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88–935 PDF 2003

S. Hrg. 108–215

OVERSIGHT OF GOVERNMENT-SPONSORED ENTERPRISES: THE RISKS AND BENEFITS OF GSEs

TO CONSUMERS

HEARING

BEFORE THE

FINANCIAL MANAGEMENT, THE BUDGET, AND 

INTERNATIONAL SECURITY SUBCOMMITTEE

OF THE

COMMITTEE ON 

GOVERNMENTAL AFFAIRS 

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

FIRST SESSION

JULY 21, 2003

Printed for the use of the Committee on Governmental Affairs

(

(II)

COMMITTEE ON GOVERNMENTAL AFFAIRS 

SUSAN M. COLLINS, Maine, Chairman 

TED STEVENS, Alaska 

GEORGE V. VOINOVICH, Ohio 

NORM COLEMAN, Minnesota 

ARLEN SPECTER, Pennsylvania 

ROBERT F. BENNETT, Utah 

PETER G. FITZGERALD, Illinois 

JOHN E. SUNUNU, New Hampshire 

RICHARD C. SHELBY, Alabama 

JOSEPH I. LIEBERMAN, Connecticut 

CARL LEVIN, Michigan 

DANIEL K. AKAKA, Hawaii 

RICHARD J. DURBIN, Illinois 

THOMAS R. CARPER, Delaware 

MARK DAYTON, Minnesota 

FRANK LAUTENBERG, New Jersey 

MARK PRYOR, Arkansas

MICHAEL D. BOPP, Staff Director and Chief Counsel 

JOYCE RECHTSCHAFFEN, Minority Staff Director and Chief Counsel 

AMY B. NEWHOUSE, Chief Clerk

FINANCIAL MANAGEMENT, THE BUDGET, AND INTERNATIONAL 

SECURITY SUBCOMMITTEE 

PETER G. FITZGERALD, Illinois, Chairman 

TED STEVENS, Alaska 

GEORGE V. VOINOVICH, Ohio 

ARLEN SPECTER, Pennsylvania 

ROBERT F. BENNETT, Utah 

JOHN E. SUNUNU, New Hampshire 

RICHARD C. SHELBY, Alabama 

DANIEL K. AKAKA, Hawaii 

CARL LEVIN, Michigan 

THOMAS R. CARPER, Delaware 

MARK DAYTON, Minnesota 

FRANK LAUTENBERG, New Jersey 

MARK PRYOR, Arkansas

MICHAEL RUSSELL, Staff Director 

RICHARD J. KESSLER, Minority Staff Director 

TARA BAIRD, Chief Clerk 

(III)

C O N T E N T S 

Opening statement: Page 

Senator Fitzgerald ............................................................................................ 1

WITNESSES 

MONDAY, JULY 21, 2003

Alex J. Pollock, President and Chief Executive Officer, Federal Home Loan 

Bank of Chicago, Chicago, Illinois ...................................................................... 4

Peter J. Wallison, Senior Fellow, American Enterprise Institute ....................... 6

Bert Ely, Ely and Company, Inc. ............................................................................ 8

W. Michael House, Executive Director, FM Policy Focus .................................... 11

James C. Miller III, Senior Fellow, Hoover Institution ........................................ 12

F. Barton Harvey III, Chairman and Chief Executive Officer, The Enterprise 

Foundation ............................................................................................................ 14

Susan M. Wachter, Wharton School of Business, University of Pennsylvania .. 16

ALPHABETICAL LIST OF WITNESSES

Ely, Bert: 

Testimony .......................................................................................................... 8

Prepared statement with an attachment ....................................................... 52

Harvey F. Barton, III: 

Testimony .......................................................................................................... 14

Prepared statement with an attachment ....................................................... 165

House, W. Michael: 

Testimony .......................................................................................................... 11

Prepared statement with attachments ........................................................... 83

Miller, James C. III: 

Testimony .......................................................................................................... 12

Prepared statement with attachments ........................................................... 103

Pollock, Alex J.: 

Testimony .......................................................................................................... 4

Prepared statement .......................................................................................... 41

Wachter, Susan M.: 

Testimony .......................................................................................................... 16

Prepared statement .......................................................................................... 181

Wallison, Peter J.: 

Testimony .......................................................................................................... 6

Prepared statement .......................................................................................... 45

(1)

OVERSIGHT OF GOVERNMENT-SPONSORED 

ENTERPRISES: THE RISKS AND BENEFITS 

OF GSEs TO CONSUMERS 

MONDAY, JULY 21, 2003

U.S. SENATE,

SUBCOMMITTEE ON FINANCIAL MANAGEMENT,

THE BUDGET, AND INTERNATIONAL SECURITY,

OF THE COMMITTEE ON GOVERNMENTAL AFFAIRS, Washington, DC. 

The Subcommittee met, pursuant to notice, at 2 p.m., in room 

SD–342, Dirksen Senate Office Building, Hon. Peter G. Fitzgerald, 

Chairman of the Subcommittee, presiding. 

Present: Senator Fitzgerald. 

OPENING STATEMENT OF SENATOR FITZGERALD 

Senator FITZGERALD. I would like to call this meeting to order. 

Let me first welcome our distinguished panel of experts here today. 

We appreciate all of you making time in your busy schedules to be 

here for this important topic. 

Let me first set forth the purpose of this hearing, as I see it. The 

purpose is, No. 1, to examine the current status of Fannie Mae and 

Freddie Mac and possibly the Federal Home Loan Bank Boards, 

which are also Government-Sponsored Enterprises and are involved in housing. At least, the Chicago Federal Home Loan Bank 

is. And two, to engage in a balanced and healthy debate about the 

risks and benefits of these large corporations, which were established by Congressional charters. 

Let us stipulate at the outset that the housing GSEs fulfill an 

important public policy mission that is built into their government 

charters, to facilitate home ownership by low- to moderate-income 

families. In my judgment, the housing GSEs have contributed 

meaningfully to this cause, helping to give us perhaps the best 

housing market in the world. 

Second, GSEs, by charter, have prescribed limits on their activities. Unlike most companies, GSEs cannot enter into any business 

they want. In the case of Fannie and Freddie, they are limited 

largely to dealing in mortgages and mortgage finance. Moreover, 

the size of the mortgages they can deal in is carefully limited in 

their charters. 

Third, the GSEs have effectively promoted access to mortgage 

credit throughout the Nation, including inner cities, rural areas, 

and underserved areas, by increasing the liquidity of mortgage inVerDate 0ct 09 2002 09:35 Dec 11, 2003 Jkt 088935 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 C:\DOCS\88935.TXT SAFFAIRS PsN: PHOGAN
2

vestments and improving the distribution of investment capital 

available for residential mortgage financing. 

That being said, we cannot ignore continuing news reports regarding the size, complexity, and financial status of these housing 

GSEs, in particular, Fannie Mae and Freddie Mac. These news reports raise a number of questions. Is there adequate market discipline on Fannie and Freddie? Would more competition help in ensuring that Fannie and Freddie do not take unnecessary risks? Are 

they adequately capitalized? Are some of the features of their special status as GSEs necessary in today’s sophisticated financial 

marketplace? 

What are the implications of interest rate volatility? If lower interest rates lowered Fannie Mae’s earnings, as were recently reported, what will happen when the Federal Reserve takes away the 

proverbial punch bowl and starts raising interest rates? Are Fannie 

and Freddie both completely hedged against falling and rising 

rates? And if they are perfectly hedged, how is it that they can 

earn a profit? 

Is it appropriate for us to allow banks and S&Ls to have an unlimited amount of GSE debt on their balance sheets? By so aggressively promoting housing, are we not artificially sucking debt capital away from more productive enterprises, as American families 

move into larger and larger homes in ever-expanding metropolitan 

areas? 

After several weeks of studying Fannie and Freddie, my own 

guess is that they are probably strong enough and sufficiently 

hedged enough to survive a serious downturn in the housing market. But perhaps they are not strong enough to survive the severest 

of financial downturns, such as we had in the 1930’s. But then 

again, nor are many of our largest companies and financial institutions. 

I am pleased to welcome our distinguished panel of witnesses, 

who collectively represent some of the best minds in this debate, 

both for and against. Unfortunately, we do not have representatives from Fannie or Freddie testifying today, but notwithstanding 

their absence, we have at least one GSE, the Federal Home Loan 

Bank of Chicago, represented by its President, Alex Pollock. My 

hope is that we can engage in a balanced but vigorous debate so 

that we can ensure the continued success of GSEs in fulfilling their 

mission. 

I would now like to introduce our witnesses before calling on 

each of them for an opening statement. 

Our first witness is Alex J. Pollock, the President and Chief Executive Officer of the Federal Home Loan Bank of Chicago. Mr. Pollock has had a distinguished financial career in my home State of 

Illinois and has been in his current position since 1991. He is 

known as the architect of the innovative Mortgage Partnership Finance program, which has grown to over $35 billion in assets since 

its introduction in 1997, and is the author of numerous articles on 

banking, financial systems, and management. 

Mr. Pollock will be followed by Peter J. Wallison, Senior Fellow 

of the American Enterprise Institute and Co-Director of AEI’s program on financial market deregulation. Prior to joining AEI in 

1999, Mr. Wallison served as General Counsel of the U.S. Treasury 

3

Department and Counsel to President Ronald Reagan and was a 

partner with Gibson, Dunn and Crutcher. 

Next, we will hear from Bert Ely, who has specialized in deposit 

insurance and banking structure issues since 1981. Mr. Ely currently is the principal of Ely and Company, a consulting firm devoted to financial institutions and monetary policy. Mr. Ely has testified before Congress on numerous occasions to share his expertise 

in banking issues. Prior to the founding of his firm, Mr. Ely served 

as Chief Financial Officer of a public company and as a management consultant with Touche Ross and Company and was an auditor with Ernst and Ernst. 

I would also like to welcome W. Michael House, Executive Director of FM Policy Focus and a partner with Hogan and Hartson. In 

these capacities, Mr. House concentrates on regulatory matters before Congress, representing national and multinational corporations, trade associations, and coalitions. Prior to his current position, Mr. House served as Chief of Staff to former U.S. Senator 

Howell Heflin from Alabama. 

Next, we will hear from the Hon. James C. Miller III, Chairman 

of CapAnalysis Group, LLC, Senior Fellow at the Hoover Institution at Stanford University, and counselor to Citizens for a Sound 

Economy. From 1981 to 1985, Mr. Miller served as Chairman of the 

Federal Trade Commission and subsequently was named by President Reagan as Director of the Office of Management and Budget. 

I would also like to welcome Bart Harvey, Chairman of the 

Board and Chief Executive Officer of the Enterprise Foundation. As 

Chairman and CEO, Mr. Harvey provides seed capital, operating 

funds, financing, technical assistance, and training to help rebuild 

low-income communities. Prior to joining the Enterprise Foundation in 1984, Mr. Harvey served in a number of domestic and international positions for the investment bank Dean Witter Reynolds. 

To close our panel, the Subcommittee will hear from Dr. Susan 

M. Wachter from the Wharton School of Business at the University 

of Pennsylvania. Dr. Wachter is a professor of real estate, finance, 

and city and regional planning at the university, a position she has 

held since 1972. Dr. Wachter also serves as a visiting fellow at the 

Brookings Institution and has received numerous awards for her 

teaching excellence in the area of financial management. 

Again, I would like to thank all of you for being available today 

to testify on the risks and benefits of Government-Sponsored Enterprises. 

In the interest of time, I would ask that you summarize your testimony as best you can. I have read all of your statements and they 

are all very good. Some are very brief and actually could be read 

here, but others are much more lengthy, and for those of you who 

have written very lengthy opening statements, if you could submit 

those statements for the record, they will be included as part of the 

permanent record of this hearing. If you could just summarize your 

comments, I think that would keep us moving along much more 

quickly. 

We try to give each of you 5 minutes for your opening statement 

and then we will go for a free-for-all debate, with both advocates, 

pro and con, on the panel and we will all have a very lively debate. 

Mr. Pollock, thank you for coming from Chicago, and welcome. 

4

1The prepared statement of Mr. Pollock appears in the Appendix on page 41. 

TESTIMONY OF ALEX J. POLLOCK,1 PRESIDENT AND CHIEF EXECUTIVE OFFICER, FEDERAL HOME LOAN BANK, OF CHICAGO, CHICAGO, ILLINOIS 

Mr. POLLOCK. Thank you very much, Mr. Chairman, and thank 

you for giving us the opportunity to share our views with you. We 

believe your hearings today are very appropriate. 

The American single-family mortgage market is the biggest credit market in the world. It seems to us it is socially the most important. It is the current version of Thomas Jefferson’s view that we 

ought to have a property-owning citizenry to have a vibrant republic. Fannie Mae and Freddie Mac are surely the most important 

factors in this extremely large and important market. 

We take as the key question for today, in such a market in which 

Government-Sponsored Enterprises play the central role, how do 

we assure that the benefits of the GSE charter are passed through 

the mortgage finance system to benefit home-buying consumers? 

Before I give our thoughts on this, I do want to note that I am expressing the views of the Chicago Federal Home Loan Bank. There 

are 12 Federal Home Loan Banks. Each is a company. Each has 

its own management, its own board, and most distinctly, its own 

views. So this is the Chicago view, and given its market orientation, perhaps we fit in with other Chicago views and Chicago 

schools. 

The Chicago view on today’s key question can be summarized 

easily. It is: The best way for Congress to ensure that GSE charter 

advantages are passed through to consumers, is to encourage greater competition in the GSE sector. 

Mr. Chairman, in your opening remarks, you mentioned market 

discipline. That is another word for competition, and indeed, we believe that the market forces of competition and the innovation and 

efficiency they induce are the best disciplines for all enterprises, including GSEs. No amount of regulation or redesign in regulators or 

thinking about regulatory structures, however important that may 

be, can substitute for the effects of competition. 

There are, of course, three housing GSEs, as you mentioned, Mr. 

