Freddie Mac will not have an option to move to a different charter, and therefore some other mechanism must be developed.

There are many different ways to achieve this objective. Fundamentally, it should involve some wider review within the Administration of the new agency's budget. Congress could mandate transparency for the new agency's funding by requiring it to release for notice and comment a proposed budget and resulting assessment. This would be similar to the approach used by the National Credit Union Administration. Or the increase from year to year could be based on an objective index. Of course, we would support the agency's ability to obtain additional funding mid-year if nec

essary.

Currently, OMB authority to apportion agency funds is an important check in ensuring the most effective and economical use of resources. Their authority covers agencies funded both through the appropriations process and outside of it, and we believe it would be an important level of review that should be adopted for the new safety and soundness regulator.

A new regulator must not only have necessary resources, but those resources must also be spent appropriately. Today, the OCC and the OTS devote more than three quarters of their budgets to examination and supervision. This emphasis in their budgets is evidence of these agencies' focus on examination and supervision to monitor continuously the safety and soundness of the regulated enterprises. A new regulator for the Fannie Mae and Freddie Mac should have a similarly clear focus on examination and supervision, with a similar division of resources to ensure the regulator's priority remains on on-site, daily oversight of the safety and soundness of the operations of the regulated companies.

Independence

The independence of the new regulator is also an issue of discussion in the current legislative debate. In particular, policymakers today differ over the independence of the new regulator with respect to funding, testimony, and regulation. As I stated earlier, we do believe that there must be some review of the assessments the regulator levies on the company, to ensure the budget fully funds the regulatory mission of the agency but does not include arbitrary assessments. Because we cannot change regulators the way banks can, we favor outside review of the new regulator's budget.

With regard to the issuance of regulations, currently OFHEO's regulations are reviewed by OMB. That practice does afford broader policy input into any proposed regulation, and we believe that broader input has value. The third issue, review of testimony, raises important questions that Congress and the Administration will have to address directly and resolve.

The Powers of a New Regulator

The new regulator must have the powers necessary to carry out its role. The current debate over these powers has focused on capital, prompt corrective action, and new program approval. Let me take up each of those issues separately.

The Appropriate Capital Regime

Capital requirements are a fundamental part of financial regulation. The approach Treasury put forward in testimony before the House Financial Services Committee focuses on ways to give the regulator more flexibility in aligning capital requirements with the risks Fannie Mae takes on, while ensuring that we can continue to fulfill our mission. It is this balance that Congress struck in 1992, and it is a balance Congress should maintain in any proposed legislation.

As you know, Fannie Mae has two capital standards, a minimum capital (or leverage) requirement, and a risk-based capital requirement. The minimum capital requirement sets a floor and also incorporates the indefinable, non-quantifiable risk present with any institution. Fannie Mae must hold the greater of the minimum capital requirement or the risk-based capital requirement.

Minimum capital is defined as the sum of 2.50 percent of on-balance sheet assets and 0.45 percent of mortgage-backed securities guaranteed by, but not owned by, Fannie Mae. Including capital for off-balance sheet obligations distinguishes Fannie Mae's minimum standard from the bank leverage ratio, which requires that banks hold capital only against on-balance sheet assets.

Calculated in the same manner as the bank leverage ratio, Fannie Mae's core capital was 3.3 percent of on-balance sheet assets, or $30.7 billion, as of June 30, 2003. Furthermore, beginning in 2001, Fannie Mae has issued subordinated debt as a supplement to our equity capital. Subordinated debt can act as a risk-absorbing layer on top of core capital and can serve as a market signal of a corporation's credit risk. Fannie Mae's subordinated debt outstanding totaled $11.5 billion at June 30, 2003, or 1.2 percent of on-balance sheet assets. Thus the sum of core capital and out

standing subordinated debt represented 4.5 percent of on-balance sheet assets at the end of the second quarter, or $42.2 billion.

Fannie Mae's minimum capital requirement should be viewed in the context of the limited business in which we operate. By law, we invest only in residential mortgages, which are less risky than many bank investments such as consumer debt, commercial real estate, or foreign debt. Furthermore, our book of business is more geographically diverse than most banks, and we are required to have losssharing agreements on higher-risk loans.

As a result, Fannie Mae has far lower losses than other lenders. For instance, Fannie Mae's credit losses in 2002 were 0.5 basis points of our total single-family mortgages. That compares with bank credit losses on mortgages of 15 basis points in 2002. Furthermore, while Fannie Mae's losses have trended sharply lower in the last 5 years, banks' losses on mortgages have not followed a similar pattern.

