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derivative instruments on their balance sheets. Unfortunately, the standard can often result in an incomplete or distorted picture of a corporation's financial position. This is particularly true for investors who use derivative instruments extensively in their interest rate risk management.

The reason is that FAS 133 requires all derivatives to be recorded at their current market value, while other assets and liabilities do not obtain the same treatment. Financial statements produced under FAS 133 include a mix of treatments—some assets and liabilities are reported at their current value, while others are reported at historical cost. As a result, financial statements under GĀAP can give an incomplete picture of a company's net worth and overall risk position. Q.3. It has been alleged that permitting a regulator to review and approve Fannie and Freddie's new activities will stifle your innovation. Yet this country's banks are the most innovative in the world and they operate under a system in which their regulator has this authority. Please explain to us how reviewing Fannie and Freddie's new activities would stifle your ability to innovate. A.3. Under current law, Fannie Mae must submit a new program approval request to HUD if an initiative is "significantly different” from a program that has been previously approved or is a program in which Fannie Mae had not engaged prior to passage of the 1992 Act. HUD may deny approval of any new program if our charter does not permit it or if the Secretary determines that the activity is not in the public interest. HUD generally has 45 days within which to approve a new program request. This short time frame for decisionmaking is crucial to timely market innovation.

Some recent proposals have suggested that a regulator should review all of the “new activities” of Fannie Mae. In H.R. 2575, for example, the term “activities” is broadly defined to include "any program, activity, business process, or investment that directly or indirectly provides financing or other services related to conventional mortgages.” This definition could require prior regulatory approval for every change in underwriting standards made by Fannie Mae or every transaction in which we engage to buy mortgages.

Banks and other entities regulated by Federal financial regulators are not generally subject to prior approval requirements for their activities. In the banking context, “activity” means line of business. The Gramm-Leach-Bliley Act contains a list of “activities" financial institutions may undertake without prior approval, such as insurance, securities underwriting, and merchant banking. Particular changes in the way in which an institution engages in one of these lines of business are also not subject to prior approval. In adopting this regulatory structure for banks, Congress has recognized that innovation within permitted lines of business benefits consumers and the economy as a whole. Financial institution regu. lation is biased against time consuming preapproval processes, and instead focuses on prudently imposed limitations and safety and soundness principles, compliance with which is evaluated by financial institution examiners.

A comparable regulatory structure, if applied to Fannie Mae, would recognize that we have one main business line, mortgages,

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and would require no prior approval for new products or processes related to that line of business. The new regulator would, like bank regulators, rely on examiners, conducting on-site continuous examinations, to review all ongoing activities to determine that they are safe and sound and within our charter. Under the bank model, if Fannie Mae were to go into a broad new line of business, the company would be required to seek prior approval from its regulator.

The mortgage market today provides consumers with a wider variety of products than ever before, and therefore is better poised to meet the individual financing needs of a broader range of homebuyers. This has been possible because the program approval requirements in the 1992 law respect the need for innovation. Lenders have been able to innovate and develop new products to reach underserved communities because we have been able to review the products and, whenever possible, assure them, in a timely manner, that we will purchase these loans in the secondary market.

Imposing intrusive or cumbersome regulatory requirements or processes would put the Government-not the private sector-in the position of deciding or delaying which products are brought to market. This lack of predictability and potential for delay would inhibit our ability to work with our lender partners to support innovation to expand homeownership opportunities. Without that secondary market outlet, lenders would have to assume more risk and expense in developing innovative mortgage products that are vital for reaching new markets. Q.4. Your company charges a "guarantee fee” for each mortgage sold to Fannie. It seems those guarantee fees continue to be high while your credit losses shrink. If losses are down, why the need for proportionately higher guarantee fees, and how much does this ultimately mean out-of-pocket to the individual mortgage customer? A.4. Fannie Mae's guaranty fee has to cover the full costs of guaranteeing mortgages. These costs include: • Insurance (credit) losses; • The costs of credit enhancements where Fannie Mae pays other

parties to share possible losses, thereby dispersing risk; • The administrative costs of running the business; and • The cost of capital needed to support the business.

The proportion of the guaranty fee designed to cover expected losses is generally not the largest component of that fee. Best practice for financial institutions requires that they hold economic capital against the risks they face. Economic capital is an amount of capital sufficient to prevent company insolvency in bad economic times. In the case of Fannie Mae's guaranty business, best practice requires holding sufficient capital to withstand stressful economic conditions. That capital has to earn a competitive return-or it would not be attracted in the first place.

