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pact, and this goes to what I think is the biggest myth, that is, that Fannie Mae has the lowest cost of funds out there.

What I have plotted on this chart is since 1994 the cost of funds for commercial banks and for Fannie Mae. If you look at the cost of funds for the commercial banks, they are the low end, but it is cheating a little bit because they actually have to run branches and things to collect these funds, so it is not free. We have adjusted for that cost. As you see, throughout this entire period banks have had a lower cost of funds than Fannie Mae, and as my CFO likes to say, the real proof of this is that banks buy Fannie Mae debt. We do not buy deposits. We cannot make money buying deposits, but they make money buying Fannie Mae debt. Indeed, some people say they buy too much Fannie Mae debt, but there is no doubt that they buy Fannie Mae debt. How could they buy our debt, which is our cost of funds, if their cost of funds was higher than ours?

The great myth here is that Fannie Mae is sitting with a much lower cost of funds. Banks, if they want to grow their mortgage portfolio, do it, and we step aside. When they stop wanting to grow their mortgage portfolio, we step up. They may say, “Ah, but you can go into the agency market.” I showed you before they do not use long-term debt very much in their funding, but they can go in the agency market too through the Federal Home Loan Banks. Their primary job is to fund banks out of the agency market. So they borrow at essentially the same cost that we do and pass it on to banks. So they have lower cost deposits and the same long term funding cost as we have. So that is a pretty good deal.

The tears that are shed on behalf of the banks that somehow we have an unfair advantage against them, I do not see it. I see them able to grow whenever they want to grow, to move from business to business whenever they want to, to merge into very large institutions without anyone being concerned that somehow there is systemic risk being created or the system is at risk. I think they do a great job as diversified financial institutions. We do a pretty good job as institutions who are focused on the housing market.

Chairman SHELBY. Senator Carper, could I just interject?
Senator CARPER. Sure.

Chairman SHELBY. A lot of the banks say you have, the GSE's the unfair advantage and so forth. What is your answer to that? Is that your answer?

Mr. RAINES. I say on the cost side it is pretty clear that we do not. They have never been able to explain to me why they buy our debt if our debt is lower than their cost of funds. But even on the capital side we do not have an advantage. In fact, I would be willing to trade with them. If they are willing to take our capital standard and be subject to the OFHEO risk-based capital standard where they have to have sufficient capital to withstand huge movements in interest rates and depression level credit losses

Chairman SHELBY. They are into a lot of things that you are not into in the whole panoply of financial services. You are in a specialty.

Mr. RAINES. That is one reason why they need to hold a lot more capital because most of the things they are in outside of housing are far more risky.

But our capital standard is so rigorous that we had a firm a couple of years ago look at it and see what would happen to a thrift, which was the closest comparison to us without all these other businesses. If OFHEO capital standard were applied, the thrift would have to have 50 percent more capital.

Again, there is a lot of myth and legend that has been repeated over and over again that Fannie Mae has an easier capital standard, that we have cheaper cost of funds. The fact of the matter is that we do not.

Senator CARPER. I would like to yield back the balance of my time to Senator Dodd.

Chairman SHELBY. That was kind of you.
Senator Sarbanes.
Senator SARBANES. Thank you, Mr. Chairman.

I want to ask first what your position is on whether approval from the regulator should be required with respect to new product lines or product activity?

Mr. SYRON. Senator, I think it depends on how one defines those terms.

Senator SARBANES. Let me stop you right there. Do you agree with that?

Mr. RAINES. With what he just said so far?
Senator SARBANES. Yes.
Mr. RAINES. Yes, it does.
Senator SARBANES. Do you also agree with that, Mr. Rice?

Mr. RICE. We operate under a situation today that they approve any new business activity, the Finance Board.

Senator SARBANES. And do you think the regulator should have that power?

Mr. RICE. I have no problem with it.

Senator SARBANES. Even under a new structure here, okay. Do you agree with that statement? Mr. SYRON. As I understand the statement, I agree with it. [Laughter.] I will not claim that I understand it, Senator.