Chairman, Fannie Mae, Freddie Mac, and the Federal Home Loan 

Banks. We are all major sources of housing finance. We are all 

major issuers of debt, and indeed, we were all set up (in 1932 for 

us, 1938 for Fannie, and 1970 for Freddie), in times of economic 

stress and problems. The key function of all housing GSEs is to 

link the mortgage market to the bond market, so, of course, we are 

involved with bonds. 

I think it is safe to say all three GSEs have evolved differently 

than their designers would ever have imagined, and that is part of 

the reason why it is a good idea to think about them now. 

Of the three, there is no doubt that Fannie Mae and Freddie Mac 

dominate the secondary mortgage market. Last year, 2002, they 

represented more than 80 percent of the conforming loan volume. 

If you look at the outstanding loans of conforming size, that is to 

say, eliminating jumbos and FHA loans and sub-prime, Fannie and 

Freddie together have at least a 67 percent market share of all the 

outstanding single-family conventional loans, as defined. That is a 

5

big share measured in any way. And on top of that, they have sustained a remarkable, extremely profitable record over many years, 

with rates of return on common equity year after year in the 25 

percent range. 

It seems clear to us, as part of this, that lending institutions who 

divest their credit risk to Fannie and Freddie by paying guarantee 

fees, pay very high fees relative to the losses involved. For example, last year, those guarantee fees averaged 19 basis points per 

year, but the losses were less than one basis point per year. It was 

a good credit year, but lenders are paying what we view as a noncompetitive fee. 

We think that both businesses of the GSEs, that is the mortgage 

funding business and the credit guarantee business, are in need of 

more competition. It is that need which has, at the root, generated 

the debates about Fannie Mae and Freddie Mac, in which all of the 

distinguished panelists here today have played a role. 

In our view, there are three possible outcomes to this debate. 

One is continued expansion and even more market dominance by 

Fannie and Freddie. The second is the privatization of GSEs and 

removing all their ties to the government. The third is creating a 

more competitive, economically efficient sector. I am not speaking 

of operationally efficient; I am speaking of economically efficient, 

which means the lack of the economic rents which today characterize the GSEs. 

As to No. 1, it is easy to imagine continuation of the status quo, 

leading to ever greater market dominance by Fannie Mae and 

Fannie Mae. 

As to No. 2, you can make very strong theoretical arguments that 

privatization is the right answer, and in fact, my good friend Peter 

Wallison has and does make such arguments. However, most people think the actual probability of privatization is something close 

to zero. We conclude that, as a practical matter, the only available 

way to improve this GSE sector (which has made great contributions, Mr. Chairman, we agree), in order to get greater consumer 

benefit is to increase competition. 

As an essential fact in the mortgage funding business, only a 

GSE, because of the GSE advantages, can compete with another 

GSE. Therefore, the Home Loan Banks, through our Mortgage 

Partnership Finance business, have set out to compete in the mortgage funding business. Through the risk sharing structures of 

Mortgage Partnership Finance, we have put over 500 private financial institutions, all Federal Home Loan Bank members, into competition with Fannie Mae and Freddie Mac in the credit guarantee 

business. Because of this, credit risk which would otherwise be concentrated in Fannie and Freddie is now dispersed into hundreds of 

private institutions. 

So we are making a serious effort to carry out our own theory 

of making the GSE sector more competitive, but I am sure there 

are many other additional pro-competitive possibilities which could 

be considered. 

As Andrew Jackson said in 1832, when vetoing the rechartering 

of the Second Bank of the United States, the GSE of its day, if we 

cannot make our government all that it should be, at least we can 

6

1The prepared statement of Mr. Wallison appears in the Appendix on page 45. 

take a stand against the grants of monopolies. I imagine that Andy 

Jackson would have extended that thought to duopolies, as well. 

Mr. Chairman, thanks again for the opportunity to present our 

views. 

Senator FITZGERALD. Thank you, Mr. Pollock. I had never 

thought of the Bank of the United States as a GSE, but I guess 

now that I think about it, you are probably right. 

Mr. Wallison, thank you. You may proceed. 

TESTIMONY OF PETER J. WALLISON,1 SENIOR FELLOW, 

AMERICAN ENTERPRISE INSTITUTE 

Mr. WALLISON. Thank you, Mr. Chairman. The title of these 

hearings, it seems to me, was quite well chosen, because the real 

question for Congress is whether the benefits provided by Fannie 

Mae and Freddie Mac outweigh their costs and the risks they create. 

In my view, the case against Fannie Mae and Freddie Mac is 

very simple. They create enormous risks for the government, for 

the taxpayers, and for the economy as a whole, and yet—if I may 

disagree respectfully with your opening statement, Mr. Chairman, 

provide no significant benefit to homeowners today. 

Fannie and Freddie have been doubling in size every 5 years and 

now have combined liabilities of almost $3.3 trillion. This is not a 

problem that can, in my view, be safely or responsibly put off. 

Fannie Mae and Freddie Mac were created for a single purpose, 

to provide liquidity for the housing finance system by creating a 

market for mortgages made by banks and other mortgage originators. They did this very well. There is now a vibrant and efficient 

secondary market for residential mortgages. The structure will now 

operate without government assistance of any kind and does, in 

fact, in what is called the jumbo market. So Fannie and Freddie 

are no longer necessary for their original purpose. They should be 

thanked and sent home. 

Fannie and Freddie know all of this, so they have been diligent 

in creating a rationale for themselves that does not depend on their 

providing liquidity to the housing market. They now say that they 

help put people in homes by lowering interest rates on home mortgages. They also suggest through their advertising that they disproportionately help minority home buyers. However, they do not 

really do these things. 

Many studies have shown that Fannie and Freddie’s activities reduce rates on home mortgages by a very small amount, somewhere 

in the range of 25 basis points, or one-quarter of one percent. If I 

can put this in some perspective, every time the Fed raises interest 

rates one-quarter of a point, it has the opposite effect. If that onequarter point were as important as Fannie and Freddie suggest in 

their advertising, thousands and thousands of American families 

would be frozen out of home ownership every time the Fed raises 

interest rates by a quarter-point. I don’t think that happens. 

In any event, as shown by a Census Bureau study presented at 

an AEI conference in October, the monthly cost of owning a home 

is not the obstacle that prevents renters from buying homes. The 

7

obstacle is the down payment. Most renters do not have the down 

payment necessary to buy a home. Accordingly, the claim by 

Fannie and Freddie that they put people in homes by reducing interest rates is not true. 

Through their advertising, Fannie and Freddie also suggest that 

they provide special assistance to minority families hoping to become homeowners, but they do not do this, either. Instead, according to a study by Jonathan Brown of Essential Information, a 

Nader-related group, Fannie and Freddie buy proportionately fewer 

conventional conforming loans that banks make in minority and 

low-income areas than they buy in middle-class white areas. 

So the U.S. housing finance system gets very little benefit from 

the continued existence of Fannie and Freddie as GovernmentSponsored Enterprises. What, then, are the costs? 

In 2001, CBO estimated that Fannie and Freddie receive an implicit subsidy from the U.S. Government, in effect, an extension of 

U.S. Government credit, with an annual value of at least $10.6 billion. But the costs, stated in terms of the risks they create, are far 

greater than this. Because Fannie and Freddie are implicitly 

backed by the U.S. Government, financial problems at either of 

them could require a government bailout. The government has 

done this before for other GSEs. 

Until the recent problems at Freddie, we might have said, and 

I did say, that both were in such good financial health that a bailout was not at all likely. Now, because of doubts about the accounting of both of them, no one can be sure of this anymore. Given their 

$3.3 trillion liabilities, if even a small part of this obligation has 

to be made up by taxpayers, it will make the S&L bailout look insignificant. 

But even that does not end the risks we all face with these two 

companies. Because they are integral to the health of the housing 

market, the failure of either of them could have a systemic effect, 

meaning an adverse effect on the economy as a whole. 

One of the ways they might do this, incidentally, is through the 

holding of their securities by our financial institutions. If their securities decline in value, so does the capital of these institutions, 

reducing the amount that they can lend in any area, not just in the 

mortgage area. 

Thus, since there are only two of these companies, it is accurate 

to say that the continued health of our economy depends on decisions by only two corporate managements. If one of them makes a 

grave mistake, the entire economy could suffer. And the recent 

events at Freddie Mac show that management judgments are not 

infallible. 

So what is to be done? Congress can change this calculus in a 

number of ways. Although I favor complete privatization, there is 

a less dramatic way to reduce the risks Fannie and Freddie create. 

Congress should prohibit Fannie and Freddie from buying back 

their mortgage-backed securities or accumulating any substantial 

portfolio of mortgages. Most of the limited benefits that Fannie and 

Freddie provide to the mortgage market come from their issuance 

of mortgage-backed securities. Most of their financial risks come 

from buying back these securities and accumulating portfolios of 

mortgages. 

8

1The prepared statement of Mr. Ely with an attachment appears in the Appendix on page 

52. 

Yet buying back MBS and holding mortgages in portfolio doesn’t 

have any effect, positive or negative, on mortgage rates. So Congress, simply by prohibiting them from repurchasing their own 

mortgage-backed securities, can largely eliminate the risks they 

create without affecting mortgage interest rates. I respectfully recommend this to you, Mr. Chairman, and to the Committee. 

That concludes my testimony. Thank you. 

Senator FITZGERALD. Thank you, Mr. Wallison. Now, we would 

welcome your testimony, Bert Ely. Thank you very much for being 

here. 

TESTIMONY OF BERT ELY,1 ELY AND COMPANY, INC. 

Mr. ELY. Mr. Chairman, thank you. I am here to testify today 

with regard to America’s Government-Sponsored Enterprises. 

While I will focus on Fannie Mae and Freddie Mac, at times, I will 

touch on three other GSEs, the Federal Home Loan Bank System, 

the Farm Credit System, and Farmer Mac. 

I will first summarize major problems Fannie and Freddie pose 

and then discuss what we do not know today about the two companies. After reviewing underlying problems caused by Fannie and 

Freddie’s GSE status, I will comment on proposed GSE tweaks, 

none of which will solve the GSE problem. I will conclude by discussing longer-term solutions to the GSE problem, including complete privatization. 

The Fannie and Freddie problem today and the broader GSE 

problems stem from their relatively rapid growth, which has been 

facilitated by their numerous privileges. This growth has been driven by management desires to enhance the wealth of GSE executives as well as the wealth of stockholders in the three stockholderowned GSEs. 

In addition to being unfair competitors, the GSEs pose increased 

systemic risk to the U.S. financial system and, therefore, the taxpayers. Fannie and Freddie are too big to fail. The financial markets clearly believe Congress will rescue any troubled GSE, as it 

has done twice before. 

The potential for a third GSE rescue has been heightened by the 

troubling revelation of serious accounting problems at Freddie. 

Should those problems worsen, then a Congressional rescue of 

Freddie and its Siamese twin, Fannie, will become increasingly 

likely. 

Particularly troubling is that we don’t fully know what we don’t 

know about Fannie and Freddie. So far, Freddie’s problems have 

been characterized as just accounting problems driven by a desire 

to smooth its earnings. However, the ongoing investigation of 

Freddie’s finances may reveal serious problems in its risk management practices. Concern about Freddie’s risk management was expressed quite strongly by Senator Corzine at last Thursday’s Banking Committee hearing on the GSEs. He is better placed than perhaps any other Member of Congress to express that concern. 

One reason we don’t know what we don’t know about Fannie and 

Freddie stems from their inadequate financial disclosures, specifiVerDate 0ct 09 2002 09:35 Dec 11, 2003 Jkt 088935 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 C:\DOCS\88935.TXT SAFFAIRS PsN: PHOGAN
9

cally the risk associated with their interest rate derivatives. There 

is also a troubling lack of comparability in the disclosures of the 

two companies. 

OFHEO Director Armando Falcon has tried to soothe Congressional and public concerns about Freddie’s financial condition by 

stating that the financial restatement process should not alter the 

result of its quarterly risk-based capital stress test. However, the 

test is both outdated and too rigid. Neither Congress nor anyone 

else should take comfort in that test today or in the future. 

The special status, privileges, and benefits Congress has granted 

to the GSEs and particularly to Fannie and Freddie underlie the 

GSE problem. First, the GSE’s arbitrage the interest rate yield 

curve and their GSE status through maturity mismatching on their 

balance sheets. They partially hedge their maturity mismatching 

through derivatives. A private sector mortgage investor could not 

safely operate today with such a high degree of maturity mismatching. 

Second, America has an inefficient housing finance system stemming from its reliance upon the secondary mortgage marketplace 

and the creation of mortgage-backed securities. 

Third, by lowering the cost of debt capital for those who can borrow from a GSE or whose debt is secured by a GSE loan guarantee, 

GSEs tilt capital flows away from other sectors of the economy, notably the productive sector. 

Fourth, the United States is experiencing an unhealthy shift toward GSE financing and away from genuine private sector financial intermediation. Because GSEs are political creatures, it is extremely difficult to correct this shift. 

Fifth, because they are a statutory construct, Fannie and Freddie 

represent relatively rigid features of the American financial landscape. They are largely exempt from the market forces constantly 

reshaping the financial institution landscape. 

Sixth, according to CBO, Fannie and Freddie operate quite inefficiently in delivering a housing finance subsidy. Approximately 30 

percent of the subsidy stayed with Fannie and Freddie in 2000, 

which explains the above-market equity rates of return Fannie and 

Freddie consistently earn. 

Seventh, some portion of the Fannie and Freddie subsidy goes to 

the sellers of homes, not purchasers. A slight rise in housing prices 

fully capitalizes the subsidy, thereby shifting all of it to sellers. 

Eighth, a substantial portion of the subsidy flows to existing 

homeowners, not to first-time home buyers. 

Numerous proposals have been offered to rectify problems and 

risks Fannie and Freddie pose. These tweaks will not solve the 

Fannie-Freddie problem. Repealing the Fannie and Freddie SEC 

exemption is an easily executed reform, but that will not cure the 

problem. 

