U.S. GOVERNMENT PRINTING OFFICE

63–822cc WASHINGTON : 2000

WASTE, FRAUD, ABUSE,

AND MISMANAGEMENT

HEARINGS

BEFORE THE

TASK FORCE ON

HOUSING AND INFRASTRUCTURE

OF THE

COMMITTEE ON THE BUDGET

HOUSE OF REPRESENTATIVES

ONE HUNDRED SIXTH CONGRESS

SECOND SESSION

HEARINGS HELD IN WASHINGTON, DC: APRIL 13, MAY 25, JUNE 9, AND

JULY 25, 2000

Serial No. 10–1

(

Printed for the use of the Committee on the Budget

(II)

COMMITTEE ON THE BUDGET

JOHN R. KASICH, Ohio, Chairman

SAXBY CHAMBLISS, Georgia,

Speaker’s Designee

CHRISTOPHER SHAYS, Connecticut

WALLY HERGER, California

BOB FRANKS, New Jersey

NICK SMITH, Michigan

JIM NUSSLE, Iowa

PETER HOEKSTRA, Michigan

GEORGE P. RADANOVICH, California

CHARLES F. BASS, New Hampshire

GIL GUTKNECHT, Minnesota

VAN HILLEARY, Tennessee

JOHN E. SUNUNU, New Hampshire

JOSEPH PITTS, Pennsylvania

JOE KNOLLENBERG, Michigan

MAC THORNBERRY, Texas

JIM RYUN, Kansas

MAC COLLINS, Georgia

ZACH WAMP, Tennessee

MARK GREEN, Wisconsin

ERNIE FLETCHER, Kentucky

GARY MILLER, California

PAUL RYAN, Wisconsin

PAT TOOMEY, Pennsylvania

JOHN M. SPRATT, Jr., South Carolina,

Ranking Minority Member

JIM MCDERMOTT, Washington,

Leadership Designee

LYNN N. RIVERS, Michigan

BENNIE G. THOMPSON, Mississippi

DAVID MINGE, Minnesota

KEN BENTSEN, Texas

JIM DAVIS, Florida

ROBERT A. WEYGAND, Rhode Island

EVA M. CLAYTON, North Carolina

DAVID E. PRICE, North Carolina

EDWARD J. MARKEY, Massachusetts

GERALD D. KLECZKA, Wisconsin

BOB CLEMENT, Tennessee

JAMES P. MORAN, Virginia

DARLENE HOOLEY, Oregon

KEN LUCAS, Kentucky

RUSH D. HOLT, New Jersey

JOSEPH M. HOEFFEL III, Pennsylvania

TAMMY BALDWIN, Wisconsin

TASK FORCE ON HOUSING AND INFRASTRUCTURE

JOHN E. SUNUNU, New Hampshire, Chairman

GARY MILLER, California, Vice Chairman

NICK SMITH, Michigan

JOE KNOLLENBERG, Michigan

PAUL RYAN, Wisconsin

PAT TOOMEY, Pennsylvania

KEN BENTSEN, Texas,

Ranking Minority Member

BENNIE G. THOMPSON, Mississippi

DAVID MINGE, Minnesota

EVA M. CLAYTON, North Carolina

BOB CLEMENT, Tennessee

PROFESSIONAL STAFF

WAYNE T. STRUBLE, Staff Director

THOMAS S. KAHN, Minority Staff Director and Chief Counsel

(III)

C O N T E N T S

Page

Hearing held in Washington, DC, April 13, 2000: Abuse of the National

Transportation Safety Board’s Rapidraft Payment System ............................. 1

Statement of:

Kenneth M. Mead, Inspector General, U.S. Department of Transportation ....................................................................................................... 3

James E. Hall, Chairman, National Transportation Safety Board ....... 11

Prepared statement of:

Mr. Mead .................................................................................................... 6

Mr. Hall ...................................................................................................... 14

Hon. Paul Ryan, a Representative in Congress from the State of

Wisconsin ................................................................................................ 42

Hearing held in Washington, DC, May 25, 2000: Lack of Income Verification

in HUD-Assisted Housing—The Need to Eliminate Overpayments ................ 49

Statement of:

Emil J. Schuster, Special Agent in Charge, Southeast/Caribbean

Field Office of the HUD Inspector General ......................................... 52

Raymond A. Carolan, Special Agent in Charge, New England Office

of the HUD Inspector General .............................................................. 56

Saul N. Ramirez, Jr., Deputy Secretary, U.S. Department of Housing

and Urban Development ....................................................................... 61

Sheila Crowley, President, National Low–Income Housing Coalition .. 65

Prepared statement of:

Hon. John E. Sununu, a Representative in Congress from the State

of New Hampshire ................................................................................. 50

Mr. Schuster .............................................................................................. 55

Mr. Carolan ................................................................................................ 59

Mr. Ramirez ............................................................................................... 63

Ms. Crowley ............................................................................................... 68

Hearing held in Washington, DC, June 9, 2000: Government Failure in Disposing of Obsolete Ships ...................................................................................... 85

Statement of:

Thomas J. Howard, Deputy Assistant Inspector General for Maritime

and Departmental Programs, U.S. Department of Transportation ... 89

John E. Graykowski, Acting Maritime Administrator, U.S. Department of Transportation ......................................................................... 99

Vice Adm. James F. Amerault, Deputy Chief of Naval Operations

Logistics .................................................................................................. 103

Prepared statement of:

Mr. Sununu ................................................................................................ 87

Hon. Peter A. DeFazio, a Representative in Congress From the State

of Oregon ................................................................................................ 88

Mr. Howard ................................................................................................ 91

Mr. Graykowski ......................................................................................... 102

Vice Adm. Amerault .................................................................................. 105

Hearing held in Washington, DC, July 25, 2000: Implications of Debt Held

by Housing-Related Government-Sponsored Enterprises ................................. 127

Page

IV

Hearing held in Washington, DC, July 25, 2000—Continued

Statement of:

Barbara Miles, Specialist in Financial Institutions, Government and

Finance Division, Congressional Research Service ............................. 129

Thomas J. McCool, Director, Financial Institution & Market Issues,

General Government Division, General Accounting Office ................ 137

Bert Ely, President, Ely & Co., Inc. ......................................................... 144

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

Oversight ................................................................................................ 214

William C. Apgar, Housing and Urban Development Designee to

the Federal Housing Finance Board .................................................... 225

Prepared statement of:

Ms. Miles .................................................................................................... 132

Mr. McCool ................................................................................................. 140

Mr. Ely ....................................................................................................... 147

Hon. Eva M. Clayton, a Representative in Congress from the State

of North Carolina ................................................................................... 200

Mr. Falcon .................................................................................................. 217

Mr. Apgar ................................................................................................... 229

(1)

Abuse of the National Transportation Safety

Board’s Rapidraft Payment System

THURSDAY, APRIL 13, 2000

HOUSE OF REPRESENTATIVES, COMMITTEE ON THE BUDGET, TASK FORCE ON HOUSING AND INFRASTRUCTURE, Washington, DC.

The Task Force met, pursuant to call, at 10:15 a.m. in room 210,

Cannon House Office Building, Hon. John Sununu (chairman of the

Task Force) presiding.

Members present: Representatives Sununu, Knollenberg, Miller,

Ryan, Toomey, Bentsen, Clement and Lucas.

Mr. SUNUNU. Good morning. Today’s hearing is the first of the

Housing and Infrastructure Task Force, one of six such panels recently established by the House Budget Committee. The overriding

objective of these panels is to identify and review cases of mismanagement or misuse of Federal funds in an effort to better allocate resources, improve government operations and ultimately look

out for the taxpayers’ interests.

I do not view these issues that we are going to be addressing in

these hearings as partisan, and it is not our objective to point fingers or place blame. Frankly, both the administration and the Congress share a responsibility to oversee these agencies. If problems

occur, we need to work together to look for solutions.

I believe that success in the continuing efforts here will not be

marked by a dramatic hearing or simplistic legislation that guarantees accountability but instead by painstaking review and evaluation of what works and, of course, what doesn’t work in government.

Today’s hearing is a modest step in this direction. In reviewing

the problems associated with the Rapidraft check writing system

within NTSB, I hope that this Task Force can address three specific areas:

First, we need to understand what basic flaws of the Rapidraft

system led to very significant abuses, a significant number of drafts

being processed for inappropriate uses. Second, we should consider

the corrective action that has been taken by NTSB leadership and

assess whether or not similar changes should be implemented in

other Federal agencies that might still be relying on Rapidrafts or

other similar third party systems. And, third, I believe we should

consider whether extending legislation such as the Inspector General Act or the Chief Financial Officers Act to additional Federal

agencies would help prevent similar problems from occurring in the

future.

2

I believe that today’s two witnesses and NTSB Chairman Jill

Hall and Inspector General Ken Mead will help provide answers to

these important questions.

Before we begin, however, I want to make a few personal observations about the NTSB itself. In my view and I believe the view

of Congress and the American people, the NTSB is without peer in

the performance of its core mission. The technical expertise and objectivity of its investigators helped to ensure the safety of travelers

not just in the United States but throughout the world. And this

is indeed a unique role. The NTSB provides an invaluable service

to the country and has earned its reputation for integrity.

It should be emphasized that the problems we are going to discuss today relating to the Rapidraft system are unrelated to the

core investigatory work of the NTSB. Moreover, it was the leadership within the NTSB itself that first identified the problems and

requested that the Department of Transportation Inspector General work to begin an audit and make recommendations to the

Board.

This could not have been an easy request for Mr. Hall and the

Board to make. Moreover, implementing the changes to financial

systems, which the NTSB has already begun, is a difficult task in

any organization. Yet, throughout this process, the Board has continued to meet its critical responsibilities in an exemplary fashion.

It is a fact that I believe is a great credit to Mr. Hall’s personal

leadership.

The objective of this hearing is not to assign blame or responsibility for a system that we know is flawed and that the current

Board inherited and which had been in place for about 10 years.

The Task Force’s goal is not to second-guess the overall effort of

Mr. Hall or Mr. Mead. To the contrary, Mr. Hall’s initial problem

identification and request should really serve as a model for others

in similar positions.

Instead, I hope we will work to make the best possible use of the

hard work already done by Mr. Hall and Mr. Mead and their respective staffs and apply the important lessons before us across all

areas of the Federal Government.

It is my pleasure to yield at this time to Mr. Bentsen for an

opening statement.

Mr. BENTSEN. I thank my chairman of the Task Force, Mr.

Sununu, for yielding to me.

I want to thank or welcome both Chairman Hall and Inspector

General Mead here today. We appreciate you testifying.

I can’t help but say that—it’s not Mr. Sununu’s fault—but we

probably should have had the FAA here today. Because, as we

speak, the conference report on the budget resolution is coming up

on the floor, and you have got members of the committee who are

stuck here. But we do have important business before us today,

and I know Mr. Sununu and I are eager to get over to the floor

and do rhetorical battle with respect to the budget, as well as the

other members are.

The Task Force is charged with holding oversight hearings on

waste, fraud and abuse and reporting our findings and recommendations to the full House Budget Committee. I know of no

one, Democrat or Republican, in the Congress who believes the

3

American people should tolerate any waste, fraud and abuse involving their hard-earned tax dollars.

In this our first oversight hearing we turn to the Rapidraft check

writing program of the National Transportation Safety Board. With

all due respect to Chairman Hall, the NTSB is not really on the

Nation’s radar screen except for those tragic times when there is

a major accident. When there are tragedies in our skies like the

Egyptair crash off the coast of Nantucket or the TWA flight 800 in

New York, we look to the NTSB to investigate. I think I can safely

say that there is a broad agreement by Members on both sides of

the aisle that the NTSB is the world’s premiere independent accident investigation agency.

I would like to start also by commending you, Chairman Hall, on

your proactive stance with respect to financial inconsistencies that

your agency unearthed at the NTSB.

From my reading of the materials supplied, in 1999, when your

Office of Finance became aware of potential abuses of the Rapidraft

system, you contacted the Inspector General, who did not have jurisdiction over your agency, and requested that he come in and conduct an audit. You then terminated the Rapidraft system and replaced it with a program universally used throughout the government. Shortly after, the Chief Financial Officer, who failed to properly audit payments under the system, was voluntarily separated

from his position. All the while, you apprised the authorizing congressional committees of your activities. Moreover, I understand

that you recently contracted with an outside firm to have them conduct a complete audit of the abandoned Rapidraft system that goes

beyond the Inspector General’s investigation.

Chairman Hall, I want to commend you and your agency for

showing us how an agency can take the reins of responsibility and

initiate reform that deters waste, fraud and abuse. I think this is

something that you ought to be proud of and something that, at the

conclusion of these hearings, Mr. Chairman and members, that we

ought to hopefully hold out as a model for the Federal Government

in standing up and addressing problems within an agency rather

than not doing anything.

And, with that, I yield back the balance of my time.

Mr. SUNUNU. Thank you, Mr. Bentsen.

Mr. SUNUNU. At this time, it is my pleasure to welcome both of

our witnesses. We will take testimony from each, Mr. Mead and

Mr. Hall, and then allow members 5 minutes on alternating sides

for comments and questions.

STATEMENTS OF KENNETH M. MEAD, INSPECTOR GENERAL,

DEPARTMENT OF TRANSPORTATION; AND JAMES E. HALL,

CHAIRMAN, NATIONAL TRANSPORTATION SAFETY BOARD

Mr. SUNUNU. Welcome, Mr. Mead. We’re pleased to have you

begin.

STATEMENT OF KENNETH M. MEAD

Mr. MEAD. Thank you, Mr. Chairman and members of the Task

Force.

I want to at the very outset here reaffirm what you said in your

opening remarks. The Department of Transportation Inspector

4

General does not have statutory audit or investigative jurisdiction

over the National Transportation Safety Board. We did our work

at the request of Chairman Hall, who called us promptly upon

learning of some issues concerning this Rapidraft program; and he

just as rapidly took action upon our recommendations. Indeed, even

in advance of us issuing our formal recommendations, the chairman acted.

And that is not always the case. As you look about government,

when you find recommendations from the Inspector General or

GAO, you don’t always see such expeditious implementation. So I

just want to say I hold Chairman Hall in the highest personal and

professional regard.

Now, beginning in 1984, NTSB contracted with a vendor to provide a line of credit for writing third-party checks, which in our testimony we will refer to as Rapidrafts. They are much like your own

checks except they have NTSB’s name on them. A primary purpose

of these Rapidrafts was to eliminate extra paperwork and processing time required to issue Treasury checks. The vendor administered the Rapidraft program, including issuing blank checks and

providing NTSB with monthly transaction statements and canceled

checks.

Now our testimony is going to cover three areas: First, the established internal controls for this program were not working as intended, and clearly so; second, what our recommendations were

and NTSB’s response; and, finally, I think our findings illustrate

the need for some type of institutional oversight of NTSB in the financial management area.

The Rapidraft system was in operation from 1984 through September 1999. It authorized some NTSB employees, 177 of the total

complement of about 450 staff, to write Rapidrafts for accident and

nonaccident investigation purposes.

During the past 3 fiscal years, NTSB issued 26,000 Rapidrafts totaling nearly $13 million. During the first 11 months of 1999

about $3.6 million in Rapidraft payments were made. This system

was under the general management of NTSB’s Chief Financial Officer, called a CFO for short. Its operation was governed by an NTSB

order.

In late August 1999, after learning about incidents of possible

abuse, Chairman Hall asked for our assistance in investigating and

auditing the suspected abuse. We agreed to do so.

We performed the work under what is called a memorandum of

understanding, which actually had been under discussion between

NTSB and our office even before this abuse was uncovered. Chairman Hall told me that he wanted audit coverage just as a good financial management practice.

Well, our audit revealed that the Rapidraft system was seriously

mismanaged. Of the 1,000 Rapidrafts paid during fiscal 1999 which

we sampled, 902 of those, or over 90 percent, failed to comply with

NTSB internal controls. Now what do I mean by that? There are

seven specific deficiencies that I would like to note here.

First, 678 of the 1,000 Rapidrafts didn’t contain a required explanation for the check. Now, without an explanation or supporting

documentation, it is difficult to determine whether the disbursement is for a legitimate purpose. An example: in November, a

5

$2,150 Rapidraft was issued and negotiated with no payee and

there was no explanation on the Rapidraft as to what the purpose

of the check was.

Second deficiency: 222 of the 900 checks were paid without the

required signature or authorization number. We found, for example, a $1,416 check that was paid—issued—but it bore no authorizing signature. It is like you cashing a check but not signing it.

A third deficiency: 22 Rapidrafts were issued in 1999 in excess

of the $2,500 ceiling. For example, six ranging from $7,800 to

$24,000 were issued for building renovations.

Fourth deficiency: as a matter of practice, paid Rapidrafts were

not reconciled with supporting documentation by NTSB. In fact,

when my staff retrieved the canceled Rapidrafts from NTSB, they

were still in the same unopened envelopes that the vendor used to

send them to NTSB. That compares to getting your bank statement, throwing it in a drawer and never looking to see whether the

checks were yours or the charges appropriate.

Fifth: employees separating from NTSB weren’t required to turn

in their unused checks, and many did not. Moreover, the contractor

was not notified, in turn, that 37 employees, 37 of the 177 users,

had left the agency. The headquarter’s employee who embezzled

over $70,000 and who in fact worked for the Chief Financial Officer

used Rapidrafts that were left behind by a former employee.

Sixth: employees could order blank Rapidrafts from the contractor without management approval or knowledge. Management

didn’t track how many Rapidrafts were issued to the employees,

and they were not kept in secure locations.

And, finally, these checks were used to split purchases and circumvent Federal regulations. Splitting is the practice of using multiple checks to divide a single purchase to avoid competition. For

example, one employee wrote three checks totalling $4,600 to the

same vendor on one day for the same thing. And this lack of adherence to internal controls overall rendered the system susceptible to

fraud, waste and abuse.

Our investigations disclosed that two employees had embezzled

government funds using the Rapidraft system. The employees have

resigned. Criminal prosecution has been initiated against both of

them.

On April 4, one former employee was indicted by a Federal grand

jury on seven felony counts.

On April 11, the other former employee, the one who worked

under the Chief Financial Officer, was charged with a felony for

embezzling nearly $74,000.

In November 1999, we apprised NTSB of our findings. We recommended that they discontinue the Rapidraft system, implement

an approved payment program using credit cards and ensure that

the Chief Financial Officer’s Office developed and implemented

comprehensive internal controls.

Chairman Hall told us that he had discontinued the Rapidraft

Payment System. He adopted the governmentwide purchase credit

card and travel credit card programs. He also appointed a new

CFO. He has retained the services of a private sector audit firm to

audit the financial management systems.

6

Now the NTSB, as your opening remarks indicated, is held in

very high regard for its investigations. And, in this case, NTSB

took prompt action to get help, and it took prompt corrective action,

and they have committed to a meaningful course of corrective action on a broad front.

Now, it is necessary for Chairman Hall to seek outside assistance, because NTSB doesn’t have an Inspector General or an equivalent institutional oversight mechanism. We feel that if they had

been subject to some type of institutional oversight and follow-up

of corrective action, it is likely that the problems uncovered in 1999

may have been avoided.

And just by way of illustration, I should say that, because of the

experience at NTSB and our own prior audit work at FAA, the Department is terminating a similar program at FAA where similar

weaknesses were found. And that wouldn’t be possible if we weren’t

there to constantly monitor the situation. It just shows I think the

value of continuing oversight. And that concludes my remarks.

Mr. SUNUNU. Thank you very much, Mr. Mead.

[The prepared statement of Mr. Mead follows:]

PREPARED STATEMENT OF HON. KENNETH M. MEAD, INSPECTOR GENERAL, U.S.

DEPARTMENT OF TRANSPORTATION

Mr. Chairman and members of the Task Force, we appreciate the opportunity to

discuss the National Transportation Safety Board’s (NTSB) Rapidraft Payment System.

In 1984, NTSB contracted with a vendor to provide a line of credit for third-party

check writing privileges. A primary purpose of these checks, referred to as Rapidrafts, was to eliminate the extra paperwork and processing time required to issue

checks through the Treasury Department. The vendor served to administer the

Rapidraft program, including issuing blank checks (drawn against the vendor’s bank

account), maintaining a list of authorized NTSB users, and providing NTSB with

monthly transaction statements and canceled checks. NTSB renewed the firm’s contract, most recently in 1996.

The Rapidraft Payment System—in operation from 1984 through September

1999—authorized some NTSB employees, including on-site accident investigators, to

write Rapidrafts ‘‘for accident and nonaccident investigation costs.’’ These Rapidrafts were limited to $2,500 per transaction. During the past three fiscal years

(FY), 1997 through 1999, NTSB issued 26,097 Rapidrafts totaling $12.9 million.

During the first 11 months of FY 1999, only $227,776 (6 percent) of the $3.6 million

Rapidraft payments were associated with on-site accident investigations.

The Rapidraft Payment System was under the general management of NTSB’s

Chief Financial Officer (CFO). Its operation was governed by an NTSB Order prescribing the procedures and internal controls on use of Rapidrafts.

In late August 1999, after learning about incidents of possible abuse of the Rapidraft Payment System by one or more NTSB employees, NTSB Chairman Jim Hall

requested our assistance in investigating the suspected abuse. In addition to rendering investigative services, we agreed to perform a broader audit of the Rapidraft

Payment System. As NTSB is not within the scope of our investigative and audit

authority, we performed the work under a mutually agreed to Memorandum of Understanding and Agreement.

In brief, our audit revealed that the Rapidraft Payment System was seriously mismanaged. Our review of 1,000 Rapidrafts paid during FY 1999 showed that 902,

over 90 percent, were noncompliant with NTSB internal controls. Specific deficiencies we identified include the following:

• 678 Rapidrafts did not contain the required explanation for the check.

• 222 Rapidrafts were processed and paid without the required signature or authorization number.

• 22 Rapidrafts were issued in excess of the $2,500 limit. In the two prior fiscal

years, more than 150 Rapidrafts exceeded $2,500, including eight Rapidrafts issued

for $20,000 or more.

7

• As a matter of practice, paid Rapidrafts (forwarded by the contractor to NTSB,

similar to a bank’s return of canceled checks to a customer) were neither reviewed

nor reconciled with supporting documentation by NTSB. • The contractor was not notified that 37 of the 177 authorized users had left

NTSB. • Employees separating from NTSB employment were not required to turn in unused Rapidrafts and many did not. • Employees ordered and received blank Rapidrafts from the contractor without

management approval or knowledge. • NTSB management did not track how many Rapidrafts were issued to employ- ees. • Rapidrafts were not kept in secure locations at NTSB. • Rapidrafts were used to ‘‘split’’ purchases and circumvent Federal Acquisition

Regulations and NTSB Orders. (‘‘Splitting’’ is the practice of using multiple Rapidrafts to divide a single purchase—which exceeds the Government’s $2,500 micropurchase ceiling—into a series of separate, smaller purchases in order to circumvent

the ceiling.)

NTSB’s lack of adherence to internal controls rendered the Rapidraft Payment

System susceptible to fraud, waste and abuse, as evidenced by two known embezzlements which we investigated. Our investigations disclosed that two NTSB employees, one in a field office and one at Headquarters had separately embezzled Government funds using the Rapidraft System. The employees resigned before our investigation commenced in August 1999. Since then, our findings concerning each of

those former employees have resulted in criminal prosecution by the Department of

Justice.

Our investigation disclosed that a former employee was responsible for misappro- priating in excess of $20,000. On April 4, 2000, she was indicted by a Federal grand

jury in the Northern District of Georgia on seven felony counts of embezzlement.

On April 11, 2000, the other former employee—who worked under NTSB’s former

CFO—was charged in a one-count felony Information by the U.S. Attorney’s Office

for the District of Columbia for embezzling approximately $74,000.

In early November 1999, we apprised NTSB of our audit and preliminary investigative findings, transmitting our formal audit report. Our audit report recommended that NTSB: • Discontinue the Rapidraft Payment System. • Implement approved payment programs, such as the Governmentwide commercial purchase card and a Federal payment processor for travel-related reimbursements. • Ensure that the CFO’s office develops and implements comprehensive internal

controls for these programs.

In response to our recommendations, Chairman Hall notified us that he had discontinued the Rapidraft Payment System and NTSB adopted the Governmentwide

purchase credit card program. Moreover, NTSB appointed a new CFO in January

2000 and has retained the services of a private sector audit firm to assist in identifying weaknesses and recommending procedures and resources for improved audit

control. This outside audit firm will audit and examine internal control weaknesses

in other financial systems, such as NTSB’s travel program, accountability of property and internal controls, and electronic certifications. These programs and systems

were beyond the scope of our review of the Rapidraft Payment System.

The NTSB is held in high regard for its expertise and role in assuring the safety

of all modes of transportation. It is widely regarded as the preeminent investigative

agency of its kind in the world. We note NTSB’s prompt action in requesting assistance to identify the cause and extent of the problems with the Rapidraft program

and appreciate its cooperation with our auditors and investigators. NTSB has committed to a meaningful course of corrective action on a broad front, promptly ending

its use of Rapidrafts even before the completion of our audit, and must now follow

through in its implementation of these actions.

To help the Task Force in its efforts, our testimony today addresses three areas

related to the problems identified with the NTSB’s Rapidraft program.

• First, the established internal controls were not operating as intended,

• Second, our recommendations to correct the problems identified and NTSB actions relative to those recommendations, and

• Finally, our findings in this matter illustrate the need for some type of institutional oversight within NTSB in order to provide the Chairman and the Board with

independent reviews of NTSB’s financial management programs and business operations. This capability presently does not exist.

In December 1997, we issued an audit report to the Federal Aviation Administration (FAA) regarding the closeout of its imprest fund, which included recommendaVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00011 Fmt 6633 Sfmt 6621 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
8

tions concerning third-party drafts. At that time, we recommended FAA limit its use

of third-party drafts to exceptional circumstances. As a result of our work with the

NTSB in this matter, we made follow-up inquiries about the continued use of thirdparty drafts in the Department of Transportation (DOT).

On March 30, 2000, DOT’s Assistant Secretary for Budget and Programs issued

a memorandum informing all DOT operating administrations that the use of thirdparty drafts will be discontinued by the end of Fiscal Year 2000. As originally designed, third-party draft programs once served a useful purpose by providing a payment mechanism for time-sensitive missions such as NTSB’s. However, the Government’s adoption of purchase and travel credit card programs has supplanted the

need for third-party drafts.

INTERNAL CONTROLS WERE NOT OPERATING AS INTENDED

The Rapidraft Payment System was seriously mismanaged and subjected to embezzlement. During fiscal years (FY) 1997 through 1999, NTSB issued 26,097 Rapidrafts totaling $12.9 million. While intended ‘‘for accident and nonaccident investigation costs’’, Rapidrafts were predominately used to reimburse employees for nonaccident related travel, pay tuition for training, make equipment purchases, and pay

employees’ salaries. Also, Rapidrafts were processed and paid when they exceeded

the $2,500 limit, and employees ‘‘split’’ purchases to circumvent that limit and the

Federal Acquisition Regulations.

The internal controls designed for the Rapidraft Payment System were not followed, resulting in numerous weaknesses that left the System inherently vulnerable

to fraud, waste, and abuse. For example, Rapidraft stocks were not protected from

unauthorized use, Rapidrafts were paid without the required signature or authorization number, and 37 of the 177 authorized users no longer worked for NTSB. Rapidrafts were also paid when the signatures of current and former employees were

forged. The CFO’s office did not review paid Rapidrafts or reconcile them with required supporting documentation to ensure payments were authorized and appropriate.

Our review of 1,000 Rapidrafts paid during FY 1999 showed that they frequently

lacked supporting documentation. The lack of documentation precluded us from determining whether many of the payments were for legitimate NTSB purposes.

RAPIDRAFTS WERE USED IN VIOLATION OF NTSB POLICY

Contrary to NTSB policy, Rapidrafts were paid when they exceeded the $2,500

limit, and payments were split to circumvent acquisition regulations and the $2,500

limit. NTSB Order 1542 Section 5b(2) states ‘‘Rapidrafts are limited to a maximum

of $2,500 per item/service.’’ During FY 1999, the Rapidraft Payment System contractor processed 22 NTSB Rapidrafts that exceeded the $2,500 limit, including ones for

$11,076 and $4,070. During a limited review of FY 1998 and FY 1997 Rapidrafts,

we identified 107 and 49, respectively, that were processed for more than $2,500 including individual Rapidrafts as follows:

• $28,532 for hotel services;

• $24,461, $20,000, and $13,357 for building renovations (FY 1997);

• $16,404, $10,000, and $7,890 for building renovations (FY 1998); and

• $5,795 for telephone service.

Also, NTSB Order 1542 Section 5b(3) notes ‘‘A paid Rapidraft does not eliminate

or mitigate . . . the prohibition against subdividing foreseeable purchases, merely

to use simplified procedures.’’ However, NTSB employees—including the former

CFO—were ‘‘splitting’’ payments using multiple Rapidrafts to divide a purchase that

exceeds the government’s $2500 micropurchase ceiling into a series of separate,

smaller purchases in order to circumvent the ceiling, a violation of Federal Acquisition Regulations and NTSB Order. For example, one employee wrote three Rapidrafts totaling $4,649 to the same payee on 1 day for computer equipment.

Internal controls were not sufficient to protect the System from fraud, waste, and

abuse. Although some controls existed on paper, the controls were not followed.

Also, NTSB staff were not trained in the proper use of Rapidrafts (NTSB Order

1542, Section 5a) or the penalties for misuse (NTSB Order 1542, Section 7a).

NTSB Order 1542 prescribes internal control procedures for Rapidrafts, including

segregation of duties, limitations on use, requirements for supporting documentation, and guidance on safeguarding the Rapidrafts. For example, Section 6d states

‘‘If the Rapidrafts do not meet certain pre-established criteria, [the contractor] will

reject them for payment. The amount may not exceed $2,500. The signature appearing on the Rapidraft must be an authorized employee, and the authorization number must match the one assigned to that employee.’’

9

However, the internal control procedures were not followed by NTSB and the contractor. Specific weaknesses OIG identified include: • Rapidrafts were paid without the required signature or authorization number. • Rapidrafts were paid without the required supporting documentation. • The contractor was not notified that 37 of the 177 authorized users had left

NTSB. • Employees leaving NTSB were not required to turn in unused Rapidrafts and

many did not. • Employees ordered and received blank Rapidrafts from the contractor without

management approval or knowledge. • NTSB management did not track how many Rapidrafts were issued to employees.

• Rapidrafts were not kept in secure locations at NTSB.

• As a matter of practice, paid Rapidrafts (forwarded by the contractor to NTSB,

similar to a bank’s return of canceled checks to a customer) were neither reviewed

nor reconciled by NTSB.

Our sample of 1,000 Rapidrafts from the 7,749 paid during the first 11 months

of FY 1999 showed that 902 Rapidrafts (90 percent) were noncompliant with NTSB

internal controls. For example, 678 Rapidrafts (68 percent) did not contain the required explanation of the purpose for the check. Also, 222 Rapidrafts (22 percent)

were processed and paid even though they did not include the required authorization number. Additionally, 52 Rapidrafts contained more than one deficiency such

as no signature on the check and no explanation of the purpose for the check. While

the contractor should not have paid Rapidrafts without signatures or authorization

numbers, NTSB officials did nothing to check the contractor’s actions or processes.

Specific examples of Rapidrafts issued and transacted in violation of the usage

procedures are as follows:

• In August 1998, a $1,416 Rapidraft bearing no authorizing signature was issued

and subsequently negotiated.

• In November 1998, a $2,150 Rapidraft for which no payee was listed was issued

and later negotiated.

Further, canceled Rapidrafts were not reviewed or reconciled with supporting documentation to verify that the payments were for legitimate products or services, and

that the transacting employee was authorized to make the payment. Bundles of paid

Rapidrafts from the contractor were stored unopened, and the CFO’s office did not

compare them against supporting documentation.

The CFO’s office only compared a listing of check numbers and dollar amounts

on the contractor’s bill with check numbers and amounts entered into the accounting system by employees who issued the Rapidrafts. If there was a match, NTSB

paid the bill without question. Reconciling Rapidrafts to the supporting documentation is an important control mechanism because it provides independent assurance

that payments and purchases are authorized and appropriate.

CONTROL WEAKNESSES WERE PREVIOUSLY IDENTIFIED

Weaknesses in internal controls for the Rapidraft Payment System were identified

on at least two previous occasions. A 1992 audit report by the General Services Administration’s (GSA) Inspector General on NTSB’s travel procedures and practices

identified internal control weaknesses in the use of Rapidrafts. Also, staff began

raising concerns to the NTSB CFO in early 1999 that internal controls were not

being implemented.

The GSA Inspector General concluded that Rapidrafts were not properly safeguarded and were improperly used. Specifically, the GSA Inspector General’s report

noted that investigators or their supervisors were routinely issuing Rapidrafts for

travel advance purposes even though they were not authorized to do so. The report

also noted that subordinates issued Rapidrafts to their supervisors for travel purposes. The GSA Inspector General noted that these practices were of particular concern because they circumvented a fundamental control—separation of duties.

The then-Comptroller (former CFO) responded to the report outlining planned corrective actions to be taken, including issuing a memorandum to all employees on

authorized uses and safeguarding of Rapidrafts. Based on our work, corrective actions were either never implemented or sustained because we identified the same

weaknesses as the GSA Inspector General.

Also, in January 1999, CFO staff began raising concerns to the CFO that Rapidraft users were not complying with internal control requirements. Specifically,

CFO staff noted that Rapidraft users were not submitting required supporting documentation for purchases and not entering required data into the accounting system.

When these concerns were ultimately raised to and reviewed by senior managers

10

outside of the CFO’s office, instances of embezzlement were uncovered. Further, we

found that in January 1999, NTSB personnel in the office of the CFO alerted the

former CFO to irregularities involving the use of Rapidrafts by the former Headquarters employee who has since been charged with theft. Yet the CFO did not take

timely or adequate action and, in the next 8 months, until the Headquarters employee resigned in August 1999, this employee embezzled approximately 34 Rapidrafts totaling $30,000. The CFO resigned effective November 29, 1999, after our

investigation was commenced.

RAPIDRAFTS WERE EXPLOITED IN TWO KNOWN EMBEZZLEMENTS

In the end, the lack of adherence to internal controls subjected NTSB to separate

known embezzlements by two employees. We investigated a former GS–7 employee

in the Atlanta field office of the NTSB suspected of embezzling approximately

$20,000. The employee resigned in July 1999. Investigation disclosed that between

October 1998 and June 1999, the employee embezzled money from NTSB by writing

Rapidrafts to employees of NTSB and then fraudulently endorsing the Rapidrafts

to herself. The employee then deposited the Rapidrafts into a personal bank account. On April 4, 2000, the employee was indicted by a Federal grand jury in Atlanta, charged with seven counts of theft.

We also investigated a former GS–8 employee of the NTSB Headquarters staff

who resigned in August 1999. On April 11, 2000, the former employee was charged

in a one-count felony Information by the U.S. Attorney’s Office for the District of

Columbia for embezzling approximately $74,000 between September 1997 and August 1999, by fraudulently writing 97 Rapidrafts to herself using the signature authority of a former NTSB employee and then cashing the majority of these Rapidrafts at a local liquor store. The Headquarters employee knew that once cashed,

the canceled Rapidrafts were not reviewed by NTSB for purposes of reconciliation.

IG RECOMMENDATIONS AND NTSB CORRECTIVE ACTION

On October 26, 1999, we met with Chairman Hall and senior NTSB staff to discuss our audit results and preliminary investigative findings. On November 8, 1999,

we issued an audit report to the NTSB that recommended NTSB discontinue the

use of the Rapidraft System and instead use the Governmentwide commercial purchase card program for its on-site investigative expenses and other purchases. We

recommended that NTSB discontinue processing employee travel claims and instead

use a Federal processor for reimbursement of travel claims to ensure that proper

voucher examination is performed.

By letter dated November 5, 1999, we notified the NTSB of our preliminary investigative results. Subsequently, on March 21, 2000, we issued a final investigative

report to the NTSB. Our investigative report supported the earlier recommendations

of the audit and recommended that NTSB consider disciplinary action for employees

as appropriate.

The NTSB generally concurred with our recommendations. By letter dated November 23, 1999, Chairman Hall responded that NTSB had discontinued the Rapidraft System and adopted the Governmentwide Citibank Purchase card Program in

its place. The Chairman also reported that NTSB had commenced discussions with

a private sector audit firm for assistance in identifying audit weaknesses and recommending procedures and resources for improved audit control. We were recently

informed that such a contract has been executed and that an audit will begin in

the near future.

On January 3, 2000, the NTSB appointed a new CFO. The new CFO was hired

from the U.S. Treasury Department and has 35 years of Federal service in the field

of financial management. We have met with the new CFO several times to review

our audit and investigative results. He has identified and initiated specific actions

necessary to implement our recommendations, but his efforts require the full support of the NTSB Board and senior staff if he is to succeed in reforming and improving the financial management of the NTSB.

NEED FOR INSTITUTIONAL OVERSIGHT WITHIN THE NTSB

To his credit, NTSB Chairman Hall promptly sought our assistance in this matter. It was necessary for the Chairman to seek outside assistance because the NTSB

is without an Inspector General or an equivalent institutional oversight organization. The NTSB has historically relied on agreements with other Inspectors General

or private sector firms for audit assistance. Outside oversight has included General

Accounting Office audits and congressional oversight exercised through the authorizing and appropriations process.

11

There is no full-time oversight of NTSB. Our work with respect to the Rapidraft

System was carried out in accordance with an August 31, 1999, Memorandum of

Understanding (MOU) between our office and the NTSB. The MOU allows for our

office to conduct investigations and audits at the request of the NTSB on a reimbursable basis. It does not provide authority for us to self-initiate audits or investigations as we do for the Department of Transportation, nor does it authorize, or

create a responsibility for us to ascertain whether or not NTSB implemented the

corrective actions discussed with us. As you are aware, such follow-up is critical to

oversight. For example, as noted above, the GSA IG was not in a position to follow

up on its 1992 audit results. If NTSB had been subject to some type of institutional

oversight, it is possible that the 1992 audit would have resulted in real corrective

action and the problems uncovered in 1999 may have been avoided.

Similarly, if the NTSB had an institutional oversight organization, the employees

who reported irregularities to the CFO in January 1999 would have had an in-house

channel to pursue when they did not see action on the part of the CFO in response

to their reports of irregularities. At the Department of Transportation, we receive

approximately 600 telephone calls, letters, and E-mail messages a year reporting

suspected fraud, waste and abuse within the Department. Our fraud, waste and

abuse Hotline offers employees confidentiality or the opportunity to provide information anonymously. Reports to our Hotline receive independent attention from our

staff and are also shared with the Department management. For management, they

serve as a useful source of information about programs and operations in the Department that, at a minimum, require management attention. The NTSB does not

have a vehicle similar to our Hotline to ensure an independent review of suspected

fraud, waste and abuse.

‘‘The National Transportation Safety Board Amendments Act of 1999,’’ (H.R.2910)

was passed by the House on October 1, 1999. The legislation reauthorizes the NTSB

and also contains provisions that address Inspector General oversight at the NTSB.

The bill provides that the Inspector General at the Department of Transportation

will carry out Inspector General responsibilities only with respect to the financial

management and business operations of the NTSB. While we did not seek this additional responsibility, we concur that our audit and investigation concerning the

NTSB’s Rapidraft System strongly suggests that some type of institutional oversight

is appropriate. The Senate is considering similar provisions as part of its reauthorization legislation for the NTSB.

Mr. Chairman, this concludes our testimony. I would be happy to answer any

questions you may have.

Mr. SUNUNU. Welcome, Mr. Hall. We’re pleased to hear your testimony.

STATEMENT OF JAMES E. HALL

Mr. HALL. Thank you very much, Mr. Chairman, Congressman

Bentsen, members of the committee.

I was invited to appear before you today regarding the National

Transportation Safety Board’s request for an audit and investigation by the Department of Transportation’s Inspector General regarding financial discrepancies found during an August 1999 document reconciliation in preparation for our end-of-year financial

closeout. I have brought with me today our Managing Director,

Dan Campbell; our General Counsel, Ron Battocchi; and our Chief

Financial Officer, Mitch Levine, who will be available to be responsive to any questions the committee may have as well.

Before I begin, permit me, Mr. Chairman, to spend just a few

moments on the NTSB and its mission. Since Congress created it

as an independent agency in 1967, the Safety Board has served as

the eyes and ears of the American people at more than 100,000

aviation accidents and thousands of surface transportation accidents. Over time, it has become one of the Board’s premiere accident investigation agencies. In fact, it is only one of nine independent investigative organizations in the world.

12

Perhaps more importantly, as part of our investigations we make

safety recommendations that we hope will prevent similar accidents from recurring. In its 33-year history, the Board has issued

almost 11,000 recommendations in all transportation modes to

more than 1,250 recipients. In 1990, we began compiling the ‘‘most

wanted list’’ that highlights some of what we considered to be our

most important but not yet implemented recommendations and

covers concerns such as data recorders in all transport vehicles,

aircraft icing, fuel tank flammability and human fatigue.

It is important to note that, because the Board does not have regulatory or enforcement powers, we rely on our reputation for impartiality and thoroughness to get our recommendations implemented. To date, more than 80 percent have been adopted. Many

safety features currently incorporated into airplanes, automobiles,

trains, pipelines and marine vessels have had their genesis in Safety Board recommendations; and over the years Board recommendations on ground proximity warning systems, windshear, crew resource management, railroad passenger safety, drunk driving, seat

belts, child safety seats, graduated licensing and emergency response to hazardous material substances have been implemented.

At an annual cost of less than 20 cents a citizen, the 400-member

Safety Board I believe is one of the best investments this Congress

makes.

My testimony submitted for the record details the series of

events that led up to the August 1999 discovery. Today, I would

like to focus on what actions have occurred since I requested Mr.

Mead’s assistance.

I would, however, like to emphasize several facts. NTSB staff discovered the discrepancies and notified me of the findings. Because

I was concerned about this compromise to our agency’s financial integrity and our reputation, I immediately requested the Department of Transportation Inspector General to perform an audit and

criminal investigation to determine if our concerns were valid and

whether there were any additional problems even though, as previously mentioned, the IG had no jurisdiction over the agency. The

NTSB staff and leadership cooperated fully throughout the IG’s

audit and investigation. We were already taking corrective actions

before the IG completed their work, and we kept our appropriating

and authorizing committees fully informed throughout the investigation.

I asked the IG to look at three areas during their audit and investigation. Was there criminal conduct by any NTSB employee?

Were there systemic problems with the Rapidraft program? And

were there sufficient financial controls for small purchases?

Mr. Mead and his staff responded to my request quickly and very

effectively. He sent a full team of auditors and investigators who

devoted 3 months to the audit and 7 months to the investigation.

The IG’s audit did conclude that there were weaknesses in our internal controls and that existing controls were not followed.

The report made three recommendations: to discontinue the

Rapidraft Payment System immediately; to implement an approved

payment program to meet NTSB’s needs; and, third, to ensure that

the Chief Financial Officer’s Office develops and implements comprehensive internal controls.

13

I terminated the Rapidraft system even before I received the IG’s

preliminary report in October 1999, based on an oral briefing from

the Inspector General and his staff. Following that report, we took

a series of additional actions. I placed the Chief Financial Officer

on administrative leave. In January 2000, I hired a new Chief Financial Officer, Mr. Mitch Levine who is with us today, who has

35 years of Federal financial management service.

We are currently recruiting to fill vacancies in accounting operations and system accounting. We implemented governmentwide

commercial credit card programs for travel expenses and small purchases. Travel vouchers and purchase card bills are now paid

through the Treasury Department Disbursing Centers.

And we selected an independent audit firm, PriceWaterhouseCoopers, which began work yesterday to develop a program for

comprehensive financial integrity. As part of their audit, they will

conduct a closeout review of the Rapidraft Payment System; document NTSB’s financial management processes and systems; perform a baseline analysis of existing financial policies, procedures

and systems; test internal controls; develop internal control recommendations; and assess our audit readiness.

We received the Inspector General’s investigative report on

March 21st. It did not find any additional criminal activity beyond

that already found by the NTSB. It concluded that the two previously identified employees had embezzled about $95,000. Both

employees have left the NTSB. I have been advised that one has

been indicted by a grand jury and the other is pleading guilty for

criminal acts involving embezzlement and that restitution to the

American people will be sought.

Let me close, Mr. Chairman and members of this committee, by

saying to you that I take this situation very seriously, and it is the

most deeply troubling experience I have had in all my years of public service. It has unduly impugned the reputation of this agency

and its dedicated employees.

This has been an especially difficult time for the Board’s employees, and it has been a distraction from our mission. As you may

know, while we have been managing this event, we have had to

deal with both the Egyptair and Alaska Air investigations.

We are taking, Mr. Chairman, every action necessary to ensure

that these deficiencies are rectified and procedures are put in place

to ensure that they do not recur. I give my this committee my

pledge that will be done.

Now, I fully support independent oversight of the Board’s operations on a regular basis. In fact, that concerned me most when I

became chairman of this agency, and I was trying to move in the

that direction at the time these events occurred.

I want to publicly express my appreciation to Mr. Mead and his

staff, and to thank them for assisting us in this task.

Mr. Chairman, I appreciate your attention and the attention and

time the committee staff and you and the members have given me.

That completes my statement.

Mr. SUNUNU. Thank you very much, Chairman Hall. I appreciate

your statement and its candor and certainly want to invite Mr. Levine and Mr. Campbell to assist you as we go through the questioning process with any details that might be helpful.

14

[The prepared statement of Mr. Hall follows:]

PREPARED STATEMENT OF JIM HALL, CHAIRMAN, NATIONAL TRANSPORTATION SAFETY

BOARD

Good morning, Chairman Sununu and Members of the Task Force. I was invited

to appear before you today regarding an audit and an investigation that the National Transportation Safety Board (NTSB) requested from the Department of

Transportation’s Inspector General (IG). In August 1999, as the NTSB’s staff was

engaged in reconciling documents to close our books for the fiscal year, financial discrepancies were found and brought to my attention. I promptly called Inspector

General Mead and asked for a full and independent investigation.

Before turning to the circumstances of that request, I would like to put the problems we discovered in our program for Rapidraft payments program in context. I

became Chairman of NTSB in October 1994, and inherited a financial accounting

system and organization that had been in place for many years and had not been

modernized with automated information capabilities. Weaknesses in its utility for

budgeting purposes were apparent, and after preparation of budgets for 1996, I

asked senior managers at NTSB to rethink our finance and budget process to make

recommendations to improve our performance. Staff reviewed the provisions of the

Chief Financial Officer Act, which, although it does not apply by its own terms to

a small agency such as NTSB, appeared to reflect a ‘‘best practice’’ approach to financial operations. As a consequence of this review, in February 1997, I requested

the Department of Treasury’s Financial Management Service (FMS) to do a top-tobottom evaluation of the finance accounting system that had been in place at NTSB

for more than a decade. The cost for this service was $55,000, not insignificant for

NTSB, but we believed that modernization was critical.

NTSB received FMS’s initial report in June 1997. The report found that the existing accounting system was insufficient to support modernized accounting practices.

It recommended that we acquire a new accounting system. We contracted again

with FMS for assistance in selection of such a system. This resulted in the purchase

of an off-the-shelf, Joint-Financial-Management-Improvement-Program (JFMIP)

compliant accounting program. The FMS report also recommended that we target

October 1, 1998, as the date for changeover to a new system. We met that date,

and began use of an entirely new, modern system for fiscal year 1999. Achieving

this target placed a substantial workload on the accounting staff, but we believed

it was a critical first step in permitting us to achieve a clean audit opinion on

NTSB’s financial statements. The goal of a clean audit was a key recommendation

of FMS and is a central concept embodied in the Chief Financial Officer Act. I

wholeheartedly agreed with this approach.

I concurrently elevated the organizational structure of the comptroller’s function

to independent office status, headed for the first time by a Senior Executive level

official, also as recommended by the FMS report and the Chief Financial Officer Act.

And we undertook intensive training of administrative staff in the program offices,

in order to use the new accounting system to its full potential. We knew that the

total process of modernization and information integration would take several years.

However, by the middle of 1999, we were in the midst of a substantial revision in

our financial processes, with the goal of meeting financial accounting practices at

a level not yet, even today, required of us.

DISCOVERY OF EMBEZZLEMENT

From April 1989 until August 1999, Safety Board offices used what was for a time

a governmentwide, GSA-approved Rapidraft payment system. Rapidraft is a service

offered by a commercial vendor that enables a government employee to write checks

to pay for goods and services. NTSB Board Order 46A, issued in October 1990, established the Rapidraft program for payment of small purchases, travel advances,

travel expenses, training registration, and other services. Proper reconciliation of accounts within the program was a shared function between program offices and the

financial specialists within what is now organized as the Office of Chief Financial

Officer (CFO). In August 1999, during reviews to prepare for the fiscal year-end

closeout, a highway safety program officer asked for assistance from the CFO office

in reconciling records discrepancies concerning a particular Rapidraft payment. That

meeting triggered further analysis, and the subsequent review identified suspect behavior on the part of two NTSB employees concerning possible embezzlement. Approximately $95,000 appeared to be at issue.

15

1 Both employees identified by NTSB resigned from the agency prior to investigation by DOT

IG and the Federal Bureau of Investigation.

NTSB’S REQUEST TO IG FOR AUDIT AND INVESTIGATION

NTSB has traditionally used the services of outside, independent auditors to assess financial management issues. In this instance, I asked DOT IG if it would conduct an audit and a criminal inquiry. The IG does not have jurisdiction over the

NTSB. However, NTSB has the authority to use the services of other Federal agencies and has used the services of other IGs in the past. We were in the process of

finalizing a new voluntary audit agreement with the DOT IG when the discrepancies were uncovered. We believed that an IG, with the ability to simultaneously

pursue a financial audit and a criminal investigation, was especially well suited to

assist us. Consequently, we broadened the scope of our pending agreement to include criminal investigations and requested the DOT IG commence an immediate

two-pronged review of the problem we had uncovered. Staff and management were

instructed to cooperate fully with the work of the IG. NTSB (with DOT IG participation) briefed its Congressional authorizing and appropriating committees on the

problems identified and the initiation of work by the DOT IG. The concerns shared

with the Inspector General were:

• Was there criminal conduct by any NTSB employee? (criminal investigation)

• Were there systemic problems with the Rapidraft program? (audit)

• Are there sufficient financial controls for small purchases? (audit)

The IG completed its audit work and briefed top NTSB management on its results

on October 26, 1999, and their final report was delivered on November 8, 1999. In

addition, the IG periodically shared information on the progress of their criminal

investigation, and delivered the results of that investigation on March 21, 2000.

IG AUDIT AND INVESTIGATION REPORT RECOMMENDATIONS

The IG’s audit report concluded that there were weaknesses in internal controls,

and that existing controls were not followed. The report made the following three

recommendations:

1. Discontinue use of the Rapidraft Payment System immediately.

2. Implement an approved payment program to meet NTSB needs, specifically for:

• On-site investigative expenses, office supplies, computer equipment, tuition and

training payments, and other similar expenses, NTSB should use the Governmentwide Commercial Purchase Card Program.

• And, travel-related reimbursements, NTSB should use the same organization

that currently provides their payroll services (FAA) or another Federal processor.

3. Ensure that the CFO’s office develops and implements comprehensive internal

controls over these programs.

The IG investigative report concluded that there was criminal activity on the part

of the two employees that were originally referred by the NTSB.1 No other embezzlements were uncovered by the IG. Criminal enforcement is ongoing and restitution

will be pursued. In addition, the report recommended administrative action be considered for certain irregularities concerning use of agency e-mail, and that NTSB

ensure proper procedures for the acquisition of small purchases, the payment of performance bonuses only within the payroll process, and adherence to government regulations regarding the use of frequent flyer mileage upgrades.

NTSB ACTIONS TAKEN AND PLANNED

In September 1999, NTSB terminated the Rapidraft Payment System. After receiving the October 26 briefing on this subject, the then incumbent CFO was placed

on administrative leave. In January 2000, a new CFO with 35 years of Federal financial management service was hired. Recruitments are underway to fill additional

vacancies in accounting operations and system accounting. After the new CFO familiarized himself with the circumstances of DOT IG’s work, a series of briefings

were undertaken with NTSB’s authorizing and appropriating committees of Congress concerning the results of the IG’s work and our responses. The NTSB has initiated implementation of all the IG Audit Report’s recommendations.

1. Rapidraft Payment System has been canceled.

2. Governmentwide commercial credit card programs have been implemented for

travel expenses and small purchases. Travel vouchers and purchase card bills are

being paid through Treasury Department Disbursing Centers.

16

2 A copy of the PriceWaterhouseCoopers proposal, and the Board’s acceptance letter, were provided to the Committee. PriceWaterhouseCoopers began their audit activity on April 12, 2000,

and we expect the review to take about 4 months.

3. An independent audit firm (PriceWaterhouseCoopers) has been selected to develop a program for comprehensive financial integrity.2 PriceWaterhouseCoopers

will perform the following tasks: • Conduct a closeout review of the Rapidraft Payment System; • Document NTSB’s financial management processes and systems; • Perform a baseline analysis of existing financial polices, procedures and systems; • Test internal controls; • Develop internal control recommendations; and • Assess audit readiness.

As I noted, the IG’s report on the investigation was received at the Board on

March 21, 2000, and we are currently preparing an action plan that will address

all stated recommendations. As a result of the IG’s work, we understand that one

of the two clerical employees originally referred to the IG by NTSB has been indicted, and the other is pleading guilty for criminal acts involving embezzlement.

I would like to close by indicating NTSB’s appreciation for the work of Ken Mead

and members of his staff. This has obviously been a difficult time for NTSB, but

as an institution we strongly favor having the ability to resort to independent, expert assistance as a means of quality assurance and improved performance. We

would like to thank the DOT IG for providing that service to us in this case. Mr.

Chairman, that completes my statement and I will be happy to respond to questions.

Mr. SUNUNU. I would like to begin the questioning by discussing

the 1997 Treasury FMS recommendations and the changes that

were recommended as part of that process. And also I know there

were some controls, control changes recommended as part of the

Inspector General’s audit. Could I ask you to talk about those

changes? Specifically, has the new system for financial control been

implemented, what elements are in place and working, and what

elements are yet to be implemented?

Mr. HALL. I think the person with the most knowledge to respond to that is our CFO, Mr. Levine.

Mr. LEVINE. This is history, Mr. Chairman, so I am looking back

at a time when I wasn’t at the Board. The Board selected the new

accounting system based on work done by the Center for Applied

Financial Management, which is a Treasury entity that they

brought in to look at their old financial system. They concluded

that in order to comply with most of the government regulations

dealing with financial management and the plethora of laws that

have been enacted by the Congress, we needed to move to an integrated financial management system that was approved by the

Joint Financial Management Improvement Program and certified

by the General Services Administration.

NTSB selected a system with an assistance from the same consulting group from Treasury. A system was selected. The vendor is

ICF Kaiser, it is called FINASST. That system recently was again

recertified through independent testing by the Joint Financial

Management Improvement Program as a system that complies

with the core financial requirements that are set by JFMIP and

GSA.

Mr. SUNUNU. If I may, you are not required, though, by law to

comply with the Chief Financial Officer’s Act, is that correct?

Mr. LEVINE. I have to defer to the Chief Counsel or the Managing Director on that.

Mr. HALL. No, we are not.

17

Mr. SUNUNU. I don’t believe that is the case.

So, to be clear, you are setting—as a set of compliance standards

you are using the Joint Financial Management Improvement Program. Are you required to meet that standard by law or that is the

one that you chose as a best practice model?

Mr. CAMPBELL. There are elements within it that we would be

required to meet. We intend to meet all the elements, because we

do see it as a best practice approach.

Mr. SUNUNU. And have all of the elements been implemented to

date that enable you to meet those standards? And, if not, what

system needs to be implemented to meet the standards you have

established for yourselves?

Mr. LEVINE. The system is the accounting system of record, and

was the accounting system of record for all of fiscal 1999. It is the

system we are using to account for the fiscal year 2000 appropriation. It meets all the accounting standards. Where we find it lacking is we need to better improve the financial management information reporting capabilities of the system. I look at it as a powerful data warehouse, but somehow we don’t have a key to opening

all the doors.

Basically, we can do the obligation accounting, the expenditure

accounting, all the things required to make Treasury reporting, but

we do not have all the capabilities we need to provide information

to the executives and the managers of the NTSB to manage their

resources as effectively as they could.

Mr. SUNUNU. Have you set a time line for achieving those goals

of providing the Board with executive financial management information?

Mr. LEVINE. This year we are working with our vendor to develop

scripted management reports that we can put on the desktops of

our managers so they can click on an icon and get the kind of management information they need.

We are working with the different managers and the administrative officers to determine what is needed. In other words, we are

not just pushing it, we are trying to work with them as if they are

customers, which they are.

Through the remainder of FY 2000 and into FY 2001, we plan

to invest about $100,000 to $150,000 more for necessary system enhancements. We are also hiring an additional systems accountant

to help us roll this out.

Mr. SUNUNU. Let me ask you specifically about the disbursement

system that is, I hope, fully in place fully now to replace the Rapidraft system. You have gone to a commercial credit card system,

is that correct, the governmentwide credit card system?

Mr. LEVINE. Yes, the Board, long before I got here, implemented

both the Citibank travel card and the Citibank purchase card programs. We have issued more than 350 travel cards to our investigators and employees who travel. We have also issued over 100 purchase cards to our investigators and others with procurement responsibilities.

Mr. SUNUNU. Do you have documentation requirements that are

more formal than what was used in the past? And are you performing—I should ask, how frequently are you performing reconciliation

on those credit card accounts?

18

Mr. LEVINE. The personal travel cards are like your own personal

card. When Chairman Hall or Dan Campbell travel, or whatever,

the price of the airline ticket is put on the card through our approved travel agency. All travel expenses are placed on the card.

When we return, we file a travel voucher. That travel voucher

comes to the CFO organization and is reviewed and processed.

I am concerned because I don’t believe the review is sufficient.

One of the things that Ken Mead reported in his audit report was

that we needed to look to a third-party processor. We are in negotiations with the Department of Veterans’ Affairs to implement a

travel voucher processing system where they will review and pay

our vouchers and conduct post audits.

My intent is to also have DVA perform a post audit on a sample

of FY 2000 vouchers.

Mr. SUNUNU. Mr. Mead, I want to ask you a couple of questions

about the Rapidraft system in general before opening it up to Mr.

Bentsen for questions. Could you talk a little bit about the degree

to which the Rapidraft system was used in other departments within agencies within the Department of Transportation, the volume

of Rapidrafts that were previously used by the FAA, for example,

prior to canceling their program?

Mr. MEAD. Yes. The FAA this past year spent about $14 million

using a like system.

Mr. SUNUNU. Conceptually, at least, the subcontractor—thirdparty subcontractor—was the same Gelco, and the contractual limitations, $2,500 maximum and authorization number requirements

were similar, is that correct?

Mr. MEAD. Yes. But the fact is, we went in and audited the FAA

system in 1997. Although we found no embezzlements, we did find

weaknesses that were remarkably comparable to the ones that we

found at NTSB, unauthorized signatures and so forth. And we recommended that—at the time, that FAA tighten up that program.

We could understand how there might be exigent circumstances

or emergencies where you needed it. I don’t think that they fully

responded to the recommendations. As a result of the experience at

NTSB and that prior audit work that program must be terminated.

The Volpe Center is in Massachusetts, the research center. They,

too, were using the like system, as was the Federal Highway Administration.

Mr. SUNUNU. Now, there are 10 other Federal departments or

agencies that are using a similar third-party payment system

through the same subcontractor; and another six we have identified

that are using a different third-party draft system. I understand

that you don’t know all of the limitations associated with each of

the contracts, but I do want to ask you a general question which

is, do you believe that the weaknesses you have identified in the

nature of a third-party check writing system, in particular the system that was used through this subcontractor, do you think those

weaknesses are likely to exist at other agencies—Department of

Education, Department of Energy, Immigration? Do you think it is

in the interest of the committee at least to raise your concerns

about the weaknesses of the system with these other agencies?

Mr. MEAD. Yes, I would. I would be surprised if you didn’t find

weaknesses, at least to some degree. And here is why: When you

19

just talk NTSB, which is a small agency cashing approximately

8,000 checks a year worth about $4 million, it is a very paper-intensive system. And when you have holes that turn up where there

is no reconciliation, where checks are being paid and nobody is

even signing the check, where there is no payee, where there is no

purpose on the check, you have to have a very rigorous oversight

system to make sure that a check writing program, is going to be

airtight. And that is tough. In fact, that is why the Federal Government moved to credit cards. It is much tighter accounting system.

Mr. SUNUNU. Thank you.

One final question for Chairman Hall, and that is—and Mr. Levine as well—as you move through this credit card system, have

you found that there is anything unique regarding the NTSB’s critical mission that in certain cases might make the commercial or

government credit card system impractical and do you think there

may be situations in some of these other agencies that would somehow prevent them from ever implementing a government credit

card system if they chose?

Mr. HALL. I am not aware of any. My answer would be no.

Mr. SUNUNU. Thank you.

Mr. Bentsen.

Mr. BENTSEN. Thank you, Mr. Chairman.

Let me say, first of all, Mr. Mead, with respect to the chairman’s

most—his line of questioning there that, on its face, I think the

credit card system clearly works better than a Rapidraft. And it is

an antiquated type structure to use and does raise the potential,

if not for abuse, the potential for sloppy recordkeeping, if nothing

else.

I have yet in my experience in the private sector or the public

sector found an expense reimbursement system that has been

smooth and clean. I know in my old banking days we always wondered whether the company was carrying us or we were carrying

the company. I am sure that is sometimes the case here as well.

That being said, obviously the system has some problems; and I

do have a number of questions. Let me go to the chairman’s last

question, though.

Mr. Hall, I can see certainly in most cases where you are buying

an airline ticket, charging a hotel room, that the credit card system

works pretty well. In fact, in some cases you couldn’t do it without

a credit card. But are there instances that you could explain to us

in the—where in the case of NTSB, which is a somewhat unique

agency, where a credit card system might not work? I don’t think

we want to have Federal employees walking around with a pocketful of cash, but there are cases where you are on the ground that

you have to have something a little more liquid than a credit card.

Mr. HALL. Well, I might ask Mr. Campbell to comment on this

as well. He has more years of experience than I do in this area,

Congressman.

In the aviation area, our investigators operate sort of the highway patrol of the skies. Every time there is a fatal aviation accident, we have an investigator there. They have to take charge of

that wreckage. They have to be responsible for assisting with the

wreckage removal, with the engine tear downs, other things that

20

are routinely done as part of the investigation. Obviously, to be

able to pay for those things is very important.

On major accident investigations, it is hard to anticipate in advance things that you may be called upon to do.

The credit card system, to my knowledge, so far has served us

fairly well.

Mr. Levine wanted to comment. Somebody over was there was

rustling.

Mr. LEVINE. Congressman Bentsen, the credit card contract permits the use of convenience checks to handle situations where credit cards are not accepted by a vendor.

Convenience checks are set up for unique situations. Let me give

you some examples. Convenience checks are limited to investigators in charge at an investigation, and a handful of others.

NTSB often has to take custody of wreckage or equipment and

often needs to buy services from the local economy. For example,

the local police department may moonlight and be willing to provide protection of that material overnight. Last I heard, off-duty

policemen don’t take credit cards. The convenience check program

is one way we can handle that.

It is also possible for our people to get cash advances from their

travel card from an ATM machine. They can take these funds and

then seek reimbursement through proper channels when they come

back to their duty station.

So there are a few cases where the credit card just doesn’t work,

and the contract with Citibank which GSA negotiated for all of government does provide for that. We have limited the utilization of

the convenience checks, and very few of them have been used. We

have very bright people doing this work. They know how to get it

done.

Mr. BENTSEN. Let me ask just a few other questions. With respect to the Financial Management Service Review in 1997, there

were a number of recommendations in that report. Some included

adding budget officers and staff, implementing new systems technology for management—for financial management. The agency

didn’t follow through on all those. Were there budgetary reasons

related to that? In the scheme of your agency that you all go from

one emergency to the next emergency?

Mr. HALL. The last 10 years almost any mode of transportation

in the United States doubled. As a result, there has been a tremendous impact on the work of our agency and the number of employees we need to accomplish our mission at a time when everyone

else in Washington is basically downsizing.

I have requested every year I have been chairman more people

in my budget. And our committees of Congress normally, usually

over the objection of the Office of Management and Budget, have

assisted us in getting more people. In retrospect, we took most of

those additional people and placed them in investigative positions

in order to accomplish the mission. And I did not, at the same time,

put enough people in our accounting and budget office to perform

the mission of the additional amount of money that we were using.

We will have additional employees in the new fiscal year. Many

times, I find those employees are tied by OMB or Congress to specific slots. I have difficulty getting money to fund accountants. I am

21

going to take the first people we get and be sure that we have

enough people to be responsible stewards of the money we are

given.

So that is a long answer of saying I think, yes, we have had some

difficulties in being able to accomplish everything that we wanted

to do because of manpower limitations.

Mr. MEAD. My I offer a perspective on that?

I think in this case, as in the case in many situations in government and private industry, the leadership and stewardship of the

people you have in place is critical. And here, as is illustrated by

the experience with the Rapidraft system, there were plenty of

early warning signs given directly to the Chief Financial Officer.

And they were not acted on. And I think with the new leadership

in place, that you should see a strong improvement.

Mr. BENTSEN. This reminds me a little bit of graduate school.

This is going to be a great case study some time.

Mr. Mead, two things. One is, as I understand it, H.R. 2910, the

NTSB reauthorization that passed last year now does give you authority to look at NTSB?

Mr. MEAD. Yes, sir, on rather nonjudgmental financial management areas only. And I think it would be inappropriate to have the

Inspector General for the Department of Transportation in a position to second guess programmatic judgments or investigative judgments of the NTSB. So, yes, that is in the bill. It has passed. It

hasn’t moved through the Senate yet, and we are prepared to do

it if the Congress wants us to, but we don’t want authority into the

programmatic areas.

Mr. BENTSEN. So you want to limit it to the financial scope.

Mr. MEAD. Keep it clean, rules and regulations, internal controls

that reasonable people can agree upon and you can empirically

audit.

Mr. BENTSEN. That would solve that part of the problem in your

testimony.

Mr. MEAD. Yes, it would.

Mr. BENTSEN. In your investigation and in the investigation that

was carried out that Justice is now involved in with the two individuals that have been indicted, is the loss to the government, the

taxpayers, the fraud or theft limited to the two payments, the

$90,000? Did you find any overpayment of a contractor? Or was it

a case of inefficient bookkeeping, recordkeeping, questionable use

of using the Rapidraft Payment System for paying accounts that

probably should have been paid out of another vouchering system?

Or have you found a situation where there might be other, higher

dollar misuse of funds?

And I know there is a difference of agreement with respect to

Board orders in 1992 and 1995 as to what areas are covered, and

we could get into that debate. But I guess my question is, bottom

line, other than lax controls and using the Rapidraft system for

vouchers that other systems should have been used for, did you

find other cases where Acme Trucking Corp. was paid more money

than it should have been paid or anything like that?

Mr. MEAD. We do not know of any embezzlements other than the

one that we have reported to you. I would be surprised if there

were not other instances of abuse of this system, but they would

22

be very difficult to track down. Why? Well, when nobody signs the

check and it is paid or there is no purpose and no documentation

underlying it, it is difficult to tell what the purpose was for or

whether it was for a legitimate expense.

I think the fair answer to your question is that the vast majority

of these checks were probably written by upstanding people for legitimate purposes. Where there were weaknesses was in internal

controls and so forth, and sloppiness. But I can’t vouch that we

have uncovered all the abuse in this program.

Mr. BENTSEN. I assume the PriceWaterhouseCoopers audit

should show some of that.

You raised one issue that I hadn’t thought about, and my time

is up, but the way this system works is there is a contractor who

is the bank account holder on behalf of the agency, and the check

is written and passed through them. But they cleared checks without a signature?

Mr. MEAD. Yes, sir. Do you see this package here? When we went

to NTSB when Chairman Hall said come on in here and investigate

and audit, we said, let’s see the checks. And my auditors picked up

unopened packages of checks that had been sent to NTSB’s Chief

Financial Officer unopened, bundles of them. Well, under the

contract——

Mr. BENTSEN. Canceled checks.

Mr. MEAD. Oh, yes. These are all paid, and it was never opened

by anybody, so there was never any reconciliation done. And under

the terms of the contract with the vendor, at least our reading of

it, NTSB had 45 days to tell them don’t pay this check. But since

there was no reconciliation or review, that just wasn’t done. And

now the 45-day period that NTSB did have to assert a claim has

expired.

Mr. SUNUNU. If Mr. Bentsen would—thank you, Mr. Bentsen.

So that point—we have a check here that is displayed on our far

right that gets to the point that you raise, which is a check that

was cleared by the third-party contractor and it has no authorizing

signature on it whatsoever. And there is a 45-day period where

there might be a response but clearly there were significant problems with both internal controls not performing reconciliation but

with the controls and the process used by the third-party contractors.

I would like to ask unanimous consent that all members be allowed to revise and extend their remarks and also ask unanimous

consent that we include in the record a list of other departments

or agencies that are using this third-party contractor. Without objection.

[The information referred to follows:]

LIST OF FEDERAL DEPARTMENTS OR AGENCIES THAT GELCO PROVIDES THIRD-PARTY

DRAFT SERVICES TO

African Development Foundation

U.S. Department of Treasury—Bureau of Engraving & Printing

Federal Aviation Administration

Immigration & Naturalization Service

Internal Revenue Service

U.S. Department of Treasury

23

U.S. Mint

Office of Thrift Supervision

Federal Highway Administration

Internal Revenue Service—Southeast

U.S. Department of Energy

U.S. Department of Energy—Oak Ridge

U.S. Department of Education

U.S. Department of Transportation—Volpe

Mr. SUNUNU. I recognize Mr. Miller for 5 minutes.

Mr. MILLER. Rapidrafts, often in the private sector known as

voucher systems, meet accountability standards when they are

used properly and they are reviewed properly, so I don’t want to

get the focus off the Rapidraft, saying that is the problem. That is

not the problem. But when you have checks written to Myriad Investments and the intent of those checks, as you said, Mr. Mead,

are supposed to be used for accident and nonaccident purposes. A

flag should have come up to somebody that you don’t pay it.

When a check comes to Gelco with no signature, the fact is it

should not have been paid. When a check comes to Gelco—and

please put one of the ones up that exceed $2,500—exceeding $2,500, the fact is the check should not be paid. Period.

Now, there is not any question that there was some corruption

internally. But I don’t think there is any doubt that there is incompetence on the part of Gelco if you look what has happened and

transpired. If you go to the Gelco contract, it is very specific. Gelco

Payment System and the National Transportation Board agree to

notify each other immediately of any misuse of the Rapidraft authorization—Rapidraft orders.

Now a certain amount of those were done. Many were not, based

on the investigation.

Also, Gelco’s payment system assumes responsibility for the face

value of Rapidraft orders which fail to properly screen or be rejected. And if you look at their daily draft processing and standard

violation systems, these checks did not comply with the criteria

necessary to process those checks.

Travel cards are going to be no better than Rapidrafts if oversight does not occur. I have done dozens of loans when I was in

the building industry with lending institutions that we used voucher systems or Rapidrafts, and they work if done properly, without

a doubt.

And I don’t want to get off the focus of Rapidrafts, saying that

is our problem here and we are going to stop using Rapidrafts and

when we stop using Rapidrafts the problems go away. That is not

true. And there are certain Rapidrafts or vouchers or payments

that are going to continue into the future that are going to be made

to vendors, am I not correct? Nobody in their right mind is going

to use their travel card to pay those. So they are still going to be

paid.

And that is where the problem lies. And the shift to using a travel card does not deal with the problem.

Gelco did not do their job. They were incompetent. And there was

corruption on the part of staff, without a doubt. And we don’t know

how widespread that corruption was, and we don’t know how widespread this is here. So you have a checks and balances system.

24

In fact, Al Gore praised this system in one of his statements, saying this is how we reinvent government. We have taken care of it

because we installed the checks and balance system that, if used

properly, works.

And in your testimony—Mr. Mead, you stated, contrary to NTSB

policy, drafts were paid when they exceeded the $2,500 limits. It

was printed on the check that these Rapidrafts should not exceed

that amount. Why did Gelco honor these checks?

Mr. MEAD. I can’t respond to that.

Mr. MILLER. That is what I thought.

Mr. MEAD. The $2,500 is an NTSB order, and it was in the

agreement with the contractor. But employees internal to NTSB

wrote letters to Gelco saying for these employees, honor the checks

over $2,500 all the way up to, in one case, $20,000. In another case,

under the contract with the contractor, NTSB committed to notify

the contractor whenever somebody left and was no longer an authorized user. They did not do so. Then employees internal to

NTSB would sign somebody else’s name who had been an authorized user. Gelco pays the check. So——

Mr. MILLER. The largest checks that were cashed were to J.D.

Rainbolt Contractors—one for $7,500 one for $16,000, one for

$20,000, one for $5,000, one for $26,000, one for $13,000—were by

a former employee, not even employed at the time when he wrote

them. I mean, it is more than Rapidrafts. It is internal incompetence on the part of the government and on the part of the agency that is supposed to be supervising the payment of these.

It says clearly $2,500. And if you put one of the checks up, that

shows $2,500 crossed off by the person signing the check, and it

was paid.

I guess I have a question. Is Gelco being held accountable for

paying these? Are they being prosecuted right now? Can anybody

answer that?

Mr. MEAD. No, not to my knowledge.

Mr. MILLER. Why not? I have a contract right here signed by William Park, signed by—I can’t read the other name—but one by

Gelco, and one by part the government, that specifies what they

are to do. It specifies accountability. It specifies the process to go

through. This is not new. This has been known.

In fact, one thing that really bothers me is, when I go to the history of events—and this is for Mr. Hall. You became aware of this

in August of last year. Yet on September 23 we did a markup of

your authorization bill, and you came before us as a committee.

You never mentioned it. And on September 30, the bill was passed

on the House floor, and you never mentioned it. And yet you knew

about this problem in August.

Now, trust me, we have always voted for this stuff. Based on

statements made before us on May, 1999, that you never refuted

when you found out they were incorrect, one is, I know nothing

that has caused me any concern.

In addition, Mr. Keller notified—he was a financial officer. He

was a problem. ‘‘Eighty percent of our budget is dedicated to the

people, so there is not a whole lot of flexibility as far as abuse or

fraud or whatever that can take place,’’ was stated. And also the

25

statement was made, ‘‘The most important job you have given me

is responsibility for handling taxpayer’s money.’’

And, Mr. Hall, you gave me the courtesy of coming by my office

yesterday, and you told me that you had notified everybody when

you found out about this, and I took that at face value. I am not

trying to criticize you. But when I look back, because I was responsible for voting for your authorization last year, you knew about it

a month before we voice voted it out of committee. You never

brought it up. And it went out unanimously on the floor. You never

brought it up. Why not?

Mr. HALL. At the time that I learned of this, I notified Mr. Mead

and attempted to follow every piece of advice Mr. Mead gave me,

including when to advise our committees, because we were dealing

with an ongoing criminal investigation. At the time that Mr. Mead

said we should go and meet with committee staff and advise them

of this matter, we did so. So that is the reason.

On the matter of those checks, I would like to have a chance to

check those and respond for the record in terms of who signed

those checks and their status at the time they were signed.

Mr. MILLER. I don’t have time. We do have those checks. But I

do have the sequence of events as they unfolded. We have to break.

Mr. SUNUNU. I appreciate it, Mr. Miller. We will allow Chairman

Hall to make that response for the record.

[The information referred to follows:]

CHAIRMAN HALL’S RESPONSE FOR THE RECORD REGARDING ‘‘WHO SIGNED THOSE

CHECKS AND THEIR STATUS AT THE TIME THEY WERE SIGNED’’

The checks referred to that exceeded $2,500 were signed by Mr. Don Libera, currently the NTSB’s Deputy Chief Financial Officer. At the time he signed the checks,

he was the agency’s Budget Officer. Mr. Libera had specific written authority from

the Chief Financial Officer, which also was provided to Gelco, to write checks in excess of the $2,500 limit. Because all of the checks were preprinted with the ‘‘NTE

$2,500 limit,’’ Mr. Libera crossed through this note and initialed the checks he wrote

that exceeded this limit. All of the checks written over the $2,500 limit were to expedite payment for legitimate purposes and were paid to NTSB employees, primarily for travel-related expenses, or to vendors for supplies or services provided.

It should be noted that when Gelco received a check over the $2,500 limit, they

would usually call appropriate Safety Board CFO personnel to verify authorization

to override the established system limit.

Mr. SUNUNU. At this time, I would like to yield to Mr. Clement

and make members aware that at the conclusion of Mr. Clement’s

questioning we will recess for this vote on the rule and return back

promptly, at which time Mr. Miller will take the Chair to complete

questioning from the remaining members.

Mr. Clement.

Mr. CLEMENT. I don’t think I am going to have enough time, but

I will at least start anyway.

Mr. Chairman, as you know, I serve on the House Transportation

and Infrastructure Committee, the jurisdictional and oversight congressional committee for NTSB. I am acutely aware of the tremendous significance of the National Transportation Safety Board.

Under Chairman Hall’s leadership, the NTSB has had to address

some of the most challenging national transportation catastrophes

on record. As a fellow Tennesseean, I will say I am especially proud

of Chairman Hall’s commitment to excellence and public service.

26

Like other members here, I strongly believe that every level of

the Federal Government should be held accountable for its actions.

On behalf of American taxpayers, Chairman Hall has worked to

make improvements in the deficient financial accounting system

that he inherited from the previous administration in 1994. He has

indeed worked on behalf of taxpayers by reversing NTSB practices

that were mismanaged.

Mr. Hall—Chairman Hall, it is my understanding that NTSB

does not have an IG of its own. You contacted the Department of

Transportation’s IG to come in and do an audit of the Rapidraft

check system, payment system. You have also contracted with

PriceWaterhouseCoopers to do an outside audit as well. Do you feel

that it would be beneficial to the NTSB to have an internal IG instead of having to rely on DOT’s IG?

Mr. HALL. I certainly would have no objection to an internal Inspector General in our agency.

I was told when I first inquired about an IG that our agency was

too small to have a full-time Inspector General. I consulted with a

number of people on getting that advice. But I think it is imperative that our agency in the future have an annual audit of all of

our financial activities, and we are moving to do that.

Mr. CLEMENT. Mr. Mead, do you have any comment about the

question I asked?

Mr. MEAD. Just a point of perspective. When a problem comes up

like this, you need a critical mass to be able to deploy. I think you

can make a case for an internal IG. I think you can make a case

for having a Cabinet-level IG with the critical mass that can come

in.

Mr. Hall and I have a very good professional and personal relationship, and I think that helps a great deal. You would have a

problem if—you have a case like this come up—there is no way

that NTSB could responsibly have a permanent IG staff of 10 or

15 people. And that is the only perspective I would have. If you

want us to do it, we will do it. But please don’t give us any responsibilities that go into the programmatic area or the investigative

area. Keep it down to the financial management.

Mr. CLEMENT. I may have another question or two when we come

back.

Mr. SUNUNU. We have approximately 4 minutes left in the vote.

If you would like to ask one of your questions and you can resume

questioning when we return.

Mr. CLEMENT. I will wait.

Mr. SUNUNU. We will recess at this time. We will reconvene as

soon as we return from the vote. Thank you, gentlemen.

[Recess. ]

Mr. MILLER [presiding]. I would like to correct one misstatement

that I made on the checks that were in the individual larger

amounts, the individual was still employed. But the comment was

more directly to the Rapidrafts were not to be used for this type

of purpose at this amount. And that was the issue.

Mr. Toomey, do you have questions?

Mr. TOOMEY. Is Mr. Clement finished?

Mr. CLEMENT. I am through. And I appreciate what you just

said, Mr. Chairman; and Mr. Hall may want to comment.

27

Mr. HALL. No, that is fine.

Mr. CLEMENT. Thank you.

Mr. TOOMEY. I will be brief, but I did want to just get actually

maybe both Mr. Mead and Mr. Hall to react to some thoughts.

First of all, if we look at the case of the Rapidraft payments that

the IG reviewed, there were 1,000. And I take it there is no reason

to believe that that is not a representative sampling. And when we

consider that 90 percent of these had some kind of noncompliance,

one kind or another, it suggests, obviously, a routine lack of regard

for the rules of compliance. And I wonder if it doesn’t reveal to

some degree almost a culture of disrespect for certainly the rules

of the reimbursement, the whole Rapidraft system, and I wonder

how much more pervasive that culture would be of disregarding

rules which are really rather important.

Now, I take it that your investigation focused more on discovering individual and systemic misuse rather than focusing on whether there was criminal intent or fraud that went with that. But I

was wondering, Mr. Mead, if you could clarify that for me a little

bit.

Mr. MEAD. I will try, yes, sir.

Inspector General offices are divided into two parts. One side is

a criminal investigative, looking at quasi-criminal administrative

violations that get an individual in serious trouble. The other side

of an IG operation is audit, program evaluation, financial audit

where you look at the effectiveness of the programs.

And in a case like this, what we had was criminal misconduct,

and we suspected that from the beginning. But once we got in

there and saw the type of criminal misconduct and how it was allowed to occur, the latter—the unauthorized people signing checks,

the no-known purpose on them, the no payees, going over the limits, things of that nature—we began to see that there was an underlying vulnerability to this whole program. That triggered the

audit side of our office which led to the broader audit, sir.

Mr. TOOMEY. But as for those broader audits, we had a system

that we know was extremely vulnerable to abuse. Obviously, if you

don’t need to sign checks, you don’t even need to write a payee and

yet the check will be cashed. And yet there are only two cases of

fraud and embezzlement that have been pursued on a criminal

level. With such a high degree of noncompliance it strikes me there

must be a whole lot more flaws that occurred that we don’t know

about certainly beyond those two cases. And that is—you know, I

have no direct evidence of that, just by the sort of—intuitively

seems quite likely. So one of my questions is, what do we do about

that? What can be done?

Mr. CAMPBELL. If I may respond to that, Congressman, that is

the first order of business with our contract with PriceWaterhouseCoopers. We understood from the nature of the investigation that

DOT IG did for us that they would not necessarily get to the universe of all the difficulties that they might see. And so the first

order of business we have with the independent audit firm is to assess that problem for us and give us some advice on how to proceed. The agency has chosen to continue to pursue that issue.

Mr. TOOMEY. And specifically with respect to the checks that

were cashed a year ago or 2 years ago with the old payments, are

28

they still being investigated or is that the kind of thing where that

is being given up and we are trying to prevent repeat offenses?

Mr. CAMPBELL. No, sir we are looking at the past.

Mr. TOOMEY. In the inspection that you did do, the auditing and

investigation work that you did, was most of the noncompliance

that was cited about the handling of the Rapidraft system itself

and fault in that process? Could you also tell me about to what extent do you believe that these items that were being paid for were

purchasing things that either were not intended to be—you addressed those which were not intended to be used by the Rapidraft

system—but what about items that shouldn’t be bought at all that

were being purchased? Any more thoughts on that?

Mr. MEAD. Yes, there is clearly some instances of those where

you don’t really know what the payment was for. You see the check

behind you to American Express. That is one where nobody signed.

But even if it was signed, the question occurs, well, what about

American Express? Why were you writing checks to American Express? What was it for? And there are a lot in that category. A

large number.

Mr. CAMPBELL. If I could expand on that. The actual Gelco book

that you write checks from has a check at the top and a series of

additional documents that—additional parts of the document that

need to be filled out. What we will attempt to do is take some of

the difficult, the problematic checks and marry them back up with

their underlying documents which themselves need to be accompanied by the obligating form.

The check is not actually permission to obligate money. The

check is just a way of making the payment. Each check needs to

be accompanied either by a training form, a travel voucher, a 4400

for purchases and so forth.

So there is an opportunity to go back and look at these checks

and ask yourself, one, do we have the documents—of course, the

ones we don’t have the documents for would then by themselves be

particularly suspicious. But if we have the documents you can review the document to give you some sense of what the underlying

purchase was about and make a determination about whether it

was for an authorized purpose or not. And that is our intention.

Mr. TOOMEY. So that is ongoing, that investigation.

Well, finally, just my last question for the Chairman, are you

concerned that there may be within the Board a sort of culture of

disrespect for internal rules and procedures, a sort of lax attitude

that has been revealed by this whole discovery that might pervade

both the institution and into other areas other than just the finances?

Mr. HALL. Congressman, I have a great deal of respect for all of

my employees. Setting the culture of the agency is the responsibility of the management of the agency. I can assign that responsibility, but I must accept that accountability. In this case, the individual that was responsible was not enforcing the type of culture that

should be in place.

We are going to, as Mr. Campbell said, look at each and all of

these transactions. That is one of the things we have asked PriceWaterhouseCoopers to do. But, you know, my employee base there

does an outstanding job, in my opinion, performing their mission.

29

And a part of their mission and part of their time was supposed

to be given and needed to be more directed toward a proper accounting of these funds, and so we are going to put an emphasis

on that. If we had a cultural problem, we are going to change that

cultural problem.

I don’t know how else to comment on it. I don’t choose to be in

this position. The employees in the agency work very hard in their

job. It is the responsibility of management to lay down that culture

and direction for them. In this area we have not been as successful

as I would like. We have had this embarrassing situation, and I intend to do everything we can if there is a problem to be sure it is

effectively addressed.

Mr. MEAD. I think, just from the observations of my own auditors

and investigators, there was a culture of looseness at the top in the

Chief Financial Officer’s office. You didn’t have an IG that every

so often did visitations at the agency on a routine basis to make

sure everything was honest. We found that, transcending the Rapidraft program, there were problems with the travel vouchers not

being reviewed. The computer equipment frequently wasn’t inventoried properly. The CFO should have made sure that employees

got periodic ethics training. And these things just were not happening.

And I, too, know a number of NTSB employees and have the

highest respect for them. But I do think you have to look at that

CFO for a great deal of leadership. And I don’t believe the Board,

Mr. Hall or NTSB was being well served, sir.

