[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
GSE OVERSIGHT: THE NEED FOR
REFORM AND MODERNIZATION
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
CAPITAL MARKETS, INSURANCE AND
GOVERNMENT SPONSORED ENTEREPRISES
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
__________
JUNE 25, 2003
__________
Printed for the use of the Committee on Financial Services
Serial No. 108-43
91-771 U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2003
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512�091800
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HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana MAXINE WATERS, California
SPENCER BACHUS, Alabama CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio GREGORY W. MEEKS, New York
JIM RYUN, Kansas BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North CHARLES A. GONZALEZ, Texas
Carolina MICHAEL E. CAPUANO, Massachusetts
DOUG OSE, California HAROLD E. FORD, Jr., Tennessee
JUDY BIGGERT, Illinois RUBEN HINOJOSA, Texas
MARK GREEN, Wisconsin KEN LUCAS, Kentucky
PATRICK J. TOOMEY, Pennsylvania JOSEPH CROWLEY, New York
CHRISTOPHER SHAYS, Connecticut WM. LACY CLAY, Missouri
JOHN B. SHADEGG, Arizona STEVE ISRAEL, New York
VITO FOSSELLA, New York MIKE ROSS, Arkansas
GARY G. MILLER, California CAROLYN McCARTHY, New York
MELISSA A. HART, Pennsylvania JOE BACA, California
SHELLEY MOORE CAPITO, West Virginia JIM MATHESON, Utah
PATRICK J. TIBERI, Ohio STEPHEN F. LYNCH, Massachusetts
MARK R. KENNEDY, Minnesota ARTUR DAVIS, Alabama
TOM FEENEY, Florida RAHM EMANUEL, Illinois
JEB HENSARLING, Texas BRAD MILLER, North Carolina
SCOTT GARRETT, New Jersey DAVID SCOTT, Georgia
TIM MURPHY, Pennsylvania
GINNY BROWN-WAITE, Florida BERNARD SANDERS, Vermont
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
Robert U. Foster, III, Staff Director
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises
RICHARD H. BAKER, Louisiana, Chairman
DOUG OSE, California, Vice Chairman PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware GREGORY W. MEEKS, New York
PETER T. KING, New York JAY INSLEE, Washington
FRANK D. LUCAS, Oklahoma DENNIS MOORE, Kansas
EDWARD R. ROYCE, California CHARLES A. GONZALEZ, Texas
DONALD A. MANZULLO, Illinois MICHAEL E. CAPUANO, Massachusetts
SUE W. KELLY, New York HAROLD E. FORD, Jr., Tennessee
ROBERT W. NEY, Ohio RUBEN HINOJOSA, Texas
JOHN B. SHADEGG, Arizona KEN LUCAS, Kentucky
JIM RYUN, Kansas JOSEPH CROWLEY, New York
VITO FOSSELLA, New York, STEVE ISRAEL, New York
JUDY BIGGERT, Illinois MIKE ROSS, Arkansas
MARK GREEN, Wisconsin WM. LACY CLAY, Missouri
GARY G. MILLER, California CAROLYN McCARTHY, New York
PATRICK J. TOOMEY, Pennsylvania JOE BACA, California
SHELLEY MOORE CAPITO, West Virginia JIM MATHESON, Utah
MELISSA A. HART, Pennsylvania STEPHEN F. LYNCH, Massachusetts
MARK R. KENNEDY, Minnesota BRAD MILLER, North Carolina
PATRICK J. TIBERI, Ohio RAHM EMANUEL, Illinois
GINNY BROWN-WAITE, Florida DAVID SCOTT, Georgia
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
C O N T E N T S
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Page
Hearing held on:
June 25, 2003................................................ 1
Appendix:
June 25, 2003................................................ 45
WITNESSES
Wednesday, June 25, 2003
Cochran, Jay, Research Fellow, The Mercatus Center, George Mason
University..................................................... 22
Eagan, Sean J., Managing Director, Egan-Jones Ratings Co......... 17
Petrou, Karen Shaw, Co-Founder and Managing Partner, Federal
Financial Analytics, Inc....................................... 24
Schatz, Thomas A., President, Citizens Against Government Waste.. 85
APPENDIX
Prepared statements:
Oxley, Hon. Michael G........................................ 46
Baker, Hon. Richard H........................................ 47
Clay, Hon. Wm. Lacy.......................................... 50
Gillmor, Hon. Paul E......................................... 52
Kanjorski, Hon. Paul E....................................... 54
Maloney, Hon. Carolyn B...................................... 56
Royce, Hon. Edward R......................................... 58
Shays, Hon. Christopher...................................... 59
Cochran, Jay (with attachment)............................... 61
Eagan, Sean J................................................ 72
Petrou, Karen Shaw........................................... 78
Schatz, Thomas A. (with attachment).......................... 85
Additional Material Submitted for the Record
Maloney, Hon. Carolyn B.:
Left Out of Bill, Old Vision for Radical Reform, American
Banker, June 25, 2003...................................... 104
GSE OVERSIGHT: THE NEED FOR
REFORM AND MODERNIZATION
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Wednesday, June 25, 2003
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance,
And Government Sponsored Enterprises
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to call, at 10:01 a.m., in
Room 2128, Rayburn House Office Building, Hon. Richard Baker
[chairman of the subcommittee] presiding.
Present: Representatives Baker, Ose, Shays, Gillmor,
Bachus, Castle, Lucas of Oklahoma, Royce, Manzullo, Oxley (ex
officio), Kelly, Ney, Fossella, Green, Miller, Hart, Kennedy,
Tiberi, Harris, Kanjorski, Hooley, Meeks, Inslee, Moore, Frank
(ex officio), Ford, Lucas of Kentucky, Crowley, Clay, McCarthy,
Baca, Miller, and Scott. Also present: Representatives Watt and
Maloney.
Chairman Baker. I would like to call this meeting of the
Capital Markets Subcommittee to order.
June 15, 2002 was an important day in the history of our
national economy. The accounting firm of Arthur Anderson was
found guilty of obstructing justice by a Texas jury on that
day. The decision ultimately led to the demise of the
accounting firm and brought about a thorough reexamination of
our entire accounting industry. Frankly, the outcome could have
been a lot worse. Our understanding of corporate accounting
practices was limited, and action was quickly taken to enhance
the regulatory oversight of the industry with the passage of
the Sarbanes-Oxley Act.
However, there continue to be important elements of our
economy left, inappropriately in my opinion, outside the scope
of the Sarbanes-Oxley required disclosures. These are the only
two Fortune 500 corporations today exempted from these
essential reforms. Why were they exempted? The answer is that
they are too well run to worry about. They have set a standard
of corporate governance to be emulated by others. And by the
way, we want to make sure we don't throw anyone out of the
opportunity of homeownership. They are, of course, the two
housing GSEs.
The events surrounding the fall of Enron are indeed
unfortunate, particularly for the employees, but for anyone who
had a financial stake in the corporation. However, if either of
the nation's GSEs were to suffer a financial reversal of
similar scale, the systemic consequences are difficult to
comprehend.
The Capital Markets Subcommittee is meeting today on this
very important matter, but frankly as a result of events that
are not of our own making. The announcement by Freddie Mac that
their recent accounting practices did not properly reflect
their operations is cause for significant concern. In fact, the
initial restatement announcement was again amended just this
morning, raising the total misreported income from the original
estimate of $1 billion to $3 billion, now to in excess of $4
billion. The revelation underscores the importance of what has
been previously observed by many, and that is our current
regulatory oversight is not adequate.
To those who point out that this is an announcement of an
increase in revenue, not losses, we should not miss the
troubling point of this news if you were a shareholder of
Freddie Mac. If you sold your interest in the company before
the balancing adjustment was corrected, you were denied your
fair distribution of company earnings by this unfortunate
manipulation. I believe you will find adequate legal filings
now on record to confirm this view.
More importantly, the explanation given for the misstep is
that the corporation did not have enough properly trained staff
to oversee its complicated derivatives portfolio. Why were they
exempted from Sarbanes-Oxley? I ask again. Where was the
regulator during the 3 years this error was unreported? If
Freddie did not have enough invested in staff to properly
oversee these complex activities, how can anyone argue that
OFHEO was properly supported for the same purpose?
We should be more than just concerned. In fact, we should
feel like any other corporate CEO in America whose oversight
has been found lacking. These enterprises are our creation and
clearly our responsibility Today, nothing stands between
corporate losses and the American taxpayer except the
regulators. We are the regulator of last resort.
In spite of this circumstance, some may suggest that any
examination of the GSEs will result in market instability and
potentially throw unsuspecting victims out of the opportunity
for homeownership. I have only one question to ask. How is that
a now readjusted restatement figure, up from $3 billion to now
in excess of $4 billion, over a 3-year period of operations,
has not crippled corporate activity and the housing market
generally? Is there any action this Congress could take that
could possibly approach the significance of these revelations?
When such disclosures were made by Enron, WorldCom and other
corporate wrongdoers, the consequences were devastating to
employees and shareholders alike. The value of corporations was
decimated, and some executives are now in court defending their
actions.
What is even more troubling than the restatement at Freddie
Mac is the realization that market observers looked past the
corporate misstatements and directly into the taxpayers's
pockets. There was no reason to be concerned as an investor
about corporate misconduct, as long as the taxpayers were
standing by ready to pick up the loss. This is, in my opinion,
the most troubling aspect of all. What stands between corporate
losses and the taxpayers's pocket is the regulator and not much
else.
Looking to the current structure, in fairness, the effort
made by OFHEO has been significant in light of the resource
limitations placed on them. If Fannie and Freddie were
regulated the OCC and were commercial banks, they would be
assessed by formula almost a $70 million charge for their
regulatory purpose. We have fought difficult battles in the
Congress to get OFHEO to a $30 million level. Either the OCC
really has it wrong or OFHEO is dramatically underfunded. I
think I know which it is.
However, these problems have persisted for too long. It is
no longer possible just to put a coat of paint on the walls at
OFHEO and regain the respect of the marketplace. It is time to
construct a new regulatory mechanism. It must be funded by
assessment on the enterprises. It must have real authority to
act on par with other financial regulators. It must be
constructed to ensure independence and marketplace credibility.
H.R. 2575 is built on these principles. I have not proposed
any controversial modifications to the charters of either GSE.
I have not suggested a repeal of the current line of credit to
the U.S. Treasury. I have not included the Federal Home Loan
Banks in the proposal. This is a narrowly drawn, carefully
crafted resolution intended not to create political debate, but
to effect real change.
The legislation is carefully constructed to bring about
only three goals. One is to ensure we have an independent
regulator. Two is to ensure there is reasonable funding for the
supervision. The third is to equip this regulator with all the
necessary tools any other financial marketplace regulator
utilizes. That is it. There should be no controversy over the
legislation at all in light of the revelations over accounting
irregularities. However, where there are identified concerns
that can be supported by logical argument, I am certainly open
to any constructive modification that gets us to the stated
goals of this effort.
Some may suggest an alternate location for the regulatory
home. That is fine. Others may have some objection to a
particular enforcement authority. We will examine it, but I
cannot envision such disagreements resulting in a failure to
act on the overall mission.
To date, we have been fortunate in that no significant
reversal in the housing market has occurred on our watch. But
do not forget these enterprises exist as a result of
congressional action that created them. They continue their
favored market position with our concurrence. As long as there
is profit to share, the market works well and shareholders are
happy.
The Congress is, however, directly responsible for their
supervision and regulation. If we fail in this effort by
failing to provide minimal resources for a competent regulatory
structure, the fall could be disastrous. When a GSE fails, it
will quickly fall through its limited capital, right through
the shareholders, directly to the taxpayer. That is an outcome
we cannot accept. H.R. 2575 is a modest step to give us some
assurance we take all appropriate actions to prevent that from
ever happening.
I began my remarks this morning revisiting the events of
June 15, 2002, the day Arthur Anderson was found guilty of
obstruction of justice by a Texas court. Another historic event
occurred just 24 hours earlier on June 14, 2002, not receiving
near as much attention. An object known as 2002 NM passed
within 75,000 miles of Earth, to be known in astronomical terms
as a ``near miss.'' How close is that really? Well, the moon is
about 137,000 miles away. So this object passed inside the
orbit of the moon. As far as we know, this was the second
closest near miss in human history.
So what else is significant about this event? Well, how
about this fact: Scientists on earth did not know about 2002 NM
until three days after its passage. How is this possible in
this world of scientific technological sophistication? The
answer is simple. We don't have enough resources committed or
enough people watching to assure against a clearly cataclysmic
event from occurring.
Now, I do not want to turn this hearing into a science and
technology assessment, but the parallel is clear. Unless we act
to enhance our supervisory capacity of the two housing GSEs
that Congress has created, we may not see the next systemic
event coming until it is too late. I sincerely hope that is not
the committee's decision. Today, we will hear from four
different individuals about their concerns and their
recommendations for action this committee may consider. It is
my hope the committee will find the adoption of H.R. 2575 as an
appropriate next step in this most important responsibility.
[The prepared statement of Hon. Richard H. Baker can be
found on page 47 in the appendix.]
Mr. Kanjorski, you are recognized.
Mr. Kanjorski. Thank you, Mr. Chairman.
Maybe as an aside, we should move through this and adjourn
as quickly as possible so we can return to our families.
[LAUGHTER]
Mr. Chairman, our nation's system for housing finance is
not only extremely successful, but it is also the envy of the
world. Almost 68 percent of Americans own the homes in which
they live. Government-sponsored enterprises have contributed
greatly to this accomplishment.
This success, however, should not stop us from asking
whether or how we can do a better job with respect to
regulating Fannie Mae and Freddie Mac. We should also examine
ways by which we can improve regulatory efficiency and lower
mortgage rates. The recent events at Freddie Mac related to its
earnings restatement and its management changes have
highlighted the need for continued examination of these
matters.
As you know, Mr. Chairman, I am also one of the few
remaining members of the committee who participated in the
entire congressional battle to resolve the savings and loan
crisis. I am therefore acutely aware of the need to protect
taxpayers from risk. It is in the public's interest that we
ensure that Fannie Mae and Freddie Mac continue to operate
safely and soundly. We must further ensure that these public-
private entities achieve their public responsibilities for
advancing homeownership opportunities.
We can best achieve these dual objectives by pursuing a
three-pronged supervisory approach that includes regular
congressional oversight of, sustained effective government
regulation over, and increased market discipline for the two
GSEs. Through our extensive studies and hearings over the last
40 months, we are fulfilling our obligation in the Congress to
conduct regular oversight of the GSEs.
