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House of Representatives,
Subcommittee on Capital Markets, Securities and Government Sponsored Enterprises,
Committee on Banking and Financial Services, and the
Subcommittee on Government Management, Information, and Technology,
Committee on Government Reform and Oversight
Washington, DC.

    The subcommittees met, pursuant to notice, at 2:05 p.m., in room 2128, Rayburn House Office Building, Hon. Richard H. Baker, [chairman of the Subcommittee on Capital Markets, Securities and Government Sponsored Enterprises], presiding.
    Present: Chairman Baker; Representatives Horn, Royce, Lucas, Cook, Snowbarger, Hill, Sessions, Kanjorski, Flake, Maloney of New York, Gutierrez, and Barrett.
    Chairman BAKER. Today we have a special construction of the Subcommittee on Capital Markets, Securities, and Government Sponsored Enterprises in that we are meeting in conjunction with the Subcommittee on Government Management, Information, and Technology of the Committee on Government Reform and Oversight.
    So, this is a joint subcommittee hearing, and I extend a welcome to Chairman Horn, who is with us today.
    Both Chairman Horn and I are interested in reviewing the features of Government Sponsored Enterprises and hearing from our panels of distinguished witnesses today. I will be in the chair during the testimony of panel one, the General Accounting Office and the Congressional Research Service.
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    I anticipate learning much from their testimony, in that I understand it gives a comprehensive view of the relationship of the GSEs with their sponsor, the Federal Government.
    I think this overview is appropriate, in light of the enormous contingent liabilities to the Government that we face as a result of potentially inappropriate managerial controls. GSE debt guarantees represent a total of nearly $1.8 trillion in contingent liabilities to the American taxpayer.
    Having said that, there is nothing that would indicate at the moment that any of the GSEs, which are the subject of today's hearing, do present a current and present danger to the taxpayer, only that this subcommittee's obligation, as one of oversight, will continue to review and analyze the performance of these GSEs and take into consideration any proposals which might be proposed for ensuring continuing solvency and profitable operation.
    With that, I would like to call on Chairman Horn for any comments he would choose to make.
    Mr. HORN. Thank you very much, Mr. Chairman. We are pleased to join with our fellow subcommittee today in examining both the theory and the practice of Government Sponsored Enterprises. The Subcommittee on Government Management, Information, and Technology of the full Committee on Government Reform and Oversight is charged with monitoring the economy, efficiency, and management of the Federal Government's various operations and activities. This oversight responsibility extends to entities chartered by the Government.
    The Federal Government established the first Government Sponsored Enterprise in 1916. It was a financial entity created to provide long-term real estate loans to farmers and ranchers. Since then, many Government Sponsored Enterprises have been created for other sectors of society that have been inadequately served by the private credit markets, such as home buyers, farmers, students, and colleges.
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    While Government Sponsored Enterprises are managed and owned privately, they have strong ties to the Federal Government. The enabling legislation of each Government Sponsored Enterprise specifies its general purpose and its authorized transactions. For example, Fannie Mae is chartered to increase housing credit availability by engaging in secondary market and other transactions.
    The enabling legislation also identifies Federal agencies responsible for prescribing overall policy and regulations for the Government Sponsored Enterprises, and usually provides that a minority of their board members be appointed by the President or another Federal official.
    Government Sponsored Enterprises typically receive their financing from private investors. They issue capital stock and short- and long-term debt instruments, sell asset-backed securities, also known as mortgage-backed securities, and collect fees for guarantees and other services.
    Federal legislation confers a number of benefits on Government Sponsored Enterprises that are not provided to private companies. Most enterprises have a direct line of credit with the U.S. Treasury and their securities are exempt from Securities and Exchange Commission registration requirements. Furthermore, their investors' interest income is exempt from State and local taxation.
    As a result of such benefits and the similarity between their debt securities and those of the U.S. Treasury, most Government Sponsored Enterprise debt and mortgage-backed securities are perceived by the credit markets to be guaranteed by the Federal Government. This perception allows Government Sponsored Enterprises to borrow in the credit markets at interest rates only slightly higher than the rates paid by the Treasury on its borrowings.
    In our oversight role, we need to address a variety of issues regarding the functions of Government Sponsored Corporations and Enterprises. Generally, we need to ask whether they continue to meet their public policy objectives. We should further consider whether there are areas where the scope of existing Government Sponsored Enterprise activities should be expanded or reduced.
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    We are joined by two panels of experts today to help answer these and other questions, and we are grateful for all of your participation, and we look forward to your testimony.
    So, welcome.
    Chairman BAKER. Thank you, Mr. Chairman.
    Mr. Lucas.
    Mr. LUCAS. I have no opening statement.
    Chairman BAKER. It is not the usual custom for my subcommittee, but we are working with Government Reform today in conducting these proceedings, and I will ask both witnesses to be sworn in before proceeding with their subsequent testimony and the questions to which they might respond later.
    If you would, please stand, raise your right hand, and respond appropriately.
    [Witnesses sworn.]
    Chairman BAKER. Thank you, gentlemen. You are now considered to be under oath.
    I also wish to recognize Mr. Royce, who just joined us.
    Would you care to make an opening statement, Mr. Royce?
    Mr. ROYCE. Thank you, Mr. Chairman. I want to thank both you and Chairman Horn for holding this joint hearing today.
    This is my first hearing as a Member of the Capital Markets Subcommittee, and I am pleased to be able to participate today in what, I believe, is a critical function of this subcommittee and of Congress, and that is the examination and oversight of the Government Sponsored Enterprises.
    While the Capital Markets Subcommittee held extensive hearings on the housing-related GSEs last year, I believe that this joint hearing is particularly useful, as it provides us with a more comprehensive view of GSEs and enables us to focus on the fundamental question of whether or not, in today's financial environment, the Government should be sponsoring these privately-held corporations and, if so, what limitations should be imposed to ensure that these enterprises stay focused on the mandates they were given by the Congress?
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    Thank you, Mr. Chairman.
    Chairman BAKER. Thank you, Mr. Royce.
    Mr. Kanjorski, would you care to make an opening statement?
    Mr. KANJORSKI. Briefly, Mr. Chairman. I ask that my full statement be made part of the record.
    Chairman BAKER. Without objection.
    Mr. KANJORSKI. Mr. Chairman, I want to congratulate you and Mr. Horn for having the efficiency of having two subcommittees come together to hold a joint hearing like this.
    I think that this will be a great example for a good portion of our fellow subcommittee Members in the House to take note that joint hearings can be very successful.
    I look forward to today's hearing and to learning whether or not the GSEs are successful organizations, how we can make them more successful, and whether there are other needs to which the GSE structure could be applied to meet the challenges that we have going into the 21st century.
    I think that there are certainly strong positions on these issues on this panel and also the academic panel. I know there are some disgruntled feelings in regard to the success of these organizations.
    Finally, I just wanted to caution for the record that, through no fault of anyone here on the inviting of witnesses, we will not have a full, comprehensive review of the problem, because some people who had different views were not available to testify on the second panel. Nevertheless, today's hearing will offer an opportunity for all the Members to come up to speed on Government Sponsored Enterprises and to, more particularly, understand where they are going and how we can better utilize them.
    Thank you, Mr. Chairman.
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    Chairman BAKER. Thank you, Mr. Kanjorski, and of course, Mr. Kanjorski is the Ranking Member on the Capital Markets Subcommittee.
    I wish to recognize Mrs. Maloney, who is the Ranking Member on Chairman Horn's subcommittee.
    Mrs. MALONEY. Thank you very much, Chairman Baker. Although I am here today in my capacity as the Ranking Member on the Government Management, Information, and Technology Subcommittee, I also had the pleasure of serving and working with Chairman Baker on the Capital Markets Subcommittee last year.
    In fact, in addition to months of bipartisan work on the Federal Home Loan Bank reform, last year the Capital Markets Subcommittee held 4 days of extensive oversight hearings on Fannie Mae and Freddie Mac. During that time, we heard from GAO, CBO, HUD, and the Treasury Department. It struck me that despite their different perspectives, all of these agencies agreed on one fact: that because of Fannie Mae and Freddie Mac, the United States has the best mortgage markets in the world.
    So, if we are here today in large part to determine if and why a GSE should be formed and sustained, then that work of last year gave us a working definition: a GSE should correct a market imperfection or credit gap whose existence is detrimental to an important public purpose like housing or education.
    Mr. Chairman, as a means of clarifying this, I would like to use Fannie Mae and Freddie Mac as examples of GSEs that fit that definition.
    Before Fannie and Freddie, many institutions, particularly smaller ones, had a problem maintaining a reliable flow of mortgage credit for qualified buyers.
    That's because mortgage credit was funded through local deposits. Those institutions in areas with a large volume of home buyers, or a healthy supply of new depositors, could provide ready credit at lower rates. But those lacking these favorable conditions faced a credit crunch and had to charge higher rates.
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    Of course, because most areas took their turn facing bad economic times, mortgage availability and interest rates varied greatly from region to region.
    Worst of all, when a local economy was hit with hard times, and needed the infusion of new capital the most, local mortgage credit dried up. In short, the availability of mortgage credit was not reliable and stable.
    Freddie and Fannie changed this by making the home mortgage a nationally-liquid asset.
    Today, lenders all of the country know they can readily sell their mortgages at a fair price to one of these two GSEs.
    That is because, since Freddie and Fannie are mandated by law to operate in all 50 States, they have the expertise and experience to evaluate and purchase individual mortgages from all over the Nation almost instantaneously. Freddie Mac and Fannie Mae buy mortgages, package them together as securities, sell them to investors, and use the profit generated to buy more mortgages, continuing the cycle and providing more ready cash to local lenders to make more mortgages.
    What has this meant for the average home buyer?
    It means if you qualify for a mortgage, you can get a mortgage, that there is a system to supply mortgage credit for you, whether you live in New York City or California. And it means, because the rates are lower, more people can qualify.
    That is why, today, we have the best housing finance system in the world.
    Fannie and Freddie are examples of how GSEs have corrected a market imperfection or a credit gap—in this case, locally-based credit crunches in the home mortgage market—whose existence did harm to an important public purpose. In this case, providing every American family the chance to own their own home.
    The second issue we look to today is when a GSE should lose its Government Sponsored status. The answer to that, I think, is straightforward: a GSE should lose its Government Sponsored status when it is no longer needed to correct the market imperfection or credit gap it was designed to address.
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    Again, I would like to use Fannie and Freddie as examples of GSEs whose presence is still needed.
    In regional downturns, our housing public-private partnership GSEs have maintained their presence. They have hard targeting, tougher than any CRA requirement, keeping their loans below the 207,000 conforming limit, and reserving 40 percent of their business for those making the median income or less. On the other side of the coin, we on the subcommittee know the difficulty we have had maintaining much less rigorous CRA requirements in the private sector.
    The attention to underserved areas goes beyond regional downturns. In my home town of New York City, where co-op housing has been a path to home ownership for so many, financing has been extremely tough to come by, even through local lenders. This has artificially and unfairly frozen in many co-op owners who would like to sell, and frozen out many prospective buyers.
    The private sector, on its own, has not stepped in to solve this problem. Fannie Mae has.
    Beginning in 1993, and culminating in the House New York Plan, Fannie Mae has made a major commitment to help revitalize this market and spur new co-op sales, pledging $750 million where nothing had existed before. With the new ability to sell co-op loans to the secondary market, the banks' resources are now being freed up to make more co-op loans.
    At the point a regional market or a type of housing stock hits tough times is exactly the point it needs focus and attention from the housing finance market. And it is exactly at that moment that a fully privatized secondary market structure would not work as well.
    Having a stable national market for home mortgages that will be there in good times and bad, in booming regions and depressed regions, is a tangible benefit the American people have come to expect. If an American home buyer qualifies for a home loan, they can get a home loan at a nationally dependable fixed rate. Americans benefit from lower rates because of participation in a national market.
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    On page 70 of the GAO report presented at last year's hearing, the conclusion was made that—and I quote—''Privatization would probably mean that mortgage rates would increase in areas with higher risk, for houses with higher loan-to-value ratios, and in periods of high mortgage demand,'' end quote.
    Put another way, a privatized world would be a far different, more segmented, housing finance system than the reliable and consistent one we have today.
    Fannie and Freddie cannot be pulled out of the market. They cannot, by statute, abdicate affordable housing goals.
    To the extent some might envision a fully privatized world where you would or could abdicate these roles, we would have a housing finance system less responsive to the needs of the people.
    The delicate balance we have today has been a great success for the American consumer, and one I hope we would all be very skeptical of disturbing.
    It is not that we should not look at privatization, or continue to evaluate the performances of our GSEs, but that before we take away Government Sponsored status, we should be very careful that the important needs being filled by a particular GSE can, indeed, be filled by the private sector.
    Thank you, Mr. Chairmen, and believe it or not, this is not all of my comments. I would like to put the rest of them in the record. Thank you.
    Chairman BAKER. Without objection, and Mr. Kanjorski believes you.
    Does any other Member choose to make an opening statement?
    [No response.]
    Chairman BAKER. If not, at this time, it is my pleasure to introduce to the subcommittees Mr. James Bothwell, Chief Economist of the U.S. General Accounting Office, previously Director of GAO's work on financial institutions and financial markets, and he served as the GAO's Deputy Chief Economist.
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    Mr. Bothwell, welcome.

    Mr. BOTHWELL. Thank you very much, Mr. Chairman. It is certainly a pleasure for me to be back here testifying before your subcommittee, and it is a special pleasure for me to be testifying for the first time before your subcommittee, Mr. Horn.
    Mr. Chairman, I would first like to introduce my two colleagues, on my right, Tom McCool and Loren Yager. Tom is an Associate Director in our Financial Institutions group at GAO, which does most of our work on GSE issues, and Loren is an Assistant Director in my office at GAO.
    Mr. Chairman, I have a somewhat longer prepared statement that I would like to submit for the record, and then summarize, if I could.
