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Wednesday, June 25, 2003
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance,
And Government Sponsored Enterprises
Committee on Financial Services,
Washington, D.C.
    The subcommittee met, pursuant to call, at 10:01 a.m., in Room 2128, Rayburn House Office Building, Hon. Richard Baker [chairman of the subcommittee] presiding.
    Present: Representatives Baker, Ose, Shays, Gillmor, Bachus, Castle, Lucas of Oklahoma, Royce, Manzullo, Oxley (ex officio), Kelly, Ney, Fossella, Green, Miller, Hart, Kennedy, Tiberi, Harris, Kanjorski, Hooley, Meeks, Inslee, Moore, Frank (ex officio), Ford, Lucas of Kentucky, Crowley, Clay, McCarthy, Baca, Miller, and Scott. Also present: Representatives Watt and Maloney.
    Chairman BAKER. I would like to call this meeting of the Capital Markets Subcommittee to order.
    June 15, 2002 was an important day in the history of our national economy. The accounting firm of Arthur Anderson was found guilty of obstructing justice by a Texas jury on that day. The decision ultimately led to the demise of the accounting firm and brought about a thorough reexamination of our entire accounting industry. Frankly, the outcome could have been a lot worse. Our understanding of corporate accounting practices was limited, and action was quickly taken to enhance the regulatory oversight of the industry with the passage of the Sarbanes-Oxley Act.
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    However, there continue to be important elements of our economy left, inappropriately in my opinion, outside the scope of the Sarbanes-Oxley required disclosures. These are the only two Fortune 500 corporations today exempted from these essential reforms. Why were they exempted? The answer is that they are too well run to worry about. They have set a standard of corporate governance to be emulated by others. And by the way, we want to make sure we don't throw anyone out of the opportunity of homeownership. They are, of course, the two housing GSEs.
    The events surrounding the fall of Enron are indeed unfortunate, particularly for the employees, but for anyone who had a financial stake in the corporation. However, if either of the nation's GSEs were to suffer a financial reversal of similar scale, the systemic consequences are difficult to comprehend.
    The Capital Markets Subcommittee is meeting today on this very important matter, but frankly as a result of events that are not of our own making. The announcement by Freddie Mac that their recent accounting practices did not properly reflect their operations is cause for significant concern. In fact, the initial restatement announcement was again amended just this morning, raising the total misreported income from the original estimate of $1 billion to $3 billion, now to in excess of $4 billion. The revelation underscores the importance of what has been previously observed by many, and that is our current regulatory oversight is not adequate.
    To those who point out that this is an announcement of an increase in revenue, not losses, we should not miss the troubling point of this news if you were a shareholder of Freddie Mac. If you sold your interest in the company before the balancing adjustment was corrected, you were denied your fair distribution of company earnings by this unfortunate manipulation. I believe you will find adequate legal filings now on record to confirm this view.
    More importantly, the explanation given for the misstep is that the corporation did not have enough properly trained staff to oversee its complicated derivatives portfolio. Why were they exempted from Sarbanes-Oxley? I ask again. Where was the regulator during the 3 years this error was unreported? If Freddie did not have enough invested in staff to properly oversee these complex activities, how can anyone argue that OFHEO was properly supported for the same purpose?
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    We should be more than just concerned. In fact, we should feel like any other corporate CEO in America whose oversight has been found lacking. These enterprises are our creation and clearly our responsibility Today, nothing stands between corporate losses and the American taxpayer except the regulators. We are the regulator of last resort.
    In spite of this circumstance, some may suggest that any examination of the GSEs will result in market instability and potentially throw unsuspecting victims out of the opportunity for homeownership. I have only one question to ask. How is that a now readjusted restatement figure, up from $3 billion to now in excess of $4 billion, over a 3-year period of operations, has not crippled corporate activity and the housing market generally? Is there any action this Congress could take that could possibly approach the significance of these revelations? When such disclosures were made by Enron, WorldCom and other corporate wrongdoers, the consequences were devastating to employees and shareholders alike. The value of corporations was decimated, and some executives are now in court defending their actions.
    What is even more troubling than the restatement at Freddie Mac is the realization that market observers looked past the corporate misstatements and directly into the taxpayers's pockets. There was no reason to be concerned as an investor about corporate misconduct, as long as the taxpayers were standing by ready to pick up the loss. This is, in my opinion, the most troubling aspect of all. What stands between corporate losses and the taxpayers's pocket is the regulator and not much else.
    Looking to the current structure, in fairness, the effort made by OFHEO has been significant in light of the resource limitations placed on them. If Fannie and Freddie were regulated the OCC and were commercial banks, they would be assessed by formula almost a $70 million charge for their regulatory purpose. We have fought difficult battles in the Congress to get OFHEO to a $30 million level. Either the OCC really has it wrong or OFHEO is dramatically underfunded. I think I know which it is.
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    However, these problems have persisted for too long. It is no longer possible just to put a coat of paint on the walls at OFHEO and regain the respect of the marketplace. It is time to construct a new regulatory mechanism. It must be funded by assessment on the enterprises. It must have real authority to act on par with other financial regulators. It must be constructed to ensure independence and marketplace credibility.
    H.R. 2575 is built on these principles. I have not proposed any controversial modifications to the charters of either GSE. I have not suggested a repeal of the current line of credit to the U.S. Treasury. I have not included the Federal Home Loan Banks in the proposal. This is a narrowly drawn, carefully crafted resolution intended not to create political debate, but to effect real change.
    The legislation is carefully constructed to bring about only three goals. One is to ensure we have an independent regulator. Two is to ensure there is reasonable funding for the supervision. The third is to equip this regulator with all the necessary tools any other financial marketplace regulator utilizes. That is it. There should be no controversy over the legislation at all in light of the revelations over accounting irregularities. However, where there are identified concerns that can be supported by logical argument, I am certainly open to any constructive modification that gets us to the stated goals of this effort.
    Some may suggest an alternate location for the regulatory home. That is fine. Others may have some objection to a particular enforcement authority. We will examine it, but I cannot envision such disagreements resulting in a failure to act on the overall mission.
    To date, we have been fortunate in that no significant reversal in the housing market has occurred on our watch. But do not forget these enterprises exist as a result of congressional action that created them. They continue their favored market position with our concurrence. As long as there is profit to share, the market works well and shareholders are happy.
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    The Congress is, however, directly responsible for their supervision and regulation. If we fail in this effort by failing to provide minimal resources for a competent regulatory structure, the fall could be disastrous. When a GSE fails, it will quickly fall through its limited capital, right through the shareholders, directly to the taxpayer. That is an outcome we cannot accept. H.R. 2575 is a modest step to give us some assurance we take all appropriate actions to prevent that from ever happening.
    I began my remarks this morning revisiting the events of June 15, 2002, the day Arthur Anderson was found guilty of obstruction of justice by a Texas court. Another historic event occurred just 24 hours earlier on June 14, 2002, not receiving near as much attention. An object known as 2002 NM passed within 75,000 miles of Earth, to be known in astronomical terms as a ''near miss.'' How close is that really? Well, the moon is about 137,000 miles away. So this object passed inside the orbit of the moon. As far as we know, this was the second closest near miss in human history.
    So what else is significant about this event? Well, how about this fact: Scientists on earth did not know about 2002 NM until three days after its passage. How is this possible in this world of scientific technological sophistication? The answer is simple. We don't have enough resources committed or enough people watching to assure against a clearly cataclysmic event from occurring.
    Now, I do not want to turn this hearing into a science and technology assessment, but the parallel is clear. Unless we act to enhance our supervisory capacity of the two housing GSEs that Congress has created, we may not see the next systemic event coming until it is too late. I sincerely hope that is not the committee's decision. Today, we will hear from four different individuals about their concerns and their recommendations for action this committee may consider. It is my hope the committee will find the adoption of H.R. 2575 as an appropriate next step in this most important responsibility.
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    [The prepared statement of Hon. Richard H. Baker can be found on page 47 in the appendix.]
    Mr. Kanjorski, you are recognized.
    Mr. KANJORSKI. Thank you, Mr. Chairman.
    Maybe as an aside, we should move through this and adjourn as quickly as possible so we can return to our families.
    Mr. Chairman, our nation's system for housing finance is not only extremely successful, but it is also the envy of the world. Almost 68 percent of Americans own the homes in which they live. Government-sponsored enterprises have contributed greatly to this accomplishment.
    This success, however, should not stop us from asking whether or how we can do a better job with respect to regulating Fannie Mae and Freddie Mac. We should also examine ways by which we can improve regulatory efficiency and lower mortgage rates. The recent events at Freddie Mac related to its earnings restatement and its management changes have highlighted the need for continued examination of these matters.
    As you know, Mr. Chairman, I am also one of the few remaining members of the committee who participated in the entire congressional battle to resolve the savings and loan crisis. I am therefore acutely aware of the need to protect taxpayers from risk. It is in the public's interest that we ensure that Fannie Mae and Freddie Mac continue to operate safely and soundly. We must further ensure that these public-private entities achieve their public responsibilities for advancing homeownership opportunities.
    We can best achieve these dual objectives by pursuing a three-pronged supervisory approach that includes regular congressional oversight of, sustained effective government regulation over, and increased market discipline for the two GSEs. Through our extensive studies and hearings over the last 40 months, we are fulfilling our obligation in the Congress to conduct regular oversight of the GSEs.
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    Although we have not reached consensus on legislative reform during the last dozen hearings on GSE regulation, I do believe we have reached agreement on at least several key points. First, we have agreed that we have the world's most successful housing finance system and gained an appreciation for the important role that the GSEs play in the system. Secondly, we have agreed that Fannie Mae and Freddie Mac have grown significantly in recent years. Finally, we have agreed that we must have strong regulators for the housing GSEs.
    As I said at our very first hearing on GSE regulation in March 2000, ''We need to have strong, independent regulators that have the resources they need to get the job done.'' I continue to support strong GSE regulation. A strong regulator, in my view, will protect the continued viability of our capital markets, ensure against systemic risk, and expand housing opportunities for all Americans.
    To ensure that we have strong GSE regulation, I believe that any legislative reforms considered by the Congress in the future should adhere to at least five key principles. First, in order to conduct robust supervision, a strong regulator must have a funding stream separate and apart from the annual appropriations process. Second, a strong regulator must have a single leader for a set term with sole responsibility for making decisions. Third, a strong regulator must be independent and free from political interference. Fourth, a strong regulator must focus like a laser exclusively on GSE issues. And fifth, a strong regulator must have enhanced supervisory and enforcement powers similar to those of other federal regulators for financial institutions.
    The primary goal of today's hearing is to advance our examination of what structural changes might be necessary at the Office of Federal Housing Enterprise Oversight or the Department of Housing and Urban Development to ensure comprehensive and complete oversight of Fannie Mae and Freddie Mac. Today, we will hear primarily from one side of the debate: those who have often been critical of the GSEs and their regulators. In fact, many of our witnesses have already called on the Congress to reform GSE regulation, alter their statutory structure, or disband these entities entirely.
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    Nonetheless, as we proceed in the future, it is my hope that we will develop a balanced, deliberate and bipartisan plan of action for addressing GSE matters. In other words, we should move judiciously and objectively in conducting our oversight responsibilities. We also should understand the facts behind the current and recent events at Freddie Mac before considering any legislation.
    Moreover, we should not once again upset the securities markets. On at least one occasion, our committee's actions have unfortunately discouraged investors and raised homeownership costs. As we proceed today, we must renew our efforts to ensure that we do not repeat that mistake.
    In closing, Mr. Chairman, I commend you for your continued leadership on these issues. I will continue to work with you to conduct effective oversight over the housing government sponsored enterprises and to ensure that we maintain an appropriate and sufficiently strong supervisory system over them.
    [The prepared statement of Hon. Paul E. Kanjorski can be found on page 54 in the appendix.]
    Chairman BAKER. I thank the gentleman.
    Mr. Ose?
    Mr. OSE. Thank you, Mr. Chairman.
    I would like to thank you also for your continued hard work on this issue and for holding this hearing today. You obviously are dedicated to a strong financial market, to disclosure and accountability, and both the membership and the country is well-served by that. Mr. Chairman, recent actions at Freddie Mac have led many in the public and on the Hill to take a closer look at how government-backed institutions are regulated. Specifically, many are asking if greater disclosure and accountability requirements are necessary. This is a serious question and one that we must examine very carefully.
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    Of particular concern is whether or not the current agencies with oversight authority have the ability, authority and personnel to properly regulate this vital industry. Let us look at just one part of such authority and the questions that it raised in recent weeks, the authority of the Office of Federal and Housing Enterprise Oversight, OFHEO, to oversee executive compensation at the GSEs.
    When the accounting irregularities led Freddie to review its past actions here recently, the board at Freddie apparently was upset enough at executive actions to fire one senior executive and to ask two others to resign. However, these three individuals were still eligible for extremely generous compensation packages and stock bonuses. OFHEO reported said these would not be paid out until an investigation was carried out. You and I wrote OFHEO asking what authority they had to freeze such payments and whether their orders were being carried out. To date, there is still conflicting information on this question. I hope we will get clear answers soon.
    Perhaps part of the trouble is that OFHEO is not home to the experts on financial services matters. The Department of Housing and Urban Development does many praiseworthy things, but it is just not experienced as regulating a financial market. I am pleased to join with you in offering the legislation, H.R. 2575, to move the oversight authority to the Department of Treasury, where there is a greater depth of experience on financial oversight and a far greater likelihood of proper oversight.
