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74–625 PS 2001

OFHEO RISK-BASED CAPITAL RULE

HEARING

BEFORE THE

SUBCOMMITTEE ON

CAPITAL MARKETS, INSURANCE, AND

GOVERNMENT SPONSORED ENTERPRISES

OF THE

COMMITTEE ON

FINANCIAL SERVICES

U.S. HOUSE OF REPRESENTATIVES

ONE HUNDRED SEVENTH CONGRESS

FIRST SESSION

AUGUST 1, 2001

Printed for the use of the Committee on Financial Services

Serial No. 107–41

(
(II)

HOUSE COMMITTEE ON FINANCIAL SERVICES

MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa

MARGE ROUKEMA, New Jersey, Vice Chair

DOUG BEREUTER, Nebraska

RICHARD H. BAKER, Louisiana

SPENCER BACHUS, Alabama

MICHAEL N. CASTLE, Delaware

PETER T. KING, New York

EDWARD R. ROYCE, California

FRANK D. LUCAS, Oklahoma

ROBERT W. NEY, Ohio

BOB BARR, Georgia

SUE W. KELLY, New York

RON PAUL, Texas

PAUL E. GILLMOR, Ohio

CHRISTOPHER COX, California

DAVE WELDON, Florida

JIM RYUN, Kansas

BOB RILEY, Alabama

STEVEN C. LATOURETTE, Ohio

DONALD A. MANZULLO, Illinois

WALTER B. JONES, North Carolina

DOUG OSE, California

JUDY BIGGERT, Illinois

MARK GREEN, Wisconsin

PATRICK J. TOOMEY, Pennsylvania

CHRISTOPHER SHAYS, Connecticut

JOHN B. SHADEGG, Arizona

VITO FOSELLA, New York

GARY G. MILLER, California

ERIC CANTOR, Virginia

FELIX J. GRUCCI, JR., New York

MELISSA A. HART, Pennsylvania

SHELLEY MOORE CAPITO, West Virginia

MIKE FERGUSON, New Jersey

MIKE ROGERS, Michigan

PATRICK J. TIBERI, Ohio

JOHN J. LAFALCE, New York

BARNEY FRANK, Massachusetts

PAUL E. KANJORSKI, Pennsylvania

MAXINE WATERS, California

CAROLYN B. MALONEY, New York

LUIS V. GUTIERREZ, Illinois

NYDIA M. VELA ́ ZQUEZ, New York

MELVIN L. WATT, North Carolina

GARY L. ACKERMAN, New York

KEN BENTSEN, Texas

JAMES H. MALONEY, Connecticut

DARLENE HOOLEY, Oregon

JULIA CARSON, Indiana

BRAD SHERMAN, California

MAX SANDLIN, Texas

GREGORY W. MEEKS, New York

BARBARA LEE, California

FRANK MASCARA, Pennsylvania

JAY INSLEE, Washington

JANICE D. SCHAKOWSKY, Illinois

DENNIS MOORE, Kansas

CHARLES A. GONZALEZ, Texas

STEPHANIE TUBBS JONES, Ohio

MICHAEL E. CAPUANO, Massachusetts

HAROLD E. FORD, JR., Tennessee

RUBE ́ N HINOJOSA, Texas

KEN LUCAS, Kentucky

RONNIE SHOWS, Mississippi

JOSEPH CROWLEY, New York

WILLIAM LACY CLAY, Missiouri

STEVE ISRAEL, New York

MIKE ROSS, Arizona

BERNARD SANDERS, Vermont

Terry Haines, Chief Counsel and Staff Director
(III)

SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE, AND

GOVERNMENT SPONSORED ENTERPRISES

RICHARD H. BAKER, Louisiana, Chairman

ROBERT W. NEY, Ohio, Vice Chairman

CHRISTOPHER SHAYS, Connecticut

CHRISTOPHER COX, California

PAUL E. GILLMOR, Ohio

RON PAUL, Texas

SPENCER BACHUS, Alabama

MICHAEL N. CASTLE, Delaware

EDWARD R. ROYCE, California

FRANK D. LUCAS, Oklahoma

BOB BARR, Georgia

WALTER B. JONES, North Carolina

STEVEN C. LATOURETTE, Ohio

JOHN B. SHADEGG, Arizona

DAVE WELDON, Florida

JIM RYUN, Kansas

BOB RILEY, Alabama

VITO FOSSELLA, New York

JUDY BIGGERT, Illinois

GARY G. MILLER, California

DOUG OSE, California

PATRICK J. TOOMEY, Pennsylvania

MIKE FERGUSON, New Jersey

MELISSA A. HART, Pennsylvania

MIKE ROGERS, Michigan

PAUL E. KANJORSKI, Pennsylvania

GARY L. ACKERMAN, New York

NYDIA M. VELA ́ ZQUEZ, New York

KEN BENTSEN, Texas

MAX SANDLIN, Texas

JAMES H. MALONEY, Connecticut

DARLENE HOOLEY, Oregon

FRANK MASCARA, Pennsylvania

STEPHANIE TUBBS JONES, Ohio

MICHAEL E. CAPUANO, Massachusetts

BRAD SHERMAN, California

GREGORY W. MEEKS, New York

JAY INSLEE, Washington

DENNIS MOORE, Kansas

CHARLES A. GONZALEZ, Texas

HAROLD E. FORD, JR., Tennessee

RUBE ́ N HINOJOSA, Texas

KEN LUCAS, Kentucky

RONNIE SHOWS, Mississippi

JOSEPH CROWLEY, New York

STEVE ISRAEL, New York

MIKE ROSS, Arizona

(V)

C O N T E N T S

Page

Hearing held on:

August 1, 2001 .................................................................................................. 1

Appendix:

August 1, 2001 .................................................................................................. 27

WITNESSES

WEDNESDAY, AUGUST 1, 2001

Falcon, Hon. Armando, Jr., Director, Office of Federal Housing Enterprise

Oversight (OFHEO) ............................................................................................. 9

APPENDIX

Prepared statements:

Baker, Hon. Richard H. ................................................................................... 28

Oxley, Hon. Michael G. .................................................................................... 30

Bentsen, Hon. Ken ............................................................................................ 33

Jones, Hon. Stephanie ...................................................................................... 31

Kanjorski, Hon. Paul E. ................................................................................... 34

Falcon, Hon. Armando, Jr. ............................................................................... 36

(1)

OFHEO RISK-BASED CAPITAL RULE

WEDNESDAY, AUGUST 1, 2001,

U.S. HOUSE OF REPRESENTATIVES,

SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE,

AND GOVERNMENT SPONSORED ENTERPRISES

COMMITTEE ON FINANCIAL SERVICES,

Washington, DC.

The subcommittee met, pursuant to call, at 2:05 p.m., in room

2128, Rayburn House Office Building, Hon. Richard H. Baker,

[chairman of the subcommittee], presiding.

Present: Chairman Baker; Representatives Ney, Bachus, Lucas,

Hart, Kanjorski, Bentsen, J. Maloney of Connecticut, S. Jones of

Ohio, Capuano, Meeks, Inslee, Ford, Hinojosa, Lucas, Israel and

Ross.

Chairman BAKER. I would like to call this hearing of the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises of the Committee on Financial Services to order.

Our hearing today is our continuing oversight of Government

Sponsored Enterprises, (GSEs), and specifically the Risk-Based

Capital Rule that the Office of Federal Housing Enterprise Oversight, (OFHEO), has recently finalized. And I am looking forward

to its initial implementation within the next few weeks.

I am particularly glad to have Armando Falcon, the Director of

OFHEO here today to explain the impact, direction and intent of

the new standard, and I want to particularly express my appreciation to Mr. Falcon. I have, over the years, made comments concerning OFHEO’s performance and my frustration about their inability to produce the document and to give us the tools I feel appropriate to make an appropriate assessment about GSE performance. It has been no easy task, Mr. Falcon, and I want your professional staff to know that I, for one, truly appreciate the commitment made and the intense effort to produce this document.

I will confess to you, I have tried to read it, and admit I cannot

understand it, but I am told by those who can that it is a pretty

good piece of work. And so I intend to keep mine close by, and as

my abilities permit, understand it little pieces at a time, but congratulations to you all.

I do want to read a few lines from the report I think important

to have in the record.

Government sponsored enterprises are not immune to failure.

