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the market for residential mortgages, including, but not limited to, mortgages that qualify for the affordable housing goals. By attracting low-cost funding to the mortgage market and creating liquidity, we reduce the interest rate on all conforming mortgages by at least 0.25 percentage points. We serve this entire market in a way that expands liquidity and reduced mortgage rates for all conforming mortgages, while focusing special attention on low- and moderateincome borrowers. Q.2. Are there any new affordable housing goals you would support adding to those currently authorized? If so, please describe them. A.2. HUD sets housing goals as a regulatory requirement to ensure that Fannie Mae focuses particular attention on low- and moderate-income borrowers and underserved areas. We have consistently met or exceeded the current goals. The Agency is developing proposed goals for next year and beyond.

Over the years, HUD has sought to establish goals that require the company to stretch beyond levels we might otherwise achieve, without threatening our safety and soundness or jeopardizing the liquidity of the mortgage finance system. HUD relies on predictions of market growth to establish these goals. This kind of forecasting is not easy and predictions are likely to be inexact. The refinance boom of the last 2 years, which exceeds anything foreseen by HUD when these goals were set, highlights that fact.

It is critical that the housing goals structure allows Fannie Mae the ability to make business decisions based on actual market conditions. Under the structure created by the 1992 Act, HUD has considerable flexibility in establishing the goals in its rulemaking process, and can use that authority to focus our efforts toward specific high-priority portions of the market.

HUD's recasting of the goals in 2000 is an example of that flexibility. The Department increased all three housing goals. The goal for Fannie Mae's purchase of loans to low- and moderate-income borrowers was increased from 42 percent in 1999 to 50 percent in 2000. In addition, the new goals that gave Fannie Mae an incentive to pay special attention to financing small multifamily properties and owner-occupied 2-4 unit properties.

Going forward, it is critical that housing goals are not increased to the point that they threaten our safety and soundness or undermine our ability to serve a market that includes middle-class as well as low-income borrowers. Today, we work to expand the universe of Americans who can afford to purchase a home by increasing low-cost funding available for mortgages for middle class families, as well as for underserved communities. Goals that become too numerous or narrow can lead to fragmentation in the market and credit allocation. This would distort Fannie Mae's business and undermine the critical role we play in the market. Q.3. If Congress were to establish an independent regulator and with a well-respected impartial Director to head it, why shouldn't that Director be able to raise minimum capital standards, if he or she believed it to be necessary to ensure the safety and soundness of the GSE's? Please explain. A.3. Fannie Mae operates under two capital requirements—a minimum capital, or leverage, requirement and a risk-based capital requirement. Each quarter, Fannie Mae must meet both requirements.

The leverage requirement, also known as minimum capital, does not change based on the risk of the assets a financial institution. Instead, the leverage limit serves as a capital "floor" based on the general risk of an entity. Fannie Mae and Freddie Mac's leverage ratio, set by statute, is 2.5 percent for on-balance-sheet assets and 0.45 percent for off-balance-sheet assets. Unlike the bank leverage ratio, the GSE's leverage test requires capital support for off-balance-sheet, as well as on-balance-sheet, exposures. Fannie Mae's capital as a percentage of on-balance-sheet assets (as the bank ratio is calculated) was 3.4 percent on June 30, 2003. Including outstanding subordinated debt, that figure rises to 3.9 percent of on-balance-sheet assets. Bank regulators set minimum capital requirements, typically requiring a bank to hold 5 percent capital against on-balance-sheet assets, regardless of how risky those assets are, in order to be considered well-capitalized. The leverage measure ignores all off-balance-sheet assets, although a bank may have significant off-balance-sheet exposures.

Fannie Mae invests only in U.S. residential mortgages, which are far less risky than many bank investments like consumer debt, commercial real estate, or third-world debt. Thus, having a leverage limit for Fannie Mae and Freddie Mac that is somewhat lower than the leverage limit for banks makes sense if the average risk of Fannie Mae and Freddie Mac's assets is lower than the average risk of banks' assets. Experience shows that in fact the risks of holding a mortgage are a fraction of the risk of other loans. Furthermore, Fannie Mae's book of business is more geographically diverse than those of most banks, and the company is required to obtain mortgage insurance or other credit enhancements against higher risk loans.