    Chairman BAKER. Absolutely. Without objection.
    Mr. BOTHWELL. Thank you.
    Mr. Chairmen and Members of the subcommittees, we are pleased to be here today to discuss the large and growing role of Government Sponsored Enterprises in the Nation's credit markets.
    As you are aware, Congress originally created GSEs to enhance the credit available to home buyers, farmers, students, and colleges. Congress established GSEs as federally-chartered, but privately owned and operated corporations, limited their activities to certain economic sectors deemed worthy of public support, and gave them certain advantages to help accomplish their public purposes.
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    Today, the outstanding volume of federally-assisted GSE credit is large and rapidly increasing. Mr. Chairman, as shown in the first of the five Figures that are attached to the end of my prepared statement—and I would like to draw your attention to those Figures—the volume of GSE credit more than doubled between 1990 and 1996, from $874 billion to almost $1.8 trillion, and is now almost double the outstanding amount of credit made available through all Federal direct loan and Federal loan guarantee programs combined. If you look at that first chart, Mr. Chairman, that bottom line shows the volume of direct Federal loans, and you can see that it has been pretty flat over this period of time.
    The second line shows the amount of guaranteed loans, and that has only slightly grown over this period of time, but the top line shows the amount of GSE credit, and that has grown quite rapidly.
    As shown in Figure 2, GSE credit has also steadily increased as a percentage of the total net credit outstanding in our economy, from being less than 2 percent in 1970 to over 12 percent in 1996. By contrast, the share of total net credit accounted for by Federal direct and guaranteed loans has declined substantially over the same period, from being almost 13 percent in 1970 to less than 7 percent in 1996, so you almost had a reversal of their roles in terms of the percentage of net credit outstanding over this period.
    As shown in the Figure 3, 95 percent of total outstanding GSE credit in 1996 was housing-related, with the remaining 5 percent going for agricultural and educational purposes.
    In recent years, housing has also been the only sector where GSE credit has been growing as a percentage of the total available credit outstanding. In particular, as shown in the next figure, Figure 4, the two largest housing GSEs, Fannie Mae and Freddie Mac, have increased their share of total residential mortgage debt from 23 percent in 1990 to over 37 percent in 1996.
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    By contrast, as shown in the last of the figures, Figure 5, the share of farm credit supplied by the Farm Credit System, which is the largest of the two agricultural GSEs, actually declined between 1985 and 1995, and Mr. Chairman, as you know, Congress passed legislation in 1996 that allowed the two education GSEs, Sallie Mae and Connie Lee, to end their Government sponsorship and become fully private corporations.
    Mr. Chairman, while the legal powers, organizational structures, and operating styles of GSEs differ, they have several common characteristics. For example, each was chartered by Congress to help achieve a particular public purpose, each is privately owned and operated, as I mentioned before, and each operates under certain restrictions and obligations which would not apply to a completely private corporation.
    Each GSE was also given certain explicit advantages to help achieve its public purpose. Such advantages include exemptions from State and local corporate income taxes, lines of credit with the Treasury Department, and exemptions from SEC registration requirements and fees.
    The most important benefit that GSEs receive from their Government sponsorship, however, is an implicit one stemming from investors' perceptions that the Federal Government would not allow a GSE to default on its obligations.
    Although GSE obligations are not obligations of the U.S. Government, the lower perceived risk of holding GSE obligations allows GSEs to borrow at lower rates than comparable highly-rated private corporations that do not enjoy Federal sponsorship.
    In our recent report on the potential impacts of privatizing Fannie Mae and Freddie Mac, we estimated that this funding advantage saved those two GSEs from about $2 billion to $8 billion in 1995 alone.
    Because of their Federal sponsorship, GSEs also involve significant risks and potential cost to taxpayers, including the risk that taxpayers could be potentially liable for a GSE's obligations if it were to get into financial difficulty.
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    In 1987, Congress, in fact, did authorize $4 billion in financial assistance to the Farm Credit System when it experienced financial stress.
    Limited financial and regulatory relief was also provided to Fannie Mae when it suffered losses of $277 million between 1981 and 1984.
    So, there is some basis for this investors' perception.
    Mr. Chairman, the special nature of GSEs and the potential taxpayer exposure to large, rapidly increasing GSE obligations, raises several important policy issues, including the adequacy of GSE regulation, the potential for expansion of GSE activities, and potential ways to limit GSE exposures.
    Over the past few years, we have performed several major evaluations of the effectiveness of the various GSE regulators, and I brought a few of these evaluations with me today.
    Based on these reviews, we developed the following five criteria for an effective GSE regulator: first, objectivity and arm's-length status from the GSE; second, prominence in Government; third, consistency in regulation of similar markets; fourth, separation of primary and secondary market regulation; and fifth, economy and efficiency.
    Although Congress has enacted some recent legislative changes to strengthen and improve regulatory oversight of GSEs, our work has shown that none of the three housing GSE regulators, neither the Office of Federal Housing Enterprise Oversight, so-called OFHEO, which oversees the safety and soundness of Fannie Mae and Freddie Mac, nor HUD, which oversees their mission compliance, nor the Federal Housing Finance Board, which oversees the Federal Home Loan Bank System, meets all five of these criteria.
    In 1993, we recommended that OFHEO and the Housing Finance Board be merged to better meet these criteria, and our ongoing work continues to support merging the housing GSE regulators and making one agency responsible for both their safety and soundness and mission compliance, and Mr. Baker, as you know, we will be testifying about this topic in more detail at your hearing next week.
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    Based on our work, we have also developed several criteria that policymakers could use to evaluate proposals to expand the types of products or services that existing GSEs currently offer.
    Under our criteria, any new GSE product or service should: first, and perhaps obviously, add value and be consistent with the GSE's public mission; second, be properly priced to reflect risk; third, be within the GSE's areas of expertise; and finally, and perhaps most importantly, avoid competing with products and services offered by fully private companies or member institutions.
    Because GSEs have been given the advantages of Federal sponsorship to achieve particular public purposes, we believe that any proposals to significantly expand their existing activities should be required to meet these, or similarly rigorous, criteria before they are approved.
    Finally, Mr. Chairman, we have also done work addressing ways that Congress might limit the taxpayers' potential exposure to GSE obligations.
    One obvious way to do this is to end their Federal sponsorship. As I mentioned at the beginning of my statement, Congress passed legislation last year that would make two of the GSEs, Sallie Mae and Connie Lee, fully private entities.
    In 1996, GAO, the Treasury Department, HUD, and CBO each produced reports that analyzed the potential impacts of privatizing the two largest GSEs, Fannie Mae and Freddie Mac.
    While taking such action could eliminate taxpayers' risk exposure to these GSEs, it would also have major impacts on housing finance markets, including a likely increase in mortgage interest rates for certain borrowers.
    Our report also discussed some more limited policy options that would reduce the level of taxpayers' risk exposure to these two large and growing GSEs, such as imposing ''user fees'' or greater restrictions on their housing finance activities.
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    As with privatization, however, each of these options that we presented at that time had certain benefits, risks, and trade-offs that would need to be considered and weighed carefully.
    Mr. Chairman, this concludes my statement, and my colleagues and I would be pleased to answer any questions that you or other Members may have.
    Chairman BAKER. Thank you very much for your comments.
    At this time, I would like to introduce Dr. Thomas Woodward, a specialist in macroeconomics and head of the Income, Finance, and Housing Section of the Economics Division of the Congressional Research Service at the Library of Congress, where he has worked on issues related to macroeconomic policy and financial institutions since 1982.
    Welcome, Dr. Woodward.

    Dr. WOODWARD. Thank you. Mr. Chairman and Members of the subcommittees, good afternoon, and thank you for the invitation to discuss issues related to Government Sponsored Enterprises.
    The written version of my testimony is submitted for the record. With your permission, I will summarize my conclusions.
    Chairman BAKER. Without objection.
    Dr. WOODWARD. Government Sponsored Enterprises, or GSEs, are congressionally-chartered profit-making corporations owned by private shareholders, but operated to serve a public purpose. They differ from other corporations in that they possess certain legal privileges and exemptions not available to other firms, and that they are limited to conducting a narrow range of business activities.
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    There are five federally-chartered GSEs: the Farm Credit System and Farmer Mac for agricultural credit; and Fannie Mae, Freddie Mac, and the Federal Home Loan Banks for home mortgage credit. Sallie Mae, the GSE for student loans, is becoming a fully private corporation.
    The enterprises may use Federal Reserve banks as fiscal agents. Their debt may be purchased without limit by federally-chartered banks and thrifts, and may serve as collateral for public deposits. In most cases, their securities are eligible for Federal Reserve open market purchases. Their earnings are typically exempt from State and local income taxes. And most of them are exempt from the registration requirements of the SEC.
    The most valuable benefit is the perception that their debt is guaranteed by the Government. Even though their securities declare that they are not guaranteed, the privileges, the fact that they have special charters, and the history of Government behavior towards the enterprises, have caused market participants to infer a guarantee, which lowers their borrowing costs.
    As to when to create or terminate GSE status, most profit-making endeavors will be undertaken without the grant of special privileges, and worthwhile activities will typically yield a profit. A GSE, therefore, is not automatically justified unless there is some identifiable failure of the market to work in a sector of the economy. Even then, a GSE may not be the appropriate remedy. Because such enterprises must earn a profit, they do not work as solutions to all types of public needs.
    Presumably, any new GSE or expansion of the mission of an existing one would be built around creating a secondary market for a class of loans not easily sold. Today, however, financial markets are more sophisticated and integrated; problems with regional flows of funds and access to other parts of the credit market have largely disappeared for reasons unrelated to GSEs.
    In general, economic considerations point to ending a GSE's special status eventually.
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    In the case of a GSE that has been unsuccessful in its role in the market, the public policy concern that it was intended to address needs to be addressed in some other way. If successful, the GSE occupies a market without the discipline of competition. This outcome is a market distortion of its own, possibly worse than having an underdeveloped market in the first place. After some period of time, either the GSE needs to be weaned from its charter so that others can enter the market, or competition can be created by chartering competitors with similar privileges.
    With respect to regulation, the perception of a Government guarantee of GSE debt affects the incentives that determine the amount that the owners of the firm put at risk in the form of capital or equity. Owners, as usual, prefer to minimize the amount of capital. But creditors, who ordinarily desire greater capital, are indifferent because of the guarantee.
     Hence, without regulation, a firm with a guaranteed debt will tend to have insufficient capital, creating greater risks for Government. This suggests that the primary method of financial regulation of GSEs should be in the form of capital standards.
    Programmatic regulation most likely needs to take the form of ensuring that the chartered firm remains within the bounds set for its activities until its job is complete. Otherwise, the firm is likely to expand its activities outside the charter.
    With respect to the Government's financing costs, the existence of competing GSE debt probably has little effect on the financing cost of the Federal Government. The presence of GSEs might cause an increase in credit demand that drives up all interest rates. But the effect would have to be tiny.
    In addition, the availability of GSE debt could reduce the premium that investors are willing to pay for safe Federal securities. But a casual inspection of financial markets suggests it has had little real effect.
    With respect to compensation for privileges, the whole idea of granting benefits to the enterprise is to make it successful. Compensation for the privileges simply undoes the benefit.
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    Thus, the notion of paying for the privileges is inseparable from the issue of continuing GSE status. In the early stages of a GSE's life, a fee would be counterproductive to the whole idea of setting up the institution and making it successful. Later in the life of the enterprise, a ''user fee'' for GSE privileges may be used as a substitute mechanism for ending GSE status once the market matures.
    That concludes my remarks. I'm available to answer any questions.
    Chairman BAKER. Thank you, Dr. Woodward.
    Mr. Bothwell, I noted in your testimony and in your charts, significant market share growth of particularly Fannie and Freddie in housing finance.
    Under current mechanisms, the Federal Housing Finance Board determines the average cost of housing in the country, that then triggers an automatic increase in the authorized loan limit of Fannie and Freddie. That is not pursuant to a determination that private capital markets have been insufficient in meeting the public's need.
    Do you see, in light of the historic growth demonstrated by your data, some necessity for the Congress to look at that automatic loan limit increase, or whether that is an advisable course to follow?
    Mr. BOTHWELL. Well, certainly, Congress could look at that issue if it chose to.
    I think that the purpose of the adjustment was so that the two enterprises would still be able to buy loans underneath the so-called ''conforming limit'' adjusted for increases in housing prices.
    There was, as you know, a problem with that procedure in that, in years where housing prices went up, the conforming loan limit went up, but we had a year or two where housing prices went down, and they did not adjust downward.
    I think, because you and others have raised that issue with the enterprises, that they voluntarily did not adjust upward the conforming limit as much as they would have otherwise to take account of the inflation in housing prices that actually occurred last year. But again, I think this is a policy judgment that Congress will need to make.
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    Chairman BAKER. I may have offered that question in light of your observation that one of the things the subcommittees have to be sensitive to is encroachment into the private enterprise market, unless there is some demonstration of public necessity, and that formula does not appear to relate to a public necessity as your overview might indicate.
    Mr. BOTHWELL. Right.
    Chairman BAKER. Another area—without regard to a specific housing GSE, but with regard to the three primary housing GSEs—in your study, can you advise me as to your belief—or observation, rather—with regard to how well each meet their public policy goal as compared to, say, a commercial lending institution?
    Mr. BOTHWELL. Are you referring to the GSE regulators for each of the GSEs?
    Chairman BAKER. No, the public policy requirement to make credit available to low- and moderate-income individuals, minorities, and others that otherwise may be prejudiced in the traditional private enterprise system. The principle around which the GSEs really were authorized, to serve those credit needs, and how well they perform that task, as compared with a commercial lending institution.
    Mr. BOTHWELL. Well, both Fannie Mae and Freddie Mac have their explicit affordable housing goals. In our report, we mention that they have been meeting those housing goals, and the Federal Home Loan Bank System also has an affordable housing program.
