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Q.3.b.2. Similarly, please elaborate on what you believe are the additional issues raised by such complexities. A.3.b.2. As I stated above, traditionally the FHLB's have been portfolio lenders who acted mainly as intermediaries between capital markets and mortgage lenders. The FHLB's essentially passedthrough subsidized capital market funding to mortgage lenders, taking a passive role in the process. Over the past decade, however, the FHLB’s have evolved into active portfolio managers who offer financial options to their members. With their large portfolios, the risks involved in hedging these options can be large and, as with Fannie Mae and Freddie Mac, difficult to evaluate and worrisome given the size and scope of the portfolio. Q.3.b.3. What important concepts do you recommend that Congress consider if and when designing legislation to create a single regulator for all housing GSE's? Please elaborate. A.3.b.3. As I explained in my testimony, the regulator must be structured in a way that does not reinforce investors' perceptions that the Government implicitly backs GSE debt. Q.4. In his testimony to the Committee on February 25, 2004, Chairman Raines submitted a chart detailing the differences between 30-year conforming and jumbo mortgage rates in 2003 to demonstrate a 21 basis point difference in Fannie's mortgagebacked securities yields. In addition, after including guaranty fees, servicing costs, "carry” costs, and other miscellaneous mortgage rate expenses, he argued that there was a 26 basis point difference between the conforming and jumbo rates that are offered to homebuyers. How do you respond to such evidence? Don't these data demonstrate the difference in mortgage transaction costs, as well as the mortgage transaction prices? Why or why not? A.4. There is clearly a difference between GSE and non-GSE yields in the MBS market, as well as a difference between conforming and jumbo mortgage rates. As shown in Wayne Passmore's study, jumbo mortgage rates are usually 15 to 18 basis points higher than conforming mortgage rates. The question is, how much of the difference can be attributed to the GSE status of Fannie Mae and Freddie Mac? Passmore's study indicates that most of these differences are due to the economies of scale and other pricing efficiencies of the conforming loan and MBS markets. These market attributes would likely continue to exist even if Fannie Mae and Freddie Mac were not GSE's. The implicit subsidy is the element of the difference that would disappear should investors become convinced the GSE's were not Government-backed. According to Passmore's work, about 2 to 4 basis points of the conforming guarantee fee (embedded in the total guarantee fee, which is shown as 18 basis points in the chart you mention) is due to the subsidy. Indeed, if Fannie Mae and Freddie Mac were passing through some of their implied Government subsidies, one might generally expect the guarantee fee for conforming MBS to be less than the equivalent fee in the jumbo market, both because conforming mortgages are generally very safe assets and because Fannie Mae and Freddie Mac do not need to provide the same degree of credit enhancements for their MBS because of their implicit Government backing. In the Fannie Mae example, the guarantee fees are assumed equal. Q.5. In the context of reviewing the regulation of the housing GSE's, do you believe that the current minimum capital standard of 2.5 percent for Fannie and Freddie is too low or too high? A.5. Determining the appropriate minimum level of capital for the housing finance GSE's is a difficult and technical process that is best accomplished by the housing finance GSE regulator, which should have full access to information concerning the GSEs' activities, risks, risk management, and controls. The Federal Reserve generally does not have access to nonpublic information concerning the housing finance GSE's and has not conducted the analysis that would be required to express an opinion on the adequacy of the current minimum capital standard for the housing finance GSE's. Q.5.a. On what basis do you believe the minimum capital standard should be set? A.5.a. The housing finance GSE regulator should be encouraged to consider the three pillars of the proposed Basel Capital Accord in setting a minimum capital standard—the minimum capital requirements, the supervisory review process, and the market discipline or disclosure pillars.

Minimum capital standards should be established by the housing finance GSE regulator at a level that ensures that the major risks to which the housing finance GSE's are exposed-credit, interest rate, liquidity, and operational risks—are adequately covered, taking into account their ability to manage these risks. Ideally, one could rely primarily on a risk-based capital standard, but riskbased capital standards are not perfect and are still under development. Indeed, it likely will be many years before regulatory capital measures will be able to fully quantify and appropriately reflect all of the risks to which an entity may be subject over time. A leverage ratio places an overall constraint on the degree to which an institution can leverage its capital with debt that is implicitly or explicitly subsidized by the Government and works to limit the extent to which an institution can arbitrage the capital standard. It has been the Federal Reserve's experience that it is difficult for a banking organization to arbitrage simultaneously both the risk-based and leverage capital standards, which helps to ensure that the overall level of capital in the institution remains adequate in relation to its risk exposure.

