are highly uncertain, even if the probability of default is low. in general, interest rate risk is readily handled by adjusting maturities of assets and liabilities. but hedging prepayment risk is more complex. to manage this risk with little capital requires a conceptually sophisticated hedging framework. in essence, the current system depends on the risk managers at fannie and freddie to do everything just right, rather than depending on a market - based system supported by the risk assessments and management capabilities of many participants with different views and different strategies for hedging risks. our financial system would be more robust if we relied on a market - based system that spreads interest rate risks, rather than on the current system, which concentrates such risk with the gses. * * * as always, concerns about systemic risk are appropriately focused on large, highly leveraged financial institutions such as the gses that play substantial roles in the functioning of financial markets. i should emphasize that fannie and freddie, to date, appear to have managed these risks well and that we see nothing on the immediate horizon that is likely to create a systemic problem. but to fend off possible future systemic difficulties, which we assess as likely if gse expansion continues unabated, preventive actions are required sooner rather than later. as a general matter, we rely in a market economy upon market discipline to constrain the leverage of firms, including financial institutions. however, the existence, or even the perception, of government backing undermines the effectiveness of market discipline. a market system relies on the vigilance of lenders and investors in market transactions to assure themselves of their counterparties ’ strength. however, many counterparties in gse transactions, when assessing their risk, clearly rely instead on the gses ’ perceived special relationship to the government. thus, with housing - related gses, regulators cannot rely significantly on market discipline. indeed, they must assess whether these institutions hold appropriate amounts of capital relative to the risks that they assume and the costs that they might impose on others, including taxpayers, in the event of a financial - market meltdown. the issues are similar to those that arise in the context of commercial banking and deposit insurance indeed, they are the reason that commercial banks are regulated and subject to stringent regulatory capital standards. traditionally, questions of capital adequacy for financial institutions have been evaluated with regard to credit and interest rate risks. however, in the case of the gses and other

of banking regulators, with a free hand to set appropriate capital standards, and with a clear process sanctioned by the congress for placing a gse in receivership. however, if the congress takes only these actions, it runs the risk of solidifying investors ’ perceptions that the gses are instruments of the government and that their debt is equivalent to government debt. the gses will have increased incentives to continue to grow faster than the overall home mortgage market. because they already purchase most conforming mortgages, they, like all effective profit - maximizing organizations, will be seeking new avenues to expand the scope of their operations, assisted by a subsidy that their existing or potential competitors do not enjoy. thus, gses need to be limited in the issuance of gse debt and in the purchase of assets, both mortgages and nonmortgages, that they hold. fannie and freddie should be encouraged to continue to expand mortgage securitization, keeping mortgage markets deep and liquid while limiting the size of their portfolios. this action will allow the mortgage markets to support homeownership and homebuilding in a manner consistent with preserving the safe and sound financial markets of the united states.