Mr. TOOMEY. Thank you, Mr. Chairman. I yield the balance of

my time.

Mr. MILLER. Chairman Hall, a couple of questions I need to ask

you, just to clear up some confusion. Under Federal reg 31 CFR

208, which is under the management of the Federal Agency Disbursement Act—can you hear me?

Mr. HALL. I was having a little difficulty.

Mr. MILLER [continuing]. Which implements the Debt Collection

Improvement Act of 1996, requires the authority of the Secretary

of Treasury to grant waivers of all Federal payments made after

January 1, 1999, when it must be made by electronic fund transfer.

And 31 CFR 208 permits nonelectronic payment for national security interest, military operations, national disasters, law enforcement, amounts less than $25, certain payments in foreign countries

or in emergencies or, ‘‘mission-critical circumstances that are of

such an unusual and compelling urgency that the government

would otherwise be seriously injured.’’

Based on that, under what circumstance did NTSB qualify for a

waiver of 31 CFR 208 to continue using the Rapidrafts after January 1, 1999?

Mr. CAMPBELL. Congressman, I don’t believe that NTSB qualified

for a waiver under those provisions. And I don’t believe that we

had a waiver under those provisions. I think that the program for

the Chief Financial Officer, who is, unfortunately, not here to answer this question, was to make a transition to the purchase card

program and the travel card program which we have implemented

now as of about September of 1999. And during the period between

30

January 1 and September, I have personally asked this question

and——

Mr. MILLER. So you are confirming they should not even have

been using Rapidrafts after January 1.

Mr. CAMPBELL. It is my understanding that we should have gone

to electronic transfer.

Mr. MILLER. We need to ask this, because that issue has come

up and we didn’t have clarification. The confusion I had—there was

an ongoing problem with a system that shouldn’t even have been

in existence.

Mr. CAMPBELL. There would have been a class of transactions

which would have met the exemption standards, particularly those

in the field where the actions are—making an electronic funds

transfer at an accident scene may have been difficult, but there

was another whole class of transactions which probably would not

have met the waiver requirement.

Mr. MILLER. Probably the last question I can think of is—we ran

out of colleagues here—is part of the Rapidraft Payment System NTSB maintained $350,000 in a non-interest-bearing account with

Gelco Information Network Inc. Have you made any effort to get

that money back at this time?

Mr. LEVINE. We are, right now, trying to get that money back.

There are a couple of issues on float and miscellaneous charges

that my people are trying to reconstruct, but they have been in

contact with Gelco. That is money that was put in deposit, I believe, as far back as 1989. It is basically to cover the float. We have

been in contact with them, and I have been assured that that is

being expedited.

Mr. MILLER. Well, Mr. Hall, you have been very courteous and

kind and forthright, and Mr. Mead, also. I appreciate the input.

We were told that other members are coming, but we are going

to go check. We will not delay you any longer than you have to.

Is there any final comment you would like to make?

Mr. HALL. No, sir.

Mr. MILLER. If somebody doesn’t show up in the next 5 seconds,

we will thank you graciously for being here today. Our comments

were not an attack. I hope they were not taken as such. They were

not meant to be.

Mr. Knollenberg, I have been informed, will be here within 60

seconds, so I will have to wax eloquently for the next 60 seconds.

This is probably not the best of times—with Egyptair, what is ongoing right now? We just had a hearing in Transportation on that

issue. It is not the best of times to be here.

I know your focus is on issues very important to us, very important to commuters. I think you are doing an excellent job in that

area. It is a shame that a situation like this has to occur. I know

you are a man who probably takes this very personal because you

are the top. It is not meant to be personal.

From our perspective, it is just an issue that was believed should

have been discussed publicly, and it sounds like just the process we

have taken has changed some other agencies from the direction

they have gone in using these, trying to come up with more of an

accountable system. It sounds like and it appears like the individual now you have put in charge of CFO is going to be a thumbsVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00034 Fmt 6633 Sfmt 6602 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
31

on individual and he is going to make sure something like this

never occurs in the future, and I am glad to see that.

But your agency does an excellent job, and this hearing is not in

any way intended to impugn the quality of work you do. Because

you do top-quality work. We are not—that is not the goal. It is

more accountability. And I know that you have taken many steps

to create accountability, and we thank you for that. And, again, I

want to say there was nothing personal in the questions that had

to be asked. I think we are all glad they probably were, and we can

move forward when Mr. Knollenberg shows up to ask his final

questions.

Mr. CLEMENT. Mr. Chairman how do you stay physically in

shape and be mentally alert? That is what I would like—— Mr. MILLER. You keep me in line. I try very hard, sir.

Why don’t we talk a break for just a minute or so for Mr.

Knollenberg? We will adjourn the meeting after that.

[Recess.]

Mr. MILLER. We are going to reconvene the meeting.

Mr. Knollenberg has walked in. He has 20 seconds worth of questions left, because he has used up 40 minutes and 40 seconds already.

Mr. KNOLLENBERG. Well, I apologize for being late. Three places

at the same time doesn’t work.

Let me again welcome everybody, and I appreciate your being

here. I am sure I might touch on a question that has been handled

before, and if it has just mention that. Mr. Chairman, you obviously may want to reflect on that, too.

Simple question, and I will get right to the heart, it was how

many Rapidrafts exceeded 5,000?

Mr. LEVINE. $5,000 or $2,500, sir?

Mr. KNOLLENBERG. I am sorry. Your question was what again?

Mr. MILLER. How many exceeded 2,500?

Mr. LEVINE. I sorted it—— Mr. KNOLLENBERG. I am asking how many exceeded 5,000.

Mr. LEVINE [continuing]. I have a list. And the only reason I

asked for clarification, sir, is my list tells me we issued about 169

that were over $2,500. I will have to go back to that list and to get

you an answer. If I could provide that for the record, I will.

Mr. MEAD. I have the answer here, so you won’t have to do that.

There were 70 Rapidrafts totalling $708,000 written for amounts

between 5,000 and 28,000.

Mr. KNOLLENBERG. That is fine. What was the maximum Rapidraft limit authorized for any user?

Mr. MEAD. Under the Board order, the limit was $2,500.

Mr. KNOLLENBERG. Who were the persons primarily involved in

writing the over-limit checks?

Mr. MEAD. Mr. Libera, who was a Deputy Chief Financial Officer, and Mr. Mills, who was an Accounting Officer. And I should

note that administratively they wrote or their supervisors wrote to

the vendor Gelco and said please authorize these people to write

checks over $2,500. The NTSB Board never approved that.

Mr. KNOLLENBERG. Another quick question, for what purposes— and this is probably general, but what purposes were the checks

written for and what was the total dollar value?

32

Mr. HALL. We have Mr. Libera here.

Mr. KNOLLENBERG. That question has been raised before. I am

not trying to duplicate. If you can’t do it quickly, would you do it

for the record?

Mr. HALL. Be glad to do it for the record. Yes, sir.

[The information referred to follows:]

RAPIDRAFTS OVER $2500

[Fiscal Years 1997–1999]

No. FY Last Name First Name Cleared

Date Check Number Amount Pay to Purpose

1 1997 Libera Jr Donald P. 80697 020001231–9 $2,644.67 North American

Van Lines

Invoice

2 1997 Libera Jr Donald P. 81597 020001237–3 $4,703.21 Shane Lack Travel Voucher

3 1997 Libera Jr Donald P. 81897 020001236–4 $3,717.55 Robert Benzon Travel Voucher

4 1997 Libera Jr Donald P. 82697 020001245–4 $5,137.89 Robert Hilldrup Travel Voucher

5 1997 Libera Jr Donald P. 82997 020019002–4 $4,896.93 Ronald Schlede Travel Voucher

6 1997 Libera Jr Donald P. 90297 020019003–3 $3,807.48 Alfred Dickinson Travel Voucher

7 1997 Libera Jr Donald P. 90497 020001234–6 $3,560.19 Dennis Jones Travel Voucher

8 1997 Libera Jr Donald P. 90897 020019011–4 $8,709.96 Ronald Schlede Travel Voucher

9 1997 Libera Jr Donald P. 90897 020019008–7 $3,819.24 Ronald WentworthTravel Voucher

10 1997 Libera Jr Donald P. 90897 020019006–9 $3,176.26 Cynthia Keegan Travel Voucher

11 1997 Libera Jr Donald P. 90997 020019005–1 $3,153.58 Deepak Joshi Travel Voucher

12 1997 Libera Jr Donald P. 91097 020001249–9 $10,729.59 Robert Francis Travel Voucher

13 1997 Libera Jr Donald P. 91097 020019007–8 $3,395.38 George Black Travel Voucher

14 1997 Libera Jr Donald P. 91097 020019009–6 $2,508.58 Gordon Hookey Travel Voucher

15 1997 Libera Jr Donald P. 91297 020019001–5 $3,930.20 Keith D. Holloway Travel Voucher

16 1997 Libera Jr Donald P. 91297 020019010–5 $2,689.92 Gregory J. PhillipsTravel Voucher

17 1997 Libera Jr Donald P. 91597 020019014–1 $3,815.76 Paul Schlamm Travel Voucher

18 1997 Libera Jr Donald P. 91897 020019015–9 $2,950.35 Matthew M.

Furman

Travel Voucher

19 1997 Libera Jr Donald P. 92297 020019025–8 $2,852.08 James Skeen Travel Voucher

20 1997 Libera Jr Donald P. 92997 020019052–8 $10,162.68 Robert Benzon Reimbursement

21 1997 Libera Jr Donald P. 92997 020019018–6 $4,744.42 James R. Jeglum Travel Voucher

22 1997 Libera Jr Donald P. 92997 020019017–7 $2,890.73 Malcolm Brenner Travel Voucher

23 1998 Libera Jr Donald P. 10898 020019283–2 $3,166.52 Richard J. WentworthTravel Voucher

24 1998 Libera Jr Donald P. 11498 020019282–3 $2,871.61 Matthew M.

Furman

Travel Voucher

25 1998 Libera Jr Donald P. 12198 020019286–8 $4,596.76 Linda A. Jones Travel Voucher

26 1998 Libera Jr Donald P. 12698 020019289–5 $6,106.39 Richard J. WentworthTravel Voucher–

Prehearing

Prep

27 1998 Libera Jr Donald P. 12698 020019288–6 $6,045.76 Ronald Schlede Travel Voucher–

Prehearing

Prep

28 1998 Libera Jr Donald P. 12898 020019287–7 $5,194.33 John Goglia Travel Voucher

29 1998 Libera Jr Donald P. 20498 020019290–4 $3,509.67 Robert McGuire Travel Voucher

30 1998 Libera Jr Donald P. 20598 020019292–2 $6,183.51 Robert Hilldrup Travel Voucher

31 1998 Libera Jr Donald P. 20698 020019293–1 $5,442.72 Cynthia Keegan Travel Voucher

32 1998 Libera Jr Donald P. 20698 020019291–3 $4,897.93 Robert Francis Travel Voucher

33 1998 Libera Jr Donald P. 20998 020019295–8 $4,696.18 Jamie Finch Travel Voucher

34 1998 Libera Jr Donald P. 21798 020019296–7 $3,000.20 Robert Macintosh

Jr.

Travel Voucher

35 1998 Libera Jr Donald P. 22098 020019303–9 $6,513.41 Robert Macintosh

Jr.

Travel Voucher–

Silk Air

36 1998 Libera Jr Donald P. 22398 020019302–1 $7,714.14 Greg Phillips Travel Voucher

37 1998 Libera Jr Donald P. 22398 020019299–4 $4,473.88 Malcolm Brenner Travel Voucher

38 1998 Libera Jr Donald P. 22498 020019301–2 $6,297.40 Scott Warren Travel Voucher

39 1998 Libera Jr Donald P. 22598 020019297–6 $2,938.00 Richard Parker Travel Voucher

40 1998 Libera Jr Donald P. 31098 020019309–3 $6,692.20 Barry Sweedler Travel Voucher

41 1998 Libera Jr Donald P. 31198 020019307–5 $3,411.66 Robert Francis Travel Voucher

33

RAPIDRAFTS OVER $2500—Continued

[Fiscal Years 1997–1999]

No. FY Last Name First Name Cleared

Date Check Number Amount Pay to Purpose

42 1998 Libera Jr Donald P. 31198 020019306–6 $3,288.47 Deborah Smith Travel Voucher

43 1998 Libera Jr Donald P. 31298 020019308–4 $2,602.25 Denise Daniels Travel Voucher

44 1998 Libera Jr Donald P. 32598 020019312–9 $5,233.23 James Hall Travel Voucher

45 1998 Libera Jr Donald P. 32798 020019310–2 $4,403.19 Jerome Trachette Travel Voucher

46 1998 Libera Jr Donald P. 40198 020019311–1 $3,548.83 Paul Weston Travel Voucher

47 1998 Libera Jr Donald P. 40998 020019317–4 $5,326.21 Thomas Haueter Travel Voucher

48 1998 Libera Jr Donald P. 40998 020019314–7 $5,237.61 Deborah Smith Travel Voucher

49 1998 Libera Jr Donald P. 41398 020019319–2 $6,260.06 Robert Hilldrup Travel Voucher

50 1998 Libera Jr Donald P. 41398 020019316–5 $4,918.46 John Goglia Travel Voucher

51 1998 Libera Jr Donald P. 41498 020019320–1 $3,175.35 Thomas Conroy Travel Voucher

52 1998 Libera Jr Donald P. 41798 020019322–8 $4,655.14 Gregory A. Feith Travel Voucher

53 1998 Libera Jr Donald P. 42098 020019326–4 $9,157.86 Robert Francis Travel Voucher

54 1998 Libera Jr Donald P. 42798 020019321–9 $5,272.43 Evan Byrne Travel Voucher

55 1998 Libera Jr Donald P. 42898 020019329–1 $6,785.50 Scott Warren Travel Voucher

56 1998 Libera Jr Donald P. 42998 020019327–3 $4,387.70 James Pericola Travel Voucher

57 1998 Libera Jr Donald P. 43098 020019332–7 $6,881.87 James Hall Travel Voucher

58 1998 Libera Jr Donald P. 50898 020019331–8 $5,317.69 Gregory Salottolo Travel Voucher

59 1998 Libera Jr Donald P. 51398 020019335–4 $5,644.60 Robert Francis Travel Voucher

60 1998 Libera Jr Donald P. 51398 020019333–6 $3,395.27 Ronald Robinson Travel Voucher

61 1998 Libera Jr Donald P. 60998 020019337–2 $6,473.44 Gregory Feith Travel Voucher

62 1998 Libera Jr Donald P. 61598 020019340–8 $2,839.83 Robert Francis Travel Voucher

63 1998 Libera Jr Donald P. 62298 020019341–7 $5,000.00 Gregory Feith Advance for

Travel

64 1998 Libera Jr Donald P. 62998 020019342–6 $3,597.08 Gordon Hookey Travel Voucher

65 1998 Libera Jr Donald P. 81398 020019345–3 $6,309.77 James Hall Travel Voucher

66 1998 Libera Jr Donald P. 100197 020019057–3 $8,816.11 Gary K. Abe Travel Voucher

67 1998 Libera Jr Donald P. 100297 020019059–1 $14,466.36 Gregory Feith Travel Voucher

68 1998 Libera Jr Donald P. 100397 020019058–2 $2,995.47 Gary K. Abe Travel Voucher

69 1998 Libera Jr Donald P. 100797 020019062–7 $3,156.32 American Express Airfare RE

70 1998 Libera Jr Donald P. 100797 020019064–5 $2,694.00 Rivy Cole Travel Voucher

71 1998 Libera Jr Donald P. 100897 020019063–6 $4,830.44 Peter Goelz Reimbursement

72 1998 Libera Jr Donald P. 100997 020019066–3 $6,476.75 Woodfield Suites employee

accomodations

73 1998 Libera Jr Donald P. 101097 020019056–4 $4,089.87 Richard parker Travel Voucher

74 1998 Libera Jr Donald P. 101497 020019068–1 $2,822.63 Gregory Feith Travel Voucher

75 1998 Libera Jr Donald P. 102297 020019074–4 $4,089.87 Richard B.

Parker

Travel Voucher

76 1998 Libera Jr Donald P. 102497 020019252–6 $8,904.04 Lawrence D.

Roman

Travel Voucher

77 1998 Libera Jr Donald P. 102797 020019255–3 $2,709.00 Barry Sweedler Travel Voucher

78 1998 Libera Jr Donald P. 110697 020019258–9 $5,516.21 Robert m. MacintoshTravel Voucher

79 1998 Libera Jr Donald P. 110797 020019259–8 $3,269.50 Linda Jones Travel Voucher

80 1998 Libera Jr Donald P. 111297 020019260–7 $2,516.60 Richard J. WentworthTravel Voucher

81 1998 Libera Jr Donald P. 111897 020019263–4 $5,386.47 Jim Hall Travel Voucher

82 1998 Libera Jr Donald P. 111897 020019261–6 $2,723.47 Gregory Phillips Travel Voucher

83 1998 Libera Jr Donald P. 112497 020019264–3 $5,176.33 Jamie Finch Travel Voucher

84 1998 Libera Jr Donald P. 120997 020019267–9 $3,577.05 Dennis Grossi Travel Voucher

85 1998 Libera Jr Donald P. 121997 020019273–3 $3,339.19 Jerome Frechette Travel Voucher

86 1998 Libera Jr Donald P. 122297 020019270–6 $2,821.60 Robert Francis Travel Voucher

87 1998 Libera Jr Donald P. 122397 020019272–4 $3,212.69 Paul Misenick Travel Voucher

88 1998 Libera Jr Donald P. 122697 020019280–5 $3,789.36 Ronald Schlede Travel Voucher

89 1998 Libera Jr Donald P. 122997 020019271–5 $2,699.65 Kenneth Egge Travel Voucher

90 1998 Libera Jr Donald P. 123197 020019278–7 $2,738.41 Deborah Smith Travel Voucher

91 1999 Libera Jr Donald P. 040899 030400001 $8,202.13 James E. Hall Travel Voucher

92 1999 Libera Jr Donald P. 112398 010030512 $2,799.47 Tom Conroy Travel Reimbursement

93 1998 Mills William J. 81798 020033326–8 $4,070.00 James V. Roberts Travel Voucher

94 1998 Mills William J. 81798 020033327–7 $3,232.54 Michael T. Brown Travel Voucher

95 1998 Mills William J. 82898 020033328–6 $2,979.07 George Black Travel Voucher

96 1998 Mills William J. 90298 020033330–4 $3,003.80 Paul Alexander Travel Voucher

34

RAPIDRAFTS OVER $2500—Continued

[Fiscal Years 1997–1999]

No. FY Last Name First Name Cleared

Date Check Number Amount Pay to Purpose

97 1998 Mills William J. 90998 020033331–3 $4,435.76 Paul Misenick Travel Voucher

98 1998 Mills William J. 91198 020033332–2 $2,780.02 Dennis L. Jones Travel Voucher

99 1998 Mills William J. 92298 020033337–6 $4,693.43 Alfred Dickinson Travel Voucher

100 1999 Mills William J. 020599 020033362 $6,474.24 Robert Francis Travel Voucher

101 1999 Mills William J. 031799 020033365 $2,980.77 Deepak Joshi Travel Voucher

102 1999 Mills William J. 100898 020033343 $3,902.65 Paul Misenick Travel Voucher

103 1999 Mills William J. 101398 020033350 $2,737.00 James Hall Travel Voucher

104 1999 Mills William J. 101498 020033345 $2,576.77 Ronald Schlede Travel Voucher

105 1999 Mills William J. 101998 020033347 $4,720.01 Robert Francis Travel Voucher

106 1999 Mills William J. 102298 020033351 $4,571.66 John Goglia Travel Voucher

107 1999 Mills William J. 102798 020033352 $3,025.17 Deepak Joshi Travel Voucher

108 1999 Mills William J. 111998 020033353 $2,783.64 James Hall Travel Voucher

109 1999 Mills William J. 112598 020033357 $2,934.07 Dave Tew Travel Voucher

110 1999 Mills William J. 112598 020033356 $3,381.28 Dave Tew Travel Voucher

111 1999 Mills William J. 120998 020033360 $3,962.12 Robert Francis Travel Voucher

112 1999 Mills William J. 121198 020033358 $2,530.54 Paul D. Weston Travel Voucher

113 1999 Mills William J. 122198 020033361 $2,583.54 James Hall Travel Voucher

114 1999 Mills William J. 073099 020033372 $3,154.17 James Hall Travel Voucher

115 1997 Thomas Laura J. 63097 020018153–7 $2,604.10 American Express Airfare RE

........ ............ ........................ $515,396.10 TOTAL TRAVEL

REIMBURSEMENT

115 DRAFTS

116 1996 Caldwell Alice 100296 020005696–8 $2,772.00 Training 2000

MITAGS

Registration

117 1997 Libera Jr Donald P. 71897 020001230–1 $14,907.13 Capital Hill ReportingInvoice

118 1997 Libera Jr Donald P. 80697 020001232–8 $23,412.29 Jacksonville Hilton and Towers

Invoice

119 1997 Libera Jr Donald P. 81897 020001240–9 $17,000.00 John Davis Attorney

120 1997 Libera Jr Donald P. 81997 020001233–7 $19,723.77 Metrocall pager bill

121 1997 Libera Jr Donald P. 81997 020001239–1 $5,785.19 Tharpe Company purchases

122 1997 Libera Jr Donald P. 82097 020001238–2 $12,705.00 Dupage Airport

Authority

Invoice

123 1997 Libera Jr Donald P. 82097 020001241–8 $8,304.31 Proctor Electric Invoice

124 1997 Libera Jr Donald P. 82597 020001244–5 $11,267.20 Paul Schlamm service

125 1997 Libera Jr Donald P. 82797 020001242–7 $22,407.00 Tratech Internationalequipment

126 1997 Libera Jr Donald P. 82797 020001243–6 $3,982.17 Nelson Marketing Invoice

127 1997 Libera Jr Donald P. 90297 020001247–2 $7,000.00 Office of Coroner,

Washington

Cty

HWY41

128 1997 Libera Jr Donald P. 90897 020019004–2 $4,530.46 MicroWarehouse purchase

129 1997 Libera Jr Donald P. 90897 020001246–3 $4,500.00 Brave Audio visual, Inc.Hearing

130 1997 Libera Jr Donald P. 90997 020001248–1 $8,721.15 Embassy Suites

Hotel

Hearing rooms/

Audiovisual

equip

131 1997 Libera Jr Donald P. 91097 020001250–8 $20,500.00 G.W. Hoch, Inc Comm Ctr A/C

132 1997 Libera Jr Donald P. 91097 020019012–3 $20,000.00 J.D. Rainbolt PO–5th Fl renovation

133 1997 Libera Jr Donald P. 91097 020019013–2 $4,272.00 Spirit Telecommunications

Rewire 5th Fl

134 1997 Libera Jr Donald P. 91597 020019023–1 $13,359.20 KEV Corporation 6th floor renovations

135 1997 Libera Jr Donald P. 91597 020019022–2 $7,000.00 System Safety

Development

Accident Investigation Workshop

35

RAPIDRAFTS OVER $2500—Continued

[Fiscal Years 1997–1999]

No. FY Last Name First Name Cleared

Date Check Number Amount Pay to Purpose

136 1997 Libera Jr Donald P. 91797 020019021–3 $13,000.00 Boeing Commercial Airplane

group

Modifications to

B–727

137 1997 Libera Jr Donald P. 91997 020019024–9 $20,000.00 J.D. Rainbolt 5th floor renovations

138 1997 Libera Jr Donald P. 92297 020019051–9 $13,357.00 KEV Corporation 6th floor renovations

139 1997 Libera Jr Donald P. 92997 020019053–7 $2,800.00 Spirit Telecommunications

RE Installation

5th&6th

140 1997 Libera Jr Donald P. 93097 020019054–6 $2,918.16 GES Exposition

Services

Oshkosh Exhibit

141 1998 Libera Jr Donald P. 10798 020019281–4 $3,996.64 Phillip Humnicky Photograph TWA

800 Hearing

in Baltimore

142 1998 Libera Jr Donald P. 10898 020019284–1 $3,875.00 Federal Construction contractors

Partition RM

6100 and

paint

143 1998 Libera Jr Donald P. 11498 020019285–9 $9,459.00 Mitech Data SystemsNEC Laptops

144 1998 Libera Jr Donald P. 21198 020019294–9 $5,055.60 Southwestern

Bell

Bill for TX Sept–

Nov

145 1998 Libera Jr Donald P. 22098 020019298–5 $9,375.00 Federal Construction Contract

PO

146 1998 Libera Jr Donald P. 30998 020019304–8 $5,000.00 Donald H.

Mershon,PHD

TWA 800

147 1998 Libera Jr Donald P. 30998 020019305–7 $3,690.00 Ocngressional

Quarterly, Inc

PO

148 1998 Libera Jr Donald P. 42798 020019324–6 $2,900.00 DOD Joint Spectrum CenterInvoice

149 1998 Libera Jr Donald P. 61198 020019338–1 $5,794.70 Southwestern

Bell

Bill for TX office

150 1998 Libera Jr Donald P. 61198 020019339–9 $2,678.70 Southwestern

Bell

Bill for TX office

April 98–May

98

151 1998 Libera Jr Donald P. 90898 020019346–2 $11,510.00 J&H Marsh &

McLennan, Inc

Travel Insurance

152 1998 Libera Jr Donald P. 93097 020019054–6 $2,918.16 GES Exposition

Services

Oshkosh Exhibit

153 1998 Libera Jr Donald P. 100397 020019055–5 $2,800.00 General Testing

Laboratories

AZ accident,

Testing of

school bus

windows

154 1998 Libera Jr Donald P. 100697 020019061–8 $17,400.00 Graduate School,

USDA

Procurement

Training

155 1998 Libera Jr Donald P. 100697 020019065–4 $10,000.00 KEV Corporation 6th Floor renovation

156 1998 Libera Jr Donald P. 101797 020019067–2 $24,461.00 J. D. Rainbolt 5th floor renovations

157 1998 Libera Jr Donald P. 101797 020019071–7 $6,739.75 Campbell Carpet

Service

Install carpet/

GAPAFA

158 1998 Libera Jr Donald P. 101797 020019073–5 $3,730.75 Spirit Telecommunications

install video

cable/GAPAFA

159 1998 Libera Jr Donald P. 102097 020019072–6 $28,532.25 Loew’s L’Enfant

Plaza

Board Meeting

160 1998 Libera Jr Donald P. 102297 020019075–3 $5,980.00 S.P.Bryant Refinish furniture

161 1998 Libera Jr Donald P. 102397 020019253–5 $5,657.18 Capital Hill Reporting, IncInvoice

162 1998 Libera Jr Donald P. 102397 020019070–8 $3,278.50 Graebel Companiescontract movers/

supplies

36

RAPIDRAFTS OVER $2500—Continued

[Fiscal Years 1997–1999]

No. FY Last Name First Name Cleared

Date Check Number Amount Pay to Purpose

163 1998 Libera Jr Donald P. 102997 020019254–4 $3,912.86 Oceaneering

International

TWA 800

164 1998 Libera Jr Donald P. 110697 020019256–2 $12,000.00 KEV Corporation 6th Floor renovation

165 1998 Libera Jr Donald P. 111097 020019262–5 $16,403.80 KEV Corporation 6th floor renovations

166 1998 Libera Jr Donald P. 111097 020019257–1 $7,890.00 J.D. Rainbolt 5th renovations

167 1998 Libera Jr Donald P. 112597 020019265–2 $3,495.00 George Washington UniversityJ. Finch CED program

168 1998 Libera Jr Donald P. 121897 020019276–9 $3,714.50 American RelocationTWA 800 Hearing

Invoice

169 1998 Libera Jr Donald P. 122497 020019275–1 $3,910.00 American RelocationInvoice

170 1998 Libera Jr Donald P. 123197 020019279–6 $20,917.41 Miami Airport

Hilton & Towers

Invoice

171 1999 Libera Jr Donald P. 012799 020019350 $2,957.50 Susan T.

Strahan, MD

Conduct Psych/

Employment

Examination

172 1999 Libera Jr Donald P. 100598 020019348 $11,076.00 Hyatt Regency

Hotel

Speaker’s

Accomodations

26 Rooms

173 1999 Mills William J. 101998 020033344 $3,013.26 Elizabeth Cotham Kinko Cop.

Symp98

174 1997 Fenwick Angela C. 21897 020006368–2 $2,833.92 Digital Equipment Corp.VAX Maintenance

175 1999 Patel Seema 022699 020032545 $2,826.00 RSPA Mike

Moroney Center

Training Tuition

........ ............ ........................ $554,006.51 TOTAL PURCHASES60 DRAFTS

176 1999 Libera Jr Donald P. 011999 020019349 $3,719.56 Donna M. Seipler Advance payment

for amounts

due

177 1998 Libera Jr Donald P. 93098 020019347–1 $4,000.00 William P.

Fannon

Advance for salary

........ ............ ........................ $7,719.56 TOTAL OTHER 1 DRAFT

........ ............ ........................ $1,077,122.17 TOTAL OVER

$2500

177 DRAFTS

Mr. KNOLLENBERG. How many instances of split invoices are you

aware of?

Mr. MEAD. We are aware of two.

Mr. KNOLLENBERG. Two.

Mr. MEAD. Two instances where purchases over $2,500 were simply submitted to avoid the Federal regulations. There may be more,

but these are the ones that turned up in our sample.

Mr. KNOLLENBERG. There were copies of all the checks that were

made available. Five checks on one day to—there is five, I believe.

They were made on the same day, as I remember. That is a little

bit strange. Was that done obviously to conceal exceeding the 2,500

limit?

Mr. MEAD. Yes, well, what was happening here was you buy the

same thing but to stay under the ceiling you simply write multiple

checks that, added together, equal the purchase price.

37

Mr. KNOLLENBERG. One of these is Tratech. Another one, was it

Skill—Skillcraft, I believe it was. I think there were five made in

one day. That is kind of strange.

Mr. MEAD. One was for computers. I think the other was for

training.

Mr. KNOLLENBERG. Mr. Chairman, how is my time here?

Mr. HALL. We will be glad for the record to get you whatever information the Board has on those five checks.

Mr. KNOLLENBERG. I appreciate that.

[The information referred to follows:]

RESPONSE FROM DIRECTOR HALL TO QUERY BY MR. KNOLLENBERG ABOUT SPECIFIC

SPLIT INVOICES

There were a total of four Rapidrafts that were involved in two split purchases

with Tratech that were reported by the Inspector General in their investigative report.

There were two rapidrafts issued on February 5, 1998, for $1,400 each to pay an

invoice for $2,800 that was dated February 4, 1998.

There were two rapidrafts issued on July 7, 1999, for $2,047 and $2,338 respectively to pay for one facsimile machine purchased on June 9, 1999, and 3 computers

purchased on June 29, 1999.

With regard to the question concerning Skillcraft, our research did not yield any

information.

Mr. KNOLLENBERG. What I found too disturbing, and I am sure

this has been talked about previously, but what were these expenditures for? In the indications of the copied checks, the photocopies,

there is nothing there to say it was for carpet purchase or furniture

refinishing or payroll advances. There wasn’t a lot of disclosure.

And I think that it becomes clear that there must have been suspicion that it was beyond the scope of the authority and for purposes other than what would normally be covered in the cost of

business. Would you agree with that?

Mr. MEAD. Yes, in general, I would.

Mr. KNOLLENBERG. And I presume that these people that have

been involved with some of the accounting are no longer on the job

or are being oversighted in a fashion that would tell you that there

won’t be anymore of this?

Mr. MEAD. The former Chief Financial Officer who was incumbent during all times pertinent to this inquiry has resigned. Mr.

Levine down at the end of the table is his successor. He has 35

years of experience. I have confidence that he is going to serve the

Chairman, the Board and NTSB well.

Mr. KNOLLENBERG. Thank you.

Just very quickly I will close with this: How did these authorized

users obtain the Rapidrafts? Were they just about?

Mr. MEAD. Actually, the interesting thing, you think they would

have to go in to the Chief Financial Officer and get them, but

under the procedures they had set up you could call up the contractor and say, send me some checks, and he would send some checks.

Mr. KNOLLENBERG. We didn’t use that in my business. I guess

I was missing something. But that sounds like a pretty good deal

do me.

Well, I think that I will just close with the assurance that I am

looking for is that those who had access in such an open fashion

to these checks no longer have that access. Can we say that there

is 100 percent security on that?

38

Mr. HALL. Yes, sir. And we are bringing in an independent auditor. I would in a moment’s notice bring the IG back in if I thought

there was any difficulty. Mr. Levine has his orders, and his orders

are if there is anything improper in any way that has been going

on in the past is to change it and change it immediately.

Mr. KNOLLENBERG. Any talk about having an IG inside?

Mr. HALL. We did have that conversation, sir, while you were out

of the room, but we would be glad to respond depending on—— Mr. KNOLLENBERG. I think that concludes my questions.

Thank you, gentlemen; and thank you, Mr. Chairman.

Mr. MILLER. Mr. Ryan and Mr. Sununu are headed back. I know

Mr. Ryan has a few questions, so why don’t we take a break for

a few minutes until they arrive.

[Recess.]

Mr. SUNUNU [presiding]. In the interest of time, I am going to

reconvene the hearing at this time.

We have one additional member that would like to ask questions.

I hope he arrives in a timely way. I am confident he will.

I do have a few additional follow-up questions, and then we will

try to adjourn the hearing in a timely way, because I know all of

you gentlemen have important work to do.

Mr. Mead, we talked a little bit about other agencies that are

currently using third-party systems, some with Gelco, that was a

subcontractor to NTSB, some with other third-party draft systems.

And some discussion was made that perhaps it would be appropriate to audit some of those systems.

My question for you is, given the experience of your investigators

and auditors with the Rapidraft system at NTSB, what kind of an

audit—what kind of a scope of an audit might you suggest that the

committee seek in other agencies or departments where we might

have questions about the nature of the program?

For example, I am asking your recommendations with regard to

time period. Is it best to look at a broad period, 2 or 3 years, at

a top-level audit? Should we look in depth at a month in the documentation, in the internal controls? What kind of guidance might

you give this Task Force in making sound recommendations for

looking at this system in other agencies?

Mr. MEAD. Well certainly we have a methodology that we know

what questions to ask. And we know what answers you might get.

I would suggest that if you were to ask other agencies to do such

an audit, you would go back at least one year and ask for a description of the internal controls and whether they were in place, and

we could actually itemize those for you. For example, do people

sign the checks, what are they for, so forth and so on.

I would also go back and ask for trend lines, say, going back

about 4 or 5 years, about program usage so you could see the aberrations, if there were sharp aberrations, in program usage.

I would also want to know about the management that was in

place at all pertinent times for the program going back, say, 5

years. And I say 5 years because Congress passed a law in 1995

or 1996 that phased these programs out and said you should go to

electronic fund transfers only in emergencies and so forth should

you be using these third party drafts. So 1995 really marked a demarcation point. I would not go back before then.

39

Mr. SUNUNU. Thank you.

Mr. Hall, what kind of internal communication have you utilized

in trying to make employees aware as appropriate of the results of

this audit and the concerns regarding financial controls and are

employees making a best effort to understand those controls but

also to abide by them?

Mr. HALL. Mr. Levine has presently underway a training program for all Board employees.

Mr. LEVINE. Mr. Chairman, on March 2, almost 2 months after

my arrival, we began training managers and employees. We have

a power point presentation that I personally give, and I also include our labor-management relations specialist.

We go over the events, we discuss the audit, we review the findings, and we go over the two credit card programs. We explain the

dos and don’ts, and we explain management responsibilities.

The first one I gave was to the office directors. All of them are

getting management reports. There is no such thing as privacy

when you use a government credit card.

We have explained to them how to use it, what to look for. We

also involved the labor-management relations people because there

are cases of delinquent debt. But it is not debt owed to the government. It is debt owed by our employees who on their travel card

have incurred charges and are not paying bills timely. That has

labor-management relations implications as well. I have also

briefed the employees of several offices.

Mr. SUNUNU. If I may, you mentioned delinquent credit cards. Is

that a problem right now within NTSB? Do you have an approximate number or percentage of the cards issued that may be delinquent at this time?

Mr. LEVINE. Less than 10 percent at the last look. It has gotten

better, actually.

Mr. SUNUNU. I should ask for your definition of delinquency.

Mr. LEVINE. Per Citibank’s terms, it means they are over 60 days

delinquent in paying their bill.

Mr. HALL. One of the other things I am trying to do is get a new

travel agency, Congressman. What happens is that we end up with

people getting things put on their card by hotels or because they

changed plans because of sudden travel, and then it takes forever

to get these items reimbursed. I have asked Mr. Levine to be very

aggressive in that area, and we will be glad to provide you information on the record on the total amount.

Mr. SUNUNU. Thank you.

[The information referred to follows:]

REVIEW OF CITIBANK REPORT ON NTSB’S CREDIT CARD DELINQUENCIES

Citibank has issued 367 travel credit cards to our employees. A review of the latest Citibank report on delinquencies indicates that we have a 7 percent delinquency

rate. Approximately 75 percent of the delinquencies are just 1 month overdue.

NTSB management officials are working with employees to get their accounts current.

Mr. SUNUNU. Mr. Levine, how many employees have received a

power point presentation and how many do you intend to present

it to? I know that not—every single employee might not be an appropriate.

40

Mr. LEVINE. I have made a presentation to the top management

and the officer directors of every major mode. I have also made a

presentation to three of the smaller offices, and I have presentations scheduled right now for three more. The regional directors

for aviation are coming in this May, and I am scheduled to present

to them as well. That is our biggest mode and that is where a lot

of the travel occurs. To date, I can’t put a percentage on it, sir, but

by office I have had three of the seven major offices.

Mr. SUNUNU. Will you have all seven completed by June?

Mr. LEVINE. Yes sir. That is what the chairman wants, and that

is what I am going to do.

Mr. SUNUNU. I highly encourage to you do your best.

Mr. LEVINE. Appreciate your encouragement.

Mr. HALL. We are trying to move expeditiously, Congressman. As

you may know, we have nine regional offices, stretching from Anchorage to Miami and covering the United States. I won’t ensure

that our new CFO gets to each one of those by June, but we have

a priority right now in trying to brief our headquarters offices.

Mr. SUNUNU. I understand. Perhaps you can follow up just for

the record the detail of that schedule and just so that the Task

Force has a sense of coverage. Because I think there is a great

value, even if it is a presentation at a fairly high level, so that employees really understand what kind of an effort is being made and

also they understand the value of the oversight that has been provided in this case by the Inspector General.

Mr. LEVINE. Can I add one point of clarification, Mr. Chairman,

that you may not be aware of?

Citibank basically requires us to give very specific training on

the purchase card and the use of it before that card is issued. And

I have to say that NTSB—and this occurred before I arrived—made

sure that all employees who received that card had to receive that

training as well. So there was training in addition to what I have

given.

Mr. MEAD. I would like to, in the interest of full disclosure in

light of the conversation with Mr. Miller earlier and NTSB on this

credit card delinquency point, this is not just an issue with NTSB.

We are dealing with it at the Department of Transportation, too.

We had roughly $3.6 million of delinquencies in the serious category a couple months ago; and the Assistant Secretary for Budget,

the CFO, myself, the Deputy Secretary have all thought this is an

area we need to pay attention to as well. Since February, we have

had a marked reduction. We are down to $2.9 million, but we still

have a ways to go. So NTSB is not in this swimming pool all alone.

Mr. SUNUNU. I appreciate that clarification, Mr. Mead.

Mr. Levine, I certainly believe this is a question best addressed

to you. Can you tell me, before the system that you have in place

now, and perhaps the system that was or was not in place previously, how did you track property and equipment, not just furniture but, most importantly, electronic equipment, computers and

information systems themselves?

Mr. LEVINE. I am not sure I have a good answer here, so I need

to look over to my managing director and check.

Mr. CAMPBELL. The reason Mr. Levine is hesitating is that the

inventory system is not within his control, and marrying up the inVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00044 Fmt 6633 Sfmt 6602 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
41

ventory system and the financial system is one of the projects that

we have under way.

Mr. SUNUNU. Once the FMS recommendations are implemented,

will the inventory control system be part of the Mr. Levine’s jurisdiction?

Mr. CAMPBELL. It will be part of the same data base. The way

that the property system works now, when property is brought into

the building, it is identified as NTSB property and tagged as such

as it is in an inventory system. What we do not presently have is

a marrying between the acquisition document and the inventory

document.

Mr. SUNUNU. I believe Mr. Levine gave a rough time line for

completing the implementation of the goals set out by the FMS review and some of the additional goals of the Inspector General’s

recommendations of perhaps completing by the end of this year. My

question for Chairman Hall is, given that time line, when do you

expect to and when have you set a goal for having a clean audit

completed?

Mr. HALL. I would hope we could have a clean audit at the end

of fiscal year 2001. That is my goal. I want to do everything I can

so that my successor at this agency doesn’t experience the same situation I have. I think the best way to do that is to be sure that

this agency annually can produce a clean audit. And now I have

given Mr. Levine all these responsibilities, and I have got to get

him some more people to help him perform his responsibilities.

Mr. CAMPBELL. If I might, Mr. Chairman, one of the issues that

we have asked PriceWaterhouseCoopers to look at is the degree of

readiness that we have for such an audit and to tell us what it is

that we would necessarily have to do. Depending upon what they

come back with in terms of readiness or the lack thereof, we will

probably pick the earliest possible target date. If it could be this

year, it is this year; if it is next year, it is next year.

But we have to have an independent auditor come to us and say

these are the deficiencies and these are the needs within your existing system that will produce such a possibility. As I mentioned

once before, the first order of business was to relook at the Gelco

Rapidraft issue in terms of whether there is any continuing liability there; and the second order of business is to put us on the path

for a clean audit.

Mr. SUNUNU. Thank you.

Mr. HALL. I know you read my testimony. That was where I was

trying to head with the Treasury in 1997, 1998, because at that

time I was told we couldn’t get a clean audit without redoing our

financial house. I am committed to that, and I hope it will happen

very soon.

Mr. SUNUNU. Mr. Mead, the various responsive or the various remedial actions that NTSB has undertaken and outlined, are they

responsive to the recommendations in your report? And I mean

that in two ways.

One, of course, specifically, are you comfortable with what they

have outlined and set for goals to respond to the results of your

audit? More generally, are there any areas that are of concern for

you that it would be difficult for them to achieve the goals of your

report even if those remedial actions are implemented? In other

42

words, are there objectives or problems that you see that—areas

where we will need continued oversight in any agency? In other

words, it is not just necessarily a problem with their inventory

management system or reconciliation process, but they are just, in

your opinion, going to continue to be problem areas?

Mr. MEAD. I would have to say that the termination of the Rapidraft program, the hiring of PriceWaterhouse, the installation of a

new CFO and the broad front of actions that have been articulated

as planned are responsive and should take care of the problem.

Now, there is a lot planned, and so the key is going to be in their

implementation. You know, earlier—I think you were in the hearing room—Congressman Miller said, well, it is not just the Rapidraft that is the problem, it is a deeper issue. And he is right. Because if we don’t deal with some of these other internal control

issues such as reconciling payments you could have a recurrence of

this sort of thing with credit cards. So I think their ship is headed

in entirely the right direction. The key is going to lie in the implementation. And you are absolutely right. This is the type of situation you can find at almost any agency.

Mr. SUNUNU. Thank you.

Finally, I believe, as a result of this, it would be in our best interest to have you audit the system as it exists or was used in FAA

and at the Volpe Center within the Department of Transportation.

And I anticipate that we will be making a formal—as a full committee—formal recommendation to you to do just that.

Again, I appreciate all of your time.

I want to yield to Mr. Ryan for his question period, and then we

will adjourn forthwith. Mr. Ryan.

Mr. RYAN. Thank you, Mr. Chairman. I would like to ask unanimous consent that my opening statement be included in the record.

Mr. SUNUNU. Without objection.

Mr. RYAN. Thank you.

[The prepared statement of Mr. Ryan follows:]

PREPARED STATEMENT OF HON. PAUL RYAN, A REPRESENTATIVE IN CONGRESS FROM

THE STATE OF WISCONSIN

Mr. Chairman, I am perplexed by the apparent financial mismanagement that

has occurred over the last 18 years at the National Transportation Safety Board

(NTSB). As I had the chance to read the Inspector General’s report last night, I was

shocked to find some of the ways that our tax dollars are being spent.

In 1982, the NTSB set up the Rapidraft Payment System to provide investigators

with a mechanism to pay authorized expenses associated with on-site investigations.

This system allowed NTSB investigators to write checks, up to a $2,500 limit, for

items such as tow trucks and crane rentals. The NTSB’s Chief Financial Officer was

put in charge of the system.

In 1999, the NTSB’s Rapidraft Payment System came under investigation by the

Inspector General of the Department of Transportation. The results of the Inspector

General’s report were startling. By the Inspector General’s account, the Rapidraft

Payment System was turned into the CFO’s personal playground at the taxpayers

expense. In a random sample of one thousand FY99 Rapidrafts, the Inspector General found 902 noncompliant drafts. That’s over 90 percent of the drafts, with many

of these checks exceeding the $2,500 limit. Worse yet, the audit found that only 5

percent of the $3.6 million in allocated funds were used in on-site accident investigations. The results of the audit found that Rapidrafts were being used for such noncompliant expenses as:

• $731,000 for nonaccident related travel.

• $410,000 for tuition for training.

• $286,000 for nonaccident related equipment office supplies.

• More than 100 checks cashed at one DC liquor store.

43

• And the list goes on from there.

In 1992, a similar audit of the RPS was conducted by the General Services Administration. The GSA audit found that 92 percent of the Rapidrafts issued in the

first 9 months of Fiscal Year 1991 were improperly used. The NTSB took no appropriate actions at or since that time.

All though the 1992 audit found significant weaknesses in the system’s internal

controls, they were not corrected. The Rapidraft Payment System may just as well

have been called the Rapiddraft Profligate System. The Inspector General found

that 37 of the 177 authorized investigators that were approved to write these checks

no longer work for the NTSB. Checks were paid without signatures, authorization

numbers or explanations. The CFO did not reconcile these checks to ensure payments were authorized.

Mr. Chairman, I think that any American citizen would find this kind of abuse

offensive. Americans work hard for their money. As it is tax season, we are all reminded of the large portion that we pay in taxes every year. The average financial

tax burden that the government imposes on an individual today is 33.5 percent of

their income. In 1999, Americans worked from January 1st until May 3rd to pay

off their taxes. That’s over 4 months that Americans work just to pay their taxes.

Through the Inspector General’s report of the NTSB, we are finding today that

Americans worked hard to give entertainment money to NTSB workers. Americans

worked hard to assign blank checks to former NTSB workers with no accountability.

Americans have worked hard to provide computer upgrades to top NTSB officials

to download questionable material. This is simply unacceptable.

How does such a system become so poorly managed? Why weren’t these obvious

problems fixed after the 1992 audit? What other government agencies are using this

Rapidraft Payment System? How many tax dollars are being wasted in these agencies because of improper oversight of the RPS? These are all questions that I hope

are answered today.

I do appreciate Inspector Meade and Chairman Hall for being here and testifying

today. I also commend Chairman Hall for his willingness to request that Inspector

General Meade audit the NTSB when he saw deficiencies in the system. I understand that an audit by the Inspector General was a voluntary move by Chairman

Hall in response to widespread abuse of the financial accounting system.

Mr. Chairman, it has come to my attention that the Department of Transportation has recently called for the end of the RPS system—not only for the NTSB,

but for all related DOT agencies. I am disappointed that it took a Congressional

hearing to end the eighteen years of fraud and abuse. Government agencies like the

NTSB should be implementing new payment programs that meet its needs with appropriate controls built in. It’s time for an end to these kind of slush funds.

Weeding through government waste and abuse is serious business. For a government employee to waste taxpayers time is reprehensible, but for that employee to

waste taxpayer’s money is criminal. My staff and I take the responsibility of working for the American taxpayer very seriously. We work hard not to abuse the awesome power to which we have been entrusted. I expect nothing less from the NTSB,

or any other government agency, than to hold them to that same standard.

Mr. RYAN. Mr. Hall, I would like to go back to the 1992 GSA

audit. In 1992, the General Services Administration found serious

deficiencies in the management of the Rapidraft Payment System,

including a lack of supporting documentation, that Rapidrafts were

issued without proper authorization and that travel advances made

with Rapidrafts were sometimes used for nontravel purposes and

used to circumvent proper payroll procedures. In fact, the GSA

found that as many as 92 percent of the Rapidrafts issued for travel purposes were not in compliance with NTSB internal controls.

In response, the NTSB Comptroller identified specific solutions

for correcting those deficiencies that the NTSB intended to implement.

This was 1992. I know you weren’t there then, and I know the

people are new. But GSA did an audit in 1992. Why did it take so

long for you to take action? What happened in 1992 that NTSB

didn’t do anything to follow up on that audit and why was that the

case?

44

Mr. HALL. Congressman, I want to be responsive to you and to

this committee on all questions, but I must tell you, in all honesty,

that I was not aware of that audit. My predecessor did not inform

me of that. I was not aware of that audit until this whole matter

came up in this year.

Mr. RYAN. Who on your staff would have been aware of the

audit?

Mr. HALL. Mr. Keller, who is the individual that is no longer

with us. I am sure there are other individuals. We could get that

information for the record, but I don’t know.

The office at that time was structured differently, sir. We had an

Office of Administration, and the Accounting Office was under the

Office of Administration. The Accounting Office reported to the

head of that office, who then reported to the managing director,

who reported to the chairman.

My concern, when I read the statute in Congress, was I was accountable. But there were three people in between me and the individual that was responsible for the proper accounting of the money.

That was when I couldn’t get good numbers. The second and third

year I was there, I tried to move toward a reform of the system.

[The information referred to follows:]

RESPONSE FROM DIRECTOR HALL TO QUERIES BY MR. RYAN ABOUT 1992

DEFICIENCIES

In 1992, GSA performed an audit for NTSB to evaluate the adequacy of administrative procedures and practices for travel at the agency. The audit found that: (1)

travel advance documents were signed by officials with appropriate authority; (2) expense claims were within Federal limits; (3) required receipts were attached; (4)

amounts claimed were accurate; and (5) travel vouchers were appropriately authorized and timely.

However, the audit found problems with travel advance accounts (NTSB no longer

uses a travel advance system and has not for some time), including a failure by

NTSB to undertake periodic reviews of travel accounts balances. The audit also

found that investigators had written rapiddrafts to cover travel expenses, though investigator authority was limited to on-scene purchases. Rapiddrafts for travel reimbursements were to be written only by NTSB designated imprest fund cashiers. Additionally, it was found that rapiddraft booklets were not always adequately secured

or locked up. No fraud, waste, or theft was in any way intimated. Distribution of

the GSA audit report indicates that three copies were delivered to the then Chairman of the agency, since departed.

At the time of the report, financial management was undertaken by a division of

the Office of Administration, which in turn reported to the Managing Director, a

non-career appointee, who reported to the Chairman. As a practical matter, the

Deputy Managing Director would have had day-to-day supervisory responsibility for

the Office of Administration. None of these individuals are currently with NTSB.

According to a memorandum dated November 16, 1992, the Chief of the Financial

Management Division proposed to his immediate supervisor several remedial actions, apparently acceptable to the Director of the Office of Administration. Whether

any of these actions were reported further up the management structure, I am unable to say.

Factually speaking, NTSB did move away from the travel advance system that

was the principal issue of criticism, and I am unaware of any present issue with

investigators having subsequently written rapiddrafts to cover travel expenses. It

would appear that the chief deficiencies stated in the 1992 audit resolved themselves, whether as a result of precautionary actions or simple changes in circumstances, again I cannot say with any certainty.

I would add that NTSB has undergone an extensive administration reorganization

that should help to prevent any repetition. All purely administrative functions now

report directly to Managing Director. (The titles of Deputy Managing Director and

Managing Director are now Managing Director and Executive Director, respectively.) Financial management has been removed from administration altogether,

and, in accord with the principles of the Chief Financial Officer Act, a freestanding

45

office reporting directly to the Chairman has been established. We did not hesitate

to implement the recommendations of the DOT IG coming from the recent audit,

and I am confident that NTSB follow-through will be exemplary.

Mr. MEAD. Here is something that I think—illuminating on that.

After the General Services Administration filed its report back

then, it was the IG from GSA, the incumbent, the fellow that was

the chief financial officer who was then called the comptroller,

same person, he wrote a memo and in it he said that he was going

to write another memo reminding everybody not to do these things.

Mr. RYAN. Was the content of that memo notifying employees

about NTSB Order 46A and 1542?

Mr. MEAD. Yes, sir. And so—but we have been unable to establish whether in fact that was actually done. And, moreover, it has

been our experience, and I am sure yours, that just issuing memoranda really doesn’t do the trick.

Mr. RYAN. So the GSA audit was conducted in 1992. They said

92 percent of the Rapidrafts were for out-of-compliance check writing. And then the comptroller at that time, which is also the CFO,

you are saying, may or may not have issued a memo to the staff

reminding them of how to comply with the Rapidraft system. Is

that the gist of what you are saying?

Mr. MEAD. He did write to his boss saying he was going to do

these things. But we do not know whether in fact he actually did.

Mr. RYAN. Are you looking at—your audit was a 3-year audit,

from fiscal year 1997 through 1999. Have you looked at pre-fiscal

year 1997 checks?

Mr. MEAD. No, sir.

Mr. RYAN. Do you have them?

Mr. MEAD. No.

Mr. RYAN. Do you know how much money has been appropriated

within the agency to the Rapidraft system? Just the macro numbers of what had been appropriated to the Rapidraft system from

1992 to 1997? Because I know you know what money was deposited

into Rapidraft system for fiscal year 1997, 1998, 1999. What about

1992 to 1997?

Mr. MEAD. No, I don’t know. All I can say is that the 1997, 1998,

1999 patterns are similar. I do not know if the trend existed before

that time.

Mr. RYAN. Mr. Hall, do you have access to the data that would

show us how much money was ultimately passed through the Rapidraft system from 1992 to 1997?

Mr. HALL. We would be glad to try and obtain that for the

record, Congressman.

Mr. RYAN. If you could, that would be helpful.

[The information referred to follows:]

TOTAL DOLLARS PAID THROUGH THE RAPIDRAFT SYSTEM AND THE NUMBER OF CHECKS WRITTEN

[Fiscal year]

Fiscal year Dollar value Number of Rapidrafts written

1992 ................................................................................................. $1,202,580.57 5,937

1993 ................................................................................................. $2,677,364.18 7,929

1994 ................................................................................................. $1,398,778.13 6,718

1995 ................................................................................................. $2,407,865.42 7,685

1996 ................................................................................................. $2,824,574.71 7,696

46

TOTAL DOLLARS PAID THROUGH THE RAPIDRAFT SYSTEM AND THE NUMBER OF CHECKS

WRITTEN—Continued

[Fiscal year]

Fiscal year Dollar value Number of Rapidrafts written

1997 ................................................................................................. $4,277,124.64 8,836

Total ................................................................................... $14,788,287.65 44,801

Mr. RYAN. Mr. Mead, at your entire Department of Transportation Inspector General—I came late, so I know these questions

may have been exhausted already—but it is my understanding that

yesterday the Department of Transportation ceased all Rapidraft

procedures as of yesterday, is that correct?

Mr. MEAD. Yes, sir. This subject did come up before. And based

on the NTSB experience, our own audit of FAA previously, that Departmentwide instruction was issued yesterday that, as of May 10,

they will no longer be used in the Department. The reason for the

30 days, I hasten to add, is because we have air traffic control facilities in the field we want to make sure that they have credit

cards and they don’t say, well, thanks for leaving us hanging.

Mr. RYAN. How many Rapidraft systems were in place within the

entire Department as of yesterday?

Mr. MEAD. I believe that there were two, FAA and the Volpe

Center in Boston. The Federal Highway Administration I believe

had discontinued it. I will correct that for the record if I am wrong.

FAA had been spending, I think, about $15 million this past year;

the Federal Highway Administration, $80,000; the Volpe Center,

about 80 or 90,000. I think 40,000 checks at FAA.

Mr. RYAN. Forty thousand at the FAA.

Mr. MEAD. In 1999.

Mr. RYAN. What is the total dollar amount?

Mr. MEAD. About $15 million.

Mr. RYAN. That is, again, the total budget? You are auditing that

right now?

Mr. MEAD. No, but we soon will be.

Mr. RYAN. I hope we look at other areas within the entire Federal structure where Rapidraft systems are employed. I think that

is something that is a challenge for the committee here.

I want to go back to in 1992. What is the procedure that occurs

when another government agency like the GSA audits a program—

what is the procedure that is in place today to make sure that

those audits are actually recognized, that those audits are responded to, that the audits are acknowledged? What happens? I am

just curious as to what happens when those audits come to you.

Mr. MEAD. Within the Department of Transportation over which

we have jurisdiction, there is a requirement that they respond. In

this case, where we didn’t have the jurisdiction over NTSB, there

is no requirement for follow through; and in the GSA case the GSA

never follows up. In this case, there is follow up I think largely because of the relationship between the NTSB and us. But it is not

a legal requirement, if you will.

Mr. RYAN. So in your opinion—and I don’t want to paraphrase

for you, but this was discovered in 1992, these inherent flaws: room

47

for embezzlement, over-the-limit expenditures, and noncompliant

expenditures were known in 1992.

Mr. Hall, when you found out, you put an end to it just this last

year. Why do you think it took so long to find this out? And what

went wrong in 1992? Is it simply that they went to one individual,

which was at that time the CFO, who just let it die by the wayside?

Then it cropped back up in 1999? Or what do you think, Mr. Mead,

was the cause for that?

Mr. Hall, please feel free to answer as well.

Mr. HALL. Congressman, in fairness to the people, I don’t know.

Because I wasn’t there, I don’t know what they did. I don’t want

to respond to a question when I truly do not know the answer.

Mr. MEAD. What happens when we travel, we put it on a credit

card. In order to get paid back, we have to fill out a form that says

where we traveled, how much we spent. It has to be approved, goes

into the system. The Department of the Treasury eventually cuts

an electronic transfer to our personal bank account. And there is

also a general audit made.

That is, obviously, a more difficult procedure to get money from

the U.S. Government than a procedure where you simply write a

check to yourself and cash it. And if you have a system in place

where you don’t even have to sign the check or you don’t have to

put down the purpose, it is more expeditious. But I think we all

know that we can’t have a system like that in place in government

and public service. So it is easier.

Mr. RYAN. This question may have been asked as well, but I

would like to hear from you Mr. Hall, as part of the Rapidraft Payment System NTSB maintained a $350,000 in a noninterest-bearing account with Gelco. What efforts have NTSB undertaken to retrieve the $350,000 deposit since the Rapidraft system was

stopped?

Mr. HALL. That matter was covered, and that question responded

to. I will be glad to have Mr. Levine respond again.

Mr. RYAN. If you could respond.

Mr. LEVINE. I became aware of the deposit about a month and

a half into my tenure. I directed my people to go after Gelco. There

are some issues dealing with float charges and outstanding

charges. We intend to get that money very shortly.

Mr. RYAN. Thank you.

That is all, Mr. Chairman.

Mr. SUNUNU. Thank you very much, Mr. Ryan.

I want to thank all of our witnesses today for their time and for

their candor. Should the Task Force have any additional requests

for information, I want you to know that we will be mindful of the

burden that is on you now with the work that you do every day.

And, again, I appreciate the information that you provided that I

believe has already made a difference in putting important focus on

the way we disburse money in departments and agencies across the

Federal Government; and for that you are to be congratulated.

Thank you, all.

The Task Force is adjourned.

[Whereupon, at 12:40 p.m., the Task Force was adjourned.]

(49)

Lack of Income Verification in HUD-Assisted

Housing: The Need to Eliminate Overpayments

THURSDAY, MAY 25, 2000

HOUSE OF REPRESENTATIVES,

COMMITTEE ON THE BUDGET,

TASK FORCE ON HOUSING AND INFRASTRUCTURE,

Washington, DC.

The Task Force met, pursuant to call, at 10:05 a.m. in room 210,

Cannon House Office Building, Hon. John Sununu (chairman of the

Task Force) presiding.

Mr. SUNUNU. Good morning. I would like to start by thanking

Congressman Bentsen and all the members of the Task Force for

participating in this hearing and supporting the oversight hearings

for which we are responsible in both housing and infrastructure.

But also I would like to recognize and thank the Special Agents

that are here today, Raymond Carolan and Emil Schuster of the

U.S. Department of Housing’s IG Office; Deputy Secretary Saul Ramirez, who has testified here before on behalf of the Department

of Housing and Urban Development; and Ms. Sheila Crowley of the

National Low Income Housing Coalition.

I know you all have busy schedules. I appreciate your taking the

time out to testify.

Since its inception, the Section 8 housing assistance program has

helped millions of American families find affordable housing.

Through the Section 8 voucher and certificate programs, HUD provides rental subsidies which help over 1.4 million households in the

United States.

The subsidies are reserved only for very low-income tenants and

are based on the amount of income the tenant earns. Typically, the

tenant pays the rent capped at 30 percent of income, and HUD

pays the remaining rental cost of the apartment.

Obviously, determining a tenant’s true income level is essential

for the programs to operate not just efficiently, but fairly as well,

because as we all know, the waiting list for these positions can be

quite long.

Unfortunately, there has been a long-standing problem at the

Department of Housing and Urban Development in assuring that

subsidy payments are made in the right amount to those eligible

low-income tenants.

Both the GAO and the HUD Inspector General’s Office have determined that the systems in place ‘‘do not provide reasonable assurance that subsidies paid under the programs are valid and correctly calculated, considering tenant incomes and contract rents.’’

50

Since 1996, the HUD Inspector General has reported that HUD’s

housing subsidy programs do experience improper payments when

beneficiaries’ income status changes and they do not notify housing

authorities to adjust their benefits. HUD itself has estimated that approximately $935 million in excessive payments have been made in its Section 8 housing program

for 1998. Had this $935 million been used to assist low-income tenants, it is estimated that approximately 150,000 families could

have been assisted with their housing needs. So this is not simply

a budgetary problem, but it is also a fairness problem.

We want to make sure within HUD that resources are made

available to assist those that need help. Again, the waiting lists for

many of these programs are quite long.

In 1999, HUD developed an approach to use a large-scale computer-matching income verification process that would compare

IRS and Social Security information and identify tenants who had

underreported their income. In the first quarter of the year 2000,

HUD used its new matching methodology to identify approximately

280,000 tenant households with income discrepancies. HUD then

prepared letters to inform tenants of their responsibility to disclose

their proper income and tax data to the Public Housing Authority,

as well as notifications to the housing authorities themselves.

Although the Department had originally planned to mail notification letters to all of these tenants with income discrepancies, it was

decided to engage in a pilot program in Washington, DC. In February, about 900 letters were sent to tenants, which were not received well. As a result, the program was temporarily suspended.

Our goal today is to attempt to shed light on the nature of the

problems that were encountered early on with the 1995 problem,

understand what efforts the Department of Housing and Urban Development has made to solve the problems, and try to better understand the scope of the problem that the Inspector General’s Office

has been evaluating.

We will hear testimony from the Office of Inspector General, explaining their understanding of the problem and talking about several real-world examples of how and why overpayments are made.

In addition, we will hear testimony from the controller at HUD,

who has responsibility for monitoring these finances, and hear

about what steps HUD has taken to bring in the concerns of tenants and try to shed additional light on the tenants’ perspective in

these attempts to reduce the significant level of overpayments.

I would like to recognize Congressman Bentsen for any remarks

he might have.

[The prepared statement of Mr. Sununu follows:]

PREPARED STATEMENT OF HON. JOHN E. SUNUNU, A REPRESENTATIVE IN CONGRESS

FROM THE STATE OF NEW HAMPSHIRE

Good morning. I’d like to start by thanking Congressman Bentsen and all the

members of the Task Force for being here this morning. I’d also like to recognize

and thank Special Agents Raymond Carolan and Emil Schuster of the U.S. Department of Housing and Urban Development’s Office of Inspector General, Deputy Secretary Saul Ramirez, U.S. Department of Housing and Urban Development, and Ms.

Sheila Crowley of the National Low Income Housing Coalition. I appreciate your

taking the time out of your schedules to be here this morning.

Since its inception the Section 8 housing assistance program has helped millions

of American families to find affordable housing. Through the Section 8 voucher and

51

certificate programs HUD provides rental subsidies which help over 1.4 million

households in the United States. These subsidies are reserved only for very low-income tenants and are based on the amount of income the tenant makes. Typically,

the tenant pays a rent capped at 30 percent of income, and HUD pays the remaining rental cost of the apartment.

Clearly, determining a tenant’s true income level is essential for the programs to

operate properly and fairly. Unfortunately, there has been a longstanding problem

at the Department of Housing in assuring that subsidy payments are made in the

right amount to eligible low income tenants. Both the General Accounting Office and

the HUD Inspector General’s Office have determined that the systems in place now

do not ‘‘provide reasonable assurance’’ that ’’subsidies paid under these programs

are valid and correctly calculated considering tenant incomes and contract rents.’’

Since 1996, the HUD IG has reported that HUD’s housing subsidy programs experience improper payments when beneficiaries income status changes and they do not

notify housing authorities to adjust their benefits. In fact, HUD itself has estimated

that $935 million in excessive payments have been made in its Section 8 Housing

program for 1998. Had this $935 million been used to assist eligible low income tenants, it is estimated that an additional 150,000 families could have been helped.

In 1999 HUD developed an approach to use a large-scale Computer Matching Income Verification Process to compare IRS and Social Security information and identify tenants who had under-reported their income. In the first quarter of 2000, HUD

used its new matching methodology to identify 280,000 tenant households with income discrepancies. HUD then prepared letters to inform tenants of their responsibility to disclose their proper income and tax data to their Public Housing Authorities, as well as notifications to the PHA’s themselves. Although the Department had

originally planned to issue notification letters to all tenants with income discrepancies, it was decided instead to use the Washington, DC, Housing Authority as a

preliminary test area. In February 2000, letters were sent to approximately 900 tenants. It is my understanding that these letters were received rather negatively, and

as a result the Department has halted its income verification program.

The purpose of this hearing will be to attempt to shed light on the nature of the

problems in the income verification program, and the effort of the Department to

solve these problems. The Task Force will hear testimony from two investigators

from the HUD Inspector General Office explaining their understanding of the problem and relating real world examples of how and why the overpayments are made.

In addition, we will hear testimony from the Controller at HUD who has responsibility for monitoring the finances at HUD. Finally, we will hear what steps HUD

has taken and plans to take in the future, along with testimony from an advocate

for tenants to bring light to their perspective on recent attempts to bring down these

overpayments.

I would now like to recognize Congressman Bentsen for any opening remarks he

may have.

Mr. BENTSEN. Thank you, Chairman Sununu. I want to thank

our panelists for being here, both the individuals from the IG’s Office, as well as my fellow Texan, the Deputy Secretary, who, prior

to becoming Deputy Secretary of HUD, had real power as the county judge of Webb County, Texas, and gave that up to come here to

Washington; and also Ms. Sheila Crowley from the National Low

Income Housing Coalition.

Let me say, this Task Force of the Committee on the Budget is

charged with investigating areas where there is either fraud,

waste, or abuse in government programs. I think that there is

strong bipartisan support among all members of the committee, as

well as all Members of the House, that fraud and abuse in government programs with taxpayers’ money should not be tolerated.

That being said, I think we also—and as a member of the Committee on Banking and Financial Services, which has jurisdiction

over HUD, we also must not lose sight of the fact that we do have

a low-income housing crisis in America; that as strong as our economy has been, we still have tens of thousands, or more, Americans

who are on waiting lists trying to get into assisted homes, assisted

52

living, including in my district in the greater Houston area. It is

something that we should be focused on.

Additionally, as we have found through hearings on the Committee on Banking and Financial Services, while there is great concern, and I have great concern with respect to overpayments, we

also have concerns about underpayments.

This is a broad problem and a complicated program that has

probably been somewhat more complicated with the passage of

H.R. 2 a couple of years ago, which I was involved in drafting with

Mr. Lazio and Mr. Frank and others, that changed some of the income rules and targeting rules and others in the Section 8 program. So HUD is going through a transition with respect to that.

Finally, I am eager to hear not only about the findings of the IGs

and the methodology and how we might address this, but also

about the income verification program that HUD has instituted,

both in terms of HUD, as to how that is going; but also from the

IG, your perspective on that as well, and how that might be made

even better, given that it appears to be the first time this is even

done.

Finally, I think we must not lose sight of the fact that the clientele that we are talking about here are among the poorest of Americans, that there are many who are struggling their way up the

rungs of the ladder; and we must be cautious in our diligence to

root out fraud and abuse not to lose sight of the fact that many of

these individuals may not share the technical expertise that those

of us in the Washington realm do—and we should be cautious in

that regard.

Mr. Chairman, thank you for holding this hearing. I look forward

to participating in it. I yield back the balance of my time.

Mr. SUNUNU. Thank you, Mr. Bentsen.

I would like to begin with the testimony from the Office of Inspector General, and once we have completed that testimony, I

would ask that you gentlemen literally just slide down to one side

of the table so we can have all of the testimony presented from Ms.

Crowley and Mr. Ramirez before we get to questions.

Then if the four of you can participate in the question-and-answer session, we will have questions from both me and Mr. Bentsen, but hopefully in a somewhat informal way; and you should feel

free during that question period to make any points that you think

are relevant, even if the questions are not necessarily directed to

you, because our interest is in presenting as much information here

as we can in what is, unfortunately, a short amount of time.

Mr. Schuster, I would appreciate your testimony. I yield to you

for whatever time you might need.

STATEMENT OF EMIL J. SCHUSTER, SPECIAL AGENT IN

CHARGE, SOUTHEAST/CARIBBEAN FIELD OFFICE OF THE

HUD INSPECTOR GENERAL

Mr. SCHUSTER. Thank you. Good morning.

Chairman Sununu and Congressman Bentsen, I appreciate the

opportunity to be here before you this morning to provide a little

bit of insight on what the Office of Investigations for the Office of

Inspector General of HUD does as far as tenant fraud.

I ask that my full written statement be included in the record.

53

Mr. SUNUNU. Without objection.

Mr. SCHUSTER. My knowledge of this issue is based on the 91⁄2

years I have been in charge of the HUD Office of Inspector General, Office of Investigations Southeast/Caribbean District in Atlanta, Georgia.

We, like many in the IG community, have limited resources. Because of that, it is essential to set strict priorities in their use.

These priorities are affected in large measure by the prosecutorial

guidelines set by the various U.S. Attorneys.

There is generally a minimum dollar threshold on fraud charges

in each judicial district. For example, it might be $10,000, or it

could be as high in some districts as $100,000. In addition, each

district might have their own set of priorities, so the priorities in,

for example, Miami may be far different than in Memphis, Tennessee.

Nonetheless, there are deviations from these minimums when

circumstances are so heinous that criminal prosecution is called

for. Because of these limitations, our investigations leading to the

prosecution of tenant fraud in the Southeast District have averaged

approximately only five per year.

To further clarify our addressing of tenant fraud, I would like to

use an interview question I pose to recent college graduates who

are applying for Special Agent positions.

I explain to the person that a complaint is received and that a

Section 8 tenant, identified as Mary Doe, is defrauding HUD by not

disclosing income she is receiving from a part-time job. You conduct

an investigation and find the following: Mary Doe has been working part-time at McDonald’s for the past year. She has three elementary schoolchildren.

From the interviews, it appears that she is simply trying to earn

some extra money to buy new school clothes, shoes, et cetera, for

her children. She has not disclosed this additional income, and

thereby has defrauded HUD out of $1,000 this past year.

How do we handle this?

The answer I look for is that this is not a prosecutable criminal

case. Rather, this is the type of situation that we would refer back

to the Housing Authority and/or the HUD program staff, recommending that they take some type of appropriate administrative

action.

The purpose of this question is to show that not every fraudulent

act warrants criminal prosecution. Judgment is needed, especially

with limited resources.

Now, having identified the type of case that would generally not

be pursued, I would like to describe several specific cases where we

have undertaken investigations, alone or with other law enforcement agencies, that have led to successful prosecutions. We will

often work with the Department of Health and Human Services IG,

or Secret Service, or any of the various other IGs in looking at

fraud.

Example number one is Nashville, TN, an IRS employee we prosecuted for falsifying her income in order to obtain Section 8 benefits. She failed to report her income she earned as an IRS employee. Her fraud resulted in a loss to HUD of over $15,000.

54

Example number two, Memphis, TN. A Memphis Housing Authority employee conspired with the Shelby County Corrections Officer to create a fictitious Section 8 landlord and place the property

into the Section 8 program. The corrections officer became the tenant, receiving the Section 8 assistance. The officer would then receive the Section 8 checks and forge the fictitious owner’s signature, and they would split the money. They took in about $11,000

of HUD funds.

In Campbellsville, KY, during a Safe Home operation—and this

is our operation for violent crime in public and assisted housing;

primarily we deal a lot with drug cases—we were investigating a

situation with two people selling drugs in the Housing Authority

developments.

During the investigation, we discovered that one of the individuals was a Section 8 landlord who was renting to another individual, who was another person who was selling drugs. During the

search warrant, we found that the landlord was living actually in

the residence with the tenant.

Now, this only amounted to fraud of just $1,070, but the Assistant United States Attorney [AUSA] decided to include this in the

prosecution with the drug counts because of the heinousness of this

situation.

In Atlanta, GA, the defendant created false birth certificates in

order to obtain four different Section 8 subsidized apartments

under fictitious names in Tennessee and Georgia. In addition, she

received food stamps and welfare in each of the units. The loss to

the government was over $15,000. This was one of the situations

where we worked with the Department of Agriculture IG and the

HHS IG.

Then in Broward County, FL, 35 individuals were prosecuted for

fraudulently obtaining over $300,000 in Section 8 subsidies. The

tenants were Nigerians, or spouses of Nigerians, who were in this

country illegally or whose status had expired. The defendants were

able to create false employers and have their verification of income

forms sent to the post office boxes that they owned or were owned

by Nigerian-owned businesses.

Twelve of the defendants were employees of the Florida Department of Human Rehabilitation Services, HRS, which is a basic

State entity which handles welfare payments in the State of Florida.

Another side to this is, these people were making in the area of

$35,000 to $40,000 per year as salary from the State of Florida. In

addition, they were also receiving food stamps, AFDC, and educational grants that they were not entitled to receive.

There are certain common threads that run through these prosecutable-type cases. A subject who is a city, State, or Federal employee will spark the interest of an Assistant United States Attorney. A subject who is defrauding other government programs, like

food stamps or AFDC, likewise is seen as a good target. Another

good subject would be a drug dealer, obviously.

Of course, there are some whose actions are so flagrant that a

jury would not hesitate to convict: for example, a subject who owns

several rental houses, yet still claims Section 8 assistance.

55

Another important aspect of this case is the deterrent value prosecution will bring. For example, if there is some notoriety attached

to the case, the media will run a story which has a positive impact

on making an applicant think twice about lying. These are all

things that we consider before opening an investigation.

We continue to receive allegations from a number of sources, and

as I said, undertake approximately five investigations per year.

Over the 9-plus years I have been in Atlanta, I have seen the same

type of allegations occur and recur, understating income or failing

to report jobs for the purpose of receiving a subsidized unit or a

larger subsidy from HUD.

As both resources and prosecutorial appeal exist, we investigate

the most egregious cases. Any remaining allegations are referred to

the Housing Authority and/or HUD program staff for administrative action, as appropriate.

Mr. Chairman, that concludes my remarks. I would be happy to

answer any questions following the testimony.

Mr. SUNUNU. Thank you very much, Mr. Schuster.

[The prepared statement of Mr. Schuster follows:]

PREPARED STATEMENT OF EMIL J. SCHUSTER, SPECIAL AGENT IN CHARGE, DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT, OFFICE OF THE INSPECTOR GEN- ERAL, SOUTHEAST/CARIBBEAN DISTRICT

Chairman Sununu and members of the Housing and Infrastructure Task Force,

I appreciate the opportunity to appear before you today to provide insight on the

investigation of tenant fraud as it relates to the Department of Housing and Urban

Development, Office of Inspector General. I ask that my full written statement be

included in the record.

My knowledge of this issue is based on the 91⁄2 years I have been the Special

Agent in Charge of the HUD Office of Inspector General, Office of Investigations

Southeast/Caribbean District in Atlanta, GA. We, like many in the IG community,

have limited resources. Because of that it is essential to set strict priorities on their

use.

These priorities are affected in large measure by the Prosecutorial guidelines set

by the various U.S. Attorneys. There is generally a minimum dollar threshold on

fraud schemes for each judicial district. It may range from $10,000 to as much as

$100,000. In addition, jurisdictions have different priorities—Miami’s are not the

same as Memphis. Nonetheless, there are deviations from these minimums when

circumstances are so heinous that criminal prosecution is called for. Because of

these limitations our investigations leading to the prosecution of tenant fraud in the

Southeast District has averaged approximately five cases per year.

To further clarify our addressing of tenant fraud, I would like to use an interview

question I pose to recent college graduates who are applying for Special Agent positions in our office. I explain to the person that a complaint is received and that a

Section 8 tenant identified as Mary Doe is defrauding HUD by not disclosing income

that she is receiving from a part time job. You conduct an investigation and find

the following: Mary Doe has been working part time at McDonalds for the past year.

She has three elementary school children. From interviews it appears she is simply

trying to earn some extra money to buy new school clothes, shoes, etc., for her children. She has not disclosed this additional income and thereby has defrauded HUD

out of $1,000.00 this past year. How do you handle this? The answer that I look

for is that this is not a prosecutable criminal case. Rather this is the type of situation that we refer back to the Housing Authority and/or HUD program office recommending that they take appropriate action.

The purpose of this question is to show that not every fraudulent act warrants

criminal prosecution. Judgment is needed, especially with limited resources.

Now having identified the type case that would generally not be pursued, I would

like to describe several specific cases where we have undertaken investigations,

alone or with other law enforcement agencies, that have led to successful prosecutions. The reasons, I believe, are quite evident.

Nashville, TN—Evelyn Haggen Hodgins an IRS employee, was prosecuted for falsifying her income in order to obtain Section 8 rental assistance. Ms. Hodgins had

56

failed to report the income she earned from the IRS. Her fraud resulted in a loss

to HUD of over $15,000.

Memphis, TN—A Memphis Housing Authority employee Donna Dillihunt, conspired with a Shelby County Corrections Officer Pamela Allen to create a fictitious

Section 8 landlord and place a property in the Section 8 program. The Corrections

Officer became the tenant receiving the Section 8 assistance. The officer would receive the Section 8 checks and forge the fictitious owner’s signature. The two de- fendants received over $11,000 in HUD funds.

Campbellsville, KY—During a Safe Home Operation evidence was obtained that

Kelly Lee Shipp and Patricia May Wooley were selling drugs in the Campbellsville

Public Housing Developments. During the investigation it was discovered that Mr.

Shipp was a Section 8 landlord who was renting to Ms. Wooley. Mr. Shipp had

moved in with Ms. Wooley after he had certified that he did not reside there. The

loss to HUD was only $1,070. But due to the other criminal activities of the pair,

the fraud charge was included in their prosecution.

Atlanta, GA—The defendant Marylin Arinzee, created false birth certificates in

order to obtain four different Section 8 subsidized apartments under fictitious

names in Tennessee and Georgia. In addition, she received food stamps and welfare

at each of the units. The loss to the Government was over $15,000.

Broward County, FL—Thirty Five individuals were prosecuted for fraudulently obtaining over $300,000 in Section 8 subsidies. The tenants were Nigerians or the

spouses of Nigerians, who were in this country illegally or whose status had expired.

The Defendants were able to create false employers and have their Verification of

Income forms sent to post office boxes that they owned or were owned by Nigerian

owned businesses. Twelve of the Defendants were employees of the Florida Department of Human Rehabilitation Services (HRS). HRS is the State Agency that administers welfare payments in Florida. In addition, the defendants also received

food stamps, AFDC, and educational grants that they were not entitled to receive.

There are certain common threads that run through these prosecutable type

cases. A subject who is a City, State, or Federal employee will spark the interest

of an Assistant United States Attorney. A subject who is defrauding other Government programs like food stamps or AFDC likewise is seen as a good target. Another

good subject would be a drug dealer. And, of course, there are some whose actions

are so flagrant that a jury would not hesitate to convict. For example, a subject who

owns several rental houses yet still claims Section 8 assistance. Another important

aspect of these cases is the deterrent value prosecution will bring. For example if

there is some notoriety attached to the case the media will run a story which has

a positive impact on making an applicant think twice about lying. These are all

things that we consider before opening an investigation.

We continue to receive allegations from a number of sources and as I said undertake approximately five investigations per year. Over the 9 plus years I have been

in Atlanta I have seen the same type of allegations occur and recur—understating

income or failing to report jobs for the purpose of receiving a subsidized unit or a

larger subsidy from HUD. As both resources and prosecutorial appeal exist, we investigate the most egregious cases. Any remaining allegations are referred to the

Housing Authority and/or HUD program staff for administrative action, as appropriate.

Mr. Chairman, that concludes my remarks, and I would be happy to answer any

questions you may have.

Mr. SUNUNU. Mr. Carolan.

STATEMENT OF RAYMOND A. CAROLAN, SPECIAL AGENT IN

CHARGE, NEW ENGLAND OFFICE OF THE HUD INSPECTOR

GENERAL

Mr. CAROLAN. Good morning, Mr. Chairman, Mr. Bentsen, and

members of the committee. I am pleased to appear before you today

and highlight a few examples of our work in the subsidy fraud

area.

I would ask that my comments be entered into the record.

Mr. SUNUNU. Without objection.

Mr. CAROLAN. Mr. Chairman, I am a career Office of Inspector

General employee. I have been with the Office of Inspector General

for 28 years. I have been the Special Agent in charge of the New

England District for the last 18 years. I believe that my district,

57

New England, was the first to present subsidy fraud cases for prosecution to the United States attorney in the mid-1970’s.

The investigation of these cases today is basically the same as it

was then. The cases usually fall into four major categories: a tenant’s failure to report income or assets; a tenant’s failure to accurately report total family composition, which usually results in an

underreporting of income; conspiracy between tenants and management; and conspiracy involving subsidized tenants and property

owners.

Today, I would like to present especially egregious examples of

subsidy fraud stemming primarily from the last two categories, the

conspiracy ones.

My first example involves a 262-unit fully subsidized cooperative

housing complex in the Charlestown section of the City of Boston.

In cooperative housing, a tenant board of directors oversees all aspects of the property management. In this case, tenants were also

employed by the management company at the site office to administer the annual income recertifications and to oversee all of the

daily operations.

Our investigation revealed widespread fraud and conspiracy between some of the tenants and the management office employees.

It also included the board members. The widespread fraud at this

complex required the cooperation of the office staff, members of the

board, in order to perpetuate the scheme.

The investigation indicated that employment verifications that

were supposed to be independent were false and forged. Tenants

and management staff conspired to report half of actual income

and conspired to hide the occupancy of employed family members.

There was a pattern of this. They also conspired to falsify family

composition in order to qualify for larger unit sizes.

An example: Section 8 tenants Barbara and Michael failed to report total family income, resulting in overpayments of approximately $14,000. Michael was related to a project manager. The Section 8 forms failed to accurately reflect Michael’s total income generated from his employment at a hospital, and failed to reflect any

income generated by Barbara, the spouse, through her employment

at the same hospital.

The Section 8 forms for 1988 reflected the total family income as

$9,000, when, in actuality, in 1988 income for the gross wages for

the entire family was over $57,000.

In addition, the Section 8 forms incorrectly listed their family

composition as consisting of Michael, Barbara, and their son, Cory.

When asked by our agents who Cory was, Barbara indicated that

Cory was her dog, that she has no children. She could not explain

how her dog appeared on the Section 8 forms as her child.

Listing a child on the Section 8 forms would entitle the Section

8 tenants to a deduction which is formulated into the total rent calculation. In addition, the bedroom size allocated to a Section 8 tenant family is based upon total family composition. In this case, the

family qualified for a two-bedroom apartment. There were a lot of

these cases at this particular site, where families were overhoused

as a result of falsification of family composition.

Once these schemes were crafted, the employment verification

forms were falsified and formed in order to fit each scheme. There

58

was a pattern of this particular type of fraudulent activity at varying levels for many of the tenants at this complex.

When we attempted to verify the accuracy of their employment

forms, the employees reported that the income information was inaccurate and that the signatures were all forged. The investigation

involved the use of Federal grand juries and Federal search warrants.

Twenty-two tenants at the site, including four board members,

were federally indicted for false statements, conspiracies, and other

related charges. All defendants either pled or were found guilty in

1993. Monetary losses representing subsidy overpayments related

to these indictments were approximately $245,000.

Following our investigation, the management company was re- quired to repay HUD over $366,000, and was removed. A new management company was required to recertify all residents at this

complex. This company’s recertification process resulted in a $400,000 annual reduction in Section 8 subsidies the next year.

My second example involves a conspiracy between a property

owner and a subsidized tenant. This case was not prosecuted due

to evidence and statute of limitations issues. It is, however, I believe a good example of this type of scheme.

Our investigation indicated that a property owner transferred

ownership of a single-family property to a straw buyer just prior

to the application to the Public Housing Authority for participation

in the Section 8 program. What he did was reversed his role from

a property owner to a tenant.

From 1981 to 1995, subsidy was paid to the straw buyer in the amount of over $74,000. The scheme was disclosed when IRS began

to investigate the straw buyer for failure to report rental income

from the property to the IRS. What happened was the IRS received

a 1099 from the Housing Authority disclosing rental income to that

straw buyer.

In response to the IRS, the straw buyer stated that her ownership of the subsidized property was ‘‘in name only,’’ that the rental

income reflected on the form 1099 ‘‘was arranged’’ without her

knowledge and was sent in—these payments were sent by the

Housing Authority, the Public Housing Authority, to a post office

box rented in her name without her knowledge.

Furthermore, she stated that the subsidy checks were also

cashed without her knowledge or her endorsement on the checks.

