[Senate Hearing 108-215]
[From the U.S. Government Publishing Office]
S. Hrg. 108-215
OVERSIGHT OF GOVERNMENT-SPONSORED ENTERPRISES: THE RISKS AND BENEFITS
OF GSEs TO CONSUMERS
=======================================================================
HEARING
before the
FINANCIAL MANAGEMENT, THE BUDGET, AND INTERNATIONAL SECURITY
SUBCOMMITTEE
of the
COMMITTEE ON
GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
__________
JULY 21, 2003
__________
Printed for the use of the Committee on Governmental Affairs
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COMMITTEE ON GOVERNMENTAL AFFAIRS
SUSAN M. COLLINS, Maine, Chairman
TED STEVENS, Alaska JOSEPH I. LIEBERMAN, Connecticut
GEORGE V. VOINOVICH, Ohio CARL LEVIN, Michigan
NORM COLEMAN, Minnesota DANIEL K. AKAKA, Hawaii
ARLEN SPECTER, Pennsylvania RICHARD J. DURBIN, Illinois
ROBERT F. BENNETT, Utah THOMAS R. CARPER, Delaware
PETER G. FITZGERALD, Illinois MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama MARK PRYOR, Arkansas
Michael D. Bopp, Staff Director and Chief Counsel
Joyce Rechtschaffen, Minority Staff Director and Chief Counsel
Amy B. Newhouse, Chief Clerk
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FINANCIAL MANAGEMENT, THE BUDGET, AND INTERNATIONAL SECURITY
SUBCOMMITTEE
PETER G. FITZGERALD, Illinois, Chairman
TED STEVENS, Alaska DANIEL K. AKAKA, Hawaii
GEORGE V. VOINOVICH, Ohio CARL LEVIN, Michigan
ARLEN SPECTER, Pennsylvania THOMAS R. CARPER, Delaware
ROBERT F. BENNETT, Utah MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama MARK PRYOR, Arkansas
Michael Russell, Staff Director
Richard J. Kessler, Minority Staff Director
Tara Baird, Chief Clerk
C O N T E N T S
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Opening statement:
Page
Senator Fitzgerald........................................... 1
WITNESSES
Monday, July 21, 2003
Alex J. Pollock, President and Chief Executive Officer, Federal
Home Loan Bank of Chicago, Chicago, Illinois................... 4
Peter J. Wallison, Senior Fellow, American Enterprise Institute.. 6
Bert Ely, Ely and Company, Inc................................... 8
W. Michael House, Executive Director, FM Policy Focus............ 11
James C. Miller III, Senior Fellow, Hoover Institution........... 12
F. Barton Harvey III, Chairman and Chief Executive Officer, The
Enterprise Foundation.......................................... 14
Susan M. Wachter, Wharton School of Business, University of
Pennsylvania................................................... 16
Alphabetical List of Witnesses
Ely, Bert:
Testimony.................................................... 8
Prepared statement with an attachment........................ 52
Harvey F. Barton, III:
Testimony.................................................... 14
Prepared statement with an attachment........................ 165
House, W. Michael:
Testimony.................................................... 11
Prepared statement with attachments.......................... 83
Miller, James C. III:
Testimony.................................................... 12
Prepared statement with attachments.......................... 103
Pollock, Alex J.:
Testimony.................................................... 4
Prepared statement........................................... 41
Wachter, Susan M.:
Testimony.................................................... 16
Prepared statement........................................... 181
Wallison, Peter J.:
Testimony.................................................... 6
Prepared statement........................................... 45
OVERSIGHT OF GOVERNMENT-SPONSORED ENTERPRISES: THE RISKS AND BENEFITS
OF GSEs TO CONSUMERS
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MONDAY, JULY 21, 2003
U.S. Senate,
Subcommittee on Financial Management,
the Budget, and International Security,
of the Committee on Governmental Affairs,
Washington, DC.
The Subcommittee met, pursuant to notice, at 2 p.m., in
room SD-342, Dirksen Senate Office Building, Hon. Peter G.
Fitzgerald, Chairman of the Subcommittee, presiding.
Present: Senator Fitzgerald.
OPENING STATEMENT OF SENATOR FITZGERALD
Senator Fitzgerald. I would like to call this meeting to
order. Let me first welcome our distinguished panel of experts
here today. We appreciate all of you making time in your busy
schedules to be here for this important topic.
Let me first set forth the purpose of this hearing, as I
see it. The purpose is, No. 1, to examine the current status of
Fannie Mae and Freddie Mac and possibly the Federal Home Loan
Bank Boards, which are also Government-Sponsored Enterprises
and are involved in housing. At least, the Chicago Federal Home
Loan Bank is. And two, to engage in a balanced and healthy
debate about the risks and benefits of these large
corporations, which were established by Congressional charters.
Let us stipulate at the outset that the housing GSEs
fulfill an important public policy mission that is built into
their government charters, to facilitate home ownership by low-
to moderate-income families. In my judgment, the housing GSEs
have contributed meaningfully to this cause, helping to give us
perhaps the best housing market in the world.
Second, GSEs, by charter, have prescribed limits on their
activities. Unlike most companies, GSEs cannot enter into any
business they want. In the case of Fannie and Freddie, they are
limited largely to dealing in mortgages and mortgage finance.
Moreover, the size of the mortgages they can deal in is
carefully limited in their charters.
Third, the GSEs have effectively promoted access to
mortgage credit throughout the Nation, including inner cities,
rural areas, and underserved areas, by increasing the liquidity
of mortgage investments and improving the distribution of
investment capital available for residential mortgage
financing.
That being said, we cannot ignore continuing news reports
regarding the size, complexity, and financial status of these
housing GSEs, in particular, Fannie Mae and Freddie Mac. These
news reports raise a number of questions. Is there adequate
market discipline on Fannie and Freddie? Would more competition
help in ensuring that Fannie and Freddie do not take
unnecessary risks? Are they adequately capitalized? Are some of
the features of their special status as GSEs necessary in
today's sophisticated financial marketplace?
What are the implications of interest rate volatility? If
lower interest rates lowered Fannie Mae's earnings, as were
recently reported, what will happen when the Federal Reserve
takes away the proverbial punch bowl and starts raising
interest rates? Are Fannie and Freddie both completely hedged
against falling and rising rates? And if they are perfectly
hedged, how is it that they can earn a profit?
Is it appropriate for us to allow banks and S&Ls to have an
unlimited amount of GSE debt on their balance sheets? By so
aggressively promoting housing, are we not artificially sucking
debt capital away from more productive enterprises, as American
families move into larger and larger homes in ever-expanding
metropolitan areas?
After several weeks of studying Fannie and Freddie, my own
guess is that they are probably strong enough and sufficiently
hedged enough to survive a serious downturn in the housing
market. But perhaps they are not strong enough to survive the
severest of financial downturns, such as we had in the 1930's.
But then again, nor are many of our largest companies and
financial institutions.
I am pleased to welcome our distinguished panel of
witnesses, who collectively represent some of the best minds in
this debate, both for and against. Unfortunately, we do not
have representatives from Fannie or Freddie testifying today,
but notwithstanding their absence, we have at least one GSE,
the Federal Home Loan Bank of Chicago, represented by its
President, Alex Pollock. My hope is that we can engage in a
balanced but vigorous debate so that we can ensure the
continued success of GSEs in fulfilling their mission.
I would now like to introduce our witnesses before calling
on each of them for an opening statement.
Our first witness is Alex J. Pollock, the President and
Chief Executive Officer of the Federal Home Loan Bank of
Chicago. Mr. Pollock has had a distinguished financial career
in my home State of Illinois and has been in his current
position since 1991. He is known as the architect of the
innovative Mortgage Partnership Finance program, which has
grown to over $35 billion in assets since its introduction in
1997, and is the author of numerous articles on banking,
financial systems, and management.
Mr. Pollock will be followed by Peter J. Wallison, Senior
Fellow of the American Enterprise Institute and Co-Director of
AEI's program on financial market deregulation. Prior to
joining AEI in 1999, Mr. Wallison served as General Counsel of
the U.S. Treasury Department and Counsel to President Ronald
Reagan and was a partner with Gibson, Dunn and Crutcher.
Next, we will hear from Bert Ely, who has specialized in
deposit insurance and banking structure issues since 1981. Mr.
Ely currently is the principal of Ely and Company, a consulting
firm devoted to financial institutions and monetary policy. Mr.
Ely has testified before Congress on numerous occasions to
share his expertise in banking issues. Prior to the founding of
his firm, Mr. Ely served as Chief Financial Officer of a public
company and as a management consultant with Touche Ross and
Company and was an auditor with Ernst and Ernst.
I would also like to welcome W. Michael House, Executive
Director of FM Policy Focus and a partner with Hogan and
Hartson. In these capacities, Mr. House concentrates on
regulatory matters before Congress, representing national and
multinational corporations, trade associations, and coalitions.
Prior to his current position, Mr. House served as Chief of
Staff to former U.S. Senator Howell Heflin from Alabama.
Next, we will hear from the Hon. James C. Miller III,
Chairman of CapAnalysis Group, LLC, Senior Fellow at the Hoover
Institution at Stanford University, and counselor to Citizens
for a Sound Economy. From 1981 to 1985, Mr. Miller served as
Chairman of the Federal Trade Commission and subsequently was
named by President Reagan as Director of the Office of
Management and Budget.
I would also like to welcome Bart Harvey, Chairman of the
Board and Chief Executive Officer of the Enterprise Foundation.
As Chairman and CEO, Mr. Harvey provides seed capital,
operating funds, financing, technical assistance, and training
to help rebuild low-income communities. Prior to joining the
Enterprise Foundation in 1984, Mr. Harvey served in a number of
domestic and international positions for the investment bank
Dean Witter Reynolds.
To close our panel, the Subcommittee will hear from Dr.
Susan M. Wachter from the Wharton School of Business at the
University of Pennsylvania. Dr. Wachter is a professor of real
estate, finance, and city and regional planning at the
university, a position she has held since 1972. Dr. Wachter
also serves as a visiting fellow at the Brookings Institution
and has received numerous awards for her teaching excellence in
the area of financial management.
Again, I would like to thank all of you for being available
today to testify on the risks and benefits of Government-
Sponsored Enterprises.
In the interest of time, I would ask that you summarize
your testimony as best you can. I have read all of your
statements and they are all very good. Some are very brief and
actually could be read here, but others are much more lengthy,
and for those of you who have written very lengthy opening
statements, if you could submit those statements for the
record, they will be included as part of the permanent record
of this hearing. If you could just summarize your comments, I
think that would keep us moving along much more quickly.
We try to give each of you 5 minutes for your opening
statement and then we will go for a free-for-all debate, with
both advocates, pro and con, on the panel and we will all have
a very lively debate.
Mr. Pollock, thank you for coming from Chicago, and
welcome.
TESTIMONY OF ALEX J. POLLOCK,\1\ PRESIDENT AND CHIEF EXECUTIVE
OFFICER, FEDERAL HOME LOAN BANK, OF CHICAGO, CHICAGO, ILLINOIS
Mr. Pollock. Thank you very much, Mr. Chairman, and thank
you for giving us the opportunity to share our views with you.
We believe your hearings today are very appropriate.
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\1\ The prepared statement of Mr. Pollock appears in the Appendix
on page 41.
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The American single-family mortgage market is the biggest
credit market in the world. It seems to us it is socially the
most important. It is the current version of Thomas Jefferson's
view that we ought to have a property-owning citizenry to have
a vibrant republic. Fannie Mae and Freddie Mac are surely the
most important factors in this extremely large and important
market.
We take as the key question for today, in such a market in
which Government-Sponsored Enterprises play the central role,
how do we assure that the benefits of the GSE charter are
passed through the mortgage finance system to benefit home-
buying consumers? Before I give our thoughts on this, I do want
to note that I am expressing the views of the Chicago Federal
Home Loan Bank. There are 12 Federal Home Loan Banks. Each is a
company. Each has its own management, its own board, and most
distinctly, its own views. So this is the Chicago view, and
given its market orientation, perhaps we fit in with other
Chicago views and Chicago schools.
The Chicago view on today's key question can be summarized
easily. It is: The best way for Congress to ensure that GSE
charter advantages are passed through to consumers, is to
encourage greater competition in the GSE sector.
Mr. Chairman, in your opening remarks, you mentioned market
discipline. That is another word for competition, and indeed,
we believe that the market forces of competition and the
innovation and efficiency they induce are the best disciplines
for all enterprises, including GSEs. No amount of regulation or
redesign in regulators or thinking about regulatory structures,
however important that may be, can substitute for the effects
of competition.
There are, of course, three housing GSEs, as you mentioned,
Mr. Chairman, Fannie Mae, Freddie Mac, and the Federal Home
Loan Banks. We are all major sources of housing finance. We are
all major issuers of debt, and indeed, we were all set up (in
1932 for us, 1938 for Fannie, and 1970 for Freddie), in times
of economic stress and problems. The key function of all
housing GSEs is to link the mortgage market to the bond market,
so, of course, we are involved with bonds.
I think it is safe to say all three GSEs have evolved
differently than their designers would ever have imagined, and
that is part of the reason why it is a good idea to think about
them now.
