PREPARED STATEMENT OF ARMANDO FALCON, JR. 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 OCC. 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 addi tional 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, OFHEŎ 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 that a new regulator actively solicits and considers all views, including housing advocates, when exercising its authority. The importance of their housing mission is actually why the Enterprises exist. Strengthening their safety and soundness regulation supports that mission by ensuring that they are strong enough to provide the financial services that make that mission a reality. Conclusion Mr. Chairman, before concluding my testimony, I would be remiss in not noting my appreciation for the interest and support of Members of this Committee during last week's hearing with respect to the Administration's request of $7.5 million in additional appropriations for OFHEO in fiscal year 2004. I look forward to working with the Committee on this request, as well as legislation to strengthen regulation of the Enterprises. I will be happy to answer questions that you and the Committee may have. PREPARED STATEMENT OF DOUGLAS HOLTZ-EAKIN OCTOBER 23, 2003 Mr. Chairman, Senator Sarbanes, and Members of the Committee, thank you for this opportunity to discuss the Congressional Budget Office's (CBO's) work on the economics, costs, and regulation of the Government Sponsored Enterprises (GSE's) for housing-namely, Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Broadly speaking, that work leads to three main points: • The Federal Government confers substantial benefits on GSE's through an implied guarantee of their debt and other financial obligations; • In doing so, the Government necessarily exposes taxpayers to risks; and • Effective regulation can reduce but not eliminate the risks to taxpayers from the GSE's. The Benefits of GSE Status The principal benefit of having the status of Government Sponsored Enterprise is the ability to borrow at lower rates of interest than any fully private firm holding the same amount of private equity capital and taking the same risks is able to do. Sponsored status also enables the GSE's to borrow far larger sums than would be available to private borrowers. Low-cost capital and easy access to the market is the direct result of an implied Federal guarantee of the GSES' obligations. The implicit guarantee is communicated to investors in capital markets through a number of provisions of law that create a perception of enhanced credit quality for the Enterprises as a result of their affiliation with the Government. Those provisions include a line of credit at the U.S. Treasury; exemption from the Securities and Exchange Commission's (SEC's) registration and disclosure requirements; exemption from State and local income taxes; and the appointment of some directors by the President of the United States. In addition, although Federally chartered and Federally insured banks face a limit on the amounts that they can invest in other types of securities, that limit does not apply to the GSEs' securities. Taken together, those statutory privileges have been sufficient to overcome an explicit denial of Federal backing that the GSE's include in their prospectuses. GSE status and the benefits it conveys are no longer necessary to the functions that Fannie Mae, Freddie Mac, and the Federal Home Loan Banks perform. Those purposes include ensuring a reliable source of funds to housing and increasing access to mortgage credit by low- and moderate-income borrowers so that more families can own their homes. Private financial institutions that lack GSE status, such as Washington Mutual and Bank of America, currently maintain a reliable link between the wholesale capital markets and retail lenders who originate home mortgages not eligible for financing from the GSE's. Moreover, the Government has numerous more-direct policies to assist low-income homebuyers, including mortgage insurance offered by the Federal Housing Administration and other more-targeted programs administered by Federal agencies. Table 1. The Housing GSEs' Outstanding Mortgage-Backed Source: Congressional Budget Office based on data from the Department of Housing and Urban Development's Office of Federal Housing Enterprise Oversight, the Federal Home Loan Banks' Office of Finance, and Fannie Mae. a. MBSS = mortgage-backed securities (excluding an enterprise's own MBSs held in its portfolio). Private financial intermediaries, however, cannot match the low funding costs of the GSE's. To approach the GSEs' borrowing rates, they would have to raise more private equity capital and other private credit enhancements than do the housing GSE's. In short, they would need to convince lenders that they could replicate the Federal guarantee through private means. However, private providers of risk-bearing or credit-enhancement services require compensation commensurate with the assumed risk. The requisite backing from private sources, therefore, is costly. By contrast, the Government, provides the benefits of low-cost funding without charge. Assisted by the implied Federal guarantee, the housing GSE's have grown into some of the largest financial institutions in the world. Their outstanding securities now exceed $4 trillion-or more than the entire U.S. public debt. In the process, Fannie Mae and Freddie Mac have come to dominate the U.S. residential mortgage market, accounting for almost 57 percent of residential mortgage debt (see Table 1). The value of the Federal subsidy to the GSE's can be approximated by comparing the Enterprises' actual funding costs with those they would face as private intermediaries. In May 2001, CBO estimated that difference-on the basis of a credit rating of AA-2 for the housing GSE's-to be $10 billion to $15 billion per year from 1998 to 2000. Adjusted for the growth of the Enterprises (but with any increases in risk ignored), the current annual subsidy is, at a minimum, above the upper end of that range. The Exposure of Taxpayers to Risks from the GSE's By supporting the activities of the housing GSE's through an implied guarantee, the Government has