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If I were to construct an administrative process for the Finance Board, would I structure it precisely the way it is now? I am not sure that I would. But again, it is the only paradigm I have experienced. So, I would say it certainly works.

Senator SARBANES. Thank you.
Chairman SHELBY. (Presiding. Thank you.

Dr. Holtz-Eakin, your testimony indicates that when the GSE's hold more mortgages in portfolio the risk faced by the GSE's may be increased. You also indicate in your written testimony that this activity has increased over time. What are some of the possible explanations for the shift in activity by the GSE's, and what can you tell us about how the GSE's have managed the risk.

Mr. Holtz-EAKIN. I can only speculate on the ultimate motivation for shifts in portfolios. The result is that by holding more risk there is a greater rate of return to these activities, and one would expect that to be reflected in return on equity, for example.

The degree to which that risk is managed is very hard to quantify. Net positions on hedges and derivatives are very difficult for even the best examiners to keep up with on a day-to-day basis. It is one of the challenges that would face any regulator, and for that reason, quantifying the management of that risk is hard. The bottom line is, however, they have earned higher rates of return on equity than have comparable private-sector financial institutions, and that typically is associated with greater risk.

Chairman SHELBY. To what extent it necessary to ac eve liquidity in the housing finance markets, to have the GSE's hold mortgage or MBS's in portfolio?

Mr. HOLTZ-EAKIN. I do not think that is a central part of achieving liquidity. Financial markets will price the attributes of securities, not the names on them, and the risk characteristics—the interest rate risk, the prepayment risk-have little to do with who has actually got its name on the securities.

For the Nation as a whole, there will be an outstanding stock of mortgages at any point in time, and the bearing of that risk is typically a voluntary action in private markets. The GSE's shift some to the taxpayer in a slightly different fashion.

Chairman SHELBY. Mr. Falcon, you have indicated that you believe the new safety and soundness regulator should have program approval authority. Do you believe this would inhibit the GSEs’ ability to meet their mission of expanding homeownership?

Mr. FALCON. I do not think it would. The authority would not be used in a manner to inhibit their ability to fulfill this affordable housing mission. In fact, as we have performed our regulatory duties, because we have some role in charter compliance presently, where we see a clear violation we will step in and tell the Enterprise that is not permissible. And as we put our risk-based capital standard in place, we did that in a way that did not provide any disruption to the company, it was a smooth implementation. And they are meeting the standard now. I think it is more a necessity for the risk for the safety and soundness regulator to be able to ensure that the companies are in compliance with the charters and that none of their activities are under a cloud.

Chairman SHELBY. You also suggest a mechanism to ensure that the new regulator solicit and consider all views. How would such a process work in practice, just briefly?

Mr. FALCON. I think what would be beneficial is that when the agency decided that there was an activity that needed to be reviewed for purposes of charter compliance, that it should put out a notice to all interested parties that the agency is considering that activity, and ask for comment from anyone who is interested about whether or not in their view the activity is or is not permissible, and the benefits and the downsides of the activity.

Chairman SHELBY. Doctor, as you know, the minimum capital threshold of 2.5 percent that Fannie and Freddie are subject to is often compared to the 4 percent minimum capital standard that banks and thrifts must meet. Fannie and Freddie--and they have done it here—that they do not need to hold as much capital as banks and thrifts because they pursue lower-risk activities, which there is some truth to. How would you respond to this assertion? If a 2.5 percent threshold was appropriate in 1992 how should the Congress evaluate whether it remains the appropriate threshold today?

Mr. Holtz-EAKIN. I think there are two types of responses to that. The first is that I think the record is quite clear that the overall credit risk pursued by the GSE's is, in fact, relatively modest. However, that is only a narrow component of the overall types of risks that I outlined in my testimony. Judging the adequacy of capital standards against those other risks, which are, in fact, shared by the private sector, is probably a more fruitful way to go.

In revisiting the minimum capital requirements, it is useful to keep in mind that one part of the purpose of those capital requirements would be to ensure not just the institutions but the overall impact of those institutions on financial markets against large disruption. That is a role that regulators should have a keen eye toward and may affect the decision on capital requirements.