Although we have not reached consensus on legislative
reform during the last dozen hearings on GSE regulation, I do
believe we have reached agreement on at least several key
points. First, we have agreed that we have the world's most
successful housing finance system and gained an appreciation
for the important role that the GSEs play in the system.
Secondly, we have agreed that Fannie Mae and Freddie Mac have
grown significantly in recent years. Finally, we have agreed
that we must have strong regulators for the housing GSEs.
As I said at our very first hearing on GSE regulation in
March 2000, ``We need to have strong, independent regulators
that have the resources they need to get the job done.'' I
continue to support strong GSE regulation. A strong regulator,
in my view, will protect the continued viability of our capital
markets, ensure against systemic risk, and expand housing
opportunities for all Americans.
To ensure that we have strong GSE regulation, I believe
that any legislative reforms considered by the Congress in the
future should adhere to at least five key principles. First, in
order to conduct robust supervision, a strong regulator must
have a funding stream separate and apart from the annual
appropriations process. Second, a strong regulator must have a
single leader for a set term with sole responsibility for
making decisions. Third, a strong regulator must be independent
and free from political interference. Fourth, a strong
regulator must focus like a laser exclusively on GSE issues.
And fifth, a strong regulator must have enhanced supervisory
and enforcement powers similar to those of other federal
regulators for financial institutions.
The primary goal of today's hearing is to advance our
examination of what structural changes might be necessary at
the Office of Federal Housing Enterprise Oversight or the
Department of Housing and Urban Development to ensure
comprehensive and complete oversight of Fannie Mae and Freddie
Mac. Today, we will hear primarily from one side of the debate:
those who have often been critical of the GSEs and their
regulators. In fact, many of our witnesses have already called
on the Congress to reform GSE regulation, alter their statutory
structure, or disband these entities entirely.
Nonetheless, as we proceed in the future, it is my hope
that we will develop a balanced, deliberate and bipartisan plan
of action for addressing GSE matters. In other words, we should
move judiciously and objectively in conducting our oversight
responsibilities. We also should understand the facts behind
the current and recent events at Freddie Mac before considering
any legislation.
Moreover, we should not once again upset the securities
markets. On at least one occasion, our committee's actions have
unfortunately discouraged investors and raised homeownership
costs. As we proceed today, we must renew our efforts to ensure
that we do not repeat that mistake.
In closing, Mr. Chairman, I commend you for your continued
leadership on these issues. I will continue to work with you to
conduct effective oversight over the housing government
sponsored enterprises and to ensure that we maintain an
appropriate and sufficiently strong supervisory system over
them.
[The prepared statement of Hon. Paul E. Kanjorski can be
found on page 54 in the appendix.]
Chairman Baker. I thank the gentleman.
Mr. Ose?
Mr. Ose. Thank you, Mr. Chairman.
I would like to thank you also for your continued hard work
on this issue and for holding this hearing today. You obviously
are dedicated to a strong financial market, to disclosure and
accountability, and both the membership and the country is
well-served by that. Mr. Chairman, recent actions at Freddie
Mac have led many in the public and on the Hill to take a
closer look at how government-backed institutions are
regulated. Specifically, many are asking if greater disclosure
and accountability requirements are necessary. This is a
serious question and one that we must examine very carefully.
Of particular concern is whether or not the current
agencies with oversight authority have the ability, authority
and personnel to properly regulate this vital industry. Let us
look at just one part of such authority and the questions that
it raised in recent weeks, the authority of the Office of
Federal and Housing Enterprise Oversight, OFHEO, to oversee
executive compensation at the GSEs.
When the accounting irregularities led Freddie to review
its past actions here recently, the board at Freddie apparently
was upset enough at executive actions to fire one senior
executive and to ask two others to resign. However, these three
individuals were still eligible for extremely generous
compensation packages and stock bonuses. OFHEO reported said
these would not be paid out until an investigation was carried
out. You and I wrote OFHEO asking what authority they had to
freeze such payments and whether their orders were being
carried out. To date, there is still conflicting information on
this question. I hope we will get clear answers soon.
Perhaps part of the trouble is that OFHEO is not home to
the experts on financial services matters. The Department of
Housing and Urban Development does many praiseworthy things,
but it is just not experienced as regulating a financial
market. I am pleased to join with you in offering the
legislation, H.R. 2575, to move the oversight authority to the
Department of Treasury, where there is a greater depth of
experience on financial oversight and a far greater likelihood
of proper oversight.
Mr. Chairman, I would like to thank you for taking a closer
look at this industry. Liquidity and soundness in the housing
marketplace is crucial. So is accountability. I look forward to
hearing from our panel today and I look forward to the hearings
on this matter in the future.
Chairman Baker. Thank you, Mr. Ose.
Mr. Scott?
Mr. Scott. Thank you very much, Chairman Baker, Ranking
Member Kanjorski.
I certainly want to concur with my colleague and commend
you, Chairman Baker, for your insight and your knowledge on
this issue and this industry. I certainly look forward to
working with you as we develop legislation that will certainly
address this problem.
As I have said before in this committee, no program is so
good that it should not be reviewed. The public's confidence in
our financial institutions is paramount to this country and the
welfare of our economic system. Our nation is staggering under
scandal after scandal of accounting practices of some of our
most revered and large and impactful financial and economic
institutions. It is especially important that Freddie Mac and
Fannie Mae have meaningful oversight of their safety and
soundness because of the implicit guarantee that the United
States treasury will intervene, rather than let them fail.
Over the last 10 years, the housing GSEs have had their
obligations rise from $1 trillion to $3.2 trillion. With this
increase in credit risk and the recent accounting problems that
Freddie Mac had with Arthur Anderson, Congress should ask
questions and we will ask questions, and we get some answers. A
financial crisis at either company could shake our entire
domestic economy.
With that said, I believe that we must keep oversight
focused on what is best for the consumers and the marketplace.
Freddie and Fannie do serve important roles in housing markets,
especially when they focus on their core missions such as
increasing minority homeownership. From 1998 to 2002, African
American homeownership rates rose from 45.6 percent to 47.3
percent, compared with the overall national average increase
from 66.3 percent to 67.9 percent. With interest rates at
historical lows, I believe that we must push even harder to
help increase minority homeownership rates.
Freddie Mac and Fannie Mae have brought stability to the
housing market. I believe that when they focus on their
congressionally mandated mission, they provide a vital tool for
market stabilization. That is one reason why I hope that Fannie
Mae will reach a reasonable agreement with the manufactured
housing industry to provide 30-year home mortgages.
There are some very serious questions that we need to raise
this morning and get some answers to. For example, in the
Monday New York Times, there was an article that questioned
Fannie Mae's financial reporting. The article stated that a big
loss last year was obscured by accounting complexities. I think
we need to figure out if Fannie Mae's accounting practices show
the true net value of assets. And for the Office of Federal
Housing Enterprise Oversight or OFHEO, we need to question if
with just 140 full-time staffers and an operating budget of $30
million, is OFHEO up to the task of regulating Fannie and
Freddie? Because in fact, they are monitoring the fiscal health
of two companies that together own or back nearly half of this
nation's residential mortgage debt.
Also, we need to ask the question, is it fair to judge
Fannie Mae based upon Freddie Mac's missteps. And if Freddie
Mac only understated their earnings, then why did they fire
their CEO and then let their President and CFO leave? Serious
questions that the American people are looking to get serious
answers from.
So I look forward to joining with you, Chairman Baker. I
commend you for taking the leadership on this and I look
forward to working with you as we put forth a fair and balanced
piece of legislation to address this issue.
Chairman Baker. I thank the gentleman for his fine
statement.
Mr. Ney?
Mr. Ney. Thank you, Mr. Chairman. First, Mr. Chairman, I
want to thank you for your hearings. You have shown strong
leadership over the past years on the issue of GSEs. As we all
know, the events of the past few weeks have made it clear that
this committee will closely examine the regulatory structure
for government-sponsored enterprises. These companies have been
a vital part of promoting homeownership and bolstering the
housing market over the past few years in particular. We all
know during the tough economic times in the past three years
one of the few bright spots has actually been the housing
market itself. Because of the liquidity they provide, Fannie
Mae and Freddie Mac have been an integral part of the vibrant
housing market to have supported what I would call a fragile
economy.
However, their importance to the housing market stresses
why it is so vital that we have a sound regulatory regime for
the GSEs. Fannie Mae and Freddie Mac have been at the forefront
of disclosure, having taken steps that go above and beyond what
most companies would provide. This year they took additional
steps and met the requirements of the joint Treasury-SEC-OFHEO
mortgage-backed security disclosure study. I just point that
out because since Sarbanes-Oxley amends the 1934 SEC Act, it
applies to SEC registrants, defined as issuers. Fannie Mae and
Freddie Mac both agreed to register their equity securities
under the 1934 Act. Therefore, when Fannie Mae filed their Form
10 and 10(k) with the SEC on March 31, 2003, they became a
full, irrevocable registrant under the SEC as I would
understand it, and as such are fully bound by provisions within
Sarbanes-Oxley.
However, today's nearing obviously will go towards the
problems that have erupted and will have to go towards OFHEO,
obviously, and what has been brought into question rightfully
so is the effectiveness of OFHEO as a regulator for the GSEs.
Fannie Mae and Freddie Mac are too important to our nation's
housing market to allow a lack of confidence to develop in
their regulation. That is why we have to diligently, but
cautiously, pursue regulatory reform. These companies have been
leaders in safety and soundness and we have to ensure that
investors continue to have faith in that fact.
That is why I want to again commend Chairman Baker for this
hearing. That is why I believe that we are all here today to
endorse taking strong steps to guarantee that the housing GSEs
have a strong regulator. I think many of us also agree that we
must work with the Treasury Department and the administration
to ensure that any change to the GSE regulatory structure be
done in a way that preserves the companies' roles as GSEs in a
way that strengthens the effectiveness of the safety and
soundness regulation without foiling the financial markets. So
this committee is going to have to have a balance in the need
for strong GSE regulation with the need to be sensitive to the
housing markets.
I was joking with my good friend Sherry Boehlert, the
Chairman of the Science Committee the other day when this first
was all announced. Everybody was scrambling for a hearing in
the Congress. I told Sherry since Freddie Mac uses electricity
in their building he as the Science Committee maybe he ought to
have a hearing on Freddie Mac. I think that this is the perfect
venue here for the hearings and I want to just point out that
if there is wrongdoing, it has to be gone after. We cannot
tolerate that.
If there is slippage in the regulatory scheme, we have to
correct it. I want to echo the comments of my colleague, Mr.
Kanjorski, I think we have to do it also in a balanced way so
that we in fact to not affect the markets and hurt a lot of
innocent people. There is a difference with Enron where it
imploded and 15,000 people weren't around to be saved. In this
case, we need to do the right thing in the regulatory
mechanism. We also need to do the right thing in the markets in
fairness to all Americans.
Thank you.
Chairman Baker. I thank the gentleman.
Mr. Miller?
Mr. Miller of North Carolina. Thank you, Mr. Chairman.
The opening statements today have sounded in some cases
more like opening jury arguments than they have like opening
statements. I join with Mr. Kanjorski in pointing to the
remarkable success it is for our country, for our nation that
we have the kind of widespread homeownership that we have. We
certainly need to extend it more broadly. We need, as Mr. Scott
points out, higher homeownership among African Americans and
others. But the extent of homeownership by the middle class in
this country is a remarkable success, and these institutions,
these government-sponsored enterprises, have played a huge role
in that. Homeownership is how the middle class develops wealth.
It is how they save for their children's college educations;
how they save for retirement. It is a great asset.
The housing market in this country in the last few years
has been one of the few bright spots in a very bad economy, a
lot of which has been driven by the available capital for
housing and for homeownership. We certainly do need to pay
close attention to these institutions. We need to make sure
they are solvent and they are sound. But I have learned in my
brief service on this committee that accounting is in fact
surprisingly imprecise. It is not terribly surprising that with
interest rates dropping precipitously as they have in the last
couple of years, that there would be some imprecision in the
accounting treatment of these two government GSEs given the
nature of their business.
So before I prosecute someone or convict them, I would like
to identify exactly what the problem was, whether there was
anything that merits being compared to Enron or Arthur
Anderson, and I certainly want to make sure that we do not
choke off the supply of capital that has gone into making
homeownership possible for the middle class.
Thank you, Mr. Chairman.
Chairman Baker. I thank the gentleman for his statement.
Chairman Oxley?
Mr. Oxley. Thank you, Mr. Chairman. I want to thank you for
convening this important hearing on the oversight of the GSEs.
The recent management reorganization of Freddie Mac should give
us all pause to assess how well the operations of these GSEs
are being monitored by OFHEO.
Freddie Mac and Fannie Mae account for billions of dollars
in mortgage-backed securities which are widely held by pension
funds, mutual funds and individual investors. Given the
complexity of these institutions and their importance to the
secondary mortgage market, it is critical that their regulator
be capable of exercising rigorous oversight to ensure their
safety and soundness. Over the past six months, as Freddie Mac
first announced that it would restate its earnings and then
dismissed its three top officers, OFHEO has appeared to be
habitually slow to act and unable to predict these crises.
Chairman Baker has been tireless in his review of the
issues surrounding the GSEs and was instrumental in the
agreement by both Freddie Mac and Fannie Mae to voluntarily
register their securities with the SEC. This voluntary
registration will lead to more transparency in the operations
of the GSEs, which will make for a more efficient and better-
informed marketplace.
The U.S. housing market has remained strong through
difficult economic times and is the most sophisticated in the
world. This is largely due to the liquidity provided through
the secondary mortgage market in which Freddie and Fannie are
the key players.
I look forward to hearing from our distinguished panel.
Their insights as third party observers will be critical to our
consideration of this issue and future actions this committee
may take.
I yield back the balance of my time.
[The prepared statement of Hon. Michael G. Oxley can be
found on page 46 in the appendix.]
Chairman Baker. I want to express my appreciation to the
Chairman for his participation here today and also to
acknowledge that it has been with his leadership and counsel
that we have moved to this point in the process, and recognize
that this issue is obviously controversial and difficult, and I
certainly appreciate his willingness to be a strong leader in
the effort as well.
Mr. Meeks?
Mr. Meeks. Thank you, Mr. Chairman.
Mr. Chairman, considering the recent events of the past two
years regarding the validity of various companies' financial
statements and the related fraud committed by the management of
Enron to WorldCom, it is my understanding that Congress would
want to take a careful look at its GSEs that are so critical to
the homeownership market in this country.
Upon hearing about the removal of Freddie Mac's top brass
and the accuracy of their financial statement was in question,
all of us who have this primary responsibility for safeguarding
the country's financial system had to have concern about the
extent of the problem and be prepared for the necessary
committee action.
