Third, the regulator should have powers equal to those of other regulators. While OFHEO's regulatory powers are fairly comparable to those of other financial safety and soundness regulators, certain authorities need to be provided and others clarified. For example, a safety and soundness regulator should have independent litigation authority, enhanced hiring authority, and a full range of enforcement powers provided to financial regulators. Also, the laws should be revised to provide clearly that the regulator is empowered to address misconduct by institution-affiliated parties and to exercise general supervisory authorities.

Fourth, the regulator should have full discretion in setting capital standards. Capital is one of the fundamental bulwarks of effective safety and soundness regulation. The regulator should have broad discretion to exercise his or her best judgment, using all the information available through the examination process and otherwise, to determine if capital adjustments are necessary. All other safety and soundness regulators have this discretion.

Going forward, the Agency needs to have the authority to modify both minimum and risk-based capital standards. This authority would help meet the changing mix of enterprise business, the market environment in which they operate, and the changing nature of risk measurements themselves.

Fifth, legislation should build on progress we have made over the last 10 years. Regulating Fannie Mae and Freddie Mac requires a specialized skill set. The capacity to model the cashflows of all the mortgages, debt, and other financial instrument of the Enterprises needed for the stress test is unique among financial institution regulators.

Over the past 10 years, OFHEO has developed the specialized expertise, from our examiners and financial analysts, to our researchers and capital analysts, and that is necessary to supervise those two unique companies. The cost in terms of lost regulatory capacity spent while trying to rebuild that infrastructure would be substantial. That is why I recommend that, if a new regulator is established, OFHEO's personnel, regulations, and administrative infrastructure should be transferred intact to the new agency. I believe it would be highly counterproductive to do otherwise.

There are a couple of other matters I would like to briefly discuss. First, I agree with Secretary Snow that the Presidentially appointed board members should be discontinued. This is not a reflection of current or former Presidentially appointed directors. Rather, I think corporate governance would be enhanced if the shareholders were allowed to select all members of the board.

Also, I support the granting of authority to the safety and soundness regulator to determine whether the activities of the Enterprises are consistent with their charters. This would mean that a single regulator would have the ability to review all of the Enterprises' activities-new and existing. This change will consolidate the supervision of the enterprises in a manner consistent with the authorities of other regulators.

In conclusion, let me raise two other points. I would be remiss in not noting my appreciation for the interest and support of the Members of the Committee, as expressed by Senator Sarbanes, with respect to the Administration's request for an additional $7.5

million for the Agency to conduct its business. I would urge the Committee to help us get those additional funds, and they would be much needed.

Second, with regard to our ongoing investigation of Freddie Mac, I would like to inform the Committee of a recent development. Last night, OFHEO entered into a consent order with Mr. David Glenn, the former Vice Chairman, President, and Chief Operating Officer of Freddie Mac. Mr. Glenn now loses some $13 million in benefits, and under the order Mr. Glenn will cooperate fully with OFHEO, pay a civil money penalty of $125,000, and be barred from working for the Enterprises, even on a consultant basis. This is a significant development, and as you would expect, we will proceed deliberately and carefully in building a complete record of what has transpired. In addition, we will continue to take any appropriate regulatory action necessary to hold individuals accountable and bring this event to a proper resolution.

I look forward to working with the Committee on the legislative developments, and I would be happy to answer any questions you may have.

Senator BENNETT. [Presiding.] Thank you.
Dr. Holtz-Eakins.

STATEMENT OF DOUGLAS HOLTZ-EAKIN
DIRECTOR, CONGRESSIONAL BUDGET OFFICE

Mr. HOLTZ-EAKIN. Thank you very much, Senator Bennett, Senator Sarbanes, Members of the Committee. Thank you for the chance to be here today.

Over nearly two decades and in what amounts to nearly 15 studies and testimonies, under the direction of Congress the Congressional Budget Office has looked closely at the housing GSE's and GSE's more generally. And as Congress contemplates a restructuring of the oversight and regulation of those GSE's, I thought it would be useful to frame the discussion in the context of the broad findings of that body of research. What emerges from those studies are really three major points.