Restructuring GSE regulation will be extremely difficult, but 

moving boxes around a government organization chart will not address the myriad of GSE problems. It would be better to move directly to more fundamental GSE reform. 

Giving OFHEO more money and power will not suffice. Repealing the GSE State income tax exemption is highly meritorious, but 

extremely difficult to accomplish politically. Repealing the GSE’s 

10

Treasury line of credit would have symbolic value, but would be 

difficult to achieve. 

Higher capital levels have surface appeal, but they might not 

have the desired effect because of their arbitrary nature. Further, 

the present credit risk leverage ratio for Fannie and Freddie may, 

in fact, be adequate. 

Ending mission creep has been the goal of many, but hard to 

achieve because of the difficulty defining a new financial product. 

The greatest public policy challenge facing Congress is what to 

do should one of the GSEs experience serious financial difficulties, 

for those problems could spill over to the other GSEs. Freddie’s recent accounting problems and management shakeup highlight this 

problem. 

Complete privatization is the only real solution to the GSE problem, but first, three points. If they do not exist today, would Congress create the GSEs? I doubt it, for the political impediments 

which sparked the creation of the GSEs have largely disappeared. 

Second, little can be done to curb Fannie and Freddie’s growth. 

Given their enormous political clout, Fannie and Freddie will succeed in repelling FM Policy Focus’s containment initiatives. 

Third, Fannie and Freddie should be barred from owning mortgages or MBS, as my good friend Peter Wallison has just mentioned, beyond that needed to facilitate ongoing securitization activities. This would help mightily to reduce, if not eliminate, the 

systemic risk they pose. Limiting Fannie and Freddie to just the 

credit guarantee business might encourage them to seek privatization. 

Privatizing Fannie and Freddie would do five things. First of all, 

it would eliminate GSE risk to taxpayers. 

Second, it would create a much more efficient housing finance 

system. 

Third, it would build a level, competitive playing field among all 

private housing finance firms. 

Fourth, it would create a more flexible and adaptive housing finance industry. 

And finally, it would target delivery of the housing finance subsidy to just those home buyers on the cusp of home ownership. 

A forthcoming paper will present my Fannie and Freddie privatization proposal in great detail. It will explain how market forces 

can restructure the housing finance marketplace so that the efficiencies of moving large blocks of debt capital to private sector 

mortgage originators can be fully captured. Market forces, not arbitrary capital regulations, will determine the amount of capital that 

institutional mortgage owners would hold. 

The paper also will propose a housing finance tax credit modeled 

on the Earned Income Tax Credit that will go only to those home 

buyers on the cusp of home ownership. Finally, it will address allimportant transition issues as well as the privatization of the Federal Home Loan Banks. 

Mr. Chairman, the time is fast approaching when Congress must 

undertake fundamental reform of the GSEs by setting in motion 

the complete privatization of these anachronistic entities. I look forward to your questions. 

Senator FITZGERALD. Thank you. Mr. House. 

11

1The prepared statement of Mr. House with attachments appears in the Appendix on page 

83. 

TESTIMONY OF W. MICHAEL HOUSE,1 EXECUTIVE DIRECTOR, 

FM POLICY FOCUS 

Mr. HOUSE. Thank you, Mr. Chairman. FM Policy Focus is a coalition of seven associations of financial services companies actively 

engaged in the mortgage industry. We were pleased to be invited 

to appear before you today and commend you for holding this hearing. 

In 1938, Congress decided to rescue a distressed mortgage market. It was a genuine example of Congressional vision and we, as 

an organization, strongly support this vision through the continuation of the core mission of the two housing GSEs, Fannie Mae and 

Freddie Mac. 

Our members also believe that more can be done to expand home 

ownership among all Americans and especially among minorities 

and households who find it financially difficult to afford a home of 

their own. 

The GSEs play a vital role in this expansion, and for this reason, 

Congress subsidizes them to the tune of more than $10 billion annually. However, in order for the GSEs to be in full compliance 

with their charters and fulfill their Congressional mandated mission, they need effective government oversight founded on three 

important principles: Effective regulation, sound capital, and market discipline from enhanced disclosure. 

From where we sit today, Fannie and Freddie are zero for three. 

They are weakly regulated by an underfunded and understaffed 

agency. They hold far less capital than that required by bank regulators, and they are the only two publicly traded companies in the 

Fortune 500 that are statutorily exempt from the Nation’s security 

laws. If they were private institutions, homeowners and investors 

alike would be at great risk. But since Fannie Mae and Freddie 

Mac are Government-Sponsored Enterprises, taxpayers could go 

from being in the dark about their operations to being in the red 

to bail them out. 

The first principle of effective regulation is the establishment of 

a strong single regulator. In 1992, Congress created OFHEO as the 

safety and soundness regulator, and while making HUD responsible for overseeing the GSEs affordable housing mission and new 

programs. Unfortunately, this regulatory system has failed us in all 

three categories. 

It took 10 years for OFHEO to produce a complicated and inadequate capital rule for the GSEs. Moreover, the GSEs lag the private sector in promoting affordable housing. Don’t just take my 

word for it: There are 24 separate studies based on HUD data that 

prove it. I have attached the list to my written comments. 

In 1992, Congress passed an Act that also directed HUD to 

preapprove new programs of the GSEs, but the agency has never 

implemented a meaningful new program review. This failure takes 

on new urgency since many of the new activities that GSEs undertake are financial products targeted directly at consumers. 

Therefore, FM Policy Focus recommends that Congress replace 

the existing ineffective regulatory regime with a strong single reguVerDate 0ct 09 2002 09:35 Dec 11, 2003 Jkt 088935 PO 00000 Frm 00015 Fmt 6633 Sfmt 6633 C:\DOCS\88935.TXT SAFFAIRS PsN: PHOGAN
12

1The prepared statement of Mr. Miller with attachments appears in the Appendix on page 

103. 

lator in the Treasury with authority over safety and soundness and 

mission. This structure should have all the attributes cited by 

Chairman Greenspan in his testimony before the Senate Banking 

Committee just last week namely, expertise, regulatory authority, 

and power strong enough to keep the GSEs safe and sound. 

The second principle is that the GSEs should be required to have 

capital standards similar to that required of banks, that is, banklike capital. Fannie and Freddie are allowed to operate on a razorthin capital base that doesn’t even measure up to the capital held 

by the S&Ls in the 1980’s prior to their collapse. 

And the third principle is that the GSEs’ exemption from the Securities Act of 1933 and the Securities and Exchange Act of 1934 

should be repealed. At a time when the rest of corporate America 

is subject to stringent review, Fannie and Freddie continue to operate as islands unto themselves. It is especially dangerous in light 

of the revelations about Freddie Mac and its earnings restatement. 

Mr. Chairman, the GSEs are too big to ignore. These two companies alone are larger than the entire S&L industry combined, and 

that is why the stakes of this debate are so high. The current regulatory scheme is bifurcated and it is weak and subject to undue influence from the GSEs. Fannie and Freddie already pose a significant risk to the financial markets, a risk that is compounded by 

their incursions into new activities that go beyond their core mission. 

In closing, EM Policy Focus believes that Congress must restructure GSE regulation for all players to ensure that the GSEs are effectively regulated. I thank the Committee for allowing me to testify and ask that my entire statement be put in the record. I would 

be glad to respond to questions. 

Senator FITZGERALD. Thank you. Without objection. Mr. Miller. 

TESTIMONY OF JAMES C. MILLER III,1 SENIOR FELLOW, 

HOOVER INSTITUTION 

Mr. MILLER. Mr. Chairman, thank you for having me here. I 

have a statement with attachments I would ask be included in the 

record. 

Senator FITZGERALD. Without objection. 

Mr. MILLER. Thank you, sir. I understand the focus of this hearing is on the benefits and risks of the housing GSEs. It so happens 

that over the past couple of years, I have been involved in two 

major studies that are pretty much on target here and I would like 

to describe them briefly for you. 

The first study was prepared by Dr. James Pearce of Welch Consulting and myself and it addressed directly the benefits and costs 

of the two housing GSEs of most substantial importance here, 

Freddie and Fannie. And what we did was estimate first the benefits to consumers, and the way we went about that was, in simplified form, looking at the difference between the interest rates 

paid by consumers in the conforming market, which Freddie and 

Fannie are able to facilitate, and the jumbo market, which is above 

13

that. Mr. Pollock mentioned that jumbo market is, in fact, competitive. 

Well, what we found is that there is a big jump in the interest 

rates paid by consumers, or the mortgage rates paid by consumers 

when you traverse from the conforming rate into the jumbo rate. 

We estimated that the jump was at least 24 basis points. We also 

concluded there was an indirect effect in the jumbo market of at 

least five basis points, and if you multiply that by the conforming 

loans and jumbo loans that are outstanding, involving some ranges, 

because there was some discussion about different methodologies, 

different databases give you slightly different answers, we feel very 

confident that the benefits bestowed by the nexus that Freddie and 

Fannie have with the Federal Government generate on the order 

of $8.4 billion to $23.5 billion per year. 

Then we looked and tried to measure directly the funding advantages these two GSEs realize because of their nexus with the Federal Government, and others have talked about the reasons for 

those. We found on short-term debt, there was about a 10- to 20-

basis point advantage. On long-term debt, between 10 and 40 basis 

points. And with respect to MBSs, between 10 and 30 basis points. 

Given the amount of debt outstanding, or borrowing, this amounts 

to about $2.3 billion to $7.0 billion a year. 

Now, importantly, what this shows is even the high estimate of 

the funding advantages to the GSEs is below the low end of our 

estimate of the advantages to consumers. 

Now, I want to make a point here, Mr. Chairman, and that is 

that our study attempted to measure directly these benefits and directly the funding advantage. Others, including CBO, have used a 

model which is basically zero-sum. They estimate the funding advantages and take away from that the consumer advantages and 

there is a fee left over, ignoring the fact that these GSEs may contribute a great deal of value to the housing finance market by virtue of their greater efficiencies, the economies of scale, the innovations, and maintaining liquidity generally in the marketplace. I 

think their model is fatally flawed because you could find that your 

estimate of consumer benefits exceeded the amount of the funding 

advantage, which is a nonsensical result. 

The second study is one that CapAnalysis, the group that I chair, 

did. As you know and was mentioned here, OFHEO recently promulgated a risk-based capital standard for judging the capitalization of these two GSEs. What this standard does is hypothesize a 

4-year period during which there is a dramatic fall in housing 

prices, disruption of housing, and dramatic reductions in interest 

rates. That is one part of the test. The other part of the test is a 

rise in interest rates for a 4-year period. And then the question is, 

would these GSEs survive over a 10-year period? 

Now, some questions were raised. Well, this is not just the usual 

kind of capital measures, capital-asset ratios, that apply to other 

federally-regulated financial institutions, and while Freddie and 

Fannie do have to meet certain capital requirements, it is not the 

same. So would this test really be very rigorous? 

Well, what we did was hypothesize the thrift industry as being 

a single firm, as if it were a single firm, would it, in fact, meet this 

OFHEO risk-based capital standard?—and we applied it and guess 

14

1The prepared statement of Mr. Harvey with an attachment appears in the Appendix on page 

168. 

what? In the case of the upward interest rate scenario, it failed 

after 71⁄2 years. The industry failed the test. And, in fact, it would have needed $32 billion more in capital at the beginning of the period in order to survive the 10-year test period. It did pass the interest rate reduction scenario, but since it failed one part of the 

test, it failed it in total. 

Mr. Chairman, we have an extraordinarily vigorous housing industry that is enabled by a comprehensive mortgage finance industry that is facilitated by Freddie and Fannie and other GSEs. All 

institutions, in my experience, can stand improvement. I have no 

doubt that is true of Freddie and Fannie and the other housing 

GSEs. But I think for somebody who has looked at a lot of them, 

it seems to me that these are very well-run enterprises and that 

they have done a substantially superior job of facilitating this very 

important market. Thank you. 

Senator FITZGERALD. Thank you, Mr. Miller. Mr. Harvey. 

TESTIMONY OF F. BARTON HARVEY III,1 CHAIRMAN AND 

CHIEF EXECUTIVE OFFICER, THE ENTERPRISE FOUNDATION 

Mr. HARVEY. Thank you, Mr. Chairman, for this opportunity. 

First, just a little bit about Enterprise. Enterprise is a national 

nonprofit organization that provides private capital to support affordable housing and economic development in low-income communities. We have raised and invested $4.4 billion to finance 144,000 

affordable homes for low- and very-low-income families and individuals. 

I can say at the outset, we have no more important partners in 

our work than the housing GSEs. Fannie Mae, Freddie Mac, and 

the Federal Home Loan Banks have been indispensable to Enterprise’s efforts to expand housing opportunities for low-income and 

very-low-income homeowners and renters. In many cases, the GSEs 

alone were willing and able to help Enterprise meet these needs. 

Without the GSEs, much of our work simply would not be possible. 

Now, we are no experts on macroeconomic benefits. You have got 

many of them here. We are not a research institute. We are a practitioner. I think we are the only practitioner on this panel. And we 

are one of the largest and representative of many more in the country who provide resources to consumers who are often left out of 

the mainstream housing market. Our testimony addresses how we, 

working with the GSEs, address the needs of low-income families 

and individuals. 

First of all, the GSEs must meet, as you said yourself, strong 

Federal requirements to finance affordable housing. The legislation 

that provides Fannie and Freddie’s legal and regulatory framework 

requires them to dedicate substantial portions of their business to 

serving low-income people and communities. In fact, as Frank 

Raines said in his 2002 annual report, ‘‘for Fannie Mae, focusing 

on underserved Americans is more than just the right thing to do 

or something we do on the side. It is the center of our business.’’ 

That can be said for Freddie Mac, and in its own way for the Federal Home Loan Bank System. 

