as a "fail-safe mechanism" to capture risks that allegedly cannot be addressed in the risk-based role.

Please explain in detail why the risk-based capital rule cannot address these alleged risks to the safety and soundness to the GSE's. If these risks cannot be quantified, on what basis would the regulator change the minimum capital requirements in order to act as a "fail-safe mechanism?" How would this basis for changing the minimum capital standard be different from the basis for determining the risk-based capital rule? Do you believe that it would harm the ability of Fannie and Freddie's regulator to perform its oversight functions if Congress placed restrictions on its ability to adjust the minimum capital standards? Why or why not?

A.1. Capital standards are designed to ensure that regulated institutions can survive periods of significant misfortune involving sizeable financial losses. In theory, a single standard that encompassed all relevant considerations would suffice to determine capital adequacy. In practice, that would be very difficult and Congress has wisely required OFHEO and all depository institution regulators to implement both a leverage-based standard and a more finely riskbased standard.

Evaluation of capital adequacy entails a broad range of considerations including not only an institution's current book of business; but also the current and prospective risk environment, its business strategies and potential changes in those strategies, the strength of its customer and supplier relationships, the strength of its internal controls, potential fragility if the markets in which it buys and sells, the structure of those markets and potential changes in the way those markets function, the vulnerability of the institution's reputation, the systemic importance of the institution, and many other factors.

Issues of practicality constrain the determinants of capital requirements to a small subset of these factors. Thus, for example, OFHEO's risk-based standard focuses on each Enterprise's current book of business and two possible future risk environments. It requires sufficient capital to cover losses or current positions in extended, specific adverse circumstances. This is a highly detailed rule that examines this aspect of capital adequacy in depth. It is important that the Enterprises be able to meet this requirement, but does not necessarily imply that capital is adequate. A high degree of protection against interest rate and credit risk can reduce the risk-based requirement to very low or zero levels without addressing other risks.

The minimum capital (leverage-based) standard is a fail-safe mechanism that ensures a substantial amount of capital regardless of measured interest rate and credit risks. Incorporating all other risks into the risk-based standard would be problematic. They generally do not fit well into the scenario format because the range of possibilities is essentially infinite. Also, the magnitudes of other risks generally are not easily quantifiable, but rather are more a matter of judgment.

A separate standard that encompasses these judgments makes sense. While it would be possible to add the two requirements to make a single rule that would produce an overall requirement that would be considerably more volatile than the current combination,

and might usually be higher than necessary. So far the judgment exercised by Congress in setting the ratios used to determine the minimum capital requirements has worked satisfactorily. However, institutions and their business environments change over time. An expert safety and soundness regulator is best able to judge if and when changes to a leverage-based ratio should be made. Accordingly, Congress should give the regulator of Fannie Mae and Freddie Mac the same authority it has given depository institution regulators to adjust all capital requirements if necessary.

Q.2. Do you believe the current separation of regulatory authority that gives the power to oversee new GSE programs and activities to HUD, and safety and soundness to OFHEO, has undermined your ability to oversee the safety and soundness of Fannie and Freddie? Why or why not?

A.2. The separate regulatory authority for new program review by HUD doesn't undermine OFHEO's safety and soundness authority. OFHEO has endorsed bringing new program authority into the safety and soundness regulator as this is the case with other financial regulators. This will also permit the examination and on-site expertise of OFHEO to be brought to bear in making decisions on new programs and potentially produce fuller and quicker review of new programs.

All of these benefits may occur without any adverse impact on housing mission or safety and soundness. Congressional goals on Enterprise housing mission are in statute and must be followed by the safety and soundness regulator and indeed today in applying safety and soundness rules under its jurisdiction. OFHEO abides by Congressional housing policy in such areas as low- and moderate-income programs undertaken by the Enterprises.

