Freddie Mac and the Federal Home Loan Banks, to provide affordable housing opportunities for our citizens. Because as I go about this country, that is one of the great sources of concern and difficulty for families all across this country. Housing prices are soaring. The housing markets are doing extremely well. As a result, rental markets are appreciating dramatically. It is impossible for anyone making a minimum wage job to afford even a decent rental unit in most places, probably every place in the country.

We have to do something. And, to date, we have been unable to harness in a proactive way the Federal policy for a housing trust fund or anything that will stimulate production and try to generate more opportunities. And if not by design, then by default, we have to rely upon some of these private entities.

I frankly think we have to challenge all of these entities to do more, not just rhetorically but practically, to provide opportunity for affordable housing, not simply to provide mortgage support for people who can afford to buy expensive homes or even mid-priced homes, but to look out and make sure that we have a place so that all of our families can find a place. I hope in the context of these discussions that you can give us your advice on that point also. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Crapo.

STATEMENT OF SENATOR MIKE CRAPO

Senator CRAPO. Thank you very much, Mr. Chairman.

Mr. Greenspan, again, we thank you for sharing your wisdom and being with us here today.

I think my focus today is going to be, as I think is indicated by Senator Carper, on the capital standards issue. Obviously, there are a lot of issues that we need to deal with as we address the relationship in the home mortgage industry between Fannie and Freddie, the Federal Home Loan Banks, and the private sector lending institutions.

To me, one of the questions that is clearly in the forefront is the question of capital standards, the questions like: Should the statute, if we pass one, set a floor? Or should the statute establish any type of capital standard as opposed to letting it be set regulatorily by any new regulator that might be established? Questions like: Should the capital requirements be different for different types of institutions depending on the nature of risk which they incur? Should capital standards be imposed that extend beyond the level of risk? And is establishment of a capital standard that exceeds risk economically inefficient?

It is questions like this which I believe we must address as we address the question of establishing a new regulator and setting the parameters and the scope of authority of such a new regulator.

I know that you have looked at this very closely, and I look forward to your testimony today. And, Mr. Chairman, I also look forward to working with you as we put this together. Thank you. Chairman SHELBY. Absolutely.

Senator Enzi.

STATEMENT OF SENATOR MICHAEL B. ENZI

Senator ENZI. Thank you, Mr. Chairman. I appreciate your holding this hearing. I would ask that my full statement be a part of the record.

Chairman SHELBY. Without objection, it is so ordered.

Senator ENZI. I would mention something a little more basic on getting homes, and that is having jobs. I passed the Workforce Investment Act, and I am going to be pressing both sides to come up with conferees for that so that people can upgrade their skills, make a little bit more money, and be able to afford houses.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Sarbanes.

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Mr. Chairman, first of all, I want to express my appreciation to you once again for continuing the Committee's thorough and careful examination of the issue of the regulation of the housing GSE's. This is an important series of hearings, and obviously, I hope at the end of it we will be able to develop a consensus with respect to a world-class regulator for Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.

I think it is always important, of course, to remind ourselves that the primary purpose of Fannie Mae and Freddie Mac is to maintain a strong, liquid, stable secondary market for residential mortgages, including multifamily mortgages. I think most people feel they have done this well over the years and it is reflected in the rates of homeownership that exist in this country when compared with what exists elsewhere in the world.

The other primary purpose of these Enterprises is to expand access to affordable housing for low-income families and for those who live in underserved areas. We have sought to accomplish this by setting certain affordable housing goals, and while those targets have been met, there is some considerable sentiment that more could be done to expand housing opportunities.

Housing has a special place in American society. A home of one's own is part of the American Dream. Both the current and previous Administrations have made expanded homeownership, particularly for minorities, an important goal. And, indeed, I think it should be. Homeownership is associated with a whole set of social and civic virtues, from better school performance to lower levels of juvenile delinquency, to higher levels of voting and civic participation. And I think we need to keep that in mind as we consider the framework within which these institutions will operate.