However, I counsel prudence in taking legislative action
based on the initial reports. All indications thus far are that
the GSEs are still two of the best capitalized and financially
solvent financial services companies in America. They have met
OFHEO's risk-based capital standards and met their cooperative
agreements for transparency. Once Freddie Mac registers its
common stock, something Fannie Mae has already done, they will
have completed another step in complying with additional calls
for transparency.
There are individuals who believe that GSEs need a stronger
financial regulator. There are others who are seeking greater
regulatory control over their products and programs. Perhaps
those concerns have some validity that needs further
exploration. But let me tell you about my concerns. My concerns
are that GSEs continue to help Americans achieve the highest
homeownership rate we have ever experienced. I am concerned
with GSEs's continuing to close the gap in minority and non-
minority homeownership rates. My concerns are with the GSEs's
continuing to make homeownership more affordable to low-and
moderate-income individuals in America.
Of course, safety and soundness must be our primary concern
as legislators. But we cannot let a rush to judgment lead us
down the path of unintended consequences. The role of GSEs is
too critical to our economy to have their mission interrupted.
We must not throw the baby out with the bathwater and we must
make sure that we keep and strengthen these institutions.
I yield back the balance of my time.
Chairman Baker. I thank the gentleman for his statement.
Mr. Green?
Mr. Green. Thank you, Mr. Chairman.
I will be brief. I don't want the opening statements to
overtake the testimony. I want to associate myself with your
remarks in particular, and that of my colleague, the Chairman
of the Housing Subcommittee, Congressman Ney. Look, Fannie Mae
and Freddie Mac are a vital part of our housing finance system.
I think we understand that. I think we also understand that
nothing that we undertake here today or talk about here today
is discussed in a vacuum. There are observers and there will be
reactions. We must tread carefully because of the sensitivity
to the potential responses by housing market observers.
On the other hand, I believe tread we must. People may not
fully understand the role of Fannie and Freddie in our economy
and the housing finance system. More importantly, they will
never understand why we failed to take action when we could
when we learned that there are in fact changes that need to be
undertaken. So while we do need to tread carefully, again I
think we have no choice but to take certain steps and tread we
must.
With that, I yield back, Mr. Chairman.
Chairman Baker. I thank the gentleman.
Ms. Maloney, by unanimous consent, not a member of the
committee, but who would like to make a statement. Without
objection, she is recognized.
Mrs. Maloney. Thank you, Mr. Chairman. I request permission
to put my comments in whole in the record, but to summarize it,
I thank you for your leadership and would like permission to
put in the record the lead article today in the American
Banker, which outlines the work of this important committee.
[The following information can be found on page 104 in the
appendix.]
I would just like to say that oversight of the GSEs is one
of the most important issues the Financial Services Committee
presides over. These institutions are pillars of our housing
system and millions of our constituents benefit from the
liquidity they provide our lending institutions.
At the same time, the recent events at Freddie Mac are
deeply troubling. While the company's new leadership is trying
to repair the damage, the reality of the accounting and
corporate governance shortcomings that occurred at the company
are unsettling given the size of the institution.
I joined this committee just as our country was emerging
from the S&L crisis. My first vote was a huge bailout of these
institutions. Because of this experience, I regard
congressional oversight of the safety and soundness of the
financial services industry as really our most important
responsibility. In this regard, I have long supported efforts
to provide more resources to the Office of Federal Housing
Enterprise and Oversight and I joined the Chairman last year,
along with Representative Bentsen and Kanjorski, in legislation
that would have removed the agency from the appropriations
process, thereby making it more independent.
I want to note that OFHEO took very, very long to come
forward with its risk-based capital rule, but despite these
shortcoming in OFHEO's history, I do believe in taking a
deliberative and thorough approach to legislating major changes
to our nation's housing markets. I understand the Chairman is
coming forward with a total change to this, but I have not had
a chance to look at that legislation. Before acting, we need to
know exactly what happened at Freddie Mac and whether it
represents a one-time occurrence or a systemic problem.
The U.S. mortgage market is the best in the world, as we
all know, and in the current low interest rate environment
mortgages are being refinanced at a record rate that would be
impossible without automation from national laws like the FCRA
and our incredibly successful mortgage finance system. The
Washington Post detailed the impact that the ability to
refinance so easily is having on our economy in a June 8
article. I request permission to put this article in the
record. I just want to note that it pointed out that since
2001, banks have processed more than 27 million mortgage
refinances by the end of this year, and in total since 2001
refinancing will have delivered about $300 billion directly to
consumers who will have more money to spend and pump up the
economy. That is in comparison to the $263 billion that the
Bush tax cuts of 2001 and 2003 will have put into the economy
by year's end. So I thank the Chairman for his oversight, for
calling this hearing, and really for his leadership. I look
forward to working with him to make sure that our housing
system remains preeminent in the world. I thank him.
Chairman Baker. I thank the gentlelady for her statement.
Her statement, of course, and all ancillary materials
referenced will be included in the record without objection.
[The prepared statement of Hon. Carolyn B. Maloney can be
found on page 56 in the appendix.]
Mr. Bachus?
Mr. Bachus. First of all, Mr. Chairman, I want to thank you
for this legislation. I think it is a measured approach, and
for your approach to these hearings. We are going to
investigate the matters.
There has been absolutely no suggestion by anyone that
Fannie and Freddie are not sound financially. What has been
suggested, and I think recent events have borne out, and that
is that OFHEO has failed to be the regulator that they needed
to be. Your approach has been to shift regulatory oversight to
the Treasury Department. That has been suggested for some years
as the best approach. The Department of Treasury has years of
financial regulatory experience and has proven to be up to the
task.
Other than what the others have testified, I would simply
add is evidence that we do need to transfer oversight and
regulation to the Department of Treasury. The budget for OFHEO
last year was $27 million. Despite this, in their latest report
to Congress, OFHEO certified that Freddie Mac's audit functions
were independent and effective. So obviously they failed to do
their job.
Now, it could be that they simply did not have the
authority that the Treasury has, but your bill takes care of
that by transferring it to Treasury and then OTS, and giving
the regulator of Fannie and Freddie the same authorities as
your other bank regulators have. So for whatever reason, it may
have simply been that they did not have sufficient authority in
their regulation.
One thing that I do want to express some reservation about,
and I have discussed this with you, is the part of the
legislation with regard to HUD's new program authority. I do
not want to stifle innovation in the marketplace by micro-
managing these new product issues. I think we ought to take a
very careful look at that. But other than that, I think you
have a good bill and I look forward to working with you.
Chairman Baker. I thank the gentleman for his kind remarks
and his cosponsorship of the measure as well.
At this time, the Ranking Member of the full committee, Mr.
Frank.
Mr. Frank. Thank you, Mr. Chairman.
I want to apologize, first, because this committee has a
bill on the floor which I will be managing. It is very
important bill. It will be up this morning on suspension, to
provide a gold medal to Tony Blair and I guess payback his
legitimate part of things. So I will be temporarily absent
while I preside over that important piece of legislation.
I just want to say that I am glad to hear members talking I
think in very thoughtful terms. We are not talking about a
crisis that is comparable to those that affected some of the
major corporations. We have a general agreement that the
important function of easing housing finance at the two big
companies involved here is important to protect. I think it is
very legitimate for us to look at what went wrong here and
what, if anything, we could do legislatively to stop it. But I
would include in this that this is an issue it seems to me not
simply of Freddie Mac, but also of accounting.
I had not, I must say, prior to becoming the ranking
member, paid as much attention to the accounting industry as my
duties now require me to. I think part of the question now is I
think to a good part of America, the issue is whether
accounting more resembles astrology or alchemy in the way in
which it is practiced. As we deal with the question of what is
the appropriate structure for the GSEs, I think this is a
reminder that we also need to look further in to the question
of how we regulate the accounting industry because some of
these issues are not just GSE-specific, but they are generic to
the question of accounting.
That also includes, and I hate to say this because I cannot
think of anything that would be less fun for us, but
derivatives also is something we have to look into. I say that
with all the enthusiasm of being told that we have to go back
to trigonometry and take a test in it. But it does seem to me
that, as I said, some of this is possibly GSE-specific, but
much of it deals with generic accounting issues and derivative
issues and I think these need to be on the agenda.
Thank you, Mr. Chairman.
Chairman Baker. I thank the gentleman for his remarks.
Mr. Gary Miller?
Mr. Gary G. Miller of California. Thank you, Mr. Chairman.
I applaud you for holding this hearing today and the
approach you have taken on this issue has been very
deliberative and reasonable. We all know that home equity
appreciation is one of the most important drivers of wealth
creation in the United States. By helping people become
homeowners, we promote long-term economic stability for our
nation.
Congress must continue its goal of helping millions of
Americans to achieve the dream of homeownership by ensuring
that Americans have access to mortgage funds at the lowest
cost. Fannie Mae and Freddie Mac were chartered by Congress in
1970 to provide stability and ongoing assistance to the
secondary market for residential mortgages and to promote
access to mortgage credit and homeownership in the United
States. It is imperative and important to ensure the safety and
soundness of the secondary mortgage market.
The question of impropriety that has surfaced as a result
of the revelation of accounting irregularities at Freddie Mac
could be devastating to the strong housing market. We must
examine whether OFHEO is truly up to the task of regulating
Freddie and Fannie. It is our responsibility to examine the
situation and understand how Freddie Mac's regulators could
have released an annual report that the audit functions at
Freddie Mac were effective and that the internal-external audit
functions had the appropriate independence necessary. This was
a mere three days before Freddie Mac's announcement that its
top three executives were being ousted because of accounting
irregularities.
As we proceed with our examination, we must be cautious and
deliberative. Chairman Baker has proposed creating a new safety
and soundness regulator in the Treasury Department with
independent funding, reasonable enforcement authority, and
sufficient standing to provide Congress and the investigators a
clear and accurate financial assessment of GSEs. We must be
mindful that our ultimate goal is to expand the supply of
affordable mortgage credit in order to stimulate the production
of affordable housing. As we move forward, we must be sure we
completely understand the implications of changes in the
regulatory structure in meeting this important goal.
In California, we have had some very difficult economic
times and the housing industry has really kept California
afloat, and this is a tremendously important issue for
California.
I yield back, Mr. Chairman.
Chairman Baker. I thank the gentleman.
At this time, I don't know that there are other members on
the Democrat side to be recognized.
Let me ask it this way, are there others wishing to make an
opening statement at this time?
Mr. Crowley. Mr. Chairman?
Chairman Baker. Mr. Crowley?
Mr. Crowley. Thank you. Mr. Chairman, I want to express my
pleasure in your holding these hearings and at the same time
express some concerns about what I believe may be too broad an
approach when we are examining these issues. There is no
question that the troubles of Freddie are troubles we on both
sides of the aisle are concerned about. We know that Fannie Mae
right now registers with the SEC so its corporate documents can
be disclosed to the public and investors.
What I really question is why we are focusing on all the
GSEs when not all of them have problems. In fact, Fannie has
received clean financial reports. It is as if we looked at
Coca-Cola and saw that they had problems in their accounting
and then also looked at Pepsico; or if we go a little further,
examining Halliburton after the failure of Enron. I do want to
recognize that both these entities, as mentioned on the other
side, are sound institutions and have historically provided
great opportunities for Americans. I just don't want to see,
and I don't think this committee will do that, Mr. Chairman,
with your leadership, a degradation of these two institutions.
With that, I yield back.
Chairman Baker. I thank the gentleman.
Mr. Royce, did you have an opening statement?
Mr. Royce. Thank you, Mr. Chairman.
I want to thank you for holding this hearing. I would like
to commend you for your unwavering commitment to the topic of
GSE regulatory reform. I also greatly look forward to hearing
from our witnesses today to see what they have to say to
contribute on this ongoing discussion.
Government-sponsored enterprises have really focused on
homeownership and have been around since 1934. Since that time,
they have played an important role in developing the secondary
mortgage market in the United States. Fannie Mae and Freddie
Mac buy mortgages from originators in order to provide
liquidity in the market. The Federal Home Loan Bank system
provides advances to banks and thrifts so that those
organizations can offer mortgage products to their customers.
Like the rest of corporate America, the GSEs have developed
comprehensive business models to achieve their mission and to
get results for their shareholders. As a result, the housing
GSEs have become three of the most sophisticated financial
institutions in the world. In total, the three GSEs have over
$2 trillion in debt and a derivative portfolio with a total of
$1.9 trillion. As a result of their evolving business models,
the three housing GSEs now must protect their balance sheet not
only from credit risk, but also from interest rate risk.
With these facts in mind, I think that it is crucial that
these organizations are subject to competent regulation. I
regret to say that I do not have enough confidence in the
Office of Federal Housing Enterprise Oversight which regulates
Fannie Mae and Freddie Mac, or in the Federal Housing Finance
Board which regulates the Federal Home Loan Bank system.
I believe that we need to fold these two regulatory bodies
into a new agency under the umbrella of the Treasury
Department. In my view, such a regulatory institution will have
better direction through its association with the Treasury and
its sister regulators, the OCC and the OTS. The new regulator
will also have the ability to achieve best practices of
regulation because it will have a broader scope than either
OFHEO or the FHFB has today, and it will be focused on
protecting the taxpayer from like-types of systemic risk.
I think that it is important for this committee to act on
this matter through perception and reality or both. All three
housing GSEs are inadequately regulated. I look forward to
working with my colleagues to create a new, more effective
regulatory structure for Fannie Mae, Freddie Mac and the
Federal Home Loan Bank system.
I would like to thank our witnesses here today and would
once again like to thank Chairman Baker for his longstanding
interest in this issue.
I yield back the balance of my time.
[The prepared statement of Hon. Edward R. Royce can be
found on page 58 in the appendix.]
Chairman Baker. I thank the gentleman for his remarks.
Ms. Harris?
Ms. Harris. Thank you, Mr. Chairman.
I want to express my appreciation for your willingness to
conduct these hearings on the oversight of the government-
sponsored enterprises. This morning we will consider the
oversight body of Fannie Mae and Freddie Mac, focusing upon the
structural changes that may be necessary to improve the
oversight of these two GSEs.
As this committee examines the proposed reforms, we must
recognize the vital role that both Fannie Mae and Freddie Mac
play in maintaining the health of our nation's housing
industry. The housing industry serves as the backbone of our
American economy, having enjoyed vibrant growth and economic
prosperity while other sectors of our economy have struggled
recently. In particular, I believe we must remain aware of the
impact that additional hearings or legislation could have upon
the housing industry and global markets. Our actions could
provoke unintended consequences in the market for mortgage-
backed securities.