The further an institution moves away from specialization in mortgages, the greater the level of losses relative to capital. Reflective of our low level of risk, Fannie Mae's capital was 357 times its credit losses for the first two quarters of 2003. The thrift industry, which also specializes in mortgages, had a comparable ratio of 47:1, less than one-seventh the capital coverage that Fannie Mae had. Large commercial banks, on the other hand, had a capital coverage ratio of only 15:1, with the entire banking industry at 18:1.

The question for policymakers is not how to eliminate credit risk from the system. That is not possible. The question is how do institutions manage this risk, and what capital is necessary to cover the risk. In the event of a credit crisis, Fannie Mae is in a much stronger position to survive than are the other potential holders of mortgage credit risk. If credit losses were to increase by a factor of 20, Fannie Mae would have sufficient capital to cover the resulting losses. The average bank

wouldn't.

For these reasons, Fannie Mae's minimum capital requirement should remain set in statute at 2.5 percent for on-balance-sheet assets and 0.45 percent for off-balancesheet assets. Doing so supports Fannie Mae's mission of bringing low-cost capital to housing. Increasing minimum capital absent any increase in risk raises the cost of capital to housing and undercuts our ability to fulfill our mission of constantly providing liquidity in all markets and through all economic conditions. Quite simply, if you raise capital requirements for the same level of risk, you will substantially reduce the impact Fannie Mae can have in fulfilling its mission.

Of course, a key responsibility of a safety and soundness regulator is to evaluate continuously the risks the company faces and adjust capital requirements accordingly. Financial regulators achieve this goal through a risk-based capital standard. In Fannie Mae's case, this requirement is determined by a statutory "stress test," computing the capital needed to survive a prolonged adverse economic environment, assuming no new business and adding a 30 percent capital cushion for operations risk. The regulation that implements this standard has been in place for one year, after 10 years of development. Fannie Mae has met the requirements of that rule every quarter.

A world-class regulator must have the ability to adjust this risk-based capital requirement to reflect both changes in the economy and in the risks facing an institution. Under the current statute, our regulator has considerable flexibility to adjust the standard. The Administration has asked for additional flexibility in this area. We support giving the regulator more flexible authority in this area, while recognizing that there is a need for stability in capital standards, which should not be subject to frequent change. Additional flexibility in altering the risk-based capital standard will ensure that the regulator can require the companies to hold appropriate levels of capital consistent with the risks they take.

Location and Standard for New Program Approval

To carry out our mission effectively, Fannie Mae must be able to harness the innovation and efficiency of the private sector to promote affordable housing as a clearly articulated public policy goal. The standard Congress created in 1992 has fostered an environment of unprecedented innovation in the mortgage industry over the last 10 years.

In a constantly changing interest rate environment and faced with unprecedented volumes of business, Fannie Mae and the mortgage finance industry have created a revolution in underwriting, product innovation, and streamlined technology processes, to produce significant gains in lending to low- and moderate-income and other traditionally underserved borrowers. We have automated our underwriting, reducing mortgage origination costs by an average of $800, and enabling applicants to get an answer from a mortgage lender in minutes rather than weeks. Our improved credit analysis has helped us to develop mortgage products for credit-impaired bor

rowers who previously had little access to conventional mortgages. We have worked with lenders to develop low-downpayment loans, bringing homeownership within reach of Americans who can afford a monthly mortgage payment but do not have savings for a 20 percent downpayment. Much of this innovation is driven by our lender customers, who routinely challenge us to add features to match their offerings, and to partner with them to increase access and efficiency.

Some of our competitors have decried innovation as somehow outside our charter. But the facts are these: In 1992, when our charter was last revised, mortgages made up 86 percent of Fannie Mae's total assets. Another 11 percent was devoted to maintaining necessary liquidity and the remaining 3 percent consisted of other assets. In 2002, mortgages made up 90 percent of Fannie Mae's total assets. Another 7 percent was devoted to our liquidity portfolio and—just as in 1992-only 3 percent consisted of other assets. Clearly, our devotion to our mission has not changed. The innovations we have pioneered or adopted from others are not only within our charter; but they are also necessary to meet our charter obligations. We cannot serve our mission of making homeownership more affordable unless we can innovate continuously to create products and processes that better serve the industry and homebuyers.

The mortgage market today provides consumers with a wider variety of products than ever before, and therefore is better poised to meet the individual financing needs of a broader range of homebuyers. This has been possible because the program approval requirements in the 1992 law respect the need for innovation. Lenders have felt free to innovate and develop new products to reach underserved communities because we have been able to review the products and, whenever possible, assure them that we will purchase these loans in the secondary market. Without that secondary market outlet, lenders would have to assume more risk and expense in developing innovative mortgage products that are vital for reaching new markets.

