The Federal Housing Board's Responsibility for Safety and Soundness Regulation of the FHLBS

SPEAKERS       CONTENTS       INSERTS

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THE FEDERAL HOUSING BOARD'S
RESPONSIBILITY FOR SAFETY AND
SOUNDNESS AND MISSION REGULATION
OF THE FEDERAL HOME LOAN BANK SYSTEM

THURSDAY, SEPTEMBER 24, 1998
U.S. House of Representatives,
Committee on Banking and Financial Services,
Subcommittee on Capital Markets, Securities and
Government Sponsored Enterprises,
Washington, DC.

    The subcommittee met at 11:10 a.m. in room 2128 of the Rayburn House Office Building, Hon. Richard H. Baker, [chairman of the subcommittee], presiding.

    Present: Chairman Baker; Representatives Leach, Bachus, Royce, Sessions, Kanjorski, Bentsen, and J. Maloney of Connecticut.

    Chairman BAKER. I'd like to call this meeting of the Capital Markets Subcommittee to order, and make this observation: given the nature of the weather outside today, and the subject matter before us, it's obvious that we're lucky to have anyone in the room.

    [Laughter.]

    Chairman BAKER. But I do welcome all the witnesses.

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    In August 1997, the Committee asked the GAO to audit the Federal Housing Finance Board, which is the safety and soundness and mission regulator of the Federal Home Loan Bank. The result of the audit and the response of the Housing Finance Board were released on Monday and will be discussed here today.

    The GAO study followed a release of GAO audits of the Office of Federal Housing Enterprise Oversight in July 1997, and the Department of Housing and Urban Development in July of 1998. OFHEO is the safety and soundness regulator and HUD is the mission regulator for the GSEs, Fannie Mae and Freddie Mac.

    These audits have produced very useful information for the Congress on the safety and soundness and mission regulation of the housing GSEs. Each of these audits has pointed to substantial regulator concerns that offer meaningful opportunities for improvement.

    GAO, which performs the independent audit function for Congress, has issued critical observations of the dual regulatory role performed by the Finance Board, and the GAO also offers some suggestion of where safety and soundness regulatory responsibility may be strengthened. The Federal Housing Finance Board takes issue with these comments, and it is notable that this was the pattern of earlier GAO audits and related GAO oversight for the GSEs. I believe it worth mentioning that the earlier audits of the regulators, of OFHEO and HUD, have produced some measurable improvements in regulatory responsibility.

    The Congress does charter GSEs with definite market advantages. The financial obligations of the GSEs are contingent obligations for taxpayers. It is therefore incumbent upon Congress to make certain that the GSEs' market advantages are properly matched and measured against the public purposes for which they were authorized.

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    A significant advantage of the GSE is that its debt obligations are used by investors as an attractive alternative to the debt of the United States Government. This means that the GSE may finance at a narrow spread to Treasury obligations, and with modest extensions of maturity then invest the funds borrowed in order to earn arbitrage profits. Recently the Treasury provided the Finance Board with its views on the use of investments by the FHL bank system. I have asked the Treasury to testify today because I believe their insights would be helpful as we consider the Federal Home Loan Bank System modernization and the role of the Finance Board as a regulator.

    [The prepared statement of Hon. Richard H. Baker can be found on page 36 in the appendix.]

    Chairman BAKER. I do look forward to the testimony of each of our three witnesses here this morning, and I'd like to introduce first our Assistant Secretary for Financial Institutions from the Department of Treasury, Mr. Richard Carnell.

    Welcome, Mr. Carnell.

STATEMENT OF HON. RICHARD S. CARNELL, ASSISTANT SECRETARY FOR FINANCIAL INSTITUTIONS, DEPARTMENT OF THE TREASURY

    Mr. CARNELL. Thank you, Mr. Chairman.

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    I appreciate this opportunity to present the Treasury's views on the investment practices of the Federal Home Loan Bank System. We at the Treasury commend the leadership that you, Mr. Kanjorski and others have demonstrated in pursuing reform legislation and other policy issues relating to the System. These issues are of great importance, and the financial stakes are high.

    Although much about the System warrants scrutiny, the System does some good and could do more. We believe that for the System to achieve the goals we all have for it, the System must be refocused on lending to its members, particularly its community bank members, and must be stopped from conducting Government-sponsored arbitrage to earn artificially high net income.

    Mr. Chairman, let me turn now to the topic you've asked me to cover: the Home Loan Bank System's investment portfolio. Last year, the System issued over $2 trillion of debt securities. During the first half of this year, the System issued $1.2 trillion in debt securities and replaced the U.S. Treasury as the world's largest issuer of debt.

    The System's debt receives favorable treatment in the capital markets because of the System's Government sponsorship. In effect, the System can borrow at subsidized rates. Most of the System's debt is short-term, and thus poses less risk than the numbers might suggest.

    Yet we must ask why the System issues so much short-term, even overnight, debt only to reinvest the proceeds in other short-term capital market instruments. We must particularly ask why the System does this when its mission is to fund generally long-term mortgages. The answer is that the Federal Home Loan Banks are using their Government sponsorship to benefit their bank and thrift shareholders, even if doing so doesn't necessarily advance the System's public purpose. This arbitrage makes sense from the perspective of maximizing net income, but makes little sense from the perspective of public policy.

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    Since the early 1990's, the System has been increasingly borrowing funds in the capital markets and investing those funds in other marketable securities. As of June 30 of this year, the System's investment portfolio stood at $143 billion. Out of every dollar borrowed by the System, 43 cents goes into this investment portfolio.

    Now the System argues that these investments are necessary for three reasons. First, to insure that the Fedeeral Home Loan Banks have adequate liquidity. Second, to produce income to pay certain congressionally-imposed obligations. And third, to generate dividends sufficient to keep the System's members from leaving the System.

    We find these arguments unpersuasive. First, the Federal Home Loan Banks often argue that they need their large investment portfolios to maintain adequate liquidity: that is, to hold assets sufficiently marketable that they can easily be turned into cash. Yet the System's Government sponsorship gives it ready access to the capital markets, permitting it to borrow on better terms than fully private firms.

    The sheer size of the System's debt issuance demonstrates that the System has no difficulty raising funds whenever it wants in almost any amount it needs. Thus it need not hold a large portfolio of short-term liquid investments to maintain adequate liquidity.

    Second, although the 1989 thrift rescue legislation imposed two obligations on the System, those obligations do not explain current arbitrage. The first of the obligations is that the System must make $300 million in annual interest payments on the so-called REFCorp bonds. The second is that the System must contribute to its own affordable housing program the greater of $100 million a year or 10 percent of the System's net income.

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    In the early 1990's, thrift institutions' demand for Federal Home Loan Bank advances fell dramatically as the Government closed troubled thrifts, and as a national recession led other thrifts to decrease their borrowing. To meet the System's new obligations in the face of this declining demand for advances, the Federal Home Loan Banks sharply increased their investment portfolios.

    Whatever the logic of that step as a temporary measure, the circumstances giving rise to it are long past. The System's membership has risen steadily. So has the amount of advances outstanding, which has significantly increased the System's earnings. That means that the REFCorp and affordable housing obligations do not justify maintaining such a large investment portfolio.

    By the end of 1997, outstanding advances reached an all-time high of $208 billion, representing a 154 percent increase since 1992. Yet the System's investment portfolio also increased 88 percent in the same time.

    Given that you are today receiving a report from the General Accounting Office, it's worth noting that the GAO warned Congress and the finance board in 1993 that the Federal Home Loan Banks would do exactly what they have done: continue to use their new investment authority to increase their profits, even as any policy justification for the increased investments disappeared.

    The Federal Home Loan Banks contend that to keep the System stable, they need to pay a dividend adequate to retain voluntary members. The underlying reasoning goes like this: most Federal Home Loan Bank members join voluntarily. They can redeem their stock and leave on six months' notice. As profit-maximizing firms, these members are said to be ready to leave if the return on their Federal Home Loan Bank stock falls below some market rate of return.

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    Thus, the reasoning goes, since the Federal Home Loan Banks don't have enough lending opportunities to earn the desired rate of return, they should hold investments in order to maximize profits for members.

     Besides helping to retain existing members, paying attractive dividends also helps the System attract members.

    But this argument does not reflect the real economics of Federal Home Loan Bank membership, and ignores the overall benefits of the System's Government sponsorship. Banks and thrifts have powerful incentives to become Federal Home Loan Bank members regardless of dividend rates. The bottom line is that the overall economic returns of System membership, of which dividends are only one facet, are very attractive.

    Indeed, any argument that the Federal Home Loan Banks' current investment portfolio is necessary to make the benefits of System membership outweigh its cost seems dubious. From 1993 through 1997, only 25 institutions withdrew from the System, while more than 3,000 commercial banks became System members.

    Moreover, System members hold $2.3 billion more in Federal Home Loan Bank stock than the minimum required by law. This fact suggests that System members find the current return on their stock attractive enough to hold extra amounts of it: that is, as an investment, its return exceeds its opportunity costs.

    We believe that the System's large investment portfolio violates the spirit, and arguably the letter, of the Home Loan Bank Act. In our view, the only effective way to limit such investments is through objective limits on the amount of those investments. Thus we would propose as a general principle that the Federal Home Loan Banks' consolidated obligations should not exceed their advances. This would limit a Federal Home Loan Bank's investments to its capital plus its member deposits. Such a limit would still permit the Federal Home Loan Banks to hold a considerable investment portfolio.

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    Thank you, Mr. Chairman, for this opportunity to present Treasury's views, and at the appropriate time I'll be pleased to respond to questions.

    [The prepared statement of Hon. Richard S. Carnell can be found on page 73 in the appendix.]

    Chairman BAKER. Thank you, Mr. Carnell.

    Before I recognize the next witness, I understand Mr. Bachus may have to leave here momentarily, and I want to recognize him for a brief statement.

    Mr. BACHUS. I appreciate that, Mr. Baker.

