A rough indication of the likelihood of such an event is provided by the cumulative average historical default rate for corporate debt with a credit rating comparable to that of Fannie Mae and Freddie Mac. Standard & Poor's reports that for debt rated AA-, the cumulative average default rate over 15 years is 1.92 percent. By that indication, a default by Fannie Mae or Freddie Mac is highly unlikely over the next 15 years. But it is not an impossibility. The Role of Regulation in Limiting Taxpayers' Risks By enhancing the housing GSEs' credit quality, the Federal Government gives the Enterprises substantial control over the risks faced by taxpayers and over the amount of the Federal subsidy. The Enterprises can increase that subsidy by expanding their volume of guaranteed debt, by engaging in riskier activities, by reducing their efforts to hedge existing risks, and by diverting income to activities outside their missions or distributing it to shareholders. Fannie Mae and Freddie Mac have two means of channeling funds from the capital markets to retail lenders: Investing in mortgages and guaranteeing mortgage-backed securities (MBS's). To invest in mortgages, the Enterprises issue debt obligations and purchase mortgages. Alternatively, they pool individual mortgages, insure the pools against credit risk, and sell undivided interests in the pools directly to investors in the form of mortgage-backed securities. Purchasing and holding mortgages as investments entails greater risks and returns for the GSE's than guaranteeing MBS's does. Fannie Mae and Freddie Mac have dramatically increased the size of their investment portfolios relative to their guarantees of MBS's since 1990 (see Table 2). In fact, Fannie Mae and Freddie Mac now hold in portfolio about onethird of their guaranteed MBS's. Similarly, the Federal Home Loan Banks have increased their portfolio holdings of mortgages from less than $1 billion in 1998 to more than $60 billion in 2002 and to $90 billion by the middle of 2003. When the Enterprises buy and hold mortgage assets in portfolio, they are retaining interest rate, prepayment, and credit risks on those loans. But when the GSE's sell mortgages to investors through guaranteed MBS's, they transfer interest rate and prepayment risks, retaining only the more transparent, manageable credit risk. As the GSE's move mortgages into their portfolios, they increase both the expected returns and risks to shareholders; for taxpayers, only the risks increase. The increase in risk is reflected in the statutory minimum for private capital to be held by Fannie Mae and Freddie Mac of 2.5 percent for mortgages in portfolio and 0.45 percent for MBS's. Whether those differences in capital requirements accurately reflect true differences in the level of risk, however, is impossible to know because the Enterprises can vary the extent to which they hedge portfolio risks. Determining the adequacy of the Federal Home Loan Banks' capital is further complicated by the ability of members to redeem some capital at par. Redeemable capital is unlikely to be available to absorb the Banks' losses or to protect taxpayers. Table 2. The Housing GSEs' Mortgage Portfolios Expressed as a Share of Their Outstanding Debt and Mortgage-Backed Securities, Year-End 1990 and 2002 Source: Congressional Budget Office based on data from the Department of Ilousing and Urban Development's Office of Federal Housing Enterprise Oversight and the Federal Home Loan Banks' Office of Finance. a. MBSS - mortgage-backed securities (excluding an enterprise's own MBSs held in its portfolio). An important purpose of the regulation of GSE's is to limit taxpayers' risks and the size of the subsidy. To do so, regulators must understand, monitor, and assess the risks of the Enterprises virtually to the same extent that their management does. But some dimensions of risk are not easily transparent. Even world-class regulators-well-funded, well staffed, and politically independent are unlikely to be able to maintain a complete understanding of the extent to which taxpayers are exposed to risks. Nonetheless, regulators can limit the GSEs' ability to leverage the value of the Federal guarantee. To do that, they need a range of capabilities to address the varied means by which the GSE's can increase the risk exposure of taxpayers. Those capabilities include being able to adjust capital requirements, to assess the extent to which the GSE's have retained interest rate and prepayment risks and the effectiveness of hedges against those risks, to hold management responsible for the adequacy of internal systems and controls, and to prevent a failed GSE from continuing to use the Federal guarantee. The regulators also need enough public support to enable them to exercise their authority to compel changes in risky behavior by the housing GSE's. Toward that end, increased public disclosure of the findings of regulatory oversight of the Enterprises could be useful. Freddie Mac has agreed to