There is a consensus in the housing industry that innovation is best protected by maintaining HUD's role as mission regulator for Fannie Mae and Freddie Mac. Many of our lender partners and leaders in the housing industry, such as the National Association of Home Builders, the National Association of Realtors, the Independent Community Bankers of America, the Enterprise Foundation, LISC, and Self-Help Credit Union, fear that moving program approval authority away from HUD could diminish housing as a public policy priority, and create a barrier to innovation that hinders us from achieving our mission within our charter. We share those concerns, and as a result we support maintaining HUD's authority to review new programs.

The current debate over whether program approval authority should be housed at HUD or at the new Treasury bureau misses a critical point. Maintaining HUD's role as mission regulator to review new programs does not diminish the power and authority of the safety and soundness regulator on matters of financial risk. In our view, a world-class financial regulator must have the ability to address any issues that pose a risk to safety and soundness. The new regulator will have on-site examination staffs_continually reviewing and assessing programs, products and business processes at Fannie Mae. Just like a bank regulator, the new bureau could examine any activity in detail at any time, and address any activity it found to pose a safety and soundness risk, even if it has been approved by HUD for charter compliance. Wherever Congress decides to locate the program approval authority, our greatest concern is that the process and standard allow Fannie Mae the freedom to work with lenders to create innovative mortgage products that meet consumers' needs. Lenders eager to reach underserved communities have developed mortgage features that make homeownership more affordable to these communities. Before they make these innovative mortgages available, they want to know that Fannie Mae will purchase them in the secondary market.

If new legislation creates a bureaucratic process in which every new mortgage "product" or "activity" must be formally approved before we can tell a lender we will buy it, or every process innovation to improve efficiency must first be vetted by some third party, then innovation to address tough housing problems will come to a screeching halt. Without a secondary market partner, lenders will be less able to pursue the creative partnerships that are critical to meeting Congress' public policy goal of bringing homeownership opportunities to underserved communities. Any new program approval regulatory regime must ensure Fannie Mae's continued freedom to work with lenders, non-profits, community organizations and local governments to develop new products and new business processes without intrusive regulation that seeks to replace business judgment with the government's judgment.

Prompt Corrective Action Authority

In determining the appropriate and necessary powers to ensure a world-class regulator for Fannie Mae, there has also been some debate over what prompt corrective action, or PCA, powers a new regulator should have.

Congress created a PCA regime for OFHEO one year after creating a PCA regime for bank regulators, purposely altering the bank regime to make it appropriate to Fannie Mae and Freddie Mac. Because Fannie Mae and Freddie Mac differ from banks, Congress crafted a prompt corrective action regime for OFHEO that focuses specifically on how Fannie Mae and Freddie Mac operate in the secondary market without importing those wholly inapplicable aspects of the bank-like PCA regime. Interestingly, prompt corrective action is not the preferred method of supervisory enforcement by banking regulators. In fact, capital deterioration is seen as a lagging indicator of problems at banks. Thus, bank regulators often take action pursuant to their cease and desist, civil money penalty, and suspension and removal authority long before a bank would be subject to PCA. As reflected in its enforcement regulations and as we have seen by the recent actions it has taken, OFHEO has considerable enforcement authority. Fannie Mae supports the enhancement of these authorities by giving the new regulator cease and desist and civil money penalty authority consistent with the authority of bank regulators. Fannie Mae also supports the addition of express authority for the new regulator to suspend and remove personnel from the Enterprise for violations of laws, regulations, final cease and desist orders and written agreements.

As part of our PCA regime, Congress specifically provided for the authority of our regulator to appoint a conservator should an enterprise become significantly or critically undercapitalized. By providing for a conservatorship process in the 1992 Act, Congress, and in particular this Committee, made clear its preference that an enterprise be privately recapitalized rather than liquidated in order for the important mission of the Enterprise to be protected. Moreover, Congress reserved, as Fannie Mae and Freddie Mac's chartering body, the right to extinguish those charters.

We welcome Congress' discussion of potential enhancement of the conservatorship powers enumerated in the 1992 Act. Certainly, we believe a conservator for an enterprise should be able to take such actions as may be necessary to put the Enterprise in a sound and solvent condition as well as those that are appropriate to carry on the business of the Enterprise and preserve and conserve the Enterprise's assets and property.

HUD's Continuing Oversight Role

Finally, the Committee has asked for our thoughts on HUD's role in the oversight of the Fannie Mae and Freddie Mac. As I stated earlier, I support maintaining HUD's authority to review new programs for charter compliance, and I share the concerns of the housing industry that moving this authority from HUD to the Treasury Department could diminish the overall public policy commitment to homeownership as a national priority.