15

HUD substantially strengthened the public policy requirements 

for Fannie Mae and Freddie Mac in 2000. We strongly supported 

that. We are not aware of any other corporations that have such 

demanding public purpose responsibilities as Fannie Mae and 

Freddie Mac. And similarly, the Federal Home Loan Bank Boards 

are required to dedicate 10 percent of their net income every year 

to fund affordable housing. That has amounted to more than $1.7 

billion that has financed $25 billion worth of affordable housing. 

And billions more are available, as Alex Pollock knows, at a slight 

discount for community investment. 

I have served on the board of the Atlanta bank, which went beyond the mandatory and reached out voluntarily to serve their mission in other ways. 

Enterprise has worked in productive partnerships with the GSEs 

to provide housing for many thousands of low-income families and 

individuals. For example, Fannie Mae, Freddie Mac, and the Enterprise Foundation pioneered the use of the corporate market for lowincome housing tax credits in the late 1980’s. Fannie stepped up 

to invest when few others would and encouraged other corporations 

to follow suit. Freddie Mac was a very early investor, as well. That 

credit today is the most important Federal incentive for the development of rental housing for low-income people in the country, and 

Fannie Mae and Freddie Mac are the most important sources of 

capital for it. 

The pictures that you see here show you two examples of the 

kind of housing Fannie Mae and Freddie Mac, working with Enterprise, have made possible. I hope it gives a face to this sometimes 

abstract issue of the critical housing benefits that the GSEs provide. Ultimately, what we are talking about are peoples and families and communities. 

The first here that you see, Sheldon Village in Eugene, Oregon, 

provides 35 homes and numerous supportive services for very lowincome people, including formerly homeless individuals with special 

needs. It is located to provide easy access to educational and recreational facilities and public transportation for residents. Freddie 

Mac was the major financial partner. 

The next example is Arbor Park Village with Fannie Mae. This 

is a large-scale development, 282 homes in 28 garden-style buildings, all for very low-income people. It is helping revitalize a neighborhood near downtown, Cleveland. 

Now, these are just two of many examples that we could give 

you. We use the low-income housing tax credits. We could use 

many other types of financing mechanisms. 

We believe the current statutory and regulatory framework for 

Fannie Mae and Freddie Mac has enhanced their ability and willingness to do this kind of work with organizations like Enterprise. 

These partnerships deliver housing resources to people and places 

that cannot take full advantage of our Nation’s generally well-functioning housing system. 

These companies have consistently met their affordable housing 

responsibilities, even as HUD steadily and substantially increased 

them over the past decade. They have the best people, the best 

technology, enormous access, broad partnerships, all working on 

16

1The prepared statement of Ms. Wachter appears in the Appendix on page 181. 

ways to mainstream new products and services. They have the ability to test market ideas that people like us bring to them. 

Congress has expressedly provided Fannie and Freddie the flexibility to respond to fast-moving market conditions and emerging 

needs. We believe that curtailing Fannie Mae and Freddie Mac’s 

flexibility to innovate would undermine these gains and limit future progress towards meeting our Nation’s most serious affordable 

housing needs. 

Certainly, the safety and soundness of the housing GSEs is critical for consumers and the economy. Vigorous regulation is essential. But there is no reason that strong safety and soundness oversight should chill or constrain the GSEs’ vitally important affordable housing activities. In fact, the interest of affordable housing 

and safety and soundness are very compatible if carried out the 

right way. Thank you. 

Senator FITZGERALD. Thank you, Mr. Harvey. Dr. Wachter. 

TESTIMONY OF SUSAN M. WACHTER,1 WHARTON SCHOOL OF 

BUSINESS, UNIVERSITY OF PENNSYLVANIA 

Ms. WACHTER. Thank you, Chairman Fitzgerald, for the invitation to testify today on Government-Sponsored Enterprises. I ask 

that my full statement be included in the record. 

Senator FITZGERALD. Without objection. 

Ms. WACHTER. Currently, the United States has one of the best 

housing finance systems in the world. The efficiency of this system 

has been advanced by the Federal chartering of Government-Sponsored Enterprises, particularly Fannie Mae and Freddie Mac. 

These institutions have enabled the securitization and the development of the secondary market for the funding of mortgages. 

Securitization and the efficient trading of mortgages and liquidity 

in secondary markets have achieved the integration of U.S. mortgage markets into national and international capital markets. 

The goal of the Federal chartering of Fannie Mae and Freddie 

Mac is to achieve public policy objectives, including the promotion 

of home ownership for all Americans, and economic research indicates that this mission is being accomplished. Today, I will address 

how this mission is accomplished, how increased access to home 

ownership for all Americans has been accomplished through the 

Federal chartering of Fannie Mae and Freddie Mac. 

In my testimony, I will specifically refer to a research paper authored by myself and colleagues, which I request be entered into 

the record. 

Senator FITZGERALD. Without objection. 

Ms. WACHTER. In addition, I believe the GSEs have had a critical 

role, through the strength of the U.S. housing market, in the recovery of the overall U.S. economy since the 2001 recession. 

Based on my research and that of multiple colleagues, Fannie 

Mae and Freddie Mac have contributed to the expansion of home 

ownership in America, providing affordable residential mortgages 

for households who otherwise would not have had the opportunity 

to become homeowners. Freddie Mac and Fannie Mae’s efforts have 

helped to advance gains in overall home ownership rates, as well 

17

as in home ownership rates among minority and low-income households occurring over the past decade. This has been a phenomenal 

decade for home ownership which I do not believe would have been 

as strong without the role of the GSEs, a decade resulting in a 

record high home ownership rate of 68 percent in 2003. 

GSEs have accomplished this, in part, through their special affordable lending programs, of which Bart Harvey has spoken. But 

also, the GSEs have accomplished this through lower mortgage interest rates and through lower down payment rates. These have 

been made possible through the innovation and technological advances that the GSEs have brought about over the last decade. 

The findings of the recently-released research study, ‘‘The Impacts of Affordable Lending Efforts on Home Ownership Rates,’’ by 

myself, Roberto Guercia, and George McCarthy, which was published in March 2003 in the Journal of Housing Economics, indicate that affordable lending efforts can increase home ownership 

opportunities overall and for underserved populations. For example, they can result in a 30 percent increase in the relative probability of home ownership for younger households, 20 percent increase in the relative probability of home ownership for minority 

households, and a 15 percent increase for households residing in 

central cities. 

The potential gains in home ownership are attributable, in part, 

to improved credit risk management, which enables lower down 

payments without an increase in credit risk. Thus, it is not just 

lower interest rates, mortgage rates, but also technical innovations, 

such as automated underwriting, that are responsible for increasing home ownership throughout this past decade. 

The GSEs and a strong secondary market deliver a second major 

benefit, not only to homeowners but to the American consumer 

overall. Their role in accessing global capital markets and stabilizing U.S. mortgage markets was evident in August 1998 upon the 

defaulting of Russia’s foreign-held debt. In the global crisis, interest rates moved sharply higher and illiquidity appeared to be a 

growing concern worldwide. Purchasing a record number of mortgages, the GSEs staved off crisis by adding liquidity. Therefore, no 

credit crunch evolved in the U.S. residential sector, as opposed to 

other markets at the time. 

This pivotal effect is even more evident in the recent role housing 

has played in stabilizing the overall U.S. economy. The role of 

mortgage market access to global capital markets as an automatic 

stabilizer with the U.S. economy has been demonstrated by the 

strength of the housing sector and its role in moving the economy 

out of the 2001 recession. It is access to international capital flows 

during a period of low and falling interest rates that has resulted 

in additional consumer spending, which has supported the U.S. 

economy. 

This benefit that the GSEs and secondary markets deliver to the 

American consumer is, I believe, a major, if not the major, contributing factor to today’s housing market, which has helped stabilize 

and grow the U.S. economy. This, together with increased access to 

home ownership for all Americans, I believe, is a testimony to the 

role the GSEs have played and to the importance of ensuring that 

they continue to play this role going forward. 

18

Thank you, Mr. Chairman. 

Senator FITZGERALD. Dr. Wachter, thank you very much. 

What I would like to do now is take a 2-minute recess so that 

you can all stretch and stand for a minute, and then we will resume and go quickly into the question and answer section. We will 

be right back. 

[Recess.] 

Senator FITZGERALD. If we could resume the hearing, I would appreciate it. 

I would like to, at the outset, note there is so much money involved in the mortgage business, and some of you who are pro and 

some of you who are con, have relations with some of the companies involved on either side of the debate. I would like to explain 

any possible conflicts of interest to the media and the members of 

the public before we start going with the question and answer session. 

I would start with Alex Pollock. You are President of the Federal 

Home Loan Bank of Chicago. Is it correct that the Federal Home 

Loan Bank of Chicago is trying to compete with Fannie and 

Freddie in the conforming loan market? 

Mr. POLLOCK. That is very true, Mr. Chairman. 

Senator FITZGERALD. Please pull the microphones close, and Mr. 

House and Mr. Miller, you are going to have to share your microphone because we only have six and there are seven witnesses. 

But is that correct? 

Mr. POLLOCK. That is correct. 

Senator FITZGERALD. You are competing with them. You are a 

GSE yourself. You have nothing against GSEs, but you would like 

to compete with them on better terms, which I gather, would be a 

simple way of saying it? 

Mr. POLLOCK. It is correct. We view anything as an advantage 

for the mortgage market and the country that makes the secondary 

sector more competitive. Clearly, I have an interest in this, being 

a competitor in the market, as you say, Mr. Chairman. 

Senator FITZGERALD. And there have been calls, is it not correct, 

to get you out of the mortgage business or the mortgage securitization business that you are in? 

Mr. POLLOCK. I don’t want to give a speech on securitization. We 

are not in securitization per se. But certainly, a few ill-advised people have thought we shouldn’t create this competition, yes, sir. 

Senator FITZGERALD. OK. Dr. Wachter, have you been paid for 

any of your research by any party to this debate? 

Ms. WACHTER. I have not been paid for my research. However, 

the paper that I have just mentioned has been supported by the 

Wharton Real Estate Center and has also received a small amount 

of funding support from Freddie Mac. 

Senator FITZGERALD. OK. Mr. Harvey, I notice on The Enterprise 

Foundation website you received a $1 million contribution from the 

Fannie Mae Foundation last year, is that——

Mr. HARVEY. Let me just say, we solicit funds, loans, grants, capital, from all financial institutions and we have significant—as I 

said, we have received grants from Freddie Mac, from Fannie Mae, 

loans and other capital and from all financial institutions——

Senator FITZGERALD. And from a lot of banks? 

19

Mr. HARVEY. From banks, as well. 

Senator FITZGERALD. That maybe are part of the funding of FM 

Policy Focus, possibly. I am not sure. 

Mr. HARVEY. That is right. [Laughter.] 

Senator FITZGERALD. We will get to that in a minute. 

Mr. Wallison, your research at AEI, is it funded by anybody? 

Mr. WALLISON. No, it is not directly funded by anybody, but AEI 

does get contributions from organizations that are in the financial 

services industry and some of them, although I do not know, may 

be part of any of the organizations that are opposing Fannie and 

Freddie. 

Senator FITZGERALD. OK. Mr. Miller, your study that you talked 

about in your opening statement, that was, am I correct, financed 

by Freddie Mac? 

Mr. MILLER. Yes. It was a study commissioned by Freddie Mac. 

Senator FITZGERALD. OK. And you were paid to do that study of 

the benefits? 

Mr. MILLER. Yes, but I call them as I see them. 

Senator FITZGERALD. OK. Mr. Ely, have you been paid by anybody? 

Mr. ELY. First of all, the American Bankers Association is a client of mine with regard to the Farm Credit System. I have done 

three reports for the ABA on the Farm Credit System. 

Senator FITZGERALD. To the Farm Credit System? 

Mr. ELY. Yes, which, of course, is another one of the GSEs. In 

addition, with regard to Fannie and Freddie, I have received modest grants from AEI for several of the papers that I have done for 

AEI and for Mr. Wallison’s program. 

Senator FITZGERALD. OK. Mr. House, who funds FM Policy 

Focus, of which you are the Executive Director, and does ‘‘FM’’ 

stand for Fannie Mae or Freddie Mac? 

Mr. HOUSE. It stands for both. [Laughter.] 

Senator FITZGERALD. It stands for both, OK. Who funds that? 

Mr. HOUSE. That is funded, as I said, by people in the financial 

services industry. It is very interesting, because the GSEs have 

characterized our group as a group of competitors, and frankly, we 

are their customers. That is one of the reasons we are here today, 

because if they characterize us as competitors, then we have a real 

problem. That is why effective regulation is needed. 

Senator FITZGERALD. OK. 

Mr. ELY. Mr. Chairman, if I can just add one point. 

Senator FITZGERALD. Yes? 

Mr. ELY. Many people have suggested over the years that I have 

done consulting work for FM Policy Focus. As I am sure Mr. House 

will confirm, there has been absolutely no relationship between myself and FM Policy Focus. 

Senator FITZGERALD. OK. I just wanted to get that out on the 

table so that everybody knows where everybody else stands. 

Professor Wachter, I have a question for you. You are a professor 

of real estate finance at Wharton? 

Ms. WACHTER. I am a professor of real estate and finance at the 

Wharton School. 

Senator FITZGERALD. And finance, OK. Right now, the housing 

industry in America has been very strong with declining interest 

20

rates. The values of homes have been appreciating very rapidly as 

rates have declined. If we got into a situation where rates started 

to rise, would it not be the case that the value of homes themselves 

could plummet? In other words, a home worth $300,000 that is 

today with low interest rates of 4.5 percent, let us say, and if mortgage interest rates go back up to 7.5, 8, or 9 percent, that $300,000 

home, all things being equal, may no longer be worth $300,000. 

Would you agree or disagree with that statement? 

Ms. WACHTER. I would respectfully disagree with that statement. 

If mortgage interest rates increase, of course, there will be other 

factors that cause this increase. A most likely reason that they will 

increase is increased strength in the overall economy, and if that 

occurs, I do not believe that housing prices will plummet. 