assumed, on behalf of taxpayers, the risk of losses that might exceed the Enterprises' holdings of private equity capital. The housing GSE's offer public assurances that their assumed risks, especially for credit or default losses, are low in relation to their private capital. As a result, taxpayers may conclude that their own risk exposure is also low. The housing GSE's appear to be principally exposed to interest rate, prepayment, and operations risks. Interest rate risk refers to the different effect that changes in interest rates can have on the value of a firm's assets and liabilities and thus on its net worth. For example, an increase in interest rates will reduce the value of both fixed-rate assets and fixed-rate liabilities, but the value of assets will be hit harder if the assets have a longer maturity than the liabilities do. A rise in interest rates, therefore, can wipe out a financial intermediary's equity capital. Entities that hold portfolios of fixed-rate mortgages are also subject to prepayment risk. Specifically, the value of a portfolio of fixed-rate mortgages declines when borrowers exercise their option to refinance and prepay their existing mortgages in response to a decline in market rates. In combination, interest rate and prepayment risks mean that the housing GSE's are potentially vulnerable to losses from both increases and decreases in interest rates. Even those firms that appear to be well-managed are subject to operations risk, or the adverse effects of errors in judgment by management in protecting the value of a firm. That threat can manifest itself in lapses in the integrity and performance of existing controls, systems, and practices. Private equity holders and other stakeholders in the housing GSE's have some incentive to manage and control risk, but overall those incentives are weaker than those for investors in other entities. Market discipline is weakened by the Federal guarantee, which reduces the need for bondholders to monitor and restrict the Enterprises' risks. Further, equity holders have diminished incentives to resist risk taking to the extent that they believe that the Government would intervene to sustain the GSE's. Member institutions holding equity in the Federal Home Loan Banks may undervalue the Enterprises' risks because they can withdraw some of their equity from a financially troubled bank to reduce their potential losses. Following severe losses, equity holders who cannot withdraw their capital can have an incentive to accept increased risks by the Enterprises because that approach may be their only means of recovering those losses. In sum, the Federal Government cannot count exclusively on non-Federal stakeholders to limit the risks to taxpayers from the housing GSE's. Nonetheless, the housing GSE's are managing prepayment risk and interest rate risk through such means as issuing debt securities that can be redeemed at par before maturity and using derivatives, including interest rate swaps. Also, the GSES' internal monitoring and safeguards reduce operations risk. Finally, the housing GSE's are limiting their exposure to credit risk by requiring private mortgage insurance on loans with less than a 20 percent downpayment and by leaving some of that risk with the loan originators. As a practical matter, however, the Enterprises' risks cannot be eliminated, nor would doing so be in the interests of equity investors. The risks of financing and holding a portfolio of mortgages are simply too varied and complex to permit management to identify them all and to find another party willing to accept them at a reasonable cost. The more feasible objective of holding interest rate and prepayment risks within acceptable bounds is among the most complex and difficult tasks facing the managers of mortgage portfolios. At the housing GSE's, risk management is assigned a high priority and is reported to be vigorously pursued with state of the art systems and analytical procedures. Even so, best practices intended to achieve vital objectives occasionally fail and produce unpleasant surprises. Matters are complicated further by shareholders' desire to retain some risks. The return on riskless financial activity is close to the return on U.S. Treasury securities. In competitive markets, investors can obtain high rates of return only by assuming risks. Fannie Mae and Freddie Mac have consistently earned high rates of return on equity. For example, the average annual return on their equity from 1990 to 2002 was over 23 percent. A comparison group of large financial services firms averaged returns of less than 14 percent during that period. One essential operating difference between those two GSE's and private firms is that the GSE's hold less than half as much private equity capital per dollar of assets as the comparison firms do (3.70 percent versus 9.14 percent). If Fannie Mae and Freddie Mac retained about the same risks as private financial services firms, then their higher rates of return on capital could be explained by their lower levels of capital. Future losses from risks retained by the housing enterprises would be borne by the Enterprises' equity investors up to the limit of the GSEs' equity and reserves. Creditors could then look to the Federal Government to cover losses above those amounts. Some observers claim that the Government's commitment is only conjectural and therefore potentially illusory. However, when another GSE, the Farm Credit System, suffered threatening losses in the 1980's, the Congress authorized up to $4 billion in Federal financial assistance to avoid a default on bonds that carried a similar guarantee. In that case, at least, the implied Federal guarantee became real. In the event of future losses by the housing GSE's in excess of their private capital, the Government would face a choice between ignoring a financial shock of unknown magnitude or confirming that its guarantee would be honored. The significant difference in the expected short-term costs of those alternatives suggests that the capital markets are likely to be correct in supposing that the Government will not walk away from its implied guarantee when the need for Federal support arises. |