This lower risk is reflected in the comparable capital-to-loss ratios of Fannie Mae and commercial banks. For the first half of 2003, Fannie Mae's ratio of capital to credit losses, on annualized basis, was 357. By comparison, large commercial banks had a capital coverage ratio of only 17.7, and for the whole banking industry the ratio was 14.5.

Increasing minimum capital when there is no increase in risk raises the cost of funds to housing and undercuts our ability to fulfill our mission. Q.4. In [Director] Falcon's testimony from the October 23, 2003 GSE hearing, he described adjusting the minimum capital requirement as a "fail-safe" mechanism, because the risk-based capital standard cannot quantify all of the potential risks to the GSE's. Do you believe the current risk-based capital does not quantify all of the potential risks to the GSE's? Why or why not? What is your response to the notion of the need for a "fail-safe" mechanism? A.4. No capital standard can quantify all the risks a financial institution faces. However, the risk-based standards applied to Fannie Mae and Freddie Mac are the most comprehensive in the industry and come much closer to covering all the risks the companies face


than the capital standards that are applied to banks.1 These risks include credit risk, interest-rate risk (including prepayment risk), and operations risk. Credit Risk

Fannie Mae and Freddie Mac are required to have enough capital to survive Depression-era credit conditions that last for 10 years. Such conditions over that period of time have never been seen in the country at large, at least in modern times.

The coverage of credit risk in bank capital standards is, in contrast, less sophisticated-as is admitted by bank regulators worldwide. As a result, in a process commonly known as Basel II, the international bank capital standard setters are in the process of updating capital rules to make them more responsive to risk, although this effort will probably take several more years to implement. Interest Rate Risk

In the companies' RBC requirement, the draconian and prolonged credit shock is coupled with dramatic and sustained changes in interest rates. Indeed, an econometric study conducted for Fannie Mae by Nobel laureate Joseph Stiglitz and colleagues found that "the probability of the stress test conditions occurring is less than one in 500,000.” 2

Banks do not have an interest-rate component in their risk-based capital requirements. Interest-rate risk tends to be the largest risk in mortgage lending, particularly for a portfolio with geographic diversification. The standards applied to Fannie Mae cover this risk comprehensively; those for banks do not cover it at all. Operations Risk

To some extent, operational risk is the unquantifiable risk that is not covered by the credit and interest rate risk components of the stress test. In OFHEO's risk-based capital requirements, there is a 30 percent add-on to the stress test to provide an extra cushion to the capital already required by the stress test.

Currently, banks do not have a requirement covering operational risk. Basel II contemplates adding one, but it will be lower than that applied to the GSE's. The add-on charge for banks is likely to be around 9 percent to 12 percent, roughly one-third of that applied to Fannie Mae.3

1 “Primary emphasis is placed on a risk-based capital standard that reflects risks more accurately than bank and thrift standards by directly incorporating interest rate risk and by disaggregating credit risk to a much finer degree. The standard for GSE's also explicitly sets an acceptable limit for those risks: Survival for a 10-year period in an environment with credit losses equal on a national basis to the worst actual experience on a regional basis and sustained interest rate movements more threatening than any experienced in GSE history. At the same time, substantial allowance is made for other, less quantifiable risks. The result is a more forward looking standard, less tied to current, and sometimes misleading, balance sheet data.Federal Housing Enterprises Regulatory Reform Act of 1992, Report of the Senate Banking Committee, May 15, 1992 at 19 (emphasis added).

2 Implications of the New Fannie Mae and Freddie Mac Risk-Based Capital Standard, Joseph E. Stiglitz, Jonathan M. Orszag and Peter R. Orszag, Fannie Mae Papers, Volume 1, Issue 2, March 2002 at 2. Paper available at /pdf/commentary/ fmpuli2.pdf.

Regulatory Treatment of Operational Risk, Basel Committee, September 2001.

In addition to the distinctive structure of their risk-based capital requirement, the minimum leverage ratio for Fannie Mae and Freddie Mac is unique in that it requires capital support for offbalance-sheet, as well as on-balance-sheet, exposures. As the Senate Banking Committee reported with regard to the minimum capital requirements in the 1992 Act:

"[T]he risk-based measure is supplemented by a more traditional minimum capital standard, which actually bears more in common with the risk-based measures for banks and thrifts, in that it explicitly covers the very sizable off-balance-sheet risks of the GSE's.5

The leverage requirement for banks does not have a similar provision. Banks often have large off-balance-sheet exposures, and those exposures have been increasing in recent years, partly in an effort to avoid the leverage requirement that would apply if they were held on balance sheet.