An administrative process to recoup this overpaid subsidy is ongoing.

So even though this case was not prosecuted for various reasons,

the administrative process is ongoing, and I heard recently that

what this straw buyer is doing is turning the deed back to the

Housing Authority for that property, so the Housing Authority will

be the owner, in an attempt to recoup the $74,000.

Some other examples that parallel income issues. An investigation was initiated to determine whether Jose and Rose, public

housing tenants in Manchester, NH, failed to report their income.

This was a joint investigation with the Social Security Administration Office of Inspector General.

The only income claimed on their public housing applications was

Social Security and SSI, disability benefits. Both Rosa and Jose

59

worked at a variety of jobs during the period of overpayment,

which was July, 1995, to November, 1996. None of this income was

reported on the applications.

Jose was indicted on December 9, 1998, on four counts of making

false statements, three to HUD and one to the Social Security Administration, and two counts of misusing Social Security numbers.

Jose pled guilty. A Federal judge sentenced him on June 30, 1999,

to time served, which was 6 months. He got 3 years probation and

an assessment of $200, and was ordered to make repayments in

the form of restitution in the amount of $25,000.

In another case, this particular Section 8 tenant received Section

8 assistance in Lynn and Lexington, MA, from January 1987 until

August 1998. During the period, they only claimed benefits received from Aid to Families with Dependent Children. They also

held occasional part-time jobs.

Penny, using another name and another Social Security number

of a deceased uncle, worked at a computer company from December, 1989, to July 1989, and did not report this income. On September 13, 1999, a criminal complaint was filed in U.S. District Court

in Massachusetts, charging Penny with violating 18 U.S.C. 641,

conversion of government funds.

On January 5, 2000, Penny waived her right to indictment and

pled guilty to one count, information. The Federal district judge

sentenced Penny to 6 months’ confinement in a halfway house, 2

years’ probation, a $100 special assessment, and $37,000 in restitution to the Federal Government.

Mr. Chairman, that concludes my remarks. I would be pleased

to answer any questions you may have following the other

witnesses’s testimony.

Mr. SUNUNU. Thank you very much, Mr. Carolan.

[The prepared statement of Mr. Carolan follows:]

PREPARED STATEMENT OF RAYMOND A. CAROLAN, SPECIAL AGENT IN CHARGE, DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT, OFFICE OF THE INSPECTOR

GENERAL, NEW ENGLAND DISTRICT

Mr. Chairman and members of the committee. I am pleased to appear before you

today to highlight a few examples of our work in the subsidy fraud area. I am a

career Office of the Inspector General employee with over 28 years of service. I have

been the Special Agent in Charge of the New England District for the last 18 years.

I believe that my District was the first to present subsidy fraud cases for prosecution to the United States Attorney in the mid 1970’s. The investigation of these

cases today is basically the same as it was then. The cases usually fall into four

major categories:

• Tenants failure to report income and/or assets.

• Tenants failure to accurately report total family composition resulting in understated total family income.

• Conspiracy between tenants and management.

• Conspiracy involving a subsidized tenant and a property owner.

Today I would like to present especially egregious examples of subsidy fraud

stemming primarily from the last two categories.

CONSPIRACY BETWEEN TENANTS AND MANAGEMENT

My first example involves a 262 unit, fully subsidized. cooperative housing complex in the Charlestown section of the City of Boston. In cooperative housing, a tenant Board of Directors oversees all aspects of the property management. In this

case, tenants were also employed by the management company at the site office to

administer the annual income recertifications and to supervise daily operations.

Our investigation revealed widespread fraud and conspiracy between the tenants

and the management office employees.

60

The widespread fraud at this complex required the cooperation of the office staff

and members of the tenant Board of Directors in order to perpetuate the scheme.

The investigation indicated that employment verifications that were supposed to be

independent were falsified and forged.

Tenants and management staff conspired to report half of actual income and conspired to ‘‘hide’’ the occupancy of employed family members. They also conspired to

falsify family composition in order to qualify for larger unit sizes:

Section 8 tenants, Barbara and Michael failed to report total family income result- ing in an overpayment of $14,506. Michael was related to a project manager. The

Section 8 forms failed to accurately reflect Michael’s total income generated from

employment at a hospital and failed to reflect any income generated by Barbara

through her employment at the same hospital. The Section 8 forms for 1988 reflected the total family income as $9,073, when in actuality, the 1988 income for

gross wages was $57,785.92. In addition, the Section 8 forms incorrectly listed their

family composition as consisting of Michael, Barbara and their son, Cory. When

asked by the agents who Cory was, Barbara indicated that Cory was her dog, that

she has no children. She could not explain how her dog appeared on the Section

8 forms as her child. Listing a child on the Section 8 forms entitles the Section 8

tenants to a deduction which is formulated into their total tenant rent payment calculation. In addition, the bedroom size allotted to a Section 8 family is based upon

total family composition. In this case, the family qualified for a two bedroom apartment.

Once the schemes were crafted, the employment verification forms were falsified

and forged in the management office in order to fit each scheme. There was a pattern of this particular type of fraudulent activity at varying levels for many of the

tenants at the complex.

When we attempted to verify the accuracy of the forms, the employers reported

that the income information was inaccurate and that the signatures were forged.

The investigation involved the use of the Federal Grand Jury and Federal Search

Warrants. Twenty two tenants, including four board members, were federally indicted for false statements, conspiracy and other related charges. All defendants either plead or were found guilty in 1993. Monetary losses representing subsidy overpayments, related to the indictments, were approximately $245,000.

Following the OIG investigation, the management company was required to repay

HUD over $366,000 and was removed by HUD. A new management company was

required to recertify all residents. This company’s recertification process resulted in

a $400,000 annual reduction in Section 8 subsidies.

CONSPIRACY BETWEEN TENANT AND PROPERTY OWNER

My second example involves a conspiracy between a property owner and a subsidized tenant. This case was not prosecuted due to evidence and statute of limitations issues. It is however a good example of this type of scheme.

Our investigation indicated that a property owner transferred ownership of his

single family property to a straw buyer just prior to the application to the public

housing authority (PHA) for participation in the Section 8 program.

From 1981—1995 subsidy was paid to the straw buyer in the amount of $74,508.

The scheme was disclosed when the IRS began to investigate the straw buyer for

failure to report rental income from the property to the IRS. The IRS had received

a Form 1099 from the PHA disclosing payment of this rental income to the straw

buyer.

In a response to the IRS, the straw buyer stated that her ownership of the subsidized property was ‘‘in name only′′; that the rental income reflected on the Form

1099 was ‘‘arranged’’ without her knowledge and was sent by the PHA to a post office box rented in her name without her knowledge. Furthermore she stated that

the subsidy checks were cashed without her knowledge or endorsement. An administrative process to recoup the overpaid subsidy is ongoing.

OTHER EXAMPLES

An investigation was initiated to determine whether Jose and Rosa, Public Housing Tenants, Manchester, NH, failed to report their income. This was a joint investigation with the Social Security Administration, Office of Inspector General. The

only income claimed on their public housing applications was SS/SSI. Both Rosa and

Jose worked at a variety of jobs during the period of overpayment, July 1, 1995 to

November 26, 1996, and none of this income was reported on their public housing

applications.

Jose was indicted on December 9, 1998 on four counts of making false statements

(18 USC 1001; 3 related to SSA and 1 to HUD) and two counts of misusing Social

61

Security numbers (42 USC 408, SSA violation). Jose plead guilty to counts 1

(18USC1001 re: SSA) and 4 (18USC1001 re: HUD) and the other four counts were

dismissed. A Federal judge sentenced him on June 30, 1999 to time served (6

months), 3 years probation, an assessment of $200, and restitution of $25,906.33

($18,650.33 to SSA and $7,256 to HUD)

Penelope, a/k/a Penny, received Section 8 assistance in Lynn and Lexington, MA,

from January 1987 until August 1998 and during that period of time Penny only

claimed benefits received from Aid to Families with Dependent Children and/or an

occasional part time job. Penny, using another name and a SSN of her deceased

uncle, worked at a computer company from December 1989 until July 1998 and did

not report this income on her Section 8 applications.

On September 13, 1999 a Criminal Complaint was filed in U.S. District Court,

District of Massachusetts charging Penny with violating 18USC641, Conversion of

Government Funds. On January 5, 2000 Penny waived her right to indictment and

plead guilty to a one count Information charging her with violating 18USC641. On

April 10, 2000 a U.S.

District Judge sentenced Penny to 6 months confinement in a halfway house, 2 years probation, $100 special assessment, and $37,709 in restitution.

Mr. Chairman, that concludes my remarks, and I would be pleased to answer any

questions you may have.

Mr. SUNUNU. At this time, I would like to ask Ms. Crowley and

Mr. Ramirez to please have a seat at the witness table.

Mr. Bentsen.

Mr. BENTSEN. Mr. Chairman, I misspoke. Secretary Ramirez was

the mayor of Laredo, not the county judge of Webb County. I apologize for that. I have found, as you have probably found, that the

mayor of a city is the most powerful individual you can meet. So

I want to make sure I got that right.

Mr. RAMIREZ. That is OK.

Mr. SUNUNU. I appreciate Mr. Ramirez’ sacrifice, giving up that

power for a little bit of public service, and obviously serving the

needs of those looking for decent, affordable housing.

At this time, I would be happy to yield to Mr. Ramirez for his

testimony for any time that he may require.

STATEMENT OF SAUL N. RAMIREZ, JR., DEPUTY SECRETARY,

U.S. DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT

Mr. RAMIREZ. Thank you very much, Mr. Chairman, and Ranking Member Bentsen, as well as other members of the committee.

I would like to submit my written testimony and its exhibits for the

record, and provide you with just a summary of the key points of

my testimony to move on to the question-and-answer period, if I

may, Mr. Chairman.

First, let me say that it is historic for us at the Department to

be able to deal with an issue such as tenant income verification.

Let me just clear up a point. It is not just Section 8 that we are

talking about when we are talking about tenant income verification; that we are actually talking about 4.5 million families that include residents of public housing, as well, and not just Section 8

subsidized housing.

What we have done is, we have a tool for assisting the Department in furthering our goal of targeting rental assistance only to

eligible families and ensuring that each family pays the correct

amount of rent. But we cannot act alone; both tenants and our

partners who provide the housing have a direct responsibility for

correcting and actually correctly determining the rental assistance,

and HUD’s new income verification program does not alter those

roles.

62

The complexities associated with providing eligible individuals

with the correct level of rental assistance are numerous. Legislation over the last couple of years has given different POAs, or private owners and agents, such as Housing Authorities, different

types of wide discretion, or discretion in the delivery of rental assistance and recovery of excess rental assistance.

The differences include varied recertification policies, exclusion of

specific income from rent determination calculations, the establishment of ceiling rents, and the adoption of diverse recovery policies.

Until now, the Department’s past efforts to enhance the effectiveness of POAs, efforts to ensure that low-income eligible families receive the correct level of rental assistance, have been limited. However, the Department is now implementing a large-scale computermatching income verification program to dramatically enhance the

information our partners need to fulfill their income verification responsibilities.

HUD has matched tenant-reported income with Federal tax information, and has identified approximately 230,000 tenants who

have underreported income. At this very moment, letters are being

sent to these tenants and notifications are being sent to the POAs.

HUD has worked with the tenant groups, as well as industry

groups, to obtain the highest level of support for this initiative.

Also, in the interests of fairness to all parties, the Department

is also addressing the overreporting of income, and will be mailing

letters as part of this initiative in the near future to tenants who

might not have received all the assistance to which they were entitled.

HUD’s new large-scale computer-matching program achieves the

delicate balance between the needs of tenants, including tenants’ rights to privacy and due process, the responsibilities and work

loads of our private owners and agents that are partners out there,

and the ultimate goal of allocating scarce resources to eligible tenants at correct levels of rental assistance.

For several years, staff from OIG have conducted a sample of

1,000 households to estimate excess rental assistance. These estimates have ranged from—anywhere between $417 million and

$935 million.

There are many reasons why this excess rental assistance cannot

be fully recovered by HUD. Perhaps many tenants who have underreported their income will leave once they are identified, before any

back rents can be collected. Recovery costs can be excessive and

often fall way short of any rental assistance that could be received.

Administrative costs paid by the POAs associated with tracking recoveries reduce the amount of any potential to us in the long run.

Moreover, when a tenant vacates after underreporting of income

is identified, the tenant typically is replaced by another eligible

family requiring assistance. And, of course, we endorse the goal of

targeting rental assistance only to eligible families. However, we

must point out that in cases like this, when an eligible family replaces an ineligible family, the net amount of rental assistance may

not decline and may even increase. This is one reason why our program focuses on setting current rents correctly to prevent future

abuses before they happen, when it is much more difficult for us

to actually go out and collect after the abuses have occurred.

63

Through the use of our large-scale computer-matching income

verification process, HUD is providing our partners, the private

owners and agents, with an additional tool to help identify tenants

responsible for program abuses.

In this first year of large-scale computer-matching income verification, HUD is seeking to establish a baseline by which to measure the private owners’ and agents’ income verification efficiency

and effectiveness at the level at which the tenant program abuses

can be better detected and better deterred.

With that, I would like to conclude by saying that our efforts to

further enhance our abilities to create a more on-time system of

verifying could probably be strengthened by seeking a stronger

partnership with the Department of Health and Human Services

quarterly new-hire reports, so that both the POAs and HUD can

better track incomes, but that would certainly take some help on

your part with additional legislation.

That concludes my summary of my written testimony, Mr. Chairman. I am prepared to answer any questions when we are done.

Mr. SUNUNU. Thank you very much, Mr. Ramirez.

[The prepared statement of Mr. Ramirez follows:]

PREPARED STATEMENT OF SAUL N. RAMIREZ, DEPUTY SECRETARY, U.S. DEPARTMENT

OF HOUSING AND URBAN DEVELOPMENT

Thank you for allowing us this opportunity to testify on the Department’s computer matching income verification efforts. For the first time in the history of public

housing, we have a tool for assisting the department in furthering its goal of targeting rental assistance only to eligible families and ensuring that each family pays

the correct amount of rent.

The Department acknowledges that more could be done to assure only eligible low

income tenants receive HUD rental assistance and to assure that all tenants pay

their fair share of rent as required by statute. We are aware—indeed we have estimated—the size of possible under-reporting of income. And, we are moving to do

more by implementing an income verification program under the authorities given

us by the Congress.

We are confident that our computer matching income verification efforts will improve the targeting of our scarce rental subsidy dollars, make the administration

of these programs more fair, and bring in additional resources to offset the cost of

reaching more of the 5.4 million low-income families who have severe housing

needs.

The complexities associated with providing eligible individuals with the correct

level of rental assistance are numerous. First, we cannot act alone in this area. As

you know, HUD has no direct relationship with the tenants who benefit from our

programs. Rather, both tenants and our partners who provide the housing each

have a direct responsibility for correctly determining the rental assistance. Tenants

must accurately and completely report their income to their housing managers—the

Public Housing Authorities and private owners, and agents who administer our

rental assistance programs. In turn, the housing providers have ultimate responsibility for verifying tenant incomes and setting the rents correctly. Our new computer matching tool is designed to dramatically improve the information our partners need to fulfill their income verification responsibilities.

In addition, comparing IRS or Social Security data with the income reported by

tenants is not a straightforward calculation. Great care must be taken in drawing

conclusions from the matching process because there are many reasons that IRS

data, for example, might indicate that an improper underpayment is occurring

when, in fact, it is not. Legislation over the years has given different housing providers wide discretion or varying directions in how they set rents, calculate tenant

contributions and go about recovering excess rental assistance. These differences include exclusion of specific types of income from rent determination calculations and

the establishment of rent ceilings that do not go up with increases in household income. Recent legislation has added additional variables in the form of longer intervals between recertifications for tenants under some of the Department’s programs

64

which means that increases in a tenant’s income may not be captured in a timely

manner by the recertification process.

Frankly, until now the Department’s past efforts to enhance the effectiveness of

POAs’ (Private Owner or Agent) efforts to ensure that low income-eligible families

receive the correct level of rental assistance have been limited. Beginning in the

mid-1980’s and continuing until 1992, the Department performed several narrow

matches of tenant-reported income with tenant income supplied by State wage agencies and the Office of Personnel Management to identify under-reported income and

excess rental assistance. The Omnibus Budget Reconciliation Act of 1993 allowed

the Department to expand its computer matching efforts to include Federal tax information provided by the Internal Revenue Service and the Social Security Administration. There are a number of laws and other requirements to adequately safe

guard the privacy of this sensitive data, for example Section 6103 of the Internal

Revenue Code (IRC) and the Computer Matching and Privacy Protection Act of

1988. HUD and its partners have worked diligently on these issues and continue

to work on ensuring that this sensitive data remains protected. The Department

used that new authority to complete computer matching initiatives focused on individual POAs and on sampling the universe of subsidized tenants to estimate overpaid rental assistance. This sampling was conducted by HUD’s Office of the Inspector General with the goal of quantifying under-reported income for financial statement purposes.

The Department is now implementing a large-scale computer matching income

verification program. HUD has matched tenant-report income with Federal tax information and has identified approximately 230,000 tenants who under-reported income at some fairly large thresholds levels set by the Department for this initial

effort. At this very moment, letters are being sent to those tenants and notifications

are being sent to all our housing authorities and landlords requesting that tenants

resolve the potential discrepancies we have identified through our income-matching

program. The letters to the housing providers do not disclose any income data regarding tenants, but only advise the housing provider to recertify the income of

these particular tenants.

HUD has worked diligently with tenant and industry groups to obtain the highest

level of support for this initiative. For example, we conducted two training sessions

for our partners and stakeholders, soon to be followed by a third. We developed an

online guide to help our housing providers in processing and resolving income discrepancies, and we established two call centers to handle both housing provider and

tenant inquiries. We are also including a fact sheet on the income verification program with all mis-match letters that are being sent to tenants.

In the interest of fairness to all parties, the Department is also addressing overreporting of income and will soon be mailing letters as part of this initiative in the

near future to tenants who might not have received all of the assistance to which

they were entitled.

This large-scale computer matching program achieves the delicate balance between the needs of tenants, including tenants’ rights to privacy and due process, the

responsibilities and workload of housing providers, the responsibility to assure fairness among all tenants by assuring that each pays his/her proper amount as require

by statute, and the ultimate goal of allocating scarce resources to eligible tenants

at correct levels of rental assistance. HUD is undertaking these efforts because of

statutory requirements and because it is the right thing to do. It is important to

recognize, however, that this income verification efforts is primarily designed to improve voluntary compliance by providing reasonable assurance that tenants pay the

proper amount in the future. We do not expect a large windfall from collections of

past underpayments, Indeed, we ask POAs to be work with tenants on an prudent

payment plan as appropriate that does not overwhelm their finances.

For many years now, the Department’s financial statement has reflected an estimate that tenant underpayments total some $900 million. I think it is important

to advise the Committee that this number is a gross estimate of underpayments and

not a net amount that could be collected through tenant income verification efforts.

For several years, staff conducted a sample of 1,000 households to estimate excess

rental assistance. These estimates were developed under specific parameters and assumptions with numerous qualifying statements and have a wide statistical range

$417 million and $935 million. It is extremely important to note that these are estimates of total excess rental assistance if all tenants reported income on a retrospective basis. It is not a total of recoverable excess rental assistance. Nor are they estimates of achievable departmental savings.

There are many reasons excess rental assistance cannot be fully recovered by

HUD. First of all, our experience with a pilot income verification program indicates

that approximately 30 percent of tenants who have under-reported their income will

65

leave once they are identified before any back rents or future higher rents can be

collected. In accordance with recent statutory changes, these tenants will be replaced by eligble households who are predominately very low-income households

with the end result probably being little or no significant increased returns to the

housing provider. Indeed, in such instances, the rents being paid to the provider for

that unit may decrease. Our experience also suggests that even where a tenant

agrees to pay off back rent owed, the average length of the agreed-upon payment

plan is between 5 and 7 years. Given these circumstances, we do not expect big dollar returns to result from back rent collections under the income verification effort.

Second, while HUD has advised housing providers to pursue cases of blatant

fraud, the recovery costs for the run-of-the-mill tenant underpayment can be excessive, and often far exceed any rental assistance that could be recovered. These include direct costs associated with verifying excess rental assistance and recovering

funds through the legal system and administrative costs associated tracking recoveries. Businesses associated with debt collection have often cited 20 percent as a

reasonable estimate of debt recovery, and recent experience with tenant income verification efforts around the country have been consistent with this benchmark. For

example, in a recent computer matching initiative, the Dallas Housing Authority

identified 95 tenants who received excess rental assistance totaling $350,000. The

housing authority was able to establish repayment agreements with only 17 of these

tenants. The repayment agreements totaled $80,000, or about 20 percent. The $900

million figure makes no attempt to calculate these costs of collection.

For all of these reasons—tenant move-outs, high administrative costs, the administrative payments to our partners—the amount of ‘‘excess’’ assistance paid to tenants cannot be easily recaptured by HUD. We believe that more is gained by looking

forward than back. In the case of the Dallas Housing Authority, the agency terminated rental assistance to 42 of the 95 tenants who under-reported their incomes—

freeing up units for eligible families. Through the use of large-scale computer

matching income verification, HUD is providing housing providers with an additional tool to help identify tenants responsible for program abuses. In this first year

of large-scale computer matching income verification, HUD is seeking to establish

a baseline by which to measure housing provider’s income verification effectiveness

and the level of tenant program abuses. This information will allow HUD to effectively target its future enforcement and monitoring efforts to those areas where the

problem is most acute.

HUD continues to work to improve its income verification program. The Department needs your support to better serve the needs of those eligible to receive rental

assistance.

Mr. SUNUNU. Ms. Crowley, welcome. Thank you for being here.

I am pleased to yield to you, for testimony, whatever time you

might need.

Ms. CROWLEY. Thank you.

STATEMENT OF SHEILA CROWLEY, PRESIDENT, NATIONAL

LOW–INCOME HOUSING COALITION

Mr. Sununu, Mr. Bentsen, I am very pleased to be here. I would

like to submit my written testimony and attachments for the

Record.

Mr. SUNUNU. Without objection.

Ms. CROWLEY. I am Sheila Crowley, the President of the National Low Income Housing Coalition. We are a membership organization. We represent individuals and organizations around the

country that are committed to ending the affordable housing crisis

and assuring decent housing and healthy neighborhoods for everyone.

Our members include nonprofit housing providers, homeless

service providers, fair housing groups, State and local housing coalitions, public housing agencies, private developers and private

owners, housing researchers, local and State government agencies,

faith-based organizations, and residents and their organizations.

66

So on behalf of all our members, thank you for the opportunity

to offer our perspective on the income verification issue and how

it fits into the broader picture of housing affordability and the Federal response to the affordable housing crisis.

We have worked closely over the last 2 months with our partner

resident organizations and HUD officials to shape the implementation of the income verification program in a manner that will

achieve the objective of assuring that scarce housing assistance is

used to help as many eligible families and individuals as possible,

while preventing unwarranted panic and housing destabilization

for thousands of public and assisted housing residents who have

done nothing wrong.

Everyone, all of us, agree that people who fraudulently misreport

their income in order to accrue more Federal benefits than that to

which they are entitled should not be allowed to get away with it.

As someone who is acutely aware of the severe limits of housing

choices for poor Americans, I make no excuses for people who deliberately deprive others of badly needed housing assistance.

However, we believe that a substantial percent of the discrepancy between the rent certifications and the tax returns that have

been identified in the IG’s report have occurred for one of a number

of legal and legitimate reasons or as the result of honest mistakes,

or are rooted in errors made by Housing Authorities or private

owners.

It is wrong to jump to the conclusion that lots of poor people are

ripping off the system. The list of possible explanations for socalled ‘‘false positives,’’ that is, leaseholders with legitimate discrepancies, is extensive. Mr. Ramirez has reviewed some of those.

Indeed, Congress has authorized many explanations for this discrepancy in order to reduce the disincentives for work that have

been a problem in Federal housing programs. Further, if there are

inaccuracies in how a tenant’s share of rent is calculated that results in overpayment by the Federal Government, there are also

many cases where residents are making overpayments.

As I understand it, the amount of resident overpayment has not

yet been determined, so a true picture of what the overpayment

problem is will emerge once both the false positives and the tenant

overpayment are factored into the equation.

The concern of residents and their advocacy partners was that

HUD’s initial plan for implementation of the income verification

program had the effect of accusing many innocent people of wrongdoing and then requiring them to prove otherwise. While there are

some lingering concerns, I am happy to report that it is very accurate that HUD leadership has been very responsive to the issues

raised by residents, and the income verification program has undergone significant improvements as a result.

The negotiations have necessarily slowed down the program, but

we believe that taking the time to do it right is the right thing to

do.

We want to solve the income discrepancy problem and eliminate

the income discrepancy issue as an argument that has been raised

against increased funding for housing assistance. Solving the problem in a way that causes precipitous harm to low-income residents

for no valid reason is counterproductive and simply wrong.

67

It is equally wrong for Congress to use this income discrepancy

analysis as justification for failing to address serious housing affordability problems. So I want to put this problem into perspective.

The widely accepted standard in the housing industry is that

housing should cost no more than 30 percent of household income.

Our analysis shows that in 1997 10.8 million very low-income

households, that is, households with incomes at less than 50 percent of the area median, paid over half of their income for their

housing. This is nearly 11 percent of all households in the United

States. That includes 8.4 million renters and 2.4 million homeowners.

A more vivid illustration of the depth and breadth of the housing

affordability crisis is our analysis of housing costs in comparison to

wages in every jurisdiction in the country. We can say with assurance that nowhere in the country can a full-time minimum-wage

worker afford the fair market rent for a two-bedroom rental unit.

Nowhere.

The housing wage which we calculate, that is, the hourly wage

one needs on a full-time basis to afford basic rental housing, ranges

from $8.02 in West Virginia to $17.10 in Hawaii. In the Manchester, New Hampshire, metropolitan statistical area, for example, 44 percent of renter households cannot afford the two-bedroom

fair market rent, and the housing wage is $13.20 an hour. One

hundred and 2 hours of minimum wage work a week is required

to afford the fair market rent in the Manchester SMA.

In the Houston SMA, 40 percent of the renters cannot afford the fair market rent. The housing wage is $11.56 an hour, and one

must work 90 hours at the minimum wage in order to afford the

fair market rent.

I have attached to my written testimony analysis of the housing

costs and income gaps in the States that are represented by all the

members of the Task Force for your review. The numbers are

stark, but what does it mean to be a low-income family and have

a severe housing cost burden?

One or more of the following happens: The family pays a precariously high percentage of its income for its housing, and then must

scrimp on other necessities, like food or medicine; or adults in the

family work two or three or more low-wage jobs and have precious

little time left over to devote to family and parenting duties; or

they are forced into substandard or overcrowded housing, paying

rent to unscrupulous landlords who can take advantage of the severe housing shortage that poor people experience; or they simply

cannot pay the rent, are threatened with eviction, gain poor credit

records, and in some cases, spiral down into homelessness.

We are increasingly aware that the high rate of mobility among

poor families, driven in large part by staying on the move to stay

a step ahead of the eviction server, contributes to poor school performance by children who drift from one school to another and just

never catch up. In the age of standardized tests as the primary indicator of academic achievement, these kids do not have a chance

at success.

We all tacitly understand the centrality of stable housing in our

ability to do our jobs and raise our families. If we ponder even for

68

a moment how we would cope if maintaining our housing was a

daily struggle, we could easily understand the human dimensions

of the affordable housing crisis.

We know that receipt of Federal housing assistance contributes

to housing stability for formerly homeless families and is associated

with success at moving from welfare to work. It is a good investment in American families.

Federal expenditures on low-income housing are woefully inadequate in the face of this challenge, and when examined in comparison—and this is an analysis the National Low Income Housing

Coalition has done for some time—when we examine this in comparison to Federal expenditures to subsidize the housing of middleand upper-income households, the lack of investment in low-income

housing becomes more apparent.

In 1997, assisted housing outlays were $26 billion, while housing

tax expenditures, mostly mortgage interest deductions and property tax deductions, were $97 billion. In constant 2000 dollars, the

tax expenditure level will go to $123 billion by 2005. It is going to

take much more than fine tuning the existing low-income housing

programs, which we must continue to do, to seriously make a dent

in this program.

The good news is that we know how to solve the affordable housing crisis. It is not rocket science. We have a thriving, mission-driven, community-based, nonprofit housing sector that is only increasing in its capacity to provide safe, decent, and affordable housing.

We believe strongly that the resources exist to intervene at the

scale needed to make a difference. What we need now is creative

and visionary leadership.

Thank you for your consideration of my remarks. I will be happy

to answer any questions.

Mr. SUNUNU. Thank you very much, Ms. Crowley.

[The prepared statement of Ms. Crowley follows:]

PREPARED STATEMENT OF SHEILA CROWLEY, PRESIDENT, NATIONAL LOW-INCOME

HOUSING COALITION

Mr. Sununu and Mr. Bentsen, I am Sheila Crowley, President of the National

Low Income Housing Coalition. I would like to submit my written testimony and

attachments for the record.

The National Low Income Housing Coalition is a membership organization representing individuals and organizations that are committed to ending the affordable

housing crisis in America and to assuring decent housing in healthy neighborhoods

for everyone. Our members include non-profit housing providers, homeless service

providers, fair housing organizations, state and local housing coalitions, public housing agencies, private developers and property owners, housing researchers, local and

state government agencies, faith-based organizations, and residents of public and

assisted housing and their organizations. On behalf of our membership, I thank you

for the opportunity to offer our perspective on the income verification issue and how

it fits into the broader picture of housing affordability and the Federal response to

the affordable housing crisis.

We have worked closely over the last 2 months with our partner resident organizations and HUD officials to shape the implementation of the income verification

program in a manner that will achieve the objective of assuring that scarce housing

assistance is used to help as many eligible families and individuals as possible,

while preventing unwarranted panic and housing destabilization for thousands of

public and assisted housing residents who have done nothing wrong.

Everyone agrees that people who fraudulently misreport their income in order to

accrue more Federal subsidy than that to which they are entitled should not be allowed to get away with it. As someone who is acutely aware of the severe limits

69

of housing choices of very poor Americans, I make no excuses for people who deliberate deprive others of badly needed housing assistance.

However, we believe that a substantial percent of the discrepancy between rent

certifications and tax returns that is identified in the Inspector General’s report has

occurred for one of a number of legal and legitimate reasons or is the result of honest mistakes or is rooted in errors on the part of housing authorities or property

owners. It is wrong to jump to the conclusion that poor people are ripping off the

system. The list of possible explanations for so-called ‘‘false positives,’’ that is, leaseholders with legitimate discrepancies, is extensive. Indeed, Congress has authorized

many explanations for the discrepancy to reduce the disincentives for work that

have been a problem in Federal housing policy. Further, if there are inaccuracies

in how tenant share of rent is calculated that results in overpayment by the Federal

Government, there also are cases where residents are making overpayments. As I

understand it, that amount has not yet been determined. A truer picture of the Federal overpayment problem will emerge once both the ‘‘false positives’’ and tenant

overpayments are factored into the equation.

The concern of residents and their advocacy partners was that HUD’s initial plan

for implementation of the Income Verification Program had the effect of accusing

many innocent people of wrongdoing and then requiring them to prove otherwise.

While there are some lingering concerns, it is accurate to say that HUD leadership

has been responsive to issues raised by residents and the income verification program has undergone significant improvements as a result. The negotiations have

slowed down the program, but we believe that taking the time to do it right is the

right thing to do and is well worth the effort.

We want to solve the income discrepancy problem and eliminate the income discrepancy issue as an argument against increased housing funding. But solving the

problem in a way that causes precipitous harm to low income residents for no valid

reason is counterproductive and simply wrong. It is equally wrong for Congress to

use this income discrepancy analysis as justification for failing to seriously address

the affordable housing crisis of low income Americans. Let’s put this problem into

perspective.

The widely accepted standard in the housing industry is that housing should cost

no more than 30 percent of household income. Our analysis shows that in 1997, 10.8

million very low income households (that is, households with income less than 50

percent of the area median) paid over half of their income for their housing. This

is over 11 percent of all households in the United States and includes 6.4 million

renter households and 4.4 million homeowners.

A more vivid illustration of the depth and breadth of the affordable housing crisis

is our analysis of housing costs in comparison to wages in every jurisdiction in the

country. We can say with assurance that nowhere in the country can a full time

minimum wage worker afford the Fair Market Rent for a two bedroom rental unit.

The housing wage, that is, the hourly wage one needs on a full time basis to afford

basic rental housing, ranges from $8.02 in West Virginia to $17.01 in Hawaii. In

the Manchester, NH, Metropolitan Statistical Area, 44 percent of the renter households cannot afford the two bedroom Fair Market Rent and the housing wage is

$13.02. One hundred and 1 hours of minimum wage work a week is required to afford the Fair Market Rent. In the Houston, TX, MSA, 40 percent of renters cannot

afford the Fair Market Rent, the housing wage is $11.56, and one must work 90

hours a week at minimum wage to afford a basic rental unit. I have attached to

my written testimony analysis of the housing costs and income gap for the states

of each of the members of the Task Force. I also have provided a copy of the complete jurisdiction by jurisdiction analysis for your use.

The numbers are stark. But what does it mean to be a low income family and

have a severe housing cost burden? One or more of the following happens. The family pays a precariously high percentage of its income for its housing and must

scrimp on other necessities like food and medicine. Or the adults in the family work

two, three, or more low wage jobs and have precious little time left over to devote

to family and parenting responsibilities. Or they are forced into substandard or

overcrowded housing, paying rent to unscrupulous landlords who can take advantage of the severe housing shortage affordable for the poor. Or they simply cannot

pay the rent and are threatened with eviction, gain poor credit records, and in some

cases, spiral down into homelessness.

We are increasingly aware that the high rate of mobility among poor families,

driven in large part by staying on the move to stay a step ahead of the eviction server, contributes to poor school performance by children who drift from one school to

another and never catch up. In the age of standardized tests as the primary indicator of academic achievement, these kids do not have a chance at success. We all tacitly understand the centrality of stable housing in our ability to do our jobs and

70

raise our families. If we ponder even for a moment how we would cope if maintaining our housing was a daily struggle, we can easily understand the human dimensions of the affordable housing crisis.

We know that receipt of Federal housing assistance contributes to housing stability for formerly homeless families and is associated with success at moving from

welfare to work. It is a good investment in American families.

Federal expenditures on low income housing are woefully inadequate in the face

of this challenge. And when examined in comparison to Federal expenditures to subsidize the housing of middle and upper income households, the lack of investment

in low income housing becomes even clearer. In 1997, assisted housing outlays were

$26 billion, while housing tax expenditures (mortgage interest and property tax deductions) were $97 billion. In constant 2000 dollars, the tax expenditure level will

go to $123 billion by 2005.

It will take much more than fine-tuning existing low income housing programs,

which we must continue to do, to seriously make a dent in this problem. The good

news is that we know how to do solve the affordable housing crisis. We have a thriving mission-driven, community-based, non-profit housing sector that is continually

increasing its capacity to provide safe, decent, and affordable housing. We believe

strongly that the resources in our country to intervene at the scale needed to make

a difference. What we need now is the creative and visionary leadership to make

it happen.

Thank for your consideration of my remarks.

Mr. SUNUNU. I would like to begin the questioning now, touching

on a few of the points that you raised with Mr. Ramirez.

First, you raised, I think, a very important concern about false

positives, about trying to approach the verification process carefully.

There is no question when you have the number of letters that

are going out, the number of discrepancies in income reporting that

we have, there are going to be some legitimate reasons that both

of you touched on in your testimony for the problem.

I think we can minimize those issues by putting in place a reasonable threshold for income discrepancy. We are not talking about

a difference of $100 or $500 or even $1,000, as I understand it, in

the income that is reported. It is at a higher threshold than that.

Mr. Ramirez, can you review for instance what those thresholds

are?

Mr. RAMIREZ. Yes. We have actually two thresholds. One is for

the multifamily Section 8 subsidized housing, which is a $4,000

threshold. Then we have an $8,000 threshold for public housing.

Mr. SUNUNU. For annual income?

Mr. RAMIREZ. Yes, sir, annual income.

Mr. SUNUNU. In your testimony on March 8, you suggested that

there were, I think, 260,000 letters that were about to go out. In

your testimony today, you mentioned 230,000 letters. It is a difference of about 10 percent. I just want to be clear for the record;

how many letters are being mailed out today?

Mr. RAMIREZ. We have two family incomes, so the number has

shrunk in matching up addresses and individuals in those incomes.

We anticipate that that will be the case in a bigger mailing that

will take place after working with the different industry groups, as

it relates to the overpayments that will be discovered as we run the

analysis, as well as the notification to all residents that are currently receiving some sort of subsidy that—in their verification recertification process, we are advising them, in the same form that

we have advised by way of information and handout attached to

these letters, what kind of income they need to take with them as

they get recertified for the following year, sir.

71

Mr. SUNUNU. In your testimony, you said those letters are being

sent as we speak. How many letters are being sent out this week?

Mr. RAMIREZ. I couldn’t tell you exactly how many this week. It

is a massive mailing of 230,000.

Mr. SUNUNU. When is the goal for having completed the entire

mailing?

Mr. RAMIREZ. We should be done mailing all of these letters

within the next 2 weeks or so, sir.

Mr. SUNUNU. Two weeks? That is the initial——

Mr. RAMIREZ. This is the initial match of discrepancies for underreporting income as it relates to the entire population.

Mr. SUNUNU. That is a total of 230,000 notifications?

Mr. RAMIREZ. Approximately, yes, sir.

Mr. SUNUNU. You talked about the concern of those that may be

overreporting income, and therefore—and Ms. Crowley touched on

that, as well. You didn’t give an estimate of the number of cases

of overreporting.

Has a similar IRS match been done to try to quantify the number?

Mr. RAMIREZ. Yes. We are currently working on that match. But

let me, if I may, Mr. Chairman, just bring some perspective to

where we are and where we were.

We have over the last several years depended on the Inspector

General’s review of a random sample of 1,000 residents. We have

now gone to matching the entire population that is receiving some

sort of benefit from public housing or subsidized housing.

We have worked very hard to reduce the false positive percentage on the underreporting process, and we feel comfortable in saying that we are running at about 20 percent in comparison to perhaps up to maybe as much as 50 percent in the old sampling method; and we are currently calibrating the false positives based on

the thresholds that we have for the overpayment.

We run a similar risk in estimating an overpayment, if we are

not careful, in first getting these false positives, as small a number

as it can be, because you can imagine someone receiving a letter

saying, you have something due you, and they go in and they then

find out that they don’t have anything due them as a result of us

advising them that they have overpaid.

So we are in the process of doing that. We have gone through

two runs of getting it. The number has reduced from about 55 percent to about 30 right now. We are not comfortable yet with where

we are on the false positives. We are running the systems to see

if we can further reduce that.

We are also working with the different industry groups to get together with them in the near future on these notifications and to

report out to them.

Mr. SUNUNU. Ms. Crowley, I don’t want to put you on the spot,

but in the March testimony, Mr. Ramirez talked about trying to

touch base with industry groups and tenant groups.

My question is, to what extent have you or your members participated in discussions with HUD, and what more do you think that

HUD can do to make sure that the process they are undertaking

is fair?

72

Ms. CROWLEY. I would say that our interactions with HUD officials have been extensive. My experience was that it did take getting it to the attention of the very highest levels to get us heard,

but once that happened, then we were heard loud and clear. So

there have been a series of meetings and discussions about that.

There are, as I said, lingering concerns. It is not 100 percent resolved. There are—my concern, my more than concern at this

point, is about how it is going to play out at the local level and how

we are going to assure that what it is that we have agreed to at

this level actually happens there.

That is the tricky part, because if everything unfolds the way we

have been told it will, then it should happen in a fair kind of way.

But we are talking about the behavior of a large number of different people who are going to get communications through several

layers, and there is always the danger of distorted communication.

So we will be very alert to how it is happening on the ground

with our members and be prepared to advocate at that level as

well.

Mr. SUNUNU. We don’t need to take Mr. Ramirez to task for not

including you?

Ms. CROWLEY. No.

Mr. SUNUNU. Good.

A few final questions about the scope of the problem, because

there are two large issues here. One is the financial issue, which

is estimating the size of the underpayments. That is important because the demand for the services are high.

You gave a very stark picture of that, Ms. Crowley. If we take the estimate of $935 million that has been presented to the Task

Force by HUD and the Inspector General’s Office, that does translate into 150,000 or so certificates, new certificates, which is even

more than is being requested by the administration this year. So

it is a significant number.

If I can finish, the other side of the problem is that if there is

a case of someone who is ineligible receiving housing, then that

means someone is on the waiting list, obviously, who is in need

that would otherwise qualify for a slot. Of course, it is worth emphasizing that the vast majority of all of the tenants here are completely honest, law-abiding, and deserving of the services.

Even if you take the full figure of $935 million—I think you used

the total figure of 26 million for low-income housing—but just at

the Federal level, if you look at a figure of 151⁄2 million for the certificate program, it is well under 10 percent. It is probably—that

is roughly 7 percent. So at the absolute worst, 93 or 94 percent of

the people in this are not even matched, so there is not an issue

there.

So there are two sides to the problem. The specific question I

have Mr. Ramirez, is the gross figure of $935 million—you gave an

estimate of $400 million to $935 million—that is an annual loss; is

that correct?

Mr. RAMIREZ. Well, that is the estimate that comes out of the

methodology that was recommended to us to employ in partnership

with the Inspector General, sampling only 1,000 of—after taking

dual incomes, of about 41⁄2 million families. So it is a broad estimate or a big estimate——

73

Mr. SUNUNU. Based on a sample of 1,000?

Mr. RAMIREZ. Yes.

The other thing is, because of some of the reasons I cited as to

the difficulty in recapturing these funds, as a result of folks moving

away and other activities, that the more realistic estimate that

OMB has come out with in the budget we believe is closer to accurate, which is about $80 million. That is taking into consideration

not just the turnaround that may occur, but also remember that

there is that category of overpayments.

It is very preliminary for me to make any real estimate on that,

but based even on a 50 percent false positive, the number is quite

substantial on the overpayment side, as well.

So our goal in the end, Mr. Chairman, is to try to get folks qualified at the front end to avoid the back-end discrepancies that could

lead to any sort of waste, fraud, and abuse that we know is occurring, as was highlighted by the Office of Inspector General.

Mr. SUNUNU. Ms. Crowley.

Ms. CROWLEY. I do not pretend to understand all the intricacies

of these numbers, but my understanding—and Mr. Ramirez, correct me if I’m wrong—is that the 935 million is the first cut at the

analysis, and it is before all the false positives have been cleaned

out.

So once—as I said, to get to the true overpayment, you have to

screen out all the false positives and you have to do the overpayment, and then you will get to what that real number is. So it is

going to be something substantially less than that.

So the 230,000 letters that are going out, the total of that does not get up to $935 million because that analysis was based on sort

of a gross analysis at that point.

Mr. RAMIREZ. Yes.

Ms. CROWLEY. So that has to be further refined to get at some

understanding of what the true number is.

Mr. SUNUNU. Thank you.

Mr. RAMIREZ. May I just say—real quick, just to say that what

we have done is that this year, for the first time ever, we will have

an accurate baseline of what that number really is, instead of these

estimates that are based on a small population of a greater population.

Mr. SUNUNU. That is the importance of keeping to your time line

with regard to the issuance of the first 230,000?

Mr. RAMIREZ. Yes. On that one, working with the industry, because that is also an important piece of correspondence that needs

to go out, we would anticipate that we could finish up our work on

that letter and what we need to refine in our estimates to get that

letter out on the overpayment side by June 30, Mr. Chairman.

Mr. SUNUNU. Thank you.

Mr. Bentsen.

Mr. BENTSEN. Thank you, Mr. Chairman. Mr. Chairman, let me

talk a little bit about the methodology, and then I want to talk a

little bit about the broader program.

Again, in the methodology, this is based upon a—the $935 million figure is based upon a random sample of 1,000 households, so

it is a sampling-type issue which has questions of accuracy, and

then is extrapolated out against the entire program; but false

74

positives and overpayments by tenants are not netted out, so it is

still a rather nebulous figure that is out there.

The 230,000 notices that you are sending out, that is not net

false positives?

Mr. RAMIREZ. It is—we have 90 days after they get sent out. We

anticipate there may be as high as 20 percent false positives on the

230,000. That is just based on local policy for exemptions of certain

incomes. Again, because of the way the law is now structured,

there is a great deal of discretion that is given at the local level.

The difference between the old methodology and what we are employing now is that there is a complete match of income and Social

Security, and based on that and the tiers we have established, we

have narrowed down that universe to just 230,000 where there are

these discrepancies.

Mr. BENTSEN. Can the IG’s Office tell me, in these cases that

have been going on for some time—this is a 60-year-old program,

in effect, and a lot of your cases go back to the early 1980’s, and

have gone on for periods of time, unacceptable periods of time. In

the IG’s study, if you could speak to that, is there a preponderance

of underpayment by tenants in the high-dollar range or the lowdollar range, and is it $10 and $20 a month, just outright fraud,

or several thousand dollars?

Secondly, is there a preponderance of individual tenant abuse

through PHAs, or is it with respect to third-party private-sector operators?

Mr. SCHUSTER. Sir, basically, as criminal investigators in our little world, we are just dealing with what we would call prosecutable

criminal cases, so we would not get into the whole universe. We

could not answer that.

Mr. BENTSEN. On that issue, Mr. Chairman, I will submit for the

record from the IG’s Office—I would be interested to know where

the mean is and where they come down.

Let me ask this. From an investigator standpoint, the way I understand this, reading through this, Congress in 1993 adopted a

law allowing, in the famous Omnibus Budget Reconciliation Act of

1993—one of the many things that did not get talked about in the

1994 elections was a change in the law that allowed for the use of

IRS data for income verification and match; I believe that is correct.

From the IG’s perspective and investigators’ perspective, do you

believe this new income verification will be a sufficient tool in trying to root out either outright fraud or just inadvertent underreporting of income?

Mr. SCHUSTER. Once again, I don’t know, as a Special Agent,

whether I am equipped to answer that particular question. I think

it would give you maybe an idea. But once again, dealing with our

resources and our priorities and what the U.S. Attorney’s offices

are, in a sense dictating to us, we probably would not get into those

specific areas unless we had proper resources.

Mr. BENTSEN. Mr. Carolan.

Mr. CAROLAN. I would say that it is very helpful, and some of the

things that we talked about around the table, in some of the testimony, as long as this information is timely, where it is not old information, as long as it is accurate, apples to apples, and as long

75

as we are all sensitive to the individual circumstances, the case-bycase family——

Mr. SUNUNU. If the gentleman would yield for a moment——

Mr. BENTSEN. Yes.

Mr. SUNUNU. Specifically, would an income matching program,

as we are beginning to implement here, would that have assisted

you in the Charlestown case? Would that have uncovered the income discrepancies that were prevalent in that case?

Mr. CAROLAN. I would assume that it may have pointed to a pattern, multiple cases at a particular site, which would have led us

to look at something other than individual tenant fraud; that there

had to be something there that was a common denominator. So I

think, like I said, it would be helpful.

We have to remember, most of the cases we look at are the egregious ones. They are multiple years of underreporting of income,

resulting in multiple years of overpayments, usually. They have to

meet the test of the prosecutor.

We also look at ability to make restitution.

Mr. BENTSEN. Just a couple more questions. Let me ask, let me

look at this from a broader perspective in the income verification.

As I understand how the Section 8 assisted housing program

works, and has for the last long period of time, it has somewhat

devolved from the Federal Government to local partners which—we

actually expanded their authority through H.R. 2, or whatever the

public law is now, back in 1998, and third-party contractors to the

government who operate project-based housing and the Section 8

assistance is made to those entities.

They are required to verify the income and have that approved

by a third party, and that is what the Federal Government has relied on in the past, for the last 60 years, I guess.

The income verification program, if I understand it, which is the

first of its kind in HUD, came out of the 1993 act. It effectively is

designed to try and match W–2, W–3 data of every tenant of record

in the program against the data that is provided by the PHA, that

they collect, or the third-party Acme Project-Based Housing Corps,

whatever third party, to see whether that matches up.

So this will be the first time ever that HUD is basically looking

over the shoulder of your clients in the field; is that correct?

Mr. RAMIREZ. It is correct on the income verification side.

But let me say, it is one more component of our overall 20-20

management reform. We have always taken the other side of oversight seriously, as well, and have reshaped the way we go about

inspecting the Housing Authorities and the project-based owners

for housing quality standards, for financial stability, for tenant satisfaction, and for management, as well, through our real estate assessment system and center.

So, yes, it is the first time we have ever done that, and it is a

baseline that we are establishing so that Congress then can have

a more accurate account of underpayment, overpayment, and the

real number that is out there, and to assist you in providing the

funding that we need to provide affordable housing.

Mr. BENTSEN. To the IG’s, and then I will finish up, and I am

going to apologize, because I am going to have to leave after that;

76

there is another meeting I was supposed to start chairing 15 minutes ago.

In your history of 28 years—and I don’t know how long, Mr.

Schuster, you have been there—is this a problem that you have

seen throughout your career with HUD in the Section 8 public

housing; or is this a problem that has just sort of started to occur

in recent years?

Second of all—and you may not know the answer to this—but

how would you compare the potential loss to the program in this

with the old FHA coinsurance program that was designed to create

affordable housing, multifamily housing, primarily in the late

1970’s, but also in the 1980’s? I assume you all dealt with some of

those issues, as well.

Mr. SCHUSTER. I will start off first by saying, you know, is there

a history of it? As long as I have been a criminal investigator,

which is over 30 years, there have been people who have been out

to defraud the system. So I have always—I have never had to

worry about work. I have always had a lot of work. This has been

continually.

I worked with ATF, I worked with Health and Human Services

IG, and for the last 11 years I have worked for HUD IG. There has

been—there has been a problem. There are people who are out to

defraud the program.

As I said, we are dealing with a small number of people who are

really ripping off the system. That is the only way to say it. There

is no doubt that this is not by accident. They have a plan; they are

conspiring to do this.

Mr. BENTSEN. This is not just an innocent, ‘‘I didn’t report—I

didn’t realize that my minimum wage went up and I was getting

more money,’’ or something?

Mr. SCHUSTER. Right. This is not an accident. That is why in my

statement I wanted to point out that there are situations where

people are not trying to rip off the system, they are trying to do

for family, or whatever. They might be actually, in a sense, defrauding the system, but it is not something that, you know, we

would be concerned about in our particular responsibilities.

So I think, yes, there have always been problems. To what extent, we have no way of knowing. We don’t get into that. Probably

our audit side of the House has made more studies of that and may

be more able to respond.

Mr. BENTSEN. Thank you.

Mr. Carolan.

Mr. CAROLAN. I would agree. We presented the first cases in my

district, in the district of Massachusetts, in the 1970’s, so I believe

the problem is there and continues to be there.

But again, we look at the most egregious cases. We have a lot

of criteria where we test them, like ability to make restitution,

multiple years of the problem with one individual or family. So

there are a lot of ways we screen out those that do not meet the

standards, and refer them back to the HUD program people or to

the providers for administrative recovery, to look at it and see

whether they can recover.

As far as the second part of your question, the insurance programs, back to the 236 program and other programs, the same type

77

of things were happening. We had falsification. As my associate

said, there are people out there that are going to beat the system,

and will find a way to try to beat the matching and everything else.

I think it did exist back in some of those programs, also.

Mr. BENTSEN. Thank you, Mr. Chairman.

Mr. SUNUNU. Thank you, Mr. Bentsen.

Mr. Miller.

Mr. MILLER. Thank you, Mr. Chairman.

Deputy Secretary Ramirez, we discussed preventing waste, fraud,

and abuse from happening in the future. You briefly said how the

law is now structured.

Mr. RAMIREZ. Yes.

Mr. MILLER. That raised a question.

Is there anything Congress can do to help you?

Mr. RAMIREZ. Yes, sir. We believe that to bring the accuracy of

the system to an even more on-time basis—again, to bring a little

perspective to the situation—the 1,000 number sampling that came

out of this population of 4.5 million is based the same as we base

our current verification process, which is prior year returns. So a

year has gone by before we can actually match up and see if there

was any discrepancy in what was certified and what income was

actually reported.

If we were to be able to get legislative relief to work in greater

cooperation with HHS, and in particular, for the 941 quarterly reports on new hires, that would help enhance the ability of the private owners or operators, as well as agents and our agency, to be

more on time in capturing any discrepancies in recertification and

underreporting.

Mr. MILLER. Has anybody asked for that legislative relief to

date?

Mr. RAMIREZ. Consider it asked, sir.

Mr. MILLER. OK. I would like to follow up after the hearing with

you on that.

Mr. RAMIREZ. We will be——

Mr. MILLER. If that has not occurred and there is something we

can do to help you, we need to do that.

You basically talked about the DC pilot program and the new

verification program we will be using in the future.

Can you give me just a brief overview of the difference, if you

have not already done that? I know I missed part of the hearing.

Mr. RAMIREZ. The difference between the pilot and what we are

doing now?

Mr. MILLER. The DC pilot program and the new verification program you are going to be using now.

Mr. RAMIREZ. What we have done—the biggest difference is that

the letter, as Ms. Crowley mentioned earlier, what was sent in our

pilot to the District of Columbia residents was a little more menacing then it needed to be. It was pretty bureaucratic, and had not

really been vetted at the highest levels to be able to be a little more

descriptive and clear in the objective of sending this letter and,

also, in outlining the facts as to the type of incomes that qualified,

did not qualify, what kind of rights tenants had in pursuing their—

any remedial action they felt they needed to take.

78

I would like to acknowledge the great work and cooperation that

we got, not just from Ms. Crowley, but, as well, other industry

groups both on the private owners’ side, the agents’ side, through

the Housing Authorities, and the tenants, which I thought was

somewhat historic, to be able to get all these groups together

around a table for the first time.

This was the issue that brought it. We have worked together

since then. We will continue.

We now have a couple of issues that we need to resolve together,

and now that we have gotten into a rhythm of exchanging documentation and corrections in language and whatnot, we need to

clear up the correspondence that is going out to the agents and operators, advising them of what they need to do as a result of people

receiving—the tenants having received these letters for over- or underpayments.

We have the letter for overpayment that we will be working on,

and then a bigger mailing that will just lay out what qualifies,

what does not qualify, and remedies that a tenant can pursue that

will be going out.

Again, let me reiterate for the record that our notices—the way

the mail works, and everything else, for underpayments, June 30,

we are hoping to work with the industry to have the overpayment

discussion done by that time as well, to get those letters out and

proceed accordingly, and be able to come back with a more defined—because there is a 90-day period; sometime by December 1

this process should be concluded for this first cycle.

Mr. MILLER. Knowing that you could never eliminate all the

waste, fraud, and abuse that might exist within any system, based

on what you are proposing—and you are moving forward now—do

you believe the next time you come before Congress, you will have

fairly much resolved this problem?

Mr. RAMIREZ. We will have the baseline and an accurate number,

gross number, of what we believe would be underreporting on the

part of tenants.

We need to then, at that point, factor, as we believe is correct,

the probability of being able to recapture those funds, and up to

what level, without it becoming overly costly for this collection.

Finally, let me say that what we will have been able to accomplish, which is our goal in this process, is to be able to have eligible

residents that are sitting on waiting lists, that have doubled over

the last year and a half, into these units, and ineligible residents

out of those units; and we feel that in that regard we will be able

to meet that particular area of our mission.

I cannot say that we will be meeting our mission as completely

as we should. There were some very accurate figures brought out

by Ms. Crowley as to the real need that is out there. There are additional resources we would need to be able to create affordable

housing opportunities.

Mr. MILLER. As a type of an aside, are you involved in any way

with down-payment assistance with nonprofits?

Mr. RAMIREZ. Yes, sir.

Mr. MILLER. One problem we have noticed in the last few years,

and I don’t know why it is—I have dealt with a couple. Some I

have looked at and I shake my head; some are doing a good job,

79

but it seems like there is vague and ambiguous language that HUD

keeps putting out. I have written letters to try to get this resolved.

We have been effective in every instance.

It seems like there is a problem with HUD about putting out

vague language, whether certain nonprofits’ loans are going to be

approved in the future, with no data to say that they are not going

to be, no scheduled hearings to say there is going to be an overview. I am wondering why that continues to happen. It is becoming

a problem.

There are some out there that are providing down-payment assistance for groups that are not using any government funds and

are very successful. It seems like they are repeatedly being impacted in some fashion by HUD. It does not make any sense to me.

Mr. RAMIREZ. There are two issues there that you have touched

on, Congressman.

The first issue is that when we put out a regulation to create the

facilitation of the delivery of whatever programs we have, or activities that we have jurisdiction over, we purposely try to make sure

that this regulation is as flexible and as open as possible to create

as much local flexibility as possible. That may be interpreted as

ambiguity, perhaps, in some instances.

We believe that it is better for us to refine it than to come out

with something that is—that will, in essence, lock communities and

not-for-profits into doing things a certain way, and we have learned

that the cookie-cutter approach does not work.

The other side of the equation is that we do have some very successful not-for-profits that do not use any government funds that

provide down-payment assistance to low- and moderate-income

families for home ownership.

Our concern there, and we are working with the different groups,

is that there are—there is a negative equity that is built as a result

of what is brought in at the front end of these loans that, in essence, creates a bigger burden through the life of a loan for these

low- and moderate-income families.

Mr. MILLER. Through inflated appraisals or such?

Mr. RAMIREZ. Correct.

So what we have been doing is, we have been talking to both the

ones that are effective in doing this and have worked to monitor

their activity to make sure that this does not occur, as well as

those that are quite lax in dealing with it.

We have to step in and make sure that in the end what we are

doing is that we are truly creating the opportunity for a family to

realize the American dream and not end up living the American

nightmare.

Mr. MILLER. One thing—and I think it is really important, because we have gone over this, I have done this too many times in

the last year with nonprofits—that HUD should be a little more

sensitive.

There are some that there is absolutely no—even suggestion that

they are inflating appraisals, they are dealing with approved lenders who are providing quality appraisals; and yet some of the language comes out that implies that at a future date this specific

nonprofit might not be an approved HUD agent to deal with those

types of loans.

80

I would ask that you try to create more sensitivity. I understand

that you try to deal with the problem, but in some cases, a problem

is being created where there is none. I have not tried to be an advocate of any one specific group, but when we come back and approach HUD, we find no reason at all that they should be using

language like that, and they change it. It just causes some problems and hurts some people who have tried to take advantage of

these down-payment assistance programs, because their loan has

not been recorded or has been delayed for some reason. It should

not have been.

If you can just do that, I will appreciate it.

Mr. RAMIREZ. Yes, sir. We will get back to you with a response.

Mr. SUNUNU. Mr. Clement.

Mr. CLEMENT. Thank you, Mr. Chairman, Mr. Secretary, and the

panel. It is a pleasure to have you here today.

Let me ask you this question, first. What percentage of households eligible for Federal rental subsidies actually get help?

Ms. CROWLEY. It is about one-third. That is the number that is

most frequently cited; that if you defined the eligibility under what

the law allows now and then you look at how many are actually

getting assistance, it is about one-third.

There are other ways of looking at the number. Our number is,

as I said, 10.8 million households with a severe housing cost burden who are low-income people. That includes both homeowners

and renters. HUD’s analysis is that the worst-case housing needs

is 5.4 million households. Those are renters who receive no assistance and have a variety of housing problems.

Mr. CLEMENT. Of course, we all, Democrats and Republicans,

want to stop waste and fraud. We should do everything we can to

stop Federal payments to families who are not eligible.

If you assume that a $935 million overestimate is accurate, and

every penny went to eligible families, how many more families

would be covered?

Mr. RAMIREZ. About 150,000. But we don’t agree with that assumption, Congressman.

Mr. CLEMENT. I wish you would expand on that.

Mr. RAMIREZ. As we went into this subject earlier in our testimony and in earlier questioning, the $935 million figure that is out

there is based on a small sampling of—I hate to sound repetitive,

but just to be able to clear things up, in the past, what we have

done is that we would take a sampling of 1,000 residents in a total

population of about 4.5 million. Then from there, the methodology

that was employed would extrapolate to that number that you see

up there.

What we are doing now is that we have actually matched up

these households through tax returns, Social Security benefits that

are paid, and their residency, and set thresholds as to whether

they are underreporting or not. We have gotten down to the point

of refining that, and have identified, in that universe of about 4.5

million, 230,000 households that have technically underreported.

I need to add that within that number, because of the broad discretion that has been provided to local Housing Authorities and operators, that they do have discretion as to what they would allow

81

or disallow as eligible income. So we are going to be going through

that process of getting down to the final number.

The other circumstance that we run into is that there are situations where people overpay in the program. We are currently

matching up income and payments that get to a number that

would reflect, as closely as possible, those amounts that are being

overpaid, to advise those residents as well that they need to go in

and clear up those overpayments, so they can actually be getting

what they are entitled to.

The $935 million number that is out there is a number that is—

that is, we believe, quite inaccurate in reflecting a true picture of

what actually exists in the overpayment category.

Once we have—because this year is a baseline year, Congressman, for establishing that number, that baseline then is also impacted by certain situations, again allowable exceptions plus collection difficulties that occur, to get to a real number of actual recovery of any overpayments that are out there.

Our goal in the end, by establishing this system, is to be able to

better qualify at the inception the residents, number one; and number two, that when we do find these discrepancies, and someone is

living in a unit that is not qualified to live in that unit, that that

unit then be vacated by that individual, or that family, and that

it now be occupied by someone that is eligible.

Mr. BENTSEN. Mr. Secretary, there is no doubt in your mind

there is a huge unmet need that exists?

Mr. RAMIREZ. I would further add that even after getting to this

number, we would not be making a dent in the need.

It was earlier stated that we have over 11 million American families out there that—or close to 11 million that are out there that

are suffering conditions of housing where they are paying more

than 50 percent of their income in rent. So it is an unacceptable

condition that exists.

Even with the current request that the President has proposed

of 120,000 additional vouchers, it is a baby step in trying to resolve

this problem, but a step that we feel is absolutely necessary, because it is an escalating problem.

Mr. CLEMENT. Mr. Secretary, these numbers up here on this

chart, you don’t really accept those numbers as true or accurate

numbers?

Mr. RAMIREZ. That is correct. We accept those as rough estimates

based on the methodology that has been employed in partnership

with the figure of the Department of Housing and Urban Development to come up with a number that needs to be included in our

financial statements.

Mr. CLEMENT. All right. Thank you.

Mr. SUNUNU. Thank you very much, Mr. Clement.

I have just a few final questions.

Mr. Ramirez, has the Department shared the match list of the

230,000 tenants that have a significant underreporting of income

with the Inspector General’s Office in order to try to identify patterns that might exist there that would be worthy of their investigation?

82

Mr. RAMIREZ. No, sir. It is premature for us to share that list

with anybody, first off, because it has not gone through the cycle

of it being exempted or not.

Secondly, it is—the private operators and agents, such as the

Housing Authorities, it is up to them to assume the principal responsibility in rectifying any differences in underreporting.

So the principal obligation of having this reported to the Inspectors General throughout the country that serve the Department

would be based, more than likely, on referrals from the Housing

Authorities, agents, or private owners, sir.

Mr. SUNUNU. As this process moves forward, however, is it your

intention to share information that HUD might develop regarding

patterns in income underreporting, or egregious cases of income

underreporting, to the Office of Inspector General?

Mr. RAMIREZ. We are prepared to share information that would

not violate the Privacy Act and the method in which we were able

to collect this information, and certainly we are not going to be the

ones initially to make the call as to whether there is fraud or not

occurring.

Inspectors General, as has been my experience through the years

that I have been with the Department now—they have the run of

the room. If they so wish to come in and audit these numbers, they

are certainly welcome to.

Mr. SUNUNU. There is nothing that would prevent them statutorily from reviewing the income underreporting information that

you might generate?

Mr. RAMIREZ. That would be a question that I would suggest be

posed to the inspectors.

Mr. SUNUNU. Mr. Carolan, is there anything that would prevent

you from reviewing information to identify patterns or egregious

cases of underreporting that might be worthy of investigation?

Mr. CAROLAN. I don’t believe there would be any barrier.

Mr. SUNUNU. Thank you.

A final question: Mr. Ramirez, we have talked a lot about this

process, which I think is important. Mr. Clement mentioned the

value of determining whether or not $935 million is recoverable,

identifying what is recoverable. Ms. Crowley talked about looking

at income overreporting as well.

These are all issues, though, at the end of the process, where we

are trying to verify after the fact and match actual income to what

was initially reported.

What has been done to deal with the front end of the process,

to improve the internal control systems of HUD so that the Housing Authorities can better determine tenant income up front when

they first apply, or when they are recertified?

Mr. RAMIREZ. One of the things, because of the discretion that is

written into the law to create greater flexibility at the State level

and local level, there have been some States that have been

proactive in trying to get more on-time information as it relates to

wages. So there are State wage reports that now go to Housing Authorities, but it is on a State-by-State basis. That is the only way

it could be done.

Mr. SUNUNU. How many States do that?

83

Mr. RAMIREZ. I think there are three—we are actually using two

right now. Two.

Mr. SUNUNU. Is that something that you are encouraging States

to do?

Mr. RAMIREZ. Absolutely, sir. But that is, again, at their discretion.

Mr. SUNUNU. Thank you very much.

Thank you to all the witnesses for your testimony today. This is

a significant problem, both in terms of the finances, but also in

terms of the fairness of the program.

It is important that these programs are viewed by both the public that does not benefit from the program and those that are in

need, that they are fair, in order to ensure the credibility of HUD

that has a number of other programs that it uses to reach out to

communities with, and the credibility of the Federal Government

that is trying to oversee these and other programs efficiently and

effectively.

Your testimony has helped us a great deal here today. Thank you

for your time.

The committee is adjourned.

[Whereupon, at 11:41 a.m., the Task Force was adjourned.]

(85)

Government Failure in Disposing of Obsolete

Ships

FRIDAY, JUNE 9, 2000

HOUSE OF REPRESENTATIVES,

COMMITTEE ON THE BUDGET,

TASK FORCE ON HOUSING AND INFRASTRUCTURE,

Washington, DC.

The Task Force met, pursuant to call, at 10:10 a.m. in room 210,

Cannon House Office Building, Hon. John E. Sununu (chairman of

the Task Force) presiding.

Chairman SUNUNU. Good morning and welcome to the witnesses.

I want to thank Ken Bentsen and all the committee members for

participating in the hearing today.

Today we welcome three witnesses to testify on the problems and

the failure governmentwide in disposing of obsolete ships. Our witnesses today are Thomas Howard, Deputy Assistant Inspector General for the Department of Transportation; John Graykowski of the

Maritime Administration; and Vice Admiral James Amerault, Deputy Chief of Naval Operations for Logistics. I understand all of you

have busy schedules and I appreciate your taking the time today.

The Merchant Ship Sales Act of 1946 created the National Defense Reserve Fleet to provide merchant and nonmilitary vessels to

meet shipping requirements during national emergencies. The Maritime Administration, MARAD, administers this fleet, and they are

responsible for disposing of obsolete vessels of 1,500 gross tons or

more. DOD provides funding to maintain the fleet, and right now

there are 114 vessels that have been designated for disposal because most of them are no longer operational and they do pose

problems that are both financial and environmental.

Unfortunately, we have a situation that is beginning to develop

into a crisis. Over the last 5 years, in a number of ways, the government has restricted the ability of MARAD to engage in this

task. There are current restrictions on MARAD to use its own

funds to pay for the scrapping of these vessels. There have in the

past been restrictions on utilizing foreign scrap yards, and there is

a problem with the domestic supply of available scrap yards to handle the disposal of these obsolete vessels.

The vessels are maintained at three locations: James River Reserve Fleet in Virginia; Beaumont Reserve Fleet in Texas; and the

Suisun Bay Reserve Fleet in California. During 1999 the cost to

maintain this disposable fleet exceeded 4.2 million and there was

an additional $1 million that we will have Mr. Graykowski talk

about in some more detail for emergency repair.

86

This is really no direct fault of MARAD. These are old vessels,

in some cases decades old. They have hazardous materials in some

cases on them. They can leak oil and I think this environmental

issue has really been undiscussed, at least unquantified. That is

one of the issues I hope we can touch on today to better understand

the potential environmental threat, the cost of that environmental

threat, and the threat it poses not just on the river itself or the bay

where these boats are being held but on local economy, shipping,

and local navigation safety.

The estimates to deal with this problem in its entirety range

from $500 million to over $2 billion. That is a significant amount

of money. It is an enormous range of costs and I think that is simply an indication of how little we really understand both the shortterm and long-term costs of dealing with these problems.

Since 1995 MARAD has only scrapped 7 vessels. Several were

sold to contractors in 1999, but a number of the vessels were never

removed and remain moored with the MARAD fleet. Progress has

clearly dropped off in the past 10 years; but at the same time the

longer we wait, the larger this problem becomes. The problem

grows because over the next year over a dozen additional vessels

are scheduled to come into the MARAD fleet.

Now, between 1987 and 1994, MARAD disposed of 130 vessels,

most of which were exported to China, India, Mexico and Taiwan.

Problems with the world price of scrap metal has also hindered efforts by MARAD to scrap the vessels because when scrap metal

prices are depressed, there is less likelihood that either a foreign

or a domestic scrap yard is going to be willing to pay to take the

vessel off MARAD’s hands. Current legislative restrictions exist, as

I said earlier, that prevent MARAD from engaging in contracts to

pay for the scrapping of these vessels and as a result the problem

grows.

I think it is a problem that is getting worse. The estimate is that

there would be as many as 155 vessels waiting for disposal by the

end of 2001. The administration response to date, in addition to imposing a moratorium that lasted for some time and significantly delayed the scrapping process, was to move the date that we required

these ships to be disposed of back 5 years or at least to request a

movement in that date. While I understand that this reflects a recognition of the slow pace of progress in this area, I don’t think that

moving the date that we require all these vessels to be scrapped

in and of itself is going to really address the problem. Delaying

when we have a known environmental crisis before us really is no

solution.

I am very interested to hear what our real options are for dealing

with this problem. I don’t think waiting is acceptable. I think and

I hope Mr. Graykowski from MARAD will be candid and even creative in perhaps looking beyond some of the existing financial restraints or political restraints and talking through with this subcommittee, with this Task Force, what some of the potential options might be. And I am sure that members on both sides of the

Task Force recognize that this is a problem that may actually cost

money in the short term in order to save money in the long term,

and certainly it warrants our closest attention.

87

We don’t have a good handle on the costs and the potential risks

associated with this, with these obsolete vessels, but I hope at the

end of this hearing today we will have a much clearer picture of

the options ahead of us.

[The prepared statement of Mr. Sununu follows:]

PREPARED STATEMENT OF HON. JOHN E. SUNUNU, A REPRESENTATIVE IN CONGRESS

FROM THE STATE OF NEW HAMPSHIRE

I would like to start by thanking Congressman Bentsen and all the members of

the Task Force for being here this morning. I would also like to thank and recognize

Mr. Thomas J. Howard, Deputy Assistant Inspector General, Department of Transportation, Mr. John E. Graykowski, Deputy Administrator of the Maritime Administration (MARAD), and Vice Admiral James F. Amerault, Deputy Chief of Naval Operations for Logistics. I appreciate your taking time out of your busy schedules to

be here with us.

The Merchant Ship Sales Act of 1946 created the National Defense Reserve Fleet

(NDRF), which would provide merchant and nonmilitary vessels to meet shipping

requirements during national emergencies. The Maritime Administration (MARAD)

administers the fleet and is charged with the responsibility of disposing of vessels

of 1,500 gross tons or more. The Department of Defense (DOD) provides funding to

maintain the fleet. At this time, 114 vessels have been designated for disposal because many of them are no longer operational and pose serious problems both financial and environmental. It is my hope that we can explore here today the extent

of the problems with scrapping these ships and discuss the possible solutions. Furthermore, I would like to know what we in Congress can do to help move this potentially costly situation forward or at least closer toward a comprehensive resolution.

These 114 NDRF vessels are maintained at three locations: the James River Reserve Fleet in Virginia; the Beaumont Reserve Fleet in Texas; and the Suisun Bay

Reserve Fleet in California. During fiscal year 1999, the cost to maintain 110 vessels awaiting disposal exceeded $4.2 million, and an additional $1 million was spent

on an emergency repair. The estimates to do away with this problem range from

$500 million to $2 billion. The yearly costs to maintain an NDRF ship averages

$20,000. If some of these ships are not disposed of soon, they may sink, causing serious environmental problems. Repairing and drydocking these vessels could be very

expensive and may cost as much as $900,000 per vessel. Environmental cleanup and

remediation could be even more expensive to address, and appears to be very hard

to estimate, which is a large concern in my mind.

Since 1995, MARAD has only scrapped 7 vessels. Several vessels were sold to contractors in 1999, but the vessels were never removed and remain moored with the

MARAD fleet. Progress in scrapping vessels has clearly dropped off in the past 10

years. The longer we wait the larger and more costly the problem becomes.

Typically, a ship scrapping company buys the rights to scrap a government ship

and later sells the salvaged metal to recyclers. Remediation of hazardous materials

takes place before and during the dismantling process. If a vessel is taken apart improperly, a ship scrapping operation can pollute the land and water surrounding the

scrapping site and risk the health and safety of the scrapping operation’s employees.

Exporting these ships is not an option at present. In 1994, the Environmental

Protection Agency (EPA) prohibited the Navy and MARAD from exporting vessels

after determining that the export of government ships for scrapping was prohibited

by the Toxic Substances Control Act. In fact, MARAD has not sold a vessel to overseas markets for scrapping since 1994. MARAD disposed of 130 vessels between

1987 and 1994, of which 128 were exported to China, India, Mexico, and Taiwan.

In September 1998, the Clinton administration placed a moratorium on overseas

scrapping due to concerns about environmental and worker health and safety. The

moratorium expired October 1, 1999. Currently, the administration requires

MARAD to request approval from the EPA to sell vessels overseas to markets that

are capable of scrapping in an environmental complaint manner.

It is apparent that this problem cannot continue to go unresolved. The Department of Transportation Inspector General’s office indicated in its audit report of

March 10, 2000, that the number of obsolete vessels could be as high as 155 by the

end of fiscal year 2001. We can surely all agree that this situation is getting worse

and something must be done soon.

I am interested to hear what plans are currently being made and developed to

deal with these issues. I am hopeful that MARAD and the Navy can coordinate their

efforts to bring about a solution. Solutions may range from allowing overseas scrapping of these vessels, creating a domestic scrapping industry in the United States

88

to handle the workload, or to simply spend the money necessary to dispose of every

obsolete vessel.

The bottom line is that the U.S. Government does not have a good understanding

of the potential long-term cost of scrapping these ships or the environmental impact

resulting from a ship-related accident. I look forward to hearing the thoughts of our

panel members. I would like to recognize Congressman Bentsen for any opening

comments he may have.

Chairman SUNUNU. Mr. Bentsen.

Mr. BENTSEN. Thank you, Mr. Chairman, and I thank the members of the panel for testifying today. As the Chairman pointed out,

this Task Force is charged with holding oversight hearings on

waste, fraud, and abuse and reporting our findings and recommendations to the full House Budget Committee.

In this, our third oversight committee hearing, we turn to disposal of obsolete vessels in the National Defense Reserve Fleet by

the Maritime Administration, MARAD program. I have a dual interest in this, the one which you all are doing; but, I also might

add, representing the district which includes a great deal of watershed in the port of Houston and the ship channel.

I have had my own experience in trying to remove abandoned

barges from the San Jacinto River, which the Coast Guard was

kind enough to do with a little nudging from Congress. And, Mr.

Chairman, we did find that in many cases, the cost of removal and

decontamination exceeds the scrap value greatly and ends up being

a net loss situation.

I am particularly interested in hearing about the Navy’s pilot

project for scrapping obsolete vessels and whether it can be used

as a model for MARAD. While I am interested in learning the magnitude of the inventory excess problem, I am primarily concerned

about how MARAD plans to economically scrap these vessels while

complying with safety and environmental standards. I understand

the issue is the relative feasibility of scrapping these vessels in the

United States and overseas.

I might mention that our colleague, Mr. DeFazio of Oregon, has

introduced a bill, H.R. 4189, which would establish a pilot program

for the Department of Transportation to carry out the vessel scrapping and processing program in the United States. At his request,

Mr. Chairman, I would ask unanimous consent at the appropriate

time that his statement regarding his bill in this matter be included in the record.

Chairman SUNUNU. Without objection. And I would ask also

unanimous consent that all members be given 5 days to submit

written statements for the record.

[The information referred to follows:]

PREPARED STATEMENT OF HON. PETER A. DEFAZIO, A REPRESENTATIVE IN CONGRESS

FROM THE STATE OF OREGON

Thank you very much for the opportunity to testify on the issue of how to dispose

of the U.S. Government’s obsolete ships. As the ranking Democrat on the House

Transportation and Infrastructure Committee’s Subcommittee on Coast Guard and

Maritime Transportation, I am keenly interested in resolving this problem. I have

introduced legislation, H.R.4189, to address the issue and the Subcommittee has

held two hearings on this subject.

As you know, the U.S. used to send its surplus vessels for scrapping at overseas

facilities, under terrible conditions. Public outrage over the U.S. sending its toxic

legacies overseas, led the Administration to halt this practice several years ago.

Since that time, virtually no ships have been scrapped. Why? Because the U.S. Maritime Administration (MARAD) is statutorily obligated to sell these ships, and canVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00092 Fmt 6601 Sfmt 6621 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
89

not, under current law, provide funds for their disposal here in the United States.

No U.S. shipyard can possibly scrap these ships in an environmentally responsible

and safe manner. So, these ships remain rotting at anchor in U.S. harbors.

The government’s current options are to again send its vessels to overseas shipyards where third world workers toil in unspeakable conditions, or leave them in

U.S. harbors where they risk sinking and polluting our waters.

Instead of lamenting over this dilemma, Congress should take the initiative to

change MARAD’s statute and allow the agency to provide funding for shipyards in

the United States to scrap ships. These ships are the responsibility of the U.S. Government and we should take responsibility the environmental hazards and safety

risks posed by these vessels.

It is time to admit that it will cost money to take care of our toxic legacy. I have

introduced legislation to do just that. My bill, H.R.4189, authorizes funding for a

ship scrapping pilot program at MARAD, to pay qualifying shipyards to scrap its

obsolete vessels.

I hope that as a result of this hearing, more Members of Congress and the public

will be aware of this problem and work to enact legislation to solve it.

Mr. BENTSEN. I thank the Chairman and with that, I will yield

back the balance of my time and look forward to hearing the testimony today.

Chairman SUNUNU. Thank you very much Mr. Bentsen.

I would like to begin our testimony with Mr. Howard from the

Inspector General’s office and then provide time for Mr.

Graykowski to talk about his perception of the problem and

thoughts on ways to deal with the problem. And then we will hear

from Vice Admiral Amerault about the Navy pilot program which

I know has met with some success, and even more important, I

hope has yielded a good deal of information about the process, the

costs, and the technical and financial obstructions to dealing with

this problem.

Mr. Howard, welcome, and we are pleased to hear your testimony.

STATEMENTS OF THOMAS J. HOWARD, DEPUTY ASSISTANT INSPECTOR GENERAL FOR MARITIME AND DEPARTMENTAL

PROGRAMS, U.S. DEPARTMENT OF TRANSPORTATION; JOHN

E. GRAYKOWSKI, ACTING MARITIME ADMINISTRATOR, U.S.

DEPARTMENT OF TRANSPORTATION; AND VICE ADM. JAMES

F. AMERAULT, DEPUTY CHIEF OF NAVAL OPERATIONS LOGISTICS

STATEMENT OF THOMAS J. HOWARD

Mr. HOWARD. Thank you, Mr. Chairman, members of the Task

Force. I ask that my statement be submitted for the record and I

will summarize my remarks.

Chairman SUNUNU. Without objection.

Mr. HOWARD. My statement is based on our March 10th report

on MARAD’s ship-scrapping program. The Office of Inspector General has identified MARAD’s ship-scrapping program as one of the

12 most pressing management issues in the Department of Transportation. The Department, the administration, and the Congress

face a challenge in determining how to dispose of MARAD’s fleet

of old, environmentally dangerous ships in a timely manner.

The current approach of selling ships for domestic scrapping is

not working. MARAD will not be able to meet the legislative mandate to dispose of its ships by September 30, 2001. It also will not

be able to gain meaningful financial returns from these ships.

90

As you mentioned, Mr. Chairman, MARAD maintains its ships in

the water in three locations. The picture being displayed shows a

few of the ships in Suisun Bay. The one in the foreground is the

Mission Santa Ynez, which is 56 years old and has been awaiting

disposal for 25 years. Environmental dangers associated with these

old, deteriorating ships are increasing daily. The so-called worstcondition ships average 50 years old and have been awaiting disposal for 22 years.

These photos show actual conditions on 3 of the 40 worst-condition ships. The ships contain hazardous materials such as PCBs,

asbestos, lead-based paint, and fuel oil. Some have deteriorated to

the point where a hammer can penetrate their hulls. If the oil from

these ships was to leak into the water, immediate and potentially

expensive Federal and State action would be required.

MARAD currently has 114 obsolete ships awaiting disposal. As

shown in the chart being displayed now, this number has grown

from 66 just 3 years ago. It is expected to reach 155 by the end

of fiscal year 2001.

As shown in the next chart, only 7 ships have been scrapped

since 1995. This represents a significant change from 1991 through

1994 when 80 ships were scrapped overseas. In addition, recent

sales to domestic scrappers have only yielded between $10 and

$105 per ship. This is down from an average price of $433,000 per

ship during the early nineties.

MARAD’s inability to reduce the backlog of ships awaiting disposal is attributable to a couple of factors: the loss of overseas

sales, current limited domestic scrapping capacity and the Navy’s

pilot program.

Since 1994 MARAD has been relying on the domestic ship-scrapping market but its capacity is currently limited. Only four companies have passed MARAD’s technical compliance reviews to scrap

ships. Although MARAD sold 22 ships to these domestic scrappers

since 1995, 13 are still moored in MARAD’s fleet. Recent contractor

delays in picking up ships and a default by one contractor raise a

question as to whether the ships will be removed from the fleet.

The Department of the Navy experienced a similar inability to

sell its obsolete combatant ships in the domestic market. In 1998

Congress authorized and appropriated funding for a pilot project allowing the Navy to pay domestic contractors to scrap ships. Last

year the Navy awarded contracts amounting to $13.3 million for

the scrapping of 4 ships. The contractor that defaulted on MARAD

is scrapping a ship under the Navy pilot program. MARAD is coordinating with the Navy on its initiatives and is pursuing alternative disposal methods, but due to capacity limitations, no one of

those alternatives has the potential of significantly reducing the

backlog in a timely manner.

In our March report we recommended that the Maritime Administrator take several actions:

First, seek legislative approval to obtain an extension on the disposal mandate and eliminate the requirement to gain financial returns on vessel sales.

Second, continue to pursue programs to improve scrapping sales

and identify alternative disposal methods.

91

Third, develop a proposal seeking authority and funding to pay

domestic contractors to scrap ships, targeting the 40 worst-condition ships for priority disposal.

In its authorization request for fiscal year 2001, MARAD proposed a 5-year extension to develop and begin implementing a plan

to dispose of these ships. We do not believe it is acceptable to begin

disposal within 5 years, considering the condition of some of the

ships, the environmental risk, and the cost to maintain them. In

our opinion, the legislation should require MARAD to develop a

disposal plan and substantially dispose of these ships within 5

years. Further, MARAD’s plan needs to identify viable disposal

methods, set milestones, and target the worst-condition ships for

priority disposal.

This concludes my remarks. I will be happy to answer questions.

Chairman SUNUNU. Thank you Mr. Howard.

[The prepared statement of Thomas Howard follows:]

PREPARED STATEMENT OF THOMAS J. HOWARD, DEPUTY ASSISTANT INSPECTOR GENERAL FOR MARITIME AND DEPARTMENTAL PROGRAMS, U.S. DEPARTMENT OF TRANSPORTATION

Mr. Chairman and members of the Task Force, we appreciate the opportunity to

be here today to discuss the Maritime Administration’s (MARAD) program for scrapping obsolete vessels. We have identified this program as 1 of the 12 most pressing

management issues in the Department of Transportation. The Department, the Administration, and the Congress face a challenge in determining how to dispose of

MARAD’s Fleet of old, environmentally dangerous vessels in a timely manner.

The current approach of selling obsolete vessels for domestic scrapping is not

working. There is limited capacity in the domestic scrapping market and the Navy

is paying contractors to scrap its obsolete warships while MARAD is asking contractors to pay to scrap its vessels. Further, MARAD has been constrained from selling

vessels overseas for scrapping, although this had been a key market in the past.

MARAD will not meet the legislative mandate to dispose of its obsolete vessels

by the end of fiscal year (FY) 2001 in a manner that will yield financial benefits.

MARAD will need relief from those requirements. MARAD will also need authorization and funding for a program to pay for the disposal of obsolete vessels if it is

to have the potential to significantly reduce the Fleet.

MARAD is pursuing a number of alternatives for disposing of its obsolete vessels,

but because of capacity limitations, no one has the potential to significantly reduce

the backlog of vessels in a timely manner. MARAD needs to develop a plan and take

prompt action to dispose of all of its obsolete vessels.

Our statement is based on our March 10, 2000 report on the scrapping program.

We will discuss three issues today:

• The environmental threats posed by MARAD’s growing backlog of obsolete vessels;

• Key factors contributing to MARAD’s inability to scrap vessels domestically; and

• The need for prompt implementation of a plan that prioritizes disposal of the

‘‘worst condition’’ vessels and identifies methods and milestones for disposing of all

obsolete vessels in the Fleet.

GROWING BACKLOG OF OBSOLETE VESSELS IS A THREAT TO THE ENVIRONMENT

MARAD currently has 114 obsolete vessels awaiting disposal. This number has

grown from 66 vessels 3 years ago. Moreover, the inventory of obsolete vessels

awaiting disposal is continuing to increase, and is expected to reach 155 by the end

of FY 2001.

