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

    The subcommittee met, pursuant to call, at 2:00 p.m., in room 2128, Rayburn House Office Building, Hon. Richard H. Baker, [chairman of the subcommittee], presiding.

    Present: Chairman Baker; Representatives Lazio, Sessions, Snowbarger, Vento, Bentsen, Kilpatrick, and J. Maloney of Connecticut.

    Chairman BAKER. I would like to call our meeting of the Capital Markets Subcommittee to order and to welcome our witnesses. Given the events of the day, I want to first express my appreciation to each of you for the late and inconvenient notice of our change in time for the hearing. Given the circumstances though, we felt it most appropriate not to conduct our proceedings, given the day's events. I do express my appreciation to you.

    In 1992, the Congress through legislation gave the Secretary of Housing and Urban Development the responsibility of mission regulation for Fannie Mae and Freddie Mac. The intent of Congress was to make certain that targeted housing needs are being met by these Government sponsored enterprises. Last year, the committee asked the General Accounting Office to perform the first comprehensive audit of HUD's role as mission regulator of Fannie Mae and Freddie Mac.
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    Today we will hear testimony from representatives of the GAO and HUD on the results of this audit. I must report, unfortunately, after reviewing the audit, that I am not comforted by GAO findings nor do I believe HUD has fulfilled its principal regulatory obligation. In addition, we will hear testimony from the Acting Director of the Office of Federal Housing Enterprise Oversight. It should be remembered that last October, the subcommittee received testimony from the GAO on an audit of OFHEO's work as a safety and soundness regulator of Fannie Mae and Freddie Mac, a responsibility which was also created by the act of Congress in 1992.

    Today we will be brought up to date by OFHEO as to its progress in correcting deficiencies reported in the initial GAO audit. It is important that Congress through oversight hearings makes certain that the GSEs fulfill a clearly defined, measured housing mission. It is essential that Fannie and Freddie operate in a safe and sound manner so they will never become a financial burden to the American taxpayer. Further, it should be clearly determined that the benefits that flow to the GSEs are fully warranted by the public policy goals they are purported to achieve.

    At this time I would like to welcome our panel of witnesses and appreciate your courtesy in being here. First to give her presentation will be Nancy Kingsbury, Assistant Comptroller General, General Government Division of the General Accounting Office.

    [The prepared statement of Hon. Richard H. Baker can be found on page 34 in the appendix.]

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    Ms. KINGSBURY. Thank you, Mr. Chairman. I assume you can hear me all right here. I would like to also introduce Tom McCool, who is the Director of our Financial Institutions and Markets Issues area, and Bill Shear, who is the Assistant Director who has directed most of our work about the enterprises. As you know, we have prepared a formal statement for this hearing, but I think in the interests of moving along, I will summarize that and assume that it will be included in the record.

    Chairman BAKER. Certainly. Without objection.

    Ms. KINGSBURY. We are very pleased to be here today to discuss our work on the Department of Housing and Urban Development's housing mission oversight of the two largest Government sponsored enterprises, Fannie Mae and Freddie Mac. As you know, this latest report just released on Tuesday is one of a series of efforts we have undertaken to evaluate regulators' oversight of the housing GSEs. As a part of GSE oversight, HUD has a basic responsibility to ensure that the enterprises' mortgage purchase activities serve the credit needs of all Americans and that the enterprises' financial activities are consistent with their housing mission.

    In 1992, Congress concluded that HUD's regulatory framework had not been effective in ensuring that the enterprises' activities benefited specific targeted groups, including low and moderate income Americans, and those who live in the underserved areas, such as central cities and rural communities.

    To address this concern, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act of 1992. Among other provisions, the 1992 act directed HUD to set numeric housing goals, which required the enterprises to meet specific criteria each year for the purchase of mortgages serving targeted groups. Our most recent work addresses HUD's implementation of these responsibilities.
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    We concluded, among other things, that HUD adopted a generally conservative approach in 1995 to setting the final enterprise housing goals for 1996 through 1999 that placed a high priority on maintaining the enterprises' financial soundness. Fannie Mae and Freddie Mac were in compliance with the final housing goals in 1996 and 1997, according to data the enterprises submitted to HUD.

    We also concluded there are several weaknesses in HUD's mission oversight that need to be addressed. Specifically, HUD has not yet implemented a program to assess the accuracy of the enterprises' housing goal compliance data. Knowledge of the accuracy of the reported data is important in any effort to evaluate whether the purposes of the 1992 act are being achieved.

    Second, HUD's research agenda does not address several issues necessary to fully understand the extent to which the housing goals promote housing opportunities. Although HUD has a variety of research projects under way, they do not address the extent to which the housing goals provide lenders with incentives to make mortgage credit more affordable to targeted groups. For example, in our report we recommend that HUD include in its research agenda analyses of the effect of the housing goals on mortgage interest rates and other loan terms for targeted groups.

    Third, we observed that HUD has not yet fully implemented a process under its general regulatory and new mortgage program approval authorities to ensure that the enterprises' financial activities are consistent with their housing mission. Given the short period of time available for HUD to evaluate new mortgage proposals, it is critical that appropriate expertise be readily available to fully assess the relationship of new proposals to the enterprises' housing mission. As we reported in March of this year, that expertise has not always been readily available in the past.
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    As you know, regulation of the activities of Fannie Mae and Freddie Mac involves two organizations, both of whom are here, HUD and the Office of Federal Housing Enterprise Oversight, that operate largely independently of one another. Over the years we have given considerable attention to the issue of regulation of the housing GSEs.

    On the basis of that work, we have identified five criteria that a GSE regulatory agency structure should meet. These are objective and arm's-length status from the GSE, prominence in Government, economy and efficiency, consistency in regulation of similar markets, and separation of primary and secondary market regulation. On the basis of these criteria, we have, for a number of years, recommended the creation of a single housing enterprise regulator.

    Since we developed this view, we have completed work on HUD and OFHEO and we are now nearing completion of our work on the Federal Housing Finance Board. This work provides further evidence that the current regulatory structure results in a fragmented approach to regulation that may not adequately consider potential tradeoffs between financial safety and soundness and the housing mission. As a result, we continue to support the creation of a single regulator for Federal housing enterprises to help ensure coherent and efficient regulation.

    In the meanwhile, we also recommend in our most current report that HUD in its current role propose to Congress that the cost of its housing enterprise mission oversight activities be borne by the enterprises, as is the case with the other GSE regulators.

    Finally, Mr. Chairman, as we were completing our work on our statement for this hearing, we received a letter from you requesting that we address several specific questions in our testimony today. Two of the questions, whether the enterprises should be assessed for the cost of HUD's mission regulation and whether we still favor a single regulator for both mission and safety and soundness for the enterprises, have already been addressed in my comments this afternoon. I will briefly summarize our thoughts on the other questions so we can create a complete record.
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    You asked whether OFHEO has addressed the shortcomings that we identified in our October 1997 report on its role as the enterprises' safety and soundness regulator. In that report, we identified several weaknesses in OFHEO's safety and soundness examination program. We also reported that OFHEO's effort to implement risk-based capital standards for the enterprises was taking substantially longer than originally contemplated by the Congress, which had set a December 1994 deadline, and that its current plan was to issue those standards by 1999.

    We issued a letter to you yesterday summarizing our current assessment of OFHEO's progress on these matters in which we observe that OFHEO has enhanced its examination resources and made progress in implementing a revised financial safety and soundness examination program. We also observe that although OFHEO officials report that they have largely completed the economic and technical components of the stress test necessary to complete the risk-based capital standards, the organization faces significant challenges in completing the rulemaking process and achieving their goal of issuance of a final rule in 1999.

    Your other questions address issues about HUD's current mission oversight activities. Can HUD manage its role, both as a business partner and a mission regulator of Freddie Mac and Fannie Mae? Can HUD or any other mission regulator effectively regulate the mission activities of large organizations like Fannie Mae and Freddie Mac with the level of resources currently committed at HUD? And does HUD's mission regulation role need to be statutorily strengthened?

    With respect to whether HUD has conflicting roles, as we have reported, the kinds of business partnerships you refer to can generate social benefits. However, they also present challenges, especially in maintaining HUD's independence. One reason why we have favored an arm's-length single regulator is that these challenges would not arise.
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    On the issue of resources, we believe that HUD, like many organizations, may be able to more efficiently and effectively manage its available resources to carry out its mission oversight responsibility. But we note in our report that some of HUD's mission oversight activities may be constrained by its having to compete with other HUD priorities for increasingly scarce appropriated funds. That is a major reason for our recommendation that the costs of their activities be borne by the enterprises.

    Finally, with respect to HUD's mission oversight authorities, we recommended in our March 1998 report that HUD implement its plan to develop criteria through appropriate rulemaking processes to help ensure that the housing enterprises' nonmortgage investments are consistent with the purposes expressed in their charter acts. If HUD is not successful in developing such criteria through rulemaking, further statutory guidance from the Congress may be warranted.

    With that, I have completed my statement and will be happy to take your questions.

    [The prepared statement of Nancy Kingsbury can be found on page 66 in the appendix.]

    Chairman BAKER. Thank you very much, Ms. Kingsbury. I appreciate your remarks very much.

