Most of the concerns associated with systemic risks flow from the size of the balance sheets that these GSE's maintain. One way the Congress could constrain the size of these balance sheets is to alter the composition of Fannie's and Freddie's mortgage financing by limiting the dollar amount of their debt relative to the dollar amount of mortgages securitized and held by other investors. Although it is difficult to know how best to set such a rule, this approach would continue to expand the depth and liquidity of mortgage markets through mortgage securitization but would remove most of the potential systemic risks associated with these GSE's. Ideally, such a ratio would focus the business operations of Fannie and Freddie on the enhancement of secondary markets and not on the capture of the implicit subsidy.

Limiting the debt of Fannie and Freddie and expanding their role in mortgage securitization would be consistent with the original Congressional intent that these institutions provide stability in the market for residential mortgages and provide liquidity for mortgage investors. Deep and liquid markets for mortgages are made possible using mortgage-based securities that are held by non-GSE private investors. Fannie's and Freddie's purchases of their own or each other's securities with their debt do not appear needed to supply mortgage market liquidity or to enhance capital markets in the United States.

The expansion of homeownership is a widely supported goal in this country. A sense of ownership and commitment to our communities imparts a degree of stability that is particularly valuable to society, as Senator Sarbanes pointed out. But there are many ways to enhance the attractiveness of homeownership at significantly less potential cost to taxpayers than through the opaque and circuitous GSE paradigm currently in place.

In sum, Mr. Chairman, the Congress needs to create a GSE regulator with authority on a par with that of banking regulators, with a free hand to set appropriate capital standards, and with a clear process sanctioned by the Congress for placing a GSE into receivership. However, if the Congress takes only these actions, it runs the risk of solidifying investors' perceptions that the GSE's are instruments of the Government and that their debt is equivalent to Government debt. The GSE's will have increased incentives to continue to grow faster than the overall home mortgage market. Because they already purchase most conforming mortgages, they, like all effective profit-maximizing organizations, will be seeking new avenues to expand the scope of their operations, assisted by a subsidy that their existing or potential competitors do not enjoy.

Thus, GSE's need to be limited in the issuance of GSE debt and in the purchase of assets, both mortgages and nonmortgages, that they hold. Fannie and Freddie should be encouraged to continue to expand mortgage securitization, keeping mortgage markets deep and liquid while limiting the size of their portfolios. This action will allow the mortgage markets to support homeownership and homebuilding in a manner consistent with preserving the safe and sound financial markets of the United States.

Thank you very much, Mr. Chairman, and I would appreciate it if my complete remarks are included for the record, and I look forward to your questions.

Chairman SHELBY. Without objection, your written statement will be made a part of the record in its entirety.

Mr. Chairman, to go back over this again, you state that possible future systemic difficulties are likely if GSE expansion continues unabated. Why do you feel that such systemic problems are likely—your word—and what can be done to prevent such problems? I think this is important here.

Chairman GREENSPAN. Senator, this is the most crucial issue. As I have stated in my written remarks, Fannie Mae and Freddie Mac are extraordinarily effective institutions, and they have done a great deal for this country in developing the secondary mortgage market, which has been a very important issue in the whole structure of the developed asset-backed securities markets in which they originally took the lead.

The problem that exists is that because of the fact that they have a subsidy, granted, as I indicated before, not by the Congress, but by the expectation that Government will bail them out in the event of a crisis, they have been able to take a highly competitive position and, indeed, essentially are elbowing out a number of competitors who did not have such a subsidy, and as a result, they have been growing at an exceptionally rapid rate, increasing their share of the market. And if you project into the future, you effectively get a system in which they will be increasingly pressing to move beyond the mortgage markets because they need a continuous growth rate in their profitability to maintain the level of their stock price. Chairman SHELBY. What do you mean "move beyond the mortgage" into other products?

Chairman GREENSPAN. Yes, into other products and into nonmortgage areas. And to the extent that they are a profit-making organization, they are very properly concerned about the value of their stock, and the value of their stock has been largely a function of the extraordinarily stable gain in earnings, although I must admit that has come into question with respect to the accounting at Freddie Mac, but nonetheless they have been very effective increasing balance sheets, increasing earnings, and increasing stock prices.