Q.3. You testified that while you have been OFHEO Director, HUD has never approved (or declined to withhold approval) a new GSE program or product that you believed would have undermined Fannie and/or Freddie's safety and soundness. In light of this history, why do you believe that the authority to approve any new GSE programs or products must be included in the oversight authority of the GSE safety and soundness regulator? What is wrong with the current GSE program and product review system, which includes OFHEO in a consultative role?

A.3. HUD has addressed few new program proposals over the years since passage of the 1992 Act that required OFHEO to review the matters for safety and soundness consideration. Thus, our experience is not one of problems with the current situation insofar as safety and soundness is concerned, as noted in my response to Question #2 above.

However, OFHEO's "consultative" role may create a potential conflict should a situation arise where HUD and OFHEO have differing views on a particular program. For the reasons stated in my response to Question #2, it is my belief that the benefits of a new structure are more than sufficient to review the existing separation of functions. It would be beneficial, as is the case with other financial regulators, to have independent authority to review new programs for charter compliance.

Q.4. At the July 17, 2003, GSE oversight hearing, you testified that OFHEO would conduct a special investigation of the accounting practices of Freddie Mac. The report of the investigation is now expected to be completed in November. Has the investigation provided you with any insights or further recommendations about how Congress might improve the oversight of the GSE's?

A.4. Yes, the investigation gave the Agency insights into additional authority OFHEO needs to be better able to accomplish its regulatory goals. These are included in the report of our special examination of Freddie Mac.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM DOUGLAS HOLTZ-EAKIN

Conservatorship/Receivership Authority

The Administration has proposed that the new regulator have all the receivership authority necessary to direct the orderly liquidation of assets.

Q.1.a. What difficulties would you see in moving to receivership powers akin to those held by the FDIC?

A.1.a. One purpose of receivership is to prevent a failing institution from continuing to incur losses after its equity capital has been exhausted. In the case of Federally insured banks and Government Sponsored Enterprises, the Government has a direct interest in preventing failed institutions from taking on additional risks in an attempt to win back their losses. Another purpose is to transfer the function of the failed entity to a new service provider. For the most part, the FDIC seems to have adequate authority to ensure an orderly winding down of the affairs of a troubled bank without exposing the Government to excessive additional risks. I would note, however, that the housing GSE's are far larger than the typical failed bank and that their greater size may present special challenges to a receiver's attempts to limit risk and transfer operations to another firm or other firms. But with that caveat, the receivership powers of the FDIC would seem to be a reasonable starting point.

Q.1.b. What impact would receivership authority have on the ability of the GSE's to access the debt markets?

A.1.b. Providing receivership authority to a regulator might cause investors in debt securities to consider how they might be affected by the exercise of such authority and then to monitor the financial condition of the Enterprises more carefully. While that increased attention to financial fundamentals could reduce the price that investors pay for GSE debt, it would not be expected to interfere with access to the debt markets by financially sound GSE's.

For a failed GSE, appropriate receivership authority would preclude access to the debt markets, except as necessary to ensure an orderly transfer of functions to another financial institution.

Office of Finance in the FHLBank System

Q.2. If the regulator for the Federal Home Loan Bank System were to be moved into the Treasury Department, should the Finance

Board's Office of Finance also be moved, or how would you suggest handling the Office of Finance?

A.2. The Office of Finance, even though a part of the Federal Housing Finance Board, has no regulatory duty or authority. Rather, its role is to fund the lending operations of the Banks by issuing and servicing their debt securities as efficiently as possible. Given its purpose and function, it would be appropriate for the Office of Finance to continue to operate privately, outside of Treasury.

RESPONSE TO A WRITTEN QUESTION OF SENATOR REED FROM DOUGLAS HOLTZ-EAKIN

Capital Standards

Q.1. In your testimony, you mention that regulators can limit GSEs' risk exposure to taxpayers by having the capabilities to adjust capital requirements and other tools. Currently, the GSE safety and soundness regulator can adjust the risk-based capital standard. Why does the minimum capital standard need to be changed in addition to the regulator being able to change the riskbased capital standard? Please explain in detail.

