Federal Reserve Chairman Ben Bernanke on Tuesday called for tighter supervision of the two "government sponsored entities" that back home mortgages and suggested that they be limited in scope to promoting affordable housing.

The GSEs, Fannie Mae and Freddie Mac, now control huge mortgage portfolios, only 30% of which are associated with affordable housing. Bernanke cited the risk of having such large portfolios vested in the GSEs. Fannie Mae engaged in financial chicanery under its former CEO, Franklin Raines, which has prompted calls in Congress for tighter regulation. Currently, the GSEs are overseen by the Office of Federal Housing Oversight, which has limited authority in governing the financial operations of Fannie and Freddie.

In a speech to bankers in Hawaii, Bernanke said, "Legislation to strengthen the regulation and supervision of GSEs is highly desirable, both to ensure that these companies pose fewer risks to the financial system and to direct them toward activities that provide important social benefits. Financial safety and soundness can be enhanced by giving the GSE regulator capital powers comparable to those of bank supervisors and by creating a clear and credible receivership process that leads debt holders to recognize that they would suffer financial losses should a GSE fail. Finally, the Federal Reserve Board believes that the GSEs' investment portfolios should be firmly anchored to a measurable public purpose, such as the promotion of affordable housing."

Brenanke's remarks marked the first time a Fed Chairman called for directly limiting the scope and function of the GSEs. SEE THE ENTIRE SPEECH

In explaining his reasoning for calling for legislation, Bernanke said, "The GSEs' second line of business is the main focus of my remarks today. It involves the purchase of mortgage-backed securities and other types of assets for their own investment portfolios. This line of business has raised public concern because its fundamental source of profitability is the widespread perception by investors that the U.S. government would not allow a GSE to fail, notwithstanding the fact that-as numerous government officials have asserted-the government has given no such guarantees. The perception of government backing allows Fannie and Freddie to borrow in open capital markets at an interest rate only slightly above that paid by the U.S. Treasury and below that paid by other private participants in mortgage markets. By borrowing at this preferential rate and purchasing assets (including MBS) that pay returns considerably greater than the Treasury rate, the GSEs can enjoy profits of an effectively unlimited scale. Consequently, the GSEs' ability to borrow at a preferential rate provides them with strong incentives both to expand the range of assets that they acquire and to increase the size of their portfolios to the greatest extent possible."