MARAD maintains its vessels in the water at three locations—the James River

in Virginia; Beaumont, Texas; and Suisun Bay, California. Environmental dangers

associated with these old, deteriorating ships are increasing daily. The so-called

‘‘worst condition’’ vessels are about 50 years old and have been awaiting disposal

for 22 years on average.

92

VESSELS AWAITING DISPOSAL AT SUISUN BAY RESERVE FLEET

These vessels contain hazardous materials such as polychlorinated biphenyls

(PCBs), asbestos, lead-based paint and fuel oil. Some vessels have deteriorated to

the point where a hammer can penetrate their hulls. If the oil from these vessels

were to enter the water, immediate and potentially very expensive Federal and

State action would be required. For example, MARAD spent $1.3 million on a costly

environmental cleanup because one of the ‘‘worst condition’’ vessels deteriorated to

a point where oil leaked into the water.

MARAD’S INABILITY TO SCRAP VESSELS IS ATTRIBUTABLE TO SEVERAL KEY FACTORS

Since 1995, only seven vessels have been scrapped. This represents a significant

change from 1991 through 1994 when 80 ships were sold overseas at an average

price of $433,000 per vessel. Recent sales to domestic scrappers have only yielded

between $10 and $105 per vessel.

MARAD VESSELS SCRAPPED

MARAD stopped selling vessels overseas for scrapping in 1994 due to Environmental Protection Agency (EPA) restrictions. In September 1998, the AdministraVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00096 Fmt 6601 Sfmt 6621 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
93

tion placed a moratorium on all sales of vessels for scrapping overseas that remained in force through October 1, 1999. MARAD has continued to refrain from exporting obsolete vessels because of concerns about the environment and worker safety.

Since 1994, MARAD has been relying on the domestic ship scrapping market, but

its capacity is limited. Only four companies have passed MARAD’s technical compliance review to scrap vessels. Although MARAD sold 22 vessels to these domestic

scrappers since 1995, 13 of the vessels are still in MARAD’s Fleet. Recent contractor

delays and a contractor default raise a question as to whether these vessels will be

removed by contractors from the Fleet.

The Department of the Navy experienced a similar inability to sell its combatant

vessels for domestic scrapping. In 1998, Congress authorized and appropriated funding for a pilot project allowing the Navy to pay domestic contractors to scrap vessels.

On September 29, 1999, the Navy awarded four contracts amounting to $13.3 million for the scrapping of four vessels.

MARAD cannot compete with the Navy pilot program in the limited domestic

market because, by law, MARAD is prohibited from paying for scrapping services.

The contractor that defaulted on MARAD, is scrapping a Navy ship under the pilot

program.

MARAD NEEDS A PLAN AND PROMPT ACTION

To Dispose Of its Obsolete Vessels

While MARAD has been pursuing alternative ways to dispose of vessels, it is constrained by the legislative requirement to maximize financial returns. Also, the alternatives MARAD is pursuing have capacity limitations and, therefore, no single

option has the potential to significantly reduce the backlog of vessels in a timely

manner. These alternatives include: coordinating with the Navy and a west coast

company on a proposal for a potential scrapping site; participating in interagency

work groups to look for innovative ways to improve the ship scrapping process; and

requesting approval from EPA to sell vessels to overseas markets.

The National Maritime Heritage Act of 1994 requires MARAD to dispose of its

obsolete vessels by the end of FY 2001, which is an extension from 1999, the original deadline. MARAD does not have a plan to dispose of these vessels.

We recently recommended that the Maritime Administrator:

1. Seek legislative approval to obtain an extension on the disposal mandate and

eliminate the requirement to gain financial returns on vessel sales;

2. Develop a proposal seeking authority and funding to pay domestic contractors

to scrap vessels, and target the ‘‘worst condition’’ vessels for priority disposal; and

3. Continue to pursue programs to improve scrapping sales and identify alternative disposal methods for its obsolete vessels.

In its authorization request for FY 2001, MARAD proposed a 5-year extension ‘‘to

develop and begin implementing a plan to dispose of these vessels.’’ We do not believe it is acceptable to begin disposal within 5 years considering the condition of

some of the vessels, the environmental risks, and the costs to maintain them. In

our opinion, the legislation should require MARAD to develop a disposal plan and

substantially dispose of these vessels within 5 years. Further, MARAD needs to

identify viable disposal methods, set milestones, and target the ‘‘worst condition’’ vessels for priority disposal.

BACKGROUND

The Merchant Ship Sales Act of 1946 created the National Defense Reserve Fleet

(NDRF), a Government-owned and administered Fleet of inactive, but potentially

useful, merchant and non-military vessels to meet shipping requirements during

National emergencies. MARAD administers the Fleet, and the Department of Defense provides the funding to maintain the Fleet. The Federal Property and Administrative Services Act gave MARAD responsibility for disposing of all Federal Government merchant-type vessels of 1,500 gross tons or more. The National Maritime

Heritage Act of 1994 required MARAD to dispose of obsolete vessels in the Fleet

by September 30, 1999, in a manner that maximizes financial return to the United

States, but the Act was amended to extend the original disposal date by 2 years,

from 1999 to 2001.

As of April 30, 2000, 114 obsolete vessels were designated for disposal because

the majority of them are no longer operational. MARAD maintains the inactive vessels in the water at the following locations:

• James River Reserve Fleet (JRRF) at Ft. Eustis, Virginia (61 vessels);

• Beaumont Reserve Fleet (BRF) in Beaumont, Texas (9 vessels); and

• Suisun Bay Reserve Fleet (SBRF) in Benecia, California (42 vessels).

94

The Coast Guard holds two vessels in Mobile, Alabama for fire fighting training.

As shown in the following chart, the average age of the 114 obsolete vessels is

48 years. These vessels have been in the Fleet for an average of 15 years.

THE NUMBER OF OBSOLETE VESSELS AWAITING DISPOSAL IS INCREASING

The number of obsolete vessels has almost doubled since 1997. MARAD expects

its inventory of obsolete vessels awaiting disposal will increase to 155 vessels by the

end of FY 2001, as shown in the following chart.

VESSELS AWAITING DISPOSAL

This projected increase is due to additional vessel transfers from the Navy, downgrades of other NDRF vessels to obsolete status, and the inability to sell ships for

95

scrap. Of the 155 vessels, 132 will be targeted for scrapping. The remaining 23 vessels will be targeted for disposal through the fish reef program, use by a State or

Federal agency, or held for useful parts and equipment. However, some of these vessels may be transferred into the scrapping category in future years if they cannot

be disposed of through other means.

OBSOLETE VESSELS POSE ENVIRONMENTAL RISKS

The 114 obsolete vessels currently awaiting disposal pose environmental risks because they are deteriorating, contain hazardous materials, and contain oil that could

leak into the water. These vessels are literally rotting and disintegrating as they

await disposal. Some vessels have deteriorated to a point where a hammer can penetrate their hulls. They contain hazardous substances such as asbestos and solid

and liquid polychlorinated biphenyls (PCBs). If the oil from these vessels were to

enter the water, immediate and potentially very expensive Federal and state action

would be required.

In 1999, MARAD identified the 40 ‘‘worst condition’’ vessels. These vessels were

classified as ‘‘worst condition’’ due to their severe deterioration and threat to the environment. As of April 30, 2000, 3 of the 40 had been moved out of the Fleet to

domestic scrappers. As shown in the following chart, the ‘‘worst condition’’ vessels

are older and have been in the Fleet longer than the other vessels awaiting disposal.

The ‘‘worst condition’’ vessels are in particularly bad condition, and may require

additional or special maintenance. Our inspection of 11 of the original 40 ‘‘worst

condition’’ vessels revealed corrosion, thinning, and rusting of the hull; asbestos

hanging from pipes below deck; lead-based paint easily peeled from the ship; solid

PCBs (in cabling); and in some instances, remnants of liquid PCBs in electrical

equipment.

96

DETERIORATING VESSEL AT JAMES RIVER RESERVE FLEET

Costs to maintain these vessels will likely increase due to their deteriorating condition, leaks, and the need for additional time-sensitive maintenance. For example,

MARAD spent $1.3 million to maintain 1 of the 40 ‘‘worst condition’’ vessels over

the past 2 years. This vessel is over 35 years old, contains hazardous substances

including asbestos, and has deteriorated to the point where oil leaked into the water

requiring costly environmental clean-up. MARAD has applied over 20 patches to

leaks, removed hazardous materials, deployed containment booms, and pumped oil

out of the vessel. The vessel is disintegrating to a point where it will not be seaworthy much longer. Monitoring efforts for this vessel are ongoing.

97

PROGRESS IN SCRAPPING VESSELS IS LIMITED

Although MARAD has sold 22 vessels since 1995, only 7 have been scrapped. Two

other vessels have been towed to scrapping sites. The remaining 13 vessels sold are

still moored in MARAD’s Fleet, requiring continued maintenance at U.S. Government expense.

Between 1991 and 1994, MARAD sold 80 vessels overseas for scrapping at an average price of $433,000 per vessel. During the past year, vessel sales yielded between $10 and $105 per vessel. On October 25, 1999, MARAD sold three vessels for

$10 per vessel. The most recent sale was for two vessels at $105 per vessel on December 21, 1999.

LOSS OF OVERSEAS MARKETS CONTRIBUTED TO THE DECLINE IN SCRAPPING

MARAD suspended the sale of vessels to overseas scrappers in 1994 because the

EPA prohibited the export of Government-owned ships containing PCBs. In September 1998, an Administration moratorium halted all sales of Government-owned vessels for scrapping overseas. The moratorium expired on October 1, 1999, but

MARAD has refrained from exporting vessels overseas for scrapping.

Based on a 1997 agreement between MARAD and EPA, MARAD is required to

request EPA’s approval to sell vessels to overseas contractors that can scrap them

in an environmentally compliant manner. The agreement requires MARAD to ensure that all liquid PCBs in transformers, capacitors, hydraulic and heat transfer

fluids and that all ‘‘readily removable’’ solid PCBs are removed prior to exporting

these vessels. This agreement also requires EPA to notify countries of import that

they will be receiving vessels and that these vessels may contain PCBs. To date,

MARAD has not requested EPA approval to sell any of its vessels awaiting disposal

to overseas scrappers. However, on April 14, 2000, the Maritime Administrator sent

a letter to the EPA requesting its assistance on developing an option for exporting

vessels for scrapping and implementation of the 1997 EPA/MARAD agreement.

LIMITED DOMESTIC CAPACITY HAMPERS PROGRESS IN SCRAPPING

Since 1995 MARAD has been relying on the domestic market, but capacity in the

domestic market is limited. In the 1970’s, there were 30 U.S. contractors in the ship

scrapping industry. Over the past 19 months, however, only four companies have

bid on MARAD’s scrapping contracts and passed MARAD’s technical compliance review to scrap vessels. These four companies can only handle approximately one to

five vessels at a time, depending on the size of the scrap yard and the dimensions

of the vessel. For example, one company could only scrap two or three vessels per

year. According to industry sources, it takes approximately 4 to 6 months to completely scrap a MARAD vessel.

Additional companies are not attracted to this industry because of the low profits

currently available. Scrap steel prices in the United States are low and contractors

must comply with environmental regulations. Most of the domestic scrapping company officials we contacted indicated that the profit from scrapping vessels is not

worth the effort. At a minimum, contractors in this business must pay for the towing costs and provide $150,000 as a performance bond to secure a vessel after a contract has been awarded. Contractors receive no return on a vessel until scrap metal

and the equipment removed from the vessel are sold.

Even when it has been able to sell vessels, MARAD has encountered problems

with domestic contractors. In 1999, MARAD sold 17 vessels to 3 ship scrapping comVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00101 Fmt 6601 Sfmt 6621 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
98

panies located in Brownsville, Texas. At the time of our review, we found that only

two companies were actively scrapping ships, and only one of these companies was

currently scrapping a MARAD ship. MARAD has granted a number of extensions

to contractors, and in one instance, MARAD had to resell vessels because of contractor default. During our review, we also found that another company had not taken

possession of any vessels because of an ongoing dispute with the Port of Brownsville

regarding contamination of its scrapping site. It has since taken possession of its

vessels.

NAVY PILOT PROJECT POSES COMPETITION FOR MARAD

The Department of the Navy experienced a similar inability to sell its combatant

vessels for domestic scrapping. In 1998, Congress authorized and appropriated funding for a Navy pilot project for the disposal of obsolete warships. The Navy and

MARAD are coordinating efforts to improve ship scrapping programs, as recommended by the Interagency Panel on Ship Scrapping and the General Accounting

Office. The Navy agreed to share its findings from the pilot project with MARAD.

On September 29, 1999, the Navy awarded four cost-plus contracts totaling $13.3

million for the scrapping of four vessels under its new Pilot Ship Disposal Project.

This pilot project departs from the sales contracting process by providing for cost

plus incentive fees for scrapping the first vessels. It guarantees profitability by providing for the cost of scrapping the vessels and gives the contractor the opportunity

to earn incentive fees, which encourages and rewards superior contractor performance. If the contractors are successful in scrapping the first 4 vessels, they will be

given the opportunity to scrap more vessels, potentially leading to the disposal of

66 warships.

One of these contractors was also under contract with MARAD to scrap its vessels. The company completed scrapping four MARAD vessels during 1998 and 1999;

however, it defaulted on a contract for another five MARAD vessels in August 1999.

MARAD cannot compete with the Navy’s pilot project while it is required by law

to maximize financial return on its vessels. If MARAD were authorized to implement such a project, it could cost as much as $515 million to dispose of the obsolete

vessels that MARAD expects to have by the end of FY 2001.

ALTERNATIVES OFFER POTENTIAL BUT HAVE LIMITATIONS

While MARAD has been pursuing ways to improve scrapping sales, its ability to

explore creative solutions for disposing of vessels is constrained by the requirement

to maximize financial returns. Also, the alternatives MARAD is pursuing have capacity limitations, so no one single option has the potential to significantly reduce

the backlog of vessels awaiting disposal in a timely manner. We have identified additional alternatives that MARAD has not pursued that may have the potential to

contribute to the goal of disposing of obsolete vessels.

Programs to improve scrapping sales and alternatives MARAD is pursuing include: coordination with the Navy and a west coast company on a proposal for a

potential scrapping site; participation in interagency work groups to look for innovative ways to improve the ship scrapping process and establish consistent procedures;

donation of vessels designated for disposal for uses such as museums and the fish

reef program, given legislative or executive approval; and coordination with the

Navy on its program to sink vessels in deep water after hazardous materials are

removed.

MARAD may be able to explore alternatives that have the potential to assist in

disposing of some of its vessels such as: selling vessels to other countries for nonmilitary uses, given legislative approval and approval from the EPA to sell vessels

to overseas markets that are capable of scrapping them in an environmentally compliant manner.

According to MARAD, selling vessels overseas for non-military uses would require

a change in the law that only allows MARAD to sell vessels for disposal or nontransportation use. However, legislation was passed in 1996 for four vessels to be

sold on a competitive basis for operational use. One vessel was sold in 1999 and bids

on two vessels are currently under review. The fourth vessel requires an EPA approval, which MARAD requested April 1999.

On April 14, 2000, MARAD sent a memorandum to EPA requesting its assistance

in facilitating an export option for scrapping based on the 1997 EPA/MARAD agreement. MARAD also said it would contact the EPA staff to discuss recommendations

made by the Interagency Panel on Ship Scrapping.

99

1 Report on the Program for Scrapping Obsolete Vessels, MARAD, March 10, 2000.

DISPOSAL PLAN AND PROMPT ACTION ARE NEEDED

The National Maritime Heritage Act of 1994 requires MARAD to dispose of its

obsolete vessels by the end of FY 2001, which is an extension from 1999, the original deadline. MARAD does not have a plan to dispose of these vessels.

In our March 10, 2000 audit report, MA–2000–067 1, we recommended that the

Maritime Administrator:

1. Seek legislative approval to extend the 2001 mandate to dispose of obsolete vessels and to eliminate the requirement that MARAD maximize financial returns on

the sale of its obsolete vessels.

2. Continue to pursue programs to improve scrapping sales and identify alternative disposal methods that can contribute to the goal of reducing the number of

obsolete vessels awaiting disposal, to include working with the Navy on the results

of its studies on the environmental impact of sunken vessels.

3. Develop a proposal for submission to Congress seeking approval and funding

for a project to pay contractors for vessel scrapping. The proposal should include a

plan to target the ‘‘worst condition’’ vessels first, identify funding and staffing requirements, and provide milestone dates to dispose of all obsolete vessels.

MARAD concurred with our recommendations. In its FY 2001 authorization request, MARAD proposed a ‘‘five year extension [in the deadline that] will provide

MARAD with additional time to develop and begin implementing a plan to dispose

of these vessels.’’ Considering the condition of some of the vessels, the environmental risks, and the costs to maintain them, we find the MARAD proposal unacceptable. MARAD must develop and implement a disposal plan for its obsolete vessels once legislative approval is obtained for an extension.

As a part of its disposal plan, MARAD must state specific milestones and steps

it will take to scrap its obsolete vessels within the next 5 years. The plan must state

how MARAD proposes to dispose of these vessels taking into consideration all the

available options. MARAD must identify viable disposal methods, and target the

‘‘worst condition’’ vessels for priority disposal.

Mr. Chairman, this concludes our statement. I would be pleased to answer any

questions.

Chairman SUNUNU. Mr. Graykowski.

STATEMENT OF JOHN E. GRAYKOWSKI

Mr. GRAYKOWSKI. Thank you, Mr. Chairman. And thank you,

members of the Task Force, for the opportunity today to appear before you to talk about what we consider to be a serious and a growing problem with national significance.

By way of background, I am John Graykowski and I am currently the Acting Administrator of the Maritime Administration,

which is a modal administration within the Department of Transportation. MARAD is a small Federal agency with a large portfolio

of responsibilities generally focused on the promotion, enhancement, and strengthening of the U.S. maritime industries, consisting of vessel owners, maritime labor, our shipyards and our ports.

MARAD performs these duties in direct support of U.S. national

and economic security objectives, one of which is to maintain a

commercial sealift capability and shipyard capacity to be made

available to the Department of Defense in times of war, national

emergency, or under Presidential directive. In effect, MARAD

serves as a bridge between the national defense apparatus of the

country and the commercial maritime assets which are critical to

support national needs.

I note the attendance today of one of our major partners in our

effort to support the United States maritime industry, Vice Admiral Amerault, who will, I am certain, concur that our current defense posture relies heavily on the commercial maritime industry

to maintain its readiness and response capabilities.

100

Mr. Chairman and Members of the Task Force, it is precisely

this partnership with the Department of Defense that has created

the situation we have today, where a civilian agency, MARAD, has

control and title to a large fleet of obsolete ships around the country.

I have submitted written testimony and I will thus simply summarize a few points:

One, the problem is ours, the Federal Government’s problem. It

is our responsibility to fix it. No matter how hard one might try

to look at it differently, these are government ships, they are stored

and maintained by the government and required by law to be disposed of properly by the government.

Secondly, the problem will not go away on its own. Indeed this

problem grows larger with each passing day, both in terms of the

increasing number of ships that need to be scrapped and in the

simple and inescapable fact that like all of us, ships get old, steel

wastes, and structural integrity degrades. We simply cannot ignore

it. We can’t pretend it doesn’t exist and we can’t simply persist in

holding our collective breaths each time there is a storm near one

of these fleets or in the calm of the night that something, quote,

‘‘bad’’ might happen.

We are paying considerable amounts of money now, as the Chairman noted, and that amount of expenditure will continue to grow.

For example, we spent around $3 million last year just to take care

of this fleet. We anticipate spending perhaps five times that in the

next couple of years unless we resume scrapping operations.

As the Chairman referred to and wanted me to speak to, last

year with that ship right there, the Export Challenger which is

some 40 years old, we and the taxpayers spent $1.3 million to

pump out some oil, to fix it up and return it to site in the James

River where she sits today. And this, Mr. Chairman, and all of you,

as all of us who are responsible for managing the taxpayers’ resources, it is very hard to justify that type of expenditure but it is

not going to stop with the Export Challenger.

We are going to begin, and it is no secret to Admiral Amerault

or anybody familiar with this program, we are going to begin dry

docking these ships, ships such as the Export Challenger. Their average age is 48 years old. That is older than me, I think it is older

than the Chairman and older than others here, at the cost of

$900,000 apiece minimum, because we don’t know what it is going

to take once they are in the dry dock to fix them up.

We will have 155 ships under our control at MARAD by the end

of 2001. Anyone here can do the math and see that it will cost this

country hundreds of millions of dollars in the next decade. And

what do we end up with? Exactly what we have today—155 ships

sitting in the James River, Beaumont, Texas, and Suisun Bay—unless we resume scrapping.

How we got here has been chronicled in my written testimony.

Admiral Amerault will speak to it. Tom Howard just spoke to it.

I am not going to repeat it. I will say, however, that there have

been a series of decisions taken within our government that have

resulted in the current impasse, decisions that were well founded

in intention and desire but which did not address the fundamental

101

and again inescapable fact that something has to be done with

these vessels.

In a sense, I think that we have substituted in the last 7 years

an appearance of action on this problem for real action while the

infinite patience of time continues to take its toll on our vessels.

But I would caution all of us against leveling recriminations

against any of the agencies or people who have been involved in

this matter, since that would, I believe, undermine our common

purpose and desire to eliminate these ships as fast as possible and

in the most responsible fashion we can.

Mr. Chairman and members of the Task Force, my agency

MARAD is forbidden by law to do anything other than sell these

ships. We did it for quite a number of years and very successfully

and yielded a lot of money that was used to offset our need for appropriations. But because of this situation, MARAD has not taken

any of the actions that might be necessary to inventory the fleet

for both the hazardous materials that might exist and to estimate

possible recoveries from the sale of metals from the ships. To do

that would require a huge amount of money and a devotion of staff

resources that we simply don’t have at this time.

However, let me stress, if the statutory mandate is changed, and

MARAD is given the authority to pay for scrap vessels domestically, MARAD is fully prepared, equipped and, I would submit emphatically, the right agency for the job. We are already charged by

DOD for these, to take care of these vessels and to keep the ready

reserve force ready to fight, and we do that in an outstanding fashion. We know these vessels, we know the shipyards that might be

willing to participate in a program, and indeed we have a very

strong and vibrant relationship with those shipyards that is in all

senses a commercial partnership by virtue of the other programs

MARAD implements. Thus I am confident that if directed by Congress, we, MARAD could establish a program that yields the best

value to the government. We have proved that elsewhere and I am

confident we would do it here.

Finally, Mr. Chairman, members of the Task Force, we all need

to remove the extensive mystery about ship disposal—and I mentioned this to you yesterday—the mystery which leads to imposing

regulations and treating this situation different from disposal situations elsewhere.

A ship is nothing more in a sense than a building. It differs because it floats, but it is a building. Fifty years ago, just as buildings

were made using materials such as asbestos and PCBs, so are

ships. But the problems are the same, the challenge is identical,

and the technical responses to that need to be much different,

whether it is a ship or a building. We have those resources, we

have that capability, and we have the ability to take care of the

problem.

I thank you for your interest, look forward to working with you,

and again this is a long overdue opportunity.

Chairman SUNUNU. Thank you very much Mr. Graykowski.

[The prepared statement of John Graykowski follows:]

102

1 All references to tonnage in this statement are to lightship displacement tonnage. Lightship

displacement tonnage refers to the actual weight of the ship.

PREPARED STATEMENT OF JOHN E. GRAYKOWSKI, ACTING MARITIME ADMINISTRATOR,

U.S. DEPARTMENT OF TRANSPORTATION

Good morning Mr. Chairman and Members of the Task Force. I welcome the opportunity to be here today to discuss an issue of great importance to the Maritime

Administration (MARAD)—the disposal of obsolete government vessels. As you

know, the Federal Property and Administrative Procedures Act of 1949 designates

MARAD as the Government’s disposal agent for merchant type vessels of 1,500

gross tons or more. Thus, in addition to MARAD’s own National Defense Reserve

Fleet (NDRF) obligations, the agency has taken title to over 40 merchant type Navy

ships for disposal in the last 2 years.

Currently, there are 114 vessels slated for scrapping moored at the James River

Reserve Fleet in Ft. Eustis, Virginia; Beaumont Reserve Fleet in Beaumont, Texas;

and Suisun Bay Reserve Fleet in Benecia, California. This number is expected to

grow to 155 by the end of Fiscal Year 2001 if additional vessels are not disposed

of. MARAD is committed to finding an appropriate means of scrapping these vessels

safely, economically and in an environmentally sound manner.

Under the National Maritime Heritage Act of 1994, MARAD is required to dispose

of obsolete NDRF vessels by September 30, 2001, in a manner that maximizes financial return to the United States. Fifty percent of the amounts received from

scrapping are to be used by the Maritime Administrator for the acquisition, maintenance, repair, reconditioning or improvement of NDRF vessels. Twenty-five percent

is to be used for expenses incurred by the State or Federal maritime academies for

facility and training ship maintenance, repair, modernization and the purchase of

simulators and fuel; the remaining 25 percent is to be made available to the Secretary of Interior for maritime heritage grants.

Historically, MARAD’s primary means of disposing of obsolete vessels has been

to sell them for scrapping. From 1987 to 1994, MARAD sold approximately 130 obsolete vessels for scrapping overseas. During that period the agency received an average of $108 per ton for those ships.1 Since an average ship in the NDRF weighs

approximately 6,000 tons, the gross returns for scrapping such a ship overseas have

been about $600,000.

Since 1995, MARAD has not scrapped any vessels overseas due to concerns raised

by the Environmental Protection Agency (EPA) about the export of hazardous substances. Specifically, the EPA advised MARAD of its position that the export of a

Government ship for scrapping was the equivalent of distributing in commerce regulated quantities of Polychlorinated Biphenyls (PCBs) under the Toxic Substances

Control Act (TSCA). In November 1995, EPA issued a discretionary enforcement letter to MARAD allowing the export of two ships for scrapping once all PCBs had

been removed. That procedure was unworkable since the removal of all PCBs could

have compromised the watertight integrity of the ships.

In 1997, MARAD and the EPA signed an agreement allowing foreign ship disposal

after removal of liquid PCBs and readily removable solid PCBs. Prior to implementation of the export agreement, however, the Department of Defense formed an

Interagency Panel on Ship Scrapping to review the process for scrapping Government vessels. Thus, in January 1998, MARAD agreed to continue to refrain from

selling any vessels for scrapping abroad until the Panel had completed its review.

Additionally, in the fall of 1998, an executive memorandum requested that MARAD

and the Department of Defense observe a moratorium until October 1, 1999, on the

export of obsolete vessels to be scrapped, to ensure that the Panel’s recommendations were fully considered. MARAD complied with this request.

The Interagency Panel, composed of representatives from DOD, the EPA, the Occupational Safety and Health Administration (OSHA), the Department of State, the

Department of Justice, the U.S. Coast Guard and MARAD reviewed the process and

procedures for scrapping ships. The Panel made recommendations regarding economic soundness and environmental and worker safety. It also concluded that all

options for ship scrapping, including overseas scrapping, should remain open.

With regard to exports, the Panel made a number of recommendations—such as

expansion of the notification process to importing countries regarding the presence

of hazardous materials, and the requirement for bidders to submit a technical compliance plan—which could be incorporated into the process relatively quickly. Nevertheless, developing meaningful technical assistance, and determining how to enforce

contractual requirements and monitor contractual performance overseas could take

significant time and resources to implement.

103

Since 1996, MARAD has been exploring the domestic ship scrapping market. The

agency has revised its solicitation process for domestic sales, incorporating environmental and safety issues as part of the award. A bidder is required to submit a technical compliance plan including environmental, worker health and safety, business,

and operational plans that describe the bidder’s knowledge and ability to address

the problems inherent in ship scrapping. Following a review of the bidder’s technical

compliance plan, its compliance history and a site visit, MARAD awards vessels to

qualified bidders on the basis of price. During the scrapping process, MARAD also

conducts both announced and unannounced visits to the scrapping site to monitor

the contractor’s compliance with the sales contract.

Unfortunately, the capacity of the domestic market for buying and scrapping obsolete MARAD ships is limited, and the drop in the price of scrap steel has eroded

the profitability of existing scrappers. Moreover, only four bidders have satisfied the

requirements of MARAD’s technical review since 1997, and only 9 of the 22 ships

sold domestically during that time have been removed from the fleet sites. Three

of these vessels were sold for $10.00 each. One sales contract for five vessels was

terminated last year because the purchaser did not take possession of the vessels.

We are likely to continue facing a backlog given the number of ships waiting to be

scrapped.

You may be aware that about 40 NDRF vessels are in extremely poor condition.

Time is critical in this effort. The cost to the Department of Defense of maintaining

each NDRF vessel is approximately $20,000 per year. However, as obsolete vessels

in the NDRF continue to deteriorate, the costs of upkeep will rise. For example, the

Export Challenger, a vessel in the James River Virginia Reserve Fleet, experienced

a relatively minor release of oil in 1998. Due to the deteriorated condition of the

hull, the remainder of the oil aboard needed to be removed. The combined cost of

clean up and removal of oil from the vessel was $1.3 million. The cost of dry-docking

a vessel in order to prevent it from sinking is estimated to be about $900,000 per

ship. MARAD expects to begin dry-docking 16 obsolete vessels in poor condition per

year beginning in fiscal year 2002 in order to avoid environmental problems. In the

meantime, these ships are monitored closely by MARAD to prevent sinking or a hazardous discharge.

We are fully committed to working with Congress to find a swift and appropriate

solution for scrapping obsolete NDRF vessels. MARAD’s authorization proposal for

fiscal year 2001 contains a provision that would extend the deadline for the disposal

of obsolete NDRF vessels from 2001 to 2006. During this period, MARAD intends

to develop and implement a program to scrap these vessels safely, economically and

in an environmentally sound manner.

In addition, Maritime Administrator Clyde J. Hart, Jr. recently wrote to Carol

Browner, Administrator of the EPA, seeking to explore the possibility of resuming

exports in a manner consistent with the prior agreement negotiated between EPA

and MARAD. Although we have not yet received a response to our inquiry, we do

not believe that this option has been foreclosed.

Mr. Chairman and Members of the Task Force, we appreciate the concern that

you have shown in this area and want to assure you that we are working diligently

to resolve the matter as soon as possible. This concludes my statement. I would be

happy to answer any questions you may have.

Chairman SUNUNU. Admiral.

STATEMENT OF VICE ADM. JAMES F. AMERAULT

Vice Adm. AMERAULT. Good morning, Mr. Chairman, and distinguished members of the Task Force. I am very pleased to appear

before you today to discuss the Navy’s approach to reducing our

own inventory of excess ships. With your permission, I would like

to submit my prepared statement for the record but take a few

minutes here to give you a shortened summary version.

Chairman SUNUNU. Without objection.

Vice Adm. AMERAULT. Thank you sir. The Navy’s Inactive Fleet

has 57 ships designated for scrapping. The decision to scrap a Navy

ship is made only after carefully evaluating all other options, and

these include several such as retention as a mobilization asset, sale

to allied Nations under the foreign military sales program, use as

104

a war memorial or historical museum, use for training, or use as

a weapons development asset.

The Navy’s primary interest is to dispose of all of our excess

ships in a manner that is environmentally sound, economically

neutral, and worthy of the proud service that these ships have performed for this Nation.

Historically, the scrapping rights to our ships have been sold to

domestic shipbreakers, very much like what has gone on in the

MARAD fleet. More recently, environmental concerns, worker safety, and changing economic conditions have impacted the methods

and locations available to scrap our ships. Up until the mid-1990’s,

domestic shipbreakers were willing to pay for the rights to scrap

Navy ships because the value of metal and other equipment in the

ships offset their costs and provided a profit. This, of course,

matched our goals and reinforced our expectation that Navy ships

could be scrapped at no cost to the Navy. However, since 1996

eight scrapping contracts have defaulted, causing the Navy to expend over $12 million to return 28 ships to a safe storage condition.

So within Navy we faced a dilemma: A backlog of ships to be

scrapped was growing but there was no domestic market in which

scrapping could be accomplished at no cost.

Consequently, we began in 1997 to work with EPA to determine

the conditions under which scrapping might be accomplished overseas. In 1998 increased interest by the Congress and the public resulted in both the Vice Presidential and Secretary of the Navy moratorium on overseas scrapping. At the same time, the Under Secretary of Defense for Acquisition and Technology created an interagency panel to explore the problems and solutions to disposing of

excess Navy and MARAD ships. The panel recommended that the

Navy conduct a pilot program to determine the conditions under

which domestic scrapping could be made feasible.

Consistent with this recommendation the Navy developed a ship

disposal project with a pilot phase that was designed to qualify and

quantify the technical scope and costs associated with ship scrapping. That pilot phase is currently underway. The goals of this

project are:

1. To document all processes, costs, revenues and hazardous materials generation while demonstrating an environmentally sound

and cost-effective method for dismantling ships;

2. To minimize the Navy’s net cost of ship disposal by realizing

a fiscal return on scrap metal and other equipment sales; and

3. Develop a viable domestic capability to scrap additional ships

from the Navy’s inventory after the pilot phase is completed.

A significant feature of the ship disposal project is that the Navy,

not the shipbreaker, assumes the risks associated with the vagaries

of the scrap metal market and equipment resale. The shipbreaker’s

profit is set in terms of the contract. Proceeds generated by the sale

of scrap metals in excess equipment are then credited against the

cost of the contract.

It is by decoupling this volatile scrap market from the contractor’s profit or loss that a contractor can establish a stable economic

model within which scrapping processes can be optimized, and

hopefully that is our solution to defaulting contracts.

105

In September 1999 we awarded four indefinite delivery/ indefinite quantity contracts for the pilot phase. The initial task order

under each of these contract is to dispose of one ship—and all

ships, by the way, all four are exactly the same type and model of

ship—to dispose of one ship under a cost plus incentive fee structure. Progress to date has been satisfactory. The data concerning

the processes utilized and the cost revenue stream is being collected but has not yet been completely evaluated. The last of the

four ships should be completely dismantled and all materials recycled in the fall of this year.

It became obvious to us during the initial performance of these

task orders that much of the contract cost was attributable to process start-up of an infrastructure facilitation required for the dismantling process to provide further insight into the true cost of

shipbreaking. Two additional task orders were awarded under the

pilot phase on May 24th of this year under a fixed price incentive

structure.

Task order awards after the pilot phase will be made following

careful examination of the data collected and dependent upon the

availability of Navy funding.

The Navy has also worked with MARAD on the ship disposal

problem for several years. Through group participation in several

joint agency working groups, we have shared our technical and

process information. We will continue our open dialogue and provide the ship disposal project data when it is completely available

to MARAD.

In summary, the Navy is committed to dismantling our excess

ships in a way that is environmentally sound, publicly acceptable,

and advantageous to the Navy and the government. The ship disposal project assists in accomplishing these goals while providing

empirical data on the processes and costs associated with domestic

ship scrapping in an environmentally safe way.

Mr. Chairman and member of the Task Force, this concludes my

remarks. Thank you for your interest in the program. I would be

happy to answer questions that you may have.

Chairman SUNUNU. Thank you, Admiral.

[The prepared statement of Vice Adm. James Amerault follows:]

PREPARED STATEMENT OF VICE ADM. JAMES F. AMERAULT, DEPUTY CHIEF OF NAVAL

OPERATIONS (LOGISTICS)

Mr. Chairman and distinguished members of the panel, thank you for the opportunity to appear before you to discuss the Navy’s approach to reducing our inventory

of excess ships and how we are working with the Maritime Administration on this

problem. We sincerely appreciate your interest in our program and processes.

Before going further, I would like to note for the committee that I have not included in my testimony any discussion of our process for disposing of nuclear powered warships. This is because that work is accomplished exclusively in our public

shipyards and is subject to requirements more stringent than those necessary to dispose of non-nuclear powered ships.

I also wish to point out that Navy warships may present a more complex dismantling challenge than traditional merchant ships due to two facts. First, our warships

are constructed to maintain mission capability despite battle damage; and second,

they have a high density in terms of equipment and compartments.

The Navy’s interest is to dispose of our excess ships in a manner that is environmentally sound, economically neutral and worthy of the proud service they have

performed for this nation.

Let me now briefly explain the process we use to determine the manner in which

we dispose of our conventionally powered ships. After a careful evaluation, the Chief

106

of Naval Operations may declare a ship to be ‘‘excess’’ to the current operational

needs of the Navy. The next step is to determine if the ship is required as a Mobilization Asset. If the ship is needed, it is placed in a state of preservation such that

it can be reactivated and returned to active service.

If the ship is not needed as a Mobilization Asset, then it is made available for

sale or lease to an allied Navy under the Foreign Military Sale/Lease program.

If the ship is not a candidate for lease, it is stricken from the Naval Vessel Register and may then be designated for transfer to a nonprofit organization for display

as a historical memorial or museum. The requirements and mechanics of these

transfers are governed by statute.

If not designated as a potential historical museum or memorial, the ship may be

made available for Navy fleet weapons training or developmental testing of weapon

systems. If used in this manner, the ship is usually sunk as a result of the training

or testing. Therefore, prior to conducting the training or testing the ship is prepared

in accordance with requirements set forth by the Environmental Protection Agency.

The ship may also be held as a logistics support asset to fill requests by active

ships for parts or equipment that are no longer manufactured or stocked.

If the ship is not disposed of or held for any of the aforementioned purposes and

it is a merchant type ship, then it must be transferred to the Maritime Administration (MARAD) in accordance with Federal Property and Administrative Services Act

of 1949. Navy ships transferred to MARAD supplement the National Defense Reserve Fleet.

If it is not practical to use the ship in any of the ways I have mentioned, then

the ship is designated for scrapping.

Ships that are declared to be in excess and are awaiting final disposition enter

the Navy’s Inactive Fleet. Today the Navy Inactive Fleet has 144 ships in its inventory, 28 of which are being prepared for transfer to MARAD, and 57 of which are

designated for scrapping. The average age of the ships waiting scrapping is approximately 37 years and they have been out of active Navy service for an average of

7 years.

The traditional method the Navy used to scrap conventionally powered ships was

to engage the Defense Reutilization and Marketing Service (DRMS) as a Government sales agent to sell the scrapping rights to a domestic shipbreaker. Proceeds

from the sale of these rights were deposited with the United States Treasury, not

the Navy. The shipbreaker’s profitability was solely a function of his costs and the

price of scrap metals on the open market.

No matter where the shipbreaking is accomplished, the ‘‘Title’’ to the ship remains

with the Navy until the ship is deemed by the Navy to no longer be a ship. This

generally occurs when the hull is no longer floatable. I think it is important to note

that while the Navy holds the title it is the Navy that is presumed to be responsible

for the disposition of the ship, even if the shipbreaker defaults on the contract.

Until 1996, DRMS awarded scrapping rights principally to the highest bidder. As

scrap metal prices began fluctuating in the mid-nineties, these shipbreakers experienced fiscal difficulties leading in many instances to contract defaults.

In 1996, seeking to address the problem of contract defaults, DRMS initiated

changes to improve the selection process for scrapping contractors. A two-step process was instituted that included an evaluation of the contractor’s technical plans followed by an invitation to bid. Oversight at the contractor’s facility was increased.

Under the old sales to the highest bidder process, eight scrapping sales contracts

were defaulted and five sales contracts were completed between 1996 and 1999. The

Navy has expended approximately $12 million since 1996 to return 28 of the ships

from the eight defaulted contracts to a safe storage condition. Under the new twostep sales process, only two contracts have been awarded. One contract has been

satisfactorily completed and contract default procedures have been initiated on the

second contract. The contractor being defaulted has informed DRMS that it does not

intend to pick up the eight remaining ships under this two step sales contract because the company will lose money.

Since the domestic scrapping industry was not meeting the needs of the Navy, the

Navy entered into an agreement with the Environmental Protection Agency (EPA)

in 1997 that identified the conditions under which EPA would exercise enforcement

discretion against the Navy for exporting vessels that may contain regulated levels

of PCBs for disposal.

At about that same time, Congress and the media increased their interest in both

the environmental and safety concerns associated with ship scrapping. Overseas

scrapping came under scrutiny; and some foreign scrappers were identified as not

adhering to procedures that protected the environment and their workforce, especially when compared to the standards required in the United States. In response,

on 19 December 1997, the Secretary of the Navy (SECNAV) suspended all initiaVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00110 Fmt 6601 Sfmt 6621 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
107

tives to explore overseas ship scrapping. In addition, congressional hearings on ship

scrapping were conducted in March 1998 and June 1998.

As a result of public and congressional interest, the Under Secretary of Defense

(Acquisition and Technology) established the Interagency Ship Scrapping Panel on

24 December 1997. The panel was charged to review Navy and MARAD scrapping

programs and investigate ways to ensure that Navy ships are scrapped in an environmentally sound, economically feasible and occupationally safe manner.

The panel issued its report in April 1998. One of its recommendations was that

the Navy carry out a pilot project to quantify the scope and costs associated with

ship scrapping in private industry. This pilot project would also serve as a vehicle

for gathering information to improve the ship scrapping process.

On 23 September 1998, Vice President Gore requested both Navy and MARAD to

observe a moratorium on efforts to award contracts or transfer vessels for scrapping

overseas. This moratorium expired on 2 October 1999; however, Navy continues to

operate under the previously mentioned SECNAV suspension.

Consistent with the panel’s recommendation, the Navy initiated the Ship Disposal

Project (SDP) in 1999 with three goals in mind. These are:

1. Document all processes, costs, revenues, and hazardous material generation

while demonstrating an environmentally sound and cost effective method for dismantling ships;

2. Minimize the Navy’s net cost of ship disposal by realizing a fiscal return on

scrap metal and equipment sales; and

3. Develop a viable domestic capability to scrap additional ships from the Navy’s inventory after a pilot phase is completed.

The Ship Disposal Project is structured in two parts. The first part, referred to

as the ‘‘pilot,’’ is underway and is intended to gain insight into the process and costs

of scrapping warships. Navy will gather all revenue and expense data, document

quantities and locations of hazardous waste that are generated during the scrapping

process, and develop cost models for future decision making. The domestic

shipbreaker is required to maximize the value (within a specified time period) of the

recyclable equipment and scrap metal and sell these items as an offset to the Navy

costs incurred under the contract. Part Two of our Ship Disposal Project is to award

additional ships to one or more of these same shipbreakers as funds are available.

A significant feature of our Ship Disposal Project is that the Navy, not the

shipbreaker, assumes the risk associated with vagaries of the scrap metal market

and equipment resale. The shipbreaker’s profit is set in the terms of the contract

(i.e., cost contract or fixed price contract). Any proceeds realized from the sale of

scrap metal or equipment are used to offset Navy contract costs. With this decoupling mechanism in place the contractor can establish a profitable economic model

to optimize scrapping processes. The contractor is paid for the services he provides.

The SDP also features a performance incentive for effective environmental and safety programs.

The Navy’s Supervisor of Shipbuilding, Conversion, and Repair (SUPSHIP) performs oversight and contract administration for the SDP. This allows the contractors to benefit from the Navy’s ship repair experience and further facilitates the exchange of information between the Navy and the contractor.

Prior to a ship arriving at a contractor’s facility for scrapping, the Navy accomplishes some environmental remediation of the vessel. Nearly all hazardous waste

and some other hazardous materials are removed from the ship. The Navy also performs limited sampling on each vessel to identify the existence and location of other

hazardous materials.

On 29 September 1999, Navy awarded four Indefinite Delivery/Indefinite Quantity (IDIQ) contracts under Phase One of the Ship Disposal Project (i.e., the pilot

phase). The initial task order under each of these contracts is to dispose of one ship

under a Cost Plus Incentive Fee structure. Progress to date by the four domestic

contractors has been satisfactory. Data concerning the processes utilized and cost/

revenue stream are being collected but have not yet been evaluated. The last of the

four originally awarded ships should be completely dismantled and all materials recycled in the fall of this year.

Two additional task orders were awarded under the pilot portion of the SDP to

provide the Navy with further insight into shipbreaker’s start-up costs. These additional task orders were offered under a Fixed Price Incentive structure to provide

additional encouragement to reduce dismantling costs.

Decisions concerning Phase Two task order awards will be made after careful

evaluation of the data collected during the pilot phase and are dependent on the

availability of funding.

The Navy has worked with MARAD on the ship disposal problem for several

years. Through participation in several joint agency working groups, we have shared

108

our technical and process information. We will continue our open dialogue and provide the Ship Disposal Project data when it is available.

In summary, our Ship Disposal Project is pursuing the goal of dismantling our

excess ships in a manner that is environmentally friendly, publicly acceptable, and

advantageous to the Navy. The backlog of ships awaiting disposal presents an increasing burden on the Navy’s resources and could present an environmental concern as they continue to age. We are committed to eliminating our backlog and

avoiding any environmental risks. The Ship Disposal Project assists in accomplishing these goals while providing empirical data on the processes and costs associated

with domestic ship scrapping. In addition, we continue to look for and study other

disposal methods that may contribute to further reducing our backlog and our costs.

Mr. Chairman and members of the Committee, I thank you for your interest in

our program and the opportunity to tell you about the Navy’s ship disposal goals

and programs. I will be pleased to respond to any questions.

Chairman SUNUNU. Let me begin the questioning with Mr.

Graykowski. I think you have touched on this in your remarks but

I want to be clear as to exactly what the problem is. Why hasn’t

MARAD at least put together a plan for disposing of obsolete vessels during the period where you have received an extension on disposal, a temporary one, from 1999 to 2001? What has kept you at

least from putting together a strategic plan outlining how this

might be accomplished?

Mr. GRAYKOWSKI. Well, as I mentioned in my opening statement,

Mr. Chairman, first and foremost, we don’t have any authority beyond selling the ships at a cost which generates a positive cash

flow to the government and we have endeavored to do that. We

have had a number of offerings of ships which you know have been

taken at low prices and the ships never get picked up. We had one

instance of contractor default.

So in one sense we have been sort of struggling to take the program into a domestic context. In 1993 we had run an export program for years generating tremendous amounts of money. We

didn’t have that much familiarity with domestic scrapping and

there were constraints which, frankly, resulted in a lot of conflicting signals, I think, among various agencies as to how we were

going to solve this problem. So MARAD tried to respond that way.

We have never really explored or had the opportunity to explore

with the Navy with respect to a pilot project but I don’t think it

is fair to say——

Chairman SUNUNU. Do you have any legislative mandate to develop such a plan?

Mr. GRAYKOWSKI. No, we do not have a legislative mandate to

develop any plans.

Chairman SUNUNU. Do you think it is, despite the fact that you

don’t have a plan in place now, do you think that we really can afford to wait 5 years before we begin the disposal process? I was

struck by the request by the administration to move that date back

5 years and that the disposal process would have been required to

begin then. That would seem to be far too much time, given the

condition of the vessels. Would you agree with that?

Mr. GRAYKOWSKI. I think that the perception that was created by

the legislation was that we were going to somehow take all 5 years,

and then at the end of 60 months we are going to sort of start

doing what we came up with to do; and I think that a fairer assessment is give us a reasonable amount of time. We could have, I

think, done what we did several years ago, which was asked for 2

109

years, knowing that that was unrealistic, from our perspective. The

60 months was an outside date.

I don’t think in our hearts and minds at MARAD it was going

to take that long or be that long and, quite frankly, looking at the

development of the interest level within the Congress, both House

and Senate, I think it is going to be overtaken by events. I am confident there is going to be some action and directives from the Congress which will both shorten the time and increase the pace of activity.

Chairman SUNUNU. I would tend to agree and very much hope

that it is overtaken by proactive events rather than defensive

events. And to that point, could you talk a little bit more about the

problems associated with the Challenger? Was it a single leak, a

single fracture, or a series of problems? And again, could you summarize the total cost associated with that one vessel?

Mr. GRAYKOWSKI. I will do that, Mr. Chairman, and I will also— I would like to submit a better answer for the record.

All of these ships, or many of them, have pockets of oil, I mean,

for want of a better term. In some cases there are 1,000 barrels

and in other cases 20 barrels. But we have surveyed 40 ships and

I think I came up with a ballpark figure of some 40,000 barrels of

oil that are scattered around the country, which would cause a

problem in anybody’s district, anybody’s river.

On the Challenger there were small leaks and the Coast Guard

notified us, as I recall, and I may be wrong on this, that this was

a problem. And we had to boom it by putting containment booms

around her, and were sort of—‘‘directed’’ is too strong a word—encouraged and supported by the Coast Guard to sort of remediate

the potential for additional oil to leak and this is oil deep in tanks.

The ships are just laid up in some cases.

Chairman SUNUNU. Are you unable to pump it?

Mr. GRAYKOWSKI. Yeah. You have got to see it to believe it. In

some cases, this is bunker oil, if any of you are familiar with the

thick, heavy, sludgy stuff which over the years hardens into tarlike road tar. So just the process of peeling open the tanks and

heating up the oil, if you will, to the point where you can pump

is extensive and a very arduous process. So that is what we went

through on her, to the cost of $1.3 million.

Chairman SUNUNU. All of the effort was done while it was still

on the water?

Mr. GRAYKOWSKI. Yes, sir. She still remains there, and indeed we

spent some more money down at the James River when Hurricane

Floyd came through and we were very concerned. That was the reference I made there, additional funds we didn’t anticipate having

to spend.

Chairman SUNUNU. How many of the vessels, approximately, of

the 40 worst-condition vessels are at or near the condition of the

Export Challenger?

Mr. GRAYKOWSKI. We have triaged it or identified sort of a priority list and we have got sort of—not a new term—but the ‘‘dirty

dozen.’’ There are 12 ships that really, Mr. Chairman, are—Export

Challenger, she is our poster child, but she has a lot of siblings.

And so I say there are 12 that really are approaching the condition

of the Export Challenger.

110

Chairman SUNUNU. Was it ever in danger of sinking?

Mr. GRAYKOWSKI. I don’t think so. I mean, I don’t want to impart—it is a tough question to answer.

Chairman SUNUNU. I don’t know if that is an encouraging answer or discouraging answer from my perspective.

Mr. GRAYKOWSKI. I could say none of them sunk yet. No, we

monitor them carefully, we do the best we can, and I don’t think

they are in danger of imminent sinking and hulling, absent sort of

major storm and waves and conditions that don’t exist today. These

are calm waters. Congressman Bentsen, I think if he is familiar

with where Beaumont sits, is a very well protected area. Over time

will they sink? I think it is unavoidable, yes, but not imminent. I

would like that message to be there.

Chairman SUNUNU. Has any effort been made to quantify what

the potential costs would be of a catastrophic accident, either a

sinking or a serious hull rupture of one of these vessels?

Mr. GRAYKOWSKI. I am getting no encouragement from the folks

behind me. My bench is weak here. Well, to quantify the costs, fine;

what kind of accident, we would have to remediate whatever leakage problem or environmental damage that occurs. And frankly as

a lawyer, I have always looked at it as I have got the ultimate

strict liability here. I am a generator under EPA, under TSCA,

under CERCLA, under Fish and Wildlife and Migratory Birds;

there are a whole number of acts out there. And the Federal Government is the ultimate deep pocket, so quantification depends on

the extent of damage to a certain extent, but the checkbook is

going to be open for a long time.

Chairman SUNUNU. OK. What kinds of marine wildlife are there

in the James River, and was there any damage to the ecosystem

or the wildlife with the Export Challenger accident?

Mr. GRAYKOWSKI. The answer is an emphatic no. There was no

damage. We contained very limited minor leaks. We have got a

containment boom pretty much around the fleet now in terms of

where that is. There are State certified oyster beds. I understand

there are a couple of wildlife refuges. Indeed we have ospreys

building nests on our ships, and certain times of the year we can’t

go near them. They are wildlife habitat wetlands which we have

got to protect as best we can.

Chairman SUNUNU. Your predecessor, Mr. Hart, wrote at least

twice to the EPA requesting a meeting with the Administrator to

resolve the issues that are preventing the timely scrapping of government vessels. Has there been any response from Ms. Brown or

the EPA today?

Mr. GRAYKOWSKI. Mr. Chairman, there hasn’t. I think that recently Deputy Administrator Bonnie Green, who testified in front

of Congressman Gilchrest, has written the Administrator of the

EPA, and I intend on writing her today to tell her once again that

we have testified and we need to work in an interagency fashion.

To date, no sir, there has not been a response.

Chairman SUNUNU. Has the EPA put together guidelines for you

or for the Navy, that you are aware of, for the disposing of obsolete

vessels?

Mr. GRAYKOWSKI. We have got a memorandum of understanding,

if you will, or agreement with EPA on certain conditions that have

111

to be conformed with before we can scrap a ship, so that is in place.

However, there are still some of the guidelines—I was just getting

to that. While we have this memorandum, the particulars in terms

of the regulations, for instance PCBs, and that the guidelines that

we would employ to scrap and to monitor are not in place, sir.

Chairman SUNUNU. Would you explain that in a little more detail? What do you mean, the guidelines aren’t in place?

Mr. GRAYKOWSKI. I think that EPA, and I am going to have to

elaborate for the record if I could, EPA, we have got this memorandum of understanding, but it lacks sort of—that says we are going

to cooperate, and here’s the basic structure of that: Before MARAD

scraps a ship, you have to clean out all the PCBs, for example, but

in terms of the exact procedures and the quantities that would be

allowed or not, they are still under development at EPA.

Chairman SUNUNU. I am confused. Does the memorandum, does

the agreement that you signed, lay out what you need to do before

you can move forward with a scrapping—is that valid or invalid?

Either those are the guidelines you need to follow or the EPA has

changed their minds and is walking away from this agreement and

saying we are going to come up with different guidelines.

Mr. HOWARD. Mr. Chairman, may I speak to the agreement?

Chairman SUNUNU. Please.

Mr. HOWARD. The agreement contains three conditions: one, that

all liquid PCBs be removed; that solid PCBs be removed to the extent possible; and that the country that is accepting the vessel be

notified that the PCBs were on board and attempts were made to

remove them. That is what the agreement covers.

Chairman SUNUNU. Those sound like reasonable guidelines.

Mr. HOWARD. MARAD received authority in 1997 or 1998 to sell

two ships under those guidelines. When they attempted to put together a plan that complied with the guidelines they found that

once they had removed the PCBs, that the ship wouldn’t be seaworthy and it wouldn’t be able to be towed to the foreign country

that was willing to purchase it.

Mr. GRAYKOWSKI. So we are still waiting for final guidance, if

you will, out of EPA to avoid this conundrum.

Chairman SUNUNU. I understand. So you are looking for a little

additional guidance so that you won’t have to destroy the seaworthiness of the vessel in an effort to scrap it efficiently and economically.

Mr. GRAYKOWSKI. Yes, sir; and I don’t know what the status of

the guidelines are at this point in time.

Chairman SUNUNU. Has MARAD or anyone else evaluated EPA’s

environmental concerns to determine whether they are supportable

on an environmental or economic basis?

Mr. GRAYKOWSKI. The short answer would be no. I guess it would

be very difficult for the Maritime Administration to second guess

the Environmental Protection Agency on a determination of

environmental—— Chairman SUNUNU. I understand that is not your expertise, but

there has been no other outside or independent evaluation.

Mr. GRAYKOWSKI. No. We are sort of leaning—we as a country

by approaching it this way are way ahead of, if you will, the rest

of the world. Scrapping practices vary worldwide, and what we are

112

trying to impose as standards and that the Admiral has worked

with, for example, is where I believe sincerely the world is going

to end up. But it is going to be several years before it gets there,

but we will be the first to get there.

Chairman SUNUNU. Thank you very much. Mr. Bentsen.

Mr. BENTSEN. Thank you, Mr. Chairman. I have a few questions.

First of all, I am familiar with the Beaumont area, even though I

am in Houston. But let me tell you, when a hurricane comes up

the Gulf Coast, and a lot of times they head toward an island in

the Beaumont area, you can be in that protected part of the Sabine

River and still get some pretty good surf over there. In my district

back in 1994, as well as just last year, when you get either a storm

or a hurricane or heavy rainstorm, you move the current on that

river and you can lose control of operating ships.

Plus we had in 1994 a situation with these abandoned barges,

some that were beached, that got moved off the beach, off the

banks, and smashed into the I-10 bridge, was involved in part setting off an explosion in a pipeline.

So even though you are in a protected water area, the force of

nature can sometimes change it, and that is something that we

have to be concerned about, particularly in—at least I am most familiar with the Texas areas. And I do understand the environmental hazard related to these with, again, my own experience in

going through it with these barges and most of the working ships

in the Texas area.

Again, though, it is—and I know you have been having this discussion with Mr. Sununu about this—but it is my understanding

that EPA has said that you could—if MARAD would remove the

hazardous waste, be it PCB or whatever, then you could direct the

vessel for scrapping. And I guess what you are saying is in some

cases the vessel becomes unseaworthy and you can’t do it. Why not

salvage the vessel on site? I mean, we do that. I don’t, but the organizations along the Houston ship channel do that from time to

time, where they just do an onsite salvaging instead of trying to

tow something in and take it apart.

Mr. GRAYKOWSKI. Well, number one—and probably you don’t

have to go farther than number one—we don’t have the money for

it, Mr. Bentsen.

Number two, the EPA agreement—let me correct myself if I

could, please. And the Admiral was kind enough to tell me this. It

pertained to exports, OK and it is very dicey at this point in time

politically as well as I think practically, if you will, to be exporting

these ships. And so while we have turned our attentions domestically as I have indicated—— Mr. BENTSEN. Can I say that, for a second, on EPA, on the exports, they were opposing the export of the ships because of PCB

content?

Mr. GRAYKOWSKI. Primarily; and other what they consider to be

toxic waste, they viewed it as——

Mr. BENTSEN. It is an interesting notion, and I only add that because I have had a small battle with the EPA over the last several

years changing what has been the position for the last 15 years to

allow for the export of PCBs for disposal and incineration abroad,

which we believe violates the TSCA act, although EPA seems to beVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00116 Fmt 6601 Sfmt 6602 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
113

lieve that it doesn’t. EPA has taken the position that they would

like to export PCBs to Mexico and Latin America and other countries where they can be disposed of. Some would argue that this

is because the volume of American PCBs is declining and there

continues to be industry demand.

So it sounds to me like EPA may have a—the left hand may not

know what the right hand is doing at the EPA. I would encourage

you all to go back and talk to them.

Now they are under court order precluding them from doing that,

from the California circuit, the West Coast circuit and we have

tried to block them from doing that through the defense bill in the

past. Again, EPA has taken this position that in some cases, at

least, you would export PCBs for incineration.

Mr. GRAYKOWSKI. I am incredulous, frankly. This is news to me

because when I leaf through, this is the agreement that I signed

with EPA in 1997, it specifically links PCBs, the vessels and TSCA

and the prohibition against introducing PCBs into international

commerce and that is what ground the exporting to a halt.

Mr. BENTSEN. Maybe instead of offering up the ship for scrap

metal you should have offered it up for PCB consideration. I would

encourage you to revisit that, and that is in the courts, I think the

9th Circuit.

Let me ask you this. The chairman mentioned that the range of

cost for addressing this problem would be between half a billion to

$2 million. Why is there that amount of fluctuation or band in the

cost? Is it because you don’t know necessarily what you have out

there until you get into the ship?

Mr. GRAYKOWSKI. We have not inventoried, and I told the chairman this yesterday, we have not really conducted the inventory

necessary to say we have 5 pounds or 5,000 pounds of PCBs, I don’t

know, liquid versus solid. My impression is that most of the liquids

have been removed except those transformers and capacitors that

are buried in the bowels of the ship. We don’t know approximately

how much we can get off of the ship. I think the admiral can speak

to the fact that—it is a net outlay when you pay to have someone

scrap it, but there is a return that we would anticipate having a

similar experience with.

Vice Adm. AMERAULT. Assuming you will ask about this anyway,

but our program is based on the fact that we are paying someone

to scrap the ships. Heretofore that was very difficult to do because

they would default, there being no longer a viable market for the

scrap material which used to finance the whole venture. So what

we do is we reduce their risk of making nothing by paying their

workforce and facilitization and other costs, by paying the cost of

doing business, if you will, just the labor and so forth.

Any materials that come off the ships that then can be sold in

the scrap market are, by contract, used to net the total cost in our

favor.

Now, we don’t know exactly how well that is going to do and I

think it is going to depend on some things, one being facilitization

that is taking place up front, and we have paid for that in the four

pilots, the four yards that we have used as pilot program participants. Part of what we pay for is the facilitization to be able to

handle the environmental and the other things. Once that is done,

114

then you have learning curve, which can reduce the cost of their

operation, and you have of course the value of that material. As

you get a good steady throughput and the learning curve comes

into play, their costs will go down and you will have a volume of

material that you can sell for scrap. And the net, if things were to

work out, might, and I say might because we don’t have the final

information and we don’t have this—we don’t know how scalable

this is, but it could be that the net cost of this whole thing equals

the cost of living up to the EPA agreements of taking out the PCBs

and making the ships environmentally safe for export. So that is

our hope.

Then you would have at least two processes that you could look

at and compare. I would think that we would want to try to export

a few ships so we could test that hypothesis to see if doing it domestically with a net value, if you will, approach, that we have

done in this pilot program is indeed better or if you can still beat

it overseas even if you pay the up front environmental costs.

Mr. BENTSEN. It seems to me there would be a couple of factors

between domestically and overseas, the laboratory input and the

capacity, but also there are some transportation costs associated as

well. I am sure that these ships are not cheap to move around.

Vice Adm. AMERAULT. There is a cost of getting them there. That

could work in our favor domestically.

Mr. BENTSEN. There are two bills, one being Mr. DeFazio’s bill,

and I would be interested in your comments on that. I don’t know

if MARAD has taken a position on that.

The other, in the Senate, the chairman of the Senate Commerce

Committee, Senator McCain, has introduced a bill which gives

DOT the authority to scrap 39 foreign vessels under terms determined by the agency. Is this an effective way to deal with the problem or do you have a position on that bill?

Mr. GRAYKOWSKI. No, we have not taken a position on any of the

legislation. There are four bills in total. We don’t have an administration position on any of the bills introduced.

Mr. SUNUNU. If I could interject there, Mr. Howard, those two alternatives, correct me if I’m wrong, were part of the recommendations that you made, one, to release the restriction on these exports, and, two, to authorize MARAD or get rid of the restriction

on MARAD from being able to pay to scrap, and that is what Mr.

DeFazio’s bill does. He includes an authorization amount but of

course in order to do that he needs to eliminate that restriction?

Mr. HOWARD. Yes, sir, that is consistent with what we recommended.

Mr. BENTSEN. It seems to me that this is a situation that there

isn’t going to be much of a market for and we just need to get a

handle on this and how much it is going to cost and deal with it

because again I realize these ships are docked and they are in

somewhat secure waters most of the time, but I guarantee you

there will be another storm that will come up high island and there

will be more water in Suisun and Beaumont and everywhere else

you have these and it is going to become a problem. It would be

worthwhile for us to get a handle on this now and address this and

figure out a way to do it. This is not unlike a Superfund situation

115

or any other hazardous waste disposal, we just have to deal with

it.

Mr. GRAYKOWSKI. Mr. Bentsen, I didn’t mean to imply in my

statement that the calm waters are always calm. Hurricane Floyd

caused us some sleepless nights. The first report indicated that

some of the nests had not broken but they were drifting apart, had

hurricane Floyd been stronger and hit differently, our lives would

have been differently. These ships cannot withstand heavy water.

Number two, I might take issue with you. I do see a potential

for this country. There are 10,000 commercial ships operating

around the world. If indeed we set the standard as we have consistently through the years on environmental matters and the rest of

the world does catch up and I would point to the Basel Convention,

which is part of the U.N. Process, if you will, moving toward declaring obsolete ships as a hazardous waste, the country of the

Netherlands, which is a major world shipowner, there was one conference, they are pushing for another one, Norway has been talking

about incorporating scrapping into the life cycle cost of the vessel,

imputing to owners this notion that you are going to have to pay

to scrap.

I would pose to you if we put a program together now with these

government ships, quite possibly we are in a position to take advantage of it in a commercial sense when the rest of the world

says, oh, my gosh, we are going to have to.

Mr. BENTSEN. That is a legitimate point. I had a discussion last

week with some people in the maritime industry in Houston, where

there is a discussion going on both in Texas and I think somewhat

through the international maritime organization regarding emissions controls. Houston, of course has a serious ozone problem. One

idea—and part of the contribution of that comes from the ships

that go up and down the Houston ship channel. We can’t impose

a Houston emissions control policy on ships calling on our port because they will go somewhere else. There probably needs to be a

national standard, but it is difficult to impose a national standard

with respect to WTO and other international agreements that we

have, and perhaps it needs to go through the International Maritime Organization. I do appreciate that.

However, surely you have some ships that are decaying to the

point where we may not be able to wait for an international convention to—you know, necessarily get an agreement. We may be

talking something more prospective than retroactive.

Mr. GRAYKOWSKI. The imminence is undeniable. I think long

term there are benefits to be gained by sort of creating this new

industry just as we have seen in other environmental recovery operations. Right now, Mr. Bentsen, we have to do something with,

as I said, these 12 or the 40. I mean there are other benefits. We

have not really looked at it in a broad perspective. If we attack it,

we ought to attack it in a comprehensive fashion. We are dying for

people to work in basic shipbuilding industries and trades. The

shipyards are essential to the national defense. This is the type of

program that can help support them different than building brand

new ships. We have a source of labor to keep people coming in because this is another problem that has not been looked at.

116

Mr. BENTSEN. I agree with that. In order to get there, it may be

something that has to be subsidized initially. The chairman doesn’t

always like to hear that word, but I think he understands as well

this may be a situation where the need is great to deal with this

problem, and I understand the need and the idea of maintaining

shipyard operations. You might be able to match the two. Perhaps

in the long run you are right. As in other environmental services

which we have seen grow in waste disposal, this may be applicable

also.

Mr. GRAYKOWSKI. Yards that I have talked with this about comment that there is a crossover point. If we guarantee a certain

feedstock at some point, however many ships, the economies become such that it becomes a positive situation for the company or

in this case the joint venture between government and industry.

You are running so many ships, ostensibly you get the efficiencies

down and the yields up in terms of the metals. And the projections

that I have seen show a definite crossover point from subsidy to a

revenue generating or certainly a wash situation referred to by the

admiral. Until we start it, we are not going to know and we right

now don’t know much other than our ships are getting old and the

problem is getting bigger.

Mr. BENTSEN. Thank you.

Mr. SUNUNU. Thank you.

Ms. Hooley.

Ms. HOOLEY. I am sorry that I missed your testimony but I have

the written statements.

Having gone through your information, Mr. Graykowski, do you

think we have the capacity to dismantle the ships today in a domestic market?

Mr. GRAYKOWSKI. Nope.

Ms. HOOLEY. You do not?

Mr. GRAYKOWSKI. No.

Ms. HOOLEY. Let me ask the vice admiral if we have enough capacity in domestic market to dismantle the ships?

Vice Adm. AMERAULT. I don’t think now. It could possibly be generated but again as Mr. Graykowski said, I think one of the problems in trying to get it generated is what will be the throughput

so that when it is capitalized there will be a continuous throughput

to pay off that capitalization. So if we were to generate it, it would

either have to be subsidized, or there would have to be some feeling

that in an economic or business model, that there will be throughput to keep it going.

Ms. HOOLEY. When you say that we don’t have the capacity, that

has nothing to do with that we may have to pay to get this dismantled, it is simply that there are not enough shipbuilders or facilities?

Vice Adm. AMERAULT. There are people in the ship maintenance

business and shipbuilding business and public yards.

Ms. HOOLEY. Which have the capability?

Vice Adm. AMERAULT. Yes. This is not rocket science. You need

basically a berm or a dry dock or some sort of containment and

metal workers and the new part of it is the environmental sense

or the ability to deal with the environmental issues.

117

Ms. HOOLEY. Don’t you think on the domestic side that we have

much greater ability to deal with the environmental issues?

Mr. GRAYKOWSKI. Yes, ma’am. I was trying to get at that. I think

export ought to be looked at as almost a last resort option. We will

have 155 ships by the end of fiscal year 2001 and the Navy has—— Vice Adm. AMERAULT. We have 57 that are in excess category

that will be disposed of in some way or another, and an additional

28 of which we will turn over to MARAD, so we will add to their

problem.

Mr. GRAYKOWSKI. Exporting is almost giving up on the notion

that we can do it better. I believe we can do it better here in America. Our standards are higher, but we have proven that is a better

way to go. We have yards that are interested. When I say there is

not the capacity, today there is not. People are not bidding on our

ships because they have to pay us.

Ms. HOOLEY. As long as they have to pay you, they can’t afford

to do it?

Mr. GRAYKOWSKI. If we turn it around, I am confident that we

can put a program together and there will be sufficient people to

do it. But we need to do 12 to 15 ships a year, not onesies and

twosies.

Ms. HOOLEY. Right now does MARAD have to maximize the economic value of the ships, and is that a problem?

Mr. GRAYKOWSKI. Absolutely. I mean, we went from selling ships in 1993 or so at $108 a ton which netted us several hundred thousand dollars, netted to the government, so we didn’t have to ask

for appropriations to the last bid we had accepted was $10 a ship

for the whole ship that people paid us and even those contracts ran

into problems.

Ms. HOOLEY. Most of those were foreign; is that right? The bids?

Mr. GRAYKOWSKI. No, the $10 ship bid was domestic.

Ms. HOOLEY. OK. OK. How much does it cost for you to store

these ships? Wouldn’t we be better off to pay somebody to dismantle them than storing them?

Mr. GRAYKOWSKI. Well, I have the statutory problem which precludes that. Intuitively, logically, and as a taxpayer, absolutely; but

the money that we are spending to care take, which was $3 million

last year, isn’t enough to address the problem in a substantive and

dramatic fashion. We would still have to increase the amount of

money. The admiral spent a lot of money last year just on four

ships. But we—you missed the part of the testimony regarding the dry dock. We are projecting that it is going to cost us $900,000 per

ship times 155, and that is sort of a benchmark level of expenditure to just take it into the garage, if you use the analogies of a

car. That is every single ship. That is a nonavoidable cost. We are

going to spend that irrespective of a scrapping problem or not, but

if we have a scrapping problem, we don’t have to do it, we can devote the money to scrapping and we will have to do that with fewer

ships. That is a function of time.

But your point remains. We are spending the money now and we

are going to spend more and more money and end up exactly where

we are today with ships sitting in the James River and elsewhere.

Ms. HOOLEY. Didn’t the Navy have a pilot project and what happened with that?

118

Vice Adm. AMERAULT. Yes, ma’am. We still have the pilot program underway.

Ms. HOOLEY. It has been going what, a couple of years?

Vice Adm. AMERAULT. We had a 1999 contract for four ships. We

have some money in 2000 that we are applying to two other ships,

four contractors. So that ship breaking is underway. All four contractors are working on ships. All four ships are frigates. So if you

look at this as a pilot or experiment, the control variable is the

same. We had some money in 2000 which we asked for bids to continue. The best value bids were taken up on two of the contractors.

So we basically are scrapping two more. We will learn a little more

with those two.

What we are hoping to do is find out some data with regard to

what are the costs of facilitizing a yard to take care of the environmental aspects of this and other things that they might need to

create an efficient ship breaking process that is environmentally

safe, by paying for their labor, and then finding out how much the

value is in a typical ship in terms of the scrap material and scrap

metals. Copper alloys, aluminum, steel, these are all in abundance.

That would then net against the cost, and we would like to find out

what the net value is and then subtract the initial facilitization,

and then we would have some data to say if you create a steady

stream and apply a learning curve. Maybe that net cost could go

down over time and approach zero, or at least we would know what

it would be and we can compare it to exactly the costs that are you

talking about. If we do spend money on these ships in both the reserve fleet and in our own reserve fleet or in active fleet to keep

them from sinking and having these environmental disasters, and

in fact if eventually there is a cost of dry docking at a lot of money,

considerable cost, it could be that your present value one-time costs

are cheaper than your annualized costs of keeping all of that going.

So I think that is where you are going and that is what the

project is all about to some degree. It is not the same kind of ships

in their reserve fleet but there should be lessons——

Ms. HOOLEY. But MARAD cannot do a pilot project?

Vice Adm. AMERAULT. They are still enjoined to produce a scrap

ship at no cost to the government. It is impossible for them to do

that under statute. We are giving them all of the information that

we find, or will, and there will be some—I don’t know how scalable

this is. There are lessons to be learned.

Ms. HOOLEY. Mr. Graykowski, Peter DeFazio from Oregon has

introduced a piece of legislation that would allow you to do that.

Are you supporting that?

Mr. GRAYKOWSKI. No, we have not taken a position as the administration on that legislation. But I am aware of it and following it

with great interest.

Ms. HOOLEY. Why haven’t you taken a position? It would seem

to me that here is an opportunity for you to do a pilot project, to

try this out. You are spending a ton of money keeping the ships,

you know. Tell me why.

Mr. HOWARD. If I might comment on that, ma’am, Mr. DeFazio’s

bill is consistent with the recommendation that we made in our

March 10 report. We recommended that the Maritime Administration develop a proposal for a pilot program and seek legislation and

119

funding for that program. In order to do that, the Maritime Administration has to work that proposal through the Department of

Transportation and through the Office of Management and Budget.

What they told us in response to our report is that they would

work that in next year’s authorization bill.

Mr. SUNUNU. Ms. Hooley, recognizing that it wouldn’t be good

form, to say the least, for Mr. Graykowski to lobby for or against

any single piece of legislation, I think it probably does bear emphasizing Mr. DeFazio’s bill would be consistent with the goal of helping to build a domestic capability to do this work.

Ms. HOOLEY. Thank you. I am sorry that I put you on the spot.

Mr. GRAYKOWSKI. No, I am not on the spot. Look at—when I

say——

Ms. HOOLEY. It just seems to me that it seems stupid. I don’t

know any other way to put it. It seems stupid that we don’t develop

our own program in this country based on some of the information

that was in your testimony not only to keep our shipyards going

and the workers there and trained workers, but it is costing us so

much money to store these ships right now and we could be dismantling them in an environmentally sound way and put people to

work, and we need to do that in this country. I am hoping that that

can be something that we can look at this year, frankly, to begin

at least if nothing else a pilot project on figuring out how do we

do this the best way possible.

Thank you, Mr. Chairman.

Mr. SUNUNU. Thank you very much.

Let me take some time to ask one final round of questions and

begin with the issue of subsidies, foreign or domestic. Mr.

Graykowski, your predecessor Mr. Hart attended an international

ship scrapping conference in the Netherlands last year, you are

probably aware of that. One of the issues they discussed was providing international assistance to improve the working conditions

or environmental conditions at ship breaking facilities in third

world countries.

My first question, is the U.S. Government to your understanding

considering providing any type of assistance to foreign countries or

foreign ship breaking facilities?

Mr. GRAYKOWSKI. I am unaware of any efforts. We are not aware

of anything at MARAD.

Mr. SUNUNU. Is that something that MARAD would support or

oppose?

Mr. GRAYKOWSKI. Hmm. I am trying to be diplomatic here because we are talking about international things.

It strikes me if there is going to be a decision made to subsidize

foreign companies and we are not willing as a country to spend the

same tax dollars on a domestic program, that that might be hard

to sustain politically in the body in which you serve and others

serve. That is a gut reaction.

Mr. SUNUNU. EPA’s moratorium on exporting vessels, was it

based solely on the hazardous materials issue or was it also based

on concerns for environmental and labor standards abroad?

Mr. GRAYKOWSKI. Yeah. I am just confirming that.

The moratorium, so-called, we are sort of confusing a number of

different events. EPA was concerned about TSCA, as I discussed

120

with Mr. Bentsen, and in 1993–1994 began to look at ships covered

by TSCA and, therefore, restricting its exports. The moratorium

was imposed by the administration, by Vice President Gore, to enable this DOD interagency panel to come up with a solution. So in

a sense one may have fed into another, and the moratorium was

extended until October 1999.

Mr. SUNUNU. Has the government done anything to express concerns, to discuss guidelines or objectives with any foreign ship

breaking facilities since these discussions and the panel was convened and the memorandum of understanding was signed?

Mr. GRAYKOWSKI. I know we have maintained contacts. We had

relationships with foreign scrapping facilities because we had dealt

with them in the past, but let me give you an update in terms of

our conversations with them.

Mr. SUNUNU. Has MARAD inspected any overseas facilities since

1994?

Mr. GRAYKOWSKI. No, we have not.

The notion of us imposing our standards on other countries

around the world is difficult.

Mr. SUNUNU. Without question. Mr. Bentsen touched on those

points, and the imposition of any number of requirements would be

a violation of the regulations or the guidelines that we agree to

abide by as part of the WTO.

Mr. GRAYKOWSKI. Furthermore, any requirements that we levy

on the exports of our ships would require—would raise the cost to

the scrap and lower the yield to the government, thereby making

our ships less competitive with others.

Mr. SUNUNU. Are there any limits on the use of foreign scrap

yards that are imposed on privately owned U.S. vessels?

Mr. GRAYKOWSKI. No, sir.

Mr. SUNUNU. None at all?

Mr. GRAYKOWSKI. They can take a ship any time, any way up to

these foreign scrap yards and sell it without restriction.

Mr. SUNUNU. At this point under the memorandum of understanding that has been signed with the EPA, given those guidelines, you have the ability to utilize those breaking yards as well?

Mr. GRAYKOWSKI. Well, you mean under the EPA agreement?

Theoretically if we clean up all of the PCBs, we are in that loop,

but we have to make the ship unstable.

Mr. SUNUNU. The remaining issue is seaworthiness.

Mr. GRAYKOWSKI. You have to tell the country formally as the

United States, we are going to send you a ship that might contain

stuff, PCBs and other stuff, which in a political context is hard for

a country to say no problem because every country has an environmental movement or green party, however you want to characterize

it.

Mr. SUNUNU. It doesn’t seem to me that the notification that a

vessel going to a breaking yard might contain lead paint or PCBs

or residual asbestos would surprise anyone in this country or

abroad.

Mr. GRAYKOWSKI. Actually, I think our experience—actually, Mr.

Chairman, we did run into a problem in India, which is 50 percent

of the world market in scrapping. Because of that we are notifying

you, Mexico is another outlet that—you know, I suppose in a lot

121

of ways people don’t know what they don’t want to know, if you

will. So private people take the ships and run them up on the

beach and life goes on. But formal notification to the government,

we are sending stuff that might be bad for you, do you mind?

Mr. SUNUNU. I am confident that your technical presentation

could be a little more detailed on that.

Let me ask about the growth of the fleet. Do you have the option

to object to or reject any additions to the reserve fleet?

Mr. GRAYKOWSKI. There are no additions. We don’t have the

money.

Oh, no. We have to take them under contract.

Mr. SUNUNU. Why have you never included funds in your budget

request to cover the costs of domestic scrapping?

Mr. GRAYKOWSKI. Because we do not have the statutory authority to do anything other than sell them.

Mr. SUNUNU. That has never been part of the budget request either? You have never requested a repeal of that statutory limitation?

Mr. GRAYKOWSKI. No, because we had this DOD interagency

panel. So we saw the panel in place and so there was no impetus

to develop that legislative position.

Mr. SUNUNU. Admiral, could you run through the costs of the

pilot program? You talked about the initial vessels, the two that

were done using 2000 money. What have been the gross costs of

the contracts that were let, the number of ships for each, and then

the amount of scrap credits that have come?

Vice Adm. AMERAULT. I don’t have the scrap credit yet, but I can

tell you what we have paid so far. There have been four contractors

and thus four contracts. Metro Machine Corporation in Philadelphia and Chester, PA, we paid $3.5 million for the initial phase,

that is for one ship. That includes some facilitization, as I mentioned, the cost of labor, and we have yet to get a full accounting

of the sales, and thus the net costs.

Mr. SUNUNU. So that is $3.5 million gross. Then anything they

get through the sale of scrap will be credited against that. Do you

split it 50/50?

Vice Adm. AMERAULT. No, sir, it always comes to us because

again the insurance for them is that their costs will be borne. We

are taking the risk, and that is what we are paying for.

Mr. SUNUNU. These are aluminum hull?

Vice Adm. AMERAULT. These are steel hull with aluminum superstructure.

Mr. SUNUNU. So the scrap value is a little higher?

Vice Adm. AMERAULT. I can’t say with authority. Aluminum is

one of the more saleable commodities, however. And I think warships tend to have more copper. There are other things that are

good about those in a sense; however you determine goodness, I

guess.

Baltimore Marine Industries, the cost is $4 million. The variance

in this is mostly facilitization, what they were prepared and able

to do to start with.

Again when we come out of this, we will have four facilitized contractors.

122

International Shipbreaking in Brownsville, Texas, $2.7 million.

They are fully facilitized. This is a contractor that once defaulted

on I think MARAD as well as us. And the reason that they are

working out now is again, we have removed the risk. The reason

that they defaulted was they bought the ship from us expecting to

make money and didn’t. So that puts them back in the business in

a sense.

Ship Dismantling and Recycling, which is a consortium working in San Francisco, that is $3.9 million. So the ones that have to be

facilitized are roughly about the same amount.

Mr. SUNUNU. Which were the two that were let with 2000?

Vice Adm. AMERAULT. We added a ship to Metro Machine and we

added a ship to Ship Dismantling and Recycling.

Mr. SUNUNU. What were the incremental costs for adding each

of those?

Vice Adm. AMERAULT. $2.7 million and $3.2 million. Again, that

doesn’t have the cost reduction that will come.

Mr. SUNUNU. The 2.7 was let to whom?

Vice Adm. AMERAULT. Metro Machine, and the other was 3.2.

That is to Ship Dismantling and Recycling, which is a joint

venture—— Mr. SUNUNU. That is six ships that have been placed?

Vice Adm. AMERAULT. Four contractors. Two of them have two

ships.

Mr. SUNUNU. In the case of Metro Machine, the difference between the 2.7 and the 3.5 represents the start-up costs and the

facilitization costs?

Vice Adm. AMERAULT. It will be that, yes, sir. And what we will

find out is again how much this will all be reduced because none

of these figures have the reduction for the sale of scrap.

Mr. SUNUNU. Did Metro Machine complete the scrapping of the

first vessel?

Vice Adm. AMERAULT. They are almost done.

Mr. SUNUNU. But you don’t have the cost figures?

Vice Adm. AMERAULT. Not yet, but that is part of the deliverable

on the contract.

Mr. SUNUNU. To what detail will those cost figures be provided?

Vice Adm. AMERAULT. I think to great detail. It will almost have

to be a CPA like accounting because it is contractual. I don’t think

that we will get it until some of these sales—— Mr. SUNUNU. There is a joke in here about whether or not DOD’s

books meet FASB standards, but——

Vice Adm. AMERAULT. Yes, I have been involved in that previously.

Mr. SUNUNU. Will all of that cost information be shared with

MARAD?

Vice Adm. AMERAULT. It is open. Since I have been in this job,

I have tried to engage MARAD in this problem. So I feel like a

partner. I don’t particularly want to have the Navy bear the cost

of the problem they have.

Mr. SUNUNU. There are obviously economies of scale in the numbers that we are dealing with here. To the extent that there is cooperation or a long-term solution to the problem with MARAD, it

is going to help both groups.

123

Are there any issues or concerns that you have, Mr. Graykowski,

with regard to information sharing, either administrative problems

or legislative problems, that somehow inhibit you from getting information that you think might be helpful?

Mr. GRAYKOWSKI. No. You are too modest. I told the admiral

that. When he took over, he was the first person who really took

ahold of this, not only on behalf of the Navy, but reached out to

MARAD.

I don’t see any impediments. We all have the same problem here,

and I think we all want a solution.

Mr. SUNUNU. Admiral, do you have even a rough estimate for the

scrap credit?

Vice Adm. AMERAULT. Let me just say that it is encouraging.

Mr. SUNUNU. Give me a range.

Vice Adm. AMERAULT. Any figures I had seen were rough and I

don’t want to pin them down to anything.

Mr. SUNUNU. Give me a wild range?

Vice Adm. AMERAULT. Well, it could be that say—say a million

dollars a ship. $800,000 to a million dollars.

Mr. SUNUNU. If I were you testifying to me, I probably would

have said something like well, between $200,000 to a million five.

Vice Adm. AMERAULT. That is my answer.

Mr. SUNUNU. If we have the opportunity, we will correct the

record.

Vice Adm. AMERAULT. The reason is that I would be hesitant to

create a program based on that figure would not be in either ours

or your best interests.

Mr. SUNUNU. I understand. If we look at the gross numbers, it

is 1,300 a ton to scrap the ships and that is an enormous figure

at 10 times the scrap value. There seems to be a disconnect, so I

would expect the credits to be significant in just trying to gauge

where we might be at the end of this process.

Vice Adm. AMERAULT. I think the other thing is that this is a

one-time venture, too. I think again their costs will come down and

that probably affects it almost more than the price of the market.

Mr. SUNUNU. How much of their costs are driven by EPA mandated directives and environmental concerns?

Vice Adm. AMERAULT. I would say that is the second most significant thing. Labor is the most, and then the environmental concerns.

Mr. SUNUNU. Thank you.

The Navy received $284 million in fiscal year 2000 for environmental restoration. What is that funding directed for and why

would the Navy need a new program for disposal of vessels if it

could utilize that funding for this program?

Vice Adm. AMERAULT. Sir, the environmental remediation Navy

is the appropriation or the line item, and it is for remediation. So

I would say in our case, our ships that are scrappable, if you will,

are not yet needing remediation. So I would have to find out

whether those funds—we have appropriation lawyers, would tell us

whether we can spend those funds on this.

Also in terms of the MARAD fleet, it is not just a Navy fleet. I

am not so sure we would be spending our ERN funds on their fleet.

124

If we—and I think part of the answer might be in what Mr.

Graykowski mentioned in terms of this has not yet—or these ships

have not yet been declared as environmental hazards. So environmental restoration Navy is for declared environmental hazards.

Mr. SUNUNU. Who makes that declaration?

Vice Adm. AMERAULT. I am not sure.

Mr. GRAYKOWSKI. We have to find out what the scope of the ERN

program is. I am guessing that it is SECNAV, but I don’t know.

Mr. SUNUNU. If you would provide any clarification for the

record, I would appreciate it.

