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Testimony of John T. Korsmo,

Chairman, Federal Housing Finance Board,
Before the House of Representatives' Committee on Financial Services

Washington, D.C.
September 25, 2003

Testimony of John T. Korsmo,

Chairman, Federal Housing Finance Board,
Before the House of Representatives' Committee on Financial Services

Washington, D.C.
September 25, 2003

Good morning, Chairman Oxley, Ranking Member Frank, and distinguished members of the Committee. Thank you for inviting me to be part of this panel today on H.R. 2575 and the Administration's proposals regarding government sponsored enterprises.

Over the past year and a half, my colleagues and I at the Federal Housing Finance Board have undertaken a disciplined, continuing, and, I believe, successful effort to improve the agency's supervision and regulation of the Federal Home Loan Banks.

This process has been instructive, providing many lessons that I believe may be of value to you as you consider the best ways to strengthen government sponsored enterprise (GSE) oversight. Allow me to highlight several of these lessons.

First, a GSE safety and soundness and mission regulator should today - and for the foreseeable future - concentrate on understanding and keeping pace with the rapidly evolving mortgage finance sector.

Second, a GSE safety and soundness and mission regulator should have specialized knowledge of the business and risks of the enterprises it supervises.

Third, a GSE safety and soundness and mission regulator must guard its independence in establishing standards and in conducting examinations so as not to revert to a failed model of mixing supervision duties with other mandates.

Fourth, a GSE safety and soundness and mission regulator should possess all the tools and enforcement authority granted to commercial bank and thrift regulators.

And, finally, a GSE safety and soundness and mission regulator's effectiveness is enhanced by exemption from the appropriation process, allowing it flexibility to determine and structure its budget based on the primacy of safety and soundness.

The Finance Board has learned these lessons as a result of its efforts to build a stronger, more capable regulator for the Federal Home Loan Banks. We have been fortunate in that the Federal Home Loan Bank Act affords the Finance Board the prerogatives and authority required to build a truly world-class, arm's length regulator for the Banks. I believe the fast progress my Finance Board colleagues and I have made in increasing the capacity and sophistication of the agency's supervision staff demonstrates the Finance Board is well on the way to becoming just such a regulator.

Mr. Chairman, members of the committee, I respect the responsibility of the Congress to take aggressive steps to foster strong, independent regulation of both Fannie Mae and Freddie Mac and the Federal Home Loan Banks, and it goes without saying I will support whatever policy Congress adopts in this regard. Given the progress we have made at the Finance Board and the very different charters, ownership and capital structures, and business models of the Banks as compared to the other housing GSES, however, I believe the Finance Board is achieving the goal of providing effective, efficient, and independent regulation of the Federal Home Loan Banks. Moreover, I believe it is critical that significant enhancements now underway not be lost or deferred in transition to any new regulatory regime at a time when the 12 Banks are entering a far more demanding risk-management environment.

IMPROVEMENTS IN SAFETY AND SOUNDNESS OVERSIGHT

For most of their history, the Federal Home Loan Banks were overseen by the Federal Home Loan Bank Board. That agency had a mixed mandate to help operate the Banks, to regulate the Banks' owners – federally insured thrifts - and to promote the Federal Home Loan Banks and thrifts.

Congress sorted out this puzzle with the passage of the Financial Institutions Reform Recovery and Enforcement Act (FIRREA) in 1989. Nevertheless, in a 1998 report, the General Accounting Office (GAO) found that the Federal Housing Finance Board – nine years after its creation – remained inadequately focused on safety and soundness supervision and too closely involved in operating the Banks, and at times appeared to be a cheerleader for the Banks, rather than an arm's length regulator.

Upon becoming chairman in December 2001, I quickly determined these problems still existed and had to be corrected for the Finance Board to effectively oversee the Federal Home Loan Banks and Office of Finance for safety and soundness and achievement of their housing finance mission. Just one example demonstrates this point: At the time of my appointment, the Finance Board had only eight bank examiners on staff to review and supervise a dozen financial institutions with, at the time, more than $700 billion in assets, more than $30 billion in capital, and some $650 billion in outstanding debt. Yet, at the same time, the agency also had eight people in its Office of Public Affairs. The relative allocation of resources simply did not meet the agency's statutory mandates.