First, the sponsored status of the GSE's provides an implied guarantee which bestows upon them substantial benefits; second, these substantial benefits at the same time expose taxpayers to a risk that they will be forced to pick up the losses from the failure of a GSE in excess of those that can be accommated by private capital and, finally, an effective regulator can help to manage these risks, but not entirely eliminate them. These findings may be helpful to the Congress in thinking about the design of a new regulator. Let me talk about each of these points in turn.

The benefit bestowed upon GSE's is that, compared to a fully private sector enterprise that has equivalent capital and takes equivalent risks, a GSE can both borrow more and borrow at a lower rate than this comparison firm. How can it do this? Well, the implied guarantee stems from the existence of several features of its setup: the line of credit at the Treasury, the exemption from SEC registration and disclosure requirements, the exemption from State and local taxes, the fact that some members of the board of directors are appointed by the President, and that Federally insured banks can hold larger amounts of GSE's' securities than private se

curities. These are sufficient in the eyes of market participants to overwhelm the explicit denial of such a guarantee by the GSE's.

In 2001, the Congressional Budget Office estimated that the implied subsidy to the housing GSE's during the period 1998 to 2000 was on the order of $10 to $15 billion per year, and if we were to update that today, we would guess that the current subsidy would be at the higher end of that range.

This subsidy exists despite the fact that with the evolution of private capital markets and the maturation of mortgage finance in general, it no longer appears necessary for GSE's to be present in the market in order to generate a reliable flow of money to the housing sector.

Nevertheless, the presence of this subsidy does place the taxpayer at risk. The implied guarantee means that taxpayers may be forced to assume risks for losses above the GSE's capital holdings. These risks emerge from various sources. The GSE's face credit risk from the default on mortgages, interest rate risks from changes in long-term rates, prepayment risks from the decisions of private borrowers, and operations risks in the conduct of any hedges against the previous risks, including the possibility of counterparty default in their derivative operations.

The fact that a small credit risk may be present in GSE operations should not change the overall focus on the risk faced from the composite of these different sources, and indeed the ability to assess the overall risk facing a GSE is one of the paramount features of thinking about a new regulator.

It is true that the presence of private capital in the GSE's provides some inherent incentives for monitoring and risk management, and the GSE's undertake great efforts, in fact, to manage their risks from prepayment and interest rate. However, this risk cannot be eliminated due to the private market incentives alone. As a result, it is useful to keep it within bounds so that the taxpayer does not face risks that are undesirable, and that there be a transparent statement of risks so that regulators, taxpayers, and Congress may be able to assess the risks that they face.

Importantly, there is an extent to which shareholders will want to undertake more risk. If one looks at the record from 1990 to 2000, the GSE's' average return on their equity of about 23 percent compared to 14 percent for similar private-sector financial entities. The source of this increased rate of return is the fact that they held lower capital, less than half of the capital held by comparable private sector entities. This ability to get a higher return stems directly from the ability to exploit higher risk with that lower capital. The low capital, of course, places the taxpayer in the position of dealing with the consequences should there be some financial distress at a GSE, and in turn would place Congress in the very difficult position of deciding either to walk away from a GSE or to face the consequences of a financial shock of unknown magnitude. With that background, the design of any enhanced regulatory agency should have many objectives, and these should include the ability to limit taxpayer risk and the overall subsidy to GSE's. GSE's, Fannie and Freddie, in particular, have the ability to either hold directly mortgages which they purchase or to sell off mortgage-based securities. In holding mortgages, they undertake to

incur the entire interest, prepayment, and operations risks. In selling off the mortgage-backed securities, they retain only the credit risk.

In this way, their business model allows them to determine the degree to which the taxpayer is exposed to risk, and for that reason, the regulator should have the power to limit the risk that the GSE's undertake in order to protect the taxpayer's interest.

Given the complex activities used to hedge against prepayment and interest rate risk, the regulator must have the ability to assess the quality of those hedges and the overall exposure to risk. The regulator must be able to prevent, in the worst case, a failed GSE from continuing to exploit such a subsidy by taking on more risk in an effort to return to solvency.