Of the three, there is no doubt that Fannie Mae and Freddie
Mac dominate the secondary mortgage market. Last year, 2002,
they represented more than 80 percent of the conforming loan
volume. If you look at the outstanding loans of conforming
size, that is to say, eliminating jumbos and FHA loans and sub-
prime, Fannie and Freddie together have at least a 67 percent
market share of all the outstanding single-family conventional
loans, as defined. That is a big share measured in any way. And
on top of that, they have sustained a remarkable, extremely
profitable record over many years, with rates of return on
common equity year after year in the 25 percent range.
It seems clear to us, as part of this, that lending
institutions who divest their credit risk to Fannie and Freddie
by paying guarantee fees, pay very high fees relative to the
losses involved. For example, last year, those guarantee fees
averaged 19 basis points per year, but the losses were less
than one basis point per year. It was a good credit year, but
lenders are paying what we view as a noncompetitive fee.
We think that both businesses of the GSEs, that is the
mortgage funding business and the credit guarantee business,
are in need of more competition. It is that need which has, at
the root, generated the debates about Fannie Mae and Freddie
Mac, in which all of the distinguished panelists here today
have played a role.
In our view, there are three possible outcomes to this
debate. One is continued expansion and even more market
dominance by Fannie and Freddie. The second is the
privatization of GSEs and removing all their ties to the
government. The third is creating a more competitive,
economically efficient sector. I am not speaking of
operationally efficient; I am speaking of economically
efficient, which means the lack of the economic rents which
today characterize the GSEs.
As to No. 1, it is easy to imagine continuation of the
status quo, leading to ever greater market dominance by Fannie
Mae and Fannie Mae.
As to No. 2, you can make very strong theoretical arguments
that privatization is the right answer, and in fact, my good
friend Peter Wallison has and does make such arguments.
However, most people think the actual probability of
privatization is something close to zero. We conclude that, as
a practical matter, the only available way to improve this GSE
sector (which has made great contributions, Mr. Chairman, we
agree), in order to get greater consumer benefit is to increase
competition.
As an essential fact in the mortgage funding business, only
a GSE, because of the GSE advantages, can compete with another
GSE. Therefore, the Home Loan Banks, through our Mortgage
Partnership Finance business, have set out to compete in the
mortgage funding business. Through the risk sharing structures
of Mortgage Partnership Finance, we have put over 500 private
financial institutions, all Federal Home Loan Bank members,
into competition with Fannie Mae and Freddie Mac in the credit
guarantee business. Because of this, credit risk which would
otherwise be concentrated in Fannie and Freddie is now
dispersed into hundreds of private institutions.
So we are making a serious effort to carry out our own
theory of making the GSE sector more competitive, but I am sure
there are many other additional pro-competitive possibilities
which could be considered.
As Andrew Jackson said in 1832, when vetoing the
rechartering of the Second Bank of the United States, the GSE
of its day, if we cannot make our government all that it should
be, at least we can take a stand against the grants of
monopolies. I imagine that Andy Jackson would have extended
that thought to duopolies, as well.
Mr. Chairman, thanks again for the opportunity to present
our views.
Senator Fitzgerald. Thank you, Mr. Pollock. I had never
thought of the Bank of the United States as a GSE, but I guess
now that I think about it, you are probably right.
Mr. Wallison, thank you. You may proceed.
TESTIMONY OF PETER J. WALLISON,\1\ SENIOR FELLOW, AMERICAN
ENTERPRISE INSTITUTE
Mr. Wallison. Thank you, Mr. Chairman. The title of these
hearings, it seems to me, was quite well chosen, because the
real question for Congress is whether the benefits provided by
Fannie Mae and Freddie Mac outweigh their costs and the risks
they create.
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\1\ The prepared statement of Mr. Wallison appears in the Appendix
on page 45.
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In my view, the case against Fannie Mae and Freddie Mac is
very simple. They create enormous risks for the government, for
the taxpayers, and for the economy as a whole, and yet--if I
may disagree respectfully with your opening statement, Mr.
Chairman, provide no significant benefit to homeowners today.
Fannie and Freddie have been doubling in size every 5 years
and now have combined liabilities of almost $3.3 trillion. This
is not a problem that can, in my view, be safely or responsibly
put off.
Fannie Mae and Freddie Mac were created for a single
purpose, to provide liquidity for the housing finance system by
creating a market for mortgages made by banks and other
mortgage originators. They did this very well. There is now a
vibrant and efficient secondary market for residential
mortgages. The structure will now operate without government
assistance of any kind and does, in fact, in what is called the
jumbo market. So Fannie and Freddie are no longer necessary for
their original purpose. They should be thanked and sent home.
Fannie and Freddie know all of this, so they have been
diligent in creating a rationale for themselves that does not
depend on their providing liquidity to the housing market. They
now say that they help put people in homes by lowering interest
rates on home mortgages. They also suggest through their
advertising that they disproportionately help minority home
buyers. However, they do not really do these things.
Many studies have shown that Fannie and Freddie's
activities reduce rates on home mortgages by a very small
amount, somewhere in the range of 25 basis points, or one-
quarter of one percent. If I can put this in some perspective,
every time the Fed raises interest rates one-quarter of a
point, it has the opposite effect. If that one-quarter point
were as important as Fannie and Freddie suggest in their
advertising, thousands and thousands of American families would
be frozen out of home ownership every time the Fed raises
interest rates by a quarter-point. I don't think that happens.
In any event, as shown by a Census Bureau study presented
at an AEI conference in October, the monthly cost of owning a
home is not the obstacle that prevents renters from buying
homes. The obstacle is the down payment. Most renters do not
have the down payment necessary to buy a home. Accordingly, the
claim by Fannie and Freddie that they put people in homes by
reducing interest rates is not true.
Through their advertising, Fannie and Freddie also suggest
that they provide special assistance to minority families
hoping to become homeowners, but they do not do this, either.
Instead, according to a study by Jonathan Brown of Essential
Information, a Nader-related group, Fannie and Freddie buy
proportionately fewer conventional conforming loans that banks
make in minority and low-income areas than they buy in middle-
class white areas.
So the U.S. housing finance system gets very little benefit
from the continued existence of Fannie and Freddie as
Government-Sponsored Enterprises. What, then, are the costs?
In 2001, CBO estimated that Fannie and Freddie receive an
implicit subsidy from the U.S. Government, in effect, an
extension of U.S. Government credit, with an annual value of at
least $10.6 billion. But the costs, stated in terms of the
risks they create, are far greater than this. Because Fannie
and Freddie are implicitly backed by the U.S. Government,
financial problems at either of them could require a government
bailout. The government has done this before for other GSEs.
Until the recent problems at Freddie, we might have said,
and I did say, that both were in such good financial health
that a bailout was not at all likely. Now, because of doubts
about the accounting of both of them, no one can be sure of
this anymore. Given their $3.3 trillion liabilities, if even a
small part of this obligation has to be made up by taxpayers,
it will make the S&L bailout look insignificant.
But even that does not end the risks we all face with these
two companies. Because they are integral to the health of the
housing market, the failure of either of them could have a
systemic effect, meaning an adverse effect on the economy as a
whole.
One of the ways they might do this, incidentally, is
through the holding of their securities by our financial
institutions. If their securities decline in value, so does the
capital of these institutions, reducing the amount that they
can lend in any area, not just in the mortgage area.
Thus, since there are only two of these companies, it is
accurate to say that the continued health of our economy
depends on decisions by only two corporate managements. If one
of them makes a grave mistake, the entire economy could suffer.
And the recent events at Freddie Mac show that management
judgments are not infallible.
So what is to be done? Congress can change this calculus in
a number of ways. Although I favor complete privatization,
there is a less dramatic way to reduce the risks Fannie and
Freddie create. Congress should prohibit Fannie and Freddie
from buying back their mortgage-backed securities or
accumulating any substantial portfolio of mortgages. Most of
the limited benefits that Fannie and Freddie provide to the
mortgage market come from their issuance of mortgage-backed
securities. Most of their financial risks come from buying back
these securities and accumulating portfolios of mortgages.
Yet buying back MBS and holding mortgages in portfolio
doesn't have any effect, positive or negative, on mortgage
rates. So Congress, simply by prohibiting them from
repurchasing their own mortgage-backed securities, can largely
eliminate the risks they create without affecting mortgage
interest rates. I respectfully recommend this to you, Mr.
Chairman, and to the Committee.
That concludes my testimony. Thank you.
Senator Fitzgerald. Thank you, Mr. Wallison. Now, we would
welcome your testimony, Bert Ely. Thank you very much for being
here.
TESTIMONY OF BERT ELY,\1\ ELY AND COMPANY, INC.
Mr. Ely. Mr. Chairman, thank you. I am here to testify
today with regard to America's Government-Sponsored
Enterprises. While I will focus on Fannie Mae and Freddie Mac,
at times, I will touch on three other GSEs, the Federal Home
Loan Bank System, the Farm Credit System, and Farmer Mac.
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\1\ The prepared statement of Mr. Ely with an attachment appears in
the Appendix on page 52.
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I will first summarize major problems Fannie and Freddie
pose and then discuss what we do not know today about the two
companies. After reviewing underlying problems caused by Fannie
and Freddie's GSE status, I will comment on proposed GSE
tweaks, none of which will solve the GSE problem. I will
conclude by discussing longer-term solutions to the GSE
problem, including complete privatization.
The Fannie and Freddie problem today and the broader GSE
problems stem from their relatively rapid growth, which has
been facilitated by their numerous privileges. This growth has
been driven by management desires to enhance the wealth of GSE
executives as well as the wealth of stockholders in the three
stockholder-owned GSEs.
In addition to being unfair competitors, the GSEs pose
increased systemic risk to the U.S. financial system and,
therefore, the taxpayers. Fannie and Freddie are too big to
fail. The financial markets clearly believe Congress will
rescue any troubled GSE, as it has done twice before.
The potential for a third GSE rescue has been heightened by
the troubling revelation of serious accounting problems at
Freddie. Should those problems worsen, then a Congressional
rescue of Freddie and its Siamese twin, Fannie, will become
increasingly likely.
Particularly troubling is that we don't fully know what we
don't know about Fannie and Freddie. So far, Freddie's problems
have been characterized as just accounting problems driven by a
desire to smooth its earnings. However, the ongoing
investigation of Freddie's finances may reveal serious problems
in its risk management practices. Concern about Freddie's risk
management was expressed quite strongly by Senator Corzine at
last Thursday's Banking Committee hearing on the GSEs. He is
better placed than perhaps any other Member of Congress to
express that concern.
One reason we don't know what we don't know about Fannie
and Freddie stems from their inadequate financial disclosures,
specifically the risk associated with their interest rate
derivatives. There is also a troubling lack of comparability in
the disclosures of the two companies.
OFHEO Director Armando Falcon has tried to soothe
Congressional and public concerns about Freddie's financial
condition by stating that the financial restatement process
should not alter the result of its quarterly risk-based capital
stress test. However, the test is both outdated and too rigid.
Neither Congress nor anyone else should take comfort in that
test today or in the future.
The special status, privileges, and benefits Congress has
granted to the GSEs and particularly to Fannie and Freddie
underlie the GSE problem. First, the GSE's arbitrage the
interest rate yield curve and their GSE status through maturity
mismatching on their balance sheets. They partially hedge their
maturity mismatching through derivatives. A private sector
mortgage investor could not safely operate today with such a
high degree of maturity mismatching.
Second, America has an inefficient housing finance system
stemming from its reliance upon the secondary mortgage
marketplace and the creation of mortgage-backed securities.
Third, by lowering the cost of debt capital for those who
can borrow from a GSE or whose debt is secured by a GSE loan
guarantee, GSEs tilt capital flows away from other sectors of
the economy, notably the productive sector.
Fourth, the United States is experiencing an unhealthy
shift toward GSE financing and away from genuine private sector
financial intermediation. Because GSEs are political creatures,
it is extremely difficult to correct this shift.
Fifth, because they are a statutory construct, Fannie and
Freddie represent relatively rigid features of the American
financial landscape. They are largely exempt from the market
forces constantly reshaping the financial institution
landscape.
Sixth, according to CBO, Fannie and Freddie operate quite
inefficiently in delivering a housing finance subsidy.
Approximately 30 percent of the subsidy stayed with Fannie and
Freddie in 2000, which explains the above-market equity rates
of return Fannie and Freddie consistently earn.
Seventh, some portion of the Fannie and Freddie subsidy
goes to the sellers of homes, not purchasers. A slight rise in
housing prices fully capitalizes the subsidy, thereby shifting
all of it to sellers.
Eighth, a substantial portion of the subsidy flows to
existing homeowners, not to first-time home buyers.
Numerous proposals have been offered to rectify problems
and risks Fannie and Freddie pose. These tweaks will not solve
the Fannie-Freddie problem. Repealing the Fannie and Freddie
SEC exemption is an easily executed reform, but that will not
cure the problem.
Restructuring GSE regulation will be extremely difficult,
but moving boxes around a government organization chart will
not address the myriad of GSE problems. It would be better to
move directly to more fundamental GSE reform.
Giving OFHEO more money and power will not suffice.
Repealing the GSE State income tax exemption is highly
meritorious, but extremely difficult to accomplish politically.