publicly report its fair-value, or mark-to-market, net worth quarterly. That practice increases transparency and might be usefully adopted by all of the GSE's. The Congress could facilitate the regulators' difficult task by setting statutory boundaries on the GSEs' ability to increase the value of the Federal subsidy. For example, the Congress could legislate a higher margin of safety in the minimum capital standards. It could also act to limit the growth (or profitability) of GSEs' portfolio investments and move toward more-equal treatment of the Enterprises and their potential competitors. Some Members of Congress have proposed requiring SEC registration of GSE securities, for example. A May 2003 CBO report on that topic found that such a requirement would be unlikely to have a significant adverse effect on the GSE's or on the mortgage markets. Similarly, in the absence of evidence that Presidentially appointed directors have a unique advantage in defending taxpayers' interests, the selection of directors might be left entirely to private shareholders. Action by the Congress to bolster regulators' ability to ensure safe operation by the GSE's would better protect taxpayers. Furthermore, the GSEs' public mission does not appear to require them to sacrifice safety and soundness. Certainly, from the taxpayers' perspective, having the GSE's pursue a low-risk strategy is strongly preferable to tolerating a risky one. PREPARED STATEMENT OF JOHN D. KOCH ON BEHALF OF AMERICA'S COMMUNITY BANKERS, WASHINGTON, DC OCTOBER 23, 2003 Mr. Chairman and Members of the Committee, my name is John D. Koch, Executive Vice President and Chief Credit and Lending Officer of Charter One Bank, NA in Cleveland, Ohio. I am also a member of the board of America's Community Bankers and chairman of its GSE Policy Committee. ACB appreciates this opportunity to testify on proposals to improve the regulation of the housing-related Government Sponsored Enterprises, Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. ACB members include State and Federally chartered savings institutions and commercial banks. Our members are both stock- and mutually owned. As community bankers, many are specialists in mortgage lending. They are actively involved in the secondary market through Fannie Mae and Freddie Mac and other secondary market participants. Charter One services over $15 billion in home mortgages for Fannie Mae and Freddie Mac. ACB members are also substantial stockholders in and borrowers from the FHLBanks. ACB has long supported the traditional role Fannie Mae and Freddie Mac serve in the secondary mortgage market. They have provided great benefits to homebuyers and mortgage originators. In fact, they have significantly increased their commitment to community banks over the last several years. ACB helped initiate these changes by entering into business relationships with both companies that enable community banks to be more competitive in the marketplace. Similarly, ACB members depend tremendously on the advances provided by the FHLBanks. Our bank's FHLBank advances total nearly $10 billion. These advances make it possible for community banks to make sound home loans that may not conform to the strict criteria of the secondary market. FHLBank advances also provide an alternative funding source for community banks that choose to keep loans they originate whether conforming or not-in their own portfolios. In addition, ACB members own more than half of the stock issued by FHLBanks and hold significant amounts of mortgage backed securities and other debt issued by Fannie Mae, Freddie Mac, and the FHLBanks. Charter One's investment in FHLBank stock totals $700 million, by far our largest single investment. Clearly, the continued financial health of all of these entities is critical to Charter One and other ACB members and their communities. Therefore, ACB strongly supports this Committee's effort to improve the regulatory system for the GSE's. Scope of the Agency The Administration has recommended that Congress establish a new agency that would regulate all of the housing GSE's. ACB agrees with the Administration that the regulatory structure for these entities should be substantially improved and supports proposals to create a new independent regulator for FHLBanks that is housed inside Treasury. However, ACB recognizes that we are involved in a fluid and dynamic legislative situation. For example, the Treasury Department has raised concerns about the establishment of a new independent agency within the Department. ACB differs with Treasury on this issue. As we emphasize later in our testimony, it is essential that the new regulator be independent. Therefore, as an alternative way to address Treasury's concerns, ACB would support formation of a new, independent regulator as a stand-alone agency. ACB continues to prefer a separate regulator for the FHLBanks. Nevertheless, ACB strongly supports an amendment drafted by Representatives Royce, Maloney, and Leach