a director at federal government watchdog Citizens Against Government Waste. “It was gamesmanship with the numbers.”

And critics assail the pace of affordable housing development, saying the principles on which Fannie and Freddie are based—helping to make housing available to all—have been minimized. African-American and Hispanic homeownership rates have yet to crack the 50 percent mark; in contrast, that rate for Caucasians is 75 percent.

“In the time that Fannie has supposedly helped low-income people and featured lots of African-Americans in their ads, African-American homeownership hasn’t hit 50 [percent]; so where is all this extra homeownership going?” Paige asked.

Split personality

The GSEs are at a critical point in their respective evolutions, and as Congress plays tug-of-war with their business plans, the organizations are waiting like everybody else to see what the outcome will be.

Some call the GSEs’ privileges anti-competitive, and would like to see them either privatized or limited only to those segments of the mortgage market inherent in their missions—the affordable housing markets. They also believe that the GSEs pose a systemic risk to the economy due to the size of their businesses. Should the GSEs ever go under, the economic ripples would cause a tsunami, they argue.

Others believe that a government has a responsibility to house its people, and that the creation and preservation of affordable housing is one of the nation’s most critical needs. All you need to do is look in the poorest corners of any major U.S. city to get the sense that you’re living in a third-world country. The world’s richest nation can do better, they argue.

It’s precisely these two forces that made the GSEs what they are today—part industry, part government—reflecting the split personality of a nation that worships at the altar of profits while feeling the pull of a social conscience.