Repealing the GSE's Treasury line of credit would have symbolic
value, but would be difficult to achieve.
Higher capital levels have surface appeal, but they might
not have the desired effect because of their arbitrary nature.
Further, the present credit risk leverage ratio for Fannie and
Freddie may, in fact, be adequate.
Ending mission creep has been the goal of many, but hard to
achieve because of the difficulty defining a new financial
product.
The greatest public policy challenge facing Congress is
what to do should one of the GSEs experience serious financial
difficulties, for those problems could spill over to the other
GSEs. Freddie's recent accounting problems and management
shakeup highlight this problem.
Complete privatization is the only real solution to the GSE
problem, but first, three points. If they do not exist today,
would Congress create the GSEs? I doubt it, for the political
impediments which sparked the creation of the GSEs have largely
disappeared.
Second, little can be done to curb Fannie and Freddie's
growth. Given their enormous political clout, Fannie and
Freddie will succeed in repelling FM Policy Focus's containment
initiatives.
Third, Fannie and Freddie should be barred from owning
mortgages or MBS, as my good friend Peter Wallison has just
mentioned, beyond that needed to facilitate ongoing
securitization activities. This would help mightily to reduce,
if not eliminate, the systemic risk they pose. Limiting Fannie
and Freddie to just the credit guarantee business might
encourage them to seek privatization.
Privatizing Fannie and Freddie would do five things. First
of all, it would eliminate GSE risk to taxpayers.
Second, it would create a much more efficient housing
finance system.
Third, it would build a level, competitive playing field
among all private housing finance firms.
Fourth, it would create a more flexible and adaptive
housing finance industry.
And finally, it would target delivery of the housing
finance subsidy to just those home buyers on the cusp of home
ownership.
A forthcoming paper will present my Fannie and Freddie
privatization proposal in great detail. It will explain how
market forces can restructure the housing finance marketplace
so that the efficiencies of moving large blocks of debt capital
to private sector mortgage originators can be fully captured.
Market forces, not arbitrary capital regulations, will
determine the amount of capital that institutional mortgage
owners would hold.
The paper also will propose a housing finance tax credit
modeled on the Earned Income Tax Credit that will go only to
those home buyers on the cusp of home ownership. Finally, it
will address all-important transition issues as well as the
privatization of the Federal Home Loan Banks.
Mr. Chairman, the time is fast approaching when Congress
must undertake fundamental reform of the GSEs by setting in
motion the complete privatization of these anachronistic
entities. I look forward to your questions.
Senator Fitzgerald. Thank you. Mr. House.
TESTIMONY OF W. MICHAEL HOUSE,\1\ EXECUTIVE DIRECTOR, FM POLICY
FOCUS
Mr. House. Thank you, Mr. Chairman. FM Policy Focus is a
coalition of seven associations of financial services companies
actively engaged in the mortgage industry. We were pleased to
be invited to appear before you today and commend you for
holding this hearing.
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\1\ The prepared statement of Mr. House with attachments appears in
the Appendix on page 83.
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In 1938, Congress decided to rescue a distressed mortgage
market. It was a genuine example of Congressional vision and
we, as an organization, strongly support this vision through
the continuation of the core mission of the two housing GSEs,
Fannie Mae and Freddie Mac.
Our members also believe that more can be done to expand
home ownership among all Americans and especially among
minorities and households who find it financially difficult to
afford a home of their own.
The GSEs play a vital role in this expansion, and for this
reason, Congress subsidizes them to the tune of more than $10
billion annually. However, in order for the GSEs to be in full
compliance with their charters and fulfill their Congressional
mandated mission, they need effective government oversight
founded on three important principles: Effective regulation,
sound capital, and market discipline from enhanced disclosure.
From where we sit today, Fannie and Freddie are zero for
three. They are weakly regulated by an underfunded and
understaffed agency. They hold far less capital than that
required by bank regulators, and they are the only two publicly
traded companies in the Fortune 500 that are statutorily exempt
from the Nation's security laws. If they were private
institutions, homeowners and investors alike would be at great
risk. But since Fannie Mae and Freddie Mac are Government-
Sponsored Enterprises, taxpayers could go from being in the
dark about their operations to being in the red to bail them
out.
The first principle of effective regulation is the
establishment of a strong single regulator. In 1992, Congress
created OFHEO as the safety and soundness regulator, and while
making HUD responsible for overseeing the GSEs affordable
housing mission and new programs. Unfortunately, this
regulatory system has failed us in all three categories.
It took 10 years for OFHEO to produce a complicated and
inadequate capital rule for the GSEs. Moreover, the GSEs lag
the private sector in promoting affordable housing. Don't just
take my word for it: There are 24 separate studies based on HUD
data that prove it. I have attached the list to my written
comments.
In 1992, Congress passed an Act that also directed HUD to
preapprove new programs of the GSEs, but the agency has never
implemented a meaningful new program review. This failure takes
on new urgency since many of the new activities that GSEs
undertake are financial products targeted directly at
consumers.
Therefore, FM Policy Focus recommends that Congress replace
the existing ineffective regulatory regime with a strong single
regulator in the Treasury with authority over safety and
soundness and mission. This structure should have all the
attributes cited by Chairman Greenspan in his testimony before
the Senate Banking Committee just last week namely, expertise,
regulatory authority, and power strong enough to keep the GSEs
safe and sound.
The second principle is that the GSEs should be required to
have capital standards similar to that required of banks, that
is, bank-like capital. Fannie and Freddie are allowed to
operate on a razor-thin capital base that doesn't even measure
up to the capital held by the S&Ls in the 1980's prior to their
collapse.
And the third principle is that the GSEs' exemption from
the Securities Act of 1933 and the Securities and Exchange Act
of 1934 should be repealed. At a time when the rest of
corporate America is subject to stringent review, Fannie and
Freddie continue to operate as islands unto themselves. It is
especially dangerous in light of the revelations about Freddie
Mac and its earnings restatement.
Mr. Chairman, the GSEs are too big to ignore. These two
companies alone are larger than the entire S&L industry
combined, and that is why the stakes of this debate are so
high. The current regulatory scheme is bifurcated and it is
weak and subject to undue influence from the GSEs. Fannie and
Freddie already pose a significant risk to the financial
markets, a risk that is compounded by their incursions into new
activities that go beyond their core mission.
In closing, EM Policy Focus believes that Congress must
restructure GSE regulation for all players to ensure that the
GSEs are effectively regulated. I thank the Committee for
allowing me to testify and ask that my entire statement be put
in the record. I would be glad to respond to questions.
Senator Fitzgerald. Thank you. Without objection. Mr.
Miller.
TESTIMONY OF JAMES C. MILLER III,\1\ SENIOR FELLOW, HOOVER
INSTITUTION
Mr. Miller. Mr. Chairman, thank you for having me here. I
have a statement with attachments I would ask be included in
the record.
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\1\ The prepared statement of Mr. Miller with attachments appears
in the Appendix on page 103.
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Senator Fitzgerald. Without objection.
Mr. Miller. Thank you, sir. I understand the focus of this
hearing is on the benefits and risks of the housing GSEs. It so
happens that over the past couple of years, I have been
involved in two major studies that are pretty much on target
here and I would like to describe them briefly for you.
The first study was prepared by Dr. James Pearce of Welch
Consulting and myself and it addressed directly the benefits
and costs of the two housing GSEs of most substantial
importance here, Freddie and Fannie. And what we did was
estimate first the benefits to consumers, and the way we went
about that was, in simplified form, looking at the difference
between the interest rates paid by consumers in the conforming
market, which Freddie and Fannie are able to facilitate, and
the jumbo market, which is above that. Mr. Pollock mentioned
that jumbo market is, in fact, competitive.
Well, what we found is that there is a big jump in the
interest rates paid by consumers, or the mortgage rates paid by
consumers when you traverse from the conforming rate into the
jumbo rate. We estimated that the jump was at least 24 basis
points. We also concluded there was an indirect effect in the
jumbo market of at least five basis points, and if you multiply
that by the conforming loans and jumbo loans that are
outstanding, involving some ranges, because there was some
discussion about different methodologies, different databases
give you slightly different answers, we feel very confident
that the benefits bestowed by the nexus that Freddie and Fannie
have with the Federal Government generate on the order of $8.4
billion to $23.5 billion per year.
Then we looked and tried to measure directly the funding
advantages these two GSEs realize because of their nexus with
the Federal Government, and others have talked about the
reasons for those. We found on short-term debt, there was about
a 10- to 20-basis point advantage. On long-term debt, between
10 and 40 basis points. And with respect to MBSs, between 10
and 30 basis points. Given the amount of debt outstanding, or
borrowing, this amounts to about $2.3 billion to $7.0 billion a
year.
Now, importantly, what this shows is even the high estimate
of the funding advantages to the GSEs is below the low end of
our estimate of the advantages to consumers.
Now, I want to make a point here, Mr. Chairman, and that is
that our study attempted to measure directly these benefits and
directly the funding advantage. Others, including CBO, have
used a model which is basically zero-sum. They estimate the
funding advantages and take away from that the consumer
advantages and there is a fee left over, ignoring the fact that
these GSEs may contribute a great deal of value to the housing
finance market by virtue of their greater efficiencies, the
economies of scale, the innovations, and maintaining liquidity
generally in the marketplace. I think their model is fatally
flawed because you could find that your estimate of consumer
benefits exceeded the amount of the funding advantage, which is
a nonsensical result.
The second study is one that CapAnalysis, the group that I
chair, did. As you know and was mentioned here, OFHEO recently
promulgated a risk-based capital standard for judging the
capitalization of these two GSEs. What this standard does is
hypothesize a 4-year period during which there is a dramatic
fall in housing prices, disruption of housing, and dramatic
reductions in interest rates. That is one part of the test. The
other part of the test is a rise in interest rates for a 4-year
period. And then the question is, would these GSEs survive over
a 10-year period?
Now, some questions were raised. Well, this is not just the
usual kind of capital measures, capital-asset ratios, that
apply to other federally-regulated financial institutions, and
while Freddie and Fannie do have to meet certain capital
requirements, it is not the same. So would this test really be
very rigorous?
Well, what we did was hypothesize the thrift industry as
being a single firm, as if it were a single firm, would it, in
fact, meet this OFHEO risk-based capital standard?--and we
applied it and guess what? In the case of the upward interest
rate scenario, it failed after 7\1/2\ years. The industry
failed the test. And, in fact, it would have needed $32 billion
more in capital at the beginning of the period in order to
survive the 10-year test period. It did pass the interest rate
reduction scenario, but since it failed one part of the test,
it failed it in total.
Mr. Chairman, we have an extraordinarily vigorous housing
industry that is enabled by a comprehensive mortgage finance
industry that is facilitated by Freddie and Fannie and other
GSEs. All institutions, in my experience, can stand
improvement. I have no doubt that is true of Freddie and Fannie
and the other housing GSEs. But I think for somebody who has
looked at a lot of them, it seems to me that these are very
well-run enterprises and that they have done a substantially
superior job of facilitating this very important market. Thank
you.
Senator Fitzgerald. Thank you, Mr. Miller. Mr. Harvey.
TESTIMONY OF F. BARTON HARVEY III,\1\ CHAIRMAN AND CHIEF
EXECUTIVE OFFICER, THE ENTERPRISE FOUNDATION
Mr. Harvey. Thank you, Mr. Chairman, for this opportunity.
First, just a little bit about Enterprise. Enterprise is a
national nonprofit organization that provides private capital
to support affordable housing and economic development in low-
income communities. We have raised and invested $4.4 billion to
finance 144,000 affordable homes for low- and very-low-income
families and individuals.
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\1\ The prepared statement of Mr. Harvey with an attachment appears
in the Appendix on page 168.
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I can say at the outset, we have no more important partners
in our work than the housing GSEs. Fannie Mae, Freddie Mac, and
the Federal Home Loan Banks have been indispensable to
Enterprise's efforts to expand housing opportunities for low-
income and very-low-income homeowners and renters. In many
cases, the GSEs alone were willing and able to help Enterprise
meet these needs. Without the GSEs, much of our work simply
would not be possible.
Now, we are no experts on macroeconomic benefits. You have
got many of them here. We are not a research institute. We are
a practitioner. I think we are the only practitioner on this
panel. And we are one of the largest and representative of many
more in the country who provide resources to consumers who are
often left out of the mainstream housing market. Our testimony
addresses how we, working with the GSEs, address the needs of
low-income families and individuals.
First of all, the GSEs must meet, as you said yourself,
strong Federal requirements to finance affordable housing. The
legislation that provides Fannie and Freddie's legal and
regulatory framework requires them to dedicate substantial
portions of their business to serving low-income people and
communities. In fact, as Frank Raines said in his 2002 annual
report, ``for Fannie Mae, focusing on underserved Americans is
more than just the right thing to do or something we do on the
side. It is the center of our business.'' That can be said for
Freddie Mac, and in its own way for the Federal Home Loan Bank
System.
