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House of Representatives,
Subcommittee on Capital Markets, Securities and Government Sponsered Enterprises,
Committee on Banking and Financial Services,
Washington, DC.

    The subcommittee met, pursuant to notice, at 10:10 a.m., in room 2128, Rayburn House Office Building, Hon. Richard H. Baker, [chairman of the subcommittee], presiding.

    Present: Chairman Baker; Representatives Lucas, Kanjorski, Gutierrez, and Roybal-Allard.

    Chairman BAKER. I'd like to call this hearing of the Capital Markets Subcommittee to order, and to begin the hearing this morning, just a brief remark about the subject of today's hearing, the General Accounting Office's report on its findings with regard to the Office of Federal Housing Enterprise Oversight, the regulator of our two principal housing Government Sponsored Enterprises.

    Suffice it to say, I have had some concern about the process that was established. In researching the record, I had something in my mind about this that troubled me. I went back and found that on July 31, 1991, the committee marked up the bill which laid the basis for the establishment of OFHEO, and for whatever reason, I was the only Member to have voted against that stress test delineation, and in looking at the record, my comments at that point were that I felt that the structure would not be sufficiently flexible to give us the data we needed in a timely manner, and that it would take considerable time and effort to even construct such a new model. For one time in my legislative career, I was apparently very correct.
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    From that beginning until now, little if any progress has been made. The report by the Accounting Office suggests that OFHEO cannot give us the answers that the Congress has sought. Although in my opinion, Fannie and Freddie today appear to be in sound financial condition, and today there has been an expansion of their lines of business and potential liabilities to at one point, $6 trillion.

    OFHEO does have a statutory obligation to ensure that Fannie and Freddie are financially sound, and to complete that mission, it must establish a risk-based capital standard sufficient to withstand the rigors of a stress test. OFHEO's other tool for regulating the two entities is to conduct detailed examinations. OFHEO, at best, receives a grade of ''incomplete'' in this regard as well. Having established its own biannual examination plan in September, 1994, despite a statutory requirement of annual on-site examinations, it has not even completed its own targeted exam goal. This creates extreme difficulty for those of us charged with the responsibility in Congress of monitoring the performance and financial soundness of these two critically important financial institutions.

    I hope during the course of today's hearing and by information that's provided, to reach some level of comfort or gain assurances that the ability to properly regulate and govern will, in fact, become a reality in a very short while.

    Chairman BAKER. At this time, I call on Mr. Kanjorski for any opening remarks he might make.

    Mr. KANJORSKI. Thank you very much, Mr. Chairman.
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    First of all, I'd ask unanimous consent that all Members have the right to submit written opening statements and questions to be answered by the witnesses.

    Chairman BAKER. Without objection.

    Mr. KANJORSKI. Mr. Chairman, thank you very much for setting this hearing up. I'd like to take the opportunity to welcome both Tom McCool of GAO and Mark Kinsey, the Acting Director of OFHEO. Both are very dedicated public servants and, perhaps, we task them with some difficult situations, particularly, the development of the stress test and the GSE examinations and the risk-based capital standards that were established.

    I tend to agree with Director Kinsey's notes in his testimony that ''The quality of the projections is important here.'' As it's well pointed out, just one-half of one percentage point in mortgage credit losses could result in a $7.5 billion error in profits, and wipe out more than one-third of the enterprises' capital. So, it is as important to get this work done correctly as it is to get it done quickly, and I more than appreciate that and think now that we have that more or less behind us, that we can get on with the establishment. I know what staffing of this type of enterprise takes and the delays incumbent.

    I look forward to the testimony and the reports today, and only hope that there's some continued successes reflected in some of the findings. The AA rating by Standards and Poor's, and the equity return of over 20 percent certainly are encouraging. I hope that the testimony will indicate that that's going to continue for a long time in the future and that we can work with these GSEs in the future to see them meet the needs of both the American people, Congress, and the private market.
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    Thank you, Mr. Chairman.

    Chairman BAKER. Thank you, Mr. Kanjorski.

    It's my pleasure to welcome Mr. Thomas McCool, Director of Financial Institutions and Market Issues from the General Accounting Office. Welcome Mr. McCool.


    Mr. MCCOOL. Thank you. I'd like to introduce my colleague, William Shear, who's the Assistant Director in our group and has been responsible for the work we've done on OFHEO.

    Chairman BAKER. Welcome.

    Mr. MCCOOL. I'd also like to submit that my written statement be put in the record.

    Chairman BAKER. Without objection. If you would, pull the microphone a little closer to you.

    Mr. MCCOOL. Sure, sure.
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    Mr. Chairman and Members of the subcommittee, we're pleased to be here today to discuss the operations of the Office of Federal Housing Enterprise Oversight and the status of OFHEO's efforts to fulfill its mission of helping to ensure the safety and soundness of the two largest housing Government Sponsored Enterprises, Fannie Mae and Freddie Mac.