Recent events have prompted multiple agencies to
investigate the accounting operations of Freddie Mac. I hope
these investigations will produce findings that can help us
frame the legislation that will alleviate the concerns that
these events have created, while preserving those positive
contributions that Freddie Mac has made to the housing
industry.
I wish to thank the individuals who are here today on our
panel for their insights regarding the oversight of Fannie Mae
and Freddie Mac, and moreover I look forward to a healthy
debate regarding this critical matter.
Thank you, Mr. Chairman.
Chairman Baker. I thank the gentlelady.
Mr. Shays?
Mr. Shays. Thank you, Mr. Chairman.
Mr. Chairman, I would like to submit a written statement,
but just say that we are looking at two fine companies in
Fannie Mae and Freddie Mac, the second and fourth largest
financial institutions on the New York Stock Exchange. Fannie
is under the 20th largest company; Freddie the largest under
40th. I mean, these are huge and important companies. But it
blows me away that they are not by law under the 1933 and 1934
Securities Acts. When we dealt with Enron and WorldCom, all
those reforms did not apply to them because they were under the
SEC requirements and they were not part of it. It blows me away
they pay no federal and state taxes. They are not under the
privacy laws, state consumer laws, truth-in-lending laws. I am
amazed that they are under a regulator that has half the
resources, and I feel quite candidly that they tell the
regulator what to do, not vice versa. I am hoping that your
legislation will move forward. We will have a stronger
regulator. It will be under the Treasury Department. I hope
they will have greater powers and will treat this on a level
playing field.
I do not fault Fannie and Freddie for not wanting to have
to play by the rules that everyone else plays by, but I do
fault Congress for not addressing this issue. I am grateful
that we are beginning to.
Chairman Baker. I thank the gentleman for his statement.
[The prepared statement of Hon. Christopher Shays can be
found on page 59 in the appendix.]
If there are no members desiring to make any further
statements, at this time I would like to recognize our first
witness. Welcome to each of our panelists this morning for your
endurance.
Our first witness is Mr. Sean Egan, Managing Director of
Egan-Jones Rating Co. Welcome, sir.
Let me quickly add, all statements will be made part of the
official record. To the extent possible, if you can constrain
your remarks to five minutes, it will enable the committee to
engage in more thorough questioning. We appreciate your
participation.
Welcome, Mr. Egan.
STATEMENT OF SEAN J. EGAN, MANAGING DIRECTOR, EGAN-JONES
RATINGS CO.
Mr. Egan. Thank you.
Chairman Baker, members of the subcommittee, good morning.
I am Sean Egan, Managing Director of Egan-Jones Ratings
Company, a credit rating firm. By way of background, I am the
Co-founder of Egan-Jones, which was established to provide
timely accurate ratings to institutional investors.
Our business model differs significantly from other rating
agencies in that we are not paid by issuers of debt, which we
view as a conflict of interest. Instead, we are paid by
approximately 300 firms consisting mainly of institutional
investors and broker-dealers. Unlike the major rating firms, we
provide early warning to investors on major debacles such as
Enron, WorldCom, Global Crossing, Genuity and ABB. We are based
in the Philadelphia, Pennsylvania area, although we have
employees that operate from other offices.
The three areas I would like to briefly address today are
the GSEs's current status, their development, and our proposed
reforms.
Regarding their current status, Fannie Mae and Freddie Mac,
collectively the GSEs, started life under the protection of the
federal government and were given a line of credit from the
U.S. Treasury. When they were small, the $2.5 billion line of
credit was adequate. However, as they have grown, that line has
become inadequate. I direct everyone's attention to the chart
that we have on the first page of my written testimony. That is
a list of the asset base of Fannie Mae and Freddie Mac. If you
look at the asset base, as of the year 2000, they had $675
billion in total assets. That is the first line. It grew in
2001 to approximately $800 billion and in 2002, to $877
billion.
The next line is shareholders equity. It is interesting. It
went from basically $21 billion down to $16.3 billion. They
reported profits last year. I don't think they paid out $2
billion in common stock dividends, so it is still a mystery how
they went from $18 billion to $16 billion, but they did it. The
more telling figure is equity divided by assets. In the year
2000, it is 3.1 percent. It dropped down to 1.9 percent in the
year 2002.
Freddie Mac, interestingly, its equity to assets looks
fairly reasonable. However, we are always skeptical of some of
these accounting results. It is very easy with derivatives, to
manipulate the valuation of derivatives. Keep in mind that the
GSEs are providing a lot of liquidity for these derivatives to
bolster the earnings and capital account.
What we take away from these two charts is that 1.9 percent
equity to assets and the 3 percent is really just a sliver. It
is a sliver of capital for institutions that have huge
positions.
Let me move on. As the GSEs grew, they were not able to
grow their capital base sufficiently to keep pace with the
rapid asset growth. What used to be high leverage has become
excessive leverage. Below is a comparison of the GSEs's current
ratios to other firms' ratios. It is difficult to find perfect
comparables to the GSEs. They are unique institutions in some
regards, but there are some that at least provide some
guidance. You see in the second chart on page two, Countrywide
Financial which is rated by Moody's A3, by S&P an A. You see
the total debt-to-capital is 89 percent. It means that they
have roughly 10 percent capital. That compares to Fannie Mae's
less than 2 percent capital. It just means that there is a big
difference, but yet they are given a AAA rating.
Let me move down. Egan-Jones currently rates Fannie Mae at
A+, which is approximately four notches below S&P and Moody's
AAA ratings. Egan-Jones uses the same rating categories as S&P
in the investment-grade segment.
Attached is a history of our ratings and below our comments
from a June 10, 2003 report on Fannie Mae. This is quoting from
the report. ``Far from a AAA, Fannie Mae is not fully backed by
the U.S. and only has a sliver of equity. The general rule for
banks is to maintain equity at 8 percent of assets. Fannie Mae
has only 1.96 percent. Also, Fannie Mae has greater volatility
than some banks because of its business focus and absence of
loan prepayment penalties.'' In other words, if you borrowed
from a bank and if you want to prepay that bank loan, you have
to pay a penalty because a bank normally is match-funded with
liabilities so they don't have to worry about prepayment. In
the case of Fannie Mae and Freddie Mac, they don't have that.
Although Fannie Mae claims that it is hedged, there are few
perfect hedges. Keep in mind, they are one of the biggest
hedging institutions probably in the world. Most traders say
there are very few perfect hedges. That applies here. Still
unresolved is the support Fannie Mae will get from the federal
government if it gets into trouble. Fannie Mae's prospectuses
state that the federal government is under no obligation to
support Fannie Mae, but most investors assume it will, probably
up to only $2 billion. The assumption of the U.S. guaranteeing
all Fannie Mae's debt and shareholders getting the up-side is
likely to change.
Egan-Jones currently rates Freddie Mac at A, which is
approximately five levels below S&P. Let me skip forward. We
have similar comments on Freddie Mac. A reasonable question
would be why one rating agency, Egan-Jones, would rate the GSEs
at A and A+, whereas Moody's and Standard & Poor's and Fitch
would rate the GSEs at AAA. Our view is that, number one, there
is substantial pressure on major rating agencies to maintain a
high rating for various large issuers. Number two, there is
relatively little penalty if the rating ultimately proves to be
wrong.
Regarding pressure to maintain a high rating, Moody's,
Standard & Poor's and Fitch obtain approximately 90 percent of
their revenues from issuers such as the GSEs. I am quoting from
the Wall Street Journal. Over the years, S&P and Moody's have
rated over $500 billion of Freddie Mac debt and earned tens of
millions of dollars of fees. They don't tell you exactly how
much they have earned, but if you use their standard rate of 2
basis points, that adds up to $100 million for one of the
agencies for one of the GSEs. That is a lot of money. It has to
be one of their biggest clients, if not their biggest clients.
Unlike Moody's, S&P and Fitch, Egan-Jones is not paid by
the issuers for its ratings. Regarding the lack of penalty if
Moody's, S&P and Fitch ratings prove to be disastrously wrong,
there are relatively few alternatives. The major rating
agencies therefore face few penalties. Up until earlier this
year, the three major rating firms were the only firms
recognized by the SEC, and DBRS which was recognized in March
2003, has little market presence in the U.S.
Over the past 3 years, there have been numerous examples of
investment-grade firms filing for bankruptcy protection on
short notice. Enron was rated investment-grade four days before
it's filing. National Century was rated AAA 2 months before
it's filing. WorldCom was rated at the Baa/BBB level 3 months
before filing. The California utilities were rated at the A
level 16 days before defaulting. Despite these failures, the
major rating firms have regularly grown their revenues because
of the restrictions on competition.
We have several suggestions.
Chairman Baker. Can you begin to conclude for us, too?
Mr. Egan. Yes. We have several suggestions that are listed
in the report. One is the establishment of a revised regulatory
body. You can read that. Two is restricting the growth,
rebuilding the capital of the GSEs. Three is encouraging the
development of additional funding sources. I don't care if
these GSEs are the best-managed entities in the history of the
world, things happen. My teenage son might have put it slightly
differently. You can't concentrate on just two agencies. If a
bomb explodes in their computer center, you don't want to shut
down the country. Four is enhance the ratings firms'
independence. This is an important issue. We think that it has
to be addressed. If it is left unaddressed, it will continue to
fester and cause additional problems.
[The prepared statement of Sean J. Egan can be found on
page 72 in the appendix.]
Chairman Baker. Thank you very much, Mr. Egan. Your full
written testimony will be made part of the record as well.
Our next witness is Mr. Thomas Schatz, President, Citizens
Against Government Waste. Welcome, sir.
STATEMENT OF THOMAS SCHATZ, PRESIDENT, CITIZENS AGAINST
GOVERNMENT WASTE
Mr. Schatz. Thank you very much, Mr. Chairman and members
of the subcommittee. I appreciate being here today on behalf of
Citizens Against Government Waste.
We are pleased to testify about the adequacy of oversight
of Fannie Mae and Freddie Mac. We agree that Fannie Mae and
Freddie Mac provide a very useful service to the American
economy. We also believe that these organizations should
ultimately be privatized.
That being said, we do support reasonable regulation as
well as greater accountability and transparency as interim
steps toward full privatization. Thanks to your good work, Mr.
Chairman, and the hearings you have held over the last several
years and the work of this subcommittee, improved regulation of
the GSEs has been amply examined. It is now time to act.
Certainly the changes that have been made at the GSEs in terms
of voluntarily registering with the SEC and other steps they
have taken have been as a result of the work of this committee.
The current system of GSE oversight certainly does need
improvement. Freddie Mac is the fourth largest financial
services company in the United States, yet as others have
pointed out, it's safety and soundness regulator, OFHEO, gave
Freddie Mac a clean bill of health less than a week before the
announcement of the company's accounting problems.
My written statement includes 15 suggested improvements for
GSE oversight, and I would like to mention a few of them now.
Strengthen safety and soundness regulation by moving this
responsibility to the Department of the Treasury and provide
the new regulator with powers comparable to those available to
bank regulators; require that the GSEs hold bank-like capital,
and Mr. Egan pointed out the differences between the capital
held at banks and other financial institutions and Fannie Mae
and Freddie Mac; fund the regulator through assessments on the
GSEs; permit new programs as long as they do not violate the
GSEs's charters or undermine the safety and soundness of the
GSEs and also do not involve direct consumer lending; repeal
Fannie Mae and Freddie Mac's exemption from federal securities
laws; and finally, repeal the line of credit of $2.25 billion
that exists for each GSE.
We recognize that our list is ambitious, yet you have
included a number of these provisions in your new bill, Mr.
Chairman. The three provisions we believe are essential right
now are bank-like capital for Fannie Mae and Freddie Mac;
consolidation of safety and soundness and new program authority
in a single strong regulator; and repeal of the GSEs's
exemption from federal securities laws.
Mr. Chairman, we support your bill's establishment of
prompt corrective action powers for the new regulator, but
again we reiterate Fannie Mae and Freddie Mac should be subject
to the same capital standards as banks. In March of this year,
William Poole, President of the Federal Reserve Bank of St.
Louis, recommended that, quote, ``Over a transitional period of
several years, the GSEs should add to the amount of capital
they hold,'' unquote. I ask, Mr. Chairman, that the entire text
of Mr. Poole's speech be included. I have attached it to my
statement. Without the imposition of stricter capital
standards, the GSEs will always pose a problem of systemic risk
to taxpayers.
CAGW supports your plan to move the GSEs's regulator from
HUD to Treasury and to make it more independent by removing it
from the appropriations process, and financing it through the
assessment of fees on the two GSEs.
We also believe that new program approval should come under
this new Treasury regulator, as most of the new programs that
GSEs propose are financial products. The possibility of
systemic risk posed by the GSEs is inextricably tied to the
scope of their activities.
Finally, we believe your bill should include provisions
comparable to H.R. 2022, legislation introduced by
Representatives Chris Shays and Ed Markey, to repeal the GSEs's
exemption from federal securities laws. This month's news
regarding Freddie Mac clearly demonstrates the implication of
the GSEs's current exemption from these laws. Any other company
which was forced to re-state earnings must continue to file its
financial statements with the SEC or be subject to SEC
sanctions. In such cases, the message is clear to investors
that the company has not complied with the law. In Freddie
Mac's case, despite its failure to live up to its commitment to
register, the agency did nothing and in fact did not initiate
an investigation of Freddie Mac until after the company's
announcement of its management shakeup. Certainly, no other
public company would have experienced such forbearance from the
SEC.
We endorse the view of the Treasury, OFHEO and the SEC in
February in terms of MBS disclosure which concluded that any
adverse effects from additional disclosure will be short-term
and will be outweighed by the benefits of greater information
flowing into the MBS market. The Congressional Budget Office
agreed with this last month, and last week Moody's Investor
Service stated that making all GSE securities subject to SEC
registration would be a good thing. These financial giants
should be held to the gold standard of disclosure, as both
former SEC Chairman William McDonough and Federal Reserve
Chairman Alan Greenspan have said.
Mr. Chairman, we commend the subcommittee for its continued
oversight and efforts to improve the management of the GSEs.
The time for inquiry is over. We believe it is time for action
to be taken by this Subcommittee to exercise its responsibility
to the taxpayers. We urge members of the subcommittee to enact
legislation that will establish a strong regulator with the
authority to impose bank-like capital standards and repeal the
GSEs's exemption from the securities laws. Thank you, Mr.
Chairman.
[The prepared statement of Thomas A. Schatz can be found on
page 85 in the appendix.]
Chairman Baker. Thank you very much, sir.
Our next witness is Dr. Jay Cochran, Research Fellow at the
Mercatus Center, George Mason University. Welcome, sir.