For most firms, debt markets provide strong capital discipline, penalizing a firm that is excessively leveraged with higher borrowing

costs. That discipline is largely lacking for the enterprises because

of their status as Government sponsored enterprises.
2

‘‘The economic distress of Fannie Mae from 1979 to 1985 was significant. But for fortuitous changes in interest rates, Fannie Mae

might have collapsed, costing investors, or the Government, billions

of dollars. Because of the growth of the enterprises, a failure today

could result in much greater loss. Depending on the response of the

Government to such a failure, significant disruption to financial

and housing markets, significant burdens on the taxpayers, or both

would result. The enterprises have considerably more dollar exposure than the entire savings and loan industry had in 1986.’’ I find these particular provisions of the rule extremely important,

and I think it is the basis on which the subcommittee should begin

its understanding of the importance of this work. I believe the regulator of Fannie and Freddie should be a more bank-like regulator

in its structure. Specifically, I have looked at moving the regulation

of Fannie and Freddie to other sites or to the Treasury. Based on

a GAO study, I want to give this new regulator whatever we ultimately decide with regard to regulatory structure, the full set of

tools necessary to do this work. OFHEO today, in my opinion, still

lacks some of the similar supervisory resources other regulators

enjoy. OFHEO has chosen a risk-based capital system that is dependent on its ability to field a large team of financial market experts. I encourage OFHEO to work constructively with GSE management in continuing to improve this oversight ability.

I am particularly interested in exploring how the OFHEO rule

differs from bank risk-based capital standards. For example, it is

my understanding that bank regulators take a very cautious view

of hedging and derivative devices specifically, and requiring banks

to hold risk-based capital regardless of how many hedging devices

or derivatives may be in place. That is a view which I hope will

receive additional consideration from the agency.

I also want to say at the outset today that Fannie Mae and

Freddie Mac today are very well managed, very profitable and very

important contributors to the housing market of our country, and

our actions here today in no way reflect on the current financial

conditions of the enterprises, but are, in fact, forward-looking in

our effort to ensure that, in the event of a long-term market downturn, we would have in place the necessary tools and abilities to

minimize adverse consequences should we face undesirable economic conditions. That is why I am so pleased that OFHEO has

come forward with the capital standard today, and very much look

forward to Mr. Falcon’s remarks in a few moments.

Mr. Kanjorski.

[The prepared statement of Hon. Richard H. Baker can be found

on page 28 in the appendix.]

Mr. KANJORSKI. Thank you, Mr. Chairman.

Thank you for the opportunity to comment before we begin our

hearing to review the final risk-based capital standard recently released by OFHEO. Because our subcommittee will hear from just

one witness, we should probably frame today’s hearing instead as

a briefing. The briefing will help us to better understand the contents of the Risk-Based Capital Rule, the process of its development and the procedures for implementing it.

OFHEO is the safety and soundness regulator for Fannie Mae

and Freddie Mac, the Nation’s two largest GSEs and two of the
3

country’s largest financial institutions. Since its creation nearly a

decade ago, OFHEO has developed and implemented a robust and

continuous examination program that works to protect taxpayers

from risk. Each quarter, for example, the regulator examination

teams review more than 150 separate components of safety and

soundness to develop a comprehensive account for each of the

GSEs’ financial conditions.

With the release of this stress test, which the agency spent nearly 7 years drafting, OFHEO supplements its existing capital standards and complements its already-tough examination program. Implemented properly, this rule will ensure that the two GSEs remain at the forefront of financial regulation. Furthermore, the implementation of this regulation, in my opinion, enhances the ability

of Fannie Mae and Freddie Mac to achieve their mission of helping

low- and middle-income families to own homes.

More specifically, this new standard calculates how much capital

Fannie Mae and Freddie Mac need to hold to withstand a 10-year

period of economic stress. Relying on the parameters contained in

the 1992 GSE law, OFHEO’s stress test simulates dramatic

changes in interest rates and the highest historical declines in

property values to determine these capital requirements. Notably,

the regulator believes its regulation will, more accurately tie capital to risk than any other current or proposed standard, for any

financial institution.

As you know, Mr. Chairman, our subcommittee has closely followed the development and issuance of this innovative rule, holding numerous hearings on the subject, and GSE regulation in general, since 1997. Some have expressed impatience with the amount

of time OFHEO has taken to develop this standard, but the relatively quick approval by the Office of Management and Budget of

this complicated regulation demonstrates its confidence in OFHEO,

its competency, reliability and credibility.

OFHEO’s dedicated experts additionally deserve congratulations

for their hard work in finalizing this intricate rule. In particular,

the Director, Armando Falcon, has demonstrated leadership in successfully guiding this complex standard through the regulatory

process. I look forward to learning of his thoughts later today during our briefing. It is also, in my opinion, especially important that

the regulator maintain continuity in its leadership in the months

and years ahead as it works to implement this rule.

Anticipating the complexity of the GSE stress test, Congress further authorized a 1-year transition period following the final rule’s

publication in the Federal Register. This interlude will allow

OFHEO and the affected parties to work through any concerns and

address the procedural issues likely to arise as the rule becomes

operational. Consistent with the requirements of the 1992 GSE law

and the Administrative Procedures Act, our subcommittee should

support these consultations and reasonable technical modifications.

As they have done in recent weeks, I also hope that all of the

involved parties will work constructively with one another to implement this rule efficiently. I am also confident that the management

teams of both Freddie Mac and Fannie Mae will swiftly address

any changes required by this regulation.
4

Finally, I hope that my colleagues will work with me to ensure

that OFHEO receives the resources it needs to get the job done and

consider removing the agency from the annual appropriations process as we have done with other financial regulators.

In closing, Mr. Chairman, I continue to share with you your desire to conduct effective oversight over the housing GSEs and to ensure that we maintain an appropriate and sufficiently strong supervisory system for them. The implementation of this risk-based

capital regulation will provide more immediate protection for taxpayers, investors and homeowners than any legislation that we

could pursue in the 107th Congress. I consequently look forward to

not only our briefing today, but also to working with you to put this

long-awaited rule into practice.

[The prepared statement of Hon. Paul Kanjorski can be found on

page 34 in the appendix.]

Chairman BAKER. Thank you, Mr. Kanjorski.

Mr. Ney, do you have an opening statement?

Mr. NEY. Thank you, Mr. Chairman, and thank you for calling

another oversight hearing on the safety and soundness of Fannie

Mae and Freddie Mac. You are to be commended for your thorough

work on these two companies. This afternoon marks the eleventh

hearing in 16 months.

Today’s hearing is on a long-awaited risk-based capital standard

for Fannie Mae and Freddie Mac. In coming weeks, this 567-page

regulation will be published in the Federal Register. One year after

the publish date, the regulation will be enforceable.

Mr. Chairman, I know you have worked long and hard pushing

for the standards and pushing for the conclusion of the work on

this rule, and today I think the credit is due to both you and also

the regulatory agency. I would like to take a moment to commend

Director Falcon for his leadership in bringing this risk-based capital stress test to completion. Both he and his staff have worked

hard to craft this capital stress test, and they have worked under

tremendous pressure. Mr. Falcon took office only 18 months ago, I

believe. In that time, he has managed to complete this rule in a

fair and balanced manner. We now have in place a vital component

for an effective and efficient regulatory program. The new riskbased capital standard puts in place a new sophisticated model

that more specifically aligns capital to risk.

Because of the length and complexity of this final rule, and because it will be another year before the rule is enforceable, I would

really like to encourage the cooperation and work of Mr. Falcon

and the agency to work with Fannie Mae and Freddie Mac to make

any necessary technical changes and to ensure the complex regulation conforms to the 1992 Act. This is a very complicated, complex

and sophisticated rule which will help ensure that Fannie Mae and

Freddie Mac remain safe, well-capitalized and able to continue

their housing mission.

However, as with any highly complex Government regulation, it

is inevitable, I think we all know that, that the rule mandates will

have unintended consequences, potentially, or other problems. So I

would encourage Fannie Mae, Freddie Mac and Mr. Falcon and the

agency and the subcommittee to work together to solve these problems to ensure that this rule is implemented on time.
5

Mr. Falcon, your agency has set out to accomplish a very formidable task, creating a sophisticated internal model that closely

aligns and ties capital to risk. If you consider the already-existing

minimum capital standard, the new risk-based standard and the

six voluntary initiatives put forth by Fannie Mae and Freddie Mac

last October, these two companies really do stand at the forefront,

I think, of financial services, safety and soundness regulation.

And again, Mr. Chairman, thank you for your diligence on the

issue.

Chairman BAKER. Thank you very much, Mr. Ney.