    I think it is being modified in H.R. 10, the financial modernization bill that is now before the Congress.
    I am sure that there are those who believe that perhaps the goals could be raised some for the moderate- and low-income mortgages purchased by the enterprises, but we really have no position on that.
    Tom, do you have anything to add?
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    Mr. MCCOOL. Yes. I think that the issue, for example, has been recently whether the enterprises should match the market or lead the market, and I think that HUD has, for the moment, chosen to have them match the market, so I think that they have achieved that. The issue about whether they should be asked to lead the market, I think, is still up in the air.
    Chairman BAKER. One other question, because I will try to stick to the 5-minute rule here, if I may.
    You made reference to the investment portfolio strategies of both Fannie and Freddie, indicating that both, to some extent, seem to be engaged in more portfolio investment strategies yielding higher rates of return, but consequently also resulting in a higher risk profile.
    Given that enhanced position, do you have any concerns about the long-term implications of that strategy, particularly as it relates to the necessity of doing it to meet the public policy goals?
    Mr. BOTHWELL. The answer to that would be yes.
    One of our tenets for good GSE regulation is that there be risk-based capital standards imposed on the GSEs, and as you know, OFEHO has been somewhat late in coming forth in issuing its risk-based capital standards.
    The mortgages that Fannie Mae and Freddy Mac hold in their portfolios bring them, of course, more credit risk, but it also brings them more interest rate risk. So, we think it is important that OFEHO try to issue its risk-based capital standards based on its stress testing as soon as they possibly can.
    Chairman BAKER. Thank you, sir.
    I will now try to keep within 5 minutes and recognize Mr. Kanjorski. It will be the Chair's intention, after Mr. Kanjorski finishes his questions, to recess for a vote, which I understand will take us about 20 minutes.
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    Mr. KANJORSKI. Thank you very much, Mr. Chairman.
    First off, has anyone done a model in terms of looking at the financial position of what the GSEs are doing in the credit market, particularly for real estate, and if all the taxes and obligations of a private enterprise were applied, what would be the differential?
    Are they still competitive if they kept the rate down, or would they materially have to go up to show a profit?
    Mr. BOTHWELL. Mr. Kanjorski, in our report on the potential impacts of eliminating Government sponsorship of Fannie Mae and Freddie Mac, we say that, if they lost that Government sponsorship, that one of the impacts would be, of course, increased funding costs on those two enterprises, from $2 billion to $8 billion.
    They would pass some of that on to home buyers in terms of higher mortgage rates. We think that mortgage rates for borrowers at or below their conforming lending limit, would go up from 15 to 30 basis points.
    Mr. KANJORSKI. So, it would cost the average home buyer, the user of a GSE, about 20 to 30 basis points if they were to comply in contributing costs according to obligations that the private sector has? Is that correct?
    Mr. BOTHWELL. Yes. We figured out, in more easily understandable terms, for a typical mortgage of $100,000, which is typical of the mortgage that is purchased, that the increase in costs to the borrower would be from $10 to $25 a month. So, over a year, you are talking about a few hundred dollars.
    Mr. KANJORSKI. Now, that would be nationwide?
    Mr. BOTHWELL. Yes.
    Mr. KANJORSKI. Was that looked at on a regional basis?
    Mr. BOTHWELL. No, that is nationwide.
    Mr. KANJORSKI. Because I am looking at it on a regional basis. In other words, it seems to me that the GSEs were formed because in some areas there was a very active, competitive mortgage market, and in other areas there was not.
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    Mr. BOTHWELL. Exactly.
    Mr. KANJORSKI. So, the differential in mortgage rates would be significant from one State to the other, or from one region to the other.
    Mr. BOTHWELL. Yes, sir. That's a national average.
    Mr. KANJORSKI. So, we have successfully averaged out, in some respect, the mortgage rate in the country by having a GSE perform that function. Is that correct?
    Mr. BOTHWELL. Well, that is not to say that, if the GSEs were privatized, the secondary market would go away. Presumably, there might be an increase in competition in the secondary market, and other fully private firms would come in.
    Mr. KANJORSKI. I am relatively satisfied that we have handled the competition on the credit side very well to get a very low-cost product out there to stimulate building, to stimulate home ownership, to do everything that was intended when these organizations were structured.
    Has anybody been looking at the other side of that question, in terms of where the distribution of that benefit goes in the economy? I will give you—I am very parochial here.
    I represent Pennsylvania, and obviously, Pennsylvania, when you look at the numbers, does not participate in the amount of home building, the amount of mortgages, and some of us tend to think that the reason for that is the lack of economic development in Pennsylvania and some other States that are in rather static form in our economy.
    The question is, could we look to the GSE model to provide some targeting of economic stimulus funds outside of the normal things like the Economic Development Administration and the Department of HUD and the Department of Commerce and all these other programs?
    Instead of having all this mish-mash of programs out there, would it be beneficial for regional economic development and creating a level playing field in the country, to change and enlarge the charters of the GSEs to get much more involved in assisting economic development?
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    Mr. BOTHWELL. Mr. Kanjorski, that is one of the changes that would be made to the charter of the Home Loan Bank System in H.R. 10.
    For certain member institutions with assets of $500 million or less, they would be allowed to receive advances, and have as collateral for those advances its rural development loans and small business loans.
    Mr. KANJORSKI. I am very close to that mission expansion, as you know, but do you see that this is also a potential tool that should be used, or do you see a real down-side to that? Are we playing with fire?
    Mr. BOTHWELL. Well, again, if Congress deems that there is a legitimate public purpose that is not being adequately served by the private capital markets, or if it just wants to redirect credit resources into particular usage and particular sectors of the economy, a GSE is probably an efficient vehicle to do that, but there are costs to that.
    When you redirect credit to a particular sector, it is obviously coming from another sector. Sometimes those costs are hidden and much harder to measure, but if Congress deems that there is a particular public purpose that is not being well-met by private capital markets, a GSE is a logical vehicle.
    Mr. KANJORSKI. Thank you, Mr. Bothwell.
    Thank you very much, Mr. Chairman.
    Chairman BAKER. The hearing will stand in recess for approximately 20 minutes, and we will then reconvene. Thank you.
    Chairman BAKER. I would reconvene our hearing, and a word of explanation to our very patient witnesses.
    We have just endured three votes, during one of which, after casting votes, 102 Members or so decided to change their vote. So, it was an unusual event, explaining our rather lengthy delay.
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    I know other Members are on their way back. I thought I might take advantage of our interim time, while we are waiting on other Members to return, to ask just a few more follow-up questions that I did not get the opportunity to pose the first time around.
    Dr. WOODWARD. Mr. Chairman.
    Chairman BAKER. Yes.
    Dr. WOODWARD. I was wondering if I could have the chance to answer Mr. Kanjorski's question that Mr. Bothwell also answered in the first part of the hearing?
    Chairman BAKER. Certainly, for the record, if you would like to proceed.
    Dr. WOODWARD. Yes. Thank you.
    Mr. Kanjorski asked if the current GSEs would possibly be a model for addressing the needs of certain regions that have problems with economic development.
    My answer to that would be no, they probably would not be a very good model, because the kinds of regional disparities that the very successful GSEs that we have have addressed, are very different than the phenomenon that Mr. Kanjorski is talking about.
    What happened in mortgage markets was that you had very solid demand for mortgages in certain regions of the country from people who were creditworthy, but who could not access funds because there was a lack of supply within that region.
    Typically, when you have regions that need development money, there is a general perception that it is not necessarily a high-return investment, which is kind of different. It is a demand-side phenomenon.
    A GSE that makes funds available nationwide is not going to be able to enhance, necessarily, the creditworthiness of those kinds of loans.
    Consequently, integrating the national market is not really going to address the problem of a region that needs money for development.
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    In particular, Mr. Bothwell correctly said that, if the Congress decides that there is a public purpose to be served by trying to allocate credit to those kinds of needs, that is, of course, very appropriate. But, a GSE is probably a very inefficient way of delivering that credit, and that is because a GSE is a profit-making institution. It is not necessarily an efficient way to deliver a subsidy.
    We can expect, typically, the subsidy there, the value of the benefits going to the GSE—only part of that will be passed on, and in particular, they are looking to make loans that will earn a profit and earn a high return, so that all the more likely, if they are directed to make loans in a specific area, it is in their interest to try to skim the market for the very best ones, some of which might have been able to access credit anyway. Consequently, it is not nearly as efficient as delivering that credit directly.
    Chairman BAKER. Thank you, sir.
    A couple of questions.
    Both of you seem to indicate that the finding was because of the implicit guarantee backing both—all GSE debt issuance, that they enjoyed favorable pricing in the markets.
    To that extent, are there tangible actions that could be taken that would send signals to the markets that these entities do, in fact, stand on their own financial bottom?
    For example, the Federal Home Loan Bank and Fannie enjoy, although on a very conditional basis, lines of credit that can be called on in times of financial duress. Neither has found it necessary in the last decade to exercise those lines of credit.
    Would it be ill-advised to consider rescinding those conditional lines of credit, in light of the fact that there does appear in the markets the perception that, if there is a difficulty, the U.S. Government will step up and meet the obligations?
    Mr. BOTHWELL. Mr. Baker, I would say that there might be some slight effect, but most of the effect of the investors' perception comes about through the Federal charter itself, that these are federally-chartered entities, and there are GSEs that do not have those lines of credit and they enjoy the same sort of funding advantage.
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    In addition, if you do start taking away their advantages and the value of those benefits, then you start to lose some of the very reasons why they are in existence, in terms of making home ownership more affordable.
    Chairman BAKER. As a follow-up, the Federal Home Loan Bank System was originally intended to be the credit window for the thrift industry. As a result of consolidations and closures of institutions, smaller asset-size banks make up a majority of the membership of that system today.
    Absent the provisions of H.R. 10, which create a new mission for the Federal Home Loan Bank, in light of the growth of Fannie and Freddie as the predominant housing GSEs, do you see a future for the Bank System as currently constituted, if the provisions of H.R. 10 are not met? Let me restate—a public necessity for the continuance of the operation of the Federal Home Loan Bank System absent the provisions of H.R. 10?
    Either one of you may choose to respond.
    Dr. WOODWARD. Well, certainly, in terms of the original purpose of the Federal Home Loan Banks, much of the rationale has disappeared. I would say their primary usefulness at this point is in creating some viable competition for Fannie and Freddie.
    The degree to which that depends on H.R. 10 will depend on how much regulatory room they get under the current arrangements.
    Chairman BAKER. Mr. Bothwell, any comment?
    Mr. BOTHWELL. Well, certainly, with the dramatic change in the thrift industry, the original rationale for that system is much less today.
    Congress addressed this somewhat a few years ago when it opened its membership to banks as well as thrifts. Now, a majority of the member institutions are banks and not thrifts anymore.
    Chairman BAKER. On that point, don't a significant number of the banks now use the system primarily for liquidity purposes, as opposed to the public policy reasons that are the underpinning of the original charter of the Federal Home Loan Banks?
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    Mr. BOTHWELL. Yes, sir.
    Dr. WOODWARD. I would say that the public policy reason primarily had to do with liquidity though, so that is probably appropriate.
    Chairman BAKER. Well, it was—perhaps a slightly different view—to facilitate home ownership through the thrift charter and making portfolio lending a possibility with long-term fixed-rate money being advanced by the bank system.
    We have other Members returning, and my time has expired.
    Mr. Lucas, would you choose to ask questions?
    Mr. LUCAS. Thank you, Mr. Chairman, and having just stepped in, perhaps being a little out of sync with the discussion, I guess kind of a general purpose question of the panel, and either of the gentlemen who care to respond.
    It was obvious in the testimony given that clearly there was a view that, if these GSEs did not exist, that there would be, in effect, a rate increase for the folks who use the services that they fundamentally provide.
    Could you touch just for a moment, since the GSEs cover a broad swath of activity out there, what the potential impact, from your perspective, would be in the agricultural sector, since a couple of these entities, such as Farm Credit System and Farmer Mac, certainly are a component?
    Mr. BOTHWELL. Mr. Lucas, our estimates are for the impact on homeowners, I do not think we have looked at the impact on agricultural borrowers from Farm Credit.
    Is that right, Tom?
    Mr. MCCOOL. Yes. We have not looked at that.
    Mr. LUCAS. It would be safe to say that the same liquidity situation, the same availability of credit that the GSEs attempt to touch in the direction of homeowners or potential homeowners—those same kind of issues would potentially impact the agriculture sector, too?
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    Mr. BOTHWELL. Yes.
    Mr. LUCAS. The same potential impacts would be out there in the ag community, also?
    Mr. BOTHWELL. Yes. You have two agricultural GSEs.
    One, the oldest GSE and the largest of the agricultural GSEs, is the Farm Credit System. That is a cooperative system. That GSE is a direct lender to farmers for various types of purposes, and again, they are raising their money in the capital markets and have the implied Government guarantee, so, the money they are raising has a funding advantage that they are passing on, to some extent, to the agricultural borrowers.
    The second one is Farmer Mac, which was created in 1988 to establish a secondary market for agricultural loans. So, their operations now are much similar to Fannie and Freddie in the residential housing market. They are buying agricultural loans from the loan originators and then securitizing those loans, and again, they have Federal sponsorship and the lower funding costs, as well, which they are probably passing on, to some extent, to the agricultural borrowers.
    Mr. LUCAS. It may have been Dr. Woodward, but one of you, I think, raised the point, either in your oral or written testimony, about the idea of creating competing GSEs to limit some of the—I think the phrase was used—''monopolistic tendencies.''
    In a sense, in Farm Credit and in Farmer Mac, we have such competition, don't we? Because in the real estate sector, they are both, in a sense—Federal Land Bank and Farmer Mac—providing similar services or, some might say, competing services. Wouldn't that be an example of the point that was raised?
    Dr. WOODWARD. That would be an example of the kind of thing we are talking about. Fannie and Freddie also compete to some extent. It is a question, however, of how many institutions you have to have for viable competition.
