I would like to begin my testimony by briefly describing the missions and activities of each of the GSEs, and the risks they pose to taxpayers. Then I will describe the current GSE regulatory structure. Fannie Mae and Freddie Mac’s mission is to enhance the availability of mortgage credit across the nation during both good and bad economic times by purchasing mortgages from lenders (banks, thrifts, and mortgage lenders), which then use the proceeds to make additional mortgages available to home buyers. Most mortgages purchased by Fannie Mae and Freddie Mac are conventional mortgages, which have no federal insurance or guarantee. The companies’ mortgage purchases are subject to a conforming loan limit that currently stands at $359,650 for a single-family home in most states. Although Fannie Mae and Freddie Mac hold some mortgages in their portfolios that they purchased, most mortgages are placed in mortgage pools to support mortgage-backed securities (MBS). MBS issued by Fannie Mae or Freddie Mac are either sold to investors (off- balance sheet obligations) or held in their retained portfolios (on-balance sheet obligations). Fannie Mae and Freddie Mac guarantee the timely payment of principal and interest on MBS that they issue. The 12 FHLBanks that constitute the FHLBank System traditionally made loans—also known as advances—to their members (typically banks or thrifts) to facilitate housing finance and community and economic development. FHLBank members are required to collateralize advances with high-quality assets such as single-family mortgages. More recently, the FHLBanks initiated programs to purchase mortgages directly from their members and hold them in their retained portfolios. This process is similar to Fannie Mae and Freddie Mac’s traditional business activities, although the FHLBanks do not currently have the authority to securitize mortgages. The housing GSEs’ activities have generally been credited with enhancing the development of the U.S. housing finance market. For example, when Fannie Mae and the FHLBank System were created during the 1930s, the housing finance market was fragmented and characterized by regional shortages of mortgage credit. It is widely accepted that the housing GSEs’ activities helped develop a unified and liquid mortgage finance market in this country. While the housing GSEs have generated public benefits, their large size and activities pose potentially significant risks to taxpayers. As a result of their activities, the GSEs’ outstanding debt and off-balance sheet financial obligations were about $4.6 trillion as of year-end 2003. The GSEs face the risk of losses primarily from credit risk, interest rate risk, and operational risks. Although the federal government explicitly does not guarantee the obligations of GSEs, it is generally assumed on Wall Street that assistance would be provided in a financial emergency. In fact, during the 1980s, the federal government provided financial assistance to both Fannie Mae and the Farm Credit System (another GSE) when they experienced difficulties due to sharply rising interest rates and declining agricultural land values, respectively. The potential exists that Congress and the executive branch would determine that such assistance was again necessary in the event that one or more of the GSEs experienced severe financial difficulties. Because the markets perceive that there is an implied federal guarantee on the GSEs’ obligations, the GSEs are able to borrow at interest rates below that of private corporations. The GSEs also pose potential risks to the stability of the U.S. financial system. In particular, if Fannie Mae, Freddie Mac, or the FHLBank System were unable to meet their financial obligations, other financial market participants depending on payments from these GSEs may in turn become unable to meet their financial obligations. To the extent that this risk, called systemic risk, is associated with the housing GSEs, it is primarily based on the sheer size of their financial obligations. For example, as discussed in OFHEO’s 2003 report on systemic risk, if either Fannie Mae or Freddie Mac were to become insolvent, financial institutions holding the enterprise’s MBS could be put into a situation where they could no longer rely on those securities as a ready source of liquidity. Depending on the response of the federal government, the financial health of the banking segment of the financial services industry could decline rapidly, possibly leading to a decline in economic activity. As another example, derivatives counterparties holding contracts with a financially troubled GSE could realize large losses if the GSE were no longer able to meet its obligations. If such an event were to occur, widespread defaults could occur in derivatives markets. The current regulatory structure for the housing GSEs is divided among OFHEO, HUD, and FHFB, as described below: OFHEO is an independent office within HUD and is responsible for regulating Fannie Mae and Freddie Mac’s safety and soundness. OFHEO oversees the two GSEs through its authority to examine their operations, determine capital adequacy, adopt rules, and take enforcement actions. Although OFHEO’s financial plans and forecasts are included in the President’s budget and are