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As to other information regarding mortgage-backed and related securities, in late
2002, staff of the Commission, Department of the Treasury, and OFHEO conducted
a joint study of disclosure regarding mortgage-backed securities with a view to en-
sure that investors in mortgage-backed securities are provided with the information
that they should have. The task force issued a report in January 2003.? The report
notes that market participants found the mortgage-backed securities market ex-
tremely efficient. The report concluded that some additional disclosures would be
both useful and feasible in the mortgage-backed securities market. These include:
• Loan purpose (that is, whether a purchase or refinance)
• Original loan-to-value (LTV) ratios
• Standardized credit scores of borrowers
• Servicer for the pool (this may not always be the seller or originator)

Occupancy status (owner-occupied or investor)
Property type (for example, detached, condo)
Both Fannie Mae and Freddie Mac have implemented these new disclosures.

Finally, registration of offerings of the GSE's mortgage-backed and related securities under the Securities Act may raise another significant and uniquely complex factor—the impact on the mortgage market—that should be considered. In particular, a substantial portion, and recently a majority, of the GSE's mortgage-backed securities have been sold into the so-called "To Be Announced," or TBA, market. These transactions involve forward sales of mortgage-backed securities comprised of pools of mortgages not yet identified and in many, if not most, cases not yet in existence. The parameters which the securities and the mortgages in the pools must meet are set forth in standards established for the TBA market by market participants and discussed in the January 2003 report. Because actual mortgage pools are not established at the time of the forward sale transactions, there can be no disclosure of mortgage pool characteristics at the time of registration of the offerings. The TBA standards the mortgage pools must meet are already available to the market.

In addition, we understand that the TBA market is used to set or "lock in" mortgage rates in the U.S. housing market. A decision to require registration under the Securities Act of offers and sale of mortgage-backed securities should properly take into account whether, and if so, how such registration might impact the mortgage market and the operation of the TBA market. I believe that similar considerations formed at least a portion of the background for the conclusion expressed in the 1992 Report. Federal Home Loan Banks

The Federal Home Loan Bank System was created prior to enactment of the Securities Act and the Exchange Act and the creation of the Securities and Exchange Commission in 1934. The System was created in 1932 to restore confidence to the Nation's financial institutions and improve the supply of funds to local lenders.8 The System is comprised of 12 banks. The Federal Home Loan Bank System through the Office of Finance is one of the largest issuers of debt securities in the world with $673.7 billion outstanding as of December 31, 2002. We believe that the holders of debt issued by the Office of Finance, for which the 12 Banks are jointly and severally liable, are entitled to the same type of information that is provided to investors in other public debt securities. Our interest is in assuring that public investors in this debt are provided with sufficient information when they are making their investment decisions.

The Federal Home Loan Banks are also exempt from the Federal securities laws. The Banks prepare financial statements based on regulations of the Federal Housing Finance Board, which refer to Commission disclosure regulations. However, the staff of the Commission does not review these financial statements or any other disclosure documents of the Banks. The Banks are also not subject to the provisions of Sarbanes-Oxley Act of 2002 applicable to issuers, as discussed above. However, the Banks are subject to general antifraud restrictions prohibiting false or misleading statements of material facts or the omission of material facts necessary to make the statements made, in light of the circumstances under which they are made, not misleading. In September 2003, the Finance Board proposed for comment a rule to require registration under the Exchange Act by the Banks with the Commission. The comment period for that rule ended January 15, 2004.

7 Department of the Treasury, Office of Federal Housing Enterprise Oversight, Securities and Exchange Commission, Staff Report: Enhancing Disclosure in the Mortgage-Backed Securities Market, January 2003.

8 Federal Home Loan Bank Act, Pub. L. No. 72–304, 47 Stat. 725 (1932)

The Banks, although Federally chartered entities, have many of the same disclosure issues as any financial institution whose securities are issued to, and held by, the public. Consolidated obligations for which each Bank is either primarily or secondarily obligated are sold to the public in underwritten offerings. As discussed above, we believe investors in those debt securities are entitled to the same type of information as that provided by other issuers of public debt. As also discussed above, we further believe that the Commission's detailed disclosure rules and filing requirements and the staff review and comment process provide the best framework for disclosing information to which investors are entitled.

Because the debt of the Banks does not carry the full faith and credit backing of the United States and investors in the Banks' debt must therefore look only to the Banks for repayment of the debt, disclosures by the Banks should give the holders of its debt a materially complete and accurate picture of the Banks' financial and operational situation to evaluate an investment. As is the case with Fannie Mae and Freddie Mac, the focus for disclosure has been the corporate disclosure required for a reporting company that registers under the Exchange Act. Registration of offers and sales of securities under the Securities Act has not been the focus and is not the subject of the proposed Finance Board rule. In particular, as with Fannie Mae and Freddie Mac, corporate disclosure resulting from Exchange Act registration is the same as would be required as a result of Securities Act registration.

Because of the structure of the Federal Home Loan Bank System, including the Office of Finance, however, there are some issues that may be unique to the Banks. Staff of the Commission has met with members and staff of the Federal Housing Finance Board, representatives of the Banks and a group of directors of certain Banks, in each case at their request, to discuss the issues that registration under the Exchange Act may raise.