A.1. The risk-based capital standard is based on a complex computer-based effort to model the risk assumed by the GSE's. The minimum capital standard, by contrast, is intended to provide a margin of safety against unquantifiable risks, including systemic risks, and against errors and failures in the risk-based capital stress test. Indeed, the regulator who is responsible for setting the risk-based capital standard may be uniquely positioned to appreciate the limitations of that standard.

Both standards could be useful in providing a measure of protection for taxpayers against the adverse consequences of assumed risk. Thus, I see no reason to restrict the authority of the safety and soundness regulator to setting capital standards based solely on quantified risks.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM DALE J. TORPEY

Oversight of the FHLB Housing Programs

Q.1.a. Your testimony addressed HUD's mission control for Fannie Mae and Freddie Mac. HUD, however, does not oversee the housing mission or affordable housing programs of the Federal Home Loan Banks. Do you believe that the Federal Home Loan Banks' affordable housing mission needs to be changed?

A.1.a. ICBA believes that the Federal Home Loan Banks have performed extremely well in accomplishing their affordable housing mission. According to the FHLBanks' Office of Finance, during 2002, the FHLBanks contributed some $286 million to the Affordable Housing Program. Since the program's inception in 1990, the FHLBanks have awarded over $1.7 billion in AHP subsidies helping to create nearly 359,000 housing units for low-income families. ICBA does not see any need to make changes to this program. Q.1.b. If a single regulator for the GSE's is created, should the FHLBanks' housing mission be treated differently than that of Freddie Mac and Fannie Mae?

A.1.b. Congress established different ways for the FHLBanks to fulfill their housing mission compared to those established for Fannie Mae and Freddie Mac. Congress gave Fannie Mae and Freddie Mac goals for the purchase of mortgage loans for certain geographic areas and for certain consumers based on income levels. These goals are consistent with the secondary market function of Fannie Mae and Freddie Mac. Congress, however, created a very different program, the Affordable Housing Program, for the FHLBanks. This program funnels a specified portion of the FHLBs' net income to their members so they in turn can help their customers qualify for affordable housing loans. ICBA sees the difference in these programs as complementing the differences in the function, operation and structure of the FHLBanks that serve primarily as a source of funding to their members, versus the secondary market function of Fannie Mae and Freddie Mac.

Prompt Corrective Action

Q.2. OFHEO and the Finance Board clearly do not have the complete arsenal of Prompt Corrective Action tools that the OCC and other bank regulators have. In fact, the Finance Board has no statutory Prompt Corrective Action authority. Do you believe that a new regulator must have the same Prompt Corrective Action tools as the bank regulators?

A.2. We believe that the GSE's should have strong regulatory oversight. ICBA has not yet concluded its analysis of the differences in regulatory powers of OFHEO and the Finance Board as compared to those of the bank regulators, and we have not yet determined if the GSE regulators should have the exact same powers as those of the bank regulators.

Program Approval Authority

Q.3. Do you believe that moving prior program approval from HUD to a new safety and soundness regulator would have any adverse impacts on the GSES' housing mission?

A.3. ICBA testified that for the housing GSE's to continue to be innovative in the development and implementation of new products to meet the demands of the marketplace, there should be a smooth and seamless process for getting these products online. As we stated, if a FHLBank, Fannie Mae, or Freddie Mac develops a program that is inconsistent with safety and soundness or with their Congressionally mandated mission, there must be a review process to make that determination. We continue to believe that there should not be disincentives for the GSE's to be innovative and adaptive to new market conditions. Our housing finance system has evolved rapidly over the recent past due to changing technology and changes in the demands of consumers. The housing GSE's must have the flexibility to develop the housing finance products needed by consumers in a timely manner and not have new products, programs, and activities be bogged down by bureaucracy. Because of its responsibilities and expertise, we prefer that prior program review for Fannie Mae and Freddie Mac remain in the hands of HUD. We would also reiterate our strong concern that given the Treasury Department's existing tax and fiscal policy responsibilities, moving authority for housing policy to Treasury would likely