    Mr. Chairman, I would like to thank you for taking a closer look at this industry. Liquidity and soundness in the housing marketplace is crucial. So is accountability. I look forward to hearing from our panel today and I look forward to the hearings on this matter in the future.
    Chairman BAKER. Thank you, Mr. Ose.
    Mr. Scott?
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    Mr. SCOTT. Thank you very much, Chairman Baker, Ranking Member Kanjorski.
    I certainly want to concur with my colleague and commend you, Chairman Baker, for your insight and your knowledge on this issue and this industry. I certainly look forward to working with you as we develop legislation that will certainly address this problem.
    As I have said before in this committee, no program is so good that it should not be reviewed. The public's confidence in our financial institutions is paramount to this country and the welfare of our economic system. Our nation is staggering under scandal after scandal of accounting practices of some of our most revered and large and impactful financial and economic institutions. It is especially important that Freddie Mac and Fannie Mae have meaningful oversight of their safety and soundness because of the implicit guarantee that the United States treasury will intervene, rather than let them fail.
    Over the last 10 years, the housing GSEs have had their obligations rise from $1 trillion to $3.2 trillion. With this increase in credit risk and the recent accounting problems that Freddie Mac had with Arthur Anderson, Congress should ask questions and we will ask questions, and we get some answers. A financial crisis at either company could shake our entire domestic economy.
    With that said, I believe that we must keep oversight focused on what is best for the consumers and the marketplace. Freddie and Fannie do serve important roles in housing markets, especially when they focus on their core missions such as increasing minority homeownership. From 1998 to 2002, African American homeownership rates rose from 45.6 percent to 47.3 percent, compared with the overall national average increase from 66.3 percent to 67.9 percent. With interest rates at historical lows, I believe that we must push even harder to help increase minority homeownership rates.
    Freddie Mac and Fannie Mae have brought stability to the housing market. I believe that when they focus on their congressionally mandated mission, they provide a vital tool for market stabilization. That is one reason why I hope that Fannie Mae will reach a reasonable agreement with the manufactured housing industry to provide 30-year home mortgages.
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    There are some very serious questions that we need to raise this morning and get some answers to. For example, in the Monday New York Times, there was an article that questioned Fannie Mae's financial reporting. The article stated that a big loss last year was obscured by accounting complexities. I think we need to figure out if Fannie Mae's accounting practices show the true net value of assets. And for the Office of Federal Housing Enterprise Oversight or OFHEO, we need to question if with just 140 full-time staffers and an operating budget of $30 million, is OFHEO up to the task of regulating Fannie and Freddie? Because in fact, they are monitoring the fiscal health of two companies that together own or back nearly half of this nation's residential mortgage debt.
    Also, we need to ask the question, is it fair to judge Fannie Mae based upon Freddie Mac's missteps. And if Freddie Mac only understated their earnings, then why did they fire their CEO and then let their President and CFO leave? Serious questions that the American people are looking to get serious answers from.
    So I look forward to joining with you, Chairman Baker. I commend you for taking the leadership on this and I look forward to working with you as we put forth a fair and balanced piece of legislation to address this issue.
    Chairman BAKER. I thank the gentleman for his fine statement.
    Mr. Ney?
    Mr. NEY. Thank you, Mr. Chairman. First, Mr. Chairman, I want to thank you for your hearings. You have shown strong leadership over the past years on the issue of GSEs. As we all know, the events of the past few weeks have made it clear that this committee will closely examine the regulatory structure for government-sponsored enterprises. These companies have been a vital part of promoting homeownership and bolstering the housing market over the past few years in particular. We all know during the tough economic times in the past three years one of the few bright spots has actually been the housing market itself. Because of the liquidity they provide, Fannie Mae and Freddie Mac have been an integral part of the vibrant housing market to have supported what I would call a fragile economy.
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    However, their importance to the housing market stresses why it is so vital that we have a sound regulatory regime for the GSEs. Fannie Mae and Freddie Mac have been at the forefront of disclosure, having taken steps that go above and beyond what most companies would provide. This year they took additional steps and met the requirements of the joint Treasury-SEC-OFHEO mortgage-backed security disclosure study. I just point that out because since Sarbanes-Oxley amends the 1934 SEC Act, it applies to SEC registrants, defined as issuers. Fannie Mae and Freddie Mac both agreed to register their equity securities under the 1934 Act. Therefore, when Fannie Mae filed their Form 10 and 10(k) with the SEC on March 31, 2003, they became a full, irrevocable registrant under the SEC as I would understand it, and as such are fully bound by provisions within Sarbanes-Oxley.
    However, today's nearing obviously will go towards the problems that have erupted and will have to go towards OFHEO, obviously, and what has been brought into question rightfully so is the effectiveness of OFHEO as a regulator for the GSEs. Fannie Mae and Freddie Mac are too important to our nation's housing market to allow a lack of confidence to develop in their regulation. That is why we have to diligently, but cautiously, pursue regulatory reform. These companies have been leaders in safety and soundness and we have to ensure that investors continue to have faith in that fact.
    That is why I want to again commend Chairman Baker for this hearing. That is why I believe that we are all here today to endorse taking strong steps to guarantee that the housing GSEs have a strong regulator. I think many of us also agree that we must work with the Treasury Department and the administration to ensure that any change to the GSE regulatory structure be done in a way that preserves the companies' roles as GSEs in a way that strengthens the effectiveness of the safety and soundness regulation without foiling the financial markets. So this committee is going to have to have a balance in the need for strong GSE regulation with the need to be sensitive to the housing markets.
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    I was joking with my good friend Sherry Boehlert, the Chairman of the Science Committee the other day when this first was all announced. Everybody was scrambling for a hearing in the Congress. I told Sherry since Freddie Mac uses electricity in their building he as the Science Committee maybe he ought to have a hearing on Freddie Mac. I think that this is the perfect venue here for the hearings and I want to just point out that if there is wrongdoing, it has to be gone after. We cannot tolerate that.
    If there is slippage in the regulatory scheme, we have to correct it. I want to echo the comments of my colleague, Mr. Kanjorski, I think we have to do it also in a balanced way so that we in fact to not affect the markets and hurt a lot of innocent people. There is a difference with Enron where it imploded and 15,000 people weren't around to be saved. In this case, we need to do the right thing in the regulatory mechanism. We also need to do the right thing in the markets in fairness to all Americans.
    Thank you.
    Chairman BAKER. I thank the gentleman.
    Mr. Miller?
    Mr. MILLER OF NORTH CAROLINA. Thank you, Mr. Chairman.
    The opening statements today have sounded in some cases more like opening jury arguments than they have like opening statements. I join with Mr. Kanjorski in pointing to the remarkable success it is for our country, for our nation that we have the kind of widespread homeownership that we have. We certainly need to extend it more broadly. We need, as Mr. Scott points out, higher homeownership among African Americans and others. But the extent of homeownership by the middle class in this country is a remarkable success, and these institutions, these government-sponsored enterprises, have played a huge role in that. Homeownership is how the middle class develops wealth. It is how they save for their children's college educations; how they save for retirement. It is a great asset.
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    The housing market in this country in the last few years has been one of the few bright spots in a very bad economy, a lot of which has been driven by the available capital for housing and for homeownership. We certainly do need to pay close attention to these institutions. We need to make sure they are solvent and they are sound. But I have learned in my brief service on this committee that accounting is in fact surprisingly imprecise. It is not terribly surprising that with interest rates dropping precipitously as they have in the last couple of years, that there would be some imprecision in the accounting treatment of these two government GSEs given the nature of their business.
    So before I prosecute someone or convict them, I would like to identify exactly what the problem was, whether there was anything that merits being compared to Enron or Arthur Anderson, and I certainly want to make sure that we do not choke off the supply of capital that has gone into making homeownership possible for the middle class.
    Thank you, Mr. Chairman.
    Chairman BAKER. I thank the gentleman for his statement.
    Chairman Oxley?
    Mr. OXLEY. Thank you, Mr. Chairman. I want to thank you for convening this important hearing on the oversight of the GSEs. The recent management reorganization of Freddie Mac should give us all pause to assess how well the operations of these GSEs are being monitored by OFHEO.
    Freddie Mac and Fannie Mae account for billions of dollars in mortgage-backed securities which are widely held by pension funds, mutual funds and individual investors. Given the complexity of these institutions and their importance to the secondary mortgage market, it is critical that their regulator be capable of exercising rigorous oversight to ensure their safety and soundness. Over the past six months, as Freddie Mac first announced that it would restate its earnings and then dismissed its three top officers, OFHEO has appeared to be habitually slow to act and unable to predict these crises.
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    Chairman Baker has been tireless in his review of the issues surrounding the GSEs and was instrumental in the agreement by both Freddie Mac and Fannie Mae to voluntarily register their securities with the SEC. This voluntary registration will lead to more transparency in the operations of the GSEs, which will make for a more efficient and better-informed marketplace.
    The U.S. housing market has remained strong through difficult economic times and is the most sophisticated in the world. This is largely due to the liquidity provided through the secondary mortgage market in which Freddie and Fannie are the key players.
    I look forward to hearing from our distinguished panel. Their insights as third party observers will be critical to our consideration of this issue and future actions this committee may take.
    I yield back the balance of my time.
    [The prepared statement of Hon. Michael G. Oxley can be found on page 46 in the appendix.]
    Chairman BAKER. I want to express my appreciation to the Chairman for his participation here today and also to acknowledge that it has been with his leadership and counsel that we have moved to this point in the process, and recognize that this issue is obviously controversial and difficult, and I certainly appreciate his willingness to be a strong leader in the effort as well.
    Mr. Meeks?
    Mr. MEEKS. Thank you, Mr. Chairman.
    Mr. Chairman, considering the recent events of the past two years regarding the validity of various companies' financial statements and the related fraud committed by the management of Enron to WorldCom, it is my understanding that Congress would want to take a careful look at its GSEs that are so critical to the homeownership market in this country.
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    Upon hearing about the removal of Freddie Mac's top brass and the accuracy of their financial statement was in question, all of us who have this primary responsibility for safeguarding the country's financial system had to have concern about the extent of the problem and be prepared for the necessary committee action.
    However, I counsel prudence in taking legislative action based on the initial reports. All indications thus far are that the GSEs are still two of the best capitalized and financially solvent financial services companies in America. They have met OFHEO's risk-based capital standards and met their cooperative agreements for transparency. Once Freddie Mac registers its common stock, something Fannie Mae has already done, they will have completed another step in complying with additional calls for transparency.
    There are individuals who believe that GSEs need a stronger financial regulator. There are others who are seeking greater regulatory control over their products and programs. Perhaps those concerns have some validity that needs further exploration. But let me tell you about my concerns. My concerns are that GSEs continue to help Americans achieve the highest homeownership rate we have ever experienced. I am concerned with GSEs's continuing to close the gap in minority and non-minority homeownership rates. My concerns are with the GSEs's continuing to make homeownership more affordable to low-and moderate-income individuals in America.
    Of course, safety and soundness must be our primary concern as legislators. But we cannot let a rush to judgment lead us down the path of unintended consequences. The role of GSEs is too critical to our economy to have their mission interrupted. We must not throw the baby out with the bathwater and we must make sure that we keep and strengthen these institutions.
    I yield back the balance of my time.
    Chairman BAKER. I thank the gentleman for his statement.
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    Mr. Green?
    Mr. GREEN. Thank you, Mr. Chairman.
    I will be brief. I don't want the opening statements to overtake the testimony. I want to associate myself with your remarks in particular, and that of my colleague, the Chairman of the Housing Subcommittee, Congressman Ney. Look, Fannie Mae and Freddie Mac are a vital part of our housing finance system. I think we understand that. I think we also understand that nothing that we undertake here today or talk about here today is discussed in a vacuum. There are observers and there will be reactions. We must tread carefully because of the sensitivity to the potential responses by housing market observers.
    On the other hand, I believe tread we must. People may not fully understand the role of Fannie and Freddie in our economy and the housing finance system. More importantly, they will never understand why we failed to take action when we could when we learned that there are in fact changes that need to be undertaken. So while we do need to tread carefully, again I think we have no choice but to take certain steps and tread we must.
    With that, I yield back, Mr. Chairman.
    Chairman BAKER. I thank the gentleman.
    Ms. Maloney, by unanimous consent, not a member of the committee, but who would like to make a statement. Without objection, she is recognized.
    Mrs. MALONEY. Thank you, Mr. Chairman. I request permission to put my comments in whole in the record, but to summarize it, I thank you for your leadership and would like permission to put in the record the lead article today in the American Banker, which outlines the work of this important committee.
    [The following information can be found on page 104 in the appendix.]
    I would just like to say that oversight of the GSEs is one of the most important issues the Financial Services Committee presides over. These institutions are pillars of our housing system and millions of our constituents benefit from the liquidity they provide our lending institutions.
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    At the same time, the recent events at Freddie Mac are deeply troubling. While the company's new leadership is trying to repair the damage, the reality of the accounting and corporate governance shortcomings that occurred at the company are unsettling given the size of the institution.
    I joined this committee just as our country was emerging from the S&L crisis. My first vote was a huge bailout of these institutions. Because of this experience, I regard congressional oversight of the safety and soundness of the financial services industry as really our most important responsibility. In this regard, I have long supported efforts to provide more resources to the Office of Federal Housing Enterprise and Oversight and I joined the Chairman last year, along with Representative Bentsen and Kanjorski, in legislation that would have removed the agency from the appropriations process, thereby making it more independent.
    I want to note that OFHEO took very, very long to come forward with its risk-based capital rule, but despite these shortcoming in OFHEO's history, I do believe in taking a deliberative and thorough approach to legislating major changes to our nation's housing markets. I understand the Chairman is coming forward with a total change to this, but I have not had a chance to look at that legislation. Before acting, we need to know exactly what happened at Freddie Mac and whether it represents a one-time occurrence or a systemic problem.