    Our next witness is Mr. Ira Peppercorn, General Deputy Assistant Secretary for Housing of the Department of Housing and Urban Development. Welcome.
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    Mr. PEPPERCORN. Thank you, Mr. Chairman.

    Thank you for the opportunity to speak about the role of HUD as the regulator of the two largest housing Government sponsored enterprises, Fannie Mae and Freddie Mac. As the mission regulator of both of these institutions, we understand the importance of very meaningful oversight of the GSEs. I would like to thank the GAO staff for its study and for pointing us in some of the directions we need to go.

    What I will do in the testimony is, first, discuss the regulatory framework, then mention some of the accomplishments as the result of the 1992 act, and talk about the challenges ahead.

    In 1992, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act. The GSE Act reaffirmed HUD's oversight role and reinforced Fannie Mae's and Freddie Mac's obligations to fulfill public purposes in exchange for the substantial public privileges derived from being a GSE.

    The GSEs' public purposes include: Increasing the liquidity of mortgage investments, providing ongoing assistance to the secondary mortgage market for residential mortgages, and promoting access to mortgage credit.
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    The GSE Act established three housing goals to target a reasonable amount of GSEs' mortgage purchases to housing for very low, low and moderate income families located in central cities, rural areas, and other underserved areas.

    Additionally, the act created OFHEO, which my colleague mentioned. HUD's mission oversight is distinctly different and separate from that of OFHEO. Congress created OFHEO as an independent agency within HUD to provide safety and soundness oversight to GSEs. As the safety and soundness regulator, OFHEO oversees the GSEs' capital requirements and conducts regulatory examinations of the GSEs' business operations and practices to identify those that pose a risk to their financial viability, and, thus, potentially, to the taxpayer.

    HUD's mission oversight is different. It is the responsibility of a multi-disciplinary team which is experienced and knowledgeable with regard to housing finance, mortgage markets, and the regulation of financial institutions. The team's objective is to carry out Congress', your, intent to ensure that Fannie Mae and Freddie Mac meet their public purpose. We set, monitor and enforce the GSEs' housing goals, review new programs, evaluate fair lending activities, and monitor other activities.

    As an example of the quality of the team, to my left is Janet Tasker, who is the head of the housing office for GSE oversight. Her background is a significant amount of time in private industry, including service as the chief of staff to the president of Shawmut Bank, where she served on the board of directors. We work in HUD not just within housing, but across a broad range of cylinders, including policy and development and research, where we have two PhD economists, we have excellent help from the Office of the General Counsel, and we also receive help from the fair housing staff.
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    Team GSE, as it is called, works closely together to provide a consistent and coordinated approach to mission oversight.

    One of the main purposes of the housing goals is to encourage the GSEs to increase their purchases of affordable housing loans in three areas, low and moderate income, special affordable housing, and geographically targeted.

    When you take a look at where we are now, compared to where we were in 1992, you will see several main accomplishments: Increased performance trends under the housing goals, increased efforts to reach out to underserved families and communities, and, most importantly, expansion of the information available so that we can all understand the nature of the GSEs' mortgage purchases.

    As the GSEs' housing goal performance demonstrates, the percentage of mortgage loans purchased by the GSEs that were made to very low, low and moderate income families has increased steadily since 1992. The housing goals were set for a four-year period in order to allow the GSEs to devote resources to this effort, conduct necessary market research and develop affordable housing products designed to reach the underserved. You set it for a four-year period, knowing we would have to come back and reevaluate and see what we were doing well and see what we would need to improve, which is really where we are today. But the parameters that were set were viewed as a floor, not a ceiling. We have always hoped and worked with the GSEs that these targets, these goals, were a minimum level of performance and would also encourage them to exceed them.

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    You have in your testimony a chart that lays out what the required goals were, where Freddie Mac's performance was and where Fannie Mae's performance was and is today. Let me point out just a few highlights of what the chart shows.

    Under the low and moderate income goal, Fannie Mae's mortgage loan purchases increased from 34.4 percent in 1993 to 45.5 percent in 1997, or an increase of 11 percentage points over the five years. Under the special affordable housing goal, multifamily sub-goal, Fannie Mae purchases have increased from $2.06 billion to $3.19 billion, more than a 50 percent increase.

    As for Freddie Mac, under the low and moderate income goal, Freddie Mac's mortgage loan purchases increased from 29.2 percent to 42.9 percent in 1997. These are just examples. The full text of the chart is in the printed copy of the testimony. But the pattern is very clear, that the GSEs have substantially increased the percentage of affordable housing mortgage loans they purchase. The progress by the GSEs would not have been achieved had it not been for the enactment of the 1992 GSE Act by Congress. In order to achieve this level of performance, the GSEs have had to adopt new approaches and consider new ways to meet the mortgage credit needs of nontraditional borrowers. The initiatives are wide ranging. They include the development of new mortgage loan products and new technology to create outreach and education.

    In terms of the data we are seeing, when you go back to 1992, you will note that there was little comprehensive information on Fannie Mae and Freddie Mac's mortgage loan purchases. After the 1992 act, we were authorized to collect and analyze data so that we could understand the market better. Since then, we have established a detailed database containing loan level information on the GSEs mortgage purchases. At the time the goals were set in 1995, we only had two years of data available to the Department. We now have five years, and we can go back and analyze them in detail, knowing that we know much more about the nature of the GSE mortgage purchases than we did in 1995, knowing where we are succeeding, knowing where we need improvement.
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    Further, as required by you, HUD established a public use database to disseminate information on the GSEs' single-family and multifamily mortgage purchases. The purpose of the database is to aid mortgage purchasers and others in studying the flow of mortgage credit capital into America's communities. It is our belief that this database can become a full partner with the Home Mortgage Disclosure Act, HMDA, providing comprehensive information on residential mortgage markets.

    The research we have done utilizing the GSE data has helped fill what was called an information vacuum surrounding the GSEs that was noted by you, by Congress, during consideration of the GSE Act.

    The Department's research efforts subsequent will be including a report on the desirability and feasibility of privatizing the GSEs, releasing the GSE public use loan level database. These are some of the things that we have done: Issuing numerous analytical reports on GSE-related issues, and awarding grants and contract studies.

    Now, as I have talked about the accomplishments, I want to make note of where the challenges are. While Fannie Mae and Freddie Mac have made significant progress, there is room for further improvement. Analysis of the HMDA data shows that both GSEs lag other market participants in funding affordable housing loans for lower income families and in underserved communities. For instance, HMDA data shows that very low income borrowers accounted for 8.3 percent of the GSEs' purchases compared to 13.5 percent of mortgages originated by commercial banks.

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    Similarly, underserved neighborhoods, as defined by HUD, accounts for 20.3 percent of the GSEs mortgage purchases, compared with 26.1 percent of commercial bank originations.

    In addition, GSE data shows that only a small portion of their purchases support minority applicants. For instance, in 1997, according to the data, only 4.2 percent of Fannie Mae's purchases of home loans were for African-American borrowers; Freddie Mac's was even lower, at 2.8 percent. For comparison purposes, 1996 HMDA data shows that 5.7 percent of mortgage loans in conforming markets were made to African-American borrowers.

    Further, a recent study by the Federal Reserve Board examined the degree to which mortgage insurers, GSE, FHA, depositories and private mortgage insurers, are taking on the credit risk associated with funding affordable mortgages. The study compared market share and down payment data with data on projected foreclosure rates to estimate the credit risk assumed by each institution for each borrower group. The study found that Fannie Mae and Freddie Mac, together, provided only 4 to 5 percent of the credit support for lower income and minority borrowers and their neighborhoods, according to the Federal Reserve Board.

    I will conclude my remarks by discussing where the regulatory impact is and where we need to go.

    As you are aware, over the past year HUD has embarked upon a very significant management effort. At the cornerstone of this reform is Secretary Cuomo's focus on restoring the public trust, including a commitment to strong regulation and enforcement. Mission regulation of Fannie Mae and Freddie Mac is an essential part of this plan. While we believe we have built an effective regulatory framework, including a multi-disciplined and talented staff, we can certainly enhance and build upon this framework in a number of ways.
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    One: resources. Currently, HUD's budget for mission regulation of the GSEs is approximately $2.7 million, with 17 full-time equivalent positions. OFHEO's budget is $16 million to support 72 full-time staff in 1998. We are committed to allocating additional resources in 1999 to enhance our capacity.

    As the GAO report notes and was stated today, assessing Fannie Mae and Freddie Mac for the cost of the regulation may help the Department to devote additional resources to ensure that the GSEs achieve their public purpose responsibilities. The practice is common amongst other Federal financial institution regulators, including OFHEO, the Comptroller of the Currency, the FDIC, the Office of Thrift Supervision, the Federal Reserve Board and the Federal Housing Finance Board.

    Two: data verification. We agree with GAO that HUD should take further steps to independently ensure the accuracy and completeness of the data. In addition to the analyses HUD currently perform, a plan to independently verify the GSEs' compliance with counting rules and the accuracy of the data has been developed. This includes a review of the data quality and counting rule issues by independent auditors and HUD's on-site review of the GSE data collection process and application of the counting rules.