HUD substantially strengthened the public policy
requirements for Fannie Mae and Freddie Mac in 2000. We
strongly supported that. We are not aware of any other
corporations that have such demanding public purpose
responsibilities as Fannie Mae and Freddie Mac. And similarly,
the Federal Home Loan Bank Boards are required to dedicate 10
percent of their net income every year to fund affordable
housing. That has amounted to more than $1.7 billion that has
financed $25 billion worth of affordable housing. And billions
more are available, as Alex Pollock knows, at a slight discount
for community investment.
I have served on the board of the Atlanta bank, which went
beyond the mandatory and reached out voluntarily to serve their
mission in other ways.
Enterprise has worked in productive partnerships with the
GSEs to provide housing for many thousands of low-income
families and individuals. For example, Fannie Mae, Freddie Mac,
and the Enterprise Foundation pioneered the use of the
corporate market for low-income housing tax credits in the late
1980's. Fannie stepped up to invest when few others would and
encouraged other corporations to follow suit. Freddie Mac was a
very early investor, as well. That credit today is the most
important Federal incentive for the development of rental
housing for low-income people in the country, and Fannie Mae
and Freddie Mac are the most important sources of capital for
it.
The pictures that you see here show you two examples of the
kind of housing Fannie Mae and Freddie Mac, working with
Enterprise, have made possible. I hope it gives a face to this
sometimes abstract issue of the critical housing benefits that
the GSEs provide. Ultimately, what we are talking about are
peoples and families and communities.
The first here that you see, Sheldon Village in Eugene,
Oregon, provides 35 homes and numerous supportive services for
very low-income people, including formerly homeless individuals
with special needs. It is located to provide easy access to
educational and recreational facilities and public
transportation for residents. Freddie Mac was the major
financial partner.
The next example is Arbor Park Village with Fannie Mae.
This is a large-scale development, 282 homes in 28 garden-style
buildings, all for very low-income people. It is helping
revitalize a neighborhood near downtown, Cleveland.
Now, these are just two of many examples that we could give
you. We use the low-income housing tax credits. We could use
many other types of financing mechanisms.
We believe the current statutory and regulatory framework
for Fannie Mae and Freddie Mac has enhanced their ability and
willingness to do this kind of work with organizations like
Enterprise. These partnerships deliver housing resources to
people and places that cannot take full advantage of our
Nation's generally well-functioning housing system.
These companies have consistently met their affordable
housing responsibilities, even as HUD steadily and
substantially increased them over the past decade. They have
the best people, the best technology, enormous access, broad
partnerships, all working on ways to mainstream new products
and services. They have the ability to test market ideas that
people like us bring to them.
Congress has expressedly provided Fannie and Freddie the
flexibility to respond to fast-moving market conditions and
emerging needs. We believe that curtailing Fannie Mae and
Freddie Mac's flexibility to innovate would undermine these
gains and limit future progress towards meeting our Nation's
most serious affordable housing needs.
Certainly, the safety and soundness of the housing GSEs is
critical for consumers and the economy. Vigorous regulation is
essential. But there is no reason that strong safety and
soundness oversight should chill or constrain the GSEs' vitally
important affordable housing activities. In fact, the interest
of affordable housing and safety and soundness are very
compatible if carried out the right way. Thank you.
Senator Fitzgerald. Thank you, Mr. Harvey. Dr. Wachter.
TESTIMONY OF SUSAN M. WACHTER,\1\ WHARTON SCHOOL OF BUSINESS,
UNIVERSITY OF PENNSYLVANIA
Ms. Wachter. Thank you, Chairman Fitzgerald, for the
invitation to testify today on Government-Sponsored
Enterprises. I ask that my full statement be included in the
record.
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\1\ The prepared statement of Ms. Wachter appears in the Appendix
on page 181.
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Senator Fitzgerald. Without objection.
Ms. Wachter. Currently, the United States has one of the
best housing finance systems in the world. The efficiency of
this system has been advanced by the Federal chartering of
Government-Sponsored Enterprises, particularly Fannie Mae and
Freddie Mac. These institutions have enabled the securitization
and the development of the secondary market for the funding of
mortgages. Securitization and the efficient trading of
mortgages and liquidity in secondary markets have achieved the
integration of U.S. mortgage markets into national and
international capital markets.
The goal of the Federal chartering of Fannie Mae and
Freddie Mac is to achieve public policy objectives, including
the promotion of home ownership for all Americans, and economic
research indicates that this mission is being accomplished.
Today, I will address how this mission is accomplished, how
increased access to home ownership for all Americans has been
accomplished through the Federal chartering of Fannie Mae and
Freddie Mac.
In my testimony, I will specifically refer to a research
paper authored by myself and colleagues, which I request be
entered into the record.
Senator Fitzgerald. Without objection.
Ms. Wachter. In addition, I believe the GSEs have had a
critical role, through the strength of the U.S. housing market,
in the recovery of the overall U.S. economy since the 2001
recession.
Based on my research and that of multiple colleagues,
Fannie Mae and Freddie Mac have contributed to the expansion of
home ownership in America, providing affordable residential
mortgages for households who otherwise would not have had the
opportunity to become homeowners. Freddie Mac and Fannie Mae's
efforts have helped to advance gains in overall home ownership
rates, as well as in home ownership rates among minority and
low-income households occurring over the past decade. This has
been a phenomenal decade for home ownership which I do not
believe would have been as strong without the role of the GSEs,
a decade resulting in a record high home ownership rate of 68
percent in 2003.
GSEs have accomplished this, in part, through their special
affordable lending programs, of which Bart Harvey has spoken.
But also, the GSEs have accomplished this through lower
mortgage interest rates and through lower down payment rates.
These have been made possible through the innovation and
technological advances that the GSEs have brought about over
the last decade.
The findings of the recently-released research study, ``The
Impacts of Affordable Lending Efforts on Home Ownership
Rates,'' by myself, Roberto Guercia, and George McCarthy, which
was published in March 2003 in the Journal of Housing
Economics, indicate that affordable lending efforts can
increase home ownership opportunities overall and for
underserved populations. For example, they can result in a 30
percent increase in the relative probability of home ownership
for younger households, 20 percent increase in the relative
probability of home ownership for minority households, and a 15
percent increase for households residing in central cities.
The potential gains in home ownership are attributable, in
part, to improved credit risk management, which enables lower
down payments without an increase in credit risk. Thus, it is
not just lower interest rates, mortgage rates, but also
technical innovations, such as automated underwriting, that are
responsible for increasing home ownership throughout this past
decade.
The GSEs and a strong secondary market deliver a second
major benefit, not only to homeowners but to the American
consumer overall. Their role in accessing global capital
markets and stabilizing U.S. mortgage markets was evident in
August 1998 upon the defaulting of Russia's foreign-held debt.
In the global crisis, interest rates moved sharply higher and
illiquidity appeared to be a growing concern worldwide.
Purchasing a record number of mortgages, the GSEs staved off
crisis by adding liquidity. Therefore, no credit crunch evolved
in the U.S. residential sector, as opposed to other markets at
the time.
This pivotal effect is even more evident in the recent role
housing has played in stabilizing the overall U.S. economy. The
role of mortgage market access to global capital markets as an
automatic stabilizer with the U.S. economy has been
demonstrated by the strength of the housing sector and its role
in moving the economy out of the 2001 recession. It is access
to international capital flows during a period of low and
falling interest rates that has resulted in additional consumer
spending, which has supported the U.S. economy.
This benefit that the GSEs and secondary markets deliver to
the American consumer is, I believe, a major, if not the major,
contributing factor to today's housing market, which has helped
stabilize and grow the U.S. economy. This, together with
increased access to home ownership for all Americans, I
believe, is a testimony to the role the GSEs have played and to
the importance of ensuring that they continue to play this role
going forward.
Thank you, Mr. Chairman.
Senator Fitzgerald. Dr. Wachter, thank you very much.
What I would like to do now is take a 2-minute recess so
that you can all stretch and stand for a minute, and then we
will resume and go quickly into the question and answer
section. We will be right back.
[Recess.]
Senator Fitzgerald. If we could resume the hearing, I would
appreciate it.
I would like to, at the outset, note there is so much money
involved in the mortgage business, and some of you who are pro
and some of you who are con, have relations with some of the
companies involved on either side of the debate. I would like
to explain any possible conflicts of interest to the media and
the members of the public before we start going with the
question and answer session.
I would start with Alex Pollock. You are President of the
Federal Home Loan Bank of Chicago. Is it correct that the
Federal Home Loan Bank of Chicago is trying to compete with
Fannie and Freddie in the conforming loan market?
Mr. Pollock. That is very true, Mr. Chairman.
Senator Fitzgerald. Please pull the microphones close, and
Mr. House and Mr. Miller, you are going to have to share your
microphone because we only have six and there are seven
witnesses.
But is that correct?
Mr. Pollock. That is correct.
Senator Fitzgerald. You are competing with them. You are a
GSE yourself. You have nothing against GSEs, but you would like
to compete with them on better terms, which I gather, would be
a simple way of saying it?
Mr. Pollock. It is correct. We view anything as an
advantage for the mortgage market and the country that makes
the secondary sector more competitive. Clearly, I have an
interest in this, being a competitor in the market, as you say,
Mr. Chairman.
Senator Fitzgerald. And there have been calls, is it not
correct, to get you out of the mortgage business or the
mortgage securitization business that you are in?
Mr. Pollock. I don't want to give a speech on
securitization. We are not in securitization per se. But
certainly, a few ill-advised people have thought we shouldn't
create this competition, yes, sir.
Senator Fitzgerald. OK. Dr. Wachter, have you been paid for
any of your research by any party to this debate?
Ms. Wachter. I have not been paid for my research. However,
the paper that I have just mentioned has been supported by the
Wharton Real Estate Center and has also received a small amount
of funding support from Freddie Mac.
Senator Fitzgerald. OK. Mr. Harvey, I notice on The
Enterprise Foundation website you received a $1 million
contribution from the Fannie Mae Foundation last year, is
that----
Mr. Harvey. Let me just say, we solicit funds, loans,
grants, capital, from all financial institutions and we have
significant--as I said, we have received grants from Freddie
Mac, from Fannie Mae, loans and other capital and from all
financial institutions----
Senator Fitzgerald. And from a lot of banks?
Mr. Harvey. From banks, as well.
Senator Fitzgerald. That maybe are part of the funding of
FM Policy Focus, possibly. I am not sure.
Mr. Harvey. That is right. [Laughter.]
Senator Fitzgerald. We will get to that in a minute.
Mr. Wallison, your research at AEI, is it funded by
anybody?
Mr. Wallison. No, it is not directly funded by anybody, but
AEI does get contributions from organizations that are in the
financial services industry and some of them, although I do not
know, may be part of any of the organizations that are opposing
Fannie and Freddie.
Senator Fitzgerald. OK. Mr. Miller, your study that you
talked about in your opening statement, that was, am I correct,
financed by Freddie Mac?
Mr. Miller. Yes. It was a study commissioned by Freddie
Mac.
Senator Fitzgerald. OK. And you were paid to do that study
of the benefits?
Mr. Miller. Yes, but I call them as I see them.
Senator Fitzgerald. OK. Mr. Ely, have you been paid by
anybody?
Mr. Ely. First of all, the American Bankers Association is
a client of mine with regard to the Farm Credit System. I have
done three reports for the ABA on the Farm Credit System.
Senator Fitzgerald. To the Farm Credit System?
Mr. Ely. Yes, which, of course, is another one of the GSEs.
In addition, with regard to Fannie and Freddie, I have received
modest grants from AEI for several of the papers that I have
done for AEI and for Mr. Wallison's program.
Senator Fitzgerald. OK. Mr. House, who funds FM Policy
Focus, of which you are the Executive Director, and does ``FM''
stand for Fannie Mae or Freddie Mac?
Mr. House. It stands for both. [Laughter.]
Senator Fitzgerald. It stands for both, OK. Who funds that?
Mr. House. That is funded, as I said, by people in the
financial services industry. It is very interesting, because
the GSEs have characterized our group as a group of
competitors, and frankly, we are their customers. That is one
of the reasons we are here today, because if they characterize
us as competitors, then we have a real problem. That is why
effective regulation is needed.
Senator Fitzgerald. OK.
Mr. Ely. Mr. Chairman, if I can just add one point.
Senator Fitzgerald. Yes?
Mr. Ely. Many people have suggested over the years that I
have done consulting work for FM Policy Focus. As I am sure Mr.
House will confirm, there has been absolutely no relationship
between myself and FM Policy Focus.
Senator Fitzgerald. OK. I just wanted to get that out on
the table so that everybody knows where everybody else stands.
Professor Wachter, I have a question for you. You are a
professor of real estate finance at Wharton?
Ms. Wachter. I am a professor of real estate and finance at
the Wharton School.
Senator Fitzgerald. And finance, OK. Right now, the housing
industry in America has been very strong with declining
interest rates. The values of homes have been appreciating very
rapidly as rates have declined. If we got into a situation
where rates started to rise, would it not be the case that the
value of homes themselves could plummet? In other words, a home
worth $300,000 that is today with low interest rates of 4.5
percent, let us say, and if mortgage interest rates go back up
to 7.5, 8, or 9 percent, that $300,000 home, all things being
equal, may no longer be worth $300,000. Would you agree or
disagree with that statement?