    First of all, I want to thank you for calling this hearing. I think it's very important. I believe there's probably no more important oversight matter before the Committee at this time than this, and I appreciate your leadership.

    If I were to summarize my remarks in ten words or less, I'd just say I'm very concerned about the GAO report, and I would hope that we all are. The business of safety and soundness regulation must be taken seriously, and the GAO in this report details inadequacies of the type that have led some of our other industry sectors into pretty deep trouble—and in fact, in the case of the savings and loans, led to a huge bailout.

    I think we often see mission creep, and sometimes it can be a major problem for Government institutions. And the GAO appears to say that the Federal Housing Finance Board has some mission creep.

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    Let me point out specifically, Mr. Chairman, two examples that the GAO cites in terms of the Federal Housing Finance Board and the Federal Home Loan Banks. I don't know if it's a coincidence, but we're having this hearing today, and just yesterday the Federal Housing Finance Board announced that it will expand from $750 million to $9 billion the Chicago mortgage purchase pilot program and make it a nationwide program.

    That's right on the heels of the Finance Board being referred to by the GAO as lacking mission focus, as questioning whether they're an arm's-length regulator, their independence in regulating, and expressing growing safety and soundness concerns.

    So I basically have a number of questions. One of them concerns the authority of the Federal Housing Finance Board to expand this program, the readiness of the Board to deal with their portfolio investments of this large a scale, and the risk and underwriting standards that will be used to build this portfolio.

    I'm going to ask permission, Mr. Chairman to submit a series of questions for answer at a later time. Some of them will be: what are the specific housing goals of the program? What are the risk-based capital standards and other controls envisioned by the Chicago pilot project, and other questions.

    A second concern other than this expansion of the Chicago mortgage purchase pilot program is the borrowing patterns from the U.S. Treasury by the Federal Home Loan Banks. Treasury money intended for the mission of home ownership is being used to fund an investment pool. In fact, the Treasury Department itself has labeled the Federal Home Loan Banks' $150 billion investments as: ''An inappropriate use of the Federal Home Loan Banking System's Government sponsorship.''

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    That's a pretty serious charge. Congress itself only allows the Federal Home Loan Banks to invest for three purposes: deposit liquidity, reserves and surplus assets. This being true, figures suggest that the Federal Home Loan Banks' investments consist of some $108 billion in inappropriate investments.

    The FHFB has both management and regulatory responsibility for the Federal Home Loan Bank System. The GAO and others have pointed out that there are inherent conflicts in having both these functions. I would specifically point to page 8 of the GAO report, which really points out some pretty relevant arguments on why it's tough to do both these things.

    The approval and expansion of the Chicago pilot is a good example of how these distinct functions have become blurred, in my mind. How is it possible for you to be management in the morning and regulator in the afternoon?

    So those are some of my concerns. I would just sum up by saying that this is certainly a set of circumstances that demand more thought and consideration. And I said—$750 million to $9 billion, or did I say $900 billion?

    Chairman BAKER. I think you said $900 million. It's $9 billion.

    We'll make your inquiry part of the record for response at a later time.

    Mr. BACHUS. Thank you.

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    Chairman BAKER. At this time I'd like to recognize the Assistant Comptroller General of the General Accounting Office, Nancy Kingsbury, and Mr. Thomas McCool. Welcome.

STATEMENT OF HON. NANCY R. KINGSBURY, ACTING ASSISTANT COMPTROLLER GENERAL, GENERAL GOVERNMENT PROGRAMS, GENERAL ACCOUNTING OFFICE; ACCOMPANIED BY THOMAS J. McCOOL, DIRECTOR, FINANCIAL INSTITUTIONS AND MARKETS, GENERAL ACCOUNTING OFFICE

    Ms. KINGSBURY. Good morning, Mr. Chairman. Thank you very much.

    We're very pleased to be here today to share with you the results of our review of the Federal Housing Finance Board's regulatory oversight of the Federal Home Loan Bank System and its banks, and our more general views about regulation of the housing GSEs. As you know, we recently issued a report on this work that you referred to in your opening statement.

    Because that report and our written statement provide the details of the results of the work, I'll only briefly summarize our results this morning so the hearing can move on to questions of particular interest to you and Members of the Subcommittee.

    Tom McCool, who is joining me of course, and his team are responsible for completing this work. That work involved a detailed review of recent examinations and supporting work papers at half of the Federal Home Loan Banks, a review of the Finance Board's offsite monitoring practices and enforcement activities, and a review of the Finance Board's housing mission compliance program, and its role in managing and shaping mission activities.

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    As you know, this work completes a series of reports we've issued on oversight of the housing GSEs that we've undertaken for the Subcommittee, and our views about the regulation of the enterprises are based on the results of this substantial series of assignments as well as past work.

    Our observations about the Finance Board's oversight of the banks and systems are focused on four areas of concern. First, we reviewed the 1996 and 1997 examinations and supporting work papers for a sample of six Federal Home Loan Banks whose assets represented 60 percent of the System's asset at year end 1996. We found that examiners performed required examinations but did not follow all the policies and procedures specified in the Finance Board's examination.

    Most notably, examiners did not always assess critical elements of bank operations that the Board itself, other financial regulators, and we have evaluated as vital in evaluating an institution's risk management capability, such as internal controls, board of directors and management oversight, and reliability of internal audits. In some cases, these vital areas were not examined at all. In others, they were examined incompletely, and even when problems were identified, those findings did not lead to a more comprehensive analysis of other possible problems.

    None of our findings or other evidence indicates that a concrete safety and soundness concern exists today, and the System has governing regulations, internal and external audit requirements, and significant operating advantages that reduce the likelihood of significant losses, particularly during good economic times.

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    Nonetheless, a fundamental premise of financial institution regulation is that a sound, comprehensive examination process is critical to minimize the risk that unforeseen events, operational risks, or changing economic circumstances would lead to financial loss. The Board's recent actions to encourage the development of additional mission-related assets may also raise additional risks, making a comprehensive and thorough examination program increasingly important. On the basis of our findings, we did make some recommendations to the Chairman to strengthen the Board's examination program.

    A regulator's oversight of financial institutions often depends on other monitoring and enforcement activities. A second area of concern about the effectiveness of the Finance Board's oversight of the banks arises from weaknesses we observed in offsite monitoring of bank activities, and in enforcement programs.

    Recognizing the need for timely monitoring, the Board's Office of Supervision developed a regulatory oversight and offsite monitoring system in 1996 that required monthly reviews by examiners of bank data, including minutes of board of directors meetings, internal audit reports and financial data. In 1997, the practice of monthly monitoring was abandoned, reportedly because of lack of resources, and subsequently the data were reviewed only in annual preparation for examinations.

    Both the Board's Office of Supervision and the Office of Policy produced several periodic reports on such topics as financial management policy compliance, financial trends or unsecured credit which have some monitoring benefits. However, these offices did not coordinate their monitoring activities, and their reports are geared toward keeping the Board informed about the banks rather than keeping examiners appraised of the condition and current activities of the banks.

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    We also found that the Board's supervisory enforcement program does not have clear policies and procedures for taking enforcement actions, and does not specify what actions would be taken if certain conditions exist. While the Board appears to have been able to obtain bank cooperation in resolving issues that arose in examinations, our long history of work on GSE regulators identified certain principles necessary for effective enforcement of rules and regulations.

    One such principle is that certain enforcement actions should be mandatory when previously specified conditions are met, and should be the result of a clear and reasonable process. We believe that the Finance Board would be better assured of its ability to take forceful action in critical situations if its statute enumerated the authorities granted other GSE regulators, such as cease and desist and civil money penalty powers. Therefore in our report, we recommend that Congress grant the Board such specific enforcement authority.

    Our third observation is the Finance Board does not have examination policies or procedures to determine whether, or the extent to which, the banks are supporting their public mission of housing finance outside of its reviews of the special affordable housing and community investment programs, which are a very small portion of the System's activities. This key responsibility is especially important as the System expands its mission activities, and it is an important framework from which to consider the banks' investments that have been discussed further this morning.

    We recognize that mission compliance evaluation is a challenging task, and we note that the Finance Board has taken steps recently to better assess the System's mission compliance, such as requiring annual reports from the banks that describe their new products, pricing and investment partnerships, and developing and testing draft examination procedures related to mission compliance. We encourage the Board to continue its efforts in this important area.

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    Although the Finance Board has some similarities to other housing GSE regulators, the Board is more than just the System's regulator. It is also involved in various aspects of the System's business, including management decisionmaking. This type of regulator-manager structure is unique among the GSE regulators.

    Some of the Finance Board's business responsibilities arise from the Board's authorizing legislation. Others, according to Board officials, are undertaken to ensure the System's mission achievement. Whatever the origin of the Board's involvement in the promotion or management of System business, we remain concerned that combining the roles of oversight and involvement in System business may undermine the independence necessary for the Finance Board to be an effective safety and soundness and mission regulator.

    We believe that the Board should have regulatory authority over business functions to ensure safety and soundness and mission compliance. But we emphasize that having such regulatory authority differs from being a participant in System business on a regular basis, and from promoting a particular program activity over other mission-related activities. Mission promotion is not a substitute for mission regulation, which is to be built on measurable and enforceable regulations and policies.

    Finally, Mr. Chairman, the last issue you asked us to address today is our suggestion that Congress consider creating a single regulator to oversee safety and soundness and mission compliance of the three housing GSEs: the Federal Home Loan Bank System, Freddie Mac, and Fannie Mae. As you know, these latter entities are regulated for safety and soundness by the Office of Federal Housing Enterprise Oversight, an independent regulator within the Department of Housing and Urban Development, and by HUD itself, which has mission compliance responsibility.

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    In past work on the oversight of housing GSEs, we discuss the advantages and disadvantages of creating a single housing GSE regulator. Our continuing series of reports and oversight of these GSEs, as well as our current work on the Finance Board, have strengthened our conclusion that oversight of these housing entities would be more effective if combined.

