Senator SARBANES. Thank you, Mr. Chairman.
Chairman SHELBY. Senator Allard.

Senator ALLARD. Thank you, Mr. Chairman.

I am going to base my question on what you think the impact of the debt that both of the GSE's have on our economy potentially. I have been looking at some of the figures too. The figures I have is on the CBO. I think they said about 50 percent of the value of the subsidy goes to homeowners and about 50 percent goes to administration, which is mainly executive salaries and then also the shareholder profits.

And then I also look at the total debt that you have in the GSE's. It is around $2.2 trillion I think in 2002, and the public debt for the Federal Government was at $3.2 trillion, and the trend, as expressed by Dr. Gregory Mankiw, who is Chairman of the President's Council of Economic Advisers, said if that trend continues, it could exceed the privately held debt of the Federal Government. So my question to you, Mr. Chairman, and I would appreciate hearing your thoughts on the future of the GSE's, as it relates to debt and systemic risk, and do you believe that this debt poses any threat to the U.S. economy?

Chairman GREENSPAN. I believe the process, in the long-run, would, in the sense that we have now in place a very ambiguous structure which I do not think should be allowed to continue. Either the Congress should agree that, in the event of default, it will guarantee GSE debt or not. If the former is the case, then it should be stipulated explicitly, and the Congress obviously can do that, and that would clarify a good deal of the issue.

The problem is that, unless that is done, we are confronted with a situation in which, on the one hand, there is a general belief in the marketplace that these securities are backed by the full faith and credit of the U.S. Government, even though they are explicitly not so stated, and the law says they are not, and the question is, the larger that debt becomes, the more this is an issue.

What we have is an ambiguity which, in the event of a crisis migth require explicit guaranteeing of the debt, and a crisis could occur not because Fannie and Freddie are doing anything wrong, and indeed, as I said in my opening remarks, they are very skillful operators. I think they do risk management exceptionally well, and I think they are very well-run organizations in general.

The problem is that it is not in their control to really comprehend all of the type of crises that can arise, and because they have concentrated interest risk, what that basically means is that their ability to hedge that risk is limited; that is, it is theoretically possible to fully hedge interest rate risk. As a practical matter, it is extremely costly and never quite fully the case, for reasons I could get into, but I do not think it is really necessary at this point. My major concern is that if you just project this debt into the future without resolving either the subsidy question that is implicit there or what will happen in the event of a crisis, it may be many years hence before you can address the issue again. I find that an issue which can be addressed now or in the immediate future in a manner which would fend off that concern which I think will grow as the years go on.

Senator ALLARD. Mr. Chairman, I even worry about the Federal Government. If the Federal Government guarantees this debt of $2.2 trillion, that would add into the public debt. That is going to have an impact, would it not?

Chairman GREENSPAN. It becomes equivalent to public debt, certainly.

Senator ALLARD. Yes, and then all of a sudden your public debt has really a marked increase, and I wonder what that would do, as far as instilling confidence in the economy when that figure would come out? It seems to me that even that would have an adverse impact on the economy.

Chairman GREENSPAN. Well, I think the main issue here is to get this issue resolved sooner rather than later. I am not sure exactly what the impact would be now, but I would certainly agree with you if the issue were left to fester for a number of years, and we tried to address it at a later time.

Senator SARBANES. Is the Senator referring the U.S. Government debt?

Senator ALLARD. Yes, I am referring to the debt that we have with the GSE's. He is assuming, in his response to me, he said, well, one way that we could assure that the debt would not be a problem, as far as the economy is concerned, is if there was a guarantee from the Federal Government.

My point is, if there is a guarantee from the Federal Government, then that $2.2 trillion gets added into the $3.2 trillion, and if people all of a sudden see that jump to $5.4 trillion, that could have an impact on people's thinking, and consequently an impact on the economy.

Senator SARBANES. Oh, I see.

Is the $3.2 trillion, that is the Government debt?

Senator ALLARD. That is the public debt.