that would merge the Office of Federal Housing Enterprise Oversight and the Federal Housing Finance Board into a new, independent, and fully funded Treasury agency. We recommend that you strongly consider taking a similar approach in your legislation. The Royce Amendment recognizes the differences between the FHLBanks and Fannie Mae and Freddie Mac by establishing two deputy directors and maintaining separate funding for the costs of regulation. Under the amendment, the new agency would administer the unique statutory arrangements that apply to the FHLBanks and Fannie Mae/Freddie Mac. If the new agency does become the regulator for the FHLBanks, it should maintain the Banks access to the capital markets and their current well-defined mission to support the mortgage finance, affordable housing, and community development activities of member banks. The advance programs of the FHLBanks ensure homebuyers have ready access to home mortgage financing through FHLBank members. ACB recognizes that the Finance Board has increased its commitment to safety and soundness regulation. However, we believe there is substantial room for improvement and change in the regulation of the FHLBank System. A merged agency would avoid a perception that any of these Government Sponsored Entities are subject to more effective regulation than any of the others. We also note that the FHLBanks, Fannie Mae, and Freddie Mac are all engaged in extensive interest rate risk management and believe a combined agency would be better able to supervise these risks. While dealing with concerns common to all of the entities, the legislation would have to ensure that the new regulatory structure recognizes the unique and successful business model of the FHLBank System. Unlike Freddie Mac and Fannie Mae, the System is a cooperative owned by its member institutions. The FHLBanks' stock is not publicly traded and does not fluctuate in value. In addition, each of the FHLBanks is jointly and severally liable to all the others. Each of these GSE business models has their strengths. Any revised regulatory system should continue to respect those differences, while advancing the common goal-to maintain their financial safety and soundness. Agency Structure, Funding, and Independence The Administration recommends that Congress eliminate OFHEO and the Finance Board and move their functions into an independent agency housed in the Department of the Treasury. This structure works for two key regulators, the Comptroller of the Currency and the Office of Thrift Supervision. A key element behind each agency's success is their high degree of independence from the Treasury, which insulates them from concerns about political influence. Additionally, both the OCC and OTS enjoy—and OFHEO does not have the ability to fund its operations without resort to the annual Congressional appropriations process. ACB strongly endorses the repeated recommendation of OFHEO Director Falcon to eliminate this anomaly and allow the regulator of Fannie Mae and Freddie Mac to assess those companies without the cumbersome appropriations process. It is important that the final bill provide the new agency with a complete exemption from the appropriations process, similar to that provided to other financial regulators. Independence is the other characteristic of the various financial regulators that ACB strongly believes must also be in the regulator for Fannie Mae, Freddie Mac, and the FHLBanks. Again, this has served our financial system and consumers very well. If a new agency is created within Treasury, it should have autonomy in the following key areas: • Appointment of Director. The director should be appointed by the President and confirmed by the Senate for a fixed term and be removable by the President only for good cause. • Testimony. Congress should be able to count on receiving the agency's unvarnished views on all issues it faces. • Rulemaking. There should be no opening for politically appointed officials to delay or prevent the agency from issuing rules it believes necessary. • Supervision and Examination. All parties involved will benefit from a strict separation between political appointees and supervisory and examination staff. • Enforcement. The agency's enforcement actions must be independent from any outside interference. • Litigation Authority. The director should be able to act in his own name and through his own attorneys rather than have the Attorney General represent the agency. Employment Authority. The director should have the ability to employ officers and employees under authority comparable to that of other financial regulators. Authority over Mission and Programs The Finance Board has authority over all aspects of the FHLBanks: Ensuring safety_and_soundness and that they carry out their statutory housing finance mission. The Royce Amendment would continue this approach under the new agency. ACB strongly endorses the Administration's position that the new agency should have