Ms. Wachter. I would respectfully disagree with that
statement. If mortgage interest rates increase, of course,
there will be other factors that cause this increase. A most
likely reason that they will increase is increased strength in
the overall economy, and if that occurs, I do not believe that
housing prices will plummet.
It is, I think, quite likely in that situation that housing
prices will no longer appreciate at the rate that they have
been appreciating, and in fact, they may appreciate less than
the inflation rate. There has been no period in the recent
history of the United States that we have documented where
housing prices have declined in nominal terms.
Senator Fitzgerald. Not during the 1930's, during the Great
Depression?
Ms. Wachter. In the database that I have seen post-World
War II, where we have good data, there has not been a recession
where housing prices have decreased.
Senator Fitzgerald. Would anyone else like to comment on
that? Mr. Wallison or Mr. Ely? What do you think would happen
to the value of homes if interest rates go up sharply? What I
am getting at is, right now, the loans that are securitized by
Fannie and Freddie have strict underwriting requirements. They
have to have a 20 percent downpayment. If they don't have a 20
percent downpayment, the borrower has to have mortgage
insurance. Could not that downpayment or equity, the owner's
equity in the home, disappear in a scenario where there is a
substantial general rise in mortgage interest rates?
Mr. Ely. If I could add some thoughts to that, the question
comes as to what is driving the increase in nominal interest
rates. Is it a higher inflation factor, or higher inflation
premium in the nominal interest rate, in which case the value
of real assets are going to be increasing in nominal terms? On
the other hand, if the real interest rate increases, then you
will not see a plummeting, I wouldn't expect to see that, but
as Dr. Wachter said, a slowing in the rate of appreciation.
There is one other thing that we want to keep in mind, too,
as we look forward that may be somewhat of an overhang on the
housing market going forward--the ratio of mortgage debt to the
estimated market value of owner-occupied housing has been
increasing significantly. We do not yet know what the
implications are going to be, particularly from a macroeconomic
standpoint, if the housing price appreciation slows down. As
has been commented on by the panel, one of the drivers in the
economy in recent years has been the fact that people have been
cashing out some of their home equity through refinances. If
interest rates go up, if the refinance activity slows down, if
housing starts to get squeezed a little bit, then we may see
some macroeconomic effects that will certainly not be positive
for housing.
Mr. Wallison. May I add something, Mr. Chairman?
Senator Fitzgerald. Yes.
Mr. Wallison. I think Dr. Wachter's analysis is probably
correct, and that is to say interest rates would not likely go
up unless the economy were recovering and, therefore, housing
prices might stabilize or not decline. On the other hand, we
did have, in the 1970's, a period known as stagflation, when we
had very high inflation and we had very little economic
growth--indeed some decline in growth--and high unemployment,
much higher than today. As a result, it is actually high
unemployment which is the greater danger to Fannie and Freddie,
and to the mortgage market in general, because that is when
people can no longer afford to service their mortgages, when
they are no longer employed.
So there are all kinds of scenarios that might occur in our
economy which could result in many more defaults than we have
seen in the 1990's and the early 2000's, and that is why
financial institutions are required to maintain high levels of
capital--financial institutions, I might add, other than Fannie
Mae and Freddie Mac.
Senator Fitzgerald. Mr. Pollock, I want to go back to you
to describe exactly what you are doing at the Federal Home Loan
Bank of Chicago. You say you aren't securitizing mortgage debt
per se, and I know in your opening statement, or in your
written opening statement, you describe that you absorb the
interest rate risk and allow the financial institution to keep
the credit risk. How does that work? What exactly do you do?
Mr. Pollock. Mr. Chairman, what we do, we call ``Mortgage
Partnership Finance.'' We chose the name seriously because we
create a partnership with our member institution, which is a
commercial bank or a savings bank or a savings and loan, and
each one of those partners takes one of Fannie Mae's or Freddie
Mac's main businesses. As I said in my testimony, Fannie and
Freddie have two businesses. The first is a credit guarantee
business, the one that Peter and Bert want them to have to
stick to. That happens to be one I think is better done by
private financial institutions, because if you are the lender
actually making the loan yourself, you ought to be
fundamentally advantaged in knowing that credit and being able
to manage it and bear the credit risk.
On the other hand, the other business is the mortgage
funding business, and if you are dealing with 30-year fixed-
rate, freely prepayable mortgages, you must have a long-term
funding base, in my opinion, which is only available in the
bond market and in the international hedging markets. In order
to access that base efficiently with the current structures in
the United States, you have to be a GSE to compete in the
funding of long-term fixed rate mortgages. It is not advisable
for private financial institutions to own 30-year cash flows
and finance them on their deposit bases. That is a pretty clear
lesson of our financial history.
So with Mortgage Partnership Finance, we take these two
pieces, we put our member, which is a bank or a savings bank or
a savings and loan, into the credit guarantee business, dealing
only with loans they have made themselves in which they are
fundamentally advantaged. Instead of divesting the credit of
their own customer and paying a guarantee fee to Fannie Mae and
Freddie Mac, they credit enhance the loan to us and we pay them
what is in effect----
Senator Fitzgerald. For guaranteeing it?
Mr. Pollock. For guaranteeing it.
Senator Fitzgerald. You pay----
Mr. Pollock. We put them into a business they ought to be,
and in fact, are, fundamentally advantaged in. We then provide
the funding and the interest rate risk management, and if you
put the two pieces together, you have the entire financing.
The competitive outcome is that in the credit guarantee
business, we now have about 550 lending institutions approved
to participate in MPF. So there are 500 new competitors----
Senator Fitzgerald. You are growing very rapidly now,
aren't you?
Mr. Pollock. We are, yes, sir.
Senator Fitzgerald. How many billion in assets are you up
to?
Mr. Pollock. The Mortgage Partnership Finance Program is
approximately $70 billion, a little----
Senator Fitzgerald. Seventy-billion? So the figures I said,
$35 billion, those are a year or two old?
Mr. Pollock. They were true when they were printed, Mr.
Chairman. [Laughter.]
Senator Fitzgerald. OK, and growing very rapidly.
Mr. Pollock. Yes.
Senator Fitzgerald. Now, in talking to bankers in the
Midwest, I am told that small community banks will have Fannie
Mae, Freddie Mac, and the Home Loan Bank of Chicago all coming
in to get their business. But I have also heard that for the
conforming mortgages, there are private banks that come in and
try to sell some services for those conforming mortgages to
small banks, such as someone mentioned, ABN and ROE operating
in the Midwest. What would those commercial banks do? It
indicates to me that there is a degree of competition out there
for Fannie, Freddie, and the Federal Home Loan Bank that isn't
generally known to the public.
Mr. Pollock. It is very true for the smaller banks that
they could deal with a GSE, and, of course, get a better deal
if they have three bidders for their business compared to two.
There are also large bank aggregators, as they are called in
the mortgage business, who will buy loans from smaller
correspondent banks. This is called the correspondent channel.
Senator Fitzgerald. OK.
Mr. Pollock. But those loans, in turn, are generally turned
into Fannie Mae securities or Freddie Mac securities or also
financed with us.
Senator Fitzgerald. So it is hard to see how that would be
more profitable, to sell it to the correspondent bank which
then resells to Fannie or Freddie. How could that make sense
for the small bank?
Mr. Pollock. It is a question of whether you are a
retailing or wholesaling part of the business, but I think that
is a fair question.
Senator Fitzgerald. Now, Mr. Pollock, you said that the
guarantee fees charged by Fannie and Freddie were 19 basis
points and that they are too high. Do Fannie and Freddie both
charge 19 basis points for guarantee fees?
Mr. Pollock. Mr. Chairman, guarantee fees are negotiated
individually. The 19 basis points is the average for 2002 and
Fannie and Freddie are quite similar in that level,
approximately----
Senator Fitzgerald. Where was that average 10 years ago or
so?
Mr. Pollock. In the 20s.
Senator Fitzgerald. So it has----
Mr. Pollock. It started off being 25----
Senator Fitzgerald. It has been coming down.
Mr. Pollock. Yes.
Senator Fitzgerald. OK.
Mr. Pollock. The 19, relative to losses, is still very
high. A typical, good small bank lender will average losses on
their mortgage portfolio of perhaps two basis points or less
per year.
Senator Fitzgerald. In this kind of a market environment,
though?
Mr. Pollock. Even in this market.
Senator Fitzgerald. But in a bad recession, say, like we
had in the early 1980's----
Mr. Pollock. It is cyclical, but I am speaking of the
averages, Mr. Chairman.
Senator Fitzgerald. OK.
Mr. Pollock. The long-term average, if I may just complete
the thought, for Fannie and Freddie is about four or five basis
points in their portfolio of annual losses per year. So you can
think of that as the loss versus the guarantee fee being the
insurance premium against that loss.
Senator Fitzgerald. Well, that brings up an interesting
point, though, because Mr. Wallison recommended that Fannie and
Freddie not be allowed to hold mortgage-based securities on
their own balance sheet, and you suggested that there is a
great deal of risk to having them do so. But as Mr. Pollock
pointed out, when they are guaranteeing the mortgages of
others, their losses are very small. My own experience as a
bank lawyer, prior to being in the Senate, was that home
mortgages are the safest loans you can make. People will allow
you to repossess their car, they will put their business in
bankruptcy, but they will work wonders to come up with the
money to stay in their home.
Mr. Wallison. May I respond to that, Mr. Chairman?
Senator Fitzgerald. Yes.
Mr. Wallison. There are two kinds of risk, basically. There
is credit risk, which is what Alex is talking about, and then
there is interest rate risk. When they issue mortgage-backed
securities and guarantee them, they are taking only the credit
risk.
Senator Fitzgerald. Right.
Mr. Wallison. That is the three or four basis points
maximum that Alex was talking about. Interest rate risk is the
risk that they are taking when they buy back their mortgage-
backed securities and when they hold portfolios of mortgages.
That is where their major risk comes from.
Senator Fitzgerald. Well, let me tell you what they tell
me, and I did talk to an executive VP from Fannie. I wish he
could have been here today to testify, but in fairness to him,
I did not give adequate notification of this hearing, either.
But they claim that they are really fully hedged now, that
they learned the lesson from the early 1980's in which we had
the case of rising interest rates. They say that now in this
era of declining rates, about 70 percent of their debt is
callable, and, in fact, every day they are calling debt issued
at higher interest rates and replacing it with low-yielding
debt. And in a situation in which rates were to rise rapidly,
they would simply keep their low-cost debt in place and not
call it and that they have derivatives that hedge substantially
all of their interest rate risk.
Does anybody care to comment on that? Why would that not be
possible?
Mr. Ely. Well, first of all, let me provide a couple points
of information here, not that the risk-based capital
requirements are magic, but it is important to keep in mind
that the minimum capital requirement on a strict leverage basis
for Fannie and Freddie for credit risk is 45 basis points. For
interest rate risk, it is 205 basis points. So there is in the
statutes a recognition that there is much greater risk with
interest rate risk.
The other thing about interest rate risk is that you can be
partially hedged, fully hedged, or maybe engaged in
speculation, which also is risky. The problem that we have with
Fannie and Freddie is that we are much less certain as to where
they are in the risk perspective in terms of their hedging
activities. They may assert that they are fully hedged. As I
listened to the telephone conference with analysts last week
that Tim Howard, the Executive Vice President and Chief Finance
Officer held when Fannie announced its second quarter results,
he was not talking as if Fannie was fully hedged. Fannie has
significantly reduced its duration gap, but it didn't strike me
as being fully hedged.
So there is still a risk there, but there is also another
very important factor to keep in mind. It is the assumption of
interest rate risk by not only buying back MBS but also by
holding mortgages in portfolio that causes the two GSEs'
balance sheets to balloon, to loom as large as they do in the
economy. If Fannie and Freddie were strictly credit guarantors,
as Freddie was initially back in the 1970's, then they would
have much smaller balance sheets today and, frankly the concern
about systemic risk would be much less than it is today.
But also coming back to a point that Peter made, and I
might add the Congressional Research Service, among others, has
made, there is no value added to the housing marketplace and to
the provision of affordable housing when Fannie and Freddie buy
back their MBS. Why do they do that? Because there is more
profit per mortgage dollar, if you are assuming interest rate
risk. This, therefore, provides them with an avenue for
maintaining their high earnings growth rate and their high ROE
than is the case if they were just credit guarantors.
Senator Fitzgerald. Mr. Miller.
Mr. Miller. Mr. Chairman, I think we are asking several
``what if '' kind of questions, sort of pulling them out of the
air. This OFHEO risk-based capital test is a comprehensive,
systematic test, a scenario of the sort where you have a lot of
things going wrong, one in which interest rates rise, one in
which interest rates fall. This comprehensive test applied to
Freddie and Fannie show that they both pass for 10 years. They
do not have a problem.
Senator Fitzgerald. And you said the S&L industry as a
whole would not pass that.