Chairman SHELBY. Mr. Korsmo, the Finance Board supports requiring each Federal Home Loan Bank to register with the Securities and Exchange Commission. I agree with enhancing disclosure, but I am not sure that all the appropriate issues have been addressed here. My question to you is: How does the Finance Board propose to address certain unique structural factors in the Federal Home Loan Bank System, such as joint and several liability of the system?

Mr. KORSMO. That is an excellent question, Mr. Chairman. And our view on that has been that the best way to address those questions is to have the questions resolved between the 12 potential registrants and the SEC themselves. At least 5 of the Banks have been actively engaged in those discussions. There were certainly any number of threshold issues that we recognized that the Finance Board is having to have some successful resolution in terms of their accounting practice prior to moving ahead. I think we have made sufficient progress, that the final progress needs to be made between the staff of the SEC and the staffs of the 12 potential registrants.

Chairman SHELBY. Senator Corzine.
Senator CORZINE. Thank you, Mr. Chairman.

Let me just follow on on this joint and several concept. Do you have joint oversight of the consolidated balance sheet? Do you look at balance sheet and the risk-based capital standards? Are they applied on a consolidated basis?

Mr. KORSMO. I understand that joint and several liability only applies to consolidated obligations. I guess the short answer to your question is yes.

Senator CORZINE. So you look at the minimum capital standards and the risk-based capital standards for the overall balance sheet even though the joint and several only relates to the

Mr. KORSMO. No, no. I am sorry.
Senator CORZINE. You look at the individual unit banks.
Mr. KORSMO. That is correct.

Senator CORZINE. I just have a question then. The main financing technique for the Banks is through the consolidated borrowing debentures. One last question that I had. Mr. Falcon, I think I used the term "mind boggling” last time when I talked about a $1.5 to $3 billion estimate, under reported earnings, and that seemingly has grown from that $1.5 to $3 to $4.5. Are there any obvious explanations on the size of what moved us out of that range, and when do we feel that a full accounting for the difference in Freddie Mac can actually be explained?

Mr. FALCON. The process is on track to be concluded sometime in mid-November, and so they will then be issuing statements, assuming everything goes as planned. That is just the magnitude of which earnings were moved into future time periods, rather than being recognized in the earlier time periods if the proper accounting rules were utilized. It is just a reflection of the cumulative impact of all the different transactions that we are engaged in to try to smooth out these earnings over time.

Senator CORZINE. Was there a standard procedure that was used that was used to move forward earnings?

Mr. FALCON. There was a wide variety of different types of transactions.

Senator CORZINE. Pardon?

Mr. FALCON. There was a wide variety of different types of transactions.

Senator CORZINE. It was not just one kind.
Mr. FALCON. Right, right.
Senator CORZINE. It was not a generic methodology.
Mr. FALCON. No.
Senator CORZINE. Thank you.
Chairman SHELBY. Senator Bennett.
Senator BENNETT. Thank you, Mr. Chairman.

Two quick questions. Simply the terminology that has been used around here. There has been reference to the taxpayer subsidy. Subsidy usually means that if it is not done, money ends up in the Treasury. Is there a suggestion that if the GSE's were eliminated there would be an extra $10 billion in the Treasury?

Mr. HOLTZ-EAKIN. The nature of the subsidy is the lower borrowing costs to the GSE's and the budgetary reflection of that is the low probability, over long periods of time, that there would be an event which would place the taxpayer at the risk of actually providing funds directly was done with the Federal Farm Credit System in the 1980's.

Senator BENNETT. But there is not a subsidy like a farm subsidy that we can quantify every year. If we were to eliminate the GSE's, presumably there would be an elimination of risk, but there would not be an immediate amount of money showing up in the Treasury if we eliminated the GSE's.

Mr. HOLTZ-EAKIN. There would not be a cashflow to the Treasury, but the situation is similar to credit reform, where we could reflect on the budget the implicit cost of that risk and take account of it in budgetary deliberations.

Senator BENNETT. Is there a budget figure for implied risk?

Mr. HOLTZ-EAKIN. Not in this area, but in other areas where guarantees are provided by the Federal Government credit reform does allow for an explicit entry in the budget for the value of that guarantee.