It is, I think, quite likely in that situation that housing prices 

will no longer appreciate at the rate that they have been appreciating, and in fact, they may appreciate less than the inflation 

rate. There has been no period in the recent history of the United 

States that we have documented where housing prices have declined in nominal terms. 

Senator FITZGERALD. Not during the 1930’s, during the Great Depression? 

Ms. WACHTER. In the database that I have seen post-World War 

II, where we have good data, there has not been a recession where 

housing prices have decreased. 

Senator FITZGERALD. Would anyone else like to comment on 

that? Mr. Wallison or Mr. Ely? What do you think would happen 

to the value of homes if interest rates go up sharply? What I am 

getting at is, right now, the loans that are securitized by Fannie 

and Freddie have strict underwriting requirements. They have to 

have a 20 percent downpayment. If they don’t have a 20 percent 

downpayment, the borrower has to have mortgage insurance. Could 

not that downpayment or equity, the owner’s equity in the home, 

disappear in a scenario where there is a substantial general rise 

in mortgage interest rates? 

Mr. ELY. If I could add some thoughts to that, the question 

comes as to what is driving the increase in nominal interest rates. 

Is it a higher inflation factor, or higher inflation premium in the 

nominal interest rate, in which case the value of real assets are 

going to be increasing in nominal terms? On the other hand, if the 

real interest rate increases, then you will not see a plummeting, I 

wouldn’t expect to see that, but as Dr. Wachter said, a slowing in 

the rate of appreciation. 

There is one other thing that we want to keep in mind, too, as 

we look forward that may be somewhat of an overhang on the 

housing market going forward—the ratio of mortgage debt to the 

estimated market value of owner-occupied housing has been increasing significantly. We do not yet know what the implications 

are going to be, particularly from a macroeconomic standpoint, if 

the housing price appreciation slows down. As has been commented 

on by the panel, one of the drivers in the economy in recent years 

has been the fact that people have been cashing out some of their 

home equity through refinances. If interest rates go up, if the refinance activity slows down, if housing starts to get squeezed a little 

21

bit, then we may see some macroeconomic effects that will certainly 

not be positive for housing. 

Mr. WALLISON. May I add something, Mr. Chairman? 

Senator FITZGERALD. Yes. 

Mr. WALLISON. I think Dr. Wachter’s analysis is probably correct, 

and that is to say interest rates would not likely go up unless the 

economy were recovering and, therefore, housing prices might stabilize or not decline. On the other hand, we did have, in the 1970’s, 

a period known as stagflation, when we had very high inflation and 

we had very little economic growth—indeed some decline in 

growth—and high unemployment, much higher than today. As a 

result, it is actually high unemployment which is the greater danger to Fannie and Freddie, and to the mortgage market in general, 

because that is when people can no longer afford to service their 

mortgages, when they are no longer employed. 

So there are all kinds of scenarios that might occur in our economy which could result in many more defaults than we have seen 

in the 1990’s and the early 2000’s, and that is why financial institutions are required to maintain high levels of capital—financial 

institutions, I might add, other than Fannie Mae and Freddie Mac. 

Senator FITZGERALD. Mr. Pollock, I want to go back to you to describe exactly what you are doing at the Federal Home Loan Bank 

of Chicago. You say you aren’t securitizing mortgage debt per se, 

and I know in your opening statement, or in your written opening 

statement, you describe that you absorb the interest rate risk and 

allow the financial institution to keep the credit risk. How does 

that work? What exactly do you do? 

Mr. POLLOCK. Mr. Chairman, what we do, we call ‘‘Mortgage 

Partnership Finance.’’ We chose the name seriously because we create a partnership with our member institution, which is a commercial bank or a savings bank or a savings and loan, and each one 

of those partners takes one of Fannie Mae’s or Freddie Mac’s main 

businesses. As I said in my testimony, Fannie and Freddie have 

two businesses. The first is a credit guarantee business, the one 

that Peter and Bert want them to have to stick to. That happens 

to be one I think is better done by private financial institutions, because if you are the lender actually making the loan yourself, you 

ought to be fundamentally advantaged in knowing that credit and 

being able to manage it and bear the credit risk. 

On the other hand, the other business is the mortgage funding 

business, and if you are dealing with 30-year fixed-rate, freely 

prepayable mortgages, you must have a long-term funding base, in 

my opinion, which is only available in the bond market and in the 

international hedging markets. In order to access that base efficiently with the current structures in the United States, you have 

to be a GSE to compete in the funding of long-term fixed rate mortgages. It is not advisable for private financial institutions to own 

30-year cash flows and finance them on their deposit bases. That 

is a pretty clear lesson of our financial history. 

So with Mortgage Partnership Finance, we take these two pieces, 

we put our member, which is a bank or a savings bank or a savings 

and loan, into the credit guarantee business, dealing only with 

loans they have made themselves in which they are fundamentally 

advantaged. Instead of divesting the credit of their own customer 

22

and paying a guarantee fee to Fannie Mae and Freddie Mac, they 

credit enhance the loan to us and we pay them what is in effect——

Senator FITZGERALD. For guaranteeing it? 

Mr. POLLOCK. For guaranteeing it. 

Senator FITZGERALD. You pay——

Mr. POLLOCK. We put them into a business they ought to be, and 

in fact, are, fundamentally advantaged in. We then provide the 

funding and the interest rate risk management, and if you put the 

two pieces together, you have the entire financing. 

The competitive outcome is that in the credit guarantee business, 

we now have about 550 lending institutions approved to participate 

in MPF. So there are 500 new competitors——

Senator FITZGERALD. You are growing very rapidly now, aren’t 

you? 

Mr. POLLOCK. We are, yes, sir. 

Senator FITZGERALD. How many billion in assets are you up to? 

Mr. POLLOCK. The Mortgage Partnership Finance Program is ap- proximately $70 billion, a little——

Senator FITZGERALD. Seventy-billion? So the figures I said, $35 

billion, those are a year or two old? 

Mr. POLLOCK. They were true when they were printed, Mr. 

Chairman. [Laughter.] 

Senator FITZGERALD. OK, and growing very rapidly. 

Mr. POLLOCK. Yes. 

Senator FITZGERALD. Now, in talking to bankers in the Midwest, 

I am told that small community banks will have Fannie Mae, 

Freddie Mac, and the Home Loan Bank of Chicago all coming in 

to get their business. But I have also heard that for the conforming 

mortgages, there are private banks that come in and try to sell 

some services for those conforming mortgages to small banks, such 

as someone mentioned, ABN and ROE operating in the Midwest. 

What would those commercial banks do? It indicates to me that 

there is a degree of competition out there for Fannie, Freddie, and 

the Federal Home Loan Bank that isn’t generally known to the 

public. 

Mr. POLLOCK. It is very true for the smaller banks that they 

could deal with a GSE, and, of course, get a better deal if they have 

three bidders for their business compared to two. There are also 

large bank aggregators, as they are called in the mortgage business, who will buy loans from smaller correspondent banks. This 

is called the correspondent channel. 

Senator FITZGERALD. OK. 

Mr. POLLOCK. But those loans, in turn, are generally turned into 

Fannie Mae securities or Freddie Mac securities or also financed 

with us. 

Senator FITZGERALD. So it is hard to see how that would be more 

profitable, to sell it to the correspondent bank which then resells 

to Fannie or Freddie. How could that make sense for the small 

bank? 

Mr. POLLOCK. It is a question of whether you are a retailing or 

wholesaling part of the business, but I think that is a fair question. 

Senator FITZGERALD. Now, Mr. Pollock, you said that the guarantee fees charged by Fannie and Freddie were 19 basis points and 

23

that they are too high. Do Fannie and Freddie both charge 19 basis 

points for guarantee fees? 

Mr. POLLOCK. Mr. Chairman, guarantee fees are negotiated individually. The 19 basis points is the average for 2002 and Fannie 

and Freddie are quite similar in that level, approximately——

Senator FITZGERALD. Where was that average 10 years ago or so? 

Mr. POLLOCK. In the 20s. 

Senator FITZGERALD. So it has——

Mr. POLLOCK. It started off being 25——

Senator FITZGERALD. It has been coming down. 

Mr. POLLOCK. Yes. 

Senator FITZGERALD. OK. 

Mr. POLLOCK. The 19, relative to losses, is still very high. A typical, good small bank lender will average losses on their mortgage 

portfolio of perhaps two basis points or less per year. 

Senator FITZGERALD. In this kind of a market environment, 

though? 

Mr. POLLOCK. Even in this market. 

Senator FITZGERALD. But in a bad recession, say, like we had in 

the early 1980’s——

Mr. POLLOCK. It is cyclical, but I am speaking of the averages, 

Mr. Chairman. 

Senator FITZGERALD. OK. 

Mr. POLLOCK. The long-term average, if I may just complete the 

thought, for Fannie and Freddie is about four or five basis points 

in their portfolio of annual losses per year. So you can think of that 

as the loss versus the guarantee fee being the insurance premium 

against that loss. 

Senator FITZGERALD. Well, that brings up an interesting point, 

though, because Mr. Wallison recommended that Fannie and 

Freddie not be allowed to hold mortgage-based securities on their 

own balance sheet, and you suggested that there is a great deal of 

risk to having them do so. But as Mr. Pollock pointed out, when 

they are guaranteeing the mortgages of others, their losses are 

very small. My own experience as a bank lawyer, prior to being in 

the Senate, was that home mortgages are the safest loans you can 

make. People will allow you to repossess their car, they will put 

their business in bankruptcy, but they will work wonders to come 

up with the money to stay in their home. 

Mr. WALLISON. May I respond to that, Mr. Chairman? 

Senator FITZGERALD. Yes. 

Mr. WALLISON. There are two kinds of risk, basically. There is 

credit risk, which is what Alex is talking about, and then there is 

interest rate risk. When they issue mortgage-backed securities and 

guarantee them, they are taking only the credit risk. 

Senator FITZGERALD. Right. 

Mr. WALLISON. That is the three or four basis points maximum 

that Alex was talking about. Interest rate risk is the risk that they 

are taking when they buy back their mortgage-backed securities 

and when they hold portfolios of mortgages. That is where their 

major risk comes from. 

Senator FITZGERALD. Well, let me tell you what they tell me, and 

I did talk to an executive VP from Fannie. I wish he could have 

24

been here today to testify, but in fairness to him, I did not give 

adequate notification of this hearing, either. 

But they claim that they are really fully hedged now, that they 

learned the lesson from the early 1980’s in which we had the case 

of rising interest rates. They say that now in this era of declining 

rates, about 70 percent of their debt is callable, and, in fact, every 

day they are calling debt issued at higher interest rates and replacing it with low-yielding debt. And in a situation in which rates 

were to rise rapidly, they would simply keep their low-cost debt in 

place and not call it and that they have derivatives that hedge substantially all of their interest rate risk. 

Does anybody care to comment on that? Why would that not be 

possible? 

Mr. ELY. Well, first of all, let me provide a couple points of information here, not that the risk-based capital requirements are 

magic, but it is important to keep in mind that the minimum capital requirement on a strict leverage basis for Fannie and Freddie 

for credit risk is 45 basis points. For interest rate risk, it is 205 

basis points. So there is in the statutes a recognition that there is 

much greater risk with interest rate risk. 

The other thing about interest rate risk is that you can be partially hedged, fully hedged, or maybe engaged in speculation, which 

also is risky. The problem that we have with Fannie and Freddie 

is that we are much less certain as to where they are in the risk 

perspective in terms of their hedging activities. They may assert 

that they are fully hedged. As I listened to the telephone conference with analysts last week that Tim Howard, the Executive 

Vice President and Chief Finance Officer held when Fannie announced its second quarter results, he was not talking as if Fannie 

was fully hedged. Fannie has significantly reduced its duration 

gap, but it didn’t strike me as being fully hedged. 

So there is still a risk there, but there is also another very important factor to keep in mind. It is the assumption of interest rate 

risk by not only buying back MBS but also by holding mortgages 

in portfolio that causes the two GSEs’ balance sheets to balloon, to 

loom as large as they do in the economy. If Fannie and Freddie 

were strictly credit guarantors, as Freddie was initially back in the 

1970’s, then they would have much smaller balance sheets today 

and, frankly the concern about systemic risk would be much less 

than it is today. 

But also coming back to a point that Peter made, and I might 

add the Congressional Research Service, among others, has made, 

there is no value added to the housing marketplace and to the provision of affordable housing when Fannie and Freddie buy back 

their MBS. Why do they do that? Because there is more profit per 

mortgage dollar, if you are assuming interest rate risk. This, therefore, provides them with an avenue for maintaining their high 

earnings growth rate and their high ROE than is the case if they 

were just credit guarantors. 

Senator FITZGERALD. Mr. Miller. 

Mr. MILLER. Mr. Chairman, I think we are asking several ‘‘what 

if ’’ kind of questions, sort of pulling them out of the air. This 

OFHEO risk-based capital test is a comprehensive, systematic test, 

a scenario of the sort where you have a lot of things going wrong, 

25

one in which interest rates rise, one in which interest rates fall. 

This comprehensive test applied to Freddie and Fannie show that 

they both pass for 10 years. They do not have a problem. 

Senator FITZGERALD. And you said the S&L industry as a whole 

would not pass that. 

Mr. MILLER. Did not pass, and that gives me an opportunity, Mr. 

Chairman, to correct an omission, not in my statement but in my 

oral presentation. I saw the light on. The fact that the thrifts failed 

the test should not really be viewed as evidence of a shortcoming 

of the capital requirements of the thrifts, but it should be viewed, 

I think, as evidence that this OFHEO risk-based capital test is a 

pretty tough test. Now, you can go in and change some of the parameters or whatever and you can ask a lot of ‘‘what if ’’ questions——

Senator FITZGERALD. I would like to give Mr. Ely a chance to respond. You foretold the S&L debacle in the 1980’s. In one of your 

papers, you point out now that most S&Ls hold variable interest 

rate mortgages only, and I think you cited Washington Mutual as 

94 percent of their mortgages were floating rate mortgages on their 

books and they weren’t holding long-term fixed-rate mortgages on 

their books. You would think if that is the case, the S&L industry 

as a whole would be pretty well hedged against rising or declining 

rates. 