I must say to you these are very effectively run organizations, and I wish they would be running without their subsidy because I think they would still be doing very well.

Chairman SHELBY. Mr. Chairman, you stated that the GSE's receive a funding advantage from the market's perception that they are too big to fail. What about large banking institutions like Citigroup or Bank of America, does the market perceive them too big to fail in perhaps a different vein? Do they receive a similar funding advantage?

Chairman GREENSPAN. I think they receive some, Senator.

Chairman SHELBY. Have you ever quantified that? Has anybody at the Federal Reserve?

Chairman GREENSPAN. Yes, it is very substantially less than the types of numbers we are looking at. Remember that there are significant differences. Remember that these large banking organizations are fairly well-capitalized, far better, of course, than Fannie or Freddie, and they are supervised with respect to all of their ac

tions and activities in a way which we are hopeful that the Congress will move on shortly on the GSE's.

So the answer is, yes, there are similarities here, but the degree of difference is very large. And I would say one of the reasons why the issue of Fannie and Freddie did not arise earlier is they were not large enough, and they did not create a potential significant problem for the overall financial system-not that they do today, as I point out, but they will almost surely do in years ahead unless some changes are made in the structure of how these organizations function.

Chairman SHELBY. If these huge banking institutions, Citigroup, Bank of America and so forth, if they are perceived as too big to fail, do we need

Chairman GREENSPAN. Let me just say that I did not mean to imply that. I think there are some who do believe that. I do not think that is the general market.

Chairman SHELBY. There is a perception by some people that some of the largest banks are too big to fail.

Chairman GREENSPAN. Yes, the reason I say "not quite" is that if you look at the prices of their securities in the marketplace, it is fairly evident that there is very considerable question as to whether in the event of failure they will in fact be bailed out. That is far less the case on the part of the securities of Fannie and Freddie, which very significantly indicate a generalized expectation of support by the Government in the event of crisis.

Chairman SHELBY. In that context, do we need to give the new proposed GSE regulator the same type of systemic risk powers that FDIC has?

Chairman GREENSPAN. I would certainly think so, sir.

Chairman SHELBY. Senator Sarbanes.

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

Chairman Greenspan, do you favor, as a goal, privatizing the GSE's?

Chairman GREENSPAN. As a goal, I would, and, in fact, I have stated so on many occasions-but the main problem is to reduce the subsidy and to make these particular institutions far more balanced in the way they function in the market. I think privatizing them would do that, but I think, short of that, the types of recommendations that I have made will also do that.

And since I fully recognize that my view about privatization is a highly minority point of view, I think it is sometimes important to go to the really important issue, which is eliminating the subsidy, and that could be substantially done and taken out of the marketplace as a crucial disturbing factor without privatization.

Senator SARBANES. Why do you think your view on privatization is a highly minority view?

Chairman GREENSPAN. Because I have taken surveys amongst a lot of people.

[Laughter.]

Senator SARBANES. Well, that explains the quantity of it, but it does not explain the quality of it. What is the rationale that prevents it or that keeps it as a highly minority point of view?

Chairman GREENSPAN. I suspect it is an issue of experience and education. I believe my concern is that we do not get educated in

a way which will make us all recognize that privatization is a potential goal.

I do think that if Fannie and Freddie were to function mainly by securitizing mortgage-backed securities, which is a profitable business, I think that the extent of the subsidy which is involved in that is really quite small. And considering the advantages that would carry with it, I think it could be well within the realm of the types of subsidies which the Congress has created over the years, and certainly would not, in any way, from my point of view, induce concerns about systemic risk.

The systemic risk issue is wholly related to the question of issuing debentures and investing the proceeds of those debentures in other assets, whether they be mortgages, mortgage-backed securities or, as a significant part of the portfolio of the GSE's indicate, nonmortgage assets.

Senator SARBANES. In a letter to Representative Baker back in 2000, you said that "lower mortgage costs that may result from the implicit subsidy would result in housing expanding relative to nonhousing investment, including private-sector initiatives such as investment in productivity-enhancing plant and equipment."