In addition and importantly, the housing finance GSE regulator should have broad statutory authority to adopt regulations or take other actions that are necessary or appropriate to ensure the safety and soundness of the institutions it supervises. This authority, which is an important complement to the capital authority, would allow the housing finance GSE regulator to address financial and operational weaknesses at an institution. Q.5.b. Do you believe that allowing Fannie and Freddie's regulator to have discretion only over risk-based capital is insufficient to maintain the safety and soundness of the GSE's? Why or why not? A.5.b. As noted in my response to the prior question, a leverage ratio provides an important complement to a risk-based capital standard because risk-based standards are still relatively new and require significant ongoing development to encompass the many risks and arbitrage possibilities that exist in today's financial markets. Both types of standards are needed and, in my view, it is important for the Congress to provide the housing finance GSE regulator with clear authority to adjust standards for the entities under its jurisdiction.

History indicates that supervisors need the ability to revise and modify both the risk-based and leverage capital standards to ensure that these capital measures appropriately reflect changes in the financial markets, capital instruments, and the structure, operations, and risks of supervised institutions. In the banking area, the Federal banking supervisors have modified the leverage capital requirement in several significant ways since it was first adopted in the early 1980's. Most of these revisions altered the definition of capital as used under the leverage ratio requirement in response to accounting changes, financial product innovations, and market developments. The Congress should provide the housing finance GSE regulator with similar

flexibility to update the minimum capital requirements for the GSE's as needed to ensure that they adequately capture risks and reflect the rapidly changing housing finance industry. Q.5.c. 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.5.c. Statutory restrictions on the ability of the housing finance GSE regulator to adjust the minimum capital standards would impede the ability of the regulator to modify those standards to respond in a timely way to market innovations in capital instruments, revisions in accounting rules, advances in techniques for measuring exposure to risk, and the natural tendency of institutions to arbitrage capital rules. Accordingly, such restrictions have the potential, over time, to cause the minimum capital standards to become increasingly disconnected from the supervised entities' risk profiles, and to significantly diminish their usefulness in ensuring their safety and soundness. Q.5.d. At a staff briefing given by Fannie Mae on the issue of minimum capital, a Fannie representative said that raising minimum capital would require the GSE's to raise mortgage rates in order to keep earnings per share at current levels. In the context of capital standards, is there a way to ensure that more of the implied GSE benefits go toward the GSEs' housing mission, and less to the shareholders? A.5.d. In my view, capital standards should be used solely as a mechanism to ensure the safety and soundness of supervised entities, rather than as a mechanism to promote the GSEs' housing mission. As I mentioned in my testimony, channeling the activities of the housing finance GSE's toward mortgage securitization could help to ensure that more of the implied GSE benefits accrue to the housing mission rather than investors. Refocusing the housing finance GSE's in this manner also would be consistent with the original Congressional intent that the GSE's provide stability in the market for residential mortgages and provide liquidity for mortgage investors.

Q.6. Do you believe the fact that current law gives authority to oversee new GSE programs and activities to HUD, and safety and soundness oversight to the Office of Federal Housing Enterprise Oversight (OFHEO), have undermined OFHEO's ability to oversee the safety and soundness of Fannie and Freddie? Why or why not? A.6. Under current law, the Federal Reserve Board serves as the safety and soundness supervisor for bank holding companies and also has primary responsibility for reviewing and approving (or disapproving) proposals by bank holding companies to engage in new activities. (In some instances, the Board must coordinate its review of new activities with the Treasury Department.) Importantly, this authority permits the Board to review the potential risks involved with a proposed new activity, and the systems and procedures a bank holding company will use to monitor and control these risks, before the activity is commenced by a bank holding company. This authority also provides the Board with the ability to prevent bank holding companies from commencing any new activity that would present unacceptable risks to the safety and soundness of the banking organization or that is not authorized by applicable law.