Mr. ELY. Well, two points. First of all, I am very skeptical of this 

finding that the thifts would fail the test in a rising interest rate 

market. One of the problems is, what is the database that you are 

working from? OFHEO has access to proprietary, non-public information in running the risk-based capital test for Fannie and 

Freddie. With regard to the thrift industry, I assume that Jim has 

worked with the same data the rest of us do, which is the so-called 

Thrift Financial Report or the Quarterly Call Report, which I 

would not want to try and read too much into. 

Let me say something else also about the risk-based capital test. 

As I indicated in my testimony, it is a highly flawed test because 

it is based on the assumption that we are going to have a rerun 

of the interest rate environment of the late 1970’s or early 1980’s. 

It is an unfortunate test because it does not reflect present day realities. 

But there is another fundamental problem with it. It is a snapshot that is taken four times a year. These two companies can look 

great on December 31 or March 31, but the question is, what do 

they look like on April 1 or March 30? It is dangerous to go too far 

in making judgments just based on how things look on a particular 

date. What is more important is what the range of values are over 

a period of time. We don’t see that with the risk-based capital test. 

Mr. HOUSE. Mr. Chairman, I think if you want to pursue this 

further, if you look at OFHEO, with the recent revelations of 

Freddie Mac, OFHEO has testified before the House and Senate 

and I would think that the members have been somewhat appalled 

by their response. I think if you would want to bring OFHEO here 

and ask them exactly what it is they knew, when they knew it, and 

also on their risk-based capital test, whether or not it is adequate, 

because it seems that from their own testimony, even they are not 

26

sure what—it took them 9 years, and they are still not sure exactly 

what it is. 

That is important. I think Senator Corzine said last week, if we were talking about a $300 million situation here or something like 

that, I could understand it, but I think, if I am not mistaken, the 

quote was it is appalling that we are talking about a $3 billion miscalculation. 

So my suggestion is, rather, we can argue all day back and forth 

here about whether it is good, bad, or whatever, but you may want 

to pursue that and really get into that because it may be that the 

test itself is fundamentally flawed, and that is important because 

today, for instance, the Central European banks, and this goes to 

something we were talking earlier about, whether or not you want 

worldwide, be able to have access to capital worldwide, the Central 

European banks said that they are looking into the amount that 

their banks should hold Fannie and Freddie on MBSs and when 

you——

Senator FITZGERALD. Did they say that or was that just a rumor? 

Mr. HOUSE. That was a report today that we heard. 

Senator FITZGERALD. OK. 

Mr. HOUSE. That they are looking into it, nothing—but the point 

is, is that having a good, sound regulatory structure is important. 

So anybody that says that you shouldn’t have a good regulatory 

structure because it will erode the markets, not having one is even 

worse, and I think with everything going on, nobody—Bert said it 

earlier. Nobody is sure what is going on, and I think it is very important that Congress really get in and understand exactly what is 

going on and what needs to be set up to make sure it doesn’t happen again. 

Mr. MILLER. Could I just say, I don’t think the record will show 

that anyone here has argued against having a sound regulator for 

Freddie and Fannie. It is an empirical question, I guess, whether 

the risk-based capital test is sufficiently severe. But certainly——

Senator FITZGERALD. Is that test——

Mr. MILLER [continuing]. A test of a major industry, the thrift industry, that fails is to suggest it is quite significantly stringent. 

Senator FITZGERALD. OFHEO says that Fannie and Freddie did 

well on their risk-based capital stress test. Did they release a study 

to the public or anything or do we just take their word for it, that 

they are fine? 

Mr. ELY. We take their word for it, Mr. Chairman. Most of the 

data that goes into that test is proprietary to Fannie and Freddie. 

OFHEO sees it, but the world in general cannot. So we really have 

to take their word for it. 

The other thing to keep in mind about the risk-based test, and 

this is a very unfortunate circumstance, is that it is written into 

statutory language in quite some detail, and, of course, as you 

know, it takes a little while to get laws changed around here. I am 

very concerned about its relevancy at this point in time. In other 

words, OFHEO is probably doing a pretty good job of trying to 

make this test work, but it is, unfortunately, a flawed test. 

Senator FITZGERALD. They are doing the risk test that is set 

forth in a statute, whether or not it is necessarily the——

Mr. ELY. That is correct. 

27

Senator FITZGERALD [continuing]. The test that should be applied. It is doing that test. 

Mr. MILLER. Could I just say, Bert has had enough experience 

in Washington to know that if either one of these GSEs actually 

failed the test but OFHEO leadership went out and told the press 

it passed the test, surely, someone in the press would find out and 

the Nation would find out, so I don’t think——

Senator FITZGERALD. But what do you say about the test being 

set in a statute on exactly what the parameters of the test should 

be? Certainly, it could be that the lobbyists for those entities have 

influenced what the test is, then. If it is in a statute, the regulator 

isn’t empowered to come up with its own test. 

Mr. MILLER. Well, you know, I think the regulator did come up 

with a pretty stringent test. At both Freddie and Fannie, some people there very much opposed its being implemented so soon, wanted to find out more about it, questioned it in some ways. But it is, 

in fact, in place today. But it is an empirical question of how stringent it is. You might want to have more flexibility, I would suggest, 

than having each element in statute because something may come 

up of a sort you think, well, maybe this is a part that ought to be 

added, or maybe this part of the test really isn’t relevant at this 

time or something like that, or less relevant. So you might want 

to define——

Senator FITZGERALD. OFHEO does have people who came from 

the Controller of the Currency at it, is that not correct? My understanding is one of the on-site examiners at Fannie Mae actually 

used to be in charge of the detail at Citibank, so from what I am 

hearing, at least anecdotally, and it hasn’t been confirmed to me, 

is that they do have some very good people over there. Does anybody wish to challenge that? Or, with respect to the effectiveness 

of the regulator, does anybody think that the regulation at the 

OFHEO—that the OFHEO personnel are not up to the task? 

Mr. WALLISON. Can I make a general point on that? 

Senator FITZGERALD. Yes. 

Mr. WALLISON. I think we put a tremendous amount of stock in 

regulation, but the events of the last 6 weeks should show us that 

we are not fully protected by regulation no matter how extensive 

it is. Ultimately, the major decisions that affect the health of a 

company are made at the very top, and the regulators very seldom 

have access to that. We saw just in the case of Freddie Mae that 

OFHEO did not have access to the accounting problems that were 

roiling the top of the company. 

Senator FITZGERALD. But are not the GAAP accounting problems 

that they had, a somewhat different issue? It may be that OFHEO 

is not necessarily relying on GAAP numbers. GAAP numbers are 

what you need to disseminate to the public for the securities reports. Freddie is seeking to voluntarily comply. I know from my 

own experience that bank regulators have a different set of accounting numbers that they like to see that may not have anything 

to do with GAAP, that are more stringent than GAAP. 

Mr. WALLISON. We don’t understand everything about what happened at Freddie Mac, nor do we actually know anything other 

than what the newspapers have reported. But it does appear that 

they were doing things with their derivatives that caused a probVerDate 0ct 09 2002 09:35 Dec 11, 2003 Jkt 088935 PO 00000 Frm 00031 Fmt 6633 Sfmt 6633 C:\DOCS\88935.TXT SAFFAIRS PsN: PHOGAN
28

lem with the reporting of income for certain periods. And OFHEO 

does look at their derivatives That is one of the functions that they 

are supposed to perform. How those derivatives are classified, what 

they are and so forth are things that OFHEO should have come 

across in the course of their investigation that would have given 

them a hint about how effectively these companies are operating. 

May I say a couple of other things, Mr. Chairman, while I am 

talking? One is that when the tests were done on Fannie and 

Freddie, all kinds of tests have been run by OFHEO, including the 

stress test that Jim Miller was talking about. Fannie always came 

out very close to the line. Freddie came out way ahead most of the 

time. In fact, people would have said 2 months ago, if we are going 

to have any kind of accounting problem, we are going to have it at 

Fannie, because Freddie was always very well-managed, it seemed, 

from an accounting point of view. We would never have any difficulty there. 

Well, it turns out, ironically, that it is Freddie with the accounting problems. Fannie, which was always very close to the line, taking a lot of risks, has not been challenged as yet. I think now that 

investigations have begun, Fannie will get a good going over and 

I think we will find, based on some of the stuff you see coming out 

of the private sector today, that they are having their own difficulties. 

But in any event, you can’t rely too much on a regulator to protect you, especially in a case where these two companies are the 

only two companies involved in this major part of our economy. If 

there is a major error by one of those companies, and the regulator 

does not recognize it, as I suggested in my prepared statement, we 

could have serious systemic problems in our economy. 

Also, finally, on the question of whether they are profitable after 

the hedging that they have to do to address their interest rate risk, 

I think, Mr. Chairman, if I heard you correctly in your opening 

statement, you made the fundamental and true point that if a company is fully hedged, it is not going to be profitable. There is some 

risk that has to be taken in order to make a profit. 

Senator FITZGERALD. I see a lot of witnesses want to address that 

issue. Dr. Wachter, can you get 100 percent hedged and still make 

a profit? 

Ms. WACHTER. It does depend on the business that you are in. 

You can make a profit in other elements of your business. You 

could take additional interest rate risk and make profit on the interest rate risk. But as a general statement——

Senator FITZGERALD. But to hedge themselves, they have to do 

a series of things that add to their costs. 

Ms. WACHTER. Absolutely. 

Senator FITZGERALD. To hedge themselves on their liability side 

with respect to the debt they have issued, they have to make it 

callable. That requires them to pay higher interest rates. Investors 

who are going to hold callable debt want a premium and so forth. 

To buy all sorts of options and derivatives to cover everything in 

their portfolio, it gets very expensive. But you believe it is possible 

to——

Ms. WACHTER. Mr. Chairman, in an equilibrium setting, I absolutely agree with you. It would not be possible to make profit on 

29

hedging operations alone in equilibrium. But this is not necessarily 

an equilibrium market. That is, there is innovation going on. There 

are economies of scale. And separately, you can make money on 

other aspects of your business. 

I also do want to address, if I may, Mr. Chairman, the very fact 

that, of course, regulation is very important here. I think it is a 

great advantage that these are regulated institutions. These are 

private institutions. And for all of the concern that has been expressed around this table—I am not saying that there shouldn’t be 

concern—I think we also should look at the market response to the 

events of the questions on Freddie Mac’s accounting and the market response was not very significant. 

Senator FITZGERALD. Well, does not Freddie have a problem of 

having overstated their earnings as opposed to having understated 

their earnings, which is the opposite of Enron’s problems? Mr. Miller. 

Mr. MILLER. Mr. Chairman, could I first agree with Dr. Wachter. 

You can earn profits when you are fully hedged. 

Senator FITZGERALD. Let me go back and correct myself. Freddie 

has a problem of having understated their earnings——

Mr. MILLER. Right. Right. 

Senator FITZGERALD [continuing]. Whereas Enron overstated 

their earnings. Understating your earnings would be much less 

alarming, I would think, to investors than overstating. 

Mr. MILLER. And one explanation of the phenomena that Dr. 

Wachter was just pointing to at the end is that there is a difference 

between, on the one hand, the accounting treatment of derivatives, 

over which there is some dispute, some suspicion, or some concern, 

and I think the jury is still out. We just ought not jump to conclusions until we have the evidence. That’s on the one hand, and on 

the other hand is safety and soundness. 

I think, at least the reports as I have read them, and the reaction to the question of the accounting of derivatives, is that the 

market interprets the two quite separately and believes in the fundamental safety and soundness of these two institutions. 

Senator FITZGERALD. Mr. House, I want to get back to capital requirements. You suggested that Fannie and Freddie be required to 

have bank-like capital. Fannie and Freddie right now have to have 

2.5 percent capital for the mortgages on their books and 0.45 basis 

points for the guarantees that they make. Banks are required to 

have 4 percent risk-based capital for mortgages that they keep on 

their books. My understanding is there is a new Basel round of 

international risk-based capital guidelines that will lower the capital requirements for banks holding mortgages. Is it down to——

Mr. ELY. The so-called Basel II capital standards could bring 

them down, some suggest to a range of 1.4 to 2 percent. 

Senator FITZGERALD. That would be lower than Fannie and 

Freddie. 

Mr. ELY. Well, that is before taking into account maturity 

mismatching. I was just the other night having a hard time getting 

to sleep and so I was reading through some of the Basel II discussion. [Laughter.] 

There is an awful lot of judgment that is extended to the regulators in terms of how maturity mismatching is to be worked in 

30

there. So we want to be a little careful about quantifying the extent 

that the capital will be reduced. But in general, particularly for the 

larger banks that opt to go into Basel II, it appears that the capital 

requirement will drop somewhat. 

There is a very important point here to understand, and that is 

that any kind of capital regulation is arbitrary because if you take 

no risk, if you are perfectly hedged, then you don’t need much capital, if any at all, because you don’t need a capital cushion to absorb loss. What we have with Fannie and Freddie is they have capital levels that, in effect, they can arbitrage. At 2.05 percent for interest rate risk, they have to take a certain amount of risk in order 

to be able to earn a return on that 2.05 percent. If their ratio is 

pushed up to, let us say, 4 percent, they are either going to have 

to charge higher interest rates, earn a greater spread, or take more 

risk. 

A fundamental problem we have with capital standards, both as 

they apply to the GSEs as well as to the banks, is that they don’t 

necessarily reflect the risk that the particular institution is taking. 

Instead, they become a target to arbitrage, and frankly, banks do 

that just as much as GSEs do. The difference is the lack of a level 

playing field. Presently, Fannie and Freddie don’t have quite as 

high a capital hurdle to clear as the banks and, therefore, they 

have more room to arbitrage on credit risk, but more importantly 

on interest rate risk. 

