the gses. moreover, the gse regulator should be able to adjust capital requirements quickly and as needed to address developing or foreseeable concerns, rather than being required by cumbersome procedures to wait until after the damage has been done. a strong capital base would significantly reduce the implicit subsidy and incentive problems that now distort gse investment decisions ( lucas and mcdonald, 2006 ), while also increasing their safety and soundness. the establishment of a clear and credible gse receivership process, the second element, is needed to create market discipline for these companies. reform legislation should establish ( 1 ) a well - defined and mandatory process for placing a gse in receivership and ( 2 ) a method for resolving a gse once it is placed in receivership. both parts are necessary for the receivership process to be meaningful and credible. market participants should clearly understand that, once certain conditions arise, regulatory forbearance will be impermissible and a gse receivership will be established. importantly, the gse receivership process should include a mechanism for ensuring that both the shareholders and legal provisions such as prompt corrective action and the least - cost - resolution requirement probably contribute to the perception of bank debt holders that their investments are not guaranteed if the bank gets into financial trouble. recently, the federal deposit insurance corporation ( fdic ) has proposed to require that large banks maintain depositor records in a common format to help ensure that those creditors do not escape losses in the event of a bank failure. also, the ability of bank holding companies to increase their government - backed funding is limited. by law, banks cannot make additional banking acquisitions if the resulting firm would control more than 10 percent of u. s. insured deposits. this comparison excludes the temporary 30 percent additional capital currently required by ofheo because of the operational risks posed by the gses ’ recent accounting problems. interest rate risk depends on the degree of hedging, which is at the discretion of firm management. however, because the gses ’ portfolios are concentrated in the mortgage - backed securities market and thus are subject to rapid changes in market value, the risk profile of the gses can change rapidly in response to unexpected movements in interest rates. in contrast, banks hold a more diversified mix of liabilities and assets, many of which are less sensitive to unexpected changes in interest rates, suggesting that banks as a general matter are less prone to interest rate risk. regardless, little social benefit is

. public policy issues raised by gse operations i will begin by discussing gse operations and some issues of public policy raised by these activities. broadly speaking, fannie mae and freddie mac each run two lines of business. their first line of business involves purchasing mortgages from primary mortgage originators, such as community bankers ; packaging them into securities known as mortgage - backed securities ( mbs ) ; enhancing these mbs with credit guarantees ; and then selling the guaranteed securities. through this process, securities that trade readily in public debt markets are created. this activity, known as securitization, increases the liquidity of the residential mortgage market. in particular, the securitization of mortgages extended to low - and middle - income home purchasers likely has made mortgage credit more widely available. the gses ’ second line of business is the main focus of my remarks today. it involves the purchase of mortgage - backed securities and other types of assets for their own investment portfolios. this line of business has raised public concern because its fundamental source of profitability is the widespread perception by investors that the u. s. government would not allow a gse to fail, notwithstanding the fact that – as numerous government officials have asserted – the government has given no such guarantees. the perception of government backing allows fannie and freddie to borrow in open capital markets at an interest rate only slightly above that paid by the u. s. treasury and below that frame and white ( 2005 ) provide a general description of gses and the associated policy debates. paid by other private participants in mortgage markets. by borrowing at this preferential rate and purchasing assets ( including mbs ) that pay returns considerably greater than the treasury rate, the gses can enjoy profits of an effectively unlimited scale. consequently, the gses ’ ability to borrow at a preferential rate provides them with strong incentives both to expand the range of assets that they acquire and to increase the size of their portfolios to the greatest extent possible. the gse portfolios have been the subject of much controversy. first, analysts disagree about whether the gse portfolios serve any public purpose. the gses themselves argue that their purchases of mbs provide additional support to the mortgage market, particularly during periods of financial stress. in contrast, research at the federal reserve board and elsewhere has found that the gse portfolios appear to have no material effect on the cost or availability of residential mortgages. 2 at the margin, the gses finance their purchases