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    Also, with respect to the differences in the farm sector and the housing GSEs. When I talked about creating competition, that was in the context of successful GSEs, and I think some people might question whether the Farm Credit System really is a successful GSE or not, given its history.
    Mr. LUCAS. Maybe just for a moment, if you would elaborate again on what you would call the definition of a ''successful GSE'', just remind me.
    Dr. WOODWARD. Well, it would be one in which there is, for example, a market failure to identify, typically the one that has to do with credit flows, in which the GSE has truly managed to make the credit flow from one place to another to remedy the failure.
    If the real problem is you just want to get some credit to a worthy sector of the economy, not because it is a high rate of return sector, because for other reasons we have decided it is worthy, then probably, you know, a GSE structure is not necessarily a really good way to do it. I am not as conversant with the agricultural GSEs as I am with the housing GSEs, but I think the way some people might look at it, given its history and the bailout that occurred in the 1980's, there is some question of whether that GSE is actually operating to smooth out differences in the flows of funds, or whether it really exists to deliver a small subsidy to farmers.
    Mr. LUCAS. Since my time is about to expire, Mr. Chairman, I believe I will pass on the opportunity to delve deeper into this.
    Chairman BAKER. Thank you, Mr. Lucas.
    Just as a follow-up, to either of the gentlemen, on the point of the Farm Credit System specifically. In the graphs presented to the subcommittees, I believe, in your testimony, Mr. Bothwell, you show that over the last 10–year period the share of Farm Credit lending has declined from 29 percent down to 24, but the interesting thing is the ''other'' category.
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    I do not know what that means. I assume that is like commercial paper, a farm implement dealer perhaps?
    Mr. BOTHWELL. Yes.
    Chairman BAKER. It has grown from 30 percent to 36 percent, while bank lending has increased from 23 to 39.
    Mr. BOTHWELL. Yes.
    Chairman BAKER. In further explanation of the graph, I am told, although I am not certain it is accurate, that the Farm Credit System tends to lend more to the older, well established, collateralized farm operation, as opposed to the younger, startup, new capital borrower. You may not have the information immediately available, but being interested in all GSE performance and what their public policy mission is, at some future point if you could provide that, it would be helpful, I think.
    Mr. BOTHWELL. Sure. I would be happy to.
    Chairman BAKER. Did you have a follow-up, Mr. Lucas?
    Mr. LUCAS. If I might just for an observation, Mr. Chairman, that tends to be the nature of all financial institutions lending in the ag sector, being very complicated, very capital-intensive, that is the weakness that all financial institutions have.
    Chairman BAKER. I agree, and I think it would be interesting to contrast that of the Farm Credit System history with that of commercial banks to see, as I requested on Fannie and Freddie and others with the housing GSEs.
    Mr. Cook.
    Mr. COOK. Thank you.
    I would like to thank each of the panelists for their testimony today, helping me and others understand a little bit more about how the Government Sponsored Enterprises work to help provide financing in certain areas of our economy, and I am certainly interested in the more affordable credit in agriculture and in education.
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    I do represent the Salt Lake City area, a very urban area, where housing prices have really been skyrocketing and low-income families—and also young families—are really just being priced right out of the market.
    I happen to believe that America's overall system of helping people get financing for homes is probably the best in the world.
    I am sure there is lots of room for improvement, but I would like to ask each of the panelists, in general terms, if they feel a new housing finance system is needed to help, especially young families and low-income families, getting into homes? Do they believe that the housing-oriented Government Sponsored Enterprises and the system we have today, with those entities, is really the most efficient system of delivering affordable mortgage financing? Is there a better way to go?
    I take it there are a lot of concerns you have about the way, particularly the housing ones, are operating, and what would you put in place, if so?
    Mr. BOTHWELL. Well, Mr. Cook, as you pointed out, the housing GSEs now account for 37 percent of the total outstanding housing credit. That is a pretty large percentage of the market.
    Then you have the guaranteed FHA program, as well, providing assistance to homeowners, usually for the lower value types of mortgages, for the first-time home buyers.
    I think a good deal of Government assistance, either directly through guaranteed loans, or indirectly through sponsorship of Fannie and Freddie and the Home Loan Bank System, is being made available to home buyers.
    We have one of the highest rates of home ownership in the world, 65 percent, and I agree that home ownership is a laudable public goal, but one has to recognize that this type of assistance also involves costs and diversions of credit from other types of borrowers, such as small businesses, that also—probably—have laudable objectives.
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    Mr. COOK. Is the problem, if any, in the way that these Government Sponsored Enterprises are operating, or is there a better way to go?
    Is there a better financial structure through something similar, or through another Government-type of a program, or should we continue to believe—and I do believe now, in the absence of other evidence, that these Government Sponsored Enterprises are absolutely the best way, and a real part of the success that this country has had, and the success we hope to have in housing. I am just kind of looking to see where you really think we ought to go with this whole question?
    Mr. BOTHWELL. In our big report on the potential impacts of privatizing Fannie and Freddie, we discussed the potential benefits and costs of doing that, and the potential impacts.
    As I mentioned in my statement, the CBO and Treasury Department also did studies, and they addressed this issue, that we really did not address in our study, in terms of how much of the subsidy, the implied subsidy through the funding advantage, gets passed along to home buyers and how much gets absorbed, if you will, by the corporations. Dr. Woodward mentioned that as well, and they concluded in their studies that one-third of the subsidy got absorbed by Fannie and Freddie through higher stock prices, or higher manager compensation levels.
    Now, if that is correct—and I am not saying that is correct, I am just saying that was the conclusion of those two studies—then that does raise questions about whether or not that is the most efficient delivery mechanism that you have available.
    Now, in the case of the education GSEs, the decision was made by the Congress and the Administration that the most direct way to provide credit assistance to students was not through Sallie Mae, but was through direct student loans, and the policy decision was made by the Congress to start funding more student loans directly, and that was partially the reason why Sallie Mae was set on the road to privatization.
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    So, a decision was made in that case that there was a much more efficient subsidy delivery vehicle there, but we did not reach any conclusion about that with regard to the housing GSEs in our report.
    Mr. COOK. OK.
    Well, if I could just, in conclusion, say that I happen to think that the Government Sponsored Enterprises are a rather wonderful example—I do not want to wax on too strong, because I realize there are problems, there ought to be some corrections and some reform—but a really great example of where the money comes in through the private sector—individuals, companies, and so forth—and it is just kind of a very nice partnership in the public and private sector to do a very important national goal, or to be a major player in that goal of providing affordable housing.
    Mr. BOTHWELL. Yes.
    Dr. WOODWARD. If I may, in answer to your question. While there is no doubt that the GSEs have been very successful in what they do in terms of helping funds flow, a lot of what they do is not so much directed at what I think your concern is.
    You are asking what more can be done, and specifically, there are some groups of people who may not be able to have access to housing finance now, not because funds do not flow from one part of the country to another, but because, again, they are perceived, for whatever reason, not being quite as creditworthy, either because of their income or credit history or whatever.
    In that case, the name of the game is not shaving a small amount off the interest rate that they pay. That is not really going to make it affordable. Their threshold is probably going to be on the downpayment, because if you can make the 20 percent downpayment, you can generally swing the loan.
    So, it is in risk management, and that is not what Fannie and Freddie do. Fannie and Freddie get a certain amount of privileges, a certain amount of it gets passed on, they keep a certain amount.
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    So, that is kind of a nice subsidy that may go to homeowners to the tune of 15 or 20 basis points that is incidental to their real mission of making funds flow.
    So, if you are interested in bringing in these other home buyers, you really need to look to whatever entities turn them into better credit risks. That is not Fannie and Freddie. You would be looking at some variant of mortgage insurance and who holds the risk there.
    That is where you would want to direct your interest, and that could be done whether Fannie and Freddie exist as private institutions or whether they have Government sponsorship. It really would not make that much difference.
    Chairman BAKER. Thank you, Mr. Cook.
    Mrs. Maloney.
    Mrs. MALONEY. Thank you.
    I would really like to begin by quoting from the GAO report, and I quote, ''Each GSE was chartered by Congress to help achieve a particular public purpose,'' and then it goes on, and I would like to ask each of you to discuss whether or not a structured public purpose evaluation, like encouraging housing or education or whatever, should be applied when evaluating the need for, or expansion of, a GSE? I would like you each to—if you would like—to pay particular close attention to the dilemma that we often face as legislators, and that is what may seem like a very valid and necessary public purpose to some of our Members of Congress. To others it may seem like a Government overreach, and I would like to know if you believe there is an objective way to look at this evaluation, or is it always going to involve the differing perspective of the Government's role and our own personal experiences that each of us bring to the table?
    I would like to begin with Mr. Bothwell.
    Mr. BOTHWELL. Yes.
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    In my statement, we laid out five criteria that we think are pretty rigorous, and that we believe should be used to evaluate any potential expansion in the activities of existing GSEs.
    The first one of those criteria was that it be consistent with the public purpose for the existence of that GSE and add value.
    The others are that it be priced properly to reflect risk, so you do not have additional uncompensated risks in the product, that there be expertise, that it be managed and controlled properly, and that it avoid competing with products or services that are already offered by fully private corporations.
    So, we think that those are a good set of criteria that policymakers could use to evaluate any potential expansion in the roles or missions or products of GSEs, and as far as the second part of the question, I would say that, yes, how one evaluates a proposed expansion of new activity against those criteria can be pretty subjective.
    Mrs. MALONEY. Dr. Woodward, would you like to comment?
    Dr. WOODWARD. Yes.
    I think we are talking about two possible things here.
    First of all, it has to do with evaluating the goal itself. As you say, people may disagree about what the goals should be. As Mr. Bothwell pointed out, there are other uses for this credit, and while there are some objective criteria you can use in terms of returns, in the end that is a matter of judgment, and it is a judgment that rests with the Members of this body. But then, assuming that it is decided that one of these laudable goals is, for example, subsidizing housing in some way, or pursuing housing goals, then we get into a realm of where more objective criteria can be used. Because you can ask yourself, ''If I want to deliver a subsidy, what is the most efficient way to do it?''
    Mrs. MALONEY. I would like both of you to comment or describe when, and under what conditions, you think Government Sponsored Enterprises are justified and why?
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    Mr. BOTHWELL. Congresswoman, I was actually, in preparing for this hearing, looking through the budget, in particular the analytical perspectives portion of the budget on page 148, and there, OMB has actually laid out three program justifications, which I think are actually pretty good.
    The first one is—and this is not necessarily just for GSEs, but for any kind of credit program that is federally-assisted or supplied. The first one is that credit assistance should be provided only when it has been demonstrated that private credit markets cannot achieve clearly-defined Federal objectives.
    The second justification is that credit assistance should be provided only when it is the best means to achieve Federal objectives.
    The third is that credit assistance should be provided only when its benefits exceed its costs.
    So, I think the OMB has laid out three pretty good criteria for when one would try to set up a GSE or other type of credit assistance program.
    Mrs. MALONEY. My time is up, but I have a few more questions. I am going to submit them to the subcommittees in writing, if that is all right?
    Thank you, Mr. Chairman.
    Chairman BAKER. Thank you, Mrs. Maloney.
    Mr. Horn.
    Mr. HORN. Thank you, Mr. Chairman. I just have a few questions. I am very conscious of the second panel that is coming soon.
    Tell me, in terms of the written statement, Dr. Woodward, that you had noted that Government Sponsored Enterprises operate with market privileges that provide them with a certain monopolistic position in the market.
    I guess I would ask you, what are the alternatives in introducing competition into GSEs and, thus, minimizing the monopolistic position? What would be the ones you might think of, other things that could be done to level the playing field for some, if you will?
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    Dr. WOODWARD. Well, I think you probably have three choices.
    One is, in one way or another, terminating the charter or the charter privileges.
    The second one is the implementation of a fee for the charter privileges, which would slowly raise the cost of the privileged organization until some non-privileged competitors are able to work in the market, compete with it.
    The third would be to charter similar organizations with similar privileges. Each one has its advantages and disadvantages. I do not know whether you want me to go into those or not.
    Mr. HORN. I think it would be helpful, because the question would be is there any need to do this, and if there were a need to do that, what would you do?
    I mean, do you transfer them to another type of Government corporation, or Government Sponsored Enterprise in the form of a corporation, and so on?
    Dr. WOODWARD. Well, I think, in the cases of Fannie and Freddie, given what they do, there is ample evidence to suggest that that secondary market is not going to go away and that Fannie and Freddie, being very capably run, could operate in it very well.
    So, there would not be, necessarily, any reason to set up any other Government program to do what they do, unless, like I say, if you want to take the money and somehow subsidize housing, and that is a different story. But in terms of the secondary market operations, I think there is a great deal of evidence that that is not going to go away.
    Everything that they have done in terms of making sure that money goes from one place to another will continue to happen.
    The advantage of a fee, over just strictly privatizing them, is that you can make that adjustment gradual. The fee can be adjusted upward over time until they feel the heat of competition enough that they decide that they would rather not have the charter.
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    Mr. HORN. When you talk of a fee, are you talking about a certain percentage?
    Dr. WOODWARD. In all probably, you would levy a fee of one type on the amount of their direct borrowings outstanding and a lower fee on the amount of the mortgage-backed securities. It would be expressed as a percentage.
    Mr. HORN. As a percentage of whatever the value was?
    Dr. WOODWARD. Yes.
    Mr. HORN. Let me ask you, Mr. Bothwell. In 1993, the General Accounting Office recommended that the Office of Federal Housing Enterprise Oversight and the Federal Housing Finance Board be merged. Am I correctly informed that the merger has not taken place?
    Mr. BOTHWELL. No, it has not.
    Mr. HORN. If so, what is GAO's feelings on this one way or the other?