    We also are considering future rulemaking. The Department is now undertaking substantial additional research which will be utilized in considering the appropriate level of the goals for the post–1999 housing period. These goals include national housing needs, economic housing and demographic conditions, performance and efforts of the GSEs toward achieving the housing goals in previous years, the size of the conventional market, the ability of the GSEs to lead the industry, and the need to maintain the sound financial conditions of the enterprises.
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    We are also looking at nonmortgage investments, and we published an advanced notice of a proposed rule in 1997. This included the need for regulations governing GSE nonmortgage investments, the appropriate purposes for those investments, its need for restrictions and types of standards, and the appropriate nature of HUD's monitoring methods.

    In conclusion, we believe much has been done to carry out both the spirit and intent of the GSE Act of 1992. As a result, there has been substantial increase in the GSEs' purchase of affordable housing mortgage loans. Of course, there is more to be done and we continue to look for ways to improve our role as a mission regulator by enhancing our monitoring of the GSEs' programs and activities in order to ensure that the GSEs, Fannie Mae and Freddie Mac, achieve their public purpose responsibilities.

    Mr. Chairman, thank you very much for the opportunity to testify today. Secretary Cuomo has directed me to convey to you his personal assurance that an effective GSE oversight is a priority of the new HUD. We will continue to assess ways to increase our public purpose activities, to improve our Federal oversight, and we would be happy to answer any questions that you may have.

    Thank you.

    [The prepared statement of Ira G. Peppercorn can be found on page 164 in the appendix.]

    Chairman BAKER. Thank you, Mr. Peppercorn.
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    Our next witness is Mr. Mark Kinsey, Acting Director of the Office of Federal Housing Enterprise Oversight.


    Mr. KINSEY. Thank you, Mr. Chairman. I want to apologize for being late. We are on the wrong side of Constitution Avenue.

    Mr. Chairman and Members of the subcommittee, I appreciate the opportunity to appear here today to discuss the GAO report on HUD's role as a mission regulator of Fannie Mae and Freddie Mac. In addition, I will discuss the work that OFHEO is doing as the safety and soundness regulator of the enterprises, and I will address the questions you posed to me in your letter of invitation for this hearing.

    In the interests of time, I will omit certain sections of my written testimony, but I would like to request that the full text be included in the record.

    Chairman BAKER. Certainly, without objection.

    Mr. KINSEY. This testimony represents the views of the Office of Federal Housing Enterprise Oversight, which are not necessarily those of the President or of the Secretary of Housing and Urban Development.

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    Let me first start off by commenting on HUD's mission oversight of Fannie Mae and Freddie Mac.

    I believe HUD has performed its responsibilities well, given the resources available to it. It has established goals for Fannie Mae and Freddie Mac's purchases of affordable housing loans and a public use data base for these purchases. It has conducted research on the impact of the enterprises' purchases on housing opportunities and has fulfilled other regulatory responsibilities, such as new program review.

    Communication between HUD and OFHEO has been good, and the sharing of regulatory responsibility for the enterprises is working. Our coordination on new program approval is an excellent example. We provided our assistance to HUD in the drafting of their housing goals regulation, and HUD has been providing this to us as we develop our risk-based capital regulation. In addition, we provided suggestions on how they might proceed to ensure the integrity of the data submissions from the enterprises.

    We also share information on key industry trends, such as credit scoring and automated underwriting through informal discussions. Fannie Mae and Freddie Mac are continually innovating in their secondary mortgage market activities, and it is important for OFHEO and HUD to leverage our respective capabilities as we evaluate safety and soundness and mission implications.

    One innovation involves the purchases of mortgages that previously would not have been considered prime quality. This activity raises issues ranging from safety and soundness to affordable housing opportunity to fair lending that OFHEO and HUD have discussed and will continue to have discussions about in the future.
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    Now let me turn to the questions you raised in your letter of invitation.

    In its October 1997 audit of OFHEO, GAO made recommendations with respect to OFHEO's examination program and development of a risk-based capital standard. We have made considerable progress in both areas. GAO recommended that I periodically report to Congress on OFHEO's progress toward completing a stress test and risk-based capital standard. I have done that, and do so again today.

    GAO also recommended that OFHEO: one, examine the staff resources necessary to cover all risk areas on a one and two year examination cycle; two, identify the most appropriate examination cycle after considering the tradeoffs between examination coverage and resource requirements; and, three, develop a strategy for obtaining the necessary examination office resources. We have designed and implemented a comprehensive annual risk-based examination program that addresses these recommendations. This revised examination program is described in detail in OFHEO's annual report to Congress that we submitted last month. I will describe briefly the attributes of the comprehensive examination program.

    First, the examination program covers all of the relevant areas of risk, credit, market and operations, and the risk management techniques at the enterprises. The examination program requires that each area of risk and risk management be examined every year at the enterprises. By compressing the examination cycle and assessing all areas of risk and risk management annually, OFHEO will be positioned to communicate its findings to the enterprises and the Congress on a timely basis.

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    Second, in order to enhance its effectiveness, the examination program establishes a standardized vocabulary and sets out our expectations in evaluating safety and soundness at the enterprises. These materials have also been shared and discussed with both enterprises, and are highlighted in our annual report to Congress, and will be incorporated in our examination handbook.

    Third, building on the transparency of the examination program's standardized vocabulary and shared expectations, communication with the enterprises is another key attribute of our examination program. Our examination staff and the Director of the Office of Examination and Oversight are continuously engaged in a dialogue with all levels of the enterprises' management teams and their boards of directors. Maintaining a meaningful dialogue and exchanging views with the enterprises are critical to the effective implementation of our revised examination program.

    We have already seen that improved communications with the enterprises, together with the increased transparency, or clarity, about the examination program, have greatly enhanced the relationship between the enterprises and OFHEO. We remain committed to ensuring that this dialogue continues and that OFHEO's relationship with each of the enterprises strengthens even further.

    I am also pleased to report that we have moved aggressively to remedy GAO's concerns about the examination staffing level. We have not only increased and filled positions in the Office of Examination and Oversight, but we have also hired individuals who possess significant experience and expertise. Each examination staff member brings particular skills and knowledge to the program, and all have demonstrated the ability to communicate effectively with the enterprises.
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    You also asked me about both status of the risk-based capital regulation and its expected implementation. The risk-based capital rule for Fannie Mae and Freddie Mac will constitute a new approach in capital regulation. OFHEO is in a unique position relative to other regulators of financial institutions. Although Fannie Mae and Freddie Mac are very large companies, the range of their activities is narrow compared to the range of activities taken by the 10,000 banks and thrifts that operate in this country. Therefore, we can tailor a risk-based capital standard to the particular risk profiles of the GSEs in a way that has proven to be exceedingly difficult for the other financial institution regulators. We can use actual balance sheet information for the two institutions at a level of detail that is not possible for the regulators of significantly larger numbers of institutions. As a result, the risk-based capital standard for Fannie Mae and Freddie Mac will more closely align capital with risk and will promote an effective balance between financial safety and soundness and achievement by Fannie Mae and Freddie Mac of their public missions.

    The stress test is a simulation of the financial performance of the enterprises over a 10-year period. It begins with their actual assets, liabilities and off-balance-sheet obligations and simulates the financial cash flows that might result under specific economic conditions. In this way, it captures the effect of both the credit risk and the interest rate risk embedded in the enterprises' balance sheets.

    This approach reflects the risks to which the enterprises are exposed. We have had literally hundreds of meetings with the enterprises and other mortgage industry participants to enhance our understanding of the risks associated with secondary mortgage market activities.
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    The stress test subjects the enterprises to a common set of assumptions about economic conditions while at the same time reflecting the unique risk positions of each company. The factors that drive the stress test are the same for both GSEs. For example, a mortgage with a 90 percent loan to value ratio poses the same credit risk, regardless of the institution that holds it. Interest rate shocks will cause mortgages to prepay at the same rate, regardless of who holds them. What differs from institution to institution is the mix of risk and risk management practices.

    The stress test does not impose assumptions about relative risk as leverage ratios do. Instead, it models the cash flows of the enterprises' assets and liabilities. The results of the stress test reflect the risk management decisions that the enterprises make. As such, the enterprises can achieve their risk-based capital requirement by determining their risk mix and making their own risk management decisions.

    One other significant feature of the stress test is that it reflects changes in risk, both in terms of the financial condition of the enterprises and in terms of the conditions of the housing market. The risk-based capital standard, therefore, is dynamic, changing as conditions change and providing early warning when potential financial problems occur.

    We have made substantial additional progress on completing the proposed risk-based capital regulation since I was last before this subcommittee. Our efforts are now focused in four main areas. First, we are completing the technical documentation of the model which involves documenting the data variables, the mathematical equations, and the computer code. Second, we are using this documentation in our ongoing testing efforts to ensure that the stress test specifications which will be described in the proposed regulation are accurate.
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    Third, we are running an extensive set of simulations of the model to demonstrate how changes in the enterprises' risk profiles affect their capital requirements. The results of these simulations will be described in the regulation.

    Finally, we are drafting the proposed regulation. This is no easy task. We must provide sufficient detail for technical audiences to comment meaningfully on the stress test. Yet the regulation must be sufficiently clear for nontechnical audiences to be able to comment.

    As a result, the proposed rule will contain both general descriptions of the stress test and the policy issues and, technical details such as data inputs and mathematical calculations. All of this material is in various stages of drafting at this time.