    The U.S. mortgage market is the best in the world, as we all know, and in the current low interest rate environment mortgages are being refinanced at a record rate that would be impossible without automation from national laws like the FCRA and our incredibly successful mortgage finance system. The Washington Post detailed the impact that the ability to refinance so easily is having on our economy in a June 8 article. I request permission to put this article in the record. I just want to note that it pointed out that since 2001, banks have processed more than 27 million mortgage refinances by the end of this year, and in total since 2001 refinancing will have delivered about $300 billion directly to consumers who will have more money to spend and pump up the economy. That is in comparison to the $263 billion that the Bush tax cuts of 2001 and 2003 will have put into the economy by year's end. So I thank the Chairman for his oversight, for calling this hearing, and really for his leadership. I look forward to working with him to make sure that our housing system remains preeminent in the world. I thank him.
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    Chairman BAKER. I thank the gentlelady for her statement. Her statement, of course, and all ancillary materials referenced will be included in the record without objection.
    [The prepared statement of Hon. Carolyn B. Maloney can be found on page 56 in the appendix.]
    Mr. Bachus?
    Mr. BACHUS. First of all, Mr. Chairman, I want to thank you for this legislation. I think it is a measured approach, and for your approach to these hearings. We are going to investigate the matters.
    There has been absolutely no suggestion by anyone that Fannie and Freddie are not sound financially. What has been suggested, and I think recent events have borne out, and that is that OFHEO has failed to be the regulator that they needed to be. Your approach has been to shift regulatory oversight to the Treasury Department. That has been suggested for some years as the best approach. The Department of Treasury has years of financial regulatory experience and has proven to be up to the task.
    Other than what the others have testified, I would simply add is evidence that we do need to transfer oversight and regulation to the Department of Treasury. The budget for OFHEO last year was $27 million. Despite this, in their latest report to Congress, OFHEO certified that Freddie Mac's audit functions were independent and effective. So obviously they failed to do their job.
    Now, it could be that they simply did not have the authority that the Treasury has, but your bill takes care of that by transferring it to Treasury and then OTS, and giving the regulator of Fannie and Freddie the same authorities as your other bank regulators have. So for whatever reason, it may have simply been that they did not have sufficient authority in their regulation.
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    One thing that I do want to express some reservation about, and I have discussed this with you, is the part of the legislation with regard to HUD's new program authority. I do not want to stifle innovation in the marketplace by micro-managing these new product issues. I think we ought to take a very careful look at that. But other than that, I think you have a good bill and I look forward to working with you.
    Chairman BAKER. I thank the gentleman for his kind remarks and his cosponsorship of the measure as well.
    At this time, the Ranking Member of the full committee, Mr. Frank.
    Mr. FRANK. Thank you, Mr. Chairman.
    I want to apologize, first, because this committee has a bill on the floor which I will be managing. It is very important bill. It will be up this morning on suspension, to provide a gold medal to Tony Blair and I guess payback his legitimate part of things. So I will be temporarily absent while I preside over that important piece of legislation.
    I just want to say that I am glad to hear members talking I think in very thoughtful terms. We are not talking about a crisis that is comparable to those that affected some of the major corporations. We have a general agreement that the important function of easing housing finance at the two big companies involved here is important to protect. I think it is very legitimate for us to look at what went wrong here and what, if anything, we could do legislatively to stop it. But I would include in this that this is an issue it seems to me not simply of Freddie Mac, but also of accounting.
    I had not, I must say, prior to becoming the ranking member, paid as much attention to the accounting industry as my duties now require me to. I think part of the question now is I think to a good part of America, the issue is whether accounting more resembles astrology or alchemy in the way in which it is practiced. As we deal with the question of what is the appropriate structure for the GSEs, I think this is a reminder that we also need to look further in to the question of how we regulate the accounting industry because some of these issues are not just GSE-specific, but they are generic to the question of accounting.
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    That also includes, and I hate to say this because I cannot think of anything that would be less fun for us, but derivatives also is something we have to look into. I say that with all the enthusiasm of being told that we have to go back to trigonometry and take a test in it. But it does seem to me that, as I said, some of this is possibly GSE-specific, but much of it deals with generic accounting issues and derivative issues and I think these need to be on the agenda.
    Thank you, Mr. Chairman.
    Chairman BAKER. I thank the gentleman for his remarks.
    Mr. Gary Miller?
    Mr. GARY G. MILLER OF CALIFORNIA. Thank you, Mr. Chairman.
    I applaud you for holding this hearing today and the approach you have taken on this issue has been very deliberative and reasonable. We all know that home equity appreciation is one of the most important drivers of wealth creation in the United States. By helping people become homeowners, we promote long-term economic stability for our nation.
    Congress must continue its goal of helping millions of Americans to achieve the dream of homeownership by ensuring that Americans have access to mortgage funds at the lowest cost. Fannie Mae and Freddie Mac were chartered by Congress in 1970 to provide stability and ongoing assistance to the secondary market for residential mortgages and to promote access to mortgage credit and homeownership in the United States. It is imperative and important to ensure the safety and soundness of the secondary mortgage market.
    The question of impropriety that has surfaced as a result of the revelation of accounting irregularities at Freddie Mac could be devastating to the strong housing market. We must examine whether OFHEO is truly up to the task of regulating Freddie and Fannie. It is our responsibility to examine the situation and understand how Freddie Mac's regulators could have released an annual report that the audit functions at Freddie Mac were effective and that the internal-external audit functions had the appropriate independence necessary. This was a mere three days before Freddie Mac's announcement that its top three executives were being ousted because of accounting irregularities.
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    As we proceed with our examination, we must be cautious and deliberative. Chairman Baker has proposed creating a new safety and soundness regulator in the Treasury Department with independent funding, reasonable enforcement authority, and sufficient standing to provide Congress and the investigators a clear and accurate financial assessment of GSEs. We must be mindful that our ultimate goal is to expand the supply of affordable mortgage credit in order to stimulate the production of affordable housing. As we move forward, we must be sure we completely understand the implications of changes in the regulatory structure in meeting this important goal.
    In California, we have had some very difficult economic times and the housing industry has really kept California afloat, and this is a tremendously important issue for California.
    I yield back, Mr. Chairman.
    Chairman BAKER. I thank the gentleman.
    At this time, I don't know that there are other members on the Democrat side to be recognized.
    Let me ask it this way, are there others wishing to make an opening statement at this time?
    Mr. CROWLEY. Mr. Chairman?
    Chairman BAKER. Mr. Crowley?
    Mr. CROWLEY. Thank you. Mr. Chairman, I want to express my pleasure in your holding these hearings and at the same time express some concerns about what I believe may be too broad an approach when we are examining these issues. There is no question that the troubles of Freddie are troubles we on both sides of the aisle are concerned about. We know that Fannie Mae right now registers with the SEC so its corporate documents can be disclosed to the public and investors.
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    What I really question is why we are focusing on all the GSEs when not all of them have problems. In fact, Fannie has received clean financial reports. It is as if we looked at Coca-Cola and saw that they had problems in their accounting and then also looked at Pepsico; or if we go a little further, examining Halliburton after the failure of Enron. I do want to recognize that both these entities, as mentioned on the other side, are sound institutions and have historically provided great opportunities for Americans. I just don't want to see, and I don't think this committee will do that, Mr. Chairman, with your leadership, a degradation of these two institutions. With that, I yield back.
    Chairman BAKER. I thank the gentleman.
    Mr. Royce, did you have an opening statement?
    Mr. ROYCE. Thank you, Mr. Chairman.
    I want to thank you for holding this hearing. I would like to commend you for your unwavering commitment to the topic of GSE regulatory reform. I also greatly look forward to hearing from our witnesses today to see what they have to say to contribute on this ongoing discussion.
    Government-sponsored enterprises have really focused on homeownership and have been around since 1934. Since that time, they have played an important role in developing the secondary mortgage market in the United States. Fannie Mae and Freddie Mac buy mortgages from originators in order to provide liquidity in the market. The Federal Home Loan Bank system provides advances to banks and thrifts so that those organizations can offer mortgage products to their customers.
    Like the rest of corporate America, the GSEs have developed comprehensive business models to achieve their mission and to get results for their shareholders. As a result, the housing GSEs have become three of the most sophisticated financial institutions in the world. In total, the three GSEs have over $2 trillion in debt and a derivative portfolio with a total of $1.9 trillion. As a result of their evolving business models, the three housing GSEs now must protect their balance sheet not only from credit risk, but also from interest rate risk.
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    With these facts in mind, I think that it is crucial that these organizations are subject to competent regulation. I regret to say that I do not have enough confidence in the Office of Federal Housing Enterprise Oversight which regulates Fannie Mae and Freddie Mac, or in the Federal Housing Finance Board which regulates the Federal Home Loan Bank system.
    I believe that we need to fold these two regulatory bodies into a new agency under the umbrella of the Treasury Department. In my view, such a regulatory institution will have better direction through its association with the Treasury and its sister regulators, the OCC and the OTS. The new regulator will also have the ability to achieve best practices of regulation because it will have a broader scope than either OFHEO or the FHFB has today, and it will be focused on protecting the taxpayer from like-types of systemic risk.
    I think that it is important for this committee to act on this matter through perception and reality or both. All three housing GSEs are inadequately regulated. I look forward to working with my colleagues to create a new, more effective regulatory structure for Fannie Mae, Freddie Mac and the Federal Home Loan Bank system.
    I would like to thank our witnesses here today and would once again like to thank Chairman Baker for his longstanding interest in this issue.
    I yield back the balance of my time.
    [The prepared statement of Hon. Edward R. Royce can be found on page 58 in the appendix.]
    Chairman BAKER. I thank the gentleman for his remarks.
    Ms. Harris?
    Ms. HARRIS. Thank you, Mr. Chairman.
    I want to express my appreciation for your willingness to conduct these hearings on the oversight of the government-sponsored enterprises. This morning we will consider the oversight body of Fannie Mae and Freddie Mac, focusing upon the structural changes that may be necessary to improve the oversight of these two GSEs.
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    As this committee examines the proposed reforms, we must recognize the vital role that both Fannie Mae and Freddie Mac play in maintaining the health of our nation's housing industry. The housing industry serves as the backbone of our American economy, having enjoyed vibrant growth and economic prosperity while other sectors of our economy have struggled recently. In particular, I believe we must remain aware of the impact that additional hearings or legislation could have upon the housing industry and global markets. Our actions could provoke unintended consequences in the market for mortgage-backed securities.
    Recent events have prompted multiple agencies to investigate the accounting operations of Freddie Mac. I hope these investigations will produce findings that can help us frame the legislation that will alleviate the concerns that these events have created, while preserving those positive contributions that Freddie Mac has made to the housing industry.
    I wish to thank the individuals who are here today on our panel for their insights regarding the oversight of Fannie Mae and Freddie Mac, and moreover I look forward to a healthy debate regarding this critical matter.
    Thank you, Mr. Chairman.
    Chairman BAKER. I thank the gentlelady.
    Mr. Shays?
    Mr. SHAYS. Thank you, Mr. Chairman.
    Mr. Chairman, I would like to submit a written statement, but just say that we are looking at two fine companies in Fannie Mae and Freddie Mac, the second and fourth largest financial institutions on the New York Stock Exchange. Fannie is under the 20th largest company; Freddie the largest under 40th. I mean, these are huge and important companies. But it blows me away that they are not by law under the 1933 and 1934 Securities Acts. When we dealt with Enron and WorldCom, all those reforms did not apply to them because they were under the SEC requirements and they were not part of it. It blows me away they pay no federal and state taxes. They are not under the privacy laws, state consumer laws, truth-in-lending laws. I am amazed that they are under a regulator that has half the resources, and I feel quite candidly that they tell the regulator what to do, not vice versa. I am hoping that your legislation will move forward. We will have a stronger regulator. It will be under the Treasury Department. I hope they will have greater powers and will treat this on a level playing field.
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    I do not fault Fannie and Freddie for not wanting to have to play by the rules that everyone else plays by, but I do fault Congress for not addressing this issue. I am grateful that we are beginning to.
    Chairman BAKER. I thank the gentleman for his statement.
    [The prepared statement of Hon. Christopher Shays can be found on page 59 in the appendix.]
    If there are no members desiring to make any further statements, at this time I would like to recognize our first witness. Welcome to each of our panelists this morning for your endurance.
    Our first witness is Mr. Sean Egan, Managing Director of Egan-Jones Rating Co. Welcome, sir.
    Let me quickly add, all statements will be made part of the official record. To the extent possible, if you can constrain your remarks to five minutes, it will enable the committee to engage in more thorough questioning. We appreciate your participation.
    Welcome, Mr. Egan.
    Mr. EGAN. Thank you.
    Chairman Baker, members of the subcommittee, good morning. I am Sean Egan, Managing Director of Egan-Jones Ratings Company, a credit rating firm. By way of background, I am the Co-founder of Egan-Jones, which was established to provide timely accurate ratings to institutional investors.
    Our business model differs significantly from other rating agencies in that we are not paid by issuers of debt, which we view as a conflict of interest. Instead, we are paid by approximately 300 firms consisting mainly of institutional investors and broker-dealers. Unlike the major rating firms, we provide early warning to investors on major debacles such as Enron, WorldCom, Global Crossing, Genuity and ABB. We are based in the Philadelphia, Pennsylvania area, although we have employees that operate from other offices.