    A single regulator would be more able to evaluate the tradeoff between mission and safety and soundness, as well as to evaluate the financial aspects of new mortgage products or other GSE activities such as non-mortgage investments, because it would combine expertise in housing and finance.

    A single regulator would be more independent and objective than separate agencies, because it would not be affiliated with one particular GSE, or dependent on the GSE for its continued existence and thus potentially subject to its influence.

    A single regulator would be more prominent in Government than the current agencies, which should further enhance the regulator's independence and make it more competitive in attracting and retaining staff with appropriate experience and expertise.

    For all of these reasons, we continue to support our 1994 and 1997 positions that a single housing GSE regulator be created to oversee the safety and soundness and mission compliance of the housing GSEs.

    That concludes my statement this morning, Mr. Chairman. We'll be happy to answer your questions at the appropriate time.

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    [The prepared statement of Hon. Nancy R. Kingsbury can be found on page 97 in the appendix.]

    Chairman BAKER. Thank you, Ms. Kingsbury.

    Our next witness is the Chairman of the Federal Housing Finance Board, Bruce Morrison. Welcome, Bruce.

STATEMENT OF HON. BRUCE A. MORRISON, CHAIRMAN, FEDERAL HOUSING FINANCE BOARD

    Mr. MORRISON. Thank you very much, Mr. Chairman, and thank you for the opportunity to be here this morning. And thanks to you in particular and to the Ranking Member of this Subcommittee, Mr. Kanjorski, and to your respective staffs for the active interest in the Federal Home Loan Bank System.

    You talked about the weather and whether people would be interested. In good weather and bad, you and your staffs have paid attention, and I think that's very much in the public interest and in the interest of improving the Federal Home Loan Bank System, and I thank you for it.

    We've submitted an extensive statement with attachments, and would ask that it be made part of the record.

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    Chairman BAKER. Without objection.

    Mr. MORRISON. And I will summarize what is contained therein.

    We appreciate GAO's contribution. It's never fun to be the subject of an audit of any kind, and I know that my regulated entities are enjoying this process very much, because they have the same reaction to our examination process as I imagine we have to this one.

    I am concerned at what I would call a mismatch between what the GAO actually did and looked at, and some of the rhetoric that emerged from it. The recommendations the GAO has made, as you will see, are relatively narrow scale, and while we could quibble with them in some regard, those are not substantial quibbles. The fact is that we will be reacting to those, taking those as items on which we can work, and hope to report back to you and to GAO over the months ahead in ways that will please you that we've listened carefully to those recommendations.

    But we do feel that in looking at the question of safety and soundness regulation that, while the statement this morning is more balanced, the report itself is not, in confusing the examination process and the overall program of insuring safety and soundness. This System, the Federal Home Loan Bank System, is the most conservative Government-sponsored enterprise—the most conservative in what the statute permits. And the rules under which the System operates are still more conservative than the statute in terms of the risks that are allowed to be taken.

    And in that context, the rulemaking, policymaking and compliance process that goes beyond the annual examination, but includes that, needs to be taken into account. And I concur with Ms. Kingsbury's statement that there is not a safety and soundness problem out there, that we never want one to develop, and that we will endeavor to make sure our examinations are as good as they can be, and that our policies are documented and followed as well as they can be.

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    But I don't think the Committee ought to believe that the overall framework under which operations are occurring raises any safety and soundness concern. And that is not because we're in good times. The safety and soundness of this System has been tested in the worst of times for the savings and loan industry in the 1980's, and the System has not fundamentally changed its risk profile since that time.

    Now the second half of the GAO's observations are more disturbing, and I would say, more confusing. That involves what they choose to call involvement in the business, and includes both managerial functions and an attempt to do what Congress has said, which is to insure that the housing finance mission is carried out.

    I would note that in what we are charged with doing, Congress has said we should ensure safety and soundness, and we should ensure that the housing finance mission is carried out. And ''ensure'' is a very strong word, and we take it as a strong word in both contexts.

    The managerial items—which are things like approving the dividends, things like setting the compensation for the employees, setting the rates and policies with respect to advances beyond safety and soundness and mission conformity—those kinds of managerial responsibilities don't belong with us. They are with us as a matter of statute. The Committee and we have long agreed that this should be changed, and in fact in both H.R. 10 and the Senate Banking Committee amendment to H.R. 10, these items are addressed. And we think that's important.

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    While there are those who would comment on our devolution regulatory actions as positive or negative, in fact the statutory change is the real solution to that problem.

    But managerial involvement is different from ensuring mission. And I fear that GAO is not really giving us any help, in the way that they talk about mission regulation. Because frankly, when I asked them what their model was out there in the world of GSEs that we should work toward, I didn't get an answer. And I frankly think there's no answer in this report.

    The fact is that mission oversight—and especially for a wholesale funding institution—is a real challenge, because somehow one must find an appropriate middle ground between interfering with the business and just permitting whatever the regulated entities want to do. We think this is a big challenge. We've spent a lot of time and money on it. We've done a recent study, and we've done a number of rulemaking proposals and policy proposals, and we're going to continue to work at it.

    We think this is relatively unplowed territory, and we're going to keep plowing. But the place where we really depart from GAO is not that we ought to learn to measure these things; we just think it's a tough job and we're going to continue to work on it. And not that we shouldn't say yes and no to particular activities as to whether they fall within or outside of mission conformity, but whether in addition the public sector representative in this public-private partnership ought to be aggressive in seeing to it that needs in the Nation are being addressed by this System.

    We think that when Congress said we should ensure that the mission was carried out, that didn't mean if the regulated entities feel like it, and ask us, we'll say yes; but if they don't feel like it, we'll sit there and say, ''Here's the measurement, Congress, they got 40 percent. What do you want us to do?''

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    We think when you said ''ensure,'' you meant do something to move it along. There is no evidence—you will find none—that the Finance Board has ordered the Federal Home Loan Banks to do a particular kind of transaction, a particular kind of business. But we have encouraged, maybe even jawboned, in order to get them to explore new ways of expanding credit availability for housing and targeted community investment in the Nation.

    Frankly, we think that's what Congress is expecting.

    If Congress is not expecting that, if Congress takes the rather passive view of mission regulation that GAO suggests, then I think Congress should change the word, because that's not ''ensuring.'' That's ''measuring'' and ''tinkering,'' but it's not ''ensuring.'' We think what you asked of us in safety and soundness is, if we see a problem, dive in there and make them change it. In fact, GAO's recommendation that we write specific rules about when we'll intervene in exactly what way to make sure that a problem in safety and soundness is taken care of is the thing they're criticizing with respect to mission regulation.

    Let me move on to the other part of this hearing, which has to do with the investment question, the testimony of Mr. Carnell, and some of the references in the GAO's testimony as well. First, let me say that this investment issue is a mission issue. There's been no suggestion that the investment portfolios of the Federal Home Loan Banks raise serious questions as far as risk. There are risks in that portfolio. They need to be managed. We are confident that those risks are being managed.

    However, the criticism is that the investments represent a misuse of the Government-sponsored debt authority such that profits are being made that ought not to be made off of that advantage that Congress has granted the Federal Home Loan Banks.

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    We at the Finance Board agree with the values that are reflected in GAO's 1993 report, in Mr. Carnell's testimony today, and in the Treasury's submission to the Finance Board, that arbitrage investment ought to be avoided; that it isn't why the Federal Home Loan Banks were created. They were created to directly assist credit availability through their members in communities. That's what the name of the game is.

    So there is no value difference. In fact, I would point out that among the GSE regulators, we stand second to none in our willingness to take on this issue. In fact, appended to my testimony is a staff report from March of this year in which these very issues are laid out. And in fact, Treasury's suggestion—that a certain relationship should exist between mission assets, like advances, and consolidated obligations—is exactly the approach that is contained in the staff paper. The questions are: what is the percentage: and what ought to be included in the numerator? We all know what the denominator is.

    So we're really not in any dispute over that. The real challenge is: how do you carry it out? What is the appropriate set of numbers that you ought to be using? Here there are a number of things I think the Committee needs to take into account.

    First of all, whatever the view of the Federal Home Loan Banks may be, it is not the view of the Finance Board that the goal is an attractive dividend. The Finance Board's view is that it is imperative as a safety and soundness matter—in pursuing this mission objective of reducing arbitrage—for the Finance Board to insure a stable situation, not to provoke a run on the Federal Home Loan Bank System; that it would be unwise to do so.

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    Now, there's speculation in Treasury's testimony about so-called ''non-financial benefits'' or ''non-dividend advantages'' of Federal Home Loan Bank membership, and what that may mean about dividend levels. Well, that's an empirical question, and we are going to be very cautious about the experiment. Because I don't want to be up here with you asking me why it is there's a huge run on the System, and it's all falling apart, and is there a risk to the taxpayer. I think that you want to make sure that I take that one real slow as we go, and that is what's suggested in the staff paper.

    The staff paper suggests that significant reductions in non-mission investments can be accomplished while still not in any way threatening the safety and soundness of the System. And that's how we ought to proceed. To the extent the suggestion is that you ought to write some kind of an objective standard into the law, I caution you against it. I think the regulator should have objective standards, and we are pursuing that. But if you write it into the law and you get it wrong, you're not going to be very happy with what comes afterwards. I think the regulator is competent to do that.

    When you think about arbitrage and the GSEs, please do not commit the offense that I see reflected in the Treasury's testimony—not one word about the other two housing GSEs. I've submitted to you as an attachment to my testimony a comparison of the mortgage-backed securities investments of the Federal Home Loan Banks and of Fannie Mae and Freddie Mac. And when you read the numbers and see the multiples of capital, you will know that the Federal Home Loan Bank System is a piker in this business.

    And of course, the dividend that's being criticized here is based on a rate of return on equity for the Federal Home Loan Bank System of about 8 1/2 percent. Contrary to what Mr. Carnell said, this has not gone up. The profitability in ROE terms has not gone up significantly since 1993. It's been preserved, but it has not significantly increased.

