HOUSING ENTERPRISES

The Roles of Fannie Mae

and Freddie Mac in the

U.S. Housing Finance

System

Statement of Thomas J. McCool

Director, Financial Institutions and Markets Issues

General Government Division

United States General Accounting Office

GAO Testimony

Before the House Budget Committee’s Task Force on

Housing and Infrastructure

For Release on Delivery

Expected at

10:00 a.m. EDT

Tuesday

July 25, 2000

GAO/T-GGD-00-182

Statement 

Housing Enterprises: The Roles of Fannie Mae

and Freddie Mac in the U.S. Housing Finance

System

Page 1 GAO/T-GGD-00-182

Mr. Chairman and Members of the Task Force:

We are pleased to be here today to discuss the roles of Fannie Mae and

Freddie Mac in our nation’s housing finance system. Congress created

Fannie Mae and Freddie Mac (the enterprises), the two largest government

sponsored enterprises (GSEs), to promote home ownership in the United

States. The enterprises fulfill their housing mission by borrowing funds or

issuing mortgage-backed securities (MBS) and using the proceeds to

purchase home mortgages from banks, thrifts, and other financial

institutions. Financial institutions, in turn, may use the proceeds from

their mortgage sales to the enterprises to fund additional mortgage loans,

thereby helping to ensure a stable supply of mortgage credit across the

nation. Financial institution mortgage lending is commonly referred to as

the “primary residential mortgage market,” while the enterprises’ mortgage

purchase activities are commonly referred to as the “secondary residential

mortgage market.”

Most analysts agree that the enterprises’ activities have successfully

lowered mortgage costs and increased home ownership in the United

States. However, these benefits must be weighed against the potential

costs associated with the federal government’s implied sponsorship of the

enterprises, which had combined debt and MBS liabilities of over $2

trillion at the end of 1999. In particular, the federal government could

potentially decide to provide financial assistance to the enterprises in an

emergency situation.

In recent years, we have issued several reports that assess the enterprises’

roles in the housing finance system and federal oversight of their activities.

My testimony today will briefly discuss the following important topics

covered in these reports:

• the benefits and costs of the enterprises’ housing finance activities,

• federal efforts to ensure the enterprises’ safety and soundness, and

• federal efforts to ensure that the enterprises promote home ownership

opportunities for all Americans.

The enterprises are hybrid organizations that contain elements of both

private- and public-sector organizations. Like many private companies, the

enterprises issue equity and debt instruments to the investing public. The

enterprises have also developed compensation packages that reward top

executives for increasing shareholder value. On the other hand, the

enterprises’ close relationship with the federal government and their

federal charters provide them with several important advantages over

The Benefits and Costs

of the Enterprises’

Housing Finance

Activities
Statement

Housing Enterprises: The Roles of Fannie Mae and Freddie Mac in the U.S. Housing Finance

System

Page 2 GAO/T-GGD-00-182

private-sector companies. The most important of these benefits is an

indirect one--the perception in the financial markets that the government

would not allow the enterprises to fail, which allows them to borrow and

issue MBS to finance mortgage purchases at relatively lower cost than

private firms. The enterprises’ federal charters also exempt them from

paying state and local income taxes and some of the fees charged by the

Securities and Exchange Commission for securities and debt issuances.

The charters also provide each enterprise with a $2.25 billion conditional

line of credit with the Treasury Department.

In a May 1996 report, we estimated that the total annual value of these

benefits to the enterprises ranged from $2.2 billion to $8.3 billion on a

before-tax basis and $1.6 billion to $5.9 billion on an after-tax basis.1

 To

some extent, the enterprises pass these savings on to home buyers in the

form of lower mortgage interest rates. Although it is not possible to

calculate these savings precisely, we estimate that in 1995 the enterprises’

mortgage purchase activities resulted in savings of about a quarter of a

percentage point annually on a typical $100,000 mortgage. This translated

into savings of about $10 to $25 per month on such a $100,000 mortgage, or

about $3 billion to $7 billion annually for the approximately $2 trillion in

mortgages that the GSEs were eligible to purchase and that were

outstanding at the time.2

 Most analysts also agree that the enterprises’

activities, such as their imposition of greater standardization on mortgage

products and processes, have also facilitated the development of an

efficient, nationwide mortgage finance system.