Mr. Miller. Did not pass, and that gives me an opportunity,
Mr. Chairman, to correct an omission, not in my statement but
in my oral presentation. I saw the light on. The fact that the
thrifts failed the test should not really be viewed as evidence
of a shortcoming of the capital requirements of the thrifts,
but it should be viewed, I think, as evidence that this OFHEO
risk-based capital test is a pretty tough test. Now, you can go
in and change some of the parameters or whatever and you can
ask a lot of ``what if '' questions----
Senator Fitzgerald. I would like to give Mr. Ely a chance
to respond. You foretold the S&L debacle in the 1980's. In one
of your papers, you point out now that most S&Ls hold variable
interest rate mortgages only, and I think you cited Washington
Mutual as 94 percent of their mortgages were floating rate
mortgages on their books and they weren't holding long-term
fixed-rate mortgages on their books. You would think if that is
the case, the S&L industry as a whole would be pretty well
hedged against rising or declining rates.
Mr. Ely. Well, two points. First of all, I am very
skeptical of this finding that the thifts would fail the test
in a rising interest rate market. One of the problems is, what
is the database that you are working from? OFHEO has access to
proprietary, non-public information in running the risk-based
capital test for Fannie and Freddie. With regard to the thrift
industry, I assume that Jim has worked with the same data the
rest of us do, which is the so-called Thrift Financial Report
or the Quarterly Call Report, which I would not want to try and
read too much into.
Let me say something else also about the risk-based capital
test. As I indicated in my testimony, it is a highly flawed
test because it is based on the assumption that we are going to
have a rerun of the interest rate environment of the late
1970's or early 1980's. It is an unfortunate test because it
does not reflect present day realities.
But there is another fundamental problem with it. It is a
snapshot that is taken four times a year. These two companies
can look great on December 31 or March 31, but the question is,
what do they look like on April 1 or March 30? It is dangerous
to go too far in making judgments just based on how things look
on a particular date. What is more important is what the range
of values are over a period of time. We don't see that with the
risk-based capital test.
Mr. House. Mr. Chairman, I think if you want to pursue this
further, if you look at OFHEO, with the recent revelations of
Freddie Mac, OFHEO has testified before the House and Senate
and I would think that the members have been somewhat appalled
by their response. I think if you would want to bring OFHEO
here and ask them exactly what it is they knew, when they knew
it, and also on their risk-based capital test, whether or not
it is adequate, because it seems that from their own testimony,
even they are not sure what--it took them 9 years, and they are
still not sure exactly what it is.
That is important. I think Senator Corzine said last week,
if we were talking about a $300 million situation here or
something like that, I could understand it, but I think, if I
am not mistaken, the quote was it is appalling that we are
talking about a $3 billion miscalculation.
So my suggestion is, rather, we can argue all day back and
forth here about whether it is good, bad, or whatever, but you
may want to pursue that and really get into that because it may
be that the test itself is fundamentally flawed, and that is
important because today, for instance, the Central European
banks, and this goes to something we were talking earlier
about, whether or not you want worldwide, be able to have
access to capital worldwide, the Central European banks said
that they are looking into the amount that their banks should
hold Fannie and Freddie on MBSs and when you----
Senator Fitzgerald. Did they say that or was that just a
rumor?
Mr. House. That was a report today that we heard.
Senator Fitzgerald. OK.
Mr. House. That they are looking into it, nothing--but the
point is, is that having a good, sound regulatory structure is
important. So anybody that says that you shouldn't have a good
regulatory structure because it will erode the markets, not
having one is even worse, and I think with everything going on,
nobody--Bert said it earlier. Nobody is sure what is going on,
and I think it is very important that Congress really get in
and understand exactly what is going on and what needs to be
set up to make sure it doesn't happen again.
Mr. Miller. Could I just say, I don't think the record will
show that anyone here has argued against having a sound
regulator for Freddie and Fannie. It is an empirical question,
I guess, whether the risk-based capital test is sufficiently
severe. But certainly----
Senator Fitzgerald. Is that test----
Mr. Miller [continuing]. A test of a major industry, the
thrift industry, that fails is to suggest it is quite
significantly stringent.
Senator Fitzgerald. OFHEO says that Fannie and Freddie did
well on their risk-based capital stress test. Did they release
a study to the public or anything or do we just take their word
for it, that they are fine?
Mr. Ely. We take their word for it, Mr. Chairman. Most of
the data that goes into that test is proprietary to Fannie and
Freddie. OFHEO sees it, but the world in general cannot. So we
really have to take their word for it.
The other thing to keep in mind about the risk-based test,
and this is a very unfortunate circumstance, is that it is
written into statutory language in quite some detail, and, of
course, as you know, it takes a little while to get laws
changed around here. I am very concerned about its relevancy at
this point in time. In other words, OFHEO is probably doing a
pretty good job of trying to make this test work, but it is,
unfortunately, a flawed test.
Senator Fitzgerald. They are doing the risk test that is
set forth in a statute, whether or not it is necessarily the--
--
Mr. Ely. That is correct.
Senator Fitzgerald [continuing]. The test that should be
applied. It is doing that test.
Mr. Miller. Could I just say, Bert has had enough
experience in Washington to know that if either one of these
GSEs actually failed the test but OFHEO leadership went out and
told the press it passed the test, surely, someone in the press
would find out and the Nation would find out, so I don't
think----
Senator Fitzgerald. But what do you say about the test
being set in a statute on exactly what the parameters of the
test should be? Certainly, it could be that the lobbyists for
those entities have influenced what the test is, then. If it is
in a statute, the regulator isn't empowered to come up with its
own test.
Mr. Miller. Well, you know, I think the regulator did come
up with a pretty stringent test. At both Freddie and Fannie,
some people there very much opposed its being implemented so
soon, wanted to find out more about it, questioned it in some
ways. But it is, in fact, in place today. But it is an
empirical question of how stringent it is. You might want to
have more flexibility, I would suggest, than having each
element in statute because something may come up of a sort you
think, well, maybe this is a part that ought to be added, or
maybe this part of the test really isn't relevant at this time
or something like that, or less relevant. So you might want to
define----
Senator Fitzgerald. OFHEO does have people who came from
the Controller of the Currency at it, is that not correct? My
understanding is one of the on-site examiners at Fannie Mae
actually used to be in charge of the detail at Citibank, so
from what I am hearing, at least anecdotally, and it hasn't
been confirmed to me, is that they do have some very good
people over there. Does anybody wish to challenge that? Or,
with respect to the effectiveness of the regulator, does
anybody think that the regulation at the OFHEO--that the OFHEO
personnel are not up to the task?
Mr. Wallison. Can I make a general point on that?
Senator Fitzgerald. Yes.
Mr. Wallison. I think we put a tremendous amount of stock
in regulation, but the events of the last 6 weeks should show
us that we are not fully protected by regulation no matter how
extensive it is. Ultimately, the major decisions that affect
the health of a company are made at the very top, and the
regulators very seldom have access to that. We saw just in the
case of Freddie Mae that OFHEO did not have access to the
accounting problems that were roiling the top of the company.
Senator Fitzgerald. But are not the GAAP accounting
problems that they had, a somewhat different issue? It may be
that OFHEO is not necessarily relying on GAAP numbers. GAAP
numbers are what you need to disseminate to the public for the
securities reports. Freddie is seeking to voluntarily comply. I
know from my own experience that bank regulators have a
different set of accounting numbers that they like to see that
may not have anything to do with GAAP, that are more stringent
than GAAP.
Mr. Wallison. We don't understand everything about what
happened at Freddie Mac, nor do we actually know anything other
than what the newspapers have reported. But it does appear that
they were doing things with their derivatives that caused a
problem with the reporting of income for certain periods. And
OFHEO does look at their derivatives That is one of the
functions that they are supposed to perform. How those
derivatives are classified, what they are and so forth are
things that OFHEO should have come across in the course of
their investigation that would have given them a hint about how
effectively these companies are operating.
May I say a couple of other things, Mr. Chairman, while I
am talking? One is that when the tests were done on Fannie and
Freddie, all kinds of tests have been run by OFHEO, including
the stress test that Jim Miller was talking about. Fannie
always came out very close to the line. Freddie came out way
ahead most of the time. In fact, people would have said 2
months ago, if we are going to have any kind of accounting
problem, we are going to have it at Fannie, because Freddie was
always very well-managed, it seemed, from an accounting point
of view. We would never have any difficulty there.
Well, it turns out, ironically, that it is Freddie with the
accounting problems. Fannie, which was always very close to the
line, taking a lot of risks, has not been challenged as yet. I
think now that investigations have begun, Fannie will get a
good going over and I think we will find, based on some of the
stuff you see coming out of the private sector today, that they
are having their own difficulties.
But in any event, you can't rely too much on a regulator to
protect you, especially in a case where these two companies are
the only two companies involved in this major part of our
economy. If there is a major error by one of those companies,
and the regulator does not recognize it, as I suggested in my
prepared statement, we could have serious systemic problems in
our economy.
Also, finally, on the question of whether they are
profitable after the hedging that they have to do to address
their interest rate risk, I think, Mr. Chairman, if I heard you
correctly in your opening statement, you made the fundamental
and true point that if a company is fully hedged, it is not
going to be profitable. There is some risk that has to be taken
in order to make a profit.
Senator Fitzgerald. I see a lot of witnesses want to
address that issue. Dr. Wachter, can you get 100 percent hedged
and still make a profit?
Ms. Wachter. It does depend on the business that you are
in. You can make a profit in other elements of your business.
You could take additional interest rate risk and make profit on
the interest rate risk. But as a general statement----
Senator Fitzgerald. But to hedge themselves, they have to
do a series of things that add to their costs.
Ms. Wachter. Absolutely.
Senator Fitzgerald. To hedge themselves on their liability
side with respect to the debt they have issued, they have to
make it callable. That requires them to pay higher interest
rates. Investors who are going to hold callable debt want a
premium and so forth. To buy all sorts of options and
derivatives to cover everything in their portfolio, it gets
very expensive. But you believe it is possible to----
Ms. Wachter. Mr. Chairman, in an equilibrium setting, I
absolutely agree with you. It would not be possible to make
profit on hedging operations alone in equilibrium. But this is
not necessarily an equilibrium market. That is, there is
innovation going on. There are economies of scale. And
separately, you can make money on other aspects of your
business.
I also do want to address, if I may, Mr. Chairman, the very
fact that, of course, regulation is very important here. I
think it is a great advantage that these are regulated
institutions. These are private institutions. And for all of
the concern that has been expressed around this table--I am not
saying that there shouldn't be concern--I think we also should
look at the market response to the events of the questions on
Freddie Mac's accounting and the market response was not very
significant.
Senator Fitzgerald. Well, does not Freddie have a problem
of having overstated their earnings as opposed to having
understated their earnings, which is the opposite of Enron's
problems? Mr. Miller.
Mr. Miller. Mr. Chairman, could I first agree with Dr.
Wachter. You can earn profits when you are fully hedged.
Senator Fitzgerald. Let me go back and correct myself.
Freddie has a problem of having understated their earnings----
Mr. Miller. Right. Right.
Senator Fitzgerald [continuing]. Whereas Enron overstated
their earnings. Understating your earnings would be much less
alarming, I would think, to investors than overstating.
Mr. Miller. And one explanation of the phenomena that Dr.
Wachter was just pointing to at the end is that there is a
difference between, on the one hand, the accounting treatment
of derivatives, over which there is some dispute, some
suspicion, or some concern, and I think the jury is still out.
We just ought not jump to conclusions until we have the
evidence. That's on the one hand, and on the other hand is
safety and soundness.
I think, at least the reports as I have read them, and the
reaction to the question of the accounting of derivatives, is
that the market interprets the two quite separately and
believes in the fundamental safety and soundness of these two
institutions.
Senator Fitzgerald. Mr. House, I want to get back to
capital requirements. You suggested that Fannie and Freddie be
required to have bank-like capital. Fannie and Freddie right
now have to have 2.5 percent capital for the mortgages on their
books and 0.45 basis points for the guarantees that they make.
Banks are required to have 4 percent risk-based capital for
mortgages that they keep on their books. My understanding is
there is a new Basel round of international risk-based capital
guidelines that will lower the capital requirements for banks
holding mortgages. Is it down to----
Mr. Ely. The so-called Basel II capital standards could
bring them down, some suggest to a range of 1.4 to 2 percent.
Senator Fitzgerald. That would be lower than Fannie and
Freddie.
Mr. Ely. Well, that is before taking into account maturity
mismatching. I was just the other night having a hard time
getting to sleep and so I was reading through some of the Basel
II discussion. [Laughter.]
There is an awful lot of judgment that is extended to the
regulators in terms of how maturity mismatching is to be worked
in there. So we want to be a little careful about quantifying
the extent that the capital will be reduced. But in general,
particularly for the larger banks that opt to go into Basel II,
it appears that the capital requirement will drop somewhat.
There is a very important point here to understand, and
that is that any kind of capital regulation is arbitrary
because if you take no risk, if you are perfectly hedged, then
you don't need much capital, if any at all, because you don't
need a capital cushion to absorb loss. What we have with Fannie
and Freddie is they have capital levels that, in effect, they
can arbitrage. At 2.05 percent for interest rate risk, they
have to take a certain amount of risk in order to be able to
earn a return on that 2.05 percent. If their ratio is pushed up
to, let us say, 4 percent, they are either going to have to
charge higher interest rates, earn a greater spread, or take
more risk.
A fundamental problem we have with capital standards, both
as they apply to the GSEs as well as to the banks, is that they
don't necessarily reflect the risk that the particular
institution is taking. Instead, they become a target to
arbitrage, and frankly, banks do that just as much as GSEs do.