Mr. Israel, you are next by time of arrival.

Mr. ISRAEL. Thank you, Mr. Chairman, and thank you for convening this hearing.

I am pleased to welcome the Director and join my colleagues in

welcoming the Director this afternoon.

Mr. Chairman, if ever there was any evidence of the critical need

for safe and sound GSEs like Fannie and Freddie, it is contained

in this morning’s edition of Newsday, which is my hometown newspaper. The headline is: ‘‘Long Island Named Most Expensive Area,’’

and it reports on a study done by the Economic Policy Institute

that indicates that Nassau and Suffolk Counties on Long Island

are the number one most expensive areas to live, more expensive

than Boston, than Washington, DC., than San Francisco, than San

Jose, California and others. According to the study, a family of two

parents and two children would need to make an after-tax salary

of $52,000 a year to afford living in my congressional district. And

housing costs are cited as the major reason why Long Island is

ranked as the most expensive area in the country.

Because of that situation, as I have said in the past, it is critically important that we support Fannie Mae and Freddie Mac in

their mission to provide affordable housing. An article in the National Mortgage News states that recent HMDA data suggests that

Fannie and Freddie are helping to increase homeownership numbers for all individuals. By improving their underwriting guidelines

and adding new loan products, Fannie and Freddie are helping to

improve the chances that all borrowers, particularly low- and moderate-income individuals, are approved for a loan and receive affordable housing opportunities.

The new Risk-Based Capital Rule is meant to help the companies

remain efficient and operational even in times of severe economic

stress. It may be too early to determine how this highly complex

rule will affect Fannie and Freddie’s ability to continue to fulfill

their mission, however I hope that we will be mindful that anytime

greater restrictions are placed on the business activities of Fannie

and Freddie, it is more difficult for them to continue to work to

achieve their mission and close the home ownership gap.

I hope that OFHEO will continue to work with this subcommittee, the Chairman and the Ranking Member, and Fannie

and Freddie to ensure that this new risk-based capital standard

will achieve its intended purpose of helping the two companies to

operate more efficiently. The more efficient those two GSEs are,

the more they will be able to continue to fulfill their mission and

I hope that we will continue to support them as they work to suc-
6

cessfully implement this rule in the year ahead. And I thank the

Chairman for my time.

Chairman BAKER. Thank you sir.

Mr. Lucas.

Mr. LUCAS. Thank you, Mr. Chairman. And I want to congratulate both you and Director Falcon for finishing this important capital rule. I know it has been certainly your priority, both of you,

for that matter, priority for several years.

And Director Falcon, I appreciate your appearance before this

subcommittee and certainly commend you on this monumental

task. I understand, as the Chairman and a number of my colleagues have pointed out, that this is a very complex rule, 567

pages long in total length, and of course it has not been fully evaluated by the two companies that you regulate, or for that matter,

by this subcommittee. Of course, this rule is intended, as has been

mentioned, to implement the intent of Congress in the 1992 oversight legislation. And it should be consistent with that Act and

should be appropriate in how it aligned capital with risk.

Because the operation of this capital rule may well have an enormous impact on the mortgage markets, on lenders in my district,

and ultimately on home buyers, I urge you to work with Fannie

and Freddie to identify any needed clarifications. And I also hope

that these modifications will be made without delay so that certainly any unintended consequences will be minimized.

With that, Mr. Chairman, I look forward to the Director’s comments.

Chairman BAKER. Thank you very much, Mr. Lucas.

Mrs. Jones, you would be next.

Mrs. JONES. Thank you, Mr. Chairman.

Good afternoon, Ranking Member Kanjorski and other Members

of the subcommittee.

To Mr. Falcon, welcome back to our subcommittee.

I am pleased and would like to congratulate you and your organization for the completion of this rule. I guess this is about our

tenth hearing on safety and soundness. We have a rule now. Hopefully, you as a regulatory agency, and Fannie and Freddie can walk

through this and get things going so that we can continue to move

on and perhaps have Capital Markets Subcommittee hearings on

something else as we go along through the year.

I think it is laudable, however, that as we look at safety and

soundness and to assure the strength of the housing market in our

communities that we engage in some conversation on the issue. I

am confident that Freddie and Fannie, having already agreed to

about six commitments or regulations, are prepared to sit with you

and make sure that the housing industry is safe and sound.

I have a full statement, Mr. Chairman, that I would seek unanimous consent to have submitted for the record so that we can allow

sufficient time to proceed through the hearing.

Thank you very much.

[The prepared statement of Hon. Stephanie Jones can be found

on page 31 in the appendix.]

Chairman BAKER. Without objection, your statement and all

Members’ statements will be included in the record.

Thank you, Mrs. Jones.
7

Ms. Hart.

Ms. HART. Thank you, Mr. Chairman.

I am pleased that you chose to have this hearing as well. Since

I am a freshman and have not been long-awaiting this rule, I will

be just very interested in hearing the testimony from Mr. Falcon,

and I will reserve the rest of my time for questions.

Thank you, Mr. Chairman.

Chairman BAKER. Thank you, Ms. Hart.

Mr. Bentsen.

Mr. BENTSEN. Thank you, Mr. Chairman.

Let me start by welcoming our former staff member, Mr. Falcon,

who was the General Counsel to the Democratic staff for many

years on the subcommittee and is also my fellow Texan. And we

appreciate you being here and we look forward to your testimony.

Mr. Chairman, I want to commend you for holding this hearing

which will examine the Office of Federal Housing Enterprise Oversight’s final regulation related to risk-based capital that was released on July 19, 2001. As a Member of this subcommittee, I am

pleased that OFHEO has released this long-awaited risk-based capital regulation. As you know, in 1992, Congress approved a new

law which established OFHEO and required OFHEO to draft a

risk-based capital regulation within 2 years. As we know, it has

taken some time to develop this very complex model, but we believe

and we hope that this regulation will provide the necessary safeguards to ensure that the Federal housing enterprises of Fannie

Mae and Freddie Mac have sufficient capital to sustain themselves

during extremely difficult economic conditions, which are described

as part of the law.

As you know, this risk-based capital regulation is an extremely

complex model which requires extensive data input from the housing enterprises. Because of the complexity of this model, Congress

provided additional time before the GSEs must comply with the

rule. The effective date will be 1 year after the publication of the

final rule in the Federal Register. I believe that Congress and this

subcommittee should use this time to examine the rule in its entirety to ensure that it is both fair and reasonable. By holding additional oversight hearings on the rule, Congress will have such time

to review and make any necessary recommendations for the rule.

In addition, I believe such hearings should bring forward expert

witnesses who can discuss this complex model. For instance, I believe it would be appropriate, Mr. Chairman, to invite some of the

major rating agencies, such as Moody’s and Standard and Poor’s,

who have familiarity with such complex model and will be reviewing this risk-based rule when they make their own rating determinations for GSE-sponsored debt instruments.

In addition, major market participants should be heard from, and

I think we should also hear from witnesses who can provide us

more information on other risk-based capital rules, particularly the

Basel risk-based capital proposals which are currently under discussion as they related to derivatives instruments.

This is an important hearing that we are having today. I commend the Chairman for calling this hearing. I commend OFHEO

and the staff for the work that they have done. But of course, as

we all know, this will not be the last word, either on this rule or
8

the question of the GSEs, and I look forward to additional hearings

that I am sure our esteemed Chairman will call.

Thank you, Mr. Chairman.

[The prepared statement of Hon. Ken Bentsen can be found on

page 33 in the appendix.]

Chairman BAKER. Thank you very much, Mr. Bentsen for that

hearing recommendation. I was not sure whether we would go further, but based on your request, we certainly will.

[Laughter.]

Mr. Lucas.

Mr. Inslee.

Mr. INSLEE. I have nothing to add to the brilliance of my colleagues. Thank you, Mr. Chairman.

[Laughter.]

Chairman BAKER. Mr. Ross.

Mr. Hinojosa.

Mr. HINOJOSA. Yes, thank you, Mr. Chairman.

I am pleased to congratulate my fellow Texan, Armando Falcon,

today on finalizing the long-awaited Risk-Based Capital Rule and

the complex computer code that implements the rule.

Combined, the rule brings into force any important requirement

of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, the risk-based capital stress test, a simulation

that determines the amount of capital Fannie Mae and Freddie

Mac would need to survive a 10-year period of wild fluctuations in

interest rates and large credit losses.