    Congress has a longstanding concern that the safety and soundness of the enterprises be maintained so that they can continue to fulfill their public purposes while taxpayers are protected from unnecessary financial risks. Consequently, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, which established OFHEO as an independent regulator within the Department of Housing and Urban Development. Under the act, OFHEO is authorized to help ensure the enterprises' safety and soundness by setting capital standards, conducting examinations and taking enforcement actions if unsafe and unsound financial and management practices are identified.

    In our recently issued report, we conclude that OFHEO has not yet fully implemented its statutory responsibilities and faces considerable future challenges of doing so. In particular, OFHEO currently does not expect to establish final risk-based capital standards for the enterprises until 1999, even though this process was to have been completed under the act by December 1, 1994.

    Further, OFHEO has not fully implemented the comprehensive and timely safety and soundness enterprise examination program. Although Fannie Mae and Freddie Mac have been consistently profitable in recent years, we believe it is essential, given the enterprises' outstanding financial commitments of over $1.5 trillion, that OFHEO implement safety and soundness responsibilities as quickly as feasible, so that any potential long-term financial risks to taxpayers are lowered.
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    First, I'd like to speak a little bit about the development of the risk-based capital standards. In OFHEO's planning process and in its published documents, the organization has consistently underestimated the time necessary to complete major components of the stress test and risk-based capital standards. We identified several reasons why OFHEO did not comply with the statutory deadline and found that OFHEO faces continuing challenges in meeting its current estimates.

    Let me outline a few of the problems OFHEO encountered. The first is that the statutory mandate to develop a stress test and risk-based capital standards presented very complex and time consuming challenges to OFHEO. The final stress test OFHEO is developing is meant to be flexible and capable of assessing the effects of different credit and interest rate scenarios on differing components of the enterprises' portfolios, such as single-family and multi-family mortgages as well as new financial products.

    As a contrast, the risk-based capital standards developed by Federal banking regulators categorized assets into broad categories, which may not account for changes in the institutions' business practices that could affect their risk profiles.

    OFHEO did decide to develop a new stress test rather than trying to adopt and modify existing stress tests. During OFHEO's startup phase in 1993 and 1994, there were strategies available that OFHEO could have pursued that might have resulted in a faster completion of the stress test and risk-based capital standards. However, OFHEO officials determined that pursuing these strategies would have left the organization with an inadequate basis for assessing the risks facing the enterprises. Consequently, OFHEO concluded that it could establish capital standards that would be more closely related to enterprise risks by developing its own sophisticated stress test and associated financial modeling capability. We note that OFHEO's approach has ultimately involved a substantial development period and commitment of resources.
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    Our review also found that OFHEO faces several continuing challenges in completing the stress test and capital standards development process by 1999 as they currently plan. These challenges include the need to coordinate an interagency review process in which OFHEO officials are to share the technical components of the stress test with staff from OMB, HUD, and Treasury. They have to make key policy decisions about the stress test, such as forecast of future interest rates and the relationship between home prices and interest rates. And they need to translate the complex components of the stress test into proposed and final rules while protecting proprietary enterprise data from unauthorized disclosure.

    Given OFHEO's history of consistently underestimating the time necessary to complete the stress test and risk-based capital standards, we believe congressional oversight is necessary to ensure that OFHEO completes the process as soon as possible. Accordingly, we recommended in our report that OFHEO report periodically to Congress on the organization's progress toward compliance with its plan, and inform Congress of any problems that may arise in the completion of the process by 1999, along with any proposed corrective action.

    In addition to the delays in developing the risk-based capital standards, OFHEO has also not fully implemented a comprehensive and timely examination oversight program. In the absence of a stress test and risk-based capital standards, OFHEO's primary means of helping to ensure the safety and soundness of the enterprises is its examination program. However, OFHEO has not fully implemented the detailed examination schedule and plan that it established in 1994, which limits the organization's ability to monitor the enterprises' financial condition. OFHEO's current three to four-year cycle for assessing the six core risks is considerably longer than a two-year cycle established in the plan. In addition, OFHEO has scaled back the planned coverage of its most recently completed core risk examination. The examination covered only one of four business areas. One important factor that contributed to OFHEO's inability to fully implement the 1994 examination plan was the amount of time that OFHEO examination staff needed to develop an understanding of the enterprises' operations and risk management. We also believe that limited resources allocated to the examination office, as well as staff attrition, contributed to OFHEO's inability to fully implement the 1994 plan.
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    During the course of our audit work, OFHEO officials told us that the organization plans to reassess its examination program during 1997 and implement an annual examination cycle for all core risks by early 1998 to ensure that the enterprises' safety and soundness is adequately monitored. This reassessment is to include a review of examination office staff resources to ensure that an annual examination cycle can be implemented. We stated in our report that without a reassessment and potential reallocation of resources, OFHEO may not be able to implement an annual examination cycle by early 1998, since it has not fully implemented a two-year cycle with existing examination office resources. In fact, only this past summer, did OFHEO initiate the last component of the core risk examination plan it established in 1994, which is the operations risk examination.