In addition to being understaffed, the examination function insufficiently focused on the Banks' risk assessment processes and the Banks' internal control systems. Such shortcomings had been identified in the 1998 GAO report on the Finance Board's examination program

These circumstances called for an immediate and vigorous response, beginning with the recruitment of new leadership for the agency's Office of Supervision. Following a national search, the Finance Board has in place a new director and a new deputy director

of supervision, who between them have 40 years of regulatory experience with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation (FDIC).

My Finance Board colleagues and I increased the resources available for supervision, expanding the agency's examination staff to 17 full-time bank examiners. Our goal is to have 24 in place by the end of this calendar year, and 30 by October 2004.

The Finance Board is now conducting more thorough, risk-focused examinations, and communicating the results of those examinations more effectively to the Banks.

Examinations now recognize that banking – including AAA-rated, GSE banking is a business of managing risks, and the responsibility of bank supervisors is to ensure that the institutions they regulate understand those risks and monitor and control them through prudent risk management practices.

To enhance analysis and oversight in the risk management area, we have established two risk units - a Risk Modeling Division and a Risk Monitoring Division. The Risk Modeling Division is responsible for the development of our asset/liability modeling and for monitoring the Bank's internal interest rate risk models. The Risk Monitoring Division pulls together our data and the Banks' own financial reporting into a risk-monitoring framework.

We have hired an Associate Director for Examinations who oversees all our safety and soundness examiners. She has more than 15 years of bank regulatory experience with the FDIC. We also have hired a Senior Advisor to the Director of Supervision to provide support to the Risk Modeling and Risk Monitoring Divisions. That Senior Advisor possesses some 30 years of bank supervision, capital markets, and capital regulation experience with the Board of Governors of the Federal Reserve System and the Office of Thrift Supervision.

While on-site examinations remain the primary tool of supervisors, the agency now complements exams with off-site monitoring and regular communication with the Banks. Our new "Bank Analyst Program" charges a member of our Office of Supervision with following an individual Bank and reviewing monthly and quarterly financial reports for trends and changes, while also keeping abreast of issues in the financial and housing industries to determine their effect on each Bank.

Our Office of General Counsel has also assigned attorneys who serve as points of contact for the examiners on issues concerning particular Banks.

In short, the Finance Board's safety and soundness oversight of the Federal Home Loan Banks has improved dramatically. We have more work ahead of us, to be sure, but the Finance Board is a much stronger and more capable regulatory agency than it was as recently as 12 months ago.

GOVERNANCE

When Congress passed the Gramm-Leach-Bliley Act of 1999, it gave the board of directors at each Federal Home Loan Bank the clear responsibility for making business decisions concerning that Bank. Any business decisions previously made by the Federal Housing Finance Board were devolved to the Banks.

This new, post-Gramm-Leach-Bliley relationship makes it even more critical that the Federal Home Loan Banks meet the highest standards of corporate governance, and that the Federal Housing Finance Board pursue rigorous safety and soundness supervision of board governance at these Banks.

Therefore, the Finance Board recently completed a thorough assessment of corporate governance at each of the Banks. This effort included the first-ever horizontal review - that is, a systemwide supervisory review of a single issue at each of the 12 Banks - which addressed the Banks' effectiveness relative to eight indicators of effective board governance.

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The Finance Board's final report on this review includes a variety of general recommendations for improving corporate governance. The agency also provided specific, confidential feedback to each of the 12 Banks.

The Board's next step is to solicit from the Banks, their member institutions, experts, and interested members of the public any ideas for reform in this important area. Input generated may be used in the design of proposals aimed at making the Federal Home Loan Banks role models in corporate governance.

Earlier this year, the Finance Board also undertook a second systemwide horizontal review, that of the Federal Home Loan Banks' implementation of the statutorily mandated Affordable Housing Program (AHP). The AHP is a highly successful program that warrants a separate discussion.

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