    While significant challenges remain, it is still our goal to submit the risk-based capital proposal to OMB for interagency clearance by the end of September. Specifically, this will be in the form of a notice of proposed rulemaking. By Presidential order, OMB has 90 days to review regulations submitted by agencies. Because of the complex nature of this rule, however, OMB has suggested that it might need more than 90 days for review. However, OMB cannot be certain of the precise time that will be needed until it sees the proposed rule and until agencies like Treasury and HUD determine how much time they will need to analyze the rule. To facilitate the clearance process, OFHEO will continue to work closely with Treasury and HUD to brief them on the proposed rule, both before and after the rule is submitted to OMB.

    Following OMB review, OFHEO will submit the NPR to Congress for the mandatory 15-day review period. It is at this point, Mr. Chairman, that we will brief Congress on the specifics of the proposed rule.
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    Following the 15-day congressional review, the proposed regulation will be published in the Federal Register for public comment. It is at this point that Fannie Mae and Freddie Mac, as well as all other interested parties, will have an opportunity to analyze and review the regulation. In our 1999 performance plan, we estimate that the rule would be open for public comment for 4 months. With respect to potential requests for a longer comment period, I will reevaluate the time needed for the public to submit comments once they have had the opportunity to read the rule.

    The rulemaking process is designed to provide the public with an opportunity to comment on proposed regulations. It is OFHEO's responsibility to fairly and fully analyze the comments that we receive on our proposed risk-based capital regulation. How much time this will take is hard to estimate at this point since we do not know the volume or the nature of the comments that we will receive.

    What happens to the proposed rule after OFHEO has analyzed all of the comments depends on the nature of the comments. If OFHEO decides that significant changes are needed, we will be required to re-propose the rule and extend a new comment period. If OFHEO determines that significant changes are not needed, we will publish the rule in final form.

    Mr. Chairman, I appreciate the opportunity to testify before the subcommittee, and I will be pleased to respond to any questions.

    [The prepared statement of Mark Kinsey can be found on page 152 in the appendix.]
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    Chairman BAKER. I thank each of you.

    My first question, to Ms. Kingsbury, I note in the report that, according to your observation, HUD had neglected two ''important research issues.'' One issue is the impact of affordable housing goals on the interest rates and other terms of mortgage that Fannie and Freddie buy. The other issue is the effect of any change in these terms on the incentives primary lenders have to originate affordable loans.

    Given the significance of those two oversights, or inability to study appropriately, do you feel that without that information, neither HUD or the Congress can properly evaluate the effectiveness of HUD's affordable housing goals without research on those two points?

    Ms. KINGSBURY. We feel quite strongly that research on those two points is necessary for that kind of information to really enter the decisionmaking that has to be made for the future.

    Chairman BAKER. Also I note that there was a comment made that HUD was at least cautious in setting affordable housing goals for Fannie and Freddie because of the concern that taking more credit risk would weaken the GSE safety and soundness. But couldn't the enterprises at HUD's suggestion, congressional suggestion, raise their guarantee fees to cover the cost of the identifiable credit risk on loans that count toward these goals? In other words, isn't there a way to enhance the affordable housing accomplishments with some innovative process of guaranteeing against risk?

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    Ms. KINGSBURY. I am sure there is, and I am also reasonably confident that with some additional research, it is clear to us that further accomplishment is possible without affecting the safety and soundness at all, let alone the need to charge for additional activities.

    Tom, did you want to add anything to that?

    Mr. MCCOOL. I think part of our discussion, and in particular the discussion of multifamily goal, we talk about the issue of credit enhancements, for example, and other ways that Fannie Mae and Freddie Mac have to mitigate risk. I think there are lots of ways to either offset or reduce the risk that they take on with these projects, or to receive payment for the risk that they take on. I think our question and our challenge for HUD is to try to understand this better so that these can be better incorporated into the goals and the goals can reflect the relative degrees of risk they take and the extent to which there is value added in the transaction.

    Chairman BAKER. Stating it another way, you might have an impact on profitability of a GSE, but you would transfer funds from profit to coverage of risk assumed by the extension of credit to the lower income market.

    Mr. MCCOOL. Well, I think it is true that clearly there is different ways of pricing and taking into account the risk-pricing tradeoff. There is also the issue, I guess, which we didn't get into in too much detail in this report, about the possibility of using profits from one approach or one part of the portfolio to cross-subsidize a different part of their portfolio. That is a different question.
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    Chairman BAKER. Your report also indicated on another subject that when HUD considered Fannie Mae's request for approval of a new plan with regard to the, I think it is MPP, HUD accordingly did not take into account the cost in taxes in lost tax revenue of the GSEs' investment in cash value life insurance under that plan.

    Ms. KINGSBURY. That is correct, sir.

    Chairman BAKER. If HUD had taken that into the cost of accounting, the plan's benefit to the mortgage market probably would have diminished a bit.

    Do you think it was appropriate for HUD to ignore those tax consequences in making a decision, and, if it was, should tax consequences of a GSE program at least be reviewed by Treasury or someone competent to make those determinations?

    Mr. MCCOOL. I think we believe that somehow the social benefit and cost to the Government as a whole should have been evaluated in the program. There are different ways of doing that, but I think that some consideration to the tax consequences should have been included in the process.

    Chairman BAKER. If you look at the overall program costs, not just the mission costs.

    Mr. MCCOOL. Exactly.

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    Mr. PEPPERCORN. May I answer the question you asked before? You raised a question about whether or not HUD was too conservative. In some places—I come from Indiana—being conservative is not a bad thing. I think what I would say to you is look at the numbers. The housing goals for low and moderate income folks were set at 30 percent, and in the first year, in 1993, Fannie Mae's performance was at 34 percent. By 1997, it had climbed to 45.5 percent.

    Freddie Mac in 1993 was 30 percent, in 1997 was 42.9 percent.

    What I urge you, rather than say we are conservative or not conservative, look at the performance and the dramatic increase in the housing goals, because I think the record is there.

    Chairman BAKER. I certainly understand your point, and I would not at all argue with that. You raise an interesting issue though in that HUD does not verify, or at least from the report I am basing this statement, does not verify the overall integrity of the data collection with reporting of the enterprises, which is used to determine the compliance with the goals.

    Now, whether their achievement is actually higher or lower, isn't data verification an essential component of effective regulation?

    Mr. PEPPERCORN. I think that is probably somewhat misunderstood. We do an extensive analysis of the data, and we review the data and replicate the data. In fact, there are times when we do see inconsistencies, and we identify them and ferret them out. To be more specific, let me turn it over to Janet Tasker for her to tell you what are the specific things that we do to really analyze the data.
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    Ms. TASKER. Thank you. We get low level data on every mortgage loan purchased by the GSEs twice a year, and we take that data—they are required to report to us quarterly on their performance against the goals. We take that data and actually try to replicate the tables ourselves, look for—as we are replicating it, if we are not getting the same numbers, we start looking to see, asking questions in terms of why we are having inconsistencies. We work with the GSEs then to resolve the issues. At times the GSEs have resubmitted the data to us. Certainly we need to move to do an independent verification of the data, but we do believe that the work we have done is substantial.

    Chairman BAKER. Thank you. I have been told our clock is not working properly. Our lights have died. Ms. Kingsbury or Mr. McCool, would you care to respond to that point about data verification any further?

    Ms. KINGSBURY. We would grant that they have done some efforts to identify inconsistencies in the existing data and, as Mr. Peppercorn's statement said, there is a plan to do more, which will certainly take them another step forward in that regard. But the accuracy of that data is going to be critically important to making decisions about goals in the future.

    Chairman BAKER. At this moment there remains some question as to its validity?

    Ms. KINGSBURY. In the original reporting. You have to go out and check to make sure that the original data, the individual loan level data, has been accurately recorded and transmitted and added up. I think that is an important next step.
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    Chairman BAKER. Thank you. I know that I have gone on for more than five minutes.

    Mr. Vento.

    Mr. VENTO. Thank you, Mr. Chairman. I have to go to the floor on this trade issue that is going on, too, so I appreciate your recognition.

    I think the question that the Chairman asked was whether or not there has been any demonstration of inaccuracy or unreliability with regard to data. I didn't hear the GAO answer that question. I heard you say that you thought that the next step was positive in terms of doing research that Mr. Peppercorn referred to, but the issue is, I am saying, do we know, it is just a question we don't know whether it is accurate? You don't know whether it is accurate or not? There ought to be a demonstration, but there is no demonstration today of inaccuracy or unreliability of that data?

    Ms. KINGSBURY. We haven't done the work to look at that.

    Mr. VENTO. That is what I thought. Everybody wants more information, but as you compare this particular information that is used in this as compared to other housing data that we use, such as HMDA or other data, how does it compare? Is it about the same, is it a little better?

    Ms. KINGSBURY. Bill, you have worked more with that data than I have.
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    Mr. VENTO. In comparison to what?

    Mr. SHEAR. What I will say is that with HMDA data, there is certainly a question as to following up on the accuracy of it. There are similar issues here.

    In the case of HUD, we have a regulator that is the mission regulator, and do we know there is a problem? And the answer is no. The GSEs have reported to us that they undertake steps to verify their data. So is there something broken? We don't know and neither does HUD.