The difference is the lack of a level playing field. Presently,
Fannie and Freddie don't have quite as high a capital hurdle to
clear as the banks and, therefore, they have more room to
arbitrage on credit risk, but more importantly on interest rate
risk.
Senator Fitzgerald. Mr. House.
Mr. House. No matter where the Basel Accords come out, and
that is--to say that is in flux is probably an understatement,
and I can't believe--Bert, I will send you a book, a novel, if
you stayed up reading that---- [Laughter.]
But I think the key thing--what Bert just said is very
important. What we are really about is a level playing field.
So, we think that they are large financial institutions, just
like any other financial institutions, no matter how you cut
it. So when it comes to SEC registration, when it comes to
capital requirements, when it comes to other things, they
should be treated just like any other financial institution.
Senator Fitzgerald. OK. So FM Policy Focus mainly wants,
you have said, effective regulation, sufficient capital, and no
exemptions from security acts. You don't have a problem with
their overall mission, is that correct?
Mr. House. No, we don't. We have said that. As long as they
are in the secondary market. I mean, the liquidity in the
secondary market was why they were founded.
Senator Fitzgerald. It occurs to me that if Mr. Wallison's
approach of privatization were ever adopted, Fannie and
Freddie, in return for being privatized, would probably want to
have restrictions on their operation lifted, too, so that they
could compete in the jumbo mortgage market with many of your
members. Would your group be opposed to that privatization and
unleashing these giants in the areas where they have not
heretofore tried?
Mr. House. From day one, we have said that we are opposed
to privatization. That has been----
Senator Fitzgerald. So you are opposed to that.
Mr. House. In fact, I feel very----
Senator Fitzgerald. Is there self-interest involved in
that?
Mr. House. No. I feel very comfortable. I have got
privatization on my right. I have got business as usual on my
left. I am sitting right here. [Laughter.]
So we are fine.
Mr. Ely. Mr. Chairman, if I could add to that, if there was
a genuine privatization, it means basically peeling away or
denying them all of the various special benefits they have now,
including the implicit government guarantee. In that case, they
would just be plain old business corporations. And then the
question is, how well would they be able to compete, lacking
any kind of meaningful origination capability, which comes back
to this basic question: Is the secondary market really as
efficient as we think it is, or does it look efficient only
because of the GSE advantages that Fannie and Freddie have?
Senator Fitzgerald. Mr. Wallison.
Mr. Wallison. The advantages that Fannie and Freddie
provide, it appears from all the studies, is about 25 basis
points. It also appears from the CBO study that that 25 basis
points comes from the support they get from the Federal
Government. So we don't find that Fannie and Freddie are adding
very much to the value of the secondary mortgage market.
Senator Fitzgerald. They have to be adding a lot to the
mortgage market, though, because of the statutory provision
that says banks and S&Ls can hold an unlimited amount of their
debt, and that prefers mortgage debt capital in this country to
other debt capital, perhaps for more productive uses. Would it
not be the case that we are putting an incredible, incredible
emphasis in our country on mortgage financing and it must, at
the end of the day, be sucking debt capital out of other
perhaps more productive uses? Does anybody care to comment on
that?
Mr. Ely. This is another area where we don't have a level
playing field in terms of the allocation of capital within the
economy. And, of course, it also happens through the tax code,
too, with the favorable tax breaks that owner-occupied housing
gets. That is why many would suggest that the middle class and
the upper-middle class are over-housed in this country compared
to other countries.
But there are two different issues. One is the competitive
level playing field, which I think Mike House is addressing.
And then the other more significant public policy question is,
to what extent, if at all, do we want to tilt capital flows in
one direction or another? There is clearly, for a variety of
reasons, including the housing GSEs, a tilt towards shifting
capital flows into housing and particularly owner-occupied
housing.
Senator Fitzgerald. Dr. Wachter, is that a good idea, to
tilt capital flows into housing as opposed to anything else?
What about small business?
Ms. Wachter. The issue of how interest rates overall are
impacted by this is very complicated and it has to do with
whether our growing deficit is increasing interest rates. So it
is that literature that, in fact, needs to be--this needs to
be.
In other words, Fannie and Freddie are accessing capital,
not just in the United States, but global capital. So do they,
in fact, increase overall interest rates? Do they, in fact,
increase the share from a limited basket of funds? Do they
increase the share from that limited basket of funds to housing
at the expense of others, or is the effect to simply increase
on the margin funds coming to the United States without any
impact on other funding in the United States? This is an open
question, and it may very well be that there is an impact
drawing capital from small business. It may very well be, and I
am not saying it isn't. I am saying it is an empirical
question, to what degree that there is that impact.
Second, there may very well be, and I do believe it is the
case that Fannie and Freddie increase the overall efficiency of
this market. That is, interest rates are lower--mortgage rates,
that is, are lower than they otherwise would be. Mortgage costs
are lower than they otherwise would be because of the technical
efficiencies that they bring to the market. If that is the
case, then this is not due to their drawing funds from another
source.
Senator Fitzgerald. You support the concept of the housing
GSEs. Would you support the creation of GSEs in other areas
that would promote equally as worthy sectors of our economy,
such as small business? In other words, if housing GSEs are a
good thing, since we all favor home ownership in this country,
aren't small businesses a good thing and don't we want to
encourage people to own businesses? Why not then create GSEs to
securitize loans to small businesses? Do you think that would
be a good idea?
Ms. Wachter. No, I do not. See, I think that the
fundamental--a fundamental factor in our democracy, and I
believe it was Peter Wallison who started his comments with
that, is the Jeffersonian concept of ownership, and I believe
that it is the ability of ordinary American families to have
substantial ownership in America. This means as America
prospers, as America expands, as our productivity expands, and
as a result of that, housing costs go up, that we will not have
a Nation of ``haves'' and ``have nots.'' And I don't think that
there is anything more important than economic democracy along
with political democracy.
Senator Fitzgerald. Owning your own home. But what about
economic democracy, everybody owns their own business?
Ms. Wachter. Well, I do believe that owning your own home
and having access to capital at low rates is what enables
people then to go out and start their own small business, what
enables people to go out and invest in their children's
education, and what has enabled people to protect themselves in
their old age.
Senator Fitzgerald. Well, what about--do you favor
Government-Sponsored Enterprises to further securitization of
student loans? We used to have that with the student loan
marketing GSE, but it has now been privatized.
Ms. Wachter. Yes.
Senator Fitzgerald. Do you simply think housing is the most
important and all other areas of the economy should not have
any kind of special push, just housing?
Ms. Wachter. Well, I actually think that home ownership and
housing, because it is a basic need, but home ownership
absolutely should. I don't really have a position on these
others except for the fact that I have in my studies seen what
happens to economies where home ownership is not equally
accessed and the political difficulties that so arise.
And the other side of it is I believe we, in some sense,
have the best of both possible worlds, which is that we have
lower cost capital delivered in this very important sector. I
think it is the ability, in part, to lower the costs of capital
for housing through the diversification, etc., that comes
through the secondary markets that wouldn't necessarily be able
to be delivered to small businesses through secondary markets.
Senator Fitzgerald. All right. A question for all of the
panelists. The issue of competition has come up several times,
first and foremost from Mr. Pollock, who is competing to some
extent now with Fannie and Freddie. If our country decides that
GSEs for housing are a good thing, then why just have two of
them? Why not have four or six of them? Certainly, Mr. Pollock,
you don't mind being one. I would be interested in your
thoughts on that. I suppose those who are against GSEs wouldn't
want any more GSEs. Those of you who are for them, Mr. Miller,
Mr. Harvey, Dr. Wachter, would you be for more GSEs or just
limit it to Fannie and Freddie? Mr. Harvey.
Mr. Harvey. I would just say, we would be for whatever
competition increases either the efficiency of capital for
lower-income Americans one way or another, and if you think
there is a net benefit out of the competition, we would be all
for it, between the GSEs.
I just have to point out, we also have a very unfair, or a
tilted system, however you want to put it, as far as mortgage
interest deduction goes in this country. It is far more
favorable to the wealthier Americans than to lower-income
Americans in this country. So there are a set of policies that
are in place and you have to look at the totality of them.
One of the reasons I am for the housing GSEs is that it is
a means of getting favorable capital and there is a public
policy objective that is front and center and it makes Fannie
and Freddie accessible and the Federal Home Loan Bank System
far more accessible than Wall Street is to those of us who are
trying to reach down into lower-income communities and to make
sure that there is equity in the housing in this country.
Mr. Ely. Mr. Chairman, if I could throw in two points
there. As you might have inferred from my remarks, I am not a
fan of Fannie and Freddie and I support the notion of their
privatization. But if we are going to look at the question of
whether or not there should be more than two housing finance
GSEs like Fannie and Freddie, their returns on capital indicate
that there is clearly a lack of competition. As someone pointed
out, we are seeing companies that consistently are earning
returns on equity capital in the mid-20 percent range. That is
clearly excessive compared to the type of competition and
returns we see over time in other industries.
So the fact that their ROEs are so high is an indication
that what we have is effectively a duopoly in which there is an
implicit understanding between the two companies to compete but
not too aggressively or not so aggressively as to reduce their
return on equity.
Coming back to the question of the role that Fannie and
Freddie play in terms of helping to level the playing field in
favor of lower-income people who pay lower tax rates, if we
take a look at the current conforming loan limit of $322,700 in
order to meet that limit, you probably have to be able to buy a
house worth at least $400,000, if not more. Those are not homes
being bought by lower-middle-income, or lower-income people.
Much of the Fannie-Freddie subsidy goes to the middle class
and the upper-middle class and beyond. A very important public
policy question should be, to what extent should the middle
class and upper-middle class be subsidized in this way, given
the fact that they are already being subsidized tremendously
because of not only the mortgage interest deduction and the
deduction of real estate taxes, but also because of the now
very liberal capital gains treatment with regard to owner-
occupied housing?
Mr. Pollock. Mr. Chairman, could I take a try at addressing
the question directly?
Senator Fitzgerald. Yes, Mr. Pollock?
Mr. Pollock. I think Bert is right, that if we got to a
truly competitive GSE sector, we would know it because the
returns on equity would be at the market competitive cost of
capital, which in this country now is around 13 or 14 percent,
as opposed to someplace in the 20s.
In terms of more GSEs, you could think of the Federal Home
Loan Banks as one GSE, or you could perhaps more accurately
think of them as 12, or think of us as 12, which would give you
14.
It seems to me that the burden of proof for creating a GSE
must always fall on those who would wish to create a GSE. We
have a long history, not always in the form of GSEs, but of
governmental credit programs. You mentioned, Mr. Chairman,
student loans. We have Farm Credit. We have the Pension Benefit
Guaranty Corporation. We had the Federal Savings and Loan
Insurance Corporation. A very large number of them had rather
unhappy experiences, or continue to. So to those who would
create such programs, as I say, I think that the burden of
proof is on them.
My point is that if you already have GSEs and you are
asking what can you do best now and you believe the GSEs will
continue to exist, it is our view that the best thing you can
do is to ensure at least that it is a competitive sector so
that the benefits given to the GSEs, which turn into economic
advantages, become consumer advantages as opposed to economic
rents, to use the technical term, in the GSE.
But that is a ``second-best'' argument.
Senator Fitzgerald. Well, we have been talking here a lot
about risk and what is the risk on their balance sheets. If
they had more competition, would there not be much more risk of
a financial----
Mr. Wallison. Actually, Mr. Chairman, if I can respond to
that----
Senator Fitzgerald. OK.
Mr. Wallison If we had to have GSEs doing what Fannie and
Freddie are doing, it would be better to have more of them than
fewer of them for the reasons I said in my testimony, and that
is that the two that we have, if one of them fails, could
produce a disaster in our economy, whereas a management
misjudgment at one of six or eight would not have that effect.
Senator Fitzgerald. The margins of Fannie and Freddie,
then, would get thinner and thinner----
Mr. Wallison. Yes, of course, and they should, and that is
what benefits consumers. In fact, the ROEs that they are
showing, as Bert suggested, reflect either one of two things.
Either they are taking the risks that I said they were taking--
they are not adequately hedging--or there is some sort of
parallelism going on in their pricing.
Senator Fitzgerald. Well, banks don't ordinarily make that
kind of return, but they have to have a lot more E, and so
their R on the E is lower because there is much more E. Because
Fannie and Freddie have such low levels of required capital----
Mr. Wallison. That is given to them as a benefit.
Senator Fitzgerald. Yes.
Mr. Wallison. Let me just complete a couple of thoughts
here. So competition would be better than nothing, but why
would we create more GSEs when we can eliminate the risk, as I
suggested, simply by not allowing them to buy their own
mortgage-backed securities which have already been sold to the
market? We have developed--they have developed, or others have
developed and they then picked up on--a very good technology in
offering mortgage-backed securities. Investors will buy these
instruments and take the interest rate on them. Why are we now
allowing them to go out into the market, borrow money on the
Federal Government's credit, and then go out and buy mortgage-
backed securities to take additional risk away from investors?
Senator Fitzgerald. Mr. Miller, do you want to address
that?