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    That's as compared to rates of return for the other two housing GSEs that exceed 20 percent, and the dividends go to the financial institutions that are extending credit in the Federal Home Loan Bank System. In the other two GSEs, they go to private shareholders in the marketplace.

    So if you're concerned about arbitrage, please think about whatever rule is established ought to extend across the board for fairness, for efficiency, for appropriateness and to see to it that the market remains competitive. That has not been the rule in this discussion up to now.

    Finally and last—and I thank you for your patience in giving me this much time—with respect to the reasons why there is arbitrage, the one thing that has not been mentioned is the most important reason. The capital structure of the Federal Home Loan Banks contained in the statute is inflexible. By its nature it collects more capital than the core business requires.

    This is because the subscription requirements for members is not based on the needs of the Federal Home Loan Bank balance sheets, but on member balance sheets. So we have overcapitalization, and therefore a problem of how you pay a rate of return.

    If you eliminated all of the non-mission activities today, the return on equity of the stock would fall to between 2 and 3 percent, whether it's paid out in a dividend or in some other way. This is par stock. You only get the value through a dividend. That I think would be a problem.

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    The most important thing the Congress can do to assist us at the Finance Board in limiting arbitrage investment is to fix that capital structure. You, Mr. Chairman, did that in your amendment to H.R. 10. There were discussions to modify and in some ways even improve upon that in the Senate, but they've fallen by the wayside.

    In what the Senate Banking Committee reported, they did not include the reform of capital. In fact, they made the capital situation worse by creating universal voluntary membership, eliminating mandatory capital, and not at the same time reforming the capital structure. That is very unfortunate.

    If there is a conference on H.R. 10, I would hope that the Members of the House will hold firm to the need to reform the capital structure at the same time as you reform the membership. And I thank you, Mr. Chairman.

    [The prepared statement of Hon. Bruce A. Morrison can be found on page 218 in the appendix.]

    Chairman BAKER. Thank you, Mr. Chairman.

    I would like to start my questions with Mr. Carnell, relative to the observation that the scope of the GAO report did focus on what they saw as regulatory insufficiencies and investment practices which were of some concern. At the same time, little mention has been made by that report or yourself with regard to capital adequacy, which I think investment reform and capital adequacy are the two things I had hoped we could accomplish. Unfortunately, both are left out of the H.R. 10 as it's currently constituted.

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    I would like your response to points made by Chairman Morrison in his written testimony, where he cites that the Home Loan Bank System's debt to 20 times capital assure that the banks have capital-to-asset ratios which approximate the 5 percent ratio for well-capitalized depository institutions, and are about twice the 2 1/2 percent capital-to-asset requirements for Fannie and Freddie.

    On a risk-adjusted basis—skip across here a little bit—the banks held over 22 percent risk-based capital at year end 1997. Taking that statement as being absolutely accurate, I still have capital concerns. But my issue is, why don't we hear these same concerns directed toward the other housing GSEs with regard to capital? And of the Treasury's list of things that bother you, is investments number one, or is capital number one?

    Mr. CARNELL. Our top two targets—and I'm not sure I could put one above the other—would include insuring that there is a close link between the activities of the System and the mission of the System. We don't believe that's true in existing law, and we don't believe that either bill currently pending would achieve the appropriate linkage.

    Our second top priority would be curtailing the investment activity of the System, which we believe does not promote its mission and is an abuse of its Government sponsorship.

    We do believe it would be desirable in principle to reform capital, but there are differences of views about how that ought to be done. We believe that the existing redeemable capital structure of the System, with some adjustments, is appropriate to retain. We'd like to see one class of stock, so as to avoid giving one group of shareholders incentives to have the System take risks at the expense of others. We've said all along that equal rights and responsibilities among members should be a hallmark for reform of the System.

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    I think that hits the basic points that we have here.

    Chairman BAKER. Let me follow up more specifically.

    GAO has consistently supported the concept of a single housing GSE regulator. Wouldn't that also go to the point of having uniform standards for regulatory purposes? What continues to bother me is that it appears that we look at each GSE slightly differently, I think, given the nature of their similar missions and function.

    Where is Treasury on that point?

    Mr. CARNELL. Well, there's a lot to be said for looking at the GSEs together as well as separately. There are separate challenges in dealing with policy issues connected with each of them, but there are also a lot of common characteristics.

    Earlier this year, in a letter to the General Accounting Office, the Treasury said we believed it was appropriate for the investment activities of all the GSEs to get closer scrutiny, including closer Congressional scrutiny, than they have historically received.

    Now I think that the GAO makes some very cogent arguments about why a single GSE regulator would be desirable. These include the increased prominence in the Government of such an agency, which would be a strength in recruiting and retaining people at all levels for the agency; some potential for increased efficiency; and greater independence from the entities regulated.

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    I think it's well understood that it's natural for any regulator to have a kind of symbiosis with the regulated entity. That's not wrong in itself. That's human nature. To some degree, you identify with people that you spend a lot of time thinking about. The challenge is, how do you structure the regulatory System so you build in an appropriate degree of independence for the regulator?

    There's a lot of experience suggesting that a regulator who regulates institutions that differ significantly from one another—whether it's large banks and small banks, or whether it's different kinds of financial institutions—will tend to have much greater independence from the regulated industry than someone who regulates very homogeneous entities.

    One dramatic example of that can be found in the savings and loan debacle. The States where failed thrift institutions caused the largest losses to the Federal Savings and Loan Insurance Corporation were, with only one exception, among the minority—about one-third—of the States that had a separate thrift regulator. States where the State banking commissioner was also the State thrift regulator—the majority of States—in most cases did not contribute greatly to the insurance fund's losses.

    And I think it's reasonable to infer that this resulted in part because the State banking commissioners, who generally regulated a bunch of different kinds of institutions—banks, thrifts, credit unions, perhaps others—were able to have a greater degree of independence than regulators whose very existence was closely linked to thrift institutions, and closely linked to them at a time when they were under stress.

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    To put it in a broader perspective, we find many of the reasons stated by the GAO to be cogent. But since two of these GAO reports have only recently been issued, we do need more time to consider their findings and weigh the options available. When we've done that, we'd be very glad to work with you in considering these issues going forward.

    Chairman BAKER. Thank you.

    Just for clarification, I think I perceive your answer properly, but I want to make sure.

    Does that mean your position is you do favor a single regulator, or you do not?

    Mr. CARNELL. We're not taking a bottom-line position on that right now, because we'd like to be able to go over the recent GAO reports more closely. But we do find the reasons cited by the GAO to be cogent.

    Chairman BAKER. I'd just further add—I find the mission, function and operation of the three housing GSEs so similar I cannot fathom how we could distinguish that there should be a separate regulator, when the FDIC governs a broad array of financial activities, and your own argument says that for a regulator to be associated with diverse activities strengthens the arm's-length capacity of that regulator. So maybe we can revisit that at another time.

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    Since we have such a large array of Members here, I hope Members will give me just a little more latitude to move forward. I assure you we'll grant wide latitude to everyone.

    Ms. Kingsbury, I appreciate your work. Thank you for the difficult task that the GAO has in carrying out some of the Committee's requests.

    I know there are aspects of your report with which Mr. Morrison has deep differences. But I do appreciate your ability to look inside and give the Congress direction.

    Your report recommends that the Federal Housing Finance Board take several actions to strengthen its primary oversight role as the safety and soundness supervisor of the System. Are there specific action steps which you're prepared to recommend, since your report also goes on to suggest the establishment of a single regulator? Do we in the short term take statutory steps to strengthen the hand of the Finance Board, or should we simply press on toward the consolidated single regulator and fix the problem?

    Ms. KINGSBURY. Well certainly, on the safety and soundness side, I think Mr. Morrison makes a number of very strong arguments about the existence of a strong and safe System. Our concerns are not so much with the policies and procedures and examination manuals that the office has, but rather that they are incompletely carried out for what may be a variety of reasons, and don't approach a systematic top-down examination function the way we have seen it in other regulators.

    We've done work in most of the financial institution regulatory bodies, and we wouldn't recommend the approach in this one to substitute for the ones we see elsewhere. So I don't know that we're saying that there needs to be any statutory changes within the Finance Board. And the issue of the single regulator is much broader than the examination function.

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    Our real concern there is the strengthened ability it gives the regulator to look at the tradeoffs between mission compliance and safety and soundness. And this would apply to all the GSEs.

    Chairman BAKER. I take it, as I understood the report, your findings were such that the Finance Board may have not been complying with current regulatory requirements in fulfilling its regulatory mission.

    Ms. KINGSBURY. Certainly with their examination procedures: yes, sir.

    Chairman BAKER. One last question.

    In your judgment, does the Finance Board have the necessary capacity, procedures, information stream available to it, to properly monitor the use of the arbitrage; in that, are we able to know the extent to which that investment portfolio does or does not support residential mortgage lending?

    Ms. KINGSBURY. As we have said in some of our other GSE reports, we don't address it directly in this one because we didn't look at investments as directly in this one.

    The question of the relationship of an investment to mission is a continuum. It's not it is or it isn't. Some of them are more closely related than others. Some seem to us to be considerably less related than others. Where you draw the line in that continuum about what's acceptable and what's not is not something we think it's our role to decide. But we certainly think that continued Congressional attention to that would be very important.

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    Once those criteria are made somewhat clear, it may be possible to figure out more about what a given investment portfolio looks like.

    Chairman BAKER. An additional follow-up thought along that line.

    What if anything does your report suggest that the Committee take action on on a statutory basis? As I've read it, it's principally advisory to the Chairman that abiding by current rules for examination purposes is important, and that doesn't require our action.

    That we may consider a single regulator as a matter of policy at some future point—but between those two internal mechanisms of concern and the creation of a single regulator, are there other steps which you are suggesting we should take?

    Ms. KINGSBURY. The one other thing we do mention in our report is that we do recommend that the Finance Board be given more specific enforcement powers in carrying out its examination function. Other regulators have cease-and-desist powers and civil money penalty powers.