In addition, the 1992 Act requires that the GSEs each maintain

an additional 30 percent of capital to protect against management

and operations risk in order to meet their risk-based capital standard. My message to you today, Mr. Falcon, is very concise. It is sincere and based on the physicians’ credo: ‘‘First, do no harm.’’ I congratulate you and OFHEO on this accomplishment.

The new rule, all 567 pages of it, is extremely technical and reflects countless hours of dedicated work by you and your staff. But

the rule by its nature is long and complex, and the enterprises it

is created to test are dynamic and they are sophisticated. This,

combined with the importance of homeownership to our economy

and the well-being of our people, require that you take the time,

the energy and the resources you need over the next year to get

this rule right.

In closing, I want to say that I fully support OFHEO’s mission

and encourage you to make the corrections necessary to improve

the rule and its code so that they conform fully to the 1992 Act and

the intent of Congress. The 1992 Act specifically gives you significant sole discretion to decide on many aspects of the risk-based

capital test. Use it. Align risk to capital for GSEs in a meaningful,

realistic and necessary way.

Chairman BAKER. Thank you, Mr. Hinojosa.

At this time, I would like to introduce to the subcommittee the

Director of the Office of Federal Housing Enterprise Oversight,

OFHEO, Mr. Armando Falcon.

Welcome sir. I know you have been waiting a long time for this

day yourself.
9

STATEMENT OF HON. ARMANDO FALCON, JR., DIRECTOR,

OFFICE OF FEDERAL HOUSING ENTERPRISE OVERSIGHT

Mr. FALCON. I have. Thank you very much, Mr. Chairman. It is

a pleasure to be back here in the subcommittee’s hearing room.

Mr. Chairman, Ranking Member Kanjorski, and Members of the

subcommittee, thank you for the opportunity to testify this morning on OFHEO’s Risk-Based Capital Rule.

Last year, I appeared before this subcommittee and assured you

that completing this much-anticipated rule was my highest priority

as Director of OFHEO. Today, I am pleased to report to you that

the job is done. On July 19, we formally submitted a Final RiskBased Capital Rule to the Federal Register for publication. I am

proud of the efforts of the many talented and dedicated OFHEO

employees who worked tirelessly to complete this unprecedented

task. I am also grateful for the support of this subcommittee, particularly yourself, Mr. Chairman and Ranking Minority Member

Kanjorski. Your input and encouragement certainly kept us, shall

we say, focused and motivated.

As you know, this rule is the final major component of OFHEO’s

comprehensive regime to ensure the safety and soundness and capital adequacy of Fannie Mae and Freddie Mac. Once the rule is

published in the Federal Register, which is estimated to occur

sometime in early September, Fannie Mae and Freddie Mac will be

subject to one of the most sophisticated regulatory capital standards in the world.

Yet while the rule represents a state-of-the-art approach to tying

capital to risk, it in no way makes the other parts of OFHEO’s regulatory program less vital. Rather, it complements our current activities by providing yet another assessment of the enterprise risk.

When the results of the stress test are considered along with other

information available to me as the Director, I will have the best

possible view of the companies current and prospective financial

health.

This afternoon, I will provide the subcommittee with background

on the development of the rule, its contents and rationale and the

process for its implementation. In addition, I will also describe how

the test fits into OFHEO’s overall regulatory program.

While the Risk-Based Capital Rule has received the bulk of attention in recent years, the 1992 Act establishing OFHEO directed

the agency to establish and enforce two major capital tests for the

enterprises, a minimum capital test and the risk-based capital

stress test. The minimum capital requirement is a leverage standard that is similar to existing capital requirements for banks and

thrifts. The enterprises have satisfied this minimum capital requirement every quarter since its implementation.

To supplement minimum capital, we have a more sophisticated

measure of risk. The risk-based capital requirement uses a stress

test to simulate the performance of the enterprises’ balance sheets

during a 10-year period of severe economic stress in the Nation’s

housing and credit markets.

Mr. Chairman, allow me to provide a brief history of the development of the Risk-Based Capital Rule as background for the subcommittee.
10

After staffing and equipping the agency and completing initial

study of the issues involved, OFHEO sought public input through

an Advance Notice of Proposed Rulemaking and two Notices of Proposed Rulemaking, or NPR as we call them. The first NPR, published in June, 1996, proposed the methodology for developing a

house price index and identifying a benchmark loss experience for

use in the stress test. The second NPR was published in April,

1999, and described how these stress tests would work. At the conclusion of the comment period, OFHEO proceeded to analyze and

address the comments and finalize the rule. On March 29 of this

year, OFHEO formally submitted the rule to the Office of Management and Budget for clearance. On July 16, OMB completed its review and OFHEO sent the rule to the Federal Register on July 19.

With that short history providing context on how we got where

we are today, I would now like to turn to the rule itself.

First, the stress test factors in large moves in interest rates,

mortgage rates, Treasury rates and enterprise borrowing costs.

Congress went so far as to specify that the 10-year Treasury rate

changes by as much as 6 percentage points. Other interest rate

changes are done in tandem as determined by OFHEO using historical experience as a reference point.

Second, the test provides for loan defaults and loss severity on

a nationwide basis comparable to the largest default and severity

rates in any region in recent history.

Third, the test incorporates no new enterprise business and no

asset sales to raise cash. It simply runs off their existing assets,

liabilities and off-balance-sheet activities under these stressful conditions. This no-new-business requirement, or a wind-down scenario, is explicitly mandated in the 1992 Act.

If all of these stress conditions were to occur, the enterprises

would be expected to suffer severe losses as homeowners default or

pay off the loans early, and the enterprises’ assets and liabilities

go out of balance. OFHEO’s task is essentially to estimate the

losses that would occur in the current books of business and determine how much capital each enterprise would need to maintain

positive capital throughout this period. To this amount, an additional 30 percent is added to compensate for operations and management risk.

As compared to other contemporary ‘‘risk-based’’ standards,

which simply apply haircuts to buckets of assets, OFHEO’s standard determines an enterprise’s actual risk exposure as measured by

the stress test.

I do not mean to suggest that leverage requirements are inappropriate, but like the proposed new Basel Accord, OFHEO’s riskbased capital standard recognizes the need to more closely tie capital to risk. And because both approaches give institutions credit

for risk mitigation activities, good risk management will be rewarded with a lower capital requirement.

But this is not just a capital standard. It will also serve as a valuable analytical tool. It will help us to identify and understand the

strengths, weaknesses and exposures of the enterprises under different scenarios. We will use it to its full capacity for this purpose.

As noted earlier, the risk-based capital standard will be published in the Federal Register in September. While the rule is ‘‘ef-
11

fective’’ immediately, Congress granted the enterprises a year to

come into compliance before OFHEO can take an enforcement action based on noncompliance with the standard. However, because

the rule is effective upon publication, OFHEO will announce in

early 2002 how the enterprises fare under the standard using 4th

quarter 2001 data.

To achieve compliance, the enterprises will have many options.

For example, they can raise additional capital, adjust hedging practices, offset more of their risk, retain more of their earnings or any

combination of these. A capital shortfall generally can be eliminated at a fraction of the cost of new equity capital. Thus, another

valuable aspect of this rule is that it will allow the enterprises to

choose for themselves the most efficient means to comply with the

rule.

So while the finalization of the rule is a landmark, it certainly

does not close the door on work on the rule. The standard will not

be static. The enterprises will be free to innovate. OFHEO will

work with the enterprises to assess the risk of new activities and

appropriately address them within the stress test. In addition, the

1992 Act requires us to soon consider whether or not to incorporate

new business into the rule.

As I mentioned earlier, OFHEO’s capital regulation is a component of an overall regulatory program. We will use the stress test

in conjunction with other tools, which include examination reports

and OFHEO’s research. OFHEO’s examiners maintain a physical

presence at the enterprises and have unlimited access to all levels

of management and to highly sensitive corporate records. By staying apprised of the enterprises’ risk and business activities on a

timely basis, the examiners are able to evaluate an extensive array

of risk-related factors and to assess the enterprises’ financial safety

and soundness.

As with all financial regulators, research is an area of great importance to OFHEO’s ability to fulfill its mission. Our research provides the independent analysis necessary to consider our examination and capital findings in the broader context of the economy and

the markets in which the enterprises operate.

In conclusion, OFHEO is meeting the mission Congress gave us.

The enterprises are subject to ongoing oversight through our examination program, must meet quarterly minimum capital requirements, will be the only entities subject to a risk-based capital

stress test which closely ties capital to risk, and can be held accountable if found lacking in any of these areas.

