GSE Capital Requirements

Second to questions of GSE role and benefits, I have quickly learned that questions about GSE capital adequacy are highly contentious and can serve as "stalking horses" for other issues. There is no question these issues are of paramount importance. Capital adequacy is the touchstone of investor confidence and is key to our ability to attract low-cost mortgage funds. On that score, Freddie Mac consistently has exceeded both its minimum capital and risk-based capital standards.

However, from the perspective of a former regulator, I believe there are many difficult and sometimes confusing aspects about the direction of the debate on GSE regulatory oversight. The first is the view that the GSE's should be held to the same capital standard as for banks. Let me begin by stating the obvious: GSE's are not banks.

• There are nearly 10,000 banks and savings institutions in this country. There are two GSE's focused exclusively on housing.

• Banks are largely funded by deposits. GSE's must rely exclusively on the capital markets for their funding.

• Banks can (and do) invest in a wide range of higher-risk assets, ranging from unsecured loans, to commercial loans and loans to foreign countries. In contrast, GSE's are restricted to one line of business: Residential mortgages finance. We invest almost exclusively in conventional conforming mortgages, among the safest investment vehicles around.

Given these important distinctions, it is entirely appropriate that the GSE capital regime be distinct from the bank capital model. GSE capital_requirements_reflect the confinements of its GSE charter, such as the conforming loan limit and credit enhancement requirements for high loan-to-value mortgages. These charter limitations necessarily result in a lower GSE risk profile.

Since 1994, charge-off losses at the five largest banks have been, on average, 17 times larger each year than charge-offs at Freddie Mac. Even in these banks' best year, charge-offs were more than five times higher than Freddie Mac's worst year.9 Limiting the comparison to mortgage assets, the residential mortgages found in bank portfolios typically entail greater risk than those in Freddie Mac's portfolio. In 2002, FDIC-insured institutions had an average charge-off rate of 11 basis points on their mortgage portfolios, compared to 1 basis point for Freddie Mac. 10 Given this lower risk exposure relative to banks, we believe that the GSE minimum capital requirement is adequate and need not be changed.

The second troubling aspect of the current debate is the fixation on the GSE minimum capital ratio, when the risk-based capital standard is a far more effective regulatory tool. Leverage ratios are last year's capital "model." They have significant limitations and, depending on how they are enforced, can do more harm than good. I observed first-hand the problems with overzealous enforcement of simple leverage ratios during my tenure at the Federal Reserve Bank of Boston in the early 1990's. While many financial institutions in the Northeast were adequately capitalized on a risk-adjusted basis, the strict enforcement of simple leverage ratios required them to liquidate a substantial portion of their assets. This resulted in a drying up of commercial credit that greatly exacerbated the economic downturn. The infamous "credit crunch" had profound effects on small and mid-size businesses and employment in the Northeast. It turned a 2-year recession into a 5- to 6-year slump.11 I discuss these issues in two articles I wrote on this subject. 12

My experiences are consistent with leading international trends in capital management. Drawing from recent statements by the Basel Committee on Banking Supervision, risk-based capital regimes are preferable to the use of simple ratios to set capital standards. In its 1999 Basel Consultative Paper and the 2001 New Basel

9 Federal Financial Institutions Examination Council, Consolidated Reports of Condition and Income and Freddie Mac annual reports for 1994 to 2001. For 2002 Freddie Mac credit information, see http://www.freddiemac.com/news/archives/investors/2003/4qer02.html.

10 Federal Financial Institutions Examination Council, Consolidated Reports of Condition and Income and Freddie Mac. See http://www.freddiemac.com/news/archives/investors/2003/ 4qer02.html.

11 History of the Eighties, Lessons for the Future: An Examination of the Banking Crises of the 1980's and Early 1990's, vol. 1, part 2, Sectors and Regional Crises, Ch. 10, Banking Problems in the Northeast, Federal Deposit Insurance Corporation, 1997.