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    The three areas I would like to briefly address today are the GSEs's current status, their development, and our proposed reforms.
    Regarding their current status, Fannie Mae and Freddie Mac, collectively the GSEs, started life under the protection of the federal government and were given a line of credit from the U.S. Treasury. When they were small, the $2.5 billion line of credit was adequate. However, as they have grown, that line has become inadequate. I direct everyone's attention to the chart that we have on the first page of my written testimony. That is a list of the asset base of Fannie Mae and Freddie Mac. If you look at the asset base, as of the year 2000, they had $675 billion in total assets. That is the first line. It grew in 2001 to approximately $800 billion and in 2002, to $877 billion.
    The next line is shareholders equity. It is interesting. It went from basically $21 billion down to $16.3 billion. They reported profits last year. I don't think they paid out $2 billion in common stock dividends, so it is still a mystery how they went from $18 billion to $16 billion, but they did it. The more telling figure is equity divided by assets. In the year 2000, it is 3.1 percent. It dropped down to 1.9 percent in the year 2002.
    Freddie Mac, interestingly, its equity to assets looks fairly reasonable. However, we are always skeptical of some of these accounting results. It is very easy with derivatives, to manipulate the valuation of derivatives. Keep in mind that the GSEs are providing a lot of liquidity for these derivatives to bolster the earnings and capital account.
    What we take away from these two charts is that 1.9 percent equity to assets and the 3 percent is really just a sliver. It is a sliver of capital for institutions that have huge positions.
    Let me move on. As the GSEs grew, they were not able to grow their capital base sufficiently to keep pace with the rapid asset growth. What used to be high leverage has become excessive leverage. Below is a comparison of the GSEs's current ratios to other firms' ratios. It is difficult to find perfect comparables to the GSEs. They are unique institutions in some regards, but there are some that at least provide some guidance. You see in the second chart on page two, Countrywide Financial which is rated by Moody's A3, by S&P an A. You see the total debt-to-capital is 89 percent. It means that they have roughly 10 percent capital. That compares to Fannie Mae's less than 2 percent capital. It just means that there is a big difference, but yet they are given a AAA rating.
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    Let me move down. Egan-Jones currently rates Fannie Mae at A+, which is approximately four notches below S&P and Moody's AAA ratings. Egan-Jones uses the same rating categories as S&P in the investment-grade segment.
    Attached is a history of our ratings and below our comments from a June 10, 2003 report on Fannie Mae. This is quoting from the report. ''Far from a AAA, Fannie Mae is not fully backed by the U.S. and only has a sliver of equity. The general rule for banks is to maintain equity at 8 percent of assets. Fannie Mae has only 1.96 percent. Also, Fannie Mae has greater volatility than some banks because of its business focus and absence of loan prepayment penalties.'' In other words, if you borrowed from a bank and if you want to prepay that bank loan, you have to pay a penalty because a bank normally is match-funded with liabilities so they don't have to worry about prepayment. In the case of Fannie Mae and Freddie Mac, they don't have that.
    Although Fannie Mae claims that it is hedged, there are few perfect hedges. Keep in mind, they are one of the biggest hedging institutions probably in the world. Most traders say there are very few perfect hedges. That applies here. Still unresolved is the support Fannie Mae will get from the federal government if it gets into trouble. Fannie Mae's prospectuses state that the federal government is under no obligation to support Fannie Mae, but most investors assume it will, probably up to only $2 billion. The assumption of the U.S. guaranteeing all Fannie Mae's debt and shareholders getting the up-side is likely to change.
    Egan-Jones currently rates Freddie Mac at A, which is approximately five levels below S&P. Let me skip forward. We have similar comments on Freddie Mac. A reasonable question would be why one rating agency, Egan-Jones, would rate the GSEs at A and A+, whereas Moody's and Standard & Poor's and Fitch would rate the GSEs at AAA. Our view is that, number one, there is substantial pressure on major rating agencies to maintain a high rating for various large issuers. Number two, there is relatively little penalty if the rating ultimately proves to be wrong.
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    Regarding pressure to maintain a high rating, Moody's, Standard & Poor's and Fitch obtain approximately 90 percent of their revenues from issuers such as the GSEs. I am quoting from the Wall Street Journal. Over the years, S&P and Moody's have rated over $500 billion of Freddie Mac debt and earned tens of millions of dollars of fees. They don't tell you exactly how much they have earned, but if you use their standard rate of 2 basis points, that adds up to $100 million for one of the agencies for one of the GSEs. That is a lot of money. It has to be one of their biggest clients, if not their biggest clients.
    Unlike Moody's, S&P and Fitch, Egan-Jones is not paid by the issuers for its ratings. Regarding the lack of penalty if Moody's, S&P and Fitch ratings prove to be disastrously wrong, there are relatively few alternatives. The major rating agencies therefore face few penalties. Up until earlier this year, the three major rating firms were the only firms recognized by the SEC, and DBRS which was recognized in March 2003, has little market presence in the U.S.
    Over the past 3 years, there have been numerous examples of investment-grade firms filing for bankruptcy protection on short notice. Enron was rated investment-grade four days before it's filing. National Century was rated AAA 2 months before it's filing. WorldCom was rated at the Baa/BBB level 3 months before filing. The California utilities were rated at the A level 16 days before defaulting. Despite these failures, the major rating firms have regularly grown their revenues because of the restrictions on competition.
    We have several suggestions.
    Chairman BAKER. Can you begin to conclude for us, too?
    Mr. EGAN. Yes. We have several suggestions that are listed in the report. One is the establishment of a revised regulatory body. You can read that. Two is restricting the growth, rebuilding the capital of the GSEs. Three is encouraging the development of additional funding sources. I don't care if these GSEs are the best-managed entities in the history of the world, things happen. My teenage son might have put it slightly differently. You can't concentrate on just two agencies. If a bomb explodes in their computer center, you don't want to shut down the country. Four is enhance the ratings firms' independence. This is an important issue. We think that it has to be addressed. If it is left unaddressed, it will continue to fester and cause additional problems.
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    [The prepared statement of Sean J. Egan can be found on page 72 in the appendix.]
    Chairman BAKER. Thank you very much, Mr. Egan. Your full written testimony will be made part of the record as well.
    Our next witness is Mr. Thomas Schatz, President, Citizens Against Government Waste. Welcome, sir.
    Mr. SCHATZ. Thank you very much, Mr. Chairman and members of the subcommittee. I appreciate being here today on behalf of Citizens Against Government Waste.
    We are pleased to testify about the adequacy of oversight of Fannie Mae and Freddie Mac. We agree that Fannie Mae and Freddie Mac provide a very useful service to the American economy. We also believe that these organizations should ultimately be privatized.
    That being said, we do support reasonable regulation as well as greater accountability and transparency as interim steps toward full privatization. Thanks to your good work, Mr. Chairman, and the hearings you have held over the last several years and the work of this subcommittee, improved regulation of the GSEs has been amply examined. It is now time to act. Certainly the changes that have been made at the GSEs in terms of voluntarily registering with the SEC and other steps they have taken have been as a result of the work of this committee.
    The current system of GSE oversight certainly does need improvement. Freddie Mac is the fourth largest financial services company in the United States, yet as others have pointed out, it's safety and soundness regulator, OFHEO, gave Freddie Mac a clean bill of health less than a week before the announcement of the company's accounting problems.
    My written statement includes 15 suggested improvements for GSE oversight, and I would like to mention a few of them now. Strengthen safety and soundness regulation by moving this responsibility to the Department of the Treasury and provide the new regulator with powers comparable to those available to bank regulators; require that the GSEs hold bank-like capital, and Mr. Egan pointed out the differences between the capital held at banks and other financial institutions and Fannie Mae and Freddie Mac; fund the regulator through assessments on the GSEs; permit new programs as long as they do not violate the GSEs's charters or undermine the safety and soundness of the GSEs and also do not involve direct consumer lending; repeal Fannie Mae and Freddie Mac's exemption from federal securities laws; and finally, repeal the line of credit of $2.25 billion that exists for each GSE.
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    We recognize that our list is ambitious, yet you have included a number of these provisions in your new bill, Mr. Chairman. The three provisions we believe are essential right now are bank-like capital for Fannie Mae and Freddie Mac; consolidation of safety and soundness and new program authority in a single strong regulator; and repeal of the GSEs's exemption from federal securities laws.
    Mr. Chairman, we support your bill's establishment of prompt corrective action powers for the new regulator, but again we reiterate Fannie Mae and Freddie Mac should be subject to the same capital standards as banks. In March of this year, William Poole, President of the Federal Reserve Bank of St. Louis, recommended that, quote, ''Over a transitional period of several years, the GSEs should add to the amount of capital they hold,'' unquote. I ask, Mr. Chairman, that the entire text of Mr. Poole's speech be included. I have attached it to my statement. Without the imposition of stricter capital standards, the GSEs will always pose a problem of systemic risk to taxpayers.
    CAGW supports your plan to move the GSEs's regulator from HUD to Treasury and to make it more independent by removing it from the appropriations process, and financing it through the assessment of fees on the two GSEs.
    We also believe that new program approval should come under this new Treasury regulator, as most of the new programs that GSEs propose are financial products. The possibility of systemic risk posed by the GSEs is inextricably tied to the scope of their activities.
    Finally, we believe your bill should include provisions comparable to H.R. 2022, legislation introduced by Representatives Chris Shays and Ed Markey, to repeal the GSEs's exemption from federal securities laws. This month's news regarding Freddie Mac clearly demonstrates the implication of the GSEs's current exemption from these laws. Any other company which was forced to re-state earnings must continue to file its financial statements with the SEC or be subject to SEC sanctions. In such cases, the message is clear to investors that the company has not complied with the law. In Freddie Mac's case, despite its failure to live up to its commitment to register, the agency did nothing and in fact did not initiate an investigation of Freddie Mac until after the company's announcement of its management shakeup. Certainly, no other public company would have experienced such forbearance from the SEC.
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    We endorse the view of the Treasury, OFHEO and the SEC in February in terms of MBS disclosure which concluded that any adverse effects from additional disclosure will be short-term and will be outweighed by the benefits of greater information flowing into the MBS market. The Congressional Budget Office agreed with this last month, and last week Moody's Investor Service stated that making all GSE securities subject to SEC registration would be a good thing. These financial giants should be held to the gold standard of disclosure, as both former SEC Chairman William McDonough and Federal Reserve Chairman Alan Greenspan have said.
    Mr. Chairman, we commend the subcommittee for its continued oversight and efforts to improve the management of the GSEs. The time for inquiry is over. We believe it is time for action to be taken by this Subcommittee to exercise its responsibility to the taxpayers. We urge members of the subcommittee to enact legislation that will establish a strong regulator with the authority to impose bank-like capital standards and repeal the GSEs's exemption from the securities laws. Thank you, Mr. Chairman.
    [The prepared statement of Thomas A. Schatz can be found on page 85 in the appendix.]
    Chairman BAKER. Thank you very much, sir.
    Our next witness is Dr. Jay Cochran, Research Fellow at the Mercatus Center, George Mason University. Welcome, sir.
    Mr. COCHRAN. Good morning, Mr. Chairman, Mr. Kanjorski, members of the committee. I am Jay Cochran, a Research Fellow in Regulatory Studies at the Mercatus Center at George Mason University, and adjunct professor of economics at GMU.
    Our mission at the regulatory studies program is to advance knowledge of the impact of regulations on society from the perspective of the public interest. Therefore, our work does not represent the views of any particular affected party or special interest group, but rather is designed to evaluate the effects of government policies on overall consumer welfare. I would like to emphasize, however, for the record that my comments today do not represent an official position of the university.
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    In 2001, Catherine England, professor of finance at Marymount University and I authored a study entitled ''Neither Fish Nor Fowl: An Overview of the Big Three Government Sponsored Enterprises in the U.S. Housing Finance Markets.'' The big three, of course, being Fannie Mae, Freddie Mac and the Federal Home Loan Banks. I respectfully request, Mr. Chairman, that this study be incorporated into the record as part of my remarks here today.
    Chairman BAKER. Without objection.
    Mr. COCHRAN. Our aim then, as now, in writing this study was to bring a measure of objectivity to a subject that, as I am sure everyone on this committee is well aware, can be quite contentious. This morning, I will briefly touch on some of the risks presented by the GSEs, as well as some of the oversight and regulatory issues pertaining to them.
    First with respect to risk, the big three GSEs on balance sheet assets have grown since 1995 from $726 billion to just under $2.4 trillion by the end of 2002. Mr. Chairman, in my written testimony provided earlier, that was a misprint and said $2.4 billion. It should read $2.4 trillion. This represents an annual growth rate over the period of more than 18 percent per year. By comparison, real GDP over the same period grew by roughly 3 percent and the overall U.S. residential mortgage market grew by slightly more than 9 percent per year.
    By itself, rapid growth is not necessarily troublesome so long as general principles of financial safety and soundness are followed. Of course, one of the most important principles of sound finance is diversification. That is, not having all of one's eggs in one basket. For the last several years, though, Fannie Mae and Freddie Mac have been placing more of their own eggs in their own basket. They have gone from holding a combined $125 billion of their own mortgage-backed securities in portfolio in 1995 to holding nearly $850 billion of their own MBS internally as of 2002, a growth rate exceeding 30 percent per year.
    In this connection, it is well to recall that Congress's original aim in creating the GSEs was to help the banking and thrift industries off-load and spread the risks of mortgage finance by creating an active secondary market in mortgages through the GSEs. If, however, the GSEs are increasingly holding their own mortgage-related products in portfolio rather than selling them to investors, mortgage lending risks may again be concentrating rather than dispersing throughout the economy.