    Thus, we recommend that OFHEO include in its reassessment an analysis of the staff resources necessary to carry out alternative examination schedules such as a one- or two-year schedule. Through such an analysis, OFHEO could help ensure a fuller consideration of the tradeoffs associated with examination coverage provided versus costs involved, and, thereby engage in a more informed decisionmaking process.

    Senior OFHEO officials recently told us that they are in the process of reviewing examination and office resources, and have decided to reallocate two positions from other offices to the examination office. In addition, the Director of OFHEO's examination office told us that OFHEO plans to make greater use of bank regulatory detailees than has been the case in the past. It will also help ensure the effective implementation of the annual cycle by early 1998. Nevertheless, given OFHEO's past difficulties in implementing its enterprise safety and soundness examination responsibilities, we believe that OFHEO's future efforts, including the implementation of its annual cycle, should be closely monitored.
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    And to conclude, I'd like to reiterate that OFHEO has a crucial role in helping to maintain the safety and soundness of Fannie Mae and Freddie Mac, and, thereby, ensure that the enterprises can continue to meet their housing mission without posing unnecessary risks to taxpayers. As a relatively new Federal regulatory organization with complex responsibilities, OFHEO has faced considerable challenges in implementing its statutory safety and soundness requirements. OFHEO has assembled a professional staff that appears to have considerable expertise in housing economics, mortgage finance, computer systems analysis, and financial institution examination. The development process has been slow, but OFHEO has developed a working financial model that it believes will serve as a basis for the stress test, and plans to complete the final risk-based capital rule by 1999. However, given the challenges that remain in meeting the schedule, as well as OFHEO's efforts to implement an annual examination cycle during 1998, we believe that continued strong congressional oversight of OFHEO's progress is essential.

    Mr. Chairman, that concludes my statement. I'd be pleased to answer any questions.

    Chairman BAKER. Thank you, Mr. McCool. On that point, with regard to the projected completion date, given your understandings based on this study, what level of confidence do you have that without additional staffing and without outside supervision that a self-imposed reporting deadline will, in fact, be met? What level of confidence do you have?

    Mr. MCCOOL. I'm not sure I'd be able to state it in percentage terms, but I guess we're concerned about the steps that still need to be taken between now and the early part of next year. There still is some testing and some software that has to be run through some tests; there's some decisions that still have to be made. I guess one of the biggest questions we have is the fact that a very complicated rule still has to be written once there is some buy-in from OMB and HUD and Treasury, which in itself may be a task. So, I think that there's a lot of potential places for slip ups still to occur, and so I guess we are concerned that there's clearly no guarantee, and there's at least some probability that this new plan will also slip.
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    Chairman BAKER. To my knowledge, all other Federal financial safety and soundness regulators are exempt from the annual appropriations process, save or fail. OFHEO is the only one that is subject to the appropriations regimen. Do you think this limits OFHEO's ability to maintain adequate staff and to obtain adequate resources in order to meet their supervision responsibilities?

    Mr. MCCOOL. Well, that's a difficult question. I guess, to our knowledge, I think it is the only one that we know of, of the safety and soundness regulators subject to annual appropriations, and, clearly, that does potentially raise the concern that the appropriations process may add a little bit of difficulty in coming up with new resources, but it also adds the potential for more accountability, so there's a tradeoff there. Whether it's limited their ability to come up with sufficient resources, I think the question is they have to make a case to the Appropriations Committee that if they feel they need resources, they have to make that case, and I don't know whether they've made a reasonable case or not.

    Chairman BAKER. Another comparison perhaps: between OFHEO and its ability to do the examinations off-site of Fannie and Freddie, as compared to say the OCC and a money center bank, are the resources and the effort roughly comparable or is there in your mind an imbalance in what the OCC might do to a large financial institution and what OFHEO appears to be doing with the GSEs?

    Mr. MCCOOL. Well, I think I'll follow up by asking Mr. Shear for more detail, but my sense is that from the standpoint of this overall approach, there are probably a lot of similarities. The OCC has moved to this risk-based approach; OFHEO takes a similar approach of looking at things from a top-down perspective to try to figure out where they need to devote their time and attention for any particular examination, but at the same time, I think that, from our quick and dirty calculations, it appears that OCC would use a fair number more examiners than OFHEO does when OCC does a money center bank, but a money center bank has a lot more things to look at and a lot more complicated activities and a lot more lines of business than Fannie and Freddie do. So, whether that's appropriate or inappropriate; whether there's a disproportionate number of staff—that's a real hard comparison to make. Do you want to add anything on that?
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    Mr. SHEAR. To say that over the recent period where OFHEO, you could say broken up among the two enterprises might have seven or eight examiners on average over the past couple of years, and they have been supplemented with some detailees and some specialized contractors the OCC tends to have at the money center banks. In terms of full-time examiners at the banks, the numbers tend to be more like 15 or 20; in that range, but then, again, as Tom pointed out, the money center banks have a wider range of business activities. So, it's really not directly comparable.