As I mentioned in my testimony, I believe the GSE regulator should have authority similar to that of the banking regulators. This would include the authority to review and approve (or deny) proposals by a GSE to engage in new business activities, to place conditions on any such approvals to ensure that any new business activity commenced by a GSE is conducted in a safe and sound manner and is consistent with applicable law, and to enforce these prior approval requirements and any decisions made by the GSE regulator under this authority. Q.7. In your testimony, you reiterated your support for privatization of the housing GSE's. However, in response to a question from Senator Sarbanes, you also appeared to disavow one of your previous recommendations advocating for redirecting capital away from housing and toward other, more “productive uses. In a May 19, 2000 letter to Representative Baker, you said,“ nizations alter the housing finance markets only to the degree that they pass through to homebuyers part of their Government subsidy. They accomplish this by diverting real resources from other market-determined uses." Later in that letter, you stated, “Subsidies accorded to the GSE's are, of necessity, at the expense of other Federal or private sector initiatives.” In a subsequent August 25, 2000 letter to Representative Baker, you said, “If the lower costs associated with these implicitly subsidized funds are passed through to the mortgage market in the form of lower mortgage rates, then housing will expand relative to nonhousing investment, including private sector initiatives such as investment in productivity-enhancing plant and equipment.” If the GSE's were privatized, wouldn't it result in capital being redirected away from housing toward other sectors of the economy, reducing liquidity in the secondary market, and thus resulting in higher mortgage rates for homebuyers? Why or why not? A.7. In recent years, I have become impressed with how important wide homeownership has been to a general acceptance of property rights as a pillar of our society. This is not an issue I had given

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adequate thought to previously. Hence, although subsidizing of homeownership does divert capital from more “productive” uses, it is, in my judgment, a small price to pay for the benefits.

Subsidizing homeownership, as I indicated earlier, is far more efficiently implemented by on-budget programs. Too large a part of subsidies granted implicitly to GSE's is diverted to shareholders. None is diverted from on-budget subsidies.

Whether or not privatization of the GSE would raise mortgage rates or reduce liquidity in the secondary market depends on how much the GSEs' status as Government Sponsored Enterprises, and the implied subsidy that flows from this status, actually influences mortgage rates or provides liquidity. The evidence to date is that their influence on mortgage rates is small. The consequences of privatization do not seem to be significant except to the extent that it may cause Fannie Mae's and Freddie Mac's portfolio growth rates to lessen, thus reducing the systemic risk associated with such portfolios. As I indicated during my testimony, even after any privatization, it is likely Fannie Mae and Freddie Mac would continue to play important roles in the housing and mortgage markets.

RESPONSSE TO WRITTEN QUESTIONS OF SENATOR DOLE

FROM ALAN GREENSPAN Q.1. In your testimony you state “GSE's need to be limited in the issuance of GSE debt and in the purchase of assets, both mortgages and nonmortgages.” You explain earlier in your testimony that these mortgage investments". ... concentrate interest rate and prepayment risks at these two institutions.” Some have argued that these mortgage investments help Fannie and Freddie to fulfill their mission. What are your thoughts on that? A.1. Federal Reserve staff is not aware of any evidence that convincingly shows that channeling GSE activity toward mortgage securitization and away from holding mortgage-backed securities in portfolio would negatively impact liquidity in mortgage markets. Whatever liquidity or other benefits the GSE's bring to the markets, if any, likely can be supported by GSE's with a greater emphasis on mortgage securitization and with less emphasis

on enhancing their subsidy by holding their own MBS. Moreover, as I noted in my testimony, any proposal to direct the flow of Fannie Mae's and Freddie Mac's activities toward mortgage securitization would still leave the GSE's among the largest financial institutions in the United States and would allow them to grow with the mortgage markets. Q.2. Chairman Greenspan, the General Accounting Office has warned us that the incentives to use the benefits of Government sponsorship to increase shareholder value could, over time, erode the public mission. Do you agree with that warning? A.2. Given the large nonmortgage portfolios held by the GSE's, I can understand GAO's concern. Q.3. In your testimony you state: “... 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." Do you believe there is any practical way of strengthening

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