    In terms of data verification, one of the things I would like to point out here is that OFHEO conducted a data integrity examination at Freddie Mac about a year ago, and in that case we just saw, in terms of coordination with HUD, a lack of coordination. So what we are identifying is really what we think HUD should be thinking about going forward, rather than identifying any inaccuracy in the data.

    Mr. VENTO. I think it is important to just establish that, because I think some might imply that there is a problem with it. I note that HUD has suggested they are going to do several new research projects in terms of identifying. Hopefully they will lend themselves to demonstrate this data. But it is sort of the mission statement or mission regulator versus the financial regulator or fiscal regulator, as in the case of OFHEO.

    One of the aspects we are doing, for example, we are all ready now to expand the FHA program. I think after about five years we are probably going to raise the floor and raise the ceiling, not quite as much as the Secretary wants of the new HUD, but raise it. Now, will that mean to the GAO, is it your estimation that HUD will have to adjust its low and moderate income goals because FHA will be taking up a greater part of the market?
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    Right now, for instance, you did a report, I might remind you, my staff showed it to me, great staff, that about a third of the FHA loans probably qualify for PMI, or for private mortgage insurance. But the question is if we are going to expand the universe of those included in FHA, this is something the GSEs are obviously a little concerned about, but wouldn't that then mean we have to do something to change their goals, maybe reduce them or modify them to interface with this new FHA, Ms. Kingsbury?

    Ms. KINGSBURY. It may be we will have that implication. On the other hand, it is not clear to me that the market out there has a fixed outer edge. It may in fact be possible to expand both parts of the market. Without the research, without understanding the underlying variables, I am not in a position to say one way or another.

    Mr. VENTO. It is a variable that would have to be adjusted, assuming a constant in terms of—just as right now, I suppose, HUD has to adjust it, they can talk about their expanding conservative goals, as you identified them, as being simply a demonstration of sort of economic growth, increased home ownership, increased transactions in terms of turnover of mortgages. I don't know, it used to be about seven years. I guess in this climate it probably has been reduced some. Is that correct? In other words, those goals have to be adjusted based on what the market is. Interest rates go up and there is less turnover. That would be another factor, isn't it?

    Ms. KINGSBURY. All of those factors would have to be taken into account.

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    Mr. VENTO. Mr. Peppercorn, did you have any comment on the adjustment of goal issue?

    Mr. PEPPERCORN. Yes. The data we have shows that an increase in the loan limits, what it really does is expands the pie. We are not competing for the same slice of the pie. The majority of people that we serve, whether they are first time home buyers, minority buyers, whether they are people that do very high loan to value loans, are folks that are often not getting served in the market, period. So by increasing the loan limits, we don't think it is a market share issue. We don't think we wind up competing with Fannie Mae and Freddie Mac.

    Mr. VENTO. I know you don't believe that, but GAO thinks you may have to take into consideration, but I guess you are convinced that you are not in competition, FHA is not in competition with the private market. But I think there is some overlap here. They say that in the report here, there is some overlap. I think the net benefit, and the reason I support the FHA limits and ceiling and floor, in fact, especially the floor in Minnesota, is because I think that they will expand the market and it will help.

    Mr. PEPPERCORN. I think the point we are really heading to is really a learning point. We have gone through a curve from 1995 until now to say are the goals right? Should you adjust the goals? Are we in the right goals, regardless of the other side of the market. And I think that is really the point that we are coming to, is to say now that we have got the data, let us all look at it and let us see where the goals shall be improved, where do we need to set new goals, where do we need to verify the data, if in fact there is a problem, which we don't think there is.

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    But the issue is less the issue between FHA and Fannie Mae and Freddie Mac, and more look at the learning curve and together let's look at whether or not we need to revise the goals.

    Mr. VENTO. It all operates together. I wanted to point that out. I think one of the other questions you hit here is the issue of multifamily funding, which, of course, has been in the tank for many years now, it is coming out of it, I guess. The fact it has been a problem area in terms of lending, Fannie Mae says we will buy the paper, but if it doesn't meet the warrants and performance that you are subscribing as a financial institution, you have to take it back. You criticize them for that. But isn't that fundamentally one of their responsibilities with regard to warrants and representations in terms of paper? I understand what you are saying, but aren't we moving back and forth? You suggest that is really a reneging on their fundamental goal in terms of multifamily, that that is not a true commitment, as it were, to the goals that have been articulated here by HUD for multifamily lending.

    Chairman BAKER. If you can make it your last question? This round?

    Mr. VENTO. Absolutely.

    Mr. PEPPERCORN. We understand that multifamily lending is difficult, no doubt about it. We have seen an increase again in Fannie Mae from 1993 to 1997; it was double. Actually for both Fannie Mae and Freddie Mac it was double. So we are seeing an increase. But again, now that we have the data in front of us, I think this is the right time to go back and reevaluate the goal.
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    Mr. VENTO. My question is I think that is part of a market function.

    Ms. Kingsbury.

    Ms. KINGSBURY. I think there is perhaps a little bit of a misunderstanding about the point we are making about this. We are not commenting directly on how Fannie Mae or Freddie Mac conducts their business for these transactions, but rather raising a question, given those different credit enhancement arrangements, whether they should be counted in the same way toward the goals as other kinds of transactions where they absorb more of the risk. That is a question that is also susceptible to research, which is all we are really suggesting.

    Mr. VENTO. It gets us beyond the area. It is an argumentative point. In 1992 we said we won't get in the way of their doing the business in terms of market forces.

    Thank you, Mr. Chairman.

    Chairman BAKER. Mr. Snowbarger.

    Mr. SNOWBARGER. Thank you, Mr. Chairman.

    First of all, Mr. Peppercorn, I would like your permission to maybe quote you out of context, but in this election year it is nice to hear you say conservative is not a bad thing. If I can pull that out and use it in my brochures, I appreciate that.
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    My question may be a little different. I realize you are here as the mission regulator and not necessarily here to comment on questions that some of your testimony raised to me about the mission.

    In I believe, Mr. Peppercorn, your statement, you talked about GSEs lag other market participants in funding affordable housing loans for lower income families and in underserved communities. I guess the report also cites a 1996 Treasury study that Government sponsorship is indicative that HUD's housing goals have not materially affected the existing mortgage finance market for the targeted groups.

    First of all, do you agree with that statement or have any comment about that observation?

    Mr. PEPPERCORN. The statement was in two parts. The statement that the goals have not materially affected people and have not materially affected the population, I do disagree with that, because I think the numbers in the aggregate do not bear that statement out.

    When you drill down into the specific and you say, ''But are we succeeding together in all of the important markets?'', that is where we say there is room for improvement.

    So, yes, in the general performance, the numbers are very good. In the specific performance and targeted groups, there is room for improvement.

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    Mr. SNOWBARGER. Mr. Kinsey, do you have any comment on that aspect?

    Mr. KINSEY. No.

    Mr. SNOWBARGER. One more question, Mr. Chairman, and I will yield back. I think as we look through all of these GSEs and other kinds of Government-related programs, I guess we come down to a question at some point of if we are meeting a desired goal, if it is a program that Government should be involved in. I guess the bottom line I would like to hear again, I understand you are here as mission regulators and not as necessarily commenting on mission, but why should Fannie Mae or Freddie Mac, either one, be allowed to get affordable housing credits for loans for which private companies, insurance companies, the mortgage companies excluding Fannie Mae and Freddie Mac, which effectively bear all their risk, they don't get the same kinds of credits?

    Mr. PEPPERCORN. Well, I think we need to give credit where credit is due, and Fannie Mae and Freddie Mac are federally-chartered institutions. You have to take a look at what is in their charter versus what is in the charter of a private company. And we have an obligation because they are Government-chartered enterprises to comment on that as opposed to commenting on the issues of corporations that are in the private sector.

    Mr. SNOWBARGER. I guess the concern, actually it was your statement that raised the concern, that you are saying that these GSEs are not participating in as large a market share as the private sector, when maybe we would have expected they would be the major source of lending in that target area, target range.
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    Mr. PEPPERCORN. I think what happens is we get to a point where we have several years of data, and we look at it. We try to figure out when we see the data and there are weaknesses, what is causing the weaknesses. For instance, one possibility might be the ratio of the loan to the value that they will finance. If they finance a lower loan to value as opposed to a higher loan to value, that might be one of the things that is cutting people out of market in these specific targeted groups.

    So when you say, ''OK, you are doing a great job over here, but here is room for improvement'', we can all go back and say, ''OK, how to improve?'' I would suggest that one of the places might be in driving toward higher loan to value purchases.

    Mr. SNOWBARGER. I guess the question that that raises to me is if you were trying to analyze why these GSEs have a smaller share of the market than we might expect, is it because the GSEs haven't been aggressive enough, or is it because the private sector is moving in to meet those needs and perhaps questioning the basic mission of the two GSEs?

    Mr. PEPPERCORN. I think what happens is the housing market has learned a lot over the past few decades. If you go back to the 1970's, to do a loan that was higher than an 80 percent loan to value was pretty impossible. As you learn and you balance the mission with the risk, you learn that there are ways to increase the loan to value, but also keep a financial soundness.

    I think that is exactly what is happening, is that different segments of the market innovate and see that, yes, in fact you can. In fact, FHA—not to pat ourselves on the back—but, FHA has clearly been in that mode all along. How do you serve a population that is generally perceived as riskier in ways that really do not increase risk to the portfolio? I think the GSEs are learning and they will do better and we will certainly encourage them to do better in that regard.
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    Mr. SNOWBARGER. Thank you. Mr. Chairman, I yield back.