Mr. Miller. I am not sure in which order to take these
things. One reason----
Senator Fitzgerald. The one I would like you to address is
Fannie and Freddie holding mortgage-backed securities on their
balance sheets.
Mr. Miller. That is the one I was going to start with.
Senator Fitzgerald. OK. [Laughter.]
Mr. Miller. They have a comparative advantage in having
those assets on their balance sheets because they know them
better than anyone else.
Senator Fitzgerald. They don't know them better than the
person or the bank or the S&L that made the loan. . . .
Mr. Miller. No, but when they consolidate and do the MBS,
they know what the MBS is.
Second, I want to get to the competition point, but let me
return to the--you asked the question, should you establish new
GSEs for other industries or other areas of economic activity,
and I would distinguish two things there. One, is that an area
that is appropriate for promotion? I don't think there is any
question but that the Congress of the United States and
administrations from one to another have viewed housing as
being a priority, and the establishment of the housing GSEs,
and continuation of the housing GSEs are a reflection of that
priority. That is something for you to debate.
The second part, though, is the question of liquidity. If
you were to establish that in such-and-such an industry there
was a significant liquidity problem for which there were
institutional barriers or some such, it might make sense to
establish something that would increase liquidity there. The
liquidity problems in the housing industry sources are very
well known--regional problems, banking, finance that were not
solved or are not completely solved even today.
But on the question of competition, I as an economist will
tell you, yes, maybe rents are being earned, but the rents that
are flowing are to increased skill at management, innovation,
other things, not rents that are flowing to the firm because it
limits competition.
My impression is, these two GSEs, first, they are very
competitive with each other. Second, they are run by very smart
people who are constantly innovating, coming out with new
things, and that is the reason that the firms are doing well in
terms of ROE. You find other firms in the economy that do very
well, and, of course, in some industries, rates of return are
much, much higher than for the GSEs.
Now, my own personal view is if you gave an opportunity for
someone to enter under the same circumstances, that would be
fine. But I would just caution you that if you established a
GSE sort of organization, it would take a long time, if ever,
for them to be competitive with Freddie and Fannie, in part
because of their scale economy. So if you set something up, you
might be buying a commitment to engage in a lot of Federal
promotion and direct subsidy of such an enterprise over time.
Mr. House. But Mr. Chairman----
Senator Fitzgerald. We are going to wrap up in a few
minutes. I will let everybody who wants have a final say here.
Mr. House.
Mr. House. To go back, you asked our group how we would
feel about competition. We would support it if you had proper
regulation and a level playing field. Something that Mr. Miller
just said really emphasizes that point. He said nobody
understands the MBSs better than Fannie and Freddie, and this
is something that Mr. Wallison talked about on MBS. So when the
GSEs purchase their own MBS, it is called ``cherry picking''
because they do understand their MBS better than anybody else.
This is exactly why we think they should have to register their
MBSs under the SEC, so everybody knows, so everybody has the
same information.
The next thing is, the GSEs were originally established to
lead the market in providing for home ownership. And as I said
earlier in my remarks, 24 studies say they are not leading the
market. We think it is very important, and I think Mr. Harvey,
I would hope, would agree that in order to do that--banks have
to buy CRA loans--and I think the GSEs, which are exempt from
CPA standards, should be required to invest in community
reinvestment loans.
And the second thing is, in applying affordable housing
standards, it is now done on a national average. We all know
that you can play all kinds of games with national averages. So
you say, gosh, I am going to meet my affordable housing
standards. You can just play with those averages. Take those
averages and take it down to MSA basis, which is the
Metropolitan Statistical Area, so it is done by areas. So if
you really want to increase affordable homeownership, those are
the kinds of things you can do, instead of taking the GSEs'
word for it. We think that is very important.
Senator Fitzgerald. Mr. Ely.
Mr. Ely. Just a couple of points I wanted to pick up on,
responding to Jim. First of all, with regard to having more
competition among the GSEs, you made a point about increased
risk to these institutions. That is right, there would be
increased risk and it is increased risk for the taxpayer
because many of us believe that if a GSE gets into trouble, it
will be rescued in some fashion by the government. Congress has
done that twice in the last 16 years, first with the Farm
Credit System in 1987 and then in 1997 with the FICO bonds,
which gets back to a key difference between Fannie and Freddie,
on the one hand, and the banking industry on the other.
Fannie and Freddie are a ``heads we win, tails you lose''
proposition because to the extent they are able to capitalize
on their implicit Federal guarantee, then their shareholders
are winners. If, on the other hand, one of them fails, then it
is the taxpayers who are the loser. Deposit insurance, post-
FDICIA, and post-FIRREA, doesn't work that way anymore. It is
an industry-financed program, if you will, that is run by the
government. So as we think about GSE risks, we have to realize
that the GSEs are getting a free ride off of the taxpayer,
which is showing up in their high ROE.
Just one other thing about the liquidity problem. The
banking industry and the thrift industry have changed
enormously from the time Fannie and Freddie were set up. Back
then, and you will remember this very well, we had branching
restrictions and relatively small banking companies. Today, we
have large players out there as mortgage originators and as
aggregators who are operating on literally a nationwide basis--
Washington Mutual, Wells Fargo, J.P. Morgan Chase, Citi, and so
forth.
And so the private sector, through the consolidation
process and the lifting of branching restrictions, has been
able to develop an ability to provide liquidity to the mortgage
market. That vitiates one of the original reasons for creating
both Fannie and Freddie.
Senator Fitzgerald. Mr. Wallison, we are getting to the end
of the hearing. I do want to ask you if you favor privatization
of the Federal Home Loan Banks, too.
Mr. Wallison. By all means. [Laughter.]
They survive, in my mind, only as competition to Fannie and
Freddie. [Laughter.]
Alex and I have talked about this at length.
Senator Fitzgerald. OK, and you are still friends.
[Laughter.]
Mr. Wallison. If we could not do anything about Fannie and
Freddie, then it makes a lot of sense to have some competitive
organizations.
Let me mention a couple of things on competition. First of
all, in my prepared statement, I noted that Fannie and Freddie
compete against Treasury securities and they thus raise the
cost of Treasury securities. The Treasury pays more interest
because foreign central banks and others accessing the foreign
capital markets are looking at Fannie and Freddie as U.S.
Government securities, to some extent. So they are buying
Fannie Mae and Freddie securities instead of buying Treasuries.
The Treasury has to pay somewhat higher interest. No one has
done a study--it is probably impossible to do a study of how
much it is--but it is not insignificant. That is one of the
costs that they cause the U.S. taxpayer.
It is certainly true that people have their wealth in
housing in this country, but that is because of our national
policy that causes a lot of investment to go into housing,
Fannie and Freddie and the Home Loan Banks being part of that.
If we didn't have that direction of funds into housing, people
would have better jobs. People would have more income from the
businesses that would have been established here and people
would have more stock market investments than they have
investments in their homes.
So that is the way--our economy is structured that way
because of government policy. It is not because of any
particular reason that we should organize our economy that way.
We ought to realize what the trade-offs are when we push money
into housing.
I heard an argument, I thought, that rents, economic rents,
cause or help innovation. I was always under the impression
that the more competition there is, the more innovation there
will be, and that is certainly the lesson of our free market.
So I can't imagine that we would want to encourage people to
make profits, rent-type profits, in order to encourage
innovation when, in fact, what it does encourage is waste and
inefficiency in the economy.
And finally, the important thing that we should focus on
here, what Congress should focus on, it seems to me, is
eliminating the risk to the taxpayer and the risks to the
economy. I happen to think that privatization does that more
effectively than anything else. There is no good reason to have
these organizations anymore. But if that is too big a bite for
Congress to take, I do recommend that we look at simply the
question of forbidding them to buy their mortgage-backed
securities and accumulate portfolios of mortgages.
Since Fannie and Freddie were established, the technology
involved in selling mortgage-backed securities, the
distribution system, has been developed. It now works
wonderfully without any government support in the jumbo market.
It could work for the conforming and conventional market, too,
if we simply eliminated the government support there, and we
would then by that Act eliminate the risk. Thank you.
Senator Fitzgerald. Any final----
Mr. Miller. Could I just make a correction?
Senator Fitzgerald. Yes.
Mr. Miller. My reference to rents was the rent that is the
return for innovative activity. It is not the way that was
characterized by Mr. Wallison.
Senator Fitzgerald. Mr. Pollock.
Mr. Pollock. Mr. Chairman, I think you have conducted a
great and a very lively discussion, but I did note there was
one question you very pointedly asked and it didn't get
answered, so I would like to try to answer it.
You discussed the presentation by Fannie Mae about being
hedged and the different ways you could hedge a mortgage book
with debt and hedges and you asked, is that reasonable? In my
opinion, that is very reasonable as long as we don't talk about
perfect hedging. I have been in the banking business one way
and another about 34 years now and I have never met anybody who
was perfectly hedged or even claimed to be perfectly hedged and
I would greatly distrust anybody who did.
But if the question is, can you prudently hedge a book of
mortgages with debt and with hedges, the answer is, you
absolutely can if you are a GSE under current American
circumstances.
I think as a general----
Senator Fitzgerald. Do you think private companies could
absorb all those long-term fixed rates in America and hedge
themselves?
Mr. Pollock. Not if they have to compete with GSEs, Mr.
Chairman.
Senator Fitzgerald. If they didn't have to, you think they
could?
Mr. Pollock. I think the market will always work that out.
Senator Fitzgerald. OK.
Mr. Pollock. Embedded in every hedge is somebody's cost of
operations and cost of capital for providing the risk bearing
or the risk distribution that the hedge represents. The market
would work that out.
I do think it is very clear that every GSE, Home Loan Banks
and Fannie Mae in particular, was set up with an important
truth in mind: That is, if you are going to have long-term
fixed-rate mortgages, you have to link them to the bond market
in some way. You can't finance them with deposits, which are
short-term by nature. Whatever system we would end up with, if
we want to have fixed-rate mortgages, which I think the
American people should want and do want, then we have to design
a system that has a highly efficient bond market link. GSEs are
one way to do that. Obviously, you could imagine others. And
thank you very much, Mr. Chairman.
Senator Fitzgerald. Thank you.
I know you had some comments down here. These will be the
last two, Mr. Harvey, then Dr. Wachter.
Mr. Harvey. Great. Thank you, Mr. Chairman. I think one of
the points that we have missed here is the huge productivity
gains that have come over the last decade from Fannie and
Freddie and from the Home Loan Bank System. But if I was to
take, and this is a negative comparison, where the FHA is and
Ginnie Mae has been over that period of time versus what has
happened in Fannie and Freddie, there has been a huge benefit
that has come out of the GSE system. They have been able to
access technology, they have been able to have huge through-
puts with the same amount of people. They have been able to
have dedicated people and resources on their public mission
goals, and every time the goals have gone up, they have been
able to meet them or exceed them along the way.
So as an advocate for low-income people and housing, what
is there to fix here, because it has been hugely productive. It
has been a tremendously productive system.
As far as not leading the market, yes, I would love to
stretch the GSEs to do more around CRA and other loans. What I
fear is if you get a capital structure where they can't do that
or that discourages them from taking the very prudent risk that
they ought to take, then you are defeating some of the purpose
as to why you have a GSE in the first place.
As far as not leading the market, I think you have to
look--and in minority home ownership, you have got to look at
the sub-prime market, which is a large part of the lending
right now that goes to minorities in this country. It has grown
exponentially over this period of time. Now, there is a sub-
prime market that makes sense and there is a predatory market.
They are different, but they are sometimes linked together, and
this will probably horrify everybody on the stage, but I think
the GSEs getting into that sub-prime market will make it more
accountable, cleaner, better, with more efficient capital as
long as you have accountability and oversight on it, and I
applaud----
Senator Fitzgerald. But doesn't that put more risk on the
GSE's balance sheets?
Mr. Harvey. As long as they do the business the way the
business ought to be done, and not in a predatory way, but in a
way to get capital to those people that don't have perfect
credit, and that can be done--I applaud every time Citibank
takes over Associates and Associates has to clean up the way
that they have been doing their business, and it was a huge
fight, as you know, or Chase takes over, because they have a
reputation they have to defend and it allows advocates and
others to say, look, this hasn't been done the right way. There
are parts of this business that make no sense at all for low-
income home owners.
So I think the GSEs have worked remarkably. Of course, we
believe in public-private partnerships to get to parts of the
market that you can't get to otherwise.
Senator Fitzgerald. Thank you. Dr. Wachter.
Ms. Wachter. Thank you. I believe that it is very much the
ability to earn profits in the short run before technology is
widely implemented that encourages innovation, and that is,
indeed, part of the reason we have had so much innovation in
this sector.
The investors will lose, obviously, if these institutions
take on too much risk. This, too, is a safeguard. So it is, in
fact, the genius of the private institution with public
purposes that I think has accomplished so much and there is
more to accomplish yet.
Senator Fitzgerald. All of you, thank you very much. This
has really been a great panel. These are some of the best minds
in the country on this issue. It was a delight to have all of
you here.
Without objection, the hearing record will remain open for
any additional statements or questions from Senator through 5
p.m. tomorrow.
With no further business to come before the Committee, this
hearing is adjourned. Thank you.
[Whereupon, at 4:20 p.m., the Subcommittee was adjourned.]
A P P E N D I X
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