    While there's nothing that we see in the current Federal Home Loan Bank System that would necessarily warrant stepping in with those powers, they're useful to have in a critical situation, and we think that could be rectified.

    Chairman BAKER. Thank you very much.

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    Mr. Chairman, I'm going to have questions. But in deference to other Members' time, I'm going to recognize Mr. Bentsen at this time.

    Mr. BENTSEN. Thank you, Mr. Chairman.

    Mr. Carnell, is the Treasury objection to the level of debt, non-mission debt issuance on safety and soundness, or is that part of the historical aversion of Treasury to arbitrage; that this is an artifice that is being exploited by the Federal Home Loan Bank System?

    Mr. CARNELL. It is essentially the second of the two you list. And if I could just restate the point, Congress established the Federal Home Loan Bank System for a specific purpose. Like other GSEs and unlike, say, a regular commercial bank, it isn't chartered to do any lawful business in a broad area of financial services. The System was set up to correct specific kinds of market failures.

    And our concern is that 43 cents in every dollar being borrowed by the System is going into this portfolio that, by and large, does not advance the System's mission. It's bulking up net income, but not advancing the mission, and it's in there in the market with Government agency securities.

    We think that is a misuse of the privileges that have been accorded to the Home Loan Bank System.

    Mr. BENTSEN. But of the 43 cents that represents the non-mission debt, Treasury has found no yield off of those investments that otherwise flowed back into the mission of the bank System?

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    Mr. CARNELL. We don't believe that there's any appreciable contribution. Let me be more specific.

    Mr. BENTSEN. It sounds to me what they're doing is, they do have a market advantage. They're able to borrow at one price, they're issuing debt at another and there's an arbitrage play. And so there's a spread they're earning. Otherwise they wouldn't be doing it.

    Now I have some concerns with respect to potential safety and soundness that might occur with that, and Congress probably has to make a decision at some point as to whether or not we think this is an unfair advantage. We've done it in other areas before. But you're saying that none of that spread goes back into the mission in any form?

    Mr. CARNELL. None is a very strong word, Mr. Bentsen. But I think that whatever really goes back into furthering the System's mission is negligible. Let me be specific.

    Among the arbitrage investments are mortgage-backed securities. The Federal Home Loan Bank System borrows at below-market rates in the GSE market, and invests at market rates in the mortgage-backed securities market.

    Now if you went back to a very old way of thinking about the thrift charter, you might say, well, this is housing, because the mortgage-backed securities fund housing. And so therefore there must be some connection to the mission.

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    But the fact is, as you know, that the mortgage-backed securities markets are about as deep and liquid and efficient as any markets in the world. They're extraordinarily efficient. And Federal Home Loan Bank purchases of mortgage-backed securities are a negligible part of the overall market.

    If the home loan banks were to phase down their investment portfolio, their withdrawal would not be——

    Mr. BENTSEN. I agree that's a hollow argument. The point I'm going to make is that, if they're borrowing at 5 and investing at 5 1/4 percent, what are they doing with the 25 basis point spread?

    Mr. CARNELL. It's increasing net income.

    Mr. BENTSEN. It increases net income, so it's just going back to the shareholders of the System?

    Mr. CARNELL. Or others such as System insiders who are able to have a higher level of expenses.

    Mr. BENTSEN. But not into the AHP or CIP programs, or by increasing return to shareholders. That doesn't in any particular way benefit the System?

    Mr. CARNELL. The AHP and REFCorp are expenses of the System, and the arbitrage program makes more money available for the System to pay its expenses.

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    Now Congress didn't contemplate that there was going to be an arbitrage program at the time that these obligations were imposed. They were part of a Congressional decision to essentially raise the rent on the System, to demand more of it in return for its Government sponsorship.

    The rest, beyond what the System spends on its own expenses and on its various programs, goes to the member banks and thrifts.

    Mr. BENTSEN. Ms. Kingsbury, in your analysis, did you find any safety and soundness issues? Now, I realize that the banks are better capitalized per se to the other GSEs. But again, even the wisest investment in triple-A mortgage-backed securities can at some point lose money.

    Did you all find any level of concern or lack of oversight in terms of maturity matching or interest rate risk?

    Ms. KINGSBURY. No, sir, we didn't. But one of the points that we make with respect to our comments about the need to have a more comprehensive and systematic examination program is that, as the Board moves into other areas which may in fact be, if not backed by less collateral certainly backed by different collateral, that risks may in fact be different and need to be overseen rigorously; and that that kind of examination program is going to be more important as these things happen.

    So that's really the only indicator we have of concern.

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    Mr. BENTSEN. Mr. Morrison—and I'll finish up, because I know we're out of time—two things you can answer for the record as well.

    One of the arguments made is that you need to increase return to your shareholders, since it's a voluntary system for most, in order to keep them in the System, although Treasury points out you have had actually a net increase in the number of members if I read that correctly.

    There's certainly a benefit that members get from the System other than return on their equity investment. And in addition, I've heard from some who are concerned about the proportionality or the lack of proportionality of shareholder power, I guess, within the System. I think there's a cap at which point all shareholders are treated the same, so larger members cannot dominate the System.

    Would it perhaps be more appropriate to lift that cap, if that's the case? And second of all—and you can answer for the record, if you want—I appreciate the idea of earning arbitrage when there's a legal arbitrage opportunity available, even if it's an inefficiency that's legally created in this case.

    But at some point, shouldn't the Congress be concerned that if the level of debt continues to get higher and higher, and the earnings aren't completely plowed back into what the original mission is, that ultimately the Home Loan Bank System might go out and look for other missions? I know there's been concern raised with respect to the Chicago project.

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    But furthermore, that the desire for more yield may also result in greater risk.

    Mr. MORRISON. Those are very good questions.

    Let me start by saying that the Chicago pilot is not a different mission. It's a different way of providing housing finance through members.
    With respect to the concern about arbitrage, while you might get a different answer from presidents or chairs of the Federal Home Loan Banks, from me, as the Federal Regulator, I have no affection for the arbitrage because I think it is a less-favorable use of the Government-sponsored status than having that money go directly to benefit borrowers through members.

    So our goal, and the goal that has been expressed by the Treasury is the same. The only question is practicalities, and I think that some of the comments about what can be done are theoretically true, but practically dangerous.

    That means how low can you drive the dividend. The dividend is sufficiently attractive now that no one is leaving, and the dividend varies among the 12 banks by a significant number of basis points.

    People are joining the System, not leaving, so there's stability now. And we are considering, and you have in your testimony, a staff document considering a decrease in authority for investments that would cause a modest reduction in the rate of return on the stock.

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    The question isn't whether but how fast and how much that arbitrage activity ought to be adjusted.

    Mr. BENTSEN. Thank you, and if for the record you can answer the question with respect to the cap.

    Mr. MORRISON. Oh, the cap is for voting, it's not on dividends. It's a cap on how many votes you can cast for members of the Board. In the House bill, there is a change in that, in H.R. 10, and the Senate also used to have a change in that before they threw the capital changes out the window.

    Mr. BENTSEN. Thank you.

    Thank you, Mr. Chairman.

    Chairman BAKER. May I suggest to Members, we're down to about six minutes. Mr. Royce, in fairness to you, I think we ought to get out of here in three or four minutes.

    Mr. ROYCE. I'll be quick, Mr. Chairman.

    Chairman BAKER. Mr. Royce, you are recognized.

    Mr. ROYCE. Mr. Carnell, I believe you are familiar with the Chicago pilot program or, more formally, the Mortgage Finance Partnership program.

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    Let me just state that I do not believe that the business of holding mortgage loans in portfolio accords with the traditional functions of the Federal Home Loan Bank System.

    Not only do I believe that this function puts the bank in direct competition with the private markets, I also believe it poses significant safety and soundness concerns.

    In fact, independent studies have been done by the CBO and the GAO and HUD in recent years and have concluded that if the Federal Home Loan Banks were to enter the business of portfolio mortgage lending, it would constitute a sweeping expansion of their authority, and pose grave new risks to the System.

    It was two years ago that I expressed my concern for this program, when it was a $750 million regional pilot. Now, with yesterday's decision by the Finance Board, it is a $9 billion nationwide program.

    I'm interested in your thoughts on this pilot.

    In your view, does the current capital structure of the FHLB and the participating depository institutions protect sufficiently against the risks posed by this program?

    And what is the Administration's position on the pilot?

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    Mr. CARNELL. As I mentioned earlier, we believe that the Home Loan Bank's current capital structure can be appropriate if it has some adjustments made in it.

    That's a general statement; it isn't specific to this program. I'll get back to the program more specifically in a moment.

    We do believe that the System's capital needs to be given greater permanence. We'd like to see the maintenance of a single class of redeemable stock maintained, but with a longer waiting period for withdrawals and with a haircut imposed on members so there is not an incentive to run for the door.

    The Chicago program, as compared to some other expansions of the System, does have the virtue of actually being connected to the production of housing finance.

    But I think it is a source for concern that here the System is going from being a conduit between its member institutions and the housing markets to actually competing with member institutions.

    You asked about risks to the System. Certainly this program has the potential to pose greater risks than advances, but it's not clear how much more. The System's advance business, as historically conducted, is an exceedingly low-risk business. So risks will be greater here, but it's not clear how much the increment is.

    Mr. ROYCE. Let me ask you one other follow-up question, if I could.

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    The Finance Board functions as both management and regulator of the Federal Home Loan Banks.

    The GAO and others have pointed out the conflict inherent in these functions.

    What, in your view, is the impact of this conflict on the FHLB's ability to be an effective and unbiased regulator?

    Chairman BAKER. Mr. Royce, let me just suggest that since we're down to a couple of minutes, you'll be recognized when we get back, or you can get the rest of his response in writing at your discretion.

    Mr. ROYCE. We'll take the response in writing, and I want to thank the witnesses on the panel, and thank you, Mr. Chairman.

    Chairman BAKER. Certainly.