Very early in our discussions with all of these parties, we sought to clearly and carefully address concerns raised by the Banks about whether registration would require the structure of the System to change. The Commission has no regulatory interest in changing the structure of the System. Registration under the Exchange Act of each of the 12 Banks would not alter the structure of the Federal Home Loan Bank System. In addition, insofar as registration of a class of each Bank's securities under the Exchange Act is being considered, there would be no impact on the timing or other aspects of offering transactions as a result of registration.

Because our focus on disclosure relates to the debt issued by the Banks and not to their common stock, Commission staff had initially considered with the Finance Board and the Banks the possibility of the Banks registering a class of debt securities. Under the Exchange Act the corporate disclosure required of a company is the same whether the security registered is debt or common stock. However, registration of equity could implicate additional requirements for the Banks, such as the proxy rules. Therefore Commission staff suggested the Banks register a class of debt securities. In our discussions with the Banks, each Bank expressed a preference for registering a class of its stock, if any security was to be registered under the Exchange Act. Because the corporate disclosure is the same, this is acceptable to us. Staff have also indicated to the Banks that we would work with them to determine if there were certain requirements, such as the proxy rules, from which it should be clear the Banks are exempted because the publicly held securities that implicate registration and disclosure issues are their debt securities. This would produce the same result as would be the case for corporate issuers whose only public securities are debt securities.

In addition to these items, there have been four accounting related issues that have been identified as significant for the Banks in terms of ascertaining our staff's view prior to any registration process. We have met with representatives and advisers of some of the Banks to resolve these issues. Those issues include: The accounting treatment of the payment to REFCORP, the role of the combined financial statements of the 12 Banks, the accounting classification of redeemable capital stock, and the accounting treatment related to the joint and several nature of the Banks' obligations: • The Financial Institutions Reform, Recovery, and Enforcement Act of 19899 oblisystem are equivalent to a $300 million annual annuity with a final maturity date of April 15, 2030. The Banks view the REFCORP payments as similar to a tax and accordingly, no obligation for future payments is recorded on their balance sheets. The Commission staff has indicated to the Banks that we would not object

gated the Banks to make an annual $300 million payment to the U.S. Treasury until 2030 for the partial payment of interest on bonds issued by the Resolution Funding Corporation, or REFCORP. The Gramm-Leach-Bliley Act 10 in 1999 changed how REFCORP payments are calculated and due. Each Bank is now obligated to pay 20 percent of earnings annually until these amounts for the whole

9 Pub. L. No. 103–73 (1989).
10 Pub. L. No. 106-102 (1999).

to this current presentation of the treatment of REFCORP payments. • Each Bank is a separate corporation with its own management, employees, and

board of directors. The Office of Finance, which is an agent for the Banks, prepares combined financial statements of the 12 Banks for public distribution. The financial statements are not consolidated because there are separate and distinct stockholder groups

for each Bank with no common management or ownership at the system level. The Commission staff believes that the correct way to proceed is to have individual Banks register. Because of the structure of the System, there is no issuer tied to the combined statements to register under the Exchange Act. Commission staff believes, however, there are policy reasons for us to have an opportunity to review and comment on the combined financial statements which are distributed to investors. Under Finance Board regulations the Board determines whether the combined financials statements comply with their requirements.11 Staff have proposed that we would have arrangements with the Finance Board so that their reviews would give the Commission staff the opportunity to review the combined financial statements and provide the Finance Board comments, if any. None of the Banks would have additional responsibility for the combined financial statements as a result of registration under the Exchange Act or the staff's proposed arrangements with the Finance Board regarding the combined statements. The Gramm-Leach-Bliley Act required each of the Banks to create a new capital structure. That Act allows each Bank to create two classes of stock, one with a redemption period of 6 months and the other with a redemption period of 5 years. The Banks are in the process of implementing their new capital plans. Because the stock will be redeemable, the issue arose as to whether the stock could be included as permanent equity on the financial statements of the Banks. Because all of the stock of each of the banks is "puttable,” the Commission staff will not object if it is not separated from the equity section of the balance sheet. This would be similar to the treatment of the equity for co-ops currently registered under the Exchange Act. The face of the financial statements would need to indicate the stock is "puttable” and the notes to the financial statements would include disclosure on how the puts work and on how much of the stock is in excess of the amount required to be held by member banks which is generally based on the member bank's activity. We have indicated to the Banks that we will continue to have dialogue with them on the proper accounting treatment in the event a stock

holder puts the stock to a Bank. • The Commission staff has also had discussions with the Banks regarding the ap

propriate treatment of the joint and several nature of the Consolidated Obligations. Staff has indicated to the Banks that it would not object to each Bank reflecting on the face of its balance sheet as long-term indebtedness only the amount of Consolidated Obligations for which that Bank has received proceeds and is therefore viewed by the Banks as primarily liable. The Banks would also disclose the total amount of outstanding obligations. The Commission staff has also indicated to the Banks that it would not object to their accounting treatment for the contingent liability related to each Bank's guarantee of the remainder of

the outstanding Consolidated Obligations for which it is not primarily liable. Conclusion