    Mr. BOTHWELL. I think this is the subject of a hearing Mr. Baker is going to have next week, but we feel that merging those two entities and creating a single independent, arm's-length regulator, perhaps headed by a board, rather than being within an Executive Branch agency, would better meet those criteria that I discuss in my statement for being an effective GSE regulator. It would be more prominent in Government, it would be arm's-length, and perhaps lead to more consistency in regulation.
    Mr. HORN. I will let it stop at that, because most of the questions I have really need the agency head in the room, or somebody that can speak for the agency head.
    If I might, Mr. Chairman, I would like to swear the other two witnesses, since they did testify, and if you would just raise your right hand.
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    [Witnesses sworn.]
    Mr. HORN. All right. Thank you.
    The clerk can note two witnesses affirmed.
    Thank you.
    Chairman BAKER. Thank you, Mr. Horn.
    Mr. Hill.
    Mr. HILL. Thank you, Mr. Chairman.
    Has anyone done a study—I guess I would ask Dr. Woodward first and then Mr. Bothwell—but has anyone done any sort of a study to determine how much risk—or I guess I would put it this way—how much of the profits that are currently being earned by the GSEs that are profitable comes from the interest maturity, different interest maturities that might exist on the portfolio loans that they have, that they borrow against?
    What I am questioning is, is this—the profit—is it a consequence of leveraging different maturities? Is that contributing to the profit of the GSEs right now?
    Dr. WOODWARD. That is part of what has to do with their portfolio, what they hold in portfolio.
    If they buy the mortgages and hold them themselves and just borrow in credit markets, they are making a certain amount of profit off of the maturity mismatch. If they package them in mortgage-backed securities and pass them on, then that interest risk is passed on.
    So, it is a rough idea of what that amount is that would be the difference that they make on what they hold in portfolio versus the mortgage-backed securities, and they do make more off what they hold in portfolio.
    One of the things you will notice is that Freddie Mac, that had a large amount in the mortgage-backed securities, has increased what it holds in portfolio, has increased its profits that way, but also increased some of the risk that it holds.
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    Fannie at one time did just about everything in portfolio and, over time, was able to decrease its risk exposure by moving more into mortgage-backed securities.
    Mr. HILL. In good economic times, that would translate into more profits. In poor economic times, that translates into greater risk, theoretically greater risk to the taxpayers here. Is that correct?
    Dr. WOODWARD. Well, it is more risk no matter what the economic times are, but you might wind up burying the costs during certain types of economic downturns.
    A very good example of that, if I may. In 1982, I believe if you had taken Fannie Mae's portfolio of mortgages and marked them to market value because of high interest rates, they probably would have been insolvent, but it did not cause problems for them because of the perceived guarantee. As times changed, of course, the valuation of those changed, and they made other adjustments, and they came through it OK, but that is an example of what can happen.
    Mr. HILL. Do any of the GSEs use any other form of derivative to hedge that interest rate exposure? Do you know?
    Mr. BOTHWELL. Yes, they use derivatives to hedge, and in addition, that is why we think it is so important that the Fannie and Freddie regulator, OFEHO, issue its risk-based capital standards, because those capital standards are going to be derived from a pretty strenuous stress test to ensure that they have adequate capital to withstand a pretty significant adverse change in interest rates, as well as a pretty significant deterioration in the credit quality of their portfolio and their MBS. I do not know that anyone has actually looked at the distribution of the profit in terms of their book assets and their MBS that they sell to investors, but the difference is certainly seen in their funding advantage.
    In our big study of last year, we estimated that on the debt that they issue, they get a funding advantage of from 30 to 106 basis points. On the MBS, it is only 5 to 35 basis points, which reflects the differences.
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    Mr. HILL. Dr. Woodward, earlier there were some questions about this, and I want to follow up on it.
    You were talking about the value of the privilege eventually is lost to customers, and others become the beneficiary, and that it is your view, ultimately, that charters should be either given competition or taken away.
    How and when should Congress know when that point is? You know, what kind of measures should there be that those that are making policy would say, ''Well, this is the time now that we ought to take that charter away or we ought to force competition.''?
    Dr. WOODWARD. Well, it is certainly the area where a lot of reasonable people can disagree. I am not sure if I can give you any really good litmus test to follow.
    I have heard, I think, some very compelling arguments from a number of people who feel that Fannie and Freddie are ready for graduation, based on the fact that what they primarily do, there is plenty of evidence that it is done. The thing that they were supposed to do, which was to integrate the market, is complete. That it would continue if they were moved to private status, and there is certainly evidence that they have privileges in excess of what they are passing forward to their ultimate customers and that potential competitors are disadvantaged by the privileges.
    Mr. HILL. Mr. Chairman, if you would indulge me one last question. It seems to me that there would be costs if Congress said, ''OK, we are going to have the private market meet these goals,'' providing products into low-income areas, geographic diversity, through regulation. And so, if there is some privilege, or some benefit, that accrues to the GSEs to accomplish that same goal, it seems to me that Congress should then say, ''Well, what would the regulatory cost be if we were going to go about doing it another way?''
    Has there been any analysis done of what that regulatory cost would be if we just totally privatized those functions, trying to accomplish the same goals?
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    Dr. WOODWARD. Well, some of what you are talking about would happen automatically.
    If you are talking about the regional disparities, that was not a matter of trying to make somebody engage in money-losing activities. That was a matter of funds not flowing to where they could potentially have a high return. You would not, presumably, need any regulatory function to ensure that that happens. The disparity in rates of return across the regions would ensure that happens.
    In terms of the low-income housing initiatives, that might best be handled by a non-regulatory means. At this point, it is not clear exactly what they are paying for those, but we may think of those as an example of a fee that is already imposed on the institutions, an in-kind fee. We mandate that they engage in certain activities.
    So, we are extracting back some of the value of the privileges, and one of the problems with extracting it in-kind is that you do not know what it costs, and that is one of the things that makes it a clumsy subsidy.
    Mr. HILL. Thank you, Mr. Chairman.
    Chairman BAKER. Thank you, Mr. Hill.
    Mr. Flake.
    Mr. FLAKE. Thank you very much.
    Mr. Chairman, as I listen to this discussion, my antennae rises, because I hear a great deal that would suggest that, in some ways, GSEs have outlived their usefulness, or certainly have not fulfilled their mission in some instances, or are viewed as competitors by others who are in the same market.
    I guess my concern is that, as I have been able to work with some of these GSEs, Fannie Mae in particular, and have been personally involved as a developer and builder in an underserved, traditionally red-lined community where banks have not historically seen it wise, by virtue of their sense of risk, to want to invest in those communities. Yet, when I have been able to get Fannie Mae involved in the process, or even Freddie, in a particularly huge project that would have gone into foreclosure without their intervention, it seems to me that there is, in some communities, not a competitive advantage that the GSEs have, but in fact, without them, these particular kind of loans would not be made.
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    I will give you a classic example.
    The most depressed part of my district, or what was the most depressed part of my district, represented by high crime and all of the other issues that are attendant to a community that is depressed. When I talked to the leaders in Fannie Mae about my desire to build new housing in that particular community, because no bank at that point would look favorably upon that, they gave me a guarantee that they would, in fact, fund 500 units of housing.
    We worked with the State of New York, and were able to get them to become involved in the process where they were willing to assure that the mortgage rates would be low, discounted, and at the same time, down payments would only be 5 percent. And with the synergy of these groups, the banks were not only willing to do it, but were fighting each other for the opportunity to be able to do the loan.
    Those 500 housing units in that particular community, turned that community around to such a degree that it made it impossible for a community that could have easily applied for, and qualified for an enterprise zone, to certainly be out of the necessary range to qualify for an enterprise zone.
    How do we turn America around? How do we turn urban communities around, if we don't have the institutions that will take the risk? And, by providing the guarantee that we do, we actually put an institution or institutions in place that will say, ''Yes, we will take the risk.'' And we are not doing this on a competitive basis with other institutions.
    As a matter of fact, we are doing this because the other institutions would not do it unless we came in and made that guarantee. So, I am concerned about some of what I hear in this testimony, because I don't think that one can sit here in Washington and necessarily fully appreciate what the GSEs have to do in a community like South Jamaica, as Fannie Mae did, or in Rockaway, what Freddie Mac did, in taking almost 4,000 units of housing, and if that housing had gone down, that whole area would have been destroyed.
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    So, I would just like to ask you, starting with you, Dr. Woodward. Have you really taken a close look at how this stuff works on a micro basis, and from that micro analysis, would you still conclude that these entities may have outlived their usefulness by having already fulfilled whatever mission we set for them back at the time of the inception?
    Dr. WOODWARD. Well, let me give it with reference to the specific example that you have. Now, I am not familiar with that, but my guess is what you might be seeing is what might be called in economics literature ''rent seeking.''
    Mr. FLAKE. Called what? I'm sorry.
    Dr. WOODWARD. ''Rent seeking.'' What that phenomenon is, is if the Government is in a position to give favorable treatment to an entity, they will be willing to spend a certain amount of money in order to keep that favorable treatment.
    In that sense they can engage in certain activities that may not be making money at all, or maybe making less than the best rate of return, but they earn a great deal of goodwill from it, and therefore increase the chances of perpetuating the privileges that they have.
    Mr. FLAKE. But, their goodwill is the difference between whether an individual has an opportunity for home ownership.
    Dr. WOODWARD. Oh, yes.
    Mr. FLAKE. That goodwill generates for the American taxpayers individuals who otherwise would not be paying taxes, would not be property owners, would not be participating fully in the American Dream. So, the goodwill ought to be worth the fact that you, in fact, put more people into home ownership. Wouldn't you agree?
    Dr. WOODWARD. It is certainly valuable, but you have to realize it's always going to be worth less than the value of the privileges. They are never going to pay more for their privileges than the privileges are worth, so what you are getting is a remainder. You are getting a part of what the Government has put into these entities to begin with.
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    In terms of the recycling and the political situation, maybe that's worth it, but you have to remember the privileges go to these GSEs. The value of these privileges are going to be split four ways.
    Part of it will go to the ultimate customers; part of it will go to the owner-stockholders; part of it will go to the officers and employees; and part of it will go to this rent-seeking activity, the goodwill, giving some of it back in order to ensure that they keep the privileges.
    Mr. FLAKE. And what is wrong with that. if you open up the doors of opportunity and you turn around communities in this Nation which generate no resources otherwise?
    This is a depressed area which generates nothing. There are no homes there. There's nothing there but land that is vacant, that is fallow, that is undeveloped. There's junk on these lots. Nobody can come in and do anything in that community because it is not attractive enough.
    When you put 500 new units of housing in, enough of those kinds of communities around the country, you, in fact, begin to make this America that we dare to talk about in terms of ''we.'' In fact, we talk about it hypocritically, because we really have two nations and it goes all the way back to the Kerner Report. Much of it hasn't changed, because these other entities will not even take that kind of risk, and the Government does get a return.
    Even if that mortgage is discounted down to 6.5 or 7 percent, it is not like you are putting people in who are not paying it back. If they are paying that mortgage back, we are getting a certain percentage of that money as well, so the Government is also getting a benefit from that.
    The Government is getting a dual benefit from that, because it is not only getting the benefit of the mortgage, it is getting the benefit of people who have now become taxpayers.
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    Chairman BAKER. Mr. Flake, if I might—not to curtail your statement, but, if I could, I'll give Mr. Bothwell an opportunity to respond before we move on.
    Mr. FLAKE. I would be most appreciative if you would, and he looks like he is ready to do that.
    A wonderful and fair Chairman.
    Mr. BOTHWELL. Congressman Flake, I think you raise a good point.
    I don't agree that in all cases private markets work effectively or efficiently or adequately. As I said, I think there are legitimate public purposes to be served through credit assistance governmentally-supplied when the Congress believes that there is a legitimate need there that is not being met by the private capital markets.
    I think the example you gave is actually a very good one. It's been used a lot in the literature, that when you have areas and inner cities that are depressed and run-down, you just don't see private capital flowing there.
    Sometimes it takes a little jump start, a little subsidy, to get it going, to get it turned around, so I think we disagree a little bit there.
    Dr. WOODWARD. I am not sure if we disagree on that point.
    My only other point is what you are talking about, there is nothing wrong with it. That's great, but remember, you are only getting a fraction back of what you have spent.
    If you haven't given the value of the privileges in the first place, you would have more money to spend on those things than you are getting back from the GSEs.
    Mr. FLAKE. But what difference does it make whether it is a fraction, if you were getting nothing back, if you did not have an entity that was willing to make that investment?
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    Ultimately, if you are putting people in homes that are going to be there for the next 100–150 years, and those people are going to amortize their mortgage over 20–25 years, that stabilizes the community.
    We are not talking about a strong rental population necessarily. We are talking about home ownership, and it seems to me that if home ownership represents for the majority of Americans their greatest asset, their first asset-building possibility, because many of them would not develop those assets otherwise. You know what the savings statistics are in this country. They will save though to buy a home, so the long-term benefits are constantly being renewed. They are constantly growing. They are constantly developing.
    Those people ultimately will spend out of their profit, go to the marketplace then, when they can afford a conventional mortgage, and they won't need Fannie Mae. They can do conventional, but they have got to have a start somewhere.
    Chairman BAKER. Mr. Flake, if I may, I hate to interrupt, but we do have another panel yet to be heard from.
    Mr. FLAKE. All right. Give the benediction.
    Thank you very much.
    Chairman BAKER. Thank you very much. Thank you.
    And, if we can call the next round. I thank the witnesses for their participation today.
    I will recede from the chair, and Congressman Horn will conduct the second panel.
    Mr. FLAKE. Mr. Chairman, CDFI is on the floor right now, so I ask unanimous consent that I might supply questions in writing and that they might be sent back to you.
    Chairman BAKER. Without objection.
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    Chairman HORN [presiding]. Will the second panel please come forward?
    Thomas H. Stanton, Fellow, Johns Hopkins University; Dr. Susan Wachter, Professor of Real Estate and Finance, The Wharton School, University of Pennsylvania; and Francis X. Cavanaugh, Public Finance Consultant.