However, federal sponsorship of the enterprises’ activities as GSEs also

creates significant risks and costs. First, the potential exists that U.S.

taxpayers would end up paying for a portion of the enterprises’ debt and

MBS obligations, which stood at over $2 trillion at the end of 1999. In fact,

Fannie Mae experienced significant financial difficulties because of a

sharp rise in interest rates between 1981 and 1984, resulting in losses of

$277 million. To help Fannie Mae overcome these problems, the federal

government provided limited tax relief and relaxed the enterprise’s capital

requirements. Congress also showed its willingness to assist GSEs that

experience financial difficulty in 1987 when it authorized up to $4 billion to

 

1

 Housing Enterprises: Potential Impacts of Severing Government Sponsorship (GAO/GGD-96-120, May

13, 1996).

2

 The enterprises’ charters restrict them from purchasing mortgages above a set dollar amount, known

as the conforming loan limit. The conforming loan limit depends upon how many housing units are

financed by a single residential mortgage loan. The conforming loan limit is currently set at $252,700.

The charters also require the enterprises to meet certain underwriting standards for mortgage loan

purchases.
Statement

Housing Enterprises: The Roles of Fannie Mae and Freddie Mac in the U.S. Housing Finance

System

Page 3 GAO/T-GGD-00-182

help the Farm Credit System, another GSE, overcome a farm crisis and the

resulting increase in loan defaults. Second, opportunity costs can also be

generated when the perceived backing of a GSE by the federal government

diverts funds from other financial institutions that may otherwise be able

to provide more efficient services to the public. Third, opportunity costs

can also be generated if a GSE enters into activities that are outside its

statutory mission.

To help ensure that the enterprises conduct their business in a safe and

sound manner and use their government-provided benefits to achieve a

public purpose, in 1992 Congress passed the Federal Housing Enterprises

Financial Safety and Soundness Act (1992 Act). The 1992 Act established

the Office of Federal Housing Enterprise Oversight (OFHEO) to ensure

that the enterprises are adequately capitalized and operating safely. The

1992 Act also provided the Department of Housing and Urban

Development (HUD) with additional regulatory authority to ensure that the

enterprises fulfill their housing finance mission. As part of the 1992 Act,

Congress concluded that the financial benefits that the enterprises derive

from their government sponsorship involve a corresponding obligation to

meet the mortgage credit needs of all potential home buyers, including

those with low- and moderate-incomes. This regulatory scheme allows the

enterprises to continue to have the same powers as private companies to

conduct their day-to-day business.

In the remaining two sections of my testimony, I will discuss the status of

OFHEO and HUD’s efforts to fulfill their regulatory responsibilities under

the 1992 Act.

The 1992 Act established OFHEO as an independent agency within HUD to

monitor the enterprises’ financial safety and soundness. Under the act,

OFHEO is subject to the congressional appropriations process but the

enterprises pay assessments to finance its activities. OFHEO’s budget was

about $16 million in fiscal year 1999. The act provided OFHEO with two

essential responsibilities to carry out its safety and soundness mission: (1)

establish capital standards for the enterprises and (2) establish an

examination program.

As required by the 1992 Act, OFHEO has established minimum capital

standards for the enterprises, which are capital ratios applied to certain

on-balance-sheet and off-balance-sheet obligations. OFHEO has

consistently classified the enterprises as in compliance with the minimum

capital standards since they were established in 1993. The act also

mandated that OFHEO develop a stress test to serve as the basis for more

OFHEO Monitors the

Financial Safety of the

Enterprises
Statement

Housing Enterprises: The Roles of Fannie Mae and Freddie Mac in the U.S. Housing Finance

System

Page 4 GAO/T-GGD-00-182

sophisticated risk-based capital standards. The purpose of the stress test

is to help manage taxpayer risks by simulating, in a computer model,

situations where the enterprises are exposed to adverse credit and interest

rate scenarios. The enterprises are required to hold sufficient capital to

withstand these adverse conditions for 10 years, plus an additional 30

percent of the required capital to cover operations and management risk.

Although the 1992 Act directed OFHEO to complete the stress test and

risk-based capital standards by December 1, 1994, OFHEO has not yet

completed these tasks. In an October 1997 report, we identified several

reasons for OFHEO’s inability to comply with the deadline, including (1)

the complexity of the task, (2) OFHEO’s decision to develop a new stress

test rather than adopt or modify existing stress tests, (3) OFHEO’s initial

difficulties in obtaining required financial data from the enterprises, and

(4) greater than expected managerial and technical difficulties.3

 OFHEO

has proposed a rule to implement the stress test and risk-based capital

standards and expects to issue a final rule by the end of 2000.