STATEMENT OF JAY COCHRAN, RESEARCH FELLOW, THE MERCATUS CENTER,
GEORGE MASON UNIVERSITY
Mr. Cochran. Good morning, Mr. Chairman, Mr. Kanjorski,
members of the committee. I am Jay Cochran, a Research Fellow
in Regulatory Studies at the Mercatus Center at George Mason
University, and adjunct professor of economics at GMU.
Our mission at the regulatory studies program is to advance
knowledge of the impact of regulations on society from the
perspective of the public interest. Therefore, our work does
not represent the views of any particular affected party or
special interest group, but rather is designed to evaluate the
effects of government policies on overall consumer welfare. I
would like to emphasize, however, for the record that my
comments today do not represent an official position of the
university.
In 2001, Catherine England, professor of finance at
Marymount University and I authored a study entitled ``Neither
Fish Nor Fowl: An Overview of the Big Three Government
Sponsored Enterprises in the U.S. Housing Finance Markets.''
The big three, of course, being Fannie Mae, Freddie Mac and the
Federal Home Loan Banks. I respectfully request, Mr. Chairman,
that this study be incorporated into the record as part of my
remarks here today.
Chairman Baker. Without objection.
Mr. Cochran. Our aim then, as now, in writing this study
was to bring a measure of objectivity to a subject that, as I
am sure everyone on this committee is well aware, can be quite
contentious. This morning, I will briefly touch on some of the
risks presented by the GSEs, as well as some of the oversight
and regulatory issues pertaining to them.
First with respect to risk, the big three GSEs on balance
sheet assets have grown since 1995 from $726 billion to just
under $2.4 trillion by the end of 2002. Mr. Chairman, in my
written testimony provided earlier, that was a misprint and
said $2.4 billion. It should read $2.4 trillion. This
represents an annual growth rate over the period of more than
18 percent per year. By comparison, real GDP over the same
period grew by roughly 3 percent and the overall U.S.
residential mortgage market grew by slightly more than 9
percent per year.
By itself, rapid growth is not necessarily troublesome so
long as general principles of financial safety and soundness
are followed. Of course, one of the most important principles
of sound finance is diversification. That is, not having all of
one's eggs in one basket. For the last several years, though,
Fannie Mae and Freddie Mac have been placing more of their own
eggs in their own basket. They have gone from holding a
combined $125 billion of their own mortgage-backed securities
in portfolio in 1995 to holding nearly $850 billion of their
own MBS internally as of 2002, a growth rate exceeding 30
percent per year.
In this connection, it is well to recall that Congress's
original aim in creating the GSEs was to help the banking and
thrift industries off-load and spread the risks of mortgage
finance by creating an active secondary market in mortgages
through the GSEs. If, however, the GSEs are increasingly
holding their own mortgage-related products in portfolio rather
than selling them to investors, mortgage lending risks may
again be concentrating rather than dispersing throughout the
economy.
To their credit, the GSEs cite adequate risk protection
through hedging activities and by other means. However, such
claims raise the issue of counter-party risk. Are the
institutions on which the GSEs rely for risk-sharing
financially sound? And just as importantly, are they likely to
remain so during less than ideal economic conditions? But even
beyond the basic question of financial soundness, if banks are
important counter-parties to the hedging and risk-control
operations of the GSEs, then in an important if less obvious
way, the risks attendant with mortgage finance may be quietly
reentering the banking system, only this time through an off-
balance sheet side door.
With respect to Fannie Mae's and Freddie Mac's safety and
soundness regulation in particular, I trust that the staff of
OFHEO is well intentioned and doing the best job that they can,
given the economic and political constraints that they face.
However, no realistic assessment of GSE oversight can ignore
the fact that OFHEO consists of just over 100 people operating
on a $30 million annual budget. Yet this small organization is
expected to oversee two enterprises that hold a combined $1.6
trillion in assets and produce business volumes on a monthly
basis measured in the billions of dollars. This vast disparity
in size and resources may explain in part why, for example,
OFHEO gave Freddie Mac and its audit procedures an unqualified
endorsement, only to have that endorsement undermined by recent
events.
It is also noteworthy that OFHEO took nearly 10 years to
develop a risk-based capital standard for the GSEs. To be sure,
the risk-based capital standard that emerged is a sophisticated
and complex model. Still, I cannot help but be concerned given
my earlier remarks about diversification, for example, that we
may have substituted modeling sophistication for adherence to
basic principles of sound finance.
In conclusion, I think the history is clear that the
housing finance GSEs have delivered benefits, not only to their
owners, but also to homebuyers and lenders. Despite these
benefits, however, one must always keep in mind that the GSEs
are neither fully responsive to market forces nor to government
control. Being neither fish nor fowl, neither fully private nor
fully public enterprises, prudence and rational public policy
require that the GSEs undergo regular scrutiny by government
and market participants. With respect to this last point in
particular, Mr. Chairman, I would like to applaud you and the
members of this committee for your steadfast willingness to
undertake this difficult, but necessary responsibility.
Thank you.
[The prepared statement of Jay Cochran can be found on page
61 in the appendix.]
Chairman Baker. Thank you very much, doctor, we appreciate
your testimony.
Our next witness is Ms. Karen Shaw Petrou, Co-founder and
Managing Partner of Federal Financial Analytics, Incorporated.
Welcome.
STATEMENT OF KAREN SHAW PETROU, CO-FOUNDER AND MANAGING
PARTNER, FEDERAL FINANCIAL ANALYTICS, INC.
Ms. Petrou. Mr. Chairman, thank you, and Mr. Kanjorski and
members of the subcommittee, for inviting me here today to
speak on the topic of improving the regulation for the housing
GSEs.
I am Karen Shaw Petrou, Managing Partner of Federal
Financial Analytics, a firm that provides information and
consulting services on an array of legislative, regulatory and
policy issues that affect the financial services industry. Our
information service includes one on the GSEs, which is used by
combatants on all sides of this debate. On our consulting and
advisory services, our clients include U.S. and international
bank regulators who we have assisted over the years in
improving their own work.
We have been doing a great deal of work of late on the
Basel Risk-Based Capital Accords and we also advise numerous
firms and associations on concerns that Fannie Mae and Freddie
Mac serve their homeownership mission, and not engage in new
activities in a risky fashion.
Today, I would like to focus on tenets of effective bank
supervision that I believe can be easily, quickly and
appropriately adopted for Fannie Mae and Freddie Mac. There is
I believe no evidence that effective bank supervision and
meaningful capital requirements have in any way undermined
homeownership. I think it is very important to remember that
Fannie and Freddie cannot serve their mission and promote
homeownership unless America's financial services firms, banks
and savings associations, first do theirs. They originate the
mortgages. Fannie and Freddie then securitize them. Effective
supervision has not inhibited the ability of lenders to
originate mortgages and I do not believe it will be in any way
an impediment to an effective secondary market that will
promote homeownership.
In fact, as this panel has recognized in its work on the
Basel rules, effective supervision and meaningful capital has
been a key to the success of the U.S. financial services
industry and especially our banking sector. We lead the world.
Many of our institutions are the largest, and most importantly
I think without dispute, American banks are the most innovative
on derivatives and asset securitization, many other new
products and services that promote economic growth and serve
consumers, and do so with effective safety and soundness
supervision and meaningful capital.
I believe that this will promote homeownership if applied
to Fannie and Freddie. Indeed, I think effective supervision
and meaningful capital will reduce the cost of homeownership if
investors, particularly bondholders in Fannie and Freddie, have
confidence in the regulator and believe that meaningful capital
is a discipline on risk-taking. And if they have enough
information on which to base informed decisions, Fannie's and
Freddie's cost of funding will drop and that should be
translated into reduced homeownership costs, especially for the
minority and low-income customers for whom the benefits of the
GSEs were initially intended. The three tenets of effective
bank supervision as established by the Basel Committee and
adopted by all of the U.S. bank regulators, the Fed, the OCC,
the FDIC and Office of Thrift Supervision, are first, capital;
second, supervision; and third, disclosure. I suggest that as
you look at the system for Fannie and Freddie, you keep those
principles in mind and ensure that the new regulator you
establish has ample authority to ensure that all three of those
pillars are strong and lasting.
The 1992 regulatory structure established at that time for
Fannie and Freddie, who were then one-third the size they are
now, taking very different risks than the ones they take now. I
must say, I view that as a divide and conquer structure which
would have had a difficult time working under any circumstance.
If it ever could have worked, it certainly has not. The news we
have had from the markets of late, especially that related to
the Freddie Mac restatement, and again the news this morning as
more information was released by Freddie Mac as to how it sees
its balance sheet and its earnings going forward, are deeply
troubling.
The role of OFHEO as the safety and soundness regulator,
not only in anticipating, but fundamentally a safety and
soundness regulator should prevent these types of risk. We have
seen no signs, for example, that OFHEO has undertaken the
reviews of internal audits, of management and of controls at
Fannie and Freddie that the bank regulators have rightly
undertaken in the wake of the Enron case and of Sarbanes-Oxley.
Secondly, the regulatory capital rules need significant
fixing. OFHEO's standards, complex to be sure, are vastly
different than the rules the bank regulators now employ and the
rules pending in the Basel Committee for all large financial
services firms. They are premised on derivatives. Mr. Frank
mentioned earlier his concern about these. I think it is
important to note that the OFHEO risk-based capital rules
allows Fannie and Freddie to count hedges as if they were real
shareholder capital. They are not and they should not be
permitted going forward. Effective supervision requires an
independent agency and I think safety and soundness supervision
means new program control. Often the riskiest things an
institution does are its newest. Safety and soundness
supervision there is essential.
Finally, good disclosure, a real stand-alone rating, and
SEC registration, and I think call reports comparable to those
used by banks.
Thank you very much.
[The prepared statement of Karen Shaw Petrou can be found
on page 78 in the appendix.]
Chairman Baker. Thank you, Ms. Petrou.
I would like to note that your observation with regard to
the Basel Accord, capital supervision and disclosure are
exactly the principles around which we have tried to construct
the regulatory reform recommendation. Importantly from
strategy, some have questioned why have we moved so quickly. It
was to frankly get the bill into the public domain so that
markets could respond, and through this morning, the comment
has been very favorable and already begun to have some positive
impact on market pricing for GSEs's capital.
I was very troubled in understanding your testimony. I now
know that Freddie has announced that it cannot under GAP
standards treat any of its derivatives in portfolio as GAP-
qualified accounting hedges. You made the comment that then
these hedges could not then count as capital or shareholder
equity. What I am troubled by, or ask your opinion on, does the
rules-based capital test that OFHEO now utilizes permit these
derivatives that are not now GAP-compliant still to be counted
as capital?
Ms. Petrou. Yes, sir. It is my understanding that it does.
Chairman Baker. What possible relevance could the stress
test then have to properly assessing the capital adequacy of
the enterprises?
Ms. Petrou. I do not know.
Chairman Baker. I understand, too, that Freddie now is
having to basically take back credit risk as a result of
implicit recourse, because it was basically backing its own
credit risk instead of having laid off that risk to third
parties. If that is correct, and I am making an assumption, how
can that be consistent with its own charter obligations?
Ms. Petrou. I do not know, sir. The charter requires all of
the GSEs to hand-off the risk of high-risk mortgages, those
with loan-to-value ratios above 80 percent, to qualified third
parties, generally mortgage insurers. It is unclear from the
results this morning the degree to which that in fact was done.
Chairman Baker. So could that possibly be, in your opinion,
a violation of the charter?
Ms. Petrou. The facts will need to be carefully examined,
but it is certainly possible.
Chairman Baker. What about Freddie eliminating its held-to-
maturity book? And what implications does that have on Fannie
Mae, if any?
Ms. Petrou. Again, it remains to be seen. This gets to the
very complicated question of the relationship between FAS 133
and how assets are valued on the balance sheet and which assets
are marked to market and which ones are not. Freddie Mac this
morning reported that its investigation to date found that
assets were held to maturity that were in fact being traded or
sold. It is again somewhat still unclear what actually was
going on.
Chairman Baker. So there apparently were assets being held
to maturity while being available for sale?
Ms. Petrou. That is correct. And the accounting rules
require that once that finding has been made, the entire pool
of held-to-maturity assets is, if you will, tainted. So now
everything has had to be moved over to available for sale.
Chairman Baker. Let me ask each of you. I know that some
have suggested that we go further with our regulatory reform.
Are there any of you who have any objection to any particular
portion of H.R. 2575 in the time you have had to review it,
understandably being short? Are there portions of it which you
have concerns may adversely affect the functions of either GSE
as proposed? Anybody?
Ms. Petrou. I would say, sir, that I think that making HUD
the regulator for new programs is something at which I would
suggest you take another look. It has had that authority for 10
years. To my knowledge, it has only acted on one new program
and that was at the direct request of Mr. Leach, going back to
1997 when one of the GSEs decided to enter an aspect of the
life insurance industry, and then HUD approved it. It does not
have a good record here, nor does it have the skills to be a
safety and soundness analyst of new programs.
Chairman Baker. One further question before my time
expires. It appears, and I am only acting now on a quick read
of the morning news with regard to Freddie's most recent
disclosure, that they are acknowledging that they did not have
sufficient resources or personnel to sufficiently gauge and
manage their derivatives risk portfolio. It might even be
broader with regard to internal operational risk management
functions. If that is the corporation's position, how is it
possible, given the resources that Freddie does have available
to it for risk management purposes, that we could view OFHEO by
contrast in any credible light, not because of the quality of
individuals, but because of the limitations of funding and
simple numbers of personnel? Is that a fair comparison to make?
Mr. Schatz. Mr. Chairman, if I may, I would agree with
that. It is one of the reasons why we support your efforts to
move the regulatory authority over to the Department of
Treasury. These are large financial institutions that engage in
very complex financial transactions. Certainly they are still
achieving the goal of providing greater homeownership for the
American people, but certainly given the developments and the
changes in what they are now engaged with compared to 10 or 15
years ago, Treasury is the only place where that expertise
would reside. I would agree with Ms. Petrou's remarks about the
safety and soundness, as well as new program authority, really
being together as opposed to being separate.
Chairman Baker. Thank you. My time has expired, but I have
just got to make a comment. If the facts presented this morning
are accurate, and I presume that they are and we will take time
to examine it and understand it more fully, I cannot comprehend
how anyone could go home feeling confident that the current
regulatory structure is in any way adequate in light of the
risk that has been published to date.
Mr. Kanjorski?
Mr. Kanjorski. Thank you, Mr. Chairman.