In addition, it would be useful for the new regulator to be able to leverage the Public Company Accounting Oversight Board and the most obvious way to do that would be to give the regulator the ability to adjust the capital requirements of the GSE's in order to place the broad oversight of private capital markets on the side of the regulator. And to make that easier for the private sector, it would be useful to increase the public disclosure of oversight findings and the transparency of the GSE's in general.

In closing, I would point out that Congress can support such a regulator in a variety of ways, not the least of which would be by setting boundaries for capital requirements that support the regulator's need to provide some insurance against the taxpayers facing unwanted risks and by forcing greater disclosure and registration requirements as a part of the ongoing oversight of the operations of the GSE's.

I thank you for the opportunity to be here today and look forward to answering your questions.

Senator BENNETT. Thank you very much.

Senator Bunning, you were the first Member of the majority here, let's start with you.

Senator BUNNING. A question for Chairman Korsmo. What issue Iwould arise if all three GSE's were consolidated under one regulator? I know in your testimony you gave some examples, but do you foresee any others?

Mr. KORSMO. I do not think it is possible, Senator, really to overstate the importance of recognizing the differences in the way that Fannie Mae and Freddie Mac and the Federal Home Loan Banks are structured and what constitutes their membership, their capital structure, and how they do business. The cooperative nature of the 12 Federal Home Loan Banks I think is significant. It was you, Senator Bunning, who cited the small banks in your State. I am from North Dakota. The 70 members of the Federal Home Loan Bank of Des Moines from my State are extremely dependent on the liquidity options that membership in the Federal Home Loan Banks affords them.

I think that important mission, as I say, has to be recognized and protected. I also think it is incumbent upon policymakers as they look at the possibility of combining regulation to recognize the importance of the competition that exists on a minimal level, but potentially at a larger level, between the Federal Home Loan Banks and Fannie and Freddie. I think the fact that the acquired

member assets programs, which are really another methodology of providing housing finance liquidity to member banks, the growth of those programs is indicative of the need for another outlet, another service, if you will, to be provided, particularly to community lenders, but lenders of all sizes who are members of the system, another outlet for liquidity sources for mortgage financing that is afforded by their membership in the banks.

I think also we want to take a very careful look at the affordable housing programs and measure the affordable housing programs at the Federal Home Loan Banks against the affordable housing goals that are now relevant for Fannie and Freddie. There are arguments in favor of both, but I think the success of the affordable housing programs, the importance that any number of Members of Congress have cited, the importance that those programs play in providing another source of affordable housing funding I think are significant. And so any review, I would hope, that would look at consolidation would take that into play.

And, finally, of course, the whole question of the operation of the Office of Finance. The Office of Finance, of course, is the vehicle through which the Federal Home Loan Banks issue debt in the debt markets. It is an odd creature. It is not incorporated. It does not have a balance sheet. It has no management responsibilities. It is, if you will, a joint venture of the 12 Federal Home Loan Banks, and I think how that would function under a combined regulator needs to be looked at carefully.

Senator BUNNING. You almost took up my entire 5 minutes with

one answer.

Mr. KORSMO. Sorry, Senator.

Senator BUNNING. The last hearing that we had with Secretary Snow and Secretary Martinez, the need for financial experts to staff a new regulator for Freddie and Fannie, with the recent discoveries of losses at the banks in New York and Atlanta, there is a concern that the Finance Board may not have the resources to effectively regulate the Federal Home Loan Bank System.

How do you respond to those concerns?

Mr. KORSMO. I think certainly 18 months ago those concerns were legitimate, and I do not want to downplay what has occurred at both New York and Atlanta, although I will say that the Atlanta loss is an accounting loss, reflective of the vagaries of FAS 133. That is not to say that it is not significant.

I will say that it has been an important process for us to set up a process to attract the kind of talent that is necessary, and I would suggest that we have made dramatic improvement in that regard over the last 18 months. And I think it goes beyond the question of adding examiners, for example.

We have nine Ph.D.s in economics and finance on who

our staff

Senator BUNNING. And all of them have a different opinion. Mr. KORSMO. Who are involved in the process of establishing risk-monitoring procedures and risk-modeling procedures. They are the ones that-supervision, I should say, is more than just examination. Part of what we have accomplished is we have actually built a supervision function at the Federal Housing Finance Board that really did not exist until 2 years ago.