    Chairman BAKER. And it's hard to throw a net over any of this where you find another model that you can stand up beside it and say, ''Yes, this is good'' or ''This is bad.'' But, again, here's another comparative question: regarding the time elapsed for the development of complex regulatory oversight, and consider a rule dealing with the marketing and suitability requirements for derivatives as an example. Does the track record of other regulators in developing complex regulatory oversight mechanisms infer that OFHEO has just not done its job, or is this area really so extraordinarily unusual and different that it, perhaps, does warrant some slippage of time in order to do it properly?

    Mr. MCCOOL. Well, I guess I'm not sure that I know of a comparable—at least in a financial regulatory arena—comparable task with the same degree of difficulty, and I think the bank regulators have had their own problems in coming out with certain types of regulations, partly, that comes from the fact that there are so many of them, they have to agree, and that's a different kind of problem than OFHEO has. And it's also true that when it comes to certain types of the more complicated risk-based capital kind of regulations, a lot of times they don't necessarily go as far as they initially intended to. They kind of tend to back off a little bit. I think that happened, for example, in some of the market risk capital standards that they've decided to primarily focus on large banks rather than all banks, because the difficulties in trying to come up with standards that could fit over what is a fairly highly variable entity.
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    So, I think that again, I can't think of any cases where the bank regulators have taken as long, but at the same time, I don't think they've had a mandate that's quite so explicit and also so complicated to my knowledge.

    Chairman BAKER. I think you currently have underway work to analyze the Federal Housing Finance Board's ability to oversee the Home Loan Bank System. First, can you give me some idea as to when you think that report might be made available?

    Mr. MCCOOL. Well, I think right now, we're thinking about having the report out by, I would say by the summer of next year; maybe June, I think, is a reasonable target date.

    Chairman BAKER. Well, I think it will be very instructive when we get to reap the benefit of that work as well. As you know, the self-imposed deadline of OFHEO is somewhere in the neighborhood of September to try to have a rule ready for promulgation—or the tests ready to be reviewed. In the event that we get the Home Loan Bank study back, indicating some concerns there, it's no secret, there have been discussions about merging the regulators. The completion of that report, I think, would form a basis to take such action, if in fact OFHEO does neglect its own self-imposed guidelines, and I'll just make that point, because the importance of your findings in that area are equally of concern to the subcommittee.

    Mr. Kanjorski.

    Mr. KANJORSKI. Thank you very much, Mr. Chairman. I have a question that's probably off the board, and maybe it's not worthwhile now, but how do we test the stress test for the accuracy that it predicts in the events that happened in the stock market on Monday as it affects the enterprises profits or capital? Have you looked into that? To take Monday's event, and see what the stress test does?
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    Mr. MCCOOL. Well, we didn't look at Monday's market activity particularly, but we've looked at the stress test, the development process, but the focus of our work so far was primarily on the process itself rather than on the content of the test. We do have, actually, a mandate from the 1992 act to evaluate the test once it's finished, and we intend to do that as part of the process, but at the present point we've sort of been monitoring and keeping our eye on what they're doing, rather than really doing a full scale evaluation of the actual content of the test.

    Mr. KANJORSKI. Do you think what they're formulating in the stress test, will it give us a reasonable position to be able to predict the affect on capital, and so forth, say at a drop that Monday reflected or down as low, as say, 25 percent?

    Mr. MCCOOL. Well, I guess our sense is that the process they're pursuing, while you might argue with this or that minor piece of it or certain aspects of the approach, the approach they're taking seems to be a reasonable approach.

    Mr. KANJORSKI. I noticed your eyes roll back in your head when you heard the word ''derivative.'' I was curious, will the stress test take into consideration the ramification of derivatives action on this?

    Mr. MCCOOL. That's one of the reasons I think it's taking so long, because they're doing a very thorough and careful job to make sure they are taking into account the ramifications of derivatives on the portfolios. I think that's an important part of their process.
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    Mr. KANJORSKI. And these little fellows are somewhat like the AIDS virus; they keep mutating. So, how will a test be established so that we'll anticipate all of those new creative products?

    Mr. MCCOOL. Well, again, I think that the test itself will focus on the sorts of derivatives that Fannie and Freddie have on their books. The question, I guess, about going forward, how it will be adjusted to take into account new viruses—new products—is an interesting one, and I'm not sure I'm completely certain about exactly how they will include new products as the process evolves. Maybe Bill can.

    Mr. KANJORSKI. Is there anything that you've discovered in your examination that indicates that there need to be anything done by the Congress and the statute that we passed, or is it just the implementation, or is there something in there that we haven't taken into consideration?

    Mr. MCCOOL. Again, I think at this stage, it's a question of fairly consistent oversight.

    Mr. KANJORSKI. Do you think we're going to get to the intention of the statute in Congress?

    Mr. MCCOOL. I think we will eventually. We hope it will be in the next two years.

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    Mr. KANJORSKI. OK. In your examination, did OFHEO take into consideration the year 2000 computer problem?

    Mr. MCCOOL. They have, as part of their information technology exam, which is ongoing, I think they are looking at the year 2000 issue, but we don't have a real sense of just how effective that oversight has been.

    Mr. KANJORSKI. Thank you very much, Mr. Chairman.