Vice Adm. AMERAULT. We have not had difficulty in paying for

the scrapping of ships that need to be scrapped. We are not running into an environmental problem with the ships that are in our

Navy controlled inactive fleet.

Mr. SUNUNU. Would the Navy consider holding onto those vessels

that are scheduled to be transferred to MARAD in order to dispose

of them through the pilot project?

Vice Adm. AMERAULT. We are enjoined by statute to transfer

them.

Mr. SUNUNU. Mr. Graykowski, putting aside political constraints

and financial constraints, what do you think would be an ideal

path forward for your agency?

Mr. GRAYKOWSKI. Give me a moment to sort of bask in this new

found freedom that you have sort of given me.

Mr. SUNUNU. Believe me, it is very temporary.

Mr. GRAYKOWSKI. You don’t know how temporary. I have to go

back to my office.

The answer is obvious. You have picked up on it and you know

it. Your colleagues have as well. We need, A, to have the statutory

constraints lifted. We have to recognize reality and pay people.

B, I think we can set up a real partnership with the shipbuilding

industry and create a ship breaking industry which focuses on

breaking them in an efficient and economically and environmentally responsible way, and that is going to take money. I think

we should start with, as the Navy has done with a pilot program,

although I would suggest perhaps a bit more ambitious, and guarantee to a yard we will give you 12 ships. I have 40 to work with

and so we could give them to 2 or 3 different yards. We can say

here is the results, it is going to work or not.

I suggest that we hold off on exporting until we have a chance

to get a program up and running, and I think we could do that in

fairly short order if we have got the money and if the statute

changes.

Mr. SUNUNU. What other alternatives are there for dealing with

this that we haven’t discussed? I will also editorialize by emphasizing that it seems to me that there is a problem where we probably

want to take multiple approaches, where there is no single solution

that is going to be ideal or best for every single vessel that we are

talking about. There is the—I think the need to deal with the 40

vessels that are in the most serious condition and I think with the

memorandum of understanding in place, foreign breaking yards

ought to be an alternative. I think there is the very promising prospects of the Navy’s pilot program and I think we need to continue

to have discussions about the statutory requirement that hinders

125

you, whether or not that means that we authorize a 12-ship or 40-

ship pilot or we simply get rid of the requirement and allow you

to use your annual maintenance budget more creatively.

But outside of those alternatives that we have discussed, are

there any other opportunities that you see as strong alternatives

for disposing of these ships?

Mr. GRAYKOWSKI. I am really racking my brain here. Because of

the criticality of the problem, we have to focus. We cannot chase

different options. To me we are going to export it or do it here. If

we need to do it here we need to come up with a decision tree and

come up with money. Limited capability and you have to ship everything out of the ship. Other than that, I mean knowing the

ships as I do, I don’t see anything other than getting them out of

the water and cut up and disposed of as soon as possible. That is

scrapping, either domestic or foreign.

Mr. SUNUNU. Thank you very much. Thank you, gentlemen. We

are adjourned.

[Whereupon, at 11:46 a.m., the Task Force was adjourned.]

(127)

Implications of Debt Held by Housing-Related

Government-Sponsored Enterprises

TUESDAY, JULY 25, 2000

HOUSE OF REPRESENTATIVES,

COMMITTEE ON THE BUDGET,

TASK FORCE ON HOUSING AND INFRASTRUCTURE,

Washington, DC.

The Task Force met, pursuant to call, at 10 a.m. in room 210,

Cannon House Office Building, Hon. John Sununu (chairman of the

Task Force) presiding.

Members present: Representatives Sununu, Bentsen, Miller,

Smith, Ryan, Toomey, Hoekstra, Minge, and Clayton.

Chairman SUNUNU. Good morning. The purpose of today’s hearing is to discuss recent trends in the issuance and accumulation of

mortgage-backed securities at government-sponsored enterprises

and other financial institutions.

As the internal portfolio is held by the GSEs continues to grow,

a number of questions have been raised by Federal regulators,

Members of Congress and others regarding the change in the risk

profiles and the ability of GSEs and others to appropriately manage these risks.

This hearing will focus on the economic implications of this GSE

debt, but, most important, it is meant to provide information. We

intend to shed light on the nature of these portfolios, their size and

their economic implications, rather than engage in extended policy

debate over potential legislative prescriptions.

These questions are made even more timely by the current

trends in the growth of the Federal budget surpluses and the projected pace of debt retirement over the next 3 years. Today, the

GSEs play a central role not only in the housing finance market,

but also in the global debt markets.

According to the Treasury Department, the GSEs’ debt of $1.4

trillion is roughly the size of the municipal bond market and more

than half of the outstanding amount of privately held Treasury

debt.

Given that the Treasury Department forecasts that GSEs may

well double over the next four to 5 years, it will likely surpass the

level of privately held, marketable Treasury debt by 2004.

GSE debt also represents a significant portion of the assets of the

banking system. Federally-insured deposit institutions hold around

one-fifth of all GSE debt. Naturally, the strength, the safety, the

soundness of this GSE debt is going to have an impact on financial

institutions around the country.

128

Today, our budget Task Force will hear from witnesses who will

describe the structure of GSE held debt in mortgage-backed portfolios, the nature of the financial risks involved in GSE debt and

mortgage-backed securities, and the degree to which interest rate

risk, credit risk, prepayment risk and other risks exist under different economic scenarios.

I think it is essential for policy-makers to better understand the

nature of these risks and their relative sizes and the strategies for

managing these risks before making assumptions or commitments

regarding policy initiatives.

The housing GSEs continue to operate very successfully in today’s marketplace. They are literally the backbone of America’s residential mortgage system that is the most liquid and competitive

in the world.

Moreover, GSE regulators in the most recent reports have offered

clear opinions supporting the safety and soundness of the GSEs.

However, these institutions are enormous and complex entities and

we should understand the impact that an economic downturn

might have on the GSEs themselves and the holders of their securities.

In the 1980’s, Congress learned a difficult lesson when the American taxpayers were called upon to provide a financial backstop for

the savings and loan industry. Despite the fact that GSE debt securities clearly disclose that they are not guaranteed by the United

States, some analysts and investors do believe that GSE debt is implicitly backed by the Federal Government’s moral obligation to

support these important institutions.

Our goal is to better understand this potential liability as investors look toward GSE debt as a potential benchmark security.

The markets will ultimately decide whether or not to confer such

a benchmark status, but as policymakers we will determine whether such a status is based upon safety and soundness alone or precipitated by Federal regulation, sponsorship or subsidy.

I look forward to the testimony of our witnesses and am pleased

to yield to Representative Bentsen.

Mr. BENTSEN. Thank you, Mr. Chairman. I thank you for calling

this hearing. As the members of the panel know, this Task Force

is charged with holding oversight hearings on waste, fraud, and

abuse and reporting our findings and recommendations to the full

House Budget Committee.

This is our fourth oversight hearing and in this hearing we turn

to the economic implications of debt held by government-sponsored

enterprises. This is an issue which, as I think members of the

panel know and I would imagine the rather large audience we have

today for this task farce knows, has been a subject of numerous

hearings before the House Banking Committee Subcommittee on

Capital Markets, of which I am a member. I appreciate those who

are testifying today.

I think in talking with the chairman this is an interesting subject which we are embarking upon. It is one that we should look

at more from, I think, an academic perspective rather than whether or not GSEs in and of themselves are a good or bad thing.

I think the focus ought to be on the question of GSE debt, in particular, the issuance of GSE corporate debt, the issuance of GSE

129

conduit debt in the form of mortgage-backed securities and the repurchase of such conduit debt and whether or not that constitutes

either a secondary market function, taking advantage of an arbitrage function or both.

I look forward, Mr. Chairman, to the testimony of our panel and

the ability to question them on their expertise of this subject. I

would say that this is a subject, the question of the GSEs themselves is a subject that will go on for quite some time.

Let me just close in saying this. The GSEs have without doubt

contributed tremendously to a very stable housing market in the

United States, along with the Federal Housing Administration. We

know this has been of great benefit. It is something that was jump

started by the Congress and the Federal Government.

The question before us on the House Banking Committee at least

at this point is to what extent is a continued Federal involvement

still necessary, have the GSEs grown too large and rather than aid

the market now distort the market and is the answer to curtail the

activities of the GSEs.

I am not sure that is the right question that is being asked or

is the answer to unleash the GSEs and have the Federal Government get out of the business all together.

I am not sure that is the answer that those who are asking the

question want. So this is an issue that is going to be around for

a couple of years and I think, Mr. Chairman, that you are on point

in having this hearing.

I yield back the balance of my time.

Chairman SUNUNU. Thank you, Mr. Bentsen.

Our witnesses today on our first panel are Barbara Miles of the

Congressional Research Service, Thomas McCool of the GAO, and

Bert Ely of Ely & Company.

We would like to try to keep our testimony to 5 minutes, and

once we have taken testimony from each of the panelists, we will

have questions from the members.

Ms. Miles, we will begin with you. Welcome, and thank you for

being here.

STATEMENTS OF BARBARA MILES, SPECIALIST IN FINANCIAL

INSTITUTIONS, GOVERNMENT AND FINANCE DIVISION, CONGRESSIONAL RESEARCH SERVICE; THOMAS J. McCOOL, DIRECTOR, FINANCIAL INSTITUTION & MARKET ISSUES, GENERAL GOVERNMENT DIVISION, GENERAL ACCOUNTING OFFICE; AND BERT ELY, PRESIDENT, ELY & COMPANY, INC.

STATEMENT OF BARBARA MILES

Ms. MILES. Good morning. Mr. Chairman and members of the

committee, I am Barbara Miles, a specialist in financial institutions in the Congressional Research Service of the Library of Congress. Thank you for inviting me to appear this morning to discuss

the housing-related government-sponsored enterprises and the implications that their activities may pose for the economy and the

Federal budget.

At the end of the first of quarter of this year, the three housing

GSEs—Fannie Mae, Freddie Mac and the Federal Home Loan

130

Banks—had outstanding debt of $1.47 trillion. For comparison, publicly held marketable Treasury debt was about $2.7 trillion.

The current and projected declines in the publicly held debt of

the U.S. Government imply that at current growth rates, GSE debt

could surpass Treasury debt as early as 2003.

When Fannie Mae and Freddie Mac’s outstanding guarantees of

mortgage-backed securities are added in, the GSE presence in capital markets is very nearly equal to the size of the Treasury market

today.

Both the absolute size of the debt and its rapid growth have

raised questions and concerns about the risks that the GSEs’ activities pose for the economy and for the government. In this regard, I will discuss briefly two fundamental questions.

The first is what is the Federal Government’s responsibility to

and for the housing GSEs?

And, second, what are the specific risks that these companies’ activities pose?

GSEs are a special class of financial institutions in our economy.

They are government in that they serve as instruments of public

policy for influencing credit allocation in our economy—in this case,

into the housing sector. Their sponsorship means that they have

congressional charters that assign them narrow lending powers,

but that also grant them exemptions and privileges that lower

their costs, in part by implying a guarantee that is formally denied.

That they are enterprises means that they operate as private sector

institutions for the benefit of their owners.

The public policy purpose of the housing GSEs is reasonably

clear. They all provide liquidity to mortgage markets by lending to

primary lenders or by buying and selling mortgages in a secondary

market that crosses geographic and institutional boundaries that

for many years characterized our banking system.

The charter benefits of sponsorship are significant. They are

arrayed in the table that I attached to my written testimony.

Some of the benefits are clear subsidies, exemption from State

and local income taxes, for example. Others accord preferential

treatment, granting GSEs securities agency status. The main value

resides, however, not in the individual benefits but in the nature

of the charter itself. Even though there is no explicit Federal backing, the benefits and public policy importance of the mission denoted by the charters leads market participants to infer that the

GSEs would not be allowed to fail such that creditors would lose

their money.

This is the implied guarantee. It effectively lowers funding costs

for the GSEs and lowers the capital requirements below those of

other private companies in otherwise similar financial conditions.

The risks that the GSE operations pose fall into two categories.

The normal business risks experienced by any intermediary in

mortgage markets include interest rate risk, credit risk, a variety

of business and market risks. All of these risks can be managed.

They cannot be made to disappear, but they can be managed by a

prudent company and by all accounts they are being managed well.

Ordinarily, the private market can be expected to exercise discipline over any excessive risk taking, but the market discipline is

weakened by the implied guarantees in the case of the GSEs. As

131

a result, all three GSEs have safety and soundness regulators to

examine and to test the companies and control for those excessive

risks.

The Office of Federal Housing Enterprise Oversight is responsible for safety and soundness regulation of Fannie Mae and

Freddie Mac, while HUD oversees their mission, and the Federal

Housing Finance Board has responsibility for the Home Loan

Banks. Both OFHEO and FHFB have proposed risk based capital

standards, although they are not yet in effect.

OFHEO, HUD and the FHFB are, in an important way, the last

line of defense against the larger risks to the economy. And those

greater risk to the financial system and the economy are systemic

risks and a kind of systematic risk.

Systemic risk is the likelihood that a failure of a GSE would

cause widespread failures of other financial institutions and result

in severe damage to the financial system. In this case, it is partly

a direct result of the charter provision that allows depository institutions to hold GSE securities without the normal limits that

would be imposed on banks by their safety and soundness regulators.

According to the Treasury, banks currently hold GSE debt that

is equivalent to one-third of bank capital and many banks have

sufficient holdings that a GSE failure could wipe out their capital.

A failure of a GSE under these circumstances could create a domino effect and seriously strain the deposit insurance funds.

Systematic risk is risk that cannot be controlled by diversification. It is the problem of having all your eggs in one basket, but

there is only one basket. Portfolio theory holds that diversification

makes for better management of risk, but by law GSEs can only

diversify so far. Ultimately, they build and grow on a single sector

of the economy—and actually only a large part of that sector—and

that sector therefore poses systematic risks for the companies. Beyond some point, they cannot continue to grow in their current

path without ‘‘breaking out’’ of their assigned market.

For the government, this same risk is one of having an entire

sector of the economy more or less identified with the GSEs. So

long as the GSEs have their benefits fully operating, the sector becomes dependent upon the companies and cannot diversify away

from them. If, on the other hand, GSEs are allowed into other sectors, they are better diversified, but the economy is not.

The growth in GSE debt has also led to consideration of GSE

debt as the ‘‘risk-free’’ benchmark for pricing in securities markets.

But for a benchmark asset to function properly, it should reflect

risks that are inherent to the economy overall. These clearly do

not. Yet because of their inferred safety, the private sector could

turn to them and, as a result, there could be pressures on the

GSEs other than their announced growth plans and, as a result,

also on their regulators to allow them to expand their missions further to fill that kind of benchmark role.

This completes my prepared statement and I would be pleased

to answer any questions you may have.

[The prepared statement of Barbara Miles follows:]

132

1There are five GSEs in our financial system. Two operate in farm credit markets—the Farm

Credit System and ‘‘Farmer Mac.’’ A sixth GSE, Sallie Mae, provides student loans and is currently in the process of converting to a fully private company. 2Sources: quarterly statements of Fannie Mae, Freddie Mac and the Office of Finance of the

Federal Home Loan Banks. 3This excludes non-marketable debt which, by definition, does not trade in capital markets

and is, therefore, not an indicator of market size.

PREPARED STATEMENT OF BARBARA MILES, SPECIALIST IN FINANCIAL INSTITUTIONS,

GOVERNMENT AND FINANCE DIVISION, CONGRESSIONAL RESEARCH SERVICE

Mr. Chairman and members of the committee, I am Barbara Miles, Specialist in

Financial Institutions in the Congressional Research Service of the Library of Congress. Thank you for inviting me to appear before you to discuss the housing-related

government-sponsored enterprises (GSEs) 1 and the implications their activities may

pose for the economy and the Federal budget.

At the end of the first quarter of this year, the three housing GSEs—Fannie Mae,

Freddie Mac, and the Federal Home Loan Bank System—had outstanding debt totaling $1.47 trillion. 2 For comparison, publicly held, marketable Treasury debt was

about $2.7 trillion. 3 The current and projected declines in the publicly held debt of

the U.S. government imply that, at current growth rates of about 20 to 25 percent

per year, GSE debt could surpass Treasury debt outstanding by 2003. When Fannie

Mae and Freddie Mac’s outstanding guarantees of mortgage-backed securities

(MBS), $1.21 trillion (net of the $508 billion of MBS the GSEs have repurchased),

are added in, the GSE presence in capital markets is very nearly equal to the size

of the Treasury market.

Both the absolute size of the GSE debt, and its rapid growth have raised concerns

about the risks the GSE’s activities pose for the economy and the U.S. Government.

In this regard, I will discuss two fundamental questions:

First, what is the Federal Government’s responsibility to and for the housing

GSEs?

Second, what are the specific risks that these companies’ activities pose?

WHAT ARE GSES AND WHY DO WE HAVE THEM?

The answer to the first question is tied up in what GSEs are, why we have them,

how they are perceived by investors and why. GSEs are a special class of financial

institutions in our economy. They are government in that they serve as instruments

of public policy for influencing credit allocation in the economy—in this case into

the housing sector or, more accurately, into mortgage finance. Their sponsorship

means that they have congressional charters that assign them narrow lending powers, but also grant special exemptions and privileges that lower their costs, in part

by implying a guarantee that is formally denied. That they are enterprises means

that they operate as private sector institutions for the benefit of their owners.

Public Policy Purpose. The initial government purpose of the three housing GSEs

is reasonably clear. The 12 regional Federal Home Loan Banks were chartered in

1934 as a collective GSE in order to provide liquidity to savings and loan associations so that they could continue lending for home mortgages, or at least not be

forced by depositor withdrawals to call in mortgage loans already made. There was

only very limited private sector ability to take the risks associated with assisting

thrifts facing liquidity problems; and nothing, short of the commercial banks’ Federal Reserve or the Federal Government itself, could fill the financing gaps on a

scale sufficient to deal with the widespread problems of the 1930’s. The Banks were

chartered to be owned by the S&Ls themselves, and given a series of benefits that

lowered their costs. In turn, the Banks made low-cost loans (called ‘‘advances’’) to

the S&Ls on the strength of their mortgage lending, and turned a profit for their

member-owners in doing so.

Fannie Mae and Freddie Mac were both started to assist in providing liquidity

to lenders by developing a secondary mortgage market. A series of problems—including Federal and state laws restricting depository institutions—impeded nationwide flows of mortgage funds and made tapping the resources of general capital

markets difficult. As a result, funds did not flow in a normal market response from

areas with high savings or from investments with low returns into the regions and

mortgages where rates and yield were higher. Fannie Mae, originally a government

agency in 1938, but rechartered as a GSE in 1968, and Freddie Mac in 1970, were

to help solve these problems by doing what the primary lenders could not do: act

as national intermediaries to first, move funds across the country by borrowing

where funds were cheap to invest in mortgages where rates were high, and second,

133

4This assumes a state tax average of about 8 percent and cooperation under the state tax

compacts. See Zimmerman, Dennis. Unfunded Mandates and State Taxation of the Income of

Fannie Mae, Freddie Mac, and Sallie Mae: Implications for D.C. Finances. CRS Report 95-952

E.5 All GSEs are required to inform investors that their securities do not carry full-faith-andcredit guarantees. Yet the statutory equivalence of GSE and Federal debt for a variety of purposes reassures investors that the government in some way stands behind the debt. Investors

are probably correct in their assessments: when the Farm Credit System was in trouble in the

late 1980’s, it was rescued so that no investors lost. 6 Jud, G. Donald. Regional Differences in Mortgage Rates: An Updated Examination. Journal

of Housing Economics, June 1991. Hendershott, Patrick, and Robert Van Order. Integration of

Mortgage and Capital Markets and the Accumulation of Residential Capital. Regional Science

and Urban Economics, May 1989.

develop appropriate securities to tap into non-traditional investment sources. Both

actions made mortgages funds more uniformly available.

The charter benefits. The benefits that have been granted to the GSEs are significant and valuable. (See Table, attached.) Some of the benefits directly and explicitly

lower the costs of operation of the GSEs below those of any other private-sector company. Exemption from State and local income taxes, for example, was worth about

$490 million to Fannie Mae and Freddie Mac last year. 4 The SEC registration exemption, according to the U.S. Treasury, was worth another approximately $280

million. CBO estimates that, were all five GSEs required to register, the Federal

budget would gain $313 million in 2001, and about $1.5 billion for 2001-2005.

Other benefits accord GSE debt preferential treatment, including the eligibility for

unlimited investment by depository institutions—circumventing the normal safety

and soundness limits on loans to a single borrower—and the eligibility of their debt

and MBS as collateral for public deposits. Still others simply provide links that signal that these companies are more ‘‘important’’ than ‘‘normal’’ corporations as a

matter of public policy.

Implied Guarantee. The charter value resides not simply in the sum of the individual preferences but in the nature of the charter itself. Even though there is no

explicit government backing, because of the benefits and because of the public policy

importance of the GSE mission as demonstrated by their special charters, market

participants infer that the Federal Government would not allow the GSEs to fail

such that creditors would lose their money. 5 This is usually referred to as the ‘‘implied guarantee,’’ and it effectively lowers funding costs for the GSEs below those

of other private companies in similar financial condition. A series of studies since

1990 have generally put the funding advantage at about 30 basis points (or 0.3 percentage point) below what is available to triple-A companies and about 40 basis

points below double-A companies. While there appears to have been some narrowing

of this advantage in the past few months, the advantage is still significant.

The implied guarantee also allows for high leverage on the part of GSEs. That

is, less capital is needed to assure investors of safety for any given level of assets.

Relatively low financial capital allows a higher rate of return for the company so

that there is an incentive toward toward maintaining minimum levels consistent

with investor comfort and low borrowing costs. Capital provides a kind of cushion

against losses for investors. But the implied guarantee replaces, to some extent, the

normal market discipline that would take into account the actual risks of the business operations of the company.

Market power. By most accounts, the problems that gave rise to creation of the

housing GSEs have been corrected. 6 Correction is generally measured in terms of

the degree to which housing finance is integrated with general capital markets.

Mortgage rates are effectively uniform across the country, and mortgage markets

tap funds in the rest of the capital market with relative ease. Further, many sources

of liquidity are now available to primary mortgage lenders, although they would

generally be more expensive than the terms available from the GSEs. The charters

continue, however, and now contribute to considerable market power.

Because their costs are lower than for non-favored companies, many private sector

observers are particularly concerned that GSEs can reap greater-than-competitive

profits, even while undercutting pricing of potential competitors. They need only

price their products a little below what fully private companies would have to

charge. And GSEs control the value of their charters, because increasing business

volume increases the extent of the benefits conferred by the charter, while increasing risk adds to the depth of the gains. In short, the special charters confer benefits

on the GSEs that increase in value as a company’s business volume and risk increase. This arguably provides incentives not only to dominate the assigned market

but also to seek ways to continue to grow even after the market to which the GSEs

134

are constrained by charter is saturated. This, in turn, gives rise to new risks for

the government.

THE RISKS OF GSE OPERATIONS

The risks that GSE operations pose fall into two separate categories: the normal

business risks of the GSEs’ operations, and the larger risks to the financial system

and the economy.

Normal business risks. Normal risks are those that would be experienced by any

intermediary in mortgage markets and include the following.

• Interest rate risk: that changes in interest rates will result in a loss of economic

value.

• Credit risk: that borrowers will default on (not repay) loans or other obligations.

• Business risk: that factors beyond a firm’s control could result in unanticipated

loss of earnings, or capital.

• Management risk: losses arising from decisions made (or not made) by managers.

Ordinarily, the private market can be expected to maintain discipline over risktaking by assessing the riskiness of a company’s operations and acting in accordance

with what it sees. If leverage were high enough (capital were low enough), for example, to raise concerns about insolvency, creditors would demand prompt payment or

attempt to accelerate principal repayment where possible, and new credit would become costly. This market-imposed discipline means that a company has every reason, so long as it is solvent, to control its own risk-taking in order to avoid the costs

that would be imposed by creditors. GSEs, like other companies, have an incentive

to maintain their shareholder value.

In the case of GSEs, however, the market discipline is weaker because of the implied government-backing. Creditors, so long as they continue to infer that GSE debt

is near-equivalent to Treasury debt, will allow greater risk and countenance lower

capital. GSEs can borrow at preferential rates in good times, and in bad times.

While this is supposed to be a strength, it is also a problem if matters get out of

hand because once capital is lost, the GSE may have reason to take greater risks

in the pursuit of rewards large enough to work itself back out of difficulty.

A case of not-well handled interest rate risk did create severe problems for Fannie

Mae. The secular rise in interest rates that occurred in the 1970’s and the sharp

rise in 1979 presented major problems for all mortgage lenders who had basically

lent for long-term mortgages at fixed rates while financing at shorter term rates.

Fannie Mae was such a lender at that time and its high leverage exacerbated its

problems. The spread between interest rates on mortgages and the rates required

on new debt turned negative. At the same time, fewer mortgages were being prepaid

as home buyers either assumed the mortgages of the sellers, or homeowners simply

did not move, both reactions to high interest rates that prolonged the expected life

of loans held by Fannie Mae and prolonged their losses. According to a 1986 study

by HUD (then the sole regulator for Fannie Mae), the GSE was insolvent on a

mark-to-market basis every year from 1978 through 1984. The worst year was 1981

when estimated net worth fell to minus $11 billion and the corporation actually

booked losses. Ultimately, Fannie Mae was allowed to grow its way out of difficulty,

although it required regulatory forbearance, some tax adjustments, and declining interest rates to return to health after 1985.

All three housing GSEs have safety and soundness regulators who are specifically

charged with examination and testing to keep these risks in check. The Federal

Housing Finance Board oversees the Banks. The Office of Federal Housing Enterprise Oversight (OFHEO) oversees Fannie Mae and Freddie Mac for safety and

soundness, while HUD has responsibility for mission oversight. Both the FHFB and

OFHEO have proposed risk-based capital standards that are intended to test the

GSEs for excessive interest rate and credit risk and would require capital holdings

accordingly. If the tests work as intended and are timely, it should be possible for

regulators to require sufficient capital at all times to avoid a repeat of the 1980’s

experience. Those tests are not yet in effect.

Repurchase of mortgage backed securities. The repurchase of their own MBS by

the GSEs can be thought of as a case of repatriating interest rate risk. When mortgages are securitized and sold, the GSE retains the credit risk on the loans, but

sells to investors the interest rate risk. MBS are less profitable than portfolio holdings as a result. Repurchase restores profits along with risk. Fannie Mae and

Freddie Mac are the largest holders and purchasers of their own MBS, holding nearly 30 percent of their own issuances and in some recent periods repurchasing a volume equal to or greater than what they issued.

135

7The exception would be if GSE debt and MBS were not good substitutes for one another,

i.e., the products were not well integrated in capital markets. 8Wallison, Peter J. and Bert Ely. Nationalizing Mortgage Risk: The Growth of Fannie Mae

and Freddie Mac. AEI Studies on Financial Market Deregulation, 2000.

While it is clear that this increases shareholder value, it is difficult to understand

what, if anything, it does for mortgage markets. In order to repurchase the securities, the GSEs must issue new debt. Given that U.S. capital markets are highly integrated, mainstream economic theory holds that there should be no lasting change

in yields required by the market on either the debt or the MBS. As a result there

should be no benefit to pass through to housing markets. 7

Larger Risks. The larger risks to the financial system and the economy are systemic risk and systematic risk.

Systemic risk. Systemic risk is the likelihood that a failure of one institution

would cause widespread failures of other institutions and result in severe damage

to the financial system. In the case of the GSEs, the potential for systemic risk is

a direct result of the charter provision that allows depository institutions to hold

their debt and MBS without limit. Normally, depositories are restricted to no more

than 15 percent of capital in loans to a single borrower. According to the Treasury,

banks held over $210 billion in GSE debt 1 year ago, which constituted one-third

of bank capital, and over $355 billion in MBS. These holdings have raised concern

among banking regulators. A failure of a GSE could create a domino effect if it resulted in the sudden loss of capital at banks and thrift institutions, and could strain

the deposit insurance funds were the situation unanticipated or severe enough.

Systematic risk. Systematic risk is basically that risk that cannot be controlled

by diversification. This kind of risk brings to mind the old adage about the dangers

of putting all your eggs in one basket: it is generally a very risky thing to do. In

the case of the GSEs, there are two sides to the risk: first, portfolio theory holds

that diversification makes for better management of risk. But by law, the GSEs can

only diversify so far. Ultimately, they build and grow on a single sector of the economy, one that because of their dominance and ability to increase dominance, poses

systematic risks for the companies. They cannot diversify away from residential

mortgages without a change in mission. Beyond some point, they cannot continue

to grow without ‘‘breaking out’’ of their assigned market. One recent study estimates

that by 2003, Fannie Mae and Freddie Mac will have to control (retain or guarantee) better than 90 percent of all outstanding conventional/conforming mortgage

loans, and essentially all of new loans originated. 8

On the other side, if the GSEs take over the housing sector, the government runs

systematic risk with respect to the housing sector. So long as the agencies have

their benefits fully operating, the sector becomes dependent upon these companies

and cannot diversify away from them. If the GSEs are allowed into other sectors,

they are better diversified, but the economy is not.

Recall now the data on Treasury and GSE debt. The growth in GSE debt, combined with the projected declines in Treasury debt, has led to consideration of GSE

debt as the ‘‘risk-free’’ benchmark for pricing debt in securities markets. Indeed, the

GSEs have been positioning themselves to fill such a function by regular issuances

of debt in a manner that creates an alternative to the Treasury yield curve. The

possibility that the Federal Reserve might use GSE securities for conducting monetary policy has also arisen. But a major economic drawback of using GSE securities—or the securities of any other corporation—is that for the benchmark asset to

function properly, it should reflect only risks inherent to the economy overall. GSE

securities, on the other hand, include risks specific to their corporations, in this case

housing sector risks, which are very different than risks to the overall economy. Yet,

because of their inferred safety, the private sector could use them as a benchmark

anyway. Thus, the problem arises again that the GSEs may have cause to expand

their missions to fill the benchmark role.

The point behind creating GSEs is to increase efficiency by improving the allocation of credit in the economy. But the risk to the economy from introducing what

is effectively a subsidized entity into a new market is that current competition will

be displaced and economic inefficiency increased.

That completes my prepared statement, Mr. Chairman. I will be pleased to respond to any questions you may have.

136

TABLE 1.

—GOVERNMENT–SPONSORED ENTERPRISE LINKS TO THE FEDERAL GOVERNMENT

Feature

Federal National

Mortgage Association

Federal Home Loan

Mortgage Corporation Federal Home Loan Banks Farm Credit System Federal Agricultural Mortgage Corpora- tion Student Loan Mar- keting Association

Chartered by Act of Congress ..................................................................................................... Yes Yes Yes Yes Yes YesForm of Ownership ...................................................................................................................... Publicly held Publicly held Cooperative Cooperative Cooperative and

publicly held

Publicly held

President or Presidential Appointees Name Some Board Members ........................................... Yes (5/18) Yes (5/18) Yes (6/14)1 No Yes (5/15) Yes (7/21)

Treasury Lending Authorized ....................................................................................................... $2.25 billion $2.25 billion $4.0 billion No2 $1.5 billion3 $1.0 billion

Treasury Approval of Debt Issuance ........................................................................................... Yes Yes Yes No No YesSecurities Eligible for Federal Reserve Open Market Purchases ............................................... Yes Yes Yes Yes N/A YesUse of Federal Reserve as Fiscal Agent ..................................................................................... Yes Yes Yes Yes Yes YesDebt Eligible to Collateralize Public Deposits (All U.S. Government; Most State and Local) ... Yes Yes Yes Yes Yes YesExempt from SEC Registration (1933 Act) ................................................................................. Yes Yes Yes Yes No YesGovernment Securities for Purposes of the SecuritiesExchange Act of 1934 ........................... Yes Yes Yes Yes No YesSecurities Eligible for Unlimited Investment by NationalBanks and State Bank FR Member .. Yes Yes Yes Yes Yes YesSecurities Eligible for Unlimited Investment by Thrifts Regulated by FDIC or OTS .................. Yes Yes Yes Yes Yes YesExemption of Corporate Earnings from Federal Income Tax ...................................................... No No Yes Yes4 No No

Exemption of Corporate Earnings from State and LocalIncome Tax ......................................... Yes Yes Yes Yes No YesExemption of Interest Paid from State Income Tax ................................................................... No No Yes Yes No YesSubject to GAO Audit .................................................................................................................. Yes5 Yes5 Yes No Yes No

Federal Regulator ........................................................................................................................ HUD/OFHEO6 HUD/OFHEO6 FHFB7 FCA8 FCA ED

1 Each bank.2 Treasury is authorized to guarantee up to $4 billion of Financial Assistance Corporation bonds.3 Upon required certification from FAMC, borrowing from Treasury authorized to make payments under guarantee.4 Federal Land Banks, Farm Credit Banks and Financial Assistance Corporation.5Mortgage transactions may be subject to GAO audit under rules that may be prescribed by the Comptroller General.6 HUD regulates mission and program; the Office of Federal Housing Enterprise Oversight regulates safety and soundness.7 Federal Housing Finance Board.8 The Farm Credit System Assistance Board also has certain powers with respect to the Financial Assistance Corporation and the System institutions needing financial assistance.

Source: Statutes and regulations pertaining to the GSEs as compiled in Report of the Secretary of the Treasury on Government Sponsored Enterprises, May 1990, updated by CRS.

137

Chairman SUNUNU. Thank you very much.

Mr. McCool.

STATEMENT OF THOMAS J. McCOOL

Mr. MCCOOL. Thank you, Mr. Chairman.

Mr. Chairman and members of the Task Force, we are pleased

to be here today to discuss the roles of Fannie Mae and Freddie

Mac in our nation’s housing finance system.

Congress created Fannie Mae and Freddie Mac to promote home

ownership in the United States. The enterprises fulfill their mission by borrowing funds or issuing mortgage-backed securities and

using the proceeds to purchase home mortgages from banks, thrifts

and other financial institutions.

Financial institutions in turn may use the proceeds from their

mortgage sales to the enterprises to fund additional mortgage

loans, thereby helping to ensure a stable supply of mortgage credit

across the nation.

Most analysts agree that the enterprise’s activities have successfully lowered mortgage costs and increased home ownership in the

United States. However, these benefits must be weighed against

the potential costs associated with the Federal Government’s implied sponsorship of the enterprises, in particular, the cost of any

financial assistance the Federal Government might decide to provide in an emergency situation.

In recent years, GAO has issued several reports that assess the

enterprises’ role in the housing finance system and Federal oversight of their activities. My testimony today will briefly discuss topics covered in these reports, including the benefits and costs of the

enterprises’ housing finance activities, Federal efforts to ensure the

enterprises’ safety and soundness and Federal efforts to ensure the

enterprises promote home ownership opportunities for all Americans.

Now, I will shorten my discussion of the benefits, since Barbara

has already gone through some of the benefits that the GSEs obtain.

The enterprises are hybrid organizations that contain elements

of both private and public sector organizations. Like many private

companies, the enterprises issue equity and debt instruments to

the investing public. The enterprises have also developed compensation packages that reward top executives for increasing

shareholder value.

On the other hand, the enterprises’ close relationship with the

Federal Government and their Federal charters provide them with

several important advantages over private sector companies. Again,

the most important of these benefits is the perception in the financial markets that the government would not allow the enterprises

to fail, which allows the enterprises to borrow and issue MBS to

finance mortgage purchases at relatively lower cost than fully private firms.

These and other benefits, again, which have been discussed already, are to some extent passed on to home buyers in the form

of lower mortgage interest rates.

In our report on privatization, which we issued in 1996, we gave

an example of a reduction in mortgage interest rates for a $100,000

138

mortgage would add up to about $10 to $25 a month. So again,

there are substantial benefits passed on to homeowners.

However, Federal sponsorship of the enterprises’ activities as

GSEs also creates significant risks and costs. First, the potential

exists that U.S taxpayers would end up paying for a portion of the

enterprises’ debt and MBS obligations which stood at over $2 trillion at the end of 1999.

Second, opportunity costs are generated when the perceived

backing of the GSE by the Federal Government diverts funds from

other financial institutions that may otherwise be able to provide

more efficient services to the public.

Third, opportunity costs can also be generated if a GSE enters

into activities that are outside of its statutory mission.

To help ensure that the enterprises conduct their business in a

safe and sound manner and use their government-provided benefits

to achieve a public purpose, in 1992 Congress passed the Federal

Housing Enterprises Financial Safety and Soundness Act.

This act established the Office of Federal Housing Enterprise

Oversight, OFHEO, to ensure that the enterprises are adequately

capitalized and operating safely and provide the Department of

Housing and Urban Development with additional regulatory authority to ensure that the enterprises fulfill their housing finance

mission.

The 1992 act established OFHEO as an independent agency

within HUD to monitor the enterprises’ financial safety and soundness. The act provided OFHEO with two essential responsibilities

to carry out its mission: first, to establish capital standards for the

enterprises and, second, to establish an examination program.

As required by the 1992 act, OFHEO established minimum capital standards for the enterprises, which are capital ratios applied

to certain on balance and off balance sheet obligations.

The act also mandated that OFHEO develop a stress test to

serve as the basis for more sophisticated risk-based capital standards. The purpose of the stress test is to help manage taxpayer

risks by simulating situations where the enterprises are exposed to

adverse credit and interest rate scenarios.

OFHEO has proposed a rule to implement the stress test and

risk-based capital standards and expects to issue a final rule by the

end of 2000.

OFHEO also has the authority to establish an examination program, to monitor the enterprises’ management and financial conditions. At the time of our 1997 report, OFHEO has revised its examination program and implemented an annual examination schedule. OFHEO’s examination staff has generally found that the enterprises have been operated in a safe and sound manner.

HUD has statutory authority to ensure that the enterprises fulfill their mission of promoting housing and home ownership opportunity for all Americans. The 1992 act required HUD to development, implement and enforce a comprehensive housing mission

regulatory framework. This included setting housing goals which

required the enterprises to meet specified criteria each year for the

purchase of mortgages serving targeted groups.

139

In our work, we found that HUD generally adopted a conservative approach to setting the housing goals that placed a high priority on maintaining the enterprises’ safety and soundness.

In March of this year, HUD proposed a new rule setting housing

goal requirements for the period 2000 through 2003 which are

higher than the previous goals. HUD believes that the proposed

housing goals will provide strong incentives for the enterprises to

more fully meet the housing needs of targeted groups. The comment period on the proposed rule ended in May. HUD is currently

reviewing comments and expects to issue a final rule by the end

of 2000.

The 1992 act also defined HUD’s general regulatory authority

over the enterprises to ensure that the enterprises’ activities are

consistent with their housing mission and its new mortgage program approval authority to review new mortgage programs proposed by the enterprises to ensure the programs are consistent

with the enterprises’ charters and not contrary to the public interest.

In giving HUD this mission oversight authority, Congress correctly recognized that the enterprises face a natural tension between maximizing profitability for their shareholders and fulfilling

their housing mission. For example, we have pointed out that the

enterprises have incentives to use the funding advantage associated with their government sponsorship to make non-mortgage investments, some of which may result in arbitrage profits.

While our reports found that HUD had not acted promptly to ensure that the enterprises’ non-mortgage investments were consistent with their housing mission, in 1997, HUD initiated a rulemaking process designed to develop criteria that would help ensure

that the enterprises’ non-mortgage investments are consistent with

their housing mission and Federal charters. However, HUD has yet

to develop criteria for overseeing the enterprises’ non-mortgage investments.

Enterprises have also engaged in other complex financial activities whose relation to their housing mission is not always clear. We

reported on HUD’s approval of a new mortgage program by Fannie

Mae that would have involved Fannie Mae purchasing cash value

life insurance. More recently, the enterprises’ involvement in other

activities have raised questions as to whether they are attempting

to move beyond the secondary mortgage market into areas traditionally served by private lenders in the primary mortgage market.

In summary, Congress provided Fannie Mae and Freddie Mac

with substantial financial benefits so that they can fulfill their

housing finance mission. There is widespread agreement that the

enterprises’ secondary mortgage activities have lowered the cost of

home ownership for millions of Americans. However, perceived

Federal sponsorship of the enterprises’ activities as GSEs also involves significant risks and costs.

In passing the 1992 act, Congress created a regulatory structure

with the potential to help ensure the enterprises would focus on

and fulfill their public mission without exposing U.S. taxpayers to

undue risk.

In their oversight roles, OFHEO and HUD face a difficult challenge in ensuring that the enterprises meet their housing responVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00143 Fmt 6601 Sfmt 6602 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
140

sibilities in a safe and sound manner while simultaneously being

afforded sufficient latitude to manage their day-to-day business

needs and meet their shareholder obligations.

As large sophisticated institutions, the enterprises have become

engaged in complex financial activities that may serve multiple

purposes. It is difficult to assess the financial risks of many of their

activities as well as the relationship between their activities and

mission achievement.

Nonetheless, the making of such assessments by the enterprises’ regulators and Congress is imperative to ensure that the interests

of U.S. taxpayers are protected.

Mr. Chairman, this concludes my statement. I will be happy to

answer any questions.

[The prepared statement of Thomas J. McCool follows:]

PREPARED STATEMENT OF THOMAS J. MCCOOL, DIRECTOR, FINANCIAL INSTITUTIONS

AND MARKETS ISSUES, GENERAL GOVERNMENT DIVISION

Mr. Chairman and members of the Task Force, we are pleased to be here today

to discuss the roles of Fannie Mae and Freddie Mac in our nation’s housing finance

system. Congress created Fannie Mae and Freddie Mac (the enterprises), the two

largest government sponsored enterprises (GSEs), to promote home ownership in

the United States. The enterprises fulfill their housing mission by borrowing funds

or issuing mortgage-backed securities (MBS) and using the proceeds to purchase

home mortgages from banks, thrifts, and other financial institutions. Financial institutions, in turn, may use the proceeds from their mortgage sales to the enterprises to fund additional mortgage loans, thereby helping to ensure a stable supply

of mortgage credit across the nation. Financial institution mortgage lending is commonly referred to as the ‘‘primary residential mortgage market,’’ while the enterprises’ mortgage purchase activities are commonly referred to as the ‘‘secondary residential mortgage market.’’

Most analysts agree that the enterprises’ activities have successfully lowered

mortgage costs and increased home ownership in the United States. However, these

benefits must be weighed against the potential costs associated with the Federal

Government’s implied sponsorship of the enterprises, which had combined debt and

MBS liabilities of over $2 trillion at the end of 1999. In particular, the Federal Government could potentially decide to provide financial assistance to the enterprises

in an emergency situation.

In recent years, we have issued several reports that assess the enterprises’ roles

in the housing finance system and Federal oversight of their activities. My testimony today will briefly discuss the following important topics covered in these reports:

• the benefits and costs of the enterprises’ housing finance activities,

• Federal efforts to ensure the enterprises’ safety and soundness, and

• Federal efforts to ensure that the enterprises promote home ownership opportunities for all Americans.

THE BENEFITS AND COSTS OF THE ENTERPRISES’ HOUSING FINANCE ACTIVITIES

The enterprises are hybrid organizations that contain elements of both privateand public-sector organizations. Like many private companies, the enterprises issue

equity and debt instruments to the investing public. The enterprises have also developed compensation packages that reward top executives for increasing shareholder value. On the other hand, the enterprises’ close relationship with the Federal

Government and their Federal charters provide them with several important advantages over private-sector companies. The most important of these benefits is an indirect one—the perception in the financial markets that the government would not

allow the enterprises to fail, which allows them to borrow and issue MBS to finance

mortgage purchases at relatively lower cost than private firms. The enterprises’

Federal charters also exempt them from paying state and local income taxes and

some of the fees charged by the Securities and Exchange Commission for securities

and debt issuances. The charters also provide each enterprise with a $2.25 billion

conditional line of credit with the Treasury Department.

In a May 1996 report, we estimated that the total annual value of these benefits

to the enterprises ranged from $2.2 billion to $8.3 billion on a before-tax basis and

141

$1.6 billion to $5.9 billion on an after-tax basis.1 To some extent, the enterprises

pass these savings on to home buyers in the form of lower mortgage interest rates.

Although it is not possible to calculate these savings precisely, we estimate that in

1995 the enterprises’ mortgage purchase activities resulted in savings of about a

quarter of a percentage point annually on a typical $100,000 mortgage. This translated into savings of about $10 to $25 per month on such a $100,000 mortgage, or

about $3 billion to $7 billion annually for the approximately $2 trillion in mortgages

that the GSEs were eligible to purchase and that were outstanding at the time.2

Most analysts also agree that the enterprises’ activities, such as their imposition of

greater standardization on mortgage products and processes, have also facilitated

the development of an efficient, nationwide mortgage finance system.

However, Federal sponsorship of the enterprises’ activities as GSEs also creates

significant risks and costs. First, the potential exists that U.S. taxpayers would end

up paying for a portion of the enterprises’ debt and MBS obligations, which stood

at over $2 trillion at the end of 1999. In fact, Fannie Mae experienced significant

financial difficulties because of a sharp rise in interest rates between 1981 and

1984, resulting in losses of $277 million. To help Fannie Mae overcome these problems, the Federal Government provided limited tax relief and relaxed the enterprise’s capital requirements. Congress also showed its willingness to assist GSEs

that experience financial difficulty in 1987 when it authorized up to $4 billion to

help the Farm Credit System, another GSE, overcome a farm crisis and the resulting increase in loan defaults. Second, opportunity costs can also be generated when

the perceived backing of a GSE by the Federal Government diverts funds from other

financial institutions that may otherwise be able to provide more efficient services

to the public. Third, opportunity costs can also be generated if a GSE enters into

activities that are outside its statutory mission.

To help ensure that the enterprises conduct their business in a safe and sound

manner and use their government-provided benefits to achieve a public purpose, in

1992 Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act (1992 Act). The 1992 Act established the Office of Federal Housing Enterprise Oversight (OFHEO) to ensure that the enterprises are adequately capitalized

and operating safely. The 1992 Act also provided the Department of Housing and

Urban Development (HUD) with additional regulatory authority to ensure that the

enterprises fulfill their housing finance mission. As part of the 1992 Act, Congress

concluded that the financial benefits that the enterprises derive from their government sponsorship involve a corresponding obligation to meet the mortgage credit

needs of all potential home buyers, including those with low- and moderate-incomes.

This regulatory scheme allows the enterprises to continue to have the same powers

as private companies to conduct their day-to-day business.

In the remaining two sections of my testimony, I will discuss the status of

OFHEO and HUD’s efforts to fulfill their regulatory responsibilities under the 1992

Act.

OFHEO MONITORS THE FINANCIAL SAFETY OF THE ENTERPRISES

The 1992 Act established OFHEO as an independent agency within HUD to monitor the enterprises’ financial safety and soundness. Under the act, OFHEO is subject to the congressional appropriations process but the enterprises pay assessments

to finance its activities. OFHEO’s budget was about $16 million in fiscal year 1999.

The act provided OFHEO with two essential responsibilities to carry out its safety

and soundness mission: (1) establish capital standards for the enterprises and (2)

establish an examination program.

As required by the 1992 Act, OFHEO has established minimum capital standards

for the enterprises, which are capital ratios applied to certain on-balance-sheet and

off-balance-sheet obligations. OFHEO has consistently classified the enterprises as

in compliance with the minimum capital standards since they were established in

1993. The act also mandated that OFHEO develop a stress test to serve as the basis

for more sophisticated risk-based capital standards. The purpose of the stress test

is to help manage taxpayer risks by simulating, in a computer model, situations

where the enterprises are exposed to adverse credit and interest rate scenarios. The

enterprises are required to hold sufficient capital to withstand these adverse conditions for 10 years, plus an additional 30 percent of the required capital to cover operations and management risk.

Although the 1992 Act directed OFHEO to complete the stress test and risk-based

capital standards by December 1, 1994, OFHEO has not yet completed these tasks.

In an October 1997 report, we identified several reasons for OFHEO’s inability to

comply with the deadline, including (1) the complexity of the task, (2) OFHEO’s decision to develop a new stress test rather than adopt or modify existing stress tests,

142

(3) OFHEO’s initial difficulties in obtaining required financial data from the enterprises, and (4) greater than expected managerial and technical difficulties.3 OFHEO

has proposed a rule to implement the stress test and risk-based capital standards

and expects to issue a final rule by the end of 2000.

OFHEO also has the authority to establish an examination program to monitor

the enterprises’ management and financial condition. Our 1997 report found that

OFHEO had not been able to implement its plan to examine all relevant operations

of the enterprises on a 2-year schedule. We attributed OFHEO’s inability to meet

the schedule to limited staff resources and the start-up challenges associated with

examining the enterprises, which are extremely large and complex financial institutions. Since that time, OFHEO has revised its examination program and implemented an annual examination schedule. OFHEO’s examination staff has generally

found that the enterprises have been operated in a safe and sound manner.

HUD HAS RESPONSIBILITY FOR OVERSEEING THE ENTERPRISES’ FULFILLMENT OF THEIR

HOUSING MISSION

HUD has statutory authority to ensure that the enterprises fulfill their mission

of promoting housing and home ownership opportunities for all Americans. In passing the 1992 Act, Congress concluded that HUD’s regulatory framework had not

been effective in ensuring that the enterprises’ activities benefit low- and moderateincome Americans and those who live in underserved areas, such as central cities

and rural communities (targeted groups). The 1992 Act required HUD to develop,

implement, and enforce a comprehensive housing mission regulatory framework.

Among other provisions, the 1992 Act directed HUD to set housing goals, which require the enterprises to meet specified criteria each year for the purchase of mortgages serving targeted groups.

In 1995, HUD established a final rule for enterprises’ housing goal mortgage purchases for the years 1996 through 1999. In a July 1998 report, we found that HUD

generally adopted a conservative approach to setting the housing goals that placed

a high priority on maintaining the enterprises’ financial soundness.4 For example,

HUD and OFHEO conducted research during the rulemaking process that concluded

that the proposed housing goals were modest and would not materially affect the

enterprises’ financial condition. According to HUD data, the enterprises met or exceeded the housing goals between 1996 and 1998.

In March of this year, HUD proposed a new rule setting housing goal requirements for the period 2000 through 2003. HUD’s proposed housing goals are set higher than the goals set for the period 1996 through 1999. According to HUD, the enterprises’ share of the affordable housing market remains below desired levels. For

example, banks and other lenders continue to make relatively more mortgage loans

in the primary market to targeted groups than the enterprises purchase in the secondary residential mortgage market. HUD believes that the proposed housing goals

will provide strong incentives for the enterprises to more fully meet the housing

needs of targeted groups. The comment period on the proposed rule ended in May

2000. HUD is currently reviewing comments and expects to issue a final rule by the

end of 2000.

The 1992 Act also defined HUD’s general regulatory authority over the enterprises and its new mortgage program approval authority.5 HUD has the general regulatory authority to ensure that the enterprises’ activities are consistent with their

housing mission. HUD also has the authority to review new mortgage programs proposed by the enterprises to ensure that the programs are consistent with the enterprises’ charters and not contrary to the public interest. In our view, Congress correctly recognized, in passing the 1992 Act, that the enterprises-given their hybrid

structure-face a natural tension between maximizing profitability for their shareholders and fulfilling their housing mission.

In a March 1998 report, we provided an example of this natural tension and

HUD’s critical responsibility to exercise its general regulatory authority in a way

that ensures that the enterprises fulfill their housing mission.6 We pointed out that

the enterprises have incentives to use the funding advantage associated with their

government sponsorship to make nonmortgage investments-such as corporate bond

purchases-that may result in arbitrage profits.7 Our report recognized that some

nonmortgage investments, particularly short-term investments, can contribute to

mission achievement by facilitating liquidity in the secondary market for residential

mortgages. However, our report concluded that the relationship between long-term

nonmortgage investments and the enterprises’ housing mission is not entirely clear.

Our March 1998 report found that HUD did not act promptly to ensure that the

enterprises’ nonmortgage investments were consistent with their housing mission.

In fact, HUD did not exercise its general regulatory authority provided in the 1992

143

Act until 1997, when a public controversy erupted over Freddie Mac’s investment

in long-term Philip Morris corporate bonds. In 1997, HUD initiated a rulemaking

process designed to develop criteria that would help ensure that the enterprises’ nonmortgage investments are consistent with their housing mission and Federal

charters. We recommended that HUD promptly implement this rulemaking process,

and HUD agreed to do so. However, HUD has not yet developed criteria for overseeing the enterprises’ nonmortgage investments.

The enterprises have also engaged in other complex financial activities whose relation to their housing mission is not entirely clear. For example, in our March 1998

report, we pointed out that HUD approved a new mortgage program by Fannie Mae

that would involve Fannie Mae in purchasing cash value life insurance, which is essentially a nonmortgage investment.8 HUD officials told us that they lacked expertise in cash value life insurance when they approved the Fannie Mae program.

More recently, the enterprises’ involvement in other activities-such as automated

underwriting-have raised questions as to whether they are attempting to move beyond the secondary mortgage market into areas traditionally served by private lenders in the primary mortgage market. Some lenders believe that the enterprises’ automated systems standardize the mortgage loan process to such an extent that

the lenders’ role in mortgage lending is minimized.

CONCLUSIONS

In summary, Congress provided Fannie Mae and Freddie Mac with substantial financial benefits so that they can fulfill their housing finance mission. There is widespread agreement that the enterprises’ secondary mortgage market activities have

lowered the cost of home ownership for millions of Americans. However, perceived

Federal sponsorship of the enterprises’ activities as GSEs also involves significant

risks and costs. In passing the 1992 Act, Congress created a regulatory structure

with the potential to help ensure that the enterprises, in their attempts as private

corporations to create shareholder value, would do so by focusing on and fulfilling

their public missions without exposing U.S. taxpayers to undue risk.

In their oversight roles, OFHEO and HUD face a difficult challenge in ensuring

that the enterprises meet their housing responsibilities in a safe and sound manner,

while simultaneously being afforded sufficient latitude to manage their day-to-day

business needs and meet their shareholder obligations. The enterprises are large,

sophisticated financial institutions. Beyond various nonmortgage investments, the

enterprises have become engaged in complex financial activities that may serve multiple purposes. Therefore, it is difficult to assess the financial risks of many of their

activities as well as the relationship between their activities and mission achievement. Nonetheless, the making of such assessments by the enterprises’ regulators

and Congress is imperative to ensure that the interests of U.S. taxpayers are protected.

Mr. Chairman, this concludes my statement. My colleagues and I would be

pleased to respond to any questions that you or other members of the Task Force

may have.

ENDNOTES

1. Housing Enterprises: Potential Impacts of Severing Government Sponsorship

(GAO/GGD-96-120, May 13, 1996).

2. The enterprises’ charters restrict them from purchasing mortgages above a set

dollar amount, known as the conforming loan limit. The conforming loan limit depends upon how many housing units are financed by a single residential mortgage

loan. The conforming loan limit is currently set at $252,700. The charters also require the enterprises to meet certain underwriting standards for mortgage loan purchases.

3. Federal Housing Enterprises: OFHEO Faces Challenges in Implementing a

Comprehensive Oversight Program (GAO/GGD-98-6, Oct. 22, 1997).

4. Federal Housing Enterprises: HUD’s Mission Oversight Needs to Be Strengthened (GAO/GGD-98-173, July 28, 1998).

5. 12 U.S.C. § 4541-2. The 1992 Act defines a ‘‘new program’’ as being significantly different from mortgage programs that have been approved or that represent

an expansion, in terms of the dollar volume or number of mortgages or securities

involved, of programs previously approved.

6. Government-Sponsored Enterprises: Federal Oversight Needed for Nonmortgage Investments (GAO/GGD-98-48, Mar. 11, 1998).

7. We defined the term ‘‘arbitrage’’ to mean that the enterprises use their funding

advantage from government sponsorship to raise funds for making certain nonmortgage investments. Our definition of arbitrage is similar to the definition of an arbiVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00147 Fmt 6601 Sfmt 6621 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
144

trage bond defined in reference to Federal income tax exemption for interest on

state and local bonds in the U.S. tax code.

8. The program was called the Mortgage Protection Plan (MPP). Under MPP,

Fannie Mae would purchase a cash value life insurance on a first-time home buyer

after the selected borrower’s residential mortgage was purchased by Fannie Mae

and the borrower agreed to such coverage. MPP was designed to protect Fannie Mae

and the borrower against default caused by the borrower’s death. Fannie Mae did

not go ahead with MPP because of tax law changes.

Chairman SUNUNU. Thank you, Mr. McCool.

Mr. Ely.

STATEMENT OF BERT ELY

Mr. ELY. Mr. Chairman and members of the Task Force, I am

pleased to testify this morning on the economic implications of debt

issued by government-sponsored enterprises, or GSEs. I request

permission to submit additional material to the committee for inclusion in the record of this hearing.

Also, I am testifying today on my own behalf. The statements I

will make and the opinions I will offer are mine alone and do not

necessarily reflect those of any client.

I will begin by addressing the issue of the systemic risks posed

by the GSEs and specifically Fannie Mae and Freddie Mac. Within

that context, I will then discuss the amount of GSE obligations federally-insured banks and thrifts hold relative to their capital. GSE

obligations include mortgage-backed securities the GSEs have

guaranteed as well as the debt they have issued. I will close by offering a recommendation.

Systemic risk arises when the failure of a large financial institution threatens the stability of the financial markets. While the failure of a small institution would not threaten financial stability, the

failure of a large institution could. Hence, size matters.

Because stable financial markets are essential to the smooth

functioning of the economy overall, systemic risk must be treated

extremely seriously. Systemic risk also can arise when a large financial institution begins to suffer funding problems. That is, it experiences difficulty and high costs in rolling over its debt because

the financial market fears that the institution might be sliding toward insolvency.

That situation arose in the fall of 1998 when a large, highly leveraged hedge fund, Long-Term Capital Management, experienced

a funding problem. Although LTCM apparently never was actually

insolvent on a mark-to-market basis, there were grave doubts

about its solvency in the aftermath of the Russian debt market default in the summer of 1998.

Due only to the intervention of the New York Fed, Long-Term

Capital Management was able to keep rolling over its debt in sufficient quantities to enable it to shrink itself in an orderly manner.

Had LTCM been forced to sell its assets at fire sale prices in

order to pay its maturing debts, chaos would have reigned in the

financial markets. Those fire sale prices would have caused tremendous mark-to-market losses for other financial firms, possibly

rendering some of them insolvent. A cascade of losses could have

wracked global economic havoc.

I mention LTCM because as big as it was, its outstanding debt

at the time of its troubles was less than one-seventh of the amount

145

of debt Fannie and Freddie combined had outstanding at the end

of last year. Adding in their MBS, the total outstanding obligations

of Fannie and Freddie at the end of 1999, $2.125 trillion, was 17

times LTCM’s obligations when it crashed. Unquestionably, Fannie

and Freddie pose serious systemic risks. Clearly, they are too-bigto-fail institutions.

The fact that Fannie and Freddie are GSEs makes it nearly certain that the Federal Government will rescue them should they experience financial problems. History bears out this statement. In

1988, Congress threw a $4 billion life ring to the much smaller

Farm Credit System, even though it was solvent on a book value

basis, after yields on FCS debt over longer Treasuries went above

100 basis points, signalling that new FCS debt might become virtually unmarketable.

In 1996, Congress averted a possible default on FICO bonds by

extending the FICO interest bond assessment from S&Ls to all federally-insured depository institutions. And, of course, Congress

coughed up approximately $160 billion drawn from various sources

to ensure that the Federal deposit insurance commitment would be

met for all failed S&Ls.

Much has been made in hearings held earlier this year by the

Capital Markets Subcommittee of the House Banking Committee

that a statutorily required stress test will prevent Fannie or

Freddie from reaching insolvency. Although OFHEO has strived

valiantly to implement this stress test, the test will not prevent either Fannie or Freddie from creating systemic risk.

This is a most important point that Representative Richard

Baker, chairman of the Capital Markets Subcommittee, made in a

hearing last Thursday. This is the case because any meaningful deterioration in the financial condition of either Fannie or Freddie,

even if neither is insolvent, will create funding problems for both

GSEs since they are, for all practical purposes, Siamese twins.

According to a recent American Banker article, over two-thirds of

federally-insured banks and thrifts hold more GSE debt and MBS,

relative to their capital, than would be permissible for them to hold

if GSE obligations were held to the same loan-to-one borrower and

investment-per-company rules that apply to credit extensions by

banks and thrifts to genuinely private organizations.

Due to data limitations, it is not possible to identify the specific

GSEs for which banks and thrifts have exceeded the credit limits

applicable to private entities. However, given their enormous size

relative to the other GSEs, most banks and thrifts are overexposed

to Fannie and Freddie obligations.

This overexposure has undoubtedly created solvency concerns

about banks and thrifts heavily invested in GSE debt and MBS

should Fannie or Freddie get into trouble. This is the case because

if funding problems drove down the market value of GSE debt, that

drop would cause capital reductions in banks and thrifts that

would trigger regulatory sanctions that in turn would force banks

and thrifts to reduce their lending to consumers and businesses.

The resulting credit crunch could easily cause a recession, which

would magnify the downward spiral.

If banks and thrifts continue to hold a proportionate share of the

total amount of Fannie and Freddie obligations, then Fannie’s and

146

Freddie’s continued growth will increase the systemic risk they

pose to America’s banks and thrifts.

Ironically, the growing presence of Fannie and Freddie obligations on bank and thrift balance sheets further increases the likelihood that the Federal Government will rescue the GSEs should

they experience funding problems because of the adverse effects

that those problems would have on federally-insured depository institutions.

Although the reforms Congress enacted in the early 1990’s have

essentially eliminated the taxpayer risk posed by Federal deposit

insurance, Congress would still understandably be concerned about

the credit crunch effects of Fannie and Freddie’s funding problems.

While GSE obligations owned by banks and thrifts should be

subject to the same loan and investment limitations applicable to

the obligations of private sector firms, forcing banks and thrifts to

trim their Fannie and Freddie obligations would merely shift systemic risk elsewhere in the financial system, not eliminate it. In

any event, the GSE exception to these limitations should be of less

concern to Congress than the enormous and increasing size of these

two undercapitalized GSEs.

Until such time as Fannie and Freddie can be transformed into

genuinely private sector firms by eliminating their special privileges, Congress must ensure that a reliable mechanism is in place

to rescue Fannie or Freddie should one of them stumble financially.

Because there are innumerable reasons why they might stumble,

some of which lie outside the U.S. financial system, it would be

pointless to try to prevent an external event. Instead, if needed, a

rescue mission should be executed as quickly and smoothly as possible.

It would be foolhardy to rely upon ‘‘market discipline’’ to prevent

a stumble because the exercise of market discipline could collapse

the financial markets. We got a whiff of that potential effect in the

aftermath of Treasury Under Secretary Gary Gensler’s testimony

in March before the Capital Markets Subcommittee when yields on

Fannie and Freddie debt shot up at the mere suggestion that they

are not government-backed institutions.

The two existing rescue mechanisms are grossly inadequate.

First, Fannie’s and Freddie’s Treasury lines of credit, at $2.25 billion for each institution, pale in light of the total amount of their

outstanding debt in MBS. Fannie’s line of credit is less than .2 percent of its outstanding obligations. The comparable figure for

Freddie is about 2.5 percent, or in effect one-four-hundredth of its

outstanding obligations.

Second, if Congress were out of session and the Treasury lines

of credit had been fully drawn down, then presumably the Fed

could lend to Fannie and Freddie or buy their securities. But to do

so, the Fed would have to sell a like amount of Treasury securities.

Massive sales of Treasury debt could be highly disruptive to the financial markets.

Key, therefore, to dealing with a Fannie or Freddie funding crisis

would be congressional enactment of a line of credit comparable to

the life ring Congress tossed to the Farm Credit System in 1988

that the Treasury Department could draw upon to keep the finanVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00150 Fmt 6601 Sfmt 6602 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
147

cial markets funding Fannie and Freddie even if these GSEs were

experiencing financial difficulties.

That action would give Congress time resolve their problems in

a manner that would minimize the cost of any rescue. As distasteful as this recommendation may seem, going forward with the

present limited rescue resources is playing Russian roulette with

the U.S. economy.

Mr. Chairman and members of the Task Force, I thank you for

your time, and I welcome your questions.

[The prepared statement and other submitted materials of Bert

Ely follows:]

PREPARED STATEMENT OF BERT ELY, ELY & CO., INC.

ECONOMIC IMPLICATIONS OF DEBT ISSUED BY GOVERNMENT-SPONSORED ENTERPRISES

Mr. Chairman and members of the Task Force on Housing and Infrastructure, I

am pleased to testify this morning on the economic implications of debt issued by

government-sponsored enterprises, or GSEs. I request permission to submit additional material to the Committee for inclusion in the record of this hearing, specifically a monograph I co-authored recently, titled ‘‘Nationalizing Mortgage Risk: The

Growth of Fannie Mae and Freddie Mac.’’ Also, I am testifying today in my own

behalf. The statements I will make and the opinions I will offer are my alone and

do not necessarily reflect those of any client.

I will begin by addressing the issue of the systemic risk posed by the GSEs, and

specifically Fannie Mae and Freddie Mac. Within that context, I will then discuss

the amount of GSE obligations federally insured banks and thrifts hold relative to

their capital. GSE obligations include mortgage-backed securities, or MBS, the

GSEs have guaranteed as well as the debt they have issued. I will close by offering

a recommendation.

SYSTEMIC RISK

Systemic risk arises when the failure of a large financial institution, due to its

actual or apparent insolvency, threatens the stability of the financial markets.

While the failure of a small institution would not threaten financial stability, the

failure of a large institution could. Hence, size matters. Because stable financial

markets are essential to the smooth functioning of the economy overall, systemic

risk must be treated extremely seriously.

Systemic risk also can arise when a large financial institution begins to suffer

funding problems; that is, it experiences difficulty and high cost in rolling over its

debt because of financial market fears that the institution might be sliding toward

insolvency. That situation arose in the fall of 1998 when a large, highly leveraged

hedge fund, Long Term Capital Management, or LTCM, experienced a funding problem. Although LTCM apparently never was actually insolvent, on a mark-to-market

basis, there were grave doubts about its solvency in the aftermath of the Russian

debt default in the summer of 1998.

Due only to the intervention of the Federal Reserve Bank of New York, LTCM

was able to keep rolling over its debt in sufficient quantities to enable it to shrink

itself in an orderly manner. Had LTCM been forced to sell its assets at fire-sale

prices, in order to pay its maturing debt, chaos would have reigned in the financial

markets. Those fire-sale prices would have caused tremendous mark-to-market

losses for other financial firms, possibly rendering some of them insolvent. A cascade of losses could have wracked global economic havoc.

I mention LTCM because as big as it was, its outstanding debt at the time of its

troubles was less than one-seventh of the amount of debt Fannie and Freddie combined had outstanding at the end of last year. Adding in their MBS, the total outstanding obligations of Fannie and Freddie at the end of 1999, $2.125 trillion, was

17 times LTCM’s obligations when it crashed. Unquestionably, Fannie and Freddie

pose serious systemic risks. Clearly, they are too-big-to-fail financial institutions.

The fact that Fannie and Freddie are GSEs makes it nearly certain that the Federal Government will rescue them should they experience financial problems. History bears out this statement. In January 1988, Congress threw a $4 billion life ring

to the much smaller Farm Credit System, or FCS, even though it was solvent on

a book-value basis, after yields on FCS debt over longer term Treasuries went above

100 basis points, signalling that new FCS debt might become virtually unmarketVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00151 Fmt 6601 Sfmt 6621 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
148

able. In September 1996, Congress averted a possible default on the so-called FICO

bonds by extending the FICO bond interest assessment from savings-and-loans, or

S&Ls, to all federally insured depository institutions. And of course, starting in

1989, Congress coughed up approximately $160 billion, drawn from various sources,

to ensure that the Federal deposit insurance commitment would be met for all failed

S&Ls.

Much has been made in hearings held earlier this year by the Capital Markets

Subcommittee of the House Banking Committee that a statutorily required stress

test will prevent Fannie or Freddie from reaching insolvency. Although the Office

of Federal Housing Enterprise Oversight, or OFHEO, has strived valiantly to implement this stress test, the test will not prevent either Fannie or Freddie from creating systemic risk. This is a most important point that Rep. Richard Baker, Chairman of the Capital Markets Subcommittee, made in a hearing last Thursday. This

is the case because any meaningful deterioration in the financial condition of either

Fannie or Freddie, even if neither is insolvent, will create funding problems for both

GSEs since they are, for all practical purposes, Siamese twins.

INVESTMENTS BY BANKS AND THRIFTS IN GSE OBLIGATIONS

According to a recent (April 14, 2000) American Banker article, over two-thirds

of federally insured banks and thrifts hold more GSE debt and MBS, relative to

their capital, than would be permissible for them to hold if GSEs obligations were

held to the same loan-to-one-borrower and investment-per-company rules that apply

to credit extensions by banks and thrifts to genuinely private organizations. Due to

data limitations, it is not possible to identify the specific GSEs for which banks and

thrifts have exceeded the credit limits applicable to private entities. However, given

their enormous size, relative to the other GSEs, most banks and thrifts are most

overexposed to Fannie and Freddie obligations.

This overexposure has understandably created solvency concerns about banks and

thrifts heavily invested in GSE debt and MBS should Fannie or Freddie get into

trouble. This is the case because if funding problems drove down the market value

of GSE debt, that drop would cause capital reductions in banks and thrifts that

would trigger regulatory sanctions that, in turn, would force banks and thrifts to

reduce their lending to consumers and businesses. The resulting credit crunch could

easily cause a recession, which would magnify the downward spiral. If banks and

thrifts continue to hold a proportionate share of the total amount of Fannie and

Freddie obligations, then Fannie’s and Freddie’s continued growth will increase the

systemic risk they pose to America’s banks and thrifts.

Ironically, the growing presence of Fannie and Freddie obligations on bank and

thrift balance sheets further increases the likelihood that the Federal Government

will rescue the GSEs should they experience funding problems because of the adverse effect those problems would have on federally insured depository institutions.

Although reforms Congress enacted in the early 1990’s have essentially eliminated

the taxpayer risk posed by Federal deposit insurance, as I explain in a paper titled

‘‘Banks Do Not Receive a Federal Safety Net Subsidy,’’ Congress would still understandably be concerned about the credit-crunch effects of Fannie’s and Freddie’s

funding problems.

While GSE obligations owned by banks and thrifts should be subject to the same

loan and investment limitations applicable to the obligations of private-sector firms,

forcing banks and thrifts to trim their Fannie and Freddie obligations would merely

shift systemic risk elsewhere in the financial system, not eliminate it. In any event,

the GSE exception to these limitations should be of less concern to Congress than

the enormous and ever increasing size of the two undercapitalized GSEs.

WHAT TO DO ABOUT THE SYSTEMIC RISKS FANNIE AND FREDDIE POSE

Until such time as Fannie and Freddie can be transformed into genuinely privatesector firms by eliminating their special privileges, Congress must ensure that a reliable mechanism is in place to rescue Fannie and Freddie should one of them stumble financially. Because there are innumerable reasons why they might stumble,

some of which lie outside the U.S. financial system, it would be pointless to try to

prevent an external event. Instead, if needed, a rescue mission should be executed

as quickly and smoothly as possible.

It would be foolhardy to rely upon ‘‘market discipline’’ to prevent a stumble because the exercise of market discipline could collapse the financial markets. We got

a whiff of that potential effect in the aftermath of Treasury Under Secretary Gary

Gensler’s testimony in March before the Capital Markets Subcommittee when yields

on Fannie and Freddie debt shot up at the mere suggestion that they are not government-backed institutions.

149

The two existing rescue mechanisms are grossly inadequate. First, Fannie’s and

Freddie’s Treasury lines of credit, at $2.25 billion for each institution, pale in light

of the total amount of their outstanding debt and MBS. Fannie’s line of credit is

less than .2 percent of its outstanding obligations; the comparable figure for Freddie

is about .25 percent. Second, if Congress were out of session and the Treasury lines

of credit had been fully drawn, then presumably the Fed could lend to Fannie and

Freddie or buy their securities, but to do so, the Fed would have to sell a like

amount of Treasury securities. Massive sales of Treasury debt could be highly disruptive to the financial markets.

Key, therefore, to dealing with a Fannie or Freddie funding crisis would be congressional enactment of a line of credit, comparable to the life ring Congress tossed

to the Farm Credit System in 1988, that the Treasury Department could draw upon

to keep the financial markets funding Fannie and Freddie even if these GSEs were

experiencing financial difficulties. That action would give Congress time to resolve

their problems in a manner that would minimize the cost of any rescue. As distasteful as this recommendation may seem, going forward with the present limited rescue resources is playing Russian roulette with the U.S. economy.

Mr. Chairman and members of the Task Force, I thank you for your time. I welcome your questions.

ELY & COMPANY, INC.,

FINANCIAL INSTITUTIONS AND MONETARY POLICY CONSULTING,

Alexandria, VA, July 29, 2000.

Hon. EVA M. CLAYTON,

U.S. House of Representatives, Washington, DC.

DEAR MS. CLAYTON: I am writing to clarify an answer I gave to a question you

posed to me at the Budget Committee’s Housing and Infrastructure Task Force

hearing on Tuesday about the GSEs. I stated something to the effect that I do not

believe that the lower interest rates Fannie Mae and Freddie Mac provide are necessarily beneficial to housing finance. However, I am not an advocate of high mortgage interest rates. Instead, I fear that the interest rate subsidy Fannie and Freddie

deliver may actually harm housing affordability if that subsidy gets overcapitalized

in housing prices. Let me explain.

At present interest rate levels, a .25 percent reduction in the rate on a 30-year

fixed-rate mortgage enables a borrower to finance a mortgage approximately 2.4

percent larger than the borrower could finance without that interest rate reduction;

a .375 percent rate reduction will finance an approximately 3.6 percent larger mortgage. While that may seem desirable, if the existence of the Fannie/Freddie subsidy

causes housing prices to rise by more than 2.4 percent to 3.6 percent, then it is the

seller of a house, rather than the buyer, who receives the benefit of the mortgage

subsidy. My research suggests that at times, and perhaps much of the time, Fannie

and Freddie’s interest rate subsidy has been overcapitalized in housing prices, thus

making it more difficult for moderate income people to buy a home. In my opinion,

a more much effective and lower cost housing finance subsidy would target the subsidy to just those homebuyers on the cusp of home ownership.

I would welcome the opportunity to meet with you to discuss in greater depth the

issues you raised at the hearing.

Very truly yours,

BERT ELY.

NATIONALIZING MORTGAGE RISK: THE GROWTH OF FANNIE MAE AND FREDDIE MAC

Peter J. Wallison and Bert Ely

1. INTRODUCTION

Fannie Mae and Freddie Mac are today the largest financial institutions in the

United States. Many economic studies, including one by the Congressional Budget

Office (CBO), have concluded that these government-sponsored enterprises (GSEs)

receive an implicit government subsidy arising out of the statutory benefits they retained at the time they were ‘‘privatized’’ (Fannie in 1970, Freddie in the 1980’s).

In 1996, the CBO estimated the value of that subsidy at $6.5 billion for the previous

year, and the subsidy has grown substantially larger since then.

150

1 In its 1996 report, Assessing the Public Costs and Benefits of Fannie Mae and Freddie Mac,

CBO concluded that the GSEs reduced interest rates in the conventional/conforming market by

passing along about two-thirds of the implicit subsidy they received from the government, while

retaining the balance for themselves. CBO estimated that subsidy as $6.5 billion in 1995, a figure that was derived by estimating the GSEs’ funding cost savings as a result of their implicit

government backing. Prior assessments of the GSEs’ credit quality had concluded that, without

government backing, Fannie and Freddie would have private-sector credit ratings in the Aa

range. That permited CBO to estimate the savings attributable to the government’s implicit

credit enhancement by computing the difference between the costs the GSEs would have faced

without government backing and the costs they actually paid. That savings was estimated at

about 50 basis points for each dollar of funds acquired. CBO then noted that the difference between interest rates in the jumbo market and those in the conventional/conforming market

amounted to approximately 35 basis points, and concluded that the GSEs were retaining about

15 basis points, or about one-third of their implicit subsidy.

According to the CBO, only a portion of that subsidy is actually passed along to

the mortgage markets.1 The balance, almost a third, is retained for the share-holders and managements of the two companies, accounting for more than 40 percent

of their 1995 profits (which ranked them among the most profitable publicly held

companies in the United States).

The lower interest rates that Fannie and Freddie can command because of their

government backing permit them to out-compete any private-sector rival and to

dominate any market they are permitted to enter. Although their charters are supposed to limit their activities preventing them from competing with companies that

must raise their funds without government backing the vagueness of the charters

and the political power of Fannie and Freddie have enabled them to expand with

few constraints. That they can and do make soft-money political contributions, hire

legions of lobbyists, and employ people with close ties to Congress as top management further ensures their insulation from scrutiny.

Meanwhile, their dominance of the residential mortgage markets grows ever

greater. Reasonable projections based on statements by Franklin Raines, the chairman of Fannie Mae, suggest that, by the end of 2003, the two companies will have

assumed the risk associated with almost half of all the residential mortgages in the

United States. That means that the taxpayers, who ultimately stand behind the obligations of these two companies, will have unwittingly become responsible for almost $3 trillion of residential mortgage risk that should be on the books of private

sector firms.

An important decision point lies immediately ahead. As shown in this analysis,

in 4 years, Fannie and Freddie will have either acquired for their portfolios or guaranteed more than 91 percent of all the conventional/conforming mortgages in the

United States. Those are the high-quality loans on middle-class homes that have

until now been virtually the only mortgages the GSEs would purchase. As they grow

beyond their traditional market segment, Fannie and Freddie will have to purchase

increasing amounts of lower-quality loans and hold more of those loans in portfolio,

increasing their risks. If they fully hedge those risks, their extraordinary profitability will decline.

The question is whether Fannie and Freddie will (1) slow their growth to reduce

the risks they take on; (2) continue their growth at the rate Franklin Raines predicted, but accept reduced profitability by hedging those risks; or (3) continue the

growth in both those assets and risks in order to achieve high profitability. The evidence is that they are pursuing the third course.

To be sure, there is nothing wrong with growth, risk, or profitability. But the

growth of the GSEs—aided as it is by government support—creates enormous risks

for taxpayers only a decade after the savings and loan bailout, and it threatens to

drive a whole sector of the private financial community out of the residential mortgage market. Those factors raise serious policy issues. The purpose of this study is

to examine the implications of that growth for the mortgage market, for those who

compete with Fannie and Freddie, and for the nation’s taxpayers.

Chapter 2 provides background on the GSEs and the mortgage markets. It outlines the statutory links to the Federal Government that have led the financial markets to conclude that Fannie and Freddie will not be allowed to fail, describes the

mortgage market in the United States, and summarizes both the functions and

growth of the GSEs.

Chapter 3 contains detailed information on the structure of the residential mortgage market today, the growth of Fannie and Freddie’s share of that market since

1995, and (if the forecasts of Fannie’s chairman are correct) the share they will hold

together and separately at the end of 2003. It shows that the GSEs’ total risk including both the mortgages they will own and those they have guaranteed will inVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00154 Fmt 6601 Sfmt 6621 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
151

crease from somewhat more than a third of the market today to almost half of a

much larger market 4 years hence.

The growth of Fannie and Freddie in relation to the growth of the conventional/

conforming sector of the market is examined in chapter 4. It shows that, beginning

in 1998, they were already acquiring more net mortgage assets in each year than

the total net principal amount of the conventional/conforming loans made in that

year. The data presented in chapter 4 also show that, by the end of 1998, Fannie

and Freddie were holding in portfolio or had guaranteed more than 73 percent of

all conventional/conforming mortgages, and that figure could reach almost 92 percent by 2003.

The implications of that growth are addressed in chapter 5, which discusses the

possibility that to make up for the absence of sufficient conventional/conforming

mortgages—Fannie and Freddie will have to drive deeper into the subprime markets, taking more risk and displacing more of the genuine private-sector lenders

who have traditionally made these loans. The chapter also discusses other financial

services that Fannie and Freddie might be preparing to offer if their charters are

not more strictly interpreted.

Chapter 6 continues the analysis of the implications of GSE growth, focusing on

the risks to taxpayers that will be associated with the nationalization of almost half

the residential mortgage market by 2003. The chapter points out that Fannie and

Freddie have a choice—to hedge the greater risks they will be taking and reduce

their profitability, or to maintain their level of profit growth by taking greater risk.

It suggests that the incentives of management and the pressures of the financial

markets will push the two GSEs toward greater risk-taking.

The study’s conclusion notes that there is an inherent conflict between the GSEs’

status as private, profit-making companies and the government mission they are expected to perform. There is ample evidence that their government mission is no

longer necessary, and that they are using the subsidy they receive primarily to enhance their profitability and to dominate their market. Even if that were not true,

the risks they are creating for taxpayers and the threat they represent to non-subsidized private-sector competitors would argue strongly for more strictly confining

them to limited areas of activity, eliminating their links to the government, or taking steps toward recapturing their subsidy through a complete privatization.

2. BACKGROUND

The Federal National Mortgage Association (popularly known as Fannie Mae) and

the Federal Home Loan Mortgage Corporation (Freddie Mac) are two governmentchartered and government-sponsored corporations that have been assigned the statutory mission of improving liquidity in the middle-class residential mortgage markets by buying and selling residential mortgages.

Fannie Mae and Freddie Mac carry on their functions in two ways—by purchasing

and holding mortgages originated by mortgage lenders, and by placing their guarantee on securities (mortgage-backed securities, or MBSs) that represent an interest

in pools of mortgages they have assembled. Whether they are holding mortgage

loans or MBSs in their portfolio or are guaranteeing MBSs that are then sold to

investors, they are assuming the credit risk associated with those loans.

Although initially established to enhance liquidity in the mortgage markets, it is

doubtful that Fannie and Freddie are necessary for that purpose today. Many private organizations are now capable of purchasing mortgages from originators and

selling them—either directly or through securitization—into the capital markets.

However, Fannie and Freddie now argue that they perform their public mission by

reducing interest rates on the mortgages they are permitted to buy, and thus help

homebuyers to obtain lower-cost financing. That claim is dubious; economists believe

that the lower rates attributable to the GSEs’ subsidized borrowing are simply capitalized into the cost of the homes, thus benefiting developers and home sellers rather than buyers.

Fannie and Freddie were originally government agencies but were ‘‘privatized’’

when they were permitted to sell shares to the public. Today, both companies are

among the largest and most profitable financial institutions in the world, with their

securities listed on the New York Stock Exchange.

The unusual thing about their privatization, however, is that Fannie and Freddie

continue to retain a large number of connections to the government, as well as various privileges and immunities that no genuinely private company can claim:

• The president appoints up to five members (a minority) of their boards of directors.

• The secretary of the Treasury is authorized to invest up to $2.25 billion in their

securities, and to approve their issuance of debt.

152

2 Although Ginnie Mae can borrow at a lower rate than Fannie and Freddie, the GSEs have

been able, from time to time, to offer a lower mortgage rate to many subprime borrowers eligible

for FHA and VA loans. That may be a consequence of the fact that Fannie and Freddie’s MBSs

have greater liquidity than Ginnie Mae’s, and perhaps shorter duration. It may also be attributable to better underwriting skills at Fannie and Freddie, which might leave Ginnie with higher credit losses. It remains to be seen whether Fannie and Freddie will be able to maintain a

permanent beachhead in the FHA/VA market. 3The limit, which is keyed to housing prices, was $240,000 in 1999.

4 Not to be outdone, in a November 1999 statement to securities analysts, Leland Brendsel,

the chairman of Freddie Mac, also predicted a mid-teens growth in profitability, without specifying the period over which that would occur.

• They are exempt from state and local income taxes and from the requirement

to register their securities with the Securities and Exchange Commission.

• Their debt securities are eligible for open-market transactions by the Federal

Reserve Board and for investment by insured banks.

• Their debt securities are eligible collateral for the Federal Government’s deposits of tax revenues in banks.

• Their securities require only a 20 percent risk weighting (versus 100 percent

for the securities and debt of private companies) under the Basel risk-based capital

standards applicable to banks.

Those extraordinary advantages have convinced the capital markets that the Federal Government will never allow Fannie and Freddie to fail. Thus, they are able

to sell their debt securities at interest rates that are consistently better than any

AAA-rated corporation in the world and just slightly above the rate paid by the

Treasury itself. Moreover, that favored position allows them to operate with capital

levels that are much lower than those of other financial intermediaries, since the

capital markets are not concerned that those low capital levels will ever mean losses

to the holders of their debt or their MBSs.

THE MARKET IN WHICH THE GSES OPERATE

The residential mortgage market is composed of a number of segments—government-guaranteed Veterans Administration (VA) and Federal Housing Administration (FHA) loans; multifamily housing loans; middle-class mortgages (known as conventional/conforming mortgages, the basic loans that Fannie Mae and Freddie Mac

purchase or guarantee); subprime loans (loans with credit deficiencies); home equity

loans; and so-called jumbo loans, which exceed the size limit on conventional/conforming loans.

According to Federal Reserve data, FHA and VA loans constitute about 11 percent

of the total market. Although similarly authoritative numbers are difficult to obtain

for jumbo loans, most observers agree that those mortgages constitute another 15

percent of the market. Fannie and Freddie cannot compete for most FHA and VA

loans, since those are purchased and marketed by the Government National Mortgage Association (known as Ginnie Mae), an on-budget government agency that obtains its funds at Treasury rates and thus can offer lower rates than can Fannie

and Freddie.2 Nor can Fannie and Freddie compete for jumbo mortgages, which

have initial loan amounts above $252,700, the limit on the size of the loans Fannie

and Freddie can purchase in the year 2000.3

That leaves 74 percent of the total residential market in which Fannie and

Freddie can invest. Of that portion, most are conventional/conforming loans; the balance are subprime, home equity, and multifamily housing loans.

In the past, the GSEs purchased almost exclusively conventional/conforming

loans, because those are the best credits available in the middle-class market. But

increasingly in recent years—as they have foreseen that their need for assets will

outstrip the conventional/conforming market—the GSEs have entered the market

for subprime, home equity, and multifamily housing loans. Those assets are riskier

middle-class credits, since they represent loans to borrowers with impaired credit

(subprime loans), subordinated debt (home equity loans), and rental housing (multifamily).