OFHEO also has the authority to establish an examination program to

monitor the enterprises’ management and financial condition. Our 1997

report found that OFHEO had not been able to implement its plan to

examine all relevant operations of the enterprises on a 2-year schedule.

We attributed OFHEO’s inability to meet the schedule to limited staff

resources and the start-up challenges associated with examining the

enterprises, which are extremely large and complex financial institutions.

Since that time, OFHEO has revised its examination program and

implemented an annual examination schedule. OFHEO’s examination staff

has generally found that the enterprises have been operated in a safe and

sound manner.

HUD has statutory authority to ensure that the enterprises fulfill their

mission of promoting housing and home ownership opportunities for all

Americans. In passing the 1992 Act, Congress concluded that HUD’s

regulatory framework had not been effective in ensuring that the

enterprises’ activities benefit low- and moderate-income Americans and

those who live in underserved areas, such as central cities and rural

communities (targeted groups). The 1992 Act required HUD to develop,

implement, and enforce a comprehensive housing mission regulatory

framework. Among other provisions, the 1992 Act directed HUD to set

 

3

 Federal Housing Enterprises: OFHEO Faces Challenges in Implementing a Comprehensive Oversight

Program (GAO/GGD-98-6, Oct. 22, 1997).

HUD Has

Responsibility for

Overseeing the

Enterprises’

Fulfillment of Their

Housing Mission
Statement

Housing Enterprises: The Roles of Fannie Mae and Freddie Mac in the U.S. Housing Finance

System

Page 5 GAO/T-GGD-00-182

housing goals, which require the enterprises to meet specified criteria each

year for the purchase of mortgages serving targeted groups.

In 1995, HUD established a final rule for enterprises’ housing goal

mortgage purchases for the years 1996 through 1999. In a July 1998 report,

we found that HUD generally adopted a conservative approach to setting

the housing goals that placed a high priority on maintaining the

enterprises’ financial soundness.4 For example, HUD and OFHEO

conducted research during the rulemaking process that concluded that the

proposed housing goals were modest and would not materially affect the

enterprises’ financial condition. According to HUD data, the enterprises

met or exceeded the housing goals between 1996 and 1998.

In March of this year, HUD proposed a new rule setting housing goal

requirements for the period 2000 through 2003. HUD’s proposed housing

goals are set higher than the goals set for the period 1996 through 1999.

According to HUD, the enterprises’ share of the affordable housing market

remains below desired levels. For example, banks and other lenders

continue to make relatively more mortgage loans in the primary market to

targeted groups than the enterprises purchase in the secondary residential

mortgage market. HUD believes that the proposed housing goals will

provide strong incentives for the enterprises to more fully meet the

housing needs of targeted groups. The comment period on the proposed

rule ended in May 2000. HUD is currently reviewing comments and

expects to issue a final rule by the end of 2000.

The 1992 Act also defined HUD’s general regulatory authority over the

enterprises and its new mortgage program approval authority.5

 HUD has

the general regulatory authority to ensure that the enterprises’ activities

are consistent with their housing mission. HUD also has the authority to

review new mortgage programs proposed by the enterprises to ensure that

the programs are consistent with the enterprises’ charters and not contrary

to the public interest. In our view, Congress correctly recognized, in

passing the 1992 Act, that the enterprises—given their hybrid structure—

face a natural tension between maximizing profitability for their

shareholders and fulfilling their housing mission.

 

4

 Federal Housing Enterprises: HUD’s Mission Oversight Needs to Be Strengthened (GAO/GGD-98-173,

July 28, 1998).

5

 12 U.S.C. § 4541-2. The 1992 Act defines a “new program” as being significantly different from

mortgage programs that have been approved or that represent an expansion, in terms of the dollar

volume or number of mortgages or securities involved, of programs previously approved.
Statement

Housing Enterprises: The Roles of Fannie Mae and Freddie Mac in the U.S. Housing Finance

System

Page 6 GAO/T-GGD-00-182

In a March 1998 report, we provided an example of this natural tension and

HUD’s critical responsibility to exercise its general regulatory authority in

a way that ensures that the enterprises fulfill their housing mission.6

 We

pointed out that the enterprises have incentives to use the funding

advantage associated with their government sponsorship to make

nonmortgage investments—such as corporate bond purchases—that may

result in arbitrage profits.7

 Our report recognized that some nonmortgage

investments, particularly short-term investments, can contribute to

mission achievement by facilitating liquidity in the secondary market for

residential mortgages. However, our report concluded that the

relationship between long-term nonmortgage investments and the

enterprises’ housing mission is not entirely clear.