Senator SARBANES. And is that what we were told 3 years ago we were paying down too quickly?

[Laughter.]

Chairman GREENSPAN. I just want to point one thing out; that when the Government guarantees debt, it is handled in a somewhat different way. But from an economic point of view, there is no question that what you are stating is correct, Senator.

Senator ALLARD. Mr. Chairman, may I proceed with a second question?

Chairman SHELBY. Go ahead. One more question.

Senator ALLARD. I am interested in OFHEO. It has a lot of regulatory responsibilities, and the question I have is do you believe that funding for the regulator should be guaranteed in the President's budget or should it be subjected to the annual appropriations process? And also do you believe that the need for resources would differ greatly if the regulator resided independently rather than within the Treasury?

Chairman GREENSPAN. With respect to the latter question, I am not sure, and I am not sure it should be an issue one way or the other.

I do think that you want the funding of the resources of the new regulator to be outside the appropriations process, if that is at all feasible.

Senator ALLARD. Mr. Chairman, my time has expired, and I appreciate your generosity on that.

Thank you.

Chairman SHELBY. Senator Carper.

Senator CARPER. Thanks.

Chairman Greenspan, I have a couple of questions I am going to ask, and I am going to ask you just to limit your responses. So just be as direct with me as you can, and I know you will.

Let us just back up just for a moment, and just share, at least with me, and maybe with some of my colleagues, what is the wrong that we are trying to right here? What is the potential harm that we are trying to avert?

Chairman GREENSPAN. I believe that is a very good question, Senator.

What we are trying to avert is we have, in our financial system right now, two very large and growing financial institutions which are very effective and are essentially capable of gaining market shares in a very major market, to a large extent as a consequence of a subsidy that prevents the markets from adjusting appropriately. It prevents competition and the normal adjustment processes that we see on a day-by-day basis from functioning in a way that creates stability.

It is basically creating an abnormality which the system cannot close around, and the potential of that is a systemic risk sometime in the future if they continue to increase at the rate at which they

are.

Senator CARPER. You spoke of your own minority view as to the course that we should take with respect to privatizing the GSE's. You also shared with us a different approach, and I believe that it dealt with limiting GSE issuance of debt. Would you go back to that and just explain that again for us, please.

Chairman GREENSPAN. Yes, Senator. There are two businesses here in the GSE's. First of all, the GSE's purchase mortgages from mortgage originators: Commercial banks, savings and loans, mortgage bankers, and the like.

Part of their business is to securitize those mortgages, guarantee them, charge a fee for servicing and the guarantee and then selling the mortgage-backed security on to other investors like pension funds, commercial banks or a number of other institutions. That is a profitable business, and that is indeed the secondary mortgage market.

There is another business which relates to the issue of taking part of the mortgages which are purchased and holding them on the balance sheets of the GSE's. These mortgages are selling at market interest rates. But if you have a subsidy in issuing debt, the GSE's are picking up an abnormal profit, which is the normal profit in the spreads plus the size of the subsidies, so that there is the incentive to put assets on the balance sheet, whether or not they are mortgages, corporate bonds, or other things which are on the GSE balance sheets, that, in effect, harvests the subsidy, which, remember, because it is not restricted by the Congress, can be expanded at will by the GSE's.

And so what we have is a structure in which a very rapidly growing organization, holding assets and financing them by subsidized

debt, is growing in a manner which really does not, in and of itself, contribute to either homeownership or necessarily liquidity or other aspects of the financial markets.

There are disputes, I must tell you, and there are some people who do believe that has some effect on securities markets. I think the evidence here is very murky and clearly, in any event, more of a secondary issue than anything else.

The crucial question there is these are two businesses. They are both subsidized. They both have a high rate of return on equity. Indeed, the rate of return on equity on the part of the GSE's is significantly above that of, say, large commercial banks, which is an indication that they have a special advantage. And I am saying that there is one part of this business which we should be endeavoring to get them to expand because that is the base in which the secondary mortgage market functions.