Do you think, as a society, we channel too much capital into housing?

Chairman GREENSPAN. I do not. I think that, from an economic point of view, there is no question that doing that, in a technical sense, is less efficient than moving capital into productivity-enhancing assets.

I made a speech on Friday in which I indicated how important the issue of the sense of property rights and ownership is to the basis of a free market capitalist system in this country. And while I certainly recognize the inefficiencies that might technically be involved with respect to moving capital from so-called productivityproducing assets to homeownership, I think the value that homeownership has is far superior as an important value in maintaining our economic and social system than the question of efficiency.

There is no doubt that it is, from a technical point of view, less efficient in the creation of wealth. But from the overall view of what is important for a market capitalist system, to have broad acceptance of property rights and a broad ownership of property in this country far exceeds, in my judgment, the values of the efficiency questions which I raised.

Senator SARBANES. Let me address this Passmore study. There are two CBO studies which find a greater reduction in mortgage rates for borrowers than the Fed study. You found a reduction of 7 basis points in the mortgage rates. The two CBO studies found 25 basis points in one, 35 basis points in the other.

Now, in your testimony, you seem to dismiss this difference by saying that the Fed and CBO come essentially to the same conclusions, that shareholders were paying a portion of the subsidy. But the degree might be quite significant from a policy point of view. The CBO studies indicate the benefit to the public of the GSE's is considerably greater than one would conclude from the Fed study. Chairman GREENSPAN. But they are both very small in the sense that all of the analysis that we have done, and others, have indicated that 25 or 35 or 45 basis points has very little effect on the

rate of homeownership or on housing starts. We have examined, over the years, the sensitivity of home construction and homeownership to interest rates.

Senator SARBANES. Let me be clear on this point. So you are shifting your argument now away from how much of the benefit goes to the borrower to the argument that even if all of the benefit went to the borrower, it would still not affect the rate of homeownership; is that correct?

Chairman GREENSPAN. No. "All of the benefits" is a very large number.

Senator SARBANES. The CBO study has about two-thirds of the benefits going to the borrower.

Chairman GREENSPAN. Let me put it this way, very specifically. There are two questions here. One is there is a gross subsidy and how much of it passes through directly to the homeowner, that number is a fraction of the total by everyone's calculation. And the question essentially is, is this an efficient way of creating homeownership, when we know, statistically, that the major contributors to homeownership are issues of downpayment and income? I am not saying that interest rates do not have an effect. What I am largely saying is that where the numbers are concentrated with respect to estimates, the notion that significantly enhances homeownership is something we find statistically difficult to sustain.

One of the reasons why I am suggesting that this issue be examined in far greater detail is that we are dealing with a very major public policy question, and how one concludes on this issue and how one decides what to do I think requires the best analysis.

Obviously, Wayne Passmore and his staff had full access to the previous studies, and I think it is a question of people sitting down who are technically expert in this field and making judgments of which sets of data are accurate. I will just say this: One, all of the estimates imply that a very significant amount of the subsidy goes to the profits of these institutions and, two, the major estimates indicate levels which do not historically suggest to us that they have a major impact on homeownership. I would suggest, finally, that issues of downpayment be looked at far more carefully. FHA, for example, does it quite efficiently in that regard.

Senator SARBANES. Mr. Chairman, I am still not getting an answer. If all of the benefits pass through, I take it, it would still be your position against because you do not think it affects homeownership rates; is that right?

Chairman GREENSPAN. First of all, let us remember this is not a legal subsidy. This is a subsidy granted by the private sector. If all of the subsidies went through, and it was sanctioned by the Congress, I would say that was an appropriate procedure by which the Congress endeavored to lower mortgage interest rates, which have value.

I am not saying it has no value. I am just saying its impact on homeownership and on housing starts is not great, but it is obviously a very important financial advantage to a homeowner to get a lower interest rate, and if the whole subsidy were passed through to homeowners, it would make a significant difference. I am saying that it is not a substantial proportion and that, in my judgment, is not the way a subsidy should function.