Senator SARBANES. Rather than giving me all the qualifications, each of you tell me what power you think the regulator should have in this area?

Mr. SYRON. Can I try to answer that? Let me give you a case in which I think they should not be required to approve it and a case in which I think they should be required to approve it. Should we decide we are not about to do this—but should we decide that we wanted to offer something like mortgage insurance or to go further toward the retail end, toward the origination end, I totally agree that the regulator

Senator SARBANES. No, no. I have to get you down into the ball game. I have to get you onto the ball field. It does not help me to get these examples that are outside of the ball park because if we are going to have a regulator, the first question is are they going to have power in this area. Everyone, as I understand it, has said, yes, but it has to be properly defined, and I am trying to get a definition out of you. I want to know where you see the line, how do you define that line?

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Mr. RAINES. Let me take a crack at that. I believe that the line should be exactly where it is today, at the program level. If we are doing something brand new, then the regulator should have the ability to preapprove that.

Chairman SHELBY. Or reject it.

Mr. RAINES. Or reject it. But, for example, one of the first things I did when I came in as Chairman of Fannie Mae is we had never been in the business of helping people with impaired credit. It was within our loan limit. It was a conventional loan. It was a mortgage. We had simply set our standards at a level that made them not qualify. I do not think I should have had to go to a regulator and say: Well, what do you think? Do you think that we should be able to do that? We cut down payments. I do not think we should have had to go to the regulator with that. I announced 3 or 4 weeks ago our expansion of our American Dream Commitment, 60 different initiatives. I do not think that the regulator should have been telling me whether or not I should set a goal of increasing the minority homeownership rate to 55 percent. I do not think they should be in the business of telling me that we should or should not be able to tighten up our predatory lending standards. I think that should be left to private management.

But for example, we had never been in the business of doing acquisition, development, and construction financing, which is different. We took that to HUD and HUD looked at it and they approved it. They could have said no. But that was a wholly different thing. It was not a mortgage where we were changing around the criteria. It is a wholly different business that we had been encouraged to get into, and we experimented with in cooperation with HUD. They approved that. So that is the distinction.

If every time I have a new product or a new activity, and I have to get approval, do you have any idea how long it would take me to get the 60 initiatives approved, even just to put together the request and to have all of the evidence that a regulator would want to look at? That is not a business. That is running a bureaucracy, and I do not think that the Congress should want to turn these companies that have been innovative companies with private management, into simply an extension of a bureaucracy.

Chairman SHELBY. Excuse me. I know it is Senator Sarbanes' time. How would you compare that to a bank regulator for a bank to get into various things, do they have to deal with a regulator?

Mr. RAINES. Banks do not have prior approval as long as they are within banking. Only if they are going into one of these new powers do they have to go and get approval. So it is quite similar. The term "new activity” is probably the most pernicious aspect of this because every time we change a process, we would have to go and get approval from a regulator. I think it would stifle not only these businesses but also any business. I cannot see how any entrepreneurial enterprise, public or private, could operate having to ask permission every time they wanted to have an innovation.

Senator SARBANES. Mr. Raines and Mr. Syron, everyone asserts that you get a subsidy flowing off of the implicit guarantee, and then there are various figures as to what portion of that subsidy gets passed through in order to benefit the consumer. What do you think the figure is that passes through to benefit the consumer?

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Mr. RAINES. I think I can illustrate it for you pretty easily because we see it every day, and we can calculate it for you, and this may be a little bit different way than you have seen it before, but it is pretty clear as to what happens. This chart compares our market, the conforming market, below the $333,700 in the jumbo market. What I am comparing at the top is the yield on a mortgagebacked security issued by Fannie Mae versus a mortgage-backed security issued by a bank or someone else in the jumbo market. You can see that the difference in the yield between the two is about 21 basis points. That is what we bring to the party. The way we reduce rates is to bring down the yield on our mortgage-backed securities. We do that by increasing liquidity and by buying them ourselves through our portfolio. That is our contribution.