The considerable question has been raised as to the adequacy of existing regulations, with considerable concern about the Federal Housing Finance Board, whose examination and supervisory capac ity is being far short of what is required. OFHEO, which has been working quite hard recently to catch up on its responsibilities, seems not to have been aware of the depth of the problems at Freddie Mac. And because the housing GSE's are so important to our economy and our financial system, obviously we have an important responsibility to ensure that they are properly supervised and regulated.

Mr. Chairman, I am pleased that we have Chairman Greenspan here with us today. I understand, I think, that tomorrow afternoon we will be hearing from the representatives of the

Chairman SHELBY. That is right, the GSE's.

Senator SARBANES. The three GSE's, and I look forward to that hearing as well.

Thank you very much.

Chairman SHELBY. Chairman Greenspan, welcome again to the Committee. You spend a lot of time with us, but we think that is quality time. You proceed as you wish.

Senator SARBANES. They tell us you look forward to it with unanticipated joy. Is that correct?

[Laughter.]

Chairman GREENSPAN. It is always a joy, Senator.
Senator SARBANES. Thank you.

Chairman SHELBY. The Chairman can handle his own, I am sure.

STATEMENT OF ALAN GREENSPAN, CHAIRMAN

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Chairman GREENSPAN. Mr. Chairman, Senator Sarbanes, and Members of the Committee, thank you very much for inviting me to discuss the role of the housing-related Government Sponsored Enterprises in our economy this morning.

As you know, Fannie Mae, Freddie Mac, and the Federal Home Loan Banks collectively dominate the financing of residential housing in the United States. Indeed, these entities have grown to be among the largest financial institutions in the United States.

During the 1980's and 1990's, Fannie and Freddie contributed importantly to the development of the secondary mortgage markets for home loans and to the diversification of funding sources for depository institutions and other mortgage originators, as I explain in somewhat greater detail in my written remarks.

Yet given their history of innovation in mortgage-based securities, why do Fannie and Freddie now generate such substantial concern? The unease relates mainly to the scale and growth of the mortgage-related asset portfolios held on their balance sheets. That growth has been facilitated, at least in part, by a perceived special advantage of these institutions that keeps normal market restraints from being fully effective.

The GSES' special advantage arises because, despite the explicit statement on the prospectus of GSE debentures that they are not backed by the full faith and credit of the U.S. Government, most investors have apparently concluded that during a crisis the Federal Government will prevent the GSE's from defaulting on their debt. An implicit guarantee is thus created not by the Congress but by the willingness of investors to accept a lower rate of interest on GSE debt than they would otherwise require in the absence of Federal sponsorship.

Because Fannie and Freddie can borrow at a subsidized rate, they have been able to pay higher prices to originators for their mortgages than can potential competitors and to gradually but inexorably take over the market for conforming mortgages. This process has provided Fannie and Freddie with a powerful vehicle and incentive for achieving extremely rapid growth of their balance

sheets. The resultant scale gives Fannie and Freddie additional advantages that potential private sector competitors cannot overcome. Importantly, the scale itself has reinforced investors' perceptions that, in the event of a crisis involving Fannie and Freddie, policymakers would have little alternative than to have the taxpayers explicitly stand behind GSE debt. This view is widespread in the marketplace despite the privatization of Fannie and Freddie and their control by private shareholders, because these institutions continue to have Government missions, a line of credit with the Treasury, and other Government benefits, which confer upon them a special status in the eyes of many investors.

A recent study by a Federal Reserve economist, Wayne Passmore, attempts to quantify the value of that implicit subsidy to the private shareholders of Fannie and Freddie. His research indicates that it may account for more than half of the stock market capitalization of these institutions.