Mr. Chairman, Ranking Member Kanjorski, you have in OFHEO

a very talented group of men and women who are dedicated to fulfilling the agency’s mission ensuring the safety and soundness of

Fannie Mae and Freddie Mac. I hope you will consider that the

best investment in safety and soundness regulation is an investment in the team and talent we have assembled at OFHEO. Toward that end, I would renew my request that the Congress consider enacting some enhancements to OFHEO’s statutory authorities. While those enhancements are not essential, they would help

ensure that OFHEO has all the tools necessary to respond quickly

and effectively to any situation.
12

Let me again thank you, Mr. Chairman, Ranking Member Kanjorski and other Members of the subcommittee for your comments

and the support you have given this agency.

I would be pleased to answer any questions you may have, Mr.

Chairman.

[The prepared statement of Hon. Armando Falcon Jr. can be

found on page 36 in the appendix.]

Chairman BAKER. Thank you very much, Mr. Falcon. Again, congratulations.

There is one sort of process question that I would like to start

with that I think is very important. You have labored long. We now

have a rule approved by OMB, basically back in your area of jurisdiction awaiting final publication. It is also my understanding concurrent that our 60-day congressional review period would commence beginning the date of July 29, I think is correct. And since

it has 60 legislative days, that would be to expire sometime in October. I do not have the correct date.

Between now and the time that the rule is promulgated formally,

would it be your intent that the modifications to the rule that

would be considered would be technical in nature, or to ensure conformity of the rule to the agency’s intent, as opposed to a substantive policy alteration that would depart from the original proposal?

Mr. FALCON. Mr. Chairman, I view the process going forward between the time we submitted the rule to the Federal Register and

the time that it is published as similar to what happens with the

House when the enrolling clerk takes a bill that has been enacted

by the House and the clerk makes technical corrections to fix punctuation and other things to make sure, as you stated, it is consistent with the intent of the Congress. Any changes that we would

make to the rule between now and the date of publication would

be consistent with that spirit. And if we recognize a need to make

any changes in the rule, we will do so through probably a notice

and comment period, perhaps an expedited one, so that we can

move quickly to make sure that the rule works properly.

Chairman BAKER. Terrific. Because it would be my interest, and

would intend to do so, to make comment to the agency early in the

August recess about some areas of concern that, and I have regard

for your judgment. Whether I am right or not would be for you to

determine. But for example, in the area of hedging, it is my understanding that a financial regulator in looking at interest rate risk

and let’s say credit risk is two categories, and where we find an excess of hedge with regard to interest rate, but a deficiency on credit

risk, that they cannot be averaged. So that if you are over a little

bit in one and under a little bit in the other, the aggregate hedge

is deemed to be adequate under the risk-based standard, but insufficient under financial standards. I want to make sure I am understanding it properly, but I will forward that at a later date to give

you a more detailed explanation.

And then, generally the whole question of the first step being left

to the enterprises, let’s assume they are modestly deficient, and

that a relatively small acquisition of hedging devices would get

them into proper balance. I would be a lot more comfortable if rather than having the enterprises manage to maintain minimum cap-
13

ital, that we—and there are operative reasons for this—minimize

the use of hedging devices and instead establish a preference for

capital, principally because of the enormity of their hedging portfolio and, frankly, the limited number of counter-parties internationally available for these enterprises to be able to acquire those

hedging instruments. So it is against the international capital markets concern that I am worried about the level of their derivatives

portfolio. Again, I will forward that in a comment.

And I do not want to get Mr. Bentsen in more trouble with his

colleagues, but I shared some of his concerns in his opening statement about having broader formal comment on the applicability of

the rule beyond the agencies. So I do not know exactly the process

by which I will pursue that, but I do want to have other financial

opinions about the applicability and consequences of the rule.

I also want to compliment you, because I think your decision to

run the test based on the last quarter of 2001 data is very, very

important. Many Members of this subcommittee are concerned

about the volatility in the marketplace, and that unanticipated consequence of the rule, either requiring significant capital or reducing

risk exposure, could potentially have some impact on interest rate

costs to homeowners. I think by taking this step as an early market indicator a year out, should give great confidence to everyone

that if in fact there is a deficiency, that the 12 month intervening

period can easily be utilized to come into conformity with your requirements without any of the adverse market consequences some

are concerned about.

Given that general statement, I am sure I am going to come

back. I do not want to run too far over my own time. I will yield

my time at this time to Mr. Kanjorski.

Mr. KANJORSKI. Thank you very much, Mr. Chairman, and congratulations to you for taking a very strong leadership role on this

entire issue.

Congratulations to you and the employees and staff of the agency, Mr. Falcon. You have only been there 18 months, but it has

been a long process, 9 years now, and I am sure the Members of

the subcommittee, those even that are not here or do not know

about this event can breathe a little easier today to know that we

finally do have the regulation ready to go.

One of the things I have been concerned about all along, and intend to support the agency and the GSEs, is that they have given

a vitality to our economy at this particular point in time, the real

estate transactions in the country. I hope they can maintain that

vitality and remain healthy, because I see it as one of the two remaining legs to see the economy afloat, that and consumer confidence, and consumer confidence may start to wane in the latter

part now of this year. So it is very important that we stabilize and

keep a very vibrant real estate market in the country. And I think

your risk-based regulation will help to accomplish that, but also the

fact that we attended this briefing, and this entire issue, was the

fact that we are providing tremendous stability for 10 years of

downturn. There is little worry in the marketplace. We have a very

secure financing structure in the United States, and not only in the

domestic market, but the international markets should be perfectly
14

willing to buy the securities of these entities as we proceed through

the rest of this year and the following year.

I want to be a little optimistic. I think by next spring we will see

a turnaround. We will be turning out of this thing. But if we do

not, as I understand, the regulation will have a capacity to support

a 10-year downturn, which no one anticipates now, nor should we,

since it probably has never occurred other than maybe the Great

Depression.

I think it is important that you maintain a relationship with the

Chairman of this subcommittee and the Chairman of the full committee, maybe the Ranking Members, and also on the Senate side.

If there are technical adjustments or substantive adjustments that

may have to be made that we are not presently aware of, I think

to speed that process along, communications should be set up between your office and the Congress so that they can be attended

to and understood, so that we move through this process without

the need for hearings, without the need for even communication by

letters of question, but that we are only responding to issues that

you or the GSEs raise as they look at the implementation of this

role.

I join the Chairman in congratulating you on picking that quarter at the end of the year to be the base which we will gear off of.

I hope we do not have a real bad downturn in that quarter, and

that could always happen, but maybe that is what the rule is really

promulgated to protect against.

Again, this has been a long series of hearings and a lot of skin

has been left on the roadway, so to speak, but I congratulate you

and the agency for coming to the extent that you have, and wish

you well. And I certainly offer my assistance if there is anything

we can do, and I am sure the Chairman joins me in that.

Thank you.

Chairman BAKER. Ms. Hart, did you have questions?

Mr. Bentsen.

Mr. BENTSEN. Thank you, Mr. Chairman.

So to clarify the Chairman’s question, the ink is dry on the rule

now, and any changes you will make will be purely technical and

the rule will be published prior to or within that 60-day legislative

period?

Chairman BAKER. It is my expectation that the rule will be, I

think, printed before the 60-day legislative day comment period expires. Is that correct, Mr. Falcon?

Mr. FALCON. That is out of our control, Mr. Chairman. It is subject to the ability of the Federal Register to get the rule typeset and

proofed within that timeframe. But our expectation is that they

could do it within 45 days of the day that it was submitted to them.

So it would be within that 60-day time period.

Chairman BAKER. Mr. Bentsen, it is my intent to, believe it or

not, be the least amount of disruptive element in this process. That

is the reason for the hearing today, for Members to be aware of the

rule. And as quickly as we return, if there are any issues which

we would need to address, do that early in September so the agency would have appropriate time, if warranted, to respond before the

final promulgation.
15

Mr. BENTSEN. Although I think what Mr. Falcon is saying is the

final promulgation has occurred, other than really dotting ‘‘i’s’’ and

crossing ‘‘t’s.’’ And if that is the case, then once the final rule is

published, and I do not want to get into a long drawn-out discussion of the Administrative Procedures Act, as interesting as that

would be; but once the rule is published, then we go to, what, an

APA-type mechanism, which is Congress or others have issues that

they petition OFHEO and OFHEO then takes under advisement

can propose a rule or if OFHEO itself determines that something

needs to be modified, and then you go under the standard APA?