    We're going to bolt for the door, we'll recess for just a minute and be right back.

    [Recess.]

    Chairman BAKER. I'll reconvene our hearing. I guess my friends are coming back.

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    In the meantime, I've got a few follow-up questions while we're waiting on them to return.

    Chairman Morrison, one of the things that I'm wrestling with is this investment control question.

    I know in your remarks and previously, you've indicated that the Board does want to move in some direction in a responsible manner to bring the level of investments down if they are not specifically mission-related.

    In looking at the performance and investment practices of the various district banks, San Francisco appears to be functioning quite well, but with a significantly lower, at least apparent to me, percentage of investments.

    Would the San Francisco model, in your judgment, be an inappropriate plan to follow or pursue?

    Give me your thoughts on why they are treated differently than the rest of the other operators.

    Mr. MORRISON. First of all, they're not treated differently. They have chosen to behave differently.

    The San Francisco Bank is the largest bank in the System. It has predominantly mandatory members in terms of the bulk of its capital is owned by mandatory members. Numerically, it's probably about evenly split. And it has some very large borrowers.

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    And it has been able to maintain a very good advance business, compared to the capital that it has. The mandatory members, who are QTL thrifts, tend to borrow as much as they can, so there's no extra capital being generated.

    They have limited their amount of MBS investment to two times capital, although they are permitted under the rules to go to three times. Their behavior, if that's the word, is from a normative judgment, better than some of the others. But their circumstances are somewhat more favorable.

    So whether it's a moral virtue or an economic one that they're gifted with, you know, people could argue.

    In any case, our goal, as expressed in the Staff paper, this is not something that the Board of Directors of the Finance Board has adopted, but speaking for myself on this, I would like to move the whole System in that direction, and I think we can.

    And if you look at the charts that are attached to my testimony, you will see that jawboning alone has made a significant difference, and that whereas the ratios of advance and banking assets to borrowing were much lower at an earlier time, the systemwide ratios are significantly up over the last few years.

    That I think is the result of concern about these issues, not only expressed by me and the Finance Board, but coming from Members of the Congress and from the Treasury as well.

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    And I think that's all to the good. And we are in a regulatory process where we have to decide how to write the rules and what the rules ought to be to get there.

    So San Francisco—but let me say that San Francisco, well as it is doing, would not meet the Treasury's tests, because San Francisco has essentially 85 percent of its CO's—i.e., consolidated obligations—in advances and 15 percent in mortgage-backed securities. Treasury would want them to get rid of the 15 percent too and go to 100, and San Francisco already has one of the lowest dividends in the System.

    If you did that experiment, you'd cut their dividends in half. And the mandatory members, who would have no choice, would be up here beating their brains out for the fact that you gave them a non-economic return of 3 percent.

    So there are other things, when you get beneath the surface, the flexibility isn't all that we might like.

    Mr. CARNELL. Mr. Chairman, if I could respond?

    Chairman BAKER. Sure.

    Mr. CARNELL. I want to note that San Francisco is just 16 percent above the cap that the Treasury is proposing. Pittsburgh, a different district, with different types of institutions, is just 24 percent above. Atlanta is just 26 percent above. So San Francisco is not altogether an anomaly. There are other Home Loan Banks with a reasonably close relationship of investments to advances.

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    As for the efficacy of jawboning, I'd urge you to consider that the Home Loan Banks hold their current investment portfolios under a statute that lets them invest money not needed for advances.

    Mr. Chairman, we're talking about $100 billion in net additional borrowing by a System that's in the capital markets every business day borrowing money.

    So $100 billion is being artificially created, then it's declared surplus, and then it's put into the investment portfolio.

    What use is regulatory jawboning if it can't deal with that?

    Chairman Morrison has also raised the specter of a run on the Home Loan Banks and the specter of a threat to the taxpayers. Those are both very serious points and I'd like to respond to each of them.

    First let's keep in mind some very basic numbers here. Twenty-five institutions have left the System since 1992 and 3,000 have joined. The movement is all in one direction. It doesn't suggest that, in thinking about whether the System is worth staying in, members are balanced on a knife edge.

    Second, Chairman Morrison has, several times so far, equated the return to Federal Home Loan Bank members with the Home Loan Banks' dividend rate. That suggests an extraordinary misunderstanding of finance on this point.

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    In the case of Fannie Mae and Freddie Mac, it's fair to equate shareholders' return on equity with their total return, because stock ownership is the only relevent relationship between the stockholders of Fannie and Freddie and the corporations themselves.

    But in the case of the Home Loan Bank System, members are getting a wide variety of services. As we point out in our written statement, various Home Loan Banks, including San Francisco, have chosen to price their services in a way that conveys the benefits of Government sponsorship to their members.

    As for the suggestion of a threat to the taxpayers, I would be very interested to hear it detailed how some shrinkage in the Home Loan Banks' investment portfolio—or even shrinkage in their members—would pose a threat to the taxpayers.

    The fact is that the current law makes it clear that a depository institution cannot withdraw from the System without repaying its advances in full.

    The System is set up in a way so that it should be possible to liquidate the activities that are being done for a particular member, or even to liquidate the Home Loan Banks themselves, without a risk to the taxpayer.

    Chairman BAKER. Is it correct, Mr. Carnell, that Treasury has the right to limit any GSE's borrowings?

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    Mr. CARNELL. My understanding, Mr. Chairman, is that GSEs' issuance of debt securities requires prior Treasury approval.

    Now the Treasury has traditionally viewed this as a traffic cop function with the goal being to avoid disruptions in the Government and agency securities markets.

    Chairman BAKER. But, given the capacity that you're granted, should you view an inappropriate level of activity being engaged in, you do have a statutory-provided tool to limit should the traffic cop get incensed.

    Mr. CARNELL. Mr. Chairman, I think you're raising two different points here. Insofar as we're talking just about a traffic cop function, then as long as there's an orderly market, I'm not sure that the traffic cop does get incensed.

    But it seems to me that you are raising another possibility here, which is looking at whether this authority could be used for a broader purpose.

    Chairman BAKER. One more follow-up since the Chairman has returned.

    You have indicated that California is 14 percent, Pittsburgh 24 percent, I don't remember the actual numbers, but something to that effect.

    Do you have similar numbers for Fannie and Freddie?

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    Mr. CARNELL. Well, the ratio that I'm talking about is a ratio of investments-to-advances. Fannie and Freddie don't make advances so it's a little hard to compare.

    But if it would be helpful, I do have some numbers, like the ratio of investments-to-assets, with or without mortgage-backed securities.

    For example, if you look at investments and include mortgage-backed securities, the Home Loan Banks have investments that amount to 40 percent of assets. Fannie Mae has 50 percent. Freddie Mac has 70 percent. Farmer Mas has 94 percent. The Farm Credit System, which is the only GSE with a quantitative investment limit set by Congress, has 16 percent.

    If you look at the ratio of investments-to-assets without mortgage-backed securities, the Home Loan Banks have 26 percent, Fannie Mae has 17 percent, Freddie Mac has 10 percent, Farmer Mac has 62 percent, and the Farm Credit System has 10 percent.

    Chairman BAKER. Thank you.

    Mr. Chairman.

    Mr. LEACH. Thank you, Mr. Chairman.

    I appreciate your holding this hearing.

    We've had several hearings on this subject, and theoretically and philosophically, various issues have been raised.

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    I just feel compelled to suggest to the Department of the Treasury that in sum total we have the scandal of neglect at the Department of the Treasury and some relates directly to the statistics you've just related to the Chairman.

    I want to go first to a non-housing policy, and then go back to the housing theme.

    The United States Congress created something called Farmer Mac to advance the secondary market for agricultural investments.

    Today, it has about a billion dollars in arbitrage activity. It is one-third owned by a private commercial bank. This is using the power of the United States Treasury for the private interest in competition with the public interests of the United States.

    And the United States Department of Treasury is to guard the public interest.

    Now how that relates to the housing GSEs is very simple. That is, the Department of the Treasury, for a whole spectrum of reasons, chemistry and otherwise, appears to me to be unwilling to stand up to the housing GSEs. It therefore can't stand up to a non-housing GSE because that would set a precedent for standing up to the housing GSE.

    But the Department of Treasury has legal authority. It also has the authority of its position as the center of finance policy in the United States Government, and it ought to be instructing what is appropriate and what is inappropriate, and it ought to be using its authority to safeguard the public interest.

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    Statistically, the Federal Home Loan Bank System issued over $2 trillion in securities in 1997 to support combined System advances of about $200 billion, a ten-to-one relationship.

    In the first quarter of this year, the Federal Home Loan Bank System issued more debt than the United States Department of the Treasury.

    This is a System that is not being watched, other than in an observant sense, and the very statistics, Secretary Carnell, that you just stipulated to the distinguished Chairman, are statistics that you ought to be red in the face about.

    It is beyond belief that the taxpayer should be so ill-served while private sector owners of financial institutions are benefiting by misusing the power of GSEs under alleged basis that this is all for liquidity.

    So my first question to you is, is there any GSE that has arbitrage instruments that have anything to do with the need to maintain liquidity, which is the sole rationalization for existence of these instruments, as close as I can see?

    Mr. CARNELL. Let me say, before turning to your specific question, that I agree that the extent of investment activities by the Home Loan Bank System and by GSEs more generally is cause for real concern—that it is in many cases an abuse of their Government sponsorship.

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    Now some GSEs make a market in their own securities. Fannie Mae and Freddie Mac do that. It can be argued that making that market provides justification for an investment portfolio. That doesn't necessarily mean it justifies the existing size of the investment portfolios there. But that would be one case where an investment portfolio may have a mission relationship.

    It might be that in the case of the Home Loan Banks, a small investment portfolio might be justified. We suggested, Mr. Chairman, a limit under which the Home Loan Bank's investment portfolio could not exceed about $40 billion. That would be member deposits plus member equity. We think that would be more than sufficient for any legitimate needs of the Home Loan Bank System.

    Mr. LEACH. You suggest that. Why don't you implement it?