similar authority to ensure that Fannie Mae and Freddie Mac are also carrying out their secondary market mission. This agency must have the authority to review both current and future programs of Freddie Mac and Fannie Mae. In par ticular, new activities should be subject to an application and approval process similar to what is in place for bank holding companies today. For over a decade, the Department of Housing and Urban Development has not exercised its current program approval authority. As a result, Fannie Mae and Freddie Mac have engaged in or attempted to engage in activities inconsistent with their secondary market responsibilities. For example, both entities have issued retail debt instruments in denominations of as little as $1,000. These are being marketed by third parties to consumers with considerable emphasis on their implied Federal Government backing, when there is no such guarantee. Fannie Mae and Freddie Mac have responded to this problem by significantly improving disclosures. However, we doubt the public is adequately informed and protected. In addition to principal risk, these notes carry interest rate and call risk that relatively unsophisticated investors do not understand. Of course, these risks do not exist for traditional deposit products, such as certificates of deposit. Nevertheless, these small-denomination notes unfairly compete with CD's, weakening community banks' ability to meet housing finance and other community credit needs. ACB is concerned that these debt programs may be part of an attempt to create a “name brand” image for Fannie Mae and Freddie Mac in the mind of average consumers. Their extensive retail advertising is further strong evidence that this is a major goal for these entities. This branding effort could help Fannie Mae and Freddie Mac's efforts to move into the primary mortgage market. In one example of this, Freddie Mac entered into an agreement with an online mortgage company that attempted to reduce primary mortgage originators to, at best, a nominal role in the process. An effective mission regulator is needed to prevent Freddie Mac and Fannie Mae from using their Government-provided advantages to supplant private firms that compete in the primary mortgage market. The Administration's proposal makes clear that HUD would retain its mission authority to set affordable housing goals for Fannie Mae and Freddie Mac. As Secretary Mel Martinez testified, HUD would actually gain new regulatory clout to enforce those goals. However, ACB does not support the Administration recommendation that HUD be authorized to set new sub goals. Sub goals, while perhaps assuring a certain result, may lead to GSE purchase behaviors with unexpected and potentially undesirable consequences. Some housing advocates have expressed concern that, if HUD does not retain all mission and program oversight over Fannie Mae and Freddie Mac, their commitment to housing, particularly low- and moderate-income housing will suffer. However, Secretary Martinez testified in strong support of the Administration's proposal to shift these responsibilities, other than affordable housing goals, to the Treasury. If Congress provides for a substantial degree of independence for the new agency and affirms the companies' housing mission, there should be no decrease in their support for housing. În fact, we believe Fannie Mae and Freddie Mac must continue to be challenged to increase homeownership by minority families. And, as mentioned, under the Administration's proposal HUD's role would be enhanced in the area of affordable housing. Capital Requirements ACB strongly agrees with the Administration position that, while the existing capital regulation adopted by OFHEO should be the new agency's starting point for Fannie Mae and Freddie Mac, there should be no limit on its ability to adjust capital requirements for Fannie Mae and Freddie Mac if it finds that necessary. Capital is the foundation for the safety and soundness of our financial system. Therefore, the new agency must have complete authority to adjust all capital requirements as necessary, subject to rulemaking. The Finance Board already has this authority with respect to the FHLBanks. The Royce Amendment would maintain the new agency's authority to adjust the FHLBanks' capital requirements. The new regulator should respect genuine differences between the FHLBanks and Fannie Mae/Freddie Mac-including their very different capital structures. However, a regulator's ability to adjust capital levels is fundamental and must apply to all of the regulated entities. As Congress has recognized, the taxpayers are ultimately at risk when a major part of the financial system is undercapitalized. While there is no explicit Federal guarantee for Fannie Mae and Freddie Mac, it is impossible to believe the Government would stand aside if either of these companies faced serious difficulty. Requiring them to maintain adequate capital will provide vital insulation for the taxpayers. |