The individual and institutional investors who hold debt securities of the Banks depend for repayment on the Banks and not a Government guarantee. We believe that applying the Commission's disclosure requirements and processes is the preferred method of helping to ensure that these investors receive the materially accurate and complete disclosure they deserve. We believe that the Commission's detailed disclosure rules and filing requirements, and our staff review and comment process, provide the best framework for disclosing that information. We have a long history of reviewing the disclosure of companies in many diverse industries and we regularly review the complex debt and equity structures of these companies. We have not initiated any process to seek voluntary registration by the Federal Home Loan Banks of their securities, but we do believe that our rules and registration would provide the desired result. If registration by the Banks is pursued, we are committed to achieving that result with maximum protection for investors and maximum efficiency for all registrants consistent with our mission to protect investors.

11 12 CFR 985.6(b).

PREPARED STATEMENT OF RICHARD S. CARNELL
ASSOCIATE PROFESSOR OF LAW, FORDHAM UNIVERISTY SCHOOL OF LAW

NEW YORK, NEW YORK

FEBRUARY 10, 2004 Mr. Chairman, Senator Sarbanes, and Members of the Committee, I am pleased to have this opportunity to discuss ways to improve the regulation of Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System.

As Government Sponsored Enterprises, these entities are privately owned, profitoriented corporations that have Congressional charters and receive an array of Federal benefits not available to businesses generally. More importantly, capital market participants believe that the Government implicitly backs each GSE—and would not let the GSE's creditors go unpaid. This perceived implicit guarantee is the GSEs’ most important and most distinctive characteristic. It enables the three housing GSE's to borrow $2.2 trillion at rates below those available to even the most creditworthy fully private borrowers.

For years the GSE's assured us that they met the highest standards of corporate governance, fully complied with generally accepted accounting principles, provided disclosure at least as good as what the Federal securities laws required, faced tough and effective safety-and-soundness regulation, and were so well run that no one had any business requiring them to do anything they did not want to do. Recent scandals and other developments cast doubt on these claims and on the adequacy of GSE regulation. The Administration has proposed major reforms of such regulation, including the creation of a new GSE regulatory agency. Treasury Secretary Snow has rightly called for “a strong, credible, and well-resourced regulator" with “powers . comparable in scope and force to those of other world-class financial regulators, fully sufficient to carry out the agency's mandate, with accountability to avoid dominance by the entities it regulates.

In my testimony today, I will: • identify six fundamental questions Congress faces in structuring a GSE regulator; • offer suggested answers to those questions; • describe the double game by which the GSE's deny that they have “full faith and

credit” Government backing—in ways that leave the impression that they have no Government backing at all even as they work to reinforce the market percep

tion of implicit Government backing; • refute the GSEs' attempt to liken FDIC-insured banks to GSE's and to argue that

we should not concern ourselves with GSE subsidies because the Government

gives banks greater subsidies; and • examine “systemic risk”—particularly the argument that if a GSE got into finan

cial trouble, the Government would have no choice but to rescue it, lest its failure

unacceptably damage the financial system. Structuring the Regulator

In designing (or redesigning) a regulatory agency, Congress faces six fundamental questions: • Jurisdiction: Who will the agency regulate? Mission: What objectives should the agency seek to achieve? Governance: Who will run the agency,

and under what ground rules? Resources: How will the agency pay its expenses? Legal Authority: What legal tools will the agency have to do its job? • Incentives: What incentives will the agency's officers and employees have?

I will first briefly analyze OFHEO's structural weaknesses in light of these questions. I will then discuss how to structure a new GSE regulatory agency, considering the first five questions in turn and (in so doing) noting how the answers given to those questions will affect the agency's incentives. For the new agency's incentives will be crucial to the agency's success or failure. OFHEO'S STRUCTURAL WEAKNESSES

Congress created OFHEO with significant structural weaknesses. Specifically, the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (1992 Act) created a small, hyper-specialized agency-with uncertain funding and overly narrow powers-to regulate two huge, relatively homogeneous firms with great political clout. The Act housed that agency in a department with no institutional commitment to safety and soundness, little credibility

to spare, and little ability to protect OFHEO against pressure from Fannie and Freddie. Í summarize some of these structural weaknesses and their consequences in the table following this page. Building these weaknesses into OFHEO was a bit like keeping a watchdog hobbled, muzzled, and underfed. JURISDICTION

The new agency should regulate Fannie, Freddie, and the Federal Home Loan Bank System, taking over the functions currently performed by OFHEO and the Federal Housing Finance Board. 1

Having a single agency regulate all three housing GSE's would have several advantages over the current system. The General Accounting Office identified and aptly summarized these advantages in its excellent report, Government Sponsored Enterprises: Advantages and Disadvantages of Creating a Single Housing ĠSE Regulator (1997), on which I will draw extensively in this part of my testimony.

11 will argue below that the new agency should, ideally, also become responsible for overseeing Fannie and Freddie's housing mission, taking over functions currently performed by HUD.

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