    Mr. CARNELL. We proposed it in our testimony, Mr. Chairman. This would require legislation. And we made the same proposal to this Committee. I made it to you personally at the time of this Committee's markup of HR 10.

    As you are aware, it was not something for which it was possible to get Committee approval.

    Mr. LEACH. There is a lot of reluctance here, and that's why we're turning—by here, I mean in the Committee as a whole—not this Member or the gentleman in the Chair.

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    Let me turn to the Federal Home Loan Bank.

    Mr. Morrison, you proposed a minimum leverage ratio of 2 1/2 percent. I've not met anyone that thinks that's sufficient.

    You proposed a zero risk factor for the Federal Home Loan Bank advances. I don't know anyone who is in a neutral setting who considers that sufficient. I don't know anyone who believes there's justification for requiring risk-based capital to consist almost exclusively of new permanent capital.

    It doesn't seem to me that the Federal Home Loan Bank System is itself monitoring itself as fully as it might.

    I have a series of questions.

    Let me just say, how big is the off-balance sheet activity for the Federal Home Loan?

    Mr. MORRISON. I don't have a precise number for you. The off-balance sheet activity is very limited.

    Mr. LEACH. Do you train your examiners to audit these investments?

    Mr. MORRISON. Yes, we do.

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    Mr. LEACH. What off-site reports do you get with which you can monitor this sector?

    Mr. MORRISON. There are a large number of off-site reports that are received by the Finance Board. They are—the risk-oriented reports are primarily about compliance with the limits of our financial management policy, which is a specific set of investments that are permitted, and also a duration of equity testing on a market risk basis as well as the credit risk model that comes from the particular instruments.

    Each bank is required to report to its board of directors monthly on that, and to report to us any deviation from these standards that may occur in any given month, or to report compliance.

    There are also specific reports with respect to the volume of activity, such as advances, and actual investments acquired.

    Mr. LEACH. As you know, the borrowings in the System are double the advances. How do you rationalize that?

    Mr. MORRISON. I don't want to quibble about the numbers.

    Mr. LEACH. Nearly double.

    Mr. MORRISON. It's not quite double, but the borrowings are substantial. There are two points I want to make sure we're clear about.

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    The volume of issuances, which the Chairman has mentioned in his statement, is an artifact of the investment activity.

    And when our Board looked at this question as to whether we should intervene at that point, which we explicitly did last winter, our judgment was that we should act directly on the investment activity and not on the issuance activity, because if we acted on the issuance activity, that would just be modified in order to serve the investment activity.

    And that is the reason that the staff of the Finance Board in March issued its report on how to reduce the arbitrage activities of the banks.

    We are in agreement with what you expressed, and others have expressed about the reduction in the arbitrage activities. When I speak on this, I'm speaking for myself as Chairman, and I'm speaking for the staff of the Finance Board.

    I cannot promise you the votes of the members of the Board of Directors of the Finance Board because it's a collegial body that will have to vote on that.

    Mr. LEACH. I understand you're on the public record in that regard, but you're also on public record as enthusiastically endorsing Senator Hagel's amendment in the Senate, which would have allowed the Federal Home Loan Bank to substantially expand its non-mission activity.

    That would have eliminated the authority of the Federal Home Loan Bank to regulate, the Financing Bank to regulate.

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    Mr. MORRISON. I actually don't believe that's correct, but maybe you can clarify where you think that is.

    I am on record as supporting Senator Hagel's initiative and I do support it. And I am unaware of any reduction of our regulatory authority over either the debt issuance process or the investment process.

    In fact, I would say that both HR 10 in the House and HR 10 in the Senate have expanded the authority of the Finance Board to regulate the activities of the Federal Home Loan Banks, and I support that.

    The other item that you mentioned was the capital provision in the Hagel bill. Let me speak about capital for just a moment, if I might.

    First and foremost, the capital system the banks currently have is not a good one. It has permanent capital in the form of mandatory members. It has voluntary member capital that is hardly capital at all. It's redeemable on six months' notice.

    I support a capital system that has the following characteristics. One, that the amount of capital is driven by the balance sheet of the Federal Home Loan Bank, not by the balance sheets of the members, so that the Federal Home Loan Banks don't get more capital than they need to serve their members.

    Second, one that has a significant risk-based permanent nature.

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    Now we could disagree, some may disagree about what the right leverage number is, and some other aspects of that capital system. The 2 1/2 percent leverage that is in the Hagel bill comes from the other two housing GSE standards set by this Congress. This does not restrict OFHEO or the Finance Board from a risk-based number that may be lower or higher depending on the risk.

    I heard you say that you thought I did not support permanent capital.

    Mr. LEACH. I didn't say that. What I understand the Hagel amendment does is put forth a 2 1/2 percent leverage capital, but then it also has zero risk weighting for all advances.

    I may be wrong in that.

    Mr. MORRISON. I'm too familiar with that provision, so let me address your question directly.

    It does include a zero credit risk weighting for advances. That is correct. They would be 20 percent risk weighted under the Basel standards for credit risk.

    They would not be zero market risk. The market risk would depend completely on what kind of market risks were imbedded in that particular kind of an advance and whether and how the risks were hedged.

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    With respect to the credit risk, I would say to you that the standards for advances in terms of collateral and the super-lien that this Congress has accorded to the Federal Home Loan Banks with respect to advances, as demonstrated in the 1980's, when the members went south and no credit losses were incurred, is that the zero weighting is an accurate standard.

    Now if those rules were to change, then that conclusion would have to change.

    Mr. LEACH. Mr. Chairman, I have a series of questions but I don't want to go on too much longer.

    I would point out that I've gone over each of the Federal Home Loan Banks, and I'm a little disappointed that my own, in Iowa, has a higher non-mission portfolio than I would like.

    But I'd note that the largest of the banks, which is the one in California, in San Francisco has, by all odds, the lowest percentages and it seems to operate credibly, which makes me wonder why the others can't have lower too, other than that they want to pad their profits in competition with United States Treasuries, which is the public's interest.

    Now does that strike you as a reasonable operation?

    Mr. MORRISON. We're not having any debate, you and I, nor the Treasury and I, about where we need to try to go. We may seem like we're moving more slowly than some would like, but we are the ones ultimately that will be accountable for going too far too fast.

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    The reason I say that, and Mr. Carnell spoke, I don't know whether you were in the room when he spoke, that there was no risk to the taxpayer in moving too far, too fast.

    The System has $600 million in fixed annual costs. That comprises $300 million to the Treasury for REFCorp, $100 million in affordable housing credits, which can be relieved in emergency circumstances, and $200 million of ongoing expenses which obviously could be reduced but not instantaneously.

    In that situation, one does have to worry about when you reduce income, what is the impact, and there is the possibility of wholesale departure from the System by voluntary members.

    Now there is no threat of that today and we, in our paper, have expressed the view that we can move a significant chunk, $50 billion of investments, off of the books of the banks nationwide, without worrying in any way, shape, or form, about that safety or soundness problem.

    But when the Treasury comes here and says that we could eliminate all of the investments, save for the amounts that are allowed for deposits and by capital, they are saying that we could immediately sustain a return on equity of the System of between 2 and 3 percent and not have any danger of a meltdown.

    I invite the Treasury to take over and run the experiment, but this fiduciary would not run such an experiment. I think that is too risky.

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    I would move more slowly because I don't think there's a safety and soundness problem here. I think there's a mission problem, and we all want to end up, I think, in the same place.

    So I would hope that the Committee will want us to move in that direction.

    And my last point on this is, if you think we're moving too slowly, what do you think about the other GSE regulators who aren't moving at all?

    Mr. CARNELL. Mr. Chairman, if I could respond.

    The word ''immediately,'' which Mr. Morrison has just used, is a word that the Treasury has not used here at all. In fact, my written statement makes clear that any decrease in investments could be phased down.

    As I mentioned at a point when you were out of the room, the System is set up so that a member cannot withdraw from membership without fully repaying advances—so that, in this and in other respects, the System is set up to be self-liquidating.

    So that means there is no solvency risk to the taxpayer in terms of the System's basic assets and liabilities.

    Now Chairman Morrison points to the question of what would happen going forward with the REFCorp and AHP payments. I would ask whether that's proposing to have the tail wag the dog.

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    On top of that, it is reasonable to believe that the hundreds of billions of dollars of debt issuance by the Home Loan Bank System has some effect—even if we can't measure it—on the rates that the U.S. Treasury must pay to finance the public debt. If that's the case, then the so-called savings to the Treasury from the $300 million annual REFCorp payment is completely illusory.

    Finally, I'd want to point out once again that Chairman Morrison has equated the dividend on Home Loan Bank stock with Home Loan Bank members' return on equity. It's just a very basic point of finance, which needs to be understood here, that the return on equity for Home Loan Bank shareholders is the total package of services that they get from their Home Loan Banks. The benefits of Government sponsorship can be built into the pricing of products. They can be built into the services that are provided. So it is really an error to equate the dividend rate with total return on equity.

    Mr. LEACH. I appreciate that.

    I just maybe ought to conclude by saying I appreciate also some of the things that Treasury is doing in this regard. What we—and there is complicity with the Congress in some of these problems—we've put some burdens on the housing GSEs; we've given new institutions unfair funding and capital advantages over all other sectors of the economy, and that's the reason we have to be so careful.

    I would say Farmer Mac has no special cost. They have none of these housing obligations, and I think Farmer Mac deserves serious review.

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    One of the problems quite frankly is that there are other Committees of jurisdiction and that is a problem that we have with this model, but I would hope that Treasury could use its moral suasion, as well as its other powers.

    After all, the Government makes some appointments to the regulatory agencies. And one of the interesting issues is, do appointees become co-opted by the institutions, or do they represent the public interest.

    That's a great philosophical question—an issue, by the way, which I think Treasury shares a concern.

    But I think it's remarkable to me that in the most sophisticated market economy in the world, with the most sophisticated financial structures, we're giving Government grants of authority which in effect tilt the market.