12 See Richard F. Syron, statement before the Subcommittee on Domestic Monetary Policy of the Committee on Banking, Finance, and Urban Affairs, U.S. House of Representatives, May 8, 1991, reprinted in "Are We Experiencing a Credit Crunch?," New England Economic Review (July/August 1991), pp. 3-10; and Richard F. Syron, "The New England Credit Crunch," Credit Markets in Transition: Proceedings of the 28th Annual Conference on Bank Structure and Competition, Federal Reserve Bank of Chicago (1992), pp.483–9.

Capital Accord, the Committee proposed a capital adequacy framework to replace the 1988 Capital Accord for U.S. bank capital standards, which relied heavily on simple ratios to set capital standards. The new framework, which is currently under consideration in this country, more accurately aligns capital requirements to the actual risks incurred by regulated institutions. 13

Notwithstanding my philosophic differences regarding the efficacy of leverage ratios, I can understand the need for regulator discretion to increase the leverage ratio in the event of a finding of an unsafe and unsound practice. We believe parameters should be put in place in statute that define the circumstances under which such an increase could be undertaken, as well as parameters for resetting the ratio to the statutory minimum once the unsafe and unsound practice has been satisfactorily addressed.

Discretion on Risk-Based Capital

In my view, greater discretion with regard to the GSE risk-based capital rule is the best way to avoid potential negative unintended consequences associated with strict enforcement of leverage ratios. Ten years in the making, the GSE risk-based standard is unique among financial services regulation. It requires Freddie Mac to hold capital sufficient to survive 10 years of severe economic conditions; under the risk-based test, both the credit and interest-rate risk of the GSE's mortgage holdings are stressed to historic proportions. Without a doubt, this rule is at the cutting edge of financial services regulation.14 It ties capital to the specific risks of an institution ensuring safety and soundness without raising costs unnecessarily or crippling the smooth flow of mortgage capital. It is the standard-bearer in capital regulation.

To ensure that the GSE capital standard remains at the forefront of capital regulation, the new regulator must have adequate discretion to keep pace with developments. Although the basic parameters of the risk-based capital stress test are set in law, our present regulator has significant discretion in adjusting the risk-based capital requirements. Additional discretion, such as provided to Federal banking agencies, could help ensure the GSE risk-based capital standard remains at the forefront of financial sophistication, while continuing to tie capital to risk.

Discretion must be balanced with continuity, however. Unnecessarily changing the risk-based capital standard harms those who made investment decisions based on a particular set of rules, only to find later that the rules were changed. This "regulatory risk" increases costs that are ultimately borne by mortgage borrowers. Therefore, until such time as an overhaul of the risk-based capital stress test appears warranted, the regulator should be encouraged to continue to apply the existing risk-based capital rule. The rule has been in effect for only 1 year and has yet to show signs of need for reform.

We also believe the new regulator should be encouraged to gather information over the entire business cycle before making changes. This could be accomplished by requiring that the current rule remain in place for a period of time and expressing Congressional intent to this effect. When a new rule appears warranted, policymakers should ensure that certain fundamental principles remain firmly intact. It would be our strong suggestion that any future capital standard must continue to tie capital levels to risk; be based on an analysis of historical mortgage market data; remain operationally workable and as transparent as possible; and accommodate innovation so the GSE's can carry out their missions.

Further, we would expect that any changes to the rule be accomplished through notice-and-comment rulemaking, with an adequate comment period for all interested parties to express their views, followed by an adequate transition period for the GSE's to make any necessary adjustments to comply with new requirements. In summary, Freddie Mac supports improvements to the GSE capital regime that reflect the unique role of the GSE's, while ensuring public trust in our financial strength. Based on my experience as a regulator, I fully support granting the regulator greater discretion to set risk-based capital levels that accurately reflect the risks we undertake. Discretion on risk-based capital greatly mitigates the need to

13 The New Basel Capital Accord, Consultative Document, Basel Committee on Banking Supervision (January 2001) (the 2001 Basel Accord).