Senator SARBANES. Yes, but the more you talk that way, the more explicit the guarantee becomes and everyone runs around saying this is not an explicit guarantee and they are required to state it absolutely. Then everyone comes along here, it is—I mean you are sitting there at the table taking an implicit guarantee and making it explicit, are you not?

Mr. Holtz-EAKIN. I am not. I am not in any way advocating a particular budgetary treatment. I am trying to explain that to the extent that it is perceived to be a guarantee, it has consequences for the real provision of resources and perhaps for the Government.

Senator BENNETT. There is no cashflow subsidy.
Mr. HOLTZ-EAKIN. Not at present.

Senator BENNETT. The only other question. We talk about taxpayer risk, and I admit there is an implication of some taxpayer risk, but isn't the first line of risk the shareholders? They stand to lose everything if the GSE's fail, do they not?

Mr. HOLTZ-EAKIN. Absolutely. And the empirical question is the degree to which that line of defense is adequate. As was mentioned, I think in Mr. Falcon's opening remarks, capital is the bulwark against which you would place these risks, and the question is whether the capital is adequate.

Senator BENNETT. And if the capital is attracted to the GSE by the noncash subsidy and the risk is borne by the capital, maybe this is a good idea.

Mr. HOLTZ-EAKIN. The outcome is that the GSE's, as compared to simliarly rated private sector entities, have less capital. There is less there, and there is a higher rate of return because of this lower capital.

Senator BENNETT. Now we get into the Chairman's question about the reason there is less capital is that there is less risk because they do not issue credit cards, they stay with mortgages. And that is another philosophical argument. I simply wanted to be sure I understood the terms we are using here and when we are talking about subsidy we are not talking about a cash subsidy, we are talking about an implied subsidy, and when we are talking about risk, it is true that the risk is all held by the shareholders, and there is an implied risk for tax holders, but again, we cannot truly quantify it until we see how much of a disaster the shareholders have to absorb.

Mr. HOLTZ-EAKIN. The degree to which it can be quantified, we have taken one approach in our past studies which is to compare borrowing costs of comparable private sector entities with the GSE's. There is another approach basically called an options value approach—where by you could, in the same way, try to quantify the magnitudes involved, and if that was something of interest, we would be happy to work with you on that.

Senator BENNETT. Thank you, Mr. Chairman.

Chairman SHELBY. When we are talking about risk, the 2.5 versus the 4, have there been any studies that any of you know done showing the real risk in the marketplace there? In other words, what is the percentage of losses of Freddie and Fannie compared to an ordinary bank that is into all kinds of other risk? See, they, by statute, are limited to what they can invest in. Is that not right, Mr. Falcon?

Mr. FALCON. Yes, sir.

Chairman SHELBY. Go ahead. Do you know if there are any studies showing this, if there are risks, and then their risks?

Mr. HOLTZ-EAKIN. I think the spirit of the question is what are the outcomes that you can look at. You can look at the default rates and outcomes for comparable private sector entities. In my testimony, I reference this. Over a 15-year period for comparably rated private sector entities, that rate is nearly 2 percent. .

Chairman SHELBY. Gentlemen, we thank you for your testimony here today and participating. I apologize for having to leave and come back, but I am Chairman of a Subcommittee on Appropriations that has opened up on the floor, so I will be on the floor a lot today. Thank you.

Chairman SHELBY. We will now move to our second panel. All of your written testimony will be made part of the hearing record in its entirety, and if you would take 5 minutes apiece-I know that is compressing your time to sum up your remarks, we would be very appreciative, and then we will get into the others.

Mr. Koch, we will start with you. First, I want to yield to Senator Sarbanes for a statement.

Senator SARBANES. Mr. Chairman, I join with you in welcoming the witnesses, but I particularly want to welcome Iona Harrison, who is here on behalf of the National Association of REALTORS® Ms. Harrison is from Upper Marlboro, Maryland in nearby Prince George's County. She has long been active in her community there. She has played an important leadership role with the realtors, both in the Maryland chapter and nationally, and we are very pleased she is here today, and I am looking forward to her testimony. Thank you.

Chairman SHELBY. Thank you.
Mr. Koch.

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