    And if we do that for specific purposes we ought to be very careful that only those purposes are advanced, and no others.

    My sense is people have figured out that these are powerful institutions with powerful advantages and they use them in powerful ways.

    So it will take the Government to constrain them.

    Thank you, Mr. Chairman.

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    Chairman BAKER. Thank you, Mr. Chairman.

    I would also point out, Mr. Chairman, that the GAO study of Farmer Mac will also be available to the Committee next spring, so I'm certain we'll return to that subject.

    Mr. Kanjorski.

    Mr. KANJORSKI. Is that before planting time or after?

    Mr. Chairman, first let me apologize for not appearing when the Committee first sat. Unexpectedly, the Vice President came up to the Hill and had a meeting with the Democratic Members of the Congress, so the lack of attendance here shouldn't be taken as a lack of respect for either the witnesses or the issues involved.

    Let me say very quickly just a few things for the record so we can wind this up.

    One, I am disappointed we don't have HUD here. I think it would have been to our advantage to have them as part of the panel.

    Two, the point that I would like to make, perhaps the Chairman just did make, that there are an awful lot of differences that ought to be on, and probably we won't come to agreement on, except one thing we can all agree on is that the System is safe and sound.

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    And if any of the witnesses feel that isn't true, certainly they should speak up now or forever hold their peace.

    That being the case, we seem to be dealing around with how to perfect the System, and that's always wise in the exercise of our oversight of the System.

    But I was particularly struck with the arguments that GAO made four major advantages for a single regulator. And what that could accomplish.

    In going through some of those, it was for not being captured, being large enough not to be captured, that there would be more clout in overseeing the various GSEs, the fact that the staff would have more expertise than a single regulator, and I think there's good argument for that.

    And then finally that there'd be more consistency in the application of regulations if that were the case.

    All of those arguments are very strong, but I would sort of like to turn them around and get some opinion from the witnesses on the issue.

    You could take those four advantages and apply them to the need for reformation of the House of Representatives. If we had a single committee of jurisdiction over banking and commerce, rather than having to split this jurisdiction all over the Hill, would we have the advantages of all four of those advantages?

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    Maybe let me direct that question to GAO, since you have passed on the advantages of a single regulator for the regulators, could you give us an opinion of what you think of a mixed jurisdiction in the House of Representatives?

    Ms. KINGSBURY. Mr. Kanjorski, GAO has a long history and a very strong work ethic that we don't draw conclusions or make statements about things we have done no work on.

    And we almost never do work on the organization of the Congress, so I'm going to dodge this one, with all due respect.

    [Laughter.]

    Mr. KANJORSKI. You've been here long enough to become a good politician, right?

    And I understand that.

    But I think perhaps we should, as we are critical of some of the regulators and the Executive Branch, perhaps, Mr. Chairman, we should address this question to Mr. Dreier and his future analysis of the structure of the House of Representatives, actually to give us a little more expertise, a little more direction, and perhaps a little more clout to handle some of these problems.

    The final situation I guess I'd like to talk to is this question of investments and mission, and I hear everybody's argument on it.

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    If you have to draw down too much money, you're making investments, and there seems to be an indication of something evil about that.

    That's not necessarily so that it's a question of good and evil. It's a question of where it impacts on the mission of the GSEs.

    Isn't that correct?

    As opposed to just by looking at raw numbers.

    And one of the questions that are corollary to that, I guess I should direct to my friend, Mr. Morrison, whom I've never heard, as the Chairman may have indicated, who is someone under the heel or control of the institutions he's regulating.

    That's not the calls I'm getting.

    [Laughter.]

    Mr. KANJORSKI. But what would the average FHLB dividend be, if you have an idea, in terms of what's the return there?

    Mr. MORRISON. There's a range of dividends.

    I believe the average is in the vicinity of 7 percent. The stock is par value stock, so it doesn't appreciate in value, so there's no return that comes from that.

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    The Federal Home Loan Banks have a practice which we have not restricted, but we could, of not accumulating retained earnings. And the politics of that is that in the 1980's, in order to help pay for the thrift crisis, the Congress appropriated all the retained earnings of the System in excess of $3 billion.

    I voted for that, so I'm not apologizing for it, but obviously the banks feel that their retained earnings are at risk, and it would be something we might consider to get permanence in capital building up retained earnings.

    But at the present time, they pay out all their earnings.

    The range of dividends is from 6.3, 6.4 percent to 8 percent or a little over. There's clearly some room for difference.

    Some people would say that's a risk-adjusted difference. I'm somewhat skeptical. I think the lower end could be sustained by most of the banks at the upper end.

    Mr. KANJORSKI. But in reality, the banks could certainly invest that money in some other investments and draw equal or better return.

    Mr. MORRISON. The investments that they currently make are essentially all they're allowed to make. For instance, corporate securities are not allowed—they can only invest in mortgage-backed securities up to a limit, and then in very high quality credits in money market funds.

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    So what they're in is what they are allowed to be in and nothing else, but we're talking about allowing them to be in less.

    Your point about the fact that the investment power can be used for mission-related activities is absolutely correct.

    High credit quality investments can be generated on the books of the banks for the benefit of members using the investment authority, rather than the advance authority.

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

    Mr. Chairman, since I haven't spent all the time at the hearing, I think I should take no greater time of the Committee.

    Thank you for the opportunity.

    Chairman BAKER. Thank you, Mr. Kanjorski.

    I have just a couple more follow-ups before we wrap this up.

    I note, Chairman Morrison, that in 1997, based on some information provided to me, that about $165 million of long-term debt securities were issued by the System, about $388 million basically to the 360-day debt securities, but it was $1.5 billion issued in overnight debt securities.

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    Can you tell me how that function matches with the long-term obligations of the banks?

    What is the purpose, as best you can determine, of that volume of overnight debt securities?

    Mr. MORRISON. The volume of overnight debt securities actually represents about $6.5 to $7 billion in outstandings over time. And it is essentially used to fund comparable amounts of overnight investments.

    And from a safety and soundness perspective, the matching of terms of the activities is a good thing.

    But the question that's probably asked is do we need this activity at all?

    And our staff paper says that we can dramatically reduce the amount of this activity from about $100 billion to about $50 billion in outstanding money market investments with about a 20 basis point reduction in dividends across the board.

    That's something the Staff is working toward recommending to the Board to act on.

    Now some would go farther, and this would be step one, but it is a step one the staff is suggesting.

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    Chairman BAKER. Because it cannot, I don't believe it can be alleged that the overnight securities instruments are mission-related.

    Mr. MORRISON. No. They are, at best, liquidity, and obviously there are other sources of funding for liquidity like deposits and the like.

    I'm not a fan of huge liquidity pools for the System, because I agree with Treasury that they have virtually instant access to the capital markets.

    Chairman BAKER. And with regard to the provisions that were in the House version of HR 10 on capital and investments, just for the record, can you tell me again that that approach was preferable to the Senate approach? The Senate approach was preferable to the House-passed approach? Or do you want something else?

    Mr. MORRISON. The Senate Banking Committee reported HR 10 has neither provision.

    I support both of the provisions that are in HR 10 as reported by the House. I also believe that the capital provision can be improved to create a better permanent capital base than the House version has.

    Chairman BAKER. Just as sort of a summary, I understand Mr. Carnell's position or Treasury's position, rather, with regard to a single regulator, certainly we have it on the record in Ms. Kingsbury's report, and I know of your earlier statements on the subject with certain assumptions.

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    Is there anyone, I guess Ms. Kingsbury or Chairman Morrison perhaps would be the ones to respond, if we were to suggest the formulation of a single regulator office, say in the next session of the Congress, what elements of authority do you think it important to be within the hands of that newly formed regulator that are not currently authorities given to the Finance Board?

    Or is it simply to separate regulatory function from business function?

    Mr. MCCOOL. Mr. Chairman, I think that from our perspective, the fundamental difference would be to take the regulator, the single regulator out of the business of the System and whatever other GSE it regulates.

    Pretty obviously we're in favor of capital standards that are risk-based, and having some investment authority regarding mission, that is the ability to regulate the mission of the GSEs that are part of the single regulator.

    Chairman BAKER. Mr. Chairman, any additional authority you think should be granted?

    Mr. MORRISON. With respect to what the business items we should not be involved in, HR 10 in both Houses takes care of those statutory problems.

    The difference of opinion between GAO and us about how you effectively regulate mission remains, and I think it will remain unless the Congress changes the terms of how it wants mission carried out, which is certainly subject to your consideration, either in HR 10 or otherwise.

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    But most important, in our view, is that safety and soundness and mission must be in the same regulator. If you observe the input that HUD received in its Advanced Notice of Proposed Rulemaking with respect to non-mission investments by the two other housing GSEs, you will observe that they were essentially told that anything that they might propose to do was actually in the jurisdiction of the other regulator.

    I think that is not an uncommon result when you divide the world in that way.

    Chairman BAKER. I share your concerns.

    I'm very much troubled by the fact that OFHEO, four years after the target, is still perfecting the stress tests for the other two principal GSEs.

    I may be wrong. The apparent inconsistencies in the rules that are applied to each of the GSEs for various purposes, and that no public purpose is well-served by having these disparities.

    In fact, I think you may have observed that with different regulators in different roles, one GSE is able to utilize that to their own unique business advantage.

    So I am very strongly considering moving forward with something for the Committee to consider next session perhaps, that would pursue the goals of both, I believe, GAO, and Chairman Morrison have outlined in their remarks.

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    Any further questions from any Member or comments?

    Mr. KANJORSKI. Mr. Chairman, just that I have additional questions and my opening statement, and I would ask that they be answered in writing for the record.

    Chairman BAKER. Absolutely.

    [The prepared statement of Hon Paul Kanjorski can be found on page 69 in the appendix.]

    Chairman BAKER. With that, I call the hearing adjourned.

    Thank you.

    [Whereupon, at 1:20 p.m., the hearing was adjourned.]

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