GSE GROWTH

In a statement to a September 1999 financial conference, Franklin Raines predicted that by the end of 2003 Fannie Mae will have 28 percent of the U.S. residential mortgage market, and that its profitability will have doubled. Raines’s forecast

implies an 11.3 percent annual rate of growth in risk and a 15 percent annual rate

of growth in profitability during 1999 and over the following 4 years.4

153

The Raines statement provides a valuable benchmark for assessing both the steps

that Fannie Mae must take to achieve that goal and the shape of the residential

mortgage market in 2003, if the goal has then been achieved.

At the end of 1999, the residential mortgage market—that is, all outstanding residential mortgage loans in the United States—had an aggregate book value of just

over $5 trillion. In 1998 and 1999, that market grew strongly—by more than 8 percent each year. But its long-term growth rate has been about 6 percent. If we make

the conservative assumption that the residential mortgage market will grow at that

rate for the next 4 years, it will have a total value of about $6.4 trillion in the year

2003.

Thus, when its chairman predicts that Fannie Mae will have 28 percent of the

residential mortgage market in 2003, he is saying that it will in that year have assumed the risk of mortgage loans with an aggregate value of more than $1.8 trillion.

At that size, Fannie Mae may or may not be the largest financial institution in the

world—depending on the size of future mergers among the world’s largest banks—

but it will unquestionably be the largest S&L the world has ever seen.

And in second place will be Freddie Mac, which in 1999 was about two-thirds the

size of Fannie. If we assume that that relative size differential will continue through

2003, then Freddie Mac will hold in portfolio, or will have guaranteed, mortgages

with an aggregate value of more than $1.2 trillion, a growth rate of 11.4 percent

between 1998 and 2003.

Together, then, the GSEs in 2003 will be bearing the risk associated with more

than $3 trillion in residential mortgages, or almost 48 percent of all home mortgages

in the United States. The balance of the market—barely more than half—will be

left to the thousands of private, non-subsidized lenders who have traditionally provided mortgage finance in the United States.

Those extraordinary facts have a number of equally startling corollaries:

• Since the U.S. government stands behind the obligations of the GSEs, the nation’s taxpayers—rather than the shareholders of private sector mortgage lenders—

will ultimately bear the risks associated with almost half of all the residential mortgage debt outstanding in the United States.

• If the total residential mortgage market is growing at 6 percent a year, and

Fannie and Freddie are growing, respectively, at 11.3 percent and 11.4 percent a

year, then the GSEs cannot achieve their growth goals solely within their traditional segment of the residential mortgage market. They will have to strike out into

other areas.

• The current private-sector sources of mortgage finance will be forced to consolidate and will gradually be squeezed out of the residential market; in effect, half of

that sector of the economy will have been nationalized.

• Just as ominously, achieving a 15 percent annual rate of profit growth will require that Fannie and Freddie take on and retain more financial risk—in a process

reminiscent of the S&L industry’s ultimately fatal effort to achieve high levels of

profitability only fifteen years ago.

3. MARKET SHARES

Table 3–1 shows the growth of the residential mortgage markets since 1995. The

data for the size of the FHA/VA market (line 3), multifamily mortgages (line 5), and

the mortgage market as a whole (line 6), during the years 1995 through 1998, are

taken from reports published by the Federal Reserve Board. Information on the size

of the jumbo market (line 1) and the conventional/conforming market (line 2) was

derived from industry sources. Other one-to-four-family mortgages (line 4), a residual figure, consists primarily of subprime and home equity loans. For the purpose

of this study, those loans and multifamily loans (loans for apartment buildings)

have been combined into a category called ‘‘all other.’’

ASSUMPTIONS AND DATA

The projections for 1999 through 2003 are based on our judgment that the very

strong residential real estate market during 1998 and 1999 will return gradually

over the next 4 years to its historical pattern. Thus, although the market grew by

9.3 percent in 1998, we project that it will have grown by about 8 percent when

all the data on 1999 are in, by 7 percent in 2000, and by 6 percent in each of the

3 years thereafter.

Historically, total residential real estate mortgage debt has grown slightly faster

than nominal gross domestic product (GDP). In that context, residential mortgage

debt’s extraordinary growth in 1998 cannot be expected to continue. If we assume

that the market will gradually return to its historic growth pattern in relation to

154

GDP, that would reinforce the projection of a gradual return to a 6 percent growth

rate beginning in 2001.

155

TABLE 3–1.—SIZE OF THE RESIDENTIAL MORTGAGE MARKET, PAST, PRESENT, AND PROJECTED, 1995–2003

[Dollars, in millions]

History (year-end) Projection (year-end) Annual

growth

rate:

1995–

1998

(%)

Annual

growth

rate:

1998–

2003

(%)

Growth

rate difference 1995 1996 1997 1998 1999 2000 2001 2002 2003

Composition of outstanding mortgage market:

1. Jumbo mortgages ................................................ 568,008 602,069 639,797 699,485 755,444 808,325 856,825 908,234 962,728 7.2 6.6 –0.6

2. Conventional/conforming .................................... 1,969,096 2,087,172 2,217,961 2,424,882 2,618,873 2,802,194 2,970,326 3,148,545 3,337,458 7.2 6.6 –0.63. FHA/VA mortgages .............................................. 466,620 497,684 525,000 524,354 546,377 566,456 584,300 602,705 621,690 4.0 3.5 –0.5

4. Other 1- 4-family mortgages ............................. 505,997 532,085 572,096 673,732 747,556 818,051 883,279 952,928 1,027,281 10.0 8.8 –1.2

5. Multifamily: all kinds .......................................... 277,002 294,783 310,456 340,782 368,045 393,808 417,436 442,482 469,031 7.2 6.6 –0.6

6. Total residential mortgages ................................ 3,786,723 4,013,793 4,265,310 4,663,235 5,036,294 5,388,834 5,712,164 6,054,894 6,418,188 7.2 6.6 –0.6

7. Annual growth rate (%) ..................................... 4.3 6.0 6.3 9.3 8.0 7.0 6.0 6.0 6.0

Sources: For all tables, historic data sources are as follows: Federal Reserve Bulletin, December 1999; periodic financial reports issued by Fannie Mae and Freddie Mac; and industry nestimates. Projected data are the projections of Peter J.

Wallison and Bert Ely.

156

5 In a recent statement, Fannie chairman Franklin Raines divided the residential mortgage

market into seven subcategories: conventional/conforming (49 percent), FHA/VA (11 percent),

jumbo (19 percent), subprime (6 percent), home equity loans (6 percent), seller-financed (2 percent), and multifamily (7 percent). 6 If Mr. Raines is correct that the jumbo market is 19 percent of the total, that would indicate

that Fannie and Freddie have an even larger percentage of the total eligible market.

The division of the market into four subcategories—jumbo, conventional/conforming, FHA/VA, and all other (subprime, home equity, and multifamily loans)—is necessarily somewhat arbitrary. There are no official or government estimates of the

size of key market segments; apart from FHA/VA and multifamily mortgages, there

are no formally recognized and defined subcategories into which the market has

been divided for purposes of official reporting.

Although official figures are lacking, there is a wide variety of unofficial market

breakdowns.5 The data we have received from market sources, however, indicate

that jumbo loans account for about 15 percent of the market and FHA-VA loans for

about 11 percent. Accordingly, conventional/conforming plus all other loans—the

loans in which Fannie and Freddie can invest—account for about 74 percent.6

FANNIE AND FREDDIE MARKET SHARES

Table 3–2 contains data on the respective market shares of Fannie and Freddie.

The information on their shares between 1995 and 1998 was derived by comparing

the information in their financial statements to known market totals. For the years

after 1998, we assumed a growth rate in market shares that would permit Fannie

Mae to reach the 28 percent market share projected by Franklin Raines for the year

2003. We then assumed that Freddie’s growth rate would be such as to maintain

its market share in relation to Fannie. That means that Fannie, which had grown

at a rate of 11.2 percent annually between 1995 and 1998 (line 11), would have to

grow at a slightly greater rate, 11.3 percent, from 1999 through 2003, and that

Freddie would have to increase its growth rate from 9 percent to 11.4 percent (line

17).

157

TABLE 3–2.

—FANNIE MAE AND FREDDIE MAC MARKET SHARES, PAST, PRESENT, AND PROJECTED, 1995–2003

[Dollars, in millions]

History (year-end) Projection (year-end) Annual

growth

rate:

1995–

1998

(%)

Annual

growth

rate:

1998–

2003

(%)

Growth

rate difference 1995 1996 1997 1998 1999 2000 2001 2002 2003

Fannie/Freddie retained portfolios, total mortgages outstanding:

Fannie Mae:

8. Retained portfolio: ..................................... 252,868 286,527 316,592 415,434 528,811 635,882 754,006 877,960 1,020,492 18.0 19.7 1.79. Total residential (%) ................................. 6.7 7.1 7.4 8.9 10.5 11.8 13.2 14.5 15.910. Conventional/conforming & all other (%) 9.2 9.8 10.2 12.1 14.2 15.8 17.7 19.3 21.111. Retained + guaranteed: .......................... 766,098 834,700 895,730 1,052,577 1,208,711 1,347,209 1,485,163 1,634,821 1,797,093 11.2 11.3 0.112. Total residential (%) ............................... 20.2 20.8 20.9 22.5 24.0 25.0 26.0 27.0 28.013. Conventional/conforming & all other (%) 27.8 28.6 28.9 30.6 32.4 33.6 34.8 36.0 37.2

Freddie Mac:

14. Retained portfolio: ................................... 107,706 137,826 164,543 255,670 337,432 420,329 506,383 605,489 712,419 33.4 22.7 –10.7

15. Total residential (%) ............................... 2.8 3.4 3.8 5.5 6.7 7.8 8.9 10.0 11.116. Conventional/conforming & all other (%) 3.9 4.7 5.3 7.4 9.0 10.5 11.9 13.3 14.717. Retained + guaranteed: .......................... 566,751 610,891 640,528 734,021 846,097 943,046 1,039,614 1,144,375 1,257,965 9.0 11.4 2.418. Total residential (%) ............................... 15.0 15.2 15.0 15.7 16.8 17.5 18.2 18.9 19.619. Conventional/conforming & all other (%) 20.6 21.0 20.7 21.3 22.7 23.5 24.3 25.2 26.0

Fannie + Freddie:

20. Retained portfolio: ................................... 360,574 424,353 481,135 671,104 866,243 1,056,212 1,262,388 1,483,449 1,732,911 23.0 20.9 –2.121. Total residential (%) ............................... 9.5 10.6 11.2 14.3 17.2 19.6 22.1 24.5 27.022. Conventional/conforming & all other (%) 13.1 14.6 15.5 19.5 23.2 26.3 29.6 32.6 35.923. Retained + guaranteed: .......................... 1,332,849 1,445,591 1,536,258 1,786,598 2,054,808 2,290,255 2,524,777 2,779,196 3,055,057 10.3 11.3 1.124. Total residential (%) ............................... 35.2 35.9 35.9 38.2 40.8 42.5 44.2 45.9 47.625. Conventional/conforming & all other (%) 48.4 49.6 49.5 51.9 55.0 57.1 59.1 61.2 63.226. Conventional/conforming only (%) .......... 67.7 69.3 69.3 73.7 78.5 81.7 85.0 88.3 91.5

158

7Serious questions arise if Fannie and Freddie are now meeting their growth objectives by

purchasing MBSs that are already outstanding in the market. If their purchases of MBSs are

made in sufficient amounts to increase prices and decrease yields on outstanding MBSs, then

Fannie and Freddie will be reducing the spread between their borrowing costs and the yield

they receive on their MBS portfolios. That in itself will raise their risks. If their purchases do

not substantially affect yields in the MBS market, however, it is questionable whether that activity has any salutary effect on mortgage rates for homebuyers. Unless they can show such an

effect, Fannie and Freddie will be hard put to explain why that use of subsidized funds qualifies

as anything more than a strategy to maintain their targeted earnings growth rate. Indeed, it

seems unlikely that Fannie and Freddie’s purchases will appreciably influence MBS market

yields. If they reduce homebuyers’ interest rates by only about 30 basis points when they transfer two-thirds of their annual subsidy directly into the mortgage markets, the indirect effect of

their purchase of outstanding MBSs in the $3 trillion MBS market should be even smaller.

Table 3–2 displays market share data in two ways: (1) the respective mortgage

portfolios of Fannie and Freddie as a percentage of the market as a whole, and (2)

those mortgage portfolios plus the principal amount of the mortgage-backed securities that Fannie and Freddie have guaranteed—again, as a percentage of the market as a whole. We show those data separately for two reasons.

First, while there is no significant difference between the credit risk of guaranteeing MBSs and the risk of holding whole mortgages, there is a substantial difference

in profitability. Fannie and Freddie earn considerably more from retaining mortgages in their portfolios than from receiving guarantee fees on MBSs. That is because they assume an additional risk—interest-rate risk—when they retain mortgages. Accordingly, as Fannie strives to meet Franklin Raines’s forecast of 15 percent annual profitability growth, we would expect to see greater proportional growth

in its mortgage portfolio than in its guarantees of MBSs.7 That differential is reflected in our projections.

Indeed, just such a trend is visible between 1995 and 1998, when Fannie’s mortgage portfolio grew by 18 percent (line 8), while its total risk (mortgages plus MBSs

it had guaranteed) increased by only 11.2 percent (line 11). We believe that trend

will continue and will become more pronounced from 1999 to 2003, with Fannie’s portfolio of mortgages increasing by 19.7 percent on an annualized basis during that

period.

We project a different trend for Freddie, which (starting at a much lower base

than Fannie) grew its portfolio at the unsustainable rate of 33.4 percent annually

between 1995 and 1998. Since we are assuming that for 1999 and the next 4 years

Freddie will remain about two-thirds the size of Fannie, we are projecting that

Freddie will reduce the rate of growth of its retained mortgage portfolio to 22.7 percent (line 14)—a rate that will still be higher than Fannie’s but will bring Freddie

in 2003 to a position at which its retained mortgage portfolio will be roughly 70 percent the size of Fannie’s. Second, making a distinction between mortgages retained in portfolio and mortgages guaranteed through MBSs reveals that Fannie and Freddie have only a limited range of options available to them. When Franklin Raines predicted that

Fannie Mae would reach 28 percent of the total residential mortgage market in

2003 (line 12), he could have been referring to substantial growth in Fannie’s issuance of MBSs, with much lower growth in the company’s mortgage portfolio.

However, when he forecast that Fannie would double its profitability during that

period, he could only have been talking about a substantial increase in Fannie’s

mortgage portfolio, since only by enlarging that portfolio can a 28 percent market

share be consistent with a 15 percent year-over-year rate of profit growth.

Fannie’s options are further limited by the fact that the GSEs are permitted to

purchase or guarantee only those mortgages with an initial principal amount that

(in 2000) does not exceed $252,700. As noted above, that limitation essentially confines them to 74 percent of the total residential market, which for ease of reference

we shall call the middle-class mortgage market. Accordingly, table 3–2 also shows

the growth in the GSEs’ risk (mortgages and MBSs) as a proportion of that market.

Those data indicate that by 2003, Fannie is likely to hold in its portfolio 21 percent of all mortgages in that segment (line 10), and it will have assumed the risk

(through holding mortgages in its portfolio or guaranteeing MBSs) of 37 percent of

that market (line 13). In that same year, Fannie and Freddie together will hold in

their portfolios about 36 percent of all middle-class mortgages outstanding (line 22),

and will bear the risk (through ownership of the underlying mortgages or guarantees of MBSs) of 63 percent of that entire market segment (line 25).

The numbers are even more dramatic if we consider only the conventional/conforming portion of the market. In that case, by the end of 1998, Fannie and Freddie

had purchased and retained or guaranteed almost 74 percent of all the conventional/

conforming mortgages outstanding (line 26). We project that by 2003 they will have

159

assumed the risk of virtually all these mortgages—91.5 percent. It is no wonder,

then, that Fannie and Freddie are advertising their efforts to acquire loans in the

subprime categories. They are making a virtue of necessity, since their growth requirements leave them no choice.

Thus, if Fannie remains on the growth path forecast by Franklin Raines and if

Freddie keeps pace, by the end of 2003 they will hold in their portfolios more than

one-third of all middle-class residential mortgages in the United States (line 22),

and more than a quarter (line 21) of all residential mortgages of any kind. Moreover, if we include their guarantees of MBSs, these two companies will be bearing

the credit and other risk that is associated with almost half of all the mortgages

outstanding (line 24), almost two-thirds of all middle-class mortgages (line 25), and

more than 91 percent of all conventional/conforming mortgages (line 26).

In chapter 4 of this study, as those percentages suggest, we show that Fannie and

Freddie can meet their growth objectives in the years ahead only by purchasing the

riskier loans in the subprime, home equity, and multifamily categories. There will

simply not be a sufficient amount of the higher quality, conventional/conforming

mortgages to meet their needs. So in addition to assuming a greater degree of risk

simply through their growth over the next 4 years, the GSEs will also be increasing

their overall risk by going more deeply into the lower-quality sectors of the market

that until now have been served satisfactorily by non-subsidized lenders. We explore

the nature and possible consequences of the GSEs’ growing risk profiles in chapter

6 of this study.

Also, as the GSEs move into the lower-quality market sectors they have previously shunned, they will reduce the portfolio assets, revenues, and profits of thousands of mortgage lenders now active in that market. Although some might think

that mortgage lenders will have a choice whether to sell the mortgages they originate to Fannie and Freddie, that is not really the case. Because the GSEs can offer

lower government supported rates for the mortgages they are willing to buy, no

lender can offer a competitive rate against another lender who is willing to sell the

resulting loan to Fannie or Freddie. Their lower rates also permit Fannie and

Freddie to skim the cream from the mortgage markets, leaving other lenders with

riskier loans to weaker borrowers. That problem will become more severe as Fannie

and Freddie drive deeper into the subprime market.

In other words, if Fannie and Freddie are permitted to continue their growth,

even if they don’t move outside the secondary mortgage market itself, they will

gradually strangle the other participants in the mortgage markets. Those markets

will become more concentrated and less diverse than any other financial market in

the United States and, increasingly, an obligation of the Federal Government rather

than of the private sector. The impact on competition of Fannie and Freddie’s

growth is discussed in detail in chapter 5 of this study.

4. GROWTH

Table 4–1 presents data on the year-to-year growth in the mortgage assets of

Fannie Mae and Freddie Mac since 1995. The information for the years 1995

through 1998 is taken from their financial statements; the projections for the years

1999 through 2003 are derived from the assumptions that were used in chapter 3

to project their asset totals for those years.

The data show Fannie and Freddie’s growth as a percentage of the growth of: (1)

the entire residential mortgage market (line 29); (2) the conventional/conforming

portion of the market (line 32); and (3) the conventional/conforming plus ‘‘all other’’

portion of the market (line 35).

By presenting the information in that way, we are able to show that, as Fannie

and Freddie grow in the year ahead, they will have to drive deeper and deeper into

the subprime loan categories in order to find the assets their growth requires. Clearly, Fannie and Freddie cannot continue to grow indefinitely by purchasing and guaranteeing conventional/conforming mortgages. If the conventional/conforming loan

market grows at the same rate as the market as a whole in each of the next 4 years,

conventional/conforming mortgages outstanding will increase by $720 billion. But to

maintain their projected growth rates, Fannie and Freddie will have to increase

their mortgage investments and guarantees by $1 trillion. At the end of 1998, they

had retained in their portfolios or guaranteed 74 percent of those loans, and we

project that by 2003 they will have retained or guaranteed almost 92 percent.

Thus, beginning in 1998, Fannie and Freddie together, to meet their combined

growth goals, were required to add new assets at a rate that exceeded the growth

in conventional/conforming mortgages that year. Line 30 of table 4–1 shows that in

1998, the total amount of conventional/conforming mortgage debt outstanding increased by $207 billion. But in that same year, Fannie and Freddie together added

160

$250 billion in new mortgage assets and guarantees to their balance sheets, so that

their increase in mortgage credit risk was 121 percent of the net increase in the

conventional/conforming market (line 32). By 2003, Fannie and Freddie’s need for

new assets will equal 146 percent of all net new conventional/conforming loans.

Accordingly, unless they can break into the jumbo market through a change in

law, or out-compete Ginnie Mae for a substantial share of the FHA-VA market, the

only recourse for Fannie and Freddie is the subprime market.

However, the subprime market, as its name implies, involves considerably greater

credit risk than does the conventional/conforming market. By entering that market,

Fannie and Freddie will be taking on more risk than they have in the past—risk

that may be only partially compensated by the higher interest rates and guarantee

fees those mortgages generally yield. We cover that issue more fully in chapter 6.

161

TABLE 4–1.—GROWTH IN RESIDENTIAL MORTGAGES: FANNIE MAE AND FREDDIE MAC VERSUS THE MORTGAGE TOTALS, PAST, PRESENT, AND PROJECTED, 1995–2003

[Dollars, in millions]

History (year-end) Projection (year-end) Annual

growth

rate:

1995–

1998

(%)

Annual

growth

rate:

1998–

2003

(%)

Growth

rate difference 1995 1996 1997 1998 1999 2000 2001 2002 2003

27. Annual growth in residential mortgage market

—

total .............................................................................. 227,070 251,517 397,925 373,059 352,541 323,330 342,730 363,294 32.4 –1.8 –34.2

28. Growth in GSE portion ............................................... 112,742 90,667 250,340 268,210 235,447 234,522 254,420 275,861 49.0 2.0 –47.129. GSE portion of total (%) ........................................... 49.7 36.0 62.9 71.9 66.8 72.5 74.2 75.930. Growth in conventional/conforming

—total ............... 118,076 130,789 206,921 193,991 183,321 168,132 178,220 188,913 32.4 –1.8 –34.2

31. Growth in GSE portion ............................................... 112,742 90,667 250,340 268,210 235,447 234,522 254,420 275,861 49.0 2.0 –47.132. GSE portion of total (%) ........................................... 95.5 69.3 121.0 138.3 128.4 139.5 142.8 146.033. Growth in conventional/conforming & all other

mortgages

—total ........................................................ 161,945 186,473 338,882 295,077 279,580 256,987 272,915 289,814 44.7 –3.1 –47.7

34. Growth in GSE portion ............................................... 112,742 90,667 250,340 276,079 236,348 235,420 255,394 276,917 49.0 2.0 –47.035. GSE portion of total (%) ........................................... 69.6 48.6 73.9 93.6 84.5 91.6 93.6 95.536. Nominal GDP

—4th quarter ....................................... 7,529,300 7,981,400 8,453,000 8,947,600 9,394,980 9,864,729 10,357,965 10,875,864 11,419,657 5.9 5.0 –0.9

37. GDP annual growth rate (%) .................................... 6.0 5.9 5.9 5.0 5.0 5.0 5.0 5.038. Assumed growth rate after 1998 (%) ....................... 5.039. Total mortgages outstanding/GDP (%) ..................... 50.3 50.3 50.5 52.1 53.6 54.6 55.1 55.7 56.240. Change in mortgage/GDP ratio (%) .......................... 0.6 0.0 0.2 1.7 1.5 1.0 0.5 0.5 0.5

162

5. THREAT TO PRIVATE-SECTOR COMPETITORS

Since Fannie and Freddie are growing faster than the mortgage market itself,

their growth comes from taking market share, revenue, and profits from genuinely

private-sector mortgage lenders. As shown earlier, to maintain the rate of profit

growth on which their stock price depends, Fannie and Freddie must encroach further and further on the private sector. Although they had previously concentrated

on the best and most creditworthy loans within the conventional/conforming sector—leaving to the banks, S&Ls, and other non-subsidized lenders the subprime,

home equity, and multifamily loans that represent greater default risks—they are

now compelled to wade into that market and begin to take market share from the

companies that are already there.

The figures in table 3–2 illustrate quite well the problem that confronts Fannie

and Freddie’s private sector competitors. As shown by line 22, the GSEs’ share of

all residential mortgages (conventional/conforming and ‘‘all other’’) will grow from

19.5 percent at the end of 1998 to almost 36 percent at the end of 2003. That increase of 16.4 percentage points would equal approximately $800 billion, or 12.4 percent of the aggregate principal amount of all mortgages outstanding at the end of

2003. In other words, in 4 years, $800 billion in principal amount of mortgages—

which would otherwise be in the portfolios of private-sector lenders now operating

in those markets—will instead be in the portfolios of Fannie and Freddie. That will

substantially reduce the mortgage supply for the lenders now in the market, and

will force many of them to leave the mortgage lending business entirely.

In effect, the growth of Fannie and Freddie is leading to a steady nationalization

of the residential mortgage markets in the United States, without any debate—or

even apparent awareness—by Congress.

As shown by lines 29, 32, and 35 of table 4–1, Fannie and Freddie must take most

of the growth in mortgages outstanding if they are to meet their market share, revenue, and earnings growth objectives. Since they cannot meet their needs for product

solely out of the conventional/conforming mortgages that will come to market between 1999 and 2003, they must look elsewhere for product.

One easy target would be the jumbo market, which will become available if Congress can be induced to eliminate the ceiling on conventional/conforming mortgages.

Opening the door for Fannie and Freddie to enter the jumbo mortgage market

would, by 2003, give them access to almost $1 trillion of mortgages that are now

off-limits.

Other mortgage markets beckon to Fannie and Freddie, including those to be

accessed by dipping deeper into the subprime loan pool and assuming the higher

credit risks associated with those loans; by expanding more aggressively into the financing of multifamily housing designed for renters, not homeowners; and by acquiring home equity loans in addition to first mortgages. But those can be merely

stopgaps. Our projections extend only through 2003; if the growth of Fannie and

Freddie continues beyond that year at the rate Frank Raines has forecast, they will

at some point acquire all the available residential mortgage product in the United

States. As the practical limits of the residential mortgage market are reached, one

can easily envision Fannie and Freddie arguing that they should extend their skills

and cost advantages into the commercial mortgage market. After all, many office

building and shopping center owners would welcome the taxpayer subsidy Fannie

and Freddie can deliver.

Fannie and Freddie’s other opportunity for growth outside the residential mortgage market is to provide financial services generally, especially consumer credit

services. Home equity loans, for example, provide a ready entry into consumer financial services. Once the GSEs hold a home equity loan, they have the opportunity

to use it as a revolving loan fund with which Fannie and Freddie would be able to

supply credit directly to the homeowner/borrower. Although in one sense that might

be considered loan origination, such a determination would have to be made by the

Department of Housing and Urban Development (HUD)—which in the past has

shown little appetite for challenging Fannie and Freddie’s expansion. If in fact that

activity goes unchallenged by HUD, the GSEs could become very large sources of

consumer credit, and through their implicit government subsidy they would be able

to offer consumers better rates than banks and other consumer lenders.

Perhaps the greatest competitive threat, however, remains in the mortgage origination process. Although Fannie and Freddie vigorously deny that they have any

intention to originate mortgages, pointing out that they lack the statutory authority

to do so, what exactly constitutes origination of a mortgage is a matter of interpretation. If Fannie and Freddie were to open their automated underwriting facilities to

direct borrower access over the Internet, it might be possible for them to provide

the prospective homebuyer with a certification that his or her mortgage would qualVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00166 Fmt 6601 Sfmt 6621 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
163

ify for purchase by Fannie or Freddie. At that point, the actual lender would have

little to do except to perform the ministerial acts necessary to fund the loan and

deliver it to one or another of the GSEs. The compensation for that role would, of

course, be small.

In a November 1999 speech to securities analysts, Leland Brendsel, the chairman

of Freddie Mac, referred in rather vague terms to major changes in the offing for

the mortgage market:

I can safely predict that within a few short years, the mortgage industry will

change dramatically. When the dust settles in the mortgage market, we will be left

with an industry structure where investor funds flow to consumers with little drag

from antiquated, inefficient processes. Consumers will be able to tap global capital

markets at even lower cost than they can today.

And later in the same statement he was even more explicit. Citing the potential

of technology ‘‘to streamline the entire mortgage process and eliminate inefficiency

in the housing finance system,’’ he continued:

Freddie Mac has brought tremendous efficiency to the mortgage market, but the

industry still generates significant costs from redundant operations and expensive

transfer of information through all the steps in the mortgage process. As technology

wrings out remaining inefficiencies, Freddie Mac’s role will be enhanced, as we deliver low-cost funds to consumers even faster and more effectively.

There can be little doubt that Mr. Brendsel was describing a mortgage industry

in which, through technology, Freddie Mac would be dealing directly with borrowers

and perhaps with consumers generally.

6. RISKS

It is impossible to understand the risks that Fannie and Freddie create for the

government and taxpayers without understanding their similarities to the S&Ls

that collapsed at the end of the 1980’s. Like the S&Ls,

• their principal investments are home mortgages, long-term assets that can

abruptly become short-term assets when a home is sold or refinanced;

• they can borrow at government-assisted rates that do not substantially increase

as they take on more risk;

• they are unable to manage risk through asset diversification because virtually

all their assets are home mortgages.

But Fannie and Freddie are like 1980’s S&Ls in another significant way. Scholars

reviewing the S&L collapse have shown that it came about in substantial part because the industry was seeking high profits in order to recover the capital depleted

by losses during the high-interest-rate period at the beginning of the 1980’s. To

achieve that profitability, through a process ultimately called ‘‘gambling for resurrection,’’ the S&Ls reached for greater and greater risk. Although the debt market

usually requires much higher interest rates from companies that are taking on increased risk—if those companies can access the debt market at all—that was not

true for the S&Ls. Because their deposits were backed by the government, weak and

failing S&Ls were able to raise the necessary funds to keep on gambling—ultimately

causing immense losses to the government and the taxpayers.

Of course, Fannie and Freddie are not weak companies, and they have no need

to take risks to restore their capital. But they have strong—indeed, compelling—reasons to continue increasing their profitability. That circumstance creates the same

incentives to take on risk that the managements of weak S&Ls confronted fifteen

years ago.

The incentives are clear. Fannie and Freddie are public companies; their shares

are listed on the New York Stock Exchange and are closely monitored by the investment community. The value that investors place on their stock at any given moment

is not only a vote on their earnings growth prospects and the quality of their management, but also directly affects management’s compensation. Like the managements of most large, publicly held companies, the managements of Fannie and

Freddie are compensated in part through stock options, which in turn acquire increasing value only if the price of their stock increases.

That creates a strong incentive for the managements of the GSEs, like those of

conventional private firms, to increase their profits and to impress investors with

their potential for profit growth. For example, at the Merrill Lynch investor conference in September 1999, Fannie Mae chairman Franklin Raines projected that

Fannie Mae would achieve annual earnings growth of 15 percent in 1999 and over

the next 4 years. But profit growth at that rate is highly unusual. Fannie already

boasts that it is one of only eight companies in the S&P 500 that can claim to have

had a double-digit rate of earnings growth for twelve straight years. Continuing that

164

growth in profitability—and indeed increasing it—would be extraordinary for any

company in today’s low-inflation environment.

We can only speculate why Mr. Raines would place such a burden on himself and

his management. Possibly it is because he wants to be seen as a highly capable

manager, or he feels an obligation to match the success of his predecessors. However, the fact that his compensation and that of the top managers at Fannie Mae

are tied to increases in Fannie’s stock price also provides a substantial incentive to

impress the financial markets.

Once we look at Fannie and Freddie as gigantic S&Ls that are seeking an almost

unprecedented rate of profitability growth, we can begin to see why they create risks

for the government and the taxpayers that parallel the risks created by the S&Ls

in the 1980’s. Because of their government backing, they are essentially exempt

from debt market discipline—just like the insured S&Ls of the 1980’s. The incentives may be different, but the objectives are the same—to increase profitability by issuing debt at a government-backed rate, while achieving higher profitability through taking on greater risk. In the 1980’s, S&Ls tried to do that to replenish their capital; Fannie and Freddie are doing it to maintain the profit growth

that sustains a growing market valuation of their stock.

To be sure, Congress has attempted to address the question of GSE risk, using

the familiar device of a regulatory agency. In 1991, Congress established the Office

of Federal Housing Enterprise Oversight (OFHEO), a regulatory agency charged

with supervising the GSEs the way banking regulators supervise banks and S&Ls.

Given the experience of the 1980’s—not only with the S&Ls but with banks themselves—we should be skeptical about the effectiveness of regulators in controlling

the risks of the companies they regulate.

For one thing, there is always the question of asymmetric information—the regulated company knows more than its supervisor about the risks it is taking on. For

another, as demonstrated in the case of the S&L industry, the regulated companies

frequently have more power to influence Congress than has the regulatory agency,

and they are frequently successful in limiting the agency’s resources. It is useful to

recall that Congress repeatedly supported the S&L industry’s efforts to avoid regulatory restriction on its activities. As it happens, in the case of OFHEO, that phenomenon was clearly demonstrated in 1999, when a Senate committee initially

capped OFHEO’s appropriation at the previous year’s $16 million level—despite an administration request for a 20 percent increase. Although an increase to $19 million was ultimately voted, the special effort that was required sent a signal to

OFHEO about how much congressional support it will receive if it seriously attempts to control Fannie and Freddie’s behavior.

Even without those negative signals, there are good reasons to believe that

OFHEO will not act to reduce the GSEs’ risk-taking. For example, if Fannie or

Freddie’s capital ratios slipped too low, OFHEO could direct the troubled GSE to

reduce its assets as part of a plan to strengthen its capital position. Shrinkage, however, implies that the GSE in question would sharply reduce its buying and guaranteeing of mortgages. It might even be required to sell assets. That would improve

its capital ratios, but the cutback and asset sales could force an increase in mortgage interest rates and a sudden, sharp reduction in housing construction, with secondary effects throughout the economy.

The possibility that there might be severe macro-economic consequences as a result of an OFHEO regulatory action should raise both systemic—risk concerns about

OFHEO’s new capital regulations and doubts about the likelihood that they will

ever be effectively applied. If OFHEO’s capital regulations are believed to threaten

severe macroeconomic consequences—and certainly Fannie and Freddie will not be

shy about pointing that out—it is easily foreseeable that Congress will act to prevent the enforcement of the regulations. That example, not at all far-fetched, suggests how difficult it will be for OFHEO to be an effective source of discipline over

Fannie and Freddie. And without OFHEO, there is effectively no means of controlling their risk-taking.

Nevertheless, OFHEO has proposed a regulation intended to control the riskiness

of Fannie and Freddie—including a risk-based capital requirement that imposes

capital penalties when risks are not adequately hedged. Undoubtedly, Fannie and

Freddie will cite those regulations as a basis for quelling congressional concerns.

The question, however, is whether it is reasonable to believe that Fannie and

Freddie can achieve the extraordinary rates of growth they are projecting while

keeping their risks within tolerable levels. If they do so, they will be unusual companies indeed.

The GSEs’ sagging stock prices demonstrate that Wall Street is skeptical on that

score. As shown on lines 52 and 55 of table 6–1, both GSEs have experienced a significant decline, per dollar of portfolio investment, since 1995. We project that that

165

trend will continue through 2003. On January 12, 2000, Fannie’s common stock

closed 20 percent below its twelve-month high, while Freddie closed down a more

troubling 28 percent for the same period. That development seems to be puzzling

to Fannie Mae chairman Raines, who asked at the Merrill Lynch conference, ‘‘So

why does the market trade Fannie Mae at a discount to the other companies with

similar growth rates?’’

There are two possible reasons.

First, some investors may have recognized that Fannie and Freddie are simply

running out of room to grow by purchasing the high-quality conventional/conforming

mortgages that have been their traditional assets, and that the cost of hedging the

risks of lower-quality product may reduce their profitability.

Second, and more ominously, Fannie and Freddie’s lagging stock prices may reflect a growing concern in the equity markets that the GSEs are not adequately

hedging their risks, so that their future earnings may be hit by losses on the riskier

mortgages they are purchasing or guaranteeing today.

In addition to their inherent lack of diversification, Fannie and Freddie face a

number of other risks as guarantors of MBSs and as holders of large portfolios of

mortgages and MBSs. Those risks include credit risk, interest-rate risk, counterparty risk, and spread-compression risk, all of which are discussed more fully below.

As we will show, each of those risks can be reduced or hedged, but doing so is costly

and will inevitably reduce Fannie and Freddie’s profitability. To compensate for

those costs—while trying to maintain and surpass their past levels of profitability—

they must take on still more risk, always keeping one step ahead of their regulator.

Credit Risk. In common with all housing lenders, the GSEs have enjoyed a substantial decline in their credit losses in recent years. Fannie’s pre-tax losses, per

mortgage dollar owned or guaranteed, dropped from 5.3 basis points in 1996 to 2.9

basis points in 1998 (table 6–2, line 59); Freddie’s pre-tax credit losses dropped from

10.5 basis points in 1996 to 5.1 basis points in 1998 (line 65).

But the housing market is historically volatile, and it regularly passes through

boom and bust periods related to national economic conditions, interest rates, and

other factors. Completely exogenous factors—an example might be a change in the

tax system that alters the deductibility of mortgage interest in a significant way—

could have seriously adverse effects, for which the participants have no effective

way to prepare. It is important to keep in mind that Fannie and Freddie will be

more exposed to the risks of the housing market than any lenders in history, since

their already unprecedented market shares will—as discussed earlier in this

study—grow even larger in the future.

166

TABLE 6–1.—FANNIE MAE AND FREDDIE MAC NET INCOME BY LINE OF BUSINESS, PAST, PRESENT, AND PROJECTED, 1995–2003

[Dollars, in millions]

History (year-end) Projection (year-end) Annual

growth

rate:

1995–

1998

(%)

Annual

growth

rate:

1998–

2003

(%)

Growth

rate difference 1995 1996 1997 1998 1999 2000 2001 2002 2003

Net income by line of business (basis points):

Fannie Mae:

41. Portfolio investment ................................. 1,369 1,694 1,894 1,878 2,219 2,621 2,988 3,346 3,702 11.1 14.5 3.442. Credit guarantee ...................................... 1,003 1,031 1,162 1,540 1,583 1,661 1,770 1,872 1,973 15.4 5.1 –10.3

43. Total ......................................................... 2,372 2,725 3,056 3,418 3,802 4,282 4,758 5,218 5,675 12.9 10.7 –2.344. Federal tax rate (%) ................................ 28.0 29.5 29.3 25.9

Freddie Mac:

45. Portfolio investment ................................. N.A. 785 892 1,021 1,305 1,591 1,857 2,116 2,372 14.0 18.4 4.346. Credit guarantee ...................................... N.A. 458 503 679 751 760 793 819 841 21.8 4.4 –17.4

47. Total ......................................................... 1,091 1,243 1,395 1,700 2,055 2,352 2,650 2,935 3,213 15.9 13.6 –2.448. Federal tax rate (%) ................................ 31.2 30.0 29.0 27.8

Fannie + Freddie:

49. Portfolio investment ................................. N.A. 2,479 2,786 2,899 3,524 4,212 4,846 5,462 6,074 8.1 15.9 7.850. Credit guarantee ...................................... N.A. 1,489 1,665 2,219 2,333 2,422 2,563 2,691 2,814 22.1 4.9 –17.2

51. Total ......................................................... 3,463 3,968 4,451 5,118 5,857 6,634 7,409 8,153 8,888 13.9 11.7 –2.2

Net income per $ of business (basis points):

Fannie Mae:

52. Portfolio investment ................................. 62.8 62.8 51.3 47.0 45.0 43.0 41.0 39.053. Credit guarantee 1 ................................... 13.3 14.0 16.9 14.0 13.0 12.5 12.0 11.5

54. Total ......................................................... 34.0 35.3 35.1 33.6 33.5 33.6 33.4 33.1

Freddie Mac:

55. Portfolio investment ................................. 63.9 59.0 48.6 44.0 42.0 40.0 38.0 36.056. Credit guarantee 1 ................................... 7.9 8.2 10.2 9.5 8.5 8.0 7.5 7.057. Total ......................................................... 21.1 22.3 24.7 26.0 26.3 26.7 26.9 26.7

1 Assumes no credit risk on GSE/government-guaranteed debt held in portfolio.

N.A. = Not available.

167

Obviously, credit risk is closely related to conditions in the general economy. In

recent years, a sustained economic expansion, soon to be the longest in U.S. history,

has brought unemployment to record lows while boosting incomes. Both of those factors have led to a steady rise in housing prices. Rising prices in turn have given

homeowners more equity in their homes, which protects mortgage lenders and guarantors, notably Fannie and Freddie. However, an economic down-turn could depress

housing prices while causing a jump in mortgage delinquencies as the unemployment rate rises. Mortgage foreclosures would increase, substantially raising Fannie

and Freddie’s credit losses.

As Fannie and Freddie are also diving deeper into the pool of subprime mortgages, they will be in largely uncharted waters. Although Fannie and Freddie claim

that technology has greatly increased their loan-underwriting capabilities, thereby

lowering their risks in sub-prime lending, that assertion has not been tested by a

recession. Further, because of lower down payments from more financially challenged borrowers on properties that may not hold their values well during an economic downturn, losses on subprime lending could be much higher than on higherquality loans.

Unlike their deep knowledge of and databases on conventional/conforming loans,

the GSEs’ relative inexperience with the subprime market makes their judgments

concerning the risks they are assuming much less sure. Thus, Fannie and Freddie

face not only higher likely losses in subprime loans per dollar lent or guaranteed

but also greater uncertainty as to how high those losses will be. To cover their risks

in those cases, Fannie and Freddie have in the past relied in part on private mortgage insurance, but recently they have been exploring various devices that would

enable them to assume more of the mortgage insurer’s risk and thus keep more of

the profit for themselves. That is consistent with their desire to increase their profits, but obviously it will also increase their risks of loss in the event of a market

turndown.

TABLE 6–2.—CREDIT–RELATED EXPENSES FOR FANNIE MAE AND FREDDIE MAC, 1995–1998

History (year-end)

1995 1996 1997 1998

Fannie Mae:

58. Pre-tax credit-related expenses ($, in millions) ............................ 409 375 261

59. Pre-tax credit cost (B.P.) ............................................................... 5.3 4.5 2.9

60. Credit guaranty tax rate (%) ......................................................... 31.4 31.1 24.3

61. After-tax credit cost ($, in millions) .............................................. 281 258 198

62. After-tax credit cost (B.P.) ............................................................. 3.6 3.1 2.2

63. Credit income before credit expense (B.P.) ................................... 16.9 17.1 19.1

Freddie Mac:

64. Pre-tax credit-related expenses ($, in millions) ............................ 608 529 342

65. Pre-tax credit cost (B.P.) ............................................................... 10.5 8.6 5.1

66. Credit guaranty tax rate (%) ......................................................... 28.2 28.4 28.2

67. After-tax credit cost ($, in millions) .............................................. 437 379 246

68. After-tax credit cost (B.P.) ............................................................. 7.5 6.2 3.7

69. Credit income before credit expense (B.P.) ................................... 15.4 14.4 13.9

70. Difference: line 63 1 line 69 (B.P.) ............................................... 1.5 2.7 5.2

Fannie Mae ($, in millions) ......................................................... 22,200 29,200 43,200 83,600

% of total portfolio ............................................................. 8.8 10.2 13.6 20.1

Freddie Mac ($, in millions) ........................................................ 7,665 10,056 12,567 29,817

% of total portfolio ............................................................. 7.1 7.3 7.6 11.7

B.P. = Basis points. 1 B.P. = .01%.

Memoranda data—government/GSE securities in portfolio. They presumably have no credit risk.

Finally, Fannie is seeking substantial loan growth in the multifamily housing

market, specifically to meet affordable housing goals. Multifamily mortgages can be

much riskier than those for owner-occupied, single-family homes, as Freddie learned

to its regret a few years ago, because tenant income is more vulnerable to economic

downturns and rental property deterioration can be more severe than owner-occupied housing.

Credit-guarantee fees, per dollar of risk assumed, declined during 1999 for both

Fannie and Freddie, reflecting lower credit costs as well as increased competition

between them for the business of large mortgage originators. A decline in fees is

probably only the visible portion of the competition between the GSEs for that business. It is likely that they are also placing their guarantees on MBSs that are

backed by somewhat riskier pools of mortgages, for which they are also attempting

168

to assume more of the risk previously taken by mortgage insurers. A sharp and

largely unpredictable upswing in credit losses a few years hence could therefore result in substantial losses in their guarantee business.

Interest-Rate Risk. Fannie and Freddie’s potential interest-rate risk is growing

rapidly as they grow their mortgage portfolios. Those portfolios consist of both whole

mortgages and MBSs. In just twenty-one months, from the end of 1997 to September 30, 1999, Fannie increased its mortgage investments by 59 percent, or $188 billion; Freddie’s increase was 91 percent, or $150 billion.

Like the S&Ls before them, Fannie and Freddie are heavily dependent on shortterm funding to finance the long-term, fixed-rate mortgages they own. That is the

classic borrow-short-to-lend-long strategy that S&Ls pursued, with disastrous consequences, when interest rates skyrocketed in the early 1980’s. On September 30,

1999, 41 percent of Fannie’s debt matured within 1 year. Freddie was worse off on

that date, with 51 percent of its debt due within 1 year. The two GSEs have tried

to lessen their maturity mismatching through various devices, such as callable debt

and interest-rate hedging. But such devices are costly, as discussed below, and their

extensive use will reduce the GSEs’ profitability.

Theoretically, Fannie and Freddie can minimize their interest-rate risk in two

ways. First, they can ‘‘match fund’’ their mortgage portfolios. That is, they can sell

debt that matches the maturity of their mortgage investments. Maturity matching

is complicated, though, by mortgage prepayments, which are not as predictable as

risk managers would like. Because the ease and cost of mortgage refinancing have

come down in recent years, mortgage prepayments accelerate dramatically whenever longer-term interest rates decline even moderately.

Prepayments create a maturity mismatch because longer-term funding now exceeds longer-term assets. To some extent, Fannie and Freddie can neutralize maturity mismatching by issuing debt that can be called, or repaid, before maturity. But

callable debt carries a higher interest rate than non-callable debt, so Fannie and

Freddie pay a price for that form of interest-rate risk protection.

The reverse form of interest-rate risk occurs when interest rates rise. In that case,

there is likely to be a sharp slowdown in home sales and mortgage refinancing, so

that low-rate mortgages remain on the GSEs’ books longer than anticipated and

have to be supported with higher-rate liabilities. That can result in substantial

losses or profit reduction and is exactly what happened to the S&L industry when

interest rates spiked in the late 1970’s and early 1980’s.

Second, Fannie and Freddie have reduced their exposure to higher rates through

the use of various financial derivatives, largely interest-rate swaps. That is, for a

fee, the two GSEs shift some of their interest-rate risk to third parties. That practice enables them to increase their reliance on cheaper short-term funding. But derivatives can be costly, particularly when interest-rate volatility causes significant

changes in the shape of the interest-rate yield curve.

Counterparty Risk. Hedging interest-rate risk through derivatives raises a separate risk—counterparty risk, which is essentially a form of credit risk. That is, will

the counterparty be able to pay when called on to do so under a swap agreement

or other form of derivative contract? Counterparty-risk assessment is not a simple

process, though, particularly when the counterparty is another financial institution

that has entered into many other financial contracts.

The increasing challenge Fannie and Freddie face as they grow larger is finding

sufficient counterparty capacity among highly rated potential counterparties: that is,

firms with AAA or AA credit ratings. At the end of 1998, 32 percent of Fannie’s

counterparty risk was with entities rated less than AA; 7 percent of its counterparty

risk was with entities rated less than A. Freddie is less forthcoming about its

counterparty risk, merely stating that at the end of 1998, its five largest

counterparties, which accounted for 60 percent of its total counterparty exposure,

were rated at least A+. Consequently, as Fannie and Freddie’s risk-hedging needs

grow, they may have to pay steadily higher fees for a given amount of protection

while relying increasingly on less creditworthy counterparties.

Spread-Compression Risk. In terms of their desire to maintain their profitability,

the most serious risk the two GSEs now confront is spread compression: that is, a

narrowing of their interest margins. Spread compression has become quite evident

at both companies, as reflected in the net income they earn on their portfolio investments per dollar of investment. In 1996, Fannie’s net income (excluding the cost of

credit risk) per dollar of portfolio investment was 62.8 basis points (table 6–1, line

52); for the first half of 1999, that profit margin had declined to 49.3 basis points.

Freddie has experienced a similar reduction—its net income, per dollar of portfolio

investment, declined from 63.9 basis points in 1996 (table 6–1, line 55) to 46.6 basis

points during the first half of 1999. During the third quarter of 1999, Freddie’s inVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00172 Fmt 6601 Sfmt 6621 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
169

terest margin declined seven points from the second quarter, which suggests that

its net income per dollar of portfolio investment declined again.

Spread compression is occurring for two reasons. First, as Fannie and Freddie

continue to grow, their sheer size and the demands they impose on the financial

markets will force up their cost of obtaining credit and interest-rate protection, per

dollar of protection obtained. Second, Fannie and Freddie’s purchases of mortgages

and MBSs will drive up mortgage prices, thereby reducing mortgage yields, as their

mortgage portfolio growth reaches and then exceeds the growth in those portions of

the mortgage market where they can lawfully participate. That spread compression

will negatively affect Fannie and Freddie’s earnings growth and return on equity

capital. For Fannie, those data will be found in table 6–1, line 43, and table 6–3,

line 85; the comparable data for Freddie are in table 6–1, line 47, and table 6–3,

line 100. Lower mortgage and MBS yields in the face of rising risk-protection costs

will squeeze Fannie and Freddie’s net interest margins. Unless they can trim their

operating costs to fully offset that squeeze, which is unlikely, they will experience

even less net income per dollar of portfolio investment. That decline will lower their

return on equity capital and slow their earnings growth. In the face of that inevitable spread compression, Fannie and Freddie’s managements will understandably

be tempted to take greater risks—specifically, greater credit risk and increased interest-rate risk.

170

TABLE 6–3.

—FANNIE MAE AND FREDDIE MAC CAPITAL REQUIREMENTS, PAST, PRESENT, AND PROJECTED, 1995–2003

[Dollars, in millions]

History (year-end) Projection (year-end) Annual

growth

rate:

1995–

1998

(%)

Annual

growth

rate:

1998–

2003

(%)

Growth

rate difference 1995 1996 1997 1998 1999 2000 2001 2002 2003

Fannie Mae:

71. Core capital (OFHEO-defined) ........................... 10,959 12,773 13,793 15,465 18,668 22,109 25,811 29,456 33,602 12.2 16.8 4.672. Required minimum capital ............................... 10,451 11,466 12,703 15,334 18,168 21,359 24,811 28,456 32,602 13.6 16.3 2.773. Core-required minimum .................................... 508 1,307 1,090 131 500 750 1,000 1,000 1,00074. Mortgage portfolio (net) .................................... 252,588 286,259 316,316 415,223 528,811 635,882 754,006 877,960 1,020,492 18.0 19.7 1.775. Other assets ...................................................... 63,962 64,782 75,357 69,791 61,007 73,360 86,987 101,287 117,730 2.9 11.0 8.176. Total assets on B/S .......................................... 316,550 351,041 391,673 485,014 589,818 709,242 840,993 979,247 1,138,222 15.3 18.6 3.3

77. Other assets/total assets (%) .......................... 20.2 18.5 19.2 14.4 10.3 10.3 10.3 10.3 10.378. Calculated minimum capital: Assets on B/S

(2.5%) ................................................................. 7,914 8,776 9,792 12,125 14,745 17,731 21,025 24,481 28,456 15.3 18.6 3.3

79. MBS, other off-B/S (.45%) ............................... 2,310 2,467 2,606 2,867 3,060 3,201 3,290 3,406 3,495 7.5 4.0 –3.480. Other capital requirement ................................ 228 223 305 342 363 427 496 569 652 14.5 13.8 –0.781. Other/total capital required (%) ...................... 2.2 1.9 2.4 2.2 2.0 2.0 2.0 2.0 2.082. After-tax income for dividends, stock buybacks, other ........................................................ 911 2,036 1,746 599 841 1,056 1,573 1,52983. Net income (%) ................................................ 33.4 66.6 51.1 15.7 19.6 22.2 30.1 26.984. Dividend payout rate (%) 1 .............................. 31.5 30.9 30.9

85. After-tax return on core capital, before preferred dividends (%) .......................................... 23.0 23.0 23.4 22.3 21.0 19.9 18.9 18.0

Freddie Mac:

86. Core capital (OFHEO-defined) ........................... 5,829 6,743 7,376 10,715 12,229 14,728 17,248 20,019 23,062 22.5 16.6 –5.9

87. Required minimum capital ............................... 5,584 6,517 7,082 10,333 11,829 14,228 16,748 19,519 22,562 22.8 16.9 –5.988. Core-required minimum .................................... 245 226 294 382 400 500 500 500 50089. Mortgage portfolio (net) .................................... 107,424 137,520 164,250 255,348 337,432 420,329 508,383 605,489 712,419 33.5 22.8 –10.7

90. Other assets ...................................................... 29,757 36,346 30,347 66,073 37,492 46,703 56,487 67,277 79,158 30.5 3.7 –26.8

91. Total assets on B/S .......................................... 137,181 173,866 194,597 321,421 374,924 467,632 564,870 672,766 791,577 32.8 19.8 –13.1

92. Other assets/total assets (%) .......................... 21.7 20.9 15.6 20.6 10.0 10.0 10.0 10.0 10.093. Calculated minimum capital: Assets on B/S

(2.5%) ................................................................. 3,430 4,347 4,865 8,036 9,373 11,676 14,122 16,819 19,789 32.8 19.8 –13.1

94. MBS, other off-B/S (.45%) ............................... 2,066 2,129 2,142 2,153 2,289 2,352 2,391 2,425 2,455 1.4 2.7 1.395. Other capital requirement ................................ 89 42 75 145 167 200 236 275 318 17.7 17.0 –0.7

171

96. Other/total capital required (%) ...................... 1.6 0.6 1.1 1.4 2.0 2.0 2.0 2.0 2.097. A-T income for dividends, stock buy-backs,

other .................................................................... 329 762 (1,639) 542 (148) 131 164 170

98. Net income (%) ................................................ 26.5 54.6 196.4 26.4 16.3 4.9 5.6 5.399. Dividend payout rate (%) 1 .............................. 26.0 26.5 26.3

100. After-tax return on core capital, before preferred dividends (%) .......................................... 19.8 19.8 18.8 17.9 17.4 16.6 15.8 14.9

1 Common + preferred dividends as a percentage of net income.

B/S = balance sheet.

172

That temptation is troubling, given their extremely thin capital cushions. Under

existing regulations, Fannie and Freddie must have, at a minimum, equity capital

(common stock, permanent preferred stock, paid-in capital, and retained earnings)

equal to 2.5 percent of on-balance-sheet assets plus .45 percent of outstanding MBS

and other off-balance-sheet obligations. The on-balance-sheet capital ratio is onehalf the leverage capital ratio equired for commercial banks considered to be well

capitalized for regulatory purposes. Worse, as is clear from table 6–3, lines 73 and

88, Fannie and Freddie operate much closer to their minimum capital ratio requirement than is generally true for well-capitalized banks, which generally have riskbased capital of 10 percent. Therefore, increased risk-taking, which might not be immediately evident to regulators and stock market analysts, could set up either company—or both—for serious financial difficulties.

Systemic Risk. As Fannie and Freddie continue to grow, they will pose increased

systemic risk to the U.S. financial markets. They had $866 billion of debt outstanding as of September 30, 1999. By the end of 2003, that amount will increase by almost $1 trillion, rising to $1.8 trillion (table 6–4, line 105). At that point, or shortly

thereafter, the combined debt of the two GSEs may exceed the Treasury debt held

by the general public—if budget surpluses continue to shrink the amount of Treasury debt outstanding.

Recently, Fannie and Freddie have been attempting to emphasize the similarity

of their debt to Treasury securities, by mimicking Treasury’s frequent, regular

issuances of new debt. Indeed, at one point Fannie Mae’s website contained the

statement that its debt securities ‘‘will often provide investors with a spread pickup

to the Treasury structure.’’ In other words, investors can receive substantially the

same security as Treasury debt with an interest-rate premium. If those marketing

efforts are successful, actual losses at either of the GSEs—or a perception in the

markets of a sudden increase in their riskiness—could result in a serious systemic

problem for the economy as a whole.

173

TABLE 6–4.

—FANNIE MAE AND FREDDIE MAC INTEREST-BEARING DEBT OUTSTANDING, PAST, PRESENT, AND PROJECTED, 1995–2003

[Dollars, in millions]

History (year-end) Projection (year-end) Annual

growth

rate:

1995–

1998

(%)

Annual

growth

rate:

1998–

2003

(%)

Growth

rate difference 1995 1996 1997 1998 1999 2000 2001 2002 2003

Fannie Mae:

101 Interest-bearing debt O/S ................................ 299,174 331,270 369,774 460,291 560,327 673,780 798,943 930,285 1,081,311 15.4 18.6 3.2102 O/S debt as percentage of total assets .......... 94.5 94.4 94.4 94.9 95.0 95.0 95.0 95.0 95.0

Freddie Mac:

103 Interest-bearing debt O/S ................................ 119,328 156,491 172,321 287,234 337,432 420,329 508,383 605,489 712,419 34.0 19.9 –14.1104 O/S debt as percentage of total assets .......... 87.0 90.0 88.6 89.4 90.0 90.0 90.0 90.0 90.0105 Total O/S interest-bearing Fannie and Freddie

debt ..................................................................... 418,502 487,761 542,095 747,525 897,759 1,094,109 1,307,326 1,535,774 1,793,730 21.3 19.1 –2.2

O/S = outstanding.

174

8 Bert Ely and Vicki Vanderhoff, ‘‘The Farm Credit System: Reckless Lender to Rural America’’ (Alexandria, Va.: Ely & Company, Inc., November 1990).

Despite their efforts to present their securities as substitutes for Treasury securities, Fannie and Freddie are not the Treasury. Their securities are only implicitly

backed by the U.S. government; they do not carry the full-faith-and-credit promise

of the United States. Indeed, the GSEs’ securities are by statute required to state

that they are not obligations of the United States. They are able to obtain favorable

financing because the markets do not believe—given the GSEs’ many connections

with the U.S. government—that they will be allowed to fail.

But it is important to understand that that condition still leaves some room for

doubt. Ultimately the GSEs’ ability to fund themselves in the financial markets depends on their ability to manage their risks as well as on conditions in the U.S.

housing markets. The housing markets, in turn, are subject to risks—such as

changes in the tax code—that cannot be anticipated. An adverse change in the

GSEs’ financial condition could lead to an increase in the yield spread of the GSEs’

debt over Treasury debt. That could be a gradual rise, as the market worries about

whether their implicit backing will turn into a bailout, or it could reflect a sudden

shift in market perceptions. In the case of Farm Credit System (FCS) debt in 1987,

a gradual rise was followed by a sudden tipping point, when the market fled to quality. In the case of the Farm Credit System, the yield spread over longer-term Treasuries went above 100 basis points, signaling that new FCS debt might become unmarketable.8

If a similar phenomenon should affect Fannie or Freddie’s securities, the financial

intermediaries that are currently holding that debt instead of Treasuries may find

that they can sell only at substantial losses; the losses would then raise questions

about their own financial stability, and a systemic crisis would arise. To be sure,

Congress could resolve the crisis, but a great deal of damage would then have been

done to the economy as the market fled to quality and credit sources dried up. The

U.S. financial markets experienced that phenomenon during the fall of 1998, in the

aftermath of the Russian debt crisis and the Long-Term Capital Management debacle.

Of course, the effect of a Fannie and Freddie crisis would be even more calamitous

for the housing markets. If those GSEs were to face substantially higher interest

costs in marketing their debt, the costs would be transmitted immediately to the

housing market—slowing home purchases and new home construction dramatically.

That in itself would have a severely adverse effect on the general health of the U.S.

economy.

Fannie and Freddie can contain their risks, but at the cost of reduced profitability. There is no indication in their behavior thus far that they are willing to accept that result.

7. CONCLUSION

Fannie Mae and Freddie Mac are fast becoming a problem that can no longer be

ignored. By 2003, they will have assumed the risk—either through ownership or

guarantees—of almost one-half of all residential housing mortgages in the United

States. In effect, the residential mortgage market will have been partially nationalized, with the taxpayers bearing a risk that should be borne by private stockholders

and creditors.

Moreover, we project that in 2003, Fannie and Freddie will own or have guaranteed 91.5 percent of all conventional/conforming mortgages, justifying the concern of

private mortgage lenders throughout the United States that they will gradually be

squeezed out of their traditional markets, and that Fannie and Freddie are planning

to extend their activities to some form of direct relationship with the public.

It seems clear that the problem here is the peculiar structure of Fannie and

Freddie—profit-seeking companies that have been granted special status to pursue

a public mission. Those objectives are contradictory. Whatever balance Congress initially thought could be achieved between them has been lost.

What are the benefits that Fannie Mae and Freddie Mac claim to provide, and

are those benefits worth the cost in taxpayer risk and competition for non-subsidized mortgage lenders?

Although the GSEs do contribute to liquidity in the mortgage markets, they are

no longer necessary for that purpose; private firms now routinely acquire and

securitize portfolios of jumbo mortgages—which exceed the size that Fannie and

Freddie may purchase—and those private firms could certainly do the same for conventional/conforming loans.

175

Recognizing the validity of that argument, Fannie and Freddie now claim that

their purpose is to reduce middle-class mortgage rates, and point to the fact that

those rates are about 30 basis points lower than rates in the jumbo market. However, many economists have noted that that saving for homebuyers is an illusion:

the lower interest rate is immediately capitalized into the cost of the home, so that

the real benefit of the implicit subsidy goes to developers and home sellers rather

than to the homebuyers whom congress presumably intended to assist.

Weighed against those highly conjectural benefits are the real taxpayer risks that

Fannie and Freddie create, and the real danger that they will eventually evict private non-subsidized lenders from the residential mortgage market.

Policymakers have a number of appropriate potential responses: true privatization

of Fannie and Freddie through cutting their links to the Federal Government; tighter statutory and regulatory restrictions on their efforts to expand their activities;

limitations on their use of lobbyists, their political contributions, and their other efforts to manipulate the legislative process; free sale of identical GSE franchises, or

the imposition of special taxes, affordable housing burdens, or other costs that

would enable the government to recapture their implicit subsidy; forbidding the

tying of management compensation to their stock price; and even returning them

to their former status as on-budget Federal agencies.

Whatever the course ultimately adopted, it is important to recognize that options

are foreclosed and solutions become more difficult as Fannie Mae and Freddie Mac

continue their de facto nationalization of the residential mortgage market.

BANKS DO NOT RECEIVE A FEDERAL SAFETY NET SUBSIDY: A PAPER PREPARED FOR

THE FINANCIAL SERVICES ROUNDTABLE BY BERT ELY, MAY 1999

For several years, the Federal Reserve, and its chairman, Alan Greenspan, have

argued with extreme forcefulness that banks benefit from a substantial, but apparently unquantifiable taxpayer subsidy. Mr. Greenspan contends that in order to

minimize the competitive distortions caused by this alleged subsidy, expanded powers for banking companies should be exercised only through non-bank affiliates of

bank holding companies regulated by the Fed and barred for operating subsidiaries

of national banks regulated by the Treasury Department’s Office of the Comptroller

of the Currency.

The Fed cannot quantify the amount of this alleged subsidy because there is, in

fact, no such subsidy. Instead, a subsidy of at least $1.5 billion annually flows in

the opposite direction, in the form of non-interest-bearing loans banks have been

forced to make to the Federal Government through the Fed and the Federal Deposit

Insurance Corporation.

What some contend is a Federal subsidy to banks in fact is not, for two reasons.

First, deposit insurance delivers genuine economic value to banks due to its inherent risk-spreading nature which is common to all insurances. That is, deposit insurance protects deposits against bank failure because, through the premium charged

for it, deposit insurance effectively spreads bank insolvency risk over a far broader

equity capital base than just the capital of the bank holding those deposits. Deposit

insurance therefore permits each insured bank to utilize expensive equity capital

more efficiently than it otherwise could; that is, a bank with deposit insurance can

operate with higher leverage than it could without it. The fact that the Federal Government currently operates the deposit insurance system does not negate this inherent value of deposit insurance. Non-bank firms must, of necessity, operate with

lower leverage because they do not have insolvency protection for their creditors

comparable to deposit insurance.

Second, taxpayers do not subsidize Federal deposit insurance because over the

last decade Congress has made deposit insurance as risk-free as possible to taxpayers by creating mechanisms which impose all deposit insurance losses on the

banking industry, even in circumstances far worse than the S&L crisis. Because of

the reforms Congress enacted, deposit insurance is no longer simply a government

guarantee, as it was during the S&L crisis—it has been transformed into a genuine

insurance mechanism which can stand on its own without Federal backing. Ironically, these taxpayer safeguards have greatly magnified the highly undesirable

cross-subsidy within deposit insurance which flows from sound, well-managed banks

to poorly capitalized and badly run banks. Unfortunately, the existence of this crosssubsidy has been masked by Mr. Greenspan’s false assertion that taxpayers subsidize Federal deposit insurance. Worse, his false assertion has inflicted significant

and possibly lasting harm on the banking industry by making it more politically

vulnerable to the imposition of yet more social welfare obligations beyond those

which already burden it, but not its non-bank competition.

176

Interestingly, this analysis of the subsidy argument reveals that non-banks, and

specifically securities firms, receive a significant taxpayer subsidy—free access to

the Fed’s discount window during times of economic duress. Arguably, permitting

this access achieves a public good—systemic stability, but that good does not warrant a subsidy for securities firms any more than the public good of Federal deposit

insurance would warrant a taxpayer subsidy for banks.

Although banks do not receive a taxpayer subsidy, the Fed’s amazing success in

propounding this fiction has raised the question of how best to contain the alleged

subsidy. Careful analysis indicates that even if a subsidy existed, it would flow with

equal ease to operating subsidiaries of banks and non-bank subsidiaries of holding

companies. Therefore, whether there is a subsidy or not, there is no rationale for

limiting the organizational flexibility of banks by requiring that certain activities be

conducted only in non-bank subsidiaries of Fed-regulated holding companies. Mr.

Greenspan’s argument that the holding company structure better contains the fictional subsidy is entirely without merit.

INTRODUCTION

Contrary to frequent assertions by Federal Reserve Chairman Alan Greenspan,

banks do not receive a so-called Federal ‘‘safety net subsidy,’’ as this paper will demonstrate. Instead, banks pay all costs of banking’s Federal safety net, including the

Federal Government’s cost of regulating banks. What is alleged to be a safety net

subsidy, specifically that banks can operate with higher leverage than non-banks,

in fact represents the consequence of the risk-spreading nature of deposit insurance.

That is, banks can operate with higher leverage ratios than their non-bank competitors because banks participate in, and pay for the entire cost of, a risk-spreading

mechanism that safely permits higher leverage.

This paper will first explain what a Federal safety net subsidy would be if banks

did receive such a subsidy. It will then explain the structure of banking’s Federal

safety net to demonstrate that any taxpayer risk, and therefore any subsidy flowing

from this safety net, is concentrated in Federal deposit insurance. The next portion

of the paper will describe various actions Congress has taken over the last 10 years

to eliminate taxpayer risk from deposit insurance by imposing all of that risk on

the capital of the entire banking system. The paper will then explain how deposit

insurance works as a risk-spreading mechanism so as to permit higher leverage for

banks insured by the Federal Deposit Insurance Corporation (FDIC). At the same

time, as the paper will demonstrate, the banking industry pays what amounts to

a subsidy to the Federal Government of at least $1.5 billion annually. Unfortunately, as the paper will explain, Federal deposit insurance has created an

unhealthy cross-subsidy within the banking industry which flows from healthy,

well-managed banks to weak, poorly managed banks. At the same time, large nonbank financial firms receive an important Federal safety net subsidy in the form

of free access to the Federal Reserve’s discount window. Finally, the paper will conclude that while banks do not receive a Federal safety net subsidy, if there were

one it would be equally well contained in a bank-operating subsidiary structure as

in a holding company-affiliate structure.

Two other points regarding this paper are in order. First, the term ‘‘banks’’ refers,

unless otherwise indicated, to all FDIC-insured institutions, including savings-andloans and savings banks. However, the term does not encompass credit unions. Second, the paper assumes that the alleged Federal safety net subsidy ultimately is

paid by taxpayers. It is highly unlikely that there is another source for such a subsidy.

WHAT A SAFETY NET SUBSIDY WOULD BE IF THERE WERE A SUBSIDY

The threshold question in the debate over whether or not banks receive a Federal

safety net subsidy is what would constitute a taxpayer subsidy to banks if a subsidy

actually existed. That is, how would banks actually reap that subsidy? There appear

to be four ways in which a taxpayer subsidy could be transmitted to banks—direct

payment of taxpayer funds to banks, using taxpayer funds to protect depositors and

others from bank insolvency losses, using taxpayer funds to pay the cost of banking

regulation, and higher interest rates on the Federal debt because of the contingent

taxpayer liability posed by Federal deposit insurance. None of these potential

sources of a Federal safety net subsidy exist, as will be discussed shortly. The absence of any subsidy is reinforced by the fact that the Fed has never quantified the

dollar amount of this subsidy. As recently as April 28, 1999, when Mr. Greenspan

contended that permitting operating subsidiaries to engage in non-bank activities as

a principal would lead to ‘‘greater Federal subsidization’’ (Greenspan, 1999), he did

177

not quantify the amount of that increased subsidy. Surely, if a subsidy existed, Fed

economists could at least estimate its size.

DIRECT PAYMENT OF TAXPAYER FUNDS TO BANKS

The Federal Government does not directly subsidize banking activities by making

explicit payments to banks. For example, the government does not pay banks to

maintain branches in low-income communities nor does it subsidize banks operating

in remote locations. Further, any services which the Federal Government purchases

from banks are priced at competitive market rates.

USING TAXPAYER FUNDS TO PROTECT DEPOSITORS IN FAILED BANKS

Although the S&L crisis cost general taxpayers $125 billion, 1 steps Congress has

taken since then, notably the 1991 enactment of the Federal Deposit Insurance Corporation Improvement Act (FDICIA), have effectively eliminated the risk Federal

deposit insurance poses to taxpayers. These protections are summarized below,

starting on page 6, in the discussion of Federal deposit insurance.

USING TAXPAYER FUNDS TO PAY THE COST OF FEDERAL BANKING REGULATION

Federal banking regulation cost almost $1.7 billion in 1997; 2 figures are not yet

available for 1998. The Office of the Comptroller of the Currency (OCC), the regulator of national banks, is supported entirely by examination and application fees

paid by banks. The same is true for the Office of Thrift Supervision (OTS), the Federal regulator of thrift institutions (savings-and-loans and savings banks). As will

be discussed further below, the expenses and insurance losses of the FDIC are fully

covered by deposit insurance premium assessments and interest earned on the fund

balance of the FDIC’s two deposit insurance funds, the Bank Insurance Fund (BIF)

and the Savings Association Insurance Fund (SAIF). The expenses of the Federal

Financial Institutions Examination Council, the regulators’ coordinating body, are

charged to the regulatory agencies.

At the Fed, the income value of non-interest-bearing reserves which banks main- tain on deposit at the Fed was approximately $653 million in 1997, 3 or $136 million

more than the cost of the Fed’s supervision and regulation activities in 1997. As is

widely recognized, the present reserve requirement on checkable deposits is simply

a tax on those deposits. The Fed does not use these reserves to execute monetary

policy since it long ago elected to instead be an interest-rate signaler (Ely, 1997a).

Although reserve balances are declining because of bank sweep accounts (average

reserve balances declined 11 percent in 1998), the income value of reserve accounts

should continue to exceed the cost of Fed supervision and regulation for the foreseeable future. Any shortfall, though, at the Fed will be more than covered by the

FDIC’s net income, as noted below in the discussion, starting on page 12, of the

banking industry’s forced loan to the FDIC.

INCREASED COST OF FINANCING THE FEDERAL DEBT

Although it cannot be proven, it is highly unlikely that the Federal Government’s

contingent liability under Federal deposit insurance has raised the cost of financing

the Federal debt, for two reasons. Arguably, any increase in this financing cost

could be viewed as a subsidy to the banking industry. First, the Federal Government’s debt has unambiguously been rated AAA for many years. In fact, Treasury

securities, despite any contingent Federal deposit insurance liability, are widely

viewed as the closest thing to risk-free debt that exists anywhere in the world.

Therefore, it is difficult to imagine that Federal deposit insurance has raised yields

on Treasury securities.

Second, as will be discussed below, starting on page 6, over the last decade Congress has made Federal deposit insurance essentially risk-free to Federal taxpayers.

Any perceived cost advantage banks have in obtaining insured deposits therefore is

a product of the soundness of banking’s self-financed insurance safety net. Also,

bank deposits appear to be a relatively cheap source of bank funding largely, if not

entirely, because of the expense banks incur in gathering deposits through branch

offices and in the substantial regulatory costs banks must pass through to their depositors.

THE STRUCTURE OF BANKING’S FEDERAL SAFETY NET

Banking’s Federal safety net has three components—banks’ ability to borrow at

the Fed’s discount window, the Fed’s guarantee of payment finality on payments

transmitted through the Fed, and Federal deposit insurance. As a practical matter,

if banks receive a safety net subsidy, it comes only through Federal deposit insurVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00181 Fmt 6601 Sfmt 6621 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
178

ance because the Fed operates the other two components of this safety net on a riskfree basis to itself and therefore to the taxpayer.

THE FED DISCOUNT WINDOW

The Fed discount window does not provide banks with a safety net subsidy although it does provide banks, and especially small rural banks, with a very slight

funding subsidy comparable to the funding subsidy that the Federal Home Loan

Banks deliver to their members. For the 1992-98 period, discount window loans outstanding averaged $208 million—$74 million for adjustment loans (used to meet re- serve requirements and other short-term liquidity needs) and $134 million for seasonal loans to small agricultural banks; for 1998, the comparable numbers were

$162 million, $67 million, and $95 million.4 Given that the Fed’s lending or discount

rate for adjustment and seasonal loans is a below-market rate, this funding subsidy

would equal approximately $2 million annually if a market rate was 1 percent higher and $4 million if it was 2 percent higher. Although indefensible, in the larger

scheme of things, this is an extremely modest subsidy.

The Fed should not suffer any losses as a lender since it lends to banks only on

a fully collateralized basis; acceptable collateral is specified in the Fed’s Regulation

A.5 Further, because the Fed can be a very demanding lender, it can insist on substantial overcollateralization of its loans and can demand the posting of additional

collateral should the posted collateral lose market value. Any losses the Fed did experience as a lender would be borne by taxpayers because these losses would reduce,

dollar-for-dollar, the earnings the Fed sends back to the Treasury every year. Any

loss the Fed experienced on its discount window lending would occur only because

Fed officials failed to monitor the market value of the Fed’s loan collateral in a timely manner. Also, under Sec. 142 of FDICIA, the Fed could be liable to the FDIC

in a failed bank situation for any increased loss to the FDIC as a result of the Fed

failing to demand payment of outstanding discount window loans within 5 days

after the failed bank became ‘‘critically undercapitalized.’’ However, such a loss

should be a fairly easy bullet for the Fed to dodge.

Therefore, because of its essentially risk-free nature and the modest amount lent,

the Fed’s discount window does not gift a safety-net subsidy to the banking industry. Even its funding subsidy, a few million dollars per year at most, is extremely

modest compared to the funding subsidies provided by the Federal Home Loan

Banks.

THE FED’S PAYMENT SYSTEM

The Fed provides payment finality on interbank payments made through the Fed,

thereby eliminating interbank credit risk for those banks which directly access the

Fed’s payment system. These interbank payments generally take the form of checks

deposited in the Fed for collection from other banks, automated clearinghouse

(ACH) payments, and Fedwire funds transfers. In effect, when the Fed grants payment finality to a bank for a payment the Fed has not yet collected from another

bank, the Fed has assumed a credit risk on the bank upon which the payment was

drawn while the payment is being processed through the Fed’s payments system.

However, this credit risk is extremely short-term, lasting just a few minutes to a

few hours for any single payment. The Fed has recognized this payment system risk

by establishing daylight overdraft limits; that is, a limit on the amount that a bank

can be overdrawn at any point in time in its reserve or clearing account at the Fed.

Further, the Fed can charge interest on intraday overdrafts; that interest effectively

compensates the Fed for the intraday credit risk it assumes by providing payment

finality at the time a payment is presented to it for collection.6

Operating in a real-time environment, the Fed can effectively eliminate its payment system risk in two ways. First, it can refuse to accept payment requests presented to it which are drawn on weak banks. Second, it can accept such payment

requests only to the extent to which a weak bank has covered any intraday overdraft at the Fed by borrowing at the discount window on a fully collateralized basis.

In other words, through proper, timely management, the Fed can eliminate its payment system risk and therefore any subsidy that direct access to the Fed’s payment

system would provide to the banking system. As a practical matter, the Fed has always operated its payment system on a risk-free basis, which means that the Fed

has not subsidized the banking system in this manner.

Contrary to the Monetary Control Act of 1980, which bars the Fed from subsidizing the priced services (principally collecting checks, processing ACH payments, and

executing Fedwire transfers) it offers to banks, the Fed in fact does subsidize these

services by using a portion of its annual ‘‘pension cost credit’’ to lower its service

prices. In 1997 (the most recent year for which figures are available), the Fed recogVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00182 Fmt 6601 Sfmt 6621 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
179

nized a pension cost credit of $200.8 million.7 While $138 million of this cost credit

was turned over to the U.S. Treasury, the Fed retained approximately $62.8 million

of this credit to subsidize its priced-services activities.8 However, this subsidy is not

a safety net subsidy. Instead, it represents a conscious effort by the Fed to use funds

that would otherwise go to the U.S. Treasury to gain a competitive edge, through

lower prices, over private-sector providers of payment services.9 An amendment to

S. 900, the financial services modernization bill passed by the Senate on May 6,

1999, will bar the Fed from using any portion of its pension cost credit to subsidize

its priced services activities.

THE FEDERAL RESERVE PORTION OF THE SAFETY NET POSES NO TAXPAYER RISK

Clearly, Fed operations, and specifically its discount window lending and the operation of its payment system, are designed to operate on a risk-free, and therefore

loss-free, basis. To the best of the author’s knowledge, the Fed has never incurred

a loss from a bank failure. The run on and subsequent failure of Continental Illinois

in May 1984 best dramatizes the ability of the Fed to avoid losses in failed banks.

Fed advances to Continental Illinois peaked at $7.6 billion in August 1984 (Continental Illinois Corporation, 1984, p. 2), yet the Fed did not lose a penny on that

loan, or at least the Fed has never admitted to any such loss, yet the FDIC spent

$1.1 billion 10 protecting depositors and other Continental creditors against any loss

whatsoever. Clearly, losses incurred under banking’s Federal safety net are focused

on Federal deposit insurance and the FDIC.

FEDERAL DEPOSIT INSURANCE

Federal deposit insurance for banks, which is offered exclusively through the

FDIC, represents the third component of banking’s Federal safety net. Federal deposit insurance is a contingent liability of the Federal Government; as a practical

matter, though, numerous safeguards Congress has enacted since the S&L crisis

have eliminated any risk Federal deposit insurance might otherwise pose to taxpayers.

Federal deposit insurance creates the potential for a taxpayer subsidy only to the

extent that the FDIC incurs losses in protecting depositors of failed banks. If banks

never failed or always failed without losses to the BIF or SAIF, then there would

be no losses to be subsidized. Banks do fail, though, even in good times, and sometimes with substantial losses. However, those losses will not be borne, or in effect

be subsidized, by taxpayers if they instead are paid by healthy banks through deposit insurance premiums. Despite suffering $37.1 billion in losses from 1934 to

1997,11 the BIF and its predecessor, the FDIC fund, have not received a single dollar of taxpayer assistance. Instead, all BIF/FDIC losses as well as FDIC operating

expenses have been covered by deposit insurance assessments, which totaled $46.4

billion through the end of 1997,12 and earnings of the BIF/FDIC fund. Even the Federal Government’s initial $289 million capitalization of the FDIC was repaid in 1947

and 1948, with interest.13 At the end of 1998, BIF had a fund balance (unaudited)

of $29.6 billion (Federal Deposit Insurance Corporation, 1998a, p.17). SAIF, the successor to the Federal Savings and Loan Insurance Corporation (FSLIC), which has

had a comparable experience since 1989, reached an unaudited fund balance of $9.8

billion at the end of 1998 (Federal Deposit Insurance Corporation, 1998a, p.17).

Stung by the S&L crisis, and its enormous cost to taxpayers, as well as by the

commercial banking problems of the 1980’s and early 1990’s, Congress enacted numerous reforms which directly or indirectly have eliminated the taxpayer risk in

Federal deposit insurance. These reforms were intended, and to date have performed, to minimize deposit insurance losses while ensuring that all such losses will

be imposed to the maximum extent possible on banks which do not fail. By eliminating the taxpayer risk previously posed by Federal deposit insurance, Congress transformed Federal deposit insurance from a government guarantee program into a genuine insurance mechanism, albeit a mechanism with serious cross-subsidy problems

discussed below in the section on mispriced deposit insurance premiums, which

starts on page 13.

The seven principal reforms divide into two broad categories—minimizing deposit

insurance losses and imposing all deposit insurance losses on bank capital.

MINIMIZING DEPOSIT INSURANCE LOSSES

Cross-guarantees among affiliated banks (1989) The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), which launched the resolution of the S&L crisis and FSLIC’s bankruptcy, included a ‘‘cross-guarantee’’ provision (Sec. 206, enacting 12 U.S.C. 1815(e)). This provision made all ‘‘commonly controlled’’ banks liable for the FDIC’s share of an insolvency loss in any one of the

180

commonly controlled institutions. That is, the FDIC experiences an actual loss in

a failed bank only to the extent that it cannot recover its potential loss from affiliated banks of the failed bank. As a practical matter, the amount of this potential

recovery is limited to the market value of the affiliated banks. Hence, for deposit

insurance purposes, all banks in a multi-bank holding company or otherwise under

common ownership or control are treated as if they were one bank for the purpose

of absorbing at least some portion of the FDIC’s share of a failed bank’s insolvency

loss. To some extent, the value of this provision to the FDIC has been diminished

by interstate branching, which was authorized in 1994 (and is discussed on the next

page). Nonetheless, it was an important first step which Congress took to minimize

FDIC losses and remains an important loss-minimization tool for the FDIC.

Prompt regulatory action/least-cost resolution (1991) In many ways, prompt regulatory action (often referred to as prompt corrective action, or PCA) and least cost

resolution (LCR), are the heart of FDICIA,14 which Congress enacted on November

27, 1991. Together, PCA and LCR represent the most important tool the Federal

Government has to minimize deposit insurance losses in banks which have sunk

into insolvency. At the same time, they reflect a fundamental and understandable

congressional distrust of the bank regulators in the aftermath of the S&L crisis and

problems in the commercial banking industry. Briefly, regulations issued under the

authority of PCA set trigger points in a bank’s slide toward insolvency. These triggers are intended to force regulators to take timely corrective action in a failing situation or, barring a turnaround, to force the closure of a bank before it becomes insolvent. LCR is designed to minimize the FDIC’s use of purchase-and-assumption

transactions in failed bank situations because such transactions can protect the uninsured portion of deposits, which has the effect of raising the cost of a bank failure.

Although not fully tested during a severe economic crisis, in theory PCA and LCR

should minimize deposit insurance losses even during a crisis. A discussion of the

workings of PCA and LCR lies beyond the scope of this paper.

Depositor preference in failed banks (1993) Although enacted as part of the 1993

budget reconciliation bill as a spending reduction measure and with no debate whatsoever over its deposit insurance implications, the depositor preference provision of

the Federal Deposit Insurance Act 15 serves as a potentially significant legal device

for reducing FDIC losses in failed banks. Briefly, depositor preference gives both insured and uninsured deposits in domestic branches of a bank a liquidation preference over deposits in that bank’s foreign offices as well as all other general, unsecured claims on that bank. Consequently, general unsecured claims which are not

domestic deposits will absorb all of a failed bank’s insolvency loss before the first

dollar of loss will be borne by domestic deposits, and specifically by the FDIC as

the insurer of the insured portion of domestic deposits. Depositor preference already

is playing a role in reducing the FDIC’s loss in the relative handful of banks which

have failed in recent years.

Interstate banking and branching (1994) Although intended primarily to improve

the operating efficiency and customer service of commercial banks, the Interstate

Banking and Branching Efficiency Act of 1994 greatly improved the safety-andsoundness of the banking system by permitting large banks to operate regionally

or nationally. The banking problems in Texas and other states during the 1980’s as

well as the banking crisis of 1930-33, during which time 9,000 mostly small, single

office banks failed (Federal Deposit Insurance Corporation, 1983, table on p. 41)

were greatly aggravated by state and national banking and branching restrictions

and prohibitions. It is highly unlikely that even a future regional banking crisis,

such as that which struck the Southwest in the mid-1980’s or the New England

banking crisis of the late 1980’s and early 1990’s, would be as severe, in terms of

deposit insurance losses, as those crises were.

IMPOSING ALL DEPOSIT INSURANCE LOSSES ON BANKS

Recapitalizing the deposit insurance funds Sec. 104 of FDICIA established the

framework for building the BIF to a ‘‘designated reserve ratio’’ (presently 1.25 percent of insured deposits) and maintaining that ratio. FIRREA, which created the

BIF and SAIF, established similar requirements for the SAIF. Under the guise of

the designated reserve ratio, the FDIC was able to levy a substantial tax on banks

to build the BIF and SAIF to a 1.25 percent reserve ratio. Although not used solely

to build the BIF to a 1.25 percent ratio, the FDIC levied $27.9 billion of premiums

on BIF-insured institutions from 1990 to 1995 (Federal Deposit Insurance Corporation, 1997, p. 105). From 1991 to 1996, the FDIC levied $8.5 billion of premiums,

including $5.2 billion in 1996, on SAIF-insured institutions to build that fund to a

1.25 percent ratio (Federal Deposit Insurance Corporation, 1997, p. 107). These huge

assessments cannot be tapped to pay future deposit insurance losses, as is discussed

181

in the next paragraph. Hence, they form a permanent investment base which generates the interest savings on financing the Federal debt that provides much of the

special subsidy discussed below, starting on page 12, which flows from the banking

industry to the Federal Government.