Mr. FALCON. Right. Once the rule was published, it is a final

rule, and if we saw a need to make any changes to the rule, we

would utilize the amendatory process of the Administrative Procedures Act. And that allows us flexibility to move at any point in

time to make changes that we thought were necessary. We have a

wide range of tools from an extended notice and comment period

to something as quick as an interim final rule where changes are

effective immediately, subject to notice and comment and subject to

potential change after that notice and comment period.

So we have the ability to move expeditiously to correct any

changes that might need to be made. And Congressman, if we

thought that we needed to make any changes, technical or substantive, to get this right as soon as possible, we would do so, I

think, in an expeditious manner. If we see a need to make any

changes in this to make it fully operational and to correct any problems in it, we could possibly do so very quickly after the rule was

published. But we have that ability, and I think we would want to

utilize it to make sure we got this right as soon as possible.

Mr. BENTSEN. There has been some concern raised by the GSEs,

and I am sure there will be lots of concern raised from time to

time, as is the case with any regulated party, but with respect to

haircut requirements on hedging instruments, I was just looking at

an article from the Wall Street Journal from a while back regarding the mortgage insurance companies, that there is concern that

the reserve requirements on that may exceed industry standards.

Is that an issue that you would see, if you were to agree with them,

that you would see taking up in a subsequent rulemaking process?

Mr. FALCON. Yes, I am aware of the issue you are talking about,

Congressman, with respect to the counter-party haircuts that are

embedded in this rule. Part of the issue there has to do with the

distinction we have made between AAA, AA, A and so forth, and

how much of a haircut we give to the securities or the counter-parties. Our judgment on the distinctions between those various rating

levels and the reflection of those distinctions in the percentages of

the haircuts is grounded in a lot of historical analysis and various

studies that we looked at to come up with the ultimate resolution

in the rule.

However, we are very willing to look at those issues with an open

mind and take a fresh look at them. If we did not come up with

the optimal resolution of the issue, we will not hesitate to make a

correction.

Mr. BENTSEN. If I might, Mr. Chairman, very quickly, given that

the rule is not fully effective until a year following the publication

date, or whichever date, do you think that you would be able to ad-
16

dress issues, and again, you may come down and decide that there

is no merit in the arguments, in such a way that would allow the

companies the ability to deal with this without having to comply

with a rule that might otherwise be modified to meet the implementation day?

Mr. FALCON. I think we would definitely want to, if we thought

that there were improvements that could be made to the rule, I

think we would want to act expeditiously to make those modifications, certainly well before the end of the 1-year transition period,

so that it is clear to the enterprises, in fairness to them, what rule

they will be expected to meet at the end of that 1-year transition

period, and even more so before the end of the quarter when we

begin to make public pronouncements about how they fare under

this rule.

Mr. BENTSEN. Thank you.

Thank you, Mr. Chairman.

Chairman BAKER. Mr. Ford.

Mr. FORD. Thank you, Mr. Chairman.

I think my colleague Mr. Bentsen got at much of what I wanted

to ask. It is a big thick rule, and I guess it will take a lot of us

a long time to get through it all. But just so I can understand, we

will have some flexibility to make changes if need be between now

and then, Mr. Director?

Mr. FALCON. Yes, Congressman, you will. And if I can just say,

I know the Chairman held up a copy of the rule. It is a big thick

rule. But I think it is important, if I may, to just state that the

1992 Act which required the promulgation of this rule also required

that the agency promulgate a rule which was fully transparent and

was specific enough so that any interested party could replicate the

regulation and the code, the stress test that implements the rule.

So in order to meet that requirement of the 1992 Act, we had to

put out a rule which was very specific and lay out all the details

about how this model would work. Otherwise, we would not have

been in compliance with the rule. I would have loved to have a rule

which is maybe 50 pages long, but then I do not think we would

have been in compliance with the spirit or the requirements of the

1992 Act.

Mr. FORD. I am not being critical at all.

Mr. FALCON. I know you are not.

Mr. FORD. As a matter of fact, it will make for some good vacation reading during the August recess. But I appreciate you responding to the specificity that, I was not here in the Congress in

1992, you were asked to do.

Mr. Chairman, if it would be appropriate, sir, I know that perhaps this is not an appropriate venue to do this, related to this,

there was an issue or two raised in the July 11 hearing on your

part, sir, a series of assertions regarding the average loan limit and

loan-to-value ratios of loans purchased by Fannie Mae. And I had

some numbers that I would love to submit to the record. I certainly

do not want to go into those details with the Director here and

cloud this hearing, but I did want to, I was curious about that, and

asked Chairman Raines at Fannie Mae to respond to some of those

issues and have some of that. And if it would be OK without objections.
17

Chairman BAKER. Sure, without objection. Just for the record,

my comments really in the July hearing were with regard to

Freddie, but we always welcome Fannie to any fight.

Thank you.

Mr. FORD. Thank you.

Chairman BAKER. I am sorry, Mr. Meeks.

Mr. MEEKS. Timing is everything. I just walked in.

Chairman BAKER. Yes, sir. You took me by surprise.

Mr. MEEKS. I apologize in regard to missing your testimony. I am

on roller skates today. We have various hearings and markups

going all over the place. And so I only have two quick questions.

If you have answered of them already, please I apologize in advance.

But this is something that has come up, and I was just wondering if there were any conflict between the Final Risk-Based

Capital Rule and the HUD affordable housing goals of Freddie Mac

and Fannie Mae?

Mr. FALCON. There will not be, Congressman. We think this rule,

once it is implemented, will allow them to continue their affordable

housing activities and remain in compliance and exceed the goals

of the affordable housing goals as established by HUD.

Mr. MEEKS. And let me ask another question that I do not know,

maybe it is unfair, but I know that there has been a lot of discussion regarding OFHEO’s ability to properly regulate the safety and

soundness of the GSEs. And so I guess my question is in regards

to your capacity, whether there is a lack of capacity in your organization to properly regulate GSEs in general structure, or are you

lacking anywhere in legislative authority or resources?

Mr. FALCON. Thank you. I think the agency fully fulfills its mission in supervising the enterprises. I think we could use some additional tools to make sure that we can always respond adequately

to any situation that might arise. I would like to have some adjustments to our statutory responsibilities. I do not think they are essential to our ability to fulfill our mission, but items like exemption

from the appropriations process that would allow us to adjust our

budget to our needs on a real-time basis should any situation arise.

That is an authority that every safety and soundness regulator has,

and I think OFHEO should be put on par with other agencies. And

there are other issues related to enforcement powers, some independence issues, clarifications about our authority. I think those

would be nice tools to have, but currently I am comfortable that we

do a good job with the staff we have and that we are able to leverage the technology and a very experienced staff to make sure we

fulfill our mission on a daily basis.

Mr. MEEKS. Thank you.

That is all from me, Mr. Chairman.

Chairman BAKER. Thank you, Mr. Meeks.

Let me return to process again, because it is apparently a source

of concern, and in the brief interim I counseled with staff as to the

two processes. One is the current 60-day comment period in which

the subcommittee, if it so chose, could only adopt a resolution of

disapproval, thereby blocking the implementation of the entire

rule. That is not likely to happen. However, after the rule is formally promulgated and published, all changes subsequent to that
18

date would then be subject to the provisions of the Administrative

Procedures Act, which can have an expedited notice and comment

period, but would in all substantive cases require notice and public

comment period of some sort, so that the subcommittee would then

have an opportunity to understand and then again comment on any

subsequent change that might be considered at the agency’s request.

Is that your understanding of the process?

Mr. FALCON. Yes, that we are subject to all the provisions of the

Administrative Procedures Act once this is—— Chairman BAKER. Well, I only mention that because there was

some apparent view that we could get together and work this out

without going through conformity with the APA. And I think for

record purposes, we all ought to acknowledge that that is the law

and we will abide by whatever it provides.

Mr. FALCON. Right. We could not do anything inconsistent within

the express provision of the regulation absent an amendment to

those provisions.

Chairman BAKER. All right.

And the other minor point is that it is actually effective when

printed, and it is only enforceable a year later. So that is the reason why the APA becomes effective after it is printed, and that is

just again for the record purposes.

And I want to return to the issue raised about modifications. As

you know, I have been available for any suggestion by anybody

about how to enhance your ability to perform this task. Clearly,

getting you out of the appropriations process based on a fee schedule for the regulated enterprises would be something I would

strongly support, as all other financial regulators are so funded.