    Chairman BAKER. Thank you, Mr. Snowbarger.

    Mr. Bentsen.

    Mr. BENTSEN. Thank you, Mr. Chairman. Let me ask a couple of questions. With respect to the ceiling and the overlap in the raising of the FHA ceiling, isn't there a pricing difference that comes in to play between the GSEs, Fannie Mae and Freddie Mac and FHA? That is what HUD at least has asserted.

    Mr. PEPPERCORN. Yes, sir.

    Mr. BENTSEN. I don't know if GAO looked at this issue as well. But isn't there a difference in the servicing costs and the origination costs that would have some impact to deal with that overlap?

    Mr. PEPPERCORN. Our analysis shows that in loans of below 95 percent loan to value, that we are more expensive. So, in other words, if people have the opportunity—this is the whole competition argument. If folks have the opportunity to deal with other institutions, they will often do that. Then when you take a look at the very high LTV loans, where there isn't as much a difference in terms of pricing, what you find is that FHA does a significant amount of business in that area and other market participants do a much smaller business.
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    Mr. BENTSEN. Does GAO find that, or have you looked at that issue?

    Ms. KINGSBURY. We haven't looked at that issue, sir.

    Mr. BENTSEN. Do you think that would address some of the overlap?

    Ms. KINGSBURY. It should.

    Mr. MCCOOL. Yes.

    Mr. BENTSEN. Would that eviscerate some of the overlap?

    Mr. MCCOOL. Sure.

    Mr. BENTSEN. With respect to multifamily, if I understand correctly, GAO discounts the value of some of the multifamily investment because the credit risk is borne more by the borrower than the lender, is that correct?

    Mr. MCCOOL. Well, I think there are two issues there. One is we are not really discounting anything. We are just suggesting that the credit enhancement needs to be studied more carefully to be able to understand how it affects the transaction and the extent to which or how much it should count toward the goals. We are not saying credit enhancements are good, bad or otherwise. I guess the issue is whether the risk is borne by the GSE or by the originator.
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    Mr. BENTSEN. But, ultimately, I think I understand what you are saying, but I guess ultimately it would seem to me that the issue would be this, that you should be more concerned about the dollar value of investment if it is not otherwise being served, irregardless of the amount of credit risk that is being borne by the borrower or the lender. If it is an overlap, again, like going back to the FHA issue, then that is another matter. But if it is a product that may not be a conventional product, but, nonetheless, allows for investment that wouldn't otherwise occur in the multifamily market, shouldn't that receive equal weight with a more traditional product?

    Mr. MCCOOL. I think that is part of the question. We don't know what would have occurred and what wouldn't have occurred. One of the ways of getting at that I think is to think about what the value added is of the GSE participation. In many cases the GSE value added is to take on credit risk. There are many other things GSE would add to the market. That is not all of it.

    Mr. BENTSEN. Credit risk and liquidity and access to the market, which can be different things at different times or can be considered together.

    With respect to OFHEO, your risk-based capital plan, do you expect to have it done by September for OMB review?

    Mr. KINSEY. That continues to be our goal, yes.

    Mr. BENTSEN. So hopefully you think you will get it done by then?
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    Mr. KINSEY. We are going to try.

    Mr. BENTSEN. I know we have met about this before, but are you working with the various national rating agencies on the structured finance modeling that they use in developing your models?

    Mr. KINSEY. Yes. We have lots of ongoing conversations with the rating agencies about their approaches to rating structured pools and so forth.

    Mr. BENTSEN. I know the Chairman and I have had some discussions about the rating agencies not always applying their structured models to certain types of transactions where they might, but this is not one, I do not think.

    When you look at your models in trying to determine your risk-based capital rule, do you look at it in a consolidated fashion or do you always look at it in the sum of the parts, or do you—or as an aggregate, or do you look at it in a consolidated fashion where you can separate out different types of product portfolios which may have greater risks than others?

    Mr. KINSEY. I think the answer to that is both. For example, how the enterprises fund a mortgage depends a lot on their risk management techniques, whether they fund it with straight debt, callable debt, or whether they hedge it with some form of derivative. That all depends. So the risk to the corporation as a whole depends on the risk management technique. From that respect, we look at the company as a whole.
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    But I think our model allows us to say, ''All right, given their current risk preference and their current risk management techniques, tell me what the capital requirement would be if we increased $1 billion worth of 90 percent LTV 30-year fixed rate mortgages.'' I think our model would allow us to get a fairly good estimate of that. But it is contingent upon their current risk management techniques, and so there is a caveat to that.

    Mr. BENTSEN. So as I understand it, your rule might look at it—when looking at the individual parts, different risk management techniques would apply. It wouldn't be a one-size-fits-all.

    Mr. KINSEY. Absolutely not. In terms of the ultimate capital requirement for each of the enterprises, it depends in large part on each of the enterprises' own risk preferences and risk management techniques.

    Mr. BENTSEN. Even within one enterprise within their total portfolio, there could be numerous types of risk management techniques which the sum of those parts would be sufficient to meet the test that you all would require.

    Mr. KINSEY. Yes.

    Mr. BENTSEN. Thank you. Thank you, Mr. Chairman.

    Chairman BAKER. I understand Ms. Kilpatrick is going to forward her questions in writing.
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    Ms. KILPATRICK. Thank you. I would like to submit my questions in writing.

    Chairman BAKER. Thank you.

    Mr. Sessions, you are going to wait until the second round on questions?

    Mr. SESSIONS. That would be fine, unless you would like me to take that time now.

    Chairman BAKER. I will start, and then you will probably want to pick up on it.

    I want to come back to something I mentioned a little earlier and give Mr. Peppercorn a chance to respond. I asked the GAO their insights into the approvals concerning the mortgage protection plan which was submitted last year. Specifically in the report there is a charge that HUD staff lacked ''the experience and the intricacies of the cash value life insurance industry,'' and that HUD's analysis did not even include a consideration of tax consequences that would have benefited Fannie at the time of the proposal.

    I am trying to get an understanding of your analytical process in looking at these programs. Without regard to MPP, do you consider that assessment of your practices to be accurate or not?

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    Mr. PEPPERCORN. No. First in terms of the quality of the staff, as I have said, sitting next to me before is someone who was chief of staff to one of the major banks in New England. We have several Ph.D. economists. We have top notch lawyers. We were aware of the tax consequences, and so was Treasury. They opposed the proposal and they urged the prohibition in Congress. There was coordination.

    When the tax legislation was considered that year, Congress amended, you amended, the Internal Revenue Service code to bar the practice which was proposed.

    So in terms of coordination in the Administration and in terms of expertise and in terms of how it all worked out, I think this is one that was caught and caught right.

    Chairman BAKER. Let me ask then, prior to MPP's consideration, when was the last time HUD had not approved a Fannie or Freddie Mac programmatic request?

    Mr. PEPPERCORN. I don't believe we have. Is that true?

    Ms. TASKER. That is correct.

    Mr. PEPPERCORN. I believe we have not denied the requests. But, again, understanding you have to go up a learning curve, and we have to make sure that the analysis is right. These are publicly traded companies with major consequences. We do have to have high standards, and when we deny—what we have to do is really in a very targeted band; one, it is not consistent with their charter; two, that it is not in the public interest, or three; that OFHEO denies it. So we cannot just arbitrarily say, ''Well, we don't like that program.'' It either has to be not consistent with their charters or not in the public interest or a problem with OFHEO. The boundaries are very narrow.
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    Chairman BAKER. Let me get back to an earlier comment in your testimony. You contrasted your professional staff capacity and budget as against that of OFHEO. I drew from that the conclusion that you may need more tools. My question today is not to be critical of an individual, but to look at the capacity to regulate. The concerns I have gotten from the GAO report is the capacity may not be sufficient given the scope of business activity that exists within these GSEs. Can you comment on that?

    Mr. PEPPERCORN. I think, yes, I can, and thank you for the question. That was in the testimony in terms of the contrast and compare. Yes, we are smaller than OFHEO, and a proposal has been suggested by GSE to assess a fee along the lines of OFHEO or along the lines of several of the other institutions, that would in fact help us regulate in other areas, and that is absolutely something we are open to considering.

    Chairman BAKER. My concern is FHA—and I understand both GAO and yourself have commented it might not be in a competitive posture—but, some of us look at FHA as competitive to the interests of the two GSEs, competing for the low to moderate income market. On the one hand you will propose to assess a fee on two market participants and have a competitor who is an arm of your own agency. It would seem to be a little inconsistent in the normal model of regulatory oversight to have an agency in the business, practically speaking, competing with two others, who are somewhat treated differently.

    Do you see that as an operative problem?

    Mr. PEPPERCORN. Mr. Chairman, that is a very, very interesting observation. In essence, in some ways it has worked backward to that. If we were being true competitors in the marketplace, we would not be encouraging them to increase the business in an area that is perceived as ''ours.'' But our perspective on it is there is a population that needs to be served, there is a population that has often been missed, there is a population that needs housing, and that we at FHA are going to push to serve the population that has been cut out. And if there is a way we can encourage Fannie Mae and Freddie Mac to serve more in the targeted areas than they are already doing, then we will encourage that as well.
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    Chairman BAKER. One more question before I turn to Mr. Kinsey.