We seem to be moving ahead, and most recently we may have
made the error in military policy on everyone concluding on
everyone else's statements or news reports that there is
incontrovertible evidence of weapons of mass destruction. It
seems that term was thrown out there, everyone accepted it, and
accordingly policy was made, no one testing the basic premise.
Does anyone on the panel today, can they tell us actually what
happened at Freddie Mac? In fact, is there a serious violation
of law?
Mr. Cochran. Mr. Kanjorski, not having published their
financial statements for 2002, I can't make that statement. I
have not been able to look at them yet.
Mr. Kanjorski. I haven't either, and that is why I am
wondering whether or not we shouldn't first have a premise of
what happened down there, instead of deciding that clearly what
happened down there warrants significant substantive change. I
am not opposed to change, and certainly in my opening statement
I recommend and have been recommending for years certain things
that I hear the panel agreeing with, the fact that we should
have an independent regulator; that we should have an
independent regulator with the same authority that other
regulators of financial institutions have, which OFHEO has
never been given; that it should not be funded by annual
appropriations at a very meager amount, but should be self-
financing through assessments on the bodies being regulated. We
all agree on those principles, right?
I think we could very easily move forward, whether we call
it modernization or reform or anything else. I think it would
be something we could all agree on to do that for the regulator
of the GSEs. But some of the things I fall out of favor with,
or have not certainly been convinced, to taking a retail
regulator like the Office of Thrift Supervision has the
expertise to handle a very sophisticated, two or three
sophisticated entities such as the GSEs. Do you really all
believe that compared to all the regulators that exist in the
financial institutions of the United States, the Office of
Thrift Supervision is going to be the best regulator we could
select? What is your opinion on that?
Ms. Petrou. I would agree with that concern, sir. It would
be within Treasury and it does have resources, but it also has
many distractions.
Mr. Kanjorski. Right.
Mr. Egan. I would like to comment on your previous
question, and that is the accounting discrepancies and the
dismissal of the executives. From our perspective, that is a
secondary issue. The primary issue with the GSEs is their level
of capitalization. The accounting revelations were really just
an accident waiting to happen because they have relatively
little cushion in their capital base, number one; and number
two, that rating of AAA is unrealistic unless you assume that
the line of credit from the Treasury is significantly greater
than $2.25 billion. If somebody told us it is closer to $60
billion per institution, then we move above the single A level,
but we have heard nothing of the sort.
Mr. Kanjorski. So the underlying premise for this hearing,
the recent news releases and the firings at Freddie Mac
precipitated this hearing, but you are telling me they are not
the basis on which this committee should be looking at new
regulation. There are some other substantive questions.
Mr. Egan. They run much deeper than that.
Mr. Kanjorski. Right. I agree with you. We have been
carrying on our examination for more than 40 months and have
been making some progress, sometimes by voluntary disclosure
and transparency that the two organizations have had.
I tend to worry about our establishing some precedent for
action based on incomplete news reports and internal actions by
the board of directors. Quite frankly, I could understand a
board of directors being annoyed with a set of management that
have not complied with making restatements in a number of years
and just getting totally fed up and saying enough is enough and
you are gone. We are going to put somebody else in. It should
not necessarily connote to the market or to anyone else that
there was something criminal or improper that was carried out.
It was just probably a great frustration or could have been a
great frustration of the board, and a very responsible act by
the board, I may say, if that is the derivation for the action.
Would you agree?
Mr. Egan. Yes, but I would characterize it as saying these
are two critical institutions and that investors are confused
right now. They are concerned when they see executives resign.
They are concerned when they hear about accounting problems,
and they are concerned about the regulatory environment of both
GSEs. I think it requires a closer look at the entities and how
they are regulated, and whether or not investors are investing
on an appropriate basis, or whether another signal has to be
sent to the market.
There is also the issue of whether or not they lose their
AAA rating; whether or not they still can exist in their
current form. My understanding is that they are not putting up
much capital for their derivatives. In fact, in a lot of cases
they are putting up no capital because of that AAA rating. If
that goes, a question is how badly the institutions will be
hurt. So it is a very broad question that I think needs to be
addressed. Whether or not it ends up that you move it to a
different regulator is part of that broad question.
Mr. Kanjorski. Should we as a committee be acting just
perhaps a little more responsibly in finding our what happened
and starting from the core of the facts of the information
before we move? I heard so much of your testimony, ``if this
happened, if this happened, this may have happened, this could
be.'' But no substantial statement of facts as to what did
happen, and yet we are speaking to the world market here in a
way that could be very crucial at a very delicate time in our
economic structure as a whole. I am just wondering just how
responsible it is for us to conjecture as to what may have
happened and talk about it as if it in fact did happen. Not
that we should wait, but I am surprised that maybe some of our
first witnesses are not the regulators, and aren't some of the
officials that made the decisions within Freddie Mac to tell us
what they did and why they did it.
Mr. Castle. [Presiding.] If you could answer briefly, we
need to move on to other witnesses please.
Mr. Egan. Very quickly, from our perspective, the current
regulator should not have allowed the capital to dwindle to the
point that it is as a percentage of assets. That is a
fundamental issue and investors are still thinking it is a AAA
rating and hopefully it can be handled delicately so it does
not cause a panic in the market.
Ms. Petrou. If I could also just add, one thing we do know,
we don't have any ifs about, is what OFHEO has done through
this process. When Freddie Mac first announced its restatement
in January, within hours the head of OFHEO said he saw no
problems. Consistently as each revelation has come out, OFHEO
within hours has commented on it. Bank regulators never talk
about their charges because they believe in something they call
constructive ambiguity. That promotes market discipline and it
is essential. We do know that, sir.
Mr. Castle. Thank you, Mr. Kanjorski.
Mr. Ney is recognized for 5 minutes.
Mr. Ney. Thank you, Mr. Chairman.
The current regulatory regime for the GSEs has a product
review on safety and soundness regulator split between HUD and
OFHEO. The new proposal keeps that system with HUD regulating
new products and the OTS regulating safety and soundness. I am
wondering if keeping this system is in the best interests of
the GSE regulation because they could be rather intertwined. So
would it make sense or wouldn't it to centralize all the GSE
regulations under one roof or not? Anybody that would like to
answer.
Mr. Schatz. Mr. Ney, we have made that proposal and we
certainly urge the subcommittee to examine it, discuss it with
the regulators, and determine whether this would be best, and
also look at how other financial institutions are regulated to
determine whether there is a bifurcated system out there or a
single system. It seems to me that there is more or less a
single system for soundness and safety. The new program
authority is certainly unique to the GSEs in some ways, and I
would hope that as the subcommittee moves forward and the full
committee moves forward that you do discuss this in some depth.
It is our view that the new programs, if they are not tied
to safety and soundness and the same regulator is not aware of
what the GSEs are supposed to be doing in their mission, that
is one of the problems that could occur. There was a statement
earlier about the fact that OFHEO in its 10 years only
interrupted or said that it was not going to support one
particular product indicates that they are not doing a very
good job of making these determinations. I am sure there are
other products that may have been reviewed or reviewed
differently if they had been more aware, or certainly tied into
more knowledge of the financial system that the GSEs are
involved with as well.
Mr. Ney. So you approve consolidating them?
Mr. Schatz. Yes, we would approve consolidation. But again,
I think you would need to compare this to the other financial
institutions in the country as well, to be consistent.
Mr. Ney. Does the rest of the panel agree with that or
disagree?
Ms. Petrou. I would agree with that, sir.
Mr. Egan. Our view is whoever regulates them has to have
in-depth knowledge of the financial market, hedges and be able
to stress test assets and liabilities and really have a very
sophisticated banking examiner.
Mr. Cochran. You might pose the question oppositely and
ask, if you keep it bifurcated like it is now, what happens if
those two regulatory aspects come into conflict? Who dominates,
safety and soundness or mission? So there is probably a
rationale for keeping them consolidated under one regulatory
roof, so to speak.
Mr. Ney. Do you have any comments on the prior approval
that would be in the new piece of legislation?
Ms. Petrou. You are referring to the prior approval of new
activities?
Mr. Ney. Of new product. Is it enough? Does it
overregulate?
Ms. Petrou. Right now, all of the insured depositories and
their holding companies need prior approval from their safety
and soundness regulator for any new activity. Yet we have an
industry that is by far the leader in the world in innovation.
I think it is important because it protects safety and
soundness. It also protects consumers. In new products there
are potential abuses, conflicts of interest, disclosure issues.
Prior review by a skilled regulator is really essential.
Mr. Ney. So you say it is common for every single product
or change in existing product in all cases to have prior
approval?
Ms. Petrou. All new products which raise significant
issues. Congress has rightly put in place a system for
traditional products at traditional institutions of notice to
the supervisor, but those are still all done in a public
process. Any significant new activity must be reviewed by the
regulator and put out for comment so that all appropriate views
are considered before the deposit insurance funds or the lender
of last resort is put at risk through a potential new activity.
Mr. Ney. Over the years, the OTS has developed a lot of
expertise in regulating thrifts and the unique business model
that comes along with thrifts. Any thoughts about taking OTS
into a whole new different regulatory venture?
Ms. Petrou. I think it raises significant issues because we
have ``housing finance'' here, but Fannie and Freddie are so
huge and their hedging activities are so different that they
could be considered housing, financial institutions or even
hedge funds, and a supervisor with the skills to do both is
essential.
Mr. Ney. So you feel the OTS has been towards, again,
thrifts and the unique situation there. But you feel
comfortable that OTS could undertake this and be able to do
this with Fannie and Freddie?
Ms. Petrou. No, sir. I have some questions about that.
Mr. Egan. I agree. From our perspective, the hedging
operation is like the nitroglycerin of these companies. It has
to be handled very careful, made sure it is set up properly,
that it is matching their asset and liability structure. It has
to be reviewed properly. The counter-parties have to be
understood. It is far beyond the normal thrift institution. It
is more akin to regulating CitiGroup or J.P. Morgan or some of
the investment banks.
Mr. Ney. Thank you. My time has expired. Thank you, Mr.
Chairman.
Chairman Baker. Thank you, Mr. Ney.
Mr. Scott?
Mr. Scott. Thank you very much, Mr. Chairman.
I am very, very much concerned that we do move forward;
that we work very judiciously on this issue. I certainly
appreciate the chairman allowing me an opportunity to work with
him on this legislation as we move forward.
I do think we need to move with a bit of caution because
the first question I want to ask is, what impact would our
proposed legislation in this committee to strengthen the
regulatory oversight have on the stated mission of these two
entities? It is my understanding that stated mission is to buy
home loans from banks and lenders, to supply ready cash to the
home mortgage market, especially for middle-income and lower-
income individuals. Given that, and I don't know which of you
might want to respond, Ms. Petrou, I certainly want to get your
opinion on that question, what impact would it have? I think
that is a fundamental issue here as we move forward, because
Fannie Mae and Freddie Mac were created for a special purpose.
The other part of this question is that it is very complex
and complicated, but from what I am following here, the nut of
this issue it seems to me is this business of derivatives,
which are used to hedge interest rate risk. Now, if I am not
mistaken, derivatives was the key role that was played in the
Enron upheaval. So I would like to get an analysis from you of
the derivatives in relationship to this question. If we are
using these derivatives, if we are using them to hedge on this
risk-taking of interest rates and it resulted like Enron, the
fundamental question then becomes, is Fannie Mae and Freddie
Mac taking on too much risk?
If you could answer those for me, and I do have one other
point I want to get to later, so Mr. Chairman, please, if they
talk too long or I talk too long, please correct me because I
would like to ask another question. But I would like to get an
answer on that one, please.
Ms. Petrou. First with regard to the mission, sir, I think
that appropriate regulation will enhance, advance and reinforce
that mission. One provision in the Chairman's bill addresses
HUD's role in ensuring that Fannie and Freddie serve affordable
housing. In my opinion to date, the goals have been too lax;
the definition of affordable housing too generous; and the
enforcement nonexistent. We have had a lot of rhetoric, but we
need an effective supervisor to ensure real performance, just
as we have bank regulators who look in and enforce in cases
where financial services firms, especially insured
depositories, are not doing right by their low-and moderate-
income customers.
Mr. Scott. So you think that moving the regulatory
oversight to the Treasury Department would help the mission?
Ms. Petrou. Yes, sir. I know there is some issue as to
whether or not Treasury is as devoted to homeownership as it is
perhaps to safety and soundness and stable financial markets,
but I think with the role of HUD and of course with
congressional supervision and clear direction to Treasury, you
can ensure that a new regulator takes as full account of those
responsibilities as the bank regulators do. For example, you
have told them to have a Community Reinvestment Act and that
has helped bank regulators govern their charges, and you can do
the same for Fannie and Freddie.
Mr. Scott. What about the idea of registration of debt with
the Securities and Exchange Commission?
Ms. Petrou. I would support that.
Mr. Scott. You don't feel that would hamper the mission?
Ms. Petrou. No, sir. I think it might help in fact to
improve it by improving investor understanding, reducing costs.
Fannie's and Freddie's costs of funding could well diminish.
Indeed, Moody's recently suggested that it would and that is
what the GSEs should be passing on to the neediest homeowners.
Mr. Scott. The other question I wanted to ask is, just for
the record, do you believe that because of the similarities
between Freddie Mac and Fannie Mae that Fannie Mae may be being
tarred by the same brush? Do you think it is fair to judge
Fannie Mae based upon the missteps of Freddie Mac?
Ms. Petrou. I don't, sir, at this point, but I do think it
is fair to say that both GSEs operate under divided and in many
respects faulty regulation with inadequate capital and lack of
appropriate market discipline.
Mr. Scott. Okay. My final point, Mr. Chairman, the Office
of Federal Housing and Enterprise Oversight has got 140 staff
and a $30 million budget. Do you think that is enough? Do you
think they are too weak to perform the task? That they need to
be strengthened in terms of manpower and budget?
Mr. Egan. Our view is that it goes beyond even the
regulatory environment; that there are some problems in the
market itself that have gotten us to this point. There are
problems with the investment banks, all the analyst came out
positive, I think, about 10 analysts came out positive, one
came out negative after the disclosures on the accounting
issues. That is a structural problem. The fact that the major
rating firms are all paid by the issuers and get the bulk of
their compensation from these major issuers, that is a problem.
Regulation has typically lagged.
It would be terrific if you set up a huge regulatory body,
maybe you would get better disclosure, but it has to go beyond
just that issue if you are going to protect these firms in the
future and protect investors. The worst that could happen, they
are doing great work, the worst that can happen is that there
is a breakdown in the market and investors lose faith. The
investors think that the U.S. government is behind this whole
thing 100 percent. That is why there is a AAA rating. This
whole area has to be addressed and the structural problems in
the financial markets have to be addressed.