    As you know, we have a tradition on the Government Reform Committee that we do swear all witnesses under oath and even the questions they answer in writing later, the oath is assumed to carry forward for the hearing.
    [Witnesses sworn.]
    Chairman HORN. The clerk will note all three witnesses have affirmed the oath, and we are delighted to have you here on this panel.
    We will simply start with Mr. Stanton, who is a Fellow at Johns Hopkins University.
    Your testimony automatically goes in the record once I introduce you, and if you could summarize it, it would be very helpful.
    Staff have had an opportunity to go through it. Members have gone through it to the extent that they can, and we thank you for spending some time with us on this very difficult subject that has not, frankly, had that much of a congressional review, so thank you for coming.
    Mr. Stanton.

    Mr. STANTON. Chairman Horn, Chairman Baker, Members of the subcommittees, thank you very much for the invitation to testify today on the accountability of Government Sponsored Enterprises.
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    For many people, as we have heard this afternoon, the GSE offers an attractive model for Government involvement in the credit markets. They see the GSE as a way to deliver potentially huge amounts of subsidized credit, maybe hundreds, or perhaps tens of billions of dollars, to selected constituents such as home buyers, farmers, and students, without being constrained by the Federal budget.
    The purpose of this testimony today is to highlight the unfortunate fact that there is no free lunch. The GSE is a tool of Government policy, and as such, it involves, quite naturally, costs as well as benefits.
    One cost is the financial risk inherent in the implicit Federal backing of GSE obligations.
    Effective Federal supervision, and especially prudent capital requirements, are needed to protect the public against risk of financial loss. Any lending institution—a bank, a thrift, or a GSE—will act more prudently when a large cushion of its own shareholder money is at risk in its lending decisions and not merely public money.
    Yet, the hidden secret of Government Sponsored Enterprises is the way that they attempt to operate with lower capital requirements than any of their competitors.
    The subsidy benefits of GSE lending, as we heard this afternoon, can be seen here and now. By contrast, the costs of financial risk involved in matters such as too little capital involve playing the probabilities of future failure.
    As the financial failures of the Farm Credit System and the thrift industry in the 1980's show, the political process has great difficulty trying to benefit those tangible present benefits against the possibility of future losses.
    The second cost of the GSE as a tool of Government is the possibility that the Government can create an entrenched monopoly or oligopoly. Especially the investor-owned GSEs use their Government subsidy to dominate their markets. That market power, in turn, allows GSEs to mobilize their business partners, to lobby the Congress and Executive Branch for even more favorable treatment under laws and regulations.
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    Once we created GSEs, we have often found it difficult or even impossible to restrict or redirect their lending activities, even when the result would be an increase in public benefit.
    In other words, the GSE can be a remarkably inflexible tool of Government policy. The easiest parts of the process tend to be the creation of a GSE and the continuing expansion of its powers. It is much harder to go the other way.
    This testimony attempts to step back from today's entrenched GSEs and to look at the GSE as an institutional form. It suggest an institutional framework for accountability that draws upon policymakers' experiences with GSEs over the past 10 years, from the failure and Federal rescue of the Farm Credit System in the 1980's, and the creation of Farmer Mac, the GSE that the Congress permits to operate at truly exorbitant leverage compared to any other financial institutions in the same sector of the economy.
    It includes the difficult struggle to create the financial safety and soundness regulator for Fannie Mae and Freddie Mac in 1992.
    It involves, with deference, Chairman Baker, the continuing—and I'm worried, forlorn—effort of the Congress and the Federal Housing Finance Board to find a new public purpose for the Federal Home Loan Banks, now that the thrift industry is disappearing.
    Finally, last year saw legislation to remove Government sponsorship, at least eventually, from Sallie Mae.
    The entire period saw small provisions enacted in legislation that have helped greatly to expand the role of GSEs in the American economy.
    Briefly, the written testimony suggests the following framework for accountability:
    First, with respect to safety and soundness, Government Sponsored Enterprises structurally resemble banks or, more precisely, savings and loan institutions, in the sense of their dedication to a targeted financial sector whose borrowings are Government-backed, in the case of banks and thrifts, by Federal deposit insurance.
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    GSEs should be supervised similar to large money center banks and should be subjected to comparable capital requirements, otherwise the Congress risks the specter of invoking Stanton's Law: ''In today's efficient markets, financial institutions will shift risk to the place where the Government is least equipped to deal with it.'' In many sectors of the financial economy today, the Government Sponsored Enterprise is that kind of place.
    Second, the Congress needs to pay closer attention to oversight of the public purposes served by Government Sponsored Enterprises.
    In addition, it is time to bring GSE securities within the jurisdiction of the Securities and Exchange Commission, so that we can help avoid dysfunctional events such as the Orange County debacle that was based largely upon GSE securities, known as ''derivatives.'' Derivatives can be very useful in the hands of appropriate investors. In the hands of unsuitable investors, they can create considerable damage.
    Being subject to the Securities and Exchange Commission will help bring these securities within the ambit of prudent rules, such as investor suitability rules, at relatively negligible cost.
    Third, a central body, such as the General Accounting Office, needs to be requested to review the acts of GSEs that may go beyond the scope of their charter act—in legal parlance, so-called ultra vires acts.
    Especially as GSEs push against the legal limits of their charter acts, there may be temptation to engage in such activities, especially if they are more profitable than any other permitted activities.
    Finally, GSE charters would benefit from an exit strategy that is considered before, rather than after, it is needed. We have a bad habit of waiting with outmoded charters, such as the savings and loan charter in the 1970's, until the institutions hit the wall, as the thrifts did in the 1980's.
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    Banking legislation, because of the political context of those charters, tends to lag far behind market developments. GSE legislation and its political context is the same way.
    One option, at least for newly chartered GSEs, would be 10–year renewable GSE charters, so that the Congress could have an opportunity to review costs, benefits, and developments that affect each GSE in today's rapidly evolving markets.
    Many of these ideas are included in a bill introduced in the 104th Congress as S. 2095, the Government Enterprise Standards Act.
    Mr. Chairman, I would respectfully ask that S. 2095, and also a paper on GSEs distributed by a panel of the National Academy of Public Administration, be submitted for the printed record.
    Chairman HORN. Without objection, they will be put in the record at this point.
    Mr. STANTON. Thank you very much, Mr. Chairman, .
    Chairman HORN. Well, we thank you. We appreciate that summary and we will now to go to Dr. Susan Wachter, Professor of Real Estate at The Wharton School.

    Dr. WACHTER. Thank you, Mr. Chairman, it is a great pleasure to be here.
    With your permission, I ask that my full statement be made part of the record.
    Chairman HORN. It's automatic under our hearing rules.
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    Dr. WACHTER. Mr. Chairman, and Members of the subcommittees, I am Chairman of the Real Estate Department and Professor of Real Estate and Finance at The Wharton School of the University of Pennsylvania.
    My colleagues and I on the faculty of the Wharton Real Estate Department and Center, focus on a wide variety of housing and urban issues in our research, and it is a privilege to be invited to testify before this joint hearing.
    Most of my expertise and underlying research relate to mortgage markets, and thus in my testimony I will discuss the role and nature of those GSEs which support secondary markets for residential mortgages.
    In my testimony, I will also specifically refer to a research paper, authored by myself and colleagues, on how full privatization of GSEs could affect the social goals specified in the GSEs' Federal charters. This study, which I request be entered into the printed record, was commissioned by Government agencies on behalf of Congress and published in 1996 by the U.S. Department of Housing and Urban Development.
    Chairman HORN. May I ask how long is the study, how many pages?
    Dr. WACHTER. It is approximately 20 pages.
    Chairman HORN. Fine. Without objection, it will be included in the record.
    Dr. WACHTER. In my testimony today, I will first briefly address those questions posed in your invitation to testify: when, and under what circumstances, should GSEs be privatized or created? How, and for what purposes, should GSEs be regulated? Should financial compensation be required? Are there areas where the scope of GSE activities should be expanded or reduced?
    A rationale for the creation of GSEs exists if there are market imperfections that are mitigated by their activities, and if they pass a cost/benefit test.
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    ''Market imperfection,'' is a technical term used by economists, along with the related concept of externalities. A positive externality is a benefit that goes beyond the individual to society at large. Home ownership itself may be an example of an externality, if neighborhoods are better maintained where home ownership predominates.
    In any case, if GSEs' mission is not justified by market imperfection rationales, they should be privatized. Given the possibility of contingent liabilities to the U.S. taxpayers, GSEs must be monitored for financial safety and soundness to minimize risk exposure, as well as for their mission achievement.
    It is not financial compensation that should be required from the GSEs, but rather the effective achievement of their mission.
    Finally, there may well be conditions under which the scope of GSEs should be expanded. I will suggest one.
    The Federal Government provides a number of economic privileges to GSEs, most important of which is the implied Federal Government guarantee, which reduces Enterprise funding costs. In return for these benefits, the GSEs are required by their Federal charters and other statutes to provide public services.
    Given the highly developed state of the secondary market for mortgage loans in the United States and integrated national mortgage markets, and the rapid development of both information technology and global financial markets, what purposes are currently served by these economic privileges?
    In answering this question, I wish to present my thoughts on the broad social context for public policy goals embodied in the legislative acts. In my view, these public policy concerns are: the worsening problems of concentrated urban poverty in the United States, and the persistent racial and ethnic disparities in home ownership rates. In over 5 decades of increasing home ownership rates, these disparities have not narrowed at all.
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    Moreover, the concentration of poverty in urban areas has worsened, and continues to worsen over time, along with the social pathologies that result from this concentrated poverty.
    The GSEs are required to promote neighborhood reinvestment and to reduce red-lining and discrimination in mortgage lending. These goals, if achieved, have the potential to revitalize urban America.
    GSEs' lower funding costs reduce mortgage market rates and help achieve increased home ownership rates. Furthermore, technological innovations and standardization gains, likely to be attributed to the special status of the GSEs, also help achieve increased home ownership rates. Such innovations are generally facilitated by larger market players who are capable of effecting market transformations and have the incentives to do so. GSEs' innovation has increased the efficiency with which funds have been provided for mortgage markets in the past, and they have the potential to do so in the future.
    However, the Federal sponsorship of GSEs also creates significant risks for U.S. taxpayers. There is also a cost in terms of the need to monitor each GSE for safety and soundness. This added cost of Government regulation and the need for efficient and effective oversight is likely to increase with the number of GSEs. Given these ongoing risks and costs, we must clearly define the current public purpose served by GSEs.
    Government intervention may be welfare-enhancing, as I stated earlier, where there are market imperfections. The continued Federal sponsorship of GSEs helps achieve the broad public policy goal of access to affordable home ownership through lower funding costs. Thus, to the degree that home ownership is regarded as yielding external benefits to neighborhoods and society beyond those directly enjoyed by individual homeowners, existing market imperfections may justify continued Federal sponsorship of GSEs.
    The degree to which continued Federal sponsorship of GSEs contributes to increased home ownership rates is analyzed in our study on the privatization of GSEs. There, my coauthors and I, find that home ownership rates increase by about 1.5 percent in the aggregate, and more for targeted groups as a result of the Federal sponsorship of GSEs.
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    In other research, I have examined the potential for market failure in mortgage lending deriving from what may be termed ''neighborhood effect and information externalities.'' Because of such externalities, increased lending to currently underserved low-income neighborhoods may be possible without a significant increase in credit risk. Such externalities raise the possibility of a virtuous cycle to reverse the vicious cycle of neighborhood decline. Conventional lenders may, individually, rationally tend to avoid risky neighborhoods. However, such risks may be increased by the actual avoidance.
    If individual institutions come together with public and private cooperation, loans and investment in such depressed neighborhoods may be accomplished without significant heightened risk and neighborhoods may be stabilized.
    Given the GSEs' size and the extent of their market reach, they may be able to determine where such market imperfections exist, through an analysis of their affordable lending experience. However, given the initial risks and costs, encouraging affordable lending programs through effective regulation of the GSE mission and setting affordable lending goals is important. On the other hand, the GSEs' market orientation is likely to provide incentives to achieve affordable lending efficiently. In particular, as we discuss in our paper, some FHA functions should be transferred to the GSEs.
    To quote: ''...existing programs are unlikely to be as efficient and effective as the operation of the GSEs in these areas if the Federal Government is vigilant in the enforcement of the affordable housing mandates imposed upon the GSEs. Simply put, the expertise, incentives, and resources available to the GSEs are sufficient to make them private, efficient, targeted welfare providers.''
    Thus, I believe it is the GSEs, rather than FHA or direct Government intervention, that are likely to respond to market imperfections efficiently and, possibly, sufficiently well, to make affordable lending an important component of the revitalization of urban America.
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    Mr. Chairman and Members of the subcommittees, this concludes my prepared statement.
    Chairman HORN. Well, we are most grateful for that very thorough statement and your various other studies.
    Our next witness is Francis Cavanaugh, Public Finance Consultant. Mr. Cavanaugh served in the Treasury for 32 years and as a financial economist and as the senior career executive responsible for policy advice on the management of the public debt and Federal credit programs, including the Government Sponsored Enterprises which are the subject of the hearing today. So, we are delighted to have you share your expertise, including the, I guess, 8 years you spent as Executive Director/CEO of the Federal Retirement Thrift Investment Board.
    I note here you administered the Thrift Savings Plan for Federal employees. There's a worthy objective—you should do it for the rest of America and our economy might be working better. So welcome.

    Mr. CAVANAUGH. Thank you, Mr. Chairman.
    In addition to my prepared statement, which you have, I have also dealt with this subject, beyond the brief comments that I will read now, in Chapter 7 of a recent book I wrote on the national debt, which I think the subcommittee staffs have. It's about 15 pages long. I would offer it for the record.
    Chairman HORN. Yes, without objection, that will be put in the record.