As shown in Exhibit 1, insurance is somewhat unusual in that. returns above the average occur more often than those below the average. (In more formal statistical terms, the median is greater than the mean.)

Typically, in insurance, losses in very bad times tend to be greater than profits in good times. (Loss distributions are said to have “fat tails.") And, in guaranteeing loans as in other insurance, it takes many profitable outcomes to cover the losses from a single bad outcome (Exhibit 2). Thus, over a long period of time, there must be more occurrences of good outcomes to counterbalance the fewer, but weightier, bad outcomes.

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Exhibit 2

Losses on Bad Loans are Much Larger than Profits on Good Loans


And most crucially it means that one cannot look at the results from an individual year (or even from a particular cohort of business) to judge the adequacy of profits. Currently, Fannie Mae's portfolio is very strong from a credit perspective, and one should expect very good outcomes and low credit losses. Fannie Mae, like other insurers, looks beyond expected outcomes, to the unlikely possibility that a severe credit event could occur, leading to much higher levels of defaults. Holding sufficient capital to withstand such an event is a business and regulatory requirement. To do otherwise would rightly be regarded as an unsafe and unsound business practice. We compete for capital in the broader marketplace, and therefore this capital held against a potential credit event must earn the return it could have earned on a similarly risky investment elsewhere.

Fannie Mae's 10-K clearly breaks out the different components of income and expense to the credit guaranty business. In 2002, total pretax guaranty fee income was $3.2 billion, credit-related expenses were $92 million, and administrative expenses were $1.5 billion (including $638 million in Federal income taxes). The creditrelated expenses were indeed at record lows, as were delinquency and default rates for Fannie Mae.

These surprisingly low credit expenses cannot be taken for granted. Credit expenses are expected to increase. Note that administrative expenses, excluding taxes, are almost 10 times as large as credit-related expenses. Although Fannie Mae is highly efficient (these administrative expenses were incurred on a book of business that averaged $1.8 trillion in 2002), the charged guarantee fee must be sufficient to cover these expenses as well. Q.5. The Administration has proposed eliminating Presidential appointed members from your Boards and leaving the appointment responsibility in the hands of your shareholders. What are your thoughts on this?

A.5. We have seen many benefits from the presence of Presidential directors on the board of Fannie Mae. They have well represented the interests of the company's shareholders and helped advance our mission. Indeed, our board is seen as a leadership model of stakeholder representation on corporate boards. Our experience has been very good over the years with our Presidential directors and our preference would be to retain them. Ultimately, this will be an issue for the Congress and Administration to decide.


FROM FRANKLIN D. RAINES Q.1. Do you want to be under Treasury or do you want a beefed up independent regulator? If you were put into Treasury do you want [Fannie Mae/Freddie Mac and the FHLBank System) to be together under one bureau or do you prefer two separate bureaus and why? A.1. Fannie Mae supports legislation to create a new safety and soundness regulator for Fannie Mae and Freddie Mac as a bureau of the Treasury Department, funded independently of the appropriations process.

While recent events raise fresh questions about FHLBank regulation, it is also true that including the FHLBank System in regulatory reform legislation would complicate the legislative process. At a minimum, there are many questions Congress would have to answer before incorporating the Banks into any new regulatory structure. For instance, the Congress would have to decide whether to focus the Bank System on its traditional mission of providing advances or to endorse the Banks' recent ventures into acquiring mortgages. There are questions as to whether the current FHLB regulatory structure is consistent with the new lines of business the Banks are undertaking.

However, if Congress decides to include the FHLBanks in a reform proposal, we believe that Fannie Mae, Freddie Mac, and the Bank System should be placed under the umbrella of a single regulator, and that the FHLBanks mortgage acquisition activities should be subject to the same set of safety and soundness regulations that apply to Fannie Mae and Freddie Mac. Such a regime would best be served by a single bureau that could institute comparable regulatory requirements for comparable activities. Q.2. In your view, what is the difference between new program and new activity standards? A.2. Under the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, the standard for HUD prior approval of "new programs” is simple: The current law says the Secretary must disapprove a “new program” if it does not comply with our charter or is not in the public interest. The 1992 Act also established time limits for consideration of new program requests by the Secretary, A “new program” is generally defined by the 1992 Act as a broad and general plan or course of action for purchasing or dealing in mortgages that is significantly different from programs previously approved by HUD or engaged in prior to enactment of the 1992 Act.

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