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    To their credit, the GSEs cite adequate risk protection through hedging activities and by other means. However, such claims raise the issue of counter-party risk. Are the institutions on which the GSEs rely for risk-sharing financially sound? And just as importantly, are they likely to remain so during less than ideal economic conditions? But even beyond the basic question of financial soundness, if banks are important counter-parties to the hedging and risk-control operations of the GSEs, then in an important if less obvious way, the risks attendant with mortgage finance may be quietly reentering the banking system, only this time through an off-balance sheet side door.
    With respect to Fannie Mae's and Freddie Mac's safety and soundness regulation in particular, I trust that the staff of OFHEO is well intentioned and doing the best job that they can, given the economic and political constraints that they face. However, no realistic assessment of GSE oversight can ignore the fact that OFHEO consists of just over 100 people operating on a $30 million annual budget. Yet this small organization is expected to oversee two enterprises that hold a combined $1.6 trillion in assets and produce business volumes on a monthly basis measured in the billions of dollars. This vast disparity in size and resources may explain in part why, for example, OFHEO gave Freddie Mac and its audit procedures an unqualified endorsement, only to have that endorsement undermined by recent events.
    It is also noteworthy that OFHEO took nearly 10 years to develop a risk-based capital standard for the GSEs. To be sure, the risk-based capital standard that emerged is a sophisticated and complex model. Still, I cannot help but be concerned given my earlier remarks about diversification, for example, that we may have substituted modeling sophistication for adherence to basic principles of sound finance.
    In conclusion, I think the history is clear that the housing finance GSEs have delivered benefits, not only to their owners, but also to homebuyers and lenders. Despite these benefits, however, one must always keep in mind that the GSEs are neither fully responsive to market forces nor to government control. Being neither fish nor fowl, neither fully private nor fully public enterprises, prudence and rational public policy require that the GSEs undergo regular scrutiny by government and market participants. With respect to this last point in particular, Mr. Chairman, I would like to applaud you and the members of this committee for your steadfast willingness to undertake this difficult, but necessary responsibility.
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    Thank you.
    [The prepared statement of Jay Cochran can be found on page 61 in the appendix.]
    Chairman BAKER. Thank you very much, doctor, we appreciate your testimony.
    Our next witness is Ms. Karen Shaw Petrou, Co-founder and Managing Partner of Federal Financial Analytics, Incorporated. Welcome.
    Ms. PETROU. Mr. Chairman, thank you, and Mr. Kanjorski and members of the subcommittee, for inviting me here today to speak on the topic of improving the regulation for the housing GSEs.
    I am Karen Shaw Petrou, Managing Partner of Federal Financial Analytics, a firm that provides information and consulting services on an array of legislative, regulatory and policy issues that affect the financial services industry. Our information service includes one on the GSEs, which is used by combatants on all sides of this debate. On our consulting and advisory services, our clients include U.S. and international bank regulators who we have assisted over the years in improving their own work.
    We have been doing a great deal of work of late on the Basel Risk-Based Capital Accords and we also advise numerous firms and associations on concerns that Fannie Mae and Freddie Mac serve their homeownership mission, and not engage in new activities in a risky fashion.
    Today, I would like to focus on tenets of effective bank supervision that I believe can be easily, quickly and appropriately adopted for Fannie Mae and Freddie Mac. There is I believe no evidence that effective bank supervision and meaningful capital requirements have in any way undermined homeownership. I think it is very important to remember that Fannie and Freddie cannot serve their mission and promote homeownership unless America's financial services firms, banks and savings associations, first do theirs. They originate the mortgages. Fannie and Freddie then securitize them. Effective supervision has not inhibited the ability of lenders to originate mortgages and I do not believe it will be in any way an impediment to an effective secondary market that will promote homeownership.
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    In fact, as this panel has recognized in its work on the Basel rules, effective supervision and meaningful capital has been a key to the success of the U.S. financial services industry and especially our banking sector. We lead the world. Many of our institutions are the largest, and most importantly I think without dispute, American banks are the most innovative on derivatives and asset securitization, many other new products and services that promote economic growth and serve consumers, and do so with effective safety and soundness supervision and meaningful capital.
    I believe that this will promote homeownership if applied to Fannie and Freddie. Indeed, I think effective supervision and meaningful capital will reduce the cost of homeownership if investors, particularly bondholders in Fannie and Freddie, have confidence in the regulator and believe that meaningful capital is a discipline on risk-taking. And if they have enough information on which to base informed decisions, Fannie's and Freddie's cost of funding will drop and that should be translated into reduced homeownership costs, especially for the minority and low-income customers for whom the benefits of the GSEs were initially intended. The three tenets of effective bank supervision as established by the Basel Committee and adopted by all of the U.S. bank regulators, the Fed, the OCC, the FDIC and Office of Thrift Supervision, are first, capital; second, supervision; and third, disclosure. I suggest that as you look at the system for Fannie and Freddie, you keep those principles in mind and ensure that the new regulator you establish has ample authority to ensure that all three of those pillars are strong and lasting.
    The 1992 regulatory structure established at that time for Fannie and Freddie, who were then one-third the size they are now, taking very different risks than the ones they take now. I must say, I view that as a divide and conquer structure which would have had a difficult time working under any circumstance. If it ever could have worked, it certainly has not. The news we have had from the markets of late, especially that related to the Freddie Mac restatement, and again the news this morning as more information was released by Freddie Mac as to how it sees its balance sheet and its earnings going forward, are deeply troubling.
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    The role of OFHEO as the safety and soundness regulator, not only in anticipating, but fundamentally a safety and soundness regulator should prevent these types of risk. We have seen no signs, for example, that OFHEO has undertaken the reviews of internal audits, of management and of controls at Fannie and Freddie that the bank regulators have rightly undertaken in the wake of the Enron case and of Sarbanes-Oxley.
    Secondly, the regulatory capital rules need significant fixing. OFHEO's standards, complex to be sure, are vastly different than the rules the bank regulators now employ and the rules pending in the Basel Committee for all large financial services firms. They are premised on derivatives. Mr. Frank mentioned earlier his concern about these. I think it is important to note that the OFHEO risk-based capital rules allows Fannie and Freddie to count hedges as if they were real shareholder capital. They are not and they should not be permitted going forward. Effective supervision requires an independent agency and I think safety and soundness supervision means new program control. Often the riskiest things an institution does are its newest. Safety and soundness supervision there is essential.
    Finally, good disclosure, a real stand-alone rating, and SEC registration, and I think call reports comparable to those used by banks.
    Thank you very much.
    [The prepared statement of Karen Shaw Petrou can be found on page 78 in the appendix.]
    Chairman BAKER. Thank you, Ms. Petrou.
    I would like to note that your observation with regard to the Basel Accord, capital supervision and disclosure are exactly the principles around which we have tried to construct the regulatory reform recommendation. Importantly from strategy, some have questioned why have we moved so quickly. It was to frankly get the bill into the public domain so that markets could respond, and through this morning, the comment has been very favorable and already begun to have some positive impact on market pricing for GSEs's capital.
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    I was very troubled in understanding your testimony. I now know that Freddie has announced that it cannot under GAP standards treat any of its derivatives in portfolio as GAP-qualified accounting hedges. You made the comment that then these hedges could not then count as capital or shareholder equity. What I am troubled by, or ask your opinion on, does the rules-based capital test that OFHEO now utilizes permit these derivatives that are not now GAP-compliant still to be counted as capital?
    Ms. PETROU. Yes, sir. It is my understanding that it does.
    Chairman BAKER. What possible relevance could the stress test then have to properly assessing the capital adequacy of the enterprises?
    Ms. PETROU. I do not know.
    Chairman BAKER. I understand, too, that Freddie now is having to basically take back credit risk as a result of implicit recourse, because it was basically backing its own credit risk instead of having laid off that risk to third parties. If that is correct, and I am making an assumption, how can that be consistent with its own charter obligations?
    Ms. PETROU. I do not know, sir. The charter requires all of the GSEs to hand-off the risk of high-risk mortgages, those with loan-to-value ratios above 80 percent, to qualified third parties, generally mortgage insurers. It is unclear from the results this morning the degree to which that in fact was done.
    Chairman BAKER. So could that possibly be, in your opinion, a violation of the charter?
    Ms. PETROU. The facts will need to be carefully examined, but it is certainly possible.
    Chairman BAKER. What about Freddie eliminating its held-to-maturity book? And what implications does that have on Fannie Mae, if any?
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    Ms. PETROU. Again, it remains to be seen. This gets to the very complicated question of the relationship between FAS 133 and how assets are valued on the balance sheet and which assets are marked to market and which ones are not. Freddie Mac this morning reported that its investigation to date found that assets were held to maturity that were in fact being traded or sold. It is again somewhat still unclear what actually was going on.
    Chairman BAKER. So there apparently were assets being held to maturity while being available for sale?
    Ms. PETROU. That is correct. And the accounting rules require that once that finding has been made, the entire pool of held-to-maturity assets is, if you will, tainted. So now everything has had to be moved over to available for sale.
    Chairman BAKER. Let me ask each of you. I know that some have suggested that we go further with our regulatory reform. Are there any of you who have any objection to any particular portion of H.R. 2575 in the time you have had to review it, understandably being short? Are there portions of it which you have concerns may adversely affect the functions of either GSE as proposed? Anybody?
    Ms. PETROU. I would say, sir, that I think that making HUD the regulator for new programs is something at which I would suggest you take another look. It has had that authority for 10 years. To my knowledge, it has only acted on one new program and that was at the direct request of Mr. Leach, going back to 1997 when one of the GSEs decided to enter an aspect of the life insurance industry, and then HUD approved it. It does not have a good record here, nor does it have the skills to be a safety and soundness analyst of new programs.
    Chairman BAKER. One further question before my time expires. It appears, and I am only acting now on a quick read of the morning news with regard to Freddie's most recent disclosure, that they are acknowledging that they did not have sufficient resources or personnel to sufficiently gauge and manage their derivatives risk portfolio. It might even be broader with regard to internal operational risk management functions. If that is the corporation's position, how is it possible, given the resources that Freddie does have available to it for risk management purposes, that we could view OFHEO by contrast in any credible light, not because of the quality of individuals, but because of the limitations of funding and simple numbers of personnel? Is that a fair comparison to make?
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    Mr. SCHATZ. Mr. Chairman, if I may, I would agree with that. It is one of the reasons why we support your efforts to move the regulatory authority over to the Department of Treasury. These are large financial institutions that engage in very complex financial transactions. Certainly they are still achieving the goal of providing greater homeownership for the American people, but certainly given the developments and the changes in what they are now engaged with compared to 10 or 15 years ago, Treasury is the only place where that expertise would reside. I would agree with Ms. Petrou's remarks about the safety and soundness, as well as new program authority, really being together as opposed to being separate.
    Chairman BAKER. Thank you. My time has expired, but I have just got to make a comment. If the facts presented this morning are accurate, and I presume that they are and we will take time to examine it and understand it more fully, I cannot comprehend how anyone could go home feeling confident that the current regulatory structure is in any way adequate in light of the risk that has been published to date.
    Mr. Kanjorski?
    Mr. KANJORSKI. Thank you, Mr. Chairman.
    We seem to be moving ahead, and most recently we may have made the error in military policy on everyone concluding on everyone else's statements or news reports that there is incontrovertible evidence of weapons of mass destruction. It seems that term was thrown out there, everyone accepted it, and accordingly policy was made, no one testing the basic premise. Does anyone on the panel today, can they tell us actually what happened at Freddie Mac? In fact, is there a serious violation of law?
    Mr. COCHRAN. Mr. Kanjorski, not having published their financial statements for 2002, I can't make that statement. I have not been able to look at them yet.
    Mr. KANJORSKI. I haven't either, and that is why I am wondering whether or not we shouldn't first have a premise of what happened down there, instead of deciding that clearly what happened down there warrants significant substantive change. I am not opposed to change, and certainly in my opening statement I recommend and have been recommending for years certain things that I hear the panel agreeing with, the fact that we should have an independent regulator; that we should have an independent regulator with the same authority that other regulators of financial institutions have, which OFHEO has never been given; that it should not be funded by annual appropriations at a very meager amount, but should be self-financing through assessments on the bodies being regulated. We all agree on those principles, right?
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    I think we could very easily move forward, whether we call it modernization or reform or anything else. I think it would be something we could all agree on to do that for the regulator of the GSEs. But some of the things I fall out of favor with, or have not certainly been convinced, to taking a retail regulator like the Office of Thrift Supervision has the expertise to handle a very sophisticated, two or three sophisticated entities such as the GSEs. Do you really all believe that compared to all the regulators that exist in the financial institutions of the United States, the Office of Thrift Supervision is going to be the best regulator we could select? What is your opinion on that?
    Ms. PETROU. I would agree with that concern, sir. It would be within Treasury and it does have resources, but it also has many distractions.
    Mr. KANJORSKI. Right.
    Mr. EGAN. I would like to comment on your previous question, and that is the accounting discrepancies and the dismissal of the executives. From our perspective, that is a secondary issue. The primary issue with the GSEs is their level of capitalization. The accounting revelations were really just an accident waiting to happen because they have relatively little cushion in their capital base, number one; and number two, that rating of AAA is unrealistic unless you assume that the line of credit from the Treasury is significantly greater than $2.25 billion. If somebody told us it is closer to $60 billion per institution, then we move above the single A level, but we have heard nothing of the sort.
    Mr. KANJORSKI. So the underlying premise for this hearing, the recent news releases and the firings at Freddie Mac precipitated this hearing, but you are telling me they are not the basis on which this committee should be looking at new regulation. There are some other substantive questions.