subject to the appropriations process, the agency is not funded with tax dollars. Rather, Fannie Mae and Freddie Mac pay annual assessments to cover OFHEO’s costs. HUD is responsible for ensuring that Fannie Mae and Freddie Mac are accomplishing their housing missions. HUD is to accomplish this responsibility through its authority to set housing goals, and to review and approve new programs, and through its general regulatory authority. HUD is funded through appropriations. FHFB is responsible for regulating the FHLBank System’s safety and soundness as well as its mission activities. The agency has a five-member board, with the President of the United States appointing four members— each of whom serves a 7-year term—subject to Senate approval. The fifth member is the Secretary of HUD. The President also appoints FHFB’s chair subject to Senate approval. Like OFHEO, FHFB carries out its oversight authorities through examinations, establishing capital standards, rule making, and taking enforcement actions. FHFB is funded through assessments of the 12 Federal Home Loan Banks and is not subject to the appropriations process. As I stated previously, OFHEO has moved aggressively over the past year to identify and address risk management and accounting deficiencies at Fannie Mae and Freddie Mac, and FHFB has entered into written agreements with two FHLBanks to correct interest rate risk management deficiencies. Nevertheless, we continue to believe that the current fragmented regulatory structure for the housing GSEs is inadequate to monitor these large and complex financial institutions and their mission activities. Establishing a single housing GSE regulator with a board structure and equipping the agency with adequate authorities would better ensure that the GSEs operate in a safe and sound manner and fulfill their housing missions. The current fragmented structure of federal housing GSE regulation does not provide for a comprehensive and effective approach to safety and soundness regulation. Although the housing GSEs operate differently, their business activities and risks are becoming increasingly similar. As I described previously, the FHLBank System has established mortgage purchase programs over the past several years and FHLBank System mortgage holdings were $113 billion at year-end 2003. While still small compared with Fannie Mae and Freddie Mac’s combined retained mortgage portfolios of $1.3 trillion for the same time period, the FHLBank System now operates more like Fannie Mae and Freddie Mac and is increasingly incurring interest rate risks. Management of interest rate risk for mortgage holdings involves the application of sophisticated risk- management techniques, including the use of financial derivatives. Although such strategies are appropriate for risk management, they require specialized expertise, sophisticated information systems, and an understanding and application of sometimes complex accounting rules. In my view, it simply does not make sense for the federal government to entrust regulation of large and complex GSEs that are incurring similar risks to two different regulators, which have different approaches to examinations and setting capital standards. Moreover, OFHEO, and FHFB to a lesser degree, lack key authorities to fulfill their safety and soundness responsibilities, as described below: Unlike with bank regulators and FHFB, (1) OFHEO’s authority to issue cease and desist orders does not specifically list an unsafe and unsound practice as grounds for issuance and (2) OFHEO’s powers do not include the same direct removal and prohibition authorities applicable to officers and directors. Bank regulators have prompt corrective action authorities that are arguably more robust and proactive than those of OFHEO and FHFB. These authorities require that bank regulators take specific supervisory actions when bank capital levels fall to specific levels or provide the regulators with the option of taking other actions when other specified unsafe and unsound actions occur. Although OFHEO has statutory authority to take certain actions when Fannie Mae or Freddie Mac capital falls to predetermined levels, the authorities are not as proactive or broad as those of the bank regulators. OFHEO has also established regulations requiring specified supervisory actions when unsafe conditions are identified that do not include capital, but OFHEO’s statute does not specifically mention these authorities. FHFB’s statute does not establish a prompt corrective action scheme that requires specified actions when unsafe conditions are identified. Although FHFB officials believe they have all the authority necessary to carry out their safety and soundness responsibilities, the agency has significant discretion in resolving troubled FHLBanks. Consequently, there is limited assurance that FHFB would act decisively to correct identified problems. Unlike bank regulators—-which can place insolvent banks into receivership—and FHFB, which can take actions to liquidate an FHLBank, OFHEO is limited to placing Fannie Mae or Freddie Mac into a conservatorship. Thus, it is not clear that OFHEO has sufficient authority to fully resolve a situation in which Fannie Mae or Freddie Mac is unable to meet its financial obligations.