Unlimited FDIC assessment power Of particular importance to taxpayers, Sec.

103 of FDICIA gave the FDIC a blank check, through the authorization of emergency special assessments, on the capital of all of the institutions insured by a particular fund to quickly rebuild that fund to the designated reserve ratio should prior

losses have driven that ratio below the designated minimum. This unlimited assessment power gives the FDIC the power to draw heavily on the capital of the banking

industry to cover deposit insurance losses should cross-guarantees, PCA, LCR, and

depositor preference fail to minimize those losses. To the extent that the FDIC has

to draw upon its $30 billion line-of-credit at the U.S. Treasury to meet short-term

liquidity needs, those interest-bearing borrowings will effectively be repaid from future FDIC assessments.16 At December 31, 1998, the book value of the equity cap- ital of all FDIC-insured institutions was $556.7 billion (Federal Deposit Insurance

Corporation, 1998, p. 16), almost three times the amount of the insolvency losses

suffered by Federal deposit insurance since the S&L crisis first erupted in the early

1980’s. Special ‘‘systemic risk’’ or too-big-to-fail assessments In addition to the emergency

special assessment powers of FDICIA’s Sec. 103, FDICIA’s Sec. 141 codified the concept of too-big-to-fail (TBTF) and provided the means to pay for it. Specifically, this

systemic risk provision (the so-called ‘‘systemic risk exception ’’) authorizes the Fed

and FDIC, with the concurrence of the Secretary of the Treasury and the President,

to declare a bank TBTF. The FDIC may then protect, if necessary, all the liabilities

of that bank against loss in order to ‘‘avoid or mitigate’’ the ‘‘serious adverse effects

on economic conditions or financial stability’’ if the bank were liquidated under

FDICIA’s LCR provisions. The systemic risk provision of FDICIA also authorizes the

FDIC to levy one or more emergency special assessments on the other members of

the insurance fund to which the failed TBTF bank belonged to cover the cost of protecting the failed institution’s creditors. Because of this provision, healthy banks,

not taxpayers, will bear the cost of protecting uninsured creditors of TBTF banks

from any loss.

FEDERAL DEPOSIT INSURANCE PERMITS HIGHER LEVERAGE, WHICH IS NOT A SUBSIDY

Integral to the contention that banks receive a deposit insurance subsidy is the

argument that this subsidy permits banks to operate with higher leverage than nonbank institutions. Kwast and Passmore (1997, pp. 16-27) present substantial evidence that non-banks, with the possible exception of large investment banks, operate with less leverage than banks. They close the discussion of their leverage contention by opining that ‘‘these differences [in leverage ratios] are quite likely due,

in substantial part, to the fact that banks have direct access to the Federal safety

net’’ (Kwast and Passmore, 1997, p. 27) without explaining the linkage between this

direct access to the safety net, the subsidy the safety net allegedly provides, and

the higher leverage banks enjoy. Interestingly, they ignore the fact that non-bank

firms can access one important element of the safety net, the Federal Reserve discount window, as will be discussed below, starting on page 13. What is especially

intriguing about the Kwast/Passmore paper is that it ignores an explanation as to

why banks can safely operate with higher leverage—the insurance value of deposit

insurance—that this author explained in the American Banker (Ely, 1997b) 3

months prior to the publication of the Kwast/Passmore paper.

ALL FORMS OF INSURANCE PERMIT HIGHER LEVERAGE

A central element in the subsidy debate is the indisputable fact that all forms of

insurance permit an insured to operate with higher leverage than the insured could

enjoy without insurance. That is, higher feasible leverage is an inherent byproduct

of the risk-spreading nature of any form of insurance. This statement holds true for

businesses, which banks are, as well as for individuals. In effect, insurance prevents

the bankruptcy of businesses and individuals who have partially financed their assets with debt if their assets suffer an insurance-covered decline in value which exceeds the insured’s net worth. Viewed from another perspective, insurance is a credit enhancement device an insured obtains in exchange for a fee called an insurance

premium.

A simple example will illustrate this crucial point. An individual with a net worth

of $100,000 purchases a home for $200,000 that is partially financed with a

$160,000 mortgage. Having used $40,000 of her net worth to make a down payment

on the house, she has $60,000 worth of other assets. Hence, she has total assets

182

of $260,000 which have been financed by a $160,000 mortgage and her $100,000 of

net worth. If her home then suffers a $150,000 uninsured fire loss, she will now

have assets worth $110,000 and a negative net worth of $50,000 (assets of $110,000

minus the $160,000 mortgage). Personal bankruptcy will occur, which means the

mortgage holder will incur a loss of at least $50,000. The risk of this type of loss

is precisely why lenders insist that borrowers insure mortgaged assets for at least

the amount of the mortgage. Consequently, a person who cannot obtain property insurance cannot leverage herself as highly as someone who can obtain such insurance. In effect, insurance exists not just to protect the net worth of the insured, but

equally important to protect lenders against loan losses. In the context of this paper,

a depositor is a lender to a bank.

Insurance works properly, from the perspective of ensuring insurer solvency, if

the risks of loss it has assumed are diversified sufficiently; insurance premiums are

priced properly so as to cover the insurer’s losses, operating expenses, and profits

(thereby deterring moral hazard on the part of insureds); and the insurer has

enough net worth of its own to absorb extraordinarily high or unanticipated losses

and pricing errors. In effect, insurance pools the risk of loss of many insureds in

return for a premium. Consequently, by using insurance to shift the risk of a substantial loss to an unrelated party, an insured can own more assets than she otherwise could own since her net worth will not become negative if she suffers an insured loss. Put another way, an insurance contract is an option contract which give

the insured an option on its insurer’s net worth and loss reserves should the insured

suffer an insured loss. An insurance premium therefore is the price of that option

contract.

INSURANCE THEORY APPLIED TO DEPOSIT INSURANCE

This theory of insurance, which reflects the reality of insurance, is applicable to

all types of financial institutions. The creditors of banks and insurance companies

are, to some extent, protected by insurance mechanisms. The creditors of other types

of financial firms, such as investment banks and finance companies, generally

speaking do not enjoy similar insurance protection.17 Therefore, all other things

being equal, firms with insurance which protects their creditors against loss can operate with greater leverage than firms without that type of insurance. Claims on

insurance companies are protected by state guaranty funds; a discussion of these

funds lies beyond the scope of this paper. Instead, the balance of this paper will

focus only on Federal deposit insurance and the protection it provides to bank creditors, specifically depositors.

Although deposit insurance is characterized as protecting depositors, or at least

the first $100,000 of a depositor’s balance in a bank, against loss, in actuality Federal deposit insurance works in a slightly different manner. A bank fails because

it becomes insolvent; that is, it has a negative net worth because the book value

of its liabilities exceeds the market value of its assets. A bank becomes insolvent,

and therefore a failed bank, when asset losses and operating losses (current expenses exceed current income) consume any positive net worth it had. When the

FDIC takes over a failed bank, it places it in a receivership. The FDIC then advances to the receivership sufficient funds to ensure that insured deposits are made

whole, either through a direct payment to depositors or a transfer of the insured

deposits to another bank. The FDIC then assumes, under the law of subrogation,

a claim on the failed bank’s receivership in proportion to the amount of insured deposits it protected to the total amount of domestic deposits. The payment the FDIC

makes into the failed bank’s receivership is functionally equivalent to the payment

an insurance company makes to a homeowner who has suffered a fire loss or, if so

specified in the insurance contract, to the holder of the mortgage on the home.

Insured deposits permit a bank to operate with higher leverage than it could without deposit insurance because deposit insurance shifts to other banks, through FDIC

premium assessments, the bank’s insolvency risk that otherwise would be borne by

the insured deposits. Unlike a money market mutual fund, though, a bank cannot

operate with infinite leverage, that is zero capital. Instead, it must hold some capital which effectively operates as an insurance deductible that provides some insolvency risk protection for the FDIC and therefore for other banks. The fact that most

banks today are not paying explicit premiums to the FDIC does not negate the fact

that they are paying for their FDIC insurance, as will be discussed below, starting

on the next page. This insolvency risk protection potentially extends to all liabilities

in banks that most likely are TBTF although the uncertainty as to which banks are

TBTF (the so-called ‘‘constructive ambiguity’’ favored by regulators) undermines the

credit-enhancing value of TBTF protection.

183

Like any insurance entity, the FDIC must have sufficiently dispersed risks in

order to be a sound, viable insurance mechanism. The FDIC is a very viable insurer

given that it insured 8,554 banking companies at the end of 1998 (Federal Deposit

Insurance Corporation, 1998b, p. 62).18 The fact that the FDIC operates two insurance funds, the BIF and the SAIF, does not threaten the FDIC’s viability as an insurer since Congress intends to merge the two funds and in any event would quickly

merge them if one of them began to suffer high losses.

The largest individual FDIC insurance risk, BankAmerica, accounted for just 5.9 percent ($163.5 billion) of the FDIC’s insured deposits at September 30, 1998 (the

latest date for which this data is available).19 BankAmerica’s insured deposits

equaled just 29.6 percent of the total capital of FDIC-insured banks on that date

($163.5 billion/$556.7 billion). Given its size, the diversity of its assets, and its geographical spread, in the extremely unlikely event that BankAmerica should become

insolvent, the FDIC’s loss in resolving its subsidiary banks would be a tiny fraction

of their insured deposits. For example, if BankAmerica incurred an insolvency loss

equal to 5 percent of its liabilities, it would cost the FDIC $8.2 billion ($163.5 billion

x .05) to protect BankAmerica’s insured deposits against any loss; that amount equals just 1.5 percent of total bank capital ($8.2 billion/$556.7 billion). If

BankAmerica were declared to be TBTF, which almost certainly would be the case,

a loss equal to 5 percent of the total amount of liabilities to be protected might be

as high as $27-$28 billion, or approximately 5 percent of total bank capital. While

enormous (and reflective of massive regulatory failure), a loss of that magnitude

nonetheless could be borne entirely by the banking system.

Creditors of a non-bank financial firm operating without creditor insurance do not

have a third-party standing by to make them whole if the firm becomes insolvent.

Therefore, creditors of such a firm can look only to the net worth of the firm itself

to protect them against insolvency. Accordingly, without that third-party protection,

creditors properly insist that an uninsured firm operate with less leverage. However, there is nothing to prevent non-bank financial firms from establishing insurance mechanisms comparable to deposit insurance if their managements desired to

operate with higher leverage.

THE BANK SAFETY NET ACTUALLY SUBSIDIZES THE FEDERAL GOVERNMENT

Contrary to Mr. Greenspan’s assertion that Federal deposit insurance provides

banks with a Federal taxpayer safety net subsidy, the reverse is true—banks effectively provide a special subsidy to the Federal Government and hence to taxpayers.

This subsidy takes three forms—two financial and one non-financial.

BANKS’ LOW-INTEREST-RATE LOANS TO BIF AND SAIF

The Federal Deposit Insurance Act effectively bars BIF and SAIF from dropping

below a designated reserve ratio, which the FDIC Board has set at 1.25 percent of

insured deposits. That is, if the fund balance in the BIF or the SAIF drops below

1.25 percent of insured deposits, either because of deposit insurance losses or

growth in the total amount of insured deposits, then the FDIC Board of Directors

must adopt a recapitalization plan for that fund. Key to raising a fund above a 1.25

percent reserve ratio is levying higher deposit insurance premium assessments on

the members of that fund. This recapitalization requirement effectively means that

the entire fund balance below the 1.25 percent requirement is not available to absorb deposit insurance losses, except over the very short term. In effect, then, the

required reserve balance in each fund represents what is tantamount to a forced,

low-interest-rate loan from the banking industry to the Federal Government. Banks

extended that loan to the Federal Government through the high deposit insurance

assessments they paid in the early and mid-1990’s that built the BIF and SAIF to

their 1.25 percent reserve ratios. These premium payments constituted a permanent

loan to the Federal Government because the FDIC is ‘‘on budget,’’ 20

A portion of the interest on this loan, which accrues to the FDIC as income earned

on its portfolio of Treasury securities, pays for FDIC losses and expenses in excess

of its deposit insurance premium assessments and other sources of income from outside the Federal Government. The portion of its interest income the FDIC spends

effectively constitutes interest banks earn on the forced loan. That interest, which

banks never collect, in turn, is in lieu of making cash premium payments to the

FDIC.

The unspent portion of the FDIC’s interest income on its Treasury securities represents the net income value to the Federal Government of the banking industry’s

forced loan. Banks receive absolutely nothing in return for this foregone income. In

1997, this loan lowered the cost of financing the Federal debt by approximately $1.4

billion; 21 1998 figures are not yet available. If Congress had put the FDIC on a pure

184

pay-as-you-go financing basis, banks would not have had to pay heavy premium assessments to build the essentially untouchable portion of the BIF and SAIF fund

balances. That portion, at the designated reserve ratio of 1.25 percent, reached

$35.6 billion at the end of 1998.22

Arguably, the banking industry delivers another $800 million annually to Federal

taxpayers in the form of the interest banks pay on the FICO bonds issued during

the 1987-89 period to finance a limited disposal of failed S&Ls. This interest is paid

entirely by a special assessment on bank and S&L deposits. Because the S&L crisis

was rooted in numerous failed public policies reaching back to the 1930’s (Ely and

Vanderhoff, 1991), the case can be made that FICO bond interest should be paid

from general taxpayer funds rather than with a special assessment on bank deposits.

BANKS’ NON-INTEREST BEARING RESERVES

As noted on page 2, the income value of required reserves actually on deposit at

the Fed exceeded the Fed’s bank supervision expenses by $136 million in 1997.

Given that banks probably hold more vault cash than they would if interest was

paid on reserves on deposit at the Fed, the excess of the Fed’s income on required

reserves over Fed supervision and regulation expenses is somewhat higher. However, reserves on deposit at the Fed have been dropping due to sweep accounts, so

the income value of these reserves has been declining and would disappear if the

Fed opted to pay interest on reserves (contrary to popular belief, the Fed is not explicitly barred by law from paying interest on reserves).23 The time may arrive

when the Fed’s supervision and regulation expenses will exceed the income value

of required reserves. However, even if the Fed held no non-interest-bearing reserves,

its supervision and regulation expenses would be substantially less than the interest

savings the Federal Government enjoys by virtue of the forced loan the banking industry has made to the FDIC, and hence to the Federal Government.

NON-FINANCIAL SUBSIDIES

Because Congress views Federal deposit insurance as a great benefit to the banking industry, it has imposed social welfare obligations on banks that effectively save

the Federal Government substantial sums. It lies beyond the scope of this paper to

quantify those sums. The Community Reinvestment Act (CRA) is one obvious obligation. While there is great debate over whether banks make or lose money when

meeting their CRA obligations, it is highly unlikely that CRA lending and service

obligations earn the target rates of return that banks set for other products and

services, especially when considering the substantial administrative costs banks

incur in complying with the CRA. Other laws, such as the Bank Secrecy Act, which

impose obligations on banks but not on other types of financial institutions, effectively represent a special tax on banks and therefore a subsidy to the government.

Adding it all up, the banking industry effectively provided a cash subsidy to the

Federal Government of $1.5 billion in 1997 plus payment of FICO interest and an

incalculable amount of social welfare services, specifically in the form of CRA lending.

FEDERAL DEPOSIT INSURANCE CREATES AN UNDESIRABLE CROSS-SUBSIDY WITHIN

BANKING

While banks do not, contrary to Mr. Greenspan’s assertion, receive a Federal safety net subsidy, Federal deposit insurance has created a highly undesirable crosssubsidy within the banking industry which flows from healthy, well-managed banks

to weak, poorly managed banks. This cross-subsidy takes three forms—mispriced

deposit insurance premiums, excessive capital requirements for low-risk assets and

well-managed banks, and excessive regulatory compliance costs.

MISPRICED DEPOSIT INSURANCE PREMIUMS

Although it may seem odd to contend that healthy banks pay too much for their

deposit insurance while weak banks pay too little given that almost 95 percent of

the banks will pay no deposit insurance premium for the first half of 1999,24 that

in fact is the case, for this reason: The annual income foregone by banks on the deposit insurance premiums they paid to the FDIC to build the BIF and SAIF to a

1.25 percent reserve ratio, as discussed above, effectively is an implicit deposit insurance premium. Assuming banks could earn a 6 percent yield on this forced loan

to the government, this foregone income is equivalent to almost a 6 basis point deposit insurance premium.25 Hence, effective premiums for FDIC-insured deposits

range from 6 basis points to 33 basis points since explicit premium rates presently

185

range from zero to 27 basis points. In the author’s opinion, based on his substantial

research on the pricing of deposit insurance, this premium range is too narrow. The

safest banks should pay no more than two basis points for insurance of all of their

deposits while the riskiest banks should pay as much as 70-100 basis points.

The very serious problem caused by mispriced deposit insurance premiums is that

they do not deter bad banking while also causing a misallocation of credit. Thus,

the pernicious nature of mispriced deposit insurance reaches far beyond banks to

the functioning of the entire economy, as became evident in the aftermath of the

S&L crisis and the commercial banking difficulties of the 1980’s and early 1990’s. Unfortunately, the very real problem of the cross-subsidy within the banking industry caused by mispriced deposit insurance has been masked by the debate over

whether or not banks, taken as a whole, receive a Federal safety net subsidy.

The FDIC itself has acknowledged the shortcomings of its premium rate structure.

Earlier this year, it considered charging a higher premium rate to as many as 573

banks, almost all of which did not pay any premium in 1998. The premium increase

would have been levied on banks with CAMELS ratings of 3, 4, or 5 for bank management or asset quality (Barancik, 1999a) However, in response to a strong negative reaction to this proposal, the FDIC quickly announced that it was backing off

from its initial proposal, having ‘‘decided to revise and delay until next year a plan

to make more institutions pay for deposit insurance’’ (Barancik, 1999b). This retreat

by the FDIC does not negate the fact that deposit insurance premiums are underpriced for riskier banks. The FDIC’s problem is that as a government monopoly it

cannot properly price deposit insurance premiums because prices can be properly established only in private, competitive marketplaces where both buyers and sellers,

or insureds and insurers, have a choice as to whom they do business with.

EXCESS CAPITAL REQUIREMENTS

Implicitly acknowledging that neither government banking regulation nor government pricing of deposit insurance will prevent unwise banking, Congress effectively

mandated the Basle risk-based capital standards with regulations which tie prompt

regulatory action, discussed above, to various measures of bank capital. Yet like

FDIC insurance premiums, risk-based capital standards only very crudely reflect

the actual riskiness of bank assets. This is particularly evident for loans to privatesector firms where no distinction in capital requirements is made between firms

which are AAA-rated and those which have a junk bond status. Worse, capital ratios

have been set high enough to minimize banking failures caused by a combination

of inept management and regulatory failure,26 which means that capital ratios are

too high for well-managed banks. Undifferentiated capital requirements for privatesector credit risks, coupled with the inability of regulators to sufficiently differentiate good banking from bad in establishing risk-based deposit insurance premiums,

are the principal reasons why banking has steadily lost market share as a channel

of financial intermediation. In effect, regulatory inefficiencies have created substantial regulatory arbitrage opportunities which financial services entrepreneurs, utilizing electronic technology, have increasingly capitalized upon, at banking’s expense.

EXCESS REGULATORY COMPLIANCE COSTS

Because of the regulatory shortcomings cited above and congressional distrust of

the competency of the banking regulators, as FDICIA effectively proclaimed, Congress and the banking regulators have geared regulatory compliance burdens to the

lowest common denominator in banking; that is, the poorly managed banks which

are most likely to fail. This compliance burden is made worse by the inherent, onesize-must-fit-all nature of government banking regulation. This burden, which imposes higher operating costs on banks as well as regulatory straitjackets which impair the managerial flexibility of bank managers, further harms banking’s competitiveness. All of these costs are borne by banks and are in no way subsidized by the

Federal Government.

LARGE NON-BANK FINANCIAL FIRMS RECEIVE AN IMPLICIT SAFETY NET SUBSIDY

While banks pay for the entire cost of their Federal safety net, as demonstrated

above, large non-bank financial firms do not pay for their Federal financial safety

net, which is the ability to borrow at the Fed’s discount window in ‘‘unusual and

exigent circumstances.’’ 27 Although the Fed has not lent in such circumstances for

at least fifty years, it can lend to a large insurance company or investment banking

firm facing severe liquidity problems. The importance of this standby lending authority for the Fed was evidenced by a little-noticed provision in FDICIA (Sec. 473,

Emergency Liquidity) which effectively broadened the types of collateral which the

Fed could accept in lending to non-bank firms to include marketable securities. This

186

amendment reportedly was sparked by the liquidity problems some securities firms

faced in the aftermath of the 1987 stock market crash. The report accompanying the

Senate version of FDICIA made clear that this amendment to 12 U.S.C. Sec. 343

was intended to make it easier for the Fed to lend to temporarily illiquid investment

banking firms.

Unpublished reports also indicate that there have been times, specifically in the

mid-1970’s and the late 1980’s, when insurance companies suffering liquidity problems approached the Fed about borrowing at the discount window. According to

these reports, the Fed did not lend to these insurers, but that does not mean the

Fed could not have lent to them. That insurers occasionally face liquidity crises illustrates one of the great weaknesses of the state guaranty funds for insurers—the

lack of an equivalent to the Fed’s discount window.

Another close call for the Fed may have been Long Term Capital Management

(LTCM). Although the New York Fed did lean on LTCM’s principal creditors to provide additional liquidity to LTCM during its late-summer crisis last year, had that

liquidity not been forthcoming, the Fed might have been forced to lend directly to

LTCM in order to prevent a liquidity freeze-up in the global capital markets.

While the Fed theoretically would demand sufficient collateral when lending to a

non-bank to protect itself against any loss, there is the danger that the Fed could

not obtain enough collateral fast enough if the market value of the pledged securities was falling rapidly, as occurred during the 1987 stock market crash and again

last summer following Russia’s domestic debt default and LTCM’s subsequent problems. This collateralization problem is compounded by the fact that most marketable securities of investment banking firms already have been pledged as collateral

for the loans financing the purchase of those securities. In such a case, the Fed can

only obtain a junior, and very thin, lien on such securities. Consequently, the Fed’s

risk of loss on discount window lending to non-bank firms may be much greater

than it is on loans to banks which have substantial unobligated assets. Far worse

in the case of non-bank firms, the Fed does not have an FDIC to look to for a bailout. As the Continental Illinois caper discussed on page 5 so clearly illustrates, the

Fed can hide behind the FDIC when lending to a troubled bank. Sec. 142 of FDICIA

further exaggerated this difference by limiting the length of time the Fed can lend

to a troubled bank; 28 no comparable limit applies to non-bank discount window

loans.

Non-bank financial firms which have legal access to the Fed’s discount window

do not have to pay a commitment fee in advance for that right of access nor has

Congress established an after-the-fact mechanism, comparable to the FDIC’s unlimited assessment powers, to assess surviving non-bank financial firms for any losses

the Fed might incur in lending to non-bank firms. The absence of a commitment

fee and assessment power effectively has gifted non-bank financial firms with a valuable Federal financial safety net subsidy that has been denied to banks through

their forced participation in an unsubsidized Federal deposit insurance scheme. Arguably, a public good—systemic stability—flows from non-bank access to the discount window. However, that good does not warrant this subsidy any more than the

public good of Federal deposit insurance would warrant a taxpayer subsidy for

banks.

IF THERE WERE A BANK SAFETY NET SUBSIDY, THE OPERATING SUBSIDIARY STRUCTURE

WOULD BE PREFERABLE TO THE HOLDING COMPANY STRUCTURE

As should be clear by this point, banks do not receive a Federal safety net subsidy

financed by taxpayers. Consequently, it should be a moot question as to whether the

‘‘op-sub’’ or the ‘‘holding company’’ structure of a banking organization can better

contain a safety net subsidy. Unfortunately, this is not a moot question because of

the amazing success Mr. Greenspan has had in promoting the fiction that banks receive a safety net subsidy. Therefore, the balance of this paper will examine the containment issue.

ORGANIZATIONAL DIFFERENCES UNDERLYING THE OP-SUB DEBATE

The op-sub organizational structure is one in which a banking company conducts

what have traditionally been viewed as non-bank activities in an operating subsidiary of the bank; hence, the term op-sub. Notable among these non-bank activities

are securities and insurance underwriting and brokerage. An op-sub, because it is

owned by, and therefore is capitalized by, its parent bank, is subject to the regulatory oversight of the bank’s regulator. In effect, the op-sub’s equity capital, and

therefore its capacity to absorb losses, flows from the bank’s owner or owners

through the bank to the op-sub.

187

Under rules proposed by the OCC, for the purpose of measuring a national bank’s

compliance with its regulatory capital requirements, a bank’s equity capital investment in an op-sub must be fully deducted from the bank’s capital. This deduction

will eliminate any double-counting of capital and therefore any ‘‘double-leveraging’’

whereby debt of the parent is counted as equity capital in a subsidiary. Some degree

of double-leveraging is still evident in capital arrangements between bank holding

companies and their subsidiary banks, but not to the extent it once was. Still, the

OCC’s proposed rule represents a more conservative approach to op-sub capitalization than now governs the capitalization of banks by Fed-regulated bank holding

companies.

In the holding company structure, non-traditional activities, specifically securities

and insurance underwriting, are conducted in a direct subsidiary of the bank holding company. Therefore, such a subsidiary is a side-by-side, non-bank affiliate of the

bank. That is, the bank and its non-bank affiliate have a common parent, which is

regulated by the Fed as a bank holding company. The capital invested in the nonbank affiliate comes from the holding company, possibly with some degree of doubleleverage. This structural alternative is referred to as the non-bank affiliate structure.

In addition to its equity capital investment, a bank can engage in other types of

financial transactions with an op-sub, specifically lending to it or buying assets from

it. Likewise, a bank can engage in similar transactions with a non-bank affiliate.

In the latter case, Sec. 23A and 23B of the Federal Reserve Act limit the financial

dealings between a bank and its non-bank affiliates; the OCC has proposed to apply

the same restrictions to dealings between a bank and its op-subs. Therefore, the opsub debate focuses on equity capital issues and not on debt or other types of financial transactions.

GREENSPAN’S SAFETY NET SUBSIDY ASSERTION

Mr. Greenspan, with almost no support outside of the Fed, asserts that banks receive a safety net subsidy which banking companies can use to greater competitive

advantage in the op-sub structure than in an affiliate structure. The fact that the

OCC becomes the key banking regulator of a banking company opting for the opsub structure while the Fed is the key banking regulator of a banking company

electing the affiliate structure has no bearing, of course, on Mr. Greenspan’s position

in this debate.

There are two sequential pieces to Mr. Greenspan’s safety net subsidy assertion.

First, he contends that banks generate ‘‘subsidized equity capital.’’ Apparently,

based on a conversation the author had with a Fed economist familiar with Mr.

Greenspan’s thinking on this subject, subsidized equity capital represents the abovemarket rate of return banks earn on their equity capital by virtue of their safetynet access. There apparently are two sources for this additional rate of return.

The first source is that banks can lower their weighted average cost-of-funds by

operating on a more highly leveraged basis than non-banks. This favorable cost-offunds differential generates the additional return on equity that banks supposedly

earn. It is true that banks can operate on a more highly leveraged basis than nonbanks, but that advantage does not constitute a taxpayer subsidy. Instead, as was

explained above, it represents the insurance value of any form of insurance. As

noted above, if non-banks want to capture the risk-spreading benefit of insurance,

they should create private insurance vehicles comparable to Federal deposit insurance. As the author has explained in numerous fora, the cross-guarantee concept

can be utilized to privatize bank deposit insurance and can be broadened to insure

the liabilities of non-bank firms.29

The second source of above-market returns that banks supposedly earn stems

from the Federal Government’s guarantee of the FDIC’s insurance obligation. Because of this guarantee, Mr. Greenspan contends, interest rates on bank deposits

do not reflect a sufficient FDIC insolvency risk premium; that is, depositors would

demand higher interest rates if the FDIC’s insurance obligations were not federally

guaranteed. Presumably this absence of an FDIC risk premium extends to the nondeposit liabilities of TBTF banks implicitly protected under the FDICIA systemic

risk exception discussed above. However, there is no need for such a risk premium

because the congressional reforms discussed above, starting on page 6, have essentially eliminated the FDIC insolvency risk.

The author readily agrees that deposit insurance is mispriced on a bank-by-bank

basis, and grievously so in some cases, but the FDIC’s unlimited assessment powers,

which underpin the substantial cross-subsidy in deposit insurance pricing discussed

above, readily trump the effect of the bank-by-bank mispricing of Federal deposit

insurance. That is, while some banks may benefit competitively for a time by being

188

undercharged for their deposit insurance, eventually their sins will sink them, as

we saw most recently in the BestBank failure.30 Over time, though, the competitive

damage of mispriced deposit insurance falls most heavily on the stronger banks

which are hurt by the overpriced deposit insurance premiums they pay, excessive

capital requirements, and the regulatory burdens discussed above. Hence, while

mispriced deposit insurance and banking regulation adversely distort the financial

marketplace, the net effect of these distortions is far more detrimental than helpful

to well-managed banks.

The second sequential piece of the Greenspan assertion is that having once captured extraordinary profits, thereby creating subsidized equity capital, banks can

then more easily downstream that subsidized capital into op-subs than it can funnel

that capital up to the bank’s parent holding company, which would then invest that

capital in non-bank affiliates. However, that argument simply does not wash because it is just as easy, given the tax neutrality of moving earnings around within

a banking company, for the management of the banking company to invest bank

earnings downstream into an op-sub as it is to dividend bank earnings up to the

holding company for reinvestment in a non-bank affiliate. This equality will be

strengthened by the OCC’s proposed rule to require that all capital a national bank

invests in an op-sub be deducted from the bank’s capital for regulatory purposes.31

OTHER ARGUMENTS FAVORING THE OP-SUB STRUCTURE

Other arguments favor the op-sub structure over the non-bank affiliate structure,

including the inherently greater operating efficiency of op-subs. Also, op-subs will

strengthen banks, if the 100 percent capital deduction rule is in place, while nonbank affiliates could harm affiliated banks, particularly if the corporate veil between

a bank and a non-bank affiliate can be pierced if the affiliate becomes insolvent.

These arguments lie beyond the scope of this paper. However, an article by

Longstreth and Mattei (1997) does an excellent job of demonstrating the legal superiority of the op-sub structure.

CONCLUSION

The contention that banks receive, and therefore benefit competitively, from a

Federal safety net subsidy, is simply false. There is no subsidy because banks are

subject to FDIC assessments which will pay for the full cost of the banking industry’s safety net even in circumstances far worse than the S&L crisis. Further, various reforms enacted by Congress over the last decade have so dramatically reduced

the potential for such a crisis that the reoccurrence of a crisis of that magnitude

would represent unconscionable regulatory failure, partly by the very agency which

argues that banks enjoy a Federal safety net subsidy.

REFERENCES

Barancik, Scott. (1999a) ‘‘FDIC Staff is Developing A System to Make Some

Well-Capitalized Banks Pay.’’ American Banker, January 4, p. 2. ——. (1999b) ‘‘FDIC Puts Off Charging Riskier Banks More.’’ American Banker,

February 16, p. 4.

Board of Governors of the Federal Reserve System. (1997) 84th Annual Report.

Committee on Banking and Financial Services. (1997) U.S. House of Representatives, Subcommittee on Domestic and International Monetary Policy, Federal

Payment System, Hearing, 105th Congress, First Session, Serial No. 105-31,

September 16, Washington, D.C.

Continental Illinois Corporation. (1984) Annual Report.

Ely, Bert. (1997a) ‘‘Let the Market Set Interest Rates.’’ The Wall Street Journal,

May 20. ——. (1997b) ‘‘Greenspan’s Deposit Insurance Subsidy Argument is Nonsense.’’

American Banker, June 6.

——. (1997c) ‘‘Regulatory Moral Hazard: The Real Moral Hazard in Federal Deposit

Insurance.’’ A paper presented on November 22, 1997, at the annual meeting

of the Southern Finance Association. Forthcoming in The Independent Review: A Journal of Political Economy.

—— and Vicki Vanderhoff. (1991) ‘‘Lessons Learned from the S&L Debacle: The

Price of Failed Public Policy.’’ The Institute for Policy Innovation, Lewisville,

Texas.

Federal Deposit Insurance Corporation. (1980) Annual Report.

——. (1983) Annual Report.

——. (1997) Annual Report.

——. (1998a) FDIC Quarterly Banking Profile. Fourth Quarter 1998.

——. (1998b) FDIC Quarterly Banking Profile Graph Book. Fourth Quarter 1998.

189

——. (1999) ‘‘Material Loss Review: The Failure of Best Bank, Boulder, Colorado.’’

Audit report No. 99-005, January 22.

Greenspan, Alan. (1999) Testimony before the Subcommittee on Finance and Hazardous Materials, Committee on Commerce, U.S. House of Representatives,

April 28.

Kwast, Myron L. and S. Wayne Passmore. (1997) ‘‘The Subsidy Provided by the Federal Safety Net: Theory, Measurement and Containment.’’ Board of Governors

of the Federal Reserve System, September, Mimeograph.

Longstreth, Bevis and Ivan Mattei. (1997) Columbia Law Review 36 (4) October, pg.

1895.

Petri, Tom, and Bert Ely. (1995) ‘‘Better Banking for America: The 100 Percent

Cross-Guarantee Solution.’’ Common Sense, Fall 1995.

ENDNOTES

1. Author’s calculation.

2. These costs, which totaled $1.692 billion, break down by agency as follows: Federal Reserve System—$517 million; Federal Deposit Insurance Corporation (including administrative costs of the deposit insurance funds)—$677 million; Office of the

Comptroller of the Currency—$350 million; Office of Thrift Supervision—$148 million.

3. Reserves on deposit at the Fed in 1997 (excluding compensating balances for

services provided by the Fed) averaged $10.792 billion (calculated from the monthly

Federal Reserve Bulletin, Table A6). The average yield on the Fed’s securities portfolio in 1997 was estimated to be 6.05 percent (calculated from Board of Governors

of the Federal Reserve System (1997), Statistical Tables 6 and 14). $10.792 billion

x .0605 = $653 million.

4. Calculated from data published in the monthly Federal Reserve Bulletin, various issues, Table 1.12, ‘‘Reserves and Borrowings.’’

5. Codified as 12 CFR 201.

6. It is not necessary for the Fed to include a cost-of-funds element in its intraday

interest rate since it pays no interest to banks which accumulate positive intraday

account balances at the Fed.

7. Board of Governors of the Federal Reserve System (1997), Pg. 288, Table 6,

footnote 1.

8. Ibid., p. 264, footnote 2 to the financial statements for priced services provided

by Federal Reserve banks.

9. The pension cost credit is describe more fully in a report by the author, titled

‘‘An Analysis of the Fed’s Priced Services Activities,’’ appended to testimony by Mr.

Eric Roy, on behalf of the Association of Bank Couriers (Committee on Banking and

Financial Services, 1997, pp. 249-250). This report also discusses other ways in

which the Fed effectively utilizes taxpayer funds to subsidize the services which it

provides to banks.

10. This estimate was obtained in a March 31, 1999, telephone call to the Division

of Finance at the Federal Deposit Insurance Corporation.

11. Federal Deposit Insurance Corporation (1997), Table on Recoveries and Losses

for All Cases, p. 104.

12. Ibid., Table of Income and Expenses, p. 105.

13. Federal Deposit Insurance Corporation (1980), p. 299, Table 127, Footnote 3.

14. Prompt Regulatory Action constitutes Subtitle D of Title I of FDICIA (Sec.

131-133) while Least-Cost Resolution follows in Subtitle E (Sec. 141-143).

15. Depositor preference was enacted as Sec. 3001 of Public Law 103-66 and is

codified as 12 U.S.C. ?1821(d)(11).

16. This line of credit is authorized by 12 U.S.C. Sec. 1824(a). In addition, Sec.

1824(b) authorizes the FDIC to borrow from the Treasury Department’s Federal Financing Bank.

Sec. 1824(c) governs the repayment schedule for any such borrowings. Presumably, the interest rate on these borrowings will not be less than Treasury’s borrowing rate given that, in setting the interest rate on Treasury loans to the FDIC, the

Secretary of the Treasury will take ‘‘into consideration current market yields on outstanding marketable obligations of the United States of comparable maturity.’’ This

provision in Sec. 1824(a) should bar any taxpayer subsidy to banks through this borrowing channel. Given the capital strength of the banking industry today, this line

of credit could safely be canceled.

17. One exception: the Securities Investor Protection Corporation (SIPC), which

is a creature of the Federal Government. It protects the cash and securities account

balances of customers of insolvent broker/dealers against fraud, up to statutorily

specified limits.

190

18. Although there were 10,461 FDIC-insured banks at the end of 1998 (Federal

Deposit Insurance Corporation, 1998b, p. 63), the cross-guarantee provision of

FIRREA discussed on page 6 effectively consolidates the banking industry into a

smaller number of institutions for deposit insurance purposes.

19. Calculated from call reports filed with the FDIC by BankAmerica’s ten subsidiary depository institutions.

20. The FDIC is ‘‘on-budget’’ for this reason: for the purpose of calculating the

Federal Government’s revenues, spending, and therefore its annual surplus or deficit, the FDIC’s revenues from outside the government, such as the premiums it collects, count as Federal revenues while its cash outlays count as Federal spending.

It is this inclusion of the FDIC’s revenues and spending in the government’s financial statements which makes the FDIC an on-budget Federal agency. The interest

the FDIC earns on its portfolio of Treasury securities does not count as Federal revenue because it is merely a bookkeeping transfer within the Federal Government,

from the Treasury to the FDIC. 21. BIF and SAIF combined net income of $1.918 billion ($1.438 billion for BIF

plus $480 million for the SAIF) for 1997 minus a non-cash reversal of prior years’ loss provisions of $506 million equals $1.412 billion. 22. Total insured deposits of BIF and SAIF equaled $2.85 trillion at the end of

1998 (Federal Deposit Insurance Corporation, 1998a, p. 17). 1.25 percent of that

amount equals $35.63 billion.

23. According to several observers on the scene at the time, in 1978, when interest

rates were rising, the Fed proposed to pay interest on required reserves so as to

arrest a decline in Fed membership as state-chartered banks dropped their Fed

membership. Because the Federal Reserve Act does not specifically bar the Fed from

paying interest on reserves, the Fed opined that it could pay that interest. However,

members of the House and Senate Banking Committees strongly opposed this proposal, partly because payment of interest on reserves would have added substantially to the Federal budget deficit. The banking committees reportedly backed up

their position with a legal opinion from the Congressional Research Service of the

Library of Congress stating that the Fed did not have statutory authority to pay

interest on reserves; the author has not yet located that document. Faced with this

extremely negative congressional reaction, the Fed backed off from its proposal.

Congress later solved the Fed’s membership problem by mandating, in the Monetary

Control Act of 1980, that all depository institutions maintain reserves at the Fed

regardless of whether they belong to the Fed. Congress’s views in 1978 were set

forth in a June 5 letter to then Fed Chairman G. William Miller from Henry S.

Reuss, then chairman of the House Banking Committee, and William Proxmire,

then Chairman of the Senate Banking Committee, and in a June 28 letter from

Reuss to Miller.

24. For the first semiannual assessment period in 1999, 95.0 percent of all BIFinsured institutions will not pay an insurance premium while that will be the case

for 93.4 percent of all SAIF-insured institutions. Just eleven FDIC-insured institutions will pay the highest premium rate of 27 basis points (Federal Deposit Insurance Corporation, 1998a, p. 19).

25. FDIC-insured deposits equaled 74.7 percent of total domestic deposits at the

end of 1998 ($2.85 trillion/$3.814 trillion), as calculated from Federal Deposit Insurance Corporation (1998a), pp. 4, 16, and 17. The FDIC earned approximately a 6

percent yield on its Treasury securities in 1997 (1998 data is not yet available), as

calculated from Federal Deposit Insurance Corporation (1997), pp. 47, 48, 63, and

64. Assuming a minimum reserve ratio of 1.25 percent: .0125 x .06 x .747 = 5.6 basis

points.

26. The shortcomings of government banking regulation are the real moral hazard

in Federal deposit insurance (Ely, 1997c).

27. 12 U.S.C. Sec. 343, second paragraph. Unlike banks, which can borrow at the

discount window of a Federal Reserve bank without prior approval by the Board of

Governors of the Federal Reserve System, loans to non-bank firms require an affirmative vote of five members of the Board of Governors.

28. 12 U.S.C. 347b(b)(1), as amended by Sec. 142 of FDICIA, provides that

‘‘[e]xcept as provided in paragraph (2), no advances to any undercapitalized depository institution by any Federal Reserve bank under this section may be outstanding

for more than 60 days in any 120-day period.’’

29. See for example, Petri and Ely (1995). Other articles and papers on the crossguarantee concept are posted on the Ely & Company website at http://www.elyco.com.

30. On July 23, 1998, the BestBank of Boulder, Colorado, failed with total assets

of $314 million. The FDIC’s estimated loss in BestBank, as of the end of 1998, was

$171.6 million, or 55 percent of assets; that loss percentage may go higher. As

191

spelled out in a 74-page report issued by the FDIC’s Inspector General (Federal Deposit Insurance Corporation, 1999), BestBank represents an extremely serious regulatory failure by the FDIC.

31. An amendment to H.R. 10, as reported by the House Banking Committee on

March 11, 1999, would require that this capital deduction include all retained earnings in the op-sub.

Chairman SUNUNU. Thank you very much to each of our witnesses.

Let me begin with Ms. Miles.

Could you please talk in slightly more specific terms about the

trends in the size of the portfolios held by the GSEs, both whole

loans and their own mortgage-backed securities?

In relative terms, what has been the size of the increase over the

past decade? Is it a new trend or are the portfolios they hold essentially the same size as they have held historically?

Your comments.

Ms. MILES. You have two separate trends going on. Historically,

until about the middle 1980’s, Fannie Mae was a portfolio holder

and they did not start issuing mortgage-backed securities until

about 1980 and they were not a significant size until a few years

after that.

Freddie Mac, by contrast, started life as a mortgage-backed securities issuer and held very small portfolios. That started changing.

Chairman SUNUNU. Started changing when?

Ms. MILES. Again in the 1980’s and significantly in the 1990’s.

At this point, I am going to have to check my memory here. I know

Tom has some numbers in front of him. I believe that Freddie Mac

is up to about—not quite one-third of its assets in the form of its

portfolio or repurchased mortgage-backed securities and about twothirds in mortgage-backed securities.

Chairman SUNUNU. Mr. McCool, did you want to offer some specifics?

Mr. MCCOOL. That is about what we have. For Freddie Mac, it

is about one-third in portfolio and two-thirds as MBS outstanding

and for Fannie Mae it is about 43 percent in portfolio.

Chairman SUNUNU. Let’s stay focused on their portfolios, when

you say 43 percent in portfolio.

Mr. MCCOOL. That means that they hold either as whole mortgages or as repurchased mortgage-backed securities about 43 percent of the total outstanding obligations are in their portfolio rather than as outstanding mortgage-backed securities that somebody

else holds.

Chairman SUNUNU. And for Fannie Mae in particular, that amount would be approximately $550 billion currently? Is that

right?

Mr. MCCOOL. Well, 522 at the end of 1999.

Chairman SUNUNU. You mentioned both whole loans and mortgage-backed securities. What are the differences in risks that the

holder of those securities are exposed to? In other words, from the

standpoint of systematic risk, interest rate risk, prepayment risk,

is there any difference in whether or not the GSEs or any other financial institution chooses to hold whole loans versus mortgagebacked securities?

Ms. MILES. Would choose to hold them?

Chairman SUNUNU. Yes.

192

Ms. MILES. If you are holding them, you have all the risks. The

advantage of mortgage-backed securities, when you sell them, you

are selling mortgages off your books. You are retaining the credit

risk, but you are pushing off onto someone else the interest rate

risk.

One of the reasons they are less profitable than holding whole

loans is that in the process of giving someone else the interest rate

risk you also have to give them the profitability that attaches to

that. But when you buy them back on your books, you are essentially repatriating all that risk.

Chairman SUNUNU. My question is: For the purposes of us assessing a change in the risk profile, should it matter to us whether

Fannie Mae, say, previously held $100 billion in whole loans and

today holds $100 billion in mortgage-backed securities? They are

still taking the credit risk on both and because they choose to hold

them, they are holding interest rate risk and prepayment risk, correct?

Mr. MCCOOL. Interest rate and prepayment risk. Right.

Mr. ELY. Mr. Chairman, if I could add to that, there is cause for

concern because when they do take back the interest rate risk, particularly if they buy back mortgage-backed securities that they or

someone else has previously issued, they take back the interest

rate risk and they bring back the prepayment risk. This gets to

what is, I think, of concern with regard to their balance sheets.

That is, they become like the traditional S&L of the 1960’s and

1970’s, that is, they significantly maturity mismatch on their balance sheet in terms of how they fund themselves.

Now, they hedge a lot of that risk by buying interest rate swaps

and other forms——

Chairman SUNUNU. If you could hold up there, believe me, I will

get to hedging, but for the purposes of laying out information, I

want to proceed with a little bit of order, whether it is order in my

own mind only.

Mr. McCool, you talked a little bit about new product issuance

and about HUD’s proposed regulations regarding new products to

make housing more available to lower income people.

Question one is how do new products that might be offered by

the GSEs affect their risk profile and their credit risk profile in

particular. And maybe comment regarding the 3 percent down payment product which is just one new product that has been in the

news and been marketed pretty heavily.

Mr. MCCOOL. The effect on the risk profile would obviously depend on the product, but in cases where, you know, you are moving

toward lower down payment products, then it would tend to increase the credit risk, to the extent it is not hedged.

Chairman SUNUNU. You also discussed investment in, I guess,

non-mission-related vehicles, cash value life insurance and other

investments. Why has there been a delay in issuing regulations regarding those investments?

Mr. MCCOOL. Well, you would have to ask HUD that. We have

been sort of—we have recommended that HUD issue regulations to

establish criteria, as I said, in our 1998 report and they did put out

an advance notice and they did get some comment back but they

193

have not actually gone forward with the regulations to set forth criteria.

Chairman SUNUNU. Is it your contention, as you addressed those

issues in your testimony, that those investments in non-mission-related securities increases the risk profile of the GSEs?

Mr. MCCOOL. Well, actually, some of them might be quite safe

and sound, let’s put it that way. For example, some of the nonmortgage investments that Freddie Mac purchased were actually

from a safety and soundness perspective probably pretty good, but

they had nothing much to do with what Freddie Mac was in business from the GSE perspective.

So that is part of the issue, are they mission-related in the sense

that the GSEs were given privileges to achieve a mission and the

question is whether they are doing that. So they could be safe and

sound and not mission-related, they could be both risky and nonmission related, I guess. We have not seen too many examples of

that, but that is also feasible.

Chairman SUNUNU. Ms. Miles, Mr. Ely mentioned mismatch, the

concern that long-term liabilities might be funded with short-term

assets. Have you made any effort to quantify the degree to which

the portfolios held by the GSEs are well matched and how do we

as policy makers better understand whether or not there is an appropriate level of matching in these portfolios?

Ms. MILES. I have not attempted to do that recently. We have

some horrendous examples from the past, including one that I gave

you in my written testimony about what happened when Fannie

Mae in the late 1970’s and early 1980’s was in fact our largest savings and loan association. They were not well matched at that

point.

They did what every S&L did. They used the relatively short end

of the yield curve in order to fund mortgages at the longer end and

according to a study done by HUD in 1986, on a mark-to-market

basis, they were insolvent every single year from 1978 through

1984 and only came out of trouble in 1985, generally because of

regulatory forbearance.

Having said that, I do not think anyone sees anything quite like

that now and the best people to ask that question are here today.

I would ask OFHEO and also the Federal Housing Finance Board

what those matches are.

Chairman SUNUNU. Mr. Ely, you raised the case of Long-Term

Capital Management and I would like to address that a little bit,

in a little bit more detail.

You mentioned that their debt was only one-seventh of the

GSEs’. Does that include their exposure as a result of their trading

on margin?

Mr. ELY. Yes, because this was a very highly leveraged institution. In effect, it largely financed its asset portfolio with, if you will,

margin debt. It may not have been called that as such, but effectively it was very highly leveraged.

Chairman SUNUNU. But they do not actually hold their margin

exposure on their books as debt, correct?

Mr. ELY. I have never seen their financial statements. I am not

sure they have ever been published. But as I understand it, they

owned assets, a variety of securities, that were financed with debt

194

that was on their balance sheet. They also had some off balance

sheet exposures, too. As I understand it—— Chairman SUNUNU. But this is a not insignificant point. They

had debt obligations to a number of financial institutions that

eventually came and were willing to roll over their debt in order

to facilitate the orderly liquidation. And I assume that is the debt

that you talk about being one-seventh the size of the GSE debt.

Mr. ELY. That is correct.

Chairman SUNUNU. It would seem to me that that would not include, however, their exposure to margin calls which a margin call

does not necessarily require the entry of a debt or an obligation on

your books. So it would seem to me that there is at least something

of a difference here and there was an enormous exposure to margin

calls in the case of Long-Term Capital Management that I hope, assuming that the non-mission related-investments are more or less

focused, the GSEs are not exposed to. I do not know of any GSE

being exposed to a margin call, do you?

Mr. ELY. I am not aware of that.

Chairman SUNUNU. Long-Term Capital Management, they also,

I know, traded quite heavily in currencies and currency futures.

That is obviously a very volatile market that GSEs are not really

exposed to. Is that correct?

Mr. ELY. Except that they do raise funds in foreign markets, so

whether or not any of that is in foreign currencies, I do not know,

but they do sell their debt on a global basis so that the extent to

which we worry about systemic risks, we have to think not only in

terms of how U.S. investors are reacting, but also about foreign

owners of their debt.

Chairman SUNUNU. If they were effective at managing their risk

exposure, I assume they would just swap out of any exposure to

foreign currencies, correct?

Mr. ELY. That is a reasonable assumption.

Chairman SUNUNU. In the same way that they would swap out

of exposure to short-term rates if they wanted to balance their

portfolio appropriately.

Mr. ELY. That is correct. But what that does is create

counterparty risk, which is a form of credit risk. In other words,

the underlying assumption in any kind of swap or derivative arrangement is the counterparty will be able to perform if and when

called upon to do so. One of the things discussed in the report I

co-authored on nationalizing mortgage risk is that the footnote disclosures by both Fannie and Freddie, in my opinion, do not provide

enough insight into the counterparty risk that they have under all

of their swap and derivative arrangements.

Chairman SUNUNU. What is riskier, holding a whole loan or

holding a mortgage-backed security? To an individual, for example

to me. Let’s start with that.

Mr. ELY. It depends on who issues the mortgage-backed security.

If the mortgage-backed security is issued by one of the GSEs, by

Fannie or Freddie, then I would argue that that is less risky than

holding a whole mortgage because of the implicit backing of the

Federal Government.

Chairman SUNUNU. I mean, it says pretty clearly that it is not

backed, so let’s assume that to be the case.

195

What about for a financial institution? What is riskier for the

bank in my hometown, Bedford or Manchester, New Hampshire,

what would be riskier, holding a whole loan or holding a mortgagebacked security?

Mr. ELY. If you leave aside even the Federal guarantee, presumably it is riskier to hold a whole mortgage if the bank has a large

concentration of mortgages it has originated locally because one of

the benefits of mortgage-backed securities, whether they are issued

by a GSE or privately, is that they provide geographical risk dispersion.

Chairman SUNUNU. Should we be concerned, and should we include in these discussions, then, the fact that the whole loans held

by the bank and thrift industry still dwarf the number of mortgage-backed securities held by the bank and thrift industry, I think

by a factor of two to one or three to one?

Mr. ELY. Well, again, that also is a function of what the capital

levels are at the banks and thrifts. In other words, there may be

risk in the form of a geographical concentration, but if the bank or

thrift holds enough capital, then that can offset the risk. That is

the tradeoff. And basically, banks and thrifts are held to a higher

capital standard to reflect the fact that they have some degree of

concentration of risk.

Although it is not widely used, there is an instrument, known as

a credit derivative that represents another tool for trying to diversify geographical risk concentrations.

Chairman SUNUNU. Thank you.

Mr. Bentsen.

Mr. BENTSEN. Thank you, Mr. Chairman.

Let me go back just for a second to this question of risk. It seems

to me there are two types of risk related to a mortgage, whether

it is in the form of a whole loan or mortgage-backed securities, and

you all have said this, but just to clarify, there is credit risk related

to the asset itself and there is interest rate risk. Both entities, both

instruments, carry some form of that type of risk.

But I think we need to also consider the fact it is not—I do not

think we can just say because Fannie and Freddie have the implicit guarantee of the Federal Government, which I totally concur

with, that we also have to give some credit to underwriting standards, whether they be Fannie and Freddie’s underwriting standards or the bank’s underwriting standards or whoever’s underwriting standards. So I think there are other factors that come into

play as to what the risk is.

I also need to say, and I think the chairman was commenting on

this, I realize we like to use Long-Term Capital Management as a

comparison. I think that is a red herring.

And, Bert, you made this clear in your comments in response to

the chairman, that the types of investments that LTCM was in,

which I do not have objection with them doing that, are far different in most respects with the types of investments that the

GSEs are in, just as the GSE investments are different in many

respects to the types of asset investments on the part of banks, on

the part of mutual funds, et cetera.

Now, the question is the concentration, which I think is where

you make a bigger point and the question of is there too much conVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00199 Fmt 6601 Sfmt 6602 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
196

centration in the mortgage market on the part of the GSEs with

a potential for systemic risk and how that flows back to the taxpayer.

Now, let me ask a couple of questions. One issue that we have

sort of talked around which I think was sort of the initial focus of

this hearing and that is what is the risk to the taxpayer compounded by the fact that the GSEs in addition to issuing corporate

debt with which they use the proceeds to purchase whole loans and

then the corpus of which is pledged against that corporate debt, is

that risk compounded when the GSEs enter the secondary market

and purchase back mortgage-backed securities which they issued?

And, second of all, how much of that purchase is for the purpose

of supporting the primary market price of the securities itself that

they are issuing and how much of it is, for lack of a better term,

an arbitrage play because their ability to—because of both the price

of the security in the market and the cost of their capital?

And if it is such a play, how much of that—and I am not going

to ask you to quantify the difference today, but how much of that

spread, if you will, enures back to the benefit, if any, to the homeowner in terms of lower mortgage costs? Or does it all go to the

shareholder? Or do you know?

Mr. ELY. Well, to address a couple of points, in my opinion, you

do not have to have Fannie and Freddie to maintain liquidity in

the secondary market. That market is big enough that private sector firms, specifically broker dealers, could do that job.

In my opinion, the MBS buyback is to take advantage of arbitrage. It is an arbitrage play. Driving it, in my opinion, is that

Fannie and Freddie have made a commitment to the financial markets, Fannie more strongly than Freddie, to grow their earnings at

15 percent a year, to double their earnings every 5 years.

The mortgage market is not growing that fast and so they have

to figure out how to grow their revenues faster than the market is

growing. A good way to do that is to buy back MBS, to get the interest rate spread, which is significantly greater for carrying interest rate risk than carrying credit risk.

Our assessment is that on a net profit basis, depending on which

GSE you are looking at, they get about four to six times as much

net profit, per mortgage dollar outstanding, if they assume the interest rate risk which they get by buying back the MBS. So ultimately their MBS buybacks are driven by the earnings growth

commitment that they have made to Wall Street.

Now, in terms of where that benefit goes, that is something I

have not assessed. It would be a good question to pose to CBO in

the context of the study that they are doing to update their 1996

report on Fannie and Freddie. At that time, CBO made an estimate

as to how much of the overall subsidy that Fannie and Freddie

have flows through to homeowners and how much of it stays with

stockholders and management.

Mr. BENTSEN. And I want to hear your comment, but I want to

follow up with Bert here because we—— Is the reason, in your opinion, that Fannie and Freddie—let’s say

Fannie, is the commitment to the capital markets of the 15 percent

annual return because the structure of the entity is such that the

Federal Government wanted to jump start the secondary market

197

and ease the ability to gain a mortgage and in effect leverage private capital, that the entities have to be able to raise private capital at a competitive rate of return and the fact that, criticism notwithstanding, the ability for the GSEs to expand into non-mortgage

investments in any marked way, as opposed to a nominal sense, is

limited by the fact that HUD oversees them and there may be legislation, et cetera, has this created sort of a Hobson’s choice for us

of whether we want to have—of the type of entity that we have

here?

Is this part of our own creation, that they are forced to earn returns where they can in order to meet their mission and satisfy

those who are putting capital into it?

Mr. ELY. Well, there are two issues here. First, in terms of the

rate of return, they clearly are earning above-market rates of return on their equity capital. ROEs of 22 and 24 percent are earned

on a steady basis, which are quite handsome compared to genuine

private sector firms.

What is the motivation here is that it is the promise of such significant growth in earnings, that is 15 percent a year, doubling

earnings every 5 years, that is key to driving up their stock price.

That is what motivates Fannie and Freddie—not so much the striving for high ROE as it is the earnings growth rate.

And, again, the problem they face, and maybe it is their Hobson’s

choice, is that they have made a commitment to the financial markets to grow their earnings faster per year than the mortgage market as a whole is growing, which means they have to assume a

larger and larger market share, if you will, of the total interest

spread that exists in the mortgage market.

This is increasingly a dilemma for them. My sense is that the

stock market is increasingly skeptical of their ability to maintain

that earnings growth rate, which is again separate from the ROE

question.

Mr. BENTSEN. But without sufficient capital, they are unable to

purchase more mortgages in the secondary market at a rate competitive enough to meet the missions that Congress set out when

they were created in the 1930’s and in the 1960’s. Is that correct?

Mr. ELY. Well, that is true, except that a lack of capital has not

been a problem for them. At times, Fannie particularly has been

buying back stock. Given what their stock prices have been, at

least until very recently, they would certainly have no problem in

issuing additional capital stock. So I do not think——

Mr. BENTSEN. So it is not that stock buyback—it is not necessarily a bad thing. I mean, we would expect in a corporation that

has sufficient capital that it ought to support a stock price at a relatively good price through a buyback. I mean, that would be something—that would be considered a good corporate practice in most

cases, right?

Mr. ELY. That is true, but a stock buyback suggests that a corporation has more capital than it needs rather than being short of

capital, so I do not think that Fannie and Freddie have suffered

from a lack of capital.

Mr. BENTSEN. Do you all have any comment?

Ms. Miles or Mr. McCool?

198

Mr. MCCOOL. Well, I think just getting to your question, I think

it is fairly clear that holding mortgages in a portfolio, whether it

be MBS or whole loans, is both more profitable and riskier than

issuing MBS. I think that is true. What is done with the profits is

something that is very difficult to know.

I think that the question about a Hobson’s choice, in our work

on mission regulation, we talk about it as the tension between increasing shareholder value and fulfilling the mission and I think

it is fairly clear that that tension exists. That is why mission regulation is so important.

Ms. MILES. I think as far as the repurchase of mortgage-backed

securities goes, it is difficult for me to understand what that is supposed to do for housing markets because if you believe that capital

markets are well integrated, then what you are talking about is a

GSE taking one form of its means of financing mortgages and simply substituting it for another form of financing mortgages. In

other words, issuing general GSE debt in order to buy back mortgage-backed securities, which are the other way of financing them,

and you should end up with a wash.

Mr. BENTSEN. Thank you, Mr. Chairman.

Chairman SUNUNU. Thank you.

One brief point to clarify. A wash in terms of both interest cost

and liquidity?

Ms. MILES. In terms of what it is that the GSE has actually

done. I mean, if you finance the mortgages by buying them through

GSE debt or if you finance them through selling mortgage-backed

securities, those are both means of financing mortgages. And if you

simply substitute one for the other while you change who is holding

the risk, you still have the same amount of mortgage money sitting

out there in the market.

Mr. BENTSEN. Mr. Chairman, if you will yield, that is true except

for the ability, I think, to buy—if you are able to go back into the

market and buy the MBS at a discount, at a deeper discount than

the issuance price, the question is what do you do with the spread

on the discount.

We know that MBSs fluctuate in price based upon interest rate

changes which are obviously beyond the control of Fannie and

Freddie, or I think they are, and the guy who is doing that is testifying over at the banking committee now, they are over there.

And the question comes back to, again, is taking advantage of

that spread doing one of two things: is it supporting the initial

issuance price of the future MBS or the current MBS and that may

or may not be the case, although issuers do do that from time to

time, support their product in the secondary market, both private

and Fannie and Freddie, but the other is what are you doing with

the spread and is the spread somehow affecting the price of the future issuance and thus the price of the mortgage to the consumer,

which is the original mission.

Ms. MILES. Again, that depends on what you believe about the

substitutability of these instruments.

Chairman SUNUNU. Thank you.

Mr. Hoekstra.

Mr. HOEKSTRA. I thank the chairman. I thank you for doing this

hearing.

199

Ms. Miles, I would just like to go to some testimony on page 3

of your testimony and I want to get an elaboration or expansion of

your comments at the bottom of the page where it talks about market power. ‘‘By most accounts,’’ and I am quoting, ‘‘By most accounts, the

problems that gave rise to creation of the housing GSEs have been

corrected. Correction is generally measured in terms of the degree.’’ So are you saying that the circumstances and conditions that

gave rise to GSEs in this area are no longer out there, that the

need no longer exists?

Ms. MILES. The academic studies that have been done on this

would say yes, that is correct. The argument then becomes one of

does the market failure reappear if you remove GSE status from

the market and that is where most of the argument would be

today.

Mr. HOEKSTRA. OK.

Mr. ELY. If I could add something to that?

Mr. HOEKSTRA. Yes.

Mr. ELY. We have a substantial amount of asset securitization in

this country that has nothing to do with the GSEs, in the jumbo

mortgage market, credit cards, and auto loans. The markets have

learned how to securitize assets. If Fannie and Freddie went away,

the markets would still be able to securitize mortgages.

Mr. HOEKSTRA. Thank you.

Ms. MILES. And if I could pick up on one thing there. I do not

know of anyone who is actually advocating that Fannie and

Freddie go away. I have heard a lot of advocacy that they simply

graduate out of their GSE status, which is a different question.

Mr. HOEKSTRA. Right. And they graduate out of GSEs to move

them away from the benefits that I think all three of you talked

about in your testimony that they receive as being identified as a

GSE.

And I would also assume if we moved them away from a GSE

we would also perhaps move away some of the risk that is associated with the taxpayer. Would that be safe to say?

Mr. ELY. Yes.

Mr. HOEKSTRA. OK. Because I think where I then start getting

some concerns, I think, again, Ms. Miles, on page 5 of your testimony, you talk about them repurchasing their mortgage-backed securities and it is toward the bottom of the page. ‘‘While it is clear that this increases shareholder value, it is difficult to understand what, if anything, it does for mortgage markets.’’ So this really—what I see at least I think all three of you talking

about in your testimony, you are seeing behavior out of these GSEs

that is not associated with their primary mission, but is associated

with their mission to their shareholders of meeting the commitments that they have made to their financial markets.

Is that what you are saying here on page 5?

Ms. MILES. That is correct. And one of the things to bear in mind

is when we set up GSEs, I tried to make clear right up front, we

set up something that has an inherent contradiction in it. Because

while it has a public purpose and those charters are intended to

be tools to take care of that public purpose, we also set them up

200

as private enterprises with a fiduciary, a legal responsibility to

their shareholders. There is a tension there.

Mr. HOEKSTRA. That is right.

And then, Mr. McCool, in your testimony on page 6, you are

using the same type of examples. ‘‘We pointed out that the enterprises have incentives to use the funding advantage associated

with their government sponsorship to make non-mortgage investments, such as corporate bond purchases, that may result in arbitrage profits.’’ Again, you conclude, ‘‘However, our report concluded that the relationship between long-term non-mortgage investments and the

enterprise housing mission is not entirely clear.’’ So you are saying the same thing, that there is not—activity that

the GSEs are engaged in may or may not be directly related to

their primary mission.

Mr. MCCOOL. There are cases where that is very true. There are

cases where non-mortgage investments are necessary to maintain

liquidity and there are other cases, we suggest, where that relationship is not clear.

Mr. HOEKSTRA. And then at the bottom of page 6, you go on to

talk about, ‘‘For example, in our March 1998 report, we pointed out

that HUD approved a new mortgage program Fannie Mae that

would involve Fannie Mae in purchasing cash value life insurance,

which is essentially a non-mortgage investment. HUD officials told

us that they lacked expertise in cash value life insurance when

they approved the Fannie Mae program.’’ We are seeing these organizations move into an area where it

may be higher risk to the taxpayer, it gets to be even higher risk

if the people that have oversight over them do not understand the

activities that they are engaging in. Is that what you are saying

in this section?

Mr. MCCOOL. Well, part of the issue there was we thought it

would have been prudent for HUD to talk to, in this case, Treasury, who actually does understand cash value life insurance and,

in particular, the tax treatment thereof, which was one of the

issues. But in this case, that discussion did not occur.

Mr. HOEKSTRA. Well, what you are saying is that for an organization whose debt approaches that of Treasury and in some form

is overseen by HUD, HUD is approving activities and actions that

it does not understand.

Mr. MCCOOL. In this particular case, I think that was true.

Mr. HOEKSTRA. Mr. Chairman, I have no more questions. Thank

you.

Chairman SUNUNU. Thank you, Mr. Hoekstra.

Mrs. Clayton.

Mrs. CLAYTON. Thank you, Mr. Chairman. I also think this is a

significant hearing. I would also ask if my opening statement may

be a part of the record.

Chairman SUNUNU. Without objection.

[The prepared statement of Eva M. Clayton follows:]

PREPARED STATEMENT OF HON. EVA M. CLAYTON, A REPRESENTATIVE IN CONGRESS

FROM THE STATE OF NORTH CAROLINA

Chairman Sununu, this is the latest in a series of hearings and other activity that

have focused on this important subject.

201

On July 18, our colleague, Congressman Peter Hoekstra, issued a ‘‘Dear Colleague’’ calling for ‘‘A Healthy Debate on the Future of GSEs.’’

That call came on the heels of five hearings on GSEs that have been conducted

in Congress, this session.

Those hearings centered around a Bill, H.R. 3703, that has been introduced by

our colleague, Congressman Richard Baker.

Despite those hearings, it appears that we are still searching for the right thing

to do in this situation—There is no emerging consensus.

I believe it is important and useful that Congress exercise its oversight authority,

especially on a matter—housing—that affects all of our citizens.

Home ownership rates in the United States have reached historic levels.

One of the questions I hope this hearing will help answer is whether the role of

the GSEs has substantially and significantly contributed to this desirable rise in

home ownership?

And, if so, will the call for reform help or hurt this role?

No one likes debt.

But, another question I hope this hearing will answer is whether the debt of GSEs

is something about which we should be concerned to the point of panic.

It is fair to say that, while comparison of GSE debt to Treasury debt is of some

use, the comparison is not exact.

They are not the same.

Still another question I hope this hearing will help to answer is whether the

GSEs, by their activities, are exposing our Government to unreasonable and unacceptable risk?

Not all risk is unreasonable and unacceptable.

A related question is whether the GSEs, through their debt, are adding to or contributing to the debt of the United States.

We have worked hard to eliminate the national debt, and we are on track to do

just that by 2013, and activity that impedes that progress must be closely scrutinized.

What is the fundamental role of the GSEs, and can that role be better performed

by some other entity?

Is the current arrangement with the GSEs in need of repair, restructuring, radical

change?

And, finally, I hope this hearing will help us to answer the question, what is best

for the consumer—- what is best for the American people?

Can we have home ownership, without debt?

Can we ensure that every citizen, regardless of their station in life, with hard

work, determination and careful budgeting, has a chance to own a home, without

the involvement of the GSEs?

While home ownership has reached historic levels in America, still, for many, it

is out of reach.

Like home ownership generally, minority home ownership has grown.

Yet, despite that growth, home ownership among African- Americans today stands

at just over 47 percent.

And home ownership among Hispanics stands at roughly the same amount.

Yet, the home ownership rate among whites is close to 75 percent.

Home ownership, Mr. Chairman, is the backbone of this Nation’s way of life.

Whatever we do, we must promote that important goal.

Before we change anything, we must be clear as to whether what we have now

is a benefit or a burden.

And, even if it is a burden, when weighed against the good it does, is it a necessary burden.

Under current law, Fannie Mae and Freddie Mac face strict supervision and examination by OFHEO, which has a staff of 95, whose full-time responsibility is to

oversee these two entities.

Fannie Mae and Freddie Mac will argue that they employ sophisticated interestrate and credit risk management strategies, strategies, they will say, which provide

more than adequate protection.

Fannie Mae will argue that it is limited by charter to investing in residential

mortgages only

They will point out that In the 1980’s, most S & Ls failed because, through deregulation, they were allowed to invest in endeavors far beyond home mortgages.

Most of the S & Ls that stayed with their traditional mortgage business recovered, they say.

And, finally, Fannie Mae will argue that any increase in its debt does not in any

way increase the indebtedness of the U.S. government.

202

Their obligations, they say, are not in any way backed by the full faith and credit

of the United States Government.

In fact, they argue, the law requires that the front page of all their debt and mortgage-backed securities state that they ‘‘are not guaranteed by the United States and

do not constitute a debt or obligation of the United States.

Indeed, I have heard nothing to this point to suggest that the GSEs are not doing

a good job.

Moreover, I have seen no evidence that they are not well managed.

Indeed, for example, the OFHEO 2000 Report concludes, ‘‘At year- end 1999,

Fannie Mae exceeded safety and soundness standards in all examination program

areas. Mr. Chairman, I believe first and foremost, we must maintain our ability to encourage home ownership opportunities in America—for everyone.

I look forward to the testimony of our witnesses.

Mrs. CLAYTON. I guess I want to pick up on Mr. Hoekstra’s remarks. Let me just make a statement also.

I think we are indeed enjoying historical highs in terms of people

enjoying the American way of home ownership, and I think that is

a good thing. I think indeed people have calculated making debt no

one likes but taking a risk and having access in their homes, they

think that is a worthwhile activity. And so we are having historical

highs right now where people are making the calculation, buying

a home, and I certainly encourage that, but I think I would be remiss to suggest that the issue has been addressed sufficiently.

When you look at those historical highs, there is a disproportional benefit. Minorities are not increasing their homes at the

same rate. Working middle class are now having stress. There is

a recent article, I guess about 3 weeks ago, in the high tech areas

where working people who are making 60 and $75,000 a year are

finding it difficult to afford homes. So there is a constraint in the

market.

I think we acknowledge great things are happening for many

Americans, but to suggest that there is not a need for these entities

that provide for an easy way for most Americans to get housing I

think is inaccurate, so I want to challenge that.

And I do not know if you are saying that you feel that there is

no longer any problem in the marketplace, I want to suggest there

is a problem in the marketplace. Contrarily, I think because we are

indeed enjoying great prosperity in certain areas, you ask people in

Silicon Valley, you ask people in Oakland, you ask people in the

Washington area, you ask people where there is opportunity for

growth, they are not able to afford a home. So that prosperity has

almost driven the value of the land itself and house to move and

there is great genderfication going on right now, so I do not want

it to be missed in this hearing or any other hearing that we have

addressed all the housing areas.

Having said that, also, the testimony for all three of you seemed

to suggest that the risk of the debt is not—well, I take exception,

Mr. Ely, you do not suggest that because your very point is indeed

that debt is a risk—but it would seem to me that you are—both

of you have indicated, the GAO as well, tell us that the debt itself

is not as much of a risk.

Am I right in assuming that?

Mr. MCCOOL. Well, we have not actually made an explicit statement about that, I do not think. I mean, I guess——

Mrs. CLAYTON. Well, let me ask you——

Mr. MCCOOL. The issue really comes down——

203

Mrs. CLAYTON. Is the debt that Fannie Mae and Freddie Mac

hold implied to be risky and therefore we should indeed think

about restructuring, changing the structure drastically? Is that a

sufficient concern we ought to look at it? Is it fair to compare the

debt of those entities with the United States? The debts are quite

different, so is it really a serious problem?

Mr. MCCOOL. Well, again, the debt or the securities and mortgages that Fannie and Freddie hold are somewhat more risky than

issuing mortgage-backed securities, but the point is that OFHEO

is charged with overseeing their activities to make sure that the

risks are managed well, hedged well, and that they have a riskbased capital standard in place that would protect the interests of

the government. So the risks are relative.

Mrs. CLAYTON. The risks are relative to the management and

having instruments——

Mr. MCCOOL. And being well regulated.

Mrs. CLAYTON. How different is that, Mr. Ely, since you think

that Fannie Mae and Freddie Mac debt is really troubling and how

different is the risk of the banks that have this same—they buy

back securities, they have whole loans. My understanding, you represent them. How are you advising them about their debt?

Mr. ELY. Well, I am not advising banks with regard to that. I

just——

Mrs. CLAYTON. No, you advise the banks.

Mr. ELY. I am a student of what their practices are. What concerns me about the GSEs, particularly relative to the banks, is twofold. Number one, they are more thinly capitalized, particularly

with regard to credit risk. The second thing is that they are less

diversified. This is a point that the other witnesses made. Fannie

and Freddie are focused on just one sector of the economy.

Mrs. CLAYTON. Let me stop you there. They are less diversified.

I thought they were chartered for an explicit mission, to encourage

their instruments, and the advantage they had of being chartered

to direct most of their attention to the mortgage financing of

homes. So their less diversification is consistent with their mission.

Mr. ELY. Well, that is true, but we have to understand that there

is a down side to that and that is the lack of asset diversification,

the concentration in housing finance.

The fact that they are buying mortgages and guaranteeing mortgages from all over the country helps to diversify that risk, but we

cannot lose sight of the fact that they are focused strictly on housing finance whereas commercial banks generally have a broader

range of assets. That is why, when you combine the higher capital

levels of banks and thrifts with their greater asset diversification

and their balance sheets—and also the fact that Federal deposit insurance has been essentially set up as an industry self-insurance

mechanism, the banking and thrift industries do not pose the taxpayer risk that Fannie and Freddie do.

Mrs. CLAYTON. Banks do have some subsidy. I do not want you

to suggest that they do not have some. I think it is a matter of

judgment as to which of the ones pose a risk, but banks do. That

is part of what we give the depositor, that the government does indeed back some of their deposits to a certain level. So to suggest

204

that only the entities that are GSEs are posing a great risk, I think

that is inappropriate.

Mr. ELY. Well, if I could address that question, I would like to

file a paper with the committee which argues that actually the

banking industry, the nation’s banks and thrifts, do not receive any

Federal subsidy at all. If anything, the subsidy actually flows the

other way.

Chairman SUNUNU. Thank you, Mrs. Clayton.

Mr. Toomey.

Mr. TOOMEY. Thank you, Mr. Chairman.

I would like to follow up on a question that is tangentially related to what we were just discussing. Certainly if you look at the cost

of funds relative to capitalization, there is a subsidy going on for

the GSEs. I think that is pretty clear.

I am interested in pursuing a point that Ms. Miles raises in her

testimony on page 4 in particular, where there seems to be a dynamic here that I was hoping you would comment and elaborate

on a little bit and that is as follows.

The magnitude and the value of the subsidy, the implied guarantee, the various government benefits conferred upon the GSEs,

clearly grows with their size and that creates an added incentive

for these institutions to grow, arguably above and beyond the normal incentive that every corporation has to grow.

When any company grows, certainly a publicly traded company,

certainly a company that issues debt, there are a number of market

forces that put a check on that growth, that that growth be prudent and that there be sufficient capital to sustain that growth.

And if a company does not have—if there are concerns, then the

market will impose costs on a company such as a higher cost of

funds, a lower price of its share, various mechanisms that the market has to keep that growth in check in a sustainable level.

When we have an implied government guarantee and when the

market is convinced that the government is backing these institutions and it would not be allowed to fail, you raise the point that

maybe that normal market discipline is weaker than it would be

with another company, a company without such an affiliation.

So my question is have we created an inherently unstable dynamic, where we have created extra incentives to grow and we

have reduced the market discipline that normally holds that

growth in check and requires that to be done in a prudent fashion?

Is that not an inherently long-term unstable situation?

Ms. MILES. It certainly can be. Bear one thing in mind. As long

as the GSEs do have positive shareholder value, they have plenty

of reason to exercise their own discipline and not go into an area

where they would jeopardize that. If, however, they lose that value,

they then have no reason not to gamble and go in for very big

risks, knowing that they have lost everything they can lose. A big

risk gives you the opportunity of getting back out of trouble and

restoring shareholder value, but if you lose everything, you basically put it back on somebody else.

That is where it becomes very unstable and that was essentially

what did happen with the savings and loan industry in the 1980’s.

205

Mr. TOOMEY. So if I could sort of summarize what you are saying, in good times and when things are going well, this dynamic

may not be very dangerous. The problem is sort of—— Ms. MILES. When things do not go well.

Mr. TOOMEY.—leveraging up and doubling up your bet when

things are looking rather grim.

Ms. MILES. That is correct. The less capital you are carrying the

more quickly that kind of situation can come upon you.

Mr. ELY. If I could add something to that, there is a second form

of discipline and that is credit market discipline. In other words,

the debt markets. One of my real concerns is that the credit markets are not providing the discipline over Fannie and Freddie that

they should, which is very important given how highly they are leveraged, because of their implicit Federal guarantee.

Mr. TOOMEY. Al right.

Mr. Ely, you mentioned, if I recall, during your testimony that

there are numerous reasons why Fannie Mae or Freddie Mac might

run into financial problems, including events outside the U.S. financial system.

Did I understand you correctly? If so, could you elaborate on

what some of those exogenous events might be?

Mr. ELY. Well, you know, I could sit here all day long and come

up with examples and not hit the mark. One of the problems with

the world is that problems can come out of left field that no one

anticipated and yet they have a disruptive effect on the market.

The impact of the Russian debt crisis in the summer of 1998 is

a very good example. It caught a lot of people unawares. It did

have magnification effects in the U.S. financial markets.

Mr. TOOMEY. Specifically did it have any impact on interest rates

associated with mortgage-backed securities? Or the whole loan

market for that matter?

Mr. ELY. In that particular case, there was a flight to quality,

and Fannie and Freddie were beneficiaries—— Mr. TOOMEY. It was actually a good thing for the mortgagebacked securities market.

Mr. ELY. At that time, but there were other credit markets that

suffered quite a bit, particularly the junk bond market. Next time,

it could play differently.

I will give you one example that I worry about a lot and have

written about and that is the Japanese financial situation. You

have a country that is increasingly indebted, and with very weak

financial institutions.

If there is some kind of accident in Japan, I could see global effects of that. And next time, it may not inure to the benefit of

Fannie and Freddie. So we just cannot expect the same kind of reactions to the next crisis that we have had in the past.

Mr. TOOMEY. Thank you.

Thank you, Mr. Chairman.

Chairman SUNUNU. Thank you, Mr. Toomey.

Mr. Minge.

Mr. MINGE. I would like to ask two questions. First, to what extent do you believe the interest rates on residential mortgages are

lower because of Fannie Mae and Freddie Mac and the Federal

Home Loan Bank institutions?

206

And I would ask this of any of you.

Mr. Ely, I will start with you.

Mr. ELY. They may be lower, but that is only half the equation.

The other question is, and this is one again I have explored a little

bit, to what extent are the lower interest rates capitalized or possibly even overcapitalized in housing prices? In other words, you

can afford to pay more for a house because the interest rate is

lower?

Some work I have done with Fed Flow of Funds Data suggests

that at times we have possibly had an overcapitalization of the subsidy in housing prices. Specifically, overcapitalization is reflected in

the residual value of land underlying owner-occupied housing.

So it is not enough to say that rates are lower. You also have

to look at what the effect of lower rates is on housing prices because if lower interest rates have been capitalized in housing

prices, then the beneficiaries of the subsidy, if you will, are the sellers of homes, not the buyers.

Mr. MINGE. I assume that observation, then, would apply to the

availability of housing credit generally, that if we have housing

programs we might make it easier for people to finance housing

which in turn would drive up the price of housing because of greater demand.

I do not want to debate this, except to say that I think that you

can take that to its logical extreme.

Mr. ELY. Well, you have put your finger on a fundamental policy

issue. The broader a subsidy is the more likely it is to be capitalized in the price of assets. A targeted subsidy is less likely to have

that effect, which is why I believe that one of the issues that needs

to be addressed in the housing finance area is to what extent the

subsidy is misdirected and going to people who do not need it, versus those who are presumably at the cusp of home ownership and

therefore warrant a subsidy.

Mr. MINGE. So maybe we should have high interest loans so we

do not have a lot of competition for housing and we keep the price

of housing down.

Mr. ELY. No, I am not arguing for that at all.

Mr. MINGE. Mr. McCool, let me direct that same—not the little

exchange that we have just had, but the question of whether or

not——

Mr. MCCOOL. We estimated in our privatization report of 1996

that the housing enterprises probably reduced mortgage rates by

something in the range of a quarter—about 25 basis points, about

a quarter of a percent.

Mr. MINGE. Ms. Miles.

Ms. MILES. I pretty much agree with that. One of the ways to

measure that is to look at the difference between the jumbo market

where Fannie and Freddie cannot purchase mortgages and the conforming market, and it is generally 25 to 30 basis points. That

might not be the whole story.

In fact, I would argue that the great success story that is involved here is that we have far better integration of housing finance markets and capital markets generally and that is something that has occurred for a variety of reasons. You no longer get

the great curtailments of mortgage financing whenever interest

207

rates rise, but you will get some arguments as to whether that was

all Fannie and Freddie’s doing.

Mr. MINGE. Another question I would like to ask, if I can, and

this guy is sitting here with a clock, so I get just a little sliver of

this time—— Chairman SUNUNU. I will be as generous as possible.

Mr. MINGE. Well, thank you.

I am concerned with Fannie Mae and Freddie Mac and the others, when they issue their securities and the collateral is series of

mortgages that they are holding on residential property, with a

right of prepayment under certain circumstances, there may be

generally, then the question is do they match that up with the

right to call those bonds without penalty?

What have you observed in that respect? And I guess the interest

rate risk that we are talking about to some extent is whether or

not there is a match between the prepayment risk that occurs and

the ability to call bonds so as to issue new bonds at a lower interest

rate or more competitive interest rate to keep these interest rates

in synch.

Mr. Ely.

Mr. ELY. Well, both agencies do issue callable debt which helps

to protect them if rates are going down. They also enter into interest rate swaps to protect themselves if interest rates are going up.

If interest rates are going up, the prepayment rate drops off. But

what is important to realize here is that these mechanisms do not

work perfectly. While callable debt is a good way to handle the increased prepayment rate due to a decline in rates, if rates are moving up, I have a greater concern because that introduces

counterparty risk into the equation.

Mr. MINGE. OK. But if the interest rates are moving up, then I

suppose that Fannie Mae or Freddie Mac would decide not to call

those bonds, leave those bonds out there and homeowners are not

going to go out and refinance under those circumstances, so you

would have a level of stability just based upon the nature of the

market in that setting.

Mr. ELY. That is correct.

Mr. MINGE. I am also quite intrigued with the advantage that

you have identified, sort of an arbitrage advantage to Fannie Mae

and Freddie Mac investing in their own securities for the purposes

of internalizing the interest rate risk is, I believe, how you described it.

Now, maybe I have mis-identified this. To those of us that do not

come from such rarified financial backgrounds, it has a certain

mysterious side to it and I am wondering if you can offer any additional explanation that would help us better understand how this

creates profitability and, secondly, how it increases risk.

Mr. ELY. Well, if you take a look at the two basic risks, the credit

risk and the interest rate risk, when mortgages get securitized,

mortgage-backed securities are issued and the interest rate and

prepayment risks are shifted to whomever buys the mortgagebacked securities.

When Fannie or Freddie buy back their own MBS, they take that

risk back in or to use Ms. Miles’ term, they repatriate the risk. So

they have brought the interest rate risk back on their balance

208

sheet, but they are earning additional interest income spread to

compensate for that risk.

The great question is are they earning enough additional spread

to compensate for the interest rate risk that they have reassumed.

Chairman SUNUNU. Thank you, Mr. Minge.

Mr. Ryan.

Mr. RYAN. I think that this has been a very helpful hearing. I

am on the relevant banking subcommittee which goes over these

issues and I do not think I have heard a more in depth discussion

about GSE debt per se. So I am intrigued with the depth that we

have gone into in this.

Mr. Bentsen basically asked precisely the question that I was

going to ask, but I would like to go back to this issue of repurchasing mortgage-backed securities and ask each of you a question.

Number one, I think when you look at GSE debt, and that is the

scope of this hearing, you can kind of divide it into two areas, mission critical debt which is used to securitize the secondary market,

which would obviously grow as the mortgage market grows, then

you have what some people call excessive debt, which is the debt

that is issued solely for the repurchasing of mortgage-backed securities or retaining mortgage-backed securities on the books. It involves a new kind of risk, an interest rate risk or a prepayment

risk. There is an arbitrage activity that is occurring which clearly

is profit derived. I think we have established that here.

I would like to ask you does the repurchasing of mortgage-backed

securities, specifically the alarming pace of the repurchasing of

mortgage-backed securities, I think 4.6 percent in 1992 was retained, now it is about 30 percent of mortgage-backed securities are

retained by both Freddie and Fannie, does that in any way notably

extend and advance home ownership?

Does it put a new person in a home? Is it mission critical? And

then I have a follow-up, but if you can answer that quickly I would

appreciate it.

Barbara, why don’t we start with you?

Ms. MILES. How brief can I be? I would say no, I do not think

so.

Mr. RYAN. That is great. Thanks.

Mr. MCCOOL. We would, I think, agree that there is no clear advancement of the mortgage market by repurchasing mortgagebacked securities.

Mr. ELY. Mortgage repurchases are not mission critical.

Mr. RYAN. OK. So repurchasing the mortgage-backed securities

you would then say is clearly done for the ROE, for profit, for the

shareholder directive. Would you concur with that?

Barbara.

Ms. MILES. By and large.