Mr. Scott. Thank you.
Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Scott.
Mr. Castle?
Mr. Castle. Thank you, Mr. Chairman.
Let me just say to you first of all, you have wandered in
the desert for some time and I think you have found your oasis,
and I think the rest of us had better start paying some
attention to this. This is not something that is easily
understood or can be swept under the rug, in my judgment. Let
me thank the witnesses for the tutorial today, because I am
still trying to define the problem. I haven't even gotten to
whether there is a solution at this stage.
Along those lines, if I could just ask you some consumer-
type questions. I want to know what is at risk here. For
example, the housing market has been the strongest part of our
economy for the last 3 or 4 years. I just refinanced my
mortgage. I am pleased with that. Actually, it is not complete
yet; hopefully it will go through. Obviously, Fannie Mae and
Freddie Mac are tremendously helpful with that, based on all
that I read and understand, although I could not tell you why,
but that is what they tell me.
My concern is, are we by taking the actions that we might
take here, are we going to disrupt the housing market in some
way or another, or the securities market, or even the stock
market in terms of the stock values of these companies? In
other words, by dealing with the additional regulation, is it
going to be such a great burden or such a great shift that
there is going to be tremendous impact out there? On the other
hand, if we don't do it, is there going to be potentially an
impact? I can't really honestly define everything that went
wrong with Freddie Mac or whether Fannie Mae has any problems
or not, but my sense is that they are less regulated than a lot
of other financial entities, and that is potentially a problem
as well.
So if you could just, if any one of you or two of you or
whatever, can help me with understanding the potential problem
a little more in terms of what could happen here, I would
appreciate it.
Mr. Schatz. I just wanted to just jump in a little bit, Mr.
Castle. The problem really will arise if Congress does nothing.
After the Enron scandal and Arthur Anderson, certainly steps
were taken to strengthen regulation over the accounting
profession and the securities and others. Here we have two
large organizations that are exempt from many of the laws that
apply to their competitors, to every other publicly traded
company. Our view is that placing them under the scheme would
reassure investors, reassure the public. They would certainly
still be able to compete and compete very well, as they do, in
the marketplace, and that it would restore a great deal of
confidence that may have been shattered not by what you are
doing, but what happened at Freddie Mac.
So it is in a sense a problem of their own making, but it
does draw more attention to what the chairman and others, and
Mr. Shays and others have been talking about for some time,
which is simply trying to improve regulation and oversight. No
one is talking about putting them out of business. We are
talking about providing a structure that will give all these
people, the shareholders, the taxpayers, consumers, the banking
system, the housing system, more confidence that oversight is
being exercised in an appropriate manner.
Mr. Castle. Thank you.
Mr. Egan. Our view is along the lines of a stitch in time
saves nine. If you don't act, this is probably what is going to
happen, that Fannie Mae's capital base instead of dropping from
3.1 to basically 2, in another 2 years it will probably be
about 1.5, and just keep dropping from there. There is huge
pressure on these organizations to grow, so you have to hold
them back, no constraints.
What would be an ideal world is if there is a new
regulatory body. It had some real powers. It encourages these
organizations to strengthen their capital base.
Mr. Castle. Excuse me. Let me interrupt there, because I
wanted to ask this question anyhow. By a new regulatory
structure, you are suggesting that OFHEO just is not capable of
being structured in such a way that it could carry this out
responsibly?
Mr. Egan. We have not seen any evidence of that, and
hopefully it won't come to that to encourage some discipline in
the rating agency industry also, and some discipline with the
equity analysts. Obviously there are still some problems. What
would also help is that if you had some new mortgaged-backed
agencies, some mini-Freddie Macs and Fannie Maes that are
growing, so if God forbid, anything happened to these two
entities, that we are not just counting on them; that we have
some alternatives, some viable alternatives, in the market. If
we could achieve that goal in another two years, it would be a
huge positive to the people holding the mortgages, the
homeowners, the markets, everybody would benefit. On the
current path, it is just a problem, a sore, that is going to
continue to fester and grow.
Mr. Castle. Should the Federal Home Loan Banks be
considered or included in any legislation that we do?
Mr. Egan. I am going to defer to some other panelist.
Ms. Petrou. I think there are some significant supervisory
issues there that do warrant your review. The Federal Housing
Finance Board in only the last year has taken a look and found
that it had three times more PR people than it had examiners.
That is for an institution which in aggregate is about $800
billion. So I think a hard look does need to be paid.
Mr. Castle. Thank you, Mr. Chairman. I yield back.
Chairman Baker. Thank you, Mr. Castle.
Mr. Miller?
Mr. Miller of North Carolina. Thank you, Mr. Chairman.
I am just trying to understand what is the bad thing that
can happen here? Mr. Egan, you said things happen, and yes I
know exactly what your teenage son would have said instead of
that. And I know that by saying ``things happen,'' you intended
some ambiguity that we can't possibly anticipate all the bad
events. But it seems to me that the thing that these two
institutions have going for them is that ultimately they rely
upon what is for most households the ace of trumps, the
mortgage. People may or may not pay their credit card bills,
but they sure pay their mortgage.
It certainly seems like Fannie Mae and Freddie Mac should
not have to have the same kind of equity requirements that,
say, MBNA has. What can cause the meltdown here? Is it that
people don't pay their mortgage? Is that there are fluctuations
in interest rates? Is it the ways that interest rate
fluctuations are hedged is somehow risky in a way that is
incomprehensible to 99.95 percent of the population in this
room?
Mr. Egan. There are a variety of things that could happen,
and you could assess some probability of that happening. Unless
the economic environment changes drastically, probably the
mortgage payment rates are not going to change very much. What
is probably going to be a bigger problem is that there will be
some revelations that over the next six or twelve months that
both these entities are having difficulty. Because Mr. Castle
prepaid his mortgage perhaps yielding 7.5 or 8 percent, and now
is only paying 5 percent.
These entities receive that money and now can only reinvest
it in the market at 5 percent. However, on the liability side,
because they can't pay off all those liabilities, they still
have to pay 5.5 or 6 percent. That is a problem. These are huge
entities so it is difficult to hedge completely against that
problem. Maybe they have to revalue the portfolio because they
have to mark-to-market because they sold out some of the
instrument, and that 1.9 percent capital goes down to 1.5
percent. Maybe it is that our competitors S&P and Moody's
realize that maybe this really isn't AAA and they do some
investigation and realize the capital line is only $2.25
billion, and no more after that, and therefore they reassess
their position and all of a sudden it slips down to AA, and
some major investor groups, the Japanese or the Germans, pull
out their capital or reassess their investment.
It is an accident to have so much water behind the dams, is
a nice way of thinking about this. These institutions were
built to hold so much water and there is too much water behind
it. You need to let down the water level. You have to shore up
the dam so that it is safer, and hopefully get some other dams
in place, too, so that you are not dependent on this one river
system. So there are a variety of different problems that could
happen. It is hard to figure out which one exactly is going to
hit, but certainly you don't have the cushion that you should
have.
Mr. Miller of North Carolina. If we take less water behind
the dam, if we let down the water level, are we not inevitably
going to make mortgages less readily available?
Mr. Egan. No, because the markets are fluid and hopefully
there will be some other institutions that will be encouraged
to step up their activities. The other approach is just
continuing to build it up and I would argue that you don't have
enough cushion right now to continue to let it happen, and the
forces are in place that if it is not pulled back, the asset
base will continue to grow.
Ms. Petrou. I would say, sir, also that when you describe
mortgage credit risk, which is all of our desires to pay our
mortgages off first, that is the risk Fannie and Freddie were
established and chartered to take for the lowest-risk
mortgages. What they were supposed to do when Congress
established them was to buy mortgages originated by lenders,
turn them into mortgage-backed securities so the investor would
take all of that interest rate risk that Mr. Egan described.
Fannie and Freddie would hand-off the riskiest pieces of the
mortgage credit risk position to third parties, and they would
then hold the rest, the safest piece of that mortgage credit
risk. That is not how they are structured any longer.
Chairman Baker. I thank the gentleman.
Mr. Shays, you are next. And just by way of comment on the
last exchange, the last quarter of 2002 there were reported
negative duration gap difficulties for Fannie Mae which is a
reflection of the mismatch in their portfolio because of the
extraordinarily low-cost interest rates for so long. The
solution or remedy as I understand it was to merely acquire
mortgages and grow the portfolio, which does not necessarily
yield any more profitability, but does increase risk to the
taxpayers.
And by the way, Mr. Shays, you are recognized.
Mr. Shays. Thank you, Mr. Chairman.
You have the second and fourth largest financial
institutions in the United States. You have the 16th and 32nd
largest Fortune 500 companies. Under the law, they were not
under the 1933 and 1934 Security Acts. Neither of these Acts
were to punish companies, correct? What are the purposes of
both of these Acts?
Ms. Petrou. To protect investors by informing them of a
wide range of financial information and to give remedies when
these protections are not in place.
Mr. Shays. And we require all Fortune 500 companies to be
under these requirements. Is that correct?
Ms. Petrou. All publicly traded firms.
Mr. Shays. All publicly traded. So if that is the purpose,
then explain to me how putting them under the Act harms these
companies or harms these investors? I am at a loss of words to
understand how anyone can say putting them under the 1933 and
1934 Acts somehow is going to harm them and harm our economy.
Please tell me how.
Mr. Cochran. I think the claim that is being asserted is
that by coming under the Act, they will have to register and
incur the costs of registration, and that cost flows to the
bottom line.
Mr. Shays. So it is the cost issue.
Mr. Cochran. That would be my estimate.
Mr. Shays. Right. And so what we did in our legislation, we
capped them to say they would have to contribute no more than 5
percent of the total amount to the SEC, and any other company.
Wouldn't that minimize that issue?
Mr. Cochran. It probably would. And by the way, I do not
necessarily agree with that assertion in any case.
Mr. Shays. Okay. Does anyone agree with that claim that it
is going to hurt them? Okay.
Let me understand Freddie's statement today about what they
are disclosing. Would someone here tell me what you think
Freddie said today about the fact that they have to re-state
earnings. What is your sense? Tell me what you think is going
on at Freddie in short-term, not a long sentence. Sean, do you
want to do that?
Mr. Egan. That they are still getting a handle on exactly
what is going on; what their derivative positions are; how to
value the securities. They are hoping they get it right this
time, but they are not quite sure and hopefully they don't roil
the markets too much.
Mr. Shays. Anybody else want to add something?
Ms. Petrou. No, we heard this morning was that the earnings
range now will be increases of between $1.5 billion and $4.5
billion, and that the bulk of this is resulting from
significant new disciplines related to derivatives.
Mr. Shays. My understanding is they said they didn't follow
general accounting practices or what would have been required
under the SEC, and had they followed what would be required
under the SEC, they wouldn't be in this problem. Is that true?
Ms. Petrou. It is unclear whether they would have been in
this problem because firms under the SEC, of course, have also
encountered serious issues. But I think there are questions.
Mr. Shays. Let me put it differently. If they followed the
requirements under the SEC, they would have not have
encountered this.
Ms. Petrou. This morning Freddie Mac indicated there were
aspects of the restatement that might violate securities law
had they been subject to them. That is all I can speak to. That
is one of the pieces in their release this morning.
Mr. Shays. Would you explain to me when they say that their
earnings were understated, is that a good thing? Should I feel
comfortable that there is potentially $4 billion of understated
earnings in the past? Like, in other words, they have more
earnings. Does that mean, one, they didn't pay proper taxes in
the past? And two, should I say this is good news?
Mr. Cochran. I think as Congressman Frank suggested, there
are ways to interpret the application of accounting rules. But
I think what concerns the markets is that by restating the
earnings, you are going to increase the volatility or the
variance in the reported earnings. Other things being equal, we
would rather see smooth earnings over time, rather than bumpy
earnings.
Mr. Shays. So investors would rather see constant growth,
not really terrific years and bad years. And so if Fannie or
Freddie experiences that kind of growth pattern, how does the
investor respond to it?
Mr. Egan. From our perspective, it is unsettling. It is
unsettling because there is a lot more volatility in the
earnings than what they would like to have been the case. They
are trying to smooth earnings and now they found out that they
can't, and the investors are thinking it is not quite up to the
AAA rating that it should be.
Mr. Shays. Okay. Just one last question, Mr. Chairman? So
if I am an investor, I should not say this is good news that
they had really higher earnings in the past which they
understated.
Mr. Egan. No, because it is going to be depressed in the
future. It is just taking earnings that they are pushing out in
the prior years and they won't have it in the future years. It
just means that the volatility will be greater. It is not
comforting.
Mr. Shays. Okay. Thank you, Mr. Chairman. Thank you to the
panel.
Chairman Baker. Thank you, Mr. Shays.
Mr. Clay?
Mr. Clay. Thank you, Mr. Chairman. I want to thank the
panel for their testimony today.
First, a few observations in regard to this legislation and
the subject matter. I think we must identify the level of
mismanagement, be it accounting problems or criminal activity.
Solutions for Freddie Mac must be based somewhat on those
answers. Are we going too fast without knowing what we are
correcting? Or are we negatively affecting the markets with
this rush to judgment? Hopefully these hearings will bear that
out.
Let me ask about the proposed bill which imposes
restrictions on non-mission-related investment by Fannie Mae
and Freddie Mac. My understanding is that the non-markets
investment portfolio is used as an essential risk-management
tool. These liquid investment portfolios serve as a capital
cushion used by the companies to manage liquidity needs. By
restricting this risk-management too, the bill takes away
Fannie Mae's and Freddie Mac's ability to manage a liquidity
crisis like the one the country experienced in the fall of
1998. Because of the current structure, Fannie Mae and Freddie
Mac were able to step up in a turbulent time and provided
stability in the United States housing markets. Why do you
think this tool should be eliminated? We can start with you,
Mr. Egan.
Mr. Egan. I don't think it should be eliminated. I think it
has to be properly managed or you run the risk of losing the
tool, so to speak. These are great institutions. They have
created a huge amount of good for a number of people. The risk
is that they are not regulated properly; that they are
misperceived in the market; that if the problem is not
addressed in the near future, that you cut off access to
mortgage funding for a lot of people. So our view is that it
just has to be managed properly and hopefully some other
institutions will grow to compete with these two. It is a very
important area and it is unwise to leave just two major
institutions fulfilling this function.
Mr. Clay. I heard you say that before, too. Now, do you
think that other institutions will step up and follow the
mission statement of these two entities, I mean to really go
after the low-and moderate-income individuals who have that
desire to realize the American dream?
Mr. Egan. Yes, because there is a profit incentive. The
institutions have outgrown their $2.2 billion capital line.