Senator FITZGERALD. Mr. House. 

Mr. HOUSE. No matter where the Basel Accords come out, and 

that is—to say that is in flux is probably an understatement, and 

I can’t believe—Bert, I will send you a book, a novel, if you stayed 

up reading that—— [Laughter.] 

But I think the key thing—what Bert just said is very important. 

What we are really about is a level playing field. So, we think that 

they are large financial institutions, just like any other financial 

institutions, no matter how you cut it. So when it comes to SEC 

registration, when it comes to capital requirements, when it comes 

to other things, they should be treated just like any other financial 

institution. 

Senator FITZGERALD. OK. So FM Policy Focus mainly wants, you 

have said, effective regulation, sufficient capital, and no exemptions from security acts. You don’t have a problem with their overall mission, is that correct? 

Mr. HOUSE. No, we don’t. We have said that. As long as they are 

in the secondary market. I mean, the liquidity in the secondary 

market was why they were founded. 

Senator FITZGERALD. It occurs to me that if Mr. Wallison’s approach of privatization were ever adopted, Fannie and Freddie, in 

return for being privatized, would probably want to have restrictions on their operation lifted, too, so that they could compete in 

the jumbo mortgage market with many of your members. Would 

your group be opposed to that privatization and unleashing these 

giants in the areas where they have not heretofore tried? 

Mr. HOUSE. From day one, we have said that we are opposed to 

privatization. That has been——

Senator FITZGERALD. So you are opposed to that. 

Mr. HOUSE. In fact, I feel very——

31

Senator FITZGERALD. Is there self-interest involved in that? 

Mr. HOUSE. No. I feel very comfortable. I have got privatization 

on my right. I have got business as usual on my left. I am sitting 

right here. [Laughter.] 

So we are fine. 

Mr. ELY. Mr. Chairman, if I could add to that, if there was a genuine privatization, it means basically peeling away or denying 

them all of the various special benefits they have now, including 

the implicit government guarantee. In that case, they would just be 

plain old business corporations. And then the question is, how well 

would they be able to compete, lacking any kind of meaningful 

origination capability, which comes back to this basic question: Is 

the secondary market really as efficient as we think it is, or does 

it look efficient only because of the GSE advantages that Fannie 

and Freddie have? 

Senator FITZGERALD. Mr. Wallison. 

Mr. WALLISON. The advantages that Fannie and Freddie provide, 

it appears from all the studies, is about 25 basis points. It also appears from the CBO study that that 25 basis points comes from the 

support they get from the Federal Government. So we don’t find 

that Fannie and Freddie are adding very much to the value of the 

secondary mortgage market. 

Senator FITZGERALD. They have to be adding a lot to the mortgage market, though, because of the statutory provision that says 

banks and S&Ls can hold an unlimited amount of their debt, and 

that prefers mortgage debt capital in this country to other debt 

capital, perhaps for more productive uses. Would it not be the case 

that we are putting an incredible, incredible emphasis in our country on mortgage financing and it must, at the end of the day, be 

sucking debt capital out of other perhaps more productive uses? 

Does anybody care to comment on that? 

Mr. ELY. This is another area where we don’t have a level playing field in terms of the allocation of capital within the economy. 

And, of course, it also happens through the tax code, too, with the 

favorable tax breaks that owner-occupied housing gets. That is why 

many would suggest that the middle class and the upper-middle 

class are over-housed in this country compared to other countries. 

But there are two different issues. One is the competitive level 

playing field, which I think Mike House is addressing. And then 

the other more significant public policy question is, to what extent, 

if at all, do we want to tilt capital flows in one direction or another? There is clearly, for a variety of reasons, including the housing GSEs, a tilt towards shifting capital flows into housing and 

particularly owner-occupied housing. 

Senator FITZGERALD. Dr. Wachter, is that a good idea, to tilt capital flows into housing as opposed to anything else? What about 

small business? 

Ms. WACHTER. The issue of how interest rates overall are impacted by this is very complicated and it has to do with whether 

our growing deficit is increasing interest rates. So it is that literature that, in fact, needs to be—this needs to be. 

In other words, Fannie and Freddie are accessing capital, not 

just in the United States, but global capital. So do they, in fact, increase overall interest rates? Do they, in fact, increase the share 

32

from a limited basket of funds? Do they increase the share from 

that limited basket of funds to housing at the expense of others, 

or is the effect to simply increase on the margin funds coming to 

the United States without any impact on other funding in the 

United States? This is an open question, and it may very well be 

that there is an impact drawing capital from small business. It 

may very well be, and I am not saying it isn’t. I am saying it is 

an empirical question, to what degree that there is that impact. 

Second, there may very well be, and I do believe it is the case 

that Fannie and Freddie increase the overall efficiency of this market. That is, interest rates are lower—mortgage rates, that is, are 

lower than they otherwise would be. Mortgage costs are lower than 

they otherwise would be because of the technical efficiencies that 

they bring to the market. If that is the case, then this is not due 

to their drawing funds from another source. 

Senator FITZGERALD. You support the concept of the housing 

GSEs. Would you support the creation of GSEs in other areas that 

would promote equally as worthy sectors of our economy, such as 

small business? In other words, if housing GSEs are a good thing, 

since we all favor home ownership in this country, aren’t small 

businesses a good thing and don’t we want to encourage people to 

own businesses? Why not then create GSEs to securitize loans to 

small businesses? Do you think that would be a good idea? 

Ms. WACHTER. No, I do not. See, I think that the fundamental—

a fundamental factor in our democracy, and I believe it was Peter 

Wallison who started his comments with that, is the Jeffersonian 

concept of ownership, and I believe that it is the ability of ordinary 

American families to have substantial ownership in America. This 

means as America prospers, as America expands, as our productivity expands, and as a result of that, housing costs go up, that 

we will not have a Nation of ‘‘haves’’ and ‘‘have nots.’’ And I don’t 

think that there is anything more important than economic democracy along with political democracy. 

Senator FITZGERALD. Owning your own home. But what about 

economic democracy, everybody owns their own business? 

Ms. WACHTER. Well, I do believe that owning your own home and 

having access to capital at low rates is what enables people then 

to go out and start their own small business, what enables people 

to go out and invest in their children’s education, and what has enabled people to protect themselves in their old age. 

Senator FITZGERALD. Well, what about—do you favor Government-Sponsored Enterprises to further securitization of student 

loans? We used to have that with the student loan marketing GSE, 

but it has now been privatized. 

Ms. WACHTER. Yes. 

Senator FITZGERALD. Do you simply think housing is the most 

important and all other areas of the economy should not have any 

kind of special push, just housing? 

Ms. WACHTER. Well, I actually think that home ownership and 

housing, because it is a basic need, but home ownership absolutely 

should. I don’t really have a position on these others except for the 

fact that I have in my studies seen what happens to economies 

where home ownership is not equally accessed and the political difficulties that so arise. 

33

And the other side of it is I believe we, in some sense, have the 

best of both possible worlds, which is that we have lower cost capital delivered in this very important sector. I think it is the ability, 

in part, to lower the costs of capital for housing through the diversification, etc., that comes through the secondary markets that 

wouldn’t necessarily be able to be delivered to small businesses 

through secondary markets. 

Senator FITZGERALD. All right. A question for all of the panelists. 

The issue of competition has come up several times, first and foremost from Mr. Pollock, who is competing to some extent now with 

Fannie and Freddie. If our country decides that GSEs for housing 

are a good thing, then why just have two of them? Why not have 

four or six of them? Certainly, Mr. Pollock, you don’t mind being 

one. I would be interested in your thoughts on that. I suppose those 

who are against GSEs wouldn’t want any more GSEs. Those of you 

who are for them, Mr. Miller, Mr. Harvey, Dr. Wachter, would you 

be for more GSEs or just limit it to Fannie and Freddie? Mr. Harvey. 

Mr. HARVEY. I would just say, we would be for whatever competition increases either the efficiency of capital for lower-income 

Americans one way or another, and if you think there is a net benefit out of the competition, we would be all for it, between the 

GSEs. 

I just have to point out, we also have a very unfair, or a tilted 

system, however you want to put it, as far as mortgage interest deduction goes in this country. It is far more favorable to the wealthier Americans than to lower-income Americans in this country. So 

there are a set of policies that are in place and you have to look 

at the totality of them. 

One of the reasons I am for the housing GSEs is that it is a 

means of getting favorable capital and there is a public policy objective that is front and center and it makes Fannie and Freddie 

accessible and the Federal Home Loan Bank System far more accessible than Wall Street is to those of us who are trying to reach 

down into lower-income communities and to make sure that there 

is equity in the housing in this country. 

Mr. ELY. Mr. Chairman, if I could throw in two points there. As 

you might have inferred from my remarks, I am not a fan of 

Fannie and Freddie and I support the notion of their privatization. 

But if we are going to look at the question of whether or not there 

should be more than two housing finance GSEs like Fannie and 

Freddie, their returns on capital indicate that there is clearly a 

lack of competition. As someone pointed out, we are seeing companies that consistently are earning returns on equity capital in the 

mid-20 percent range. That is clearly excessive compared to the 

type of competition and returns we see over time in other industries. 

So the fact that their ROEs are so high is an indication that 

what we have is effectively a duopoly in which there is an implicit 

understanding between the two companies to compete but not too 

aggressively or not so aggressively as to reduce their return on equity. 

Coming back to the question of the role that Fannie and Freddie 

play in terms of helping to level the playing field in favor of lowerVerDate 0ct 09 2002 09:35 Dec 11, 2003 Jkt 088935 PO 00000 Frm 00037 Fmt 6633 Sfmt 6633 C:\DOCS\88935.TXT SAFFAIRS PsN: PHOGAN
34

income people who pay lower tax rates, if we take a look at the current conforming loan limit of $322,700 in order to meet that limit, 

you probably have to be able to buy a house worth at least 

$400,000, if not more. Those are not homes being bought by lowermiddle-income, or lower-income people. 

Much of the Fannie-Freddie subsidy goes to the middle class and 

the upper-middle class and beyond. A very important public policy 

question should be, to what extent should the middle class and 

upper-middle class be subsidized in this way, given the fact that 

they are already being subsidized tremendously because of not only 

the mortgage interest deduction and the deduction of real estate 

taxes, but also because of the now very liberal capital gains treatment with regard to owner-occupied housing? 

Mr. POLLOCK. Mr. Chairman, could I take a try at addressing the 

question directly? 

Senator FITZGERALD. Yes, Mr. Pollock? 

Mr. POLLOCK. I think Bert is right, that if we got to a truly competitive GSE sector, we would know it because the returns on equity would be at the market competitive cost of capital, which in 

this country now is around 13 or 14 percent, as opposed to someplace in the 20s. 

In terms of more GSEs, you could think of the Federal Home 

Loan Banks as one GSE, or you could perhaps more accurately 

think of them as 12, or think of us as 12, which would give you 

14. 

It seems to me that the burden of proof for creating a GSE must 

always fall on those who would wish to create a GSE. We have a 

long history, not always in the form of GSEs, but of governmental 

credit programs. You mentioned, Mr. Chairman, student loans. We 

have Farm Credit. We have the Pension Benefit Guaranty Corporation. We had the Federal Savings and Loan Insurance Corporation. 

A very large number of them had rather unhappy experiences, or 

continue to. So to those who would create such programs, as I say, 

I think that the burden of proof is on them. 

My point is that if you already have GSEs and you are asking 

what can you do best now and you believe the GSEs will continue 

to exist, it is our view that the best thing you can do is to ensure 

at least that it is a competitive sector so that the benefits given to 

the GSEs, which turn into economic advantages, become consumer 

advantages as opposed to economic rents, to use the technical term, 

in the GSE. 

But that is a ‘‘second-best’’ argument. 

Senator FITZGERALD. Well, we have been talking here a lot about 

risk and what is the risk on their balance sheets. If they had more 

competition, would there not be much more risk of a financial——

Mr. WALLISON. Actually, Mr. Chairman, if I can respond to 

that——

Senator FITZGERALD. OK. 

Mr. WALLISON If we had to have GSEs doing what Fannie and 

Freddie are doing, it would be better to have more of them than 

fewer of them for the reasons I said in my testimony, and that is 

that the two that we have, if one of them fails, could produce a disaster in our economy, whereas a management misjudgment at one 

of six or eight would not have that effect. 

35

Senator FITZGERALD. The margins of Fannie and Freddie, then, 

would get thinner and thinner——

Mr. WALLISON. Yes, of course, and they should, and that is what 

benefits consumers. In fact, the ROEs that they are showing, as 

Bert suggested, reflect either one of two things. Either they are 

taking the risks that I said they were taking—they are not adequately hedging—or there is some sort of parallelism going on in 

their pricing. 

Senator FITZGERALD. Well, banks don’t ordinarily make that kind 

of return, but they have to have a lot more E, and so their R on 

the E is lower because there is much more E. Because Fannie and 

Freddie have such low levels of required capital——

Mr. WALLISON. That is given to them as a benefit. 

Senator FITZGERALD. Yes. 

Mr. WALLISON. Let me just complete a couple of thoughts here. 

So competition would be better than nothing, but why would we 

create more GSEs when we can eliminate the risk, as I suggested, 

simply by not allowing them to buy their own mortgage-backed securities which have already been sold to the market? We have developed—they have developed, or others have developed and they 

then picked up on—a very good technology in offering mortgagebacked securities. Investors will buy these instruments and take 

the interest rate on them. Why are we now allowing them to go out 

into the market, borrow money on the Federal Government’s credit, 

and then go out and buy mortgage-backed securities to take additional risk away from investors? 

Senator FITZGERALD. Mr. Miller, do you want to address that? 

Mr. MILLER. I am not sure in which order to take these things. 