And second, giving you more financial regulatory authority is something I have always thought made a great deal of sense wherever

the agency may land in some future iterations of congressional legislation. So for the record, I want to acknowledge that you requested funding levels last year in the appropriations process higher than you actually received, although you did receive an increase

in budget. And to a great extent, using the OCC model and applying their standards to assessments for regulatory purposes, the two

enterprises would have an assessment of approximately $67 million

for regulatory compliance, and you are now operating on a $23 million platform.

Now, whether or not the people within the agency are working

very hard or not, on its face there is a regulatory mismatch that

should be addressed, and for your purposes, I am strongly supportive of adjusting that mismatch.

With regard to the rule, there has been some comment expressed

that the effect of the rule is to be procyclical in that in good times

that capital assessment may turn out to be excessive, but in bad

times the capital assessment may turn out to be too little, which

would then result in capital swings that might be excessive within

a short-term duration. Further, and this is, I believe, the explanation that OFHEO feels that the capital adjustments that will be

required will come from early warning devices that are now within

the agency’s ability to observe. Don’t regular examinations kind of

give you leading indications without having to wait on the applica-
19

tion of the stress test? You know, make us feel more comfortable

about how this capital requirement can and will be adjusted?

Mr. FALCON. Absolutely. As I said, the stress test is only part of

our comprehensive oversight program with the enterprises. Our examiners are looking at 150 or so different examination areas with

respect to the enterprises. They are in there on a daily basis. They

are constantly evaluating the risk of the enterprises, how they

manage those risks, and certainly they work in concert with other

areas in the agency. With respect to whether or not this rule is

procyclical, I think what makes this unique from any other capital

standard is that it incorporates a downward cycle. In a sense, it anticipates a downward cycle. That is what happens when you apply

stressful economic conditions, a 600 basis point swing, whether up

or down, in interest rates. The worst historical credit losses in any

region apply to their entire portfolio. So this anticipates the worst

possible cycle and makes sure that the enterprises can survive such

a down cycle over a 10-year period.

And if problems were to occur, the fact is that this rule gives the

enterprises the flexibility to decide for themselves the most efficient means for coming into compliance with the capital standard.

It would not have, in a true downward cycle, the effect of forcing

them to find the most inefficient means of coming to compliance

like raising pure equity capital. They would have the flexibility to

adjust the risk profile so that they would be in compliance with the

rule.

Chairman BAKER. Thank you.

Mr. Bachus has arrived. Mr. Bachus, did you have a comment or

question?

Mr. BACHUS. I appreciate it, Mr. Chairman. I commend you for

holding this hearing.

I have been on the floor of the House debating the energy bill,

and I apologize for missing your testimony, Mr. Falcon. I want to

congratulate you. You have only been on the job 18 months, and

yet you and your agency have completed the rule, and it is longawaited, but I appreciate your work.

This is a very long and complex rule. It is over 600 pages. And

I would first urge, and I am sort of doing an opening statement

here too, but I would also urge you to give the GSEs an opportunity to work with you and for them to work with OFHEO in

crafting the final rule. I hope this is not considered a final rule.

Additionally, it is my hope that the final rule will not damage

the GSEs’ mission to increase homeownership in America, and at

the same time protect the taxpayers’ interests from any unnecessary exposure from GSEs’ debt and mortgage holdings.

Let me ask you, I have two questions in mind. One is, and it goes

along with working with the GSEs and their mission of creating

home ownership, particularly for the less advantaged. What impact, if any, will the final rule have on GSEs’ efforts to finance

loans with small down payments? Will these loans become more expensive and harder to get?

Mr. FALCON. Congressman, in order to have a risk-based capital

stress test, we do look at historical defaults and prepayment rates

and loss severities for mortgages of different types, including various loan-to-value ratios for mortgages. But just because a mort-
20

gage may have less equity does not necessarily mean that it might

require greater capital. The enterprises can take steps to mitigate

their potential risk through the use of credit enhancements, offsetting risk, and we would certainly give them full credit for those

types of activities in the Risk-Based Capital Rule. So if the data

dictates that a certain type of loan has greater risk associated with

it, that risk can be mitigated through activities by the enterprises.

Mr. BACHUS. But to a certain extent, HUD, for instance, has

asked them to go and make loans in certain areas, and some of

these loans as a necessity are going to be higher risk loans than

the premium market.

Mr. FALCON. Actually, interestingly, the loans that the enterprises can count toward compliance with HUD’s affordable housing

goals fall across the spectrum of mortgages. We compared those

types of mortgages and their spread across various LTVs and found

that the spread across the LTVs for affordable housing mortgages

was about the same as it is for non-affordable-housing-goal mortgages. And the affordable-housing-goal mortgage is not quite going

to be just a high LTV mortgage. In fact, I think the bulk of them

have an LTV which is 80 percent or less.

Mr. BACHUS. Will it make it harder for the GSEs to buy loans

from borrowers with poor credit histories? The rule?

Mr. FALCON. The rule? Perhaps. We have not incorporated FICO

scores yet through this rule. That is an area of research that we

are undertaking, and if it is appropriate we will incorporate things

like FICO scores. I think if it is appropriate, we will do it, but as

far as what we are now taking into account, I guess you could

think of things like borrowers credit history as embedded in the average default rate on that type of mortgage. If it has got a higher

default rate, it is probably because it was made to someone with

a higher risk profile. And so in that sense, we do incorporate someone with a bad credit history if they receive a mortgage that

Fannie and Freddie buy, into the stress test.

Mr. BACHUS. I would simply, again, just stress to you that their

mission being to bring home ownership to the less advantaged, and

sometimes this requires smaller down payments, things of this nature, which does involve greater risk, but that is part of what Congress has charged them with a mission of doing. And I know that

there is probably some tension between some of what HUD asks

them to do, and then safety and soundness considerations, but

hopefully you can be aware of that. Are you working with HUD in

formulating the rule?

Mr. FALCON. Yes, they have been following the progress of this

rule. At various points in time, we have discussed it with them,

that is over many past years. But I am confident that this rule will

not detract from the ability of the enterprises to fulfill their mission, especially with respect to affordable housing.

Mr. BACHUS. OK, including small down payments and things?

Mr. FALCON. Yes. Absolutely.

Mr. BACHUS. All right.

Thank you, Mr. Chairman.

Chairman BAKER. Thank you, Mr. Bachus.

Mr. Bentsen.

Oh, I am sorry. Mrs. Jones.
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Mrs. JONES. Thank you, Mr. Chairman.

I want to thank my colleagues for asking questions. My questions

should not be too lengthy, though, Mr. Chairman.

Mr. Falcon, as a regulator for Fannie and Freddie, part of regulation also is to ensure that these can continue to operate, or you do

not really have a job to do if they are not in operation. Fair statement?

Mr. FALCON. Yes, ma’am.

Mrs. JONES. So it is not always an adversarial role. I guess that

is what I am trying to ask of you. Is that correct?

Mr. FALCON. Absolutely.

Mrs. JONES. And someone may have asked this question, but in

light of the fact that I was not here to hear the answer, I am going

to ask it again. On page 68 of the regulation, it says that OFHEO

has the authority to make any changes it deems necessary to the

code at any time without notice and comment, as long as those

changes are not inconsistent with the technical specification of the

RBC rule. This authority allows OFHEO to address any technical

or other problems that might arise in the operation of the code on

a timely basis. Any change to the code will be made available to

the public.

As the Director of this regulatory agency, do you believe that this

gives you the ability you need to operate or to have oversight over

agencies that operate with safety and soundness?

Mr. FALCON. Yes, Congresswoman. The way the rule will work

is the rule itself contains various mathematical equations and formulas which make up this stress test. And separate and apart from

that, we have this computer code, this model that we constructed

using the blueprint of the rule. That code implements the rule. It

is that code that we will plug various quarters’ worth of data into

and that will produce a capital requirement for the enterprises.

Now, the code is something that is separate and apart from the

rule, but code will always be consistent with any express provisions, all the policy decisions, that are embedded in the rule. If we

find ways to make the code operate more efficiently, to make it

more operational from the enterprises’ standpoint, we made sure

that we maintained the discretion to this question to do so.

Mrs. JONES. So you have what you need?

Mr. FALCON. Yes.

Mrs. JONES. But this new program or code will, as you said previously, operate in conjunction with the other means that you have

had to have regulation over Freddie and Fannie. Correct?

Mr. FALCON. Yes.