    Chairman BAKER. I just have a couple of follow ups. I didn't also ask about the expected report date for the HUD study as well. Is that a next year issue too?

    Mr. MCCOOL. Yes.

    Chairman BAKER. Like mid-year, you gave me a June-July on the Home Loan Bank. Is it June-July?

    Mr. MCCOOL. I think it's a pretty similar timeframe.

    Chairman BAKER. OK. Mid-year, then. And one other observation with regard to congressional oversight which has been mentioned in your report as a needed element. Are there any other interim steps that we should look for in the actions of OFHEO beyond the delivery of a completed stress test? Is there some other mid-year, quarterly? What do we do as a subcommittee between now and the delivery of the completed product to assure ourselves that timely work has been achieved, for example? Are there any additional examination schedules that we might request of the agency during the interim, given the fact they didn't meet their own two-year cycle? Should we ask for some additional work in that area? I'm looking for something other than a hope that September 30 produces a result.
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    Mr. MCCOOL. No, I understand that. Well, again, a part of our recommendation was that OFHEO needs to make public their progress in meeting their target, and so I guess the question is we didn't try to specify a specific timeframe, like every quarter or every month.

    Chairman BAKER. But no other event; no other activity?

    Mr. MCCOOL. No other event I could think of would be a particular decision point between now and then.

    Chairman BAKER. Mr. Gutierrez.

    Mr. GUTIERREZ. Well, Mr. Baker, I just want to thank you, Mr. Chairman, for calling these hearings, and I don't have any questions. Why don't we go to the break, and come back after this vote?

    Chairman BAKER. Thank you very much. Gentlemen, we have a vote going on the floor. I don't know that there would be any additional questions of you. We would keep the record open for any written questions that might be submitted at a later time, and I do appreciate your work and your willingness to appear here this morning. We will reconvene immediately as the Members can return from this vote. Thank you.


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    Chairman BAKER. I'm going to reconvene our hearing. I'm told there is a Democrat caucus ongoing. I know there's a Republican conference ongoing, and there's few people on the floor talking about grazing. So, as a result, our numbers are going to be depleted, but that certainly does not diminish the importance of what we're engaged with here.

    I'd like to welcome at this time Mr. Mark Kinsey, Acting Director of the Office of Federal Housing Finance Oversight. Welcome, Mr. Kinsey.


    Mr. KINSEY. Thank you, Mr. Chairman. I'm glad to have the opportunity to discuss the GAO report on OFHEO's principal regulatory and supervisory activities with you and other Members of the subcommittee. My remarks this morning are a summary of my written testimony, which, with your permission, I will submit for the record.

    Chairman BAKER. Without objection.

    Mr. KINSEY. My testimony this morning expresses my views which are not necessarily those of the President or the Secretary of HUD.

    I think the GAO report is generally fair and accurate, and it contains reasonable recommendations. The report details OFHEO's considerable achievements, while it appropriately focuses on what needs to be done. We intend to implement GAO's recommendations and have, in fact, already begun to do so. I will report on the current status of OFHEO's examinations and capital regulations programs and on our plans going forward.
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    Briefly, with respect to examinations, I am confident that beginning in January 1998, we will have the experience and resources to begin comprehensive annual examinations of the enterprises. With respect to our risk-based capital regulation, I can report that we are on schedule to send the Office of Management and Budget our proposed rule by the end of the current fiscal year.

    Mr. Chairman, I share your view of the importance of OFHEO's job. Fannie Mae and Freddie Mac now have more than $1.6 trillion of outstanding obligations, which are generally perceived as implicitly guaranteed by the Federal Government and ultimately by American taxpayers. Their on-balance-sheet holdings of mortgages and mortgage securities, where most of the risk is concentrated, have roughly doubled in the past four years. While both enterprises are currently very profitable financially healthy organizations, it is important that there be a complete program of supervision and regulatory control.

    Economic conditions and management practices are subject to adverse changes. Such changes rarely happen overnight, but we want to be fully prepared if they occur. OFHEO has two main tools to do the job, both equally important. We conduct risk-based examinations and determine required capital levels. GAO's report appropriately concentrates on these two areas.

    First, I would like to address the examination issues. While recognizing the quality of our examination staff and OFHEO's accomplishments in the examination area, GAO also raised important questions about the timing of OFHEO's examination program, which I believe we are successfully addressing. Fannie Mae and Freddie Mac are financial intermediaries whose business is to take risks and earn a satisfactory return for the shareholders, while at the same time serving their public missions. Taking risks is essential. Our job is to ensure that they are managing those risks prudently. Given that no reasonable amount of capital can provide adequate protection if risk management is weak, OFHEO has put in place a robust and dynamic risk-based examination process.
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    The first phase of that process, a full set of core risk examinations at both enterprises, will be complete in the next two to three months. This first set of exams has been particularly valuable because neither enterprise had been examined previously by any Federal agency. While the exams have shown that risk management at both Fannie Mae and Freddie Mac is generally strong, OFHEO has made many recommendations to address weaknesses and to stimulate enhancements. Both enterprises have responded satisfactorily, and, as a result, are implementing better risk management strategies, practices, and controls.