    Mr. CAVANAUGH. Now before trying to answer the seven questions in your invitation letter of July 10, I need to make some assumption as to the proper role of the Government in credit markets.
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    My working assumption is something that we have generally given lip service to; there is a presumption in our society that the provision of credit is a private, rather than a public function, and Government should try to assist the development of private credit markets and not displace them. That was the operating presumption of the President's Committee on Federal Credit Programs when I first cut my teeth in this area back under the Kennedy Administration 35 years ago.
    I think it is still a good one and I think it is very relevant today, particularly since there is now an apparent consensus for smaller and less intrusive Government and greater reliance on private markets. I'm afraid, however, that the experience of the past three decades with regard to that principle has not been good, as measured by the growing amount of net new borrowing in the United States credit markets required to finance Federal programs.
    That Federal share, which includes direct Federal borrowing, guaranteed borrowing, and GSE borrowing—which is the fastest-growing sector—increased from an average of 17 percent of net credit market borrowing in the 1960's, to 27 percent in the 1970's, and to 41 percent in the 1980's. In the 5 years 1991–1995, the percentage was an extraordinary 71 percent. We have reached a point where most of the debt securities available to private investors in the United States are direct or indirect obligations of the Federal Government. This raises serious questions about reduced market discipline in the allocation of credit, and thus potentially a reduction in the credit quality in our economy.
    With the Government standing in between the lender and borrower, the lender looks to the Government and doesn't exercise due diligence with regard to the borrower. Then we are relying on the Government to exercise due diligence with regard to the quality of credit, at this point the majority of credit, in the credit markets in our economy.
    I don't think that is a proper function for the Government, to be displacing the private market discipline.
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    While the market impact of direct Treasury borrowing, of course, is declining as the Federal budget deficits decline, borrowing to finance GSE programs continues to grow rapidly. In the fiscal year 1997 budget, estimated net GSE borrowing is $178 billion, and that's new money, which will greatly exceed the current budget deficit estimates that I hear of roughly $50 billion, so the GSEs are emerging as the prime factor in the credit markets.
    We have this anomalous situation of, on the one hand, a remarkable political consensus to reduce the size of the Federal Government and the Federal deficit, and thus shift responsibilities to the private sector, but on the other hand a seeming indifference to the growing pre-emption of our private credit markets by the GSEs and, to a lesser extent, by other Federal credit aids.
    Nevertheless, my following responses to your questions are based on the assumption that our guiding principle should continue to be that Federal credit programs should encourage, not displace, private credit markets.
    With regard to your first question, I would say Congress should create GSEs that issue debt or provide guarantees only in cases where there are credit gaps in our economy which eventually can be filled by the private market without Federal aid. In other words, the GSE structure is the wrong vehicle for credit assistance programs where Congress determines there will be a continuing need for Government subsidies. In those cases a direct loan program would be much cheaper and more effective.
    In answer to the second question, I am not aware of any particular credit gaps in our economy which would warrant expansion of existing GSE activities. Indeed, the market development of innovative securitization techniques in recent years has so expanded access to securities markets for private borrowers that the need for GSE credit has been reduced. GSE activities should be contained, if for no other reason than to be able to offer GSEs broader powers as an inducement to privatize.
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    Now, the third question: Under what circumstances should a GSE be privatized?
    GSEs make sense only if they are intended to become totally private, so the timing of privatization should be when the GSE has developed to the point that it has filled the credit gap, as intended by Congress, and it is able to support itself in the market without further Federal subsidies. The alternative of continuing the subsidies, and thus perpetuating a monopoly, defeats the basic purpose of the GSE.
    With regard to the fourth question, regulating financial activity of GSEs. A GSE should be encouraged to become financially independent, relying primarily on private audits in accordance with generally accepted standards applied to similar financial institutions in the private sector. These are the standards they must meet when they are privatized. Regulation by Federal agencies within the Administration, in my experience, has been of limited value, in part because these agencies of the Administration are political institutions. Federal agencies are unlikely to have the staff or the financial resources to match the resources of the GSEs or the private accounting firms.
    Question number five is: How should the programmatic activity of GSEs be regulated?
    As an alternative to attempted regulation by the Administration, which I don't think is very effective, a model that I would offer would be the legislation that Congress enacted to establish the Federal Retirement Thrift Investment Board in 1986.
    In that case, Congress wanted to insulate the Board from politics, from the Administration, and even from itself, it said. It insulated the Board from the congressional budget process, but it had to come up with some alternative means of ensuring adequate accountability and professional oversight. So, legislation authorized the Secretary of Labor, who happened to be responsible for regulating private pension plans, to provide for audits of the Board's programs. The Labor Department contracted with private accounting firms for a comprehensive program of annual audits of every aspect of the Board's management and operations. Those program audit reports, some 13 a year as I recall, were extremely helpful to me as Executive Director of the Board, and they were most reassuring to Congress and the public that all was well at the Board.
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    Frankly, I don't know how else you are going to get the talent that you need to regulate complex bureaucracies today without doing something like that. You need outside talent.
    The sixth question: Does the existence of competing GSE debt raise the financing costs of the U.S. Government? If so, by how much?
    Clearly, the existence of competing GSE debt does raise the financing costs of the Treasury, both because of the implied Treasury guarantee, which makes it like Treasury's own debt, and because of the many statutory provisions which give GSE debt special characteristics with regard to eligibility for investment and collateral, exemption from SEC and all that sort of thing. So, GSEs are directly competitive with Treasury. There is no question about that.
    Measuring the amount of the cost to the Treasury from that competing GSE debt is difficult, I would admit, and the amount varies with market conditions and changes in amounts of new issues and outstanding GSE debt and Treasury debt in the market.
    As you noted in your July 10 letter, total net GSE borrowing in the market, including the guaranteed obligations, exceeds $1.8 trillion, while publicly-held Treasury debt is about $3.7 trillion. So, because of the GSE debt, the total Federal securities market has been increased by roughly 50 percent, and no one can tell me that doesn't have a tremendous impact on Treasury borrowing costs.
    If the GSEs were privatized, then of course the arithmetic works the other way. You would be reducing the demands by Government in the credit markets by 33 percent, and so there would be an increase in the demand for Treasury securities, obviously, and thus a reduction in the cost of Treasury financing.
    How much? Tough to say. For each reduction of 1 basis point, just 1/100th of 1 percent. For example, if we reduced the Treasury's average borrowing cost from 6.01 to 6 percent, that in itself would save the taxpayer $370 million a year.
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    How many basis points would actually be saved if the GSEs went private and got out of the Federal securities market? I would say several, no more than 10, so clearly the Treasury, in my view, would be saving at least a billion dollars a year. I think that is a conservative estimate.
    Finally, the last question: Should the Government receive financial compensation for the special market privileges enjoyed by GSE borrowers and guarantors? Yes, especially since these privileges raise Treasury borrowing costs, as discussed above, and since Treasury is at risk in the event the GSEs get in trouble.
    This could be accomplished by charging the GSEs a fee equal to a fraction of a percent of their outstanding liabilities or new commitments, whatever is workable legally. Such a fee could also serve the purpose of encouraging the GSEs to give up their special privileges and go private. A fee that escalated each year should eventually prompt GSEs to stand on their own feet in the competitive private market. At some point it would be more profitable for them to do it, rather than pay an increasing fee. To perpetuate the present situation just gives the GSE that much more of a monopoly position and stifles private competition.
    That concludes my prepared comments, Mr. Chairman.
    Chairman HORN. Well, I thank you very much, Mr. Cavanaugh.
    Let me just ask you one or two questions and then we'll yield 5 minutes to each Member.
    You mentioned in your written statement that the Government Sponsored Enterprise structure is the wrong approach for credit assistance programs where Congress determines that there will be a continuing need for Government subsidies. I guess I would ask what kinds of direct Federal loan programs would be potentially cheaper and more effective, in your judgment?
    Mr. CAVANAUGH. Well, for any particular area where you want to subsidize with credit assistance programs—recognizing that we already have direct and guaranteed loan programs throughout the entire economy now—perhaps you have within an existing agency, like HUD, a model direct loan program, depending on the nature of the specific credit need.
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    The enormous advantage would be that any direct loan program would be financed at the Treasury borrowing rate, obviously, which is cheaper than the GSE rate. You save money there.
    The other advantage is that from the testimony you heard before, apparently the GSEs, or Fannie Mae and Freddie Mac, keep for their stockholders $1 out of every $3 that are saved through their GSE status. In the case of a direct loan program, you wouldn't have that problem.
    The other important aspect is that a direct loan program, unlike the GSEs, would be in the budget, subject to congressional appropriations and the discipline of the budget. When you are talking about permanent subsidy programs, I think there is no other way to do it.
    Chairman HORN. The direct loan program we have talked about in Congress, and actually voted on and implemented in some cases is, of course, the student direct loan program, which would get us partly away from the guaranteed loans, where I have felt for a long time, as a former university president, that there is no great incentive for the banks of America to counsel students and to tell them it's a debt, not a grant. The result is that we have a tremendous amount of debt because they simply weren't doing their job. Why should they? We guaranteed them the loan.
    Now does any of that psychology apply in some of the options here?
    Mr. CAVANAUGH. Well, I think that is a very good point. Of course, primary reliance on guarantees in the student loan program and many other areas, was necessary before the Congress changed the accounting. It used to be that if you made a direct loan of $100 it would be a budget outlay of $100, and the deficit would increase by $100. Then Congress changed that, I guess in 1990, where you said that from now on, we'll score in the budget the present value of the subsidy in the direct loan, or in the guaranteed loan, so going to the guarantee no longer takes you off budget. That equalized the situation, and I think it was a tremendous reform. Now you don't need to wind up with a situation where you get guarantees and a lack of counselling by disinterested banks simply to avoid the budget. That has been fixed.
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    Chairman HORN. Let me ask you, in your statement you also said that, ''Government Sponsored Enterprises should be encouraged to become financially independent and rely primarily on private audits in accord with the generally accepted standards which are applied to financial institutions in the private sector.''
    I guess I am just curious. Do these enterprises currently have private audits, and if so, by whom?
    Mr. CAVANAUGH. I believe they all have audits, but I am not sure of the extent to which they are done by accounting firms commissioned by the GSEs themselves, or of the extent to which there is any requirement for audit reports to Congress for this, that or the other GSE. I think the general situation is that they bring in a private financial auditor as a large private corporation would.
    What I am saying here, in response to your question about regulation of GSEs, is that the better approach is to rely on private audits by management consulting firms—not just financial audits—rather than Government regulation.
    Chairman HORN. Let me ask one last question to all three of you, and maybe you are not the people to ask it, but I thought I would tap the expertise that is before me, before giving up the questioning.
    That is, with Government Sponsored Enterprises, as we call them, and we are talking about the big ones here obviously, in your experience, what are the differences between that and what we have called for 50 or 70 years a ''Government Corporation'', whether it be the Tennessee Valley Authority, which is a Government Corporation, or the many others that we have spread across the Executive Branch?
    We have talked about making the Federal Aviation Administration a Government Corporation. Usually it has been to get around the procurement and the Civil Service requirements, basically, when you looked at a Government Corporation, but how would you differentiate?
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    I will start with Mr. Stanton at this end.
    Mr. STANTON. Mr. Chairman, I believe you have already heard from Harold Seidman and Alan Dean on the Government Corporation.
    Chairman HORN. For about 20 years, yes.
    Mr. STANTON. For about 20 years.
    Chairman HORN. They are excellent people.
    Mr. STANTON. The wholly-owned Government Corporation is owned and controlled by the Federal Government under the Government Corporation Control Act. It is an agency of the United States. That would be something like Ginnie Mae, which is part of the Department of Housing and Urban Development.
    We have entities that are misnomers called ''Mixed Ownership Government Corporations'' under the Government Corporation Control Act, such as the Federal Deposit Insurance Corporation, that are funded by assessments—in that case on financial institutions as payment for their deposit insurance—and they operate under greater flexibility, but still they are agencies of the U.S. Government with Presidential appointees.
    Then we step across the line, and we have Government Sponsored Enterprises that are privately owned and essentially privately controlled, even though they may have a minority of members of their Boards of Directors appointed by the President or a public official. Those Directors have a fiduciary responsibility to the company and to the shareholders and can get sued if they don't live up to that fiduciary responsibility.
    Dating back to the Banks of the United States—I guess the Second Bank of the United States—it's been well demonstrated that those publicly appointed Directors end up being very much—for purposes of control—like shareholder-appointed Directors because of that fiduciary responsibility, so these are quite different animals.
    Ginnie Mae can dispassionately serve its entire legal charter because it is an agency of the United States. Fannie Mae or Freddie Mac have quite different incentives.
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    I would read you from Freddie Mac's 1996 annual report: ''Freddie Mac's disciplined approach to investing shareholder capital and the success of the corporation's core business strategies resulted in a 22 percent return on common shareholders' equity in 1996, the 15th consecutive year that this rate of return has exceeded 20 percent. Disciplined deployment of shareholder capital underlies all of Freddie Mac's activities.''
    The bottom line, I guess I would suggest to Professor Wachter, is that these institutions conceivably could help poor people in inner cities, but to get a 22 percent return on equity you don't do an awful lot of it.
    Chairman HORN. Well, on that point, do we face a danger that we could go the way of the savings and loan industry in the 1970's and 1980's?
    Mr. STANTON. The dangers are as follows, and it all depends—the first guarantee of course is management.
    The management tends to be more prudent—it is a financial precept—to the extent that you have shareholders' money at stake.
    Freddie Mac is probably the thinnest capitalized financial institution in the United States today, and well below 2 percent—I guess it is a little over 1 percent, 1.04 as I recall—I am under oath—as I recall 1.04 percent shareholder capital.
    That is very little.
    If you have less shareholder capital at stake, you may be inclined to do things that yield higher returns for shareholders, because so much of the public's money is at risk.
    Going back to your original question, that is a really different institutional form, to go to Mr. Cavanaugh's point, than the Government agency that delivers direct loans.