    Mr. EGAN. They run much deeper than that.
    Mr. KANJORSKI. Right. I agree with you. We have been carrying on our examination for more than 40 months and have been making some progress, sometimes by voluntary disclosure and transparency that the two organizations have had.
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    I tend to worry about our establishing some precedent for action based on incomplete news reports and internal actions by the board of directors. Quite frankly, I could understand a board of directors being annoyed with a set of management that have not complied with making restatements in a number of years and just getting totally fed up and saying enough is enough and you are gone. We are going to put somebody else in. It should not necessarily connote to the market or to anyone else that there was something criminal or improper that was carried out. It was just probably a great frustration or could have been a great frustration of the board, and a very responsible act by the board, I may say, if that is the derivation for the action. Would you agree?
    Mr. EGAN. Yes, but I would characterize it as saying these are two critical institutions and that investors are confused right now. They are concerned when they see executives resign. They are concerned when they hear about accounting problems, and they are concerned about the regulatory environment of both GSEs. I think it requires a closer look at the entities and how they are regulated, and whether or not investors are investing on an appropriate basis, or whether another signal has to be sent to the market.
    There is also the issue of whether or not they lose their AAA rating; whether or not they still can exist in their current form. My understanding is that they are not putting up much capital for their derivatives. In fact, in a lot of cases they are putting up no capital because of that AAA rating. If that goes, a question is how badly the institutions will be hurt. So it is a very broad question that I think needs to be addressed. Whether or not it ends up that you move it to a different regulator is part of that broad question.
    Mr. KANJORSKI. Should we as a committee be acting just perhaps a little more responsibly in finding our what happened and starting from the core of the facts of the information before we move? I heard so much of your testimony, ''if this happened, if this happened, this may have happened, this could be.'' But no substantial statement of facts as to what did happen, and yet we are speaking to the world market here in a way that could be very crucial at a very delicate time in our economic structure as a whole. I am just wondering just how responsible it is for us to conjecture as to what may have happened and talk about it as if it in fact did happen. Not that we should wait, but I am surprised that maybe some of our first witnesses are not the regulators, and aren't some of the officials that made the decisions within Freddie Mac to tell us what they did and why they did it.
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    Mr. CASTLE. [Presiding.] If you could answer briefly, we need to move on to other witnesses please.
    Mr. EGAN. Very quickly, from our perspective, the current regulator should not have allowed the capital to dwindle to the point that it is as a percentage of assets. That is a fundamental issue and investors are still thinking it is a AAA rating and hopefully it can be handled delicately so it does not cause a panic in the market.
    Ms. PETROU. If I could also just add, one thing we do know, we don't have any ifs about, is what OFHEO has done through this process. When Freddie Mac first announced its restatement in January, within hours the head of OFHEO said he saw no problems. Consistently as each revelation has come out, OFHEO within hours has commented on it. Bank regulators never talk about their charges because they believe in something they call constructive ambiguity. That promotes market discipline and it is essential. We do know that, sir.
    Mr. CASTLE. Thank you, Mr. Kanjorski.
    Mr. Ney is recognized for 5 minutes.
    Mr. NEY. Thank you, Mr. Chairman.
    The current regulatory regime for the GSEs has a product review on safety and soundness regulator split between HUD and OFHEO. The new proposal keeps that system with HUD regulating new products and the OTS regulating safety and soundness. I am wondering if keeping this system is in the best interests of the GSE regulation because they could be rather intertwined. So would it make sense or wouldn't it to centralize all the GSE regulations under one roof or not? Anybody that would like to answer.
    Mr. SCHATZ. Mr. Ney, we have made that proposal and we certainly urge the subcommittee to examine it, discuss it with the regulators, and determine whether this would be best, and also look at how other financial institutions are regulated to determine whether there is a bifurcated system out there or a single system. It seems to me that there is more or less a single system for soundness and safety. The new program authority is certainly unique to the GSEs in some ways, and I would hope that as the subcommittee moves forward and the full committee moves forward that you do discuss this in some depth.
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    It is our view that the new programs, if they are not tied to safety and soundness and the same regulator is not aware of what the GSEs are supposed to be doing in their mission, that is one of the problems that could occur. There was a statement earlier about the fact that OFHEO in its 10 years only interrupted or said that it was not going to support one particular product indicates that they are not doing a very good job of making these determinations. I am sure there are other products that may have been reviewed or reviewed differently if they had been more aware, or certainly tied into more knowledge of the financial system that the GSEs are involved with as well.
    Mr. NEY. So you approve consolidating them?
    Mr. SCHATZ. Yes, we would approve consolidation. But again, I think you would need to compare this to the other financial institutions in the country as well, to be consistent.
    Mr. NEY. Does the rest of the panel agree with that or disagree?
    Ms. PETROU. I would agree with that, sir.
    Mr. EGAN. Our view is whoever regulates them has to have in-depth knowledge of the financial market, hedges and be able to stress test assets and liabilities and really have a very sophisticated banking examiner.
    Mr. COCHRAN. You might pose the question oppositely and ask, if you keep it bifurcated like it is now, what happens if those two regulatory aspects come into conflict? Who dominates, safety and soundness or mission? So there is probably a rationale for keeping them consolidated under one regulatory roof, so to speak.
    Mr. NEY. Do you have any comments on the prior approval that would be in the new piece of legislation?
    Ms. PETROU. You are referring to the prior approval of new activities?
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    Mr. NEY. Of new product. Is it enough? Does it overregulate?
    Ms. PETROU. Right now, all of the insured depositories and their holding companies need prior approval from their safety and soundness regulator for any new activity. Yet we have an industry that is by far the leader in the world in innovation. I think it is important because it protects safety and soundness. It also protects consumers. In new products there are potential abuses, conflicts of interest, disclosure issues. Prior review by a skilled regulator is really essential.
    Mr. NEY. So you say it is common for every single product or change in existing product in all cases to have prior approval?
    Ms. PETROU. All new products which raise significant issues. Congress has rightly put in place a system for traditional products at traditional institutions of notice to the supervisor, but those are still all done in a public process. Any significant new activity must be reviewed by the regulator and put out for comment so that all appropriate views are considered before the deposit insurance funds or the lender of last resort is put at risk through a potential new activity.
    Mr. NEY. Over the years, the OTS has developed a lot of expertise in regulating thrifts and the unique business model that comes along with thrifts. Any thoughts about taking OTS into a whole new different regulatory venture?
    Ms. PETROU. I think it raises significant issues because we have ''housing finance'' here, but Fannie and Freddie are so huge and their hedging activities are so different that they could be considered housing, financial institutions or even hedge funds, and a supervisor with the skills to do both is essential.
    Mr. NEY. So you feel the OTS has been towards, again, thrifts and the unique situation there. But you feel comfortable that OTS could undertake this and be able to do this with Fannie and Freddie?
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    Ms. PETROU. No, sir. I have some questions about that.
    Mr. EGAN. I agree. From our perspective, the hedging operation is like the nitroglycerin of these companies. It has to be handled very careful, made sure it is set up properly, that it is matching their asset and liability structure. It has to be reviewed properly. The counter-parties have to be understood. It is far beyond the normal thrift institution. It is more akin to regulating CitiGroup or J.P. Morgan or some of the investment banks.
    Mr. NEY. Thank you. My time has expired. Thank you, Mr. Chairman.
    Chairman BAKER. Thank you, Mr. Ney.
    Mr. Scott?
    Mr. SCOTT. Thank you very much, Mr. Chairman.
    I am very, very much concerned that we do move forward; that we work very judiciously on this issue. I certainly appreciate the chairman allowing me an opportunity to work with him on this legislation as we move forward.
    I do think we need to move with a bit of caution because the first question I want to ask is, what impact would our proposed legislation in this committee to strengthen the regulatory oversight have on the stated mission of these two entities? It is my understanding that stated mission is to buy home loans from banks and lenders, to supply ready cash to the home mortgage market, especially for middle-income and lower-income individuals. Given that, and I don't know which of you might want to respond, Ms. Petrou, I certainly want to get your opinion on that question, what impact would it have? I think that is a fundamental issue here as we move forward, because Fannie Mae and Freddie Mac were created for a special purpose.
    The other part of this question is that it is very complex and complicated, but from what I am following here, the nut of this issue it seems to me is this business of derivatives, which are used to hedge interest rate risk. Now, if I am not mistaken, derivatives was the key role that was played in the Enron upheaval. So I would like to get an analysis from you of the derivatives in relationship to this question. If we are using these derivatives, if we are using them to hedge on this risk-taking of interest rates and it resulted like Enron, the fundamental question then becomes, is Fannie Mae and Freddie Mac taking on too much risk?
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    If you could answer those for me, and I do have one other point I want to get to later, so Mr. Chairman, please, if they talk too long or I talk too long, please correct me because I would like to ask another question. But I would like to get an answer on that one, please.
    Ms. PETROU. First with regard to the mission, sir, I think that appropriate regulation will enhance, advance and reinforce that mission. One provision in the Chairman's bill addresses HUD's role in ensuring that Fannie and Freddie serve affordable housing. In my opinion to date, the goals have been too lax; the definition of affordable housing too generous; and the enforcement nonexistent. We have had a lot of rhetoric, but we need an effective supervisor to ensure real performance, just as we have bank regulators who look in and enforce in cases where financial services firms, especially insured depositories, are not doing right by their low-and moderate-income customers.
    Mr. SCOTT. So you think that moving the regulatory oversight to the Treasury Department would help the mission?
    Ms. PETROU. Yes, sir. I know there is some issue as to whether or not Treasury is as devoted to homeownership as it is perhaps to safety and soundness and stable financial markets, but I think with the role of HUD and of course with congressional supervision and clear direction to Treasury, you can ensure that a new regulator takes as full account of those responsibilities as the bank regulators do. For example, you have told them to have a Community Reinvestment Act and that has helped bank regulators govern their charges, and you can do the same for Fannie and Freddie.
    Mr. SCOTT. What about the idea of registration of debt with the Securities and Exchange Commission?
    Ms. PETROU. I would support that.
    Mr. SCOTT. You don't feel that would hamper the mission?
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    Ms. PETROU. No, sir. I think it might help in fact to improve it by improving investor understanding, reducing costs. Fannie's and Freddie's costs of funding could well diminish. Indeed, Moody's recently suggested that it would and that is what the GSEs should be passing on to the neediest homeowners.
    Mr. SCOTT. The other question I wanted to ask is, just for the record, do you believe that because of the similarities between Freddie Mac and Fannie Mae that Fannie Mae may be being tarred by the same brush? Do you think it is fair to judge Fannie Mae based upon the missteps of Freddie Mac?
    Ms. PETROU. I don't, sir, at this point, but I do think it is fair to say that both GSEs operate under divided and in many respects faulty regulation with inadequate capital and lack of appropriate market discipline.
    Mr. SCOTT. Okay. My final point, Mr. Chairman, the Office of Federal Housing and Enterprise Oversight has got 140 staff and a $30 million budget. Do you think that is enough? Do you think they are too weak to perform the task? That they need to be strengthened in terms of manpower and budget?
    Mr. EGAN. Our view is that it goes beyond even the regulatory environment; that there are some problems in the market itself that have gotten us to this point. There are problems with the investment banks, all the analyst came out positive, I think, about 10 analysts came out positive, one came out negative after the disclosures on the accounting issues. That is a structural problem. The fact that the major rating firms are all paid by the issuers and get the bulk of their compensation from these major issuers, that is a problem. Regulation has typically lagged.
    It would be terrific if you set up a huge regulatory body, maybe you would get better disclosure, but it has to go beyond just that issue if you are going to protect these firms in the future and protect investors. The worst that could happen, they are doing great work, the worst that can happen is that there is a breakdown in the market and investors lose faith. The investors think that the U.S. government is behind this whole thing 100 percent. That is why there is a AAA rating. This whole area has to be addressed and the structural problems in the financial markets have to be addressed.
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    Mr. SCOTT. Thank you.
    Thank you, Mr. Chairman.
    Chairman BAKER. Thank you, Mr. Scott.
    Mr. Castle?
    Mr. CASTLE. Thank you, Mr. Chairman.
    Let me just say to you first of all, you have wandered in the desert for some time and I think you have found your oasis, and I think the rest of us had better start paying some attention to this. This is not something that is easily understood or can be swept under the rug, in my judgment. Let me thank the witnesses for the tutorial today, because I am still trying to define the problem. I haven't even gotten to whether there is a solution at this stage.
    Along those lines, if I could just ask you some consumer-type questions. I want to know what is at risk here. For example, the housing market has been the strongest part of our economy for the last 3 or 4 years. I just refinanced my mortgage. I am pleased with that. Actually, it is not complete yet; hopefully it will go through. Obviously, Fannie Mae and Freddie Mac are tremendously helpful with that, based on all that I read and understand, although I could not tell you why, but that is what they tell me.
    My concern is, are we by taking the actions that we might take here, are we going to disrupt the housing market in some way or another, or the securities market, or even the stock market in terms of the stock values of these companies? In other words, by dealing with the additional regulation, is it going to be such a great burden or such a great shift that there is going to be tremendous impact out there? On the other hand, if we don't do it, is there going to be potentially an impact? I can't really honestly define everything that went wrong with Freddie Mac or whether Fannie Mae has any problems or not, but my sense is that they are less regulated than a lot of other financial entities, and that is potentially a problem as well.
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    So if you could just, if any one of you or two of you or whatever, can help me with understanding the potential problem a little more in terms of what could happen here, I would appreciate it.