14 According to an analysis prepared by L. William Seidman, former Chairman of the FDIC, the stringent risk-based capital standard applicable to Freddie Mac could be extremely challenging if applied to most other financial institutions. L. William Seidman, et al., Memorandum to Freddie Mac, March 29, 2000. More recently, the CapAnalysis Group, LLC, concluded that the risk-based capital stress test is "a much more stringent test for judging the safety and soundness of a financial institution than is a traditional_capital-requirements test. CapAnalysis Group, LLC, OFHEO Risk-Based Capital Stress Test Applied to U.S. Thrift Industry (March 17, 2003), p.1.

The

provide unfettered regulator discretion on minimum capital. Changing capital standards unnecessarily, capriciously or frequently will reduce the amount of mortgage business the GSE's can do, resulting in higher costs for homeowners and renters. Supervisory and Enforcement Parity

The current legislative structure provides our safety and soundness regulator an array of supervisory and enforcement authorities to ensure that Freddie Mac is adequately capitalized and operating safely.15 If Congress were to deem it appropriate, we would support providing the GSE safety and soundness regulator authorities similar to those accorded to the Federal banking agencies. These enhanced powers would include broadening the individuals against whom the regulator could initiate cease-and-desist proceedings, new authority to initiate administrative enforcement proceedings for engaging in unsafe and unsound practices, new removal and suspension authority and authority to impose industry-wide prohibitions, and new authority to assess civil money and criminal penalties.

Conservatorship v. Receivership

While it may be appropriate to draw on certain banking provisions to improve the GSE regulatory oversight structure, we strongly believe the mechanism for dealing with extreme financial distress is not one of them. Receivership is an efficient disposition mechanism for thousands of Federally insured depository institutions, whose failure would not threaten the stability of and public confidence in the financial system, particularly in the Federal deposit insurance system. However, it is not a credible option for dealing with two GSE's. In contrast to the situation for most insured institutions, the decision to liquidate a GSE would have substantial economic, market, and public policy consequences. It would threaten the public policy mission of the GSE's and could potentially disrupt the legal obligations and expectations of market participants.

Recognizing the unique role of the GSE's, and our mission to expand homeownership, Congress chose a different disposition mechanism when it established the current GSE regulatory oversight structure. To address the unlikely event of extreme financial distress, Congress gave the safety and soundness regulator the right to appoint a conservator, which would rehabilitate an ailing GSE. However, Congress reserved to itself the right to appoint a receiver.

Although Freddie Mac believes that current law provides ample convervatorship powers, we would be willing to consider whether additional authorities could enhance Congress' and the public's confidence in our safe and sound operation. Such enhancements to existing GSE conservatorship powers would achieve the important policy objective of strengthening the GSE regulatory oversight structure without the potential unintended consequences that could result from receivership. Many market participants might view a change to receivership as a first step to privatization of the GSE's. This could have significant implications on our ability to support the market for 30-year, fixed-rate mortgages.

Mission Oversight and New Program Approval

We believe that the HUD Secretary should retain all existing GSE mission-related authority consistent with HUD's mission to expand homeownership and increase access to affordable housing. Specifically, HUD should retain authority to ensure that the purposes of the GSEs' charters are accomplished and continue to have regulatory, reporting, and enforcement responsibility for the affordable housing goals, just as under current law. Additionally, HUD should retain existing fair housing authority.

We also believe that, in keeping with its housing mission, HUD should retain its authority to approve any new programs of Freddie Mac and Fannie Mac. HUD alone has the expertise to determine whether new mortgage programs are in keeping with our charter and statutory purposes. In this vein, we also urge the Committee to maintain a new program standard-not a new activity standard. Requiring the regulator to provide advance approval of each and every new activity significantly exceeds the standard required of banks and would chill innovation in mortgage lending. Our ability to lower housing costs for homeowners and renters is directly linked to our expertise in managing mortgage credit risk and our distinguished record of bringing innovative products and services to market.