    It is both better in some ways—it's private—but it is also less effective at serving public purposes because of its profit orientation.
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    Chairman HORN. Yes, and Dr. Wachter, do you want to add to that?
    Dr. WACHTER. Well, actually, I wish to disagree.
    Chairman HORN. Good, that's why we have you here.
    Dr. WACHTER. I'd say 180 degrees, although not with everything Mr. Stanton says, by any means.
    I certainly agree that there is risk exposure and promulgation of careful risk-based capital standards is important with a mixed, quasi-public organization.
    If I may just briefly, refer to the S&L question.
    Chairman HORN. Sure.
    Dr. WACHTER. In some ways the moral hazard problems that we had with the S&L meltdown may be, interestingly enough, less of a problem with Fannie Mae and Freddie Mac, because there are only two of them, and they are relatively transparent. That is not to say that there isn't a problem here and that they must be very carefully watched and we do need to have the promulgation of those risk-based capital standards.
    Second, to answer the question that you raised, Mr. Chairman, on the difference between Fannie and Freddie and Government-owned agencies. I do absolutely agree with Mr. Stanton that these are different than Ginnie Mae, and I also disagree with Mr. Cavanaugh that they are worse than Ginnie Mae. I think they are better potentially, and I do underline ''potentially.''
    I think FHA and Ginnie Mae have a major problem, to which you alluded: these are guaranteed loans, and therefore, lenders tend to push off the risk and not do careful underwriting under these circumstances.
    I think we have examples historically of disastrous lending by FHA. Under Section 236, we had high delinquencies, which led to abandoned housing in urban areas that stands there today.
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    On the other side, if you had some kind of cooperative risk undertaking with Ginnie Mae and with FHA, I think that would be a problem, too. We have seen some problems, because the private sector partners tend to be much faster on their feet. They tend to transfer the risk quite well.
    So, I think the interesting Fannie Mae-Freddie Mac answer, which is that you have private fiduciary responsibility to shareholders who are very closely watching for profit, at the same time where you have, hopefully, careful pressure on the mission is a good rule.
    However, the implementation of the rule, the implementation of the policy is key. Here I do agree with Mr. Stanton. I do think that the mission could be pushed. I think that there is room to move the envelope here, and indeed, in the past, I think that Fannie and Freddie in the past have been behind the market in terms of lending to low-income and underserved areas.
    Chairman HORN. Mr. Cavanaugh, you will have the last word on this question, then I will yield 10 minutes to each of our Members here.
    Mr. CAVANAUGH. I don't have much to add. The answers were much broader than the question as I understood it, but with regard to the difference between the types of corporations, I think the TVA and these other Government owned corporations are Federal agencies in a corporate form for accounting and other purposes. It makes a certain amount of sense if it is a business-type enterprise, but I don't see that as a very important thing. It's a matter of form. They are Government agencies and they deal with the budget problems and pressures of other agencies and so on.
    When you get to the GSEs, of course that is very different, and their corporate form is much more meaningful. In my mind, the significance is that the GSE ought to be progressing toward the private corporate form in every respect, so that when it comes time to privatize it, it is ready to go, it doesn't need all of the Government bells and whistles and everything else.
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    Chairman HORN. Well, I thank you.
    I now yield 10 minutes to Chairman Baker.
    Chairman BAKER. I thank the Chairman for yielding.
    Mr. Stanton, do you feel that there is an appropriate role in the market for GSEs, period?
    Mr. STANTON. The answer is possibly less of a role than in the past.
    Earlier witnesses noted that we once had a differential in mortgage rates. That was largely a function of the fact that by law, savings and loans and banks were limited to serving local areas, so you had the money center areas on the East Coast that had cheap mortgage rates. You had the building going on, first in the Midwest and then the West and the South, and you had tremendous gaps in mortgage rates.
    That age is behind us, thanks both to the Home Loan Bank System, Fannie Mae in the 1930's, but more importantly, thanks to getting rid of these restrictions—geographic restrictions—on financial institutions.
    Mr. Lucas, Representative Lucas, asked a question about the Farm Credit System.
    There is a recent Economic Research Service study out on the rural sector that indicates that in the rural sector, commercial banks are fairly concentrated and in that case, for example, it may be that the Farm Credit System provides a useful alternative delivery system to allow credit to get to rural borrowers if you do have a case of abnormal concentration, so that might be one example.
    Also, because I am concerned about safety and soundness, the fact that the Farm Credit System has been through the wringer once gives them a certain amount of prudence that we may not find in some of the other GSEs, and that gives me a sense of confidence.
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    I need to pick up, if I may, on Professor Wachter's comment that Fannie and Freddie were the answer to the S&L meltdown. That isn't right.
    Just as with the Farm Credit debacle, what the answer was to give bank-type regulation to the savings and loan industry, and bank-type capital requirements. That is essentially what was done to the Farm Credit System.
    Fannie Mae in 1981–1982, was a big savings and loan in the secondary market with an exorbitant interest rate mismatch, just like some of the worst savings and loans, and the housing GSEs were there, only one or two, and nobody was watching.
    If we get down to the core problem with GSEs, and again the Farm Credit System has this less than other GSEs, the core problem is, who reviews whose budget? Do Fannie and Freddie have influence over their regulators' budget? You better believe it. Do the regulators have any influence the other way around? Very little.
    There is such an absolute asymmetry of political power that regulation is not merely a technical matter of financial oversight. Regulation is a political contest, and when that regulator comes out with risk-based capital standards, there is almost no constituency that is organized on the side of urging that we make those standards a little higher, and there is a tremendous political force on the side of saying, one should make those standards a little lower.
    That regulator politically has almost no constituency.
    By contrast, when you look at something like the Farm Credit System and the expansion that has been proposed from time to time of Farm Credit activities, you get the independent bankers out there. You have got a certain political balance that tends to keep things in check, and that is a very healthy system.
    That is rather different from the monopoly system we have created—call it technically a duopoly—in the housing finance system.
    Chairman BAKER. So you are suggesting that where there is a political balance, it is OK for the GSEs to exist and perform a public policy purpose, and where you perceive there to be a political imbalance, where the power of the GSE—whatever the performance area might be—that in your view is an inappropriate conduct of authority?
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    Mr. STANTON. I'd state it slightly differently.
    It is a lot easier to control against downside risk and to assure public benefit where there is some sort of a balance.
    Chairman BAKER. My problem with your observation is that, with regard particularly to Farmer Mac, but to a lesser degree to Farm Credit, I don't look to either for stellar performance recommendations.
    I have significant concerns—as perhaps you illustrated with the Federal Home Loan Banks—where is it going and why do we need it?
    Those same questions can be asked of others. My point is, that if you believe there should be GSEs at all, I think we first describe what the public policy mission is.
    Mr. STANTON. Exactly, yes.
    Chairman BAKER. Then we determine if the cost to achieve that public policy mission is warranted in light of whatever risk the taxpayer may assume, and then we should rely, or look toward, responsible regulators to tell us when the financial condition warrants Congressional intervention before bad things happen.
    If I am understanding you properly, you do not believe today that the public policy mission is in question or that Fannie and Freddie, at least, are not performing well. Rather, your focus is as to the regulatory oversight and our ability to appropriately gauge the risk?
    Mr. STANTON. Yes.
    Chairman BAKER. I just want to get your concerns properly in focus.
    Mr. STANTON. I think I agree. I think you stated it exactly right.
    I would only add that there is a real difference, in my mind, between Farmer Mac and the Farm Credit System.
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    Chairman BAKER. Insolvency being one.
    Mr. STANTON. Tomorrow, as I understand it, in the Senate Appropriations Subcommittee, there is going to be a proposal to expand Farmer Mac lending to small business loans.
    This is an institution that is constantly searching for new purposes, and my concern at the same time, is that it gets a tremendous break on capital requirements compared to everybody else.
    Chairman BAKER. I can't argue with you very strongly.
    Dr. Wachter, in your discussion you illustrated concern as to the minority ethnic credit accessibility and the fact that over some period of time, despite whatever innovations Congress may have proposed, that those disparities have not changed dramatically.
    Is it your conclusion that, for us as the oversight committee on the GSEs, that we should look more closely at their performance in these areas in light of shareholder rates of return, or what is the reason for us to be concerned about the GSE performance?
    Is it just the inability to meet some artificial goal, or is it the fact that they seem to be profitable and they don't meet the goal?
    My concern is that you have to make a profit to engage in the public policy aspect of the social obligations or else you can't perform the public policy mission.
    Could you comment?
    Dr. WACHTER. Yes. I have no concerns about their—putting it another way—I agree that they should be profitable, so the 20 percent profit is not what I am concerned about. These are shareholder-based institutions and they should have profit incentives.
    But, I am concerned that there be a continued focus and attention to their mission and that be discussed in the light of day, that there be set up various goals, that the goals that are set up be discussed in more detail, and that there be some very serious consideration about, not just the numerical goals, but what they serve.
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    To come back to a point I started out with, which you referred to in your question, disparity in home ownership rates. The disparities across racial and ethnic groups have not narrowed over the last 20–30 years.
    Actually, disparities in mortgage application acceptance rates have narrowed some over the last several years and I do believe that this is a good sign, and indeed a desired outcome of public policy legislation, both CRA and mandates, so I think that the mandates are probably having some good effect.
    Chairman BAKER. Are you familiar with the Community Investment Program of the Federal Home Loan Bank and its operation?
    Dr. WACHTER. I am not sufficiently familiar to comment on that.
    Mr. STANTON. I would like to add something. I think it is a great model.
    It is basically a 10 percent tax. In other words, what lower income people may need is a break on their mortgage rates, and instead of something such as you have in the Fannie and Freddie charter, which says basically even on their low-income lending they shall make a profit, what the Home Loan Banks have done is pioneer a system where you allow lenders to come in and get subsidized credit.
    I think it's a tremendous idea and it might be great to have Fannie and Freddie kick into it too, along the lines of Representative Flake's concerns.
    Chairman BAKER. I think that from my experience the CIP program has been one of the better performing aspects of all Federal programs in extension of credit, and frankly beyond just the question of minorities or ethnic questions, it gets to small town water systems, fire prevention, a broad array of what I call ''public policy'' concerns.
    My last question——
    Dr. WACHTER. But if I may just follow up?
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    Chairman BAKER. Sure.
    Dr. WACHTER. It can't be simply a subsidy to loans. There are two key factors in terms of borrowing for home ownership among minorities in low-income neighborhoods—one, the down payment.
    Chairman BAKER. Sure.
    Dr. WACHTER. That is key, as opposed to the interest rate subsidy, but even more than that, the down payment is not the only—or even, at this point, the most important—it is where loans can be obtained.
    It is the specific neighborhood conditions, and local underwriters often use underwriting standards which may be, in fact, pushing the envelope. But we don't know that yet; we don't know enough about what works and what doesn't work.
    Fannie and Freddie are in the position to combine the natural experimentation that is now occurring to find out what does work in extending loans to that part of America which is not yet part of the mainstream and not part of the conventional housing finance system.
    Chairman BAKER. I would very much like to have as a follow-up, your perspectives on the CIP program at some point, if you have occasion to review it, because I think it is a model which offers a lot of potential and is not so constrained with geographic limits.
    Thank you.
    Thank you, Mr. Chairman.
    Chairman HORN. The gentleman from Oklahoma, Mr. Lucas, 10 minutes.
    Mr. LUCAS. Thank you, Mr. Chairman, and thank you, Mr. Stanton, for your observation on the unique circumstances of rural American production agriculture.
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    I guess I really only basically have one more question, and I think I will direct this to Mr. Cavanaugh, who obviously from his résumé has been involved in the process for a time and has an appreciation of these things. I don't know that, well, really, this is a question I think that's fair, because it goes from one extreme of the equation to the other.
    Do you think—just to be up-front and blunt about it—that it is politically feasible or possible, that once a GSE has been created that it will ever be uncreated or have its charter revoked?
    Mr. CAVANAUGH. There is nothing in the record to suggest that it would happen.
    Mr. LUCAS. But the sun could come up in the West tomorrow too, but it is highly unlikely?
    Mr. CAVANAUGH. The logical financial and economic answer would be obviously they are rolling in dough, in great shape, and they have been private for 25 years. If they can't stand on their own two feet in the market now, they never could. But for some reason that doesn't happen.
    I would have said the same thing 5 years ago, so to me it is a political question, and I would defer.
    Mr. LUCAS. A diplomat through and through. Thank you, Mr. Cavanaugh, and thank you, Mr. Chairman.
    Chairman HORN. Well, you are quite welcome.
    We do have some questions, if you would indulge us, that we would like to mail to you and if you, at your convenience, could just give us a brief answer or any answer you want. I know you're all busy, but we would be most grateful for your thoughts. Rather than have this go another hour, I think I would rather see some of it in writing, so we will send them to you.
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    I want to thank the staff that has prepared this hearing for both of our subcommittees: J. Russell George, staff director—in the back there—put your hand up, Russell, the staff director for Government Management, Information, and Technology; Matt Ryan, professional staff member, right behind me; John Hynes, professional staff member is not with us this evening; Andrea Miller, our staff assistant clerk.
    Then, for the minority staff on the Government Management Subcommittee, David McMillen and Jean Gosa, the clerk for the minority.
    We have interns Darren Carlson, Jeff Cobb, John Kim, Grant Newman on both sides.
    On the Banking subcommittee, Mr. Baker's staff director is Greg Wierzynski; and we have Pat Cave from Mr. Baker's personal staff; and we have professional staff members Ted Beason, Stefan Jouret, Sarah Dumont, and Terry Birchfield.
    Our court reporters have been Mark Mahoney and Sarah Dumont, who is the staff assistant for Banking.
    So, we thank you all on the staff and we thank the witnesses of both this panel and panel one. Thank you very much. We have learned a lot.
    [Whereupon, at 5:28 p.m., the hearing was adjourned.]