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APPENDIX

Testimony of John T. Korsmo,
Chairman, Federal Housing Finance Board,
Before the Senate Committee on Banking, Housing, and Urban Affairs
Washington, D.C.
October 23, 2003

Initiatives at the Federal Housing Finance Board to improve oversight

of the Federal Home Loan Banks

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, Chairman Korsmo 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 the Chairman's 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 brought on 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).

The agency also 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. In addition, a newly hired 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.

Examiners represent the foundation of the Federal Housing Finance Board's oversight function. The Finance Board has increased the resources available to fortify that foundation, expanding the agency's examination staff to 18 full-time bank examiners as of October. The goal is to have 30 in place by the end of this fiscal year.

The examination staff, including the Deputy Director of the Office of Supervision, averages more than 17 years of professional experience in banking, mortgage finance, and bank examinations. All examiners are commissioned examiners or have a professional accreditation, and many have both. (See chart.)

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Position

Examiner

Highest
Level

Years of
Education Experience

Accreditations
BA, Accounting

CPA, CFA Level II, Registered Securities
and Economics 18

Representative Series 7,63

Commissioned National Bank Examiner (NBE),
BA, Business 124

Graduate School of Banking.
BS, Business 16

CFA

Registered Securities Representative Series 7,
MBA, Finance 25 63

Examiner?
Mortgage Analyst

Mortgage Analyst

In addition to adding highly qualified and experienced examiners to the staff of the Federal Housing Finance Board, the agency has also made a fundamental - and necessary - change in approach in the examination function. 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, two risk units have been established – 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 agency data and the Banks' own financial reporting into a risk-monitoring framework.

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. The new "Bank Analyst Program" charges a member of the 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.

The 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. More work remains to be done, but the Finance Board is a much stronger and more capable regulatory agency than it was as recently as 12 months ago

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PREPARED STATEMENT OF ARMANDO FALCON, JR.
DIRECTOR, OFFICE OF FEDERAL HOUSING ENTERPRISE OVERSIGHT

OCTOBER 23, 2003 Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee, thank you for inviting me to appear before you today. I am pleased to provide my views on improvements that can and should be made to the regulatory oversight of Fannie Mae and Freddie Mac. My views are my own and are not necessarily those of the President or the Secretary of Housing and Urban Development.

When I took office as Director of the Office of Federal Housing Enterprise Oversight (OFHEO) in October 1999, I quickly realized that the Agency's long-term success was jeopardized by inadequate resources, a constraining funding mechanism, and a lack of powers equal to those of other regulators. Over the past 4 years, I have been a consistent advocate of legislation designed to address those shortcomings, and so I was encouraged by the Administration's comprehensive proposal.

I am in general agreement with it, but I do have a few concerns that I hope can be properly addressed. Guiding Principles

I would like to outline my views in the context of five guiding principles. They

are:

• The regulator should remain independent; • The regulator should be permanently funded, outside the appropriations process; • The regulator should have powers equal to those of other safety and soundness

regulators; • The regulator should have full discretion in setting capital standards; and • Legislation should build on progress made.

Adherence to each of these principles will strengthen supervision and the safe and sound operation of the Enterprises. Our ultimate goal and benchmark should be to establish a new regulator that is on an equal plane with the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS), both of which operate as independent safety and soundness regulators within the Treasury Department. I would like to elaborate on the five principles. Regulatory Independence

First, the regulator should remain independent. The concept of an independent Federal agency to oversee Fannie Mae and Freddie Mac was established in the legislative history of the 1992 Act that created OFHEO. The need for regulatory independence was borne out of Congress' experience with the savings and loan crisis. I had the privilege of serving as Counsel to the House Banking Committee during that difficult period. One of the clear lessons learned was that all safety and soundness regulators should be objective, nonpartisan, and protected from political interference. This is especially critical at times when regulators must make difficult and sometimes politically unpopular decisions. In addition, independent regulation protects Congress' ability to receive the regulator's best judgment on regulatory matters unfiltered and without delay. With billions of dollars of potential taxpayer liability at stake, it is in everyone's interest that this important safeguard not be weakened.

Like OFHEO, the Office of Thrift Supervision is another useful example of how a new independent regulator should be established as part of a Departmental organization. In 1989, Congress

transferred responsibility for thrift regulation from the Federal Home Loan Bank Board to a newly created OTS within the Treasury Department. The OTS was established as a fully independent regulator. It has the same powers and unfettered ability to use those powers as the OČC.

Congress should ensure that the new regulator has full statutory independence. Permanent Funding

Second, the regulator should be permanently funded, outside the appropriations process. Currently, OFHEO is funded annually through the Federal budget and appropriations process, even though the Agency does not utilize any taxpayer funds. OFHEO is funded through assessments on the Enterprises, but those assessments cannot occur until approved by an appropriations bill and at a level set by the bill. OFHEO is the only safety and soundness regulator funded in this limited manner. At a minimum, this serious anomaly should be fixed. Permanent funding will enable the regulator to fulfill its budgetary needs on a more reasonable basis

without the timing constraint associated with the annual appropriations process. There should also be clear language that the Agency has the authority to levy special assessments or to establish a reserve fund as needed, to meet emergencies. Currently, any additional funds required to meet urgent, unexpected needs can be obtained only after a supplemental appropriation is enacted. This can delay action by the Agency to resolve problems early, before they threaten the safety and soundness of an Enterprise. Permanent funding will contribute to operational independence and will allow the Agency to respond quickly to any crisis at the Enterprises. Enhanced Supervisory Authority

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. Flexible Capital Regulation

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 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. As Secretary Snow has said in testimony before Congress, “Broad authority over capital standards and the ability to change them as appropriate are of vital importance to a credible, world-class regulator." I agree. Build on Progress

Fifth, legislation should build on the 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 instruments owned, issued, or guaranteed by the Enterprises, needed for the stress test, is unique among financial institution regulators. Expertise in how these two secondary mortgage market companies manage mortgage risk, including the broad use of sophisticated derivatives and collectible debt is vital for effective regulation. In addition, an understanding of how the Enterprises are affected by the markets in which they operate is extremely important.

Over the past 10 years, OFHEV has developed the specialized expertise, from our examiners and financial analysts, to our researchers and capital analysts, that is necessary to supervise these 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 in the Treasury Department, OFHEO's personnel, regulations, and administrative infrastructure should be transferred intact to the new agency. It would be highly counterproductive to do otherwise. Additional Issues

There are a couple of other matters I would like to briefly discuss. First, I agree with Secretary Snow that the Presidentially appointed board positions 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. It is difficult for even the most conscientious director to fully contribute when their terms are limited to one year, unless reappointed, and last on average for only 15 months. Shareholder elected directors usually are reappointed for up to 10 years.

I also support the granting of authority to the safety and soundness regulator to determine whether the activities of an Enterprise are consistent with its charter authority. 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 authorities of other regu. lators. I appreciate the concern expressed about the primacy of the Enterprises' housing mission if and when the charter compliance responsibility is shifted. The goal, in fact, of enforcing charter compliance is to ensure that the Enterprises remain properly focused on their housing mission and not stray into extraneous ventures. Consistent with that goal, I think a mechanism can be instituted to ensure

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