Affordable Housing Goals

Meeting the annual affordable housing goals is a key aspect of our meeting our mission. Established in 1993 and increased in 1995 and 2000, the affordable housing

15 "Comparison of Financial Institution Regulators' Enforcement and Prompt Corrective Action Authorities," GAO-01-322R, January 31, 2001.

goals specify that significant shares of Freddie Mac's business finance homes for low- and moderate-income families and families living in underserved areas. In 2000, HUD specified that 50 percent of Freddie Mac's mortgage purchases must qualify for the low- and moderate-income goal,16 31 percent must be of mortgages to borrowers in underserved areas,17 and 20 percent must be of mortgages to verylow income borrowers or low-income borrowers living in low-income areas. 18 Freddie Mac has successfully met all the permanent housing goals, which are the highest and toughest of any financial institution.

The existing statutory and regulatory structure provides great discretion to our mission regulator to determine the goals—and creates strong incentives for us to achieve them. The HUD Secretary currently has the regulatory authority to establish and adjust the housing goals. In the event a GSE fails to meet one or more of the goals or there is a substantial probability that a GSE will fail one or more of the_goals-the Secretary is authorized to require the submission of a housing plan. Further, the Secretary may initiate a cease-and-desist_proceeding and impose civil money penalties for failing to fulfill the housing plan. By contrast, bank regulators do not have authority to bring enforcement proceedings against an institution that is not meeting its CRA obligations. These are strong incentives for the GSE's to strive to meet the goals year after year-to say nothing of the reputational "penalty" for failing to meet a goal.

Considering that we have consistently met the permanent affordable housing goals, and that existing powers already are the industry's toughest, additional enforcement authority seems completely unnecessary. Additional enforcement authority would add little to the legislative and regulatory incentives that Congress and HUD have put in place. Therefore, we respectfully suggest that no additional authority is needed.

Market Discipline Commitments

In October 2000, Freddie Mac and Fannie Mae announced a set of six public commitments to ensure the GSE's adhere to a high standard of financial risk management. These commitments continue to represent a very high "bar" among financial institutions. Excluding the commitment to adhere to an interim risk-based capital standard (which was rendered obsolete with the completion of the current risk-based capital stress test) the commitments are as follows:

• Periodic issuance of publicly traded and externally rated subordinated debt on a semiannual basis and in an amount such that the sum of core capital and outstanding subordinated debt will equal or exceed approximately 4 percent of onbalance-sheet assets. Because subordinated debt is unsecured and paid to the holders only after all other debt instruments are paid, the yield at which our subordinated debt trades provides a direct and quantitative market-based indication of our financial strength.

• Maintenance of at least 5 percent of on-balance sheet assets in liquid, marketable, nonmortgage securities and compliance with the Basel Committee on Banking Supervision Principles of Sound Liquidity Management, which requires at least 3 months' worth of liquidity, assuming no access to new issue public debt markets. • Public disclosure of interest-rate risk sensitivity results on a monthly basis. The test assumes both a 50 basis-point shift in interest rates and a 25 basis-point shift in the slope of the yield curve-representing an abrupt change in our exposure to interest-rate risk.

• Public disclosure of credit risk sensitivity results on a quarterly basis. The disclosure shows the expected loss in the net fair value of Freddie Mac's assets and liabilities from an immediate nationwide decline in property values of 5 percent. • Public disclosure of an annual independent rating from a nationally recognized statistical rating organization.

16 Low- and moderate-income families have incomes at or below 100 percent of the area median income.

17 Underserved areas are defined as (1) for OMB-defined metropolitan areas, census tracts having a median income at or below 120 percent of the median income of the metropolitan areas and a minority population of 30 percent or greater; or a median income at or below 90 percent of median income of the metropolitan area; and (2) for nonmetropolitan areas, counties having a median income at or below 120 percent of the state nonmetropolitan median income and minority population of 30 percent or greater; or a median income at or below 95 percent of the greater of the state nonmetropolitan median income or the nationwide nonmetropolitan median income.