The ownership of assets on the balance sheet is a very seriously lesser force. My own judgment is it has very little to do with either homeownership, home construction, or even having a very significant impact at all on interest rates. The real issue is the securitization, which is what Fannie and Freddie originated. They do an exceptionally good job of that technically.

And my own view-and why I think privatization would be the thing for them to want to do is I basically believe that if they were to fully privatize, they would be smaller organizations, their profit levels would be somewhat less, their price earnings ratios would be much higher, and in all likelihood they may even have greater market value largely because they do things so well. Senator CARPER. My time has expired.

Mr. Chairman, I had indicated earlier that I wanted to raise some questions relating to capital and different kinds of capital, but I am going to yield to Senator Crapo over there because my suspicion is he or Senator Enzi will probably get into that.

Thank you.

Chairman SHELBY. Thank you.

Senator Dole.

Senator DOLE. Chairman Greenspan, 2 weeks ago, the Comptroller General testified before this Committee and recommended that the legislation we consider contain clear criteria for nonmortgage investments.

Your testimony clearly states that you support a limitation of nonmortgage investments. Would you elaborate on why this limitation is so important?

Chairman GREENSPAN. Well, Senator, from the point of view of profitability of the GSE's, whether you hold mortgage assets, corporate bonds, or any form of securities not related to housing at all-indeed, any asset at all-will create a profit, because remember, since the issuance of debt, which has this implicit guarantee on it, is unrestrained-in fact, the initiation is wholly up to the GSE itself—it means that if you can find assets in which to invest the proceeds that are at market values, you will automatically generate a profit and in effect pick up an additional above-market profit to the extent that there is a lowered cost of your borrowed funds.

I find very little in the way of this process which helps homebuilding-or, I should say, homeownership—and if the purpose of the structure of the GSE's is to enhance the secondary mortgage market, which was its original purpose, it is not clear to me that that does anything whatever except increase the profitability of the GSE's.

Senator DOLE. I appreciate how clear you are in your prepared testimony when you state that "In the Federal Reserve's judgment, a regulator should have a free hand in determining the minimum and risk-based capital standards."

Should we have the regulator consider any factors other than safety and soundness when deciding what the proper level of minimal capital should be?

Chairman GREENSPAN. Senator, I think it is very difficult to have mixed goals. It is tough enough as it is to have safety and soundness as your purpose in regulating an institution. And I would hope that to the extent that there are changes, enlargement, or anything with respect to the GSEs' mission that those things be kept separate from the issue of how capital is determined, because the purpose of capital in this particular context is to insulate the problems of a GSE from creating overall financial problems for the system as a whole.

I would hope that the new regulator of the GSE's would have very much the same sorts of authority that the Federal Reserve, the Office of the Comptroller, and the FDIC have in order to manage the risks that we all are exposed to. To constrain that, I think, creates overall risks to the financial system which I do not think are desirable.

Senator DOLE. Now, it is my understanding that the GSE's consider families with incomes at or below 80 percent of area median income to be low income, while the Community Reinvestment Act defines families with incomes at or below 50 percent of area median income to be low income.

Chairman Greenspan, do you believe that we should create a uniform standard for what should be considered a low-income loan toward affordable housing goals?

Chairman GREENSPAN. I think that is a determination for those who are directly related to housing policy in this country, because as I indicated before, homeownership is something which is strongly supported by this Nation and, as I said before, for good reason, and how one gets there is not necessarily through secondary mortgage market, which I certainly acknowledge does help, but there are lots of other things which relate to this policy, and I think that the integration of the homeownership goal and housing goal generally of the GSE's has to be consistent with the other goals of our policies in this area. But I could not give you any judgment as to how that should be reconciled.

Senator DOLE. When Fannie and Freddie established their automated underwriting standards, they established a standard in which no lender can compare its underwriting standards to those established by the GSE's. A loan is either accepted or rejected by the GSE's, with no idea as to how risk factors are weighted or why the borrower failed to qualify.