Other institutions can be set up to serve that area. So yes, I
think that other institutions will fill the void.
Mr. Clay. Let me ask you, based on an open-ended public
interest standard, this new regulator that is proposed in the
legislation could make public any information about Fannie Mae
or Freddie Mac. Doesn't this bill throw overboard any notion of
safeguarding proprietary corporate data or examination
confidentiality? Wouldn't one impact be to make all corporate
data potentially available to competitors? Anybody can tackle
it.
Mr. Schatz. Mr. Clay, I would expect that as the
subcommittee and full committee review the specific provisions
of the bill that it would protect any proprietary information
for Fannie Mae and Freddie Mac as it would any other company. I
would hope that would be the ultimate outcome of that
particular piece of legislation. No one is intending that their
proprietary information be made public. That does not happen in
other circumstances and it would not be appropriate here.
Mr. Clay. Would that really put those two entities at a
disadvantage, those GSEs at a disadvantage?
Mr. Schatz. Again, I have not examined every single word,
but it seems to me that whatever bill comes out of the
committee would simply not do that.
Mr. Clay. Okay.
Mr. Egan. A good measure of whether or not they have
anything proprietary is whether or not they have a number of
their officers sign confidentiality agreements pertaining to
the software they use for managing derivatives and things of
that nature. It would be surprising if they have that much
proprietary information.
Mr. Clay. Okay. From what I understand, developing a new
product can take a lot of time, money and resources. When
Fannie Mae or Freddie Mac make this effort and start to work
with a group of pilot lenders, sometimes they are not sure
whether the new idea will appeal to consumers. Why would the
GSEs and lenders advance so much effort into product
development if there is a greater fear and chance that a
regulator would turn it down?
Ms. Petrou. That is the same risk that, of course, Congress
has asked all the nation's banks, savings associations and
financial holding companies to take because that investment is
backed by the taxpayer. Programs can look little. There is one
right out there now which is described as a pilot that Fannie
is working with some lenders to offer in 50 percent of the
nation's mortgage markets. That is really I think a form of
consumer lending. So prior approval which bank regulators are
good at and banks are good at filing all those applications has
never been an impediment to innovation and I don't think it
would be for Fannie or Freddie either.
Mr. Clay. I thank the panel for their answers.
Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Clay.
Mr. Baca?
Mr. Baca. Thank you very much, Mr. Chairman.
First of all, let me thank the panelists for appearing here
today. I have a couple of concerns that I would like to
express, but before I do, I would like to recognize the work
that Fannie Mae and Freddie Mac have both done. They have
served an important role particularly for the Hispanic and
minority community. Both companies have a very good track
record of expanding minority homeownership. Hispanic ownership
rates have increased from 44.7 percent in 1998 to 48.2 percent
in the year 2002. In the year 2002, more than half of Fannie
Mae's business served low-income and moderate-income families.
And Freddie Mac also financed over $135 billion in loans to
almost one million minority families in the year 2002. Finally,
Fannie Mae has also created the American dream commitment to
provide $2 trillion in financing in serving 18 million families
by the end of the decade. I am very much concerned about the
effects that this legislation is going to have. My question
would be, what information can you provide me to show that
Hispanics and other minority communities will not be hurt by
some of the proposals that we are hearing here today? That is
question number one. And two, in particular, what effect would
change in the oversight from HUD to the Treasury Department
have? That is question number two. And is the regulation
necessary to avoid more corporate scandals? That is the third
question.
Any of the panelists like to tackle this? I heard Karen
mention we are too generous. What does that mean? For whom or
what? And what effects then will it have on minorities now who
have the first opportunities to own a home? They never had it.
Are we going to change it?
Ms. Petrou. I don't think I said that any public policy was
too generous to low-income and minority homeowners. That is the
most struggling part of the market and it is really where the
$13 billion of subsidies provided on an annual basis to all of
the housing GSEs should be directed. What I tried to suggest
and I think there is some significant research out there that I
would be happy to submit for the record, is that good
regulation would reduce the funding costs of the GSEs and that
would make it easier for them to reduce homeownership costs,
particularly at the most struggling ends of the market.
Mr. Baca. What effects would it then have on minorities or
Hispanics on homeownership?
Ms. Petrou. I think it would result in increased
homeownership. For example, if you look around many areas of
the cities, the District of Columbia is the one with which I am
the most familiar, aspects of the market or access knowledge,
language barriers, and that is very costly. I think helping the
GSEs reduce their cost of operations would permit more of those
funds to translate into Hispanic homeownership.
Mr. Baca. What outreach or programs would be available to
make sure that was done? You can have the regulations, but if
you don't have the outreach into the minority communities or
others to what is available, and what Fannie Mae and Freddie
Mac are doing is that they are doing that. The educational
programs, then, would not be effective.
Ms. Petrou. That is what a good regulator is for, to say
here is what you do and to be sure that is what they are doing.
Mr. Baca. It doesn't happen all the time, though. Can
somebody else answer the additional questions that I asked?
Mr. Egan. Our perception is that the market does not give
gifts. That is that minority homeownership has increased
dramatically because it has become easier in the market to
afford the mortgage. Interest rates have dropped to record low
levels. Hopefully, these two GSEs will continue their good work
and the levels that they have in the past, and hopefully they
can get some more capital. But don't confuse the record number
of homeownership with their growing very rapidly. It is broader
than that. It is really a function of decent economic times
overall and the record drop in interest rates.
Mr. Baca. Right. Well, that is why I am concerned a little
bit with the proposal because when you open the market, then
you target certain individuals that could lead to additional
scandal and corruption and targeting especially minorities and
Hispanics, and especially if the education is not out there,
too, as well, based on these that would be available. So I
mean, that is the concern that I have as we look at what is
going on.
Mr. Egan. If you are going to give some special
consideration to a couple of entities such as a GSE, then
encourage them to focus on minority groups and make sure that
they actually do their job. They have incentives to do it and
monitor it. That is probably the most effective way.
Mr. Baca. That is why the language is very important that
is in the proposal to make sure that we have these guarantees.
Mr. Egan. Yes, but make sure that you do not jeopardize
these institutions by ignoring their capital levels.
Mr. Baca. Okay. Thank you.
Chairman Baker. Thank you, Mr. Baca.
Mr. Shays, you had a quick follow-up?
Mr. Shays. Yes, thank you. Just with Mr. Schatz, in his
statement he said Fannie and Freddie lagged the private market
in supporting the financing of affordable housing. Why is it
that Fannie and Freddie basically in spite of their mission
don't do as well as banks in terms of supporting the low-income
market?
Mr. Schatz. Mr. Shays, certainly it is a question to ask
when they come up to talk to you. I know the Chairman and
others on this subcommittee have had those questions before. I
will be happy to forward those studies. But for some reason,
maybe it is the Community Reinvestment Act, maybe it is other
requirements of banks, they have done better.
One of the things we suggested is to have all of the same
regulations and laws that apply to these banks and other
lenders, apply to Fannie Mae and Freddie Mac and the Community
Reinvestment Act would be one area where they might be forced
to participate more in the affordable housing market. And
maybe, again, looking at the dichotomy between their mission
and their objective to bring the greatest possible return to
shareholders, that the returns are not in the affordable
housing market. They are in other areas of housing that do not
improve that particular area of the marketplace.
Mr. Shays. Let me have one last question, Mr. Egan. Let me
ask you, will putting Fannie and Freddie under the 1933 and
1934 Acts hurt their ratings, be neutral, or actually help
their ratings?
Mr. Egan. They won't change our ratings because we are
comfortable with the ratings where they are. They may change
S&P and Moody's ratings if they realize that the capital line
is only $2.25 billion and it is not going to grow.
Mr. Shays. But there you are just basically saying it is
the knowledge that would hurt them, and that in fact would be
that they would learn something that already exists, not that
we created a new problem.
Mr. Egan. More disclosure is always an advantage. What is
the biggest problem that we see in the market is when there is
a big jump, such as when Enron's business was gone, basically,
they are only left with one party to go to for a savior, and
that was Dynegy. It is a ``Hail Mary"-type pass. That didn't
work out, and then the whole entity collapsed. We are better
off in getting the information out there quickly, making sure
it is accurate information, and make sure that the reports, the
ratings that are given to the investors are representative of
the true risk of these enterprises.
Mr. Shays. So basically from your testimony you are saying
more disclosure in the long run helps your ratings, rather than
hurts them.
Mr. Egan. Absolutely.
Mr. Shays. Okay. Thank you.
Chairman Baker. Thank you, Mr. Shays.
Mr. Scott, you had a follow-up?
Mr. Scott. I want to go back to a moment to this business
of derivatives, because I think that is the core of this. Why
not just ban the use of the derivatives? Billionaire investor
Warren Buffett called them financial weapons of mass
destruction. I mean, if he uses that kind of descriptive
language, that is enough for me to know that we have a problem
here.
Mr. Egan. From our standpoint, derivatives are just another
higher level of ownership. Initially land was wealth; if you
owned land, you were wealthy. Then it turned into gold; if you
held gold or silver, then you were wealthy. And then it moved
into securities. Hold the stock of AT&T or IBM, well, I am
wealthy. It is now moving to the point where information is
wealth, and you can make investment decisions faster and more
accurately by the next level of sophistication, and that is
derivatives. The problem is that volatility increases with each
step. The land isn't going anywhere. The people are not going
to move dramatically over one year or two years. You can still
use it for farming or whatever else. The hard assets, they are
less volatile. But when you move into stocks, it is a little
bit more volatile. And then derivatives are even more volatile.
Who knows whether there is going to be an additional layer of
complexity.
But the negative is that there is a huge amount of risk.
Values can change incredibly quickly. You can put on positions,
take off positions within a matter of seconds. So the risk
level is there. But to many investors, the benefit is also
there too that you are able to hedge a portfolio if you know
what you are doing. You can offset some positions
inexpensively. So as I said before, it is like nitroglycerin.
You know you can move mountains with it, but it can blow you up
if you don't handle it properly.
Mr. Scott. Right. As we move forward with this legislation,
what recommendations do you give this committee to address this
issue of derivatives? If this is the core of the problem, if
this is one of the major reasons why we are in the shape we are
in, if in fact it also was the major reason Enron went down,
would we be not fulfilling our obligation if we did not address
this in the legislation?
Mr. Egan. No, but you should make it flexible enough to
realize that the market is dynamic; that right now we probably
don't have the right information infrastructure in place to
manage many of these derivatives. Ideally, what would happen is
that all these institutions, not only the GSEs, but also the
financial institutions, would have a central clearinghouse for
their derivative positions so that a regulator could monitor
where they stand, whether or not they are getting into trouble.
When Long-term Capital was in the process or failing, you would
find out that XYZ Investment Bank had a huge exposure to it.
Fortunately the New York Fed was able to step up to the task
very quickly over the weekend and save it. But if they weren't,
they could have been a real problem.
So I would suggest that the old models for regulating
businesses need to be modified. They need to go beyond just the
10K, the 10Q, the traditional ones; developments are moving
much faster. It is unrealistic to prohibit the use of
derivatives. It is beyond that now. What needs to be done is
make sure that the regulation and the monitoring of that fits
with the prudent measures; that you are able to manage and see
whether or not these institutions are holding enough capital;
whether they are offsetting their derivative positions. It is a
fairly large task, but it is something that should be addressed
over the next couple of years.
Mr. Scott. Thank you. May I just finish? I wanted to ask
Ms. Karen Petrou, you are with Financial Service Analytics?
Ms. Petrou. Federal Financial Analytics. That is a firm
that I am Managing Partner of, along with my husband. We are a
small business that provides information and consulting
services.
Mr. Scott. Very good. You compared the capital base of the
1980s savings and loan disaster with Freddie Mac's current
capital ratios. Do you believe that OFHEO has permitted safe
capital ratios? If not, what would you recommend should be
changed to improve safety and soundness for these GSEs?
Ms. Petrou. I believe that the OFHEO capital rule, their
so-called risk-based capital rule, is analogous to the net
worth certificates that the then-Federal Home Loan Bank Board
established for savings and loans in the 1980s, because it is
fake capital. In the old days, the net worth certificates were
basically Monopoly money, pieces of paper. The regulator said,
``Let's pretend it's capital and hope that you grow out of your
problem so the taxpayer does not pick it up,'' and that was
wrong.
Now, we have a much more complex capital rule. It is 700-
plus pages long. At the end of the day, what it says is you can
count your derivatives as if they were capital. In other words,
that nitroglycerin is deemed the equivalent of real shareholder
dollars which ought to be at risk first. I do think that is a
significant failure that needs rapid attention.
Mr. Scott. Thank you.
Chairman Baker. Thank you, Mr. Scott.
I want to observe that the old rule that Ms. Petrou
referenced in her remarks, capital supervision and disclosure,
it may not work in every case, but it is a pretty sound
formula. On all three counts, we are deficient, in my judgment,
at this moment. Now, how we reconcile the deficiency is
certainly a matter for the committee to determine. H.R. 2575 is
only a point of beginning, not the end of the process.
I do appreciate each of your appearances here today and
giving the committee your insights. It has been most helpful. I
would point out that for the concerns expressed by those
worrying that if we touch in any manner or fashion GSE
operations, we will render thousands homeless is not borne out
by market performance over the last two days. In fact, as
knowledge of H.R. 2575 has been more widely understood, markets
appear to have responded favorably because in most views
additional information inside the mystical black box of GSE
performance is a helpful thing to truly understand the
investment risk you are taking by giving them your money.
I believe over the coming weeks and days as more critical
analysis is given to the proposal, certainly there may be
complaints about a particular provision. I think on balance,
however, it will be found to be a reasonable remedy in light of
the difficulties we face.
Some have suggested this morning during the course of the
committee's conduct that this really is an accounting issue
which deserves more examination. To that end, I have contacted
the GAO this morning and asked that they within a 90-day period
review the current accounting methodologies, the disclosures
made by Freddie Mac and analyze the potential impact it may
have on Fannie's market standing within the next 90 days so
that the committee upon its return from the August recess may
examine those findings.
And further to announce that in July upon our return from
the Fourth of July recess, the committee will conduct another
hearing for one or two purposes: one, to receive any published
report that may be ready for public distribution relative to
current pending inquiries; or secondly, to examine the
advisability of moving forward with H.R. 2575 or both. To that
end, I wanted to make those disclosures.
For all those here representing Fannie, Freddie and the
Home Loan Banks, if you have comments or questions you would
like to forward to me for response, I would be happy to receive
them.
Meeting adjourned.
[Whereupon, at 12:30 p.m., the subcommittee was adjourned.]
A P P E N D I X
June 25, 2003
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