Let me comment on legislative proposals regarding HUD's authority with regard to housing goals. HUD sets housing goals as a regulatory requirement to ensure that Fannie Mae focuses particular attention on low- and moderate-income borrowers and underserved areas. We have consistently exceeded those goals every year since 1994. The agency is currently developing proposed goals for next year and beyond.

Over the years, HUD has sought to establish goals that require the company to stretch beyond levels we might otherwise achieve, without threatening our safety and soundness or jeopardizing the liquidity of the mortgage finance system. HUD relies on predictions of market size to establish these goals. This kind of forecasting is not easy and predictions are likely to be inexact. The record-breaking refinance boom of the last 2 years, for instance, has resulted in a dramatically different mortgage market from the one envisioned when the current goals were set in 2000, substantially increasing the difficulty we face in meeting them.

Setting goals in the midst of changing markets requires flexibility-for HUD in setting the goals and for Fannie Mae in meeting them. HUD's recasting of the goals in 2000 is an example of the flexibility it has under current law. The Department increased all three housing goals. The goal for Fannie Mae's purchase of loans to low- and moderate-income borrowers, for instance, was increased from 42 percent in 1999 to 50 percent in 2001. In addition, the new goals created bonuses that gave Fannie Mae the incentive to pay special attention to financing small multi-family properties and owner-occupied 2-4 unit properties, which HUD identified as having particular value to underserved groups and which it believed would benefit from increased participation by Fannie Mae and Freddie Mac.

Fannie Mae also has flexibility under the current structure. We must meet three national goals through a combination of our single-family and multi-family businesses, including all types of business-both refinances and purchase money mortgages that we engage in. And we must pursue this focus on affordable lending while serving the broader market. Under the current framework, Fannie Mae has been able to achieve both objectives, though it has been very difficult in some years. Going forward, it is critical that Congress not change the structure of housing goals in a way that would fragment the market Fannie Mae serves. The mortgage market in the United States is a national market, with mortgage rates essentially the same in every community in America. Indeed, Fannie Mae and Freddie Mac were founded to, among other things, provide stability in the secondary market for residential mortgages and promote access to capital throughout the Nation by increasing the liquidity of mortgage investment and improving the distribution of investment capital. A series of regional goals, as some have suggested, could disrupt the free flow of capital into certain areas in favor of others and place these founding principles at risk. In addition, the proliferation of national goals would similarly begin to fragment the market among a number of competing credit priorities and weaken our ability to bring efficiencies to the market.

Therefore, it is essential that our affordable housing requirements drive us to expand access to underserved communities without undermining our support for the broader market. The Administration's proposal, which appears to establish a series of home purchase goals and give the Secretary open-ended authority to set or amend additional national goals would, we believe, undermine our ability to support the broader market.

Conclusion

I have tried to respond to the specific issues that have been at the center of the legislative debate over the last few weeks. I am sure there are other issues I have not addressed, and I look forward to discussing these topics with you as well.

We as a society have long made homeownership a national policy priority. And the work of the Congress to address that priority has been an unprecedented success. We have the most effective and efficient home mortgage market in the world, continually working to make homeownership affordable to an ever larger number of Americans.

I have attached the testimony delivered to the House Financial Services Committee last month, which lays out the steps Congress has taken and the steps we have taken that together have expanded homeownership opportunities for millions of America's families. I believe Congress has an opportunity this year to build on this success, by creating a new financial regulator that will ensure the continued health of the mortgage finance market and enable us to continue bringing low-cost financing to millions of American homeowners.

PREPARED STATEMENT OF GEORGE D. GOULD
PRESIDING DIRECTOR, FREDDIE MAC

OCTOBER 16, 2003

Thank you, Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee. Good morning. It is a pleasure to be here today. My name is George Gould.

I have served on Freddie Mac's board since 1990 and am currently the Presiding Director and Chairman of the Governance and Finance Committees. I am also Vice Chairman of Klingenstein, Fields & Company, a firm that manages individual assets and estates. Prior to joining this firm, I served as Undersecretary for Finance at the Department of the Treasury from 1985 to 1988. At the request of President Reagan, I chaired the Working Group on Financial Markets to examine the effect of the October 19, 1987 stock market crash.

I welcome the opportunity to be here today to discuss key aspects of a strengthened regulatory structure for Freddie Mac and Fannie Mae. Freddie Mac plays a central role in financing homeownership and rental housing for the Nation's families. Our job is to attract global capital to finance America's housing. Given the importance of housing to our economy, and the importance of housing finance to global capital markets, it is critically important that our regulatory structure provide world-class supervision. Hence, I would like to recognize Senators Hagel, Corzine, Sununu, and Dole for their legislative efforts in this regard. We commend them for helping to get these important discussions off the ground.