Our March 1998 report found that HUD did not act promptly to ensure that

the enterprises’ nonmortgage investments were consistent with their

housing mission. In fact, HUD did not exercise its general regulatory

authority provided in the 1992 Act until 1997, when a public controversy

erupted over Freddie Mac’s investment in long-term Philip Morris

corporate bonds. In 1997, HUD initiated a rulemaking process designed to

develop criteria that would help ensure that the enterprises’ nonmortgage

investments are consistent with their housing mission and federal charters.

We recommended that HUD promptly implement this rulemaking process,

and HUD agreed to do so. However, HUD has not yet developed criteria

for overseeing the enterprises’ nonmortgage investments.

The enterprises have also engaged in other complex financial activities

whose relation to their housing mission is not entirely clear. For example,

in our March 1998 report, we pointed out that HUD approved a new

mortgage program by Fannie Mae that would involve Fannie Mae in

purchasing cash value life insurance, which is essentially a nonmortgage

investment.8

 HUD officials told us that they lacked expertise in cash value

life insurance when they approved the Fannie Mae program.

 

6

 Government-Sponsored Enterprises: Federal Oversight Needed for Nonmortgage Investments

(GAO/GGD-98-48, Mar. 11, 1998).

7

 We defined the term “arbitrage” to mean that the enterprises use their funding advantage from

government sponsorship to raise funds for making certain nonmortgage investments. Our definition of

arbitrage is similar to the definition of an arbitrage bond defined in reference to federal income tax

exemption for interest on state and local bonds in the U.S. tax code.

8

 The program was called the Mortgage Protection Plan (MPP). Under MPP, Fannie Mae would

purchase a cash value life insurance on a first-time home buyer after the selected borrower’s

residential mortgage was purchased by Fannie Mae and the borrower agreed to such coverage. MPP

was designed to protect Fannie Mae and the borrower against default caused by the borrower’s death.

Fannie Mae did not go ahead with MPP because of tax law changes.
Statement

Housing Enterprises: The Roles of Fannie Mae and Freddie Mac in the U.S. Housing Finance

System

Page 7 GAO/T-GGD-00-182

More recently, the enterprises’ involvement in other activities—such as

automated underwriting—have raised questions as to whether they are

attempting to move beyond the secondary mortgage market into areas

traditionally served by private lenders in the primary mortgage market.

Some lenders believe that the enterprises’ automated systems standardize

the mortgage loan process to such an extent that the lenders’ role in

mortgage lending is minimized.

In summary, Congress provided Fannie Mae and Freddie Mac with

substantial financial benefits so that they can fulfill their housing finance

mission. There is widespread agreement that the enterprises’ secondary

mortgage market activities have lowered the cost of home ownership for

millions of Americans. However, perceived federal sponsorship of the

enterprises’ activities as GSEs also involves significant risks and costs. In

passing the 1992 Act, Congress created a regulatory structure with the

potential to help ensure that the enterprises, in their attempts as private

corporations to create shareholder value, would do so by focusing on and

fulfilling their public missions without exposing U.S. taxpayers to undue

risk.

In their oversight roles, OFHEO and HUD face a difficult challenge in

ensuring that the enterprises meet their housing responsibilities in a safe

and sound manner, while simultaneously being afforded sufficient latitude

to manage their day-to-day business needs and meet their shareholder

obligations. The enterprises are large, sophisticated financial institutions.

Beyond various nonmortgage investments, the enterprises have become

engaged in complex financial activities that may serve multiple purposes.

Therefore, it is difficult to assess the financial risks of many of their

activities as well as the relationship between their activities and mission

achievement. Nonetheless, the making of such assessments by the

enterprises’ regulators and Congress is imperative to ensure that the

interests of U.S. taxpayers are protected.

Mr. Chairman, this concludes my statement. My colleagues and I would be

pleased to respond to any questions that you or other members of the Task

Force may have.

Contact and Acknowledgements

For further information regarding this testimony, please contact Thomas J.

McCool, Director, Financial Institutions and Markets Issues, (202) 512-

8678. Individuals making key contributions to this testimony included

William B. Shear and Wesley M. Phillips.

Conclusions
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