    It has taken more than three years to complete this set of examinations. We started in 1994 with what we described to GAO at the time as an ''ambitious'' plan. We had hoped to complete a full cycle of examinations in two years. In retrospect, it is clear that our plan did not fully account for the substantial additional time required in doing initial examinations because of the need to fully acquaint ourselves with the enterprises' activities, practices and policies; to acquaint the enterprises with the examination process, and to meet our own organizational and infrastructure needs. We also, frankly, misjudged the enterprises when we formulated our 1994 plan. Given the similarities of the enterprise charters and their role in the market, we expected more consistency between the enterprises.

    In fact, we found two very different companies: in cultures, in management processes, in data structures and formats, in operating platforms, in approaches to technology, in approaches to their business, in management reporting, in accounting systems, and in an endless number of other ways. Any efficiencies we were expecting to gain from consistency were not present.

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    Early this summer, we re-evaluated our program and determined that, given the size and importance of these two enterprises, a comprehensive, annual examination is more appropriate going forward than a two-year examination cycle. Let me explain why we will be able to accomplish it.

    The first important consideration is that future examinations will require substantially less examiner time than our first set of examinations. Not only did we not possess intimate knowledge of the enterprises' processes and risk management frameworks, we did not have a wealth of historical data and information which other established financial regulators have. OFHEO now has, and we will continue to build, this base of information. Additionally, we will continue to introduce technological enhancements to introduce further efficiencies in our examination program and in the routine monitoring of the enterprises' risk profiles.

    OFHEO's acquired base of knowledge, coupled with the enhancements being implemented in our ongoing monitoring and the more frequent dialogue we are having with enterprise management, will provide a more focused examination process. The improved focus will also prioritize the areas presenting the greatest risk to the enterprises, and focus the level of OFHEO's examination testing on the areas representing the greatest risk to the enterprises' safety and soundness.

    We have also re-evaluated our examination resources as GAO recommends. This month, I have reallocated two new permanent positions to our examination staff. Their addition, in combination with filling two existing positions, will give us an examination staff of 19. That will provide roughly double the average number of examiners and specialists that were available to us over the past three years as we have conducted the first set of exams.
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    In addition, our examination function often makes use of staff from other operating units at OFHEO, and this is a practice that we will continue.
    As in the past, we will supplement these in-house resources with contractors and detailees from other regulatory agencies. To augment its own examination staff, OFHEO has used examiners from the banking and thrift regulatory agencies. We are committed to continuing this process, and we are planning accordingly. Also, we are increasing our involvement with working groups of the other financial regulators to leverage on their experience and talents. OFHEO has used, and we will continue to use, contracted resources to augment the examination process. In particular, we are using contract dollars in key areas of risk to augment the skill pallette of our core examination staff.

    Let me now turn to our other essential regulatory program, capital standards. I think it is important to keep in mind that we have two types of capital standards. The first is called the ''minimum'' capital standard. It is a key element of capital regulation, and it is in place. It represents a significant improvement over the pre-OFHEO standard. Using the minimum capital standard, which is based on a set of leverage ratios, OFHEO has classified each enterprise's capital position every quarter since OFHEO's inception, as required by law. After initially using an interim procedure, we published last year a final regulation which incorporates a more careful evaluation of the credit risks associated with swaps and other off-balance-sheet obligations. The resulting standard is comparable in its construction to the risk-based capital standards of other financial institution regulators.

    In establishing OFHEO, however, Congress recognized that a special opportunity for more advanced capital regulation exists. Because the entities OFHEO regulates are very similar and have limited lines of business, a risk-based capital regulation based on a stress test is possible and desirable. Creating such a regulation has taken longer than Congress or OFHEO anticipated. While time needed for organizing a new office was an important factor, we now realize that the one-and-one-half-year timeframe provided by statute would have been much too short, even for a fully established regulator.
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    In evaluating our process for developing a risk-based capital regulation, GAO recognized the expertise of our staff and many of our accomplishments to date. GAO concluded that the complexity and the challenges inherit in our task and our decision to develop our own stress test were the key factors in accounting for the time it will take us to complete this regulation. We agree that these were important factors. Complexity is unavoidable if we are to achieve a stress test that meets statutory requirements and fairly measures the enterprises' key risks.

    The quality of the model is vitally important. For example, a model that over- or under-predicts mortgage credit losses by 1/2 percentage point on the enterprises' combined mortgage portfolio of $1.5 trillion results in a $7.5 billion error. That would be more than one-third of the enterprises' current capital. There is a critical difference between our task and designing a model for management purposes or for assessments of an enterprise's capital adequacy in a non-regulatory context. Our model will generate legal requirements to hold capital that will indirectly affect business costs, which the enterprises will reasonably want to minimize. A stress test that does not measure risks well and provide appropriate incentives will not be an effective regulatory tool.

