April 6 (Bloomberg) -- Federal Reserve Chairman Alan Greenspan told Congress he supports a new regulator for Fannie Mae and Freddie Mac if it has the power to rein in the growth of the two mortgage lenders.

In testimony to the Senate Banking Committee today, Greenspan said the size of Fannie Mae's and Freddie Mac's portfolios, a combined $1.55 trillion, poses a risk to the global financial system. It would be difficult, if not impossible, to bail out the lenders, known as government- sponsored enterprises, should one get into financial trouble.

``If we fail to strengthen GSE regulation, we increase the possibility of insolvency and crisis,'' Greenspan said in the text of his testimony. ``We put at risk our ability to preserve safe and sound financial markets in the United States, a key ingredient of support for homeownership.''

Greenspan supported provisions of a bill introduced yesterday by Republican Representative Richard Baker of Louisiana, creating a regulator with the power to alter the lenders' capital standards, reject new lines of business, and shut down Fannie Mae and Freddie Mac in the event of default. The legislation also applies to the Federal Home Loan Banks.

The Senate is considering a similar bill, and ``we do intend to move legislation this year,'' said Andrew Gray, a spokesman for the Banking Committee. Legislation creating a stricter regulator stalled in Congress in 2003 and 2004, partly because of opposition from the companies.

Accounting Problems

Limiting the risk from the two lenders will ``require the significant strengthening of GSE regulation and the GSE regulator,'' Greenspan said. The Office of Federal Housing Enterprise Oversight, an agency within the Department of Housing and Urban Development, currently oversees the two.

Pressure to reform Fannie and Freddie comes after a series of accounting problems at both. Washington-based Fannie Mae said its accounting errors might require it to restate at least $8.4 billion in earnings. Freddie Mac, based in McLean, Virginia, disclosed in 2003 that it understated profits from 2000 until 2002 by $5 billion in an effort to reduce earnings volatility.

Baker's Capital Markets subcommittee is holding a separate hearing this morning, with Fannie and Freddie's current regulator, Armando Falcon, director of Ofheo.

Portfolio Cap

The House legislation doesn't cap Fannie Mae's and Freddie Mac's portfolios. The Federal Reserve suggested in a memo to Baker that they be limited to $200 billion each. Fannie Mae had $875.2 billion in its mortgage portfolio in February and Freddie Mac had $654.8 billion.

``Almost all of the concerns associated with systemic risks flow from the size of the balance sheets of the GSEs, not from the purchase of loans from home-mortgage originators and the subsequent securitization of these mortgages,'' Greenspan said.

The companies, which sell bonds and use the proceeds to buy mortgage loans from banks, have more than $1.7 trillion of debt, a level exceeding both France and the U.K.

Their mortgage holdings have grown from a total of $136 billion in 1990. Fannie Mae is the second-largest debtor in the U.S. after the Treasury, with $911 billion outstanding.

Implied Subsidy

Fannie Mae and Freddie Mac use derivatives, financial contracts whose value is derived from debt or equity securities, currencies, and commodities, to offset their investment risks. Fannie Mae's derivatives holdings alone exceeded $1 trillion at the end of 2003.

Greenspan noted one reason Fannie and Freddie have been able to build such large portfolios is the perception among investors that their lending is guaranteed by the government. That implied subsidy enables them to issue bonds at lower interest rates.

``We have been unable to find any purpose for the huge balance sheets of the GSEs, other than profit creation through the exploitation of the market-granted subsidy,'' Greenspan said. ``The strong belief of investors in the implicit government backing of the GSEs does not by itself create safety and soundness problems for the GSEs, but it does create systemic risk for the U.S. financial system as the GSEs become very large.''

No Market Discipline

Fannie Mae and Freddie Mac, created by Congress to increase financing available for homeownership, own or guarantee almost half the $7.6 trillion mortgage market.

Ordinary financial institutions might find such rapid growth checked by investors and lenders who might be concerned about rising risk. ``However, market discipline with respect to the GSEs has been weak to nonexistent'' because investors believe the government would bail them out, Greenspan said. In the case of Fannie and Freddie, `regulators cannot rely on market discipline to contain systemic risk.''

The GSEs make most of their profits from their mortgage portfolios. Limits on growth ``could require us to significantly alter our current business activities and could adversely affect our future profitability,'' Freddie Mac said in a supplement to its earnings report last week.

Mortgage Rate Concern

Some economists, including former Fed Vice Chairman Alan Blinder, say constraints on Fannie Mae and Freddie Mac might result in higher mortgage interest rates.

Greenspan disagreed. ``A recent study by Federal Reserve Board staff found no link between the size of the GSE portfolios and mortgage rates,'' he said.

In February, Greenspan said Congress should curtail the growth of Fannie Mae and Freddie Mac to avert financial market instability. Last week Treasury Secretary John Snow also called for limits on Fannie's and Freddie's portfolios.

``There should be some limitations on the portfolio holdings,'' Snow told reporters Thursday. ``We will be suggesting there are some constraints'' on holdings of mortgages and mortgage-backed securities ``while making sure they are fully capable of satisfying their mission.''

Snow and Housing Secretary Alphonso Jackson will testify before the Senate Banking Committee tomorrow.

To contact the reporters on this story: Alison Fitzgerald in Washington at afitzgerald@bloomberg.net

Last Updated: April 6, 2005 09:30 EDT