    Mr. SCHATZ. I just wanted to just jump in a little bit, Mr. Castle. The problem really will arise if Congress does nothing. After the Enron scandal and Arthur Anderson, certainly steps were taken to strengthen regulation over the accounting profession and the securities and others. Here we have two large organizations that are exempt from many of the laws that apply to their competitors, to every other publicly traded company. Our view is that placing them under the scheme would reassure investors, reassure the public. They would certainly still be able to compete and compete very well, as they do, in the marketplace, and that it would restore a great deal of confidence that may have been shattered not by what you are doing, but what happened at Freddie Mac.
    So it is in a sense a problem of their own making, but it does draw more attention to what the chairman and others, and Mr. Shays and others have been talking about for some time, which is simply trying to improve regulation and oversight. No one is talking about putting them out of business. We are talking about providing a structure that will give all these people, the shareholders, the taxpayers, consumers, the banking system, the housing system, more confidence that oversight is being exercised in an appropriate manner.
    Mr. CASTLE. Thank you.
    Mr. EGAN. Our view is along the lines of a stitch in time saves nine. If you don't act, this is probably what is going to happen, that Fannie Mae's capital base instead of dropping from 3.1 to basically 2, in another 2 years it will probably be about 1.5, and just keep dropping from there. There is huge pressure on these organizations to grow, so you have to hold them back, no constraints.
    What would be an ideal world is if there is a new regulatory body. It had some real powers. It encourages these organizations to strengthen their capital base.
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    Mr. CASTLE. Excuse me. Let me interrupt there, because I wanted to ask this question anyhow. By a new regulatory structure, you are suggesting that OFHEO just is not capable of being structured in such a way that it could carry this out responsibly?
    Mr. EGAN. We have not seen any evidence of that, and hopefully it won't come to that to encourage some discipline in the rating agency industry also, and some discipline with the equity analysts. Obviously there are still some problems. What would also help is that if you had some new mortgaged-backed agencies, some mini-Freddie Macs and Fannie Maes that are growing, so if God forbid, anything happened to these two entities, that we are not just counting on them; that we have some alternatives, some viable alternatives, in the market. If we could achieve that goal in another two years, it would be a huge positive to the people holding the mortgages, the homeowners, the markets, everybody would benefit. On the current path, it is just a problem, a sore, that is going to continue to fester and grow.
    Mr. CASTLE. Should the Federal Home Loan Banks be considered or included in any legislation that we do?
    Mr. EGAN. I am going to defer to some other panelist.
    Ms. PETROU. I think there are some significant supervisory issues there that do warrant your review. The Federal Housing Finance Board in only the last year has taken a look and found that it had three times more PR people than it had examiners. That is for an institution which in aggregate is about $800 billion. So I think a hard look does need to be paid.
    Mr. CASTLE. Thank you, Mr. Chairman. I yield back.
    Chairman BAKER. Thank you, Mr. Castle.
    Mr. Miller?
    Mr. MILLER OF NORTH CAROLINA. Thank you, Mr. Chairman.
    I am just trying to understand what is the bad thing that can happen here? Mr. Egan, you said things happen, and yes I know exactly what your teenage son would have said instead of that. And I know that by saying ''things happen,'' you intended some ambiguity that we can't possibly anticipate all the bad events. But it seems to me that the thing that these two institutions have going for them is that ultimately they rely upon what is for most households the ace of trumps, the mortgage. People may or may not pay their credit card bills, but they sure pay their mortgage.
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    It certainly seems like Fannie Mae and Freddie Mac should not have to have the same kind of equity requirements that, say, MBNA has. What can cause the meltdown here? Is it that people don't pay their mortgage? Is that there are fluctuations in interest rates? Is it the ways that interest rate fluctuations are hedged is somehow risky in a way that is incomprehensible to 99.95 percent of the population in this room?
    Mr. EGAN. There are a variety of things that could happen, and you could assess some probability of that happening. Unless the economic environment changes drastically, probably the mortgage payment rates are not going to change very much. What is probably going to be a bigger problem is that there will be some revelations that over the next six or twelve months that both these entities are having difficulty. Because Mr. Castle prepaid his mortgage perhaps yielding 7.5 or 8 percent, and now is only paying 5 percent.
    These entities receive that money and now can only reinvest it in the market at 5 percent. However, on the liability side, because they can't pay off all those liabilities, they still have to pay 5.5 or 6 percent. That is a problem. These are huge entities so it is difficult to hedge completely against that problem. Maybe they have to revalue the portfolio because they have to mark-to-market because they sold out some of the instrument, and that 1.9 percent capital goes down to 1.5 percent. Maybe it is that our competitors S&P and Moody's realize that maybe this really isn't AAA and they do some investigation and realize the capital line is only $2.25 billion, and no more after that, and therefore they reassess their position and all of a sudden it slips down to AA, and some major investor groups, the Japanese or the Germans, pull out their capital or reassess their investment.
    It is an accident to have so much water behind the dams, is a nice way of thinking about this. These institutions were built to hold so much water and there is too much water behind it. You need to let down the water level. You have to shore up the dam so that it is safer, and hopefully get some other dams in place, too, so that you are not dependent on this one river system. So there are a variety of different problems that could happen. It is hard to figure out which one exactly is going to hit, but certainly you don't have the cushion that you should have.
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    Mr. MILLER OF NORTH CAROLINA. If we take less water behind the dam, if we let down the water level, are we not inevitably going to make mortgages less readily available?
    Mr. EGAN. No, because the markets are fluid and hopefully there will be some other institutions that will be encouraged to step up their activities. The other approach is just continuing to build it up and I would argue that you don't have enough cushion right now to continue to let it happen, and the forces are in place that if it is not pulled back, the asset base will continue to grow.
    Ms. PETROU. I would say, sir, also that when you describe mortgage credit risk, which is all of our desires to pay our mortgages off first, that is the risk Fannie and Freddie were established and chartered to take for the lowest-risk mortgages. What they were supposed to do when Congress established them was to buy mortgages originated by lenders, turn them into mortgage-backed securities so the investor would take all of that interest rate risk that Mr. Egan described. Fannie and Freddie would hand-off the riskiest pieces of the mortgage credit risk position to third parties, and they would then hold the rest, the safest piece of that mortgage credit risk. That is not how they are structured any longer.
    Chairman BAKER. I thank the gentleman.
    Mr. Shays, you are next. And just by way of comment on the last exchange, the last quarter of 2002 there were reported negative duration gap difficulties for Fannie Mae which is a reflection of the mismatch in their portfolio because of the extraordinarily low-cost interest rates for so long. The solution or remedy as I understand it was to merely acquire mortgages and grow the portfolio, which does not necessarily yield any more profitability, but does increase risk to the taxpayers.
    And by the way, Mr. Shays, you are recognized.
    Mr. SHAYS. Thank you, Mr. Chairman.
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    You have the second and fourth largest financial institutions in the United States. You have the 16th and 32nd largest Fortune 500 companies. Under the law, they were not under the 1933 and 1934 Security Acts. Neither of these Acts were to punish companies, correct? What are the purposes of both of these Acts?
    Ms. PETROU. To protect investors by informing them of a wide range of financial information and to give remedies when these protections are not in place.
    Mr. SHAYS. And we require all Fortune 500 companies to be under these requirements. Is that correct?
    Ms. PETROU. All publicly traded firms.
    Mr. SHAYS. All publicly traded. So if that is the purpose, then explain to me how putting them under the Act harms these companies or harms these investors? I am at a loss of words to understand how anyone can say putting them under the 1933 and 1934 Acts somehow is going to harm them and harm our economy. Please tell me how.
    Mr. COCHRAN. I think the claim that is being asserted is that by coming under the Act, they will have to register and incur the costs of registration, and that cost flows to the bottom line.
    Mr. SHAYS. So it is the cost issue.
    Mr. COCHRAN. That would be my estimate.
    Mr. SHAYS. Right. And so what we did in our legislation, we capped them to say they would have to contribute no more than 5 percent of the total amount to the SEC, and any other company. Wouldn't that minimize that issue?
    Mr. COCHRAN. It probably would. And by the way, I do not necessarily agree with that assertion in any case.
    Mr. SHAYS. Okay. Does anyone agree with that claim that it is going to hurt them? Okay.
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    Let me understand Freddie's statement today about what they are disclosing. Would someone here tell me what you think Freddie said today about the fact that they have to re-state earnings. What is your sense? Tell me what you think is going on at Freddie in short-term, not a long sentence. Sean, do you want to do that?
    Mr. EGAN. That they are still getting a handle on exactly what is going on; what their derivative positions are; how to value the securities. They are hoping they get it right this time, but they are not quite sure and hopefully they don't roil the markets too much.
    Mr. SHAYS. Anybody else want to add something?
    Ms. PETROU. No, we heard this morning was that the earnings range now will be increases of between $1.5 billion and $4.5 billion, and that the bulk of this is resulting from significant new disciplines related to derivatives.
    Mr. SHAYS. My understanding is they said they didn't follow general accounting practices or what would have been required under the SEC, and had they followed what would be required under the SEC, they wouldn't be in this problem. Is that true?
    Ms. PETROU. It is unclear whether they would have been in this problem because firms under the SEC, of course, have also encountered serious issues. But I think there are questions.
    Mr. SHAYS. Let me put it differently. If they followed the requirements under the SEC, they would have not have encountered this.
    Ms. PETROU. This morning Freddie Mac indicated there were aspects of the restatement that might violate securities law had they been subject to them. That is all I can speak to. That is one of the pieces in their release this morning.
    Mr. SHAYS. Would you explain to me when they say that their earnings were understated, is that a good thing? Should I feel comfortable that there is potentially $4 billion of understated earnings in the past? Like, in other words, they have more earnings. Does that mean, one, they didn't pay proper taxes in the past? And two, should I say this is good news?
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    Mr. COCHRAN. I think as Congressman Frank suggested, there are ways to interpret the application of accounting rules. But I think what concerns the markets is that by restating the earnings, you are going to increase the volatility or the variance in the reported earnings. Other things being equal, we would rather see smooth earnings over time, rather than bumpy earnings.
    Mr. SHAYS. So investors would rather see constant growth, not really terrific years and bad years. And so if Fannie or Freddie experiences that kind of growth pattern, how does the investor respond to it?
    Mr. EGAN. From our perspective, it is unsettling. It is unsettling because there is a lot more volatility in the earnings than what they would like to have been the case. They are trying to smooth earnings and now they found out that they can't, and the investors are thinking it is not quite up to the AAA rating that it should be.
    Mr. SHAYS. Okay. Just one last question, Mr. Chairman? So if I am an investor, I should not say this is good news that they had really higher earnings in the past which they understated.
    Mr. EGAN. No, because it is going to be depressed in the future. It is just taking earnings that they are pushing out in the prior years and they won't have it in the future years. It just means that the volatility will be greater. It is not comforting.
    Mr. SHAYS. Okay. Thank you, Mr. Chairman. Thank you to the panel.
    Chairman BAKER. Thank you, Mr. Shays.
    Mr. Clay?
    Mr. CLAY. Thank you, Mr. Chairman. I want to thank the panel for their testimony today.
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    First, a few observations in regard to this legislation and the subject matter. I think we must identify the level of mismanagement, be it accounting problems or criminal activity. Solutions for Freddie Mac must be based somewhat on those answers. Are we going too fast without knowing what we are correcting? Or are we negatively affecting the markets with this rush to judgment? Hopefully these hearings will bear that out.
    Let me ask about the proposed bill which imposes restrictions on non-mission-related investment by Fannie Mae and Freddie Mac. My understanding is that the non-markets investment portfolio is used as an essential risk-management tool. These liquid investment portfolios serve as a capital cushion used by the companies to manage liquidity needs. By restricting this risk-management too, the bill takes away Fannie Mae's and Freddie Mac's ability to manage a liquidity crisis like the one the country experienced in the fall of 1998. Because of the current structure, Fannie Mae and Freddie Mac were able to step up in a turbulent time and provided stability in the United States housing markets. Why do you think this tool should be eliminated? We can start with you, Mr. Egan.
    Mr. EGAN. I don't think it should be eliminated. I think it has to be properly managed or you run the risk of losing the tool, so to speak. These are great institutions. They have created a huge amount of good for a number of people. The risk is that they are not regulated properly; that they are misperceived in the market; that if the problem is not addressed in the near future, that you cut off access to mortgage funding for a lot of people. So our view is that it just has to be managed properly and hopefully some other institutions will grow to compete with these two. It is a very important area and it is unwise to leave just two major institutions fulfilling this function.
    Mr. CLAY. I heard you say that before, too. Now, do you think that other institutions will step up and follow the mission statement of these two entities, I mean to really go after the low-and moderate-income individuals who have that desire to realize the American dream?
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    Mr. EGAN. Yes, because there is a profit incentive. The institutions have outgrown their $2.2 billion capital line. Other institutions can be set up to serve that area. So yes, I think that other institutions will fill the void.
    Mr. CLAY. Let me ask you, based on an open-ended public interest standard, this new regulator that is proposed in the legislation could make public any information about Fannie Mae or Freddie Mac. Doesn't this bill throw overboard any notion of safeguarding proprietary corporate data or examination confidentiality? Wouldn't one impact be to make all corporate data potentially available to competitors? Anybody can tackle it.
    Mr. SCHATZ. Mr. Clay, I would expect that as the subcommittee and full committee review the specific provisions of the bill that it would protect any proprietary information for Fannie Mae and Freddie Mac as it would any other company. I would hope that would be the ultimate outcome of that particular piece of legislation. No one is intending that their proprietary information be made public. That does not happen in other circumstances and it would not be appropriate here.