    Before building our own model, we examined existing models. We determined that they would not be suitable, and that reworking any one of them would have taken longer than starting fresh. With respect to the enterprises' own models, we believe they are useful management tools, but are not designed to serve regulatory purposes. Their models are tailored to meet their separate needs, different books of business, and unique database structures. Using one enterprise's model to regulate the other would raise legitimate questions of fairness. Using either enterprise's model could raise questions about OFHEO's independence.
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    We have made major strides toward completing the stress test and the risk-based capital regulation. We issued an advance notice of proposed rulemaking to obtain public comments on 65 issues involved in creating the stress test. We issued a notice of proposed rulemaking with a methodology for determining the benchmark loss experience and with a proposal to use our house price index to assess the impact of changing house prices in the stress test. Most importantly, we have developed a financial simulation model to project enterprise financial performance in the stress test. All of these steps toward the completion of the stress test are unheralded, but critical, work.

    With basic FSM development complete, we are now well into sensitivity testing; that is, running complete sets of actual enterprise data through the FSM to evaluate the appropriateness of various settings of its components for the stress test. These full-fledged simulation runs help us to evaluate stress test options, and also provide the additional benefit of helping to identify possible model anomalies or program bugs that we need to address. This is standard in a model development project of this type.

    We have now made tentative decisions on most key aspects of the stress test and are in the process of evaluating a few remaining choices. We expect to make final decisions on all key aspects of the stress test by the end of January. I will inform you when this is done. We have begun drafting several sections of the proposed rule. We have also been regularly briefing Administration analysts at OMB, Treasury, and HUD about the details of our financial simulation model. We will continue those briefings over the course of the next several months, so that when our proposal is complete, they will be familiar with our stress test. That should facilitate the timely review of the proposal by Administration officials and speed its publication. We plan to have our written proposal ready to enter the formal clearance process by the end of this fiscal year.
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    We think this plan is fully realistic, but it means a lot of work between now and then. I understand your frustration with OFHEO's past estimates of the time needed. Frankly, I share that frustration. OFHEO's planning clearly has been overly optimistic, but I can assure you I am doing everything I can to meet our current targets. During the next year, I have allocated as much of OFHEO's resources to completing this proposal as I possibly can without jeopardizing our examination goals. A majority of OFHEO's personnel and OFHEO's contracting funds will be directly involved in completing our risk-based capital proposal this year.

    We have put considerable effort into designing this plan. Earlier plans suffered from not being able to predict the outcomes and success rates in the early stages of what has been, essentially, the development of an entirely new product, involving a large creativity component. The remaining tasks, while they still present their share of novel challenges, are inherently more predictable. The likelihood of surprises is far lower, and we are diligently tracking our progress. We will report to you about that progress every three months, particularly with respect to any problems that arise and actions planned to correct them. We have met frequently with staff of this subcommittee to discuss the stress test in the past and look forward to continuing to do so, at your convenience.

    I'm proud of the work OFHEO has done. Despite the sizable potential risks posed by Fannie Mae and Freddie Mac, before OFHEO they had never been examined by a Government regulator and had no meaningful capital requirements. Now, we have nearly completed a full set of examinations, and we have the minimum capital regulations in place. These enterprises are being supervised in much the same manner as depository institutions. The risk-based capital regulation will add a very valuable piece to our overall approach. It is taking longer to complete than we and you had hoped, but the approach we have taken is the right one, and the result will be worth the wait. Thank you, Mr. Chairman.
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    Chairman BAKER. I thank you, Mr. Kinsey, and I appreciate your testimony. It's my understanding that you would issue a report late January indicating intermediate progress. In asking GAO's observations about landmarks, mileposts, is there any additional point at which you feel you could give us some intermediate goal between the January report and the September 30 delivery date?

    Mr. KINSEY. I think the January date is a logical break in our plan. If you want to conceptually view the process to date, once we make the final decisions on the stress test, the majority of the energy then goes into the writing of the document, and so that's a very logical break point that we can report to you on. Certainly, in my quarterly reports to you, I will detail more precisely the progress that we've made, and give you estimates as to what percentage I think that we've completed, in terms of the writing of the regulation and so forth.

    Chairman BAKER. With regard to staffing capability, you previously have indicated that you feel within the authorized positions that you currently have, I guess, if filled, you can achieve the goal without difficulty.

    Mr. KINSEY. Yes, I do.

    Chairman BAKER. I've noted also that you are the only financial safety and soundness regulatory subject to the appropriation's process as opposed to self-generated fees or other——

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    Mr. KINSEY. That's correct.

    Chairman BAKER. Is this a condition that you think should be altered or do you find the support levels sufficient for you to conduct your activities?

    Mr. KINSEY. Let me just give you some examples. The last two years our budget has been reduced from our budget request. We have found that the majority of interest in our activities has come from your subcommittee, the authorizing committees, and not the Appropriations Committee. That's not to say that we don't think it's appropriate for the Appropriations Committee to also conduct oversight, and we have attempted to inform them of our progress, but I think, quite frankly, the interest really isn't there in terms of what we do. So, it has proved a challenge for us, but, certainly, it's appropriate to have congressional oversight.