Mrs. JONES. And so it will be, versus two things to judge or assess their safety and soundness, you now have how ever many

there are other than this, as well as this new code that came from

the law or came from this recent ruling.

Mr. FALCON. Absolutely.

Mrs. JONES. Is that correct?

Mr. FALCON. Absolutely. We have our examination program, various other regulations designed to maintain the safety and soundness. We have our minimum capital regulation. We have this riskbased capital regulation. We have a full array of activities that we

do.
22

Mrs. JONES. Generally, we do not want to allow anyone to toot

their own horn, but based on what you had available to you previously and this new rule, do you believe that you are now in a position to help assure the safety and soundness of these two Government Sponsored Enterprises?

Mr. FALCON. Absolutely. And we do a very good job at it, Congresswoman, if I may toot our horn.

Mrs. JONES. Toot, toot, toot, you got the rest of the time.

[Laughter.]

Anything else you want to say?

Mr. FALCON. Yes. I think the 1992 Act which established OFHEO

gave us a very solid set of tools to work with, very similar to the

tools that any other financial safety and soundness regulator has.

We have sought some enhancement to that, but basically I think

we have a very talented staff, the tools. We could always use additional resources, but I think we fulfill our mission very thoroughly.

Mrs. JONES. I yield the balance of my time, Mr. Chairman.

Thank you very much.

Chairman BAKER. Thank you, Mrs. Jones.

Just to clarify, with reference to page 69 citation that is technical

in nature with regard to data and computational matters, so that

if you are provided new data or you see an error in the coding, you

can modify those in accordance with fairness to reflect an accurate

portrayal of the enterprises’ condition. But we cannot take the 2.5

percent capital standard and make it 2.0 percent, as distinguished

between substantive and technical application. If it is demonstrated by GSEs or other interested parties that an outcome of

the computations are not consistent with the agency’s intent, then

certainly that is viewed, I think, as a technical matter which could

be changed not subject to the Administrative Procedures Act.

Mr. FALCON. Right. For instance, if we wanted to change the

haircuts, we would move through the Administrative Procedures

Act to make those changes in the rule.

Chairman BAKER. I think I am very comfortable with your explanation.

Mrs. JONES. Just so the record is clear, Mr. Chairman, it is page

68 that I was reading from.

Chairman BAKER. Page 68.

Mrs. JONES. Yes.

Chairman BAKER. OK.

Fannie and Freddie will continue to evolve and provide, we hope,

creative new products to serve homeowners. Your rule as constructed today, what affect will it have on new product development? Any? None? Any delay for them to proceed? Or how will you

assess the risk associated with a new product?

Mr. FALCON. We designed this rule so that it will allow full innovation by the enterprises. There is a section of the rule that deals

with new activities. As the enterprises innovate, develop new products that might not be covered by this rule, because they just do

not exist today, we will work quickly to incorporate those new products into the stress test as soon as possible. And we will decide

whether or not to apply some interim conservative treatment to the

new activity until we are able to fully understand the risk and how

they manage the risk; decide whether or not we want to incor-
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porate a simple application to the stress test; or perhaps do a separate modeling of the performance over time of that particular product.

So we allow them full innovation, but at the same time make

sure that the risks of that innovation are incorporated as soon as

possible into the stress test.

Chairman BAKER. Thank you.

I am going to yield back my time to enable other Members to ask

questions before the break.

Mr. Bentsen.

Mr. BENTSEN. Thank you, Mr. Chairman.

Let me say at the outset, I feel a little deficient. I studied the

Administrative Procedures Act in graduate school, but I do not

think I can quote from various pages what the regs are. But obviously, there is some interest in that.

There has been some discussion and even I guess some criticism

in the construct of the rule, both as it relates to whether or not it

properly addresses the credit quality of the assets, and then the

question of the use of derivatives as hedges. On the first part, and

I realize a lot of this came straight out of the 1992 Act, is the treatment with the stress test of the mortgage portfolios, that is similar

to what is required in, it is either FIRREA or FDICIA, for the holdings of mortgage instruments by federally insured depository institutions? Is it the same type of model?

Mr. FALCON. It is a different type of risk-based capital requirement. What we currently have in place for banks and thrifts is a

risk-based capital requirement that basically places assets into different ‘‘buckets,’’ and then assigns haircuts to those ‘‘buckets’’ based on the assessment.

Mr. BENTSEN. No, I understand that. I guess what I am asking

is, I thought it was either FIRREA or FDICIA that requires if a

thrift or bank is making a purchase of a mortgage-backed security

or REMIC or some sort of mortgage portfolio. Aren’t they required

under one of those acts to engage in certain stress tests? And if so,

is that similar to what you do in this rule?

Mr. FALCON. I am not certain.

Mr. BENTSEN. If you could find out for the record, I would just

be interested in that.

Mr. FALCON. Sure. I would be glad to.

Mr. BENTSEN. Second of all, how did you all come up with your

models for determining risk for the use of derivatives or other

types of hedge instruments? The reason I ask is, I am looking at

one, on the one hand, I know there is concern that the haircuts are

too strict, and on the other, I see where someone says you are

using the same model as Long-Term Capital Management. And I

find that hard to believe. So I am curious, obviously, this is a new

phenomenon in the market used by banks, thrifts and other entities. How did you all come up with your model?

Mr. FALCON. Well, first off, on the issue of derivatives, and Mr.

Chairman, we will certainly work to provide what information you

would like on the subject that you mentioned previously, but the

enterprises use derivatives as hedging instruments to help manage

basically their interest rate risk. They do not engage at all in derivative transactions for speculative purposes. We would not allow
24

that. So the situation with Long-Term Capital Management and

the enterprises is vastly different. Long-Term Capital Management

used its pricing models to try to anticipate various swings in foreign currency and other types of investments they had. And they

lost that bet. So you saw what happened with Long-Term Capital

Management. The enterprises do not engage in derivative transactions for speculative purposes. They use them only to hedge their

risk. They do not take the naked position in the derivative or trading position. So we are comfortable that they do use derivatives in

a prudent manner.

Now, what we did with respect to haircutting for derivatives in

the rule, we looked at various studies that had been produced as

to whether or not to differentiate between different rating levels,

rating agency levels, and what that haircut should be. There were

various studies that we looked at which everyone cites, Hickman,

Moody’s, Standard and Poor’s, Duffs and Phelps, everyone has

looked at this. We came out with what we thought was a sound

judgment, but we are willing to take a fresh look to make sure that

we properly balanced a rule which was appropriately stressful, but

at the same time was not excessive.

Mr. BENTSEN. Thank you.

Thank you, Mr. Chairman.

Mr. BAKER. Thank you very much.

Mr. Falcon, again, I think every Member has expressed it. We

want to again say thank you.

Mrs. JONES. Mr. Chairman, can I just do a quick follow up from

the question. I would like one second.

Chairman BAKER. Fine.

Mrs. JONES. Mr. Chairman was talking about the change, or new

products. But any financial institution or bank or whatever may

come up with new products. And when you come up with a rule or

regulation that regulates such a thing, you conceptually would include in that the possibility that there would be new products that

would allow you to still withstand the test of time based on your

stress test, if I said that right. Did I make any sense? Or can you

answer that question?

Mr. FALCON. Yes. If we did not allow for new products in this

rule, it would be obsolete from the day that it was published. And

so it does appropriately make sure that the enterprises can innovate and put out new products, and we can incorporate them on a

timely basis into the stress test.

Chairman BAKER. Again, thank you, Mr. Falcon, for your agency’s work. There is a fair certainty that the application of the rule

eventually will cause some modification of the enterprise business

activity, which will yield, I think, benefit in the long term for the

market and for the taxpayer as well. It is my hope that the time

available for review, comment and implementation will provide us

with sufficient flexibility to ensure that there are not untoward

market consequences of the application of the test. That, of course,

is everybody’s desire. But I just want to assure you of my longstanding, intense interest in seeing the rule implemented on the

best of your professional capabilities. And I think the subcommittee

stands ready to be of assistance.
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We will probably return in the fall for sort of a wrap up after

the formal implementation of the rule, and perhaps to receive comment from others as to the advisability of the rule, even the GSEs

if they would choose to have some statement on the record as to

any concerns about the implementation. This should be an ongoing

dialogue that results in the best public policy for all parties concerned.

With that, I thank you and our hearing stands adjourned.

Mr. FALCON. Thank you, Mr. Chairman.

[Whereupon, the hearing was adjourned.]

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A P P E N D I X

August 1, 2001
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