Mr. MCCOOL. Again, we have not really studied that specifically,

but I would suspect that, again, it is a risk/return tradeoff that is

probably driving it.

Mr. ELY. Yes.

Mr. RYAN. OK. So if we are establishing that repurchasing mortgage-backed securities is done with an arbitrage activity for the

ROE, it kind of goes down to the issue that we have a contradictory

mandate, a structure that is inherently contradictory, Hobson’s

209

choice, whatever you may say, mission critical housing mandate by

Congress overseen by OFHEO which is to securitize the secondary

market, but now you have the repurchasing of these mortgagebacked securities which clearly adds to the ROE, something you

cannot really fault a company that has shareholders as well, but

something that raises very interesting questions because there is

an implied guarantee. Our job is to steward and watch over taxpayer risk.

Do you believe that this prepayment risk is sufficient hedged

against? Do you believe that the mortgage-backed security risk, the

interest rate risk is sufficiently addressed or do we even know

whether it is sufficiently addressed and do you think OFHEO is capable of calculating whether or not that risk is sufficiently hedged

or offset?

We will start with you, Barbara.

Ms. MILES. That is really a question I hope you ask OFHEO.

They have what looks to me to be a very nice capital standard

model. It is not yet in effect, there are a lot of questions about it.

By and large, it appears to handle within certain bounds the kinds

of limits you would want it to handle.

The question I would have is will it give you a signal quickly

enough if things really go badly. And given that we are talking

about relatively low capital levels, I cannot give you a good answer

to that.

Mr. RYAN. Mr. McCool.

Mr. MCCOOL. Again, I think that that is a question for OFHEO,

as Barbara has suggested. And, in fact, I mean, again, this whole

idea of the GSEs buying back mortgage-backed securities and having more risk on their portfolio should be certainly into account by

their risk-based capital standard. And it is. So a lot of that should

all be played out in their risk-based capital standard and in

OFHEO’s examination process. But that is a question, as I said, to

ask them.

Mr. ELY. In my opinion, outsiders cannot judge how well Fannie

and Freddie are managing that risk based on the information that

is publicly available. I find it troubling that there is not sufficient

information available to the public, specifically to the investment

community, to judge that risk and its management.

Mr. RYAN. Thank you. I think it is important, and I will briefly

summarize here.

Did you want to interject?

Chairman SUNUNU. No, I just wanted to ask specifically can you

give an example of what information is not available that would

enable that judgment to be made?

Mr. ELY. In my opinion, based on the footnote disclosures that

I read, that we get kind of bits and pieces of information. We are

not presented with a total picture in a comprehensive way, even

though it may be summarized, as to how they are managing the

risk and what the risk characteristics are particularly of their

counterparties.

Mr. RYAN. If I could interject, I think it also goes to the question

that we really do not know how reliable the hedging techniques

are. Hedges have obviously advanced since the early 1990’s, but no

one including OFHEO or any of us know if this is properly hedged,

210

how well the hedges would work and, you know, we had a similar

problem where we had paper insolvency of Fannie Mae in the

1980’s where you had an interest rate problem, you had an interest

rate risk, Freddie did not engage in the same kind of activity and

also missed out on having the paper insolvency. So I think it is an

interesting issue.

What is interesting that I think we have established here in this

hearing is that the debt which is relative to mortgage-backed securities in retaining or repurchasing the mortgage-backed securities,

repurchasing is a term that has been in question, but it is a term

that is used in Freddie Mac’s annual report, so I will use the repurchasing of mortgage-backed securities, the debt associated with

that is by and large it seems like our panel has agreed to is excessive debt, non-mission-related debt and debt that is more or less

used for profit.

Thank you. I yield back my time.

Chairman SUNUNU. Thank you, Mr. Ryan.

Mr. Ely, for clarification, the example you gave of information

that is not disclosed to the extent that you would like it to be to

render judgment about risks is counterparty risk. I assume you are

talking about the counterparty risk involved in primarily the interest rate swaps that the GSEs use to hedge their debt.

Can you give an example or are there examples of other publicly

traded companies that disclose counterparty exposure in their

hedging strategies?

Mr. ELY. One could argue that there is no such thing as enough

disclosure. It has been my experience, as I read their footnote disclosures, that I do not get as much and I do not get as complete

a picture as I would like to see.

Chairman SUNUNU. Is there a difference between getting as

much information as you would like and getting as much information as you would get from a comparable firm or from a firm that

is not regulated or sponsored in any way by the mortgage-backed

securities?

Mr. ELY. In my opinion, bank holding companies basically provide a more complete disclosure than Fannie and Freddie do.

Chairman SUNUNU. Bank holding companies disclose

counterparty exposure in interest rate swaps?

Mr. ELY. They provide more insight into the nature of the risks,

into the nature of their counterparties, and in other regards to the

swaps. You basically get more numbers, you get more detail. Although I will say this, it is not comparable across the different

companies. You can find fault with any one company’s disclosure.

One difference is that the bank holding companies and other financial firms issue financial statements that are subject to SEC

oversight, which is lacking in the case of Fannie and Freddie.

Chairman SUNUNU. Fair point. Thank you.

Mr. Smith.

Mr. SMITH. Mr. Chairman, just briefly.

Again, would you give me your impression of the assumed liability of the Federal Government in terms of what is anticipated from

those buying these bundles from Fannie Mae or Freddie Mac? Is

there implied liability of the Federal Government in terms of exVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00214 Fmt 6601 Sfmt 6602 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
211

pectations of the government somehow bailing out Freddie Mac or

Fannie Mae if they were to go into trouble?

Ms. MILES. I always try to be really careful how I answer that

because we officially deny that there is any responsibility at all.

But if you take a look at the list of ties, links to the Federal Government, they clearly imply something and the market infers something. The market believes, obviously, in the way they price Fannie

Mae and Freddie Mac paper, and for that matter the Federal Home

Loan Banks as well, that there is a sufficient nexus that the government would do something. And any time the market believes

that relationship is being challenged, things change. We had an example of that in March.

We had a little bit of a decrease in spreads between GSE paper

and triple-A paper. Not a big one, but it is still there.

So there is something that is being inferred. I do not want to be

in a position of measuring it, but something is there. Beyond some

point, presumably, the market perception may also break. At that

point, the government might decide to step in. Again, Bert’s example of the Farm Credit System.

Mr. SMITH. And Tom and Bert?

Mr. MCCOOL. Well, again, I would echo Barbara’s idea that clearly the market perceives there is some connection. But, I mean, the

extent to which there is or is not a government bailout should that

ever arise is up to the administration and Congress to decide. I

mean, that would be a decision for you folks.

Mr. ELY. As I said in my testimony, we have two clear cut examples of a GSE rescue: the Farm Credit System back in 1988 and

then the FICO bonds in 1996. When I talk to people in the Wall

Street community and ask them this question, they have no doubt

in their minds whatsoever that if there was a problem with any of

the GSEs, the Federal Government, in one way or another, would

ride to the rescue to protect creditors, that is holders of debt and

MBS, against any kind of loss.

There is a totally different story for stockholders. Stockholders

might get wiped out, but the belief in the credit markets is the

Federal Government would ride to their rescue. Given their size

today, the government would ride to the rescue sooner rather than

later.

Mr. SMITH. It just seems based on your answers, Mr. Chairman,

maybe there are two alternative actions of the Federal Government, either to charge Freddie Mac and Fannie Mae a fee for this

underwriting, if you will, or to somehow take action to make it

clear that they are independent organizations and even though

they are a government-sponsored enterprise, the Federal Government is not underwriting any liability that might develop.

If we were to do the latter, what kind of action might the Federal

Government take to send out a signal to the marketplace that we

are not going to underwrite them if they have problems?

Mr. ELY. I will jump into that. I do not think there is any credible action the Federal Government could take. Fannie and Freddie

are government-sponsored enterprises. As long as they are creatures of Congress, they are subject to special Federal oversight. In

my opinion, you cannot credibly say that they are not backed by

the U.S. Treasury and the U.S. taxpayer.

212

Mr. SMITH. Then, Mr. Chairman, I would come down on the side

of starting to charge them a 1 percent fee for that insurance that

probably is more real than implied and, again thank the witnesses

and yield back.

Chairman SUNUNU. Thank you, Mr. Smith.

Mr. Bentsen had some follow-up questions.

Mr. BENTSEN. Thank you, Mr. Chairman.

My colleague will probably be getting some mail as a result of

this.

Mr. Ely made a good point, we need to remember this, that the

fact that the GSEs are in this position today did not just happen

out of the blue. It happened because Congress established this with

a purpose in mind in the 1930’s and with a purpose in mind in the

1960’s.

And I know there has been discussion about the fact that banks

and thrifts hold a GSE debt in a greater proportion than they

would be allowed to hold the debt of a single corporate interest or

if it were a loan to an individual. But that is also because Congress

in the Bank Holding Company Act and other subsequent acts included GSE debt as a qualified investment, I believe, if I am correct about that.

There are reasons why we did that. We, being the royal we, did

that because we believed that through the GSE structure we were

in effect establishing a subsidy for the benefit of the American people to get into home ownership.

Has that worked, is the first question.

Second of all, if it could have been done without, which I am not

sure that it could have, that you could have had the same stable

mortgage market at least up until the 1980’s when the mortgagebacked securities market came about in the extent that we see it

today, would you have had the same stable interest rate environment for mortgage finance and the ability of Americans to get into

homes?

And if that were the case, if in fact we did not need to do this

at all, if you can make that argument, would the risk still exist because the ultimate risk we are talking about here is the risk to the

American mortgage market.

The systemic risk that might—and I say might—come from

Freddie and Fannie has to come from the standpoint that—in two

instances, it seems to be, one would be bad management practice

on the part of the GSEs themselves, and we assume through shareholder vigilance and OFHEO’s job and HUD’s job and Congress ultimately that that is watched.

The other is the credit risk associated and interest rate risk associated with the general economy. If we were to eliminate the GSEs

tomorrow and assume that there were still 67 percent home ownership rate in the United States, somebody would have to hold that

paper, including the banks and thrifts who might not be holding

as permitted or qualified investments GSE debt or MBS, but would

be holding a very high level of whole loans and portfolios or privately issued MBSs. So the risk would still exist.

Would the systemic risk still exist as well as a result of that,

that U.S. banks and thrifts might be more susceptible to a meltdown in the mortgage market?

213

Mr. ELY. Well, I will stick my neck out on that one.

Obviously, the market would be different. We would see, first of

all, a lot of privately issued MBS, just like we do in the jumbo

mortgage market now, so there would be at least a geographical

spreading of the credit risk.

What we might see is possibly a somewhat less leveraged investment in housing and finance. I, for one, am troubled by the fact

that as part of the overall debt build-up in the economy, we are

seeing steadily increasing leverage in housing finance. That in

itself is potentially destabilizing. So I think we might see greater

equity in homes.

But I would like to come back to your point about the subsidy.

The question is: should there be a subsidy and, if so, what is the

best way to deliver it? This question should be addressed in the

coming years in Congress. Do the GSEs represent the best way to

deliver the subsidy or are there alternative mechanisms for delivering the subsidy that focus it on those who, for whatever reason, are

most deserving of the subsidy?

The CBO study in 1966 suggested that in effect Fannie and

Freddie were not very efficient in delivering the subsidy. What they

did not say, and I am sorry they did not—— Mr. BENTSEN. Excuse me, in 1996 or 1966?

Mr. ELY. I am sorry, 1996. I misspoke. The study from 4 years

ago. What CBO did not get into is the extent to which the subsidy

that Fannie and Freddie deliver is going to people that do not need

a subsidy. They are middle income and above.

So there really are two policy issues that have to be dealt with

here, one of which you touched on and that is the whole issue of

financial stability generally, no matter how the financial markets

are structured. The other is the issue of what is the best, most efficient, fairest way to deliver whatever housing finance subsidy is

needed in this country in order to promote home ownership.

Mr. BENTSEN. Bert, can I just ask you to follow up on that?

Would we have achieved the same home ownership rate, say, by

1980 without the GSEs compared to what we did achieve, in your

opinion?

Mr. ELY. Sheer speculation, I could not have an answer on that,

but I do not believe we had to have the GSEs in order to get home

ownership to where it is today. For instance, if we had a subsidy

targeted to just those people who are on the cusp of home ownership, where they need a subsidy in order to move from being a

renter to a buyer or homeowner, then you would get that increase.

The problem with much of the subsidy today is it is going to people who are going to be homeowners anyway. They may end up

being able to afford a somewhat more expensive, larger home, but

they still would be homeowners.

So, again, the question is: are there alternatives for delivering

the subsidy other than through the GSEs?

Mr. BENTSEN. Thank you.

Thank you, Mr. Chairman.

Chairman SUNUNU. Thank you, Mr. Bentsen.

I am sure we could question or badger, depending on your terminology, this panel all day, but that would not be fair to our remaining witnesses.

214

I want to thank our witnesses on this panel for their testimony

and remind members that they have 5 days to submit written testimony for the record and call forward our second panel: Armando

Falcon, the director of OFHEO, and William Apgar, the HUD designee to the Federal Housing Finance Board.

Thank you for being here, gentlemen.

Mr. Falcon, since the phrase ‘‘That would be a good question for

OFHEO’’ was uttered more than ‘‘That would be a good question

for the Finance Board,’’ we will be pleased to begin with your testimony whenever you are prepared.

Again, welcome.

STATEMENTS OF ARMANDO FALCON, JR., DIRECTOR, OFFICE

OF FEDERAL HOUSING ENTERPRISE OVERSIGHT; AND WILLIAM C. APGAR, HOUSING AND URBAN DEVELOPMENT DESIGNEE TO THE FEDERAL HOUSING FINANCE BOARD

STATEMENT OF ARMANDO FALCON, JR.

Mr. FALCON. Thank you, Mr. Chairman. I did catch most of those

references to OFHEO. I am pleased to begin.

Thank you, members of the Task Force. As you are aware, the

Office of Federal Housing Enterprise Oversight, or OFHEO, was

established in 1992 as an independent entity within the Department of Housing and Urban Development. OFHEO’s primary mission is to ensure the capital adequacy and safety and soundness of

the two government-sponsored enterprises, Fannie Mae and

Freddie Mac.

To fulfill this mission, OFHEO has regulatory authority similar

to those of other Federal financial regulators, such as the FDIC

and the Federal Reserve. Those authorities include annual examinations, broad rulemaking authority, setting capital standards, enforcement actions and research.

Fannie Mae and Freddie Mac were established to create a secondary mortgage market to ensure a ready supply of mortgage

funds for affordable housing for American home buyers.

To assist Fannie Mae and Freddie Mac in achieving their public

mission, they receive numerous explicit benefits from the Federal

Government. The most important benefit the enterprises receive is

the special treatment the market bestows on their securities. Because of investors’ belief in an implied U.S. Government guarantee

on their securities, the enterprises have been able to borrow money

more cheaply and without the practical volume restrictions faced

by any fully private triple-A rated company.

This market perception allows the enterprises to safely operate

with a higher degree of leverage than fully private firms are able

to do. There is no doubt that the GSEs are large and rapidly growing. As they grow, the implications to the economy, if they were to

fail, also increases. However, the actual likelihood of any failure depends critically on how they are managed and supervised.

I want to assure you, Mr. Chairman, and members of the Task

Force, that Fannie Mae and Freddie Mac are currently in excellent

financial condition and OFHEO has a strong regulatory program in

place to ensure their continued safe and sound operation. If the

215

need ever arose, OFHEO would move quickly and forcefully to correct any financial problems at the enterprises.

OFHEO supervises the enterprises primarily through its extensive and continuous examination work. Our experts maintain a

physical presence at the enterprises at all times and have unlimited access to all levels of management and highly sensitive corporate records. By staying apprised of the enterprises’ risk and

business activities on an almost real time basis, the examiners are

able to evaluate an extensive array of risk related factors and assess the enterprises’ financial safety and soundness.

Each quarter, OFHEO examinations staff issue conclusions related to more than 150 separate components of financial safety and

soundness and thereby provide me with a comprehensive picture of

the enterprises’ financial condition.

Examiners meet frequently with management to discuss and assess business strategies and plans, financial performance results,

risk management structure and practices, and each enterprises’

overall risk profile.

Through our risk focused examination work, OFHEO constantly

evaluates such critical areas as the enterprises’ overall risk management practices, the composition of the risk profile and significant trends in the enterprises’ retained and guaranteed mortgage

portfolios, the enterprises’ ability to effectively manage interest

rate risk and other key financial exposures, the enterprises’ ability

to efficiently issue debt and hedge financial exposures and the

quality of financial performance-related information and market-related information on which the enterprises’ board and management

rely in reaching key decisions.

In summary, the examination group provides us with an accurate

and timely understanding of the enterprises’ financial condition.

Fannie Mae and Freddie Mac have two major lines of business.

First, they guarantee mortgage-backed securities, which are, of

course, securities backed by pools of residential mortgages. Enterprise mortgage-backed securities are highly regarded by investors

and can be issued at interest rates very close to those of mortgagebacked securities with an explicit government guarantee.

This guarantee business has been quite profitable for the enterprises, but mortgage borrowers receive most of the benefit from

these lower borrowing costs. While there is no precise way to measure these savings, recent estimates have generally centered around

25 to 30 basis points, I think as was mentioned by the previous

panel as well.

The enterprises’ second major line of business is portfolio investment in mortgage-backed securities and, to a lesser extent, in

whole mortgages. The enterprises fund these investments primarily

by issuing debt.

Both of these business lines have been growing at the enterprises, particularly their portfolio investment business. Since the

end of 1991, the enterprises’ mortgage assets have swelled from

$155 billion to $900 billion, an increase of approximately 475 percent. A majority of the increase reflects purchases of mortgage securities they had previously guaranteed.

216

Now, to fund the growth of these assets, the enterprises have in- creased their debt outstanding at a comparable rate from $164 billion to $963 billion over the same time period.

The guarantee business has also increased significantly. Total

mortgage-backed securities guaranteed, both those held privately

as well as those held in portfolio, has more than doubled from $731

billion 1991 to over $1.76 trillion today.

Enterprise debt and mortgage-backed securities outstanding now amounts to $2.2 trillion. Adding in the debt of the other GSEs, the

total debt of all GSEs rises to $3 trillion.

Federal reserve estimates for holdings of what is known as agency debt, about 85 percent of which is issued or guaranteed by

GSEs, shows the following breakdown:

Depository institutions hold 27 percent.

Households, mutual funds, trusts and estates hold 21 percent.

Public and private retirement funds hold 16 percent.

Foreign investors, which includes over 60 central banks, holds 12

percent.

Insurance firms hold 9.

State and local governments hold 5.

The balance remaining is 10 percent.

As should be apparent from this data, a financial crisis at the enterprises could have a disruptive impact on investors and the economy. Accordingly, OFHEO has developed and continues to improve

upon a strong supervisory program.

OFHEO is aggressively fulfilling its obligation as a strong and effective regulator. By fulfilling our core mission well, OFHEO protects against systemic risk posed by Fannie Mae and Freddie Mac.

As I have stated before, OFHEO takes a three-pronged approach

to accomplish this goal: examinations, capital regulation and research. I have already spoken about our strong examination program, so I will address our capital standards.

OFHEO’s minimum capital standard, one that is built on traditional ratio based approaches, ensures a base level of enterprise

capital to protect against risk.

Also, we are on track to complete our risk-based capital standard

by the end of the year. This standard will be the first to explicitly

link capital and risk through the use of a model that simulates financial performance of the enterprises under stress. Let me say

here we will complete this rule by the end of the year, Mr. Chairman. While we will have a final capital rule, let me differentiate

here between a final capital and a final stress test.

The stress test will be by its nature evolving and constantly

changing to take into account the different risk profile of the enterprises at any point in time. The risk-based capital standard has to

adjust itself to reflect different activities, different programs of the

enterprises, to make sure it always accurately ties capital to risk,

given what the risk profile of an enterprise is at any particular

point in time.

Any risk-based capital standard like this would be obsolete if it

was not constantly evolving, so part of OFHEO’s job is to ensure

that we consistently and constantly update the risk-based capital

requirement, although at the same time accommodating the enterprises’ uncertainty as to what their capital requirement will be and

217

*This testimony represents the view of the OFHEO Director, which are not necessarily those

of the President or Secretary of Housing and Urban Development.

how it is calculated. It will be a state of the art capital regulation

and I look forward to having it in place, as I am sure the committee does.

Finally, OFHEO is continuing to strengthen its research and analytical capability. We must stay on top of the changes taking place

in the quickly evolving secondary and primary mortgage markets.

This important research and analysis serves to better inform our

examination and capital regulation efforts.

In summary, the enterprises’ rapid growth raises important policy issues regarding their mission and the risk they pose to the financial system. However, because OFHEO is fulfilling its responsibilities, this discussion takes place not in a climate of urgency,

but at a time when the enterprises are financially sound and well

regulated.

Thank you, Mr. Chairman.

[The prepared statement of Armando Falcon, Jr. follows:]

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

FEDERAL HOUSING ENTERPRISE OVERSIGHT*

Thank you Chairman Sununu, Ranking Member Bentsen, and members of the

Task Force. As you are aware, the Office of Federal Housing Enterprise Oversight

(OFHEO) was established in 1992 as an independent entity within the Department

of Housing and Urban Development. OFHEO’s primary mission is to ensure the capital adequacy and safety and soundness of two government-sponsored enterprises

(GSEs)—Fannie Mae and Freddie Mac. To fulfill this mission, OFHEO has regulatory authority similar to other Federal financial regulators such as the Federal

Deposit Insurance Corporation (FDIC) and the Federal Reserve Board. Those authorities include annual examinations, broad rulemaking authority, setting capital

standards, enforcement actions, and research.

The Task Force has taken an important step in convening this hearing to consider

the economic implications of the size and scope of the housing GSEs activities. Because Assistant Secretary Apgar is here today representing the Federal Housing Finance Board, I will focus my discussion on the two entities within my jurisdiction.

In considering these issues, it is important to understand what the GSEs do and

how they operate.

WHO ARE FANNIE MAE AND FREDDIE MAC?

Fannie Mae and Freddie Mac are publicly-held companies chartered by Congress.

They were established to create a secondary mortgage market to ensure a ready

supply of mortgage funds for affordable housing for American homebuyers. They fulfill this very important public mission by buying mortgages from commercial banks,

thrift institutions, mortgage banks, and other primary lenders, and either hold these

mortgages in their own portfolios or package them into mortgage-backed securities

(MBS) for resale to investors. They have become two of the world’s largest financial

institutions.

To assist Fannie Mae and Freddie Mac in achieving their public mission, they receive numerous explicit benefits from the Federal Government, including an exemption from state and local taxation, an exemption from the registration requirements

of the Securities and Exchange Commission, and each firm has a potential credit

line with the U.S. Treasury.

However, the most important benefit the Enterprises receive as a result of their

GSE status is the special treatment the market bestows on their securities. Because

of investors’ belief in an implied U.S. government guarantee on their securities, the

Enterprises have been able to borrow money more cheaply and without the practical

volume restrictions faced by any fully-private triple-A rated company. This market

perception allows the Enterprises to safely operate with a higher degree of leverage

than fully private firms are able to do.

There is no doubt that the GSEs are large and rapidly growing. As they grow,

the implications to the economy if they were to fail also increases. However, the actual likelihood of any failure depends critically on how they are managed and superVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00221 Fmt 6601 Sfmt 6621 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
218

vised. I want to assure you that both Fannie Mae and Freddie Mac are currently

in excellent financial condition, are well-managed, and have exceeded minimum capital requirements every quarter that the requirement has been in place. And

OFHEO has a strong regulatory program in place to ensure their continued safe and

sound operation. If the need ever arose, OFHEO would move quickly and forcefully

to correct any financial problems at the Enterprises.

OFHEO supervises the Enterprises primarily through its extensive, and continuous, examination work. Our examiners possess impressive skills and backgrounds,

and came to OFHEO from banking and thrift regulatory bodies and from the mortgage industry itself. Our experts maintain a physical presence at the Enterprises

at all times, and have unlimited access to all levels of management and to highlysensitive corporate records. By staying apprised of the Enterprises’ risks and business activities on an almost real-time basis, the examiners are able to evaluate an

extensive array of risk-related factors and to assess the Enterprises’ financial safety

and soundness.

Each quarter, the OFHEO examination staff issue conclusions relating to more

than 150 separate components of financial safety and soundness, and thereby provide me with a comprehensive picture of the Enterprises’ financial condition. These

conclusions pertain to such key risk management areas as credit risk, interest rate

risk, liquidity risk, information technology, internal controls, business process controls, internal and external audit, management information and process, and board

of director governance and activities.

Examiners meet frequently with management to discuss and assess business

strategies and plans, financial performance results, risk management structure and

practices, and each Enterprise’s overall risk profile. These discussions include future

trends and management’s controls and practices to anticipate and prepare for potentially adverse trends in any risk areas, or combination of risk areas.

Examination teams identify opportunities for improvements in existing Enterprise

risk management practices and work directly with management to address identified opportunities to enhance financial safety and soundness. Through our risk-focused examination framework, OFHEO constantly evaluates such critical areas as:

• The Enterprises’ overall risk management practices

• The composition, risk profile, and significant trends in the Enterprises’ retained, and guaranteed, mortgage portfolios

• The Enterprises’ ability to effectively manage interest rate risk and other key

financial exposures

• The Enterprises’ ability to efficiently issue debt and hedge financial exposures

• The quality of financial performance-related information and market-related information on which the Enterprises’ boards and management rely in reaching key

decisions

In summary, the examination group provides us with an accurate and timely understanding of the Enterprises’ financial condition.

WHAT DO THE ENTERPRISES DO?

Fannie Mae and Freddie Mac have two major lines of business. First, they guarantee mortgage-backed securities: securities backed by pools of residential mortgages. When investors purchase a mortgage-backed security they are entitled to the

principal and interest payments made by the mortgage borrower, except for portions

earned by mortgage servicers and by the Enterprise which guarantee the payment

of principal and interest. In return for the portion the Enterprise earns, they agree

to protect investors against losses caused by borrower defaults. Enterprise mortgage-backed securities are highly regarded by investors and can be issued at interest rates very close to a mortgage-backed securities with explicit government guarantees. This guarantee business has been quite profitable for the Enterprises, but

mortgage borrowers receive most of the benefit from these lower borrowing costs.

While there is no precise way to measure these savings, recent estimates are generally centered around 25 to 30 basis points.

The Enterprises’ second major line of business is portfolio investment in mortgage-backed securities and, to a lesser extent, whole mortgages that are purchased

directly from lenders and are not parts of pools backing mortgage securities. The

Enterprises fund these investments primarily by issuing debt. The characteristics

of the debt issues are designed so that, in combination with a variety of derivatives

contracts and other hedges entered into by the Enterprises, the values of the debt

and the mortgage securities will be similarly affected by interest rate changes. This

help protect the Enterprises from a mismatch between the cost of funding its operations and the income derived from those operations.

219

Another risk in the portfolio business is that changes in borrowers’ prepayment

behavior, often in response to interest rate changes, are not fully predictable and

may affect mortgage security values differently than expected.

Portfolio investment has been more profitable than the guarantee business. This

activity may create additional interest savings for mortgage borrowers, though such

savings would be much smaller than those created by the guarantee business. Because empirical data on this issue is scarce, OFHEO intends further study of this

topic.

Both of these business lines have been growing at the Enterprises, particularly

their portfolio investment business. Since the end of 1991, the Enterprises’ mortgage

assets have swelled from $155 billion to $900 billion, an increase of approximately

475 percent. The majority of the increase reflects purchases of mortgage securities

they had previously guaranteed. To fund the growth in these assets, the Enterprises

have increased their debt outstanding at a comparable rate from $164 billion to

$963 billion over the same period.

Their guarantee business has also increased significantly. Total mortgage-backed

securities guaranteed—both those held privately as well as those held in portfolio—

has more than doubled from $731 billion in 1991 to over $1.76 trillion today. Although the Enterprises purchased roughly half of the increase in their guaranteed

mortgage securities in recent years, the amounts held by other investors has still

grown 73 percent to $1.2 trillion over that period.

The Enterprises debt and mortgage-backed securities outstanding now amounts to

$2.2 trillion. Adding in the debt of the other GSEs, the total debt of all GSEs rises

to $3 trillion, substantially above the total privately held, marketable debt of the

U.S. Treasury. (Further detail about Enterprise mortgage portfolios, debt, and mortgage-backed securities outstanding can be found in the attached tables.)

WHO HOLDS THE DEBT?

Federal Reserve estimates for holdings of what is known as agency debt, about

85 percent of which is issued or guaranteed by GSEs, shows the following breakdown:

Depository Institutions .......................................................................................... 27%

Households, Mutual Fund, Trusts & Estates ...................................................... 21%

Public & Private Retirement Funds ..................................................................... 16%

Foreign Investors (including 60+ central banks) ................................................ 12%

Insurance Firms ..................................................................................................... 9%

State & Local Governments .................................................................................. 5%

Others ..................................................................................................................... 10%

As should be apparent from these data, a financial crisis at the Enterprises could

have a disruptive impact on investors and the economy. OFHEO has developed and

continues to improve upon a strong supervisory program.

The Enterprises’ business lines will likely continue to grow. Recently Fannie Mae

announced its continued desire to double earnings per share over the next 5 years.

Freddie Mac has predicted double digit earnings growth over a similar period. These

earnings targets will only lead to increased pressure to generate new revenues. The

prudence and competence with which the Enterprises manage and balance their assets and liabilities becomes that much more important, the larger they grow.

In order for the Enterprises to continue to grow their asset portfolios, they have

expanded the markets for their debt securities, and built demand for debt instruments, such as callable debt, that help them manage interest rate risk. They have

expanded their domestic and international investor base, developing new products

to appeal to different investor profiles. The introduction of debt issuance programs

modeled after those of the U.S. Treasury is the most recent development in these

efforts.

WHAT IS OFHEO’S ROLE?

OFHEO is aggressively fulfilling its obligation as a strong and effective regulator.

By fulfilling our core mission well, OFHEO protects against systemic risks posed by

Fannie Mae and Freddie Mac. As I have stated before, OFHEO takes a threepronged approach to accomplish this goal-examinations, capital regulation, and research.

I have already spoken about our strong examination program, so I will next address our capital standards. OFHEO’s minimum capital standard, one that is built

on traditional, ratio-based approaches to regulation of insured depository institutions, ensures a base level of Enterprise capital to protect against risk.

220

Since our inception, we have imposed and enforced a minimum capital standard

on the Enterprises. The Enterprises have met that standard every quarter and we

are reviewing the necessity of updating the standard.

We are on track to complete our long-awaited Risk-Based Capital Standard by the

end of the year. This standard will be the first to explicitly link capital and risk

through use of a model that simulates the financial performance of the Enterprises

under stress. This is my top priority and we will meet my deadline.

Finally, OFHEO is continuing to strengthen its research and analytical capability.

We must stay on top of the changes taking place in the quickly evolving secondary

and primary mortgage markets. This important research and analysis serves to better inform our examination and capital regulation efforts. In summary, the Enterprises’ rapid growth raises important policy issues regarding their mission and the

systemic risks they pose. However, because OFHEO is aggressively fulfilling its responsibilities, this discussion takes place not in a climate of urgency, but at a time

when the Enterprises are financially sound and well regulated.

221

222

223

224

225

Chairman SUNUNU. Thank you, Mr. Falcon.

Mr. Apgar.

STATEMENT OF WILLIAM C. APGAR

Mr. APGAR. Thank you. Since the resignation of Chairman Bruce

Morrison on the 4th of July, I hold the delegated authority of

Chairman of the Finance Board, and I testify today in that role. I

would like to emphasize my intention to maintain the continuity of

the Finance Board’s recent actions with respect to safety and

soundness oversight, as well as actions to foster innovation in the

Home Loan Banks and competition among the various GSEs.

I should point out, however, that the board of directors of the

Federal Housing Finance Board has not reviewed my testimony,

nor does it represent the administration’s position.

As you know, Congress created the Federal Home Loan Bank

System in 1932 to improve on the availability of funds to support

226

home ownership. The Federal Home Loan Banks are cooperatively

owned by their member bank stockholders and they operate by enhancing member lending at the local level.

The Home Loan Banks offer as their primary product a readily

available, low cost source of funds, called an advance, to member

institutions and housing associates. Advances enhance the lending

of members both by passing through the Home Loan Banks’ costof-funds advantage in the debt markets and by having the Home

Loan Banks manage interest rate risk. To the Finance Board, activities that assist and enhance lending by members are consistent

with the Home Loan Bank mission.

Congress originally granted access to the Home Loan Bank advances primarily to thrift institutions. In response to the thrift crisis of the 1980’s, Congress enacted FIRREA in 1989 to change the

Federal Home Loan Bank System, most significantly by expanding

membership eligibility to include commercial banks and credit

unions.

In 1989, Congress also imposed a $300 million per year assessment on the Home Loan Banks to help pay for the cost of the thrift

bailout. In addition, Congress imposed a requirement that 10 percent of Home Loan Bank net earnings go to support the Affordable

Housing Program each year. Last year, the system made $199 million in AHP contributions and grants nationwide.

In November 1999, with the enactment of the Gramm-Leach-Bliley legislation, Congress in a singular vote of confidence, made

many changes to enhance the capacity of the Home Loan Banks to

carry out their housing finance and community and economic development mission.

Gramm-Leach-Bliley charged the system with supporting access

to low cost funds for community financial institutions to support

small businesses, small farm and small agri-business lending. Moreover, by changing the fixed $300 million REFCORP assessment to one based on a percentage of Home Loan Bank income by

reforming the Home Loan Banks’ capital structure, this legislation

has truly positioned the Home Loan Bank System to promote competition in housing finance, serve as a central bank for community

institutions, and serve under served populations.

I would also stress that through both proposed and final regulation including the recently proposed regulation on a new risk-based

capital structure, the Finance Board has implemented all the statutory requirements of Gramm-Leach-Bliley.

As of June 30, 2000, the assets of the Home Loan Bank System

totaled $621 billion. There were more than 7500 members on that

date.

The bonds issued to support the assets of the bank system are

expressly not obligations of the United States, but they do benefit

from the favorable investor perception associated with the Home

Loan Banks’ status as a government-sponsored enterprise.

The Home Loan Bank Act makes it clear that it is the Finance

Board’s primary duty to ensure the safety and soundness of the

bank system and, consistent with that primary duty, to ensure that

the Home Loan Banks carry out their housing finance mission.

To control the Home Loan Bank System’s risk exposure, the Finance Board has established regulations and policies that Home

227

Loan Banks must follow to evaluate and manage their credit and

interest rate risk. The principal defenses against credit interest

rate risk are sound risk-based management policies and practices,

vigilant supervision, and over $30 billion in Home Loan Bank System capital.

Among the most notable regulatory requirements are:

Collectively the Home Loan Bank must maintain a triple-A credit rating on their consolidated debt.

Each individual Home Loan Bank must maintain a double-A

credit rating.

Each Home Loan Bank must establish and implement risk management policies and controls consistent with Finance Board requirements, file compliance reports and have external and internal

auditors.

Each Home Loan Bank and the office of finance must be subject

to an annual on-site examination by the Finance Board.

And, finally, the Finance Board has recently articulated a new

set of state-of-the-art duties and responsibilities of the audit committee of each of the Home Loan Bank boards of directors along

with standards for corporate governance and internal controls that

the boards must comply with.

Risk management is central to this oversight. For example, the

Finance Board limits the interest rate risk of mortgage-backed securities owned by the Home Loan Banks. Moreover, the size the

Home Loan Banks’ mortgage-backed securities holdings is limited

to no more than three times Home Loan Bank capital or less than

$90 billion today.

The general approach of the Home Loan Banks toward managing

interest rate risk is to acquire and maintain a portfolio of assets

and liabilities, which, together with their associated interest rate

exchange agreements, limit the exposure to future interest rate

changes.

With respect to credit risk, it is important to note that in the 68-

year history of the Home Loan Bank no Home Loan Bank has ever

experienced a credit loss on an advance to a member.

While the Home Loan Banks face minimal credit risk on advances, they are subject to credit risk on some investments. Each

Home Loan Bank must comply with limits established by the Finance Board and its directors on the amounts of unsecured extensions of credit, whether on or off balance sheet.

The Finance Board also limits the amounts and terms of unsecured debt exposure to any counterpart other than the United

States Government. Unsecured credit exposure to any counterparty

is limited by the credit quality and capital level of the counterparty

and the capital level of the bank.

The Finance Board views these risk management requirements

to be more than adequate to protect against any potential loss exposure to the taxpayer.

In exchange for public support, of course, the American taxpayer

has the right to expect responsible behavior by the GSEs. It is critically important to protect the taxpayer from any potential loss by

monitoring and regulating GSE financial risk. It is also critically

important to ensure that the low cost-of-funds and other advanVerDate 11-MAY-2000 15:34 Sep 28, 2000 Jkt 000000 PO 00000 Frm 00231 Fmt 6601 Sfmt 6602 H:\DOCS\HEARINGS\10-1\63822.TXT HBUDGET1 PsN: HBUDGET1
228

tages bestowed on the GSEs are well directed and ultimately reach

their intended beneficiaries.

There is a risk that much of the government-owned benefit could

be absorbed as profits within the GSE conduit. But one of the

unique factors and features of the Home Loan Bank System, namely, its cooperative structure, inherently protects against such an

event. Because the members and shareholders are one and the

same and because the public benefit of the Federal Home Loan

Bank System is delivered by members’ retail lending, the members’

financial incentives to get the lowest cost of funds is entirely consistent with maximizing public benefit. In addition, mission regulation helps ensure this valuable GSE benefit is focused on assisting

member lending.

Mission regulation is closely linked to safety and soundness regulation. Many assets are perfectly safe and sound from a financial

point of view, but because the GSEs were created for specific purposes and GSEs are supported by agency debt, only some assets

are consistent with the mission of those GSEs.

The Finance Board has been focusing on the Home Loan Bank

core mission activities. In the past, some level of non-mission investments were necessary for the banks to meet their REFCORP

obligation of $300 million per year and to fund the Affordable

Housing Program.

This activity where the Home Loan Banks borrow at close to

Treasury rates to purchase higher yielding assets in the capital

markets such as MBS and earn a profit from the spread has been

the subject of bipartisan criticism for many years. Indeed, the arbitrage issue has been at the top of the list of many Members of Congress and the Treasury Department, and rightfully so.

Five years ago, approximately 40 percent of Home Loan Bank assets reflected core mission activities as we defined here. I am

pleased to report that through a combination of advances, growth

and Finance Board actions, the ratio is now approximately 75 percent.

Recently, Finance Board actions along with reforms passed in

Gramm-Leach-Bliley that eliminated the major drivers of arbitrage,

such as the flat REFCORP assessment and subscription-based capital, provide the best opportunity in a decade to focus the activity

of the Home Loan Banks on their mission and reduce their dependence on arbitrage investment.

On June 29, the Finance Board passed the Core Mission Assets/

Acquired Member Assets rule. This rule establishes a framework

for the Home Loan Bank System to pursue a totally mission-related balance sheet. The rule has two parts.

It makes permanent Acquired Member Assets, or AMA programs, such as the so-called Chicago pilot or the Mortgage Partnership Finance, which is the most prominent of acquired mortgage

assets. As you know, this as proved to be a very successful program

to date involving over $10.5 billion worth of assets.

Each of the 12 member banks is now offering or will soon offer

an MPF or similar program that will divide the risk of the mortgage between a member bank and a Home Loan Bank partner.

Simply stated, the member bank manages the credit risk and the

229

Home Loan Bank, experts at hedging interest rate risk, will assume and manage that risk.

These partnerships provide true competition with the secondary

market GSEs. Instead of credit risk being concentrated in those

two housing GSEs, the risk can now be dispersed through over

7500 Home Loan Bank members.

These programs serve to de-concentrate the risk of a $4 trillion

housing finance market and put the rewards in the right place,

with those who take the risk, to offer what is truly a third way

home for member institutions.

The rule also defines Core Mission Assets as assets including advances, Acquired Member Assets and certain smaller classes of securities. If there is any meaning to the mandate that the Finance

Board must ensure mission achievement, it is incumbent on the Finance Board to state in regulatory form which activities and assets

actually advance that mission.

The development of the Acquired Member Asset programs will

help the Home Loan Banks to develop Core Mission Assets to replace arbitrage investments and at the same time increase competition in the secondary market.

Of course, these new activities must be supported by a strong

capital base. For this reason as well as for purposes of capitalizing

other new Home Loan Bank activities, Gramm-Leach-Bliley has

mandated the establishment of a new risk-based capital structure

that will allow the banks to adjust their capital to the actual risk

that they have on their balance sheet.

I am pleased to report that on July 13th the Finance Board proposed a state-of-the-art risk based capital rule as required by

Gramm-Leach-Bliley which is currently out for a 90-day comment

period. The legislation requires the Finance Board to issue its final

capital rule in November and we are making progress toward that

goal.

In summary, as a result of Gramm-Leach-Bliley and the regulatory initiatives that I have described, the Home Loan Banks can

play an even broader and more important role in the future than

they have in the past and do so in a way that is mindful of the

financial interests of the American taxpayers.

Thank you.

[The prepared statement of William C. Apgar follows:]

PREPARED STATEMENT OF WILLIAM C. APGAR, HUD DESIGNEE TO THE FEDERAL

HOUSING FINANCE BOARD

Good morning Mr. Chairman, and members of the Task Force. I would like to

thank you for the opportunity to appear today to testify before the Task Force on

Housing and Infrastructure of the House Budget Committee on the subject of economic implications of debt held by government sponsored enterprises. I should point

out that the Board of Directors of the Federal Housing Finance Board has not reviewed my testimony nor does it represent the Administration’s position.

The Federal Housing Finance Board (Finance Board) is an independent agency in

the Executive Branch. It is both the mission and safety and soundness regulator for

the 12 regional Federal Home Loan Banks (FHLBanks) and the regulator of the Office of Finance, which serves as the debt issuance facility for the consolidated obligations of the FHLBanks. The Finance Board is funded through assessments made on

the FHLBanks and is not subject to the congressional appropriations process.

Since the resignation of Bruce Morrison as Chairman on July 4, 2000, I have held

the delegated authority of Chairman of the Finance Board as Secretary Cuomo’s

designee. I would like to emphasize my intention to maintain the continuity of the

230

Finance Board’s recent actions with respect both to safety and soundness and to innovation by the FHLBanks and competition among the government sponsored enterprises (GSEs) as a means of maximizing their public benefit.

Congress created the FHLBank System in 1932 to improve the availability of

funds to support homeownership. The FHLBanks are cooperatively owned by their

member-bank stockholders and they operate by enhancing member lending at the

local level. The FHLBanks offer as their primary product, a readily available, lowcost source of funds, called an advance, to its member institutions and housing associates. Advances enhance lending by members both by passing through the

FHLBanks’ cost-of-funds advantage in the debt markets, and by having FHLBanks

manage interest rate risk. To the Finance Board, activities that assist and enhance

lending by members are consistent with the FHLBanks’ mission.

Congress originally granted access to FHLBank advances primarily to thrift institutions. In response to the thrift crisis of the 1980s, Congress enacted FIRREA in

1989 to change the FHLBank System, most significantly by expanding membership

eligibility to include commercial banks and credit unions.

In 1989, Congress also imposed a $300 million per year assessment on the

FHLBanks to help pay for the costs of the thrift bailout. In addition, Congress imposed a requirement that 10 percent of FHLBank net earnings go to support an Affordable Housing Program (AHP) each year. The AHP is designed to enhance the

availability of affordable housing for very low- to moderate-income families. Last

year the FHLBank System made $199 million in AHP contributions and grants nationwide. The combination of these new financial obligations, the decline in the

thrift population, and the time lag for commercial banking institutions to join the

FHLBank System and take down advances, understandably drove the FHLBanks in

the 1990s to supplement earnings by increasing arbitrage activities.

In November 1999, by enacting Title VI of the Gramm-Leach-Bliley Act—the first

comprehensive legislation since FIRREA to affect the FHLBank System—Congress,

in a singular vote of confidence, made many changes to enhance the capacity of the

FHLBanks to carry out their housing finance and community and economic development mission as part of the modernized financial services world of the 21st century.

Significant, among other changes, is that the FHLBank System has now been

charged with supporting access to low-cost funds for community financial institutions to support small business, small farm and small agri-business lending. Moreover, by changing the fixed $300 million REFCORP assessment to one based on a

percentage of FHLBank income and by reforming the FHLBanks’ capital structure,

this legislation has truly positioned the FHLBank System to add value to consumers

and to the financial system in three critical areas: providing competition in housing

finance; serving as central bank to community institutions; and serving underserved

populations. I would also stress that, through both proposed and final regulations,

including a recently proposed regulation on the new risk-based capital structure, the

Finance Board has implemented all the statutory requirements of Gramm-LeachBliley—as well as exercising its discretionary authority to strengthen mission regulation—in a timely and expeditious fashion, and I would like to commend the Finance Board staff on their efforts in this regard.

As of June 30, 2000 the assets of the FHLBank System totaled $621 billion. There

were more than 7500 members as of that date. The bonds issued to support the assets of the FHLBank System are expressly not obligations of the United States, but

they do benefit from the favorable investor perception associated with the

FHLBanks’ status as a GSE. The Federal Home Loan Bank Act makes clear that

it is the Finance Board’s primary duty to ensure the safety and soundness of the

FHLBank System and, consistent with that primary duty, to ensure that the

FHLBanks carry out their housing finance mission.

As noted, the fundamental business of the FHLBanks is to provide member institutions with advances and other credit products in a wide range of maturities and

terms to meet member demand. Lending and investing funds and engaging in offbalance-sheet interest-rate exchange agreements have the potential for exposing the

FHLBanks to credit and interest-rate risk. The principal defenses against credit and

interest-rate risk are sound risk-management policies and practices, vigilant supervision, and the over $30 billion of FHLBank System capital.

To control the FHLBank System’s risk exposure, the Finance Board has established regulations and policies that FHLBanks must follow to evaluate and manage

their credit and interest-rate risk. Among the most notable regulatory requirements

are:

• The FHLBanks must have, and take whatever actions are necessary to maintain, a triple-A credit rating on their consolidated debt.

231

• Each FHLBank must have, and take whatever actions are necessary to maintain, a double-A credit rating that is a meaningful measure of the individual

FHLBank’s financial strength and stability.

• Each FHLBank must establish and implement risk management policies and

controls that comport with Finance Board requirements and conduct periodic assessments of these controls.

• Each FHLBank and the Office of Finance must be subject to an annual on-site

examination by the Finance Board, as well as off-site analyses.

• Each FHLBank must file periodic compliance reports with the Finance Board.

• Each FHLBank must have both an external and an internal auditor, and the

Finance Board has recently articulated a new set of state-of-the-art duties and responsibilities of the audit committee of each FHLBank’s board of directors along

with standards for corporate governance and internal controls that the boards must

comply with.

Managing Interest-Rate Risk. Interest-rate risk is the risk that relative and absolute changes in interest rates may adversely affect an institution’s financial condition. The goal of an interest-rate risk management strategy is not necessarily to

eliminate interest-rate risk but to manage it by setting appropriate limits.

The Finance Board has adopted comprehensive policies that strictly limit the

amount of interest-rate risk a FHLBank may assume. Most of the FHLBanks have

adopted internal interest-rate risk limits that are even more conservative than the

strict limits required by the Finance Board. To further limit interest-rate risk that

could arise when a member prepays an advance, the Finance Board requires that

each FHLBank generally charge a prepayment fee that makes it financially indifferent to a member’s decision to prepay an advance.

The Finance Board limits the interest-rate risk of mortgage-backed securities

(MBS) owned by the FHLBanks by restricting the types of MBS to those with limited average life changes (and hence limited price change) under certain interestrate shock scenarios. Moreover, the size of the FHLBanks’ MBS holdings is limited

to no more than three times the FHLBanks’ capital (or less than $90 billion today).

The general approach of the FHLBanks toward managing interest-rate risk is to

acquire and maintain a portfolio of assets and liabilities, which, together with their

associated interest-rate exchange agreements, limit the exposure to future interest

rate changes.

Managing Credit Risk. Credit risk is the risk of loss due to default. The FHLBank

System protects against credit risk through collateralization of all advances. In addition, each FHLBank can call for additional or substitute collateral during the life

of an advance to protect its security interest. In the 68-year history of the FHLBank

System, no FHLBank has ever experienced a credit loss on an advance to a member.

While the FHLBanks face minimal credit risk on advances, they are subject to

credit risk on some investments. Each FHLBank must comply with limits established by the Finance Board and its board of directors on the amounts of unsecured

extensions of credit, whether on- or off-balance sheet. The Finance Board also limits

the amounts and terms of unsecured credit exposure to any counterpart other than

to the U.S. Government. Unsecured credit exposure to any counterparty is limited

by the credit quality and capital level of the counterparty and by the capital level

of the FHLBank.

The Finance Board views these risk management requirements to be more than

adequate to protect against any potential loss exposure to the taxpayer. Even so,

the taxpayer has a right to expect certain benefits for taking any potential risk and

for bestowing certain advantages on the GSEs.

Congress long ago decided that promoting homeownership is desirable and worth

the cost of granting special advantages to homebuyers, such as the mortgage interest tax deduction, and the establishment of specially advantaged GSEs to facilitate

housing finance and other socially desirable activities. In exchange for public support, the American taxpayer has the right to expect responsible behavior by the

GSEs. It is obvious that it is critically important to protect the taxpayer from any

potential loss by monitoring and regulating GSE financial risk. It is also critically

important to ensure that the low cost-of-funds and other advantages bestowed upon

the GSEs are well directed and ultimately reach their intended beneficiaries. There

is a risk that much of the government-bestowed benefit could be absorbed as profits

within the GSE conduit.

One unique characteristic of the FHLBank System—namely, its cooperative structure—inherently protects against such an event. Because members and shareholders

are one and the same, and because the public benefit of the FHLBanks System is

delivered by members’ retail lending, the members’ financial incentives to get the

lowest cost of funds is entirely consistent with maximizing the public’s benefit. In

232

addition, mission regulation helps to ensure that this valuable GSE benefit is focused on assisting member lending.

Congress created GSEs to accomplish statutorily prescribed missions and provided

them with advantages, including a U.S. Treasury line of credit, which enables them

to benefit from a lower cost of funds and operations. It is up to the regulator to ensure that the public, in turn, receives the benefits of that lower cost and to ensure,

consistent with safety and soundness, that the public mission of the GSE is

achieved.

Mission regulation, while controversial, is closely related to safety and soundness

regulation. Many assets are perfectly safe and sound from a financial point of view.

But because the GSEs were created for very specific purposes, and GSE assets are

supported by agency debt, only some assets are consistent with the mission of those

GSEs.

The Finance Board has been focusing the FHLBanks on core mission activities.

In the past, some level of non-mission investments were necessary for the

FHLBanks to meet their REFCORP obligation of $300 million per year and to fund

AHP. This arbitrage activity, where the FHLBanks borrow at close to Treasury

rates to purchase higher yielding assets in the capital markets, such as MBS, and

earn a profit from the spread, has been the subject of bi-partisan criticism for many

years. Investments supported by agency debt and ultimately guaranteed by the taxpayer simply to earn a profit are much less useful than activities that would more

directly benefit members and their borrowers.

Indeed, the ‘‘arbitrage issue’’ has been at the top of the list of concerns of many

Members of Congress and the Treasury Department, and rightly so. Five years ago

approximately 40 percent of FHLBank assets reflected Core Mission Activity as we

have recently defined the term. I am pleased to report that through a combination

of advances growth and Finance Board actions, that ratio is now approximately 75

percent.

Recent Finance Board actions along with the reforms passed in Gramm-Leach-Bliley that eliminated the major drivers of arbitrage, such as the flat REFCORP assessment and subscription based capital, provide the best opportunity in a decade

to focus the activities of the FHLBanks on their mission and reduce their dependence on arbitrage investments. On June 29, the Finance Board passed the ‘‘Core

Mission Assets/Acquired Member Assets’’ rule. This rule establishes the framework

for the FHLBank System to pursue a totally mission-related balance sheet. The rule

has two parts:

1. It makes permanent the Acquired Member Assets, or AMA programs, and re- moves the $9 billion cap on the ‘‘Chicago Pilot’’ (MPF), which is the most prominent

of acquired member asset programs. MPF has proven to be very successful and has

to date acquired over $10.5 billion of assets. Each of the 12 FHLBanks is now offering, or will soon offer, MPF or a similar program that will divide the risks of mortgages between a member bank and its FHLBank partner. Rather than sell the mortgage and all its attendant risks in the secondary market, a FHLBank member will

have the option of retaining the credit risk and being rewarded for good underwriting by receiving a credit enhancement fee. The FHLBanks, experts at hedging interest rate risks, will assume and manage the market risk.

These partnership programs provide true competition with the two secondary

market GSEs. Instead of credit risk being concentrated in these two housing GSEs,

the risks can now be dispersed through the FHLBanks to their 7,500 members.

These programs de-concentrate the risks of a $4 trillion housing finance market and

put the rewards in the right place—with those who take the risk—to offer what is

truly a ‘‘third way home.’’

Rather than rail against the housing GSEs and the advantages they have been

afforded, I believe we should instead focus on how to introduce competition among

them, decrease risk to the public sector, and focus mission to maximize the public

benefit. The FHLBanks’ AMA programs accomplish these objectives.

2. The proposed rule defines Core Mission Assets (CMA) as assets (including advances, AMA and certain smaller classes of targeted assets) that the FHLBanks are

encouraged to hold. If there is any meaning to the mandate that the Finance Board

‘‘ensure’’ mission achievement, it is incumbent on the Finance Board to state in regulatory form which activities and assets actually advance that mission. Rather than

imposing a constraint, the definition of Core Mission Assets simply specifies what

we consider to be the most productive, value-added assets as tools for business and

capital purchase purposes.

The development of Acquired Member Asset programs will help the FHLBanks to

develop core mission assets to replace arbitrage investments and, at the same time,

increase competition in the secondary market. By doing so, AMA should increase

mortgage market share for depository institutions, help disperse the credit risk of

233

the $4 trillion mortgage market from the two large secondary market GSEs to the

more than 7,500 FHLBank member institutions and, most importantly, reduce

mortgage costs for American homebuyers.

These new AMA activities must be supported by a strong capital base. For this

reason, as well as for the purposes of capitalizing other new FHLBank activities,

and creating consistency with rules applied to other regulated financial institutions,

Gramm-Leach-Bliley has mandated the establishment of a new risk-based capital

structure, that will allow the FHLBanks to adjust their capital to the actual risks

that they have on their balance sheets.

Currently, members are required to buy an amount of FHLBank stock based on

the size of their balance sheets and the amount of their advance borrowings from

the FHLBanks. This has resulted in systematic over-capitalization of the

FHLBanks. The FHLBanks have been servicing this excess capital with arbitragederived profits. Risk-based capital will match required capital to actual acquired

risk and therefore alleviate the need for extraneous arbitrage earnings. Risk-based

capital offers greater protection to the System and therefore greater protection to

the taxpayer. Another way of looking at the issue of capital is as follows: member

institutions can think of the FHLBanks as their capital markets affiliate and make

a rational decision as to how much capital they wish to put up for the FHLBanks

to be able to conduct members’ business. The size of the balance sheet need be no

larger than what is actually required for business, not for arbitrary, non-mission related arbitrage. Again, this is another vital tool to minimize risk while assuring

maximum pass-through of public benefit. The Finance Board on July 13 proposed

a state-of-the-art risk-based capital rule as required by Gramm-Leach-Bliley, which

is currently out for a 90-day comment period. The legislation requires the Finance

Board to issue its final capital rule by November 12 of this year, and we are making

progress toward that goal.

In summary, as a result of both Gramm-Leach-Bliley and the regulatory initiatives that I have described, the FHLBanks can play an even broader and more important role in the future than they have in the past. The FHLBanks have new authority to expand into small business and agricultural lending to their smaller members, to expand non-mortgage lending to all members and to offer new mortgage

products that enhance competition among the housing GSEs and disperse the credit

risks of mortgage finance. The FHLBanks now have a regulatory incentive to focus

on activities that create value for members and thus for consumers, and have the

prospect of more permanence in the FHLBank capital base than has previously been

the case. In all these ways, the FHLBanks are extraordinarily well-positioned to

work with their rapidly growing membership base. Consumers of financial services

all across America will benefit if we stay this public policy course and authorize the

FHLBanks to play these important roles in the future.

Chairman SUNUNU. Thank you very much, Mr. Apgar.

Mr. Falcon, a lot of discussion in the previous panel centered

around matching the GSE portfolios in order to minimize their exposure to risk. To what extent are the long-term assets within the

GSE portfolios funded by short-term debt? How well matched are

the portfolios?

Mr. FALCON. Right now, Mr. Chairman, we consider the portfolios to be very well matched. The majority of the debt that they

issue is long term and the short-term debt that they do have is

through the use of derivatives converted to effective long-term debt

and then the majority of that long-term debt has callable or adjustment features in it which protect the enterprises from changes in

interest rates.

Chairman SUNUNU. How do you quantify or how do you measure

the degree to which the portfolio might be mismatched, that there

might be some gap in duration?

Mr. FALCON. Well, you have to take into account, Mr. Chairman,

the prepayment risk associated with mortgages and there is a well

established body of research about prepayment speeds on mortgages. And it depends on the various state of interest rates as to

whether or not mortgages will be prepaid at a certain rate, as opposed to earlier rather than later.

234

Chairman SUNUNU. In trying to forecast prepayment risk, do you

benefit from the GSEs’ considerable database of information? I

would guess that no one has better historical records than the

GSEs. Do you benefit from that information in trying to estimate

yourself what the potential for prepayment is?

Mr. FALCON. Yes. Absolutely. In fact, we have a broader base

than either one of the GSEs, since we have both GSEs’ databases.

We can look at them in the aggregate in addition to individually.

Chairman SUNUNU. Could you for a little bit of history describe

the mismatch that occurred in the early 1980’s that was mentioned

by the previous panel and the degree to which that could or could

not happen again due to changes in the policy at the GSEs?

Mr. FALCON. Certainly I would never say that anything could

never happen again, Mr. Chairman, but I think through our supervisory program I am comfortable with the way they are managing

their interest rate risk at the current time.

Certainly—and I worked for the House Banking Committee for

8 years, Mr. Chairman, and worked with that committee to help

deal with the savings and loan crisis, so I am well aware of what

is required of a regulator in order to try to prevent that from ever

happening again with any financial institution.

So I think what you had there was basically, as the previous

panel described, you had long-term assets funded with short-term

sources of funds. And that is why it is so critical to the enterprises

to ensure that there is a match in duration of assets and liabilities.

Chairman SUNUNU. Who had responsibility for oversight at

that—and that’s before S&Ls even existed, correct?

Mr. FALCON. Yes, Mr. Chairman.

Chairman SUNUNU. So who was primarily responsible for oversight or for trying to help identify whether or not a mismatch existed in the early 1980’s?

Mr. FALCON. With the enterprises?

Chairman SUNUNU. Yes.

Mr. FALCON. At that time, I think HUD had some general regulatory responsibility, but I think that was the extent of it.

Chairman SUNUNU. Could you talk a little bit about the riskbased capital stress test? What are the principles that are at the

core of that test that you have developed and are in the process of

implementing?

Mr. FALCON. I certainly enjoy talking about risk-based capital because I think it would be a very valuable tool for OFHEO in

achieving its responsibilities.

It is intended to complement our examination program and our

research program. They are all, I think, critical components to

OFHEO achieving its mission.

Risk-based capital is simply placing the enterprises’ balance

sheets under stressful economic conditions, both stressful credit

losses as well as big swings in interest rates and then seeing how

their balance sheets would fare under a 10-year scenario at those

stressful levels.

We are in the process right now of combing through the comments. In fact, we have concluded review of all the comments on

the proposal and we are in the process right now of writing a final

235

rule to reflect any changes that have been made and we will also

have to make changes to the computer model.

This involves not just writing the rule, but involves writing very

sophisticated computer code to make sure that we adequately and

properly model the assets and liabilities of the enterprises.

Chairman SUNUNU. What elements of risk cannot be adequately

captured in this kind of a model?

Mr. FALCON. I think management and operations risk is certainly

one of them, but that is why the risk based capital requirement

will have a 30 percent add on in addition to whatever is produced

by the stress test. So there is a very generous add on that is included to the stress test capital requirement.

Chairman SUNUNU. Is that 30 percent intended to cover bad

management?

Mr. FALCON. No, just to—well, to ensure that if there were any

lapses in management or unforeseen circumstances, this is just an

add on to ensure that to the next something cannot be modeled in

the risk-based capital regulation there is a cushion in addition to

that requirement which is produced by the stress test.

Chairman SUNUNU. How does OFHEO deal with oversight of risk

management strategies in hedging?

Mr. FALCON. Our examination staff, which I think consists of

very talented and experienced examiners, look at the policies of the

enterprises and not just their policies but the actual practices of

the enterprises in trying to hedge against risk. They will look at

very specific transactions that are entered into, to accommodate

changes in interest rate.

I think, Mr. Chairman, this will be complemented by our riskbased capital standard, but as great as the risk-based capital

standard will be when we get it completed at the end of the year,

I do not ever want to downplay how important it is for our examiners to be there at the enterprises, understanding everything that

the enterprises do.

We never substitute our business judgment for what they have

decided to do in running their businesses, but we certainly look at

everything that they do and try to make certain that the risk is

properly managed.

Chairman SUNUNU. As the size of the portfolio held by the GSE

grows, the GSE needs to engage in a greater volume of interest

rate swaps and utilization of option-embedded securities in order to

keep that portfolio in balance. Is that correct?

Mr. FALCON. Yes. As they add mortgage-backed securities into

their portfolio, their retained portfolio, they do take on the interest

rate risk.

Chairman SUNUNU. Does the increase in the utilization of derivatives in that situation in and of itself require a higher level of capitalization or reserves?

Mr. FALCON. I think any increase in the use of derivatives certainly requires increased supervision because you then have to deal

with counterparty risk and counterparty risk is dealt with in our

risk-based capital standard as well as in our examination program.

We will look at the nature of the counterparties, we will try to

make sure that there is not any concentration in any one or two

counterparties, but, yes, it is an important part of our supervision.

236

Chairman SUNUNU. Mr. Ely was disappointed that he did not

have access to more information regarding that counterparty exposure but for the purposes of regulation, is there any information regarding counterparty exposure that you do not have access to?

Mr. FALCON. No, sir.

Chairman SUNUNU. Mr. Bentsen.

Mr. BENTSEN. Thank you, Mr. Chairman, and thank our panel

for being here. I am sorry I missed your testimony.

I want to say I am always happy to see Mr. Falcon testify because a lot of what we are talking about with respect to the GSEs

and whether or not there is sufficient oversight and risk-based capital rules and all is sitting on Mr. Falcon’s front doorstep and we

eagerly await the publication of the final rules with respect to that

and I, for one, am eager to see Congress allow Mr. Falcon and the

agency that he represents the ability at least to carry out what we

passed in 1992 before we go and change it all again, maybe at least

for a month or two, if not longer.

Let me ask just a couple of questions.

One, to Mr. Ely’s question on derivative information, when

OFHEO conducts its analysis of the GSEs, in which case you will

be looking at counterparty risk and the like, will that information,

will your final analysis including some of that information, become

part of the public domain and thus be available to the public,

whether it is the general public, concerned investors or whatever?

Mr. FALCON. I think generally I would like to foster greater understanding of the GSEs and the secondary mortgage market. To

the extent we can provide any increased transparency to their operations, especially in this area, I think it would be of benefit to the

mortgage market and to the public. However, we have to balance

that against the requirements of the Trade Secrets Act and ensure

that we do not release any proprietary information of the enterprises, but certainly I think that that is a very worthwhile goal.

Mr. BENTSEN. It is tough in the area of derivatives, there is no

real Federal standard as it relates to disclosure of derivative investments, even in the banking industry we have had a battle

going on over FASB rules and how derivatives should be handled

and disclosure rules, but I would hope that OFHEO’s analysis that

it is disclosed to the public is useful analysis, I guess is the best

way to put it.

How would you compare in establishing your risk-based capital

standards and your stress test to those that were established under

FIRREA for savings and loans? You were involved in the passage

of both pieces of legislation as counsel on the banking committee.

FIRREA sought to impose tighter investment standards on thrifts

both in the purchase of mortgages, mortgage securities, and other

types of non-mortgage investments. Do you think the standards

you are establishing are comparable to that?

Mr. FALCON. The standards which eventually resulted from

FIRREA and FIDCIA were risk-based capital standards, but they

were more of a ratio or leverage type risk-based capital standard,

where assets were placed in buckets and the buckets had a risk

weighting and the resulting capital would be their risk-based capital standard.

237

This was in addition to the straight forward leverage capital

standard that the banks and thrifts have applied to them.

What OFHEO is doing under the 1992 act is something which is

entirely different. I do not mean to imply that one is better than

the other. I think that comparing banks and thrifts and the enterprises, it may be that one is appropriate for banks and thrifts and

this is appropriate for the GSEs. What we do is we actually place

the balance sheets of the enterprises under stressful conditions, big

interest rate swings, severe credit losses, we give them credit for

hedging activities, and we make sure that they can remain solvent

over that entire 10-year period under those stressful conditions.

If at any point in any quarter during that 10-year period they do

not have sufficient capital to remain solvent, then we will increase

their capital requirement to make sure that they always maintain

that level of minimum capital.

So we try to simulate through this risk-based capital regulation

and the stress test what would happen under severe economic

times and I think that is an entirely different way of imposing a

risk-based capital requirement and, in fact, we have been educating

the banking regulators on how this would work. There may be

some aspects of it that they are trying to understand better to see

if there is any applicability.

Mr. BENTSEN. Do you take into consideration geographic economic dislocation and how it affects the mortgage portfolio? I know

a lot has been talked about the farm crisis and the impact it had

on the Farm Credit System in the mid 1980’s. Obviously, there was

an economic problem broadly in the farm system.

Do you all take into account—I mean, short of just an overall

economic decline in the United States, the geographic changes in

the real estate market?

Mr. FALCON. Well, the worst credit losses that are built into the

stress test actually are the worst credit losses for a specific region

of the country, so to the extent that we did pick the severest credit

losses for a geographic region of the country and implied those

losses and that experience to the entire portfolio of the enterprises,

so Congressman, I think in that sense we are trying to not just

take a national average of credit experience, but actually a more

focused worst case scenario.

Mr. BENTSEN. I just have a couple more questions, Mr. Chairman.

If you find that there is under capitalization or potential under

capitalization or non-adherence to stress test risk out there, your

examiners are in the GSEs and they find there is a problem with

the portfolio or a systemic problem, what authority do you have to

correct that problem?

Mr. FALCON. We have pretty broad authority in our statute and

we have adequate authority, I believe, to step in and require the

corrective action to address the problem and we will move quickly

to do that. I would never want to place this committee, this Congress, in any position where they have to consider a deteriorating

condition of the enterprises. So we would move quickly, we would

move forcefully, utilizing all the authorities we have to ensure that

we exercise prompt, corrective action.

238

Mr. BENTSEN. Do you have similar sort of cease and desist authority in the same way the Comptroller of the Currency or the

Federal Reserve has in bank regulation?

Mr. FALCON. Yes.

Chairman SUNUNU. Finally, for Mr. Apgar and Mr. Falcon, there

has been a lot of discussion about GSE debt and we will just talk

about aggregate debt, both GSE corporate debt and mortgagebacked security debt, and how fast it is growing.

Is GSE debt—the vast majority of which is mortgage debt, I believe, in one way or the other—is it growing more rapidly than

housing debt would grow as a whole to meet housing market demand?

The point is—and this is sort of where I think the big question

we are leading to is—do the GSEs have access to so much cheap

money out there that they have issued a dramatic amount of debt

far greater than the demand they have for buying mortgages, either through direct purchase or through the MBS function?

Mr. APGAR. Well, you heard earlier that the mortgage market is

a mature market, growing only so fast, and the GSEs for a variety

of reasons, the secondary market GSEs particularly, are growing

even faster in their purchase of debt.

I think the more relevant question is is it growing faster than

maybe Congress or anybody anticipated when they laid down the

regulatory frameworks in 1992. And so I think it is a fair question

to review whether the oversight mechanisms are appropriate. I

have high confidence that in the case of the Federal Housing Finance Board we are doing an adequate job.

I have testified earlier concerning the job that OFHEO and HUD

is doing in its oversight of Fannie and Freddie, but I do think it

is an appropriate question given the fact that it is growing, I believe, faster than people would have anticipated that would review

these regulatory structures.

Mr. BENTSEN. I would just add—and that is a fair question, I

agree with you, that is a question we need to be focusing on. But

my initial question is a risk-related question.

The argument is that there is substantial risk associated with

the rise in GSE debt. The question is is that debt rising to meet

housing market demand or is it rising faster than housing market

demand would otherwise require?

And if there is a spread there, then is that where the risk would

be?

Mr. APGAR. Well, it is clearly——

Mr. BENTSEN. Assuming that the housing market is relatively

stable.

Mr. APGAR. It is what does housing market demand require,

which is the question of how much do the GSEs need in order to

maintain their operations and that is the important question that

we have been discussing.

Clearly, in order to maintain their role as secondary market activity, they need to do some purchasing of securities to maintain

price and other things. The question is whether they have been involved in excessive purchases, some way defined, and I do not have

a specific answer on that.

Mr. BENTSEN. Thank you.

239

Thank you, Mr. Chairman.

Chairman SUNUNU. Mr. Smith.

Mr. SMITH. Thank you, Mr. Chairman.

I happen to chair one of the science subcommittees in research

and we have been looking at the effect of the new technology and

our ability through computers and websites to communicate and I

am somewhat familiar with a couple of innovations such as the

muniauction.com and other websites that tend to make sure that

the market is in place as far as buyers and sellers in terms of trying to make this system a little more efficient.

What do you see as the impact of this kind of advance communication in terms of bringing the lowest possible interest rates or

the lowest possible—the best possible service to the ultimate homeowner?

Mr. APGAR. Well, as was noted earlier, capital markets are

emerging, they are integrated into the world, housing finance markets into the world, capital markets. The innovations in delivery of

mortgage products are astounding. And so I think that all enures

to the benefit of the American home buyer.

Mr. SMITH. Mr. Falcon, any comments?

Mr. FALCON. I agree generally with what Secretary Apgar said.

Technology as it evolves, and I would recommend to you our annual report which discussed this at some length, could change the

way the mortgage delivery system is used right now. I think you

are seeing some efforts by the enterprises to try to position themselves accordingly. They are developing relationships with others

such as the Freddie Mac-Microsoft joint venture to have a single

delivery mechanism for mortgages through the Internet.

So I think it is an area that we are studying carefully.

Mr. SMITH. And, Mr. Falcon, let me ask you a question about

hedging. When asked about the credit risk and interest rate risk

as a result of mortgages and MBSs in the portfolio, GSEs are quick

to point out that they have a great hedging system and so my question is is there an adequate framework in place for OFHEO to assess and review these hedging systems to look at what is going to

be the best way to do it? How do you assess it? Are you assessing

them?

Mr. FALCON. Absolutely, Congressman. We look at their overall

policies with regards to how they use hedging, derivatives for hedging purposes. They engage in derivative usage for hedging purposes

and do not engage in the use of derivatives for speculative purposes. And we do look closely at how they use hedges to deal with

any possible interest rate risk that they have with respect to their

portfolio or any other line of business that they have.

Mr. SMITH. And another question is Fannie Mae has stated on

several occasions that a bank or a thrift institution would require

much more capital if they were going to meet the risk-based capital

requirements of OFHEO. Give me your reaction.

Mr. FALCON. You really cannot compare them, Congressman.

They are two entirely different types of capital regulations, the

risk-based capital we are working on versus the risk-based capital

regulation that banks and thrifts have applied to them. And the

nature of their businesses are very different as well. So I do not

know that you could readily compare the capital requirements of

240

banks and thrifts to the capital requirement that we will have for

Fannie or Freddie under a risk-based capital regulation.

Mr. SMITH. And maybe a final question would be each of your assessment or your evaluation of the ultimate responsibility of the

Federal Government, how much of a real obligation would there be

for the Federal Government to underwrite, would it be a political

obligation?

Do you see anything that is implied in any of the laws or any

of the regulations that might go further in implying some underwriting by the Federal Government if the GSEs run into trouble?

Mr. APGAR. Well, as was noted, we are starting with securities

that say in plain English that these are not guaranteed by the Federal Government, but that does not undue the 60, 70-year history

of Federal involvement in each entity. And so clearly there is an

investor perception.

What it would take to change investor perceptions is difficult to

assess, but among other things, investors could perceive that because of the size of these organizations alone, independent of this

history of Federal involvement, that any substantial financial difficulties because of the magnitude and number of people that would

be affected by that would require some Federal action.

Mr. FALCON. I agree totally, Congressman. You could remove the

enterprises’ line of credit and you could take away their Federal

charter, you could subject them to State and local taxation, you

could take away all the explicit Federal benefits, but you still have

the question before you of would they be considered too big to fail.

This is a question that Congress has before it, not just with respect to Fannie or Freddie or the Federal Home Loan Bank System, but with respect to any large financial institution.

So would repealing the explicit benefits they receive address the

issue of the implied Federal guarantee? I am not certain it would

because of the issue of too big to fail.

Mr. SMITH. And so to what extent does this implied responsibility

of the Federal Government add to the profits of Fannie Mae and

Freddie Mac?

Mr. FALCON. It certainly makes our jobs all the more important,

to make sure that we are adequately supervising the enterprises.

The benefits they receive, as I outlined in my testimony, there is

benefit that enures to homeowners. If you look at the comparison

of the conforming mortgage interest rate to jumbos, there is certainly a difference in what it would cost the homeowner to get a

home loan.

Chairman SUNUNU. If you could elaborate on that, to what extent

is that disparity driven by the participation of the GSEs and to

what extent is it driven by market liquidity at the sort of higher

end and the larger size mortgages that might be less common?

Mr. FALCON. Well, I think certainly the enterprises’ lower cost of

funds by virtue of the GSE status is what results in some of that

differential. Whether or not all of the differential gets passed on to

homeowners is a question. I believe it was CBO several years ago

opined that roughly half of it was passed on to the homeowners

and the rest was for the benefit for shareholders.

I would like to do some more research on the subject, Mr. Chairman, on your specific question.

241

Mr. SMITH. Mr. Chairman, can I just do a quick final question?

Chairman SUNUNU. Sure.

Mr. SMITH. To what extent is this implied support and underwriting by the Federal Government jeopardizing additional competition or participation in the secondary mortgage market by other

totally private organizations?

Mr. FALCON. Well, there is a healthy amount of business done by

private label mortgage-backed securitizers and Ginnie Mae certainly engages in mortgage-backed securities of FHA loans. There

is an issue here about competition. I am not prepared to say a lot

about it, but it is one that I think is appropriate for Congress to

consider.

Generally, I think competition is good.

Mr. SMITH. So are you saying it does to some extent give Fannie

Mae and Freddie Mac somewhat additional advantage?

Mr. FALCON. Without a doubt, Congressman. The existence of the

GSE status on Fannie and Freddie does give them a competitive

advantage over any competitor that does not have GSE status.

That is certainly true.

Chairman SUNUNU. Thank you, Mr. Smith.

Mrs. Clayton.

Mrs. CLAYTON. Thank you.

To follow up, I think that the reason and the rationale for creating and giving the advantage was that indeed there was a need for

generating tools that would enhance the affordability for housing.

Is that not right?

Mr. FALCON. Yes. That was Congress’ purpose in establishing the

GSEs.

Mrs. CLAYTON. And knowingly they gave it an advantage because

there was a public good for which there was a need, otherwise, they

would not have done that.

Mr. FALCON. Yes, that is right.

Mrs. CLAYTON. All of the previous panelists indicated that the

buying back of mortgage-backed securities is perhaps not mission

driven and one, I think Ms. Miles, said it may be a wash, yet Mr.

Ely argued that the absence of a diversified portfolio increased the

risk exposure of the GSEs.

Can it be said that to buy back mortgage-backed securities really

decreases or increases the risk?

Mr. FALCON. I think certainly buying back mortgages does help

the enterprises in the sense that it increases the liquidity for their

mortgage-backed securities. Whether or not that is—it is Congress’

judgment to consider whether or not that is or is not a mission-related right of the enterprises to do that, but certainly it is a sound

business practice to increase the liquidity of the securities and to

the extent that this does increase the liquidity, I do not have a concern about it from a safety and soundness standpoint.

Now, as a mission-related standpoint, that is something I think

is appropriate for Congress to consider.

Mrs. CLAYTON. But you do not have any questions about it undermining the mission?

Mr. FALCON. No, ma’am.

Mrs. CLAYTON. You do not question that the buying back would

undermine the mission. You do see the value in that it strengthens

242

the liquidity of the GSE and therefore reduces the risk which is the

opposite of what Mr. Ely said.

Mr. FALCON. Yes, Congresswoman. It does not undermine the

mission of the enterprises.

Mrs. CLAYTON. On the matter of the implied obligation of the

U.S. Government to the creditors or the investors of the GSEs, the

fact is that the line of credit that has been argued, again, Mr. Ely,

really is very low as it relates to the portfolio, so indeed of that

being an issue to undermine the government’s debt, can you comment on that?

Mr. FALCON. The two and a quarter billion dollars line of credit

which each enterprise has is symbolic. Given their size, that

amount of money would not really do them much good if they were

to experience some severe economic troubles.

Chairman SUNUNU. Mrs. Clayton, if you would yield on that

point for a moment?

Mrs. CLAYTON. Yes.

Chairman SUNUNU. That begs the question what does it symbolize?

Mr. FALCON. I remember this came up, Mr. Chairman, in the

hearing before Congressman Baker as well. And I think it is a matter for discussion and debate by this Task Force, by the Congress,

as to whether or not Congress wants to begin to take away some

of the explicit benefits that the GSEs have.

Removing it would take away some of the aura of the implied

government guarantee. Would it have any adverse effect on homeowners? That remains to be seen and it might be an avenue for further search.

Mrs. CLAYTON. The implied obligation on the part of the government, is that enforceable?

Mr. FALCON. It is enforceable only by Congress. If something

were to happen to the enterprises——

Mrs. CLAYTON. What about a court? Is it enforceable by a court

order?

Mr. FALCON. No, ma’am. The statute—in fact, the 1992 act which

created OFHEO explicitly says that the liabilities of the enterprises

are not backed by the full faith and credit of the Federal Government. It would take an act of Congress to step in and bail out the

creditors of the enterprises if it wanted to do so.

Mrs. CLAYTON. Follow on. Should we really be concerned with

GSEs, their debt or about their safety and soundness if the two are

not the same?

Mr. FALCON. I’m sorry?

Mrs. CLAYTON. Should we really be concerned about the extent

of their debt or we should we be concerned about their safety and

soundness, the security of the GSEs, since the two are not necessarily the same?

Mr. FALCON. Right. Two issues here. One is the size of their debt.

Certainly you would be more concerned about entities like this

which have $2.2 trillion in debts and MBS outstanding as opposed

to whether or not it was $10 million. So size is important here with

respect to the implications to the financial system, should one of

the enterprises ever become insolvent.

243

However, equally or more important is the nature to which those

risks are managed and supervised. That is why OFHEO has a very

extensive examination program, that is why we have a minimum

capital regulation, we will soon have a risk-based capital regulation

in place.

I think with the tools and adequate regulation we can ensure

that those risks are properly managed and that there is not an

undue risk to the financial system. That is OFHEO’s role.

Mrs. CLAYTON. You say you can, but you have found that.

Haven’t you found that they are sound?

Mr. FALCON. Yes, ma’am. Absolutely.

Mrs. CLAYTON. OK. And so the structure or the soundness of the

management has been established and you have evaluated that to

be the case. Is that correct?

Mr. FALCON. Yes. They are financially healthy. They are well

managed institutions.

Mr. APGAR. Excuse me. Just with respect to the Home Loan

Bank System, I would echo the same thing. I think today, there is

no reason for concern about risks that the system poses to the

American taxpayer.

Mrs. CLAYTON. I think also, Mr. Chairman, that the implied advantage given to the GSEs is also an implied advantage given to

the consumer and I would just question what the interest rate

would be for our loans generated if we did not have that.

So I do not know, since we are looking for studies, we may want

to look at what that implication would be and how the interest rate

would be somewhere else if we did not have the intervention of

GSEs in the marketplace. So I think there is great value in having

them there.

Thank you.

Chairman SUNUNU. Thank you very much, Mrs. Clayton.

A few final questions.

Mr. Falcon, you seemed to suggest just a few minutes ago that

safety and soundness was not related to the size of the mortgage

portfolio held by one of the GSEs. Now, it would seem to me that

by purchasing mortgage-backed securities or whole loans and holding them that GSEs expose themselves to the risks we have talked

about, interest rate risk and the prepayment risk, that they were

not exposed to before they held those securities on their own balance sheet.

So that would impact their safety and soundness, with the appropriate caveat that they would hedge and manage those risks in an

appropriate way. But clearly the existence of the portfolio does

have an effect on and is intertwined with safety and soundness in

your evaluation of that in support of the safety and soundness.

Mr. FALCON. Yes. You are right. What I meant to say, if I did

not say it clearly, was the existence of a retained portfolio and

their purchase of mortgage-backed securities is not in and of itself

unsafe and unsound. It is more a question of how they manage the

risk inherent with that activity.

Chairman SUNUNU. And at least in your most recent report, I

think it is a 2000 report, you certainly took those increased risks

and risk management strategies into consideration in issuing the

support for their safety and soundness that you did, correct?

244

Mr. FALCON. Yes, Mr. Chairman.

Chairman SUNUNU. Could you comment briefly on whether you

think there would be some efficiencies to be gained if we combined

your mission regarding safety and soundness with the mission regulation of the GSEs?

Mr. FALCON. I am not sure what efficiencies would be gained.

There could be some. But I would say that having mission regulation is not essential to an effective safety and soundness regulation.

We work well with HUD. We are under the HUD umbrella as an

independent agency within HUD and we are constantly discussing

GSE issues amongst ourselves.

Chairman SUNUNU. One case, though, where there would seem

to be an interrelationship is in the discussion of appropriate investment vehicles and, in particular, the case of the whole cash value

life insurance policies. There was a well publicized example, I

think, several years back of investment in some equities, tobacco

securities or equities or something along those lines.

Those investments are reviewed, as I understand it, by those

looking at mission, but they would ultimately have an effect on

safety and soundness as well. Could both of you comment on that?

Mr. APGAR. Yes. With respect to non-mortgage investments, you

know, clearly, we need to look at the safety and soundness implications and so as we do our non-mortgage investments review, which

take place on the HUD side of the ledger, we coordinate very carefully with OFHEO.

Chairman SUNUNU. Why not allow OFHEO to have jurisdiction

over those issues as well?

Mr. APGAR. Because there are other issues with respect to nonmortgage investment in terms of what types of—as well as with

mortgage investments as to whether or not they enhance the overall effectiveness of the mission, whether they are in the broad public value, we have a three-part test of which safety and soundness

is just one of the criteria we use.

Mr. FALCON. And HUD does approach us on these issues and we

do offer a very thorough analysis to them about the safety and

soundness implications of any activities of the enterprises, Mr.

Chairman.

Chairman SUNUNU. There was some discussion on the previous

panel about global market disruptions such as the Russian devaluation, the series of Asian currency devaluations, and the fact that

these kinds of global economic disruptions or downturns could have

an impact on the safety and soundness of the GSEs.

Now, it seems to me in considering both of those crises that the

market reaction would be one of a flight to quality, which would

have the effect of lowering interest rates or at least supporting demand for both GSE debt and perhaps mortgage-backed securities

that are viewed as a generally less risky investment as compared

to many others that are in the marketplace.

Mr. Falcon, could you comment on whether or not there are

international economic disturbances that have been seen to have a

negative impact on the risk profile of the GSEs, one, and, two, are

the potentials for global economic disruptions, international disruptions included in the risk-based capital standard that you are soon

to release?

245

Mr. FALCON. Let me start with the risk-based capital standard.

We have very lengthy historic data that we use that we built into

our risk-based capital regulation, issues like the credit risk where

you might have defaults associated with mortgages of the enterprises.

That is built into those numbers that we use to model the likelihood of default and the severity of credit losses in the event that

there were defaults on mortgages.

Chairman SUNUNU. Just to be clear, you include historical information about international interest rates and currency values as

well?

Mr. FALCON. We think—not specifically international currency

values or international economic scenarios. We think that is all

built into the historical averages that we use on default rates and

loss severities on mortgages that the enterprises are involved in.

We could look at whether or not we would want to include specific international economic problems, but that would require us to

get into a lot of speculative modeling on how much of an impact

a crisis in Asia might have on mortgage performance in the United

States, that kind of very hypothetical exercise. We try to stay away

from that and make sure that this rule matches known risk to capital.

On the first part of your question, with respect to the risk to the

enterprises from possible international crises and the flight to quality, in 1998 there was such an event and there was a flight to quality and, in fact, Fannie Mae and Freddie Mac used their mortgage

portfolio to be the market essentially for their securities. That

helped their MBSs, their debt remain very liquid and part of a

quality investment.

Chairman SUNUNU. Are there any financial instruments that you

are aware of aside from treasuries that have the level of market

liquidity that the GSEs’ mortgage-backed securities do? I mean

even outside of that extraordinary case in 1998.

Mr. FALCON. Sure. Sure. Some would point to some triple-A rated

corporate debt of some very large companies.

Chairman SUNUNU. That have higher liquidity, similar liquidity

or nearly the same liquidity?

Mr. FALCON. That are regarded as nearly as risk—that have the

same risk level as the enterprises. But they trade closely to GSE

debt. But none of those come to mind really.

Chairman SUNUNU. Thank you very much.

We thank both witnesses again. And the good news—the bad

news, rather, is you are not Alan Greenspan, but the good news is

you were able to keep a room full for about 3 hours.

Thank you for your patience and for all of the information you

provided the Task Force.

We are adjourned.

[Whereupon, at 1 p.m., the Task Force was adjourned.]

Æ