Everything after that is our cost of a guarantee fee and lender costs. When you get down to the primary rate, the rate that you find out in the market, the consumer is paying 5.93 percent versus 6.19, actually it expanded. Our 21 basis points became 26 basis points. This is why we say we pass on more than all of the benefit. If you give the “implied guarantee” all the credit for that 21 basis points at the top—which we do not, we think we actually do some things here; our liquidity actually is a big piece of that. But if the Government got 100 percent of the credit for that 21 basis points, by the time it gets to the consumer it turned into 26 because our system is more efficient than the jumbo system. Ours has more liquidity. Lenders have to compete more ecause we have more small lenders who are competing in our market than in the jumbo market.

This is not based on some fancy equation. This is simply going into the market and looking at every element between the issuance of that mortgage-backed security, which is the cost of funds for that mortgage, and the rate the consumer gets. I offer that up to you as far better proof than econometric models that try to calculate the same thing, not by observing what happened in the market, but by running mathematical equations to simulate what happens in the market.

Senator SARBANES. Is it your position that whatever subsidy you get is entirely passed through and that none of it stays within the confines to benefit the shareholders of the company?

Mr. RAINES. That is indeed our position. The shareholders in the company are

Senator SARBANES. No one else has come here and taken that position.

Mr. RAINES. I have taken that position for years, and Fannie Mae has taken that position for years, and there are a number of studies that have been taken on, that have been conducted by conservatives, by liberals and others, who have come to exactly the same conclusion. We can provide the Committee with those studies that have examined that issue.

Chairman SHELBY. Could you do that?

Senator SARBANES. If we were to look at all these studies, your and others, and conclude that the subsidy was not being entirely passed through, what do you think should be done about that if anything?

Mr. RAINES. You have to ask the question, what is it that we do? If you believe that some of the “subsidy” was not being passed on, let us look and see where all the money that we make goes, and we can figure out where we think there is an excess. This chart shows for last year our total pretax earnings. This goes

to the question, where does it go? Twenty-five percent of it the Federal Government gets in income taxes. We are a full Federal income taxpayer, probably one of the largest in the country. Twenty-five percent goes there. Fifty-seven percent goes to capital, to bolster that capital which is the safety that we have been talking about. Our shareholders only get 18 percent of it now. So if there is a dollar of subsidy that we get, this is a pretty good idea of where it goes now. The question is: Who should it be taken from if it is going to go some other place? Are we going to take it out of capital? Are we going to take it out of the taxes or are the shareholders supposed to give up of the 18 percent they get of the funding? There is no magical

Senator SARBANES. How is it your shareholders do so well on a comparative basis, double figure payoffs and

COMMENTS OF SENATOR JON S. CORZINE
Senator CORZINE. Would the Senator yield?
Senator SARBANES. Certainly.

Senator CORZINE. I do think that the build-up in capital has something to do with shareholder value. If I am not mistaken, it does increase the book, and therefore somebody has some perspective on what value is created.

Mr. RAINES. Except the only problem here is that they can never liquidate the firm. So the only way they can

Senator CORZINE. They can liquidate the stock. The marketplace has decided the value.

Mr. RAINES. Because they cannot liquidate the firm the capital is stuck inside the firm.

Senator CORZINE. That is true.

Mr. RAINES. But also with regard to the returns, let us be brutally honest here. Fannie Mae has a price-to-earnings ratio of about 9, which is half of the P/E ratio of the S&P 500 average. So we are half of the average companies' P/E. This is not a sign that shareholders think they are getting a fabulous deal. If they thought they were getting a fabulous deal, our P/E ratio would at least be equal to the average company:

I am not poor-mouthing, saying that somehow you need to help us. I am just simply saying the idea that somehow that our shareholders are getting a bonanza, when in fact, our stock has not performed even at the same level as other financials have over the last 5 years, says something about our relative position. It may be a good thing to be a financial, although all the financials have relatively low P/E's, but this is not the market indicia of a company that is collecting what economists would call rent, ordinarily having a return higher than the market, not lower.

Senator SARBANES. Is it your position that you cannot assume any greater burdens of responsibilities with respect to affordable housing because you are really stretched right out to the limit; is that right?

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