18 Low-income areas refer to census tracts in which the median income is at or below 80 percent of the area median income. Low-income families have incomes at or below 80 percent of area median income, while very-low income families have incomes at or below 60 percent of the area median income.

In July 2002, the GSE's made an additional commitment to voluntarily register their common stock with the Securities and Exchange Commission under the Securities Exchange Act of 1934 so that both companies will become reporting companies under that law. Freddie Mac remains irrevocably committed to completing this process as soon as possible after the company's return to timely reporting.

Freddie Mac would support giving the regulator authority to ensure we carry out these important public commitments. Taken together, they significantly enhance the degree of market discipline under which the GSE's operate. Robust and frequent credit and interest-rate risk disclosures, combined with the release of annual independent ratings and the issuance of subordinated debt, constitute an important "early warning system" for investors.

Top Priorities for Freddie Mac

Finally, I would like to say a few words about Freddie Mac-and my top priorities for strengthening this vital company and restoring the trust of the Congress, the public, and investors.

Commitment to Exemplary Accounting

Clearly, my most pressing priority is to get Freddie Mac's financials done-and done right. On November 21, 2003, the Freddie Mac Board of Directors and our management team announced the release of the company's restated and revised financial results for the years 2000 through 2002. The restatement was a significant step in Freddie Mac's progress toward achieving accurate and timely financial reporting. The company will issue its annual report for 2002 on Friday, February 27, 2004 and hold the related annual stockholders' meeting on March 31, 2004.

As for 2003 and beyond, we are currently working around the clock with the objective of releasing quarterly and full-year 2003 results by June 30, 2004 and to provide the 2003 annual report and hold the related stockholders' meeting as soon as possible thereafter.

I am also focused on ensuring that these problems do not happen again. I am pleased to report that, under the guidance of our Board of Directors, Freddie Mac is building an environment that will allow us to provide comprehensive and understandable information about our company, incorporating the highest level of financial transparency, accounting controls, compliance, and professional standards. Our aim is not simply to meet what is required but to become a model of financial excellence.

We have added over 100 professionals in the accounting, reporting, and control areas, including a significant number of new officers and senior managers. We have also retained leading experts in the areas of public disclosures and corporate governance to assist the company in designing and implementing processes and practices in these areas. In October 2003, we hired a Senior Vice President-Chief Compliance Officer who is responsible for overseeing Freddie Mac's compliance with policies, procedures and practices, including compliance with laws and regulations. Additionally, in October 2003, we created the position of Chief Enterprise Risk Officer. Both of these positions currently report directly to me.

We are also working to create and implement new infrastructure and systems to ensure the quality, integrity, transparency, and timeliness of our financial reporting. Finally, we have taken steps to ensure that Freddie Mac's corporate culture promotes integrity, high ethical standards, and the importance of compliance. Virtually all of our employees have completed a corporate-wide training program on the company's Code of Conduct and the provisions of the Act sponsored by Senator Sarbanes and Chairman Oxley.

The scope of these activities is wide and deep. I was deeply involved in the transformation of a Fortune 500 company before, and I am committed to doing it again. Freddie Mac is on the path to becoming a new and better company.

Enhanced Commitment to Mission

My second priority is to renew and expand the company's commitment to mission. It is a great honor to be the leader of a company that has an explicit mission to do good things for society. There are very few publicly owned companies that have such a "higher calling"-and, as a Nation, we should work to make them better, as is the Committee's intent.

The special privileges that flow from the GSE charter entail special responsibility. While the annual affordable housing goals are an important component of our mission to expand mortgage market accessibility, I view the goals more as a threshold than a ceiling. I am particularly focused on the housing finance needs of minority consumers. The homeownership rate for African-Americans is 48 percent and 47 percent for Hispanics. We must do better-and we will.