    What is the status of HUD's review on the comments received on your advanced notice of proposed rulemaking regarding the nonmortgage investments by Fannie Mae and Freddie Mac and when do you expect to make a decision whether to or not to issue a notice of proposed rulemaking? If your determination would be not to issue an NPR, would you be able to notify the subcommittee of reasons why you made such a decision?

    Mr. PEPPERCORN. I am going to ask Janet to comment. The long and short of it though is that we have gotten comments back. We are reviewing comments. I would like to turn to Janet Tasker for specific comments on the timing and the process.

    Ms. TASKER. We received the comments, they were due March 31, I believe it was. We have reviewed them. We are engaging in discussions with other regulatory agencies in terms of how they approach investments and to learn more information about what is happening on the regulation of investments by other regulators of financial institutions. We are also getting contract resources to help us with some additional analysis in this area. Our expectation is we will be making a recommendation to the Secretary in the fall of this year as to whether or not to proceed with a rule or not.

    Chairman BAKER. If you would, please, just make note that at such time that decision is formally made, the subcommittee would certainly appreciate the reasonings of your decision.

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    Ms. TASKER. Certainly.

    Chairman BAKER. Mr. Kinsey, according to the report of GAO, HUD had not conducted research to determine the effects of credit enhancements on multifamily mortgage financial and housing opportunities. Specifically the report states that HUD did not analyze whether or not enhancements limit liquidity by preventing lenders from diversifying credit risk and whether risk-based capital standards or recourse agreements negatively impacted depositors incentives to sell multifamily mortgages to the GSEs. Do you have familiarity with that area of concern and what would be your reaction, if you do?

    Mr. KINSEY. Our efforts in looking at multifamily with respect to credit enhancements are do credit enhancements protect the enterprises? So it is from that perspective that we have done a significant amount of research in preparation for the stress test.

    We have not looked at the potential impacts of requirements on depositories and whether that has an impact. No, we have not.

    Chairman BAKER. The other concern is the enterprises hold longer term nonmortgage assets having a less clearly defined link to their housing mission, and frankly are used to arbitrage for profit purposes. From your assessment as safety and soundness regulator, can you say whether this is in fact the case, or is that not clear?

    Mr. KINSEY. This is a gray area in my opinion. I think clearly there is a very valid public policy question here as to whether or not the enterprises should be using their Government sponsored status to engage in activities outside of their direct mission. However, there is a need for liquidity for the enterprises, and typically the enterprises do invest and park funds in instruments that are of high credit quality for short periods of time.
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    The question is where do you draw the line on the types of instruments? Is that appropriate? Where do you draw the line on the maturity and the credit quality? They have, in fact, investment guidelines in place that we have looked at from a safety and soundness perspective and which we think are OK. They are very consistent with the type of guidelines that large banks have. So from that perspective, we think that is OK. But there clearly are public policy questions involved in this as well, and it is going to be a hard question for HUD to answer.

    Chairman BAKER. Two process questions, and then I will turn to Mr. Bentsen.

    From the perspective of constructing the new rule, the new stress test, obviously there are two clear-cut ways to do it. One would be on your own, separate and distinct from the governed agencies, using your own experts and financial marketplace advisers; or to do more of a supervisory model where you consult with the agencies that are affected and determine whether their own self regulatory standards are adequate and competent to clearly reflect their financial condition.

    As I understand it, you have pretty much moved in the former mode and maintained an arm's-length distance from both Fannie Mae and Freddie Mac in the formulation of this new recommendation.

    Are there pitfalls with that? There may be some complaints made upon the release of your formulation that it was not sufficiently coordinated with the two GSEs, and therefore does not reflect a true regulatory method for their market perspectives. Is that a valid concern?
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    Mr. KINSEY. You have raised actually a couple of questions. Let me just start off by saying that we certainly think it is important for the enterprises to have their own internal risk models. If they did not, in fact, we would have a problem with that. So that is not really the question.

    The real question here is whether or not the Federal Government should have the independent capacity to determine what the capital requirements are for Fannie Mae and Freddie Mac. After all, it is ultimately the Federal Government on the hook for potential insolvencies with respect to these enterprises.

    Through the work that we have done on the stress test, the devil is in the details in terms of the numbers and the results that you get with the stress test. It would not be possible, for example, for us to even give a very long list of specific assumptions to Fannie Mae and Freddie Mac and hope to have any resemblance of equity in terms of the protection that their internal models would give to the taxpayer. You would in fact get different answers to that question.

    We think that what we are doing is in fact in the vanguard of where financial regulators are going. We are in fact using a models-based approach. We have spent an awful lot of time on this. As I mentioned in my testimony, we have met with the enterprises hundreds of times to understand how they measure risk. We have met with all types of industry participants in the secondary mortgage market to understand how they measure risk. We think we have a very good understanding of how that is done.

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    Also, we are in the unique position of only regulating two companies that are very similar in what they do. So we have the capacity to actually create a single model for both companies. The other regulators don't have that freedom or don't have the ability to do that, because they regulate literally thousands of institutions and don't have the capacity or the resources to gather the type of information that you need to create such a model.

    So I think our approach is by far superior. It ensures consistent terms with respect to the protection afforded to the taxpayer, and it ensures independence.

    Chairman BAKER. Does the congressional statute authorizing OFHEO to engage in the stress test construction arbitrarily constrain you? Are there other avenues which you may from a regulatory perspective choose to pursue, but, because the law is drafted in such a way, you are not comfortable in doing so? Or is it flexible enough to meet your needs?

    Mr. KINSEY. We think at this point in time it is flexible. I do not think it constrains us along the lines you have suggested.

    Chairman BAKER. Thank you.

    Mr. Bentsen.

    Mr. BENTSEN. Thank you, Mr. Chairman.

    Mr. Kinsey, did you say that you all will not address the nonmortgage investment issue?
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    Mr. KINSEY. We address it in our stress test. We look at the credit quality associated with those types of investments and apply appropriate capital requirements for the credit quality that exists.

    Mr. BENTSEN. But otherwise no rule with respect to——

    Mr. KINSEY. No, that is——

    Mr. BENTSEN. That is beyond your scope. That is a very difficult question, I think, just to make an observation, because I think you are right. I think you want to have these institutions to have the ability to make liquid investments that are prudent, and, on the other hand, you don't want to create a situation where arbitrage may look more inviting than what the original intent of the institutions were themselves. So I think we are going to have to be very cautious in how we approach that.

    Let me just make one other observation. With respect to the issue that the Chairman brought up dealing with FHA and the fact that there is no assessment on FHA for its regulation, yesterday when we were dealing with the VA-HUD appropriations bill, there was an amendment that was offered, and like a lot of amendments, did not get as much air time perhaps as it should have, that shifted the contract authority funding, which this year is discretionary rather than mandatory, out of FHA and into the Veterans Affairs health budget, which is certainly maybe no better place to put money than the Veterans Affairs health budget, but what it did in the process was to take away all of FHA's ability, all its contracting ability for its operations, which could conceivably, as we are told, block FHA from issuing new certificates. Surely this will not survive once we go through the conference with the Senate. But given the precarious nature of the appropriations process, it may be another argument for the FHA and HUD to look at going to the mandatory side of the ledger again and through some form of assessment. I don't know if you care to comment on that on behalf of HUD.
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    Mr. PEPPERCORN. Just in general, I think sometimes what appear to be simple technical accounting issues actually can have a very significant material impact. Our Office of the Comptroller is actively working on this issue. We are concerned and want to make sure whatever is done is the right thing.

    Mr. BENTSEN. Is it your impression, however, do you concur with the impression that that amendment would preclude FHA from operating in a normal function, both in terms of new mortgages being underwritten as well as the oversight and compliance of existing mortgages, including defaults and delinquencies and the liquidation of REO?

    Mr. PEPPERCORN. From a financial point of view, we are concerned. It is more of a financial and accounting issue than it is an oversight issue, but it is something that concerns us.

    Mr. BENTSEN. And would that ultimately affect the credit quality of the FHA portfolio?

    Mr. PEPPERCORN. I don't know if it would affect the credit quality, but it could certainly slow business down and slow it down dramatically. So this is an issue that has recently come up to us and we are working on very diligently. If there is any other information, we will get back to you within a day or two.

    Mr. BENTSEN. Thank you, Mr. Chairman.

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    Chairman BAKER. Thank you.

    Mr. Sessions.

    Mr. SESSIONS. Thank you, Mr. Chairman. I apologize for being late, but I came in on the tail-end of my colleague, the very gracious gentleman from Texas, who was engaged in a discussion with the panel today about risk management and those techniques.

    I have a question that perhaps has been asked, but I don't know. It goes directly to the report that we have here from the statement from Ms. Kingsbury. On page 11, I will direct this question first to Mr. Peppercorn and then to Ms. Kingsbury for some sort of evaluation.

    Page 11: ''HUD lacks focus and expertise as a financial regulator.''

    It says, ''Although HUD's staff has significant expertise in housing and related issues,'' which I believe you have reiterated, ''we,''—meaning GAO—''have identified weaknesses in HUD's capacity and focus as a regulator of financial institutions. We note that Congress reached similar conclusions when it passed the 1992 act.''