Additionally, it is appropriate that the leverage ratio for banks pro an additional cushion against interest rate and prepayment risks since, as outlined above and unlike the Fannie Mae stress test, bank risk-based capital requirements do not include a component for these risks.

Thus, to the extent that the minimum capital requirement is regarded as a “fail-safe” mechanism, Fannie Mae has one that is tailored to our operations and consistent with the level of risk we manage.

In order to judge the appropriateness of the mandated requirements for the GSE's, they have to be viewed within the context of the companies' restrictive charters. Fannie Mae is a private company with a single purpose-to promote homeownership through secondary market operations in residential mortgages. Confined as we are to residential mortgages, Fannie Mae is exposed to less credit risk than a typical large complex bank, operating in many countries around the world and investing in a range of asset classes that carry more risk and are more difficult to manage. Were the GSE charters as broad as a bank's, Congress would undoubtedly have required Fannie Mae to meet the same capital standards as banks.

It should also be recognized that OFHEO has a panoply of supervisory powers to deal with problem situations, from cease-and-desist orders, to civil money penalties, limitations on dividends, and a requirement to hold additional reserves against particular assets. These protections complement the capital requirements. And they reflect the practice in the banking industry where regulators have the power to set special individual capital requirements but rarely use that power, preferring to use their other supervisory powers instead.


FROM FRANKLIN D. RAINES Q.1. In a format similar to your annual report, please tell us what the fair value of Fannie Mae's shareholders' equity would have been on a quarterly basis for the last 12 quarters, using the defini

4 As of June 2003, Fannie Mae's core capital equaled 3.32 percent of total balance sheet assets. 5 Senate Banking Committee, id. (Emphasis added)

tion of fair value that you have been applying in your most recent annual reports. A.1. At the end of every year, GAAP requires us to provide the market value of our financial instruments. We go a step further by reporting the market value of all our assets and liabilities at the end of each calendar year. The estimated fair value of our net assets (net of tax effect) was $22.1 billion as of December 31, 2002, $22.7 billion as of December 31, 2001, and $20.7 billion as of December 31, 2000. Our fair value as of year-end 2003 will be included in our 2003 Form 10-K, which is due by March 15, 2004. Like many other large financial institutions, we believe this fair value balance sheet is an imperfect means to determine our profitability and value as an ongoing enterprise. We do not primarily use mark-to-market valuation measures to run our business or prepare a full fair value balance sheet on a quarterly basis.

We run our business on the basis of core business results, which rely on historical cost accounting. Assets and liabilities are booked at their initial value and the cost is amortized and the income recognized over time. We believe this traditional approach to accounting provides the best representation of how our business operates.

Mark-to-market valuation, on the other hand, takes a snapshot of the market value of an asset or liability at a specific moment in time. This would be useful for certain investors such as hedge funds that trade securities in the market every day, because that is how they would determine the net value of their business on a given day.

But for portfolio investors like Fannie Mae, especially those that hold assets to maturity, marking to market is not a very meaningful way to measure our performance. Indeed, it might be misleading for management-and investors—to value our performance solely on a mark-to-market basis, for a very important reason.

Mark-to-market accounting produces paper gains and losses that a held-to-maturity enterprise may never realize. That is why financial regulators generally do not consider these noncash, unrealized gains or losses in judging a company's financial strength, or in judging whether it meets regulatory capital requirements. Q.2. With reference to the $16.09 billion of “cashflow hedging results” losses in your equity account, as reported in your quarterly statement, exactly what proportion of those losses are either realized, unrecoverable, or not recoupable because you have closed out the derivatives at a loss, and paid out the loss amount in cash? Are these losses likely to reverse themselves as the hedges come to maturity? A.2. We provide on a quarterly basis our cashflow hedging results according to GAAP requirements. As you may be aware, these numbers have become very volatile since the implementation of Financial Accounting Standards Number 133 (FAS 133), Accounting for Derivative Financial Instruments and Hedging Activities. The details behind these numbers are not publicly disclosed and are confidential and proprietary.

FAS 133, Accounting for Derivative Financial Instruments and Hedging Activities, became effective for Fannie Mae in January 2001 and requires companies to record the current market value of

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