    Mr. CLAY. Would that really put those two entities at a disadvantage, those GSEs at a disadvantage?
    Mr. SCHATZ. Again, I have not examined every single word, but it seems to me that whatever bill comes out of the committee would simply not do that.
    Mr. CLAY. Okay.
    Mr. EGAN. A good measure of whether or not they have anything proprietary is whether or not they have a number of their officers sign confidentiality agreements pertaining to the software they use for managing derivatives and things of that nature. It would be surprising if they have that much proprietary information.
    Mr. CLAY. Okay. From what I understand, developing a new product can take a lot of time, money and resources. When Fannie Mae or Freddie Mac make this effort and start to work with a group of pilot lenders, sometimes they are not sure whether the new idea will appeal to consumers. Why would the GSEs and lenders advance so much effort into product development if there is a greater fear and chance that a regulator would turn it down?
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    Ms. PETROU. That is the same risk that, of course, Congress has asked all the nation's banks, savings associations and financial holding companies to take because that investment is backed by the taxpayer. Programs can look little. There is one right out there now which is described as a pilot that Fannie is working with some lenders to offer in 50 percent of the nation's mortgage markets. That is really I think a form of consumer lending. So prior approval which bank regulators are good at and banks are good at filing all those applications has never been an impediment to innovation and I don't think it would be for Fannie or Freddie either.
    Mr. CLAY. I thank the panel for their answers.
    Thank you, Mr. Chairman.
    Chairman BAKER. Thank you, Mr. Clay.
    Mr. Baca?
    Mr. BACA. Thank you very much, Mr. Chairman.
    First of all, let me thank the panelists for appearing here today. I have a couple of concerns that I would like to express, but before I do, I would like to recognize the work that Fannie Mae and Freddie Mac have both done. They have served an important role particularly for the Hispanic and minority community. Both companies have a very good track record of expanding minority homeownership. Hispanic ownership rates have increased from 44.7 percent in 1998 to 48.2 percent in the year 2002. In the year 2002, more than half of Fannie Mae's business served low-income and moderate-income families. And Freddie Mac also financed over $135 billion in loans to almost one million minority families in the year 2002. Finally, Fannie Mae has also created the American dream commitment to provide $2 trillion in financing in serving 18 million families by the end of the decade. I am very much concerned about the effects that this legislation is going to have. My question would be, what information can you provide me to show that Hispanics and other minority communities will not be hurt by some of the proposals that we are hearing here today? That is question number one. And two, in particular, what effect would change in the oversight from HUD to the Treasury Department have? That is question number two. And is the regulation necessary to avoid more corporate scandals? That is the third question.
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    Any of the panelists like to tackle this? I heard Karen mention we are too generous. What does that mean? For whom or what? And what effects then will it have on minorities now who have the first opportunities to own a home? They never had it. Are we going to change it?
    Ms. PETROU. I don't think I said that any public policy was too generous to low-income and minority homeowners. That is the most struggling part of the market and it is really where the $13 billion of subsidies provided on an annual basis to all of the housing GSEs should be directed. What I tried to suggest and I think there is some significant research out there that I would be happy to submit for the record, is that good regulation would reduce the funding costs of the GSEs and that would make it easier for them to reduce homeownership costs, particularly at the most struggling ends of the market.
    Mr. BACA. What effects would it then have on minorities or Hispanics on homeownership?
    Ms. PETROU. I think it would result in increased homeownership. For example, if you look around many areas of the cities, the District of Columbia is the one with which I am the most familiar, aspects of the market or access knowledge, language barriers, and that is very costly. I think helping the GSEs reduce their cost of operations would permit more of those funds to translate into Hispanic homeownership.
    Mr. BACA. What outreach or programs would be available to make sure that was done? You can have the regulations, but if you don't have the outreach into the minority communities or others to what is available, and what Fannie Mae and Freddie Mac are doing is that they are doing that. The educational programs, then, would not be effective.
    Ms. PETROU. That is what a good regulator is for, to say here is what you do and to be sure that is what they are doing.
    Mr. BACA. It doesn't happen all the time, though. Can somebody else answer the additional questions that I asked?
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    Mr. EGAN. Our perception is that the market does not give gifts. That is that minority homeownership has increased dramatically because it has become easier in the market to afford the mortgage. Interest rates have dropped to record low levels. Hopefully, these two GSEs will continue their good work and the levels that they have in the past, and hopefully they can get some more capital. But don't confuse the record number of homeownership with their growing very rapidly. It is broader than that. It is really a function of decent economic times overall and the record drop in interest rates.
    Mr. BACA. Right. Well, that is why I am concerned a little bit with the proposal because when you open the market, then you target certain individuals that could lead to additional scandal and corruption and targeting especially minorities and Hispanics, and especially if the education is not out there, too, as well, based on these that would be available. So I mean, that is the concern that I have as we look at what is going on.
    Mr. EGAN. If you are going to give some special consideration to a couple of entities such as a GSE, then encourage them to focus on minority groups and make sure that they actually do their job. They have incentives to do it and monitor it. That is probably the most effective way.
    Mr. BACA. That is why the language is very important that is in the proposal to make sure that we have these guarantees.
    Mr. EGAN. Yes, but make sure that you do not jeopardize these institutions by ignoring their capital levels.
    Mr. BACA. Okay. Thank you.
    Chairman BAKER. Thank you, Mr. Baca.
    Mr. Shays, you had a quick follow-up?
    Mr. SHAYS. Yes, thank you. Just with Mr. Schatz, in his statement he said Fannie and Freddie lagged the private market in supporting the financing of affordable housing. Why is it that Fannie and Freddie basically in spite of their mission don't do as well as banks in terms of supporting the low-income market?
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    Mr. SCHATZ. Mr. Shays, certainly it is a question to ask when they come up to talk to you. I know the Chairman and others on this subcommittee have had those questions before. I will be happy to forward those studies. But for some reason, maybe it is the Community Reinvestment Act, maybe it is other requirements of banks, they have done better.
    One of the things we suggested is to have all of the same regulations and laws that apply to these banks and other lenders, apply to Fannie Mae and Freddie Mac and the Community Reinvestment Act would be one area where they might be forced to participate more in the affordable housing market. And maybe, again, looking at the dichotomy between their mission and their objective to bring the greatest possible return to shareholders, that the returns are not in the affordable housing market. They are in other areas of housing that do not improve that particular area of the marketplace.
    Mr. SHAYS. Let me have one last question, Mr. Egan. Let me ask you, will putting Fannie and Freddie under the 1933 and 1934 Acts hurt their ratings, be neutral, or actually help their ratings?
    Mr. EGAN. They won't change our ratings because we are comfortable with the ratings where they are. They may change S&P and Moody's ratings if they realize that the capital line is only $2.25 billion and it is not going to grow.
    Mr. SHAYS. But there you are just basically saying it is the knowledge that would hurt them, and that in fact would be that they would learn something that already exists, not that we created a new problem.
    Mr. EGAN. More disclosure is always an advantage. What is the biggest problem that we see in the market is when there is a big jump, such as when Enron's business was gone, basically, they are only left with one party to go to for a savior, and that was Dynegy. It is a ''Hail Mary''-type pass. That didn't work out, and then the whole entity collapsed. We are better off in getting the information out there quickly, making sure it is accurate information, and make sure that the reports, the ratings that are given to the investors are representative of the true risk of these enterprises.
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    Mr. SHAYS. So basically from your testimony you are saying more disclosure in the long run helps your ratings, rather than hurts them.
    Mr. EGAN. Absolutely.
    Mr. SHAYS. Okay. Thank you.
    Chairman BAKER. Thank you, Mr. Shays.
    Mr. Scott, you had a follow-up?
    Mr. SCOTT. I want to go back to a moment to this business of derivatives, because I think that is the core of this. Why not just ban the use of the derivatives? Billionaire investor Warren Buffett called them financial weapons of mass destruction. I mean, if he uses that kind of descriptive language, that is enough for me to know that we have a problem here.
    Mr. EGAN. From our standpoint, derivatives are just another higher level of ownership. Initially land was wealth; if you owned land, you were wealthy. Then it turned into gold; if you held gold or silver, then you were wealthy. And then it moved into securities. Hold the stock of AT&T or IBM, well, I am wealthy. It is now moving to the point where information is wealth, and you can make investment decisions faster and more accurately by the next level of sophistication, and that is derivatives. The problem is that volatility increases with each step. The land isn't going anywhere. The people are not going to move dramatically over one year or two years. You can still use it for farming or whatever else. The hard assets, they are less volatile. But when you move into stocks, it is a little bit more volatile. And then derivatives are even more volatile. Who knows whether there is going to be an additional layer of complexity.
    But the negative is that there is a huge amount of risk. Values can change incredibly quickly. You can put on positions, take off positions within a matter of seconds. So the risk level is there. But to many investors, the benefit is also there too that you are able to hedge a portfolio if you know what you are doing. You can offset some positions inexpensively. So as I said before, it is like nitroglycerin. You know you can move mountains with it, but it can blow you up if you don't handle it properly.
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    Mr. SCOTT. Right. As we move forward with this legislation, what recommendations do you give this committee to address this issue of derivatives? If this is the core of the problem, if this is one of the major reasons why we are in the shape we are in, if in fact it also was the major reason Enron went down, would we be not fulfilling our obligation if we did not address this in the legislation?
    Mr. EGAN. No, but you should make it flexible enough to realize that the market is dynamic; that right now we probably don't have the right information infrastructure in place to manage many of these derivatives. Ideally, what would happen is that all these institutions, not only the GSEs, but also the financial institutions, would have a central clearinghouse for their derivative positions so that a regulator could monitor where they stand, whether or not they are getting into trouble. When Long-term Capital was in the process or failing, you would find out that XYZ Investment Bank had a huge exposure to it. Fortunately the New York Fed was able to step up to the task very quickly over the weekend and save it. But if they weren't, they could have been a real problem.
    So I would suggest that the old models for regulating businesses need to be modified. They need to go beyond just the 10K, the 10Q, the traditional ones; developments are moving much faster. It is unrealistic to prohibit the use of derivatives. It is beyond that now. What needs to be done is make sure that the regulation and the monitoring of that fits with the prudent measures; that you are able to manage and see whether or not these institutions are holding enough capital; whether they are offsetting their derivative positions. It is a fairly large task, but it is something that should be addressed over the next couple of years.
    Mr. SCOTT. Thank you. May I just finish? I wanted to ask Ms. Karen Petrou, you are with Financial Service Analytics?
    Ms. PETROU. Federal Financial Analytics. That is a firm that I am Managing Partner of, along with my husband. We are a small business that provides information and consulting services.
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    Mr. SCOTT. Very good. You compared the capital base of the 1980s savings and loan disaster with Freddie Mac's current capital ratios. Do you believe that OFHEO has permitted safe capital ratios? If not, what would you recommend should be changed to improve safety and soundness for these GSEs?
    Ms. PETROU. I believe that the OFHEO capital rule, their so-called risk-based capital rule, is analogous to the net worth certificates that the then-Federal Home Loan Bank Board established for savings and loans in the 1980s, because it is fake capital. In the old days, the net worth certificates were basically Monopoly money, pieces of paper. The regulator said, ''Let's pretend it's capital and hope that you grow out of your problem so the taxpayer does not pick it up,'' and that was wrong.
    Now, we have a much more complex capital rule. It is 700-plus pages long. At the end of the day, what it says is you can count your derivatives as if they were capital. In other words, that nitroglycerin is deemed the equivalent of real shareholder dollars which ought to be at risk first. I do think that is a significant failure that needs rapid attention.
    Mr. SCOTT. Thank you.
    Chairman BAKER. Thank you, Mr. Scott.
    I want to observe that the old rule that Ms. Petrou referenced in her remarks, capital supervision and disclosure, it may not work in every case, but it is a pretty sound formula. On all three counts, we are deficient, in my judgment, at this moment. Now, how we reconcile the deficiency is certainly a matter for the committee to determine. H.R. 2575 is only a point of beginning, not the end of the process.
    I do appreciate each of your appearances here today and giving the committee your insights. It has been most helpful. I would point out that for the concerns expressed by those worrying that if we touch in any manner or fashion GSE operations, we will render thousands homeless is not borne out by market performance over the last two days. In fact, as knowledge of H.R. 2575 has been more widely understood, markets appear to have responded favorably because in most views additional information inside the mystical black box of GSE performance is a helpful thing to truly understand the investment risk you are taking by giving them your money.
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    I believe over the coming weeks and days as more critical analysis is given to the proposal, certainly there may be complaints about a particular provision. I think on balance, however, it will be found to be a reasonable remedy in light of the difficulties we face.
    Some have suggested this morning during the course of the committee's conduct that this really is an accounting issue which deserves more examination. To that end, I have contacted the GAO this morning and asked that they within a 90-day period review the current accounting methodologies, the disclosures made by Freddie Mac and analyze the potential impact it may have on Fannie's market standing within the next 90 days so that the committee upon its return from the August recess may examine those findings.
    And further to announce that in July upon our return from the Fourth of July recess, the committee will conduct another hearing for one or two purposes: one, to receive any published report that may be ready for public distribution relative to current pending inquiries; or secondly, to examine the advisability of moving forward with H.R. 2575 or both. To that end, I wanted to make those disclosures.
    For all those here representing Fannie, Freddie and the Home Loan Banks, if you have comments or questions you would like to forward to me for response, I would be happy to receive them.
    Meeting adjourned.
    [Whereupon, at 12:30 p.m., the subcommittee was adjourned.]