    Chairman BAKER. In the opening of your statement today, you talk about the existing outstanding obligations and the on-balance-sheet holdings of mortgage and mortgage securities—as you say, where most of the risk is concentrated—have roughly doubled in the past four years, while we've basically been trying to get the test developed. I asked this of Ms. Alverez, two years ago, perhaps, and would ask you now in your capacity, based on your knowledge of the two agencies, do you have any concern that the minimum capital standards today are not adequate?

    Mr. KINSEY. The minimum capital standards are not adequate in the long run to protect the interests of the American taxpayer; that's absolutely clear. Our stress test will more precisely measure in particular the interest rate risk associated with portfolio holdings, so that we can have a much more comfort level that the capital amount is the right amount.
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    Chairman BAKER. How is it that—it's difficult to ask because—given the lack of a stress test, is this coming from your examination based information or——

    Mr. KINSEY. A lot of it is. We have ongoing monitoring of their positions, so we are on top of it all the time. In addition to that, we have already some capacities with the model being developed that gives us some ideas as to the magnitude of the risks and so forth.

    Chairman BAKER. I guess what's troubling me—I'll give an example. Freddie Mac's intended plan to enter into the B&C paper; from my perspective that is a higher risk-taking business activity than the principal line of business. There should be, I think, some corresponding level of capital set aside in the event a GSE elects to engage in a new business direction, which, when viewed by the regulator, is a higher risk-taking activity.

    Mr. KINSEY. I totally agree, and I believe the stress test will allow that to happen. We have looked at their initial efforts to get into the subprime market, and we have concluded that at least their initial efforts have been accompanied by a tremendous amount of credit enhancement, so that the actual risks that the enterprises are bearing in some of these early deals is really not too significantly different from their normal lines of business, but that may change.

    Chairman BAKER. The GAO's report indicated that the agency has consistently underestimated the time necessary to complete major components. Considering the fact that this is now a multi-year problem and the urgency of getting the test in place while markets are solvent—there's not an apparent downturn on the horizon; interest rates remain relatively stable—what troubles me is any further potential delay, we may not enjoy these economic times much longer. No one knows when the next downturn may occur. In that environment, it's almost impossible to rationally engage new standards while you're trying to stop losses from occurring. What assurance can the subcommittee get that September 30 and implementation in 1999 will actually, in fact, be achieved?
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    Mr. KINSEY. I can only tell you about the progress that we've made. We now have a financial simulation model that we are using to begin looking at various options for the stress test. We weren't there a year ago. We were developing the model. We've got something that's tangible now, and we are working with it. It's so close, you can smell it in terms of getting done. I'm quite confident that we will be able to begin the writing of the regulation early next year, and from that point on, it's just a matter of getting it done, and that's an activity that, while I still think presents a lot of novel challenges, it's much more of a tangible activity. We move away from model development into regulation writing which is something that we are prepared to do.

    Chairman BAKER. To that end, I just am going to insert the subcommittee record statements from the 1994, 1995, 1996, 1997 reports, and I understand you were not the principal engaged in these activities at the time, but they basically reflect the statement of optimism and hope for success in all of the prior years' reports.

    Chairman BAKER. This statement is not meant to impair OFHEO's ability to secure resources or to have competent individuals working on staff; I certainly would not like to see that happen. In fact, I hope the statement results in absolute, 100 percent commitment from all staff to get the job done, but it would be my hope that the September 30 delivery date does, in fact, materialize a quality stress test. But assuming there could be complications that we do not know about, it would be my intention to begin at that point another look at OFHEO's charter.

    And let me also add, based on the reports we are intending to receive from GAO on HUD and the Federal Home Loan Bank Supervisor, the Federal Financial Board, to begin looking in earnest at a single regulator for all housing GSEs. I think this is really the last best opportunity OFHEO has to discharge that responsibility, and if the Federal Finance Board is found to be lacking by the GAO in that study, or that HUD's oversight has been somewhat insufficient, it would appear that on all fronts, we really need to take bold steps to get our house in order.
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    I am not suggesting today, in any way, that either Fannie or Freddie present, at the moment, any business risk to the taxpayer at all, but it is absolutely our responsibility in this subcommittee to ensure that a regulatory mechanism is, in fact, in place that can warn taxpayers and the Congress when appropriate actions should be taken. I respect your business judgment and your analysis based on your examinations that you've had to date, but these entities are changing continually, and it's often hard for the professionals to really understand what a new product represents in terms of risk. So, the stress test is absolutely essential, and it's essential that it be delivered on time, and if it is not, then we certainly, I think, will be completely warranted in taking action responsive to meet this need. Do you wish to make any response?

    Mr. KINSEY. I agree with you of the need to get this thing done, and we are committed to doing that.

    Chairman BAKER. Well, I appreciate your courtesy in appearing here today. I do look forward to visiting with you further, formally in January, but also as warranted and as you deem appropriate, and certainly hope that this leads to a productive end conclusion. Thank you very much, sir.

    Mr. KINSEY. Thank you.

    Chairman BAKER. Our hearing stands adjourned.

    [Whereupon, at 11:25 a.m., the hearing was adjourned subject to the call of the Chair.]
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