    This is now 1998. 1992 was a long time ago. I would appreciate, Mr. Peppercorn, if you could please address that for me.

    Mr. PEPPERCORN. Yes, sir. We had addressed it in part. The quality of the staff is actually quite high, is the first point. The second point is there has been a very conscious split between the office of the GSE regulations and OFHEO. So we are more of the mission regulator. OFHEO is more of the safety and soundness regulator. And from what we are seeing, the system appears to be working.
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    When it comes to the regulations, and I will turn it over to my colleague from OFHEO, when it comes to the regulations of what we are supposed to regulate, the data—regardless of what people might say editorially—the data is very, very strongly on our side in terms of the increase in the performance.

    Mr. SESSIONS. So, I hear you in your own words offer a disagreement, or a different conclusion than what might have been drawn.

    Mr. PEPPERCORN. I think GAO is always right to raise questions and concerns. That is a good thing. That keeps us in check. It makes sure that we are doing the right thing. But in terms of what the numbers say, the numbers are very good.

    If there are places to improve, then we and OFHEO will certainly look at that.

    Mr. SESSIONS. Do you know, and I am just looking at once again this report, I assume that there was more empirical data to suggest or to back up this. Were you aware of this and was there more information given, or is this just a statement that you had and it was up for interpretation?

    Mr. PEPPERCORN. I am going to turn that over to my colleagues from the GAO since they made the statement.

    Ms. KINGSBURY. It is fair. I would like to say at the outset, this whole issue is raised in the context of HUD's responsibility to approve nonmortgage investments. I certainly don't want any implication that we are saying that anyone currently employed in HUD is not qualified to do what they are doing. There are three Ph.D.'s on this panel from GAO. One of them has very little to do with this subject matter. Our concern in this issue is that the enterprises are devilishly clever, I think is the way I would put it, at coming up with new ways of investing and in managing their assets, and that is a good thing, but HUD has a responsibility for overseeing the nonmortgage investments to make sure that they in fact do fall within the mission. And as has been commented here, there are some gray areas that need to be looked at.
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    Mr. SESSIONS. So would I take it this is what I would say is a risk management, or a safety and soundness issue, to where you were looking at things that were inherent about their evaluation, that they did not include?

    Ms. KINGSBURY. There are safety and soundness issues sometimes. There were not in the one instance that raised this concern for us. The issue was more a question of given the short period of time, HUD has 45 days to approve or not approve these proposals from the GSEs. That is a relatively short period of time.

    What the one example that we looked at was, and reported on in March of 1998 suggested to us, that HUD ought to give some thought to making sure, not necessarily on their own staff, perhaps through contractor arrangements with academic experts, they had quick access to specific expertise when they see the next proposal being made by the GSEs that raising an issue such as, in that case, tax matters or something else that they had not necessarily built the expertise internally to deal with.

    We were just suggesting that some thought be given to the wide range of expertise that might be necessary in the future in order to more rigorously examine these issues and avoid the kinds of things and concerns that have been referred to here before about the potential for arbitrage profits.

    Mr. SESSIONS. I think I will tell you what I heard you say, and I am open for you to correct me, please.

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    Ms. KINGSBURY. Fair enough.

    Mr. SESSIONS. I have heard you say that within their evaluation, they do not include that criteria and they are maybe not, because it is not included in there, they need someone of the professional expertise to come and tell them what they should be looking for and to include that in their evaluation.

    Ms. KINGSBURY. There is the potential they could not be able to fully evaluate some aspect of a proposal that we can't see the shape of today.

    Mr. SESSIONS. So you tend to agree with me.

    Ms. KINGSBURY. Yes.

    Mr. SESSIONS. OK. Then my question would be, because I think somewhere along the line, and I think a lot of good things come out of a lot of hearings, could we come to some agreement that, Mr. Peppercorn, you could go back and specifically address this area, to where within a year or two when my Chairman calls another hearing and we have another GAO report, we can say with some bit of certainty that the management, including you, addressed specifically this issue and that we feel like it is satisfied, an independent investigation from GAO. Would you mind doing that?

    Mr. PEPPERCORN. I wouldn't mind doing that. I would be happy to.

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    Mr. SESSIONS. If you would do me a favor and at the time you determine that criteria, do me a favor and just write the Chairman a letter and say you are responding back to a question from the boy from Texas, and we will know we are trying to do the right thing.

    Mr. PEPPERCORN. We will be happy to do that.

    Mr. SESSIONS. Ms. Kingsbury, if you disagree with whatever that evaluation is, then offer some information that would help us get closer to that.

    Ms. KINGSBURY. We will be happy to do that.

    Mr. SESSIONS. Thank you so much.

    Thank you, Mr. Chairman.

    Chairman BAKER. Thank you, Mr. Sessions.

    Mr. Lazio, did you choose to make a comment?

    Mr. LAZIO. I just want to thank you, Mr. Chairman, for holding this hearing. I apologize for coming in late. We have had a few things going on. I just want to emphasize how important it is to continue to hold oversight hearings on the GSEs and how they are performing in terms of meeting some of their self-imposed goals and whether we should be reviewing that as we move toward all time highs in terms of home ownership. Clearly there have been folks left behind as we have been reaching these plateaus, including female heads of households, African-American heads of households, Latino heads of households. There is plenty of room to improve. Those numbers are down in the 40's, while the overall number is around 66 percent in terms of home ownership.
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    The other thing, there are certainly initiatives that I think we might be able to embrace to boost those overall numbers. It is interesting that we just had a representative of the Duma who has been visiting, Russian Duma, over here this week, looking for some support in developing effectively a GSE for home ownership over in Russia, and looking for some technical assistance. I hope I can work with you, Mr. Chairman, and possibly some members of the panel in order to give them the kind of advice they need to develop a secondary market and help them to boost home ownership as a means of people building equity and giving them the sense of being able to have a nest egg that they can borrow against for a business or for the furtherance of their children's education.

    So I just would ask for your assistance on that. You have always been a wonderful partner on everything we have done in terms of home ownership, together with Mr. Snowbarger and Mr. Sessions, who have also been outstanding on all of our home ownership initiatives. We will be moving to markup sometime next week in terms of our home ownership bill. This is a critical aspect of the high levels of home ownership, and I think the continued oversight of this committee will help us promote and develop new standards for the GSEs to meet in order to continue to beat expectations and create that goal of bridging the American dream to every American family.

    So I yield back the balance of my time, with my compliments and respect for your hard work.

    Chairman BAKER. Thank you, Mr. Chairman. I appreciate your work on the housing subcommittee. I feel confident there will be many opportunities for us to continue to work together over the next many sessions.
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    Let me just have one more procedural question, Mr. Kinsey, before we turn everyone loose.

    I note there was a working group earlier in the year trying to facilitate a timely resolution of the stress test preparation: Treasury, HUD, OTS, and OMB. It is my understanding OMB withdrew from that management team at some point. Was there any particular reason for the working group not continuing to formulate together? I thought it was excellent to try to expedite the process.

    Mr. KINSEY. You are going to have to ask OMB as to the reason they decided to withdraw their sponsorship of this. But no, there is no specific reason why OFHEO cannot continue to work with some of these agencies that you have mentioned. We are going to be working with Treasury and HUD to try to facilitate the clearance process by getting them up to speed on the rule, both prior to and during the clearance process.

    Chairman BAKER. Thank you. I just want to comment that I have had and maintain continued anxious enthusiasm to see your work product completed. To that end, anything the Congress or this subcommittee might do to facilitate that, I am certainly very much interested in it.

    I would add quickly as a caveat, there is nothing that I view in the current financial condition of any housing GSE that should give cause for any concern about taxpayer loss. In fact, all the housing outlooks, interest rate forecasts, economic models, continue to be staggeringly positive in their outlook. My role and the role of the committee is only to ensure that in the unfortunate but almost inevitable time in which we do have an economic cycle, that we are adequately prepared on that occasion to meet the consequences.
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    I would have to say in deference to all witnesses today, I certainly appreciate your comments, but I have not been made greatly at ease about our capacity to regulate what is a very sophisticated and fast moving marketplace. Although I know we are moving in the right direction, I will be very anxious to hear from the Federal Housing Finance Board in a report in September. I look with anxious eyes toward the completion of your work at the end of September, and hopefully there will not be need in the coming sessions of the Congress to make dramatic changes in regulatory structure. But I wish to express the view that unless we are able to get our arms around this in an adequate manner, that dramatic reshaping of our regulatory structure, as the GAO has suggested, is not outside the question. In fact, looking at the resources, even with OFHEO, albeit in a better financial and economic posture than that of the HUD regulator, you would appear on the surface of things to be outmanned in structural resources. It may be that a unitary regulator is the only way to get the presence, the visibility and funding levels in this city that are required to adequately do the work that is so vital in this area.

    So I am certainly not critical of your effort. I feel like you have come a very long way. We just have a very long road to travel. Hopefully we are getting closer to the end of it.

    Mr. KINSEY. I appreciate your support.

    Chairman BAKER. With that, I certainly thank all of you for your time and presence. We look forward to visiting soon. Thank you.

    [Whereupon, at 3:45 p.m., the hearing was adjourned.]
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