One reason——

Senator FITZGERALD. The one I would like you to address is 

Fannie and Freddie holding mortgage-backed securities on their 

balance sheets. 

Mr. MILLER. That is the one I was going to start with. 

Senator FITZGERALD. OK. [Laughter.] 

Mr. MILLER. They have a comparative advantage in having those 

assets on their balance sheets because they know them better than 

anyone else. 

Senator FITZGERALD. They don’t know them better than the person or the bank or the S&L that made the loan. . . . 

Mr. MILLER. No, but when they consolidate and do the MBS, 

they know what the MBS is. 

Second, I want to get to the competition point, but let me return 

to the—you asked the question, should you establish new GSEs for 

other industries or other areas of economic activity, and I would 

distinguish two things there. One, is that an area that is appropriate for promotion? I don’t think there is any question but that 

the Congress of the United States and administrations from one to 

another have viewed housing as being a priority, and the establishment of the housing GSEs, and continuation of the housing GSEs 

are a reflection of that priority. That is something for you to debate. 

The second part, though, is the question of liquidity. If you were 

to establish that in such-and-such an industry there was a significant liquidity problem for which there were institutional barriers 

36

or some such, it might make sense to establish something that 

would increase liquidity there. The liquidity problems in the housing industry sources are very well known—regional problems, 

banking, finance that were not solved or are not completely solved 

even today. 

But on the question of competition, I as an economist will tell 

you, yes, maybe rents are being earned, but the rents that are flowing are to increased skill at management, innovation, other things, 

not rents that are flowing to the firm because it limits competition. 

My impression is, these two GSEs, first, they are very competitive with each other. Second, they are run by very smart people 

who are constantly innovating, coming out with new things, and 

that is the reason that the firms are doing well in terms of ROE. 

You find other firms in the economy that do very well, and, of 

course, in some industries, rates of return are much, much higher 

than for the GSEs. 

Now, my own personal view is if you gave an opportunity for 

someone to enter under the same circumstances, that would be 

fine. But I would just caution you that if you established a GSE 

sort of organization, it would take a long time, if ever, for them to 

be competitive with Freddie and Fannie, in part because of their 

scale economy. So if you set something up, you might be buying a 

commitment to engage in a lot of Federal promotion and direct subsidy of such an enterprise over time. 

Mr. HOUSE. But Mr. Chairman——

Senator FITZGERALD. We are going to wrap up in a few minutes. 

I will let everybody who wants have a final say here. Mr. House. 

Mr. HOUSE. To go back, you asked our group how we would feel 

about competition. We would support it if you had proper regulation and a level playing field. Something that Mr. Miller just said 

really emphasizes that point. He said nobody understands the 

MBSs better than Fannie and Freddie, and this is something that 

Mr. Wallison talked about on MBS. So when the GSEs purchase 

their own MBS, it is called ‘‘cherry picking’’ because they do understand their MBS better than anybody else. This is exactly why we 

think they should have to register their MBSs under the SEC, so 

everybody knows, so everybody has the same information. 

The next thing is, the GSEs were originally established to lead 

the market in providing for home ownership. And as I said earlier 

in my remarks, 24 studies say they are not leading the market. We 

think it is very important, and I think Mr. Harvey, I would hope, 

would agree that in order to do that—banks have to buy CRA 

loans—and I think the GSEs, which are exempt from CPA standards, should be required to invest in community reinvestment 

loans. 

And the second thing is, in applying affordable housing standards, it is now done on a national average. We all know that you 

can play all kinds of games with national averages. So you say, 

gosh, I am going to meet my affordable housing standards. You can 

just play with those averages. Take those averages and take it 

down to MSA basis, which is the Metropolitan Statistical Area, so 

it is done by areas. So if you really want to increase affordable 

homeownership, those are the kinds of things you can do, instead 

of taking the GSEs’ word for it. We think that is very important. 

37

Senator FITZGERALD. Mr. Ely. 

Mr. ELY. Just a couple of points I wanted to pick up on, responding to Jim. First of all, with regard to having more competition 

among the GSEs, you made a point about increased risk to these 

institutions. That is right, there would be increased risk and it is 

increased risk for the taxpayer because many of us believe that if 

a GSE gets into trouble, it will be rescued in some fashion by the 

government. Congress has done that twice in the last 16 years, 

first with the Farm Credit System in 1987 and then in 1997 with 

the FICO bonds, which gets back to a key difference between 

Fannie and Freddie, on the one hand, and the banking industry on 

the other. 

Fannie and Freddie are a ‘‘heads we win, tails you lose’’ proposition because to the extent they are able to capitalize on their implicit Federal guarantee, then their shareholders are winners. If, 

on the other hand, one of them fails, then it is the taxpayers who 

are the loser. Deposit insurance, post-FDICIA, and post-FIRREA, 

doesn’t work that way anymore. It is an industry-financed program, if you will, that is run by the government. So as we think 

about GSE risks, we have to realize that the GSEs are getting a 

free ride off of the taxpayer, which is showing up in their high 

ROE. 

Just one other thing about the liquidity problem. The banking industry and the thrift industry have changed enormously from the 

time Fannie and Freddie were set up. Back then, and you will remember this very well, we had branching restrictions and relatively small banking companies. Today, we have large players out 

there as mortgage originators and as aggregators who are operating on literally a nationwide basis—Washington Mutual, Wells 

Fargo, J.P. Morgan Chase, Citi, and so forth. 

And so the private sector, through the consolidation process and 

the lifting of branching restrictions, has been able to develop an 

ability to provide liquidity to the mortgage market. That vitiates 

one of the original reasons for creating both Fannie and Freddie. 

Senator FITZGERALD. Mr. Wallison, we are getting to the end of 

the hearing. I do want to ask you if you favor privatization of the 

Federal Home Loan Banks, too. 

Mr. WALLISON. By all means. [Laughter.] 

They survive, in my mind, only as competition to Fannie and 

Freddie. [Laughter.] 

Alex and I have talked about this at length. 

Senator FITZGERALD. OK, and you are still friends. [Laughter.] 

Mr. WALLISON. If we could not do anything about Fannie and 

Freddie, then it makes a lot of sense to have some competitive organizations. 

Let me mention a couple of things on competition. First of all, 

in my prepared statement, I noted that Fannie and Freddie compete against Treasury securities and they thus raise the cost of 

Treasury securities. The Treasury pays more interest because foreign central banks and others accessing the foreign capital markets 

are looking at Fannie and Freddie as U.S. Government securities, 

to some extent. So they are buying Fannie Mae and Freddie securities instead of buying Treasuries. The Treasury has to pay somewhat higher interest. No one has done a study—it is probably imVerDate 0ct 09 2002 09:35 Dec 11, 2003 Jkt 088935 PO 00000 Frm 00041 Fmt 6633 Sfmt 6633 C:\DOCS\88935.TXT SAFFAIRS PsN: PHOGAN
38

possible to do a study of how much it is—but it is not insignificant. 

That is one of the costs that they cause the U.S. taxpayer. 

It is certainly true that people have their wealth in housing in 

this country, but that is because of our national policy that causes 

a lot of investment to go into housing, Fannie and Freddie and the 

Home Loan Banks being part of that. If we didn’t have that direction of funds into housing, people would have better jobs. People 

would have more income from the businesses that would have been 

established here and people would have more stock market investments than they have investments in their homes. 

So that is the way—our economy is structured that way because 

of government policy. It is not because of any particular reason 

that we should organize our economy that way. We ought to realize 

what the trade-offs are when we push money into housing. 

I heard an argument, I thought, that rents, economic rents, cause 

or help innovation. I was always under the impression that the 

more competition there is, the more innovation there will be, and 

that is certainly the lesson of our free market. So I can’t imagine 

that we would want to encourage people to make profits, rent-type 

profits, in order to encourage innovation when, in fact, what it does 

encourage is waste and inefficiency in the economy. 

And finally, the important thing that we should focus on here, 

what Congress should focus on, it seems to me, is eliminating the 

risk to the taxpayer and the risks to the economy. I happen to 

think that privatization does that more effectively than anything 

else. There is no good reason to have these organizations anymore. 

But if that is too big a bite for Congress to take, I do recommend 

that we look at simply the question of forbidding them to buy their 

mortgage-backed securities and accumulate portfolios of mortgages. 

Since Fannie and Freddie were established, the technology involved in selling mortgage-backed securities, the distribution system, has been developed. It now works wonderfully without any 

government support in the jumbo market. It could work for the 

conforming and conventional market, too, if we simply eliminated 

the government support there, and we would then by that Act 

eliminate the risk. Thank you. 

Senator FITZGERALD. Any final——

Mr. MILLER. Could I just make a correction? 

Senator FITZGERALD. Yes. 

Mr. MILLER. My reference to rents was the rent that is the return for innovative activity. It is not the way that was characterized by Mr. Wallison. 

Senator FITZGERALD. Mr. Pollock. 

Mr. POLLOCK. Mr. Chairman, I think you have conducted a great 

and a very lively discussion, but I did note there was one question 

you very pointedly asked and it didn’t get answered, so I would like 

to try to answer it. 

You discussed the presentation by Fannie Mae about being 

hedged and the different ways you could hedge a mortgage book 

with debt and hedges and you asked, is that reasonable? In my 

opinion, that is very reasonable as long as we don’t talk about perfect hedging. I have been in the banking business one way and another about 34 years now and I have never met anybody who was 

39

perfectly hedged or even claimed to be perfectly hedged and I 

would greatly distrust anybody who did. 

But if the question is, can you prudently hedge a book of mortgages with debt and with hedges, the answer is, you absolutely can 

if you are a GSE under current American circumstances. 

I think as a general——

Senator FITZGERALD. Do you think private companies could absorb all those long-term fixed rates in America and hedge themselves? 

Mr. POLLOCK. Not if they have to compete with GSEs, Mr. Chairman. 

Senator FITZGERALD. If they didn’t have to, you think they could? 

Mr. POLLOCK. I think the market will always work that out. 

Senator FITZGERALD. OK. 

Mr. POLLOCK. Embedded in every hedge is somebody’s cost of operations and cost of capital for providing the risk bearing or the 

risk distribution that the hedge represents. The market would 

work that out. 

I do think it is very clear that every GSE, Home Loan Banks and 

Fannie Mae in particular, was set up with an important truth in 

mind: That is, if you are going to have long-term fixed-rate mortgages, you have to link them to the bond market in some way. You 

can’t finance them with deposits, which are short-term by nature. 

Whatever system we would end up with, if we want to have fixedrate mortgages, which I think the American people should want 

and do want, then we have to design a system that has a highly 

efficient bond market link. GSEs are one way to do that. Obviously, 

you could imagine others. And thank you very much, Mr. Chairman. 

Senator FITZGERALD. Thank you. 

I know you had some comments down here. These will be the 

last two, Mr. Harvey, then Dr. Wachter. 

Mr. HARVEY. Great. Thank you, Mr. Chairman. I think one of the 

points that we have missed here is the huge productivity gains that 

have come over the last decade from Fannie and Freddie and from 

the Home Loan Bank System. But if I was to take, and this is a 

negative comparison, where the FHA is and Ginnie Mae has been 

over that period of time versus what has happened in Fannie and 

Freddie, there has been a huge benefit that has come out of the 

GSE system. They have been able to access technology, they have 

been able to have huge through-puts with the same amount of people. They have been able to have dedicated people and resources 

on their public mission goals, and every time the goals have gone 

up, they have been able to meet them or exceed them along the 

way. 

So as an advocate for low-income people and housing, what is 

there to fix here, because it has been hugely productive. It has 

been a tremendously productive system. 

As far as not leading the market, yes, I would love to stretch the 

GSEs to do more around CRA and other loans. What I fear is if 

you get a capital structure where they can’t do that or that discourages them from taking the very prudent risk that they ought to 

take, then you are defeating some of the purpose as to why you 

have a GSE in the first place. 

40

As far as not leading the market, I think you have to look—and 

in minority home ownership, you have got to look at the sub-prime 

market, which is a large part of the lending right now that goes 

to minorities in this country. It has grown exponentially over this 

period of time. Now, there is a sub-prime market that makes sense 

and there is a predatory market. They are different, but they are 

sometimes linked together, and this will probably horrify everybody 

on the stage, but I think the GSEs getting into that sub-prime 

market will make it more accountable, cleaner, better, with more 

efficient capital as long as you have accountability and oversight on 

it, and I applaud——

Senator FITZGERALD. But doesn’t that put more risk on the GSE’s 

balance sheets? 

Mr. HARVEY. As long as they do the business the way the business ought to be done, and not in a predatory way, but in a way 

to get capital to those people that don’t have perfect credit, and 

that can be done—I applaud every time Citibank takes over Associates and Associates has to clean up the way that they have been 

doing their business, and it was a huge fight, as you know, or 

Chase takes over, because they have a reputation they have to defend and it allows advocates and others to say, look, this hasn’t 

been done the right way. There are parts of this business that 

make no sense at all for low-income home owners. 

So I think the GSEs have worked remarkably. Of course, we believe in public-private partnerships to get to parts of the market 

that you can’t get to otherwise. 

Senator FITZGERALD. Thank you. Dr. Wachter. 

Ms. WACHTER. Thank you. I believe that it is very much the ability to earn profits in the short run before technology is widely implemented that encourages innovation, and that is, indeed, part of 

the reason we have had so much innovation in this sector. 

The investors will lose, obviously, if these institutions take on too 

much risk. This, too, is a safeguard. So it is, in fact, the genius of 

the private institution with public purposes that I think has accomplished so much and there is more to accomplish yet. 

Senator FITZGERALD. All of you, thank you very much. This has 

really been a great panel. These are some of the best minds in the 

country on this issue. It was a delight to have all of you here. 

Without objection, the hearing record will remain open for any 

additional statements or questions from Senator through 5 p.m. tomorrow. 

With no further business to come before the Committee, this 

hearing is adjourned. Thank you. 

[Whereupon, at 4:20 p.m., the Subcommittee was adjourned.] 

(41)

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