Passmore's analysis suggests that Fannie and Freddie likely lower mortgage rates less than 16 basis points, with a best estimate centering on about 7 basis points. If the estimate of 7 basis points is correct, the associated present value of homeowner savings is only about one-half the after-tax subsidy that shareholders of these GSE's are estimated to receive. Congressional Budget Office and other estimates differ, but they come to essentially the same conclusion. A substantial portion of these GSEs' implicit subsidy accrues to GSE shareholders in the form of increased dividends and stock market values.

As noted by the General Accounting Office, the task of assessing the costs and benefits associated with the GSE's is difficult. One possible way to advance the technical discussion would be for the Congress to request disinterested parties to convene groups of technical experts in an effort to better understand and measure these costs and benefits.

The Federal Reserve is concerned about the growth and the scale of the GSES' mortgage-related portfolios, which concentrate interest rate and prepayment risks at these two institutions. Unlike many well-capitalized savings and loans and commercial banks, Fannie and Freddie have chosen not to manage that risk by holding greater capital. Instead, they have chosen heightened leverage, which raises interest rate risk but enables them to multiply the profitability of subsidized debt in direct proportion to their degree of leverage. Without the expectation of Government support in a crisis, such leverage would not be possible without a significantly higher cost of debt.

In general, interest rate risk is readily handled by adjusting maturities of assets and liabilities. But hedging prepayment risk is more complex. To manage this risk with little capital requires a conceptually sophisticated hedging framework. In essence, the current system depends on the risk managers at Fannie and Freddie, as good as they are, to do everything just right, rather than depending on a market-based system supported by the risk assessments and management capabilities of many participants with different views and different strategies for hedging risks. Our financial system would be more robust if we relied on a market

based system that spreads interest rate risks, rather than on the current system, which concentrates such risk with these two GSE's. As always, concerns about systemic risk are appropriately focused on large, highly leveraged financial institutions such as the GSE's that play substantial roles in the functioning of financial markets. I should emphasize that Fannie and Freddie, to date, appear to have managed these risks well and that we see nothing on the immediate horizon that is likely to create a systemic problem. But to fend off possible future system difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are required sooner rather than later.

As a general matter, we rely in a market economy upon market discipline to constrain the leverage of firms, including financial institutions. However, the existence, or even the perception, of Government backing undermines the effectiveness of market discipline. A market system relies on the vigilance of lenders and investors in market transactions to assure themselves of their counterparties' strength. Many counterparties in GSE transactions, when assessing their risk, clearly rely instead on the GSEs' perceived special relationship to the Government. Thus, with housing-related GSE's, regulators cannot rely significantly on market discipline.

Determining the suitable amount of capital for Fannie and Freddie is both a difficult and technical process, and in the Federal Reserve's judgment, a regulator should have a free hand in determining the minimum and risk-based capital standards for these institutions.

The size of Fannie and Freddie and the complexity of their financial operations and the general indifference of many investors to the financial condition of the GSE's because of their perceived special relationship to the Government suggest that the GSE regulator must have authority similar to that of the banking regulators. In addressing the role of a new GSE regulator, the Congress needs to clarify the circumstances under which a GSE can become insolvent and, in particular, the resultant position-both during and after insolvency of the investors that hold GSE debt. This process must be clear before it is needed; otherwise, should these institutions experience significant financial difficulty, the hands of any regulator, and of public authorities generally, would be constrained by uncertainties about the process. Left unresolved, such uncertainties would only heighten the prospect that a crisis would result in an explicit guaranteeing of GSE debt.

World-class regulation, by itself, may not be sufficient and, indeed, as suggested by Treasury Secretary Snow, may even worsen the situation if market participants infer from such regulation that the Government is all the more likely to back GSE debt. This is the heart of a dilemma in designing regulation for the GSE's. On the one hand, if the regulation of the GSE's is strengthened, the market may view them even more as extensions of the Government and view their debt as Government debt. The result, short of a marked increase in capital, would be to expand the implicit subsidy and allow the GSE's to play an even larger unconstrained role in the financial markets. On the other hand, if we fail to strengthen GSE regulation, the possibility of an actual crisis or insolvency is increased.